IN THIS CHAPTER
YOU WILL . . .
Discuss how
incentives affect
people’s behavior
Learn the meaning of
opportunity cost
Learn that
economics is about
the allocation of
scarce resources
Examine some of the
tradeoffs that people
face
See how to use
marginal reasoning
when making
decisions
The word economy comes from the Greek word for “one who manages a house-
hold.” At first, this origin might seem peculiar. But, in fact, households and
economies have much in common.
A household faces many decisions. It must decide which members of the
household do which tasks and what each member gets in return: Who cooks din-
ner? Who does the laundry? Who gets the extra dessert at dinner? Who gets to
choose what TV show to watch? In short, the household must allocate its scarce re-
sources among its various members, taking into account each member’s abilities,
efforts, and desires.
Like a household, a society faces many decisions. A society must decide what
jobs will be done and who will do them. It needs some people to grow food, other
people to make clothing, and still others to design computer software. Once soci-
ety has allocated people (as well as land, buildings, and machines) to various jobs,
TEN PRINCIPLES
OF ECONOMICS
3
Consider why trade
among people or
nations can be good
for everyone
Discuss why markets
are a good, but not
perfect, way to
allocate resources
Learn what
determines some
trends in the overall
economy
4 PART ONE INTRODUCTION
it must also allocate the output of goods and services that they produce. It must
decide who will eat caviar and who will eat potatoes. It must decide who will
drive a Porsche and who will take the bus.
The management of society’s resources is important because resources are
scarce. Scarcitymeans that society has limited resources and therefore cannot pro-
duce all the goods and services people wish to have. Just as a household cannot
give every member everything he or she wants, a society cannot give every indi-
vidual the highest standard of living to which he or she might aspire.
Economicsis the study of how society manages its scarce resources. In most
societies, resources are allocated not by a single central planner but through the
combined actions of millions of households and firms. Economists therefore study
how people make decisions: how much they work, what they buy, how much they
save, and how they invest their savings. Economists also study how people inter-
act with one another. For instance, they examine how the multitude of buyers and
sellers of a good together determine the price at which the good is sold and the
quantity that is sold. Finally, economists analyze forces and trends that affect
the economy as a whole, including the growth in average income, the fraction of
the population that cannot find work, and the rate at which prices are rising.
Although the study of economics has many facets, the field is unified by sev-
eral central ideas. In the rest of this chapter, we look at Ten Principles of Economics.
These principles recur throughout this book and are introduced here to give you
an overview of what economics is all about. You can think of this chapter as a “pre-
view of coming attractions.”
HOW PEOPLE MAKE DECISIONS
There is no mystery to what an “economy” is. Whether we are talking about the
economy of Los Angeles, of the United States, or of the whole world, an economy
is just a group of people interacting with one another as they go about their lives.
Because the behavior of an economy reflects the behavior of the individuals who
make up the economy, we start our study of economics with four principles of in-
dividual decisionmaking.
PRINCIPLE #1: PEOPLE FACE TRADEOFFS
The first lesson about making decisions is summarized in the adage: “There is no
such thing as a free lunch.” To get one thing that we like, we usually have to give
up another thing that we like. Making decisions requires trading off one goal
against another.
Consider a student who must decide how to allocate her most valuable re-
source—her time. She can spend all of her time studying economics; she can spend
all of her time studying psychology; or she can divide her time between the two
fields. For every hour she studies one subject, she gives up an hour she could have
used studying the other. And for every hour she spends studying, she gives up an
hour that she could have spent napping, bike riding, watching TV, or working at
her part-time job for some extra spending money.
scarcity
the limited nature of society’s
resources
economics
the study of how society manages its
scarce resources
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 5
Or consider parents deciding how to spend their family income. They can buy
food, clothing, or a family vacation. Or they can save some of the family income
for retirement or the children’s college education. When they choose to spend an
extra dollar on one of these goods, they have one less dollar to spend on some
other good.
When people are grouped into societies, they face different kinds of tradeoffs.
The classic tradeoff is between “guns and butter.” The more we spend on national
defense to protect our shores from foreign aggressors (guns), the less we can spend
on consumer goods to raise our standard of living at home (butter). Also important
in modern society is the tradeoff between a clean environment and a high level of
income. Laws that require firms to reduce pollution raise the cost of producing
goods and services. Because of the higher costs, these firms end up earning smaller
profits, paying lower wages, charging higher prices, or some combination of these
three. Thus, while pollution regulations give us the benefit of a cleaner environ-
ment and the improved health that comes with it, they have the cost of reducing
the incomes of the firms’ owners, workers, and customers.
Another tradeoff society faces is between efficiency and equity. Efficiency
means that society is getting the most it can from its scarce resources. Equity
means that the benefits of those resources are distributed fairly among society’s
members. In other words, efficiency refers to the size of the economic pie, and
equity refers to how the pie is divided. Often, when government policies are being
designed, these two goals conflict.
Consider, for instance, policies aimed at achieving a more equal distribution of
economic well-being. Some of these policies, such as the welfare system or unem-
ployment insurance, try to help those members of society who are most in need.
Others, such as the individual income tax, ask the financially successful to con-
tribute more than others to support the government. Although these policies have
the benefit of achieving greater equity, they have a cost in terms of reduced effi-
ciency. When the government redistributes income from the rich to the poor, it re-
duces the reward for working hard; as a result, people work less and produce
fewer goods and services. In other words, when the government tries to cut the
economic pie into more equal slices, the pie gets smaller.
Recognizing that people face tradeoffs does not by itself tell us what decisions
they will or should make. A student should not abandon the study of psychology
just because doing so would increase the time available for the study of econom-
ics. Society should not stop protecting the environment just because environmen-
tal regulations reduce our material standard of living. The poor should not be
ignored just because helping them distorts work incentives. Nonetheless, ac-
knowledging life’s tradeoffs is important because people are likely to make good
decisions only if they understand the options that they have available.
PRINCIPLE #2: THE COST OF SOMETHING IS
WHAT YOU GIVE UP TO GET IT
Because people face tradeoffs, making decisions requires comparing the costs and
benefits of alternative courses of action. In many cases, however, the cost of some
action is not as obvious as it might first appear.
Consider, for example, the decision whether to go to college. The benefit is in-
tellectual enrichment and a lifetime of better job opportunities. But what is the
cost? To answer this question, you might be tempted to add up the money you
efficiency
the property of society getting the
most it can from its scarce resources
equity
the property of distributing economic
prosperity fairly among the members
of society
6 PART ONE INTRODUCTION
spend on tuition, books, room, and board. Yet this total does not truly represent
what you give up to spend a year in college.
The first problem with this answer is that it includes some things that are not
really costs of going to college. Even if you quit school, you would need a place to
sleep and food to eat. Room and board are costs of going to college only to the ex-
tent that they are more expensive at college than elsewhere. Indeed, the cost of
room and board at your school might be less than the rent and food expenses that
you would pay living on your own. In this case, the savings on room and board
are a benefit of going to college.
The second problem with this calculation of costs is that it ignores the largest
cost of going to college—your time. When you spend a year listening to lectures,
reading textbooks, and writing papers, you cannot spend that time working at a
job. For most students, the wages given up to attend school are the largest single
cost of their education.
The opportunity cost of an item is what you give up to get that item. When
making any decision, such as whether to attend college, decisionmakers should be
aware of the opportunity costs that accompany each possible action. In fact, they
usually are. College-age athletes who can earn millions if they drop out of school
and play professional sports are well aware that their opportunity cost of college
is very high. It is not surprising that they often decide that the benefit is not worth
the cost.
PRINCIPLE #3: RATIONAL PEOPLE THINK AT THE MARGIN
Decisions in life are rarely black and white but usually involve shades of gray.
When it’s time for dinner, the decision you face is not between fasting or eating
like a pig, but whether to take that extra spoonful of mashed potatoes. When ex-
ams roll around, your decision is not between blowing them off or studying 24
hours a day, but whether to spend an extra hour reviewing your notes instead of
watching TV. Economists use the term marginal changesto describe small incre-
mental adjustments to an existing plan of action. Keep in mind that “margin”
means “edge,” so marginal changes are adjustments around the edges of what you
are doing.
In many situations, people make the best decisions by thinking at the margin.
Suppose, for instance, that you asked a friend for advice about how many years to
stay in school. If he were to compare for you the lifestyle of a person with a Ph.D.
to that of a grade school dropout, you might complain that this comparison is not
helpful for your decision. You have some education already and most likely are
deciding whether to spend an extra year or two in school. To make this decision,
you need to know the additional benefits that an extra year in school would offer
(higher wages throughout life and the sheer joy of learning) and the additional
costs that you would incur (tuition and the forgone wages while you’re in school).
By comparing these marginal benefits and marginal costs, you can evaluate whether
the extra year is worthwhile.
As another example, consider an airline deciding how much to charge passen-
gers who fly standby. Suppose that flying a 200-seat plane across the country costs
the airline $100,000. In this case, the average cost of each seat is $100,000/200,
which is $500. One might be tempted to conclude that the airline should never
sell a ticket for less than $500. In fact, however, the airline can raise its profits by
opportunity cost
whatever must be given up to obtain
some item
marginal changes
small incremental adjustments to a
plan of action
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 7
thinking at the margin. Imagine that a plane is about to take off with ten empty
seats, and a standby passenger is waiting at the gate willing to pay $300 for a seat.
Should the airline sell it to him? Of course it should. If the plane has empty seats,
the cost of adding one more passenger is minuscule. Although the average cost of
flying a passenger is $500, the marginal cost is merely the cost of the bag of peanuts
and can of soda that the extra passenger will consume. As long as the standby pas-
senger pays more than the marginal cost, selling him a ticket is profitable.
As these examples show, individuals and firms can make better decisions by
thinking at the margin. A rational decisionmaker takes an action if and only if the
marginal benefit of the action exceeds the marginal cost.
PRINCIPLE #4: PEOPLE RESPOND TO INCENTIVES
Because people make decisions by comparing costs and benefits, their behavior
may change when the costs or benefits change. That is, people respond to incen-
tives. When the price of an apple rises, for instance, people decide to eat more
pears and fewer apples, because the cost of buying an apple is higher. At the same
time, apple orchards decide to hire more workers and harvest more apples, be-
cause the benefit of selling an apple is also higher. As we will see, the effect of price
on the behavior of buyers and sellers in a market—in this case, the market for
apples—is crucial for understanding how the economy works.
Public policymakers should never forget about incentives, for many policies
change the costs or benefits that people face and, therefore, alter behavior. A tax on
gasoline, for instance, encourages people to drive smaller, more fuel-efficient cars.
It also encourages people to take public transportation rather than drive and to
live closer to where they work. If the tax were large enough, people would start
driving electric cars.
When policymakers fail to consider how their policies affect incentives, they
can end up with results that they did not intend. For example, consider public pol-
icy regarding auto safety. Today all cars have seat belts, but that was not true 40
years ago. In the late 1960s, Ralph Nader’s book Unsafe at Any Speed generated
much public concern over auto safety. Congress responded with laws requiring car
companies to make various safety features, including seat belts, standard equip-
ment on all new cars.
How does a seat belt law affect auto safety? The direct effect is obvious. With
seat belts in all cars, more people wear seat belts, and the probability of surviving
a major auto accident rises. In this sense, seat belts save lives.
But that’s not the end of the story. To fully understand the effects of this law,
we must recognize that people change their behavior in response to the incentives
they face. The relevant behavior here is the speed and care with which drivers op-
erate their cars. Driving slowly and carefully is costly because it uses the driver’s
time and energy. When deciding how safely to drive, rational people compare the
marginal benefit from safer driving to the marginal cost. They drive more slowly
and carefully when the benefit of increased safety is high. This explains why peo-
ple drive more slowly and carefully when roads are icy than when roads are clear.
Now consider how a seat belt law alters the cost–benefit calculation of a ratio-
nal driver. Seat belts make accidents less costly for a driver because they reduce
the probability of injury or death. Thus, a seat belt law reduces the benefits to slow
and careful driving. People respond to seat belts as they would to an improvement
BASKETBALL STAR KOBE BRYANT
UNDERSTANDS OPPORTUNITY COST AND
INCENTIVES. DESPITE GOOD HIGH SCHOOL
GRADES AND SAT SCORES, HE DECIDED
TO SKIP COLLEGE AND GO STRAIGHT TO
THE NBA, WHERE HE EARNED ABOUT
$10 MILLION OVER FOUR YEARS.
8 PART ONE INTRODUCTION
in road conditions—by faster and less careful driving. The end result of a seat belt
law, therefore, is a larger number of accidents.
How does the law affect the number of deaths from driving? Drivers who
wear their seat belts are more likely to survive any given accident, but they are also
more likely to find themselves in an accident. The net effect is ambiguous. More-
over, the reduction in safe driving has an adverse impact on pedestrians (and on
drivers who do not wear their seat belts). They are put in jeopardy by the law be-
cause they are more likely to find themselves in an accident but are not protected
by a seat belt. Thus, a seat belt law tends to increase the number of pedestrian
deaths.
At first, this discussion of incentives and seat belts might seem like idle spec-
ulation. Yet, in a 1975 study, economist Sam Peltzman showed that the auto-safety
laws have, in fact, had many of these effects. According to Peltzman’s evidence,
these laws produce both fewer deaths per accident and more accidents. The net re-
sult is little change in the number of driver deaths and an increase in the number
of pedestrian deaths.
Peltzman’s analysis of auto safety is an example of the general principle that
people respond to incentives. Many incentives that economists study are more
straightforward than those of the auto-safety laws. No one is surprised that people
drive smaller cars in Europe, where gasoline taxes are high, than in the United
States, where gasoline taxes are low. Yet, as the seat belt example shows, policies
can have effects that are not obvious in advance. When analyzing any policy, we
must consider not only the direct effects but also the indirect effects that work
through incentives. If the policy changes incentives, it will cause people to alter
their behavior.
QUICK QUIZ: List and briefly explain the four principles of individual
decisionmaking.
HOW PEOPLE INTERACT
The first four principles discussed how individuals make decisions. As we
go about our lives, many of our decisions affect not only ourselves but other
people as well. The next three principles concern how people interact with one
another.
PRINCIPLE #5: TRADE CAN MAKE EVERYONE BETTER OFF
You have probably heard on the news that the Japanese are our competitors in the
world economy. In some ways, this is true, for American and Japanese firms do
produce many of the same goods. Ford and Toyota compete for the same cus-
tomers in the market for automobiles. Compaq and Toshiba compete for the same
customers in the market for personal computers.
Yet it is easy to be misled when thinking about competition among countries.
Trade between the United States and Japan is not like a sports contest, where one
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 9
side wins and the other side loses. In fact, the opposite is true: Trade between two
countries can make each country better off.
To see why, consider how trade affects your family. When a member of your
family looks for a job, he or she competes against members of other families who
are looking for jobs. Families also compete against one another when they go
shopping, because each family wants to buy the best goods at the lowest prices. So,
in a sense, each family in the economy is competing with all other families.
Despite this competition, your family would not be better off isolating itself
from all other families. If it did, your family would need to grow its own food,
make its own clothes, and build its own home. Clearly, your family gains much
from its ability to trade with others. Trade allows each person to specialize in the
activities he or she does best, whether it is farming, sewing, or home building. By
trading with others, people can buy a greater variety of goods and services at
lower cost.
Countries as well as families benefit from the ability to trade with one another.
Trade allows countries to specialize in what they do best and to enjoy a greater va-
riety of goods and services. The Japanese, as well as the French and the Egyptians
and the Brazilians, are as much our partners in the world economy as they are our
competitors.
PRINCIPLE #6: MARKETS ARE USUALLY A GOOD WAY
TO ORGANIZE ECONOMIC ACTIVITY
The collapse of communism in the Soviet Union and Eastern Europe may be the
most important change in the world during the past half century. Communist
countries worked on the premise that central planners in the government were in
the best position to guide economic activity. These planners decided what goods
and services were produced, how much was produced, and who produced and
consumed these goods and services. The theory behind central planning was that
only the government could organize economic activity in a way that promoted
economic well-being for the country as a whole.
Today, most countries that once had centrally planned economies have aban-
doned this system and are trying to develop market economies. In a market econ-
omy,the decisions of a central planner are replaced by the decisions of millions of
firms and households. Firms decide whom to hire and what to make. Households
decide which firms to work for and what to buy with their incomes. These firms
and households interact in the marketplace, where prices and self-interest guide
their decisions.
At first glance, the success of market economies is puzzling. After all, in a mar-
ket economy, no one is looking out for the economic well-being of society as
a whole. Free markets contain many buyers and sellers of numerous goods and
services, and all of them are interested primarily in their own well-being. Yet,
despite decentralized decisionmaking and self-interested decisionmakers, market
economies have proven remarkably successful in organizing economic activity in
a way that promotes overall economic well-being.
In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations,
economist Adam Smith made the most famous observation in all of economics:
Households and firms interacting in markets act as if they are guided by an “in-
visible hand” that leads them to desirable market outcomes. One of our goals in
“For $5 a week you can watch
baseball without being nagged to
cut the grass!”
market economy
an economy that allocates resources
through the decentralized decisions
of many firms and households as
they interact in markets for goods
and services
10 PART ONE INTRODUCTION
this book is to understand how this invisible hand works its magic. As you study
economics, you will learn that prices are the instrument with which the invisible
hand directs economic activity. Prices reflect both the value of a good to society
and the cost to society of making the good. Because households and firms look at
prices when deciding what to buy and sell, they unknowingly take into account
the social benefits and costs of their actions. As a result, prices guide these indi-
vidual decisionmakers to reach outcomes that, in many cases, maximize the wel-
fare of society as a whole.
There is an important corollary to the skill of the invisible hand in guiding eco-
nomic activity: When the government prevents prices from adjusting naturally to
supply and demand, it impedes the invisible hand’s ability to coordinate the mil-
lions of households and firms that make up the economy. This corollary explains
why taxes adversely affect the allocation of resources: Taxes distort prices and thus
the decisions of households and firms. It also explains the even greater harm
caused by policies that directly control prices, such as rent control. And it explains
the failure of communism. In communist countries, prices were not determined in
the marketplace but were dictated by central planners. These planners lacked the
information that gets reflected in prices when prices are free to respond to market
It may be only a coincidence
that Adam Smith’s great book,
An Inquiry into the Nature and
Causes of the Wealth of Na-
tions, was published in 1776,
the exact year American revolu-
tionaries signed the Declara-
tion of Independence. But the
two documents do share a
point of view that was preva-
lent at the time—that individu-
als are usually best left to their
own devices, without the heavy
hand of government guiding their actions. This political phi-
losophy provides the intellectual basis for the market econ-
omy, and for free society more generally.
Why do decentralized market economies work so
well? Is it because people can be counted on to treat one
another with love and kindness? Not at all. Here is Adam
Smith’s description of how people interact in a market
economy:
Man has almost constant occasion for the help of his
brethren, and it is vain for him to expect it from their
benevolence only. He will be more likely to prevail if he
can interest their self-love in his favor, and show them
that it is for their own advantage to do for him what he
requires of them. . . . It is not from the benevolence of
the butcher, the brewer, or
the baker that we expect our
dinner, but from their regard
to their own interest. . . .
Every individual . . .
neither intends to promote
the public interest, nor knows
how much he is promoting
it. . . . He intends only his
own gain, and he is in this, as
in many other cases, led by
an invisible hand to promote
an end which was no part of
his intention. Nor is it always
the worse for the society that
it was no part of it. By pursuing his own interest he
frequently promotes that of the society more effectually
than when he really intends to promote it.
Smith is saying that participants in the economy are moti-
vated by self-interest and that the “invisible hand” of the
marketplace guides this self-interest into promoting general
economic well-being.
Many of Smith’s insights remain at the center of mod-
ern economics. Our analysis in the coming chapters will al-
low us to express Smith’s conclusions more precisely and
to analyze fully the strengths and weaknesses of the mar-
ket’s invisible hand.
ADAM SMITH
FYI
Adam Smith
and the
Invisible Hand
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 11
forces. Central planners failed because they tried to run the economy with one
hand tied behind their backs—the invisible hand of the marketplace.
PRINCIPLE #7: GOVERNMENTS CAN SOMETIMES
IMPROVE MARKET OUTCOMES
Although markets are usually a good way to organize economic activity, this rule
has some important exceptions. There are two broad reasons for a government to
intervene in the economy: to promote efficiency and to promote equity. That is,
most policies aim either to enlarge the economic pie or to change how the pie is
divided.
The invisible hand usually leads markets to allocate resources efficiently.
Nonetheless, for various reasons, the invisible hand sometimes does not work.
Economists use the term market failureto refer to a situation in which the market
on its own fails to allocate resources efficiently.
One possible cause of market failure is an externality. An externalityis the im-
pact of one person’s actions on the well-being of a bystander. The classic example
of an external cost is pollution. If a chemical factory does not bear the entire cost of
the smoke it emits, it will likely emit too much. Here, the government can raise
economic well-being through environmental regulation. The classic example of an
external benefit is the creation of knowledge. When a scientist makes an important
discovery, he produces a valuable resource that other people can use. In this case,
the government can raise economic well-being by subsidizing basic research, as in
fact it does.
Another possible cause of market failure is market power. Market power
refers to the ability of a single person (or small group of people) to unduly influ-
ence market prices. For example, suppose that everyone in town needs water but
there is only one well. The owner of the well has market power—in this case a
monopoly—over the sale of water. The well owner is not subject to the rigorous
competition with which the invisible hand normally keeps self-interest in check.
You will learn that, in this case, regulating the price that the monopolist charges
can potentially enhance economic efficiency.
The invisible hand is even less able to ensure that economic prosperity is dis-
tributed fairly. A market economy rewards people according to their ability to pro-
duce things that other people are willing to pay for. The world’s best basketball
player earns more than the world’s best chess player simply because people are
willing to pay more to watch basketball than chess. The invisible hand does not en-
sure that everyone has sufficient food, decent clothing, and adequate health care.
A goal of many public policies, such as the income tax and the welfare system, is
to achieve a more equitable distribution of economic well-being.
To say that the government can improve on markets outcomes at times does
not mean that it always will. Public policy is made not by angels but by a political
process that is far from perfect. Sometimes policies are designed simply to reward
the politically powerful. Sometimes they are made by well-intentioned leaders
who are not fully informed. One goal of the study of economics is to help you
judge when a government policy is justifiable to promote efficiency or equity and
when it is not.
QUICK QUIZ: List and briefly explain the three principles concerning
economic interactions.
market failure
a situation in which a market left on
its own fails to allocate resources
efficiently
externality
the impact of one person’s actions on
the well-being of a bystander
market power
the ability of a single economic actor
(or small group of actors) to have a
substantial influence on market
prices
12 PART ONE INTRODUCTION
HOW THE ECONOMY AS A WHOLE WORKS
We started by discussing how individuals make decisions and then looked at how
people interact with one another. All these decisions and interactions together
make up “the economy.” The last three principles concern the workings of the
economy as a whole.
PRINCIPLE #8: A COUNTRY’S STANDARD OF
LIVING DEPENDS ON ITS ABILITY TO
PRODUCE GOODS AND SERVICES
The differences in living standards around the world are staggering. In 1997 the
average American had an income of about $29,000. In the same year, the average
Mexican earned $8,000, and the average Nigerian earned $900. Not surprisingly,
this large variation in average income is reflected in various measures of the qual-
ity of life. Citizens of high-income countries have more TV sets, more cars, better
nutrition, better health care, and longer life expectancy than citizens of low-income
countries.
Changes in living standards over time are also large. In the United States,
incomes have historically grown about 2 percent per year (after adjusting for
changes in the cost of living). At this rate, average income doubles every 35 years.
Over the past century, average income has risen about eightfold.
What explains these large differences in living standards among countries and
over time? The answer is surprisingly simple. Almost all variation in living stan-
dards is attributable to differences in countries’ productivity—that is, the amount
of goods and services produced from each hour of a worker’s time. In nations
where workers can produce a large quantity of goods and services per unit of time,
most people enjoy a high standard of living; in nations where workers are less
productive, most people must endure a more meager existence. Similarly, the
growth rate of a nation’s productivity determines the growth rate of its average
income.
The fundamental relationship between productivity and living standards is
simple, but its implications are far-reaching. If productivity is the primary deter-
minant of living standards, other explanations must be of secondary importance.
For example, it might be tempting to credit labor unions or minimum-wage laws
for the rise in living standards of American workers over the past century. Yet the
real hero of American workers is their rising productivity. As another example,
some commentators have claimed that increased competition from Japan and
other countries explains the slow growth in U.S. incomes over the past 30 years.
Yet the real villain is not competition from abroad but flagging productivity
growth in the United States.
The relationship between productivity and living standards also has profound
implications for public policy. When thinking about how any policy will affect liv-
ing standards, the key question is how it will affect our ability to produce goods
and services. To boost living standards, policymakers need to raise productivity by
ensuring that workers are well educated, have the tools needed to produce goods
and services, and have access to the best available technology.
productivity
the amount of goods and services
produced from each hour of a
worker’s time
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 13
In the 1980s and 1990s, for example, much debate in the United States centered
on the government’s budget deficit—the excess of government spending over gov-
ernment revenue. As we will see, concern over the budget deficit was based
largely on its adverse impact on productivity. When the government needs to
finance a budget deficit, it does so by borrowing in financial markets, much as a
student might borrow to finance a college education or a firm might borrow to
finance a new factory. As the government borrows to finance its deficit, therefore,
it reduces the quantity of funds available for other borrowers. The budget deficit
thereby reduces investment both in human capital (the student’s education) and
physical capital (the firm’s factory). Because lower investment today means lower
productivity in the future, government budget deficits are generally thought to de-
press growth in living standards.
PRINCIPLE #9: PRICES RISE WHEN THE
GOVERNMENT PRINTS TOO MUCH MONEY
In Germany in January 1921, a daily newspaper cost 0.30 marks. Less than two
years later, in November 1922, the same newspaper cost 70,000,000 marks. All
other prices in the economy rose by similar amounts. This episode is one of his-
tory’s most spectacular examples of inflation, an increase in the overall level of
prices in the economy.
Although the United States has never experienced inflation even close to that
in Germany in the 1920s, inflation has at times been an economic problem. During
the 1970s, for instance, the overall level of prices more than doubled, and President
Gerald Ford called inflation “public enemy number one.” By contrast, inflation in
the 1990s was about 3 percent per year; at this rate it would take more than
inflation
an increase in the overall level of
prices in the economy
“Well it may have been 68 cents when you got in line, but it’s 74 cents now!”
14 PART ONE INTRODUCTION
20 years for prices to double. Because high inflation imposes various costs on soci-
ety, keeping inflation at a low level is a goal of economic policymakers around the
world.
What causes inflation? In almost all cases of large or persistent inflation, the
culprit turns out to be the same—growth in the quantity of money. When a gov-
ernment creates large quantities of the nation’s money, the value of the money
falls. In Germany in the early 1920s, when prices were on average tripling every
month, the quantity of money was also tripling every month. Although less dra-
matic, the economic history of the United States points to a similar conclusion: The
high inflation of the 1970s was associated with rapid growth in the quantity of
money, and the low inflation of the 1990s was associated with slow growth in the
quantity of money.
PRINCIPLE #10: SOCIETY FACES A SHORT-RUN TRADEOFF
BETWEEN INFLATION AND UNEMPLOYMENT
If inflation is so easy to explain, why do policymakers sometimes have trouble rid-
ding the economy of it? One reason is that reducing inflation is often thought to
cause a temporary rise in unemployment. The curve that illustrates this tradeoff
between inflation and unemployment is called the Phillips curve,after the econo-
mist who first examined this relationship.
The Phillips curve remains a controversial topic among economists, but most
economists today accept the idea that there is a short-run tradeoff between infla-
tion and unemployment. This simply means that, over a period of a year or two,
many economic policies push inflation and unemployment in opposite directions.
Policymakers face this tradeoff regardless of whether inflation and unemployment
both start out at high levels (as they were in the early 1980s), at low levels (as they
were in the late 1990s), or someplace in between.
Why do we face this short-run tradeoff? According to a common explanation,
it arises because some prices are slow to adjust. Suppose, for example, that the
government reduces the quantity of money in the economy. In the long run, the
only result of this policy change will be a fall in the overall level of prices. Yet not
all prices will adjust immediately. It may take several years before all firms issue
new catalogs, all unions make wage concessions, and all restaurants print new
menus. That is, prices are said to be sticky in the short run.
Because prices are sticky, various types of government policy have short-run
effects that differ from their long-run effects. When the government reduces the
quantity of money, for instance, it reduces the amount that people spend. Lower
spending, together with prices that are stuck too high, reduces the quantity of
goods and services that firms sell. Lower sales, in turn, cause firms to lay off work-
ers. Thus, the reduction in the quantity of money raises unemployment temporar-
ily until prices have fully adjusted to the change.
The tradeoff between inflation and unemployment is only temporary, but it
can last for several years. The Phillips curve is, therefore, crucial for understand-
ing many developments in the economy. In particular, policymakers can exploit
this tradeoff using various policy instruments. By changing the amount that the
government spends, the amount it taxes, and the amount of money it prints,
policymakers can, in the short run, influence the combination of inflation and
unemployment that the economy experiences. Because these instruments of
Phillips curve
a curve that shows the short-run
tradeoff between inflation and
unemployment
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 15
monetary and fiscal policy are potentially so powerful, how policymakers should
use these instruments to control the economy, if at all, is a subject of continuing
debate.
QUICK QUIZ: List and briefly explain the three principles that describe
how the economy as a whole works.
CONCLUSION
You now have a taste of what economics is all about. In the coming chapters we
will develop many specific insights about people, markets, and economies. Mas-
tering these insights will take some effort, but it is not an overwhelming task. The
field of economics is based on a few basic ideas that can be applied in many dif-
ferent situations.
Throughout this book we will refer back to the Ten Principles of Economics
highlighted in this chapter and summarized in Table 1-1. Whenever we do so,
a building-blocks icon will be displayed in the margin, as it is now. But even
when that icon is absent, you should keep these building blocks in mind. Even the
most sophisticated economic analysis is built using the ten principles introduced
here.
Table 1-1
TEN PRINCIPLES OF ECONOMICS
HOWPEOPLE #1: People Face Tradeoffs
MAKEDECISIONS
#2: The Cost of Something Is What You Give Up to
Get It
#3: Rational People Think at the Margin
#4: People Respond to Incentives
HOWPEOPLEINTERACT #5: Trade Can Make Everyone Better Off
#6: Markets Are Usually a Good Way to Organize
Economic Activity
#7: Governments Can Sometimes Improve Market
Outcomes
HOWTHEECONOMY #8: A Country’s Standard of Living Depends on Its
ASAWHOLEWORKS Ability to Produce Goods and Services
#9: Prices Rise When the Government Prints Too
Much Money
#10: Society Faces a Short-Run Tradeoff between
Inflation and Unemployment
16 PART ONE INTRODUCTION
a78 The fundamental lessons about individual
decisionmaking are that people face tradeoffs among
alternative goals, that the cost of any action is measured
in terms of forgone opportunities, that rational people
make decisions by comparing marginal costs and
marginal benefits, and that people change their behavior
in response to the incentives they face.
a78 The fundamental lessons about interactions among
people are that trade can be mutually beneficial, that
markets are usually a good way of coordinating trade
among people, and that the government can potentially
improve market outcomes if there is some market
failure or if the market outcome is inequitable.
a78 The fundamental lessons about the economy as a whole
are that productivity is the ultimate source of living
standards, that money growth is the ultimate source of
inflation, and that society faces a short-run tradeoff
between inflation and unemployment.
Summary
scarcity, p. 4
economics, p. 4
efficiency, p. 5
equity, p. 5
opportunity cost, p. 6
marginal changes, p. 6
market economy, p. 9
market failure, p. 11
externality, p. 11
market power, p. 11
productivity, p. 12
inflation, p. 13
Phillips curve, p. 14
Key Concepts
1. Give three examples of important tradeoffs that you face
in your life.
2. What is the opportunity cost of seeing a movie?
3. Water is necessary for life. Is the marginal benefit of a
glass of water large or small?
4. Why should policymakers think about incentives?
5. Why isn’t trade among countries like a game with some
winners and some losers?
6. What does the “invisible hand” of the marketplace do?
7. Explain the two main causes of market failure and give
an example of each.
8. Why is productivity important?
9. What is inflation, and what causes it?
10. How are inflation and unemployment related in the
short run?
Questions for Review
1. Describe some of the tradeoffs faced by the following:
a. a family deciding whether to buy a new car
b. a member of Congress deciding how much to
spend on national parks
c. a company president deciding whether to open a
new factory
d. a professor deciding how much to prepare for class
2. You are trying to decide whether to take a vacation.
Most of the costs of the vacation (airfare, hotel, forgone
wages) are measured in dollars, but the benefits of the
vacation are psychological. How can you compare the
benefits to the costs?
3. You were planning to spend Saturday working at your
part-time job, but a friend asks you to go skiing. What
is the true cost of going skiing? Now suppose that you
had been planning to spend the day studying at the
library. What is the cost of going skiing in this case?
Explain.
4. You win $100 in a basketball pool. You have a choice
between spending the money now or putting it away
for a year in a bank account that pays 5 percent interest.
What is the opportunity cost of spending the $100 now?
5. The company that you manage has invested $5 million
in developing a new product, but the development is
not quite finished. At a recent meeting, your salespeople
report that the introduction of competing products has
reduced the expected sales of your new product to
$3 million. If it would cost $1 million to finish
Problems and Applications
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 17
development and make the product, should you go
ahead and do so? What is the most that you should pay
to complete development?
6. Three managers of the Magic Potion Company are
discussing a possible increase in production. Each
suggests a way to make this decision.
HARRY: We should examine whether our
company’s productivity—gallons of
potion per worker—would rise or fall.
RON: We should examine whether our average
cost—cost per worker—would rise or fall.
HERMIONE: We should examine whether the extra
revenue from selling the additional potion
would be greater or smaller than the extra
costs.
Who do you think is right? Why?
7. The Social Security system provides income for people
over age 65. If a recipient of Social Security decides to
work and earn some income, the amount he or she
receives in Social Security benefits is typically reduced.
a. How does the provision of Social Security affect
people’s incentive to save while working?
b. How does the reduction in benefits associated with
higher earnings affect people’s incentive to work
past age 65?
8. A recent bill reforming the government’s antipoverty
programs limited many welfare recipients to only two
years of benefits.
a. How does this change affect the incentives for
working?
b. How might this change represent a tradeoff
between equity and efficiency?
9. Your roommate is a better cook than you are, but you
can clean more quickly than your roommate can. If your
roommate did all of the cooking and you did all of the
cleaning, would your chores take you more or less time
than if you divided each task evenly? Give a similar
example of how specialization and trade can make two
countries both better off.
10. Suppose the United States adopted central planning for
its economy, and you became the chief planner. Among
the millions of decisions that you need to make for next
year are how many compact discs to produce, what
artists to record, and who should receive the discs.
a. To make these decisions intelligently, what
information would you need about the compact
disc industry? What information would you need
about each of the people in the United States?
b. How would your decisions about CDs affect some
of your other decisions, such as how many CD
players to make or cassette tapes to produce? How
might some of your other decisions about the
economy change your views about CDs?
11. Explain whether each of the following government
activities is motivated by a concern about equity or a
concern about efficiency. In the case of efficiency, discuss
the type of market failure involved.
a. regulating cable-TV prices
b. providing some poor people with vouchers that can
be used to buy food
c. prohibiting smoking in public places
d. breaking up Standard Oil (which once owned
90 percent of all oil refineries) into several smaller
companies
e. imposing higher personal income tax rates on
people with higher incomes
f. instituting laws against driving while intoxicated
12. Discuss each of the following statements from the
standpoints of equity and efficiency.
a. “Everyone in society should be guaranteed the best
health care possible.”
b. “When workers are laid off, they should be able to
collect unemployment benefits until they find a
new job.”
13. In what ways is your standard of living different from
that of your parents or grandparents when they were
your age? Why have these changes occurred?
14. Suppose Americans decide to save more of their
incomes. If banks lend this extra saving to businesses,
which use the funds to build new factories, how might
this lead to faster growth in productivity? Who do you
suppose benefits from the higher productivity? Is
society getting a free lunch?
15. Suppose that when everyone wakes up tomorrow, they
discover that the government has given them an
additional amount of money equal to the amount they
already had. Explain what effect this doubling of the
money supply will likely have on the following:
a. the total amount spent on goods and services
b. the quantity of goods and services purchased if
prices are sticky
c. the prices of goods and services if prices can adjust
16. Imagine that you are a policymaker trying to decide
whether to reduce the rate of inflation. To make an
intelligent decision, what would you need to know
about inflation, unemployment, and the tradeoff
between them?
IN THIS CHAPTER
YOU WILL . . .
Learn the difference
between positive and
normative statements
Learn two simple
models—the circular
flow and the
production
possibilities frontier
See how economists
apply the methods
of science
Consider how
assumptions and
models can shed
light on the world
Distinguish between
microeconomics and
macroeconomics
Every field of study has its own language and its own way of thinking. Mathe-
maticians talk about axioms, integrals, and vector spaces. Psychologists talk about
ego, id, and cognitive dissonance. Lawyers talk about venue, torts, and promissory
estoppel.
Economics is no different. Supply, demand, elasticity, comparative advantage,
consumer surplus, deadweight loss—these terms are part of the economist’s lan-
guage. In the coming chapters, you will encounter many new terms and some fa-
miliar words that economists use in specialized ways. At first, this new language
may seem needlessly arcane. But, as you will see, its value lies in its ability to pro-
vide you a new and useful way of thinking about the world in which you live.
The single most important purpose of this book is to help you learn the econ-
omist’s way of thinking. Of course, just as you cannot become a mathematician,
psychologist, or lawyer overnight, learning to think like an economist will take
THINKING LIKE
AN ECONOMIST
19
Examine the role of
economists in
making policy
Consider why
economists
sometimes disagree
with one another
20 PART ONE INTRODUCTION
some time. Yet with a combination of theory, case studies, and examples of eco-
nomics in the news, this book will give you ample opportunity to develop and
practice this skill.
Before delving into the substance and details of economics, it is helpful to have
an overview of how economists approach the world. This chapter, therefore, dis-
cusses the field’s methodology. What is distinctive about how economists confront
a question? What does it mean to think like an economist?
THE ECONOMIST AS SCIENTIST
Economists try to address their subject with a scientist’s objectivity. They approach
the study of the economy in much the same way as a physicist approaches the
study of matter and a biologist approaches the study of life: They devise theories,
collect data, and then analyze these data in an attempt to verify or refute their
theories.
To beginners, it can seem odd to claim that economics is a science. After
all, economists do not work with test tubes or telescopes. The essence of science,
“I’m a social scientist, Michael. That means I can’t explain
electricityor anything like that, but if you ever want to know
aboutpeople I’m your man.”
CHAPTER 2 THINKING LIKE AN ECONOMIST 21
however, is the scientific method—the dispassionate development and testing of
theories about how the world works. This method of inquiry is as applicable to
studying a nation’s economy as it is to studying the earth’s gravity or a species’
evolution. As Albert Einstein once put it, “The whole of science is nothing more
than the refinement of everyday thinking.”
Although Einstein’s comment is as true for social sciences such as economics
as it is for natural sciences such as physics, most people are not accustomed to
looking at society through the eyes of a scientist. Let’s therefore discuss some of
the ways in which economists apply the logic of science to examine how an econ-
omy works.
THE SCIENTIFIC METHOD: OBSERVATION,
THEORY, AND MORE OBSERVATION
Isaac Newton, the famous seventeenth-century scientist and mathematician, al-
legedly became intrigued one day when he saw an apple fall from an apple tree.
This observation motivated Newton to develop a theory of gravity that applies not
only to an apple falling to the earth but to any two objects in the universe. Subse-
quent testing of Newton’s theory has shown that it works well in many circum-
stances (although, as Einstein would later emphasize, not in all circumstances).
Because Newton’s theory has been so successful at explaining observation, it is
still taught today in undergraduate physics courses around the world.
This interplay between theory and observation also occurs in the field of eco-
nomics. An economist might live in a country experiencing rapid increases in
prices and be moved by this observation to develop a theory of inflation. The
theory might assert that high inflation arises when the government prints too
much money. (As you may recall, this was one of the Ten Principles of Economicsin
Chapter 1.) To test this theory, the economist could collect and analyze data on
prices and money from many different countries. If growth in the quantity of
money were not at all related to the rate at which prices are rising, the economist
would start to doubt the validity of his theory of inflation. If money growth and in-
flation were strongly correlated in international data, as in fact they are, the econ-
omist would become more confident in his theory.
Although economists use theory and observation like other scientists, they do
face an obstacle that makes their task especially challenging: Experiments are often
difficult in economics. Physicists studying gravity can drop many objects in their
laboratories to generate data to test their theories. By contrast, economists study-
ing inflation are not allowed to manipulate a nation’s monetary policy simply to
generate useful data. Economists, like astronomers and evolutionary biologists,
usually have to make do with whatever data the world happens to give them.
To find a substitute for laboratory experiments, economists pay close attention
to the natural experiments offered by history. When a war in the Middle East in-
terrupts the flow of crude oil, for instance, oil prices skyrocket around the world.
For consumers of oil and oil products, such an event depresses living standards.
For economic policymakers, it poses a difficult choice about how best to respond.
But for economic scientists, it provides an opportunity to study the effects of a key
natural resource on the world’s economies, and this opportunity persists long after
the wartime increase in oil prices is over. Throughout this book, therefore, we con-
sider many historical episodes. These episodes are valuable to study because they
22 PART ONE INTRODUCTION
give us insight into the economy of the past and, more important, because they al-
low us to illustrate and evaluate economic theories of the present.
THE ROLE OF ASSUMPTIONS
If you ask a physicist how long it would take for a marble to fall from the top of a
ten-story building, she will answer the question by assuming that the marble falls
in a vacuum. Of course, this assumption is false. In fact, the building is surrounded
by air, which exerts friction on the falling marble and slows it down. Yet the physi-
cist will correctly point out that friction on the marble is so small that its effect is
negligible. Assuming the marble falls in a vacuum greatly simplifies the problem
without substantially affecting the answer.
Economists make assumptions for the same reason: Assumptions can make
the world easier to understand. To study the effects of international trade, for ex-
ample, we may assume that the world consists of only two countries and that each
country produces only two goods. Of course, the real world consists of dozens of
countries, each of which produces thousands of different types of goods. But by as-
suming two countries and two goods, we can focus our thinking. Once we under-
stand international trade in an imaginary world with two countries and two
goods, we are in a better position to understand international trade in the more
complex world in which we live.
The art in scientific thinking—whether in physics, biology, or economics—is
deciding which assumptions to make. Suppose, for instance, that we were drop-
ping a beach ball rather than a marble from the top of the building. Our physicist
would realize that the assumption of no friction is far less accurate in this case:
Friction exerts a greater force on a beach ball than on a marble. The assumption
that gravity works in a vacuum is reasonable for studying a falling marble but not
for studying a falling beach ball.
Similarly, economists use different assumptions to answer different questions.
Suppose that we want to study what happens to the economy when the govern-
ment changes the number of dollars in circulation. An important piece of this
analysis, it turns out, is how prices respond. Many prices in the economy change
infrequently; the newsstand prices of magazines, for instance, are changed only
every few years. Knowing this fact may lead us to make different assumptions
when studying the effects of the policy change over different time horizons. For
studying the short-run effects of the policy, we may assume that prices do not
change much. We may even make the extreme and artificial assumption that all
prices are completely fixed. For studying the long-run effects of the policy, how-
ever, we may assume that all prices are completely flexible. Just as a physicist uses
different assumptions when studying falling marbles and falling beach balls, econ-
omists use different assumptions when studying the short-run and long-run ef-
fects of a change in the quantity of money.
ECONOMIC MODELS
High school biology teachers teach basic anatomy with plastic replicas of the hu-
man body. These models have all the major organs—the heart, the liver, the kid-
neys, and so on. The models allow teachers to show their students in a simple way
how the important parts of the body fit together. Of course, these plastic models
CHAPTER 2 THINKING LIKE AN ECONOMIST 23
are not actual human bodies, and no one would mistake the model for a real per-
son. These models are stylized, and they omit many details. Yet despite this lack of
realism—indeed, because of this lack of realism—studying these models is useful
for learning how the human body works.
Economists also use models to learn about the world, but instead of being
made of plastic, they are most often composed of diagrams and equations. Like
a biology teacher’s plastic model, economic models omit many details to allow
us to see what is truly important. Just as the biology teacher’s model does not in-
clude all of the body’s muscles and capillaries, an economist’s model does not
include every feature of the economy.
As we use models to examine various economic issues throughout this book,
you will see that all the models are built with assumptions. Just as a physicist be-
gins the analysis of a falling marble by assuming away the existence of friction,
economists assume away many of the details of the economy that are irrelevant for
studying the question at hand. All models—in physics, biology, or economics—
simplify reality in order to improve our understanding of it.
OUR FIRST MODEL: THE CIRCULAR-FLOW DIAGRAM
The economy consists of millions of people engaged in many activities—buying,
selling, working, hiring, manufacturing, and so on. To understand how the econ-
omy works, we must find some way to simplify our thinking about all these activ-
ities. In other words, we need a model that explains, in general terms, how the
economy is organized and how participants in the economy interact with one
another.
Figure 2-1 presents a visual model of the economy, called a circular-flow
diagram. In this model, the economy has two types of decisionmakers—house-
holds and firms. Firms produce goods and services using inputs, such as labor,
land, and capital (buildings and machines). These inputs are called the factors of
production. Households own the factors of production and consume all the goods
and services that the firms produce.
Households and firms interact in two types of markets. In the markets for
goods and services, households are buyers and firms are sellers. In particular,
households buy the output of goods and services that firms produce. In the mar-
kets for the factors of production, households are sellers and firms are buyers. In
these markets, households provide firms the inputs that the firms use to produce
goods and services. The circular-flow diagram offers a simple way of organizing
all the economic transactions that occur between households and firms in the
economy.
The inner loop of the circular-flow diagram represents the flows of goods and
services between households and firms. The households sell the use of their labor,
land, and capital to the firms in the markets for the factors of production. The firms
then use these factors to produce goods and services, which in turn are sold
tohouseholds in the markets for goods and services. Hence, the factors of produc-
tion flow from households to firms, and goods and services flow from firms to
households.
The outer loop of the circular-flow diagram represents the corresponding flow
of dollars. The households spend money to buy goods and services from the
firms.The firms use some of the revenue from these sales to pay for the factors of
circular-flow diagram
a visual model of the economy that
shows how dollars flow through
markets among households and firms
24 PART ONE INTRODUCTION
production, such as the wages of their workers. What’s left is the profit of the firm
owners, who themselves are members of households. Hence, spending on goods
and services flows from households to firms, and income in the form of wages,
rent, and profit flows from firms to households.
Let’s take a tour of the circular flow by following a dollar bill as it makes its
way from person to person through the economy. Imagine that the dollar begins at
a household, sitting in, say, your wallet. If you want to buy a cup of coffee, you
take the dollar to one of the economy’s markets for goods and services, such as
your local Starbucks coffee shop. There you spend it on your favorite drink. When
the dollar moves into the Starbucks cash register, it becomes revenue for the firm.
The dollar doesn’t stay at Starbucks for long, however, because the firm uses it to
buy inputs in the markets for the factors of production. For instance, Starbucks
might use the dollar to pay rent to its landlord for the space it occupies or to pay
the wages of its workers. In either case, the dollar enters the income of some
household and, once again, is back in someone’s wallet. At that point, the story of
the economy’s circular flow starts once again.
The circular-flow diagram in Figure 2-1 is one simple model of the economy. It
dispenses with details that, for some purposes, are significant. A more complex
Spending
Goods and
services
bought
Revenue
Goods
and services
sold
Labor, land,
and capital
Income
H11005 Flow of goods
and services
H11005 Flow of dollars
Inputs for
production
Wages, rent,
and profit
FIRMS
? Produce and sell
goods and services
? Hire and use factors
of production
? Buy and consume
goods and services
? Own and sell factors
of production
HOUSEHOLDS
? Households sell
? Firms buy
MARKETS
FOR
FACTORS OF PRODUCTION
? Firms sell
? Households buy
MARKETS
FOR
GOODS AND SERVICES
Figure 2-1
THE CIRCULAR FLOW. This
diagram is a schematic represen-
tation of the organization of the
economy. Decisions are made by
households and firms. House-
holds and firms interact in the
markets for goods and services
(where households are buyers
and firms are sellers) and in the
markets for the factors of
production (where firms are
buyers and households are
sellers). The outer set of arrows
shows the flow of dollars, and the
inner set of arrows shows the
corresponding flow of goods and
services.
CHAPTER 2 THINKING LIKE AN ECONOMIST 25
and realistic circular-flow model would include, for instance, the roles of govern-
ment and international trade. Yet these details are not crucial for a basic under-
standing of how the economy is organized. Because of its simplicity, this
circular-flow diagram is useful to keep in mind when thinking about how the
pieces of the economy fit together.
OUR SECOND MODEL: THE PRODUCTION
POSSIBILITIES FRONTIER
Most economic models, unlike the circular-flow diagram, are built using the tools
of mathematics. Here we consider one of the simplest such models, called the pro-
duction possibilities frontier, and see how this model illustrates some basic eco-
nomic ideas.
Although real economies produce thousands of goods and services, let’s imag-
ine an economy that produces only two goods—cars and computers. Together the
car industry and the computer industry use all of the economy’s factors of pro-
duction. The production possibilities frontieris a graph that shows the various
combinations of output—in this case, cars and computers—that the economy can
possibly produce given the available factors of production and the available pro-
duction technology that firms can use to turn these factors into output.
Figure 2-2 is an example of a production possibilities frontier. In this economy,
if all resources were used in the car industry, the economy would produce 1,000
cars and no computers. If all resources were used in the computer industry, the
economy would produce 3,000 computers and no cars. The two end points of
the production possibilities frontier represent these extreme possibilities. If the
1,000
2,200
Production
possibilities
frontier
A
B
C
Quantity of
Cars Produced
7006003000
2,000
3,000
1,000
Quantity of
Computers
Produced
D
Figure 2-2
THE PRODUCTION POSSIBILITIES
FRONTIER. The production
possibilities frontier shows the
combinations of output—in this
case, cars and computers—that
the economy can possibly
produce. The economy can
produce any combination on or
inside the frontier. Points outside
the frontier are not feasible given
the economy’s resources.
production possibilities
frontier
a graph that shows the combinations
of output that the economy can
possibly produce given the available
factors of production and the
available production technology
26 PART ONE INTRODUCTION
economy were to divide its resources between the two industries, it could produce
700 cars and 2,000 computers, shown in the figure by point A. By contrast, the out-
come at point D is not possible because resources are scarce: The economy does
not have enough of the factors of production to support that level of output. In
other words, the economy can produce at any point on or inside the production
possibilities frontier, but it cannot produce at points outside the frontier.
An outcome is said to be efficient if the economy is getting all it can from the
scarce resources it has available. Points on (rather than inside) the production pos-
sibilities frontier represent efficient levels of production. When the economy is pro-
ducing at such a point, say point A, there is no way to produce more of one good
without producing less of the other. Point B represents an inefficient outcome. For
some reason, perhaps widespread unemployment, the economy is producing less
than it could from the resources it has available: It is producing only 300 cars and
1,000 computers. If the source of the inefficiency were eliminated, the economy
could move from point B to point A, increasing production of both cars (to 700)
and computers (to 2,000).
One of the Ten Principles of Economicsdiscussed in Chapter 1 is that people face
tradeoffs. The production possibilities frontier shows one tradeoff that society
faces. Once we have reached the efficient points on the frontier, the only way of
getting more of one good is to get less of the other. When the economy moves from
point Ato point C, for instance, society produces more computers but at the ex-
pense of producing fewer cars.
Another of the Ten Principles of Economicsis that the cost of something is what
you give up to get it. This is called the opportunity cost.The production possibilities
frontier shows the opportunity cost of one good as measured in terms of the other
good. When society reallocates some of the factors of production from the car in-
dustry to the computer industry, moving the economy from point Ato point C, it
gives up 100 cars to get 200 additional computers. In other words, when the econ-
omy is at point A, the opportunity cost of 200 computers is 100 cars.
Notice that the production possibilities frontier in Figure 2-2 is bowed out-
ward. This means that the opportunity cost of cars in terms of computers depends
on how much of each good the economy is producing. When the economy is using
most of its resources to make cars, the production possibilities frontier is quite
steep. Because even workers and machines best suited to making computers are
being used to make cars, the economy gets a substantial increase in the number of
computers for each car it gives up. By contrast, when the economy is using most of
its resources to make computers, the production possibilities frontier is quite flat.
In this case, the resources best suited to making computers are already in the com-
puter industry, and each car the economy gives up yields only a small increase in
the number of computers.
The production possibilities frontier shows the tradeoff between the produc-
tion of different goods at a given time, but the tradeoff can change over time. For
example, if a technological advance in the computer industry raises the number of
computers that a worker can produce per week, the economy can make more com-
puters for any given number of cars. As a result, the production possibilities fron-
tier shifts outward, as in Figure 2-3. Because of this economic growth, society
might move production from point A to point E, enjoying more computers and
more cars.
The production possibilities frontier simplifies a complex economy to high-
light and clarify some basic ideas. We have used it to illustrate some of the
CHAPTER 2 THINKING LIKE AN ECONOMIST 27
concepts mentioned briefly in Chapter 1: scarcity, efficiency, tradeoffs, opportunity
cost, and economic growth. As you study economics, these ideas will recur in
various forms. The production possibilities frontier offers one simple way of think-
ing about them.
MICROECONOMICS AND MACROECONOMICS
Many subjects are studied on various levels. Consider biology, for example. Molec-
ular biologists study the chemical compounds that make up living things. Cellular
biologists study cells, which are made up of many chemical compounds and, at
the same time, are themselves the building blocks of living organisms. Evolution-
ary biologists study the many varieties of animals and plants and how species
change gradually over the centuries.
Economics is also studied on various levels. We can study the decisions of in-
dividual households and firms. Or we can study the interaction of households and
firms in markets for specific goods and services. Or we can study the operation of
the economy as a whole, which is just the sum of the activities of all these decision-
makers in all these markets.
The field of economics is traditionally divided into two broad subfields.
Microeconomicsis the study of how households and firms make decisions and
how they interact in specific markets. Macroeconomicsis the study of economy-
wide phenomena. A microeconomist might study the effects of rent control on
housing in New York City, the impact of foreign competition on the U.S. auto in-
dustry, or the effects of compulsory school attendance on workers’ earnings. A
2,100
2,000
A
E
Quantity of
Cars Produced
700750
0
4,000
3,000
1,000
Quantity of
Computers
Produced
Figure 2-3
ASHIFT IN THE PRODUCTION
POSSIBILITIES FRONTIER.An
economic advance in the
computer industry shifts the
production possibilities frontier
outward, increasing the number
of cars and computers the
economy can produce.
microeconomics
the study of how households and
firms make decisions and how they
interact in markets
macroeconomics
the study of economy-wide
phenomena, including inflation,
unemployment, and economic
growth
28 PART ONE INTRODUCTION
macroeconomist might study the effects of borrowing by the federal government,
the changes over time in the economy’s rate of unemployment, or alternative poli-
cies to raise growth in national living standards.
Microeconomics and macroeconomics are closely intertwined. Because
changes in the overall economy arise from the decisions of millions of individuals,
it is impossible to understand macroeconomic developments without considering
the associated microeconomic decisions. For example, a macroeconomist might
study the effect of a cut in the federal income tax on the overall production of
goods and services. To analyze this issue, he or she must consider how the tax
cut affects the decisions of households about how much to spend on goods and
services.
Despite the inherent link between microeconomics and macroeconomics, the
two fields are distinct. In economics, as in biology, it may seem natural to begin
with the smallest unit and build up. Yet doing so is neither necessary nor always
the best way to proceed. Evolutionary biology is, in a sense, built upon molecular
biology, since species are made up of molecules. Yet molecular biology and evolu-
tionary biology are separate fields, each with its own questions and its own meth-
ods. Similarly, because microeconomics and macroeconomics address different
questions, they sometimes take quite different approaches and are often taught in
separate courses.
QUICK QUIZ: In what sense is economics like a science? a78 Draw a
production possibilities frontier for a society that produces food and clothing.
Show an efficient point, an inefficient point, and an infeasible point. Show the
effects of a drought. a78 Define microeconomicsand macroeconomics.
THE ECONOMIST AS POLICY ADVISER
Often economists are asked to explain the causes of economic events. Why, for ex-
ample, is unemployment higher for teenagers than for older workers? Sometimes
economists are asked to recommend policies to improve economic outcomes.
What, for instance, should the government do to improve the economic well-being
of teenagers? When economists are trying to explain the world, they are scientists.
When they are trying to help improve it, they are policy advisers.
POSITIVE VERSUS NORMATIVE ANALYSIS
To help clarify the two roles that economists play, we begin by examining the use
of language. Because scientists and policy advisers have different goals, they use
language in different ways.
For example, suppose that two people are discussing minimum-wage laws.
Here are two statements you might hear:
POLLY: Minimum-wage laws cause unemployment.
NORMA: The government should raise the minimum wage.
CHAPTER 2 THINKING LIKE AN ECONOMIST 29
Ignoring for now whether you agree with these statements, notice that Polly and
Norma differ in what they are trying to do. Polly is speaking like a scientist: She is
making a claim about how the world works. Norma is speaking like a policy ad-
viser: She is making a claim about how she would like to change the world.
In general, statements about the world are of two types. One type, such as
Polly’s, is positive. Positive statements are descriptive. They make a claim about
how the world is.Asecond type of statement, such as Norma’s, is normative. Nor-
mative statementsare prescriptive. They make a claim about how the world ought
to be.
Akey difference between positive and normative statements is how we judge
their validity. We can, in principle, confirm or refute positive statements by exam-
ining evidence. An economist might evaluate Polly’s statement by analyzing data
on changes in minimum wages and changes in unemployment over time. By con-
trast, evaluating normative statements involves values as well as facts. Norma’s
statement cannot be judged using data alone. Deciding what is good or bad policy
is not merely a matter of science. It also involves our views on ethics, religion, and
political philosophy.
Of course, positive and normative statements may be related. Our positive
views about how the world works affect our normative views about what policies
are desirable. Polly’s claim that the minimum wage causes unemployment, if true,
might lead us to reject Norma’s conclusion that the government should raise the
minimum wage. Yet our normative conclusions cannot come from positive analy-
sis alone. Instead, they require both positive analysis and value judgments.
As you study economics, keep in mind the distinction between positive and
normative statements. Much of economics just tries to explain how the economy
works. Yet often the goal of economics is to improve how the economy works.
When you hear economists making normative statements, you know they have
crossed the line from scientist to policy adviser.
ECONOMISTS IN WASHINGTON
President Harry Truman once said that he wanted to find a one-armed economist.
When he asked his economists for advice, they always answered, “On the one
hand, . . . . On the other hand, . . . .”
Truman was right in realizing that economists’ advice is not always straight-
forward. This tendency is rooted in one of the Ten Principles of Economics in Chap-
ter 1: People face tradeoffs. Economists are aware that tradeoffs are involved in
most policy decisions. Apolicy might increase efficiency at the cost of equity. It
might help future generations but hurt current generations. An economist who
says that all policy decisions are easy is an economist not to be trusted.
Truman was also not alone among presidents in relying on the advice of econ-
omists. Since 1946, the president of the United States has received guidance from
the Council of Economic Advisers, which consists of three members and a staff of
several dozen economists. The council, whose offices are just a few steps from the
White House, has no duty other than to advise the president and to write the an-
nual Economic Report of the President.
The president also receives input from economists in many administrative de-
partments. Economists at the Department of Treasury help design tax policy. Econ-
omists at the Department of Labor analyze data on workers and those looking for
positive statements
claims that attempt to describe the
world as it is
normative statements
claims that attempt to prescribe how
the world should be
30 PART ONE INTRODUCTION
work in order to help formulate labor-market policies. Economists at the Depart-
ment of Justice help enforce the nation’s antitrust laws.
Economists are also found outside the administrative branch of government.
To obtain independent evaluations of policy proposals, Congress relies on the ad-
vice of the Congressional Budget Office, which is staffed by economists. The Fed-
eral Reserve, the quasi-governmental institution that sets the nation’s monetary
policy, employs hundreds of economists to analyze economic developments in the
United States and throughout the world. Table 2-1 lists the Web sites of some of
these agencies.
The influence of economists on policy goes beyond their role as advisers: Their
research and writings often affect policy indirectly. Economist John Maynard
Keynes offered this observation:
The ideas of economists and political philosophers, both when they are right and
when they are wrong, are more powerful than is commonly understood. Indeed,
the world is ruled by little else. Practical men, who believe themselves to be quite
exempt from intellectual influences, are usually the slaves of some defunct
economist. Madmen in authority, who hear voices in the air, are distilling their
frenzy from some academic scribbler of a few years back.
“Let’s switch. I’ll make the policy, you implement it, and he’ll explain it.”
Table 2-1
WEB SITES. Here are the Web
sites for a few of the government
agencies that are responsible for
collecting economic data and
making economic policy.
Department of Commerce www.doc.gov
Bureau of Labor Statistics www.bls.gov
Congressional Budget Office www.cbo.gov
Federal Reserve Board www.federalreserve.gov
CHAPTER 2 THINKING LIKE AN ECONOMIST 31
Although these words were written in 1935, they remain true today. Indeed, the
“academic scribbler” now influencing public policy is often Keynes himself.
QUICK QUIZ: Give an example of a positive statement and an example of a
normative statement. a78 Name three parts of government that regularly rely
on advice from economists.
WHY ECONOMISTS DISAGREE
“If all economists were laid end to end, they would not reach a conclusion.” This
quip from George Bernard Shaw is revealing. Economists as a group are often crit-
icized for giving conflicting advice to policymakers. President Ronald Reagan once
joked that if the game Trivial Pursuit were designed for economists, it would have
100 questions and 3,000 answers.
Why do economists so often appear to give conflicting advice to policy-
makers? There are two basic reasons:
a78 Economists may disagree about the validity of alternative positive theories
about how the world works.
a78 Economists may have different values and, therefore, different normative
views about what policy should try to accomplish.
Let’s discuss each of these reasons.
DIFFERENCES IN SCIENTIFIC JUDGMENTS
Several centuries ago, astronomers debated whether the earth or the sun was at the
center of the solar system. More recently, meteorologists have debated whether
the earth is experiencing “global warming” and, if so, why. Science is a search for
understanding about the world around us. It is not surprising that as the search
continues, scientists can disagree about the direction in which truth lies.
Economists often disagree for the same reason. Economics is a young science,
and there is still much to be learned. Economists sometimes disagree because they
have different hunches about the validity of alternative theories or about the size
of important parameters.
For example, economists disagree about whether the government should levy
taxes based on a household’s income or its consumption (spending). Advocates of
a switch from the current income tax to a consumption tax believe that the change
would encourage households to save more, because income that is saved would
not be taxed. Higher saving, in turn, would lead to more rapid growth in pro-
ductivity and living standards. Advocates of the current income tax believe that
household saving would not respond much to a change in the tax laws. These
two groups of economists hold different normative views about the tax system
because they have different positive views about the responsiveness of saving to
tax incentives.
32 PART ONE INTRODUCTION
DIFFERENCES IN VALUES
Suppose that Peter and Paul both take the same amount of water from the town
well. To pay for maintaining the well, the town taxes its residents. Peter has in-
come of $50,000 and is taxed $5,000, or 10 percent of his income. Paul has income
of $10,000 and is taxed $2,000, or 20 percent of his income.
Is this policy fair? If not, who pays too much and who pays too little? Does it
matter whether Paul’s low income is due to a medical disability or to his decision
to pursue a career in acting? Does it matter whether Peter’s high income is due to
a large inheritance or to his willingness to work long hours at a dreary job?
These are difficult questions on which people are likely to disagree. If the town
hired two experts to study how the town should tax its residents to pay for the
well, we would not be surprised if they offered conflicting advice.
This simple example shows why economists sometimes disagree about public
policy. As we learned earlier in our discussion of normative and positive analysis,
policies cannot be judged on scientific grounds alone. Economists give conflicting
advice sometimes because they have different values. Perfecting the science of eco-
nomics will not tell us whether it is Peter or Paul who pays too much.
PERCEPTION VERSUS REALITY
Because of differences in scientific judgments and differences in values,
some disagreement among economists is inevitable. Yet one should not over-
state the amount of disagreement. In many cases, economists do offer a united
view.
Table 2-2 contains ten propositions about economic policy. In a survey of
economists in business, government, and academia, these propositions were en-
dorsed by an overwhelming majority of respondents. Most of these propositions
would fail to command a similar consensus among the general public.
The first proposition in the table is about rent control. For reasons we will dis-
cuss in Chapter 6, almost all economists believe that rent control adversely affects
the availability and quality of housing and is a very costly way of helping the most
needy members of society. Nonetheless, many city governments choose to ignore
the advice of economists and place ceilings on the rents that landlords may charge
their tenants.
The second proposition in the table concerns tariffs and import quotas. For
reasons we will discuss in Chapter 3 and more fully in Chapter 9, almost all econ-
omists oppose such barriers to free trade. Nonetheless, over the years, the presi-
dent and Congress have chosen to restrict the import of certain goods. In 1993 the
North American Free Trade Agreement (NAFTA), which reduced barriers to trade
among the United States, Canada, and Mexico, passed Congress, but only by a
narrow margin, despite overwhelming support from economists. In this case,
economists did offer united advice, but many members of Congress chose to ig-
nore it.
Why do policies such as rent control and import quotas persist if the experts
are united in their opposition? The reason may be that economists have not yet
convinced the general public that these policies are undesirable. One purpose of
this book is to make you understand the economist’s view of these and other sub-
jects and, perhaps, to persuade you that it is the right one.
CHAPTER 2 THINKING LIKE AN ECONOMIST 33
QUICK QUIZ: Why might economic advisers to the president disagree
about a question of policy?
LET’S GET GOING
The first two chapters of this book have introduced you to the ideas and methods
of economics. We are now ready to get to work. In the next chapter we start learn-
ing in more detail the principles of economic behavior and economic policy.
As you proceed through this book, you will be asked to draw on many of your
intellectual skills. You might find it helpful to keep in mind some advice from the
great economist John Maynard Keynes:
The study of economics does not seem to require any specialized gifts of an
unusually high order. Is it not . . . a very easy subject compared with the higher
branches of philosophy or pure science? An easy subject, at which very few excel!
The paradox finds its explanation, perhaps, in that the master-economist must
possess a rare combinationof gifts. He must be mathematician, historian,
statesman, philosopher—in some degree. He must understand symbols and
speak in words. He must contemplate the particular in terms of the general, and
touch abstract and concrete in the same flight of thought. He must study the
Table 2-2
TEN PROPOSITIONS ABOUT
WHICH MOST ECONOMISTS
AGREE
PROPOSITION(ANDPERCENTAGEOFECONOMISTSWHOAGREE)
1. Aceiling on rents reduces the quantity and quality of housing available.
(93%)
2. Tariffs and import quotas usually reduce general economic welfare. (93%)
3. Flexible and floating exchange rates offer an effective international monetary
arrangement. (90%)
4. Fiscal policy (e.g., tax cut and/or government expenditure increase) has a
significant stimulative impact on a less than fully employed economy. (90%)
5. If the federal budget is to be balanced, it should be done over the business
cycle rather than yearly. (85%)
6. Cash payments increase the welfare of recipients to a greater degree than do
transfers-in-kind of equal cash value. (84%)
7. Alarge federal budget deficit has an adverse effect on the economy. (83%)
8. Aminimum wage increases unemployment among young and unskilled
workers. (79%)
9. The government should restructure the welfare system along the lines of a
“negative income tax.” (79%)
10. Effluent taxes and marketable pollution permits represent a better approach
to pollution control than imposition of pollution ceilings. (78%)
SOURCE:Richard M. Alston, J. R. Kearl, and Michael B. Vaughn, “Is There Consensus among Economists
in the 1990s?” American Economic Review(May 1992): 203–209.
34 PART ONE INTRODUCTION
present in the light of the past for the purposes of the future. No part of man’s
nature or his institutions must lie entirely outside his regard. He must be
purposeful and disinterested in a simultaneous mood; as aloof and incorruptible
as an artist, yet sometimes as near the earth as a politician.
It is a tall order. But with practice, you will become more and more accustomed to
thinking like an economist.
a78 Economists try to address their subject with a scientist’s
objectivity. Like all scientists, they make appropriate
assumptions and build simplified models in order to
understand the world around them. Two simple
economic models are the circular-flow diagram and the
production possibilities frontier.
a78 The field of economics is divided into two subfields:
microeconomics and macroeconomics. Microeconomists
study decisionmaking by households and firms and the
interaction among households and firms in the
marketplace. Macroeconomists study the forces and
trends that affect the economy as a whole.
a78 Apositive statement is an assertion about how the
world is.Anormative statement is an assertion about
how the world ought to be.When economists make
normative statements, they are acting more as policy
advisers than scientists.
a78 Economists who advise policymakers offer conflicting
advice either because of differences in scientific
judgments or because of differences in values. At other
times, economists are united in the advice they offer, but
policymakers may choose to ignore it.
Summary
circular-flow diagram, p. 23
production possibilities frontier, p. 25
microeconomics, p. 27
macroeconomics, p. 27
positive statements, p. 29
normative statements, p. 29
Key Concepts
1. How is economics like a science?
2. Why do economists make assumptions?
3. Should an economic model describe reality exactly?
4. Draw and explain a production possibilities frontier for
an economy that produces milk and cookies. What
happens to this frontier if disease kills half of the
economy’s cow population?
5. Use a production possibilities frontier to describe the
idea of “efficiency.”
6. What are the two subfields into which economics is
divided? Explain what each subfield studies.
7. What is the difference between a positive and a
normative statement? Give an example of each.
8. What is the Council of Economic Advisers?
9. Why do economists sometimes offer conflicting advice
to policymakers?
Questions for Review
CHAPTER 2 THINKING LIKE AN ECONOMIST 35
1. Describe some unusual language used in one of the
other fields that you are studying. Why are these special
terms useful?
2. One common assumption in economics is that the
products of different firms in the same industry are
indistinguishable. For each of the following industries,
discuss whether this is a reasonable assumption.
a. steel
b. novels
c. wheat
d. fast food
3. Draw a circular-flow diagram. Identify the parts of the
model that correspond to the flow of goods and services
and the flow of dollars for each of the following
activities.
a. Sam pays a storekeeper $1 for a quart of milk.
b. Sally earns $4.50 per hour working at a fast food
restaurant.
c. Serena spends $7 to see a movie.
d. Stuart earns $10,000 from his 10 percent ownership
of Acme Industrial.
4. Imagine a society that produces military goods and
consumer goods, which we’ll call “guns” and “butter.”
a. Draw a production possibilities frontier for guns
and butter. Explain why it most likely has a bowed-
out shape.
b. Show a point that is impossible for the economy to
achieve. Show a point that is feasible but inefficient.
c. Imagine that the society has two political parties,
called the Hawks (who want a strong military) and
the Doves (who want a smaller military). Show a
point on your production possibilities frontier that
the Hawks might choose and a point the Doves
might choose.
d. Imagine that an aggressive neighboring country
reduces the size of its military. As a result, both the
Hawks and the Doves reduce their desired
production of guns by the same amount. Which
party would get the bigger “peace dividend,”
measured by the increase in butter production?
Explain.
5. The first principle of economics discussed in Chapter 1
is that people face tradeoffs. Use a production
possibilities frontier to illustrate society’s tradeoff
between a clean environment and high incomes. What
do you suppose determines the shape and position of
the frontier? Show what happens to the frontier if
engineers develop an automobile engine with almost no
emissions.
6. Classify the following topics as relating to
microeconomics or macroeconomics.
a. a family’s decision about how much income to save
b. the effect of government regulations on auto
emissions
c. the impact of higher national saving on economic
growth
d. a firm’s decision about how many workers to hire
e. the relationship between the inflation rate and
changes in the quantity of money
7. Classify each of the following statements as positive or
normative. Explain.
a. Society faces a short-run tradeoff between inflation
and unemployment.
b. Areduction in the rate of growth of money will
reduce the rate of inflation.
c. The Federal Reserve should reduce the rate of
growth of money.
d. Society ought to require welfare recipients to look
for jobs.
e. Lower tax rates encourage more work and more
saving.
8. Classify each of the statements in Table 2-2 as positive,
normative, or ambiguous. Explain.
9. If you were president, would you be more interested in
your economic advisers’ positive views or their
normative views? Why?
10. The Economic Report of the Presidentcontains statistical
information about the economy as well as the Council of
Economic Advisers’ analysis of current policy issues.
Find a recent copy of this annual report at your library
and read a chapter about an issue that interests you.
Summarize the economic problem at hand and describe
the council’s recommended policy.
11. Who is the current chairman of the Federal Reserve?
Who is the current chair of the Council of Economic
Advisers? Who is the current secretary of the treasury?
12. Look up one of the Web sites listed in Table 2-1. What
recent economic trends or issues are addressed there?
13. Would you expect economists to disagree less about
public policy as time goes on? Why or why not? Can
their differences be completely eliminated? Why or
whynot?
Problems and Applications
APPENDIX
GRAPHING: A BRIEF REVIEW
Many of the concepts that economists study can be expressed with numbers—the
price of bananas, the quantity of bananas sold, the cost of growing bananas, and so
on. Often these economic variables are related to one another. When the price of
bananas rises, people buy fewer bananas. One way of expressing the relationships
among variables is with graphs.
Graphs serve two purposes. First, when developing economic theories, graphs
offer a way to visually express ideas that might be less clear if described with
equations or words. Second, when analyzing economic data, graphs provide a
way of finding how variables are in fact related in the world. Whether we are
working with theory or with data, graphs provide a lens through which a recog-
nizable forest emerges from a multitude of trees.
Numerical information can be expressed graphically in many ways, just as a
thought can be expressed in words in many ways. Agood writer chooses words
that will make an argument clear, a description pleasing, or a scene dramatic. An
effective economist chooses the type of graph that best suits the purpose at hand.
In this appendix we discuss how economists use graphs to study the mathe-
matical relationships among variables. We also discuss some of the pitfalls that can
arise in the use of graphical methods.
GRAPHS OF A SINGLE VARIABLE
Three common graphs are shown in Figure 2A-1. The pie chart in panel (a) shows
how total income in the United States is divided among the sources of income, in-
cluding compensation of employees, corporate profits, and so on. Aslice of the pie
represents each source’s share of the total. The bar graph in panel (b) compares a
measure of average income, called real GDP per person, for four countries. The
height of each bar represents the average income in each country. The time-series
graph in panel (c) traces the rising productivity in the U.S. business sector over
time. The height of the line shows output per hour in each year. You have probably
seen similar graphs presented in newspapers and magazines.
36
CHAPTER 2 THINKING LIKE AN ECONOMIST 37
GRAPHS OF TWO VARIABLES: THE COORDINATE SYSTEM
Although the three graphs in Figure 2A-1 are useful in showing how a variable
changes over time or across individuals, such graphs are limited in how much
they can tell us. These graphs display information only on a single variable. Econ-
omists are often concerned with the relationships between variables. Thus, they
need to be able to display two variables on a single graph. The coordinate system
makes this possible.
Suppose you want to examine the relationship between study time and grade
point average. For each student in your class, you could record a pair of numbers:
hours per week spent studying and grade point average. These numbers could
then be placed in parentheses as an ordered pairand appear as a single point onthe
graph. Albert E., for instance, is represented by the ordered pair (25 hours/week,
3.5 GPA), while his “what-me-worry?” classmate Alfred E. is represented by the
ordered pair (5 hours/week, 2.0 GPA).
We can graph these ordered pairs on a two-dimensional grid. The first number
in each ordered pair, called the x-coordinate, tells us the horizontal location of the
point. The second number, called the y-coordinate, tells us the vertical location of
the point. The point with both an x-coordinate and a y-coordinate of zero is known
as the origin. The two coordinates in the ordered pair tell us where the point is lo-
cated in relation to the origin: xunits to the right of the origin and yunits above it.
Figure 2A-2 graphs grade point average against study time for Albert E.,
Alfred E., and their classmates. This type of graph is called a scatterplot because it
plots scattered points. Looking at this graph, we immediately notice that points
farther to the right (indicating more study time) also tend to be higher (indicating
a better grade point average). Because study time and grade point average typi-
cally move in the same direction, we say that these two variables have a positive
Rental
income (2%)
Corporate
profits (12%)
(a) Pie Chart (c) Time-Series Graph
Real GDP per
Person in 1997
United
States
($28,740)
30,000
25,000
20,000
15,000
10,000
5,000
0
United
Kingdom
($20,520)
(b) Bar Graph
Mexico
($8,120)
India
($1,950)
Compensation
of employees
(72%)
Proprietors’
income (8%)
Interest
income (6%)
Productivity
Index
115
95
75
55
35
0
1950 1960 1970 1980 1990 2000
Figure 2A-1
TYPESOF GRAPHS. The pie chart in panel (a) shows how U.S. national income is derived
from various sources. The bar graph in panel (b) compares the average income in four
countries. The time-series graph in panel (c) shows the growth in productivity of the U.S.
business sector from 1950 to 2000.
38 PART ONE INTRODUCTION
correlation.By contrast, if we were to graph party time and grades, we would likely
find that higher party time is associated with lower grades; because these variables
typically move in opposite directions, we would call this a negative correlation. In
either case, the coordinate system makes the correlation between the two variables
easy to see.
CURVES IN THE COORDINATE SYSTEM
Students who study more do tend to get higher grades, but other factors also in-
fluence a student’s grade. Previous preparation is an important factor, for instance,
as are talent, attention from teachers, even eating a good breakfast. Ascatterplot
like Figure 2A-2 does not attempt to isolate the effect that study has on grades
from the effects of other variables. Often, however, economists prefer looking at
how one variable affects another holding everything else constant.
To see how this is done, let’s consider one of the most important graphs in eco-
nomics—the demand curve.The demand curve traces out the effect of a good’s price
on the quantity of the good consumers want to buy. Before showing a demand
curve, however, consider Table 2A-1, which shows how the number of novels that
Emma buys depends on her income and on the price of novels. When novels are
cheap, Emma buys them in large quantities. As they become more expensive, she
borrows books from the library instead of buying them or chooses to go to the
movies instead of reading. Similarly, at any given price, Emma buys more novels
when she has a higher income. That is, when her income increases, she spends part
of the additional income on novels and part on other goods.
We now have three variables—the price of novels, income, and the number of
novels purchased—which is more than we can represent in two dimensions. To
Grade
Point
Average
2.5
2.0
1.5
1.0
0.5
40 Study
Time
(hours per week)
3.0
3.5
4.0
0 5 10 15 20 25 30 35
Alfred E.
(5, 2.0)
Albert E.
(25, 3.5)
Figure 2A-2
USING THE COORDINATE SYSTEM.
Grade point average is measured
on the vertical axis and study
time on the horizontal axis.
Albert E., Alfred E., and their
classmates are represented by
various points. We can see from
the graph that students who
study more tend to get higher
grades.
CHAPTER 2 THINKING LIKE AN ECONOMIST 39
put the information from Table 2A-1 in graphical form, we need to hold one of the
three variables constant and trace out the relationship between the other two. Be-
cause the demand curve represents the relationship between price and quantity
demanded, we hold Emma’s income constant and show how the number of nov-
els she buys varies with the price of novels.
Suppose that Emma’s income is $30,000 per year. If we place the number of
novels Emma purchases on the x-axis and the price of novels on the y-axis, we can
Table 2A-1
NOVELS PURCHASED BY EMMA.
This table shows the number of
novels Emma buys at various
incomes and prices. For any
given level of income, the data on
price and quantity demanded can
be graphed to produce Emma’s
demand curve for novels, as in
Figure 2A-3.
INCOME
PRICE $20,000 $30,000 $40,000
$10 2 novels 5 novels 8 novels
96 9 12
810 13 6
714 7 20
618 21 4
522 5 28
Demand Demand Demand
curve, D
3
curve, D
1
curve, D
2
Price of
Novels
5
4
3
2
1
30 Quantity
of Novels
Purchased
6
7
8
9
10
$11
0 5 10 15 20 25
Demand, D
1
(5, $10)
(9, $9)
(13, $8)
(17, $7)
(21, $6)
(25, $5)
Figure 2A-3
DEMAND CURVE. The line D
1
shows how Emma’s purchases of
novels depend on the price of
novels when her income is held
constant. Because the price and
the quantity demanded are
negatively related, the demand
curve slopes downward.
40 PART ONE INTRODUCTION
graphically represent the middle column of Table 2A-1. When the points that rep-
resent these entries from the table—(5 novels, $10), (9 novels, $9), and so on—are
connected, they form a line. This line, pictured in Figure 2A-3, is known as Emma’s
demand curve for novels; it tells us how many novels Emma purchases at any
given price. The demand curve is downward sloping, indicating that a higher
price reduces the quantity of novels demanded. Because the quantity of novels
demanded and the price move in opposite directions, we say that the two vari-
ables are negatively related. (Conversely, when two variables move in the same di-
rection, the curve relating them is upward sloping, and we say the variables are
positively related.)
Now suppose that Emma’s income rises to $40,000 per year. At any given
price, Emma will purchase more novels than she did at her previous level of in-
come. Just as earlier we drew Emma’s demand curve for novels using the entries
from the middle column of Table 2A-1, we now draw a new demand curve using
the entries from the right-hand column of the table. This new demand curve
(curve D
2
) is pictured alongside the old one (curve D
1
) in Figure 2A-4; the new
curve is a similar line drawn farther to the right. We therefore say that Emma’s de-
mand curve for novels shifts to the right when her income increases. Likewise, if
Emma’s income were to fall to $20,000 per year, she would buy fewer novels at any
given price and her demand curve would shift to the left (to curve D
3
).
In economics, it is important to distinguish between movements along a curve
and shifts of a curve. As we can see from Figure 2A-3, if Emma earns $30,000 per
year and novels cost $8 apiece, she will purchase 13 novels per year. If the price of
novels falls to $7, Emma will increase her purchases of novels to 17 per year. The
demand curve, however, stays fixed in the same place. Emma still buys the same
Price of
Novels
5
4
3
2
1
30 Quantity
of Novels
Purchased
6
7
8
9
10
$11
0 5 13 1610 15 20 25
(13, $8)
(16, $8)
D
3
(income =
$20,000)
D
1
(income =
$30,000)
D
2
(income =
$40,000)
(10, $8)
When income increases,
the demand curve
shifts to the right.
When income
decreases, the
demand curve
shifts to the left.
Figure 2A-4
SHIFTING DEMAND CURVES.
The location of Emma’s demand
curve for novels depends on how
much income she earns. The
more she earns, the more novels
she will purchase at any given
price, and the farther to the right
her demand curve will lie.
CurveD
1
represents Emma’s
original demand curve when her
income is $30,000 per year. If her
income rises to $40,000 per year,
her demand curve shifts to D
2
. If
her income falls to $20,000 per
year, her demand curve shifts
toD
3
.
CHAPTER 2 THINKING LIKE AN ECONOMIST 41
number of novels at each price, but as the price falls she moves along her demand
curve from left to right. By contrast, if the price of novels remains fixed at $8 but
her income rises to $40,000, Emma increases her purchases of novels from 13 to 16
per year. Because Emma buys more novels at each price, her demand curve shifts
out, as shown in Figure 2A-4.
There is a simple way to tell when it is necessary to shift a curve. When a vari-
able that is not named on either axis changes, the curve shifts. Income is on neither
the x-axis nor the y-axis of the graph, so when Emma’s income changes, her de-
mand curve must shift. Any change that affects Emma’s purchasing habits besides
a change in the price of novels will result in a shift in her demand curve. If, for in-
stance, the public library closes and Emma must buy all the books she wants to
read, she will demand more novels at each price, and her demand curve will shift
to the right. Or, if the price of movies falls and Emma spends more time at the
movies and less time reading, she will demand fewer novels at each price, and her
demand curve will shift to the left. By contrast, when a variable on an axis of the
graph changes, the curve does not shift. We read the change as a movement along
the curve.
SLOPE
One question we might want to ask about Emma is how much her purchasing
habits respond to price. Look at the demand curve pictured in Figure 2A-5. If this
curve is very steep, Emma purchases nearly the same number of novels regardless
Price of
Novels
5
4
3
2
1
30 Quantity
of Novels
Purchased
6
7
8
9
10
$11
05 211310 15 20 25
Demand, D
1
(13, $8)
(21, $6)
6 H11002 8 H11005 H110022
21 H11002 13 H11005 8
Figure 2A-5
CALCULATING THE SLOPE OF A
LINE. To calculate the slope of
the demand curve, we can look
atthe changes in the x- and
y-coordinates as we move from
the point (21 novels, $6) to the
point (13 novels, $8). The slope of
the line is the ratio of the change
in the y-coordinate (H110022) to the
change in the x-coordinate (H110018),
which equals H110021/4.
42 PART ONE INTRODUCTION
of whether they are cheap or expensive. If this curve is much flatter, Emma pur-
chases many fewer novels when the price rises. To answer questions about how
much one variable responds to changes in another variable, we can use the con-
cept of slope.
The slope of a line is the ratio of the vertical distance covered to the horizontal
distance covered as we move along the line. This definition is usually written out
in mathematical symbols as follows:
slope = ,
where the Greek letter ? (delta) stands for the change in a variable. In other words,
the slope of a line is equal to the “rise” (change in y) divided by the “run” (change
in x). The slope will be a small positive number for a fairly flat upward-sloping line,
a large positive number for a steep upward-sloping line, and a negative number
for a downward-sloping line. A horizontal line has a slope of zero because in
this case the y-variable never changes; a vertical line is defined to have an infinite
slope because the y-variable can take any value without the x-variable changing
atall.
What is the slope of Emma’s demand curve for novels? First of all, because the
curve slopes down, we know the slope will be negative. To calculate a numerical
value for the slope, we must choose two points on the line. With Emma’s income
at $30,000, she will purchase 21 novels at a price of $6 or 13 novels at a price of $8.
When we apply the slope formula, we are concerned with the change between
these two points; in other words, we are concerned with the difference between
them, which lets us know that we will have to subtract one set of values from the
other, as follows:
slope = = = = = .
Figure 2A-5 shows graphically how this calculation works. Try computing the
slope of Emma’s demand curve using two different points. You should get exactly
the same result, H110021/4. One of the properties of a straight line is that it has the same
slope everywhere. This is not true of other types of curves, which are steeper in
some places than in others.
The slope of Emma’s demand curve tells us something about how responsive
her purchases are to changes in the price. Asmall slope (a number close to zero)
means that Emma’s demand curve is relatively flat; in this case, she adjusts the
number of novels she buys substantially in response to a price change. Alarger
slope (a number farther from zero) means that Emma’s demand curve is relatively
steep; in this case, she adjusts the number of novels she buys only slightly in re-
sponse to a price change.
CAUSE AND EFFECT
Economists often use graphs to advance an argument about how the economy
works. In other words, they use graphs to argue about how one set of events
causes another set of events. With a graph like the demand curve, there is no
doubt about cause and effect. Because we are varying price and holding all other
H110021
4
H110022
8
6H110028
21H1100213
first y-coordinateH11002second y-coordinate
first x-coordinateH11002second x-coordinate
H9004y
H9004x
H9004y
H9004x
CHAPTER 2 THINKING LIKE AN ECONOMIST 43
variables constant, we know that changes in the price of novels cause changes in
the quantity Emma demands. Remember, however, that our demand curve came
from a hypothetical example. When graphing data from the real world, it is often
more difficult to establish how one variable affects another.
The first problem is that it is difficult to hold everything else constant when
measuring how one variable affects another. If we are not able to hold variables
constant, we might decide that one variable on our graph is causing changes in the
other variable when actually those changes are caused by a third omitted variable
not pictured on the graph. Even if we have identified the correct two variables to
look at, we might run into a second problem—reverse causality.In other words, we
might decide that Acauses B when in fact B causes A. The omitted-variable and
reverse-causality traps require us to proceed with caution when using graphs to
draw conclusions about causes and effects.
Omitted Variables To see how omitting a variable can lead to a decep-
tive graph, let’s consider an example. Imagine that the government, spurred by
public concern about the large number of deaths from cancer, commissions an ex-
haustive study from Big Brother Statistical Services, Inc. Big Brother examines
many of the items found in people’s homes to see which of them are associated
with the risk of cancer. Big Brother reports a strong relationship between two vari-
ables: the number of cigarette lighters that a household owns and the prob-
abilitythat someone in the household will develop cancer. Figure 2A-6 shows this
relationship.
What should we make of this result? Big Brother advises a quick policy re-
sponse. It recommends that the government discourage the ownership of cigarette
lighters by taxing their sale. It also recommends that the government require
warning labels: “Big Brother has determined that this lighter is dangerous to your
health.”
In judging the validity of Big Brother’s analysis, one question is paramount:
Has Big Brother held constant every relevant variable except the one under con-
sideration? If the answer is no, the results are suspect. An easy explanation for Fig-
ure 2A-6 is that people who own more cigarette lighters are more likely to smoke
cigarettes and that cigarettes, not lighters, cause cancer. If Figure 2A-6 does not
Risk of
Cancer
Number of Lighters in House
0
Figure 2A-6
GRAPH WITH AN OMITTED
VARIABLE. The upward-sloping
curve shows that members of
households with more cigarette
lighters are more likely to
develop cancer. Yet we should
not conclude that ownership of
lighters causes cancer because the
graph does not take into account
the number of cigarettes smoked.
44 PART ONE INTRODUCTION
hold constant the amount of smoking, it does not tell us the true effect of owning
a cigarette lighter.
This story illustrates an important principle: When you see a graph being used
to support an argument about cause and effect, it is important to ask whether the
movements of an omitted variable could explain the results you see.
Reverse Causality Economists can also make mistakes about causality
by misreading its direction. To see how this is possible, suppose the Association
of American Anarchists commissions a study of crime in America and arrives
at Figure 2A-7, which plots the number of violent crimes per thousand people
in major cities against the number of police officers per thousand people. The an-
archists note the curve’s upward slope and argue that because police increase
rather than decrease the amount of urban violence, law enforcement should be
abolished.
If we could run a controlled experiment, we would avoid the danger of re-
verse causality. To run an experiment, we would set the number of police officers
in different cities randomly and then examine the correlation between police and
crime. Figure 2A-7, however, is not based on such an experiment. We simply ob-
serve that more dangerous cities have more police officers. The explanation for this
may be that more dangerous cities hire more police. In other words, rather than
police causing crime, crime may cause police. Nothing in the graph itself allows us
to establish the direction of causality.
It might seem that an easy way to determine the direction of causality is to
examine which variable moves first. If we see crime increase and then the police
force expand, we reach one conclusion. If we see the police force expand and then
crime increase, we reach the other. Yet there is also a flaw with this approach:
Often people change their behavior not in response to a change in their present
conditions but in response to a change in their expectations of future conditions.
Acity that expects a major crime wave in the future, for instance, might well hire
more police now. This problem is even easier to see in the case of babies and mini-
vans. Couples often buy a minivan in anticipation of the birth of a child. The
Violent
Crimes
(per 1,000
people)
Police Officers
(per 1,000 people)
0
Figure 2A-7
GRAPH SUGGESTING REVERSE
CAUSALITY. The upward-
sloping curve shows that cities
with a higher concentration of
police are more dangerous.
Yetthe graph does not tell us
whether police cause crime or
crime-plagued cities hire more
police.
CHAPTER 2 THINKING LIKE AN ECONOMIST 45
minivan comes before the baby, but we wouldn’t want to conclude that the sale
ofminivans causes the population to grow!
There is no complete set of rules that says when it is appropriate to draw
causal conclusions from graphs. Yet just keeping in mind that cigarette lighters
don’t cause cancer (omitted variable) and minivans don’t cause larger fam-
ilies (reverse causality) will keep you from falling for many faulty economic
arguments.
IN THIS CHAPTER
YOU WILL . . .
See how comparative
advantage explains
the gains from trade
Consider how
everyone can benefit
when people trade
with one another
Learn the meaning of
absolute advantage
and comparative
advantage
Apply the theory of
comparative
advantage to
everyday life and
national policy
Consider your typical day. You wake up in the morning, and you pour yourself
juice from oranges grown in Florida and coffee from beans grown in Brazil. Over
breakfast, you watch a news program broadcast from New York on your television
made in Japan. You get dressed in clothes made of cotton grown in Georgia and
sewn in factories in Thailand. You drive to class in a car made of parts manufac-
tured in more than a dozen countries around the world. Then you open up your
economics textbook written by an author living in Massachusetts, published by a
company located in Texas, and printed on paper made from trees grown in Oregon.
Every day you rely on many people from around the world, most of whom you
do not know, to provide you with the goods and services that you enjoy. Such inter-
dependence is possible because people trade with one another. Those people who
provide you with goods and services are not acting out of generosity or concern for
your welfare. Nor is some government agency directing them to make what you
INTERDEPENDENCE AND THE
GAINS FROM TRADE
47
48 PART ONE INTRODUCTION
want and to give it to you. Instead, people provide you and other consumers with
the goods and services they produce because they get something in return.
In subsequent chapters we will examine how our economy coordinates the ac-
tivities of millions of people with varying tastes and abilities. As a starting point
for this analysis, here we consider the reasons for economic interdependence. One
of the Ten Principles of Economics highlighted in Chapter 1 is that trade can make
everyone better off. This principle explains why people trade with their neighbors
and why nations trade with other nations. In this chapter we examine this princi-
ple more closely. What exactly do people gain when they trade with one another?
Why do people choose to become interdependent?
A PARABLE FOR THE MODERN ECONOMY
To understand why people choose to depend on others for goods and services and
how this choice improves their lives, let’s look at a simple economy. Imagine that
there are two goods in the world—meat and potatoes. And there are two people in
the world—a cattle rancher and a potato farmer—each of whom would like to eat
both meat and potatoes.
The gains from trade are most obvious if the rancher can produce only meat
and the farmer can produce only potatoes. In one scenario, the rancher and the
farmer could choose to have nothing to do with each other. But after several
months of eating beef roasted, boiled, broiled, and grilled, the rancher might de-
cide that self-sufficiency is not all it’s cracked up to be. The farmer, who has been
eating potatoes mashed, fried, baked, and scalloped, would likely agree. It is easy
to see that trade would allow them to enjoy greater variety: Each could then have
a hamburger with french fries.
Although this scene illustrates most simply how everyone can benefit from
trade, the gains would be similar if the rancher and the farmer were each capable
of producing the other good, but only at great cost. Suppose, for example, that the
potato farmer is able to raise cattle and produce meat, but that he is not very good
at it. Similarly, suppose that the cattle rancher is able to grow potatoes, but that her
land is not very well suited for it. In this case, it is easy to see that the farmer and
the rancher can each benefit by specializing in what he or she does best and then
trading with the other.
The gains from trade are less obvious, however, when one person is better at
producing every good. For example, suppose that the rancher is better at raising
cattle and better at growing potatoes than the farmer. In this case, should the
rancher or farmer choose to remain self-sufficient? Or is there still reason for them
to trade with each other? To answer this question, we need to look more closely at
the factors that affect such a decision.
PRODUCTION POSSIBILITIES
Suppose that the farmer and the rancher each work 40 hours a week and can de-
vote this time to growing potatoes, raising cattle, or a combination of the two.
Table 3-1 shows the amount of time each person requires to produce 1 pound of
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 49
Table 3-1
THE PRODUCTION
OPPORTUNITIES OF THE
FARMER AND THE RANCHER
HOURS NEEDED TO AMOUNT PRODUCED
MAKE 1 POUND OF: IN 40 HOURS
MEAT POTATOES MEAT POTATOES
FARMER 20 hours/lb 10 hours/lb 2 lbs 4 lbs
RANCHER 1 hour/lb 8 hours/lb 40 lbs 5 lbs
1
2
Potatoes (pounds)24
A
0
Meat (pounds)
(a) The Farmer’s Production Possibilities Frontier
20
Potatoes (pounds)2
1
/2
B
0
Meat (pounds)
(b) The Rancher’s Production Possibilities Frontier
5
40
Figure 3-1
THE PRODUCTION POSSIBILITIES
FRONTIER. Panel (a) shows the
combinations of meat and
potatoes that the farmer can
produce. Panel (b) shows the
combinations of meat and
potatoes that the rancher can
produce. Both production
possibilities frontiers are derived
from Table 3-1 and the
assumption that the farmer and
rancher each work 40 hours per
week.
50 PART ONE INTRODUCTION
each good. The farmer can produce a pound of potatoes in 10 hours and a pound
of meat in 20 hours. The rancher, who is more productive in both activities, can
produce a pound of potatoes in 8 hours and a pound of meat in 1 hour.
Panel (a) of Figure 3-1 illustrates the amounts of meat and potatoes that the
farmer can produce. If the farmer devotes all 40 hours of his time to potatoes, he
produces 4 pounds of potatoes and no meat. If he devotes all his time to meat, he
produces 2 pounds of meat and no potatoes. If the farmer divides his time equally
between the two activities, spending 20 hours on each, he produces 2 pounds of
potatoes and 1 pound of meat. The figure shows these three possible outcomes and
all others in between.
This graph is the farmer’s production possibilities frontier. As we discussed in
Chapter 2, a production possibilities frontier shows the various mixes of output
that an economy can produce. It illustrates one of the Ten Principles of Economicsin
Chapter 1: People face tradeoffs. Here the farmer faces a tradeoff between produc-
ing meat and producing potatoes. You may recall that the production possibilities
frontier in Chapter 2 was drawn bowed out; in this case, the tradeoff between the
two goods depends on the amounts being produced. Here, however, the farmer’s
technology for producing meat and potatoes (as summarized in Table 3-1) allows
him to switch between one good and the other at a constant rate. In this case, the
production possibilities frontier is a straight line.
Panel (b) of Figure 3-1 shows the production possibilities frontier for the
rancher. If the rancher devotes all 40 hours of her time to potatoes, she produces 5
pounds of potatoes and no meat. If she devotes all her time to meat, she produces
40 pounds of meat and no potatoes. If the rancher divides her time equally, spend-
ing 20 hours on each activity, she produces 2 1/2 pounds of potatoes and 20
pounds of meat. Once again, the production possibilities frontier shows all the
possible outcomes.
If the farmer and rancher choose to be self-sufficient, rather than trade with
each other, then each consumes exactly what he or she produces. In this case, the
production possibilities frontier is also the consumption possibilities frontier. That
is, without trade, Figure 3-1 shows the possible combinations of meat and potatoes
that the farmer and rancher can each consume.
Although these production possibilities frontiers are useful in showing the
tradeoffs that the farmer and rancher face, they do not tell us what the farmer and
rancher will actually choose to do. To determine their choices, we need to know
the tastes of the farmer and the rancher. Let’s suppose they choose the combina-
tions identified by points Aand B in Figure 3-1: The farmer produces and con-
sumes 2 pounds of potatoes and 1 pound of meat, while the rancher produces and
consumes 2 1/2 pounds of potatoes and 20 pounds of meat.
SPECIALIZATION AND TRADE
After several years of eating combination B, the rancher gets an idea and goes to
talk to the farmer:
RANCHER: Farmer, my friend, have I got a deal for you! I know how to improve
life for both of us. I think you should stop producing meat altogether
and devote all your time to growing potatoes. According to my
calculations, if you work 40 hours a week growing potatoes, you’ll
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 51
produce 4 pounds of potatoes. If you give me 1 of those 4 pounds,
I’ll give you 3 pounds of meat in return. In the end, you’ll get to eat 3
pounds of potatoes and 3 pounds of meat every week, instead of the
2 pounds of potatoes and 1 pound of meat you now get. If you go
along with my plan, you’ll have more of bothfoods. [Toillustrate her
point, the rancher shows the farmer panel (a) of Figure3-2.]
FARMER: (sounding skeptical)That seems like a good deal for me. But I don’t
understand why you are offering it. If the deal is so good for me, it
can’t be good for you too.
1
2
3
Potatoes (pounds)234
A
0
Meat (pounds)
(a) How Trade Increases the Farmer’s Consumption
A*
Farmer’s
consumption
with trade
Farmer’s
consumption
without trade
20
21
Potatoes (pounds)2
1
/2
B
0
Meat (pounds)
(b) How Trade Increases the Rancher’s Consumption
53
B*
40
Rancher’s
consumption
without trade
Rancher’s
consumption
with trade
Figure 3-2
HOW TRADE EXPANDS THE
SET OF CONSUMPTION
OPPORTUNITIES. The proposed
trade between the farmer and the
rancher offers each of them a
combination of meat and
potatoes that would be
impossible in the absence of
trade. In panel (a), the farmer
gets to consume at point A*
rather than point A. In panel (b),
the rancher gets to consume at
point B* rather than point B.
Trade allows each to consume
more meat and more potatoes.
52 PART ONE INTRODUCTION
RANCHER: Oh, but it is! If I spend 24 hours a week raising cattle and 16 hours
growing potatoes, I’ll produce 24 pounds of meat and 2 pounds of
potatoes. After I give you 3 pounds of meat in exchange for 1 pound
of potatoes, I’ll have 21 pounds of meat and 3 pounds of potatoes. In
the end, I will also get more of both foods than I have now. [She
points out panel (b) of Figure 3-2.]
FARMER: Idon’t know. . . . This sounds too good to be true.
RANCHER: It’s really not as complicated as it seems at first. Here—I have
summarized my proposal for you in a simple table. [The rancher
hands the farmer a copy of Table 3-2.]
FARMER: (after pausing to study the table)These calculations seem correct, but I
am puzzled. How can this deal make us both better off?
RANCHER: We can both benefit because trade allows each of us to specialize in
doing what we do best. You will spend more time growing potatoes
and less time raising cattle. I will spend more time raising cattle and
less time growing potatoes. As a result of specialization and trade,
each of us can consume both more meat and more potatoes without
working any more hours.
QUICK QUIZ: Draw an example of a production possibilities frontier for
Robinson Crusoe, a shipwrecked sailor who spends his time gathering
coconuts and catching fish. Does this frontier limit Crusoe’s consumption of
coconuts and fish if he lives by himself? Does he face the same limits if he can
trade with natives on the island?
THE PRINCIPLE OF COMPARATIVE ADVANTAGE
The rancher’s explanation of the gains from trade, though correct, poses a puzzle:
If the rancher is better at both raising cattle and growing potatoes, how can the
farmer ever specialize in doing what he does best? The farmer doesn’t seem to do
Table 3-2
THE OUTCOME THE OUTCOME THE GAINS
WITHOUT TRADE: WITH TRADE: FROM TRADE:
WHAT THEY PRODUCE WHAT THEY WHAT THEY WHAT THEY THE INCREASE IN
AND CONSUME PRODUCE TRADE CONSUME CONSUMPTION
FARMER 1 lb meat 0 lbs meat Gets 3 lbs meat 3 lbs meat 2 lbs meat
2 lbs potatoes 4 lbs potatoes for 1 lb potatoes 3 lbs potatoes 1 lb potatoes
RANCHER 20 lbs meat 24 lbs meat Gives 3 lbs meat 21 lbs meat 1 lb meat
2 1/2 lbs potatoes 2 lbs potatoes for 1 lb potatoes 3 lbs potatoes 1/2 lb potatoes
THE GAINS FROM TRADE: ASUMMARY
}
point A
}
point A*
}
A*–A
}
point B
}
point B*
}
B*–B
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 53
anything best. To solve this puzzle, we need to look at the principle of comparative
advantage.
As a first step in developing this principle, consider the following question: In
our example, who can produce potatoes at lower cost—the farmer or the rancher?
There are two possible answers, and in these two answers lie both the solution to
our puzzle and the key to understanding the gains from trade.
ABSOLUTE ADVANTAGE
One way to answer the question about the cost of producing potatoes is to com-
pare the inputs required by the two producers. The rancher needs only 8 hours to
produce a pound of potatoes, whereas the farmer needs 10 hours. Based on this in-
formation, one might conclude that the rancher has the lower cost of producing
potatoes.
Economists use the term absolute advantagewhen comparing the productiv-
ity of one person, firm, or nation to that of another. The producer that requires a
smaller quantity of inputs to produce a good is said to have an absolute advantage
in producing that good. In our example, the rancher has an absolute advantage
both in producing potatoes and in producing meat, because she requires less time
than the farmer to produce a unit of either good.
OPPORTUNITY COST AND COMPARATIVE ADVANTAGE
There is another way to look at the cost of producing potatoes. Rather than com-
paring inputs required, we can compare the opportunity costs. Recall from Chap-
ter 1 that the opportunity costof some item is what we give up to get that item. In
our example, we assumed that the farmer and the rancher each spend 40 hours a
week working. Time spent producing potatoes, therefore, takes away from time
available for producing meat. As the rancher and farmer change their allocations
of time between producing the two goods, they move along their production pos-
sibility frontiers; in a sense, they are using one good to produce the other. The op-
portunity cost measures the tradeoff that each of them faces.
Let’s first consider the rancher’s opportunity cost. Producing 1 pound of pota-
toes takes her 8 hours of work. When the rancher spends that 8 hours producing
potatoes, she spends 8 hours less producing meat. Because the rancher needs only
1 hour to produce 1 pound of meat, 8 hours of work would yield 8 pounds of meat.
Hence, the rancher’s opportunity cost of 1 pound of potatoes is 8 pounds of meat.
Now consider the farmer’s opportunity cost. Producing 1 pound of potatoes
takes him 10 hours. Because he needs 20 hours to produce 1 pound of meat, 10
hours would yield 1/2 pound of meat. Hence, the farmer’s opportunity cost of 1
pound of potatoes is 1/2 pound of meat.
Table 3-3 shows the opportunity cost of meat and potatoes for the two pro-
ducers. Notice that the opportunity cost of meat is the inverse of the opportunity
cost of potatoes. Because 1 pound of potatoes costs the rancher 8 pounds of meat,
1 pound of meat costs the rancher 1/8 pound of potatoes. Similarly, because 1
pound of potatoes costs the farmer 1/2 pound of meat, 1 pound of meat costs the
farmer 2 pounds of potatoes.
Economists use the term comparative advantagewhen describing the oppor-
tunity cost of two producers. The producer who has the smaller opportunity cost
absolute advantage
the comparison among producers of a
good according to their productivity
opportunity cost
whatever must be given up to obtain
some item
comparative advantage
the comparison among producers
ofagood according to their
opportunity cost
54 PART ONE INTRODUCTION
of producing a good—that is, who has to give up less of other goods to produce
it—is said to have a comparative advantage in producing that good. In our exam-
ple, the farmer has a lower opportunity cost of producing potatoes than the
rancher (1/2 pound versus 8 pounds of meat). The rancher has a lower opportu-
nity cost of producing meat than the farmer (1/8 pound versus 2 pounds of pota-
toes). Thus, the farmer has a comparative advantage in growing potatoes, and the
rancher has a comparative advantage in producing meat.
Notice that it would be impossible for the same person to have a comparative
advantage in both goods. Because the opportunity cost of one good is the inverse
of the opportunity cost of the other, if a person’s opportunity cost of one good is
relatively high, his opportunity cost of the other good must be relatively low. Com-
parative advantage reflects the relative opportunity cost. Unless two people have
exactly the same opportunity cost, one person will have a comparative advantage
in one good, and the other person will have a comparative advantage in the other
good.
COMPARATIVE ADVANTAGE AND TRADE
Differences in opportunity cost and comparative advantage create the gains from
trade. When each person specializes in producing the good for which he or she has
a comparative advantage, total production in the economy rises, and this increase
in the size of the economic pie can be used to make everyone better off. In other
words, as long as two people have different opportunity costs, each can benefit
from trade by obtaining a good at a price lower than his or her opportunity cost of
that good.
Consider the proposed deal from the viewpoint of the farmer. The farmer gets
3 pounds of meat in exchange for 1 pound of potatoes. In other words, the farmer
buys each pound of meat for a price of 1/3 pound of potatoes. This price of meat
is lower than his opportunity cost for 1 pound of meat, which is 2 pounds of pota-
toes. Thus, the farmer benefits from the deal because he gets to buy meat at a good
price.
Now consider the deal from the rancher’s viewpoint. The rancher buys 1
pound of potatoes for a price of 3 pounds of meat. This price of potatoes is lower
than her opportunity cost of 1 pound of potatoes, which is 8 pounds of meat. Thus,
the rancher benefits because she gets to buy potatoes at a good price.
These benefits arise because each person concentrates on the activity for which
he or she has the lower opportunity cost: The farmer spends more time growing
potatoes, and the rancher spends more time producing meat. As a result, the total
production of potatoes and the total production of meat both rise, and the farmer
Table 3-3
THE OPPORTUNITY COST OF
MEAT AND POTATOES
OPPORTUNITY COST OF:
1 POUND OF MEAT 1 POUND OF POTATOES
FARMER 2 lbs potatoes 1/2 lb meat
RANCHER 1/8 lb potatoes 8 lbs meat
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 55
and rancher share the benefits of this increased production. The moral of the story
of the farmer and the rancher should now be clear: Trade can benefit everyone in so-
ciety because it allows people to specialize in activities in which they have a comparative
advantage.
QUICK QUIZ: Robinson Crusoe can gather 10 coconuts or catch 1 fish per
hour. His friend Friday can gather 30 coconuts or catch 2 fish per hour. What is
Crusoe’s opportunity cost of catching one fish? What is Friday’s? Who has an
absolute advantage in catching fish? Who has a comparative advantage in
catching fish?
APPLICATIONS OF COMPARATIVE ADVANTAGE
The principle of comparative advantage explains interdependence and the gains
from trade. Because interdependence is so prevalent in the modern world, the
principle of comparative advantage has many applications. Here are two exam-
ples, one fanciful and one of great practical importance.
Economists have long under-
stood the principle of compara-
tive advantage. Here is how the
great economist Adam Smith
put the argument:
It is a maxim of every
prudent master of a family,
never to attempt to make
at home what it will cost
him more to make than to
buy. The tailor does not
attempt to make his own
shoes, but buys them of the shoemaker. The shoemaker
does not attempt to make his own clothes but employs a
tailor. The farmer attempts to make neither the one nor
the other, but employs those different artificers. All of
them find it for their interest to employ their whole
industry in a way in which they have some advantage over
their neighbors, and to purchase with a part of its
produce, or what is the same thing, with the price of part
of it, whatever else they have occasion for.
This quotation is from Smith’s 1776 book, An Inquiry into
the Nature and Causes of the Wealth of Nations, which was
a landmark in the analysis of trade
and economic interdependence.
Smith’s book inspired David
Ricardo, a millionaire stockbroker,
to become an economist. In his
1817 book, Principles of Political
Economy and Taxation, Ricardo de-
veloped the principle of compara-
tive advantage as we know it today.
His defense of free trade was not a
mere academic exercise. Ricardo
put his economic beliefs to work as
a member of the British Parliament,
where he opposed the Corn Laws,
which restricted the import of grain.
The conclusions of Adam Smith and David Ricardo on
the gains from trade have held up well over time. Although
economists often disagree on questions of policy, they are
united in their support of free trade. Moreover, the central
argument for free trade has not changed much in the past
two centuries. Even though the field of economics has
broadened its scope and refined its theories since the time
of Smith and Ricardo, economists’ opposition to trade re-
strictions is still based largely on the principle of compara-
tive advantage.
DAVID RICARDO
FYI
The Legacy of
Adam Smith
and David
Ricardo
56 PART ONE INTRODUCTION
SHOULD TIGER WOODS MOW HIS OWN LAWN?
Tiger Woods spends a lot of time walking around on grass. One of the most tal-
ented golfers of all time, he can hit a drive and sink a putt in a way that most ca-
sual golfers only dream of doing. Most likely, he is talented at other activities too.
For example, let’s imagine that Woods can mow his lawn faster than anyone else.
But just because he canmow his lawn fast, does this mean he should?
To answer this question, we can use the concepts of opportunity cost and com-
parative advantage. Let’s say that Woods can mow his lawn in 2 hours. In that same
2 hours, he could film a television commercial for Nike and earn $10,000. By con-
trast, Forrest Gump, the boy next door, can mow Woods’s lawn in 4 hours. In that
same 4 hours, he could work at McDonald’s and earn $20.
In this example, Woods’s opportunity cost of mowing the lawn is $10,000 and
Forrest’s opportunity cost is $20. Woods has an absolute advantage in mowing
lawns because he can do the work in less time. Yet Forrest has a comparative ad-
vantage in mowing lawns because he has the lower opportunity cost.
A COMMON BARRIER TO FREE TRADE
among countries is tariffs, which are
taxes on the import of goods from
abroad. In the following opinion col-
umn, economist Douglas Irwin dis-
cusses a recent example of their use.
Lamb Tariffs Fleece
U.S. Consumers
BY DOUGLAS A. IRWIN
President Clinton dealt a serious blow to
free trade last Wednesday, when he an-
nounced that the U.S. would impose stiff
import tariffs on lamb from Australia and
New Zealand. His decision undercuts
American leadership and makes a mock-
ery of the administration’s claims that it
favors free and fair trade.
U.S. sheep producers have long
been dependent on government. For
more than half a century, until Congress
enacted farm-policy reforms in 1995,
they received subsidies for wool. Having
lost that handout, saddled with high
costs and inefficiencies, and facing do-
mestic competition from chicken, beef,
and pork, sheep producers sought to
stop foreign competition by filing for im-
port relief.
Almost all U.S. lamb imports come
from Australia and New Zealand, major
agricultural producers with a crushing
comparative advantage. New Zealand
has fewer than four million people but as
many as 60 million sheep (compared
with about seven million sheep in the
U.S.). New Zealand’s farmers have in-
vested substantial resources in new
technology and effective marketing,
making them among the most efficient
producers in the world. New Zealand
also eliminated domestic agricultural
subsidies in the free-market reforms of
the 1950s, and is a free-trading country,
on track to eliminate all import tariffs by
2006.
Rather than emulate this example,
the American Sheep Industry Asso-
ciation, among others, filed an “escape
clause” petition under the Trade Act
of 1974, which allows temporary
“breathing space” protection to import-
competing industries. Under the escape-
clause provision, a petitioning industry is
required to present an adjustment plan
to ensure that it undertakes steps to be-
come competitive in the future. The tariff
protection is usually limited and sched-
uled to be phased out.
The U.S. International Trade Com-
mission determines whether imports are
a cause of “serious injury” to the do-
mestic industry and, if so, proposes a
remedy, which the president has full dis-
cretion to adopt, change or reject. In
February, the ITC did not find that the do-
mestic industry had suffered “serious in-
jury,” but rather adopted the weaker
ruling that imports were “a substantial
IN THE NEWS
Who has a Comparative
Advantage in
Producing Lamb?
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 57
The gains from trade in this example are tremendous. Rather than mowing his
own lawn, Woods should make the commercial and hire Forrest to mow the lawn.
As long as Woods pays Forrest more than $20 and less than $10,000, both of them
are better off.
SHOULD THE UNITED STATES TRADE
WITH OTHER COUNTRIES?
Just as individuals can benefit from specialization and trade with one another, as
the farmer and rancher did, so can populations of people in different countries.
Many of the goods that Americans enjoy are produced abroad, and many of the
goods produced in the United States are sold abroad. Goods produced abroad and
sold domestically are called imports. Goods produced domestically and sold
abroad are called exports.
cause of threat of serious injury.” The
ITC did not propose to roll back imports,
only to impose a 20% tariff (declining
over four years) on imports above last
year’s levels.
The administration at first appeared
to be considering less restrictive mea-
sures. Australia and New Zealand even
offered financial assistance to the U.S.
producers, and the administration de-
layed any announcement and appeared
to be working toward a compromise. But
these hopes were completely dashed
with the shocking final decision, in which
the administration capitulated to the de-
mands of the sheep industry and its ad-
vocates in Congress.
The congressional charge was led
by Sen. Max Baucus (D., Mont.), a
member of the Agriculture Committee
whose sister, a sheep producer, had ap-
peared before the ITC to press for higher
tariffs. The administration opted for . . .
[the following:] On top of existing tariffs,
the president imposed a 9% tariff on all
imports in the first year (declining to 6%
and then 3% in years two and three), and
a whopping 40% tariff on imports above
last year’s levels (dropping to 32% and
24%). . . .
The American Sheep Industry Asso-
ciation’s president happily announced
that the move will “bring some stability
to the market.” Whenever producers
speak of bringing stability to the market,
you know that consumers are getting
fleeced.
The lamb decision, while little no-
ticed at home, has been closely followed
abroad. The decision undercuts the ad-
ministration’s free-trade rhetoric and
harms its efforts to get other countries
to open up their markets. Some import
relief had been expected, but not so
clearly protectionist as what finally mate-
rialized. The extreme decision has out-
raged farmers in Australia and New
Zealand, and officials there have vowed
to take the U.S. to a WTO dispute set-
tlement panel.
The administration’s timing could
not have been worse. The decision came
right after an Asia Pacific Economic Co-
operation summit reaffirmed its commit-
ment to reduce trade barriers, and a few
months before the World Trade Organi-
zation’s November meeting in Seattle,
where the WTO is to launch a new round
of multilateral trade negotiations. A prin-
cipal U.S. objective at the summit is the
reduction of agricultural protection in Eu-
rope and elsewhere.
In 1947, facing an election the next
year, President Truman courageously re-
sisted special interest pressure and ve-
toed a bill to impose import quotas on
wool, which would have jeopardized the
first postwar multilateral trade negotia-
tions due to start later that year. In con-
trast, Mr. Clinton, though a lame duck,
caved in to political pressure. If the U.S.,
whose booming economy is the envy of
the world, cannot resist protectionism,
how can it expect other countries to
do so?
SOURCE:The Wall Street Journal,July 12, 1999,
p.A28.
imports
goods produced abroad and sold
domestically
exports
goods produced domestically and
sold abroad
58 PART ONE INTRODUCTION
To see how countries can benefit from trade, suppose there are two countries,
the United States and Japan, and two goods, food and cars. Imagine that the two
countries produce cars equally well: An American worker and a Japanese worker
can each produce 1 car per month. By contrast, because the United States has more
and better land, it is better at producing food: AU.S. worker can produce 2 tons of
food per month, whereas a Japanese worker can produce only 1 ton of food per
month.
The principle of comparative advantage states that each good should be pro-
duced by the country that has the smaller opportunity cost of producing that
good. Because the opportunity cost of a car is 2 tons of food in the United States
but only 1 ton of food in Japan, Japan has a comparative advantage in producing
cars. Japan should produce more cars than it wants for its own use and export
some of them to the United States. Similarly, because the opportunity cost of a ton
of food is 1 car in Japan but only 1/2 car in the United States, the United States has
a comparative advantage in producing food. The United States should produce
more food than it wants to consume and export some of it to Japan. Through spe-
cialization and trade, both countries can have more food and more cars.
In reality, of course, the issues involved in trade among nations are more com-
plex than this example suggests, as we will see in Chapter 9. Most important
among these issues is that each country has many citizens with different interests.
International trade can make some individuals worse off, even as it makes
the country as a whole better off. When the United States exports food and im-
portscars, the impact on an American farmer is not the same as the impact on an
American autoworker. Yet, contrary to the opinions sometimes voiced by politi-
cians and political commentators, international trade is not like war, in which
some countries win and others lose. Trade allows all countries to achieve greater
prosperity.
QUICK QUIZ: Suppose that the world’s fastest typist happens to be
trained in brain surgery. Should he do his own typing or hire a secretary?
Explain.
CONCLUSION
The principle of comparative advantage shows that trade can make everyone bet-
ter off. You should now understand more fully the benefits of living in an interde-
pendent economy. But having seen why interdependence is desirable, you might
naturally ask how it is possible. How do free societies coordinate the diverse ac-
tivities of all the people involved in their economies? What ensures that goods and
services will get from those who should be producing them to those who should
be consuming them?
In a world with only two people, such as the rancher and the farmer, the an-
swer is simple: These two people can directly bargain and allocate resources be-
tween themselves. In the real world with billions of people, the answer is less
obvious. We take up this issue in the next chapter, where we see that free societies
allocate resources through the market forces of supply and demand.
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 59
a78 Each person consumes goods and services produced by
many other people both in our country and around the
world. Interdependence and trade are desirable because
they allow everyone to enjoy a greater quantity and
variety of goods and services.
a78 There are two ways to compare the ability of two people
in producing a good. The person who can produce the
good with the smaller quantity of inputs is said to have
an absolute advantagein producing the good. The person
who has the smaller opportunity cost of producing the
good is said to have a comparative advantage.The gains
from trade are based on comparative advantage, not
absolute advantage.
a78 Trade makes everyone better off because it allows
people to specialize in those activities in which they
have a comparative advantage.
a78 The principle of comparative advantage applies to
countries as well as to people. Economists use the
principle of comparative advantage to advocate free
trade among countries.
Summary
absolute advantage, p. 53
opportunity cost, p. 53
comparative advantage, p. 53
imports, p. 57
exports, p. 57
Key Concepts
1. Explain how absolute advantage and comparative
advantage differ.
2. Give an example in which one person has an absolute
advantage in doing something but another person has a
comparative advantage.
3. Is absolute advantage or comparative advantage more
important for trade? Explain your reasoning, using the
example in your answer to Question 2.
4. Will a nation tend to export or import goods for which it
has a comparative advantage? Explain.
5. Why do economists oppose policies that restrict trade
among nations?
Questions for Review
1. Consider the farmer and the rancher from our example
in this chapter. Explain why the farmer’s opportunity
cost of producing 1 pound of meat is 2 pounds of
potatoes. Explain why the rancher’s opportunity cost of
producing 1 pound of meat is 1/8 pound of potatoes.
2. Maria can read 20 pages of economics in an hour. She
can also read 50 pages of sociology in an hour. She
spends 5 hours per day studying.
a. Draw Maria’s production possibilities frontier for
reading economics and sociology.
b. What is Maria’s opportunity cost of reading 100
pages of sociology?
3. American and Japanese workers can each produce
4cars a year. An American worker can produce 10 tons
of grain a year, whereas a Japanese worker can produce
5 tons of grain a year. To keep things simple, assume
that each country has 100 million workers.
a. For this situation, construct a table analogous to
Table 3-1.
b. Graph the production possibilities frontier of the
American and Japanese economies.
c. For the United States, what is the opportunity cost
of a car? Of grain? For Japan, what is the
opportunity cost of a car? Of grain? Put
Problems and Applications
60 PART ONE INTRODUCTION
thisinformation in a table analogous to
Table 3-3.
d. Which country has an absolute advantage in
producing cars? In producing grain?
e. Which country has a comparative advantage in
producing cars? In producing grain?
f. Without trade, half of each country’s workers
produce cars and half produce grain. What
quantities of cars and grain does each country
produce?
g. Starting from a position without trade, give
anexample in which trade makes each country
better off.
4. Pat and Kris are roommates. They spend most of their
time studying (of course), but they leave some time for
their favorite activities: making pizza and brewing root
beer. Pat takes 4 hours to brew a gallon of root beer and
2 hours to make a pizza. Kris takes 6 hours to brew a
gallon of root beer and 4 hours to make a pizza.
a. What is each roommate’s opportunity cost of
making a pizza? Who has the absolute advantage in
making pizza? Who has the comparative advantage
in making pizza?
b. If Pat and Kris trade foods with each other, who
will trade away pizza in exchange for root beer?
c. The price of pizza can be expressed in terms of
gallons of root beer. What is the highest price at
which pizza can be traded that would make both
roommates better off? What is the lowest price?
Explain.
5. Suppose that there are 10 million workers in Canada,
and that each of these workers can produce either 2 cars
or 30 bushels of wheat in a year.
a. What is the opportunity cost of producing a car in
Canada? What is the opportunity cost of producing
a bushel of wheat in Canada? Explain the
relationship between the opportunity costs of the
two goods.
b. Draw Canada’s production possibilities frontier. If
Canada chooses to consume 10 million cars, how
much wheat can it consume without trade? Label
this point on the production possibilities frontier.
c. Now suppose that the United States offers to buy
10million cars from Canada in exchange for 20
bushels of wheat per car. If Canada continues to
consume 10 million cars, how much wheat does
this deal allow Canada to consume? Label this
point on your diagram. Should Canada accept the
deal?
6. Consider a professor who is writing a book. The
professor can both write the chapters and gather the
needed data faster than anyone else at his university.
Still, he pays a student to collect data at the library.
Isthis sensible? Explain.
7. England and Scotland both produce scones and
sweaters. Suppose that an English worker can produce
50 scones per hour or 1 sweater per hour. Suppose that
aScottish worker can produce 40 scones per hour or
2sweaters per hour.
a. Which country has the absolute advantage in the
production of each good? Which country has the
comparative advantage?
b. If England and Scotland decide to trade, which
commodity will Scotland trade to England?
Explain.
c. If a Scottish worker could produce only 1 sweater
per hour, would Scotland still gain from trade?
Would England still gain from trade? Explain.
8. Consider once again the farmer and rancher discussed
in the chapter.
a. Suppose that a technological advance makes the
farmer better at producing meat, so that he now
needs only 2 hours to produce 1 pound of meat.
What is his opportunity cost of meat and potatoes
now? Does this alter his comparative advantage?
b. Is the deal that the rancher proposes—3 pounds of
meat for 1 pound of potatoes—still good for the
farmer? Explain.
c. Propose another deal to which the farmer and
rancher might agree now.
9. The following table describes the production
possibilities of two cities in the country of Baseballia:
PAIRS OF RED PAIRS OF WHITE
SOCKS PER WORKER SOCKS PER WORKER
PER HOUR PER HOUR
BOSTON 33
CHICAGO 21
a. Without trade, what is the price of white socks (in
terms of red socks) in Boston? What is the price in
Chicago?
b. Which city has an absolute advantage in the
production of each color sock? Which city has a
comparative advantage in the production of each
color sock?
c. If the cities trade with each other, which color sock
will each export?
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 61
d. What is the range of prices at which trade can
occur?
10. Suppose that all goods can be produced with fewer
worker hours in Germany than in France.
a. In what sense is the cost of all goods lower in
Germany than in France?
b. In what sense is the cost of some goods lower in
France?
c. If Germany and France traded with each other,
would both countries be better off as a result?
Explain in the context of your answers to parts (a)
and (b).
11. Are the following statements true or false? Explain in
each case.
a. “Two countries can achieve gains from trade even if
one of the countries has an absolute advantage in
the production of all goods.”
b. “Certain very talented people have a comparative
advantage in everything they do.”
c. “If a certain trade is good for one person, it can’t be
good for the other one.”
IN THIS CHAPTER
YOU WILL . . .
Consider the key
role of prices in
allocating scarce
resources in market
economies
Examine what
determines the
supply of a good in a
competitive market
Learn the nature of
a competitive
market
Examine what
determines the
demand for a good
in a competitive
market
See how supply and
demand together set
the price of a good
and the quantity
sold
When a cold snap hits Florida, the price of orange juice rises in supermarkets
throughout the country. When the weather turns warm in New England every
summer, the price of hotel rooms in the Caribbean plummets. When a war breaks
out in the Middle East, the price of gasoline in the United States rises, and the price
of a used Cadillac falls. What do these events have in common? They all show the
workings of supply and demand.
Supplyand demandare the two words that economists use most often—and for
good reason. Supply and demand are the forces that make market economies
work. They determine the quantity of each good produced and the price at which
it is sold. If you want to know how any event or policy will affect the economy,
you must think first about how it will affect supply and demand.
This chapter introduces the theory of supply and demand. It considers how
buyers and sellers behave and how they interact with one another. It shows how
THE MARKET FORCES OF
SUPPLY AND DEMAND
65
66 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
supply and demand determine prices in a market economy and how prices, in
turn, allocate the economy’s scarce resources.
MARKETS AND COMPETITION
The terms supplyand demandrefer to the behavior of people as they interact with
one another in markets. Amarketis a group of buyers and sellers of a particular
good or service. The buyers as a group determine the demand for the product, and
the sellers as a group determine the supply of the product. Before discussing how
buyers and sellers behave, let’s first consider more fully what we mean by a “mar-
ket” and the various types of markets we observe in the economy.
COMPETITIVE MARKETS
Markets take many forms. Sometimes markets are highly organized, such as the
markets for many agricultural commodities. In these markets, buyers and sellers
meet at a specific time and place, where an auctioneer helps set prices and arrange
sales.
More often, markets are less organized. For example, consider the market for
ice cream in a particular town. Buyers of ice cream do not meet together at any one
time. The sellers of ice cream are in different locations and offer somewhat differ-
ent products. There is no auctioneer calling out the price of ice cream. Each seller
posts a price for an ice-cream cone, and each buyer decides how much ice cream to
buy at each store.
Even though it is not organized, the group of ice-cream buyers and ice-cream
sellers forms a market. Each buyer knows that there are several sellers from which
to choose, and each seller is aware that his product is similar to that offered by
other sellers. The price of ice cream and the quantity of ice cream sold are not de-
termined by any single buyer or seller. Rather, price and quantity are determined
by all buyers and sellers as they interact in the marketplace.
The market for ice cream, like most markets in the economy, is highly compet-
itive. Acompetitive marketis a market in which there are many buyers and many
sellers so that each has a negligible impact on the market price. Each seller of ice
cream has limited control over the price because other sellers are offering similar
products. Aseller has little reason to charge less than the going price, and if he or
she charges more, buyers will make their purchases elsewhere. Similarly, no single
buyer of ice cream can influence the price of ice cream because each buyer pur-
chases only a small amount.
In this chapter we examine how buyers and sellers interact in competitive
markets. We see how the forces of supply and demand determine both the quan-
tity of the good sold and its price.
COMPETITION: PERFECT AND OTHERWISE
We assume in this chapter that markets are perfectly competitive.Perfectly competi-
tive markets are defined by two primary characteristics: (1) the goods being of-
fered for sale are all the same, and (2) the buyers and sellers are so numerous that
market
a group of buyers and sellers of a
particular good or service
competitive market
a market in which there are many
buyers and many sellers so that each
has a negligible impact on the market
price
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 67
no single buyer or seller can influence the market price. Because buyers and sell-
ers in perfectly competitive markets must accept the price the market determines,
they are said to be price takers.
There are some markets in which the assumption of perfect competition ap-
plies perfectly. In the wheat market, for example, there are thousands of farmers
who sell wheat and millions of consumers who use wheat and wheat products. Be-
cause no single buyer or seller can influence the price of wheat, each takes the
price as given.
Not all goods and services, however, are sold in perfectly competitive markets.
Some markets have only one seller, and this seller sets the price. Such a seller is
called a monopoly.Your local cable television company, for instance, may be a mo-
nopoly. Residents of your town probably have only one cable company from
which to buy this service.
Some markets fall between the extremes of perfect competition and monopoly.
One such market, called an oligopoly,has a few sellers that do not always compete
aggressively. Airline routes are an example. If a route between two cities is ser-
viced by only two or three carriers, the carriers may avoid rigorous competition to
keep prices high. Another type of market is monopolistically competitive;it contains
many sellers, each offering a slightly different product. Because the products are
not exactly the same, each seller has some ability to set the price for its own prod-
uct. An example is the software industry. Many word processing programs com-
pete with one another for users, but every program is different from every other
and has its own price.
Despite the diversity of market types we find in the world, we begin by study-
ing perfect competition. Perfectly competitive markets are the easiest to analyze.
Moreover, because some degree of competition is present in most markets, many
of the lessons that we learn by studying supply and demand under perfect com-
petition apply in more complicated markets as well.
QUICK QUIZ: What is a market? a78 What does it mean for a market to be
competitive?
DEMAND
We begin our study of markets by examining the behavior of buyers. Here we con-
sider what determines the quantity demandedof any good, which is the amount
of the good that buyers are willing and able to purchase. To focus our thinking,
let’s keep in mind a particular good—ice cream.
WHAT DETERMINES THE QUANTITY AN
INDIVIDUAL DEMANDS?
Consider your own demand for ice cream. How do you decide how much ice
cream to buy each month, and what factors affect your decision? Here are some of
the answers you might give.
quantity demanded
the amount of a good that buyers are
willing and able to purchase
68 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
Price If the price of ice cream rose to $20 per scoop, you would buy less ice
cream. You might buy frozen yogurt instead. If the price of ice cream fell to $0.20
per scoop, you would buy more. Because the quantity demanded falls as the price
rises and rises as the price falls, we say that the quantity demanded is negatively re-
latedto the price. This relationship between price and quantity demanded is true
for most goods in the economy and, in fact, is so pervasive that economists call it
the law of demand:Other things equal, when the price of a good rises, the quan-
tity demanded of the good falls.
Income What would happen to your demand for ice cream if you lost your job
one summer? Most likely, it would fall. Alower income means that you have less
to spend in total, so you would have to spend less on some—and probably most—
goods. If the demand for a good falls when income falls, the good is called a
normal good.
Not all goods are normal goods. If the demand for a good rises when income
falls, the good is called an inferior good.An example of an inferior good might be
bus rides. As your income falls, you are less likely to buy a car or take a cab, and
more likely to ride the bus.
Prices of Related Goods Suppose that the price of frozen yogurt falls.
The law of demand says that you will buy more frozen yogurt. At the same time,
you will probably buy less ice cream. Because ice cream and frozen yogurt are both
cold, sweet, creamy desserts, they satisfy similar desires. When a fall in the price
of one good reduces the demand for another good, the two goods are called
substitutes.Substitutes are often pairs of goods that are used in place of each
other, such as hot dogs and hamburgers, sweaters and sweatshirts, and movie tick-
ets and video rentals.
Now suppose that the price of hot fudge falls. According to the law of de-
mand, you will buy more hot fudge. Yet, in this case, you will buy moreice cream
as well, because ice cream and hot fudge are often used together. When a fall in the
price of one good raises the demand for another good, the two goods are called
complements. Complements are often pairs of goods that are used together,
suchas gasoline and automobiles, computers and software, and skis and ski lift
tickets.
Tastes The most obvious determinant of your demand is your tastes. If you
like ice cream, you buy more of it. Economists normally do not try to explain peo-
ple’s tastes because tastes are based on historical and psychological forces that are
beyond the realm of economics. Economists do, however, examine what happens
when tastes change.
Expectations Your expectations about the future may affect your demand
for a good or service today. For example, if you expect to earn a higher income next
month, you may be more willing to spend some of your current savings buying ice
cream. As another example, if you expect the price of ice cream to fall tomorrow,
you may be less willing to buy an ice-cream cone at today’s price.
law of demand
the claim that, other things equal, the
quantity demanded of a good falls
when the price of the good rises
normal good
a good for which, other things equal,
an increase in income leads to an
increase in demand
inferior good
a good for which, other things equal,
an increase in income leads to a
decrease in demand
substitutes
two goods for which an increase in
the price of one leads to an increase
in the demand for the other
complements
two goods for which an increase in
the price of one leads to a decrease in
the demand for the other
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 69
THE DEMAND SCHEDULE AND THE DEMAND CURVE
We have seen that many variables determine the quantity of ice cream a person
demands. Imagine that we hold all these variables constant except one—the price.
Let’s consider how the price affects the quantity of ice cream demanded.
Table 4-1 shows how many ice-cream cones Catherine buys each month at dif-
ferent prices of ice cream. If ice cream is free, Catherine eats 12 cones. At $0.50 per
cone, Catherine buys 10 cones. As the price rises further, she buys fewer and fewer
cones. When the price reaches $3.00, Catherine doesn’t buy any ice cream at all.
Table 4-1 is a demand schedule,a table that shows the relationship between the
price of a good and the quantity demanded. (Economists use the term schedulebe-
cause the table, with its parallel columns of numbers, resembles a train schedule.)
Figure 4-1 graphs the numbers in Table 4-1. By convention, the price of
icecream is on the vertical axis, and the quantity of ice cream demanded is on the
Table 4-1
CATHERINE’SDEMAND
SCHEDULE. The demand
schedule shows the quantity
demanded at each price.
PRICEOF ICE-CREAMCONE QUANTITY OFCONESDEMANDED
$0.00 12
0.50 10
1.00 8
1.50 6
2.00 4
2.50 2
3.00 0
demand schedule
a table that shows the relationship
between the price of a good and the
quantity demanded
Price of
Ice-Cream
Cone
0
2.50
2.00
1.50
1.00
0.50
1 2 3 4 5 6 7 8 9 10 11 Quantity of
Ice-Cream Cones
$3.00
12
Figure 4-1
CATHERINE’SDEMANDCURVE.
This demand curve, which
graphs the demand schedule in
Table 4-1, shows how the
quantity demanded of the good
changes as its price varies.
Because a lower price increases
the quantity demanded, the
demand curve slopes downward.
70 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
horizontal axis. The downward-sloping line relating price and quantity demanded
is called the demand curve.
CETERIS PARIBUS
Whenever you see a demand curve, remember that it is drawn holding many
things constant. Catherine’s demand curve in Figure 4-1 shows what happens to
the quantity of ice cream Catherine demands when only the price of ice cream
varies. The curve is drawn assuming that Catherine’s income, tastes, expectations,
and the prices of related products are not changing.
Economists use the term ceteris paribusto signify that all the relevant vari-
ables, except those being studied at that moment, are held constant. The Latin
phrase literally means “other things being equal.” The demand curve slopes
downward because, ceteris paribus, lower prices mean a greater quantity
demanded.
Although the term ceteris paribusrefers to a hypothetical situation in which
some variables are assumed to be constant, in the real world many things change
at the same time. For this reason, when we use the tools of supply and demand to
analyze events or policies, it is important to keep in mind what is being held con-
stant and what is not.
MARKET DEMAND VERSUS INDIVIDUAL DEMAND
So far we have talked about an individual’s demand for a product. To analyze how
markets work, we need to determine the market demand,which is the sum of all the
individual demands for a particular good or service.
Catherine’s Demand
Price of
Ice-Cream
Cone
Price of
Ice-Cream
Cone
Nicholas’s Demand
0 1 2 3 4 5 6 7 8 9 101112 Quantity of
Ice-Cream Cones
$3.00
1.50
2.00
2.50
1.00
0.50
0 123456789101112Quantity of
Ice-Cream Cones
$3.00
1.50
2.00
2.50
1.00
0.50
H11545
demand curve
a graph of the relationship between
the price of a good and the quantity
demanded
ceteris paribus
a Latin phrase, translated as “other
things being equal,” used as a
reminder that all variables other than
the ones being studied are assumed
to be constant
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 71
Table 4-2 shows the demand schedules for ice cream of two individuals—
Catherine and Nicholas. At any price, Catherine’s demand schedule tells us how
much ice cream she buys, and Nicholas’s demand schedule tells us how much ice
cream he buys. The market demand is the sum of the two individual demands.
Because market demand is derived from individual demands, it depends on
all those factors that determine the demand of individual buyers. Thus, market de-
mand depends on buyers’ incomes, tastes, expectations, and the prices of related
goods. It also depends on the number of buyers. (If Peter, another consumer of ice
cream, were to join Catherine and Nicholas, the quantity demanded in the market
would be higher at every price.) The demand schedules in Table 4-2 show what
happens to quantity demanded as the price varies while all the other variables that
determine quantity demanded are held constant.
Figure 4-2 shows the demand curves that correspond to these demand sched-
ules. Notice that we sum the individual demand curves horizontallyto obtain the
Market Demand
(H11005 4 H11001 3)
Price of
Ice-Cream
Cone
0 1 2 3 4 5 6 7 8 9 10111213141516171819 Quantity of
Ice-Cream Cones
$3.00
1.50
2.00
2.50
1.00
0.50
H11549
Figure 4-2
MARKETDEMANDASTHESUM
OFINDIVIDUALDEMANDS. The
market demand curve is found
by adding horizontally the
individual demand curves. At a
price of $2, Catherine demands
4ice-cream cones, and Nicholas
demands 3 ice-cream cones. The
quantity demanded in the market
at this price is 7 cones.
Table 4-2
INDIVIDUALANDMARKET
DEMANDSCHEDULES. The
quantity demanded in a market is
the sum of the quantities
demanded by all the buyers.
PRICEOF ICE-CREAMCONE CATHERINE NICHOLAS MARKET
$0.00 12 H11001 7 H11005 19
0.50 10 6 16
1.00 8 5 13
1.50 6 4 10
2.00 4 3 7
2.50 2 2 4
3.00 0 1 1
72 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
market demand curve. That is, to find the total quantity demanded at any price,
we add the individual quantities found on the horizontal axis of the individual de-
mand curves. Because we are interested in analyzing how markets work, we will
work most often with the market demand curve. The market demand curve shows
how the total quantity demanded of a good varies as the price of the good varies.
SHIFTS IN THE DEMAND CURVE
Suppose that the American Medical Association suddenly announces a new dis-
covery: People who regularly eat ice cream live longer, healthier lives. How does
this announcement affect the market for ice cream? The discovery changes peo-
ple’s tastes and raises the demand for ice cream. At any given price, buyers now
want to purchase a larger quantity of ice cream, and the demand curve for ice
cream shifts to the right.
Whenever any determinant of demand changes, other than the good’s price,
the demand curve shifts. As Figure 4-3 shows, any change that increases the quan-
tity demanded at every price shifts the demand curve to the right. Similarly, any
change that reduces the quantity demanded at every price shifts the demand curve
to the left.
Table 4-3 lists the variables that determine the quantity demanded in a market
and how a change in the variable affects the demand curve. Notice that price plays
a special role in this table. Because price is on the vertical axis when we graph a
demand curve, a change in price does not shift the curve but represents a move-
ment along it. By contrast, when there is a change in income, the prices of related
goods, tastes, expectations, or the number of buyers, the quantity demanded at
each price changes; this is represented by a shift in the demand curve.
Price of
Ice-Cream
Cone
Quantity of
Ice-Cream Cones
Increase
in demand
Decrease
in demand
Demand curve, D
3
Demand
curve, D
1
Demand
curve, D
2
0
Figure 4-3
SHIFTSINTHEDEMANDCURVE.
Any change that raises the
quantity that buyers wish to
purchase at a given price shifts
the demand curve to the right.
Any change that lowers the
quantity that buyers wish to
purchase at a given price shifts
the demand curve to the left.
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 73
CASE STUDY TWO WAYS TO REDUCE THE QUANTITY
OF SMOKING DEMANDED
Public policymakers often want to reduce the amount that people smoke. There
are two ways that policy can attempt to achieve this goal.
One way to reduce smoking is to shift the demand curve for cigarettes and
other tobacco products. Public service announcements, mandatory health warn-
ings on cigarette packages, and the prohibition of cigarette advertising on tele-
vision are all policies aimed at reducing the quantity of cigarettes demanded at
any given price. If successful, these policies shift the demand curve for ciga-
rettes to the left, as in panel (a) of Figure 4-4.
Alternatively, policymakers can try to raise the price of cigarettes. If the
government taxes the manufacture of cigarettes, for example, cigarette compa-
nies pass much of this tax on to consumers in the form of higher prices. Ahigher
price encourages smokers to reduce the numbers of cigarettes they smoke. In
this case, the reduced amount of smoking does not represent a shift in the de-
mand curve. Instead, it represents a movement along the same demand curve
to a point with a higher price and lower quantity, as in panel (b) of Figure 4-4.
How much does the amount of smoking respond to changes in the price of
cigarettes? Economists have attempted to answer this question by studying
what happens when the tax on cigarettes changes. They have found that a
10percent increase in the price causes a 4 percent reduction in the quantity de-
manded. Teenagers are found to be especially sensitive to the price of cigarettes:
A10 percent increase in the price causes a 12 percent drop in teenage smoking.
Arelated question is how the price of cigarettes affects the demand for illicit
drugs, such as marijuana. Opponents of cigarette taxes often argue that tobacco
and marijuana are substitutes, so that high cigarette prices encourage marijuana
use. By contrast, many experts on substance abuse view tobacco as a “gateway
drug” leading the young to experiment with other harmful substances. Most
studies of the data are consistent with this view: They find that lower cigarette
prices are associated with greater use of marijuana. In other words, tobacco and
marijuana appear to be complements rather than substitutes.
In summary, the demand curve shows what happens to the quantity demanded of a
good when its price varies, holding constant all other determinants of quantity demanded.
When one of these other determinants changes, the demand curve shifts.
Table 4-3
THEDETERMINANTSOF
QUANTITYDEMANDED. This
table lists the variables that can
influence the quantity demanded
in a market. Notice the special
role that price plays: Achange in
the price represents a movement
along the demand curve, whereas
a change in one of the other
variables shifts the demand
curve.
VARIABLESTHATAFFECT
QUANTITYDEMANDED ACHANGEIN THISVARIABLE. . .
Price Represents a movement along the demand curve
Income Shifts the demand curve
Prices of related goods Shifts the demand curve
Tastes Shifts the demand curve
Expectations Shifts the demand curve
Number of buyers Shifts the demand curve
WHATISTHEBESTWAYTOSTOPTHIS?
74 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
QUICK QUIZ: List the determinants of the quantity of pizza you demand.
a78 Make up an example of a demand schedule for pizza, and graph the
implied demand curve. a78 Give an example of something that would shift
this demand curve. a78 Would a change in the price of pizza shift this demand
curve?
Price of
Cigarettes,
per Pack
Number of Cigarettes
Smoked per Day
D
2
D
1
0100
$2.00
BA
(a) A Shift in the Demand Curve
Price of
Cigarettes,
per Pack
Number of Cigarettes
Smoked per Day
D
1
01220
$4.00
2.00
C
A
(b) A Movement along the Demand Curve
A tax that raises the price of
cigarettes results in a movement
along the demand curve.
A policy to discourage
smoking shifts the
demand curve to the left.
Figure 4-4
SHIFTSINTHEDEMANDCURVE
VERSUSMOVEMENTSALONGTHE
DEMANDCURVE. If warnings
on cigarette packages convince
smokers to smoke less, the
demand curve for cigarettes
shifts to the left. In panel (a), the
demand curve shifts from D
1
to
D
2
. At a price of $2 per pack, the
quantity demanded falls from
20to 10 cigarettes per day, as
reflected by the shift from point A
to point B. By contrast, if a tax
raises the price of cigarettes, the
demand curve does not shift.
Instead, we observe a movement
to a different point on the
demand curve. In panel (b), when
the price rises from $2 to $4, the
quantity demanded falls from 20
to 12 cigarettes per day, as
reflected by the movement from
point Ato point C.
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 75
SUPPLY
We now turn to the other side of the market and examine the behavior of sellers.
The quantity suppliedof any good or service is the amount that sellers are willing
and able to sell. Once again, to focus our thinking, let’s consider the market for ice
cream and look at the factors that determine the quantity supplied.
WHAT DETERMINES THE QUANTITY
AN INDIVIDUAL SUPPLIES?
Imagine that you are running Student Sweets, a company that produces and sells
ice cream. What determines the quantity of ice cream you are willing to produce
and offer for sale? Here are some possible answers.
Price The price of ice cream is one determinant of the quantity supplied. When
the price of ice cream is high, selling ice cream is profitable, and so the quantity
supplied is large. As a seller of ice cream, you work long hours, buy many ice-
cream machines, and hire many workers. By contrast, when the price of ice cream
is low, your business is less profitable, and so you will produce less ice cream. At
an even lower price, you may choose to go out of business altogether, and your
quantity supplied falls to zero.
Because the quantity supplied rises as the price rises and falls as the price falls,
we say that the quantity supplied is positively relatedto the price of the good. This
relationship between price and quantity supplied is called the law of supply:
Other things equal, when the price of a good rises, the quantity supplied of the
good also rises.
Input Prices To produce its output of ice cream, Student Sweets uses various
inputs: cream, sugar, flavoring, ice-cream machines, the buildings in which the ice
cream is made, and the labor of workers to mix the ingredients and operate the
machines. When the price of one or more of these inputs rises, producing ice cream
is less profitable, and your firm supplies less ice cream. If input prices rise sub-
stantially, you might shut down your firm and supply no ice cream at all. Thus, the
supply of a good is negatively related to the price of the inputs used to make the
good.
Technology The technology for turning the inputs into ice cream is yet an-
other determinant of supply. The invention of the mechanized ice-cream machine,
for example, reduced the amount of labor necessary to make ice cream. By reduc-
ing firms’ costs, the advance in technology raised the supply of ice cream.
Expectations The amount of ice cream you supply today may depend on
your expectations of the future. For example, if you expect the price of ice cream to
rise in the future, you will put some of your current production into storage and
supply less to the market today.
quantity supplied
the amount of a good that sellers are
willing and able to sell
law of supply
the claim that, other things equal, the
quantity supplied of a good rises
when the price of the good rises
76 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
THE SUPPLY SCHEDULE AND THE SUPPLY CURVE
Consider how the quantity supplied varies with the price, holding input prices,
technology, and expectations constant. Table 4-4 shows the quantity supplied by
Ben, an ice-cream seller, at various prices of ice cream. At a price below $1.00, Ben
does not supply any ice cream at all. As the price rises, he supplies a greater and
greater quantity. This table is called the supply schedule.
Figure 4-5 graphs the relationship between the quantity of ice cream supplied
and the price. The curve relating price and quantity supplied is called the supply
curve.The supply curve slopes upward because, ceteris paribus, a higher price
means a greater quantity supplied.
Table 4-4
BEN’SSUPPLYSCHEDULE. The
supply schedule shows the
quantity supplied at each price.
PRICEOF ICE-CREAMCONE QUANTITY OFCONESSUPPLIED
$0.00 0
0.50 0
1.00 1
1.50 2
2.00 3
2.50 4
3.00 5
supply schedule
a table that shows the relationship
between the price of a good and the
quantity supplied
supply curve
a graph of the relationship between
the price of a good and the quantity
supplied
Price of
Ice-Cream
Cone
0
2.50
2.00
1.50
1.00
1 2 3 4 5 6 7 8 9 10 11 Quantity of
Ice-Cream Cones
$3.00
12
0.50
Figure 4-5
BEN’SSUPPLYCURVE. This
supply curve, which graphs the
supply schedule in Table 4-4,
shows how the quantity supplied
of the good changes as its price
varies. Because a higher price
increases the quantity supplied,
the supply curve slopes upward.
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 77
MARKET SUPPLY VERSUS INDIVIDUAL SUPPLY
Just as market demand is the sum of the demands of all buyers, market supply is
the sum of the supplies of all sellers. Table 4-5 shows the supply schedules for two
ice-cream producers—Ben and Jerry. At any price, Ben’s supply schedule tells us
the quantity of ice cream Ben supplies, and Jerry’s supply schedule tells us the
quantity of ice cream Jerry supplies. The market supply is the sum of the two in-
dividual supplies.
Market supply depends on all those factors that influence the supply of indi-
vidual sellers, such as the prices of inputs used to produce the good, the available
technology, and expectations. In addition, the supply in a market depends on the
number of sellers. (If Ben or Jerry were to retire from the ice-cream business, the
supply in the market would fall.) The supply schedules in Table 4-5 show what
happens to quantity supplied as the price varies while all the other variables that
determine quantity supplied are held constant.
Figure 4-6 shows the supply curves that correspond to the supply schedules in
Table 4-5. As with demand curves, we sum the individual supply curves horizon-
tallyto obtain the market supply curve. That is, to find the total quantity supplied
at any price, we add the individual quantities found on the horizontal axis of the
individual supply curves. The market supply curve shows how the total quantity
supplied varies as the price of the good varies.
SHIFTS IN THE SUPPLY CURVE
Suppose that the price of sugar falls. How does this change affect the supply of ice
cream? Because sugar is an input into producing ice cream, the fall in the price of
sugar makes selling ice cream more profitable. This raises the supply of ice cream:
At any given price, sellers are now willing to produce a larger quantity. Thus, the
supply curve for ice cream shifts to the right.
Whenever there is a change in any determinant of supply, other than the
good’s price, the supply curve shifts. As Figure 4-7 shows, any change that raises
quantity supplied at every price shifts the supply curve to the right. Similarly, any
change that reduces the quantity supplied at every price shifts the supply curve to
the left.
Table 4-5
INDIVIDUALANDMARKET
SUPPLYSCHEDULES. The
quantity supplied in a market is
the sum of the quantities
supplied by all the sellers.
PRICEOF ICE-CREAMCONE BEN JERRY MARKET
$0.00 0 H11001 0 H11005 0
0.50 0 0 0
1.00 1 0 1
1.50 2 2 4
2.00 3 4 7
2.50 4 6 10
3.00 5 8 13
78 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
Ben’s Supply
Price of
Ice-Cream
Cone
Price of
Ice-Cream
Cone
H11545 Jerry’s Supply
0 1 2 3 4 5 6 7 8 9 101112 Quantity of
Ice-Cream Cones
$3.00
1.50
2.00
2.50
1.00
0.50
0 123456789101112Quantity of
Ice-Cream Cones
$3.00
1.50
2.00
2.50
1.00
0.50
Price of
Ice-Cream
Cone
Quantity of
Ice-Cream Cones
0
Increase
in supply
Decrease
in supply
Supply curve, S
3
Supply
curve, S
1
Supply
curve, S
2
Figure 4-7
SHIFTSINTHESUPPLYCURVE.
Any change that raises the
quantity that sellers wish to
produce at a given price shifts the
supply curve to the right. Any
change that lowers the quantity
that sellers wish to produce at a
given price shifts the supply
curve to the left.
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 79
Table 4-6 lists the variables that determine the quantity supplied in a market
and how a change in the variable affects the supply curve. Once again, price plays
a special role in the table. Because price is on the vertical axis when we graph a
supply curve, a change in price does not shift the curve but represents a movement
along it. By contrast, when there is a change in input prices, technology, expecta-
tions, or the number of sellers, the quantity supplied at each price changes; this is
represented by a shift in the supply curve.
In summary, the supply curve shows what happens to the quantity supplied of a good
when its price varies, holding constant all other determinants of quantity supplied. When
one of these other determinants changes, the supply curve shifts.
Market Supply
(H11005 3 H11001 4)
Price of
Ice-Cream
Cone
0 1 2 3 4 5 6 7 8 9 101112 Quantity of
Ice-Cream Cones
$3.00
1.50
2.00
2.50
1.00
0.50
H11549
Figure 4-6
MARKETSUPPLYASTHESUMOF
INDIVIDUALSUPPLIES. The
market supply curve is found
byadding horizontally the
individual supply curves. At a
price of $2, Ben supplies 3 ice-
cream cones, and Jerry supplies
4ice-cream cones. The quantity
supplied in the market at this
price is 7 cones.
Table 4-6
THEDETERMINANTSOF
QUANTITYSUPPLIED. This table
lists the variables that can
influence the quantity supplied in
a market. Notice the special role
that price plays: Achange in the
price represents a movement
along the supply curve, whereas
a change in one of the other
variables shifts the supply curve.
VARIABLESTHATAFFECT
QUANTITYSUPPLIED ACHANGEIN THISVARIABLE. . .
Price Represents a movement along the supply curve
Input prices Shifts the supply curve
Technology Shifts the supply curve
Expectations Shifts the supply curve
Number of sellers Shifts the supply curve
80 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
QUICK QUIZ: List the determinants of the quantity of pizza supplied.
a78 Make up an example of a supply schedule for pizza, and graph the implied
supply curve. a78 Give an example of something that would shift this supply
curve. a78 Would a change in the price of pizza shift this supply curve?
SUPPLY AND DEMAND TOGETHER
Having analyzed supply and demand separately, we now combine them to see
how they determine the quantity of a good sold in a market and its price.
EQUILIBRIUM
Figure 4-8 shows the market supply curve and market demand curve together.
Notice that there is one point at which the supply and demand curves intersect;
this point is called the market’s equilibrium.The price at which these two curves
cross is called the equilibrium price,and the quantity is called the equilibrium
quantity.Here the equilibrium price is $2.00 per cone, and the equilibrium quan-
tity is 7 ice-cream cones.
The dictionary defines the word equilibrium as a situation in which vari-
ousforces are in balance—and this also describes a market’s equilibrium. At the
equilibrium
a situation in which supply and
demand have been brought into
balance
equilibrium price
the price that balances supply and
demand
equilibrium quantity
the quantity supplied and the
quantity demanded when the price
has adjusted to balance supply and
demand
Price of
Ice-Cream
Cone
$2.00
012345678910112 Quantity of
Ice-Cream Cones
13
Equilibrium
quantity
Equilibrium price
Equilibrium
Supply
Demand
Figure 4-8
THEEQUILIBRIUMOF SUPPLY
ANDDEMAND. The equilibrium
is found where the supply and
demand curves intersect. At the
equilibrium price, the quantity
supplied equals the quantity
demanded. Here the equilibrium
price is $2: At this price, 7 ice-
cream cones are supplied, and
7ice-cream cones are demanded.
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 81
equilibrium price, the quantity of the good that buyers are willing and able to buy exactly
balances the quantity that sellers are willing and able to sell.The equilibrium price is
sometimes called the market-clearing pricebecause, at this price, everyone in the
market has been satisfied: Buyers have bought all they want to buy, and sellers
have sold all they want to sell.
The actions of buyers and sellers naturally move markets toward the equilib-
rium of supply and demand. To see why, consider what happens when the market
price is not equal to the equilibrium price.
Suppose first that the market price is above the equilibrium price, as in panel
(a) of Figure 4-9. At a price of $2.50 per cone, the quantity of the good supplied
(10cones) exceeds the quantity demanded (4 cones). There is a surplusof the
good: Suppliers are unable to sell all they want at the going price. When there is a
surplus in the ice-cream market, for instance, sellers of ice cream find their freez-
ers increasingly full of ice cream they would like to sell but cannot. They respond
to the surplus by cutting their prices. Prices continue to fall until the market
reaches the equilibrium.
Suppose now that the market price is below the equilibrium price, as in panel
(b) of Figure 4-9. In this case, the price is $1.50 per cone, and the quantity of the
good demanded exceeds the quantity supplied. There is a shortageof the good:
Demanders are unable to buy all they want at the going price. When a shortage oc-
curs in the ice-cream market, for instance, buyers have to wait in long lines for
achance to buy one of the few cones that are available. With too many buyers
chasing too few goods, sellers can respond to the shortage by raising their prices
without losing sales. As prices rise, the market once again moves toward the
equilibrium.
Thus, the activities of the many buyers and sellers automatically push the mar-
ket price toward the equilibrium price. Once the market reaches its equilibrium, all
buyers and sellers are satisfied, and there is no upward or downward pressure on
the price. How quickly equilibrium is reached varies from market to market, de-
pending on how quickly prices adjust. In most free markets, however, surpluses
and shortages are only temporary because prices eventually move toward their
equilibrium levels. Indeed, this phenomenon is so pervasive that it is sometimes
called the law of supply and demand:The price of any good adjusts to bring the
supply and demand for that good into balance.
THREE STEPS TO ANALYZING CHANGES IN EQUILIBRIUM
So far we have seen how supply and demand together determine a market’s equi-
librium, which in turn determines the price of the good and the amount of the
good that buyers purchase and sellers produce. Of course, the equilibrium price
and quantity depend on the position of the supply and demand curves. When
some event shifts one of these curves, the equilibrium in the market changes. The
analysis of such a change is called comparative staticsbecause it involves compar-
ing two static situations—an old and a new equilibrium.
When analyzing how some event affects a market, we proceed in three steps.
First, we decide whether the event shifts the supply curve, the demand curve, or
in some cases both curves. Second, we decide whether the curve shifts to the right
or to the left. Third, we use the supply-and-demand diagram to examine how the
surplus
a situation in which quantity
supplied is greater than quantity
demanded
shortage
a situation in which quantity
demanded is greater than quantity
supplied
law of supply and demand
the claim that the price of any good
adjusts to bring the supply and
demand for that good into balance
82 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
Price of
Ice-Cream
Cone
2.00
$2.50
04710 Quantity of
Ice-Cream Cones
Supply
Demand
(a) Excess Supply
Quantity
demanded
Quantity
supplied
Surplus
Price of
Ice-Cream
Cone
$2.00
1.50
04710 Quantity of
Ice-Cream Cones
Supply
Demand
(b) Excess Demand
Quantity
supplied
Quantity
demanded
Shortage
Figure 4-9
MARKETSNOTINEQUILIBRIUM.
In panel (a), there is a surplus.
Because the market price of $2.50
is above the equilibrium price,
the quantity supplied (10 cones)
exceeds the quantity demanded
(4 cones). Suppliers try to
increase sales by cutting the price
of a cone, and this moves the
price toward its equilibrium
level. In panel (b), there is a
shortage. Because the market
price of $1.50 is below the
equilibrium price, the quantity
demanded (10 cones) exceeds the
quantity supplied (4 cones). With
too many buyers chasing too few
goods, suppliers can take
advantage of the shortage by
raising the price. Hence, in both
cases, the price adjustment
movesthe market toward the
equilibrium of supply and
demand.
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 83
shift affects the equilibrium price and quantity. Table 4-7 summarizes these three
steps. To see how this recipe is used, let’s consider various events that might affect
the market for ice cream.
Example: A Change in Demand Suppose that one summer the weather
is very hot. How does this event affect the market for ice cream? To answer this
question, let’s follow our three steps.
1. The hot weather affects the demand curve by changing people’s taste for ice
cream. That is, the weather changes the amount of ice cream that people
want to buy at any given price. The supply curve is unchanged because the
weather does not directly affect the firms that sell ice cream.
2. Because hot weather makes people want to eat more ice cream, the demand
curve shifts to the right. Figure 4-10 shows this increase in demand as the
shift in the demand curve from D
1
to D
2
. This shift indicates that the quantity
of ice cream demanded is higher at every price.
3. As Figure 4-10 shows, the increase in demand raises the equilibrium price
from $2.00 to $2.50 and the equilibrium quantity from 7 to 10 cones. In other
words, the hot weather increases the price of ice cream and the quantity of
ice cream sold.
Shifts in Curves versus Movements along Curves Notice that when
hot weather drives up the price of ice cream, the quantity of ice cream that firms sup-
ply rises, even though the supply curve remains the same. In this case, economists
say there has been an increase in “quantity supplied” but no change in “supply.”
Table 4-7
ATHREE-STEPPROGRAMFOR
ANALYZINGCHANGESIN
EQUILIBRIUM
1. Decide whether the event shifts the supply curve or demand curve (or perhaps
both).
2. Decide which direction the curve shifts.
3. Use the supply-and-demand diagram to see how the shift changes the
equilibrium.
84 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
“Supply” refers to the position of the supply curve, whereas the “quantity sup-
plied” refers to the amount suppliers wish to sell. In this example, supply does not
change because the weather does not alter firms’ desire to sell at any given price. In-
stead, the hot weather alters consumers’ desire to buy at any given priceand
thereby shifts the demand curve. The increase in demand causes the equilibrium
price to rise. When the price rises, the quantity supplied rises. This increase in quan-
tity supplied is represented by the movement along the supply curve.
To summarize, a shift inthe supply curve is called a “change in supply,” and a
shift inthe demand curve is called a “change in demand.” Amovement alonga
fixed supply curve is called a “change in the quantity supplied,” and a movement
alonga fixed demand curve is called a “change in the quantity demanded.”
Example: A Change in Supply Suppose that, during another summer,
an earthquake destroys several ice-cream factories. How does this event affect the
market for ice cream? Once again, to answer this question, we follow our three
steps.
1. The earthquake affects the supply curve. By reducing the number of sellers,
the earthquake changes the amount of ice cream that firms produce and
sell at any given price. The demand curve is unchanged because the
earthquake does not directly change the amount of ice cream households
wish to buy.
2. The supply curve shifts to the left because, at every price, the total amount
that firms are willing and able to sell is reduced. Figure 4-11 illustrates this
decrease in supply as a shift in the supply curve from S
1
to S
2
.
Price of
Ice-Cream
Cone
2.00
$2.50
0710Quantity of
Ice-Cream Cones
Supply
New equilibrium
Initial
equilibrium
D
1
D
2
3. . . . and a higher
quantity sold.
2. . . . resulting
in a higher
price . . .
1. Hot weather increases
the demand for ice cream . . .
Figure 4-10
HOWANINCREASEINDEMAND
AFFECTSTHEEQUILIBRIUM.An
event that raises quantity
demanded at any given price
shifts the demand curve to the
right. The equilibrium price and
the equilibrium quantity both
rise. Here, an abnormally hot
summer causes buyers to
demand more ice cream. The
demand curve shifts from D
1
to
D
2
, which causes the equilibrium
price to rise from $2.00 to $2.50
and the equilibrium quantity to
rise from 7 to 10 cones.
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 85
3. As Figure 4-11 shows, the shift in the supply curve raises the equilibrium
price from $2.00 to $2.50 and lowers the equilibrium quantity from 7 to 4
cones. As a result of the earthquake, the price of ice cream rises, and the
quantity of ice cream sold falls.
Example: A Change in Both Supply and Demand Now suppose
that the hot weather and the earthquake occur at the same time. To analyze this
combination of events, we again follow our three steps.
1. We determine that both curves must shift. The hot weather affects the
demand curve because it alters the amount of ice cream that households
want to buy at any given price. At the same time, the earthquake alters the
supply curve because it changes the amount of ice cream that firms want to
sell at any given price.
2. The curves shift in the same directions as they did in our previous analysis:
The demand curve shifts to the right, and the supply curve shifts to the left.
Figure 4-12 illustrates these shifts.
3. As Figure 4-12 shows, there are two possible outcomes that might result,
depending on the relative size of the demand and supply shifts. In both
cases, the equilibrium price rises. In panel (a), where demand increases
substantially while supply falls just a little, the equilibrium quantity also
rises. By contrast, in panel (b), where supply falls substantially while
demand rises just a little, the equilibrium quantity falls. Thus, these events
certainly raise the price of ice cream, but their impact on the amount of ice
cream sold is ambiguous.
Price of
Ice-Cream
Cone
2.00
$2.50
047 Quantity of
Ice-Cream Cones
Demand
New
equilibrium
Initial equilibrium
S
1
S
2
2. . . . resulting
in a higher
price . . .
1. An earthquake reduces
the supply of ice cream . . .
3. . . . and a lower
quantity sold.
Figure 4-11
HOWADECREASEINSUPPLY
AFFECTSTHEEQUILIBRIUM.
Anevent that reduces quantity
supplied at any given price shifts
the supply curve to the left. The
equilibrium price rises, and the
equilibrium quantity falls. Here,
an earthquake causes sellers to
supply less ice cream. The supply
curve shifts from S
1
to S
2
, which
causes the equilibrium price to
rise from $2.00 to $2.50 and the
equilibrium quantity to fall from
7 to 4 cones.
86 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
Summary We have just seen three examples of how to use supply and demand
curves to analyze a change in equilibrium. Whenever an event shifts the supply
curve, the demand curve, or perhaps both curves, you can use these tools to predict
how the event will alter the amount sold in equilibrium and the price at which the
(b) Price Rises, Quantity Falls
Price of
Ice-Cream
Cone
Quantity of
Ice-Cream Cones
0
New equilibrium
Initial equilibrium
S
1
D
1
D
2
S
2
Q
1
Q
2
P
2
P
1
(a) Price Rises, Quantity Rises
Price of
Ice-Cream
Cone
Quantity of
Ice-Cream Cones
0
New
equilibrium
Initial equilibrium
S
1
D
1
D
2
S
2
Q
1
Q
2
P
2
P
1
Large
increase in
demand
Small
decrease in
supply
Small
increase in
demand
Large
decrease in
supply
Figure 4-12
ASHIFTINBOTHSUPPLYAND
DEMAND. Here we observe a
simultaneous increase in demand
and decrease in supply. Two
outcomes are possible. In panel
(a), the equilibrium price
risesfrom P
1
to P
2
, and the
equilibrium quantity rises
fromQ
1
to Q
2
. In panel (b), the
equilibrium price again rises
from P
1
to P
2
, but the equilibrium
quantity falls from Q
1
to Q
2
.
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 87
good is sold. Table 4-8 shows the predicted outcome for any combination of shifts
in the two curves. To make sure you understand how to use the tools of supply and
demand, pick a few entries in this table and make sure you can explain to yourself
why the table contains the prediction it does.
ACCORDINGTOOURANALYSIS, ANATURAL
disaster that reduces supply reduces
the quantity sold and raises the price.
Here’s a recent example.
4-Day Cold Spell Slams
California: Crops Devastated;
Price of Citrus to Rise
BYTODDS. PURDUM
A brutal four-day freeze has destroyed
more than a third of California’s annual
citrus crop, inflicting upwards of a half-
billion dollars in damage and raising the
prospect of tripled orange prices in
supermarkets by next week.
Throughout the Golden State, cold,
dry air from the Gulf of Alaska sent tem-
peratures below freezing beginning Mon-
day, with readings in the high teens and
low 20’s in agriculturally rich Central Val-
ley early today—the worst cold spell
since a 10-day freeze in 1990. Farmers
frantically ran wind and irrigation ma-
chines overnight to keep trees warm, but
officials pronounced a near total loss in
the valley, and said perhaps half of the
state’s orange crop was lost as well. . . .
California grows about 80 percent
of the nation’s oranges eaten as fruit,
and 90 percent of lemons, and whole-
salers said the retail prices of oranges
could triple in the next few days. The
price of lemons was certain to rise as
well, but the price of orange juice should
be less affected because most juice
oranges are grown in Florida.
In some California markets, whole-
salers reported that the price of navel
oranges had increased to 90 cents a
pound on Wednesday from 35 cents on
Tuesday.
SOURCE:The New York Times,December 25, 1998,
p.A1.
IN THE NEWS
Mother Nature Shifts
the Supply Curve
Table 4-8
WHATHAPPENSTOPRICEAND
QUANTITYWHENSUPPLYOR
DEMANDSHIFTS?
NOCHANGE ANINCREASE ADECREASE
INSUPPLY INSUPPLY INSUPPLY
NOCHANGEIN DEMAND Psame Pdown Pup
Qsame Qup Qdown
ANINCREASE INDEMAND Pup Pambiguous Pup
Qup Qup Qambiguous
ADECREASE INDEMAND Pdown Pdown Pambiguous
Qdown Qambiguous Qdown
88 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
QUICK QUIZ: Analyze what happens to the market for pizza if the price of
tomatoes rises. a78 Analyze what happens to the market for pizza if the price
of hamburgers falls.
CONCLUSION: HOW PRICES ALLOCATE RESOURCES
This chapter has analyzed supply and demand in a single market. Although our
discussion has centered around the market for ice cream, the lessons learned here
apply in most other markets as well. Whenever you go to a store to buy something,
you are contributing to the demand for that item. Whenever you look for a job,
you are contributing to the supply of labor services. Because supply and demand
are such pervasive economic phenomena, the model of supply and demand is a
powerful tool for analysis. We will be using this model repeatedly in the following
chapters.
One of the Ten Principles of Economicsdiscussed in Chapter 1 is that markets are
usually a good way to organize economic activity. Although it is still too early to
judge whether market outcomes are good or bad, in this chapter we have begun to
see how markets work. In any economic system, scarce resources have to be allo-
cated among competing uses. Market economies harness the forces of supply and
demand to serve that end. Supply and demand together determine the prices of
the economy’s many different goods and services; prices in turn are the signals
that guide the allocation of resources.
For example, consider the allocation of beachfront land. Because the amount
of this land is limited, not everyone can enjoy the luxury of living by the beach.
Who gets this resource? The answer is: whoever is willing and able to pay the
price. The price of beachfront land adjusts until the quantity of land demanded ex-
actly balances the quantity supplied. Thus, in market economies, prices are the
mechanism for rationing scarce resources.
Similarly, prices determine who produces each good and how much is pro-
duced. For instance, consider farming. Because we need food to survive, it is cru-
cial that some people work on farms. What determines who is a farmer and who is
not? In a free society, there is no government planning agency making this decision
and ensuring an adequate supply of food. Instead, the allocation of workers to
farms is based on the job decisions of millions of workers. This decentralized sys-
tem works well because these decisions depend on prices. The prices of food and
the wages of farmworkers (the price of their labor) adjust to ensure that enough
people choose to be farmers.
If a person had never seen a market economy in action, the whole idea might
seem preposterous. Economies are large groups of people engaged in many inter-
dependent activities. What prevents decentralized decisionmaking from degen-
erating into chaos? What coordinates the actions of the millions of people with
their varying abilities and desires? What ensures that what needs to get done
does in fact get done? The answer, in a word, is prices. If market economies
areguided by an invisible hand, as Adam Smith famously suggested, then the
price system is the baton that the invisible hand uses to conduct the economic
orchestra.
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 89
“—and seventy-five cents.”“Two dollars.”
a78 Economists use the model of supply and demand
to analyze competitive markets. In a competitive
market, there are many buyers and sellers, each
of whom has little or no influence on the market
price.
a78 The demand curve shows how the quantity of a good
demanded depends on the price. According to the law
of demand, as the price of a good falls, the quantity
demanded rises. Therefore, the demand curve slopes
downward.
a78 In addition to price, other determinants of the quantity
demanded include income, tastes, expectations, and
the prices of substitutes and complements. If one of
these other determinants changes, the demand curve
shifts.
a78 The supply curve shows how the quantity of a good
supplied depends on the price. According to the law of
supply, as the price of a good rises, the quantity
supplied rises. Therefore, the supply curve slopes
upward.
a78 In addition to price, other determinants of the quantity
supplied include input prices, technology, and
expectations. If one of these other determinants changes,
the supply curve shifts.
a78 The intersection of the supply and demand curves
determines the market equilibrium. At the equilibrium
price, the quantity demanded equals the quantity
supplied.
a78 The behavior of buyers and sellers naturally drives
markets toward their equilibrium. When the market
price is above the equilibrium price, there is a
surplus of the good, which causes the market price
to fall. When the market price is below the equilibrium
price, there is a shortage, which causes the market price
to rise.
a78 To analyze how any event influences a market, we use
the supply-and-demand diagram to examine how the
event affects the equilibrium price and quantity. To do
this we follow three steps. First, we decide whether the
event shifts the supply curve or the demand curve (or
both). Second, we decide which direction the curve
shifts. Third, we compare the new equilibrium with the
old equilibrium.
a78 In market economies, prices are the signals that guide
economic decisions and thereby allocate scarce
resources. For every good in the economy, the price
ensures that supply and demand are in balance. The
equilibrium price then determines how much of the
good buyers choose to purchase and how much sellers
choose to produce.
Summary
90 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
market, p. 66
competitive market, p. 66
quantity demanded, p. 67
law of demand, p. 68
normal good, p. 68
inferior good, p. 68
substitutes, p. 68
complements, p. 68
demand schedule, p. 69
demand curve, p. 70
ceteris paribus,p. 70
quantity supplied, p. 75
law of supply, p. 75
supply schedule, p. 76
supply curve, p. 76
equilibrium, p. 80
equilibrium price, p. 80
equilibrium quantity, p. 80
surplus, p. 81
shortage, p. 81
law of supply and demand, p. 81
Key Concepts
1. What is a competitive market? Briefly describe the
types of markets other than perfectly competitive
markets.
2. What determines the quantity of a good that buyers
demand?
3. What are the demand schedule and the demand curve,
and how are they related? Why does the demand curve
slope downward?
4. Does a change in consumers’ tastes lead to a movement
along the demand curve or a shift in the demand curve?
Does a change in price lead to a movement along the
demand curve or a shift in the demand curve?
5. Popeye’s income declines and, as a result, he buys
more spinach. Is spinach an inferior or a normal
good? What happens to Popeye’s demand curve for
spinach?
6. What determines the quantity of a good that sellers
supply?
7. What are the supply schedule and the supply curve, and
how are they related? Why does the supply curve slope
upward?
8. Does a change in producers’ technology lead to a
movement along the supply curve or a shift in the
supply curve? Does a change in price lead to a
movement along the supply curve or a shift in the
supply curve?
9. Define the equilibrium of a market. Describe the forces
that move a market toward its equilibrium.
10. Beer and pizza are complements because they are often
enjoyed together. When the price of beer rises, what
happens to the supply, demand, quantity supplied,
quantity demanded, and the price in the market for
pizza?
11. Describe the role of prices in market economies.
Questions for Review
1. Explain each of the following statements using supply-
and-demand diagrams.
a. When a cold snap hits Florida, the price of
orange juice rises in supermarkets throughout
the country.
b. When the weather turns warm in New England
every summer, the prices of hotel rooms in
Caribbean resorts plummet.
c. When a war breaks out in the Middle East, the price
of gasoline rises, while the price of a used Cadillac
falls.
2. “An increase in the demand for notebooks raises
the quantity of notebooks demanded, but not the
quantity supplied.” Is this statement true or false?
Explain.
3. Consider the market for minivans. For each of the
events listed here, identify which of the determinants
of demand or supply are affected. Also indicate
whether demand or supply is increased or decreased.
Then show the effect on the price and quantity of
minivans.
a. People decide to have more children.
Problems and Applications
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 91
b. Astrike by steelworkers raises steel prices.
c. Engineers develop new automated machinery for
the production of minivans.
d. The price of station wagons rises.
e. Astock-market crash lowers people’s wealth.
4. During the 1990s, technological advance reduced the
cost of computer chips. How do you think this affected
the market for computers? For computer software? For
typewriters?
5. Using supply-and-demand diagrams, show the effect of
the following events on the market for sweatshirts.
a. Ahurricane in South Carolina damages the cotton
crop.
b. The price of leather jackets falls.
c. All colleges require morning calisthenics in
appropriate attire.
d. New knitting machines are invented.
6. Suppose that in the year 2005 the number of births is
temporarily high. How does this baby boom affect the
price of baby-sitting services in 2010 and 2020? (Hint:
5-year-olds need baby-sitters, whereas 15-year-olds can
be baby-sitters.)
7. Ketchup is a complement (as well as a condiment) for
hot dogs. If the price of hot dogs rises, what happens to
the market for ketchup? For tomatoes? For tomato juice?
For orange juice?
8. The case study presented in the chapter discussed
cigarette taxes as a way to reduce smoking. Now think
about the markets for other tobacco products such as
cigars and chewing tobacco.
a. Are these goods substitutes or complements for
cigarettes?
b. Using a supply-and-demand diagram, show what
happens in the markets for cigars and chewing
tobacco if the tax on cigarettes is increased.
c. If policymakers wanted to reduce total tobacco
consumption, what policies could they combine
with the cigarette tax?
9. The market for pizza has the following demand and
supply schedules:
PRICE QUANTITYDEMANDED QUANTITYSUPPLIED
$4 135 26
5104 53
681 81
768 9
853 10
939 2
Graph the demand and supply curves. What is the
equilibrium price and quantity in this market? If the
actual price in this market were abovethe equilibrium
price, what would drive the market toward the
equilibrium? If the actual price in this market were below
the equilibrium price, what would drive the market
toward the equilibrium?
10. Because bagels and cream cheese are often eaten
together, they are complements.
a. We observe that both the equilibrium price
of cream cheese and the equilibrium quantity of
bagels have risen. What could be responsible for
this pattern—a fall in the price of flour or a fall in
the price of milk? Illustrate and explain your
answer.
b. Suppose instead that the equilibrium price of
cream cheese has risen but the equilibrium quantity
of bagels has fallen. What could be responsible for
this pattern—a rise in the price of flour or a rise
in the price of milk? Illustrate and explain your
answer.
11. Suppose that the price of basketball tickets at your
college is determined by market forces. Currently, the
demand and supply schedules are as follows:
PRICE QUANTITYDEMANDED QUANTITYSUPPLIED
$ 4 10,000 8,000
8 8,000 8,000
12 6,000 8,000
16 4,000 8,000
20 2,000 8,000
a. Draw the demand and supply curves. What is
unusual about this supply curve? Why might this
be true?
b. What are the equilibrium price and quantity of
tickets?
c. Your college plans to increase total enrollment next
year by 5,000 students. The additional students will
have the following demand schedule:
PRICE QUANTITYDEMANDED
$ 4 4,000
8 3,000
12 2,000
16 1,000
20 0
92 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
Now add the old demand schedule and the
demand schedule for the new students to calculate
the new demand schedule for the entire college.
What will be the new equilibrium price and
quantity?
12. An article in The New York Timesdescribed a successful
marketing campaign by the French champagne industry.
The article noted that “many executives felt giddy about
the stratospheric champagne prices. But they also feared
that such sharp price increases would cause demand to
decline, which would then cause prices to plunge.”
What mistake are the executives making in their
analysis of the situation? Illustrate your answer with
a graph.
IN THIS CHAPTER
YOU WILL . . .
Apply the concept of
elasticity in three
very different
markets
Learn the meaning
of the elasticity of
supply
Learn the meaning
of the elasticity of
demand
Examine what
determines the
elasticity of demand
Examine what
determines the
elasticity of supply
Imagine yourself as a Kansas wheat farmer. Because you earn all your income
from selling wheat, you devote much effort to making your land as productive as
it can be. You monitor weather and soil conditions, check your fields for pests and
disease, and study the latest advances in farm technology. You know that the more
wheat you grow, the more you will have to sell after the harvest, and the higher
will be your income and your standard of living.
One day Kansas State University announces a major discovery. Researchers in
its agronomy department have devised a new hybrid of wheat that raises the
amount farmers can produce from each acre of land by 20 percent. How should
you react to this news? Should you use the new hybrid? Does this discovery make
you better off or worse off than you were before? In this chapter we will see
thatthese questions can have surprising answers. The surprise will come from
ELASTICITY AND
ITS APPLICATION
93
94 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
applying the most basic tools of economics—supply and demand—to the market
for wheat.
The previous chapter introduced supply and demand. In any competitive
market, such as the market for wheat, the upward-sloping supply curve represents
the behavior of sellers, and the downward-sloping demand curve represents the
behavior of buyers. The price of the good adjusts to bring the quantity supplied
and quantity demanded of the good into balance. To apply this basic analysis to
understand the impact of the agronomists’ discovery, we must first develop one
more tool: the concept of elasticity. Elasticity, a measure of how much buyers and
sellers respond to changes in market conditions, allows us to analyze supply and
demand with greater precision.
THE ELASTICITY OF DEMAND
When we discussed the determinants of demand in Chapter 4, we noted that buy-
ers usually demand more of a good when its price is lower, when their incomes are
higher, when the prices of substitutes for the good are higher, or when the prices
of complements of the good are lower. Our discussion of demand was qualitative,
not quantitative. That is, we discussed the direction in which the quantity de-
manded moves, but not the size of the change. To measure how much demand re-
sponds to changes in its determinants, economists use the concept of elasticity.
THE PRICE ELASTICITY OF DEMAND
AND ITS DETERMINANTS
The law of demand states that a fall in the price of a good raises the quantity de-
manded. The price elasticity of demand measures how much the quantity de-
manded responds to a change in price. Demand for a good is said to be elasticif the
quantity demanded responds substantially to changes in the price. Demand is said
to be inelastic if the quantity demanded responds only slightly to changes in the
price.
What determines whether the demand for a good is elastic or inelastic? Be-
cause the demand for any good depends on consumer preferences, the price elas-
ticity of demand depends on the many economic, social, and psychological forces
that shape individual desires. Based on experience, however, we can state some
general rules about what determines the price elasticity of demand.
Necessities versus Luxuries Necessities tend to have inelastic de-
mands, whereas luxuries have elastic demands. When the price of a visit to the
doctor rises, people will not dramatically alter the number of times they go to the
doctor, although they might go somewhat less often. By contrast, when the price of
sailboats rises, the quantity of sailboats demanded falls substantially. The reason is
that most people view doctor visits as a necessity and sailboats as a luxury. Of
course, whether a good is a necessity or a luxury depends not on the intrinsic
properties of the good but on the preferences of the buyer. For an avid sailor with
elasticity
a measure of the responsiveness of
quantity demanded or quantity
supplied to one of its determinants
price elasticity of demand
a measure of how much the quantity
demanded of a good responds to a
change in the price of that good,
computed as the percentage change
in quantity demanded divided by the
percentage change in price
CHAPTER 5 ELASTICITY AND ITS APPLICATION 95
little concern over his health, sailboats might be a necessity with inelastic demand
and doctor visits a luxury with elastic demand.
Availability of Close Substitutes Goods with close substitutes tend
to have more elastic demand because it is easier for consumers to switch from that
good to others. For example, butter and margarine are easily substitutable. Asmall
increase in the price of butter, assuming the price of margarine is held fixed, causes
the quantity of butter sold to fall by a large amount. By contrast, because eggs are
a food without a close substitute, the demand for eggs is probably less elastic than
the demand for butter.
Definition of the Market The elasticity of demand in any market de-
pends on how we draw the boundaries of the market. Narrowly defined markets
tend to have more elastic demand than broadly defined markets, because it is
easier to find close substitutes for narrowly defined goods. For example, food, a
broad category, has a fairly inelastic demand because there are no good substitutes
for food. Ice cream, a more narrow category, has a more elastic demand because it
is easy to substitute other desserts for ice cream. Vanilla ice cream, a very narrow
category, has a very elastic demand because other flavors of ice cream are almost
perfect substitutes for vanilla.
Time Horizon Goods tend to have more elastic demand over longer time
horizons. When the price of gasoline rises, the quantity of gasoline demanded falls
only slightly in the first few months. Over time, however, people buy more fuel-
efficient cars, switch to public transportation, and move closer to where they work.
Within several years, the quantity of gasoline demanded falls substantially.
COMPUTING THE PRICE ELASTICITY OF DEMAND
Now that we have discussed the price elasticity of demand in general terms, let’s
be more precise about how it is measured. Economists compute the price elasticity
of demand as the percentage change in the quantity demanded divided by the per-
centage change in the price. That is,
Price elasticity of demand H11005 .
For example, suppose that a 10-percent increase in the price of an ice-cream cone
causes the amount of ice cream you buy to fall by 20 percent. We calculate your
elasticity of demand as
Price elasticity of demand H11005H110052.
In this example, the elasticity is 2, reflecting that the change in the quantity de-
manded is proportionately twice as large as the change in the price.
Because the quantity demanded of a good is negatively related to its price,
the percentage change in quantity will always have the opposite sign as the
20 percent
10 percent
Percentage change in quantity demanded
Percentage change in price
96 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
percentage change in price. In this example, the percentage change in price is a pos-
itive 10 percent (reflecting an increase), and the percentage change in quantity de-
manded is a negative 20 percent (reflecting a decrease). For this reason, price
elasticities of demand are sometimes reported as negative numbers. In this book
we follow the common practice of dropping the minus sign and reporting all price
elasticities as positive numbers. (Mathematicians call this the absolute value.) With
this convention, a larger price elasticity implies a greater responsiveness of quan-
tity demanded to price.
THE MIDPOINT METHOD: A BETTER WAY TO CALCULATE
PERCENTAGE CHANGES AND ELASTICITIES
If you try calculating the price elasticity of demand between two points on a de-
mand curve, you will quickly notice an annoying problem: The elasticity from
point Ato point B seems different from the elasticity from point B to point A. For
example, consider these numbers:
Point A: Price H11005$4 Quantity H11005120
PointB: Price H11005$6 Quantity H1100580
Going from point Ato point B, the price rises by 50 percent, and the quantity falls
by 33 percent, indicating that the price elasticity of demand is 33/50, or 0.66.
Bycontrast, going from point B to point A, the price falls by 33 percent, and the
quantity rises by 50 percent, indicating that the price elasticity of demand is 50/33,
or 1.5.
One way to avoid this problem is to use the midpoint method for calculating
elasticities. Rather than computing a percentage change using the standard way
(by dividing the change by the initial level), the midpoint method computes a
percentage change by dividing the change by the midpoint of the initial and final
levels. For instance, $5 is the midpoint of $4 and $6. Therefore, according to the
midpoint method, a change from $4 to $6 is considered a 40 percent rise, because
(6 H110024)/5 H11003100 H1100540. Similarly, a change from $6 to $4 is considered a 40 per-
centfall.
Because the midpoint method gives the same answer regardless of the direc-
tion of change, it is often used when calculating the price elasticity of demand be-
tween two points. In our example, the midpoint between point Aand point B is:
Midpoint: Price H11005$5 Quantity H11005100
According to the midpoint method, when going from point Ato point B, the price
rises by 40 percent, and the quantity falls by 40 percent. Similarly, when going
from point B to point A, the price falls by 40 percent, and the quantity rises by
40percent. In both directions, the price elasticity of demand equals 1.
We can express the midpoint method with the following formula for the price
elasticity of demand between two points, denoted (Q
1
, P
1
) and (Q
2
, P
2
):
Price elasticity of demand H11005 .
(Q
2
H11002 Q
1
)/[(Q
2
H11001 Q
1
)/2]
(P
2
H11002 P
1
)/[(P
2
H11001 P
1
)/2]
(a) Perfectly Inelastic Demand: Elasticity Equals 0
$5
4
Demand
Quantity1000
(b) Inelastic Demand: Elasticity Is Less Than 1
$5
4
Quantity1000 90
Demand
(c) Unit Elastic Demand: Elasticity Equals 1
$5
4
Demand
Quantity1000
Price
80
1. An
increase
in price . . .
2. . . . leaves the quantity demanded unchanged.
2. . . . leads to a 22% decrease in quantity demanded.
1. A 22%
increase
in price . . .
Price Price
2. . . . leads to an 11% decrease in quantity demanded.
1. A 22%
increase
in price . . .
(d) Elastic Demand: Elasticity Is Greater Than 1
$5
4
Demand
Quantity1000
Price
50
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
$4
Quantity0
Price
Demand
1. A 22%
increase
in price . . .
2. At exactly $4,
consumers will
buy any quantity.
1. At any price
above $4, quantity
demanded is zero.
2. . . . leads to a 67% decrease in quantity demanded.
3. At a price below $4,
quantity demanded is infinite.
Figure 5-1
THEPRICEELASTICITYOFDEMAND. The price elasticity of demand determines whether
the demand curve is steep or flat. Note that all percentage changes are calculated using
the midpoint method.
98 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
The numerator is the percentage change in quantity computed using the midpoint
method, and the denominator is the percentage change in price computed using
the midpoint method. If you ever need to calculate elasticities, you should use this
formula.
Throughout this book, however, we only rarely need to perform such calcula-
tions. For our purposes, what elasticity represents—the responsiveness of quantity
demanded to price—is more important than how it is calculated.
THE VARIETY OF DEMAND CURVES
Economists classify demand curves according to their elasticity. Demand is elastic
when the elasticity is greater than 1, so that quantity moves proportionately more
than the price. Demand is inelastic when the elasticity is less than 1, so that quan-
tity moves proportionately less than the price. If the elasticity is exactly 1, so that
quantity moves the same amount proportionately as price, demand is said to have
unit elasticity.
Because the price elasticity of demand measures how much quantity de-
manded responds to changes in the price, it is closely related to the slope of the de-
mand curve. The following rule of thumb is a useful guide: The flatter is the
demand curve that passes through a given point, the greater is the price elasticity
of demand. The steeper is the demand curve that passes through a given point, the
smaller is the price elasticity of demand.
Figure 5-1 shows five cases. In the extreme case of a zero elasticity, demand is
perfectly inelastic, and the demand curve is vertical. In this case, regardless of the
price, the quantity demanded stays the same. As the elasticity rises, the demand
curve gets flatter and flatter. At the opposite extreme, demand is perfectly elastic.
This occurs as the price elasticity of demand approaches infinity and the demand
curve becomes horizontal, reflecting the fact that very small changes in the price
lead to huge changes in the quantity demanded.
Finally, if you have trouble keeping straight the terms elastic and inelastic,
here’s a memory trick for you: Inelastic curves, such as in panel (a) of Figure 5-1,
look like the letter I. Elastic curves, as in panel (e), look like the letter E.This is not
a deep insight, but it might help on your next exam.
TOTAL REVENUE AND THE PRICE ELASTICITY OF DEMAND
When studying changes in supply or demand in a market, one variable we often
want to study is total revenue,the amount paid by buyers and received by sellers
of the good. In any market, total revenue is P H11003 Q, the price of the good times the
quantity of the good sold. We can show total revenue graphically, as in Figure 5-2.
The height of the box under the demand curve is P, and the width is Q. The area
ofthis box, P H11003 Q, equals the total revenue in this market. In Figure 5-2, where
P H11005$4 and Q H11005100, total revenue is $4 H11003100, or $400.
How does total revenue change as one moves along the demand curve? The
answer depends on the price elasticity of demand. If demand is inelastic, as in Fig-
ure 5-3, then an increase in the price causes an increase in total revenue. Here an
increase in price from $1 to $3 causes the quantity demanded to fall only from 100
total revenue
the amount paid by buyers and
received by sellers of a good,
computed as the price of the good
times the quantity sold
CHAPTER 5 ELASTICITY AND ITS APPLICATION 99
$4
Demand
Quantity
Q
P
0
Price
P H11003 Q H11005 $400
(revenue)
100
Figure 5-2
TOTALREVENUE. The total
amount paid by buyers, and
received as revenue by sellers,
equals the area of the box under
the demand curve, P H11003 Q.Here,
at a price of $4, the quantity
demanded is 100, and total
revenue is $400.
$1
Demand
Quantity0
Price
Revenue H11005 $100
100
$3
Quantity0
Price
80
Revenue H11005 $240
Demand
Figure 5-3
HOWTOTALREVENUECHANGESWHENPRICECHANGES: INELASTICDEMAND. With an
inelastic demand curve, an increase in the price leads to a decrease in quantity demanded
that is proportionately smaller. Therefore, total revenue (the product of price and quantity)
increases. Here, an increase in the price from $1 to $3 causes the quantity demanded to fall
from 100 to 80, and total revenue rises from $100 to $240.
100 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
to 80, and so total revenue rises from $100 to $240. An increase in price raises
P H11003 Qbecause the fall in Qis proportionately smaller than the rise in P.
We obtain the opposite result if demand is elastic: An increase in the price
causes a decrease in total revenue. In Figure 5-4, for instance, when the price rises
from $4 to $5, the quantity demanded falls from 50 to 20, and so total revenue falls
from $200 to $100. Because demand is elastic, the reduction in the quantity de-
manded is so great that it more than offsets the increase in the price. That is, an in-
crease in price reduces P H11003 Q because the fall in Q is proportionately greater than
the rise in P.
Although the examples in these two figures are extreme, they illustrate a gen-
eral rule:
a78 When a demand curve is inelastic (a price elasticity less than 1), a price
increase raises total revenue, and a price decrease reduces total revenue.
a78 When a demand curve is elastic (a price elasticity greater than 1), a price
increase reduces total revenue, and a price decrease raises total revenue.
a78 In the special case of unit elastic demand (a price elasticity exactly equal
to1), a change in the price does not affect total revenue.
Demand
Quantity0
Price
Revenue H11005 $200
$4
50
Demand
Quantity0
Price
Revenue H11005 $100
$5
20
Figure 5-4
HOWTOTALREVENUECHANGESWHENPRICECHANGES: ELASTICDEMAND. With an
elastic demand curve, an increase in the price leads to a decrease in quantity demanded
that is proportionately larger. Therefore, total revenue (the product of price and quantity)
decreases. Here, an increase in the price from $4 to $5 causes the quantity demanded to
fall from 50 to 20, so total revenue falls from $200 to$100.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 101
ELASTICITY AND TOTAL REVENUE ALONG
A LINEAR DEMAND CURVE
Although some demand curves have an elasticity that is the same along the entire
curve, that is not always the case. An example of a demand curve along which
elasticity changes is a straight line, as shown in Figure 5-5. Alinear demand curve
has a constant slope. Recall that slope is defined as “rise over run,” which here is
the ratio of the change in price (“rise”) to the change in quantity (“run”). This par-
ticular demand curve’s slope is constant because each $1 increase in price causes
the same 2-unit decrease in the quantity demanded.
5
6
$7
4
1
2
3
Quantity
12246810 140
Price
Elasticity is
larger
than 1.
Elasticity is
smaller
than 1.
Figure 5-5
ALINEARDEMANDCURVE.
The slope of a linear demand
curve is constant, but its elasticity
is not.
Table 5-1
TOTAL
REVENUE PERCENT PERCENT
(PRICE H11547 CHANGE IN CHANGE IN
PRICE QUANTITY QUANTITY)PRICE QUANTITY ELASTICITY DESCRIPTION
$7 0 $ 0
15 200 13.0 Elastic
62 12
18 67 3.7 Elastic
54 0
22 40 1.8 Elastic
46 24
29 29 1.0 Unit elastic
38
40 22 0.6 Inelastic
210 20
67 18 0.3 Inelastic
112 1
200 15 0.1 Inelastic
014 0
COMPUTING THEELASTICITYOFALINEARDEMANDCURVE
NOTE: Elasticity is calculated here using the midpoint method.
102 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
CASE STUDY PRICING ADMISSION TO A MUSEUM
You are curator of a major art museum. Your director of finance tells you that
the museum is running short of funds and suggests that you consider chang-
ingthe price of admission to increase total revenue. What do you do? Do you
raise the price of admission, or do you lower it?
The answer depends on the elasticity of demand. If the demand for visits to
the museum is inelastic, then an increase in the price of admission would in-
crease total revenue. But if the demand is elastic, then an increase in price
would cause the number of visitors to fall by so much that total revenue would
decrease. In this case, you should cut the price. The number of visitors would
rise by so much that total revenue would increase.
To estimate the price elasticity of demand, you would need to turn to your
statisticians. They might use historical data to study how museum attendance
varied from year to year as the admission price changed. Or they might use
data on attendance at the various museums around the country to see how the
admission price affects attendance. In studying either of these sets of data, the
statisticians would need to take account of other factors that affect attendance—
weather, population, size of collection, and so forth—to isolate the effect of
price. In the end, such data analysis would provide an estimate of the price elas-
ticity of demand, which you could use in deciding how to respond to your fi-
nancial problem.
OTHER DEMAND ELASTICITIES
In addition to the price elasticity of demand, economists also use other elastici-
ties to describe the behavior of buyers in a market.
The Income Elasticity of Demand Economists use the income
elasticity of demandto measure how the quantity demanded changes as con-
sumer income changes. The income elasticity is the percentage change in quan-
tity demanded divided by the percentage change in income. That is,
Even though the slope of a linear demand curve is constant, the elasticity is
not. The reason is that the slope is the ratio of changesin the two variables, whereas
the elasticity is the ratio of percentage changesin the two variables. You can see this
most easily by looking at Table 5-1. This table shows the demand schedule for the
linear demand curve in Figure 5-5 and calculates the price elasticity of demand
using the midpoint method discussed earlier. At points with a low price and high
quantity, the demand curve is inelastic. At points with a high price and low quan-
tity, the demand curve is elastic.
Table 5-1 also presents total revenue at each point on the demand curve. These
numbers illustrate the relationship between total revenue and elasticity. When the
price is $1, for instance, demand is inelastic, and a price increase to $2 raises total
revenue. When the price is $5, demand is elastic, and a price increase to $6 reduces
total revenue. Between $3 and $4, demand is exactly unit elastic, and total revenue
is the same at these two prices.
IFTHEPRICEOFADMISSIONWEREHIGHER,
HOWMUCHSHORTERWOULDTHISLINE
BECOME?
income elasticity of
demand
a measure of how much the quantity
demanded of a good responds to a
change in consumers’ income,
computed as the percentage change
in quantity demanded divided by the
percentage change in income
CHAPTER 5 ELASTICITY AND ITS APPLICATION 103
Income elasticity of demand H11005 .
As we discussed in Chapter 4, most goods are normal goods: Higher income raises
quantity demanded. Because quantity demanded and income move in the same
direction, normal goods have positive income elasticities. Afew goods, such as bus
Percentage change in quantity demanded
Percentage change in income
HOW SHOULD A FIRM THAT OPERATES A
private toll road set a price for its ser-
vice? As the following article makes
clear, answering this question requires
an understanding of the demand curve
and its elasticity.
For Whom the Booth Tolls,
Price Really Does Matter
BY STEVEN PEARLSTEIN
All businesses face a similar question:
What price for their product will generate
the maximum profit?
The answer is not always obvious:
Raising the price of something often has
the effect of reducing sales as price-
sensitive consumers seek alternatives or
simply do without. For every product, the
extent of that sensitivity is different. The
trick is to find the point for each where
the ideal tradeoff between profit margin
and sales volume is achieved.
Right now, the developers of a new
private toll road between Leesburg and
Washington-Dulles International Airport
are trying to discern the magic point. The
group originally projected that it could
charge nearly $2 for the 14-mile one-way
trip, while attracting 34,000 trips on an
average day from overcrowded public
roads such as nearby Route 7. But after
spending $350 million to build their much
heralded “Greenway,” they discovered
to their dismay that only about a third
that number of commuters were willing
to pay that much to shave 20 minutes off
their daily commute. . . .
It was only when the company, in
desperation, lowered the toll to $1 that it
came even close to attracting the ex-
pected traffic flows.
Although the Greenway still is los-
ing money, it is clearly better off at this
new point on the demand curve than it
was when it first opened. Average daily
revenue today is $22,000, compared
with $14,875 when the “special intro-
ductory” price was $1.75. And with traf-
fic still light even at rush hour, it is
possible that the owners may lower tolls
even further in search of higher revenue.
After all, when the price was low-
ered by 45 percent last spring, it gener-
ated a 200 percent increase in volume
three months later. If the same ratio ap-
plies again, lowering the toll another
25 percent would drive the daily volume
up to 38,000 trips, and daily revenue up
to nearly $29,000.
The problem, of course, is that the
same ratio usually does not apply at
every price point, which is why this pric-
ing business is so tricky. . . .
Clifford Winston of the Brookings
Institution and John Calfee of the Ameri-
can Enterprise Institute have considered
the toll road’s dilemma. . . .
Last year, the economists con-
ducted an elaborate market test with
1,170 people across the country who
were each presented with a series of op-
tions in which they were, in effect, asked
to make a personal tradeoff between
less commuting time and higher tolls.
In the end, they concluded that the
people who placed the highest value on
reducing their commuting time already
had done so by finding public transporta-
tion, living closer to their work, or select-
ing jobs that allowed them to commute
at off-peak hours.
Conversely, those who commuted
significant distances had a higher toler-
ance for traffic congestion and were will-
ing to pay only 20 percent of their hourly
pay to save an hour of their time.
Overall, the Winston/Calfee find-
ings help explain why the Greenway’s
original toll and volume projections were
too high: By their reckoning, only com-
muters who earned at least $30 an hour
(about $60,000 a year) would be willing
to pay $2 to save 20 minutes.
SOURCE:The Washington Post,October 24, 1996,
p.E1.
IN THE NEWS
On the Road
with Elasticity
104 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
rides, are inferior goods: Higher income lowers the quantity demanded. Because
quantity demanded and income move in opposite directions, inferior goods have
negative income elasticities.
Even among normal goods, income elasticities vary substantially in size. Ne-
cessities, such as food and clothing, tend to have small income elasticities because
consumers, regardless of how low their incomes, choose to buy some of these
goods. Luxuries, such as caviar and furs, tend to have large income elasticities be-
cause consumers feel that they can do without these goods altogether if their in-
come is too low.
The Cross-Price Elasticity of Demand Economists use the cross-
price elasticity of demand to measure how the quantity demanded of one good
changes as the price of another good changes. It is calculated as the percentage
change in quantity demanded of good 1 divided by the percentage change in the
price of good 2. That is,
Cross-price elasticity of demand H11005 .
Whether the cross-price elasticity is a positive or negative number depends on
whether the two goods are substitutes or complements. As we discussed in Chap-
ter 4, substitutes are goods that are typically used in place of one another, such as
hamburgers and hot dogs. An increase in hot dog prices induces people to grill
hamburgers instead. Because the price of hot dogs and the quantity of hamburgers
demanded move in the same direction, the cross-price elasticity is positive. Con-
versely, complements are goods that are typically used together, such as comput-
ers and software. In this case, the cross-price elasticity is negative, indicating that
an increase in the price of computers reduces the quantity of software demanded.
QUICK QUIZ: Define the price elasticity of demand. a78 Explain the
relationship between total revenue and the price elasticity of demand.
THE ELASTICITY OF SUPPLY
When we discussed the determinants of supply in Chapter 4, we noted that sellers
of a good increase the quantity supplied when the price of the good rises, when
their input prices fall, or when their technology improves. To turn from qualita-
tiveto quantitative statements about supply, we once again use the concept of
elasticity.
THE PRICE ELASTICITY OF SUPPLY
AND ITS DETERMINANTS
The law of supply states that higher prices raise the quantity supplied. The price
elasticity of supply measures how much the quantity supplied responds to
changes in the price. Supply of a good is said to be elastic if the quantity supplied
Percentage change in quantity
demanded of good 1
Percentage change in
the price of good 2
cross-price elasticity of
demand
a measure of how much the quantity
demanded of one good responds to a
change in the price of another good,
computed as the percentage change
in quantity demanded of the first
good divided by the percentage
change in the price of the second
good
price elasticity of supply
a measure of how much the quantity
supplied of a good responds to a
change in the price of that good,
computed as the percentage change
in quantity supplied divided by the
percentage change in price
CHAPTER 5 ELASTICITY AND ITS APPLICATION 105
responds substantially to changes in the price. Supply is said to be inelastic if the
quantity supplied responds only slightly to changes in the price.
The price elasticity of supply depends on the flexibility of sellers to change the
amount of the good they produce. For example, beachfront land has an inelastic
supply because it is almost impossible to produce more of it. By contrast, manu-
factured goods, such as books, cars, and televisions, have elastic supplies because
the firms that produce them can run their factories longer in response to a higher
price.
In most markets, a key determinant of the price elasticity of supply is the time
period being considered. Supply is usually more elastic in the long run than in the
short run. Over short periods of time, firms cannot easily change the size of their
factories to make more or less of a good. Thus, in the short run, the quantity sup-
plied is not very responsive to the price. By contrast, over longer periods, firms can
build new factories or close old ones. In addition, new firms can enter a market,
and old firms can shut down. Thus, in the long run, the quantity supplied can re-
spond substantially to the price.
COMPUTING THE PRICE ELASTICITY OF SUPPLY
Now that we have some idea about what the price elasticity of supply is, let’s be
more precise. Economists compute the price elasticity of supply as the percentage
change in the quantity supplied divided by the percentage change in the price.
That is,
Price elasticity of supply H11005 .
For example, suppose that an increase in the price of milk from $2.85 to $3.15 a gal-
lon raises the amount that dairy farmers produce from 9,000 to 11,000 gallons per
month. Using the midpoint method, we calculate the percentage change in price as
Percentage change in price H11005(3.15 H110022.85)/3.00 H11003100 H1100510 percent.
Similarly, we calculate the percentage change in quantity supplied as
Percentage change in quantity supplied H11005(11,000 H110029,000)/10,000 H11003100
H1100520 percent.
In this case, the price elasticity of supply is
Price elasticity of supply H11005H110052.0.
In this example, the elasticity of 2 reflects the fact that the quantity supplied moves
proportionately twice as much as the price.
THE VARIETY OF SUPPLY CURVES
Because the price elasticity of supply measures the responsiveness of quantity sup-
plied to the price, it is reflected in the appearance of the supply curve. Figure 5-6
shows five cases. In the extreme case of a zero elasticity, supply is perfectly inelastic,
20 percent
10 percent
Percentage change in quantity supplied
Percentage change in price
100 110
100 125
(a) Perfectly Inelastic Supply: Elasticity Equals 0
$5
4
Supply
Quantity1000
(b) Inelastic Supply: Elasticity Is Less Than 1
$5
4
Quantity0
(c) Unit Elastic Supply: Elasticity Equals 1
$5
4
Quantity0
Price
1. An
increase
in price . . .
2. . . . leaves the quantity supplied unchanged.
2. . . . leads to a 22% increase in quantity supplied.
1. A 22%
increase
in price . . .
Price Price
2. . . . leads to a 10% increase in quantity supplied.
1. A 22%
increase
in price . . .
(d) Elastic Supply: Elasticity Is Greater Than 1
$5
4
Quantity0
Price
(e) Perfectly Elastic Supply: Elasticity Equals Infinity
$4
Quantity0
Price
Supply
1. A 22%
increase
in price . . .
2. At exactly $4,
producers will
supply any quantity.
1. At any price
above $4, quantity
supplied is infinite.
2. . . . leads to a 67% increase in quantity supplied.
3. At a price below $4,
quantity supplied is zero.
Supply
Supply
100 200
Supply
Figure 5-6
THEPRICEELASTICITYOFSUPPLY. The price elasticity of supply determines whether the
supply curve is steep or flat. Note that all percentage changes are calculated using the
midpoint method.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 107
and the supply curve is vertical. In this case, the quantity supplied is the same re-
gardless of the price. As the elasticity rises, the supply curve gets flatter, which
shows that the quantity supplied responds more to changes in the price. At the op-
posite extreme, supply is perfectly elastic. This occurs as the price elasticity of sup-
ply approaches infinity and the supply curve becomes horizontal, meaning that
very small changes in the price lead to very large changes in the quantity supplied.
In some markets, the elasticity of supply is not constant but varies over the
supply curve. Figure 5-7 shows a typical case for an industry in which firms have
factories with a limited capacity for production. For low levels of quantity sup-
plied, the elasticity of supply is high, indicating that firms respond substantially to
changes in the price. In this region, firms have capacity for production that is not
being used, such as plants and equipment sitting idle for all or part of the day.
Small increases in price make it profitable for firms to begin using this idle capac-
ity. As the quantity supplied rises, firms begin to reach capacity. Once capacity is
fully used, increasing production further requires the construction of new plants.
To induce firms to incur this extra expense, the price must rise substantially, so
supply becomes less elastic.
Figure 5-7 presents a numerical example of this phenomenon. When the price
rises from $3 to $4 (a 29 percent increase, according to the midpoint method), the
quantity supplied rises from 100 to 200 (a 67 percent increase). Because quantity
supplied moves proportionately more than the price, the supply curve has elastic-
ity greater than 1. By contrast, when the price rises from $12 to $15 (a 22 percent in-
crease), the quantity supplied rises from 500 to 525 (a 5 percent increase). In this
case, quantity supplied moves proportionately less than the price, so the elasticity
is less than 1.
QUICK QUIZ: Define the price elasticity of supply. a78 Explain why the
the price elasticity of supply might be different in the long run than in the
short run.
$15
12
3
Quantity100 200 5000
Price
525
Elasticity is small
(less than 1).
Elasticity is large
(greater than 1).
4
Figure 5-7
HOW THEPRICEELASTICITYOF
SUPPLYCANVARY. Because
firms often have a maximum
capacity for production, the
elasticity of supply may be very
high at low levels of quantity
supplied and very low at high
levels of quantity supplied. Here,
an increase in price from $3 to $4
increases the quantity supplied
from 100 to 200. Because the
increase in quantity supplied of
67 percent is larger than the
increase in price of 29 percent, the
supply curve is elastic in this
range. By contrast, when the
price rises from $12 to $15, the
quantity supplied rises only from
500 to 525. Because the increase in
quantity supplied of 5 percent is
smaller than the increase in price
of 22 percent, the supply curve is
inelastic in this range.
108 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
THREE APPLICATIONS OF SUPPLY,
DEMAND, AND ELASTICITY
Can good news for farming be bad news for farmers? Why did the Organization of
Petroleum Exporting Countries (OPEC) fail to keep the price of oil high? Does
drug interdiction increase or decrease drug-related crime? At first, these questions
might seem to have little in common. Yet all three questions are about markets,
and all markets are subject to the forces of supply and demand. Here we apply the
versatile tools of supply, demand, and elasticity to answer these seemingly com-
plex questions.
CAN GOOD NEWS FOR FARMING BE
BAD NEWS FOR FARMERS?
Let’s now return to the question posed at the beginning of this chapter: What hap-
pens to wheat farmers and the market for wheat when university agronomists dis-
cover a new wheat hybrid that is more productive than existing varieties? Recall
from Chapter 4 that we answer such questions in three steps. First, we examine
whether the supply curve or demand curve shifts. Second, we consider which di-
rection the curve shifts. Third, we use the supply-and-demand diagram to see how
the market equilibrium changes.
In this case, the discovery of the new hybrid affects the supply curve. Because
the hybrid increases the amount of wheat that can be produced on each acre of
land, farmers are now willing to supply more wheat at any given price. In other
words, the supply curve shifts to the right. The demand curve remains the same
because consumers’ desire to buy wheat products at any given price is not affected
by the introduction of a new hybrid. Figure 5-8 shows an example of such a
change. When the supply curve shifts from S
1
to S
2
, the quantity of wheat sold in-
creases from 100 to 110, and the price of wheat falls from $3 to $2.
But does this discovery make farmers better off? As a first cut to answering
this question, consider what happens to the total revenue received by farmers.
Farmers’ total revenue is P H11003 Q,the price of the wheat times the quantity sold. The
discovery affects farmers in two conflicting ways. The hybrid allows farmers to
produce more wheat (Qrises), but now each bushel of wheat sells for less (Pfalls).
Whether total revenue rises or falls depends on the elasticity of demand. In
practice, the demand for basic foodstuffs such as wheat is usually inelastic, for
these items are relatively inexpensive and have few good substitutes. When the
demand curve is inelastic, as it is in Figure 5-8, a decrease in price causes total rev-
enue to fall. You can see this in the figure: The price of wheat falls substantially,
whereas the quantity of wheat sold rises only slightly. Total revenue falls from
$300 to $220. Thus, the discovery of the new hybrid lowers the total revenue that
farmers receive for the sale of their crops.
If farmers are made worse off by the discovery of this new hybrid, why do
they adopt it? The answer to this question goes to the heart of how competitive
markets work. Because each farmer is a small part of the market for wheat, he or
she takes the price of wheat as given. For any given price of wheat, it is better to
CHAPTER 5 ELASTICITY AND ITS APPLICATION 109
use the new hybrid in order to produce and sell more wheat. Yet when all farmers
do this, the supply of wheat rises, the price falls, and farmers are worse off.
Although this example may at first seem only hypothetical, in fact it helps to
explain a major change in the U.S. economy over the past century. Two hundred
years ago, most Americans lived on farms. Knowledge about farm methods was
sufficiently primitive that most of us had to be farmers to produce enough food.
Yet, over time, advances in farm technology increased the amount of food that
each farmer could produce. This increase in food supply, together with inelastic
food demand, caused farm revenues to fall, which in turn encouraged people to
leave farming.
Afew numbers show the magnitude of this historic change. As recently as
1950, there were 10 million people working on farms in the United States, repre-
senting 17 percent of the labor force. In 1998, fewer than 3 million people worked
on farms, or 2 percent of the labor force. This change coincided with tremendous
advances in farm productivity: Despite the 70 percent drop in the number of farm-
ers, U.S. farms produced more than twice the output of crops and livestock in 1998
as they did in 1950.
This analysis of the market for farm products also helps to explain a seeming
paradox of public policy: Certain farm programs try to help farmers by inducing
them not to plant crops on all of their land. Why do these programs do this? Their
purpose is to reduce the supply of farm products and thereby raise prices. With in-
elastic demand for their products, farmers as a group receive greater total revenue
if they supply a smaller crop to the market. No single farmer would choose to
leave his land fallow on his own because each takes the market price as given. But
if all farmers do so together, each of them can be better off.
$3
2
Quantity of Wheat1000
Price of
Wheat
1. When demand is inelastic,
an increase in supply . . .
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
110
Demand
S
1
S
2
2. . . . leads
to a large
fall in
price . . .
Figure 5-8
AN INCREASE INSUPPLYIN THE
MARKET FORWHEAT. When an
advance in farm technology
increases the supply of wheat
from S
1
to S
2
, the price of wheat
falls. Because the demand for
wheat is inelastic, the increase in
the quantity sold from 100 to 110
is proportionately smaller than
the decrease in the price from
$3to $2. As a result, farmers’
totalrevenue falls from $300
($3H11003100) to $220 ($2 H11003110).
110 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
When analyzing the effects of farm technology or farm policy, it is important
to keep in mind that what is good for farmers is not necessarily good for society as
a whole. Improvement in farm technology can be bad for farmers who become in-
creasingly unnecessary, but it is surely good for consumers who pay less for food.
Similarly, a policy aimed at reducing the supply of farm products may raise the in-
comes of farmers, but it does so at the expense of consumers.
WHY DID OPEC FAIL TO KEEP THE PRICE OF OIL HIGH?
Many of the most disruptive events for the world’s economies over the past sev-
eral decades have originated in the world market for oil. In the 1970s members of
the Organization of Petroleum Exporting Countries (OPEC) decided to raise the
world price of oil in order to increase their incomes. These countries accomplished
this goal by jointly reducing the amount of oil they supplied. From 1973 to 1974,
the price of oil (adjusted for overall inflation) rose more than 50 percent. Then, a
few years later, OPEC did the same thing again. The price of oil rose 14 percent in
1979, followed by 34 percent in 1980, and another 34 percent in 1981.
Yet OPEC found it difficult to maintain a high price. From 1982 to 1985, the
price of oil steadily declined at about 10 percent per year. Dissatisfaction and dis-
array soon prevailed among the OPEC countries. In 1986 cooperation among
OPEC members completely broke down, and the price of oil plunged 45 percent.
In 1990 the price of oil (adjusted for overall inflation) was back to where it began
in 1970, and it has stayed at that low level throughout most of the 1990s.
This episode shows how supply and demand can behave differently in the
short run and in the long run. In the short run, both the supply and demand for oil
are relatively inelastic. Supply is inelastic because the quantity of known oil re-
serves and the capacity for oil extraction cannot be changed quickly. Demand is in-
elastic because buying habits do not respond immediately to changes in price.
Many drivers with old gas-guzzling cars, for instance, will just pay the higher
CHAPTER 5 ELASTICITY AND ITS APPLICATION 111
price. Thus, as panel (a) of Figure 5-9 shows, the short-run supply and demand
curves are steep. When the supply of oil shifts from S
1
to S
2
, the price increase from
P
1
to P
2
is large.
The situation is very different in the long run. Over long periods of time, pro-
ducers of oil outside of OPEC respond to high prices by increasing oil exploration
and by building new extraction capacity. Consumers respond with greater conser-
vation, for instance by replacing old inefficient cars with newer efficient ones.
Thus, as panel (b) of Figure 5-9 shows, the long-run supply and demand curves are
more elastic. In the long run, the shift in the supply curve from S
1
to S
2
causes a
much smaller increase in the price.
This analysis shows why OPEC succeeded in maintaining a high price of oil
only in the short run. When OPEC countries agreed to reduce their production of
oil, they shifted the supply curve to the left. Even though each OPEC member sold
less oil, the price rose by so much in the short run that OPEC incomes rose. By con-
trast, in the long run when supply and demand are more elastic, the same reduc-
tion in supply, measured by the horizontal shift in the supply curve, caused a
smaller increase in the price. Thus, OPEC’s coordinated reduction in supply
proved less profitable in the long run.
OPEC still exists today, and it has from time to time succeeded at reducing
supply and raising prices. But the price of oil (adjusted for overall inflation) has
P
2
P
1
Quantity of Oil0
Price of Oil
Demand
S
2
S
1
(a) The Oil Market in the Short Run
P
2
P
1
Quantity of Oil0
Price of Oil
Demand
S
2
S
1
(b) The Oil Market in the Long Run
2. . . . leads
to a large
increase
in price.
1. In the long run,
when supply and
demand are elastic,
a shift in supply . . .
2. . . . leads
to a small
increase
in price.
1. In the short run, when supply
and demand are inelastic,
a shift in supply . . .
Figure 5-9
AREDUCTION INSUPPLYIN THEWORLDMARKET FOROIL. When the supply of oil falls,
the response depends on the time horizon. In the short run, supply and demand are
relatively inelastic, as in panel (a). Thus, when the supply curve shifts from S
1
to S
2
, the
price rises substantially. By contrast, in the long run, supply and demand are relatively
elastic, as in panel (b). In this case, the same size shift in the supply curve (S
1
to S
2
) causes
a smaller increase in the price.
112 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
never returned to the peak reached in 1981. The cartel now seems to understand
that raising prices is easier in the short run than in the long run.
DOES DRUG INTERDICTION INCREASE
OR DECREASE DRUG-RELATED CRIME?
Apersistent problem facing our society is the use of illegal drugs, such as heroin,
cocaine, and crack. Drug use has several adverse effects. One is that drug depen-
dency can ruin the lives of drug users and their families. Another is that drug
addicts often turn to robbery and other violent crimes to obtain the money needed
to support their habit. To discourage the use of illegal drugs, the U.S. govern-
mentdevotes billions of dollars each year to reduce the flow of drugs into the
country. Let’s use the tools of supply and demand to examine this policy of drug
interdiction.
Suppose the government increases the number of federal agents devoted to
the war on drugs. What happens in the market for illegal drugs? As is usual, we
answer this question in three steps. First, we consider whether the supply curve or
demand curve shifts. Second, we consider the direction of the shift. Third, we see
how the shift affects the equilibrium price and quantity.
Although the purpose of drug interdiction is to reduce drug use, its direct im-
pact is on the sellers of drugs rather than the buyers. When the government stops
some drugs from entering the country and arrests more smugglers, it raises the
cost of selling drugs and, therefore, reduces the quantity of drugs supplied at any
given price. The demand for drugs—the amount buyers want at any given price—
is not changed. As panel (a) of Figure 5-10 shows, interdiction shifts the supply
curve to the left from S
1
to S
2
and leaves the demand curve the same. The equilib-
rium price of drugs rises from P
1
to P
2
, and the equilibrium quantity falls from Q
1
to Q
2
. The fall in the equilibrium quantity shows that drug interdiction does re-
duce drug use.
But what about the amount of drug-related crime? To answer this question,
consider the total amount that drug users pay for the drugs they buy. Because few
drug addicts are likely to break their destructive habits in response to a higher
price, it is likely that the demand for drugs is inelastic, as it is drawn in the figure.
If demand is inelastic, then an increase in price raises total revenue in the drug
market. That is, because drug interdiction raises the price of drugs proportionately
more than it reduces drug use, it raises the total amount of money that drug users
pay for drugs. Addicts who already had to steal to support their habits would
have an even greater need for quick cash. Thus, drug interdiction could increase
drug-related crime.
Because of this adverse effect of drug interdiction, some analysts argue for al-
ternative approaches to the drug problem. Rather than trying to reduce the supply
of drugs, policymakers might try to reduce the demand by pursuing a policy of
drug education. Successful drug education has the effects shown in panel (b) of
Figure 5-10. The demand curve shifts to the left from D
1
to D
2
. As a result, the equi-
librium quantity falls from Q
1
to Q
2
, and the equilibrium price falls from P
1
to P
2
.
Total revenue, which is price times quantity, also falls. Thus, in contrast to drug in-
terdiction, drug education can reduce both drug use and drug-related crime.
Advocates of drug interdiction might argue that the effects of this policy are
different in the long run than in the short run, because the elasticity of demand
may depend on the time horizon. The demand for drugs is probably inelastic over
CHAPTER 5 ELASTICITY AND ITS APPLICATION 113
short periods of time because higher prices do not substantially affect drug use by
established addicts. But demand may be more elastic over longer periods of time
because higher prices would discourage experimentation with drugs among the
young and, over time, lead to fewer drug addicts. In this case, drug interdic-
tionwould increase drug-related crime in the short run while decreasing it in the
long run.
QUICK QUIZ: How might a drought that destroys half of all farm crops be
good for farmers? If such a drought is good for farmers, why don’t farmers
destroy their own crops in the absence of a drought?
CONCLUSION
According to an old quip, even a parrot can become an economist simply by learn-
ing to say “supply and demand.” These last two chapters should have convinced
you that there is much truth in this statement. The tools of supply and demand
allow you to analyze many of the most important events and policies that shape
P
2
P
1
Quantity of Drugs0 Q
2
Q
1
Price of
Drugs
Demand
S
2
S
1
Q
2
Q
1
(a) Drug Interdiction
Quantity of Drugs0
Price of
Drugs
Supply
D
2
D
1
(b) Drug Education
3. . . . and reduces
the quantity sold.
2. . . . which
raises the
price . . .
2. . . . which
reduces the
price . . .
P
1
P
2
1. Drug interdiction reduces
the supply of drugs . . .
1. Drug education reduces
the demand for drugs . . .
3. . . . and reduces
the quantity sold.
Figure 5-10
POLICIES TOREDUCE THEUSE OFILLEGALDRUGS. Drug interdiction reduces the supply
of drugs from S
1
to S
2
, as in panel (a). If the demand for drugs is inelastic, then the total
amount paid by drug users rises, even as the amount of drug use falls. By contrast, drug
education reduces the demand for drugs from D
1
to D
2
, as in panel (b). Because both price
and quantity fall, the amount paid by drug users falls.
114 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
the economy. You are now well on your way to becoming an economist (or, at least,
a well-educated parrot).
a78 The price elasticity of demand measures how much the
quantity demanded responds to changes in the price.
Demand tends to be more elastic if the good is a luxury
rather than a necessity, if close substitutes are available,
if the market is narrowly defined, or if buyers have
substantial time to react to a price change.
a78 The price elasticity of demand is calculated as the
percentage change in quantity demanded divided by
the percentage change in price. If the elasticity is less
than 1, so that quantity demanded moves
proportionately less than the price, demand is said to be
inelastic. If the elasticity is greater than 1, so that
quantity demanded moves proportionately more than
the price, demand is said to be elastic.
a78 Total revenue, the total amount paid for a good, equals
the price of the good times the quantity sold. For
inelastic demand curves, total revenue rises as price
rises. For elastic demand curves, total revenue falls as
price rises.
a78 The income elasticity of demand measures how much
the quantity demanded responds to changes in
consumers’ income. The cross-price elasticity of demand
measures how much the quantity demanded of one
good responds to the price of another good.
a78 The price elasticity of supply measures how much the
quantity supplied responds to changes in the price. This
elasticity often depends on the time horizon under
consideration. In most markets, supply is more elastic in
the long run than in the short run.
a78 The price elasticity of supply is calculated as the
percentage change in quantity supplied divided by the
percentage change in price. If the elasticity is less than 1,
so that quantity supplied moves proportionately less
than the price, supply is said to be inelastic. If the
elasticity is greater than 1, so that quantity supplied
moves proportionately more than the price, supply is
said to be elastic.
a78 The tools of supply and demand can be applied in many
different kinds of markets. This chapter uses them to
analyze the market for wheat, the market for oil, and the
market for illegal drugs.
Summary
elasticity, p. 94
price elasticity of demand, p. 94
total revenue, p. 98
income elasticity of demand, p. 102
cross-price elasticity of demand, p. 104
price elasticity of supply, p. 104
Key Concepts
1. Define the price elasticity of demand and the income
elasticity of demand.
2. List and explain some of the determinants of the price
elasticity of demand.
3. If the elasticity is greater than 1, is demand elastic or
inelastic? If the elasticity equals 0, is demand perfectly
elastic or perfectly inelastic?
4. On a supply-and-demand diagram, show equilibrium
price, equilibrium quantity, and the total revenue
received by producers.
5. If demand is elastic, how will an increase in price
change total revenue? Explain.
6. What do we call a good whose income elasticity is less
than 0?
7. How is the price elasticity of supply calculated? Explain
what this measures.
8. What is the price elasticity of supply of Picasso
paintings?
9. Is the price elasticity of supply usually larger in the
short run or in the long run? Why?
10. In the 1970s, OPEC caused a dramatic increase in the
price of oil. What prevented it from maintaining this
high price through the 1980s?
Questions for Review
CHAPTER 5 ELASTICITY AND ITS APPLICATION 115
1. For each of the following pairs of goods, which good
would you expect to have more elastic demand
andwhy?
a. required textbooks or mystery novels
b. Beethoven recordings or classical music recordings
in general
c. heating oil during the next six months or heating oil
during the next five years
d. root beer or water
2. Suppose that business travelers and vacationers have
the following demand for airline tickets from New York
to Boston:
QUANTITY DEMANDED QUANTITY DEMANDED
PRICE (BUSINESS TRAVELERS)(VACATIONERS)
$150 2,100 1,000
200 2,000 800
250 1,900 600
300 1,800 400
a. As the price of tickets rises from $200 to $250, what
is the price elasticity of demand for (i) business
travelers and (ii) vacationers? (Use the midpoint
method in your calculations.)
b. Why might vacationers have a different elasticity
than business travelers?
3. Suppose that your demand schedule for compact discs
is as follows:
QUANTITY DEMANDED QUANTITY DEMANDED
PRICE (INCOME H11549$10,000) (INCOME H11549$12,000)
$ 8 40 50
10 32 45
12 24 30
14 16 20
16 8 12
a. Use the midpoint method to calculate your price
elasticity of demand as the price of compact discs
increases from $8 to $10 if (i) your income is
$10,000, and (ii) your income is $12,000.
b. Calculate your income elasticity of demand as your
income increases from $10,000 to $12,000 if (i) the
price is $12, and (ii) the price is $16.
4. Emily has decided always to spend one-third of her
income on clothing.
a. What is her income elasticity of clothing demand?
b. What is her price elasticity of clothing demand?
c. If Emily’s tastes change and she decides to spend
only one-fourth of her income on clothing, how
does her demand curve change? What are her
income elasticity and price elasticity now?
5. The New York Timesreported (Feb. 17, 1996, p. 25) that
subway ridership declined after a fare increase: “There
were nearly four million fewer riders in December 1995,
the first full month after the price of a token increased
25 cents to $1.50, than in the previous December, a 4.3
percent decline.”
a. Use these data to estimate the price elasticity of
demand for subway rides.
b. According to your estimate, what happens to the
Transit Authority’s revenue when the fare rises?
c. Why might your estimate of the elasticity be
unreliable?
6. Two drivers—Tom and Jerry—each drive up to a gas
station. Before looking at the price, each places an order.
Tom says, “I’d like 10 gallons of gas.” Jerry says, “I’d
like $10 worth of gas.” What is each driver’s price
elasticity of demand?
7. Economists have observed that spending on restaurant
meals declines more during economic downturns than
does spending on food to be eaten at home. How might
the concept of elasticity help to explain this
phenomenon?
8. Consider public policy aimed at smoking.
a. Studies indicate that the price elasticity of demand
for cigarettes is about 0.4. If a pack of cigarettes
currently costs $2 and the government wants to
reduce smoking by 20 percent, by how much
should it increase the price?
b. If the government permanently increases the
priceof cigarettes, will the policy have a larger
effect on smoking one year from now or five years
from now?
c. Studies also find that teenagers have a higher price
elasticity than do adults. Why might this be true?
9. Would you expect the price elasticity of demandto be
larger in the market for all ice cream or the market for
vanilla ice cream? Would you expect the price elasticity
of supplyto be larger in the market for all ice cream or
the market for vanilla ice cream? Be sure to explain your
answers.
10. Pharmaceutical drugs have an inelastic demand, and
computers have an elastic demand. Suppose that
Problems and Applications
116 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
technological advance doubles the supply of both
products (that is, the quantity supplied at each price is
twice what it was).
a. What happens to the equilibrium price and
quantity in each market?
b. Which product experiences a larger change in
price?
c. Which product experiences a larger change in
quantity?
d. What happens to total consumer spending on each
product?
11. Beachfront resorts have an inelastic supply, and
automobiles have an elastic supply. Suppose that a rise
in population doubles the demand for both products
(that is, the quantity demanded at each price is twice
what it was).
a. What happens to the equilibrium price and
quantity in each market?
b. Which product experiences a larger change in
price?
c. Which product experiences a larger change in
quantity?
d. What happens to total consumer spending on each
product?
12. Several years ago, flooding along the Missouri and
Mississippi rivers destroyed thousands of acres of
wheat.
a. Farmers whose crops were destroyed by the floods
were much worse off, but farmers whose crops
were not destroyed benefited from the floods.
Why?
b. What information would you need about the
market for wheat in order to assess whether
farmers as a group were hurt or helped by the
floods?
13. Explain why the following might be true: Adrought
around the world raises the total revenue that farmers
receive from the sale of grain, but a drought only in
Kansas reduces the total revenue that Kansas farmers
receive.
14. Because better weather makes farmland more
productive, farmland in regions with good weather
conditions is more expensive than farmland in regions
with bad weather conditions. Over time, however, as
advances in technology have made all farmland more
productive, the price of farmland (adjusted for overall
inflation) has fallen. Use the concept of elasticity to
explain why productivity and farmland prices are
positively related across space but negatively related
over time.
IN THIS CHAPTER
YOU WILL . . .
See how the burden
of a tax is split
between buyers
and sellers
Consider how a tax
on a good affects
the price of the
good and the
quantity sold
Examine the effects
of government
policies that place
a ceiling on prices
Examine the effects
of government
policies that put a
floor under prices
Learn that taxes
levied on buyers
and taxes levied on
sellers are
equivalent
Economists have two roles. As scientists, they develop and test theories to explain
the world around them. As policy advisers, they use their theories to help change
the world for the better. The focus of the preceding two chapters has been scien-
tific. We have seen how supply and demand determine the price of a good and the
quantity of the good sold. We have also seen how various events shift supply and
demand and thereby change the equilibrium price and quantity.
This chapter offers our first look at policy. Here we analyze various types of
government policy using only the tools of supply and demand. As you will see,
the analysis yields some surprising insights. Policies often have effects that their
architects did not intend or anticipate.
We begin by considering policies that directly control prices. For example, rent-
control laws dictate a maximum rent that landlords may charge tenants. Minimum-
wage laws dictate the lowest wage that firms may pay workers. Price controls are
SUPPLY, DEMAND, AND
GOVERNMENT POLICIES
117
118 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
usually enacted when policymakers believe that the market price of a good or ser-
vice is unfair to buyers or sellers. Yet, as we will see, these policies can generate in-
equities of their own.
After our discussion of price controls, we next consider the impact of taxes.
Policymakers use taxes both to influence market outcomes and to raise revenue for
public purposes. Although the prevalence of taxes in our economy is obvious,
their effects are not. For example, when the government levies a tax on the amount
that firms pay their workers, do the firms or the workers bear the burden of the
tax? The answer is not at all clear—until we apply the powerful tools of supply
and demand.
CONTROLS ON PRICES
To see how price controls affect market outcomes, let’s look once again at the mar-
ket for ice cream. As we saw in Chapter 4, if ice cream is sold in a competitive mar-
ket free of government regulation, the price of ice cream adjusts to balance supply
and demand: At the equilibrium price, the quantity of ice cream that buyers want
to buy exactly equals the quantity that sellers want to sell. To be concrete, suppose
the equilibrium price is $3 per cone.
Not everyone may be happy with the outcome of this free-market process.
Let’s say the American Association of Ice Cream Eaters complains that the $3 price
is too high for everyone to enjoy a cone a day (their recommended diet). Mean-
while, the National Organization of Ice Cream Makers complains that the $3
price—the result of “cutthroat competition”—is depressing the incomes of its
members. Each of these groups lobbies the government to pass laws that alter the
market outcome by directly controlling prices.
Of course, because buyers of any good always want a lower price while sellers
want a higher price, the interests of the two groups conflict. If the Ice Cream Eaters
are successful in their lobbying, the government imposes a legal maximum on the
price at which ice cream can be sold. Because the price is not allowed to rise above
this level, the legislated maximum is called a price ceiling.By contrast, if the Ice
Cream Makers are successful, the government imposes a legal minimum on the
price. Because the price cannot fall below this level, the legislated minimum is
called a price floor.Let us consider the effects of these policies in turn.
HOW PRICE CEILINGS AFFECT MARKET OUTCOMES
When the government, moved by the complaints of the Ice Cream Eaters, imposes
a price ceiling on the market for ice cream, two outcomes are possible. In panel (a)
of Figure 6-1, the government imposes a price ceiling of $4 per cone. In this case,
because the price that balances supply and demand ($3) is below the ceiling, the
price ceiling is not binding.Market forces naturally move the economy to the equi-
librium, and the price ceiling has no effect.
Panel (b) of Figure 6-1 shows the other, more interesting, possibility. In this case,
the government imposes a price ceiling of $2 per cone. Because the equilibrium
price of $3 is above the price ceiling, the ceiling is a binding constrainton the market.
price ceiling
a legal maximum on the price at
which a good can be sold
price floor
a legal minimum on the price at
which a good can be sold
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 119
The forces of supply and demand tend to move the price toward the equilibrium
price, but when the market price hits the ceiling, it can rise no further. Thus, the
market price equals the price ceiling. At this price, the quantity of ice cream de-
manded (125 cones in the figure) exceeds the quantity supplied (75 cones). There is
a shortage of ice cream, so some people who want to buy ice cream at the going
price are unable to.
When a shortage of ice cream develops because of this price ceiling, some
mechanism for rationing ice cream will naturally develop. The mechanism could
be long lines: Buyers who are willing to arrive early and wait in line get a cone,
while those unwilling to wait do not. Alternatively, sellers could ration ice cream
according to their own personal biases, selling it only to friends, relatives, or mem-
bers of their own racial or ethnic group. Notice that even though the price ceiling
was motivated by a desire to help buyers of ice cream, not all buyers benefit from
the policy. Some buyers do get to pay a lower price, although they may have to
wait in line to do so, but other buyers cannot get any ice cream at all.
This example in the market for ice cream shows a general result: When the gov-
ernment imposes a binding price ceiling on a competitive market, a shortage of the good
arises, and sellers must ration the scarce goods among the large number of potential buyers.
The rationing mechanisms that develop under price ceilings are rarely desirable.
Long lines are inefficient, because they waste buyers’ time. Discrimination accord-
ing to seller bias is both inefficient (because the good does not go to the buyer who
values it most highly) and potentially unfair. By contrast, the rationing mechanism
(a) A Price Ceiling That Is Not Binding
$4
3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
100
Equilibrium
quantity
(b) A Price Ceiling That Is Binding
$3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
2
Price
ceiling
Demand
Supply
Price
ceiling
Shortage
75
Quantity
supplied
125
Quantity
demanded
Equilibrium
price
Equilibrium
price
Demand
Supply
Figure 6-1
AMARKET WITH A PRICE CEILING. In panel (a), the government imposes a price ceiling
of $4. Because the price ceiling is above the equilibrium price of $3, the price ceiling has no
effect, and the market can reach the equilibrium of supply and demand. In this
equilibrium, quantity supplied and quantity demanded both equal 100 cones. In panel (b),
the government imposes a price ceiling of $2. Because the price ceiling is below the
equilibrium price of $3, the market price equals $2. At this price, 125 cones are demanded
and only 75 are supplied, so there is a shortage of 50 cones.
120 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
CASE STUDY LINES AT THE GAS PUMP
As we discussed in the preceding chapter, in 1973 the Organization of Petroleum
Exporting Countries (OPEC) raised the price of crude oil in world oil markets.
Because crude oil is the major input used to make gasoline, the higher oil prices
reduced the supply of gasoline. Long lines at gas stations became commonplace,
and motorists often had to wait for hours to buy only a few gallons of gas.
What was responsible for the long gas lines? Most people blame OPEC.
Surely, if OPEC had not raised the price of crude oil, the shortage of gasoline
would not have occurred. Yet economists blame government regulations that
limited the price oil companies could charge for gasoline.
Figure 6-2 shows what happened. As shown in panel (a), before OPEC
raised the price of crude oil, the equilibrium price of gasoline P
1
was below the
price ceiling. The price regulation, therefore, had no effect. When the price of
crude oil rose, however, the situation changed. The increase in the price of crude
in a free, competitive market is both efficient and impersonal. When the market for
ice cream reaches its equilibrium, anyone who wants to pay the market price can
get a cone. Free markets ration goods with prices.
WHO IS RESPONSIBLE FOR THIS—OPEC
OR U.S. LAWMAKERS?
(a) The Price Ceiling on Gasoline Is Not Binding
Quantity of
Gasoline
0
Price of
Gasoline
(b) The Price Ceiling on Gasoline Is Binding
P
2
P
1
Quantity of
Gasoline
0
Price of
Gasoline
Q
1
Q
D
Demand
S
1
S
2
Price ceiling
Q
S
4. . . .
resulting
in a
shortage.
3. . . . the price
ceiling becomes
binding . . .
2. . . . but when
supply falls . . .
1. Initially,
the price
ceiling
is not
binding . . .
Price ceiling
P
1
Q
1
Demand
Supply, S
1
Figure 6-2
THE MARKET FOR GASOLINE WITH A PRICE CEILING. Panel (a) shows the gasoline
market when the price ceiling is not binding because the equilibrium price, P
1
, is below
the ceiling. Panel (b) shows the gasoline market after an increase in the price of crude oil
(an input into making gasoline) shifts the supply curve to the left from S
1
to S
2
. In an
unregulated market, the price would have risen from P
1
to P
2
. The price ceiling, however,
prevents this from happening. At the binding price ceiling, consumers are willing to buy
Q
D
, but producers of gasoline are willing to sell only Q
S
. The difference between quantity
demanded and quantity supplied, Q
D
H11002Q
S
, measures the gasoline shortage.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 121
oil raised the cost of producing gasoline, and this reduced the supply of gaso-
line. As panel (b) shows, the supply curve shifted to the left from S
1
to S
2
. In an
unregulated market, this shift in supply would have raised the equilibrium
price of gasoline from P
1
to P
2
, and no shortage would have resulted. Instead,
the price ceiling prevented the price from rising to the equilibrium level. At the
DURING THE SUMMER OF 1999, THE EAST
coast of the United States experienced
unusually little rain and a shortage of
water. The following article suggests a
way that the shortage could have been
averted.
Trickle-Down Economics
BY TERRY L. ANDERSON AND
CLAY J. LANDRY
Water shortages are being blamed on
the drought in the East, but that’s giving
Mother Nature a bum rap. Certainly the
drought is the immediate cause, but the
real culprit is regulations that don’t allow
markets and prices to equalize demand
and supply.
The similarity between water and
gasoline is instructive. The energy crisis
of the 1970s, too, was blamed on na-
ture’s niggardly supply of oil, but in fact
it was the actions of the Organization
of Petroleum Exporting Countries, com-
bined with price controls, that was the
main cause of the shortages. . . .
Once again, regulators are respond-
ing to shortages—in this case of water—
with controls and regulations rather than
allowing the market to work. Cities are
restricting water usage; some have even
gone so far as to prohibit restaurants
from serving water except if the cus-
tomer asks for a glass. But although
cities initially saw declines in water use,
some are starting to report increases in
consumption. This has prompted some
police departments to collect lists of res-
idents suspected of wasting water.
There’s a better answer than send-
ing out the cops. Market forces could
ensure plentiful water availability even in
drought years. Contrary to popular be-
lief, the supply of water is no more fixed
than the supply of oil. Like all resources,
water supplies change in response to
economic growth and to the price. In de-
veloping countries, despite population
growth, the percentage of people with
access to safe drinking water has in-
creased to 74 percent in 1994 from 44
percent in 1980. Rising incomes have
given those countries the wherewithal to
supply potable water.
Supplies also increase when current
users have an incentive to conserve their
surplus in the marketplace. California’s
drought-emergency water bank illus-
trates this. The bank allows farmers to
lease water from other users during dry
spells. In 1991, the first year the bank
was tried, when the price was $125 per
acre-foot (326,000 gallons), supply ex-
ceeded demand by two to one. That is,
many more people wanted to sell their
water than wanted to buy.
Data from every corner of the world
show that when cities raise the price of
water by 10 percent, water use goes
down by as much as 12 percent. When
the price of agricultural water goes up
10 percent, usage goes down by 20
percent. . . .
Unfortunately, Eastern water users
do not pay realistic prices for water.
According to the American Water
Works Association, only 2 percent of
municipal water suppliers adjust prices
seasonally....
Even more egregious, Eastern water
laws bar people from buying and selling
water. Just as tradable pollution permits
established under the Clean Air Act have
encouraged polluters to find efficient
ways to reduce emissions, tradable water
rights can encourage conservation and in-
crease supplies. It is mainly a matter of
following the lead of Western water
courts that have quantified water rights
and Western legislatures that have al-
lowed trades.
By making water a commodity and
unleashing market forces, policymakers
can ensure plentiful water supplies for
all. New policies won’t make droughts
disappear, but they will ease the pain
they impose by priming the invisible
pump of water markets.
SOURCE: The Wall Street Journal,August 23, 1999,
p.A14.
IN THE NEWS
Does a Drought Need to
Causea Water Shortage?
122 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
price ceiling, producers were willing to sell Q
S
, and consumers were willing to
buy Q
D
. Thus, the shift in supply caused a severe shortage at the regulated
price.
Eventually, the laws regulating the price of gasoline were repealed. Law-
makers came to understand that they were partly responsible for the many
hours Americans lost waiting in line to buy gasoline. Today, when the price of
crude oil changes, the price of gasoline can adjust to bring supply and demand
into equilibrium.
CASE STUDY RENT CONTROL IN THE SHORT
RUN AND LONG RUN
One common example of a price ceiling is rent control. In some cities, the local
government places a ceiling on rents that landlords may charge their tenants.
The goal of this policy is to help the poor by making housing more affordable.
Economists often criticize rent control, arguing that it is a highly inefficient way
to help the poor raise their standard of living. One economist called rent control
“the best way to destroy a city, other than bombing.”
The adverse effects of rent control are less apparent to the general popula-
tion because these effects occur over many years. In the short run, landlords have
a fixed number of apartments to rent, and they cannot adjust this number
quickly as market conditions change. Moreover, the number of people searching
(a) Rent Control in the Short Run
(supply and demand are inelastic)
(b) Rent Control in the Long Run
(supply and demand are elastic)
Quantity of
Apartments
0
Supply
Controlled rent
Shortage
Rental
Price of
Apartment
0
Rental
Price of
Apartment
Quantity of
Apartments
Demand
Supply
Controlled rent
Shortage
Demand
Figure 6-3
RENT CONTROL IN THE SHORT RUN AND IN THE LONG RUN. Panel (a) shows the short-
run effects of rent control: Because the supply and demand for apartments are relatively
inelastic, the price ceiling imposed by a rent-control law causes only a small shortage of
housing. Panel (b) shows the long-run effects of rent control: Because the supply and
demand for apartments are more elastic, rent control causes a large shortage.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 123
for housing in a city may not be highly responsive to rents in the short run be-
cause people take time to adjust their housing arrangements. Therefore, the
short-run supply and demand for housing are relatively inelastic.
Panel (a) of Figure 6-3 shows the short-run effects of rent control on the
housing market. As with any price ceiling, rent control causes a shortage. Yet
because supply and demand are inelastic in the short run, the initial shortage
caused by rent control is small. The primary effect in the short run is to reduce
rents.
The long-run story is very different because the buyers and sellers of rental
housing respond more to market conditions as time passes. On the supply side,
landlords respond to low rents by not building new apartments and by failing
to maintain existing ones. On the demand side, low rents encourage people to
find their own apartments (rather than living with their parents or sharing
apartments with roommates) and induce more people to move into a city.
Therefore, both supply and demand are more elastic in the long run.
Panel (b) of Figure 6-3 illustrates the housing market in the long run. When
rent control depresses rents below the equilibrium level, the quantity of apart-
ments supplied falls substantially, and the quantity of apartments demanded
rises substantially. The result is a large shortage of housing.
In cities with rent control, landlords use various mechanisms to ration hous-
ing. Some landlords keep long waiting lists. Others give a preference to tenants
without children. Still others discriminate on the basis of race. Sometimes, apart-
ments are allocated to those willing to offer under-the-table payments to building
superintendents. In essence, these bribes bring the total price of an apartment (in-
cluding the bribe) closer to the equilibrium price.
To understand fully the effects of rent control, we have to remember one of
the Ten Principles of Economicsfrom Chapter 1: People respond to incentives. In
free markets, landlords try to keep their buildings clean and safe because desir-
able apartments command higher prices. By contrast, when rent control creates
shortages and waiting lists, landlords lose their incentive to be responsive to
tenants’ concerns. Why should a landlord spend his money to maintain and
improve his property when people are waiting to get in as it is? In the end, ten-
ants get lower rents, but they also get lower-quality housing.
Policymakers often react to the effects of rent control by imposing additional
regulations. For example, there are laws that make racial discrimination in hous-
ing illegal and require landlords to provide minimally adequate living condi-
tions. These laws, however, are difficult and costly to enforce. By contrast, when
rent control is eliminated and a market for housing is regulated by the forces of
competition, such laws are less necessary. In a free market, the price of housing
adjusts to eliminate the shortages that give rise to undesirable landlord behavior.
HOW PRICE FLOORS AFFECT MARKET OUTCOMES
To examine the effects of another kind of government price control, let’s return to
the market for ice cream. Imagine now that the government is persuaded by the
pleas of the National Organization of Ice Cream Makers. In this case, the govern-
ment might institute a price floor. Price floors, like price ceilings, are an attempt by
the government to maintain prices at other than equilibrium levels. Whereas a price
ceiling places a legal maximum on prices, a price floor places a legal minimum.
124 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
RENT CONTROLREMAINSATOPIC OF HEATED
debate in New York City, as the follow-
ing article describes.
Threat to End Rent Control
Stirs Up NYC
BY FRED KAPLAN
NEW YORK—One recent lunch hour at
Shopsin’s, a neighborhood diner in
Manhattan’s West Village, conversation
turned to the topic of the state Senate
majority leader, Joseph L. Bruno. “If he
ever shows his face around here, we’ll
string him up,” a customer exclaimed.
“The guy deserves death,” another said
matter-of-factly.
Rarely has so much venom been
aimed at a figure so obscure as an
Albany legislator, but all over New York
City, thousands of otherwise fairly civi-
lized citizens are throwing similar fits. For
Bruno is threatening to take away their
one holy fringe benefit—the eternal right
to a rent-controlled apartment.
Massachusetts and California have
abolished or scaled back their rent-
control laws in recent years, but New
York remains the last holdout, and on a
scale that dwarfs that of the other cities.
About 2 million residents—more
than a quarter of New York City’s popu-
lation—live in apartments covered by
regulations that severely limit how much
a landlord can raise the rent and under
what conditions a tenant or even a ten-
ant’s relatives can be evicted.
Tales are legion of wealthy movie
stars, doctors, and stock brokers paying
a pittance for palatial dwellings in the
more fashionable neighborhoods of
Manhattan.
Some of these tales were knocked
off the books in 1993, when the state
Legislature passed what many called
“the Mia Farrow law”—in reference to
the actress who was paying one-fifth the
market price for a 10-room apartment on
Central Park West. Still, the bill did not
affect too many people. It lifted rent con-
trols only from apartments going for
more than $2,000 a month, and only if
the tenants’s annual household income
exceeded $250,000 two years in a row.
Far more plentiful are the unaffected
cases. An investment banker, who earns
more than $400,000 a year, pays $1,500
a month for a three-bedroom apartment
near Lincoln Center. A securities trader,
making well over $100,000 a year, pays
$800 a month for a one-bedroom on the
Upper West Side. In both cases, the
units would fetch at least three times as
much if placed on the open market. . . .
But rent control helps more than the
rich. A study by the city concludes that
the average tenant of a rent-controlled
apartment in New York City earns only
$20,000 a year. Tenants’ groups say that
ending controls would primarily raise the
rents of those who can least afford to
pay, resulting in wholesale eviction.
However, Paul Grogan, president of
the Local Initiatives Support Corp., a pri-
vate organization that finances low-
income housing, said, “In many poor
neighborhoods, the landlord can’t even
get rents as high as the regulations
allow.” . . .
Few economists and policy ana-
lysts, even liberal ones, support rent
control—not so much because it lets
rich people pay far less than they can af-
ford, but because it distorts the market-
place for everyone.
Frank Roconi, director of the Citi-
zens Housing and Planning Council, a
public-policy research organization that
supports some government intervention
in the real-estate market, spelled out
“the classic case” of this distortion:
“There is an elderly couple, their
kids are gone, they have a three-
bedroom apartment, and they are paying
$400 a month. Down the hall, there is a
young family with two kids living in a one-
bedroom for $1,000 a month. In a ratio-
nal price system, the elderly couple
would have an incentive to move to a
smaller, cheaper apartment, leaving va-
cant a larger space for the young family.”
Under the current system, though, if
the elderly couple moves away, their chil-
dren can claim the apartment at the
same rent. Or, if it is left vacant, the land-
lord, by law, can charge only a few per-
centage points more than if the tenant
had stayed.
Therefore, Roconi noted, “the land-
lord isn’t going to let just anybody in.
He’s going to let his brother-in-law have
the apartment or his accountant or
someone willing to give him a bribe.
There’s a tremendous incentive for that
apartment never to hit the open market.”
SOURCE:The Boston Globe,April 28, 1997, p. A1.
IN THE NEWS
Rent Control in
New York City
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 125
When the government imposes a price floor on the ice-cream market, two out-
comes are possible. If the government imposes a price floor of $2 per cone when
the equilibrium price is $3, we obtain the outcome in panel (a) of Figure 6-4. In this
case, because the equilibrium price is above the floor, the price floor is not binding.
Market forces naturally move the economy to the equilibrium, and the price floor
has no effect.
Panel (b) of Figure 6-4 shows what happens when the government imposes a
price floor of $4 per cone. In this case, because the equilibrium price of $3 is below
the floor, the price floor is a binding constraint on the market. The forces of supply
and demand tend to move the price toward the equilibrium price, but when the
market price hits the floor, it can fall no further. The market price equals the price
floor. At this floor, the quantity of ice cream supplied (120 cones) exceeds the quan-
tity demanded (80 cones). Some people who want to sell ice cream at the going
price are unable to. Thus, a binding price floor causes a surplus.
Just as price ceilings and shortages can lead to undesirable rationing mecha-
nisms, so can price floors and surpluses. In the case of a price floor, some sellers
are unable to sell all they want at the market price. The sellers who appeal to the
personal biases of the buyers, perhaps due to racial or familial ties, are better able
to sell their goods than those who do not. By contrast, in a free market, the price
serves as the rationing mechanism, and sellers can sell all they want at the equilib-
rium price.
(a) A Price Floor That Is Not Binding
$3
2
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
100
Equilibrium
quantity
(b) A Price Floor That Is Binding
$4
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
3
Price
floor
Demand
Supply
Price
floor
80
Quantity
demanded
120
Quantity
supplied
Equilibrium
price
Equilibrium
price
Demand
Supply
Surplus
Figure 6-4
AMARKET WITH A PRICE FLOOR. In panel (a), the government imposes a price floor of
$2. Because this is below the equilibrium price of $3, the price floor has no effect. The
market price adjusts to balance supply and demand. At the equilibrium, quantity supplied
and quantity demanded both equal 100 cones. In panel (b), the government imposes a
price floor of $4, which is above the equilibrium price of $3. Therefore, the market price
equals $4. Because 120 cones are supplied at this price and only 80 are demanded, there is
a surplus of 40 cones.
126 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
CASE STUDY THE MINIMUM WAGE
An important example of a price floor is the minimum wage. Minimum-wage
laws dictate the lowest price for labor that any employer may pay. The U.S.
Congress first instituted a minimum wage with the Fair Labor Standards Act of
1938 to ensure workers a minimally adequate standard of living. In 1999 the
minimum wage according to federal law was $5.15 per hour, and some state
laws imposed higher minimum wages.
To examine the effects of a minimum wage, we must consider the mar-
ket for labor. Panel (a) of Figure 6-5 shows the labor market which, like all
markets, is subject to the forces of supply and demand. Workers determine
the supply of labor, and firms determine the demand. If the government
doesn’t intervene, the wage normally adjusts to balance labor supply and
labor demand.
Panel (b) of Figure 6-5 shows the labor market with a minimum wage. If the
minimum wage is above the equilibrium level, as it is here, the quantity of labor
supplied exceeds the quantity demanded. The result is unemployment. Thus,
the minimum wage raises the incomes of those workers who have jobs, but it
lowers the incomes of those workers who cannot find jobs.
To fully understand the minimum wage, keep in mind that the economy
contains not a single labor market, but many labor markets for different types of
workers. The impact of the minimum wage depends on the skill and experience
of the worker. Workers with high skills and much experience are not affected,
because their equilibrium wages are well above the minimum. For these work-
ers, the minimum wage is not binding.
(a) A Free Labor Market
Quantity of
Labor
0
Wage
Equilibrium
employment
(b) A Labor Market with a Binding Minimum Wage
Quantity of
Labor
0
Wage
Quantity
demanded
Quantity
supplied
Labor
supply
Labor
demand
Minimum
wage
Labor surplus
(unemployment)
Equilibrium
wage
Labor
demand
Labor
supply
Figure 6-5
HOW THE MINIMUM WAGE AFFECTS THE LABOR MARKET. Panel (a) shows a labor
market in which the wage adjusts to balance labor supply and labor demand. Panel (b)
shows the impact of a binding minimum wage. Because the minimum wage is a price
floor, it causes a surplus: The quantity of labor supplied exceeds the quantity demanded.
The result is unemployment.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 127
The minimum wage has its greatest impact on the market for teenage labor.
The equilibrium wages of teenagers are low because teenagers are among the
least skilled and least experienced members of the labor force. In addition,
teenagers are often willing to accept a lower wage in exchange for on-the-job
training. (Some teenagers are willing to work as “interns” for no pay at all. Be-
cause internships pay nothing, however, the minimum wage does not apply to
them. If it did, these jobs might not exist.) As a result, the minimum wage is
more often binding for teenagers than for other members of the labor force.
Many economists have studied how minimum-wage laws affect the teenage
labor market. These researchers compare the changes in the minimum wage over
time with the changes in teenage employment. Although there is some debate
about how much the minimum wage affects employment, the typical study finds
that a 10 percent increase in the minimum wage depresses teenage employment
between 1 and 3 percent. In interpreting this estimate, note that a 10 percent in-
crease in the minimum wage does not raisethe average wage of teenagers by 10
percent. Achange in the law does not directly affect those teenagers who are al-
ready paid well above the minimum, and enforcement of minimum-wage laws is
not perfect. Thus, the estimated drop in employment of 1 to 3 percent is significant.
In addition to altering the quantity of labor demanded, the minimum wage
also alters the quantity supplied. Because the minimum wage raises the wage
that teenagers can earn, it increases the number of teenagers who choose to look
for jobs. Studies have found that a higher minimum wage influences which
teenagers are employed. When the minimum wage rises, some teenagers who
are still attending school choose to drop out and take jobs. These new dropouts
displace other teenagers who had already dropped out of school and who now
become unemployed.
The minimum wage is a frequent topic of political debate. Advocates ofthe
minimum wage view the policy as one way to raise the income of theworking
poor. They correctly point out that workers who earn the minimum wage can
afford only a meager standard of living. In 1999, for instance, when the mini-
mum wage was $5.15 per hour, two adults working 40 hours a week for every
week of the year at minimum-wage jobs had a total annual income of only
$21,424, which was less than half of the median family income. Many advocates
of the minimum wage admit that it has some adverse effects, including unem-
ployment, but they believe that these effects are small and that, all things con-
sidered, a higher minimum wage makes the poor better off.
Opponents of the minimum wage contend that it is not the best way to
combat poverty. They note that a high minimum wage causes unemployment,
encourages teenagers to drop out of school, and prevents some unskilled work-
ers from getting the on-the-job training they need. Moreover, opponents of the
minimum wage point out that the minimum wage is a poorly targeted policy.
Not all minimum-wage workers are heads of households trying to help their
families escape poverty. In fact, fewer than a third of minimum-wage earners
are in families with incomes below the poverty line. Many are teenagers from
middle-class homes working at part-time jobs for extra spending money.
EVALUATING PRICE CONTROLS
One of the Ten Principles of Economics discussed in Chapter 1 is that markets are
usually a good way to organize economic activity. This principle explains why
128 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
economists usually oppose price ceilings and price floors. To economists, prices are
not the outcome of some haphazard process. Prices, they contend, are the result of the
millions of business and consumer decisions that lie behind the supply and demand
curves. Prices have the crucial job of balancing supply and demand and, thereby, co-
ordinating economic activity. When policymakers set prices by legal decree, they ob-
scure the signals that normally guide the allocation of society’s resources.
Another one of the Ten Principles of Economicsis that governments can some-
times improve market outcomes. Indeed, policymakers are led to control prices be-
cause they view the market’s outcome as unfair. Price controls are often aimed at
helping the poor. For instance, rent-control laws try to make housing affordable for
everyone, and minimum-wage laws try to help people escape poverty.
Yet price controls often hurt those they are trying to help. Rent control may
keep rents low, but it also discourages landlords from maintaining their buildings
and makes housing hard to find. Minimum-wage laws may raise the incomes of
some workers, but they also cause other workers to be unemployed.
Helping those in need can be accomplished in ways other than controlling prices.
For instance, the government can make housing more affordable by paying a fraction
of the rent for poor families. Unlike rent control, such rent subsidies do not reduce the
quantity of housing supplied and, therefore, do not lead to housing shortages. Simi-
larly, wage subsidies raise the living standards of the working poor without discour-
aging firms from hiring them. An example of a wage subsidy is the earned income tax
credit,a government program that supplements the incomes of low-wage workers.
Although these alternative policies are often better than price controls, they are
not perfect. Rent and wage subsidies cost the government money and, therefore,
require higher taxes. As we see in the next section, taxation has costs of its own.
QUICK QUIZ: Define price ceilingand price floor,and give an example of
each. Which leads to a shortage? Which leads to a surplus? Why?
TAXES
All governments—from the federal government in Washington, D.C., to the local
governments in small towns—use taxes to raise revenue for public projects, such
as roads, schools, and national defense. Because taxes are such an important pol-
icy instrument, and because they affect our lives in many ways, the study of taxes
is a topic to which we return several times throughout this book. In this section we
begin our study of how taxes affect the economy.
To set the stage for our analysis, imagine that a local government decides to
hold an annual ice-cream celebration—with a parade, fireworks, and speeches by
town officials. To raise revenue to pay for the event, it decides to place a $0.50 tax
on the sale of ice-cream cones. When the plan is announced, our two lobbying
groups swing into action. The National Organization of Ice Cream Makers claims
that its members are struggling to survive in a competitive market, and it argues
that buyersof ice cream should have to pay the tax. The American Association of
Ice Cream Eaters claims that consumers of ice cream are having trouble making
ends meet, and it argues that sellers of ice cream should pay the tax. The town
mayor, hoping to reach a compromise, suggests that half the tax be paid by the
buyers and half be paid by the sellers.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 129
To analyze these proposals, we need to address a simple but subtle question:
When the government levies a tax on a good, who bears the burden of the tax? The
people buying the good? The people selling the good? Or, if buyers and sellers
share the tax burden, what determines how the burden is divided? Can the gov-
ernment simply legislate the division of the burden, as the mayor is suggesting, or
is the division determined by more fundamental forces in the economy? Econo-
mists use the term tax incidenceto refer to these questions about the distribution
of a tax burden. As we will see, we can learn some surprising lessons about tax in-
cidence just by applying the tools of supply and demand.
HOW TAXES ON BUYERS AFFECT MARKET OUTCOMES
We first consider a tax levied on buyers of a good. Suppose, for instance, that our
local government passes a law requiring buyers of ice-cream cones to send $0.50 to
the government for each ice-cream cone they buy. How does this law affect the
buyers and sellers of ice cream? To answer this question, we can follow the three
steps in Chapter 4 for analyzing supply and demand: (1) We decide whether the
law affects the supply curve or demand curve. (2) We decide which way the curve
shifts. (3) We examine how the shift affects the equilibrium.
The initial impact of the tax is on the demand for ice cream. The supply curve
is not affected because, for any given price of ice cream, sellers have the same in-
centive to provide ice cream to the market. By contrast, buyers now have to pay a
tax to the government (as well as the price to the sellers) whenever they buy ice
cream. Thus, the tax shifts the demand curve for ice cream.
The direction of the shift is easy to determine. Because the tax on buyers
makes buying ice cream less attractive, buyers demand a smaller quantity of ice
cream at every price. As a result, the demand curve shifts to the left (or, equiva-
lently, downward), as shown in Figure 6-6.
tax incidence
the study of who bears the burden
oftaxation
$3.30
3.00
2.80
Quantity of
Ice-Cream Cones
0
Price of
Ice-Cream
Cone
Price
without
tax
Price
sellers
receive
10090
Equilibrium
with tax
Equilibrium without tax
Tax ($0.50)
Price
buyers
pay
D
1
D
2
Supply, S
1
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50).
Figure 6-6
ATAX ON BUYERS. When a tax
of $0.50 is levied on buyers, the
demand curve shifts down by
$0.50 from D
1
to D
2
. The
equilibrium quantity falls from
100 to 90 cones. The price that
sellers receive falls from $3.00 to
$2.80. The price that buyers pay
(including the tax) rises from
$3.00 to $3.30. Even though the
tax is levied on buyers, buyers
and sellers share the burden of
the tax.
130 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
We can, in this case, be precise about how much the curve shifts. Because of
the $0.50 tax levied on buyers, the effective price to buyers is now $0.50 higher
than the market price. For example, if the market price of a cone happened to be
$2.00, the effective price to buyers would be $2.50. Because buyers look at their to-
tal cost including the tax, they demand a quantity of ice cream as if the market
price were $0.50 higher than it actually is. In other words, to induce buyers to de-
mand any given quantity, the market price must now be $0.50 lower to make up
for the effect of the tax. Thus, the tax shifts the demand curve downwardfrom D
1
to
D
2
by exactly the size of the tax ($0.50).
To see the effect of the tax, we compare the old equilibrium and the new equi-
librium. You can see in the figure that the equilibrium price of ice cream falls from
$3.00 to $2.80 and the equilibrium quantity falls from 100 to 90 cones. Because sell-
ers sell less and buyers buy less in the new equilibrium, the tax on ice cream re-
duces the size of the ice-cream market.
Now let’s return to the question of tax incidence: Who pays the tax? Although
buyers send the entire tax to the government, buyers and sellers share the burden.
Because the market price falls from $3.00 to $2.80 when the tax is introduced, sellers
receive $0.20 less for each ice-cream cone than they did without the tax. Thus, the
tax makes sellers worse off. Buyers pay sellers a lower price ($2.80), but the effective
price including the tax rises from $3.00 before the tax to $3.30 with the tax ($2.80 +
$0.50 = $3.30). Thus, the tax also makes buyers worse off.
To sum up, the analysis yields two general lessons:
a78 Taxes discourage market activity. When a good is taxed, the quantity of the
good sold is smaller in the new equilibrium.
a78 Buyers and sellers share the burden of taxes. In the new equilibrium, buyers
pay more for the good, and sellers receive less.
HOW TAXES ON SELLERS AFFECT MARKET OUTCOMES
Now consider a tax levied on sellers of a good. Suppose the local government
passes a law requiring sellers of ice-cream cones to send $0.50 to the government
for each cone they sell. What are the effects of this law?
In this case, the initial impact of the tax is on the supply of ice cream. Because
the tax is not levied on buyers, the quantity of ice cream demanded at any given
price is the same, so the demand curve does not change. By contrast, the tax on sell-
ers raises the cost of selling ice cream, and leads sellers to supply a smaller quantity
at every price. The supply curve shifts to the left (or, equivalently, upward).
Once again, we can be precise about the magnitude of the shift. For any mar-
ket price of ice cream, the effective price to sellers—the amount they get to keep af-
ter paying the tax—is $0.50 lower. For example, if the market price of a cone
happened to be $2.00, the effective price received by sellers would be $1.50. What-
ever the market price, sellers will supply a quantity of ice cream as if the price
were $0.50 lower than it is. Put differently, to induce sellers to supply any given
quantity, the market price must now be $0.50 higher to compensate for the effect of
the tax. Thus, as shown in Figure 6-7, the supply curve shifts upwardfrom S
1
to S
2
by exactly the size of the tax ($0.50).
When the market moves from the old to the new equilibrium, the equilibrium
price of ice cream rises from $3.00 to $3.30, and the equilibrium quantity falls from
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 131
CASE STUDY CAN CONGRESS DISTRIBUTE THE
BURDEN OF A PAYROLL TAX?
If you have ever received a paycheck, you probably noticed that taxes were de-
ducted from the amount you earned. One of these taxes is called FICA, an
100 to 90 cones. Once again, the tax reduces the size of the ice-cream market. And
once again, buyers and sellers share the burden of the tax. Because the market
price rises, buyers pay $0.30 more for each cone than they did before the tax was
enacted. Sellers receive a higher price than they did without the tax, but the effec-
tive price (after paying the tax) falls from $3.00 to $2.80.
Comparing Figures 6-6 and 6-7 leads to a surprising conclusion: Taxes on buy-
ers and taxes on sellers are equivalent.In both cases, the tax places a wedge between
the price that buyers pay and the price that sellers receive. The wedge between the
buyers’ price and the sellers’ price is the same, regardless of whether the tax is
levied on buyers or sellers. In either case, the wedge shifts the relative position of
the supply and demand curves. In the new equilibrium, buyers and sellers share
the burden of the tax. The only difference between taxes on buyers and taxes on
sellers is who sends the money to the government.
The equivalence of these two taxes is perhaps easier to understand if we imag-
ine that the government collects the $0.50 ice-cream tax in a bowl on the counter of
each ice-cream store. When the government levies the tax on buyers, the buyer is re-
quired to place $0.50 in the bowl every time a cone is bought. When the government
levies the tax on sellers, the seller is required to place $0.50 in the bowl after the sale
of each cone. Whether the $0.50 goes directly from the buyer’s pocket into the bowl,
or indirectly from the buyer’s pocket into the seller’s hand and then into the bowl,
does not matter. Once the market reaches its new equilibrium, buyers and sellers
share the burden, regardless of how the tax is levied.
$3.30
3.00
2.80
Quantity of
Ice-Cream Cones
0
Price of
Ice-Cream
Cone
Price
without
tax
Price
sellers
receive
10090
Equilibrium
with tax
Equilibrium without tax
Tax ($0.50)
Price
buyers
pay
S
1
S
2
Demand, D
1
A tax on sellers
shifts the supply
curve upward
by the amount of
the tax ($0.50).
Figure 6-7
ATAX ON SELLERS. When a tax
of $0.50 is levied on sellers, the
supply curve shifts up by $0.50
from S
1
to S
2
. The equilibrium
quantity falls from 100 to 90
cones. The price that buyers pay
rises from $3.00 to $3.30. The
price that sellers receive (after
paying the tax) falls from $3.00
to$2.80. Even though the tax is
levied on sellers, buyers and
sellers share the burden of
thetax.
132 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
acronym for the Federal Insurance Contribution Act. The federal government
uses the revenue from the FICAtax to pay for Social Security and Medicare, the
income support and health care programs for the elderly. FICAis an example of
a payroll tax,which is a tax on the wages that firms pay their workers. In 1999,
the total FICAtax for the typical worker was 15.3 percent of earnings.
Who do you think bears the burden of this payroll tax—firms or workers?
When Congress passed this legislation, it attempted to mandate a division of
the tax burden. According to the law, half of the tax is paid by firms, and half is
paid by workers. That is, half of the tax is paid out of firm revenue, and half is
deducted from workers’ paychecks. The amount that shows up as a deduction
on your pay stub is the worker contribution.
Our analysis of tax incidence, however, shows that lawmakers cannot so
easily distribute the burden of a tax. To illustrate, we can analyze a payroll tax
as merely a tax on a good, where the good is labor and the price is the wage. The
key feature of the payroll tax is that it places a wedge between the wage that
firms pay and the wage that workers receive. Figure 6-8 shows the outcome.
When a payroll tax is enacted, the wage received by workers falls, and the wage
paid by firms rises. In the end, workers and firms share the burden of the tax,
much as the legislation requires. Yet this division of the tax burden between
workers and firms has nothing to do with the legislated division: The division
of the burden in Figure 6-8 is not necessarily fifty-fifty, and the same outcome
would prevail if the law levied the entire tax on workers or if it levied the entire
tax on firms.
This example shows that the most basic lesson of tax incidence is often
overlooked in public debate. Lawmakers can decide whether a tax comes from
the buyer’s pocket or from the seller’s, but they cannot legislate the true burden
of a tax. Rather, tax incidence depends on the forces of supply and demand.
Wage without tax
Quantity
of Labor
0
Wage
Labor demand
Labor supply
Tax wedge
Wage workers
receive
Wage firms pay
Figure 6-8
APAYROLL TAX. Apayroll tax
places a wedge between the wage
that workers receive and the
wage that firms pay. Comparing
wages with and without the tax,
you can see that workers and
firms share the tax burden. This
division of the tax burden
between workers and firms does
not depend on whether the
government levies the tax on
workers, levies the tax on firms,
or divides the tax equally
between the two groups.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 133
ELASTICITY AND TAX INCIDENCE
When a good is taxed, buyers and sellers of the good share the burden of the tax.
But how exactly is the tax burden divided? Only rarely will it be shared equally. To
see how the burden is divided, consider the impact of taxation in the two markets
in Figure 6-9. In both cases, the figure shows the initial demand curve, the initial
supply curve, and a tax that drives a wedge between the amount paid by buyers
and the amount received by sellers. (Not drawn in either panel of the figure is the
new supply or demand curve. Which curve shifts depends on whether the tax is
levied on buyers or sellers. As we have seen, this is irrelevant for the incidence of
Price without tax
Quantity0
Price
Demand
Supply
Tax
Price sellers
receive
Price buyers pay
(a) Elastic Supply, Inelastic Demand
Price without tax
Quantity0
Price
Demand
Supply
Tax
Price sellers
receive
Price buyers pay
(b) Inelastic Supply, Elastic Demand
2. . . . the
incidence of the
tax falls more
heavily on
consumers . . .
1. When supply is more elastic
than demand . . .
3. . . . than
on producers.
2. . . . the
incidence of
the tax falls
more heavily
on producers . . .
3. . . . than on
consumers.
1. When demand is more elastic
than supply . . .
Figure 6-9
HOW THE BURDEN OF A TAX IS
DIVIDED. In panel (a), the
supply curve is elastic, and the
demand curve is inelastic. In this
case, the price received by sellers
falls only slightly, while the price
paid by buyers rises substantially.
Thus, buyers bear most of the
burden of the tax. In panel (b),
the supply curve is inelastic, and
the demand curve is elastic. In
this case, the price received by
sellers falls substantially, while
the price paid by buyers rises
only slightly. Thus, sellers bear
most of the burden of the tax.
134 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
CASE STUDY WHO PAYS THE LUXURY TAX?
In 1990, Congress adopted a new luxury tax on items such as yachts, private air-
planes, furs, jewelry, and expensive cars. The goal of the tax was to raise rev-
enue from those who could most easily afford to pay. Because only the rich
could afford to buy such extravagances, taxing luxuries seemed a logical way of
taxing the rich.
Yet, when the forces of supply and demand took over, the outcome was
quite different from what Congress intended. Consider, for example, the market
for yachts. The demand for yachts is quite elastic. Amillionaire can easily not
buy a yacht; she can use the money to buy a bigger house, take a European va-
cation, or leave a larger bequest to her heirs. By contrast, the supply of yachts is
relatively inelastic, at least in the short run. Yacht factories are not easily con-
verted to alternative uses, and workers who build yachts are not eager to
change careers in response to changing market conditions.
Our analysis makes a clear prediction in this case. With elastic demand and
inelastic supply, the burden of a tax falls largely on the suppliers. That is, a tax
on yachts places a burden largely on the firms and workers who build yachts
because they end up getting a lower price for their product. The workers, how-
ever, are not wealthy. Thus, the burden of a luxury tax falls more on the middle
class than on the rich.
the tax.) The difference in the two panels is the relative elasticity of supply and
demand.
Panel (a) of Figure 6-9 shows a tax in a market with very elastic supply and rel-
atively inelastic demand. That is, sellers are very responsive to the price of the
good, whereas buyers are not very responsive. When a tax is imposed on a market
with these elasticities, the price received by sellers does not fall much, so sellers
bear only a small burden. By contrast, the price paid by buyers rises substantially,
indicating that buyers bear most of the burden of the tax.
Panel (b) of Figure 6-9 shows a tax in a market with relatively inelastic supply
and very elastic demand. In this case, sellers are not very responsive to the price,
while buyers are very responsive. The figure shows that when a tax is imposed,
the price paid by buyers does not rise much, while the price received by sellers
falls substantially. Thus, sellers bear most of the burden of the tax.
The two panels of Figure 6-9 show a general lesson about how the burden of a
tax is divided: Atax burden falls more heavily on the side of the market that is less elas-
tic.Why is this true? In essence, the elasticity measures the willingness of buyers
or sellers to leave the market when conditions become unfavorable. Asmall elas-
ticity of demand means that buyers do not have good alternatives to consuming
this particular good. Asmall elasticity of supply means that sellers do not have
good alternatives to producing this particular good. When the good is taxed, the
side of the market with fewer good alternatives cannot easily leave the market and
must, therefore, bear more of the burden of the tax.
We can apply this logic to the payroll tax, which was discussed in the previous
case study. Most labor economists believe that the supply of labor is much less
elastic than the demand. This means that workers, rather than firms, bear most of
the burden of the payroll tax. In other words, the distribution of the tax burden is
not at all close to the fifty-fifty split that lawmakers intended.
“IF THIS BOAT WERE ANY MORE
EXPENSIVE, WE WOULD BE PLAYING GOLF.”
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 135
The mistaken assumptions about the incidence of the luxury tax quickly be-
came apparent after the tax went into effect. Suppliers of luxuries made their
congressional representatives well aware of the economic hardship they experi-
enced, and Congress repealed most of the luxury tax in 1993.
QUICK QUIZ: In a supply-and-demand diagram, show how a tax on car
buyers of $1,000 per car affects the quantity of cars sold and the price of cars.
In another diagram, show how a tax on car sellers of $1,000 per car affects the
quantity of cars sold and the price of cars. In both of your diagrams, show the
change in the price paid by car buyers and the change in price received by car
sellers.
CONCLUSION
The economy is governed by two kinds of laws: the laws of supply and demand
and the laws enacted by governments. In this chapter we have begun to see how
these laws interact. Price controls and taxes are common in various markets in the
economy, and their effects are frequently debated in the press and among policy-
makers. Even a little bit of economic knowledge can go a long way toward under-
standing and evaluating these policies.
In subsequent chapters we will analyze many government policies in greater
detail. We will examine the effects of taxation more fully, and we will consider a
broader range of policies than we considered here. Yet the basic lessons of this
chapter will not change: When analyzing government policies, supply and de-
mand are the first and most useful tools of analysis.
a78 Aprice ceiling is a legal maximum on the price of a
good or service. An example is rent control. If the price
ceiling is below the equilibrium price, the quantity
demanded exceeds the quantity supplied. Because of
the resulting shortage, sellers must in some way ration
the good or service among buyers.
a78 Aprice floor is a legal minimum on the price of a good
or service. An example is the minimum wage. If the
price floor is above the equilibrium price, the quantity
supplied exceeds the quantity demanded. Because of
the resulting surplus, buyers’ demands for the good or
service must in some way be rationed among sellers.
a78 When the government levies a tax on a good, the
equilibrium quantity of the good falls. That is, a tax on a
market shrinks the size of the market.
a78 Atax on a good places a wedge between the price paid
by buyers and the price received by sellers. When the
market moves to the new equilibrium, buyers pay more
for the good and sellers receive less for it. In this sense,
buyers and sellers share the tax burden. The incidence
of a tax does not depend on whether the tax is levied on
buyers or sellers.
a78 The incidence of a tax depends on the price elasticities
of supply and demand. The burden tends to fall on the
side of the market that is less elastic because that side of
the market can respond less easily to the tax by
changing the quantity bought or sold.
Summary
136 PART TWO SUPPLY AND DEMAND I: HOW MARKETS WORK
price ceiling, p. 118 price floor, p. 118 tax incidence, p. 129
Key Concepts
1. Give an example of a price ceiling and an example of a
price floor.
2. Which causes a shortage of a good—a price ceiling or a
price floor? Which causes a surplus?
3. What mechanisms allocate resources when the price of a
good is not allowed to bring supply and demand into
equilibrium?
4. Explain why economists usually oppose controls on
prices.
5. What is the difference between a tax paid by buyers and
a tax paid by sellers?
6. How does a tax on a good affect the price paid by
buyers, the price received by sellers, and the quantity
sold?
7. What determines how the burden of a tax is divided
between buyers and sellers? Why?
Questions for Review
1. Lovers of classical music persuade Congress to impose a
price ceiling of $40 per ticket. Does this policy get more
or fewer people to attend classical music concerts?
2. The government has decided that the free-market price
of cheese is too low.
a. Suppose the government imposes a binding price
floor in the cheese market. Use a supply-and-
demand diagram to show the effect of this policy
on the price of cheese and the quantity of cheese
sold. Is there a shortage or surplus of cheese?
b. Farmers complain that the price floor has reduced
their total revenue. Is this possible? Explain.
c. In response to farmers’ complaints, the government
agrees to purchase all of the surplus cheese at the
price floor. Compared to the basic price floor, who
benefits from this new policy? Who loses?
3. Arecent study found that the demand and supply
schedules for Frisbees are as follows:
PRICEPER QUANTITY QUANTITY
FRISBEE DEMANDED SUPPLIED
$11 1 million 15 million
10 2 12
94 9
86 6
78 3
610 1
a. What are the equilibrium price and quantity of
Frisbees?
b. Frisbee manufacturers persuade the government
that Frisbee production improves scientists’
understanding of aerodynamics and thus is
important for national security. Aconcerned
Congress votes to impose a price floor $2 above the
equilibrium price. What is the new market price?
How many Frisbees are sold?
c. Irate college students march on Washington and
demand a reduction in the price of Frisbees. An
even more concerned Congress votes to repeal the
price floor and impose a price ceiling $1 below the
former price floor. What is the new market price?
How many Frisbees are sold?
4. Suppose the federal government requires beer drinkers
to pay a $2 tax on each case of beer purchased. (In fact,
both the federal and state governments impose beer
taxes of some sort.)
a. Draw a supply-and-demand diagram of the market
for beer without the tax. Show the price paid by
consumers, the price received by producers, and
the quantity of beer sold. What is the difference
between the price paid by consumers and the price
received by producers?
b. Now draw a supply-and-demand diagram for the
beer market with the tax. Show the price paid by
consumers, the price received by producers, and
Problems and Applications
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 137
the quantity of beer sold. What is the difference
between the price paid by consumers and the price
received by producers? Has the quantity of beer
sold increased or decreased?
5. Asenator wants to raise tax revenue and make workers
better off. Astaff member proposes raising the payroll
tax paid by firms and using part of the extra revenue to
reduce the payroll tax paid by workers. Would this
accomplish the senator’s goal?
6. If the government places a $500 tax on luxury cars, will
the price paid by consumers rise by more than $500, less
than $500, or exactly $500? Explain.
7. Congress and the president decide that the United
States should reduce air pollution by reducing its use of
gasoline. They impose a $0.50 tax for each gallon of
gasoline sold.
a. Should they impose this tax on producers or
consumers? Explain carefully using a supply-and-
demand diagram.
b. If the demand for gasoline were more elastic,
would this tax be more effective or less effective in
reducing the quantity of gasoline consumed?
Explain with both words and a diagram.
c. Are consumers of gasoline helped or hurt by this
tax? Why?
d. Are workers in the oil industry helped or hurt by
this tax? Why?
8. Acase study in this chapter discusses the federal
minimum-wage law.
a. Suppose the minimum wage is above the
equilibrium wage in the market for unskilled labor.
Using a supply-and-demand diagram of the market
for unskilled labor, show the market wage, the
number of workers who are employed, and the
number of workers who are unemployed. Also
show the total wage payments to unskilled
workers.
b. Now suppose the secretary of labor proposes an
increase in the minimum wage. What effect would
this increase have on employment? Does the
change in employment depend on the elasticity of
demand, the elasticity of supply, both elasticities, or
neither?
c. What effect would this increase in the minimum
wage have on unemployment? Does the change in
unemployment depend on the elasticity of demand,
the elasticity of supply, both elasticities, or neither?
d. If the demand for unskilled labor were inelastic,
would the proposed increase in the minimum wage
raise or lower total wage payments to unskilled
workers? Would your answer change if the demand
for unskilled labor were elastic?
9. Consider the following policies, each of which is aimed
at reducing violent crime by reducing the use of guns.
Illustrate each of these proposed policies in a supply-
and-demand diagram of the gun market.
a. a tax on gun buyers
b. a tax on gun sellers
c. a price floor on guns
d. a tax on ammunition
10. The U.S. government administers two programs that
affect the market for cigarettes. Media campaigns and
labeling requirements are aimed at making the public
aware of the dangers of cigarette smoking. At the same
time, the Department of Agriculture maintains a price
support program for tobacco farmers, which raises the
price of tobacco above the equilibrium price.
a. How do these two programs affect cigarette
consumption? Use a graph of the cigarette market
in your answer.
b. What is the combined effect of these two programs
on the price of cigarettes?
c. Cigarettes are also heavily taxed. What effect does
this tax have on cigarette consumption?
11. Asubsidy is the opposite of a tax. With a $0.50 tax on
the buyers of ice-cream cones, the government collects
$0.50 for each cone purchased; with a $0.50 subsidy for
the buyers of ice-cream cones, the government pays
buyers $0.50 for each cone purchased.
a. Show the effect of a $0.50 per cone subsidy on the
demand curve for ice-cream cones, the effective
price paid by consumers, the effective price
received by sellers, and the quantity of cones sold.
b. Do consumers gain or lose from this policy? Do
producers gain or lose? Does the government gain
or lose?
IN THIS CHAPTER
YOU WILL . . .
See that the
equilibrium of
supply and demand
maximizes total
surplus in a market
Examine the link
between sellers’
costs of producing
a good and the
supply curve
Examine the link
between buyers’
willingness to pay
for a good and the
demand curve
Learn how to define
and measure
consumer surplus
Learn how to define
and measure
producer surplus
When consumers go to grocery stores to buy their turkeys for Thanksgiving din-
ner, they may be disappointed that the price of turkey is as high as it is. At the
same time, when farmers bring to market the turkeys they have raised, they wish
the price of turkey were even higher. These views are not surprising: Buyers al-
ways want to pay less, and sellers always want to get paid more. But is there a
“right price” for turkey from the standpoint of society as a whole?
In previous chapters we saw how, in market economies, the forces of supply
and demand determine the prices of goods and services and the quantities sold. So
far, however, we have described the way markets allocate scarce resources without
directly addressing the question of whether these market allocations are desirable.
In other words, our analysis has been positive(what is) rather than normative(what
CONSUMERS, PRODUCERS,
AND THE EFFICIENCY
OF MARKETS
141
142 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
should be). We know that the price of turkey adjusts to ensure that the quantity of
turkey supplied equals the quantity of turkey demanded. But, at this equilibrium,
is the quantity of turkey produced and consumed too small, too large, or just
right?
In this chapter we take up the topic of welfare economics, the study of how
the allocation of resources affects economic well-being. We begin by examining the
benefits that buyers and sellers receive from taking part in a market. We then ex-
amine how society can make these benefits as large as possible. This analysis leads
to a profound conclusion: The equilibrium of supply and demand in a market
maximizes the total benefits received by buyers and sellers.
As you may recall from Chapter 1, one of the Ten Principles of Economicsis that
markets are usually a good way to organize economic activity. The study of wel-
fare economics explains this principle more fully. It also answers our question
about the right price of turkey: The price that balances the supply and demand for
turkey is, in a particular sense, the best one because it maximizes the total welfare
of turkey consumers and turkey producers.
CONSUMER SURPLUS
We begin our study of welfare economics by looking at the benefits buyers receive
from participating in a market.
WILLINGNESS TO PAY
Imagine that you own a mint-condition recording of Elvis Presley’s first album.
Because you are not an Elvis Presley fan, you decide to sell it. One way to do so is
to hold an auction.
Four Elvis fans show up for your auction: John, Paul, George, and Ringo. Each
of them would like to own the album, but there is a limit to the amount that each
is willing to pay for it. Table 7-1 shows the maximum price that each of the four
possible buyers would pay. Each buyer’s maximum is called his willingness to
pay,and it measures how much that buyer values the good. Each buyer would be
eager to buy the album at a price less than his willingness to pay, would refuse to
welfare economics
the study of how the allocation of
resources affects economic well-being
willingness to pay
the maximum amount that a buyer
will pay for a good
Table 7-1
FOUR POSSIBLE BUYERS’
WILLINGNESS TO PAY
BUYER WILLINGNESS TOPAY
John $100
Paul 80
George 70
Ringo 50
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 143
buy the album at a price more than his willingness to pay, and would be indiffer-
ent about buying the album at a price exactly equal to his willingness to pay.
To sell your album, you begin the bidding at a low price, say $10. Because all
four buyers are willing to pay much more, the price rises quickly. The bidding
stops when John bids $80 (or slightly more). At this point, Paul, George, and Ringo
have dropped out of the bidding, because they are unwilling to bid any more than
$80. John pays you $80 and gets the album. Note that the album has gone to the
buyer who values the album most highly.
What benefit does John receive from buying the Elvis Presley album? In a
sense, John has found a real bargain: He is willing to pay $100 for the album but
pays only $80 for it. We say that John receives consumer surplusof $20. Consumer
surplusis the amount a buyer is willing to pay for a good minus the amount the
buyer actually pays for it.
Consumer surplus measures the benefit to buyers of participating in a market.
In this example, John receives a $20 benefit from participating in the auction be-
cause he pays only $80 for a good he values at $100. Paul, George, and Ringo get
no consumer surplus from participating in the auction, because they left without
the album and without paying anything.
Now consider a somewhat different example. Suppose that you had two iden-
tical Elvis Presley albums to sell. Again, you auction them off to the four possible
buyers. To keep things simple, we assume that both albums are to be sold for the
same price and that no buyer is interested in buying more than one album. There-
fore, the price rises until two buyers are left.
In this case, the bidding stops when John and Paul bid $70 (or slightly higher).
At this price, John and Paul are each happy to buy an album, and George and
Ringo are not willing to bid any higher. John and Paul each receive consumer sur-
plus equal to his willingness to pay minus the price. John’s consumer surplus is
$30, and Paul’s is $10. John’s consumer surplus is higher now than it was previ-
ously, because he gets the same album but pays less for it. The total consumer sur-
plus in the market is $40.
USING THE DEMAND CURVE TO MEASURE
CONSUMER SURPLUS
Consumer surplus is closely related to the demand curve for a product. To see how
they are related, let’s continue our example and consider the demand curve for
this rare Elvis Presley album.
We begin by using the willingness to pay of the four possible buyers to find
the demand schedule for the album. Table 7-2 shows the demand schedule that
corresponds to Table 7-1. If the price is above $100, the quantity demanded in the
market is 0, because no buyer is willing to pay that much. If the price is between
$80 and $100, the quantity demanded is 1, because only John is willing to pay such
a high price. If the price is between $70 and $80, the quantity demanded is 2, be-
cause both John and Paul are willing to pay the price. We can continue this analy-
sis for other prices as well. In this way, the demand schedule is derived from the
willingness to pay of the four possible buyers.
Figure 7-1 graphs the demand curve that corresponds to this demand sched-
ule. Note the relationship between the height of the demand curve and the buyers’
willingness to pay. At any quantity, the price given by the demand curve shows
consumer surplus
a buyer’s willingness to pay minus
the amount the buyer actually pays
144 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
the willingness to pay of the marginal buyer,the buyer who would leave the market
first if the price were any higher. At a quantity of 4 albums, for instance, the de-
mand curve has a height of $50, the price that Ringo (the marginal buyer) is will-
ing to pay for an album. At a quantity of 3 albums, the demand curve has a height
of $70, the price that George (who is now the marginal buyer) is willing to pay.
Because the demand curve reflects buyers’ willingness to pay, we can also use
it to measure consumer surplus. Figure 7-2 uses the demand curve to compute
consumer surplus in our example. In panel (a), the price is $80 (or slightly above),
and the quantity demanded is 1. Note that the area above the price and below the
demand curve equals $20. This amount is exactly the consumer surplus we com-
puted earlier when only 1 album is sold.
Panel (b) of Figure 7-2 shows consumer surplus when the price is $70 (or
slightly above). In this case, the area above the price and below the demand curve
Table 7-2
THE DEMAND SCHEDULE FOR THE
BUYERS IN TABLE 7-1
PRICE BUYERS QUANTITYDEMANDED
More than $100 None 0
$80 to $100 John 1
$70 to $80 John, Paul 2
$50 to $70 John, Paul, George 3
$50 or less John, Paul, George, Ringo 4
Price of
Album
50
70
80
0
$100
Quantity of
Albums
Demand
1 2 3 4
John’s willingness to pay
Paul’s willingness to pay
George’s willingness to pay
Ringo’s willingness to pay
Figure 7-1
THE DEMAND CURVE. This
figure graphs the demand curve
from the demand schedule in
Table 7-2. Note that the height of
the demand curve reflects buyers’
willingness to pay.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 145
equals the total area of the two rectangles: John’s consumer surplus at this price is
$30 and Paul’s is $10. This area equals a total of $40. Once again, this amount is the
consumer surplus we computed earlier.
The lesson from this example holds for all demand curves: The area below the
demand curve and above the price measures the consumer surplus in a market.The reason
is that the height of the demand curve measures the value buyers place on the
good, as measured by their willingness to pay for it. The difference between this
willingness to pay and the market price is each buyer’s consumer surplus. Thus,
the total area below the demand curve and above the price is the sum of the con-
sumer surplus of all buyers in the market for a good or service.
(b) Price = $70
Price of
Album
50
70
80
0
$100
Demand
1234
Total
consumer
surplus ($40)
(a) Price = $80
Price of
Album
50
70
80
0
$100
Demand
1234 Quantity of
Albums
Quantity of
Albums
John’s consumer surplus ($30)
Paul’s consumer surplus ($10)
John’s consumer surplus ($20)
Figure 7-2
MEASURING CONSUMER SURPLUS
WITH THE DEMAND CURVE.In
panel (a), the price of the good is
$80, and the consumer surplus is
$20. In panel (b), the price of the
good is $70, and the consumer
surplus is $40.
146 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
HOW A LOWER PRICE RAISES CONSUMER SURPLUS
Because buyers always want to pay less for the goods they buy, a lower price
makes buyers of a good better off. But how much does buyers’ well-being rise in
response to a lower price? We can use the concept of consumer surplus to answer
this question precisely.
Figure 7-3 shows a typical downward-sloping demand curve. Although this
demand curve appears somewhat different in shape from the steplike demand
curves in our previous two figures, the ideas we have just developed apply
nonetheless: Consumer surplus is the area above the price and below the demand
curve. In panel (a), consumer surplus at a price of P
1
is the area of triangleABC.
Quantity
(b) Consumer Surplus at Price P
2
Quantity
(a) Consumer Surplus at Price P
1
Price
0
Demand
P
1
A
BC
Consumer
surplus
Q
1
Price
0
Demand
P
1
P
2
A
B
Initial
consumer
surplus
D
C
E
F
Q
1
Q
2
Consumer surplus
to new consumers
Additional consumer
surplus to initial
consumers
Figure 7-3
HOW THE PRICE AFFECTS
CONSUMER SURPLUS. In panel
(a), the price is P
1
, the quantity
demanded is Q
1
, and consumer
surplus equals the area of the
triangle ABC. When the price
falls from P
1
to P
2
, as in panel (b),
the quantity demanded rises
from Q
1
to Q
2
, and the consumer
surplus rises to the area of the
triangle ADF. The increase in
consumer surplus (area BCFD)
occurs in part because existing
consumers now pay less (area
BCED) and in part because new
consumers enter the market at
the lower price (area CEF).
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 147
Now suppose that the price falls from P
1
to P
2
, as shown in panel (b). The con-
sumer surplus now equals area ADF. The increase in consumer surplus attribut-
able to the lower price is the area BCFD.
This increase in consumer surplus is composed of two parts. First, those buy-
ers who were already buying Q
1
of the good at the higher price P
1
are better off be-
cause they now pay less. The increase in consumer surplus of existing buyers is the
reduction in the amount they pay; it equals the area of the rectangle BCED. Sec-
ond, some new buyers enter the market because they are now willing to buy the
good at the lower price. As a result, the quantity demanded in the market increases
from Q
1
to Q
2
. The consumer surplus these newcomers receive is the area of the tri-
angle CEF.
WHAT DOES CONSUMER SURPLUS MEASURE?
Our goal in developing the concept of consumer surplus is to make normative
judgments about the desirability of market outcomes. Now that you have seen
what consumer surplus is, let’s consider whether it is a good measure of economic
well-being.
Imagine that you are a policymaker trying to design a good economic system.
Would you care about the amount of consumer surplus? Consumer surplus, the
amount that buyers are willing to pay for a good minus the amount they actually
pay for it, measures the benefit that buyers receive from a good as the buyers them-
selves perceive it.Thus, consumer surplus is a good measure of economic well-being
if policymakers want to respect the preferences of buyers.
In some circumstances, policymakers might choose not to care about con-
sumer surplus because they do not respect the preferences that drive buyer be-
havior. For example, drug addicts are willing to pay a high price for heroin. Yet we
would not say that addicts get a large benefit from being able to buy heroin at a
low price (even though addicts might say they do). From the standpoint of society,
willingness to pay in this instance is not a good measure of the buyers’ benefit, and
consumer surplus is not a good measure of economic well-being, because addicts
are not looking after their own best interests.
In most markets, however, consumer surplus does reflect economic well-
being. Economists normally presume that buyers are rational when they make de-
cisions and that their preferences should be respected. In this case, consumers are
the best judges of how much benefit they receive from the goods they buy.
QUICK QUIZ: Draw a demand curve for turkey. In your diagram, show a
price of turkey and the consumer surplus that results from that price. Explain
in words what this consumer surplus measures.
PRODUCER SURPLUS
We now turn to the other side of the market and consider the benefits sellers re-
ceive from participating in a market. As you will see, our analysis of sellers’ wel-
fare is similar to our analysis of buyers’ welfare.
148 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
COST AND THE WILLINGNESS TO SELL
Imagine now that you are a homeowner, and you need to get your house painted.
You turn to four sellers of painting services: Mary, Frida, Georgia, and Grandma.
Each painter is willing to do the work for you if the price is right. You decide to
take bids from the four painters and auction off the job to the painter who will do
the work for the lowest price.
Each painter is willing to take the job if the price she would receive exceeds
her cost of doing the work. Here the term cost should be interpreted as the
painters’ opportunity cost: It includes the painters’ out-of-pocket expenses (for
paint, brushes, and so on) as well as the value that the painters place on their own
time. Table 7-3 shows each painter’s cost. Because a painter’s cost is the lowest
price she would accept for her work, cost is a measure of her willingness to sell her
services. Each painter would be eager to sell her services at a price greater than her
cost, would refuse to sell her services at a price less than her cost, and would be in-
different about selling her services at a price exactly equal to her cost.
When you take bids from the painters, the price might start off high, but it
quickly falls as the painters compete for the job. Once Grandma has bid $600 (or
slightly less), she is the sole remaining bidder. Grandma is happy to do the job for
this price, because her cost is only $500. Mary, Frida, and Georgia are unwilling to
do the job for less than $600. Note that the job goes to the painter who can do the
work at the lowest cost.
What benefit does Grandma receive from getting the job? Because she is will-
ing to do the work for $500 but gets $600 for doing it, we say that she receives pro-
ducer surplusof $100. Producer surplus is the amount a seller is paid minus the
cost of production. Producer surplus measures the benefit to sellers of participat-
ing in a market.
Now consider a somewhat different example. Suppose that you have two
houses that need painting. Again, you auction off the jobs to the four painters. To
keep things simple, let’s assume that no painter is able to paint both houses and
that you will pay the same amount to paint each house. Therefore, the price falls
until two painters are left.
In this case, the bidding stops when Georgia and Grandma each offer to do
the job for a price of $800 (or slightly less). At this price, Georgia and Grandma
are willing to do the work, and Mary and Frida are not willing to bid a lower
price.At a price of $800, Grandma receives producer surplus of $300, and Georgia
receives producer surplus of $200. The total producer surplus in the market
is $500.
Table 7-3
THE COSTS OF FOUR POSSIBLE
SELLERS
SELLER COST
Mary $900
Frida 800
Georgia 600
Grandma 500
cost
the value of everything a seller must
give up to produce a good
producer surplus
the amount a seller is paid for a good
minus the seller’s cost
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 149
USING THE SUPPLY CURVE TO MEASURE
PRODUCER SURPLUS
Just as consumer surplus is closely related to the demand curve, producer surplus
is closely related to the supply curve. To see how, let’s continue our example.
We begin by using the costs of the four painters to find the supply schedule for
painting services. Table 7-4 shows the supply schedule that corresponds to the
costs in Table 7-3. If the price is below $500, none of the four painters is willing to
do the job, so the quantity supplied is zero. If the price is between $500 and $600,
only Grandma is willing to do the job, so the quantity supplied is 1. If the price is
between $600 and $800, Grandma and Georgia are willing to do the job, so the
quantity supplied is 2, and so on. Thus, the supply schedule is derived from the
costs of the four painters.
Figure 7-4 graphs the supply curve that corresponds to this supply schedule.
Note that the height of the supply curve is related to the sellers’ costs. At any quan-
tity, the price given by the supply curve shows the cost of the marginal seller,the
Table 7-4
THE SUPPLY SCHEDULE FOR THE
SELLERS IN TABLE 7-3
PRICE SELLERS QUANTITYSUPPLIED
$900 or more Mary, Frida, Georgia, Grandma 4
$800 to $900 Frida, Georgia, Grandma 3
$600 to $800 Georgia, Grandma 2
$500 to $600 Grandma 1
Less than $500 None 0
Price of
House
Painting
500
800
$900
0 Quantity of
Houses Painted
600
1234
Supply
Mary’s cost
Frida’s cost
Georgia’s cost
Grandma’s cost
Figure 7-4
THE SUPPLY CURVE. This figure
graphs the supply curve from the
supply schedule in Table 7-4.
Note that the height of the supply
curve reflects sellers’ costs.
150 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
seller who would leave the market first if the price were any lower. At a quantity
of 4 houses, for instance, the supply curve has a height of $900, the cost that Mary
(the marginal seller) incurs to provide her painting services. At a quantity of
3houses, the supply curve has a height of $800, the cost that Frida (who is now the
marginal seller) incurs.
Because the supply curve reflects sellers’ costs, we can use it to measure pro-
ducer surplus. Figure 7-5 uses the supply curve to compute producer surplus in
our example. In panel (a), we assume that the price is $600. In this case, the quan-
tity supplied is 1. Note that the area below the price and above the supply curve
equals $100. This amount is exactly the producer surplus we computed earlier for
Grandma.
Panel (b) of Figure 7-5 shows producer surplus at a price of $800. In this case,
the area below the price and above the supply curve equals the total area of the
two rectangles. This area equals $500, the producer surplus we computed earlier
for Georgia and Grandma when two houses needed painting.
The lesson from this example applies to all supply curves: The area below the
price and above the supply curve measures the producer surplus in a market.The logic is
straightforward: The height of the supply curve measures sellers’ costs, and the
difference between the price and the cost of production is each seller’s producer
surplus. Thus, the total area is the sum of the producer surplus of all sellers.
Quantity of
Houses Painted
Quantity of
Houses Painted
Price of
House
Painting
500
800
$900
0
Supply
600
1234
(b) Price = $800
Price of
House
Painting
500
800
$900
0
600
1234
(a) Price = $600
Supply
Grandma’s producer
surplus ($100)
Georgia’s producer
surplus ($200)
Grandma’s producer
surplus ($300)
Total
producer
surplus ($500)
Figure 7-5
MEASURING PRODUCER SURPLUS WITH THE SUPPLY CURVE. In panel (a), the price of the
good is $600, and the producer surplus is $100. In panel (b), the price of the good is $800,
and the producer surplus is $500.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 151
HOW A HIGHER PRICE RAISES PRODUCER SURPLUS
You will not be surprised to hear that sellers always want to receive a higher price
for the goods they sell. But how much does sellers’ well-being rise in response to
a higher price? The concept of producer surplus offers a precise answer to this
question.
Figure 7-6 shows a typical upward-sloping supply curve. Even though this
supply curve differs in shape from the steplike supply curves in the previous fig-
ure, we measure producer surplus in the same way: Producer surplus is the area
below the price and above the supply curve. In panel (a), the price is P
1
, and pro-
ducer surplus is the area of triangle ABC.
Panel (b) shows what happens when the price rises from P
1
to P
2
. Producer
surplus now equals area ADF. This increase in producer surplus has two parts.
First, those sellers who were already selling Q
1
of the good at the lower price P
1
are
better off because they now get more for what they sell. The increase in producer
surplus for existing sellers equals the area of the rectangle BCED. Second, some
new sellers enter the market because they are now willing to produce the good at
the higher price, resulting in an increase in the quantity supplied from Q
1
to Q
2
.
The producer surplus of these newcomers is the area of the triangle CEF.
Quantity
(b) Producer Surplus at Price P
2
Quantity
(a) Producer Surplus at Price P
1
Price
0
Supply
B
A
C
Producer
surplus
Q
1
Price
0
P
2
P
1
B
C
P
1
Supply
A
D
Initial
producer
surplus
E
F
Q
1
Q
2
Producer surplus
to new producers
Additional producer
surplus to initial
producers
Figure 7-6
HOW THE PRICE AFFECTS PRODUCER SURPLUS. In panel (a), the price is P
1
, the quantity
demanded is Q
1
, and producer surplus equals the area of the triangle ABC. When the
price rises from P
1
to P
2
, as in panel (b), the quantity supplied rises from Q
1
to Q
2
, and the
producer surplus rises to the area of the triangle ADF. The increase in producer surplus
(area BCFD) occurs in part because existing producers now receive more (area BCED) and
in part because new producers enter the market at the higher price (area CEF).
152 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
As this analysis shows, we use producer surplus to measure the well-being of
sellers in much the same way as we use consumer surplus to measure the well-
being of buyers. Because these two measures of economic welfare are so similar, it
is natural to use them together. And, indeed, that is exactly what we do in the next
section.
QUICK QUIZ: Draw a supply curve for turkey. In your diagram, show a
price of turkey and the producer surplus that results from that price. Explain
in words what this producer surplus measures.
MARKET EFFICIENCY
Consumer surplus and producer surplus are the basic tools that economists use to
study the welfare of buyers and sellers in a market. These tools can help us address
a fundamental economic question: Is the allocation of resources determined by free
markets in any way desirable?
THE BENEVOLENT SOCIAL PLANNER
To evaluate market outcomes, we introduce into our analysis a new, hypothetical
character, called the benevolent social planner. The benevolent social planner is an
all-knowing, all-powerful, well-intentioned dictator. The planner wants to maxi-
mize the economic well-being of everyone in society. What do you suppose this
planner should do? Should he just leave buyers and sellers at the equilibrium that
they reach naturally on their own? Or can he increase economic well-being by
altering the market outcome in some way?
To answer this question, the planner must first decide how to measure the eco-
nomic well-being of a society. One possible measure is the sum of consumer and
producer surplus, which we call total surplus.Consumer surplus is the benefit that
buyers receive from participating in a market, and producer surplus is the benefit
that sellers receive. It is therefore natural to use total surplus as a measure of soci-
ety’s economic well-being.
To better understand this measure of economic well-being, recall how we mea-
sure consumer and producer surplus. We define consumer surplus as
Consumer surplus H11005Value to buyers H11002Amount paid by buyers.
Similarly, we define producer surplus as
Producer surplus H11005Amount received by sellers H11002Cost to sellers.
When we add consumer and producer surplus together, we obtain
Total surplus H11005Value to buyers H11002Amount paid by buyers
H11001Amount received by sellers H11002Cost to sellers.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 153
The amount paid by buyers equals the amount received by sellers, so the middle
two terms in this expression cancel each other. As a result, we can write total sur-
plus as
Total surplus H11005Value to buyers H11002Cost to sellers.
Total surplus in a market is the total value to buyers of the goods, as measured by
their willingness to pay, minus the total cost to sellers of providing those goods.
If an allocation of resources maximizes total surplus, we say that the allocation
exhibits efficiency. If an allocation is not efficient, then some of the gains from
trade among buyers and sellers are not being realized. For example, an allocation
is inefficient if a good is not being produced by the sellers with lowest cost. In this
case, moving production from a high-cost producer to a low-cost producer will
lower the total cost to sellers and raise total surplus. Similarly, an allocation is in-
efficient if a good is not being consumed by the buyers who value it most highly.
In this case, moving consumption of the good from a buyer with a low valuation
to a buyer with a high valuation will raise total surplus.
In addition to efficiency, the social planner might also care about equity—the
fairness of the distribution of well-being among the various buyers and sellers. In
essence, the gains from trade in a market are like a pie to be distributed among the
market participants. The question of efficiency is whether the pie is as big as pos-
sible. The question of equity is whether the pie is divided fairly. Evaluating the
equity of a market outcome is more difficult than evaluating the efficiency.
Whereas efficiency is an objective goal that can be judged on strictly positive
grounds, equity involves normative judgments that go beyond economics and en-
ter into the realm of political philosophy.
In this chapter we concentrate on efficiency as the social planner’s goal. Keep
in mind, however, that real policymakers often care about equity as well. That is,
they care about both the size of the economic pie and how the pie gets sliced and
distributed among members of society.
EVALUATING THE MARKET EQUILIBRIUM
Figure 7-7 shows consumer and producer surplus when a market reaches the equi-
librium of supply and demand. Recall that consumer surplus equals the area
above the price and under the demand curve and producer surplus equals the area
below the price and above the supply curve. Thus, the total area between the sup-
ply and demand curves up to the point of equilibrium represents the total surplus
from this market.
Is this equilibrium allocation of resources efficient? Does it maximize total sur-
plus? To answer these questions, keep in mind that when a market is in equilib-
rium, the price determines which buyers and sellers participate in the market.
Those buyers who value the good more than the price (represented by the segment
AE on the demand curve) choose to buy the good; those buyers who value it less
than the price (represented by the segment EB) do not. Similarly, those sellers
whose costs are less than the price (represented by the segment CE on the supply
curve) choose to produce and sell the good; those sellers whose costs are greater
than the price (represented by the segment ED) do not.
These observations lead to two insights about market outcomes:
efficiency
the property of a resource allocation
of maximizing the total surplus
received by all members of society
equity
the fairness of the distribution of
well-being among the members of
society
154 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
1. Free markets allocate the supply of goods to the buyers who value them
most highly, as measured by their willingness to pay.
2. Free markets allocate the demand for goods to the sellers who can produce
them at least cost.
Thus, given the quantity produced and sold in a market equilibrium, the social
planner cannot increase economic well-being by changing the allocation of con-
sumption among buyers or the allocation of production among sellers.
But can the social planner raise total economic well-being by increasing or de-
creasing the quantity of the good? The answer is no, as stated in this third insight
about market outcomes:
3. Free markets produce the quantity of goods that maximizes the sum of
consumer and producer surplus.
To see why this is true, consider Figure 7-8. Recall that the demand curve reflects
the value to buyers and that the supply curve reflects the cost to sellers. At quanti-
ties below the equilibrium level, the value to buyers exceeds the cost to sellers. In
this region, increasing the quantity raises total surplus, and it continues to do so
until the quantity reaches the equilibrium level. Beyond the equilibrium quantity,
however, the value to buyers is less than the cost to sellers. Producing more than
the equilibrium quantity would, therefore, lower total surplus.
These three insights about market outcomes tell us that the equilibrium of sup-
ply and demand maximizes the sum of consumer and producer surplus. In other
words, the equilibrium outcome is an efficient allocation of resources. The job of
the benevolent social planner is, therefore, very easy: He can leave the market
Price
Equilibrium
price
0 QuantityEquilibrium
quantity
A
Supply
C
B
Demand
D
Producer
surplus
Consumer
surplus
E
Figure 7-7
CONSUMER AND PRODUCER
SURPLUS IN THE MARKET
EQUILIBRIUM. Total surplus—
the sum of consumer and
producer surplus—is the area
between the supply and demand
curves up to the equilibrium
quantity.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 155
outcome just as he finds it. This policy of leaving well enough alone goes by
the French expression laissez-faire,which literally translated means “allow them
to do.”
We can now better appreciate Adam Smith’s invisible hand of the market-
place, which we first discussed in Chapter 1. The benevolent social planner doesn’t
need to alter the market outcome because the invisible hand has already guided
buyers and sellers to an allocation of the economy’s resources that maximizes to-
tal surplus. This conclusion explains why economists often advocate free markets
as the best way to organize economic activity.
QUICK QUIZ: Draw the supply and demand for turkey. In the
equilibrium, show producer and consumer surplus. Explain why producing
more turkey would lower total surplus.
CONCLUSION: MARKET EFFICIENCY
AND MARKET FAILURE
This chapter introduced the basic tools of welfare economics—consumer and pro-
ducer surplus—and used them to evaluate the efficiency of free markets. We
showed that the forces of supply and demand allocate resources efficiently. That is,
Quantity
Price
0 Equilibrium
quantity
Supply
Demand
Cost
to
sellers
Cost
to
sellers
Value
to
buyers
Value
to
buyers
Value to buyers is greater
than cost to sellers.
Value to buyers is less
than cost to sellers.
Figure 7-8
THE EFFICIENCY OF THE
EQUILIBRIUM QUANTITY.At
quantities less than the equi-
librium quantity, the value to
buyers exceeds the cost to sellers.
At quantities greater than the
equilibrium quantity, the cost to
sellers exceeds the value to
buyers. Therefore, the market
equilibrium maximizes the sum
of producer and consumer
surplus.
156 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
even though each buyer and seller in a market is concerned only about his or her
own welfare, they are together led by an invisible hand to an equilibrium that
maximizes the total benefits to buyers and sellers.
Aword of warning is in order. To conclude that markets are efficient, we made
several assumptions about how markets work. When these assumptions do not
hold, our conclusion that the market equilibrium is efficient may no longer be true.
As we close this chapter, let’s consider briefly two of the most important of these
assumptions.
First, our analysis assumed that markets are perfectly competitive. In the
world, however, competition is sometimes far from perfect. In some markets, a sin-
gle buyer or seller (or a small group of them) may be able to control market prices.
This ability to influence prices is called market power.Market power can cause mar-
kets to be inefficient because it keeps the price and quantity away from the equi-
librium of supply and demand.
Second, our analysis assumed that the outcome in a market matters only to the
buyers and sellers in that market. Yet, in the world, the decisions of buyers and
IF AN ECONOMY IS TO ALLOCATE ITS SCARCE
resources efficiently, goods must get to
those consumers who value them most
highly. Ticket scalping is one example
of how markets reach efficient out-
comes. Scalpers buy tickets to plays,
concerts, and sports events and then
sell the tickets at a price above their
original cost. By charging the highest
price the market will bear, scalpers help
ensure that consumers with the great-
est willingness to pay for the tick-
ets actually do get them. In some
places, however, there is debate over
whether this market activity should
be legal.
Tickets? Supply Meets
Demand on Sidewalk
BY JOHN TIERNEY
Ticket scalping has been very good to
Kevin Thomas, and he makes no apolo-
gies. He sees himself as a classic Amer-
ican entrepreneur: a high school dropout
from the Bronx who taught himself a
trade, works seven nights a week, earns
$40,000 a year, and at age twenty-six
has $75,000 in savings, all by providing a
public service outside New York’s the-
aters and sports arenas.
He has just one complaint. “I’ve
been busted about 30 times in the last
year,” he said one recent evening, just
after making $280 at a Knicks game.
“You learn to deal with it—I give the
cops a fake name, and I pay the fines
when I have to, but I don’t think it’s fair. I
look at scalping like working as a stock-
broker, buying low and selling high. If
people are willing to pay me the money,
what kind of problem is that?”
It is a significant problem to public
officials in New York and New Jersey,
who are cracking down on street
scalpers like Mr. Thomas and on li-
censed ticket brokers. Undercover of-
ficers are enforcing new restrictions
on reselling tickets at marked-up
prices,and the attorneys general of the
two states are pressing well-publicized
IN THE NEWS
Ticket Scalping
THE INVISIBLE HAND AT WORK
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 157
sellers sometimes affect people who are not participants in the market at all. Pol-
lution is the classic example of a market outcome that affects people not in the
market. Such side effects, called externalities,cause welfare in a market to depend
on more than just the value to the buyers and the cost to the sellers. Because buy-
ers and sellers do not take these side effects into account when deciding how much
to consume and produce, the equilibrium in a market can be inefficient from the
standpoint of society as a whole.
Market power and externalities are examples of a general phenomenon called
market failure—the inability of some unregulated markets to allocate resources effi-
ciently. When markets fail, public policy can potentially remedy the problem and
increase economic efficiency. Microeconomists devote much effort to studying
when market failure is likely and what sorts of policies are best at correcting mar-
ket failures. As you continue your study of economics, you will see that the tools
of welfare economics developed here are readily adapted to that endeavor.
Despite the possibility of market failure, the invisible hand of the marketplace
is extraordinarily important. In many markets, the assumptions we made in this
cases against more than a dozen ticket
brokers.
But economists tend to see scalp-
ing from Mr. Thomas’s perspective. To
them, the governments’ crusade makes
about as much sense as the old cam-
paigns by Communist authorities against
“profiteering.” Economists argue that
the restrictions inconvenience the public,
reduce the audience for cultural and
sports events, waste the police’s time,
deprive New York City of tens of millions
of dollars of tax revenue, and actually
drive up the cost of many tickets.
“It is always good politics to pose
as defender of the poor by declaring high
prices illegal,” says William J. Baumol,
the director of the C. V. Starr Center for
Applied Economics at New York Univer-
sity. “I expect politicians to try to solve
the AIDS crisis by declaring AIDS illegal
as well. That would be harmless, be-
cause nothing would happen, but when
you outlaw high prices you create real
problems.”
Dr. Baumol was one of the econo-
mists who came up with the idea of sell-
ing same-day Broadway tickets for half
price at the TKTS booth in Times Square,
which theater owners thought danger-
ously radical when the booth opened in
1973. But the owners have profited by
finding a new clientele for tickets that
would have gone unsold, an illustration
of the free-market tenet that both buyers
and sellers ultimately benefit when price
is adjusted to meet demand.
Economists see another illustration
of that lesson at the Museum of Modern
Art, where people wait in line for up to
two hours to buy tickets for the Matisse
exhibit. But there is an alternative on the
sidewalk: Scalpers who evade the police
have been selling the $12.50 tickets to
the show at prices ranging from $20
to $50.
“You don’t have to put a very high
value on your time to pay $10 or $15 to
avoid standing in line for two hours for a
Matisse ticket,” said Richard H. Thaler,
an economist at Cornell University.
“Some people think it’s fairer to make
everyone stand in line, but that forces
everyone to engage in a totally unpro-
ductive activity, and it discriminates in fa-
vor of people who have the most free
time. Scalping gives other people a
chance, too. I can see no justification for
outlawing it.” . . .
Politicians commonly argue that
without anti-scalping laws, tickets would
become unaffordable to most people,
but California has no laws against scalp-
ing, and ticket prices there are not noto-
riously high. And as much as scalpers
would like to inflate prices, only a limited
number of people are willing to pay $100
for a ticket. . . .
Legalizing scalping, however, would
not necessarily be good news for every-
one. Mr. Thomas, for instance, fears that
the extra competition might put him out
of business. But after 16 years—he
started at age ten outside of Yankee
Stadium—he is thinking it might be time
for a change anyway.
SOURCE:The New York Times,December 26, 1992,
p.A1.
158 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
chapter work well, and the conclusion of market efficiency applies directly. More-
over, our analysis of welfare economics and market efficiency can be used to shed
light on the effects of various government policies. In the next two chapters we ap-
ply the tools we have just developed to study two important policy issues—the
welfare effects of taxation and of international trade.
a78 Consumer surplus equals buyers’ willingness to pay for
a good minus the amount they actually pay for it, and it
measures the benefit buyers get from participating in a
market. Consumer surplus can be computed by finding
the area below the demand curve and above the price.
a78 Producer surplus equals the amount sellers receive for
their goods minus their costs of production, and it
measures the benefit sellers get from participating in a
market. Producer surplus can be computed by finding
the area below the price and above the supply curve.
a78 An allocation of resources that maximizes the sum of
consumer and producer surplus is said to be efficient.
Policymakers are often concerned with the efficiency, as
well as the equity, of economic outcomes.
a78 The equilibrium of supply and demand maximizes the
sum of consumer and producer surplus. That is, the
invisible hand of the marketplace leads buyers and
sellers to allocate resources efficiently.
a78 Markets do not allocate resources efficiently in the
presence of market failures such as market power or
externalities.
Summary
welfare economics, p. 142
willingness to pay, p. 142
consumer surplus, p. 143
cost, p. 148
producer surplus, p. 148
efficiency, p. 153
equity, p. 153
Key Concepts
1. Explain how buyers’ willingness to pay, consumer
surplus, and the demand curve are related.
2. Explain how sellers’ costs, producer surplus, and the
supply curve are related.
3. In a supply-and-demand diagram, show producer and
consumer surplus in the market equilibrium.
4. What is efficiency? Is it the only goal of economic
policymakers?
5. What does the invisible hand do?
6. Name two types of market failure. Explain why each
may cause market outcomes to be inefficient.
Questions for Review
1. An early freeze in California sours the lemon crop. What
happens to consumer surplus in the market for lemons?
What happens to consumer surplus in the market for
lemonade? Illustrate your answers with diagrams.
2. Suppose the demand for French bread rises. What
happens to producer surplus in the market for French
bread? What happens to producer surplus in the market
for flour? Illustrate your answer with diagrams.
Problems and Applications
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 159
3. It is a hot day, and Bert is very thirsty. Here is the value
he places on a bottle of water:
Value of first bottle $7
Value of second bottle 5
Value of third bottle 3
Value of fourth bottle 1
a. From this information, derive Bert’s demand
schedule. Graph his demand curve for bottled
water.
b. If the price of a bottle of water is $4, how many
bottles does Bert buy? How much consumer
surplus does Bert get from his purchases? Show
Bert’s consumer surplus in your graph.
c. If the price falls to $2, how does quantity demanded
change? How does Bert’s consumer surplus
change? Show these changes in your graph.
4. Ernie owns a water pump. Because pumping large
amounts of water is harder than pumping small
amounts, the cost of producing a bottle of water rises as
he pumps more. Here is the cost he incurs to produce
each bottle of water:
Cost of first bottle $1
Cost of second bottle 3
Cost of third bottle 5
Cost of fourth bottle 7
a. From this information, derive Ernie’s supply
schedule. Graph his supply curve for bottled water.
b. If the price of a bottle of water is $4, how many
bottles does Ernie produce and sell? How much
producer surplus does Ernie get from these sales?
Show Ernie’s producer surplus in your graph.
c. If the price rises to $6, how does quantity supplied
change? How does Ernie’s producer surplus
change? Show these changes in your graph.
5. Consider a market in which Bert from Problem 3 is the
buyer and Ernie from Problem 4 is the seller.
a. Use Ernie’s supply schedule and Bert’s demand
schedule to find the quantity supplied and quantity
demanded at prices of $2, $4, and $6. Which of
these prices brings supply and demand into
equilibrium?
b. What are consumer surplus, producer surplus, and
total surplus in this equilibrium?
c. If Ernie produced and Bert consumed one less
bottle of water, what would happen to total
surplus?
d. If Ernie produced and Bert consumed one
additional bottle of water, what would happen to
total surplus?
6. The cost of producing stereo systems has fallen over the
past several decades. Let’s consider some implications
of this fact.
a. Use a supply-and-demand diagram to show the
effect of falling production costs on the price and
quantity of stereos sold.
b. In your diagram, show what happens to consumer
surplus and producer surplus.
c. Suppose the supply of stereos is very elastic. Who
benefits most from falling production costs—
consumers or producers of stereos?
7. There are four consumers willing to pay the following
amounts for haircuts:
Jerry: $7 Oprah: $2 Sally Jessy: $8 Montel: $5
There are four haircutting businesses with the following
costs:
Firm A: $3 Firm B: $6 Firm C: $4 Firm D: $2
Each firm has the capacity to produce only one haircut.
For efficiency, how many haircuts should be given?
Which businesses should cut hair, and which consumers
should have their hair cut? How large is the maximum
possible total surplus?
8. Suppose a technological advance reduces the cost of
making computers.
a. Use a supply-and-demand diagram to show what
happens to price, quantity, consumer surplus, and
producer surplus in the market for computers.
b. Computers and adding machines are substitutes.
Use a supply-and-demand diagram to show what
happens to price, quantity, consumer surplus,
and producer surplus in the market for adding
machines. Should adding machine producers be
happy or sad about the technological advance in
computers?
c. Computers and software are complements. Use a
supply-and-demand diagram to show what
happens to price, quantity, consumer surplus, and
producer surplus in the market for software.
Should software producers be happy or sad about
the technological advance in computers?
d. Does this analysis help explain why Bill Gates, a
software producer, is one of the world’s richest
men?
160 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
9. Consider how health insurance affects the quantity of
health care services performed. Suppose that the typical
medical procedure has a cost of $100, yet a person with
health insurance pays only $20 out-of-pocket when she
chooses to have an additional procedure performed.
Her insurance company pays the remaining $80. (The
insurance company will recoup the $80 through higher
premiums for everybody, but the share paid by this
individual is small.)
a. Draw the demand curve in the market for medical
care. (In your diagram, the horizontal axis should
represent the number of medical procedures.) Show
the quantity of procedures demanded if each
procedure has a price of $100.
b. On your diagram, show the quantity of procedures
demanded if consumers pay only $20 per
procedure. If the cost of each procedure to society is
truly $100, and if individuals have health insurance
as just described, will the number of procedures
performed maximize total surplus? Explain.
c. Economists often blame the health insurance
system for excessive use of medical care. Given
your analysis, why might the use of care be viewed
as “excessive”?
d. What sort of policies might prevent this excessive
use?
10. Many parts of California experienced a severe drought
in the late 1980s and early 1990s.
a. Use a diagram of the water market to show the
effects of the drought on the equilibrium price and
quantity of water.
b. Many communities did not allow the price of water
to change, however. What is the effect of this policy
on the water market? Show on your diagram any
surplus or shortage that arises.
c. A1991 op-ed piece in The Wall Street Journalstated
that “all Los Angeles residents are required to cut
their water usage by 10 percent as of March 1 and
another 5 percent starting May 1, based on their
1986 consumption levels.” The author criticized this
policy on both efficiency and equity grounds,
saying “not only does such a policy reward families
who ‘wasted’ more water back in 1986, it does little
to encourage consumers who could make more
drastic reductions, [and] . . . punishes consumers
who cannot so readily reduce their water use.” In
what way is the Los Angeles system for allocating
water inefficient? In what way does the system
seem unfair?
d. Suppose instead that Los Angeles allowed the price
of water to increase until the quantity demanded
equaled the quantity supplied. Would the resulting
allocation of water be more efficient? In your view,
would it be more or less fair than the proportionate
reductions in water use mentioned in the
newspaper article? What could be done to make the
market solution more fair?
IN THIS CHAPTER
YOU WILL . . .
Examine how tax
revenue and
deadweight loss
vary with the size
of a tax
Consider why some
taxes have larger
deadweight losses
than others
Examine how taxes
reduce consumer
and producer
surplus
Learn the meaning
and causes of the
deadweight loss of
a tax
Taxes are often a source of heated political debate. In 1776 the anger of the Ameri-
can colonies over British taxes sparked the American Revolution. More than two
centuries later Ronald Reagan was elected president on a platform of large cuts in
personal income taxes, and during his eight years in the White House the top tax
rate on income fell from 70 percent to 28 percent. In 1992 Bill Clinton was elected
in part because incumbent George Bush had broken his 1988 campaign promise,
“Read my lips: no new taxes.”
We began our study of taxes in Chapter 6. There we saw how a tax on a good
affects its price and the quantity sold and how the forces of supply and demand di-
vide the burden of a tax between buyers and sellers. In this chapter we extend this
analysis and look at how taxes affect welfare, the economic well-being of partici-
pants in a market.
APPLICATION: THE COSTS
OF TAXATION
161
162 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
The effects of taxes on welfare might at first seem obvious. The government
enacts taxes to raise revenue, and that revenue must come out of someone’s
pocket. As we saw in Chapter 6, both buyers and sellers are worse off when a good
is taxed: Atax raises the price buyers pay and lowers the price sellers receive. Yet
to understand fully how taxes affect economic well-being, we must compare the
reduced welfare of buyers and sellers to the amount of revenue the government
raises. The tools of consumer and producer surplus allow us to make this compar-
ison. The analysis will show that the costs of taxes to buyers and sellers exceeds
the revenue raised by the government.
THE DEADWEIGHT LOSS OF TAXATION
We begin by recalling one of the surprising lessons from Chapter 6: It does not
matter whether a tax on a good is levied on buyers or sellers of the good. When a
tax is levied on buyers, the demand curve shifts downward by the size of the tax;
when it is levied on sellers, the supply curve shifts upward by that amount. In ei-
ther case, when the tax is enacted, the price paid by buyers rises, and the price re-
ceived by sellers falls. In the end, buyers and sellers share the burden of the tax,
regardless of how it is levied.
Figure 8-1 shows these effects. To simplify our discussion, this figure does not
show a shift in either the supply or demand curve, although one curve must shift.
Which curve shifts depends on whether the tax is levied on sellers (the supply
curve shifts) or buyers (the demand curve shifts). In this chapter, we can simplify
the graphs by not bothering to show the shift. The key result for our purposes here
“You know, the idea of taxation
withrepresentation doesn’t
appeal to me very much, either.”
Price buyers
pay
Size of tax
Price
without tax
QuantityQuantity
with tax
0
Price
Price sellers
receive
Quantity
without tax
Demand
Supply
Figure 8-1
THE EFFECTS OF ATAX. Atax
on a good places a wedge
between the price that buyers pay
and the price that sellers receive.
The quantity of the good sold
falls.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 163
is that the tax places a wedge between the price buyers pay and the price sellers re-
ceive. Because of this tax wedge, the quantity sold falls below the level that would
be sold without a tax. In other words, a tax on a good causes the size of the market
for the good to shrink. These results should be familiar from Chapter 6.
HOW A TAX AFFECTS MARKET PARTICIPANTS
Now let’s use the tools of welfare economics to measure the gains and losses from
a tax on a good. To do this, we must take into account how the tax affects buyers,
sellers, and the government. The benefit received by buyers in a market is mea-
sured by consumer surplus—the amount buyers are willing to pay for the good
minus the amount they actually pay for it. The benefit received by sellers in a mar-
ket is measured by producer surplus—the amount sellers receive for the good mi-
nus their costs. These are precisely the measures of economic welfare we used in
Chapter 7.
What about the third interested party, the government? If Tis the size of the
tax and Qis the quantity of the good sold, then the government gets total tax rev-
enue of T H11003Q.It can use this tax revenue to provide services, such as roads, police,
and public education, or to help the needy. Therefore, to analyze how taxes affect
economic well-being, we use tax revenue to measure the government’s benefit
from the tax. Keep in mind, however, that this benefit actually accrues not to gov-
ernment but to those on whom the revenue is spent.
Figure 8-2 shows that the government’s tax revenue is represented by the rec-
tangle between the supply and demand curves. The height of this rectangle is the
size of the tax, T, and the width of the rectangle is the quantity of the good sold,
Q.Because a rectangle’s area is its height times its width, this rectangle’s area is
TH11003Q,which equals the tax revenue.
Price buyers
pay
Size of tax (T)
Quantity
sold (Q)
Tax
revenue
(T H11003 Q )
QuantityQuantity
with tax
0
Price
Price sellers
receive
Quantity
without tax
Demand
Supply
Figure 8-2
TAX REVENUE. The tax revenue
that the government collects
equals TH11003Q,the size of the tax T
times the quantity sold Q.Thus,
tax revenue equals the area of the
rectangle between the supply and
demand curves.
164 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
Welfare without a Tax To see how a tax affects welfare, we begin by
considering welfare before the government has imposed a tax. Figure 8-3 shows the
supply-and-demand diagram and marks the key areas with the letters Athrough F.
Without a tax, the price and quantity are found at the intersection of the supply
and demand curves. The price is P
1
, and the quantity sold is Q
1
. Because the demand
curve reflects buyers’ willingness to pay, consumer surplus is the area between the
demand curve and the price, AH11001B H11001C. Similarly, because the supply curve reflects
sellers’ costs, producer surplus is the area between the supply curve and the price,
DH11001E H11001F. In this case, because there is no tax, tax revenue equals zero.
Total surplus, the sum of consumer and producer surplus, equals the area AH11001
B H11001C H11001D H11001E H11001F. In other words, as we saw in Chapter 7, total surplus is the
area between the supply and demand curves up to the equilibrium quantity. The
first column of Table 8-1 summarizes these conclusions.
H11005 P
B
A
F
B
D
C
E
H11005 P
1
QuantityQ
2
0
Price
H11005 P
S
Q
1
Demand
Supply
Price
buyers
pay
Price
without tax
Price
sellers
receive
Figure 8-3
HOW ATAXAFFECTS WELFARE.
Atax on a good reduces
consumer surplus (by the area
BH11001C) and producer surplus (by
the area D H11001E). Because the fall
in producer and consumer
surplus exceeds tax revenue (area
B H11001D), the tax is said to impose a
deadweight loss (area C H11001E).
Table 8-1
WITHOUT TAX WITH TAX CHANGE
Consumer Surplus AH11001B H11001CAH11002(B H11001C)
Producer Surplus D H11001E H11001FFH11002(D H11001E)
Tax Revenue None B H11001D H11001(B H11001D)
Total Surplus AH11001B H11001C H11001D H11001E H11001FAH11001B H11001D H11001F H11002(C H11001E)
CHANGES IN WELFARE FROM ATAX. This table refers to the areas marked in Figure 8-3 to
show how a tax affects the welfare of buyers and sellers in a market.
The area C H11001E shows the fall in total surplus and is the deadweight loss of the tax.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 165
Welfare with a Tax Now consider welfare after the tax is enacted. The price
paid by buyers rises from P
1
to P
B
, so consumer surplus now equals only area A(the
area below the demand curve and above the buyer’s price). The price received by
sellers falls from P
1
to P
S
, so producer surplus now equals only area F (the area above
the supply curve and below the seller’s price). The quantity sold falls from Q
1
to Q
2
,
and the government collects tax revenue equal to the area BH11001D.
To compute total surplus with the tax, we add consumer surplus, producer
surplus, and tax revenue. Thus, we find that total surplus is area AH11001B H11001D H11001F.
The second column of Table 8-1 provides a summary.
Changes in Welfare We can now see the effects of the tax by comparing
welfare before and after the tax is enacted. The third column in Table 8-1 shows the
changes. The tax causes consumer surplus to fall by the area B H11001C and producer
surplus to fall by the area D H11001E. Tax revenue rises by the area B H11001D. Not surpris-
ingly, the tax makes buyers and sellers worse off and the government better off.
The change in total welfare includes the change in consumer surplus (which
is negative), the change in producer surplus (which is also negative), and the
change in tax revenue (which is positive). When we add these three pieces to-
gether, we find that total surplus in the market falls by the area C H11001E. Thus, the
losses to buyers and sellers from a tax exceed the revenue raised by the government.The
fall in total surplus that results when a tax (or some other policy) distorts a mar-
ket outcome is called the deadweight loss.The area C H11001E measures the size of
the deadweight loss.
To understand why taxes impose deadweight losses, recall one of the Ten Prin-
ciples of Economicsin Chapter 1: People respond to incentives. In Chapter 7 we saw
that markets normally allocate scarce resources efficiently. That is, the equilibrium
of supply and demand maximizes the total surplus of buyers and sellers in a mar-
ket. When a tax raises the price to buyers and lowers the price to sellers, however,
it gives buyers an incentive to consume less and sellers an incentive to produce
less than they otherwise would. As buyers and sellers respond to these incentives,
the size of the market shrinks below its optimum. Thus, because taxes distort in-
centives, they cause markets to allocate resources inefficiently.
DEADWEIGHT LOSSES AND THE GAINS FROM TRADE
To gain some intuition for why taxes result in deadweight losses, consider an ex-
ample. Imagine that Joe cleans Jane’s house each week for $100. The opportunity
cost of Joe’s time is $80, and the value of a clean house to Jane is $120. Thus, Joe
and Jane each receive a $20 benefit from their deal. The total surplus of $40 mea-
sures the gains from trade in this particular transaction.
Now suppose that the government levies a $50 tax on the providers of clean-
ing services. There is now no price that Jane can pay Joe that will leave both of
them better off after paying the tax. The most Jane would be willing to pay is $120,
but then Joe would be left with only $70 after paying the tax, which is less than his
$80 opportunity cost. Conversely, for Joe to receive his opportunity cost of $80,
Jane would need to pay $130, which is above the $120 value she places on a clean
house. As a result, Jane and Joe cancel their arrangement. Joe goes without the in-
come, and Jane lives in a dirtier house.
The tax has made Joe and Jane worse off by a total of $40, because they have
lost this amount of surplus. At the same time, the government collects no revenue
from Joe and Jane because they decide to cancel their arrangement. The $40 is pure
deadweight loss
the fall in total surplus that results
from a market distortion, such as
atax
166 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
deadweight loss: It is a loss to buyers and sellers in a market not offset by an
increase in government revenue. From this example, we can see the ultimate
source of deadweight losses: Taxes cause deadweight losses because they prevent buyers
and sellers from realizing some of the gains from trade.
The area of the triangle between the supply and demand curves (area C + E in
Figure 8-3) measures these losses. This loss can be seen most easily in Figure 8-4 by
recalling that the demand curve reflects the value of the good to consumers and
that the supply curve reflects the costs of producers. When the tax raises the price
to buyers to P
B
and lowers the price to sellers to P
S
, the marginal buyers and sell-
ers leave the market, so the quantity sold falls from Q
1
to Q
2
. Yet, as the figure
shows, the value of the good to these buyers still exceeds the cost to these sellers.
As in our example with Joe and Jane, the gains from trade—the difference between
buyers’ value and sellers’ cost—is less than the tax. Thus, these trades do not get
made once the tax is imposed. The deadweight loss is the surplus lost because the
tax discourages these mutually advantageous trades.
QUICK QUIZ: Draw the supply and demand curve for cookies. If the
government imposes a tax on cookies, show what happens to the quantity
sold, the price paid by buyers, and the price paid by sellers. In your diagram,
show the deadweight loss from the tax. Explain the meaning of the
deadweight loss.
THE DETERMINANTS OF THE DEADWEIGHT LOSS
What determines whether the deadweight loss from a tax is large or small? The an-
swer is the price elasticities of supply and demand, which measure how much the
quantity supplied and quantity demanded respond to changes in the price.
P
B
Cost to
sellers
Value to
buyers
Size of tax
Price
without tax
QuantityQ
2
0
Price
P
S
Q
1
Demand
SupplyLost gains
from trade
Reduction in quantity due to the tax
Figure 8-4
THE DEADWEIGHT LOSS. When
the government imposes a tax on
a good, the quantity sold falls
from Q
1
to Q
2
. As a result, some
of the potential gains from trade
among buyers and sellers do not
get realized. These lost gains
from trade create the
deadweightloss.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 167
Let’s consider first how the elasticity of supply affects the size of the dead-
weight loss. In the top two panels of Figure 8-5, the demand curve and the size of
the tax are the same. The only difference in these figures is the elasticity of the sup-
ply curve. In panel (a), the supply curve is relatively inelastic: Quantity supplied
responds only slightly to changes in the price. In panel (b), the supply curve is
(a) Inelastic Supply (b) Elastic Supply
Price
0 Quantity
Price
0 Quantity
Demand
Supply
(c) Inelastic Demand (d) Elastic Demand
Price
0 Quantity
Price
0 Quantity
Size
of
tax
Size of tax
Demand
Supply
Demand Demand
Supply
Supply
Size
of
tax
Size of tax
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
When supply is relatively
elastic, the deadweight
loss of a tax is large.
When demand is relatively
elastic, the deadweight
loss of a tax is large.
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
Figure 8-5
TAX DISTORTIONS ANDELASTICITIES. In panels (a) and (b), the demand curve and the
size of the tax are the same, but the price elasticity of supply is different. Notice that the
more elastic the supply curve, the larger the deadweight loss of the tax. In panels (c) and
(d), the supply curve and the size of the tax are the same, but the price elasticity of
demand is different. Notice that the more elastic the demand curve, the larger the
deadweight loss of the tax.
168 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
CASE STUDY THE DEADWEIGHT LOSS DEBATE
Supply, demand, elasticity, deadweight loss—all this economic theory is enough
to make your head spin. But believe it or not, these ideas go to the heart of a pro-
found political question: How big should the government be? The reason the de-
bate hinges on these concepts is that the larger the deadweight loss of taxation,
the larger the cost of any government program. If taxation entails very large dead-
weight losses, then these losses are a strong argument for a leaner government
that does less and taxes less. By contrast, if taxes impose only small deadweight
losses, then government programs are less costly than they otherwise might be.
So how big are the deadweight losses of taxation? This is a question about
which economists disagree. To see the nature of this disagreement, consider
the most important tax in the U.S. economy—the tax on labor. The Social Se-
curity tax, the Medicare tax, and, to a large extent, the federal income tax are
labor taxes. Many state governments also tax labor earnings. Alabor tax places a
wedge between the wage that firms pay and the wage that workers receive. Ifwe
add all forms of labor taxes together, the marginal tax rateon labor income—the
tax on the last dollar of earnings—is almost 50 percent for many workers.
Although the size of the labor tax is easy to determine, the deadweight loss
of this tax is less straightforward. Economists disagree about whether this 50
percent labor tax has a small or a large deadweight loss. This disagreement
arises because they hold different views about the elasticity of labor supply.
Economists who argue that labor taxes are not very distorting believe that
labor supply is fairly inelastic. Most people, they claim, would work full-time
regardless of the wage. If so, the labor supply curve is almost vertical, and a tax
on labor has a small deadweight loss.
Economists who argue that labor taxes are highly distorting believe that la-
bor supply is more elastic. They admit that some groups of workers may supply
their labor inelastically but claim that many other groups respond more to in-
centives. Here are some examples:
a78 Many workers can adjust the number of hours they work—for instance, by
working overtime. The higher the wage, the more hours they choose to work.
relatively elastic: Quantity supplied responds substantially to changes in the price.
Notice that the deadweight loss, the area of the triangle between the supply and
demand curves, is larger when the supply curve is more elastic.
Similarly, the bottom two panels of Figure 8-5 show how the elasticity of de-
mand affects the size of the deadweight loss. Here the supply curve and the size of
the tax are held constant. In panel (c) the demand curve is relatively inelastic, and
the deadweight loss is small. In panel (d) the demand curve is more elastic, and the
deadweight loss from the tax is larger.
The lesson from this figure is easy to explain. Atax has a deadweight loss be-
cause it induces buyers and sellers to change their behavior. The tax raises the price
paid by buyers, so they consume less. At the same time, the tax lowers the price re-
ceived by sellers, so they produce less. Because of these changes in behavior, the
size of the market shrinks below the optimum. The elasticities of supply and de-
mand measure how much sellers and buyers respond to the changes in the price
and, therefore, determine how much the tax distorts the market outcome. Hence,
the greater the elasticities of supply and demand, the greater the deadweight loss ofa tax.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 169
a78 Some families have second earners—often married women with children—
with some discretion over whether to do unpaid work at home or paid
work in the marketplace. When deciding whether to take a job, these sec-
ond earners compare the benefits of being at home (including savings on
the cost of child care) with the wages they could earn.
a78 Many of the elderly can choose when to retire, and their decisions are partly
based on the wage. Once they are retired, the wage determines their incen-
tive to work part-time.
a78 Some people consider engaging in illegal economic activity, such as the drug
trade, or working at jobs that pay “under the table” to evade taxes. Econo-
mists call this the underground economy.In deciding whether to work in the un-
derground economy or at a legitimate job, these potential criminals compare
what they can earn by breaking the law with the wage they can earn legally.
In each of these cases, the quantity of labor supplied responds to the wage (the
price of labor). Thus, the decisions of these workers are distorted when their la-
bor earnings are taxed. Labor taxes encourage workers to work fewer hours,
second earners to stay at home, the elderly to retire early, and the unscrupulous
to enter the underground economy.
These two views of labor taxation persist to this day. Indeed, whenever you
see two political candidates debating whether the government should provide
more services or reduce the tax burden, keep in mind that part of the disagree-
ment may rest on different views about the elasticity of labor supply and the
deadweight loss of taxation.
“LETMETELLYOUWHATI THINKABOUTTHEELASTICITYOFLABORSUPPLY.”
QUICK QUIZ: The demand for beer is more elastic than the demand for
milk. Would a tax on beer or a tax on milk have larger deadweight loss? Why?
170 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
Is there an ideal tax? Henry
George, the nineteenth-century
American economist and so-
cial philosopher, thought so. In
his 1879 book Progress and
Poverty, George argued that
the government should raise
all its revenue from a tax on
land. This “single tax” was, he
claimed, both equitable and ef-
ficient. George’s ideas won him
a large political following, and
in 1886 he lost a close race for
mayor of New York City (although he finished well ahead of
Republican candidate Theodore Roosevelt).
George’s proposal to tax land was motivated largely
by a concern over the distribution of economic well-being.
He deplored the “shocking contrast between monstrous
wealth and debasing want” and thought landowners bene-
fited more than they should from the rapid growth in the
overall economy.
George’s arguments for the land tax can be understood
using the tools of modern economics. Consider first supply
and demand in the market for renting land. As immigration
causes the population to rise and technological progress
causes incomes to grow, the demand for land rises over
time. Yet because the amount of land is fixed, the supply is
perfectly inelastic. Rapid increases in demand together with
inelastic supply lead to large increases in the equilibrium
rents on land, so that economic growth makes rich landown-
ers even richer.
Now consider the incidence of a tax on land. As we first
saw in Chapter 6, the burden of a tax falls more heavily on
the side of the market that is less elastic. A tax on land takes
this principle to an extreme. Because the elasticity of supply
is zero, the landowners bear the entire burden of the tax.
Consider next the
question of efficiency. As
we just discussed, the
deadweight loss of a tax
depends on the elastici-
ties of supply and de-
mand. Again, a tax on land
is an extreme case. Be-
cause supply is perfectly
inelastic, a tax on land
does not alter the market
allocation. There is no
deadweight loss, and the
government’s tax revenue
exactly equals the loss of
the landowners.
Although taxing land
may look attractive in the-
ory, it is not as straightforward in practice as it may appear.
For a tax on land not to distort economic incentives, it must
be a tax on raw land. Yet the value of land often comes from
improvements, such as clearing trees, providing sewers,
and building roads. Unlike the supply of raw land, the supply
of improvements has an elasticity greater than zero. If a
land tax were imposed on improvements, it would distort in-
centives. Landowners would respond by devoting fewer re-
sources to improving their land.
Today, few economists support George’s proposal for a
single tax on land. Not only is taxing improvements a poten-
tial problem, but the tax would not raise enough revenue to
pay for the much larger government we have today. Yet many
of George’s arguments remain valid. Here is the assess-
ment of the eminent economist Milton Friedman a century
after George’s book: “In my opinion, the least bad tax is the
property tax on the unimproved value of land, the Henry
George argument of many, many years ago.”
HENRY GEORGE
FYI
Henry George
and the
LandTax
DEADWEIGHT LOSS AND
TAX REVENUE AS TAXES VARY
Taxes rarely stay the same for long periods of time. Policymakers in local, state,
and federal governments are always considering raising one tax or lowering
another. Here we consider what happens to the deadweight loss and tax revenue
when the size of a tax changes.
Figure 8-6 shows the effects of a small, medium, and large tax, holding con-
stant the market’s supply and demand curves. The deadweight loss—the reduc-
tion in total surplus that results when the tax reduces the size of a market below
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 171
the optimum—equals the area of the triangle between the supply and demand
curves. For the small tax in panel (a), the area of the deadweight loss triangle is
quite small. But as the size of a tax rises in panels (b) and (c), the deadweight loss
grows larger and larger.
Indeed, the deadweight loss of a tax rises even more rapidly than the size of
the tax. The reason is that the deadweight loss is an area of a triangle, and an area
Demand
Supply
P
B
QuantityQ
2
0
Price
Q
1
Demand
Supply
(a) Small Tax
Deadweight
loss
Tax revenue
Tax revenue
P
S
P
B
QuantityQ
2
0
Price
Q
1
(b) Medium Tax
Deadweight
loss
P
S
Figure 8-6
DEADWEIGHT LOSS AND TAX REVENUE FROM THREE TAXES OF DIFFERENT SIZE. The
deadweight loss is the reduction in total surplus due to the tax. Tax revenue is the amount
of the tax times the amount of the good sold. In panel (a), a small tax has a small
deadweight loss and raises a small amount of revenue. In panel (b), a somewhat larger tax
has a larger deadweight loss and raises a larger amount of revenue. In panel (c), a very
large tax has a very large deadweight loss, but because it has reduced the size of the
market so much, the tax raises only a small amount of revenue.
Tax revenue
P
B
QuantityQ
2
0
Price
Q
1
Demand
Supply
(c) Large Tax
Deadweight
loss
P
S
172 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
CASE STUDY THE LAFFER CURVE AND
SUPPLY-SIDE ECONOMICS
One day in 1974, economist Arthur Laffer sat in a Washington restaurant with
some prominent journalists and politicians. He took out a napkin and drew a
figure on it to show how tax rates affect tax revenue. It looked much like panel
(b) of our Figure 8-7. Laffer then suggested that the United States was on the
downward-sloping side of this curve. Tax rates were so high, he argued, that re-
ducing them would actually raise tax revenue.
Most economists were skeptical of Laffer’s suggestion. The idea that a cut
in tax rates could raise tax revenue was correct as a matter of economic theory,
but there was more doubt about whether it would do so in practice. There was
little evidence for Laffer’s view that U.S. tax rates had in fact reached such ex-
treme levels.
Nonetheless, the Laffer curve(as it became known) captured the imagination
of Ronald Reagan. David Stockman, budget director in the first Reagan admin-
istration, offers the following story:
[Reagan] had once been on the Laffer curve himself. “I came into the Big
Money making pictures during World War II,” he would always say. At that
time the wartime income surtax hit 90 percent. “You could only make four
pictures and then you were in the top bracket,” he would continue. “So we
all quit working after four pictures and went off to the country.” High tax
rates caused less work. Low tax rates caused more. His experience proved it.
When Reagan ran for president in 1980, he made cutting taxes part of his plat-
form. Reagan argued that taxes were so high that they were discouraging hard
work. He argued that lower taxes would give people the proper incentive to
work, which would raise economic well-being and perhaps even tax revenue.
Because the cut in tax rates was intended to encourage people to increase the
quantity of labor they supplied, the views of Laffer and Reagan became known
as supply-side economics.
Subsequent history failed to confirm Laffer’s conjecture that lower tax rates
would raise tax revenue. When Reagan cut taxes after he was elected, the result
of a triangle depends on the squareof its size. If we double the size of a tax, for
instance, the base and height of the triangle double, so the deadweight loss rises by
a factor of 4. If we triple the size of a tax, the base and height triple, so the dead-
weight loss rises by a factor of 9.
The government’s tax revenue is the size of the tax times the amount of the
good sold. As Figure 8-6 shows, tax revenue equals the area of the rectangle be-
tween the supply and demand curves. For the small tax in panel (a), tax revenue is
small. As the size of a tax rises from panel (a) to panel (b), tax revenue grows. But
as the size of the tax rises further from panel (b) to panel (c), tax revenue falls be-
cause the higher tax drastically reduces the size of the market. For a very large tax,
no revenue would be raised, because people would stop buying and selling the
good altogether.
Figure 8-7 summarizes these results. In panel (a) we see that as the size of a tax
increases, its deadweight loss quickly gets larger. By contrast, panel (b) shows that
tax revenue first rises with the size of the tax; but then, as the tax gets larger, the
market shrinks so much that tax revenue starts to fall.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 173
was less tax revenue, not more. Revenue from personal income taxes (per per-
son, adjusted for inflation) fell by 9 percent from 1980 to 1984, even though av-
erage income (per person, adjusted for inflation) grew by 4 percent over this
period. The tax cut, together with policymakers’ unwillingness to restrain
spending, began a long period during which the government spent more than
it collected in taxes. Throughout Reagan’s two terms in office, and for many
years thereafter, the government ran large budget deficits.
Yet Laffer’s argument is not completely without merit. Although an overall
cut in tax rates normally reduces revenue, some taxpayers at some times may be
on the wrong side of the Laffer curve. In the 1980s, tax revenue collected from the
richest Americans, who face the highest tax rates, did rise when their taxes were
cut. The idea that cutting taxes can raise revenue may be correct if applied to
(a) Deadweight Loss
Deadweight
Loss
0 Tax Size
(b) Revenue (the Laffer curve)
Tax
Revenue
0 Tax Size
Figure 8-7
HOW DEADWEIGHT LOSS AND
TAX REVENUE VARY WITH THE
SIZE OF ATAX. Panel (a) shows
that as the size of a tax grows
larger, the deadweight loss grows
larger. Panel (b) shows that tax
revenue first rises, then falls. This
relationship is sometimes called
the Laffer curve.
174 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
those taxpayers facing the highest tax rates. In addition, Laffer’s argument may
be more plausible when applied to other countries, where tax rates are much
higher than in the United States. In Sweden in the early 1980s, for instance, the
typical worker faced a marginal tax rate of about 80 percent. Such a high tax rate
provides a substantial disincentive to work. Studies have suggested that Sweden
would indeed have raised more tax revenue if it had lowered its tax rates.
These ideas arise frequently in political debate. When Bill Clinton moved into
the White House in 1993, he increased the federal income tax rates on high-
income taxpayers to about 40 percent. Some economists criticized the policy,
arguing that the plan would not yield as much revenue as the Clinton adminis-
tration estimated. They claimed that the administration did not fully take into
WORLD LEADERS NEED TO UNDERSTAND
thecosts of taxation, even if the world
they’re leading happens to be the
figment of some game designer’s
imagination.
Supply-Side Is a
Winning Strategy
BY JOHN J. VECCHIONE
Congress may have given up on cutting
taxes, but there’s one corner of the
country where supply-side economics
still rules—the computer screens of
game enthusiasts.
Not all messages from computer
games are antisocial ones. Although
we’ve heard a lot recently about games
like Doom, known as “shooters,” in what
are known as “God games,” a player as-
sumes total control of a city, a country, or
even a galaxy, deciding everything from
military to economic policy. In SimCity, a
player runs a beleaguered municipal ad-
ministration. In Civilization and its se-
quels, the player is the leader of a historic
empire, such as Stalinist Russia or Eliza-
bethan England, in a scramble for world
domination. In Master of Orion, a player
is given command of an entire species—
whether humans or lizard-like Sakkras—
with the goal of conquering the galaxy.
One thing these games have in
common: Success requires economic
growth, and that can only be achieved by
keeping taxes low. Tax rates range from
the edenic zero to the punitive 80%. With
the proceeds of these taxes the player
must build costly military or police forces
and the infrastructure to support eco-
nomic and technological advancement.
Why not simply keep taxes high and
meet all the “societal needs” a despot
could want? Because . . . keeping taxes
high leads the population to produce
less. As tax rates increase there is, at
first, no easily discernable effect on the
populace, except perhaps a few frowns
and grumbles. But as soon as taxes
reach a certain point—10% in some
games, 20% in others—citizens begin to
revolt. . . .
In games covering a single city, citi-
zens vote with their feet and begin leav-
ing town. No new jobs are created, and
once-vibrant downtown areas are left
with little traffic but plenty of crime. Tax
rates that approach 50% or more accel-
erate the trend. . . .
In the state or galaxy games, similar
rules apply. During times of great military
conflict or bursts of government con-
struction, tax rates can be increased for
a number of years without too much
damage to the populace, and revenues
do increase from the previous year. The
government can simply buy what it
needs from increased revenue. But a
long war or government building program
creates problems in “growing the econ-
omy” if tax rates are too high. Produc-
tion slumps. The busy empire builder
finds that his starships are harder to pro-
duce. Before long a once mighty empire
is tottering on the brink of collapse and
the ruler is deposed. The wise ruler
keeps taxes as low as possible consis-
tent with enough guns and roads to keep
the country safe from a takeover by the
enemy. . . .
Who says kids are wasting their
time playing computers games?
SOURCE:The Wall Street Journal, May 5, 1999,
p.A22.
IN THE NEWS
How to Be Master
oftheUniverse
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 175
account how taxes alter behavior. Conversely, when Bob Dole challenged Bill
Clinton in the election of 1996, Dole proposed cutting personal income taxes. Al-
though Dole rejected the idea that tax cuts would completely pay for themselves,
he did claim that 28 percent of the tax cut would be recouped because lower tax
rates would lead to more rapid economic growth. Economists debated whether
Dole’s 28 percent projection was reasonable, excessively optimistic, or (as Laffer
might suggest) excessively pessimistic.
Policymakers disagree about these issues in part because they disagree
about the size of the relevant elasticities. The more elastic that supply and de-
mand are in any market, the more taxes in that market distort behavior, and the
more likely it is that a tax cut will raise tax revenue. There is no debate, how-
ever, about the general lesson: How much revenue the government gains or
loses from a tax change cannot be computed just by looking at tax rates. It also
depends on how the tax change affects people’s behavior.
QUICK QUIZ: If the government doubles the tax on gasoline, can you be
sure that revenue from the gasoline tax will rise? Can you be sure that the
deadweight loss from the gasoline tax will rise? Explain.
CONCLUSION
Taxes, Oliver Wendell Holmes once said, are the price we pay for a civilized soci-
ety. Indeed, our society cannot exist without some form of taxes. We all expect the
government to provide certain services, such as roads, parks, police, and national
defense. These public services require tax revenue.
This chapter has shed some light on how high the price of civilized society can
be. One of the Ten Principles of Economicsdiscussed in Chapter 1 is that markets are
usually a good way to organize economic activity. When the government imposes
taxes on buyers or sellers of a good, however, society loses some of the benefits of
market efficiency. Taxes are costly to market participants not only because taxes
transfer resources from those participants to the government, but also because
they alter incentives and distort market outcomes.
a78 Atax on a good reduces the welfare of buyers and
sellers of the good, and the reduction in consumer and
producer surplus usually exceeds the revenue raised by
the government. The fall in total surplus—the sum of
consumer surplus, producer surplus, and tax revenue—
is called the deadweight loss of the tax.
a78 Taxes have deadweight losses because they cause
buyers to consume less and sellers to produce less, and
this change in behavior shrinks the size of the market
below the level that maximizes total surplus. Because
the elasticities of supply and demand measure how
much market participants respond to market conditions,
larger elasticities imply larger deadweight losses.
a78 As a tax grows larger, it distorts incentives more, and its
deadweight loss grows larger. Tax revenue first rises
with the size of a tax. Eventually, however, a larger tax
reduces tax revenue because it reduces the size of the
market.
Summary
176 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
1. What happens to consumer and producer surplus when
the sale of a good is taxed? How does the change in
consumer and producer surplus compare to the tax
revenue? Explain.
2. Draw a supply-and-demand diagram with a tax on the
sale of the good. Show the deadweight loss. Show the
tax revenue.
3. How do the elasticities of supply and demand affect the
deadweight loss of a tax? Why do they have this effect?
4. Why do experts disagree about whether labor taxes
have small or large deadweight losses?
5. What happens to the deadweight loss and tax revenue
when a tax is increased?
Questions for Review
deadweight loss, p. 165
Key Concepts
1. The market for pizza is characterized by a downward-
sloping demand curve and an upward-sloping supply
curve.
a. Draw the competitive market equilibrium. Label
the price, quantity, consumer surplus, and
producersurplus. Is there any deadweight loss?
Explain.
b. Suppose that the government forces each pizzeria
to pay a $1 tax on each pizza sold. Illustrate the
effect of this tax on the pizza market, being sure to
label the consumer surplus, producer surplus,
government revenue, and deadweight loss. How
does each area compare to the pre-tax case?
c. If the tax were removed, pizza eaters and sellers
would be better off, but the government would lose
tax revenue. Suppose that consumers and
producers voluntarily transferred some of their
gains to the government. Could all parties
(including the government) be better off than they
were with a tax? Explain using the labeled areas in
your graph.
2. Evaluate the following two statements. Do you agree?
Why or why not?
a. “If the government taxes land, wealthy land-
owners will pass the tax on to their poorer renters.”
b. “If the government taxes apartment buildings,
wealthy landlords will pass the tax on to their
poorer renters.”
3. Evaluate the following two statements. Do you agree?
Why or why not?
a. “Atax that has no deadweight loss cannot raise any
revenue for the government.”
b. “Atax that raises no revenue for the government
cannot have any deadweight loss.”
4. Consider the market for rubber bands.
a. If this market has very elastic supply and very
inelastic demand, how would the burden of a tax
on rubber bands be shared between consumers and
producers? Use the tools of consumer surplus and
producer surplus in your answer.
b. If this market has very inelastic supply and very
elastic demand, how would the burden of a tax on
rubber bands be shared between consumers and
producers? Contrast your answer with your answer
to part (a).
5. Suppose that the government imposes a tax on
heatingoil.
a. Would the deadweight loss from this tax likely be
greater in the first year after it is imposed or in the
fifth year? Explain.
b. Would the revenue collected from this tax likely be
greater in the first year after it is imposed or in the
fifth year? Explain.
6. After economics class one day, your friend suggests
thattaxing food would be a good way to raise
revenuebecause the demand for food is quite inelastic.
In what sense is taxing food a “good” way to raise
revenue? In what sense is it not a “good” way to raise
revenue?
Problems and Applications
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 177
7. Senator Daniel Patrick Moynihan once introduced a bill
that would levy a 10,000 percent tax on certain hollow-
tipped bullets.
a. Do you expect that this tax would raise much
revenue? Why or why not?
b. Even if the tax would raise no revenue, what
mightbe Senator Moynihan’s reason for
proposingit?
8. The government places a tax on the purchase of socks.
a. Illustrate the effect of this tax on equilibrium price
and quantity in the sock market. Identify the
following areas both before and after the imposition
of the tax: total spending by consumers, total
revenue for producers, and government tax
revenue.
b. Does the price received by producers rise or fall?
Can you tell whether total receipts for producers
rise or fall? Explain.
c. Does the price paid by consumers rise or fall? Can
you tell whether total spending by consumers rises
or falls? Explain carefully. (Hint: Think about
elasticity.) If total consumer spending falls, does
consumer surplus rise? Explain.
9. Suppose the government currently raises $100 million
through a $0.01 tax on widgets, and another $100
million through a $0.10 tax on gadgets. If the
government doubled the tax rate on widgets and
eliminated the tax on gadgets, would it raise more
money than today, less money, or the same amount of
money? Explain.
10. Most states tax the purchase of new cars. Suppose that
New Jersey currently requires car dealers to pay the
state $100 for each car sold, and plans to increase the tax
to $150 per car next year.
a. Illustrate the effect of this tax increase on the
quantity of cars sold in New Jersey, the price paid
by consumers, and the price received by producers.
b. Create a table that shows the levels of consumer
surplus, producer surplus, government revenue,
and total surplus both before and after the tax
increase.
c. What is the change in government revenue? Is it
positive or negative?
d. What is the change in deadweight loss? Is it
positive or negative?
e. Give one reason why the demand for cars in New
Jersey might be fairly elastic. Does this make the
additional tax more or less likely to increase
government revenue? How might states try to
reduce the elasticity of demand?
11. Several years ago the British government imposed a
“poll tax” that required each person to pay a flat
amount to the government independent of his or her
income or wealth. What is the effect of such a tax on
economic efficiency? What is the effect on economic
equity? Do you think this was a popular tax?
12. This chapter analyzed the welfare effects of a tax on a
good. Consider now the opposite policy. Suppose that
the government subsidizes a good: For each unit of the
good sold, the government pays $2 to the buyer. How
does the subsidy affect consumer surplus, producer
surplus, tax revenue, and total surplus? Does a subsidy
lead to a deadweight loss? Explain.
13. (This problem uses some high school algebra and is
challenging.) Suppose that a market is described by the
following supply and demand equations:
Q
S
= 2P
Q
D
= 300 H11002P
a. Solve for the equilibrium price and the equilibrium
quantity.
b. Suppose that a tax of Tis placed on buyers, so the
new demand equation is
Q
D
= 300 H11002(PH11001T).
Solve for the new equilibrium. What happens to the
price received by sellers, the price paid by buyers,
and the quantity sold?
c. Tax revenue is TH11003Q.Use your answer to part (b)
to solve for tax revenue as a function of T. Graph
this relationship for Tbetween 0 and 300.
d. The deadweight loss of a tax is the area of the
triangle between the supply and demand curves.
Recalling that the area of a triangle is 1/2 H11003base H11003
height, solve for deadweight loss as a function of T.
Graph this relationship for Tbetween 0 and 300.
(Hint: Looking sideways, the base of the
deadweight loss triangle is T, and the height is the
difference between the quantity sold with the tax
and the quantity sold without the tax.)
e. The government now levies a tax on this good of
$200 per unit. Is this a good policy? Why or why
not? Can you propose a better policy?
IN THIS CHAPTER
YOU WILL . . .
Examine the
arguments people
use to advocate
trade restrictions
Learn that the gains
to winners from
international trade
exceed the losses
to losers
Consider what
determines whether
a country imports
or exports a good
Examine who wins
and who loses from
international trade
Analyze the welfare
effects of tariffs
and import quotas
If you check the labels on the clothes you are now wearing, you will probably find
that some of your clothes were made in another country. Acentury ago the textiles
and clothing industry was a major part of the U.S. economy, but that is no longer
the case. Faced with foreign competitors that could produce quality goods at low
cost, many U.S. firms found it increasingly difficult to produce and sell textiles and
clothing at a profit. As a result, they laid off their workers and shut down their fac-
tories. Today, much of the textiles and clothing that Americans consume are im-
ported from abroad.
The story of the textiles industry raises important questions for economic pol-
icy: How does international trade affect economic well-being? Who gains and who
loses from free trade among countries, and how do the gains compare to the
losses?
APPLICATION:
INTERNATIONAL TRADE
179
180 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
Chapter 3 introduced the study of international trade by applying the princi-
ple of comparative advantage. According to this principle, all countries can bene-
fit from trading with one another because trade allows each country to specialize
in doing what it does best. But the analysis in Chapter 3 was incomplete. It did not
explain how the international marketplace achieves these gains from trade or how
the gains are distributed among various economic actors.
We now return to the study of international trade and take up these questions.
Over the past several chapters, we have developed many tools for analyzing how
markets work: supply, demand, equilibrium, consumer surplus, producer surplus,
and so on. With these tools we can learn more about the effects of international
trade on economic well-being.
THE DETERMINANTS OF TRADE
Consider the market for steel. The steel market is well suited to examining the
gains and losses from international trade: Steel is made in many countries around
the world, and there is much world trade in steel. Moreover, the steel market is one
in which policymakers often consider (and sometimes implement) trade restric-
tions in order to protect domestic steel producers from foreign competitors. We ex-
amine here the steel market in the imaginary country of Isoland.
THE EQUILIBRIUM WITHOUT TRADE
As our story begins, the Isolandian steel market is isolated from the rest of the
world. By government decree, no one in Isoland is allowed to import or export
steel, and the penalty for violating the decree is so large that no one dares try.
Because there is no international trade, the market for steel in Isoland consists
solely of Isolandian buyers and sellers. As Figure 9-1 shows, the domestic price ad-
justs to balance the quantity supplied by domestic sellers and the quantity de-
manded by domestic buyers. The figure shows the consumer and producer
surplus in the equilibrium without trade. The sum of consumer and producer
surplus measures the total benefits that buyers and sellers receive from the steel
market.
Now suppose that, in an election upset, Isoland elects a new president. The
president campaigned on a platform of “change” and promised the voters bold
new ideas. Her first act is to assemble a team of economists to evaluate Isolandian
trade policy. She asks them to report back on three questions:
a78 If the government allowed Isolandians to import and export steel, what
would happen to the price of steel and the quantity of steel sold in the
domestic steel market?
a78 Who would gain from free trade in steel and who would lose, and would the
gains exceed the losses?
a78 Should a tariff (a tax on steel imports) or an import quota (a limit on steel
imports) be part of the new trade policy?
CHAPTER 9 APPLICATION: INTERNATIONAL TRADE 181
After reviewing supply and demand in their favorite textbook (this one, of course),
the Isolandian economics team begins its analysis.
THE WORLD PRICE AND COMPARATIVE ADVANTAGE
The first issue our economists take up is whether Isoland is likely to become a steel
importer or a steel exporter. In other words, if free trade were allowed, would
Isolandians end up buying or selling steel in world markets?
To answer this question, the economists compare the current Isolandian price
of steel to the price of steel in other countries. We call the price prevailing in world
markets the world price.If the world price of steel is higher than the domestic
price, then Isoland would become an exporter of steel once trade is permitted.
Isolandian steel producers would be eager to receive the higher prices available
abroad and would start selling their steel to buyers in other countries. Conversely,
if the world price of steel is lower than the domestic price, then Isoland would be-
come an importer of steel. Because foreign sellers offer a better price, Isolandian
steel consumers would quickly start buying steel from other countries.
In essence, comparing the world price and the domestic price before trade in-
dicates whether Isoland has a comparative advantage in producing steel. The do-
mestic price reflects the opportunity cost of steel: It tells us how much an
Isolandian must give up to get one unit of steel. If the domestic price is low, the
cost of producing steel in Isoland is low, suggesting that Isoland has a comparative
advantage in producing steel relative to the rest of the world. If the domestic price
is high, then the cost of producing steel in Isoland is high, suggesting that foreign
countries have a comparative advantage in producing steel.
Price
of Steel
Equilibrium
price
0 Quantity
of Steel
Equilibrium
quantity
Domestic
supply
Domestic
demand
Producer
surplus
Consumer
surplus
Figure 9-1
THE EQUILIBRIUM WITHOUT
INTERNATIONAL TRADE. When
an economy cannot trade in
world markets, the price adjusts
to balance domestic supply and
demand. This figure shows
consumer and producer surplus
in an equilibrium without
international trade for the steel
market in the imaginary country
of Isoland.
world price
the price of a good that prevails in
the world market for that good
182 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
As we saw in Chapter 3, trade among nations is ultimately based on compar-
ative advantage. That is, trade is beneficial because it allows each nation to spe-
cialize in doing what it does best. By comparing the world price and the domestic
price before trade, we can determine whether Isoland is better or worse at pro-
ducing steel than the rest of the world.
QUICK QUIZ: The country Autarka does not allow international trade.
In Autarka, you can buy a wool suit for 3 ounces of gold. Meanwhile, in
neighboring countries, you can buy the same suit for 2 ounces of gold. If
Autarka were to allow free trade, would it import or export suits?
THE WINNERS AND LOSERS FROM TRADE
To analyze the welfare effects of free trade, the Isolandian economists begin with
the assumption that Isoland is a small economy compared to the rest of the world
so that its actions have negligible effect on world markets. The small-economy as-
sumption has a specific implication for analyzing the steel market: If Isoland is a
small economy, then the change in Isoland’s trade policy will not affect the world
price of steel. The Isolandians are said to be price takersin the world economy. That
is, they take the world price of steel as given. They can sell steel at this price and
be exporters or buy steel at this price and be importers.
The small-economy assumption is not necessary to analyze the gains and
losses from international trade. But the Isolandian economists know from experi-
ence that this assumption greatly simplifies the analysis. They also know that the
basic lessons do not change in the more complicated case of a large economy.
THE GAINS AND LOSSES OF AN EXPORTING COUNTRY
Figure 9-2 shows the Isolandian steel market when the domestic equilibrium price
before trade is below the world price. Once free trade is allowed, the domestic
price rises to equal the world price. No seller of steel would accept less than the
world price, and no buyer would pay more than the world price.
With the domestic price now equal to the world price, the domestic quantity
supplied differs from the domestic quantity demanded. The supply curve shows
the quantity of steel supplied by Isolandian sellers. The demand curve shows the
quantity of steel demanded by Isolandian buyers. Because the domestic quantity
supplied is greater than the domestic quantity demanded, Isoland sells steel to
other countries. Thus, Isoland becomes a steel exporter.
Although domestic quantity supplied and domestic quantity demanded differ,
the steel market is still in equilibrium because there is now another participant in
the market: the rest of the world. One can view the horizontal line at the world
price as representing the demand for steel from the rest of the world. This demand
curve is perfectly elastic because Isoland, as a small economy, can sell as much
steel as it wants at the world price.
CHAPTER 9 APPLICATION: INTERNATIONAL TRADE 183
Now consider the gains and losses from opening up trade. Clearly, not every-
one benefits. Trade forces the domestic price to rise to the world price. Domestic
producers of steel are better off because they can now sell steel at a higher price,
but domestic consumers of steel are worse off because they have to buy steel at a
higher price.
To measure these gains and losses, we look at the changes in consumer and
producer surplus, which are shown in Figure 9-3 and summarized in Table 9-1. Be-
fore trade is allowed, the price of steel adjusts to balance domestic supply and do-
mestic demand. Consumer surplus, the area between the demand curve and the
before-trade price, is area AH11001B. Producer surplus, the area between the supply
curve and the before-trade price, is area C. Total surplus before trade, the sum of
consumer and producer surplus, is area AH11001B H11001C.
After trade is allowed, the domestic price rises to the world price. Consumer
surplus is area A(the area between the demand curve and the world price). Pro-
ducer surplus is area B H11001C H11001D (the area between the supply curve and the world
price). Thus, total surplus with trade is area AH11001B H11001C H11001D.
These welfare calculations show who wins and who loses from trade in an
exporting country. Sellers benefit because producer surplus increases by the area
BH11001D. Buyers are worse off because consumer surplus decreases by the area B. Be-
cause the gains of sellers exceed the losses of buyers by the area D, total surplus in
Isoland increases.
This analysis of an exporting country yields two conclusions:
a78 When a country allows trade and becomes an exporter of a good, domestic
producers of the good are better off, and domestic consumers of the good are
worse off.
Price
of Steel
Price
before trade
Price
after trade
0 Quantity
of Steel
Domestic
quantity
demanded
Domestic
quantity
supplied
Domestic
supply
World
price
Domestic
demand
Exports
Figure 9-2
INTERNATIONAL TRADE IN AN
EXPORTING COUNTRY. Once
trade is allowed, the domestic
price rises to equal the world
price. The supply curve shows
the quantity of steel produced
domestically, and the demand
curve shows the quantity
consumed domestically. Exports
from Isoland equal the difference
between the domestic quantity
supplied and the domestic
quantity demanded at the world
price.
184 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
a78 Trade raises the economic well-being of a nation in the sense that the gains of
the winners exceed the losses of the losers.
THE GAINS AND LOSSES OF AN IMPORTING COUNTRY
Now suppose that the domestic price before trade is above the world price. Once
again, after free trade is allowed, the domestic price must equal the world price. As
Figure 9-4 shows, the domestic quantity supplied is less than the domestic quan-
tity demanded. The difference between the domestic quantity demanded and the
domestic quantity supplied is bought from other countries, and Isoland becomes a
steel importer.
In this case, the horizontal line at the world price represents the supply of the
rest of the world. This supply curve is perfectly elastic because Isoland is a small
economy and, therefore, can buy as much steel as it wants at the world price.
C
B
D
A
Price
of Steel
Price
before trade
Price
after trade
0 Quantity
of Steel
Domestic
supply
World
price
Domestic
demand
Exports
Figure 9-3
HOW FREE TRADE AFFECTS
WELFARE IN AN EXPORTING
COUNTRY. When the domestic
price rises to equal the world
price, sellers are better off
(producer surplus rises from C to
B H11001C H11001D), and buyers are
worse off (consumer surplus falls
from AH11001B to A). Total surplus
rises by an amount equal to
areaD, indicating that trade
raises the economic well-being of
the country as a whole.
Table 9-1
CHANGES IN WELFARE FROM
FREE TRADE: THE CASE OF AN
EXPORTING COUNTRY. The table
examines changes in economic
welfare resulting from opening
up a market to international
trade. Letters refer to the regions
marked in Figure 9-3.
BEFORETRADE AFTERTRADE CHANGE
Consumer Surplus AH11001BAH11002B
Producer Surplus C B H11001C H11001D H11001(B H11001D)
Total Surplus AH11001B H11001CAH11001B H11001C + D H11001D
The area D shows the increase in total surplus and represents the gains from trade.
CHAPTER 9 APPLICATION: INTERNATIONAL TRADE 185
Now consider the gains and losses from trade. Once again, not everyone ben-
efits. When trade forces the domestic price to fall, domestic consumers are better
off (they can now buy steel at a lower price), and domestic producers are worse off
(they now have to sell steel at a lower price). Changes in consumer and producer
surplus measure the size of the gains and losses, as shown in Figure 9-5 and Ta-
ble9-2. Before trade, consumer surplus is area A, producer surplus is area B H11001C,
and total surplus is area AH11001 B H11001 C. After trade is allowed, consumer surplus
is area A H11001 B H11001 D, producer surplus is area C, and total surplus is area
AH11001BH11001CH11001D.
These welfare calculations show who wins and who loses from trade in an im-
porting country. Buyers benefit because consumer surplus increases by the area
BH11001D. Sellers are worse off because producer surplus falls by the area B. The gains
of buyers exceed the losses of sellers, and total surplus increases by the area D.
This analysis of an importing country yields two conclusions parallel to those
for an exporting country:
a78 When a country allows trade and becomes an importer of a good, domestic
consumers of the good are better off, and domestic producers of the good are
worse off.
a78 Trade raises the economic well-being of a nation in the sense that the gains of
the winners exceed the losses of the losers.
Now that we have completed our analysis of trade, we can better understand one
of the Ten Principles of Economicsin Chapter 1: Trade can make everyone better off.
If Isoland opens up its steel market to international trade, that change will create
Price
of Steel
Price
before trade
Price
after trade
0 Quantity
of Steel
Domestic
quantity
supplied
Domestic
quantity
demanded
Domestic
supply
World
price
Domestic
demand
Imports
Figure 9-4
INTERNATIONAL TRADE IN AN
IMPORTING COUNTRY. Once
trade is allowed, the domestic
price falls to equal the world
price. The supply curve
showsthe amount produced
domestically, and the demand
curve shows the amount
consumed domestically. Imports
equal the difference between the
domestic quantity demanded and
the domestic quantity supplied at
the world price.
186 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
winners and losers, regardless of whether Isoland ends up exporting or importing
steel. In either case, however, the gains of the winners exceed the losses of the
losers, so the winners could compensate the losers and still be better off. In this
sense, trade canmake everyone better off. But willtrade make everyone better off?
Probably not. In practice, compensation for the losers from international trade is
rare. Without such compensation, opening up to international trade is a policy that
expands the size of the economic pie, while perhaps leaving some participants in
the economy with a smaller slice.
THE EFFECTS OF A TARIFF
The Isolandian economists next consider the effects of a tariff—a tax on imported
goods. The economists quickly realize that a tariff on steel will have no effect if
Isoland becomes a steel exporter. If no one in Isoland is interested in importing
C
B
D
A
Price
of Steel
Price
before trade
0 Quantity
of Steel
Domestic
supply
Domestic
demand
Price
after trade
World
price
Imports
Figure 9-5
HOW FREE TRADE AFFECTS
WELFARE IN AN IMPORTING
COUNTRY. When the domestic
price falls to equal the world
price, buyers are better off
(consumer surplus rises from Ato
AH11001B H11001D), and sellers are worse
off (producer surplus falls from
BH11001C to C). Total surplus rises by
an amount equal to area D,
indicating that trade raises the
economic well-being of the
country as a whole.
Table 9-2
CHANGES IN WELFARE FROM
FREE TRADE: THE CASE OF AN
IMPORTING COUNTRY. The table
examines changes in economic
welfare resulting from opening
up a market to international
trade. Letters refer to the regions
marked in Figure 9-5.
BEFORETRADE AFTERTRADE CHANGE
Consumer Surplus A AH11001B H11001D H11001(B H11001D)
Producer Surplus B H11001CCH11002B
Total Surplus AH11001B H11001CAH11001B H11001C H11001D H11001D
tariff
a tax on goods produced abroad and
sold domestically
The area D shows the increase in total surplus and represents the gains from trade.
CHAPTER 9 APPLICATION: INTERNATIONAL TRADE 187
steel, a tax on steel imports is irrelevant. The tariff matters only if Isoland becomes
a steel importer. Concentrating their attention on this case, the economists com-
pare welfare with and without the tariff.
Figure 9-6 shows the Isolandian market for steel. Under free trade, the domes-
tic price equals the world price. Atariff raises the price of imported steel above the
world price by the amount of the tariff. Domestic suppliers of steel, who compete
with suppliers of imported steel, can now sell their steel for the world price plus
the amount of the tariff. Thus, the price of steel—both imported and domestic—
rises by the amount of the tariff and is, therefore, closer to the price that would
prevail without trade.
The change in price affects the behavior of domestic buyers and sellers. Be-
cause the tariff raises the price of steel, it reduces the domestic quantity demanded
from Q
1
D
to Q
2
D
and raises the domestic quantity supplied from Q
1
S
to Q
2
S
. Thus, the
tariff reduces the quantity of imports and moves the domestic market closer to its equilib-
rium without trade.
Now consider the gains and losses from the tariff. Because the tariff raises the
domestic price, domestic sellers are better off, and domestic buyers are worse off.
In addition, the government raises revenue. To measure these gains and losses, we
look at the changes in consumer surplus, producer surplus, and government rev-
enue. These changes are summarized in Table 9-3.
Before the tariff, the domestic price equals the world price. Consumer surplus,
the area between the demand curve and the world price, is area AH11001B H11001C H11001D H11001
E H11001F. Producer surplus, the area between the supply curve and the world price,
is area G. Government revenue equals zero. Total surplus, the sum of consumer
surplus, producer surplus, and government revenue, is area AH11001B H11001C H11001D H11001E
H11001F H11001G.
OUR STORY ABOUT THE STEEL INDUSTRY
and the debate over trade policy in
Isoland is just a parable. Or is it?
Clinton Warns U.S. Will
Fight Cheap Imports
BY DAVID E. SANGER
President Clinton said for the first time
today that the United States would not
tolerate the “flooding of our markets”
with low-cost goods from Asia and Rus-
sia, particularly steel, that are threaten-
ing the jobs of American workers.
The President’s statement came
days after a White House meeting of top
executives of steel companies and the
United Steelworkers of America, which
helped get out the vote for Democrats
last week, playing a pivotal role with
other unions in the party’s success in
midterm elections.
After the meeting, which included
Mr. Clinton, Vice President Al Gore, and
top Cabinet officials, aides said the
White House would not grant the unions’
demand to cut off imports of steel they
say are being dumped in the American
markets. But today, the President
warned that foreign nations must “play
by the rules,” appearing to signal that
the United States would press other na-
tions to restrict their exports to the
United States. [Author’s note: In the
end, the Clinton administration did de-
cide to limit steel imports.]
SOURCE: The New York Times,November 11, 1998,
pA1.
IN THE NEWS
Life in Isoland
188 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
Once the government imposes a tariff, the domestic price exceeds the world
price by the amount of the tariff. Consumer surplus is now area AH11001B. Producer
surplus is area C H11001G. Government revenue, which is the quantity of after-tariff
imports times the size of the tariff, is the area E. Thus, total surplus with the tariff
is area AH11001B H11001C H11001E H11001G.
To determine the total welfare effects of the tariff, we add the change in con-
sumer surplus (which is negative), the change in producer surplus (positive), and
the change in government revenue (positive). We find that total surplus in the
market decreases by the area D H11001 F. This fall in total surplus is called the dead-
weight lossof the tariff.
DEF
C
G
B
A
Price
of Steel
0 Quantity
of Steel
Domestic
supply
Domestic
demand
Price
with tariff Tariff
Imports
without tariff
Equilibrium
without trade
Price
without tariff
World
price
Imports
with tariff
2
Q
S
1
Q
S
2
Q
D
1
Q
D
Figure 9-6
THE EFFECTS OF A TARIFF.A
tariff reduces the quantity of
imports and moves a market
closer to the equilibrium that
would exist without trade. Total
surplus falls by an amount equal
to area D H11001F. These two triangles
represent the deadweight loss
from the tariff.
Table 9-3
BEFORETARIFF AFTERTARIFF CHANGE
Consumer Surplus AH11001B H11001C H11001D H11001E H11001FAH11001B H11002(C H11001D H11001E H11001F)
Producer Surplus G C H11001G H11001C
Government Revenue None E H11001E
Total Surplus AH11001B H11001C H11001D H11001E H11001F H11001GAH11001B H11001C H11001E H11001G H11002(D H11001F)
CHANGES IN WELFARE FROM A TARIFF. The table compares economic welfare when
trade is unrestricted and when trade is restricted with a tariff. Letters refer to the regions
marked in Figure 9-6.
The area D H11001F shows the fall in total surplus and represents the deadweight loss of the tariff.
CHAPTER 9 APPLICATION: INTERNATIONAL TRADE 189
It is not surprising that a tariff causes a deadweight loss, because a tariff is a
type of tax. Like any tax on the sale of a good, it distorts incentives and pushes the
allocation of scarce resources away from the optimum. In this case, we can identify
two effects. First, the tariff on steel raises the price of steel that domestic producers
can charge above the world price and, as a result, encourages them to increase pro-
duction of steel (from Q
1
S
to Q
2
S
). Second, the tariff raises the price that domestic
steel buyers have to pay and, therefore, encourages them to reduce consumption
of steel (from Q
1
D
to Q
2
D
). Area D represents the deadweight loss from the overpro-
duction of steel, and area F represents the deadweight loss from the undercon-
sumption. The total deadweight loss of the tariff is the sum of these two triangles.
THE EFFECTS OF AN IMPORT QUOTA
The Isolandian economists next consider the effects of an import quota—a limit on
the quantity of imports. In particular, imagine that the Isolandian government dis-
tributes a limited number of import licenses. Each license gives the license holder
the right to import 1 ton of steel into Isoland from abroad. The Isolandian econo-
mists want to compare welfare under a policy of free trade and welfare with the
addition of this import quota.
Figure 9-7 shows how an import quota affects the Isolandian market for steel.
Because the import quota prevents Isolandians from buying as much steel as they
want from abroad, the supply of steel is no longer perfectly elastic at the world
price. Instead, as long as the price of steel in Isoland is above the world price, the
license holders import as much as they are permitted, and the total supply of steel
in Isoland equals the domestic supply plus the quota amount. That is, the supply
curve above the world price is shifted to the right by exactly the amount of the
quota. (The supply curve below the world price does not shift because, in this case,
importing is not profitable for the license holders.)
The price of steel in Isoland adjusts to balance supply (domestic plus im-
ported) and demand. As the figure shows, the quota causes the price of steel to rise
above the world price. The domestic quantity demanded falls from Q
1
D
to Q
2
D
, and
the domestic quantity supplied rises from Q
1
S
to Q
2
S
. Not surprisingly, the import
quota reduces steel imports.
Now consider the gains and losses from the quota. Because the quota raises
the domestic price above the world price, domestic sellers are better off, and do-
mestic buyers are worse off. In addition, the license holders are better off because
they make a profit from buying at the world price and selling at the higher
domestic price. To measure these gains and losses, we look at the changes in
consumer surplus, producer surplus, and license-holder surplus, as shown in
Table 9-4.
Before the government imposes the quota, the domestic price equals the world
price. Consumer surplus, the area between the demand curve and the world price,
is area AH11001B H11001C H11001D H11001E' H11001E''H11001F. Producer surplus, the area between the sup-
ply curve and the world price, is area G. The surplus of license holders equals zero
because there are no licenses. Total surplus, the sum of consumer, producer, and
license-holder surplus, is area AH11001B H11001C H11001D H11001E' H11001E'' H11001F H11001G.
After the government imposes the import quota and issues the licenses, the
domestic price exceeds the world price. Domestic consumers get surplus equal to
area AH11001B, and domestic producers get surplus equal to area C H11001G. The license
holders make a profit on each unit imported equal to the difference between the
import quota
a limit on the quantity of a good that
can be produced abroad and sold
domestically
190 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
Isolandian price of steel and the world price. Their surplus equals this price dif-
ferential times the quantity of imports. Thus, it equals the area of the rectangle
E'H11001E''. Total surplus with the quota is the area AH11001B H11001C H11001E' H11001E'' H11001G.
To see how total welfare changes with the imposition of the quota, we add the
change in consumer surplus (which is negative), the change in producer surplus
(positive), and the change in license-holder surplus (positive). We find that total
surplus in the market decreases by the area D H11001F. This area represents the dead-
weight loss of the import quota.
D
EH11032
EH11033 F
C
G
B
A
Price
of Steel
0 Quantity
of Steel
Domestic
supply
Domestic
supply
H11001
Import supply
Domestic
demand
Isolandian
price with
quota
Imports
without quota
Equilibrium
with quota
Equilibrium
without trade
Quota
World
price
Price
without
quota
World
price
Imports
with quota
2
Q
S
1
Q
S
2
Q
D
1
Q
D
H11005
Figure 9-7
THE EFFECTS OF AN IMPORT
QUOTA. An import quota, like
atariff, reduces the quantity of
imports and moves a market
closer to the equilibrium that
would exist without trade. Total
surplus falls by an amount equal
to area D H11001F. These two triangles
represent the deadweight loss
from the quota. In addition, the
import quota transfers E' H11001E'' to
whoever holds the import
licenses.
Table 9-4
BEFOREQUOTA AFTERQUOTA CHANGE
Consumer Surplus AH11001B H11001C H11001D H11001E' H11001E'' H11001FAH11001B H11002(C H11001D H11001E' H11001E'' H11001F)
Producer Surplus G C H11001G H11001C
License-Holder Surplus None E' H11001E'' H11001(E' H11001E'')
Total Surplus AH11001B H11001C H11001D H11001E' H11001E'' H11001F H11001GAH11001B H11001C H11001E' H11001E'' H11001G H11002(D H11001F)
CHANGES IN WELFARE FROM AN IMPORT QUOTA. The table compares economic welfare
when trade is unrestricted and when trade is restricted with an import quota. Letters refer
to the regions marked in Figure 9-7.
The area D H11001F shows the fall in total surplus and represents the deadweight loss of the quota.
CHAPTER 9 APPLICATION: INTERNATIONAL TRADE 191
This analysis should seem somewhat familiar. Indeed, if you compare the
analysis of import quotas in Figure 9-7 with the analysis of tariffs in Figure 9-6, you
will see that they are essentially identical. Both tariffs and import quotas raise the do-
mestic price of the good, reduce the welfare of domestic consumers, increase the welfare of
domestic producers, and cause deadweight losses.There is only one difference between
these two types of trade restriction: A tariff raises revenue for the government
(area E in Figure 9-6), whereas an import quota creates surplus for license holders
(area E' H11001E'' in Figure 9-7).
Tariffs and import quotas can be made to look even more similar. Suppose that
the government tries to capture the license-holder surplus for itself by charging a
fee for the licenses. Alicense to sell 1 ton of steel is worth exactly the difference be-
tween the Isolandian price of steel and the world price, and the government can
set the license fee as high as this price differential. If the government does this, the
license fee for imports works exactly like a tariff: Consumer surplus, producer sur-
plus, and government revenue are exactly the same under the two policies.
In practice, however, countries that restrict trade with import quotas rarely do
so by selling the import licenses. For example, the U.S. government has at times
pressured Japan to “voluntarily” limit the sale of Japanese cars in the United
States. In this case, the Japanese government allocates the import licenses to Japan-
ese firms, and the surplus from these licenses (area E' H11001E'') accrues to those firms.
This kind of import quota is, from the standpoint of U.S. welfare, strictly worse
than a U.S. tariff on imported cars. Both a tariff and an import quota raise prices,
restrict trade, and cause deadweight losses, but at least the tariff produces revenue
for the U.S. government rather than for Japanese auto companies.
Although in our analysis so far import quotas and tariffs appear to cause sim-
ilar deadweight losses, a quota can potentially cause an even larger deadweight
loss, depending on the mechanism used to allocate the import licenses. Suppose
that when Isoland imposes a quota, everyone understands that the licenses will go
to those who spend the most resources lobbying the Isolandian government. In
this case, there is an implicit license fee—the cost of lobbying. The revenues from
this fee, however, rather than being collected by the government, are spent on lob-
bying expenses. The deadweight losses from this type of quota include not only
the losses from overproduction (area D) and underconsumption (area F) but also
whatever part of the license-holder surplus (area E'H11001E'') is wasted on the cost of
lobbying.
THE LESSONS FOR TRADE POLICY
The team of Isolandian economists can now write to the new president:
Dear Madam President,
You asked us three questions about opening up trade. After much
hard work, we have the answers.
Question:If the government allowed Isolandians to import and export
steel, what would happen to the price of steel and the quantity of steel
sold in the domestic steel market?
Answer: Once trade is allowed, the Isolandian price of steel would be
driven to equal the price prevailing around the world.
192 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
If the world price is now higher than the Isolandian price, our price
would rise. The higher price would reduce the amount of steel Isolandians
consume and raise the amount of steel that Isolandians produce. Isoland
would, therefore, become a steel exporter. This occurs because, in this case,
Isoland would have a comparative advantage in producing steel.
Conversely, if the world price is now lower than the Isolandian price,
our price would fall. The lower price would raise the amount of steel that
Isolandians consume and lower the amount of steel that Isolandians pro-
duce. Isoland would, therefore, become a steel importer. This occurs be-
cause, in this case, other countries would have a comparative advantage
in producing steel.
Question: Who would gain from free trade in steel and who would
lose, and would the gains exceed the losses?
Answer: The answer depends on whether the price rises or falls when
trade is allowed. If the price rises, producers of steel gain, and consumers
of steel lose. If the price falls, consumers gain, and producers lose. In both
cases, the gains are larger than the losses. Thus, free trade raises the total
welfare of Isolandians.
Question: Should a tariff or an import quota be part of the new trade
policy?
Answer:Atariff, like most taxes, has deadweight losses: The revenue
raised would be smaller than the losses to the buyers and sellers. In this
case, the deadweight losses occur because the tariff would move the econ-
omy closer to our current no-trade equilibrium. An import quota works
much like a tariff and would cause similar deadweight losses. The best
policy, from the standpoint of economic efficiency, would be to allow trade
without a tariff or an import quota.
We hope you find these answers helpful as you decide on your new
policy.
Your faithful servants,
Isolandian economics team
QUICK QUIZ: Draw the supply and demand curve for wool suits in the
country of Autarka. When trade is allowed, the price of a suit falls from 3 to 2
ounces of gold. In your diagram, what is the change in consumer surplus, the
change in producer surplus, and the change in total surplus? How would a
tariff on suit imports alter these effects?
THE ARGUMENTS FOR RESTRICTING TRADE
The letter from the economics team persuades the new president of Isoland to con-
sider opening up trade in steel. She notes that the domestic price is now high com-
pared to the world price. Free trade would, therefore, cause the price of steel to fall
and hurt domestic steel producers. Before implementing the new policy, she asks
Isolandian steel companies to comment on the economists’ advice.
CHAPTER 9 APPLICATION: INTERNATIONAL TRADE 193
Not surprisingly, the steel companies are opposed to free trade in steel. They
believe that the government should protect the domestic steel industry from for-
eign competition. Let’s consider some of the arguments they might give to support
their position and how the economics team would respond.
THE JOBS ARGUMENT
Opponents of free trade often argue that trade with other countries destroys
domestic jobs. In our example, free trade in steel would cause the price of steel to
fall, reducing the quantity of steel produced in Isoland and thus reducing employ-
ment in the Isolandian steel industry. Some Isolandian steelworkers would lose
their jobs.
Yet free trade creates jobs at the same time that it destroys them. When Iso-
landians buy steel from other countries, those countries obtain the resources to
buy other goods from Isoland. Isolandian workers would move from the steel in-
dustry to those industries in which Isoland has a comparative advantage. Al-
though the transition may impose hardship on some workers in the short run, it
allows Isolandians as a whole to enjoy a higher standard of living.
Opponents of trade are often skeptical that trade creates jobs. They might re-
spond that everything can be produced more cheaply abroad. Under free trade,
they might argue, Isolandians could not be profitably employed in any industry.
Our conclusions so far have
been based on the standard
analysis of international trade.
As we have seen, there are win-
ners and losers when a nation
opens itself up to trade, but the
gains to the winners exceed
the losses of the losers. Yet
the case for free trade can
be made even stronger. There
are several other economic
benefits of trade beyond those
emphasized in the standard
analysis.
Here, in a nutshell, are some of these other benefits:
a78 Increased variety of goods: Goods produced in different
countries are not exactly the same. German beer, for in-
stance, is not the same as American beer. Free trade
gives consumers in all countries greater variety from
which to choose.
a78 Lower costs through economies of scale: Some goods
can be produced at low cost only if they are produced in
large quantities—a phenomenon called economies of
scale. A firm in a small country cannot take full advan-
tage of economies of scale if it can sell only in a small
domestic market. Free trade gives firms access to
larger world markets and allows them to realize
economies of scale more fully.
a78 Increased competition: A company shielded from for-
eign competitors is more likely to have market power,
which in turn gives it the ability to raise prices above
competitive levels. This is a type of market failure.
Opening up trade fosters competition and gives the in-
visible hand a better chance to work its magic.
a78 Enhanced flow of ideas: The transfer of technological
advances around the world is often thought to be linked
to international trade in the goods that embody those
advances. The best way for a poor, agricultural nation to
learn about the computer revolution, for instance, is to
buy some computers from abroad, rather than trying to
make them domestically.
Thus, free international trade increases variety for con-
sumers, allows firms to take advantage of economies of
scale, makes markets more competitive, and facilitates the
spread of technology. If the Isolandian economists thought
these effects were important, their advice to their president
would be even more forceful.
FYI
Other Benefits
of International
Trade
“You like protectionism as a
‘working man.’ How about as a
consumer?”
194 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
As Chapter 3 explains, however, the gains from trade are based on comparative
advantage, not absolute advantage. Even if one country is better than another
country at producing everything, each country can still gain from trading with the
other. Workers in each country will eventually find jobs in the industry in which
that country has a comparative advantage.
THE NATIONAL-SECURITY ARGUMENT
When an industry is threatened with competition from other countries, opponents
of free trade often argue that the industry is vital for national security. In our ex-
ample, Isolandian steel companies might point out that steel is used to make guns
and tanks. Free trade would allow Isoland to become dependent on foreign coun-
tries to supply steel. If a war later broke out, Isoland might be unable to produce
enough steel and weapons to defend itself.
Economists acknowledge that protecting key industries may be appropriate
when there are legitimate concerns over national security. Yet they fear that this ar-
gument may be used too quickly by producers eager to gain at consumers’ ex-
pense. The U.S. watchmaking industry, for instance, long argued that it was vital
for national security, claiming that its skilled workers would be necessary in
wartime. Certainly, it is tempting for those in an industry to exaggerate their role
in national defense in order to obtain protection from foreign competition.
THE INFANT-INDUSTRY ARGUMENT
New industries sometimes argue for temporary trade restrictions to help them get
started. After a period of protection, the argument goes, these industries will ma-
ture and be able to compete with foreign competitors. Similarly, older industries
sometimes argue that they need temporary protection to help them adjust to new
conditions. For example, General Motors Chairman Roger Smith once argued for
temporary protection “to give U.S. automakers turnaround time to get the domes-
tic industry back on its feet.”
Economists are often skeptical about such claims. The primary reason is that
the infant-industry argument is difficult to implement in practice. To apply pro-
tection successfully, the government would need to decide which industries will
eventually be profitable and decide whether the benefits of establishing these in-
dustries exceed the costs to consumers of protection. Yet “picking winners” is ex-
traordinarily difficult. It is made even more difficult by the political process, which
often awards protection to those industries that are politically powerful. And once
a powerful industry is protected from foreign competition, the “temporary” policy
is hard to remove.
In addition, many economists are skeptical about the infant-industry argu-
ment even in principle. Suppose, for instance, that the Isolandian steel industry is
young and unable to compete profitably against foreign rivals. Yet there is reason
to believe that the industry can be profitable in the long run. In this case, the own-
ers of the firms should be willing to incur temporary losses in order to obtain the
eventual profits. Protection is not necessary for an industry to grow. Firms in var-
ious industries—such as many Internet firms today—incur temporary losses in the
hope of growing and becoming profitable in the future. And many of them suc-
ceed, even without protection from foreign competition.
CHAPTER 9 APPLICATION: INTERNATIONAL TRADE 195
CASE STUDY TRADE AGREEMENTS
Acountry can take one of two approaches to achieving free trade. It can take a
unilateral approach and remove its trade restrictions on its own. This is the ap-
proach that Great Britain took in the nineteenth century and that Chile and
South Korea have taken in recent years. Alternatively, a country can take a mul-
tilateral approach and reduce its trade restrictions while other countries do the
THE UNFAIR-COMPETITION ARGUMENT
Acommon argument is that free trade is desirable only if all countries play by the
same rules. If firms in different countries are subject to different laws and regu-
lations, then it is unfair (the argument goes) to expect the firms to compete in the
international marketplace. For instance, suppose that the government of Neigh-
borland subsidizes its steel industry by giving steel companies large tax breaks.
The Isolandian steel industry might argue that it should be protected from this for-
eign competition because Neighborland is not competing fairly.
Would it, in fact, hurt Isoland to buy steel from another country at a sub-
sidized price? Certainly, Isolandian steel producers would suffer, but Isolandian
steel consumers would benefit from the low price. Moreover, the case for free trade
is no different: The gains of the consumers from buying at the low price would ex-
ceed the losses of the producers. Neighborland’s subsidy to its steel industry may
be a bad policy, but it is the taxpayers of Neighborland who bear the burden.
Isoland can benefit from the opportunity to buy steel at a subsidized price.
THE PROTECTION-AS-A-BARGAINING-CHIP ARGUMENT
Another argument for trade restrictions concerns the strategy of bargaining. Many
policymakers claim to support free trade but, at the same time, argue that trade re-
strictions can be useful when we bargain with our trading partners. They claim
that the threat of a trade restriction can help remove a trade restriction already im-
posed by a foreign government. For example, Isoland might threaten to impose a
tariff on steel unless Neighborland removes its tariff on wheat. If Neighborland re-
sponds to this threat by removing its tariff, the result can be freer trade.
The problem with this bargaining strategy is that the threat may not work. If it
doesn’t work, the country has a difficult choice. It can carry out its threat and im-
plement the trade restriction, which would reduce its own economic welfare. Or it
can back down from its threat, which would cause it to lose prestige in interna-
tional affairs. Faced with this choice, the country would probably wish that it had
never made the threat in the first place.
An example of this occurred in 1999, when the U.S. government accused
Europeans of restricting the import of U.S. bananas. After a long and bitter dispute
with governments that are normally U.S. allies, the United States placed 100 per-
cent tariffs on a range of European products from cheese to cashmere. In the end,
not only were Europeans denied the benefits of American bananas, but Americans
were denied the benefits of European cheese. Sometimes, when a government en-
gages in a game of brinkmanship, as the United States did in this case, everyone
goes over the brink together.
196 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
same. In other words, it can bargain with its trading partners in an attempt to
reduce trade restrictions around the world.
One important example of the multilateral approach is the North American
Free Trade Agreement (NAFTA), which in 1993 lowered trade barriers among
the United States, Mexico, and Canada. Another is the General Agreement on
WHEN DOMESTIC PRODUCERS COMPLAIN
about competition from abroad, they
often assert that consumers are not well
served by imperfect foreign products.
The following article documents how
Russian producers of chicken reacted to
competition from the United States.
U.S. Chicken in Every Pot?
Nyet! Russians Cry Foul
BY MICHAEL R. GORDON
Moscow—A nasty little skirmish be-
tween Russia and the United States is
brewing here over a threatened trade
barrier.
But this fight is not about manufac-
tured consumer goods or high technol-
ogy, but about American chicken, which
has flooded the Russian market.
To the frustration, and considerable
anxiety, of American companies, the
Russian government has threatened to
ban further American poultry sales effec-
tive March 19. . . .
The ostensible reason for the Rus-
sian government’s warning is health—a
seemingly strange concern in a country
with a generally lax record in observing
safety standards, where virtually every
able-bodied man and woman smokes.
Today, no less an authority than the
Veterinary Department of the Russian
Agriculture and Food Ministry said the
ban was needed to protect consumers
here against infected poultry until the
United States improved its standards.
But the real agenda, American
producers contend, is old-fashioned
protectionism.
Agitated Russian producers, whose
birds, Russian consumers say, are no
match for their American competition in
terms of quality and price, have repeat-
edly complained that the United States
is trying to destroy the Russian poultry
industry and capture its market. And now
American companies fear the Russian
producers are striking back. . . .
The first big invasion of frozen poul-
try [into Russia] came during the Bush
administration. . . . The export proved
to be very popular with Russian con-
sumers, who dubbed them Bush legs.
After the demise of the Soviet
Union, American poultry exports con-
tinued to soar. Russian poultry produc-
tion, meanwhile, fell 40 percent, the
result of rising grain prices and declining
subsidies.
Astoundingly, a third of all American
exports to Russia is poultry, American
officials say. . . .
If the confrontation continues, the
United States has a number of possible
recourses, including arguing that the
Russian action is inconsistent with
Moscow’s bid to join the World Trade
Organization.
Some experts, however, believe
there is an important countervailing force
here that may lead to a softening of
the Russian position: namely Russian
consumers.
Russian consumers favor the Amer-
ican birds, which despite the dire warn-
ings of the Russian government, have
come to symbolize quality. And they
vote, too.
SOURCE:The New York Times,February 24, 1996,
pp.33, 34.
IN THE NEWS
A Chicken Invasion
A THREAT TO RUSSIA?
CHAPTER 9 APPLICATION: INTERNATIONAL TRADE 197
Tariffs and Trade (GATT), which is a continuing series of negotiations among
many of the world’s countries with the goal of promoting free trade. The United
States helped to found GATT after World War II in response to the high tariffs
imposed during the Great Depression of the 1930s. Many economists believe
that the high tariffs contributed to the economic hardship during that period.
GATT has successfully reduced the average tariff among member countries
from about 40 percent after World War II to about 5 percent today. The rules es-
tablished under GATT are now enforced by an international institution called
the World Trade Organization (WTO).
What are the pros and cons of the multilateral approach to free trade? One
advantage is that the multilateral approach has the potential to result in freer
trade than a unilateral approach because it can reduce trade restrictions abroad
as well as at home. If international negotiations fail, however, the result could
be more restricted trade than under a unilateral approach.
In addition, the multilateral approach may have a political advantage. In
most markets, producers are fewer and better organized than consumers—and
thus wield greater political influence. Reducing the Isolandian tariff on steel, for
example, may be politically difficult if considered by itself. The steel companies
would oppose free trade, and the users of steel who would benefit are so nu-
merous that organizing their support would be difficult. Yet suppose that
Neighborland promises to reduce its tariff on wheat at the same time that
Isoland reduces its tariff on steel. In this case, the Isolandian wheat farmers,
who are also politically powerful, would back the agreement. Thus, the multi-
lateral approach to free trade can sometimes win political support when a uni-
lateral reduction cannot.
QUICK QUIZ: The textile industry of Autarka advocates a ban on the
import of wool suits. Describe five arguments its lobbyists might make. Give a
response to each of these arguments.
CONCLUSION
Economists and the general public often disagree about free trade. In 1993, for ex-
ample, the United States faced the question of whether to ratify the North Ameri-
can Free Trade Agreement, which reduced trade restrictions among the United
States, Canada, and Mexico. Opinion polls showed the general public in the
United States about evenly split on the issue, and the agreement passed in Con-
gress by only a narrow margin. Opponents viewed free trade as a threat to job
security and the American standard of living. By contrast, economists overwhelm-
ingly supported the agreement. They viewed free trade as a way of allocating pro-
duction efficiently and raising living standards in all three countries.
Economists view the United States as an ongoing experiment that confirms the
virtues of free trade. Throughout its history, the United States has allowed unre-
stricted trade among the states, and the country as a whole has benefited from the
specialization that trade allows. Florida grows oranges, Texas pumps oil, Califor-
nia makes wine, and so on. Americans would not enjoy the high standard of living
198 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
they do today if people could consume only those goods and services produced
in their own states. The world could similarly benefit from free trade among
countries.
To better understand economists’ view of trade, let’s continue our parable.
Suppose that the country of Isoland ignores the advice of its economics team and
decides not to allow free trade in steel. The country remains in the equilibrium
without international trade.
Then, one day, some Isolandian inventor discovers a new way to make steel at
very low cost. The process is quite mysterious, however, and the inventor insists
on keeping it a secret. What is odd is that the inventor doesn’t need any workers
or iron ore to make steel. The only input he requires is wheat.
ECONOMIST JAGDISH BHAGWATI ARGUES
that the United States should lower its
trade barriers unilaterally.
Free Trade without Treaties
BY JAGDISH BHAGWATI
President Clinton and 17 other Asian-
Pacific leaders are meeting today in
Vancouver. Rather than the convivial
photo-op they’d planned, however, they
must contend with worrisome trade
news. A spate of Asian currency devalu-
ations has raised the specter of renewed
protectionism around the world. South
America’s Mercosur trade bloc, led by
Brazil, just raised its tariffs some 30 per-
cent. And Congress turned its back on
the president and refused to approve
fast-track authority for him to negotiate
further free-trade accords. [Author’s
note: Fast-track authority would allow
the president to negotiate trade deals
that Congress would consider without
the ability to attach amendments.]
In light of all this dismaying news,
what are the prospects for free trade? Is
the future bleak, or will the postwar trend
of dramatic liberalization continue to ac-
celerate despite these setbacks?
The immediate prospects for more
U.S.-led multilateral trade accords do in-
deed look grim after the defeat of fast-
track. But that doesn’t mean that free
trade itself is on the ropes. A large por-
tion of the world’s trade liberalization in
the last quarter-century has been unilat-
eral. Those countries that lower trade
barriers of their own accord not only
profit themselves, but also often induce
the laggards to match their example. The
most potent force for the worldwide
freeing of trade, then, is unilateral U.S.
action. If the United States continues to
do away with tariffs and trade barriers,
other countries will follow suit—fast-
track or no fast-track.
To be sure, the General Agreement
on Tariffs and Trade, the World Trade Or-
ganization, and other multilateral tariff re-
ductions have greatly contributed to
global wealth. The WTO has become the
international institution for setting the
“rules” on public and private practices
that affect competition among trading
nations. Much still needs to be done in
that mode, particularly on agriculture tar-
iffs, which remain too high around the
world. A future U.S. president, if not Mr.
Clinton, will certainly need fast-track au-
thority if another multilateral effort, such
as the “millennium round” called for by
Sir Leon Brittan of the European Union,
is to pursue these goals.
But the good news is that even if
organized labor, radical environmental-
ists, and others who fear the global
economy continue to impede fast-track
during Congress’s next session, they
cannot stop the historic freeing of trade
that has been occurring unilaterally
worldwide.
From the 1970s through the 1990s,
Latin America witnessed dramatic lower-
ing of trade barriers unilaterally by Chile,
Bolivia, and Paraguay; and the entire
continent has been moving steadily to-
ward further trade liberalization. Merco-
sur’s recent actions are a setback, but
only a small one—so far.
Latin America’s record has been
bettered by unilateral liberalizers in Asia
and the Pacific. New Zealand began dis-
mantling its substantial trade protection
apparatus in 1985. That effort was driven
by the reformist views of then-Prime
Minister David Lange, who declared, “In
IN THE NEWS
The Case for
Unilateral Disarmament
in the Trade Wars
CHAPTER 9 APPLICATION: INTERNATIONAL TRADE 199
The inventor is hailed as a genius. Because steel is used in so many products,
the invention lowers the cost of many goods and allows all Isolandians to enjoy a
higher standard of living. Workers who had previously produced steel do suffer
when their factories close, but eventually they find work in other industries. Some
become farmers and grow the wheat that the inventor turns into steel. Others en-
ter new industries that emerge as a result of higher Isolandian living standards.
Everyone understands that the displacement of these workers is an inevitable part
of progress.
After several years, a newspaper reporter decides to investigate this mysteri-
ous new steel process. She sneaks into the inventor’s factory and learns that the in-
ventor is a fraud. The inventor has not been making steel at all. Instead, he has
the course of about three years we
changed from being a country run like a
Polish shipyard into one that could be in-
ternationally competitive.”
Since the 1980s, Hong Kong’s and
Singapore’s enormous successes as
free traders have served as potent ex-
amples of unilateral market opening, en-
couraging Indonesia, the Philippines,
Thailand, South Korea, and Malaysia to
follow suit. By 1991 even India, which
has been astonishingly autarkic for more
than four decades, had finally learned the
virtue of free trade and had embarked on
a massive lowering of its tariffs and non-
tariff barriers.
In Central and Eastern Europe, the
collapse of communism led to a whole-
sale, unilateral, and nondiscriminatory re-
moval of trade barriers as well. The
French economist Patrick Messerlin has
shown how this happened in three
waves: Czechoslovakia, Poland, and
Hungary liberalized right after the fall of
the Berlin Wall; next came Bulgaria, Ro-
mania, and Slovenia; and finally, the
Baltic countries began unilateral opening
in 1991. . . .
U.S. leadership is crucial to main-
taining the trend toward free trade. Such
ultramodern industries as telecommuni-
cations and financial services gained
their momentum largely from unilateral
openness and deregulation in the United
States. This in turn led to a softening of
protectionist attitudes in the European
Union and Japan.
These developed economies are
now moving steadily in the direction of
openness and competition—not be-
cause any officials in Washington
threaten them with retribution, but be-
cause they’ve seen how U.S. companies
become more competitive once regula-
tion and other trade barriers have fallen.
A Brussels bureaucrat can argue with a
Washington bureaucrat, but he cannot
argue with the markets. Faced with the
prospect of being elbowed out of world
markets by American firms, Japan and
Europe have no option but to follow the
U.S. example, belatedly but surely, in
opening their own markets.
The biggest threat to free trade is
not the loss of fast-track per se, but the
signal it sends that Americans may not
be interested in lowering their trade bar-
riers any further. To counteract this atti-
tude, President Clinton needs to mount
the bully pulpit and explain the case for
free trade—a case that Adam Smith first
made more than 200 years ago, but that
continues to come under attack.
The president, free from the bur-
dens of constituency interests that crip-
ple many in Congress, could argue,
credibly and with much evidence, that
free trade is in the interest of the whole
world, but that, because the U.S. econ-
omy is the most competitive anywhere,
we have the most to gain. The president
could also point to plenty of evidence
that debunks the claims of protection-
ists. The unions may argue that trade
with poor countries depresses our work-
ers’ wages, for example, but in fact the
best evidence shows that such trade has
helped workers by moderating the fall in
their wages from technological changes.
Assuming that the president can
make the case for free trade at home,
the prospects for free trade worldwide
remain bright. The United States doesn’t
need to sign treaties to open markets or,
heaven forbid, issue counterproductive
threats to close our own markets if oth-
ers are less open than we are. We sim-
ply need to offer an example of
openness and deregulation to the rest of
the world. Other countries will see our
success, and seek to emulate it.
SOURCE:The Wall Street Journal,November 24,
1997, p. A22.
200 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
been smuggling wheat abroad in exchange for steel from other countries. The only
thing that the inventor had discovered was the gains from international trade.
When the truth is revealed, the government shuts down the inventor’s opera-
tion. The price of steel rises, and workers return to jobs in steel factories. Living
standards in Isoland fall back to their former levels. The inventor is jailed and held
up to public ridicule. After all, he was no inventor. He was just an economist.
a78 The effects of free trade can be determined by
comparing the domestic price without trade to the
world price. Alow domestic price indicates that the
country has a comparative advantage in producing the
good and that the country will become an exporter. A
high domestic price indicates that the rest of the world
has a comparative advantage in producing the good and
that the country will become an importer.
a78 When a country allows trade and becomes an exporter
of a good, producers of the good are better off, and
consumers of the good are worse off. When a country
allows trade and becomes an importer of a good,
consumers are better off, and producers are worse off. In
both cases, the gains from trade exceed the losses.
a78 Atariff—a tax on imports—moves a market closer to the
equilibrium that would exist without trade and,
therefore, reduces the gains from trade. Although
domestic producers are better off and the government
raises revenue, the losses to consumers exceed these
gains.
a78 An import quota has effects that are similar to those of a
tariff. Under a quota, however, the holders of the import
licenses receive the revenue that the government would
collect with a tariff.
a78 There are various arguments for restricting trade:
protecting jobs, defending national security, helping
infant industries, preventing unfair competition, and
responding to foreign trade restrictions. Although some
of these arguments have some merit in some cases,
economists believe that free trade is usually the better
policy.
Summary
world price, p. 181 tariff, p. 186 import quota, p. 189
Key Concepts
1. What does the domestic price that prevails without
international trade tell us about a nation’s comparative
advantage?
2. When does a country become an exporter of a good? An
importer?
3. Draw the supply-and-demand diagram for an
importing country. What is consumer surplus and
producer surplus before trade is allowed? What is
consumer surplus and producer surplus with free trade?
What is the change in total surplus?
4. Describe what a tariff is, and describe its economic
effects.
5. What is an import quota? Compare its economic effects
with those of a tariff.
6. List five arguments often given to support trade
restrictions. How do economists respond to these
arguments?
7. What is the difference between the unilateral and
multilateral approaches to achieving free trade? Give an
example of each.
Questions for Review
CHAPTER 9 APPLICATION: INTERNATIONAL TRADE 201
1. The United States represents a small part of the world
orange market.
a. Draw a diagram depicting the equilibrium in the
U.S. orange market without international trade.
Identify the equilibrium price, equilibrium quantity,
consumer surplus, and producer surplus.
b. Suppose that the world orange price is below the
U.S. price before trade, and that the U.S. orange
market is now opened to trade. Identify the new
equilibrium price, quantity consumed, quantity
produced domestically, and quantity imported.
Also show the change in the surplus of domestic
consumers and producers. Has domestic total
surplus increased or decreased?
2. The world price of wine is below the price that would
prevail in the United States in the absence of trade.
a. Assuming that American imports of wine are a
small part of total world wine production, draw a
graph for the U.S. market for wine under free trade.
Identify consumer surplus, producer surplus, and
total surplus in an appropriate table.
b. Now suppose that an unusual shift of the Gulf
Stream leads to an unseasonably cold summer in
Europe, destroying much of the grape harvest
there. What effect does this shock have on the
world price of wine? Using your graph and table
from part (a), show the effect on consumer surplus,
producer surplus, and total surplus in the United
States. Who are the winners and losers? Is the
United States as a whole better or worse off?
3. The world price of cotton is below the no-trade price in
Country Aand above the no-trade price in Country B.
Using supply-and-demand diagrams and welfare tables
such as those in the chapter, show the gains from trade
in each country. Compare your results for the two
countries.
4. Suppose that Congress imposes a tariff on imported
autos to protect the U.S. auto industry from foreign
competition. Assuming that the U.S. is a price taker in
the world auto market, show on a diagram: the change
in the quantity of imports, the loss to U.S. consumers,
the gain to U.S. manufacturers, government revenue,
and the deadweight loss associated with the tariff. The
loss to consumers can be decomposed into three pieces:
a transfer to domestic producers, a transfer to the
government, and a deadweight loss. Use your diagram
to identify these three pieces.
5. According to an article in The New York Times(Nov. 5,
1993), “many Midwest wheat farmers oppose the [North
American] free trade agreement [NAFTA] as much as
many corn farmers support it.” For simplicity, assume
that the United States is a small country in the markets
for both corn and wheat, and that without the free trade
agreement, the United States would not trade these
commodities internationally. (Both of these assumptions
are false, but they do not affect the qualitative responses
to the following questions.)
a. Based on this report, do you think the world wheat
price is above or below the U.S. no-trade wheat
price? Do you think the world corn price is above
or below the U.S. no-trade corn price? Now analyze
the welfare consequences of NAFTAin both
markets.
b. Considering both markets together, does NAFTA
make U.S. farmers as a group better or worse off?
Does it make U.S. consumers as a group better or
worse off? Does it make the United States as a
whole better or worse off?
6. Imagine that winemakers in the state of Washington
petitioned the state government to tax wines imported
from California. They argue that this tax would both
raise tax revenue for the state government and raise
employment in the Washington state wine industry. Do
you agree with these claims? Is it a good policy?
7. Senator Ernest Hollings once wrote that “consumers do
notbenefit from lower-priced imports. Glance through
some mail-order catalogs and you’ll see that consumers
pay exactly the same price for clothing whether it is
U.S.-made or imported.” Comment.
8. Write a brief essay advocating or criticizing each of the
following policy positions:
a. The government should not allow imports
ifforeign firms are selling below their costs
ofproduction (a phenomenon called
“dumping”).
b. The government should temporarily stop the
import of goods for which the domestic industry is
new and struggling to survive.
c. The government should not allow imports from
countries with weaker environmental regulations
than ours.
9. Suppose that a technological advance in Japan lowers
the world price of televisions.
Problems and Applications
202 PART THREE SUPPLY AND DEMAND II: MARKETS AND WELFARE
a. Assume the U.S. is an importer of televisions and
there are no trade restrictions. How does the
technological advance affect the welfare of U.S.
consumers and U.S. producers? What happens to
total surplus in the United States?
b. Now suppose the United States has a quota on
television imports. How does the Japanese
technological advance affect the welfare of U.S.
consumers, U.S. producers, and the holders of
import licenses?
10. When the government of Tradeland decides to impose
an import quota on foreign cars, three proposals are
suggested: (1) Sell the import licenses in an auction.
(2)Distribute the licenses randomly in a lottery. (3) Let
people wait in line and distribute the licenses on a first-
come, first-served basis. Compare the effects of these
policies. Which policy do you think has the largest
deadweight losses? Which policy has the smallest
deadweight losses? Why? (Hint: The government’s
other ways of raising tax revenue all cause deadweight
losses themselves.)
11. An article in The Wall Street Journal(June 26, 1990) about
sugar beet growers explained that “the government
props up domestic sugar prices by curtailing imports of
lower-cost sugar. Producers are guaranteed a ‘market
stabilization price’ of $0.22 a pound, about $0.09 higher
than the current world market price.” The government
maintains the higher price by imposing an import
quota.
a. Illustrate the effect of this quota on the U.S. sugar
market. Label the relevant prices and quantities
under free trade and under the quota.
b. Analyze the effects of the sugar quota using the
tools of welfare analysis.
c. The article also comments that “critics of the sugar
program say that [the quota] has deprived
numerous sugar-producing nations in the
Caribbean, Latin America, and Far East of export
earnings, harmed their economies, and caused
political instability, while increasing Third World
demand for U.S. foreign aid.” Our usual welfare
analysis includes only gains and losses to U.S.
consumers and producers. What role do you think
the gains or losses to people in other countries
should play in our economic policymaking?
d. The article continues that “at home, the sugar
program has helped make possible the spectacular
rise of the high-fructose corn syrup industry.” Why
has the sugar program had this effect? (Hint: Are
sugar and corn syrup substitutes or complements?)
12. (This question is challenging.) Consider a small country
that exports steel. Suppose that a “pro-trade”
government decides to subsidize the export of steel by
paying a certain amount for each ton sold abroad. How
does this export subsidy affect the domestic price of
steel, the quantity of steel produced, the quantity of
steel consumed, and the quantity of steel exported?
How does it affect consumer surplus, producer surplus,
government revenue, and total surplus? (Hint: The
analysis of an export subsidy is similar to the analysis of
a tariff.)
IN THIS CHAPTER
YOU WILL . . .
Examine the various
government policies
aimed at solving the
problem of
externalities
Examine how people
can sometimes solve
the problem of
externalities on
their own
Learn the nature of
an externality
See why
externalities can
make market
outcomes inefficient
Consider why private
solutions to
externalities
sometimes do not
work
Firms that make and sell paper also create, as a by-product of the manufacturing
process, a chemical called dioxin. Scientists believe that once dioxin enters the en-
vironment, it raises the population’s risk of cancer, birth defects, and other health
problems.
Is the production and release of dioxin a problem for society? In Chapters 4
through 9 we examined how markets allocate scarce resources with the forces of
supply and demand, and we saw that the equilibrium of supply and demand is
typically an efficient allocation of resources. To use Adam Smith’s famous
metaphor, the “invisible hand” of the marketplace leads self-interested buyers and
sellers in a market to maximize the total benefit that society derives from that mar-
ket. This insight is the basis for one of the Ten Principles of Economicsin Chapter 1:
Markets are usually a good way to organize economic activity. Should we con-
clude, therefore, that the invisible hand prevents firms in the paper market from
emitting too much dioxin?
EXTERNALITIES
205
206 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
Markets do many things well, but they do not do everything well. In this chap-
ter we begin our study of another of the Ten Principles of Economics:Governments
can sometimes improve market outcomes. We examine why markets sometimes
fail to allocate resources efficiently, how government policies can potentially im-
prove the market’s allocation, and what kinds of policies are likely to work best.
The market failures examined in this chapter fall under a general category
called externalities.An externalityarises when a person engages in an activity that
influences the well-being of a bystander and yet neither pays nor receives any
compensation for that effect. If the impact on the bystander is adverse, it is called
a negative externality;if it is beneficial, it is called a positive externality.In the pres-
ence of externalities, society’s interest in a market outcome extends beyond the
well-being of buyers and sellers in the market; it also includes the well-being of by-
standers who are affected. Because buyers and sellers neglect the external effects
of their actions when deciding how much to demand or supply, the market equi-
librium is not efficient when there are externalities. That is, the equilibrium fails to
maximize the total benefit to society as a whole. The release of dioxin into the
environment, for instance, is a negative externality. Self-interested paper firms will
not consider the full cost of the pollution they create and, therefore, will emit
too much pollution unless the government prevents or discourages them from
doing so.
Externalities come in many varieties, as do the policy responses that try to deal
with the market failure. Here are some examples:
a78 The exhaust from automobiles is a negative externality because it creates
smog that other people have to breathe. As a result of this externality, drivers
tend to pollute too much. The federal government attempts to solve this
problem by setting emission standards for cars. It also taxes gasoline to
reduce the amount that people drive.
a78 Restored historic buildings convey a positive externality because people who
walk or ride by them can enjoy their beauty and the sense of history that
these buildings provide. Building owners do not get the full benefit of
restoration and, therefore, tend to discard older buildings too quickly. Many
local governments respond to this problem by regulating the destruction of
historic buildings and by providing tax breaks to owners who restore them.
a78 Barking dogs create a negative externality because neighbors are disturbed
by the noise. Dog owners do not bear the full cost of the noise and, therefore,
tend to take too few precautions to prevent their dogs from barking. Local
governments address this problem by making it illegal to “disturb the
peace.”
a78 Research into new technologies provides a positive externality because it
creates knowledge that other people can use. Because inventors cannot
capture the full benefits of their inventions, they tend to devote too few
resources to research. The federal government addresses this problem
partially through the patent system, which gives inventors an exclusive use
over their inventions for a period of time.
In each of these cases, some decisionmaker is failing to take account of the external
effects of his or her behavior. The government responds by trying to influence this
behavior to protect the interests of bystanders.
externality
the uncompensated impact of one
person’s actions on the well-being of
a bystander
CHAPTER 10 EXTERNALITIES 207
EXTERNALITIES AND MARKET INEFFICIENCY
In this section we use the tools from Chapter 7 to examine how externalities affect
economic well-being. The analysis shows precisely why externalities cause mar-
kets to allocate resources inefficiently. Later in the chapter we examine various
ways in which private actors and public policymakers may remedy this type of
market failure.
WELFARE ECONOMICS: A RECAP
We begin by recalling the key lessons of welfare economics from Chapter 7. To
make our analysis concrete, we will consider a specific market—the market for
aluminum. Figure 10-1 shows the supply and demand curves in the market for
aluminum.
As you should recall from Chapter 7, the supply and demand curves contain
important information about costs and benefits. The demand curve for aluminum
reflects the value of aluminum to consumers, as measured by the prices they are
willing to pay. At any given quantity, the height of the demand curve shows the
willingness to pay of the marginal buyer. In other words, it shows the value to the
consumer of the last unit of aluminum bought. Similarly, the supply curve reflects
the costs of producing aluminum. At any given quantity, the height of the supply
curve shows the cost of the marginal seller. In other words, it shows the cost to the
producer of the last unit of aluminum sold.
In the absence of government intervention, the price adjusts to balance the
supply and demand for aluminum. The quantity produced and consumed in the
Equilibrium
Quantity of
Aluminum
0
Price of
Aluminum
Q
MARKET
Demand
(private value)
Supply
(private cost)
Figure 10-1
THEMARKET FORALUMINUM.
The demand curve reflects the
value to buyers, and the supply
curve reflects the costs of sellers.
The equilibrium quantity,
Q
MARKET
, maximizes the total
value to buyers minus the total
costs of sellers. In the absence of
externalities, therefore, the
market equilibrium is efficient.
208 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
market equilibrium, shown as Q
MARKET
in Figure 10-1, is efficient in the sense that it
maximizes the sum of producer and consumer surplus. That is, the market allocates
resources in a way that maximizes the total value to the consumers who buy and
use aluminum minus the total costs to the producers who make and sell aluminum.
NEGATIVE EXTERNALITIES IN PRODUCTION
Now let’s suppose that aluminum factories emit pollution: For each unit of alu-
minum produced, a certain amount of smoke enters the atmosphere. Because this
smoke creates a health risk for those who breathe the air, it is a negative external-
ity. How does this externality affect the efficiency of the market outcome?
Because of the externality, the cost to societyof producing aluminum is larger
than the cost to the aluminum producers. For each unit of aluminum produced,
the social costincludes the private costs of the aluminum producers plus the costs
to those bystanders adversely affected by the pollution. Figure 10-2 shows the so-
cial cost of producing aluminum. The social-cost curve is above the supply curve
because it takes into account the external costs imposed on society by aluminum
producers. The difference between these two curves reflects the cost of the pollu-
tion emitted.
What quantity of aluminum should be produced? To answer this question, we
once again consider what a benevolent social planner would do. The planner
wants to maximize the total surplus derived from the market—the value to con-
sumers of aluminum minus the cost of producing aluminum. The planner under-
stands, however, that the cost of producing aluminum includes the external costs
of the pollution.
The planner would choose the level of aluminum production at which the de-
mand curve crosses the social-cost curve. This intersection determines the optimal
amount of aluminum from the standpoint of society as a whole. Below this level of
Equilibrium
Quantity of
Aluminum
0
Price of
Aluminum
Q
MARKET
Demand
(private value)
Supply
(private cost)
Social cost
Q
OPTIMUM
Optimum
Cost of
pollution
Figure 10-2
POLLUTION AND THESOCIAL
OPTIMUM. In the presence of a
negative externality to
production, the social cost of
producing aluminum exceeds the
private cost. The optimal quantity
of aluminum, Q
OPTIMUM
, is
therefore smaller than the
equilibrium quantity, Q
MARKET
.
CHAPTER 10 EXTERNALITIES 209
production, the value of the aluminum to consumers (as measured by the height of
the demand curve) exceeds the social cost of producing it (as measured by the height
of the social-cost curve). The planner does not produce more than this level because
the social cost of producing additional aluminum exceeds the value to consumers.
Note that the equilibrium quantity of aluminum, Q
MARKET
, is larger than the
socially optimal quantity, Q
OPTIMUM
. The reason for this inefficiency is that the mar-
ket equilibrium reflects only the private costs of production. In the market equilib-
rium, the marginal consumer values aluminum at less than the social cost of
producing it. That is, at Q
MARKET
the demand curve lies below the social-cost curve.
Thus, reducing aluminum production and consumption below the market equi-
librium level raises total economic well-being.
How can the social planner achieve the optimal outcome? One way would be
to tax aluminum producers for each ton of aluminum sold. The tax would shift the
supply curve for aluminum upward by the size of the tax. If the tax accurately re-
flected the social cost of smoke released into the atmosphere, the new supply curve
would coincide with the social-cost curve. In the new market equilibrium, alu-
minum producers would produce the socially optimal quantity of aluminum.
The use of such a tax is called internalizing the externalitybecause it gives
buyers and sellers in the market an incentive to take account of the external effects
of their actions. Aluminum producers would, in essence, take the costs of pollution
into account when deciding how much aluminum to supply because the tax now
makes them pay for these external costs. Later in this chapter we consider other
ways in which policymakers can deal with externalities.
POSITIVE EXTERNALITIES IN PRODUCTION
Although in some markets the social cost of production exceeds the private cost, in
other markets the opposite is the case. In these markets, the externality benefits
bystanders, so the social cost of production is less than the private cost. One ex-
ample is the market for industrial robots.
“All I can say is that if being a leading manufacturer
means being a leading polluter, so be it.”
internalizing an externality
altering incentives so that people
take account of the external effects of
their actions
210 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
CASE STUDY THE DEBATE OVER TECHNOLOGY POLICY
How large are technology spillovers, and what do they imply for public policy?
This is an important question because technological progress is the key to why
living standards rise from generation to generation. Yet it is also a difficult ques-
tion on which economists often disagree.
Some economists believe that technology spillovers are pervasive and that
the government should encourage those industries that yield the largest
spillovers. For instance, these economists argue that if making computer chips
Robots are at the frontier of a rapidly changing technology. Whenever a firm
builds a robot, there is some chance that it will discover a new and better design.
This new design will benefit not only this firm but society as a whole because the
design will enter society’s pool of technological knowledge. This type of positive
externality is called a technology spillover.
The analysis of positive externalities is similar to the analysis of negative ex-
ternalities. Figure 10-3 shows the market for robots. In this case, the social cost of
production is less than the private cost reflected in the supply curve. In particular,
the social cost of producing a robot is the private cost less the value of the technol-
ogy spillover. Therefore, the social planner would choose to produce a larger quan-
tity of robots than the private market does.
In this case, the government can internalize the externality by subsidizing the
production of robots. If the government paid firms a subsidy for each robot pro-
duced, the supply curve would shift down by the amount of the subsidy, and this
shift would increase the equilibrium quantity of robots. To ensure that the market
equilibrium equals the social optimum, the subsidy should equal the value of the
technology spillover.
Quantity
of Robots
0
Price
of Robot
Q
OPTIMUM
Demand
(private value)
Supply (private cost)
Social cost
Q
MARKET
Value of
technology
spillover
Equilibrium
Optimum
Figure 10-3
TECHNOLOGYSPILLOVERS AND
THESOCIALOPTIMUM. In the
presence of a positive externality
to production, the social cost of
producing robots is less than the
private cost. The optimal quantity
of robots, Q
OPTIMUM
, is therefore
larger than the equilibrium
quantity, Q
MARKET
.
CHAPTER 10 EXTERNALITIES 211
yields greater spillovers than making potato chips, then the government should
use the tax laws to encourage the production of computer chips relative to the
production of potato chips. Government intervention in the economy that aims
to promote technology-enhancing industries is called technology policy.
Other economists are skeptical about technology policy. Even if technology
spillovers are common, the success of a technology policy requires that the
government be able to measure the size of the spillovers from different mar-
kets.This measurement problem is difficult at best. Moreover, without precise
measurements, the political system may end up subsidizing those industries
with the most political clout, rather than those that yield the largest positive
externalities.
One type of technology policy that most economists endorse is patent pro-
tection. The patent laws protect the rights of inventors by giving them exclusive
use of their inventions for a period of time. When a firm makes a technological
breakthrough, it can patent the idea and capture much of the economic benefit
for itself. The patent is said to internalize the externality by giving the firm a
property rightover its invention. If other firms want to use the new technology,
they would have to obtain permission from the inventing firm and pay it some
royalty. Thus, the patent system gives firms a greater incentive to engage in re-
search and other activities that advance technology.
EXTERNALITIES IN CONSUMPTION
The externalities we have discussed so far are associated with the production of
goods. Some externalities, however, are associated with consumption. The con-
sumption of alcohol, for instance, yields negative externalities if consumers are
more likely to drive under its influence and risk the lives of others. Similarly, the
consumption of education yields positive externalities because a more educated
population leads to better government, which benefits everyone.
The analysis of consumption externalities is similar to the analysis of produc-
tion externalities. As Figure 10-4 shows, the demand curve does not reflect the
value to society of the good. Panel (a) shows the case of a negative consumption
externality, such as that associated with alcohol. In this case, the social value is less
than the private value, and the socially optimal quantity is smaller than the quan-
tity determined by the private market. Panel (b) shows the case of a positive con-
sumption externality, like that of education. In this case, the social value is greater
than the private value, and the socially optimal quantity is greater than the quan-
tity determined by the private market.
Once again, the government can correct the market failure by inducing market
participants to internalize the externality. The appropriate response in the case of
consumption externalities is similar to that in the case of production externalities.
To move the market equilibrium closer to the social optimum, a negative external-
ity requires a tax, and a positive externality requires a subsidy. In fact, that is ex-
actly the policy the government follows: Alcoholic beverages are among the most
highly taxed goods in our economy, and education is heavily subsidized through
public schools and government scholarships.
As you may have noticed, these examples of externalities lead to some gen-
erallessons: Negative externalities in production or consumption lead markets to pro-
duce a larger quantity than is socially desirable. Positive externalities in production
212 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
orconsumption lead markets to produce a smaller quantity than is socially desirable. To
remedy the problem, the government can internalize the externality by taxing goods that
have negative externalities and subsidizing goods that have positive externalities.
QUICK QUIZ: Give an example of a negative externality and a positive
externality. a78 Explain why market outcomes are inefficient in the presence of
externalities.
PRIVATE SOLUTIONS TO EXTERNALITIES
We have discussed why externalities lead markets to allocate resources ineffi-
ciently, but have mentioned only briefly how this inefficiency can be remedied. In
practice, both private actors and public policymakers respond to externalities in
various ways. All of the remedies share the goal of moving the allocation of re-
sources closer to the social optimum. In this section we examine private solutions.
THE TYPES OF PRIVATE SOLUTIONS
Although externalities tend to cause markets to be inefficient, government action
is not always needed to solve the problem. In some circumstances, people can de-
velop private solutions.
Quantity
of Alcohol
0
Price of
Alcohol
Q
MARKET
Demand
(private value)
Supply
(private cost)
Social value
Q
OPTIMUM
(a) Negative Consumption Externality
Quantity of
Education
0
Price of
Education
Q
MARKET
Demand
(private value)
Social
value
Q
OPTIMUM
(b) Positive Consumption Externality
Supply
(private cost)
Figure 10-4
CONSUMPTIONEXTERNALITIES. Panel (a) shows a market with a negative consumption
externality, such as the market for alcoholic beverages. The curve representing social value
is lower than the demand curve, and the socially optimal quantity, Q
OPTIMUM
, is less than
the equilibrium quantity, Q
MARKET
. Panel (b) shows a market with a positive consumption
externality, such as the market for education. The curve representing social value is above
the demand curve, and the socially optimal quantity, Q
OPTIMUM
, is greater than the
equilibrium quantity, Q
MARKET
.
CHAPTER 10 EXTERNALITIES 213
Sometimes, the problem of externalities is solved with moral codes and social
sanctions. Consider, for instance, why most people do not litter. Although there are
laws against littering, these laws are not vigorously enforced. Most people do not
litter just because it is the wrong thing to do. The Golden Rule taught to most chil-
dren says, “Do unto others as you would have them do unto you.” This moral in-
junction tells us to take account of how our actions affect other people. In
economic terms, it tells us to internalize externalities.
Another private solution to externalities is charities, many of which are estab-
lished to deal with externalities. For example, the Sierra Club, whose goal is to pro-
tect the environment, is a nonprofit organization funded with private donations. As
another example, colleges and universities receive gifts from alumni, corporations,
and foundations in part because education has positive externalities for society.
The private market can often solve the problem of externalities by relying on
the self-interest of the relevant parties. Sometimes the solution takes the form of in-
tegrating different types of business. For example, consider an apple grower and a
beekeeper that are located next to each other. Each business confers a positive ex-
ternality on the other: By pollinating the flowers on the trees, the bees help the or-
chard produce apples. At the same time, the bees use the nectar they get from the
apple trees to produce honey. Nonetheless, when the apple grower is deciding
how many trees to plant and the beekeeper is deciding how many bees to keep,
they neglect the positive externality. As a result, the apple grower plants too few
trees and the beekeeper keeps too few bees. These externalities could be internal-
ized if the beekeeper bought the apple orchard or if the apple grower bought the
beehive: Both activities would then take place within the same firm, and this sin-
gle firm could choose the optimal number of trees and bees. Internalizing exter-
nalities is one reason that some firms are involved in different types of business.
Another way for the private market to deal with external effects is for the in-
terested parties to enter into a contract. In the foregoing example, a contract be-
tween the apple grower and the beekeeper can solve the problem of too few trees
and too few bees. The contract can specify the number of trees, the number of bees,
and perhaps a payment from one party to the other. By setting the right number of
trees and bees, the contract can solve the inefficiency that normally arises from
these externalities and make both parties better off.
THE COASE THEOREM
How effective is the private market in dealing with externalities? Afamous re-
sult,called the Coase theoremafter economist Ronald Coase, suggests that it can
bevery effective in some circumstances. According to the Coase theorem, if pri-
vate parties can bargain without cost over the allocation of resources, then the pri-
vate market will always solve the problem of externalities and allocate resources
efficiently.
To see how the Coase theorem works, consider an example. Suppose that Dick
owns a dog named Spot. Spot barks and disturbs Jane, Dick’s neighbor. Dick gets
a benefit from owning the dog, but the dog confers a negative externality on Jane.
Should Dick be forced to send Spot to the pound, or should Jane have to suffer
sleepless nights because of Spot’s barking?
Consider first what outcome is socially efficient. Asocial planner, considering
the two alternatives, would compare the benefit that Dick gets from the dog to the
cost that Jane bears from the barking. If the benefit exceeds the cost, it is efficient
Coase theorem
the proposition that if private
partiescan bargain without cost over
the allocation of resources, they can
solve the problem of externalities on
their own
214 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
for Dick to keep the dog and for Jane to live with the barking. Yet if the cost ex-
ceeds the benefit, then Dick should get rid of the dog.
According to the Coase theorem, the private market will reach the efficient
outcome on its own. How? Jane can simply offer to pay Dick to get rid of the dog.
Dick will accept the deal if the amount of money Jane offers is greater than the ben-
efit of keeping the dog.
By bargaining over the price, Dick and Jane can always reach the efficient out-
come. For instance, suppose that Dick gets a $500 benefit from the dog and Jane
bears an $800 cost from the barking. In this case, Jane can offer Dick $600 to get rid
of the dog, and Dick will gladly accept. Both parties are better off than they were
before, and the efficient outcome is reached.
It is possible, of course, that Jane would not be willing to offer any price that
Dick would accept. For instance, suppose that Dick gets a $1,000 benefit from the
dog and Jane bears an $800 cost from the barking. In this case, Dick would turn
down any offer below $1,000, while Jane would not offer any amount above $800.
Therefore, Dick ends up keeping the dog. Given these costs and benefits, however,
this outcome is efficient.
So far, we have assumed that Dick has the legal right to keep a barking dog. In
other words, we have assumed that Dick can keep Spot unless Jane pays him
enough to induce him to give up the dog voluntarily. How different would the
outcome be, on the other hand, if Jane had the legal right to peace and quiet?
According to the Coase theorem, the initial distribution of rights does not mat-
ter for the market’s ability to reach the efficient outcome. For instance, suppose
that Jane can legally compel Dick to get rid of the dog. Although having this right
works to Jane’s advantage, it probably will not change the outcome. In this case,
Dick can offer to pay Jane to allow him to keep the dog. If the benefit of the dog to
Dick exceeds the cost of the barking to Jane, then Dick and Jane will strike a bar-
gain in which Dick keeps the dog.
Although Dick and Jane can reach the efficient outcome regardless of how
rights are initially distributed, the distribution of rights is not irrelevant: It deter-
mines the distribution of economic well-being. Whether Dick has the right to a
barking dog or Jane the right to peace and quiet determines who pays whom in the
final bargain. But, in either case, the two parties can bargain with each other and
solve the externality problem. Dick will end up keeping the dog only if the benefit
exceeds the cost.
To sum up: The Coase theorem says that private economic actors can solve the prob-
lem of externalities among themselves. Whatever the initial distribution of rights, the in-
terested parties can always reach a bargain in which everyone is better off and the outcome
is efficient.
WHY PRIVATE SOLUTIONS DO NOT ALWAYS WORK
Despite the appealing logic of the Coase theorem, private actors on their own of-
ten fail to resolve the problems caused by externalities. The Coase theorem applies
only when the interested parties have no trouble reaching and enforcing an agree-
ment. In the real world, however, bargaining does not always work, even when a
mutually beneficial agreement is possible.
Sometimes the interested parties fail to solve an externality problem because
of transaction costs,the costs that parties incur in the process of agreeing to and
following through on a bargain. In our example, imagine that Dick and Jane speak
transaction costs
the costs that parties incur in the
process of agreeing and following
through on a bargain
CHAPTER 10 EXTERNALITIES 215
different languages so that, to reach an agreement, they will need to hire a transla-
tor. If the benefit of solving the barking problem is less than the cost of the transla-
tor, Dick and Jane might choose to leave the problem unsolved. In more realistic
examples, the transaction costs are the expenses not of translators but of the
lawyers required to draft and enforce contracts.
Other times bargaining simply breaks down. The recurrence of wars and labor
strikes shows that reaching agreement can be difficult and that failing to reach
agreement can be costly. The problem is often that each party tries to hold out for
a better deal. For example, suppose that Dick gets a $500 benefit from the dog, and
Jane bears an $800 cost from the barking. Although it is efficient for Jane to pay
Dick to get rid of the dog, there are many prices that could lead to this outcome.
Dick might demand $750, and Jane might offer only $550. As they haggle over the
price, the inefficient outcome with the barking dog persists.
Reaching an efficient bargain is especially difficult when the number of inter-
ested parties is large because coordinating everyone is costly. For example, con-
sider a factory that pollutes the water of a nearby lake. The pollution confers a
negative externality on the local fishermen. According to the Coase theorem, if the
pollution is inefficient, then the factory and the fishermen could reach a bargain in
which the fishermen pay the factory not to pollute. If there are many fishermen,
however, trying to coordinate them all to bargain with the factory may be almost
impossible.
When private bargaining does not work, the government can sometimes play
a role. The government is an institution designed for collective action. In this ex-
ample, the government can act on behalf of the fishermen, even when it is imprac-
tical for the fishermen to act for themselves. In the next section, we examine how
the government can try to remedy the problem of externalities.
QUICK QUIZ: Give an example of a private solution to an externality.
a78 What is the Coase theorem? a78 Why are private economic actors
sometimes unable to solve the problems caused by an externality?
PUBLIC POLICIES TOWARD EXTERNALITIES
When an externality causes a market to reach an inefficient allocation of resources,
the government can respond in one of two ways. Command-and-controlpoliciesreg-
ulate behavior directly. Market-based policiesprovide incentives so that private de-
cisionmakers will choose to solve the problem on their own.
REGULATION
The government can remedy an externality by making certain behaviors either re-
quired or forbidden. For example, it is a crime to dump poisonous chemicals into
the water supply. In this case, the external costs to society far exceed the benefits to
the polluter. The government therefore institutes a command-and-control policy
that prohibits this act altogether.
In most cases of pollution, however, the situation is not this simple. Despite
the stated goals of some environmentalists, it would be impossible to prohibit all
216 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
polluting activity. For example, virtually all forms of transportation—even the
horse—produce some undesirable polluting by-products. But it would not be sen-
sible for the government to ban all transportation. Thus, instead of trying to erad-
icate pollution altogether, society has to weigh the costs and benefits to decide the
kinds and quantities of pollution it will allow. In the United States, the Environ-
mental Protection Agency (EPA) is the government agency with the task of devel-
oping and enforcing regulations aimed at protecting the environment.
Environmental regulations can take many forms. Sometimes the EPAdictates
a maximum level of pollution that a factory may emit. Other times the EPAre-
quires that firms adopt a particular technology to reduce emissions. In all cases, to
design good rules, the government regulators need to know the details about spe-
cific industries and about the alternative technologies that those industries could
adopt. This information is often difficult for government regulators to obtain.
PIGOVIAN TAXES AND SUBSIDIES
Instead of regulating behavior in response to an externality, the government can use
market-based policies to align private incentives with social efficiency. For instance,
as we saw earlier, the government can internalize the externality by taxing activities
that have negative externalities and subsidizing activities that have positive exter-
nalities. Taxes enacted to correct the effects of negative externalities are called Pigov-
ian taxes,after economist Arthur Pigou (1877–1959), an early advocate of their use.
Economists usually prefer Pigovian taxes over regulations as a way to deal
with pollution because they can reduce pollution at a lower cost to society. To see
why, let us consider an example.
Suppose that two factories—a paper mill and a steel mill—are each dumping
500 tons of glop into a river each year. The EPAdecides that it wants to reduce the
amount of pollution. It considers two solutions:
a78 Regulation:The EPAcould tell each factory to reduce its pollution to 300 tons
of glop per year.
a78 Pigovian tax:The EPAcould levy a tax on each factory of $50,000 for each ton
of glop it emits.
The regulation would dictate a level of pollution, whereas the tax would give fac-
tory owners an economic incentive to reduce pollution. Which solution do you
think is better?
Most economists would prefer the tax. They would first point out that a tax is
just as effective as a regulation in reducing the overall level of pollution. The EPA
can achieve whatever level of pollution it wants by setting the tax at the appropri-
ate level. The higher the tax, the larger the reduction in pollution. Indeed, if the tax
is high enough, the factories will close down altogether, reducing pollution to zero.
The reason why economists would prefer the tax is that it reduces pollution
more efficiently. The regulation requires each factory to reduce pollution by the
same amount, but an equal reduction is not necessarily the least expensive way to
clean up the water. It is possible that the paper mill can reduce pollution at lower
cost than the steel mill. If so, the paper mill would respond to the tax by reducing
pollution substantially to avoid the tax, whereas the steel mill would respond by
reducing pollution less and paying the tax.
Pigovian tax
a tax enacted to correct the effects of
a negative externality
CHAPTER 10 EXTERNALITIES 217
CASE STUDY WHY IS GASOLINE TAXED SO HEAVILY?
In many countries, gasoline is among the most heavily taxed goods in the econ-
omy. In the United States, for instance, almost half of what drivers pay for gaso-
line goes to the gas tax. In many European countries, the tax is even larger and
the price of gasoline is three or four times the U.S. price.
Why is this tax so common? One answer is that the gas tax is a Pigovian tax
aimed at correcting three negative externalities associated with driving:
a78 Congestion:If you have ever been stuck in bumper-to-bumper traffic, you
have probably wished that there were fewer cars on the road. Agasoline tax
keeps congestion down by encouraging people to take public transporta-
tion, car pool more often, and live closer to work.
a78 Accidents:Whenever a person buys a large car or a sport utility vehicle,
hemakes himself safer, but he puts his neighbors at risk. According to the
National Highway Traffic Safety Administration, a person driving a typical
car is five times as likely to die if hit by a sport utility vehicle than if
hit by another car. The gas tax is an indirect way of making people
paywhen their large, gas-guzzling vehicles impose risk on others, which in
turn makes them take account of this risk when choosing what vehicle to
purchase.
a78 Pollution:The burning of fossil fuels such as gasoline is widely believed to
be the cause of global warming. Experts disagree about how dangerous this
threat is, but there is no doubt that the gas tax reduces the risk by reducing
the use of gasoline.
So the gas tax, rather than causing deadweight losses like most taxes, actually
makes the economy work better. It means less traffic congestion, safer roads,
and a cleaner environment.
In essence, the Pigovian tax places a price on the right to pollute. Just as mar-
kets allocate goods to those buyers who value them most highly, a Pigovian tax al-
locates pollution to those factories that face the highest cost of reducing it.
Whatever the level of pollution the EPAchooses, it can achieve this goal at the low-
est total cost using a tax.
Economists also argue that Pigovian taxes are better for the environment. Under
the command-and-control policy of regulation, factories have no reason to reduce
emission further once they have reached the target of 300 tons of glop. Bycontrast,
the tax gives the factories an incentive to develop cleaner technologies,because a
cleaner technology would reduce the amount of tax the factory has topay.
Pigovian taxes are unlike most other taxes. As we discussed in Chapter 8, most
taxes distort incentives and move the allocation of resources away from the social
optimum. The reduction in economic well-being—that is, in consumer and pro-
ducer surplus—exceeds the amount of revenue the government raises, resulting in
a deadweight loss. By contrast, when externalities are present, society also cares
about the well-being of the bystanders who are affected. Pigovian taxes correct in-
centives for the presence of externalities and thereby move the allocation of re-
sources closer to the social optimum. Thus, while Pigovian taxes raise revenue for
the government, they enhance economic efficiency.
“IFTHEGASTAXWEREANYLARGER, I’D
TAKETHEBUS.”
218 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
TRADABLE POLLUTION PERMITS
Returning to our example of the paper mill and the steel mill, let us suppose that,
despite the advice of its economists, the EPAadopts the regulation and requires
each factory to reduce its pollution to 300 tons of glop per year. Then one day, after
the regulation is in place and both mills have complied, the two firms go to the
EPAwith a proposal. The steel mill wants to increase its emission of glop by 100
tons. The paper mill has agreed to reduce its emission by the same amount if
thesteel mill pays it $5 million. Should the EPAallow the two factories to make
this deal?
From the standpoint of economic efficiency, allowing the deal is good policy.
The deal must make the owners of the two factories better off, because they are
voluntarily agreeing to it. Moreover, the deal does not have any external effects be-
cause the total amount of pollution remains the same. Thus, social welfare is en-
hanced by allowing the paper mill to sell its right to pollute to the steel mill.
The same logic applies to any voluntary transfer of the right to pollute from
one firm to another. If the EPAallows firms to make these deals, it will, in essence,
have created a new scarce resource: pollution permits. Amarket to trade these per-
mits will eventually develop, and that market will be governed by the forces of
supply and demand. The invisible hand will ensure that this new market effi-
ciently allocates the right to pollute. The firms that can reduce pollution only at
high cost will be willing to pay the most for the pollution permits. The firms that
can reduce pollution at low cost will prefer to sell whatever permits they have.
One advantage of allowing a market for pollution permits is that the initial al-
location of pollution permits among firms does not matter from the standpoint of
economic efficiency. The logic behind this conclusion is similar to that behind the
Coase theorem. Those firms that can reduce pollution most easily would be will-
ing to sell whatever permits they get, and those firms that can reduce pollution
only at high cost would be willing to buy whatever permits they need. As long as
there is a free market for the pollution rights, the final allocation will be efficient
whatever the initial allocation.
Although reducing pollution using pollution permits may seem quite different
from using Pigovian taxes, in fact the two policies have much in common. In both
cases, firms pay for their pollution. With Pigovian taxes, polluting firms must pay
a tax to the government. With pollution permits, polluting firms must pay to buy
the permit. (Even firms that already own permits must pay to pollute: The oppor-
tunity cost of polluting is what they could have received by selling their permits
on the open market.) Both Pigovian taxes and pollution permits internalize the ex-
ternality of pollution by making it costly for firms to pollute.
The similarity of the two policies can be seen by considering the market for
pollution. Both panels in Figure 10-5 show the demand curve for the right to pol-
lute. This curve shows that the lower the price of polluting, the more firms will
choose to pollute. In panel (a), the EPAuses a Pigovian tax to set a price for pollu-
tion. In this case, the supply curve for pollution rights is perfectly elastic (because
firms can pollute as much as they want by paying the tax), and the position of the
demand curve determines the quantity of pollution. In panel (b), the EPAsets a
quantity of pollution by issuing pollution permits. In this case, the supply curve
for pollution rights is perfectly inelastic (because the quantity of pollution is fixed
by the number of permits), and the position of the demand curve determines the
price of pollution. Hence, for any given demand curve for pollution, the EPAcan
CHAPTER 10 EXTERNALITIES 219
achieve any point on the demand curve either by setting a price with a Pigovian
tax or by setting a quantity with pollution permits.
In some circumstances, however, selling pollution permits may be better than
levying a Pigovian tax. Suppose the EPAwants no more than 600 tons of glop to be
dumped into the river. But, because the EPAdoes not know the demand curve for
pollution, it is not sure what size tax would achieve that goal. In this case, it can
simply auction off 600 pollution permits. The auction price would yield the ap-
propriate size of the Pigovian tax.
The idea of the government auctioning off the right to pollute may at first
sound like a creature of some economist’s imagination. And, in fact, that is how
the idea began. But increasingly the EPAhas used the system as a way to control
pollution. Pollution permits, like Pigovian taxes, are now widely viewed as a cost-
effective way to keep the environment clean.
OBJECTIONS TO THE ECONOMIC ANALYSIS OF POLLUTION
“We cannot give anyone the option of polluting for a fee.” This comment by for-
mer Senator Edmund Muskie reflects the view of some environmentalists. Clean
air and clean water, they argue, are fundamental human rights that should not be
debased by considering them in economic terms. How can you put a price on
clean air and clean water? The environment is so important, they claim, that we
should protect it as much as possible, regardless of the cost.
Quantity of
Pollution
0
Price of
Pollution
P
Q
Demand for
pollution rights
Pigovian
tax
(a) Pigovian Tax
Quantity of
Pollution
0 Q
Demand for
pollution rights
Supply of
pollution permits
(b) Pollution Permits
Price of
Pollution
P
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.
2. . . . which, together
with the demand curve,
determines the price
of pollution.
1. A Pigovian
tax sets the
price of
pollution . . .
1. Pollution
permits set
the quantity
of pollution . . .
Figure 10-5
THEEQUIVALENCE OFPIGOVIANTAXES ANDPOLLUTIONPERMITS. In panel (a), the EPA
sets a price on pollution by levying a Pigovian tax, and the demand curve determines the
quantity of pollution. In panel (b), the EPAlimits the quantity of pollution by limiting the
number of pollution permits, and the demand curve determines the price of pollution. The
price and quantity of pollution are the same in the two cases.
220 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
Economists have little sympathy with this type of argument. To economists,
good environmental policy begins by acknowledging the first of the Ten Principles
of Economicsin Chapter 1: People face tradeoffs. Certainly, clean air and clean wa-
ter have value. But their value must be compared to their opportunity cost—that
is, to what one must give up to obtain them. Eliminating all pollution is impossi-
ble. Trying to eliminate all pollution would reverse many of the technological ad-
vances that allow us to enjoy a high standard of living. Few people would be
willing to accept poor nutrition, inadequate medical care, or shoddy housing to
make the environment as clean as possible.
Economists argue that some environmental activists hurt their own cause by
not thinking in economic terms. Aclean environment is a good like other goods.
Like all normal goods, it has a positive income elasticity: Rich countries can afford
a cleaner environment than poor ones and, therefore, usually have more rigorous
environmental protection. In addition, like most other goods, clean air and water
obey the law of demand: The lower the price of environmental protection, the
more the public will want. The economic approach of using pollution permits and
Pigovian taxes reduces the cost of environmental protection and should, therefore,
increase the public’s demand for a clean environment.
QUICK QUIZ: Aglue factory and a steel mill emit smoke containing a
chemical that is harmful if inhaled in large amounts. Describe three ways the
town government might respond to this externality. What are the pros and
cons of each of your solutions?
CONCLUSION
The invisible hand is powerful but not omnipotent. Amarket’s equilibrium maxi-
mizes the sum of producer and consumer surplus. When the buyers and sellers in
the market are the only interested parties, this outcome is efficient from the stand-
point of society as a whole. But when there are external effects, such as pollution,
evaluating a market outcome requires taking into account the well-being of third
parties as well. In this case, the invisible hand of the marketplace may fail to allo-
cate resources efficiently.
In some cases, people can solve the problem of externalities on their own. The
Coase theorem suggests that the interested parties can bargain among themselves
and agree on an efficient solution. Sometimes, however, an efficient outcome can-
not be reached, perhaps because the large number of interested parties makes bar-
gaining difficult.
When people cannot solve the problem of externalities privately, the govern-
ment often steps in. Yet, even now, society should not abandon market forces
entirely. Rather, the government can address the problem by requiring decision-
makers to bear the full costs of their actions. Pigovian taxes on emissions and pol-
lution permits, for instance, are designed to internalize the externality of pollution.
More and more, they are the policy of choice for those interested in protecting the
environment. Market forces, properly redirected, are often the best remedy for mar-
ket failure.
CHAPTER 10 EXTERNALITIES 221
THIS TONGUE-IN-CHEEK EDITORIAL FROM
THE Economist, an international news-
magazine, calls attention to a common
externality that is not fully appreciated.
Mum’s the Word:
When Children Should Be
Screened and Not Heard
We live in increasingly intolerant times.
Signs proliferate demanding no smoking,
no spitting, no parking, even no walking.
. . . Posh clubs and restaurants have
long had “no jeans” rules, but these
days you can be too smart. Some Lon-
don hostelries have “no suits” policies,
for fear that boisterous city traders in
suits might spoil the atmosphere. Envi-
ronmentalists have long demanded all
sorts of bans on cars. Mobile telephones
are the latest target: some trains, airline
lounges, restaurants, and even golf
courses are being designated “no
phone” areas.
If intolerance really has to be the
spirit of this age, The Economist would
like to suggest restrictions on another
source of noise pollution: children. Lest
you dismiss this as mere prejudice, we
can even produce a good economic
argument for it. Smoking, driving, and mo-
bile phones all cause what economists
call “negative externalities.” That is, the
costs of these activities to other people
tend to exceed the costs to the individuals
of their proclivities. The invisible hand of
the market fumbles, leading resources
astray. Thus, because a driver’s private
motoring costs do not reflect the costs he
imposes on others in the form of pollution
and congestion, he uses the car more
than is socially desirable. Likewise, it is ar-
gued, smokers take too little care to en-
sure that their acrid fumes do not damage
other people around them.
Governments typically respond to
such market failures in two ways. One is
higher taxes, to make polluters pay the
full cost of their anti-social behavior. The
other is regulation, such as emission
standards or bans on smoking in public
places. Both approaches might work for
children.
For children, just like cigarettes or
mobile phones, clearly impose a nega-
tive externality on people who are near
them. Anybody who has suffered a 12-
hour flight with a bawling baby in the row
immediately ahead, or a bored youngster
viciously kicking their seat from behind,
will grasp this as quickly as they would
love to grasp the youngster’s neck. Here
is a clear case of market failure: parents
do not bear the full costs (indeed young
babies travel free), so they are too ready
to take their noisy brats with them.
Where is the invisible hand when it is
needed to administer a good smack?
The solution is obvious. All airlines,
trains, and restaurants should create
child-free zones. Put all those children at
the back of the plane and parents might
make more effort to minimize their noise
pollution. And instead of letting children
pay less and babies go free, they should
be charged (or taxed) more than adults,
with the revenues used to subsidize seats
immediately in front of the war-zone.
Passengers could then request a
no-children seat, just as they now ask for
a no-smoking one. As more women
choose not to have children and the
number of older people without young
children increases, the demand for child-
free travel will expand. Well, yes, it is a
bit intolerant—but why shouldn’t parents
be treated as badly as smokers? And at
least there is an obvious airline to pio-
neer the scheme: Virgin.
SOURCE:The Economist,December 5, 1998, p. 20.
IN THE NEWS
Children as Externalities
A NEGATIVE EXTERNALITY
222 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
a78 When a transaction between a buyer and seller directly
affects a third party, the effect is called an externality.
Negative externalities, such as pollution, cause the
socially optimal quantity in a market to be less than the
equilibrium quantity. Positive externalities, such as
technology spillovers, cause the socially optimal
quantity to be greater than the equilibrium quantity.
a78 Those affected by externalities can sometimes solve the
problem privately. For instance, when one business
confers an externality on another business, the two
businesses can internalize the externality by merging.
Alternatively, the interested parties can solve the
problem by negotiating a contract. According to the
Coase theorem, if people can bargain without cost, then
they can always reach an agreement in which resources
are allocated efficiently. In many cases, however,
reaching a bargain among the many interested parties is
difficult, so the Coase theorem does not apply.
a78 When private parties cannot adequately deal with
external effects, such as pollution, the government often
steps in. Sometimes the government prevents socially
inefficient activity by regulating behavior. Other times it
internalizes an externality using Pigovian taxes. Another
way to protect the environment is for the government to
issue a limited number of pollution permits. The end
result of this policy is largely the same as imposing
Pigovian taxes on polluters.
Summary
externality, p. 206
internalizing an externality, p. 209
Coase theorem, p. 213
transaction costs, p. 214
Pigovian tax, p. 216
Key Concepts
1. Give an example of a negative externality and an
example of a positive externality.
2. Use a supply-and-demand diagram to explain the effect
of a negative externality in production.
3. In what way does the patent system help society solve
an externality problem?
4. List some of the ways that the problems caused by
externalities can be solved without government
intervention.
5. Imagine that you are a nonsmoker sharing a room with
a smoker. According to the Coase theorem, what
determines whether your roommate smokes in the
room? Is this outcome efficient? How do you and your
roommate reach this solution?
6. What are Pigovian taxes? Why do economists prefer
them over regulations as a way to protect the
environment from pollution?
Questions for Review
1. Do you agree with the following statements? Why or
why not?
a. “The benefits of Pigovian taxes as a way to reduce
pollution have to be weighed against the
deadweight losses that these taxes cause.”
b. “Anegative production externality calls for a
Pigovian tax on producers, whereas a negative
consumption externality calls for a Pigovian tax on
consumers.”
2. Consider the market for fire extinguishers.
a. Why might fire extinguishers exhibit positive
externalities in consumption?
b. Draw a graph of the market for fire extinguishers,
labeling the demand curve, the social-value
Problems and Applications
CHAPTER 10 EXTERNALITIES 223
curve,the supply curve, and the social-cost
curve.
c. Indicate the market equilibrium level of output and
the efficient level of output. Give an intuitive
explanation for why these quantities differ.
d. If the external benefit is $10 per extinguisher,
describe a government policy that would result in
the efficient outcome.
3. Contributions to charitable organizations are deductible
under the federal income tax. In what way does this
government policy encourage private solutions to
externalities?
4. Ringo loves playing rock and roll music at high volume.
Luciano loves opera and hates rock and roll.
Unfortunately, they are next-door neighbors in an
apartment building with paper-thin walls.
a. What is the externality here?
b. What command-and-control policy might the
landlord impose? Could such a policy lead to an
inefficient outcome?
c. Suppose the landlord lets the tenants do whatever
they want. According to the Coase theorem, how
might Ringo and Luciano reach an efficient
outcome on their own? What might prevent them
from reaching an efficient outcome?
5. It is rumored that the Swiss government subsidizes
cattle farming, and that the subsidy is larger in areas
with more tourist attractions. Can you think of a reason
why this policy might be efficient?
6. Greater consumption of alcohol leads to more motor
vehicle accidents and, thus, imposes costs on people
who do not drink and drive.
a. Illustrate the market for alcohol, labeling the
demand curve, the social-value curve, the supply
curve, the social-cost curve, the market equilibrium
level of output, and the efficient level of output.
b. On your graph, shade the area corresponding to the
deadweight loss of the market equilibrium. (Hint:
The deadweight loss occurs because some units of
alcohol are consumed for which the social cost
exceeds the social value.) Explain.
7. Many observers believe that the levels of pollution in
our economy are too high.
a. If society wishes to reduce overall pollution by a
certain amount, why is it efficient to have different
amounts of reduction at different firms?
b. Command-and-control approaches often rely on
uniform reductions among firms. Why are these
approaches generally unable to target the firms that
should undertake bigger reductions?
c. Economists argue that appropriate Pigovian taxes
or tradable pollution rights will result in efficient
pollution reduction. How do these approaches
target the firms that should undertake bigger
reductions?
8. The Pristine River has two polluting firms on its banks.
Acme Industrial and Creative Chemicals each dump 100
tons of glop into the river each year. The cost of
reducing glop emissions per ton equals $10 for Acme
and $100 for Creative. The local government wants to
reduce overall pollution from 200 tons to 50 tons.
a. If the government knew the cost of reduction for
each firm, what reductions would it impose to
reach its overall goal? What would be the cost to
each firm and the total cost to the firms together?
b. In a more typical situation, the government would
not know the cost of pollution reduction at each
firm. If the government decided to reach its overall
goal by imposing uniform reductions on the firms,
calculate the reduction made by each firm, the cost
to each firm, and the total cost to the firms together.
c. Compare the total cost of pollution reduction in
parts (a) and (b). If the government does not know
the cost of reduction for each firm, is there still
some way for it to reduce pollution to 50 tons at the
total cost you calculated in part (a)? Explain.
9. Figure 10-5 shows that for any given demand curve for
the right to pollute, the government can achieve the
same outcome either by setting a price with a Pigovian
tax or by setting a quantity with pollution permits.
Suppose there is a sharp improvement in the technology
for controlling pollution.
a. Using graphs similar to those in Figure 10-5,
illustrate the effect of this development on the
demand for pollution rights.
b. What is the effect on the price and quantity of
pollution under each regulatory system? Explain.
10. Suppose that the government decides to issue tradable
permits for a certain form of pollution.
a. Does it matter for economic efficiency whether the
government distributes or auctions the permits?
Does it matter in any other ways?
b. If the government chooses to distribute the permits,
does the allocation of permits among firms matter
for efficiency? Does it matter in any other ways?
11. The primary cause of global warming is carbon dioxide,
which enters the atmosphere in varying amounts from
224 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
different countries but is distributed equally around the
globe within a year. In an article in The Boston Globe(July
3, 1990), Martin and Kathleen Feldstein argue that the
correct approach to global warming is “not to ask
individual countries to stabilize their emissions of
carbon dioxide at current levels,” as some have
suggested. Instead, they argue that “carbon dioxide
emissions should be reduced in countries where the
costs are least, and the countries that bear that burden
should be compensated by the rest of the world.”
a. Why is international cooperation necessary to reach
an efficient outcome?
b. Is it possible to devise a compensation scheme such
that all countries would be better off than under a
system of uniform emission reductions? Explain.
12. Some people object to market-based policies to reduce
pollution, claiming that they place a dollar value on
cleaning our air and water. Economists reply that
society implicitlyplaces a dollar value on environmental
cleanup even under command-and-control policies.
Discuss why this is true.
13. (This problem is challenging.) There are three industrial
firms in Happy Valley.
INITIAL COST OFREDUCING
FIRM POLLUTIONLEVEL POLLUTION BY1 UNIT
A 70 units $20
B80 25
C50 10
The government wants to reduce pollution to 120 units,
so it gives each firm 40 tradable pollution permits.
a. Who sells permits and how many do they sell?
Who buys permits and how many do they buy?
Briefly explain why the sellers and buyers are each
willing to do so. What is the total cost of pollution
reduction in this situation?
b. How much higher would the costs of pollution
reduction be if the permits could not be traded?
IN THIS CHAPTER
YOU WILL . . .
Examine why people
tend to use common
resources too much
Consider some of
the important
common resources
in our economy
Consider some of
the important
public goods in our
economy
Learn the defining
characteristics of
public goods and
common resources
Examine why
private markets
fail to provide
public goods
See why the cost-
benefit analysis
of public goods is
both necessary
and difficult
An old song lyric maintains that “the best things in life are free.” A moment’s
thought reveals a long list of goods that the songwriter could have had in mind. Na-
ture provides some of them, such as rivers, mountains, beaches, lakes, and oceans.
The government provides others, such as playgrounds, parks, and parades. In each
case, people do not pay a fee when they choose to enjoy the benefit of the good.
Free goods provide a special challenge for economic analysis. Most goods in
our economy are allocated in markets, where buyers pay for what they receive and
sellers are paid for what they provide. For these goods, prices are the signals that
guide the decisions of buyers and sellers. When goods are available free of charge,
however, the market forces that normally allocate resources in our economy are
absent.
In this chapter we examine the problems that arise for goods without market
prices. Our analysis will shed light on one of the Ten Principles of Economics
PUBLIC GOODS AND
COMMON RESOURCES
225
226 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
in Chapter 1: Governments can sometimes improve market outcomes. When a
good does not have a price attached to it, private markets cannot ensure that the
good is produced and consumed in the proper amounts. In such cases, government
policy can potentially remedy the market failure and raise economic well-being.
THE DIFFERENT KINDS OF GOODS
How well do markets work in providing the goods that people want? The answer
to this question depends on the good being considered. As we discussed in Chapter
7, we can rely on the market to provide the efficient number of ice-cream cones: The
price of ice-cream cones adjusts to balance supply and demand, and this equilib-
rium maximizes the sum of producer and consumer surplus. Yet, as we discussed in
Chapter 10, we cannot rely on the market to prevent aluminum manufacturers from
polluting the air we breathe: Buyers and sellers in a market typically do not take ac-
count of the external effects of their decisions. Thus, markets work well when the
good is ice cream, but they work badly when the good is clean air.
In thinking about the various goods in the economy, it is useful to group them
according to two characteristics:
a78 Is the good excludable?Can people be prevented from using the good?
a78 Is the good rival?Does one person’s use of the good diminish another
person’s enjoyment of it?
Using these two characteristics, Figure 11-1 divides goods into four categories:
1. Private goodsare both excludable and rival. Consider an ice-cream cone, for
example. An ice-cream cone is excludable because it is possible to prevent
someone from eating an ice-cream cone—you just don’t give it to him. An
ice-cream cone is rival because if one person eats an ice-cream cone, another
person cannot eat the same cone. Most goods in the economy are private
goods like ice-cream cones. When we analyzed supply and demand in
Chapters 4, 5, and 6 and the efficiency of markets in Chapters 7, 8, and 9, we
implicitly assumed that goods were both excludable and rival.
2. Public goodsare neither excludable nor rival. That is, people cannot be
prevented from using a public good, and one person’s enjoyment of a public
good does not reduce another person’s enjoyment of it. For example, national
defense is a public good. Once the country is defended from foreign
aggressors, it is impossible to prevent any single person from enjoying the
benefit of this defense. Moreover, when one person enjoys the benefit of
national defense, he does not reduce the benefit to anyone else.
3. Common resourcesare rival but not excludable. For example, fish in the
ocean are a rival good: When one person catches fish, there are fewer fish for
the next person to catch. Yet these fish are not an excludable good because it
is difficult to charge fishermen for the fish that they catch.
4. When a good is excludable but not rival, it is an example of a natural
monopoly.For instance, consider fire protection in a small town. It is easy to
excludability
the property of a good whereby a
person can be prevented from
using it
rivalry
the property of a good whereby one
person’s use diminishes other
people’s use
private goods
goods that are both excludable
and rival
public goods
goods that are neither excludable
nor rival
common resources
goods that are rival but not
excludable
CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 227
exclude people from enjoying this good: The fire department can just let their
house burn down. Yet fire protection is not rival. Firefighters spend much of
their time waiting for a fire, so protecting an extra house is unlikely to reduce
the protection available to others. In other words, once a town has paid for
the fire department, the additional cost of protecting one more house is
small. In Chapter 15 we give a more complete definition of natural
monopolies and study them in some detail.
In this chapter we examine goods that are not excludable and, therefore, are
available to everyone free of charge: public goods and common resources. As we
will see, this topic is closely related to the study of externalities. For both public
goods and common resources, externalities arise because something of value has
no price attached to it. If one person were to provide a public good, such as na-
tional defense, other people would be better off, and yet they could not be charged
for this benefit. Similarly, when one person uses a common resource, such as the
fish in the ocean, other people are worse off, and yet they are not compensated for
this loss. Because of these external effects, private decisions about consumption
and production can lead to an inefficient allocation of resources, and government
intervention can potentially raise economic well-being.
QUICK QUIZ: Define public goodsand common resources,and give an
example of each.
PUBLIC GOODS
To understand how public goods differ from other goods and what problems they
present for society, let’s consider an example: a fireworks display. This good is not
excludable because it is impossible to prevent someone from seeing fireworks, and
it is not rival because one person’s enjoyment of fireworks does not reduce anyone
else’s enjoyment of them.
Rival?
Yes
Yes
? Ice-cream cones
? Clothing
? Congested toll roads
? Fire protection
? Cable TV
? Uncongested toll roads
No
Private Goods Natural Monopolies
No
Excludable?
? Fish in the ocean
? The environment
? Congested nontoll roads
? National defense
? Knowledge
? Uncongested nontoll roads
Common Resources Public Goods
Figure 11-1
FOUR TYPES OF GOODS.
Goodscan be grouped into four
categories according to two
questions: (1) Is the good
excludable? That is, can people
beprevented from using it? (2) Is
the good rival? That is, does one
person’s use of the good diminish
other people’s use of it? This
table gives examples of goods in
each of the four categories.
228 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
THE FREE-RIDER PROBLEM
The citizens of Smalltown, U.S.A., like seeing fireworks on the Fourth of July. Each
of the town’s 500 residents places a $10 value on the experience. The cost of
putting on a fireworks display is $1,000. Because the $5,000 of benefits exceed the
$1,000 of costs, it is efficient for Smalltown residents to see fireworks on the Fourth
of July.
Would the private market produce the efficient outcome? Probably not. Imag-
ine that Ellen, a Smalltown entrepreneur, decided to put on a fireworks display.
Ellen would surely have trouble selling tickets to the event because her potential
customers would quickly figure out that they could see the fireworks even without
a ticket. Fireworks are not excludable, so people have an incentive to be free riders.
Afree rideris a person who receives the benefit of a good but avoids paying for it.
One way to view this market failure is that it arises because of an externality.
If Ellen did put on the fireworks display, she would confer an external benefit on
those who saw the display without paying for it. When deciding whether to put
on the display, Ellen ignores these external benefits. Even though a fireworks dis-
play is socially desirable, it is not privately profitable. As a result, Ellen makes the
socially inefficient decision not to put on the display.
Although the private market fails to supply the fireworks display demanded
by Smalltown residents, the solution to Smalltown’s problem is obvious: The local
government can sponsor a Fourth of July celebration. The town council can raise
everyone’s taxes by $2 and use the revenue to hire Ellen to produce the fireworks.
Everyone in Smalltown is better off by $8—the $10 in value from the fireworks mi-
nus the $2 tax bill. Ellen can help Smalltown reach the efficient outcome as a pub-
lic employee even though she could not do so as a private entrepreneur.
The story of Smalltown is simplified, but it is also realistic. In fact, many local
governments in the United States do pay for fireworks on the Fourth of July. More-
over, the story shows a general lesson about public goods: Because public goods
are not excludable, the free-rider problem prevents the private market from sup-
plying them. The government, however, can potentially remedy the problem. If
the government decides that the total benefits exceed the costs, it can provide the
public good and pay for it with tax revenue, making everyone better off.
SOME IMPORTANT PUBLIC GOODS
There are many examples of public goods. Here we consider three of the most
important.
National Defense The defense of the country from foreign aggressors is a
classic example of a public good. It is also one of the most expensive. In 1999 the
U.S. federal government spent a total of $277 billion on national defense, or about
$1,018 per person. People disagree about whether this amount is too small or too
large, but almost no one doubts that some government spending for national de-
fense is necessary. Even economists who advocate small government agree that the
national defense is a public good the government should provide.
Basic Research The creation of knowledge is a public good. If a mathe-
matician proves a new theorem, the theorem enters the general pool of knowledge
free rider
a person who receives the benefit of a
good but avoids paying for it
CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 229
that anyone can use without charge. Because knowledge is a public good, profit-
seeking firms tend to free ride on the knowledge created by others and, as a result,
devote too few resources to the creation of knowledge.
In evaluating the appropriate policy toward knowledge creation, it is impor-
tant to distinguish general knowledge from specific, technological knowledge.
Specific, technological knowledge, such as the invention of a better battery, can be
patented. The inventor thus obtains much of the benefit of his invention, although
certainly not all of it. By contrast, a mathematician cannot patent a theorem; such
general knowledge is freely available to everyone. In other words, the patent sys-
tem makes specific, technological knowledge excludable, whereas general knowl-
edge is not excludable.
The government tries to provide the public good of general knowledge in var-
ious ways. Government agencies, such as the National Institutes of Health and the
National Science Foundation, subsidize basic research in medicine, mathematics,
physics, chemistry, biology, and even economics. Some people justify government
funding of the space program on the grounds that it adds to society’s pool of
knowledge. Certainly, many private goods, including bullet-proof vests and the in-
stant drink Tang, use materials that were first developed by scientists and engi-
neers trying to land a man on the moon. Determining the appropriate level of
governmental support for these endeavors is difficult because the benefits are hard
to measure. Moreover, the members of Congress who appropriate funds for re-
search usually have little expertise in science and, therefore, are not in the best po-
sition to judge what lines of research will produce the largest benefits.
Fighting Poverty Many government programs are aimed at helping the
poor. The welfare system (officially called Temporary Assistance for Needy Fami-
lies) provides a small income for some poor families. Similarly, the Food Stamp
program subsidizes the purchase of food for those with low incomes, and various
government housing programs make shelter more affordable. These antipoverty
programs are financed by taxes on families that are financially more successful.
“I like the concept if we can do it with no new taxes.”
230 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
CASE STUDY ARE LIGHTHOUSES PUBLIC GOODS?
Some goods can switch between being public goods and being private goods
depending on the circumstances. For example, a fireworks display is a public
good if performed in a town with many residents. Yet if performed at a private
amusement park, such as Walt Disney World, a fireworks display is more like a
private good because visitors to the park pay for admission.
Another example is a lighthouse. Economists have long used lighthouses as
examples of a public good. Lighthouses are used to mark specific locations so
that passing ships can avoid treacherous waters. The benefit that the lighthouse
provides to the ship captain is neither excludable nor rival, so each captain has
an incentive to free ride by using the lighthouse to navigate without paying for
the service. Because of this free-rider problem, private markets usually fail to
provide the lighthouses that ship captains need. As a result, most lighthouses
today are operated by the government.
Economists disagree among themselves about what role the government
should play in fighting poverty. Although we will discuss this debate more fully in
Chapter 20, here we note one important argument: Advocates of antipoverty pro-
grams claim that fighting poverty is a public good.
Suppose that everyone prefers to live in a society without poverty. Even if this
preference is strong and widespread, fighting poverty is not a “good” that the pri-
vate market can provide. No single individual can eliminate poverty because the
problem is so large. Moreover, private charity is hard pressed to solve the problem:
People who do not donate to charity can free ride on the generosity of others. In
this case, taxing the wealthy to raise the living standards of the poor can make
everyone better off. The poor are better off because they now enjoy a higher stan-
dard of living, and those paying the taxes are better off because they enjoy living
in a society with less poverty.
USE OF THE LIGHTHOUSE IS FREE TO THE BOAT OWNER. DOES THIS MAKE THE LIGHTHOUSEAPUBLIC GOOD?
CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 231
In some cases, however, lighthouses may be closer to private goods. On the
coast of England in the nineteenth century, some lighthouses were privately
owned and operated. The owner of the local lighthouse did not try to charge
ship captains for the service but did charge the owner of the nearby port. If the
port owner did not pay, the lighthouse owner turned off the light, and ships
avoided that port.
In deciding whether something is a public good, one must determine the
number of beneficiaries and whether these beneficiaries can be excluded from
enjoying the good. Afree-rider problem arises when the number of beneficiaries
is large and exclusion of any one of them is impossible. If a lighthouse benefits
many ship captains, it is a public good. Yet if it primarily benefits a single port
owner, it is more like a private good.
THE DIFFICULT JOB OF COST-BENEFIT ANALYSIS
So far we have seen that the government provides public goods because the pri-
vate market on its own will not produce an efficient quantity. Yet deciding that the
government must play a role is only the first step. The government must then de-
termine what kinds of public goods to provide and in what quantities.
Suppose that the government is considering a public project, such as building
a new highway. To judge whether to build the highway, it must compare the total
benefits of all those who would use it to the costs of building and maintaining it.
To make this decision, the government might hire a team of economists and engi-
neers to conduct a study, called a cost-benefit analysis, the goal of which is to es-
timate the total costs and benefits of the project to society as a whole.
Cost-benefit analysts have a tough job. Because the highway will be available
to everyone free of charge, there is no price with which to judge the value of the
highway. Simply asking people how much they would value the highway is not
reliable. First, quantifying benefits is difficult using the results from a question-
naire. Second, respondents have little incentive to tell the truth. Those who would
use the highway have an incentive to exaggerate the benefit they receive to get the
highway built. Those who would be harmed by the highway have an incentive to
exaggerate the costs to them to prevent the highway from being built.
The efficient provision of public goods is, therefore, intrinsically more difficult
than the efficient provision of private goods. Private goods are provided in the
market. Buyers of a private good reveal the value they place on it by the prices
they are willing to pay. Sellers reveal their costs by the prices they are willing to
accept. By contrast, cost-benefit analysts do not observe any price signals when
evaluating whether the government should provide a public good. Their findings
on the costs and benefits of public projects are, therefore, rough approximations
atbest.
cost-benefit analysis
a study that compares the costs and
benefits to society of providing a
public good
CASE STUDY HOW MUCH IS A LIFE WORTH?
Imagine that you have been elected to serve as a member of your local town
council. The town engineer comes to you with a proposal: The town can spend
$10,000 to build and operate a traffic light at a town intersection that now has
only a stop sign. The benefit of the traffic light is increased safety. The engineer
232 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
estimates, based on data from similar intersections, that the traffic light would
reduce the risk of a fatal traffic accident over the lifetime of the traffic light from
1.6 to 1.1 percent. Should you spend the money for the new light?
To answer this question, you turn to cost-benefit analysis. But you quickly
run into an obstacle: The costs and benefits must be measured in the same units
if you are to compare them meaningfully. The cost is measured in dollars, but
the benefit—the possibility of saving a person’s life—is not directly monetary.
To make your decision, you have to put a dollar value on a human life.
At first, you may be tempted to conclude that a human life is priceless. Af-
ter all, there is probably no amount of money that you could be paid to volun-
tarily give up your life or that of a loved one. This suggests that a human life
has an infinite dollar value.
For the purposes of cost-benefit analysis, however, this answer leads to
nonsensical results. If we truly placed an infinite value on human life, we
should be placing traffic lights on every street corner. Similarly, we should all be
driving large cars with all the latest safety features, instead of smaller ones with
fewer safety features. Yet traffic lights are not at every corner, and people some-
times choose to buy small cars without side-impact air bags or antilock brakes.
In both our public and private decisions, we are at times willing to risk our lives
to save some money.
Once we have accepted the idea that a person’s life does have an implicit
dollar value, how can we determine what that value is? One approach, some-
times used by courts to award damages in wrongful-death suits, is to look at the
total amount of money a person would have earned if he or she had lived.
Economists are often critical of this approach. It has the bizarre implication that
the life of a retired or disabled person has no value.
Abetter way to value human life is to look at the risks that people are vol-
untarily willing to take and how much they must be paid for taking them. Mor-
tality risk varies across jobs, for example. Construction workers in high-rise
buildings face greater risk of death on the job than office workers do. By com-
paring wages in risky and less risky occupations, controlling for education, ex-
perience, and other determinants of wages, economists can get some sense
about what value people put on their own lives. Studies using this approach
conclude that the value of a human life is about $10 million.
EVERYONE WOULD
LIKE TOAVOID THE
RISK OF THIS, BUTAT
WHATCOST?
CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 233
We can now return to our original example and respond to the town engi-
neer. The traffic light reduces the risk of fatality by 0.5 percent. Thus, the ex-
pected benefit from having the traffic light is 0.005 H11003$10 million, or $50,000.
This estimate of the benefit well exceeds the cost of $10,000, so you should ap-
prove the project.
COST-BENEFIT ANALYSTS OFTEN RUN INTO
hard questions. Here’s an example.
They Exist. Therefore They
Are. But, Do You Care?
BY SAM HOWE VERHOVEK
It sounds like a philosophical cousin to
the age-old question of whether a tree
falling in the forest makes a sound if no
one is around to hear it. In this case,
though, federal officials are seeking to
add an economic variable to the puzzle:
Just how much is it worth to you to know
that a once-dammed river is running wild
again—even if you never visit it?
In the midst of a major study of
whether or not to breach four huge hy-
droelectric dams on the Snake River in
eastern Washington, economists with
the Army Corps of Engineers are adding
a factor known as “existence value” to
their list of costs and benefits of the con-
tentious proposal.
Breaching the dams would restore
140 miles of the lower Snake to its wild,
free-flowing condition and would, many
biologists argue, stand a good chance of
revitalizing endangered salmon runs in
the river. Aside from calculating the pro-
posal’s effects on jobs, electric bills, and
shipping rates, the Government is now
hoping to assign a dollar value to Ameri-
cans’ knowledge that a piece of their
wilderness might be regained. . . .
“The idea that you’d be willing to
pay something for some state of the
world to exist, as you would pay for a
commodity or a contract for services, is
not at all crazy,” said Alan Randall, chair-
man of the department of agricultural,
environmental, and development eco-
nomics at Ohio State University. “The
controversy, really, is mostly about
measurability.”
Proponents of the dam-breaching
proposal have pointed to polls suggest-
ing that Seattle-area residents would be
willing to pay a few extra dollars a month
on their electricity bills into order to save
salmon runs. . . . Economists at the
Corps of Engineers have calculated that
breaching the four Snake River dams
and successfully restoring the salmon is
an idea for which Americans would be
willing to shell out [in total] as much as
$1 billion. . . .
Others question whether such a
value can be accurately measured. “The
only way to do it is to ask people what
they would be willing to pay, and in my
view you ask people questions like that
and you get very upwardly biased re-
sults,” said Jerry Hausman, an econom-
ics professor at M.I.T. “When somebody
calls you on the phone to ask, it’s not
real money.”
SOURCE:The New York Times,Week in Review,
October 17, 1999, p. 5.
IN THE NEWS
Existence Value
QUICK QUIZ: What is the free-rider problem? a78 Why does the free-rider
problem induce the government to provide public goods? a78 How should the
government decide whether to provide a public good?
COMMON RESOURCES
Common resources, like public goods, are not excludable: They are available free of
charge to anyone who wants to use them. Common resources are, however, rival:
234 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
One person’s use of the common resource reduces other people’s enjoyment of it.
Thus, common resources give rise to a new problem. Once the good is provided,
policymakers need to be concerned about how much it is used. This problem is best
understood from the classic parable called the Tragedy of the Commons.
THE TRAGEDY OF THE COMMONS
Consider life in a small medieval town. Of the many economic activities that take
place in the town, one of the most important is raising sheep. Many of the town’s
families own flocks of sheep and support themselves by selling the sheep’s wool,
which is used to make clothing.
As our story begins, the sheep spend much of their time grazing on the land
surrounding the town, called the Town Common. No family owns the land. In-
stead, the town residents own the land collectively, and all the residents are al-
lowed to graze their sheep on it. Collective ownership works well because land is
plentiful. As long as everyone can get all the good grazing land they want, the
Town Common is not a rival good, and allowing residents’ sheep to graze for free
causes no problems. Everyone in town is happy.
As the years pass, the population of the town grows, and so does the number
of sheep grazing on the Town Common. With a growing number of sheep and a
fixed amount of land, the land starts to lose its ability to replenish itself. Eventu-
ally, the land is grazed so heavily that it becomes barren. With no grass left on the
Town Common, raising sheep is impossible, and the town’s once prosperous wool
industry disappears. Many families lose their source of livelihood.
What causes the tragedy? Why do the shepherds allow the sheep population
to grow so large that it destroys the Town Common? The reason is that social and
private incentives differ. Avoiding the destruction of the grazing land depends on
the collective action of the shepherds. If the shepherds acted together, they could
reduce the sheep population to a size that the Town Common can support. Yet no
single family has an incentive to reduce the size of its own flock because each flock
represents only a small part of the problem.
In essence, the Tragedy of the Commons arises because of an externality. When
one family’s flock grazes on the common land, it reduces the quality of the land
available for other families. Because people neglect this negative externality when
deciding how many sheep to own, the result is an excessive number of sheep.
If the tragedy had been foreseen, the town could have solved the problem
in various ways. It could have regulated the number of sheep in each family’s
flock, internalized the externality by taxing sheep, or auctioned off a limited num-
ber of sheep-grazing permits. That is, the medieval town could have dealt with the
problem of overgrazing in the way that modern society deals with the problem of
pollution.
In the case of land, however, there is a simpler solution. The town can divide
up the land among town families. Each family can enclose its parcel of land with a
fence and then protect it from excessive grazing. In this way, the land becomes a
private good rather than a common resource. This outcome in fact occurred dur-
ing the enclosure movement in England in the seventeenth century.
The Tragedy of the Commons is a story with a general lesson: When one per-
son uses a common resource, he diminishes other people’s enjoyment of it. Be-
cause of this negative externality, common resources tend to be used excessively.
Tragedy of the Commons
a parable that illustrates why
common resources get used more
than is desirable from the standpoint
of society as a whole
CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 235
The government can solve the problem by reducing use of the common resource
through regulation or taxes. Alternatively, the government can sometimes turn the
common resource into a private good.
This lesson has been known for thousands of years. The ancient Greek
philosopher Aristotle pointed out the problem with common resources: “What is
common to many is taken least care of, for all men have greater regard for what is
their own than for what they possess in common with others.”
SOME IMPORTANT COMMON RESOURCES
There are many examples of common resources. In almost all cases, the same prob-
lem arises as in the Tragedy of the Commons: Private decisionmakers use the com-
mon resource too much. Governments often regulate behavior or impose fees to
mitigate the problem of overuse.
Clean Air and Water As we discussed in Chapter 10, markets do not ad-
equately protect the environment. Pollution is a negative externality that can be
remedied with regulations or with Pigovian taxes on polluting activities. One can
view this market failure as an example of a common-resource problem. Clean air
and clean water are common resources like open grazing land, and excessive pol-
lution is like excessive grazing. Environmental degradation is a modern Tragedy
of the Commons.
Oil Pools Consider an underground pool of oil so large that it lies under
many properties with different owners. Any of the owners can drill and extract the
oil, but when one owner extracts oil, less is available for the others. The oil is a
common resource.
Just as the number of sheep grazing on the Town Common was inefficiently
large, the number of wells drawing from the oil pool will be inefficiently large. Be-
cause each owner who drills a well imposes a negative externality on the other
owners, the benefit to society of drilling a well is less than the benefit to the owner
who drills it. That is, drilling a well can be privately profitable even when it is so-
cially undesirable. If owners of the properties decide individually how many oil
wells to drill, they will drill too many.
To ensure that the oil is extracted at lowest cost, some type of joint action
among the owners is necessary to solve the common-resource problem. The Coase
theorem, which we discussed in Chapter 10, suggests that a private solution might
be possible. The owners could reach an agreement among themselves about how
to extract the oil and divide the profits. In essence, the owners would then act as if
they were in a single business.
When there are many owners, however, a private solution is more difficult. In
this case, government regulation could ensure that the oil is extracted efficiently.
Congested Roads Roads can be either public goods or common resources.
If a road is not congested, then one person’s use does not affect anyone else. In this
case, use is not rival, and the road is a public good. Yet if a road is congested, then
use of that road yields a negative externality. When one person drives on the road,
it becomes more crowded, and other people must drive more slowly. In this case,
the road is a common resource.
236 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
One way for the government to address the problem of road congestion is to
charge drivers a toll. Atoll is, in essence, a Pigovian tax on the externality of con-
gestion. Often, as in the case of local roads, tolls are not a practical solution because
the cost of collecting them is too high.
Sometimes congestion is a problem only at certain times of day. If a bridge is
heavily traveled only during rush hour, for instance, the congestion externality is
larger during this time than during other times of day. The efficient way to deal
with these externalities is to charge higher tolls during rush hour. This toll would
provide an incentive for drivers to alter their schedules and would reduce traffic
when congestion is greatest.
Another policy that responds to the problem of road congestion, discussed in
a case study in the previous chapter, is the tax on gasoline. Gasoline is a comple-
mentary good to driving: An increase in the price of gasoline tends to reduce the
quantity of driving demanded. Therefore, a gasoline tax reduces road congestion.
TOLLS ARE A SIMPLE WAY TO SOLVE THE
problem of road congestion and, ac-
cording to some economists, are not
used as much as they should be. In this
opinion column, economist Lester
Thurow describes Singapore’s success
in dealing with congestion.
Economics of Road Pricing
BY LESTER C. THUROW
Start with a simple observational truth.
No city has ever been able to solve its
congestion and pollution problems by
building more roads.
Some of the world’s cities have built
a lot of roads (Los Angeles) and some
have very few (Shanghai only recently
has had a lot of autos) but the degrees
of congestion and pollution don’t differ
very much. More roads simply encour-
age more people to use their cars, to live
farther away from work, and thus use
more road space. . . . A recent analysis
of congestion problems in London came
to the conclusion that London could tear
the entire central city down to make
room for roads and would still have
something approaching gridlock.
Economists have always had a the-
oretical answer for auto congestion and
pollution problems—road pricing. Charge
people for using roads based on what
roads they use, what time of day and
IN THE NEWS
The Singapore Solution
HOW CAN WE CLEAR THIS MARKET?
CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 237
Agasoline tax, however, is an imperfect solution to road congestion. The problem
is that the gasoline tax affects other decisions besides the amount of driving on
congested roads. For example, the gasoline tax discourages driving on noncon-
gested roads, even though there is no congestion externality for these roads.
Fish, Whales, and Other Wildlife Many species of animals are com-
mon resources. Fish and whales, for instance, have commercial value, and anyone
can go to the ocean and catch whatever is available. Each person has little incen-
tive to maintain the species for the next year. Just as excessive grazing can destroy
the Town Common, excessive fishing and whaling can destroy commercially valu-
able marine populations.
The ocean remains one of the least regulated common resources. Two prob-
lems prevent an easy solution. First, many countries have access to the oceans, so
any solution would require international cooperation among countries that hold
year they use those roads, and the
degree to which pollution problems exist
at the time they are using those roads.
Set prices at the levels that yield the op-
timal amounts of usage.
Until Singapore decided to try, no
city had ever had the nerve to use road
pricing. Many ideas seem good theo-
retically but have some hidden unex-
pected flaws. Singapore now has more
than a decade of experience. The sys-
tem works! There are no unexpected
flaws. Singapore is the only city on the
face of the earth without congestion and
auto-induced pollution problems.
In Singapore a series of toll booths
surrounds the central core of the city. To
drive into the city, each car must pay a
toll based on the roads being used, the
time of day when the driving will occur,
and that day’s pollution problem. Prices
are raised and lowered to get optimal
usage.
In addition, Singapore calculates the
maximum number of cars that can be
supported without pollution outside of
the central city and auctions off the
rights to license new cars each month.
Different types of plates allow different
degrees of usage. A plate that allows
one to use their car at any time is much
more expensive than a plate that only al-
lows one to use their car on weekends—
a time when congestion problems are
much less intense. Prices depend on
supply and demand.
With this system Singapore ends
up not wasting resources on infrastruc-
ture projects that won’t cure congestion
and pollution problems. The revenue col-
lected from the system is used to lower
other taxes.
If that is so, why then did London re-
ject road pricing in its recent report on its
auto congestion and pollution problems?
They feared that such a system would be
seen as too much interference from the
heavy hand of government and that the
public would not put up with a system
that allows the rich to drive more than
the poor.
Both arguments ignore the fact that
we already have toll roads, but new tech-
nologies now also make it possible to
avoid both problems.
Using bar codes and debit cards, a
city can install bar code readers at differ-
ent points around the city. As any car
goes by each point a certain amount is
deducted from the driver’s debit card ac-
count depending upon weather, time of
day, and location.
Inside the car, the driver has a me-
ter that tells him how much he has been
charged and how much remains in his
debit card account. . . .
If one is an egalitarian and thinks
that driving privileges should be distrib-
uted equally (i.e., not based upon in-
come) then each auto can be given a
specified debit card balance every year
and those who are willing to drive less
can sell their unused balances to those
that want to drive more.
Instead of giving the city extra tax
revenue, this system gives those who
are willing to live near work or to use
public transit an income supplement.
Since poor people drive less than rich
people, the system ends up being an
egalitarian redistribution of income from
the rich to the poor.
SOURCE:The Boston Globe,February 28, 1995, p. 40.
238 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
CASE STUDY WHY THE COW IS NOT EXTINCT
Throughout history, many species of animals have been threatened with extinc-
tion. When Europeans first arrived in North America, more than 60 million
different values. Second, because the oceans are so vast, enforcing any agreement
is difficult. As a result, fishing rights have been a frequent source of international
tension among normally friendly countries.
Within the United States, various laws aim to protect fish and other wildlife.
For example, the government charges for fishing and hunting licenses, and it re-
stricts the lengths of the fishing and hunting seasons. Fishermen are often re-
quired to throw back small fish, and hunters can kill only a limited number of
animals. All these laws reduce the use of a common resource and help maintain
animal populations.
NATIONAL PARKS, LIKE ROADS, CAN BE
either public goods or common re-
sources. If congestion is not a problem,
a visit to a park is not rival. Yet once a
park becomes popular, it suffers from
the same problem as the Town Com-
mon. In this opinion column, an econo-
mist argues for the use of higher
entrance fees to solve the problem.
Save the Parks,
and Make a Profit
BY ALLEN R. SANDERSON
It is common knowledge that our national
parks are overcrowded, deteriorating,
and broke. Some suggest that we ad-
dress these problems by requiring reser-
vations, closing some areas, or asking
Congress to increase financing to the
National Park Service. But to an econo-
mist, there is a more obvious solution:
Raise the entrance fees.
When the National Park Service
was established in 1916, the admission
price to Yellowstone for a family of five
arriving by car was $7.50; today, the
price is only $10. Had the 1916 price
been adjusted for inflation, the compara-
ble 1995 fee would be $120 a day—
about what that family would pay for a
day of rides at Disney World, . . . or to
see a professional football game.
No wonder our national parks are
overrun and overtrampled. We are treat-
ing our natural and historical treasures as
free goods when they are not. We are ig-
noring the costs of maintaining these
places and rationing by congestion—
when it gets too crowded, no more visi-
tors are allowed—perhaps the most
inefficient way to allocate scarce re-
sources. The price of a family’s day in a
national park has not kept pace with
most other forms of recreation. Sys-
temwide, it barely averages a dollar a
person. . . .
An increase in daily user fees to,
say, $20 per person would either reduce
the overcrowding and deterioration in
our parks by cutting down on the number
of visitors or it would substantially raise
fee revenues for the Park Service (as-
suming that legislation was passed that
would let the park system keep this
money). Greater revenue is the more
likely outcome. After spending several
hundred dollars to reach Yellowstone
Park, few people would be deterred by
another $20.
The added revenues would bring
more possibilities for outdoor recreation,
both through expansion of the National
Park Service and by encouraging private
entrepreneurs to carve out and operate
their own parks, something they cannot
do alongside a public competitor giving
away his product well below cost.
It is time to put our money where
our Patagonia outfits are: Either we value
the Grand Canyon and Yosemite and
won’t complain about paying a realistic
entrance fee, or we don’t really value
them and shouldn’t wring our hands over
their present sorry state and likely sorrier
fate.
SOURCE:The New York Times,September 30,
1995,p. 19.
IN THE NEWS
Should Yellowstone
Charge as Much as
Disney World?
CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 239
buffalo roamed the continent. Yet hunting the buffalo was so popular during the
nineteenth century that by 1900 the animal’s population fell to about 400 before
the government stepped in to protect the species. In some African countries to-
day, the elephant faces a similar challenge, as poachers kill the animals for the
ivory in their tusks.
Yet not all animals with commercial value face this threat. The cow, for ex-
ample, is a valuable source of food, but no one worries that the cow will soon be
extinct. Indeed, the great demand for beef seems to ensure that the species will
continue to thrive.
Why is the commercial value of ivory a threat to the elephant, while the
commercial value of beef is a guardian of the cow? The reason is that elephants
are a common resource, whereas cows are a private good. Elephants roam
freelywithout any owners. Each poacher has a strong incentive to kill as many
elephants as he can find. Because poachers are numerous, each poacher has
only a slight incentive to preserve the elephant population. By contrast, cows
live on ranches that are privately owned. Each rancher takes great effort to
maintain the cow population on his ranch because he reaps the benefit of these
efforts.
Governments have tried to solve the elephant’s problem in two ways. Some
countries, such as Kenya, Tanzania, and Uganda, have made it illegal to kill ele-
phants and sell their ivory. Yet these laws have been hard to enforce, and ele-
phant populations have continued to dwindle. By contrast, other countries,
such as Botswana, Malawi, Namibia, and Zimbabwe, have made elephants a
private good by allowing people to kill elephants, but only those on their own
property. Landowners now have an incentive to preserve the species on their
own land, and as a result, elephant populations have started to rise. With pri-
vate ownership and the profit motive now on its side, the African elephant
might someday be as safe from extinction as the cow.
QUICK QUIZ: Why do governments try to limit the use of common
resources?
CONCLUSION: THE IMPORTANCE
OF PROPERTY RIGHTS
In this chapter and the previous one, we have seen there are some “goods” that the
market does not provide adequately. Markets do not ensure that the air we breathe
is clean or that our country is defended from foreign aggressors. Instead, societies
rely on the government to protect the environment and to provide for the national
defense.
Although the problems we considered in these chapters arise in many different
markets, they share a common theme. In all cases, the market fails to allocate re-
sources efficiently because property rights are not well established. That is, some
item of value does not have an owner with the legal authority to control it. For ex-
ample, although no one doubts that the “good” of clean air or national defense is
valuable, no one has the right to attach a price to it and profit from its use. Afactory
“WILLTHE MARKET PROTECT ME?”
240 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
pollutes too much because no one charges the factory for the pollution it emits. The
market does not provide for national defense because no one can charge those who
are defended for the benefit they receive.
When the absence of property rights causes a market failure, the government
can potentially solve the problem. Sometimes, as in the sale of pollution permits,
the solution is for the government to help define property rights and thereby un-
leash market forces. Other times, as in the restriction on hunting seasons, the solu-
tion is for the government to regulate private behavior. Still other times, as in the
provision of national defense, the solution is for the government to supply a good
that the market fails to supply. In all cases, if the policy is well planned and well
run, it can make the allocation of resources more efficient and thus raise economic
well-being.
a78 Goods differ in whether they are excludable and
whether they are rival. Agood is excludable if it is
possible to prevent someone from using it. Agood is
rival if one person’s enjoyment of the good prevents
other people from enjoying the same unit of the good.
Markets work best for private goods, which are both
excludable and rival. Markets do not work as well for
other types of goods.
a78 Public goods are neither rival nor excludable.
Examplesof public goods include fireworks displays,
national defense, and the creation of fundamental
knowledge. Because people are not charged for their use
of the public good, they have an incentive to free ride
when the good is provided privately. Therefore,
governments provide public goods, making their
decision about the quantity based on cost-benefit
analysis.
a78 Common resources are rival but not excludable.
Examples include common grazing land, clean air, and
congested roads. Because people are not charged for
their use of common resources, they tend to use them
excessively. Therefore, governments try to limit the use
of common resources.
Summary
excludability, p. 226
rivalry, p. 226
private goods, p. 226
public goods, p. 226
common resources, p. 226
free rider, p. 228
cost-benefit analysis, p. 231
Tragedy of the Commons, p. 234
Key Concepts
1. Explain what is meant by a good being “excludable.”
Explain what is meant by a good being “rival.” Is a
pizza excludable? Is it rival?
2. Define and give an example of a public good. Can
theprivate market provide this good on its own?
Explain.
3. What is cost-benefit analysis of public goods? Why is it
important? Why is it hard?
4. Define and give an example of a common resource.
Without government intervention, will people use this
good too much or too little? Why?
Questions for Review
CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 241
1. The text says that both public goods and common
resources involve externalities.
a. Are the externalities associated with public goods
generally positive or negative? Use examples in
your answer. Is the free-market quantity of public
goods generally greater or less than the efficient
quantity?
b. Are the externalities associated with common
resources generally positive or negative? Use
examples in your answer. Is the free-market use of
common resources generally greater or less than the
efficient use?
2. Think about the goods and services provided by your
local government.
a. Using the classification in Figure 11-1, explain what
category each of the following goods falls into:
a78 police protection
a78 snow plowing
a78 education
a78 rural roads
a78 city streets
b. Why do you think the government provides items
that are not public goods?
3. Charlie loves watching Teletubbieson his local public TV
station, but he never sends any money to support the
station during their fund-raising drives.
a. What name do economists have for Charlie?
b. How can the government solve the problem caused
by people like Charlie?
c. Can you think of ways the private market can solve
this problem? How does the existence of cable TV
alter the situation?
4. The text states that private firms will not undertake the
efficient amount of basic scientific research.
a. Explain why this is so. In your answer, classify
basic research in one of the categories shown in
Figure 11-1.
b. What sort of policy has the United States adopted
in response to this problem?
c. It is often argued that this policy increases the
technological capability of American producers
relative to that of foreign firms. Is this argument
consistent with your classification of basic research
in part (a)? (Hint: Can excludability apply to some
potential beneficiaries of a public good and not
others?)
5. Why is there litter along most highways but rarely in
people’s yards?
6. The Washington, D.C., metro (subway) system charges
higher fares during rush hours than during the rest of
the day. Why might it do this?
7. Timber companies in the United States cut down many
trees on publicly owned land and many trees on
privately owned land. Discuss the likely efficiency of
logging on each type of land in the absence of
government regulation. How do you think the
government should regulate logging on publicly owned
lands? Should similar regulations apply to privately
owned land?
8. An Economistarticle (March 19, 1994) states: “In the past
decade, most of the rich world’s fisheries have been
exploited to the point of near-exhaustion.” The article
continues with an analysis of the problem and a
discussion of possible private and government solutions:
a. “Do not blame fishermen for overfishing. They are
behaving rationally, as they have always done.” In
what sense is “overfishing” rational for fishermen?
b. “Acommunity, held together by ties of obligation
and mutual self-interest, can manage a common
resource on its own.” Explain how such
management can work in principle, and what
obstacles it faces in the real world.
c. “Until 1976 most world fish stocks were open to all
comers, making conservation almost impossible.
Then an international agreement extended some
aspects of [national] jurisdiction from 12 to 200
miles offshore.” Using the concept of property
rights, discuss how this agreement reduces the
scope of the problem.
d. The article notes that many governments come to
the aid of suffering fishermen in ways that
encourage increased fishing. How do such policies
encourage a vicious cycle of overfishing?
e. “Only when fishermen believe they are assured a
long-term and exclusive right to a fishery are they
likely to manage it in the same far-sighted way as
good farmers manage their land.” Defend this
statement.
f. What other policies to reduce overfishing might be
considered?
9. In a market economy, information about the quality or
function of goods and services is a valuable good in its
Problems and Applications
242 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
own right. How does the private market provide this
information? Can you think of any way in which the
government plays a role in providing this information?
10. Do you think the Internet is a public good? Why or
whynot?
11. High-income people are willing to pay more than lower-
income people to avoid the risk of death. For example,
they are more likely to pay for safety features on cars.
Do you think cost-benefit analysts should take this fact
into account when evaluating public projects? Consider,
for instance, a rich town and a poor town, both of which
are considering the installation of a traffic light. Should
the rich town use a higher dollar value for a human life
in making this decision? Why or why not?
IN THIS CHAPTER
YOU WILL . . .
Consider the
tradeoff between
efficiency and
equity in the design
of a tax system
Learn alternative
ways to judge the
equity of a tax
system
Get an overview of
how the U.S.
government raises
and spends money
Examine the
efficiency costs
of taxes
See why studying
tax incidence is
crucial for
evaluating tax
equity
Al “Scarface” Capone, the notorious 1920s gangster and crime boss, was never
convicted for his many violent crimes. Yet eventually he did go to jail—for tax eva-
sion. He had neglected to heed Ben Franklin’s observation that “in this world
nothing is certain, but death and taxes.”
When Franklin made this claim in 1789, the average American paid less than
5 percent of his income in taxes, and that remained true for the next hundred
years. Over the course of the twentieth century, however, taxes have become ever
more important in the life of the typical person. Today, all taxes taken together—
including personal income taxes, corporate income taxes, payroll taxes, sales taxes,
and property taxes—use up about a third of the average American’s income. In
many European countries, the tax bite is even larger.
Taxes are inevitable because we as citizens expect the government to provide
us with various goods and services. The previous two chapters have started to
THE DESIGN OF
THE TAX SYSTEM
243
244 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
shed light on one of the Ten Principles of Economics from Chapter 1: The govern-
ment can sometimes improve market outcomes. When the government remedies
an externality (such as air pollution), provides a public good (such as national de-
fense), or regulates the use of a common resource (such as fish in a public lake), it
can raise economic well-being. Yet the benefits of government come with costs. For
the government to perform these and its many other functions, it needs to raise
revenue through taxation.
We began our study of taxation in earlier chapters, where we saw how a tax on
a good affects supply and demand for that good. In Chapter 6 we saw that a tax re-
duces the quantity sold in a market, and we examined how the burden of a tax is
shared by buyers and sellers, depending on the elasticities of supply and demand.
In Chapter 8 we examined how taxes affect economic well-being. We learned that
taxes cause deadweight losses:The reduction in consumer and producer surplus re-
sulting from a tax exceeds the revenue raised by the government.
In this chapter we build on these lessons to discuss the design of a tax system.
We begin with a financial overview of the U.S. government. When thinking about
the tax system, it is useful to know some basic facts about how the U.S. govern-
ment raises and spends money. We then consider the fundamental principles of
taxation. Most people agree that taxes should impose as small a cost on society as
possible and that the burden of taxes should be distributed fairly. That is, the tax
system should be both efficientand equitable.As we will see, however, stating these
goals is easier than achieving them.
A FINANCIAL OVERVIEW OF
THE U.S. GOVERNMENT
How much of the nation’s income does the government take as taxes? Figure 12-1
shows government revenue, including federal, state, and local governments, as a
percentage of total income for the U.S. economy. It shows that, over time, the gov-
ernment has taken a larger and larger share of total income. In 1902, the govern-
ment collected 7 percent of total income; in 1998, it collected 32 percent. In other
words, as the economy’s income has grown, the government has grown even
more.
Table 12-1 compares the tax burden for several major countries, as measured
by the central government’s tax revenue as a percentage of the nation’s total in-
come. The United States is in the middle of the pack. The U.S. tax burden is low
compared to many European countries, but it is high compared to many other na-
tions around the world. Poor countries, such as India and Pakistan, usually have
relatively low tax burdens. This fact is consistent with the evidence in Figure 12-1
of a growing tax burden over time: As a nation gets richer, the government typi-
cally takes a larger share of income in taxes.
The overall size of government tells only part of the story. Behind the total dol-
lar figures lie thousands of individual decisions about taxes and spending. To un-
derstand the government’s finances more fully, let’s look at how the total breaks
down into some broad categories.
CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 245
0
5
10
15
20
25
30
35
Federal
State and local
Revenue as
Percent of
GDP
Total government
1902 1922 19271913 19401932 1970 1980 1990 19981950 1960
Figure 12-1
GOVERNMENT REVENUE AS A PERCENTAGE OF GDP. This figure shows revenue of the
federal government and of state and local governments as a percentage of gross domestic
product (GDP), which measures total income in the economy. It shows that the
government plays a large role in the U.S. economy and that its role has grown over time.
SOURCE:Historical Statistics of the United States;Economic Report of the President 1999;and author’s calculations.
Table 12-1
CENTRAL GOVERNMENT TAX
REVENUE AS A PERCENT OF GDP
France 38.8%
United Kingdom 33.7
Germany29.4
Brazil 19.7
United States 19.3
Canada 18.5
Russia 17.4
Pakistan 15.3
Indonesia 14.7
Mexico 12.8
India 10.3
SOURCE:World Development Report 1998/99.
246 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
THE FEDERAL GOVERNMENT
The U.S. federal government collects about two-thirds of the taxes in our economy.
It raises this money in a number of ways, and it finds even more ways to spend it.
Receipts Table 12-2 shows the receipts of the federal government in 1999. To-
tal receipts in this year were $1,806 billion, a number so large that it is hard to com-
prehend. To bring this astronomical number down to earth, we can divide it by the
size of the U.S. population, which was about 272 million in 1999. We then find that
the average American paid $6,639 to the federal government. Atypical family of
four paid $26,556.
The largest source of revenue for the federal government is the individual in-
come tax. As April 15 approaches, almost every American family fills out a tax
form to determine how much income tax it owes the government. Each family is
required to report its income from all sources: wages from working, interest on
savings, dividends from corporations in which it owns shares, profits from any
small businesses it operates, and so on. The family’s tax liability (how much it
owes) is then based on its total income.
A family’s income tax liability is not simply proportional to its income. In-
stead, the law requires a more complicated calculation. Taxable income is com-
puted as total income minus an amount based on the number of dependents
(primarily children) and minus certain expenses that policymakers have deemed
“deductible” (such as mortgage interest payments and charitable giving). Then
the tax liability is calculated from taxable income using the schedule shown in
Table 12-3. This table presents the marginal tax rate—the tax rate applied to each ad-
ditional dollar of income. Because the marginal tax rate rises as income rises,
higher-income families pay a larger percentage of their income in taxes. (We dis-
cuss the concept of marginal tax rate more fully later in this chapter.)
Almost as important to the federal government as the individual income tax
are payroll taxes. Apayroll tax is a tax on the wages that a firm pays its workers.
Table 12-2 calls this revenue social insurance taxes because the revenue from these
taxes is earmarked to pay for Social Security and Medicare. Social Security is an in-
come support program, designed primarily to maintain the living standards of the
elderly. Medicare is the government health program for the elderly. Table 12-2
shows that the average American paid $2,239 in social insurance taxes in 1999.
Table 12-2
RECEIPTS OF THE FEDERAL
GOVERNMENT: 1999
AMOUNT AMOUNT PERCENT
TAX (IN BILLIONS) PER PERSON OF RECEIPTS
Individual income taxes $ 869 $3,194 48%
Social insurance taxes 609 2,239 34
Corporate income taxes 182 669 10
Other 146 537 8
Total $1,806 $6,639 100%
SOURCE:Economic Report of the President,1999, table B-80.
CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 247
Next in magnitude, but much smaller than either individual income taxes or
social insurance taxes, is the corporate income tax. Acorporation is a business that
is set up as a separate legal entity. The government taxes each corporation based
on its profit—the amount the corporation receives for the goods or services it sells
minus the costs of producing those goods or services. Notice that corporate prof-
its are, in essence, taxed twice. They are taxed once by the corporate income tax
when the corporation earns the profits; they are taxed a second time by the indi-
vidual income tax when the corporation uses its profits to pay dividends to its
shareholders.
The last category, labeled “other” in Table 12-2, makes up 8 percent of receipts.
This category includes excise taxes,which are taxes on specific goods like gasoline,
cigarettes, and alcoholic beverages. It also includes various small items, such as es-
tate taxes and customs duties.
Spending Table 12-4 shows the spending of the federal government in 1999.
Total spending was $1,727 billion, or $6,350 per person. This table also shows how
the federal government’s spending was divided among major categories.
The largest category in Table 12-4 is Social Security, which represents mostly
transfer payments to the elderly. (Atransfer paymentis a government payment not
made in exchange for a good or service.) This category made up 23 percent of
spending by the federal government in 1999 and is growing in importance. The
reason for its growth is that increases in life expectancy and decreases in birthrates
have caused the elderly population to grow more rapidly than the total popula-
tion. Most analysts expect this trend to continue for many years into the future.
The second largest category of spending is national defense. This includes
both the salaries of military personnel and the purchases of military equipment
such as guns, fighter jets, and warships. Spending on national defense fluctuates
over time as international tensions and the political climate change. Not surpris-
ingly, spending on national defense rises substantially during wars.
The third category is spending on income security, which includes transfer
payments to poor families. One program is Temporary Assistance for Needy Fam-
ilies (TANF), often simply called “welfare.” Another is the Food Stamp program,
which gives poor families vouchers that they can use to buy food. The federal gov-
ernment pays some of this money to state and local governments, which admin-
ister the programs under federal guidelines.
Abit smaller than spending on income security is net interest. When a person
borrows from a bank, the bank requires the borrower to pay interest for the loan.
The same is true when the government borrows from the public. The more in-
debted the government, the larger the amount it must spend in interest payments.
Table 12-3
THE FEDERAL INCOME TAX
RATES: 1999. This table shows
the marginal tax rates for an
unmarried taxpayer. The taxes
owed by a taxpayer depend on
all the marginal tax rates up to
his or her income level. For
example, a taxpayer with income
of $50,000 pays 15 percent of the
first $25,750 of income, and then
28 percent of the rest.
ON TAXABLE INCOME . . . THE TAX RATE IS . . .
Up to $25,750 15.0%
From $25,750 to $62,450 28.0
From $62,450 to $130,250 31.0
From $130,250 to $283,150 36.0
Over $283,150 39.6
248 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
Medicare, the next category in Table 12-4, is the government’s health plan for
the elderly. Spending in this category has risen substantially over time for two rea-
sons. First, the elderly population has grown more quickly than the overall popu-
lation. Second, the cost of health care has risen more rapidly than the cost of other
goods and services. The rapid growth of this budget item is one reason that Presi-
dent Clinton and others have proposed reforms of the health care system.
The next category is health spending other than Medicare. This includes
Medicaid, the federal health program for the poor. It also includes spending on
medical research, such as through the National Institutes of Health.
The “other” category in Table 12-4 consists of many less expensive functions of
government. It includes, for example, the federal court system, the space program,
and farm-support programs, as well as the salaries of Congress and the president.
You might have noticed that total receipts of the federal government shown in
Table 12-2 exceed total spending shown in Table 12-4 by $79 billion. Such an excess
of receipts over spending is called a budget surplus. When receipts fall short
of spending, the government is said to run a budget deficit. The government
finances the budget deficit by borrowing from the public. When the govern-
ment runs a budget surplus, it uses the excess receipts to reduce its outstanding
debts.
STATE AND LOCAL GOVERNMENT
State and local governments collect about 40 percent of all taxes paid. Let’s look at
how they obtain tax revenue and how they spend it.
Receipts Table 12-5 shows the receipts of U.S. state and local governments.
Total receipts for 1996 were $1,223 billion. Based on the 1996 population of about
265 million, this equals $4,615 per person. The table also shows how this total is
broken down into different kinds of taxes.
The two most important taxes for state and local governments are sales
taxesand property taxes. Sales taxes are levied as a percentage of the total amount
spent at retail stores. Every time a customer buys something, he or she pays the
Table 12-4
SPENDING OF THE FEDERAL
GOVERNMENT: 1999
AMOUNT AMOUNT PERCENT
CATEGORY (IN BILLIONS) PER PERSON OF SPENDING
Social Security$ 393 $1,445 23%
National defense 277 1,018 16
Income security243 893 14
Net interest 227 835 13
Medicare 205 754 12
Health 143 526 8
Other 239 879 14
Total $1,727 $6,350 100%
SOURCE:Economic Report of the President,1999, table B-80.
budget surplus
an excess of government receipts
over government spending
budget deficit
an excess of government spending
over government receipts
CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 249
storekeeper an extra amount that the storekeeper remits to the government. (Some
states exclude certain items that are considered necessities, such as food and cloth-
ing.) Property taxes are levied as a percentage of the estimated value of land and
structures, and are paid by property owners. Together these two taxes make up
more than a third of all receipts of state and local governments.
State and local governments also levy individual and corporate income taxes.
In many cases, state and local income taxes are similar to federal income taxes. In
other cases, they are quite different. For example, some states tax income from
wages less heavily than income earned in the form of interest and dividends. Some
states do not tax income at all.
State and local governments also receive substantial funds from the federal
government. To some extent, the federal government’s policy of sharing its rev-
enue with state governments redistributes funds from high-income states (who
pay more taxes) to low-income states (who receive more benefits). Often these
funds are tied to specific programs that the federal government wants to subsidize.
Finally, state and local governments receive much of their receipts from vari-
ous sources included in the “other” category in Table 12-5. These include fees for
fishing and hunting licenses, tolls from roads and bridges, and fares for public
buses and subways.
Spending Table 12-6 shows the total spending of state and local governments
in 1996 and its breakdown among the major categories.
By far the biggest single expenditure for state and local governments is educa-
tion. Local governments pay for the public schools, which educate most students
from kindergarten to high school. State governments contribute to the support of
public universities. In 1996, education accounted for a third of the spending of
state and local governments.
The second largest category of spending is for public welfare, which includes
transfer payments to the poor. This category includes some federal programs that
are administered by state and local governments. The next category is highways,
which includes the building of new roads and the maintenance of existing ones.
The “other” category in Table 12-6 includes the many additional services provided
by state and local governments, such as libraries, police, garbage removal, fire pro-
tection, park maintenance, and snow removal.
Table 12-5
RECEIPTS OF STATE AND LOCAL
GOVERNMENTS: 1996
AMOUNT AMOUNT PERCENT OF
TAX (IN BILLIONS) PER PERSON OF RECEIPTS
Sales taxes $ 249 $ 940 20%
Property taxes 209 789 17
Individual income taxes 147 554 12
Corporate income taxes 32 121 3
From federal government 235 887 19
Other 351 1,324 29
Total $1,223 $4,615 100%
SOURCE:Economic Report of the President,1999, table B-86.
250 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
QUICK QUIZ: What are the two most important sources of tax revenue for
the federal government? a78 What are the two most important sources of tax
revenue for state and local governments?
TAXES AND EFFICIENCY
Now that we have seen how the U.S. government at various levels raises and
spends money, let’s consider how one might evaluate its tax policy. Obviously, the
aim of a tax system is to raise revenue for the government. But there are many
ways to raise any given amount of money. In designing a tax system, policymakers
have two objectives: efficiency and equity.
One tax system is more efficient than another if it raises the same amount of
revenue at a smaller cost to taxpayers. What are the costs of taxes to taxpayers?
The most obvious cost is the tax payment itself. This transfer of money from the
taxpayer to the government is an inevitable feature of any tax system. Yet taxes
also impose two other costs, which well-designed tax policy tries to avoid or, at
least, minimize:
a78 The deadweight losses that result when taxes distort the decisions that
people make
a78 The administrative burdens that taxpayers bear as they comply with the
taxlaws
An efficient tax system is one that imposes small deadweight losses and small ad-
ministrative burdens.
DEADWEIGHT LOSSES
Taxes affect the decisions that people make. If the government taxes ice cream,
people eat less ice cream and more frozen yogurt. If the government taxes housing,
people live in smaller houses and spend more of their income on other things. If
the government taxes labor earnings, people work less and enjoy more leisure.
Table 12-6
SPENDING OF STATE AND LOCAL
GOVERNMENTS: 1996
AMOUNT AMOUNT PERCENT
CATEGORY (IN BILLIONS) PER PERSON OF SPENDING
Education $ 399 $1,506 33%
Public welfare 197 743 17
Highways 79 298 7
Other 518 1,955 43
Total $1,193 $4,502 100%
SOURCE:Economic Report of the President,1999, table B-86.
CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 251
CASE STUDY SHOULD INCOME OR CONSUMPTION BE TAXED?
When taxes induce people to change their behavior—such as inducing Jane to
buy less pizza—the taxes cause deadweight losses and make the allocation of
resources less efficient. As we have already seen, much government revenue
comes from the individual income tax. In a case study in Chapter 8, we dis-
cussed how this tax discourages people from working as hard as they otherwise
might. Another inefficiency caused by this tax is that it discourages people from
saving.
Consider a person 25 years old who is considering saving $100. If he puts
this money in a savings account that earns 8 percent and leaves it there, he
would have $2,172 when he retires at age 65. Yet if the government taxes one-
fourth of his interest income each year, the effective interest rate is only 6 per-
cent. After 40 years of earning 6 percent, the $100 grows to only $1,029, less than
half of what it would have been without taxation. Thus, because interest income
is taxed, saving is much less attractive.
Some economists advocate eliminating the current tax system’s disincentive
toward saving by changing the basis of taxation. Rather than taxing the amount
of income that people earn, the government could tax the amount that people
spend.Under this proposal, all income that is saved would not be taxed until the
saving is later spent. This alternative system, called a consumption tax, would
not distort people’s saving decisions.
This idea has some support from policymakers. Representative Bill Archer,
who in 1995 became chairman of the powerful House Ways and Means
Because taxes distort incentives, they entail deadweight losses. As we first dis-
cussed in Chapter 8, the deadweight loss of a tax is the reduction in economic well-
being of taxpayers in excess of the amount of revenue raised by the government.
The deadweight loss is the inefficiency that a tax creates as people allocate re-
sources according to the tax incentive rather than the true costs and benefits of the
goods and services that they buy and sell.
To recall how taxes cause deadweight losses, consider an example. Suppose
that Joe places an $8 value on a pizza, and Jane places a $6 value on it. If there is no
tax on pizza, the price of pizza will reflect the cost of making it. Let’s suppose that
the price of pizza is $5, so both Joe and Jane choose to buy one. Both consumers get
some surplus of value over the amount paid. Joe gets consumer surplus of $3, and
Jane gets consumer surplus of $1. Total surplus is $4.
Now suppose that the government levies a $2 tax on pizza and the price of
pizza rises to $7. Joe still buys a pizza, but now he has consumer surplus of only
$1. Jane now decides not to buy a pizza because its price is higher than its value to
her. The government collects tax revenue of $2 on Joe’s pizza. Total consumer
surplus has fallen by $3 (from $4 to $1). Because total surplus has fallen by more
than the tax revenue, the tax has a deadweight loss. In this case, the deadweight
loss is $1.
Notice that the deadweight loss comes not from Joe, the person who pays the
tax, but from Jane, the person who doesn’t. The reduction of $2 in Joe’s surplus ex-
actly offsets the amount of revenue the government collects. The deadweight loss
arises because the tax causes Jane to alter her behavior. When the tax raises the
price of pizza, Jane is worse off, and yet there is no offsetting revenue to the gov-
ernment. This reduction in Jane’s welfare is the deadweight loss of the tax.
“I was gonna fix the place up, but
if I did the city would just raise
my taxes!”
252 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
Committee, has advocated replacing the current income tax system with a con-
sumption tax. Moreover, various provisions of the current tax code already
make the tax system a bit like a consumption tax. Taxpayers can put a limited
amount of their saving into special accounts—such as Individual Retirement
Accounts, Keogh plans, and 401(k) plans—that escape taxation until the money
is withdrawn at retirement. For people who do most of their saving through
these retirement accounts, their tax bill is, in effect, based on their consumption
rather than their income.
ADMINISTRATIVE BURDEN
If you ask the typical person on April 15 for an opinion about the tax system, you
might hear about the headache of filling out tax forms. The administrative burden
of any tax system is part of the inefficiency it creates. This burden includes not
only the time spent in early April filling out forms but also the time spent
throughout the year keeping records for tax purposes and the resources the gov-
ernment has to use to enforce the tax laws.
Many taxpayers—especially those in higher tax brackets—hire tax lawyers
and accountants to help them with their taxes. These experts in the complex tax
laws fill out the tax forms for their clients and help clients arrange their affairs in a
way that reduces the amount of taxes owed. This behavior is legal tax avoidance,
which is different from illegal tax evasion.
Critics of our tax system say that these advisers help their clients avoid taxes
by abusing some of the detailed provisions of the tax code, often dubbed “loop-
holes.” In some cases, loopholes are congressional mistakes: They arise from am-
biguities or omissions in the tax laws. More often, they arise because Congress has
chosen to give special treatment to specific types of behavior. For example, the U.S.
federal tax code gives preferential treatment to investors in municipal bonds be-
cause Congress wanted to make it easier for state and local governments to borrow
money. To some extent, this provision benefits states and localities; to some extent,
it benefits high-income taxpayers. Most loopholes are well known by those in Con-
gress who make tax policy, but what looks like a loophole to one taxpayer may
look like a justifiable tax deduction to another.
The resources devoted to complying with the tax laws are a type of dead-
weight loss. The government gets only the amount of taxes paid. By contrast, the
taxpayer loses not only this amount but also the time and money spent docu-
menting, computing, and avoiding taxes.
The administrative burden of the tax system could be reduced by simplifying
the tax laws. Yet simplification is often politically difficult. Most people are ready
to simplify the tax code by eliminating the loopholes that benefit others, yet few
are eager to give up the loopholes that they use. In the end, the complexity of the
tax law results from the political process as various taxpayers with their own spe-
cial interests lobby for their causes.
MARGINAL TAX RATES VERSUS AVERAGE TAX RATES
When discussing the efficiency and equity of income taxes, economists distinguish
between two notions of the tax rate: the average and the marginal. The average tax
rate is total taxes paid divided by total income. The marginal tax rate is the extra
taxes paid on an additional dollar of income.
average tax rate
total taxes paid divided by total
income
marginal tax rate
the extra taxes paid on an additional
dollar of income
CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 253
For example, suppose that the government taxes 20 percent of the first $50,000
of income and 50 percent of all income above $50,000. Under this tax, a person who
makes $60,000 pays a tax of $15,000. (The tax equals 0.20 H11003 $50,000 plus 0.50 H11003
$10,000.) For this person, the average tax rate is $15,000/$60,000, or 25 percent. But
PEOPLE RUNNING SMALL BUSINESSES ARE
most aware of the administrative bur-
den of the tax system. Small firms must
comply with many of the same laws as
large ones. Yet, because of their size,
compliance can take a much larger frac-
tion of their revenue. According to one
study, the administrative burden is ten
times larger for small firms than for
large firms. The following article de-
scribes some of these costs.
Obeying the Tax Laws:
Small Business’s Burden
BY ROBERT D. HERSHEY, JR.
In the grand scheme of a federal system
that collects more than $1 trillion a year,
Dante’s Restaurant, Inc., a modest
three-city chain in Pennsylvania, counts
for little.
But to people like Lewis Kamin,
Dante’s controller, the Internal Revenue
Code is a year-round headache. There
are the biweekly remittances of Social
Security and withheld income tax, quar-
terly reports of payroll and unem-
ployment taxes, quarterly estimated
corporate income taxes, and, of course,
the maintaining of various records,
including tips, W-4s for withholding, and
I-9 citizenship forms.
All this doesn’t count the ubiquitous
state and local levies that in Dante’s
case are complicated because liquor-
license considerations mean each of its
ten restaurants must be separately
incorporated.
“There is a lot to watch, a lot to
worry about,” Mr. Kamin grumbled. . . .
This is the real-world side of Ameri-
can taxation, the federal chunk of which
is a system based on a monumentally
complex set of laws and regulations that
was just one-third its current size when
Jimmy Carter called it “a disgrace to the
human race.”
The code is administered by a
115,000-member Internal Revenue Ser-
vice army with a $7 billion budget. But
that amount is dwarfed by what taxpay-
ers themselves spend on meeting their
obligations.
Estimates of what it costs American
businesses to comply with federal tax
law reach into the hundreds of billions of
dollars a year. . . . Big companies are un-
der almost continuous audit. The 1992
return for one giant company ran to
21,000 pages and 30 volumes. But
the heaviest burden by far falls on small
business.
In fact, according to Arthur P. Hall, a
senior fellow at The Tax Foundation, the
local hardware store, delicatessen, or
gas station with assets of less than $1
million—a category embracing 90 per-
cent of the nation’s corporations—
spends $390 for each $100 it sends to
Washington. Put another way, the gov-
ernment got just $4.1 billion from these
businesses in 1990, compared with the
$15.9 billion they spent producing the
basic corporate forms, the 1120 and
1120S.
“What this means is that the cor-
porate income tax is a very inefficient
revenue source for the federal govern-
ment,” Mr. Hall said. . . .
Although complaints about the tax
system are often aimed at the I.R.S.,
businesspeople and policymakers gener-
ally contend that the real fault lies with
Congress and its frequent, often well-
intentioned tinkering with the law. The
resulting complexity is taking an ever-
mounting toll on respect for the system,
and thereby undermines the willingness
of even the best-intentioned taxpayer to
figure out what he or she should pay. . . .
Since 1981, Washington has put
ten major tax laws on the books, gener-
ating changes whose cumulative effect
“is pretty staggering for the small busi-
nessperson,” said Edward Koos, a tax-
policy lawyer at the Small Business
Administration.
Harold Apolinsky of the Small Busi-
ness Council says 9,371 code sections
have been amended since 1981, a total
that owes much to the lobbying and
campaign contributions of the powerful.
“It appears to me that small business
just has no clout,” Mr. Apolinsky said.
“Big business tolerates it,” he added,
referring to the resulting complexity.
“Small business really can’t.”
SOURCE:The New York Times,January 30, 1994,
Business Section, p. 4.
IN THE NEWS
Small Business and
the Tax Laws
254 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
the marginal tax rate is 50 percent because the amount of the tax would rise by
$0.50 if the taxpayer earned an additional dollar.
The marginal and average tax rates each contain a useful piece of information.
If we are trying to gauge the sacrifice made by a taxpayer, the average tax rate is
more appropriate because it measures the fraction of income paid in taxes. By con-
trast, if we are trying to gauge how much the tax system distorts incentives, the
marginal tax rate is more meaningful. One of the Ten Principles of Economics in
Chapter 1 is that rational people think at the margin. Acorollary to this principle
is that the marginal tax rate measures how much the tax system discourages peo-
ple from working hard. It is the marginal tax rate, therefore, that determines the
deadweight loss of an income tax.
LUMP-SUM TAXES
Suppose the government imposes a tax of $4,000 on everyone. That is, everyone
owes the same amount, regardless of earnings or any actions that a person might
take. Such a tax is called a lump-sum tax.
Alump-sum tax shows clearly the difference between average and marginal
tax rates. For a taxpayer with income of $20,000, the average tax rate of a $4,000
lump-sum tax is 20 percent; for a taxpayer with income of $40,000, the average tax
rate is 10 percent. For both taxpayers, the marginal tax rate is zero because an ad-
ditional dollar of income would not change the amount of tax owed.
Alump-sum tax is the most efficient tax possible. Because a person’s decisions
do not alter the amount owed, the tax does not distort incentives and, therefore,
does not cause deadweight losses. Because everyone can easily compute the
amount owed and because there is no benefit to hiring tax lawyers and accoun-
tants, the lump-sum tax imposes a minimal administrative burden on taxpayers.
If lump-sum taxes are so efficient, why do we rarely observe them in the real
world? The reason is that efficiency is only one goal of the tax system. Alump-sum
tax would take the same amount from the poor and the rich, an outcome most peo-
ple would view as unfair. To understand the tax systems that we observe, we must
therefore consider the other major goal of tax policy: equity.
QUICK QUIZ: What is meant by the efficiencyof a tax system? a78 What can
make a tax system inefficient?
TAXES AND EQUITY
Ever since American colonists dumped imported tea into Boston harbor to protest
high British taxes, tax policy has generated some of the most heated debates in
American politics. The heat is rarely fueled by questions of efficiency. Instead, it
arises from disagreements over how the tax burden should be distributed. Senator
Russell Long once mimicked the public debate with this ditty:
lump-sum tax
a tax that is the same amount for
every person
CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 255
Don’t tax you.
Don’t tax me.
Tax that fella behind the tree.
Of course, if we are to rely on the government to provide some of the goods and
services we want, taxes must fall on someone. In this section we consider the eq-
uity of a tax system. How should the burden of taxes be divided among the popu-
lation? How do we evaluate whether a tax system is fair? Everyone agrees that the
tax system should be equitable, but there is much disagreement about what equity
means and how the equity of a tax system can be judged.
THE BENEFITS PRINCIPLE
One principle of taxation, called the benefits principle, states that people should
pay taxes based on the benefits they receive from government services. This prin-
ciple tries to make public goods similar to private goods. It seems fair that a per-
son who often goes to the movies pays more in total for movie tickets than a
person who rarely goes. Similarly, a person who gets great benefit from a public
good should pay more for it than a person who gets little benefit.
The gasoline tax, for instance, is sometimes justified using the benefits princi-
ple. In some states, revenues from the gasoline tax are used to build and maintain
roads. Because those who buy gasoline are the same people who use the roads, the
gasoline tax might be viewed as a fair way to pay for this government service.
The benefits principle can also be used to argue that wealthy citizens should
pay higher taxes than poorer ones. Why? Simply because the wealthy benefit more
from public services. Consider, for example, the benefits of police protection from
theft. Citizens with much to protect get greater benefit from police than do those
with less to protect. Therefore, according to the benefits principle, the wealthy
should contribute more than the poor to the cost of maintaining the police force.
The same argument can be used for many other public services, such as fire pro-
tection, national defense, and the court system.
It is even possible to use the benefits principle to argue for antipoverty pro-
grams funded by taxes on the wealthy. As we discussed in Chapter 11, people pre-
fer living in a society without poverty, suggesting that antipoverty programs are a
public good. If the wealthy place a greater dollar value on this public good than
members of the middle class do, perhaps just because the wealthy have more to
spend, then, according to the benefits principle, they should be taxed more heav-
ily to pay for these programs.
THE ABILITY-TO-PAY PRINCIPLE
Another way to evaluate the equity of a tax system is called the ability-to-pay
principle, which states that taxes should be levied on a person according to how
well that person can shoulder the burden. This principle is sometimes justified by
the claim that all citizens should make an “equal sacrifice” to support the govern-
ment. The magnitude of a person’s sacrifice, however, depends not only on the
size of his tax payment but also on his income and other circumstances. A$1,000
tax paid by a poor person may require a larger sacrifice than a $10,000 tax paid by
a rich one.
benefits principle
the idea that people should pay taxes
based on the benefits they receive
from government services
ability-to-pay principle
the idea that taxes should be levied
on a person according to how well
that person can shoulder the burden
256 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
CASE STUDY HOW THE TAX BURDEN IS DISTRIBUTED
Much debate over tax policy concerns whether the wealthy pay their fair share.
There is no objective way to make this judgment. In evaluating the issue for
yourself, however, it is useful to know how much families of different incomes
pay under the current tax system.
Table 12-8 shows how all federal taxes are distributed among income
classes. To construct this table, families are ranked according to their income
and placed into five groups of equal size, called quintiles.The second column of
the table shows the average income of each group. The poorest one-fifth of fam-
ilies had average income of $9,880; the richest one-fifth had average income of
$174,000.
The next column of the table shows total taxes as a percent of income. As
you can see, the U.S. federal tax system is progressive. The poorest families paid
The ability-to-pay principle leads to two corollary notions of equity: vertical
equity and horizontal equity. Vertical equity states that taxpayers with a greater
ability to pay taxes should contribute a larger amount. Horizontal equity states
that taxpayers with similar abilities to pay should contribute the same amount. Al-
though these notions of equity are widely accepted, applying them to evaluate a
tax system is rarely straightforward.
Vertical Equity If taxes are based on ability to pay, then richer taxpayers
should pay more than poorer taxpayers. But how much more should the rich pay?
Much of the debate over tax policy concerns this question.
Consider the three tax systems in Table 12-7. In each case, taxpayers with
higher incomes pay more. Yet the systems differ in how quickly taxes rise with in-
come. The first system is called proportional because all taxpayers pay the same
fraction of income. The second system is called regressive because high-income
taxpayers pay a smaller fraction of their income, even though they pay a larger
amount. The third system is called progressive because high-income taxpayers
pay a larger fraction of their income.
Which of these three tax systems is most fair? There is no obvious answer, and
economic theory does not offer any help in trying to find one. Equity, like beauty,
is in the eye of the beholder.
vertical equity
the idea that taxpayers with a greater
ability to pay taxes should pay larger
amounts
horizontal equity
the idea that taxpayers with similar
abilities to pay taxes should pay the
same amount
Table 12-7
PROPORTIONAL TAX REGRESSIVE TAX PROGRESSIVE TAX
AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT
INCOME OF TAX OF INCOME OF TAX OF INCOME OF TAX OF INCOME
$ 50,000 $12,500 25% $15,000 30% $10,000 20%
100,000 25,000 25 25,000 25 25,000 25
200,000 50,000 25 40,000 20 60,000 30
THREE TAX SYSTEMS
proportional tax
a tax for which high-income and
low-income taxpayers pay the same
fraction of income
regressive tax
a tax for which high-income
taxpayers pay a smaller fraction of
their income than do low-income
taxpayers
progressive tax
a tax for which high-income
taxpayers pay a larger fraction of
their income than do low-income
taxpayers
CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 257
8.0 percent of their incomes in taxes, and the richest paid 29.1 percent of their
incomes.
The fourth and fifth columns compare the distribution of income and the
distribution of taxes among these five groups. The poorest group earns 4 per-
cent of all income and pays 1 percent of all taxes. The richest group earns 49 per-
cent of all income and pays 59 percent of all taxes.
This table on taxes is a good starting point for understanding the burden of
government, but the picture it offers is incomplete. Although it includes all the
taxes that flow from households to the federal government, it fails to include the
transfer payments, such as Social Security and welfare, that flow from the fed-
eral government back to households. Studies that include both taxes and trans-
fers show more progressivity. The richest group of families still pays about
one-quarter of its income to the government, even after transfers are subtracted.
By contrast, poor families typically receive more in transfers than they pay in
taxes. The average tax rate of the poorest quintile, rather than being 8.0 percent
as in the table, is a negative 30 percent. In other words, their income is about 30
percent higher than it would be without government taxes and transfers. The
lesson is clear: To understand fully the progressivity of government policies,
one must take account of both what people pay and what they receive.
Horizontal Equity If taxes are based on ability to pay, then similar tax-
payers should pay similar amounts of taxes. But what determines if two taxpayers
are similar? Families differ in many ways. To evaluate whether a tax code is hori-
zontally equitable, one must determine which differences are relevant for a fam-
ily’s ability to pay and which differences are not.
Suppose the Smith and Jones families each have income of $50,000. The Smiths
have no children, but Mr. Smith has an illness that causes medical expenses of
$20,000. The Joneses are in good health, but they have four children. Two of the
Jones children are in college, generating tuition bills of $30,000. Would it be fair for
these two families to pay the same tax because they have the same income? Would
it be more fair to give the Smiths a tax break to help them offset their high medical
expenses? Would it be more fair to give the Joneses a tax break to help them with
their tuition expenses?
There are no easy answers to these questions. In practice, the U.S. income
tax is filled with special provisions that alter a family’s tax based on its specific
circumstances.
Table 12-8
THE BURDEN OF FEDERAL TAXES
AVERAGE TAXES AS A PERCENT OF PERCENT OF
QUINTILE INCOME PERCENT OF INCOME ALL INCOME ALL TAXES
Lowest $ 9,880 8.0% 4% 1%
Second 26,100 15.6 11 7
Middle 44,300 20.3 16 13
Fourth 68,200 23.1 20 19
Highest 174,000 29.1 49 59
SOURCE:Congressional Budget Office; estimates are for 1999.
258 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
CASE STUDY HORIZONTAL EQUITY AND THE MARRIAGE TAX
The treatment of marriage provides an important example of how difficult it is
to achieve horizontal equity in practice. Consider two couples who are exactly
the same except that one couple is married and the other couple is not. Apecu-
liar feature of the U.S. income tax code is that these two couples pay different
taxes. The reason that marriage affects the tax liability of a couple is that the tax
law treats a married couple as a single taxpayer. When a man and woman get
married, they stop paying taxes as individuals and start paying taxes as a fam-
ily. If the man and woman have similar incomes, their total tax liability rises
when they get married.
To see how this “marriage tax” works, consider the following example of a
progressive income tax. Suppose that the government taxes 25 percent of all in-
come above $10,000. Income below $10,000 is excluded from taxation. Let’s see
how this system treats two different couples.
Consider first Sam and Sally. Sam is a struggling poet and earns no income,
whereas Sally is a lawyer and earns $100,000 a year. Before getting married, Sam
pays no tax. Sally pays 25 percent of $90,000 ($100,000 minus the $10,000 exclu-
sion), which is $22,500. After getting married, their tax bill is the same. In this
case, the income tax neither encourages nor discourages marriage.
Now consider John and Joan, two college professors each earning $50,000 a
year. Before getting married, they each pay a tax of $10,000 (25 percent of
$40,000), or a total of $20,000. After getting married, they have a total income of
$100,000, and so they owe a tax of 25 percent of $90,000, or $22,500. Thus, when
John and Joan get married, their tax bill rises by $2,500. This increase is called
the marriage tax.
“And do you promise to love, honor, and cherish each other, and to pay the
United States government more in taxes as a married couple than you
would have paid if you had just continued living together?”
CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 259
We can fix the problem for John and Joan by raising the income exclusion
from $10,000 to $20,000 for married couples. But this change would create an-
other problem. In this case, Sam and Sally would pay a tax after getting married
of only $20,000, which is $2,500 less than they paid when they were single. Elim-
inating the marriage tax for John and Joan would create a marriage subsidy for
Sam and Sally.
In practice, the U.S. tax code is an uneasy compromise that includes a com-
bination of marriage taxes and marriage subsidies. According to a study by the
Congressional Budget Office, 42 percent of married couples pay a marriage tax,
averaging 2.0 percent of their income, while 51 percent of married couples pay
lower taxes by virtue of being wed, averaging 2.3 percent of their income.
Whether a couple is better off (from a tax standpoint) being married or shacked
up depends on how earnings are split between the two partners. If a man and
woman have similar incomes (like John and Joan), their wedding will most
likely raise their tax bill. But a marriage subsidy is likely if one partner earns
much more than the other, and especially if only one of them has earnings (like
Sam and Sally).
This problem has no simple solution. To see why, try designing an income
tax with the following four properties:
a78 Two married couples with the same total income should pay the same tax.
a78 When two people get married, their total tax bill should not change.
a78 Aperson or family with no income should pay no taxes.
a78 High-income taxpayers should pay a higher fraction of their incomes than
low-income taxpayers.
All four of these properties are appealing, yet it is impossible to satisfy all of
them simultaneously. Any income tax that satisfies the first three must violate
the fourth. The only income tax that satisfies the first three properties is a pro-
portional tax.
Some economists have advocated abolishing the marriage penalty by mak-
ing individuals rather than the family the taxpaying unit, a policy that many
European countries follow. This alternative might seem more equitable because
it would treat married and unmarried couples the same. Yet this change would
give up on the first of these properties: Families with the same total income
could end up paying different taxes. For example, if each married couple paid
taxes as if they were not married, then Sam and Sally would pay $22,500, and
John and Joan would pay $20,000, even though both couples have the same to-
tal income. Whether this alternative tax system is more or less fair than the cur-
rent marriage tax is hard to say.
TAX INCIDENCE AND TAX EQUITY
Tax incidence—the study of who bears the burden of taxes—is central to evaluat-
ing tax equity. As we first saw in Chapter 6, the person who bears the burden of a
tax is not always the person who gets the tax bill from the government. Because
taxes alter supply and demand, they alter equilibrium prices. As a result, they
affect people beyond those who, according to statute, actually pay the tax. When
260 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
CASE STUDY WHO PAYS THE CORPORATE INCOME TAX?
The corporate income tax provides a good example of the importance of tax in-
cidence for tax policy. The corporate tax is popular among voters. After all, cor-
porations are not people. Voters are always eager to have their taxes reduced
and have some impersonal corporation pick up the tab.
But before deciding that the corporate income tax is a good way for the gov-
ernment to raise revenue, we should consider who bears the burden of the cor-
porate tax. This is a difficult question on which economists disagree, but one
thing is certain: People pay all taxes. When the government levies a tax on a cor-
poration, the corporation is more like a tax collector than a taxpayer. The bur-
den of the tax ultimately falls on people—the owners, customers, or workers of
the corporation.
Many economists believe that workers and customers bear much of the
burden of the corporate income tax. To see why, consider an example. Suppose
that the U.S. government decides to raise the tax on the income earned by car
companies. At first, this tax hurts the owners of the car companies, who receive
less profit. But, over time, these owners will respond to the tax. Because pro-
ducing cars is less profitable, they invest less in building new car factories. In-
stead, they invest their wealth in other ways—for example, by buying larger
houses or by building factories in other industries or other countries. With
fewer car factories, the supply of cars declines, as does the demand for auto-
workers. Thus, a tax on corporations making cars causes the price of cars to rise
and the wages of autoworkers to fall.
The corporate income tax shows how dangerous the flypaper theory of tax
incidence can be. The corporate income tax is popular in part because it appears
to be paid by rich corporations. Yet those who bear the ultimate burden of the
tax—the customers and workers of corporations—are often not rich. If the true
incidence of the corporate tax were more widely known, this tax might be less
popular among voters.
CASE STUDY THE FLAT TAX
Arecurring topic of debate is whether the U.S. federal government should com-
pletely scrap the current tax system and replace it with a much simpler system
evaluating the vertical and horizontal equity of any tax, it is important to take ac-
count of these indirect effects.
Many discussions of tax equity ignore the indirect effects of taxes and are
based on what economists mockingly call the flypaper theory of tax incidence. Ac-
cording to this theory, the burden of a tax, like a fly on flypaper, sticks wherever it
first lands. This assumption, however, is rarely valid.
For example, a person not trained in economics might argue that a tax on ex-
pensive fur coats is vertically equitable because most buyers of furs are wealthy.
Yet if these buyers can easily substitute other luxuries for furs, then a tax on furs
might only reduce the sale of furs. In the end, the burden of the tax will fall more
on those who make and sell furs than on those who buy them. Because most work-
ers who make furs are not wealthy, the equity of a fur tax could be quite different
from what the flypaper theory indicates.
THIS WORKER PAYS PART OF THE
CORPORATE INCOME TAX.
CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 261
called the flat tax. The flat tax was proposed in the early 1980s by economist
Robert Hall and political scientist Alvin Rabushka. Since then, it has from time
to time caught the attention of politicians on both the political left (such as Jerry
Brown, former governor of California and sometime candidate in the Demo-
cratic presidential primaries) and the political right (such as Steve Forbes, multi-
millionaire publisher and sometime candidate in the Republican presidential
primaries).
Although flat-tax advocates have proposed various plans that differ in de-
tail, the essence of all the plans is a single, low tax rate that would apply to all
income in the economy. If the tax rate were set at 19 percent, for example, then
every taxpayer in the economy would face a marginal tax rate of 19 percent.
Most of the plans allow a certain amount of income to be excluded from the
tax. If the income exclusion were $10,000, for instance, then a person’s tax bill
would be
Tax H110050.19 H11003(Income H11002$10,000).
Because of the income exclusion, a flat tax can be progressive: Average tax rates
rise with income, even though the marginal tax rate is constant. Some of the
plans even allow a person with very low income (in this example, less than
$10,000) to pay a “negative tax” by receiving a check from the government.
Because the flat-tax proposal calls for a major overhaul of the tax system,
it raises almost every issue discussed in this chapter, especially the tradeoff
between efficiency and equity. Here are some of the points made by flat-tax
advocates:
a78 The flat tax would eliminate many of the deductions allowed under the
current income tax, such as deductions for mortgage interest payments
and charitable giving. By broadening the tax base in this way, the flat tax is
able to reduce the marginal tax rates that most people face. Lower tax
rates mean greater economic efficiency. Thus, flat-tax advocates claim that
this change would expand the size of the economic pie.
a78 Because the flat tax is so simple, the administrative burden of taxation
would be greatly reduced. Flat-tax advocates claim that many taxpayers
could file their returns on a postcard. Because all taxpayers would pay
thesame low tax rate on all forms of income, people would have less
incentive to hire tax lawyers and accountants to take advantage of
loopholes.
a78 Because all taxpayers would face the same marginal tax rate, the tax
couldbe collected at the source of income rather than from the person
who receives the income. Income from corporate profit, for instance,
would be taxed at the corporate level rather than at the personal level.
This additional simplification also reduces administrative costs.
a78 The flat tax would replace both the personal income tax and the corporate
income tax. All income, whether from working at a job or from owning
shares in a corporation, would be taxed once at the same marginal rate.
The flat tax would eliminate the current double taxation of corporate
profits, which now discourages corporations from investing in new plants
and equipment.
262 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
a78 In computing income for tax purposes, businesses would be allowed to
deduct all legitimate business expenses, including expenses on new
investment goods. This deduction for investment makes the flat tax more
like a consumption tax than an income tax. As a result, a change to a flat
tax would increase the incentive to save (or, more precisely, would
eliminate the current tax system’s disincentive to save).
In short, advocates of the flat tax claim that there is a strong efficiency argument
for this dramatic tax reform.
Critics of the flat tax are sympathetic with the goal of a simpler and more ef-
ficient tax system, but they oppose the flat tax because they believe that it gives
too little weight to the goal of vertical equity. They claim that a flat tax would be
less progressive than the current tax system and, in particular, would shift some
of the tax burden from the wealthy to the middle class. This concern may well
be justified, but no one knows for sure. Our study of tax incidence shows that
the burden of a tax is not necessarily borne by the person who sends the check
to the government. If the flat tax did encourage greater saving, as advocates
claim, it would lead to more rapid economic growth, which would benefit all
taxpayers. No one can be certain, however, about how large the impact on eco-
nomic growth would be.
QUICK QUIZ: Explain the benefits principleand the ability-to-pay principle.
a78 What are vertical equityand horizontal equity? a78 Why is studying tax
incidence important for determining the equity of a tax system?
CONCLUSION: THE TRADEOFF BETWEEN
EQUITY AND EFFICIENCY
Almost everyone agrees that equity and efficiency are the two most important
goals of the tax system. But often these two goals conflict. Many proposed changes
in the tax laws increase efficiency while reducing equity, or increase equity while
reducing efficiency. People disagree about tax policy often because they attach dif-
ferent weights to these two goals.
The recent history of tax policy shows how political leaders differ in their
views on equity and efficiency. When Ronald Reagan was elected president in
1980, the marginal tax rate on the earnings of the richest Americans was 50 per-
cent. On interest income, the marginal tax rate was 70 percent. Reagan argued that
such high tax rates greatly distorted economic incentives to work and save. In
other words, he claimed that these high tax rates cost too much in terms of eco-
nomic efficiency. Tax reform was, therefore, a high priority of his administration.
Reagan signed into law large cuts in tax rates in 1981 and then again in 1986. When
Reagan left office in 1989, the richest Americans faced a marginal tax rate of only
28 percent. During the four years of the Bush presidency, the top tax rate increased
slightly to 31 percent.
When Bill Clinton ran for president in 1992, he argued that the rich were
not paying their fair share of taxes. In other words, the low tax rates on the rich
CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 263
violated his view of vertical equity. One of President Clinton’s first acts was to pro-
pose raising the tax rates on the highest levels of income. In 1993 the tax rates on
the richest Americans became about 40 percent.
Economics alone cannot determine the best way to balance the goals of effi-
ciency and equity. This issue involves political philosophy as well as economics.
But economists do have an important role in the political debate over tax policy:
They can shed light on the tradeoffs that society faces and can help us avoid poli-
cies that sacrifice efficiency without any benefit in terms of equity.
a78 The U.S. government raises revenue using various taxes.
The most important taxes for the federal government
are individual income taxes and payroll taxes for social
insurance. The most important taxes for state and local
governments are sales taxes and property taxes.
a78 The efficiency of a tax system refers to the costs it
imposes on taxpayers. There are two costs of taxes
beyond the transfer of resources from the taxpayer to
the government. The first is the distortion in the
allocation of resources that arises as taxes alter
incentives and behavior. The second is the
administrative burden of complying with the tax laws.
a78 The equity of a tax system concerns whether the tax
burden is distributed fairly among the population.
According to the benefits principle, it is fair for people
to pay taxes based on the benefits they receive from the
government. According to the ability-to-pay principle, it
is fair for people to pay taxes based on their capability
to handle the financial burden. When evaluating the
equity of a tax system, it is important to remember a
lesson from the study of tax incidence: The distribution
of tax burdens is not the same as the distribution of
taxbills.
a78 When considering changes in the tax laws,
policymakers often face a tradeoff between efficiency
and equity. Much of the debate over tax policy arises
because people give different weights to these two
goals.
Summary
budget surplus, p. 248
budget deficit, p. 248
average tax rate, p. 252
marginal tax rate, p. 252
lump-sum tax, p. 254
benefits principle, p. 255
ability-to-pay principle, p. 255
vertical equity, p. 256
horizontal equity, p. 256
proportional tax, p. 256
regressive tax, p. 256
progressive tax, p. 256
Key Concepts
1. Over the past several decades, has government grown
more or less slowly than the rest of the economy?
2. What are the two most important sources of revenue for
the U.S. federal government?
3. Explain how corporate profits are taxed twice.
4. Why is the burden of a tax to taxpayers greater than the
revenue received by the government?
5. Why do some economists advocate taxing consumption
rather than income?
6. Give two arguments why wealthy taxpayers should pay
more taxes than poor taxpayers.
7. What is the concept of horizontal equity, and why is it
hard to apply?
8. Describe the arguments for and against replacing the
current tax system with a flat tax.
Questions for Review
264 PART FOUR THE ECONOMICS OF THE PUBLIC SECTOR
1. Government spending in the United States has grown as
a share of national income over time. What changes in
our economy and our society might explain this trend?
Do you expect the trend to continue?
2. In a published source or on the Internet, find out
whether the U.S. federal government had a budget
deficit or surplus last year. What do policymakers
expect to happen over the next few years? (Hint: The
Web site of the Congressional Budget Office is
www.cbo.gov.)
3. The information in many of the tables in this chapter
istaken from the Economic Report of the President,
whichappears annually. Using a recent issue of
thereport at your library, answer the following
questions and provide some numbers to support
youranswers.
a. Figure 12-1 shows that government revenue as a
percentage of total income has increased over time.
Is this increase primarily attributable to changes in
federal government revenue or in state and local
government revenue?
b. Looking at the combined revenue of the federal
government and state and local governments, how
has the composition of total revenue changed over
time? Are personal income taxes more or less
important? Social insurance taxes? Corporate
profits taxes?
c. Looking at the combined expenditures of the
federal government and state and local
governments, how have the relative shares of
transfer payments and purchases of goods and
services changed over time?
4. The chapter states that the elderly population in the
United States is growing more rapidly than the total
population. In particular, the number of workers is
rising slowly, while the number of retirees is rising
quickly. Concerned about the future of Social Security,
some members of Congress propose a “freeze” on the
program.
a. If total expenditures were frozen, what would
happen to benefits per retiree? To tax payments per
worker? (Assume that Social Security taxes and
receipts are balanced in each year.)
b. If benefits per retiree were frozen, what would
happen to total expenditures? To tax payments per
worker?
c. If tax payments per worker were frozen, what
would happen to total expenditures? To benefits
per retiree?
d. What do your answers to parts (a), (b), and (c)
imply about the difficult decisions faced by
policymakers?
5. Suppose you are a typical person in the U.S. economy.
You pay a flat 4 percent of your income in a state income
tax and 15.3 percent of your labor earnings in federal
payroll taxes (employer and employee shares
combined). You also pay federal income taxes as in
Table 12-3. How much tax of each type do you pay if
you earn $20,000 a year? Taking all taxes into account,
what are your average and marginal tax rates? What
happens to your tax bill and to your average and
marginal tax rates if your income rises to $40,000?
6. Some states exclude necessities, such as food and
clothing, from their sales tax. Other states do not.
Discuss the merits of this exclusion. Consider both
efficiency and equity.
7. Explain how individuals’ behavior is affected by the
following features of the federal tax code.
a. Contributions to charity are tax deductible.
b. Sales of beer are taxed.
c. Interest that a homeowner pays on a mortgage is
tax deductible.
d. Realized capital gains are taxed, but accrued gains
are not. (When someone owns a share of stock that
rises in value, she has an “accrued” capital gain. If
she sells the share, she has a “realized” gain.)
8. Suppose that your state raises its sales tax from
5percent to 6 percent. The state revenue commissioner
forecasts a 20 percent increase in sales tax revenue. Is
this plausible? Explain.
9. Consider two of the income security programs in the
United States: Temporary Assistance for Needy Families
(TANF) and the Earned Income Tax Credit (EITC).
a. When a woman with children and very low income
earns an extra dollar, she receives less in TANF
benefits. What do you think is the effect of this
feature of TANF on the labor supply of low-income
women? Explain.
b. The EITC provides greater benefits as low-income
workers earn more income (up to a point). What do
you think is the effect of this program on the labor
supply of low-income individuals? Explain.
Problems and Applications
CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 265
c. What are the disadvantages of eliminating TANF
and allocating the savings to the EITC?
10. The Tax Reform Act of 1986 eliminated the deductibility
of interest payments on consumer debt (mostly credit
cards and auto loans) but maintained the deductibility
of interest payments on mortgages and home equity
loans. What do you think happened to the relative
amounts of borrowing through consumer debt and
home equity debt?
11. Categorize each of the following funding schemes as
examples of the benefits principle or the ability-to-pay
principle.
a. Visitors to many national parks pay an entrance fee.
b. Local property taxes support elementary and
secondary schools.
c. An airport trust fund collects a tax on each plane
ticket sold and uses the money to improve airports
and the air traffic control system.
12. Any income tax schedule embodies two types of tax
rates—average tax rates and marginal tax rates.
a. The average tax rate is defined as total taxes paid
divided by income. For the proportional tax system
presented in Table 12-7, what are the average tax
rates for people earning $50,000, $100,000, and
$200,000? What are the corresponding average tax
rates in the regressive and progressive tax systems?
b. The marginal tax rate is defined as the extra taxes
paid on additional income divided by the increase
in income. Calculate the marginal tax rate for the
proportional tax system as income rises from
$50,000 to $100,000. Calculate the marginal tax rate
as income rises from $100,000 to $200,000. Calculate
the corresponding marginal tax rates for the
regressive and progressive tax systems.
c. Describe the relationship between average tax rates
and marginal tax rates for each of these three
systems. In general, which rate is relevant for
someone deciding whether to accept a job that pays
slightly more than her current job? Which rate is
relevant for judging the vertical equity of a tax
system?
13. What is the efficiency justification for taxing
consumption rather than income? If the United States
were to adopt a consumption tax, do you think that
would make the U.S. tax system more or less
progressive? Explain.
14. If a salesman takes a client to lunch, part of the cost of
the lunch is a deductible business expense for his
company. Some members of Congress have argued that
this feature of the tax code benefits relatively wealthy
businesspeople and should be eliminated. Yet their
arguments have been met with greater opposition from
eating and drinking establishments than from
companies themselves. Explain.
IN THIS CHAPTER
YOU WILL . . .
Examine the
relationship
between short-run
and long-run costs
Learn the meaning
of average total
cost and marginal
cost and how they
are related
Examine what items
are included in a
firm’s costs of
production
Analyze the link
between a firm’s
production process
and its total costs
Consider the shape
of a typical firm’s
cost curves
The economy is made up of thousands of firms that produce the goods and ser-
vices you enjoy every day: General Motors produces automobiles, General Electric
produces lightbulbs, and General Mills produces breakfast cereals. Some firms,
such as these three, are large; they employ thousands of workers and have thou-
sands of stockholders who share in the firms’ profits. Other firms, such as the local
barbershop or candy store, are small; they employ only a few workers and are
owned by a single person or family.
In previous chapters we used the supply curve to summarize firms’ produc-
tion decisions. According to the law of supply, firms are willing to produce and sell
a greater quantity of a good when the price of the good is higher, and this response
leads to a supply curve that slopes upward. For analyzing many questions, the law
of supply is all you need to know about firm behavior.
In this chapter and the ones that follow, we examine firm behavior in more de-
tail. This topic will give you a better understanding of what decisions lie behind
THE COSTS OF PRODUCTION
269
270 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
the supply curve in a market. In addition, it will introduce you to a part of eco-
nomics called industrial organization—the study of how firms’ decisions regarding
prices and quantities depend on the market conditions they face. The town in
which you live, for instance, may have several pizzerias but only one cable televi-
sion company. How does this difference in the number of firms affect the prices in
these markets and the efficiency of the market outcomes? The field of industrial or-
ganization addresses exactly this question.
As a starting point for the study of industrial organization, this chapter exam-
ines the costs of production. All firms, from Delta Air Lines to your local deli, in-
cur costs as they make the goods and services that they sell. As we will see in the
coming chapters, a firm’s costs are a key determinant of its production and pricing
decisions. Establishing what a firm’s costs are, however, is not as straightforward
as it might seem.
WHAT ARE COSTS?
We begin our discussion of costs at Hungry Helen’s Cookie Factory. Helen, the
owner of the firm, buys flour, sugar, flavorings, and other cookie ingredients. She
also buys the mixers and ovens and hires workers to run this equipment. She then
sells the resulting cookies to consumers. By examining some of the issues that He-
len faces in her business, we can learn some lessons that apply to all firms in the
economy.
TOTAL REVENUE, TOTAL COST, AND PROFIT
We begin with the firm’s objective. To understand what decisions a firm makes, we
must understand what it is trying to do. It is conceivable that Helen started her
firm because of an altruistic desire to provide the world with cookies or, perhaps,
out of love for the cookie business. More likely, however, Helen started her busi-
ness to make money. Economists normally assume that the goal of a firm is to max-
imize profit, and they find that this assumption works well in most cases.
What is a firm’s profit? The amount that the firm receives for the sale of its out-
put (cookies) is called its total revenue. The amount that the firm pays to buy in-
puts (flour, sugar, workers, ovens, etc.) is called its total cost. Helen gets to keep
any revenue that is not needed to cover costs. We define profitas a firm’s total rev-
enue minus its total cost. That is,
Profit H11005Total revenue H11002Total cost.
Helen’s objective is to make her firm’s profit as large as possible.
To see how a firm goes about maximizing profit, we must consider fully how
to measure its total revenue and its total cost. Total revenue is the easy part: It
equals the quantity of output the firm produces times the price at which it sells its
output. If Helen produces 10,000 cookies and sells them at $2 a cookie, her total
revenue is $20,000. By contrast, the measurement of a firm’s total cost is more
subtle.
total revenue
the amount a firm receives for the
sale of its output
total cost
the market value of the inputs a firm
uses in production
profit
total revenue minus total cost
CHAPTER 13 THE COSTS OF PRODUCTION 271
COSTS AS OPPORTUNITY COSTS
When measuring costs at Hungry Helen’s Cookie Factory or any other firm, it is
important to keep in mind one of the Ten Principles of Economics from Chapter 1:
The cost of something is what you give up to get it. Recall that the opportunity cost
of an item refers to all those things that must be forgone to acquire that item. When
economists speak of a firm’s cost of production, they include all the opportunity
costs of making its output of goods and services.
Afirm’s opportunity costs of production are sometimes obvious and sometimes
less so. When Helen pays $1,000 for flour, that $1,000 is an opportunity cost because
Helen can no longer use that $1,000 to buy something else. Similarly, when Helen
hires workers to make the cookies, the wages she pays are part of the firm’s costs.
These are explicit costs.By contrast, some of a firm’s opportunity costs are implicit
costs. Imagine that Helen is skilled with computers and could earn $100 per hour
working as a programmer. For every hour that Helen works at her cookie factory,
she gives up $100 in income, and this forgone income is also part of her costs.
This distinction between explicit and implicit costs highlights an important
difference between how economists and accountants analyze a business. Econo-
mists are interested in studying how firms make production and pricing decisions.
Because these decisions are based on both explicit and implicit costs, economists
include both when measuring a firm’s costs. By contrast, accountants have the job
of keeping track of the money that flows into and out of firms. As a result, they
measure the explicit costs but often ignore the implicit costs.
The difference between economists and accountants is easy to see in the case
of Hungry Helen’s Cookie Factory. When Helen gives up the opportunity to earn
money as a computer programmer, her accountant will not count this as a cost of
her cookie business. Because no money flows out of the business to pay for this
cost, it never shows up on the accountant’s financial statements. An economist,
however, will count the forgone income as a cost because it will affect the decisions
that Helen makes in her cookie business. For example, if Helen’s wage as a com-
puter programmer rises from $100 to $500 per hour, she might decide that running
her cookie business is too costly and choose to shut down the factory in order to
become a full-time computer programmer.
THE COST OF CAPITAL AS AN OPPORTUNITY COST
An important implicit cost of almost every business is the opportunity cost of the fi-
nancial capital that has been invested in the business. Suppose, for instance, thatHe-
len used $300,000 of her savings to buy her cookie factory from the previous owner.
If Helen had instead left this money deposited in a savings account thatpays an in-
terest rate of 5 percent, she would have earned $15,000 per year. Toown her cookie
factory, therefore, Helen has given up $15,000 a year in interest income. This forgone
$15,000 is one of the implicit opportunity costs of Helen’s business.
As we have already noted, economists and accountants treat costs differently,
and this is especially true in their treatment of the cost of capital. An economist
views the $15,000 in interest income that Helen gives up every year as a cost of her
business, even though it is an implicit cost. Helen’s accountant, however, will not
show this $15,000 as a cost because no money flows out of the business to pay forit.
To further explore the difference between economists and accountants, let’s
change the example slightly. Suppose now that Helen did not have the entire
explicit costs
input costs that require an outlay of
money by the firm
implicit costs
input costs that do not require an
outlay of money by the firm
272 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
$300,000 to buy the factory but, instead, used $100,000 of her own savings and bor-
rowed $200,000 from a bank at an interest rate of 5 percent. Helen’s accountant, who
only measures explicit costs, will now count the $10,000 interest paid on the bank
loan every year as a cost because this amount of money now flows out of the firm.
By contrast, according to an economist, the opportunity cost of owning the business
is still $15,000. The opportunity cost equals the interest on the bank loan (an explicit
cost of $10,000) plus the forgone interest on savings (an implicit cost of $5,000).
ECONOMIC PROFIT VERSUS ACCOUNTING PROFIT
Now let’s return to the firm’s objective—profit. Because economists and accoun-
tants measure costs differently, they also measure profit differently. An economist
measures a firm’s economic profitas the firm’s total revenue minus all the oppor-
tunity costs (explicit and implicit) of producing the goods and services sold. An ac-
countant measures the firm’s accounting profit as the firm’s total revenue minus
only the firm’s explicit costs.
Figure 13-1 summarizes this difference. Notice that because the accountant ig-
nores the implicit costs, accounting profit is larger than economic profit. For a busi-
ness to be profitable from an economist’s standpoint, total revenue must cover all
the opportunity costs, both explicit and implicit.
QUICK QUIZ: Farmer McDonald gives banjo lessons for $20 an hour. One
day, he spends 10 hours planting $100 worth of seeds on his farm. What
opportunity cost has he incurred? What cost would his accountant measure? If
these seeds will yield $200 worth of crops, does McDonald earn an accounting
profit? Does he earn an economic profit?
economic profit
total revenue minus total cost,
including both explicit and
implicit costs
accounting profit
total revenue minus total
explicit cost
Revenue
Total
opportunity
costs
How an Economist
Views a Firm
Economic
profit
Implicit
costs
Explicit
costs
Explicit
costs
Accounting
profit
How an Accountant
Views a Firm
Revenue
Figure 13-1
ECONOMISTS VERSUS
ACCOUNTANTS. Economists
include all opportunity costs
when analyzing a firm, whereas
accountants measure only explicit
costs. Therefore, economic profit
is smaller than accounting profit.
CHAPTER 13 THE COSTS OF PRODUCTION 273
PRODUCTION AND COSTS
Firms incur costs when they buy inputs to produce the goods and services that
they plan to sell. In this section we examine the link between a firm’s produc-
tion process and its total cost. Once again, we consider Hungry Helen’s Cookie
Factory.
In the analysis that follows, we make an important simplifying assumption:
We assume that the size of Helen’s factory is fixed and that Helen can vary the
quantity of cookies produced only by changing the number of workers. This as-
sumption is realistic in the short run, but not in the long run. That is, Helen cannot
build a larger factory overnight, but she can do so within a year or so. This analy-
sis, therefore, should be viewed as describing the production decisions that Helen
faces in the short run. We examine the relationship between costs and time horizon
more fully later in the chapter.
THE PRODUCTION FUNCTION
Table 13-1 shows how the quantity of cookies Helen’s factory produces per hour
depends on the number of workers. If there are no workers in the factory, Helen
produces no cookies. When there is 1 worker, she produces 50 cookies. When there
are 2 workers, she produces 90 cookies, and so on. Figure 13-2 presents a graph of
these two columns of numbers. The number of workers is on the horizontal axis,
and the number of cookies produced is on the vertical axis. This relationship be-
tween the quantity of inputs (workers) and quantity of output (cookies) is called
the production function.
One of the Ten Principles of Economics introduced in Chapter 1 is that rational
people think at the margin. As we will see in future chapters, this idea is the key to
understanding the decision a firm makes about how many workers to hire and
how much output to produce. To take a step toward understanding these deci-
sions, the third column in the table gives the marginal product of a worker. The
marginal product of any input in the production process is the increase in the
quantity of output obtained from an additional unit of that input. When the num-
ber of workers goes from 1 to 2, cookie production increases from 50 to 90, so the
marginal product of the second worker is 40 cookies. And when the number of
workers goes from 2 to 3, cookie production increases from 90 to 120, so the mar-
ginal product of the third worker is 30 cookies.
Notice that as the number of workers increases, the marginal product declines.
The second worker has a marginal product of 40 cookies, the third worker has
a marginal product of 30 cookies, and the fourth worker has a marginal product
of 20 cookies. This property is called diminishing marginal product. At first,
when only a few workers are hired, they have easy access to Helen’s kitchen
equipment. As the number of workers increases, additional workers have to share
equipment and work in more crowded conditions. Hence, as more and more
workers are hired, each additional worker contributes less to the production of
cookies.
Diminishing marginal product is also apparent in Figure 13-2. The produc-
tion function’s slope (“rise over run”) tells us the change in Helen’s output of
production function
the relationship between quantity of
inputs used to make a good and the
quantity of output of that good
marginal product
the increase in output that arises
from an additional unit of input
diminishing marginal
product
the property whereby the marginal
product of an input declines as the
quantity of the input increases
274 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
cookies (“rise”) for each additional input of labor (“run”). That is, the slope of the
production function measures the marginal product of a worker. As the number of
workers increases, the marginal product declines, and the production function be-
comes flatter.
Quantity of
Output
(cookies
per hour)
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
Number of Workers Hired0 12345
Production function
Figure 13-2
HUNGRY HELEN’S PRODUCTION
FUNCTION. Aproduction
function shows the relationship
between the number of workers
hired and the quantity of output
produced. Here the number of
workers hired (on the horizontal
axis) is from the first column in
Table 13-1, and the quantity of
output produced (on the vertical
axis) is from the second column.
The production function gets
flatter as the number of workers
increases, which reflects
diminishing marginal product.
Table 13-1
OUTPUT (QUANTITY OF MARGINAL TOTALCOST OF INPUTS
NUMBER OFCOOKIES PRODUCED PRODUCT COST OF COST OF (COST OFFACTORY + COST
WORKERS PER HOUR) OF LABOR FACTORY WORKERS OFWORKERS )
0 0 $30 $ 0 $30
50
15 301040
40
29 25
30
3 120 30 30 60
20
4 140 30 40 70
10
5 150 30 50 80
APRODUCTION FUNCTION AND TOTAL COST: HUNGRY HELEN’S COOKIE FACTORY
CHAPTER 13 THE COSTS OF PRODUCTION 275
FROM THE PRODUCTION FUNCTION
TO THE TOTAL-COST CURVE
The last three columns of Table 13-1 show Helen’s cost of producing cookies. In
this example, the cost of Helen’s factory is $30 per hour, and the cost of a worker is
$10 per hour. If she hires 1 worker, her total cost is $40. If she hires 2 workers, her
total cost is $50, and so on. With this information, the table now shows how the
number of workers Helen hires is related to the quantity of cookies she produces
and to her total cost of production.
Our goal in the next several chapters is to study firms’ production and pricing
decisions. For this purpose, the most important relationship in Table 13-1 is between
quantity produced (in the second column) and total costs (in the sixth column). Fig-
ure 13-3 graphs these two columns of data with the quantity produced on the hori-
zontal axis and total cost on the vertical axis. This graph is called the total-cost curve.
Notice that the total cost gets steeper as the amount produced rises. The shape
of the total-cost curve in this figure reflects the shape of the production function in
Figure 13-2. Recall that when Helen’s kitchen gets crowded, each additional
worker adds less to the production of cookies; this property of diminishing mar-
ginal product is reflected in the flattening of the production function as the num-
ber of workers rises. But now turn this logic around: When Helen is producing a
large quantity of cookies, she must have hired many workers. Because her kitchen
is already crowded, producing an additional cookie is quite costly. Thus, as the
quantity produced rises, the total-cost curve becomes steeper.
Total
Cost
$80
70
60
50
40
30
20
10
Quantity
of Output
(cookies per hour)
0 10 20 30 15013011090705040 1401201008060
Total-cost
curve
Figure 13-3
HUNGRY HELEN’S TOTAL-COST
CURVE. Atotal-cost curve
shows the relationship between
the quantity of output produced
and total cost of production. Here
the quantity of output produced
(on the horizontal axis) is from
the second column in Table 13-1,
and the total cost (on the vertical
axis) is from the sixth column.
The total-cost curve gets
steeperas the quantity of
outputincreases because of
diminishing marginal product.
276 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
QUICK QUIZ: If Farmer Jones plants no seeds on his farm, he gets no
harvest. If he plants 1 bag of seeds, he gets 3 bushels of wheat. If he plants 2
bags, he gets 5 bushels. If he plants 3 bags, he gets 6 bushels. Abag of seeds
costs $100, and seeds are his only cost. Use these data to graph the farmer’s
production function and total-cost curve. Explain their shapes.
THE VARIOUS MEASURES OF COST
Our analysis of Hungry Helen’s Cookie Factory demonstrated how a firm’s total
cost reflects its production function. From data on a firm’s total cost, we can derive
several related measures of cost, which will turn out to be useful when we analyze
production and pricing decisions in future chapters. To see how these related mea-
sures are derived, we consider the example in Table 13-2. This table presents cost
data on Helen’s neighbor: Thirsty Thelma’s Lemonade Stand.
The first column of the table shows the number of glasses of lemonade that
Thelma might produce, ranging from 0 to 10 glasses per hour. The second column
shows Thelma’s total cost of producing lemonade. Figure 13-4 plots Thelma’s total-
cost curve. The quantity of lemonade (from the first column) is on the horizontal
axis, and total cost (from the second column) is on the vertical axis. Thirsty
Total Cost
$15.00
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
Quantity of Output
(glasses of lemonade per hour)
01 4327659810
Total-cost curve
Figure 13-4
THIRSTY THELMA’S TOTAL-COST
CURVE. Here the quantity of
output produced (on the
horizontal axis) is from the first
column in Table 13-2, and the
total cost (on the vertical axis) is
from the second column. As in
Figure 13-3, the total-cost curve
gets steeper as the quantity of
output increases because of
diminishing marginal product.
CHAPTER 13 THE COSTS OF PRODUCTION 277
Thelma’s total-cost curve has a shape similar to Hungry Helen’s. In particular, it
becomes steeper as the quantity produced rises, which (as we have discussed) re-
flects diminishing marginal product.
FIXED AND VARIABLE COSTS
Thelma’s total cost can be divided into two types. Some costs, called fixed costs,do
not vary with the quantity of output produced. They are incurred even if the firm
produces nothing at all. Thelma’s fixed costs include the rent she pays because this
cost is the same regardless of how much lemonade Thelma produces. Similarly, if
Thelma needs to hire a full-time bookkeeper to pay bills, regardless of the quantity
of lemonade produced, the bookkeeper’s salary is a fixed cost. The third column in
Table 13-2 shows Thelma’s fixed cost, which in this example is $3.00 per hour.
Some of the firm’s costs, called variable costs, change as the firm alters the
quantity of output produced. Thelma’s variable costs include the cost of lemons
and sugar: The more lemonade Thelma makes, the more lemons and sugar she
needs to buy. Similarly, if Thelma has to hire more workers to make more lemon-
ade, the salaries of these workers are variable costs. The fourth column of the table
shows Thelma’s variable cost. The variable cost is 0 if she produces nothing, $0.30
if she produces 1 glass of lemonade, $0.80 if she produces 2 glasses, and so on.
Afirm’s total cost is the sum of fixed and variable costs. In Table 13-2, total cost
in the second column equals fixed cost in the third column plus variable cost in the
fourth column.
Table 13-2
QUANTITY
OF LEMONADE AVERAGE AVERAGE AVERAGE
(GLASSES TOTAL FIXED VARIABLE FIXED VARIABLE TOTAL MARGINAL
PER HOUR)COST COST COST COST COST COST COST
0 $ 3.00 $3.00 $ 0.00 — — —
$0.30
1 3.30 3.00 0.30 $3.00 $0.30 $3.30
0.50
2 3.80 3.00 0.80 1.50 0.40 1.90
0.70
3 4.50 3.00 1.50 1.00 0.50 1.50
0.90
4 5.40 3.00 2.40 0.75 0.60 1.35
1.10
5 6.50 3.00 3.50 0.60 0.70 1.30
1.30
6 7.80 3.00 4.80 0.50 0.80 1.30
1.50
7 9.30 3.00 6.30 0.43 0.90 1.33
1.70
8 11.00 3.00 8.00 0.38 1.00 1.38
1.90
9 12.90 3.00 9.90 0.33 1.10 1.43
2.10
10 15.00 3.00 12.00 0.30 1.20 1.50
THE VARIOUS MEASURES OF COST: THIRSTY THELMA’S LEMONADE STAND
fixed costs
costs that do not vary with the
quantity of output produced
variable costs
costs that do vary with the quantity
of output produced
278 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
AVERAGE AND MARGINAL COST
As the owner of her firm, Thelma has to decide how much to produce. Akey part
of this decision is how her costs will vary as she changes the level of production.
In making this decision, Thelma might ask her production supervisor the follow-
ing two questions about the cost of producing lemonade:
a78 How much does it cost to make the typical glass of lemonade?
a78 How much does it cost to increase production of lemonade by 1 glass?
Although at first these two questions might seem to have the same answer, they do
not. Both answers will turn out to be important for understanding how firms make
production decisions.
To find the cost of the typical unit produced, we would divide the firm’s costs
by the quantity of output it produces. For example, if the firm produces 2 glasses
per hour, its total cost is $3.80, and the cost of the typical glass is $3.80/2, or $1.90.
Total cost divided by the quantity of output is called average total cost.Because to-
tal cost is just the sum of fixed and variable costs, average total cost can be ex-
pressed as the sum of average fixed cost and average variable cost. Average fixed
costis the fixed cost divided by the quantity of output, and average variable cost
is the variable cost divided by the quantity of output.
Although average total cost tells us the cost of the typical unit, it does not tell
us how much total cost will change as the firm alters its level of production. The
last column in Table 13-2 shows the amount that total cost rises when the firm in-
creases production by 1 unit of output. This number is called marginal cost. For
example, if Thelma increases production from 2 to 3 glasses, total cost rises from
$3.80 to $4.50, so the marginal cost of the third glass of lemonade is $4.50 minus
$3.80, or $0.70.
It may be helpful to express these definitions mathematically. If Q stands for
quantity, TC for total cost, ATC for average total cost, and MC for marginal cost,
then we can then write:
ATC = Total cost/Quantity = TC/Q
and
MC = (Change in total cost)/(Change in quantity) = H9004TC/H9004Q.
Here H9004, the Greek letter delta, represents the change in a variable. These equations
show how average total cost and marginal cost are derived from total cost.
As we will see more fully in the next chapter, Thelma, our lemonade entrepre-
neur, will find the concepts of average total cost and marginal cost extremely useful
when deciding how much lemonade to produce. Keep in mind, however, that these
concepts do not actually give Thelma new information about her costs of production.
Instead, average total cost and marginal cost express in a new way information that
is already contained in her firm’s total cost. Average total cost tells us the cost of a typical
unit of output if total cost is divided evenly over all the units produced. Marginal cost tells us
the increase in total cost that arises from producing an additional unit of output.
average total cost
total cost divided by the quantity
of output
average fixed cost
fixed costs divided by the quantity
of output
average variable cost
variable costs divided by the quantity
of output
marginal cost
the increase in total cost that arises
from an extra unit of production
CHAPTER 13 THE COSTS OF PRODUCTION 279
COST CURVES AND THEIR SHAPES
Just as in previous chapters we found graphs of supply and demand useful when
analyzing the behavior of markets, we will find graphs of average and marginal
cost useful when analyzing the behavior of firms. Figure 13-5 graphs Thelma’s
costs using the data from Table 13-2. The horizontal axis measures the quantity the
firm produces, and the vertical axis measures marginal and average costs. The
graph shows four curves: average total cost (ATC), average fixed cost (AFC), aver-
age variable cost (AVC), and marginal cost (MC).
The cost curves shown here for Thirsty Thelma’s Lemonade Stand have some
features that are common to the cost curves of many firms in the economy. Let’s
examine three features in particular: the shape of marginal cost, the shape of aver-
age total cost, and the relationship between marginal and average total cost.
Rising Marginal Cost Thirsty Thelma’s marginal cost rises with the quan-
tity of output produced. This reflects the property of diminishing marginal product.
When Thelma is producing a small quantity of lemonade, she has few workers, and
much of her equipment is not being used. Because she can easily put these idle
resources to use, the marginal product of an extra worker is large, and the marginal
cost of an extra glass of lemonade is small. By contrast, when Thelma is producing
a large quantity of lemonade, her stand is crowded with workers, and most of her
equipment is fully utilized. Thelma can produce more lemonade by adding work-
ers, but these new workers have to work in crowded conditions and may have to
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Quantity of Output
(glasses of lemonade per hour)
01 4327659810
MC
ATC
AVC
AFC
Figure 13-5
THIRSTY THELMA’S AVERAGE-
COST AND MARGINAL-COST
CURVES. This figure shows the
average total cost (ATC), average
fixed cost (AFC), average variable
cost (AVC), and marginal cost
(MC) for Thirsty Thelma’s
Lemonade Stand. All of these
curves are obtained by graphing
the data in Table 13-2. These cost
curves show three features that
are considered common: (1)
Marginal cost rises with the
quantity of output. (2) The
average-total-cost curve is U-
shaped. (3) The marginal-cost
curve crosses the average-total-
cost curve at the minimum of
average total cost.
280 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
wait to use the equipment. Therefore, when the quantity of lemonade being pro-
duced is already high, the marginal product of an extra worker is low, and the mar-
ginal cost of an extra glass of lemonade is large.
U-Shaped Average Total Cost Thirsty Thelma’s average-total-cost
curve is U-shaped. To understand why this is so, remember that average total cost
is the sum of average fixed cost and average variable cost. Average fixed cost al-
ways declines as output rises because the fixed cost is getting spread over a larger
number of units. Average variable cost typically rises as output increases because
of diminishing marginal product. Average total cost reflects the shapes of both av-
erage fixed cost and average variable cost. At very low levels of output, such as 1
or 2 glasses per hour, average total cost is high because the fixed cost is spread
over only a few units. Average total cost then declines as output increases until the
firm’s output reaches 5 glasses of lemonade per hour, when average total cost falls
to $1.30 per glass. When the firm produces more than 6 glasses, average total cost
starts rising again because average variable cost rises substantially.
The bottom of the U-shape occurs at the quantity that minimizes average total
cost. This quantity is sometimes called the efficient scale of the firm. For Thirsty
Thelma, the efficient scale is 5 or 6 glasses of lemonade. If she produces more or
less than this amount, her average total cost rises above the minimum of $1.30.
The Relationship between Marginal Cost and Average Total
Cost If you look at Figure 13-5 (or back at Table 13-2), you will see something
that may be surprising at first. Whenever marginal cost is less than average total cost,
average total cost is falling. Whenever marginal cost is greater than average total cost, av-
erage total cost is rising. This feature of Thirsty Thelma’s cost curves is not a coinci-
dence from the particular numbers used in the example: It is true for all firms.
To see why, consider an analogy. Average total cost is like your cumulative grade
point average. Marginal cost is like the grade in the next course you will take. If your
grade in your next course is less than your grade point average, your grade point av-
erage will fall. If your grade in your next course is higher than your grade point av-
erage, your grade point average will rise. The mathematics of average and marginal
costs is exactly the same as the mathematics of average and marginal grades.
This relationship between average total cost and marginal cost has an impor-
tant corollary: The marginal-cost curve crosses the average-total-cost curve at the efficient
scale. Why? At low levels of output, marginal cost is below average total cost, so
average total cost is falling. But after the two curves cross, marginal cost rises
above average total cost. For the reason we have just discussed, average total cost
must start to rise at this level of output. Hence, this point of intersection is the min-
imum of average total cost. As you will see in the next chapter, this point of mini-
mum average total cost plays a key role in the analysis of competitive firms.
TYPICAL COST CURVES
In the examples we have studied so far, the firms exhibit diminishing marginal prod-
uct and, therefore, rising marginal cost at all levels of output. Yet actual firms are of-
ten a bit more complicated than this. In many firms, diminishing marginal product
does not start to occur immediately after the first worker is hired. Depending on the
efficient scale
the quantity of output that
minimizes average total cost
CHAPTER 13 THE COSTS OF PRODUCTION 281
production process, the second or third worker might have higher marginal product
than the first because a team of workers can divide tasks and work more produc-
tively than a single worker. Such firms would first experience increasing marginal
product for a while before diminishing marginal product sets in.
Table 13-3 shows the cost data for such a firm, called Big Bob’s Bagel Bin. These
data are graphed in Figure 13-6. Panel (a) shows how total cost (TC) depends on
the quantity produced, and panel (b) shows average total cost (ATC), average fixed
cost (AFC), average variable cost (AVC), and marginal cost (MC). In the range of
output from 0 to 4 bagels per hour, the firm experiences increasing marginal prod-
uct, and the marginal-cost curve falls. After 5 bagels per hour, the firm starts to ex-
perience diminishing marginal product, and the marginal-cost curve starts to rise.
This combination of increasing then diminishing marginal product also makes the
average-variable-cost curve U-shaped.
Despite these differences from our previous example, Big Bob’s cost curves
share the three properties that are most important to remember:
a78 Marginal cost eventually rises with the quantity of output.
a78 The average-total-cost curve is U-shaped.
a78 The marginal-cost curve crosses the average-total-cost curve at the minimum
of average total cost.
Table 13-3
QUANTITY AVERAGE AVERAGE AVERAGE
OF BAGELS TOTAL FIXED VARIABLE FIXED VARIABLE TOTAL MARGINAL
(PER HOUR)COST COST COST COST COST COST COST
0 $ 2.00 $2.00 $ 0.00 — — —
$1.00
1 3.00 2.00 1.00 $2.00 $1.00 $3.00
0.80
2 3.80 2.00 1.80 1.00 0.90 1.90
0.60
3 4.40 2.00 2.40 0.67 0.80 1.47
0.40
4 4.80 2.00 2.80 0.50 0.70 1.20
0.40
5 5.20 2.00 3.20 0.40 0.64 1.04
0.60
6 5.80 2.00 3.80 0.33 0.63 0.96
0.80
7 6.60 2.00 4.60 0.29 0.66 0.95
1.00
8 7.60 2.00 5.60 0.25 0.70 0.95
1.20
9 8.80 2.00 6.80 0.22 0.76 0.98
1.40
10 10.20 2.00 8.20 0.20 0.82 1.02
1.60
11 11.80 2.00 9.80 0.18 0.89 1.07
1.80
12 13.60 2.00 11.60 0.17 0.97 1.14
2.00
13 15.60 2.00 13.60 0.15 1.05 1.20
2.20
14 17.80 2.00 15.80 0.14 1.13 1.27
THE VARIOUS MEASURES OF COST: BIG BOB’S BAGEL BIN
282 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
0
(a) Total-Cost Curve
(b) Marginal- and Average-Cost Curves
Total
Cost
$18.00
17.00
16.00
15.00
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
Quantity of Output
(bagels per hour)
TC
Quantity of Output
(bagels per hour)
1432765981413121110
2.00
1.00
Costs
$3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
0 1432765981413121110
MC
ATC
AVC
AFC
BIG BOB’S COST CURVES.Many
firms, like Big Bob’s Bagel Bin,
experience increasing marginal
product before diminishing
marginal product and, therefore,
have cost curves like those in this
figure. Panel (a) shows how total
cost (TC) depends on the quantity
produced. Panel (b) shows how
average total cost (ATC), average
fixed cost (AFC), average variable
cost (AVC), and marginal cost (MC)
depend on the quantity produced.
These curves are derived by
graphing the data from Table 13-3.
Notice that marginal cost and
average variable cost fall for a
while before starting to rise.
Figure 13-6
CHAPTER 13 THE COSTS OF PRODUCTION 283
QUICK QUIZ: Suppose Honda’s total cost of producing 4 cars is $225,000
and its total cost of producing 5 cars is $250,000. What is the average total cost
of producing 5 cars? What is the marginal cost of the fifth car? a78 Draw the
marginal-cost curve and the average-total-cost curve for a typical firm, and
explain why these curves cross where they do.
COSTS IN THE SHORT RUN AND IN THE LONG RUN
We noted at the beginning of this chapter that a firm’s costs might depend on
thetime horizon being examined. Let’s examine more precisely why this might be
thecase.
THE RELATIONSHIP BETWEEN SHORT-RUN AND
LONG-RUN AVERAGE TOTAL COST
For many firms, the division of total costs between fixed and variable costs de-
pends on the time horizon. Consider, for instance, a car manufacturer, such as Ford
Motor Company. Over a period of only a few months, Ford cannot adjust the num-
ber or sizes of its car factories. The only way it can produce additional cars is to
hire more workers at the factories it already has. The cost of these factories is,
therefore, a fixed cost in the short run. By contrast, over a period of several years,
Ford can expand the size of its factories, build new factories, or close old ones.
Thus, the cost of its factories is a variable cost in the long run.
Because many decisions are fixed in the short run but variable in the long run,
a firm’s long-run cost curves differ from its short-run cost curves. Figure 13-7
shows an example. The figure presents three short-run average-total-cost curves—
for a small, medium, and large factory. It also presents the long-run average-total-
cost curve. As the firm moves along the long-run curve, it is adjusting the size of
the factory to the quantity of production.
This graph shows how short-run and long-run costs are related. The long-run
average-total-cost curve is a much flatter U-shape than the short-run average-total-
cost curve. In addition, all the short-run curves lie on or above the long-run curve.
These properties arise because of the greater flexibility firms have in the long run.
In essence, in the long run, the firm gets to choose which short-run curve it wants
to use. But in the short run, it has to use whatever short-run curve it chose in
thepast.
The figure shows an example of how a change in production alters costs over
different time horizons. When Ford wants to increase production from 1,000 to
1,200 cars per day, it has no choice in the short run but to hire more workers at its
existing medium-sized factory. Because of diminishing marginal product, average
total cost rises from $10,000 to $12,000 per car. In the long run, however, Ford can
expand both the size of the factory and its workforce, and average total cost re-
mains at $10,000.
How long does it take for a firm to get to the long run? The answer depends
on the firm. It can take a year or longer for a major manufacturing firm, such as a
284 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
car company, to build a larger factory. By contrast, a person running a lemonade
stand can go and buy a larger pitcher within an hour or less. There is, therefore, no
single answer about how long it takes a firm to adjust its production facilities.
ECONOMIES AND DISECONOMIES OF SCALE
The shape of the long-run average-total-cost curve conveys important information
about the technology for producing a good. When long-run average total cost de-
clines as output increases, there are said to be economies of scale.When long-run
average total cost rises as output increases, there are said to be diseconomies of
scale. When long-run average total cost does not vary with the level of output,
there are said to be constant returns to scale.In this example, Ford has economies
of scale at low levels of output, constant returns to scale at intermediate levels of
output, and diseconomies of scale at high levels of output.
What might cause economies or diseconomies of scale? Economies of scale
often arise because higher production levels allow specialization among workers,
which permits each worker to become better at his or her assigned tasks. For in-
stance, modern assembly-line production requires a large number of workers. If
Ford were producing only a small quantity of cars, it could not take advantage of
this approach and would have higher average total cost. Diseconomies of scale can
arise because of coordination problems that are inherent in any large organization.
The more cars Ford produces, the more stretched the management team becomes,
and the less effective the managers become at keeping costs down.
This analysis shows why long-run average-total-cost curves are often U-
shaped. At low levels of production, the firm benefits from increased size be-
cause it can take advantage of greater specialization. Coordination problems,
Quantity of
Cars per Day
0 1,2001,000
Average
Total
Cost
$12,000
10,000
Economies
of
scale
ATC in short
run with
small factory
ATC in short
run with
medium factory
ATC in short
run with
large factory ATC in long run
Diseconomies
of
scale
Constant
returns to
scale
Figure 13-7
AVERAGE TOTAL COST IN THE
SHORT AND LONG RUNS.
Because fixed costs are variable in
the long run, the average-total-
cost curve in the short run differs
from the average-total-cost curve
in the long run.
economies of scale
the property whereby long-run
average total cost falls as the
quantity of output increases
diseconomies of scale
the property whereby long-run
average total cost rises as the
quantity of output increases
constant returns to scale
the property whereby long-run
average total cost stays the same as
the quantity of output changes
CHAPTER 13 THE COSTS OF PRODUCTION 285
meanwhile, are not yet acute. By contrast, at high levels of production, the benefits
of specialization have already been realized, and coordination problems become
more severe as the firm grows larger. Thus, long-run average total cost is falling at
low levels of production because of increasing specialization and rising at high
levels of production because of increasing coordination problems.
QUICK QUIZ: If Boeing produces 9 jets per month, its long-run total
cost is$9.0 million per month. If it produces 10 jets per month, its long-run
total cost is $9.5 million per month. Does Boeing exhibit economies or
diseconomiesof scale?
CONCLUSION
The purpose of this chapter has been to develop some tools that we can use to study
how firms make production and pricing decisions. You should now understand
what economists mean by the term costs and how costs vary with the quantity of
output a firm produces. To refresh your memory, Table 13-4 summarizes some of
the definitions we have encountered.
“Jack of all trades, master of
none.” This well-known adage
helps explain why firms some-
times experience economies of
scale. A person who tries to do
everything usually ends up doing
nothing very well. If a firm wants
its workers to be as productive
as they can be, it is often best
to give them a limited task that
they can master. But this is pos-
sible only if a firm employs a
large number of workers and
produces a large quantity of output.
In his celebrated book, An Inquiry into the Nature and
Causes of the Wealth of Nations, Adam Smith described an
example of this based on a visit he made to a pin factory.
Smith was impressed by the specialization among the work-
ers that he observed and the resulting economies of scale.
He wrote,
“One man draws out the wire, another straightens 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 peculiar
business; to whiten it is another; it is even a trade by
itself to put them into paper.”
Smith reported that because of this specialization, the pin
factory produced thousands of pins per worker every day.
He conjectured that if the workers had chosen to work sep-
arately, rather than as a team of specialists, “they certainly
could not each of them make twenty, perhaps not one pin a
day.” In other words, because of specialization, a large pin
factory could achieve higher output per worker and lower av-
erage cost per pin than a small pin factory.
The specialization that Smith observed in the pin fac-
tory is prevalent in the modern economy. If you want to build
a house, for instance, you could try to do all the work your-
self. But most people turn to a builder, who in turn hires
carpenters, plumbers, electricians, painters, and many other
types of worker. These workers specialize in particular jobs,
and this allows them to become better at their jobs than if
they were generalists. Indeed, the use of specialization to
achieve economies of scale is one reason modern societies
are as prosperous as they are.
FYI
Lessons from a
Pin Factory
286 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
By themselves, of course, a firm’s cost curves do not tell us what decisions the
firm will make. But they are an important component of that decision, as we will
begin to see in the next chapter.
Table 13-4
THE MANY TYPESOF COST:
ASUMMARY
MATHEMATICAL
TERM DEFINITION DESCRIPTION
Explicit costs Costs that require an outlay of —
money by the firm
Implicit costs Costs that do not require an outlay —
of money by the firm
Fixed costs Costs that do not vary with the FC
quantity of output produced
Variable costs Costs that do vary with the VC
quantity of output produced
Total cost The market value of all the inputs TC H11005 FC H11001 VC
that a firm uses in production
Average fixed cost Fixed costs divided by the quantity AFC H11005 FC/Q
of output
Average variable cost Variable costs divided by the AVC H11005 VC/Q
quantity of output
Average total cost Total cost divided by the quantity ATC H11005 TC/Q
of output
Marginal cost The increase in total cost that arises MC H11005H9004TC/H9004Q
from an extra unit of production
a78 The goal of firms is to maximize profit, which equals
total revenue minus total cost.
a78 When analyzing a firm’s behavior, it is important to
include all the opportunity costs of production. Some of
the opportunity costs, such as the wages a firm pays its
workers, are explicit. Other opportunity costs, such as
the wages the firm owner gives up by working in the
firm rather than taking another job, are implicit.
a78 Afirm’s costs reflect its production process. Atypical
firm’s production function gets flatter as the quantity
ofan input increases, displaying the property of
diminishing marginal product. As a result, a firm’s
total-cost curve gets steeper as the quantity produced
rises.
a78 Afirm’s total costs can be divided between fixed costs
and variable costs. Fixed costs are costs that do not
change when the firm alters the quantity of output
produced. Variable costs are costs that do change when
the firm alters the quantity of output produced.
a78 From a firm’s total cost, two related measures of cost are
derived. Average total cost is total cost divided by the
quantity of output. Marginal cost is the amount by
which total cost would rise if output were increased by
1 unit.
a78 When analyzing firm behavior, it is often useful to
graph average total cost and marginal cost. For a typical
firm, marginal cost rises with the quantity of output.
Average total cost first falls as output increases and then
Summary
CHAPTER 13 THE COSTS OF PRODUCTION 287
rises as output increases further. The marginal-cost
curve always crosses the average-total-cost curve at the
minimum of average total cost.
a78 Afirm’s costs often depend on the time horizon being
considered. In particular, many costs are fixed in the
short run but variable in the long run. As a result, when
the firm changes its level of production, average total
cost may rise more in the short run than in the long run.
total revenue, p. 270
total cost, p. 270
profit, p. 270
explicit costs, p. 271
implicit costs, p. 271
economic profit, p. 272
accounting profit, p. 272
production function, p. 273
marginal product, p. 273
diminishing marginal product, p. 273
fixed costs, p. 277
variable costs, p. 277
average total cost, p. 278
average fixed cost, p. 278
average variable cost, p. 278
marginal cost, p. 278
efficient scale, p. 280
economies of scale, p. 284
diseconomies of scale, p. 284
constant returns to scale, p. 284
Key Concepts
1. What is the relationship between a firm’s total revenue,
profit, and total cost?
2. Give an example of an opportunity cost that an
accountant might not count as a cost. Why would the
accountant ignore this cost?
3. What is marginal product, and what does it mean if it is
diminishing?
4. Draw a production function that exhibits diminishing
marginal product of labor. Draw the associated total-
cost curve. (In both cases, be sure to label the axes.)
Explain the shapes of the two curves you have drawn.
5. Define total cost, average total cost, and marginal cost.
How are they related?
6. Draw the marginal-cost and average-total-cost curves
for a typical firm. Explain why the curves have the
shapes that they do and why they cross where they do.
7. How and why does a firm’s average-total-cost curve
differ in the short run and in the long run?
8. Define economies of scale and explain why they might
arise. Define diseconomies of scale and explain why they
might arise.
Questions for Review
1. This chapter discusses many types of costs: opportunity
cost, total cost, fixed cost, variable cost, average total
cost, and marginal cost. Fill in the type of cost that best
completes the phrases below:
a. The true cost of taking some action is its _______.
b. _______ is falling when marginal cost is below it,
and rising when marginal cost is above it.
c. Acost that does not depend on the quantity
produced is a _______.
d. In the ice-cream industry in the short run, _______
includes the cost of cream and sugar, but not the
cost of the factory.
e. Profits equal total revenue less _______.
f. The cost of producing an extra unit of output is
_______.
2. Your aunt is thinking about opening a hardware store.
She estimates that it would cost $500,000 per year to rent
the location and buy the stock. In addition, she would
have to quit her $50,000 per year job as an accountant.
a. Define opportunity cost.
b. What is your aunt’s opportunity cost of running a
hardware store for a year? If your aunt thought she
could sell $510,000 worth of merchandise in a year,
should she open the store? Explain.
Problems and Applications
288 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
3. Suppose that your college charges you separately for
tuition and for room and board.
a. What is a cost of attending college that is not an
opportunity cost?
b. What is an explicit opportunity cost of attending
college?
c. What is an implicit opportunity cost of attending
college?
4. Acommercial fisherman notices the following
relationship between hours spent fishing and the
quantity of fish caught:
HOURS QUANTITY OF FISH (IN POUNDS)
00
110
218
324
42
530
a. What is the marginal product of each hour spent
fishing?
b. Use these data to graph the fisherman’s production
function. Explain its shape.
c. The fisherman has a fixed cost of $10 (his pole). The
opportunity cost of his time is $5 per hour. Graph
the fisherman’s total-cost curve. Explain its shape.
5. Nimbus, Inc., makes brooms and then sells them door-
to-door. Here is the relationship between the number of
workers and Nimbus’s output in a given day:
AVERAGE
MARGINAL TOTAL TOTAL MARGINAL
WORKERS OUTPUT PRODUCT COST COST COST
0 0 _______ _______
_______ ______
1 20 _______ _______
_______ _______
2 50 _______ _______
_______ _______
3 90 _______ _______
_______ _______
4 120 _______ _______
_______ _______
5 140 _______ _______
_______ _______
6 150 _______ _______
_______ _______
7 155 _______ _______
a. Fill in the column of marginal products. What
pattern do you see? How might you explain it?
b. Aworker costs $100 a day, and the firm has fixed
costs of $200. Use this information to fill in the
column for total cost.
c. Fill in the column for average total cost. (Recall that
ATC = TC/Q.) What pattern do you see?
d. Now fill in the column for marginal cost. (Recall
that MC = H9004TC/H9004Q.) What pattern do you see?
e. Compare the column for marginal product and the
column for marginal cost. Explain the relationship.
f. Compare the column for average total cost and the
column for marginal cost. Explain the relationship.
6. Suppose that you and your roommate have started a
bagel delivery service on campus. List some of your
fixed costs and describe why they are fixed. List some of
your variable costs and describe why they are variable.
7. Consider the following cost information for a pizzeria:
Q(DOZENS)TOTALCOST VARIABLE COST
0 $300 $ 0
1 350 50
2 390 90
3 420 120
4 450 150
5 490 190
6 540 240
a. What is the pizzeria’s fixed cost?
b. Construct a table in which you calculate the
marginal cost per dozen pizzas using the
information on total cost. Also calculate the
marginal cost per dozen pizzas using the
information on variable cost. What is the
relationship between these sets of numbers?
Comment.
8. You are thinking about setting up a lemonade stand.
The stand itself costs $200. The ingredients for each cup
of lemonade cost $0.50.
a. What is your fixed cost of doing business? What is
your variable cost per cup?
b. Construct a table showing your total cost, average
total cost, and marginal cost for output levels
varying from zero to 10 gallons. (Hint: There are 16
cups in a gallon.) Draw the three cost curves.
9. Your cousin Vinnie owns a painting company with fixed
costs of $200 and the following schedule for variable
costs:
CHAPTER 13 THE COSTS OF PRODUCTION 289
QUANTITY OF HOUSES
PAINTED PER MONTH
1234 5 6 7
Variable costs $10 $20 $40 $80 $160 $320 $640
Calculate average fixed cost, average variable cost, and
average total cost for each quantity. What is the efficient
scale of the painting company?
10. Healthy Harry’s Juice Bar has the following cost
schedules:
Q(VATS)VARIABLE COST TOTALCOST
0$0 $ 30
11 4
225 5
34 7
4 70 100
5 100 130
6 135 165
a. Calculate average variable cost, average total cost,
and marginal cost for each quantity.
b. Graph all three curves. What is the relationship
between the marginal-cost curve and the average-
total-cost curve? Between the marginal-cost curve
and the average-variable-cost curve? Explain.
11. Consider the following table of long-run total cost for
three different firms:
QUANTITY
1234 5 6 7
Firm A $60 $70 $80 $90 $100 $110 $120
Firm B 11 24 39 56 75 96 119
Firm C 21 34 49 66 85 106 129
Does each of these firms experience economies of scale
or diseconomies of scale?
IN THIS CHAPTER
YOU WILL . . .
See how firm
behavior determines
a market’s short-
run and long-run
supply curves
Examine how
competitive firms
decide when to shut
down production
temporarily
Learn what
characteristics
make a market
competitive
Examine how
competitive firms
decide how much
output to produce
Examine how
competitive firms
decide whether
to exit or enter
a market
If your local gas station raised the price it charges for gasoline by 20 percent, it
would see a large drop in the amount of gasoline it sold. Its customers would
quickly switch to buying their gasoline at other gas stations. By contrast, if your lo-
cal water company raised the price of water by 20 percent, it would see only a
small decrease in the amount of water it sold. People might water their lawns less
often and buy more water-efficient shower heads, but they would be hard-pressed
to reduce water consumption greatly and would be unlikely to find another sup-
plier. The difference between the gasoline market and the water market is obvious:
There are many firms pumping gasoline, but there is only one firm pumping wa-
ter. As you might expect, this difference in market structure shapes the pricing and
production decisions of the firms that operate in these markets.
In this chapter we examine the behavior of competitive firms, such as your lo-
cal gas station. You may recall that a market is competitive if each buyer and seller
FIRMS IN
COMPETITIVE MARKETS
291
292 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
is small compared to the size of the market and, therefore, has little ability to in-
fluence market prices. By contrast, if a firm can influence the market price of the
good it sells, it is said to have market power.In the three chapters that follow this
one, we examine the behavior of firms with market power, such as your local wa-
ter company.
Our analysis of competitive firms in this chapter will shed light on the deci-
sions that lie behind the supply curve in a competitive market. Not surprisingly,
we will find that a market supply curve is tightly linked to firms’ costs of produc-
tion. (Indeed, this general insight should be familiar to you from our analysis in
Chapter 7.) But among a firm’s various costs—fixed, variable, average, and mar-
ginal—which ones are most relevant for its decision about the quantity to sup-
ply? We will see that all these measures of cost play important and interrelated
roles.
WHAT IS A COMPETITIVE MARKET?
Our goal in this chapter is to examine how firms make production decisions in
competitive markets. As a background for this analysis, we begin by considering
what a competitive market is.
THE MEANING OF COMPETITION
Although we have already discussed the meaning of competition in Chapter 4,
let’s review the lesson briefly. Acompetitive market,sometimes called a perfectly
competitive market,has two characteristics:
a78 There are many buyers and many sellers in the market.
a78 The goods offered by the various sellers are largely the same.
As a result of these conditions, the actions of any single buyer or seller in the mar-
ket have a negligible impact on the market price. Each buyer and seller takes the
market price as given.
An example is the market for milk. No single buyer of milk can influence the
price of milk because each buyer purchases a small amount relative to the size of
the market. Similarly, each seller of milk has limited control over the price because
many other sellers are offering milk that is essentially identical. Because each seller
can sell all he wants at the going price, he has little reason to charge less, and if he
charges more, buyers will go elsewhere. Buyers and sellers in competitive markets
must accept the price the market determines and, therefore, are said to be price
takers.
In addition to the foregoing two conditions for competition, there is a third
condition sometimes thought to characterize perfectly competitive markets:
a78 Firms can freely enter or exit the market.
competitive market
a market with many buyers and
sellers trading identical products
sothat each buyer and seller is a
price taker
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 293
If, for instance, anyone can decide to start a dairy farm, and if any existing dairy
farmer can decide to leave the dairy business, then the dairy industry would sat-
isfy this condition. It should be noted that much of the analysis of competitive
firms does not rely on the assumption of free entry and exit because this condition
is not necessary for firms to be price takers. But as we will see later in this chapter,
entry and exit are often powerful forces shaping the long-run outcome in compet-
itive markets.
THE REVENUE OF A COMPETITIVE FIRM
Afirm in a competitive market, like most other firms in the economy, tries to max-
imize profit, which equals total revenue minus total cost. To see how it does this,
we first consider the revenue of a competitive firm. To keep matters concrete, let’s
consider a specific firm: the Smith Family Dairy Farm.
The Smith Farm produces a quantity of milk Qand sells each unit at the mar-
ket price P.The farm’s total revenue is PH11003Q.For example, if a gallon of milk sells
for $6 and the farm sells 1,000 gallons, its total revenue is $6,000.
Because the Smith Farm is small compared to the world market for milk, it
takes the price as given by market conditions. This means, in particular, that the
price of milk does not depend on the quantity of output that the Smith Farm pro-
duces and sells. If the Smiths double the amount of milk they produce, the price of
milk remains the same, and their total revenue doubles. As a result, total revenue
is proportional to the amount of output.
Table 14-1 shows the revenue for the Smith Family Dairy Farm. The first two
columns show the amount of output the farm produces and the price at which it
sells its output. The third column is the farm’s total revenue. The table assumes
that the price of milk is $6 a gallon, so total revenue is simply $6 times the number
of gallons.
Just as the concepts of averageand marginalwere useful in the preceding chap-
ter when analyzing costs, they are also useful when analyzing revenue. To see
what these concepts tell us, consider these two questions:
Table 14-1
TOTAL, AVERAGE, AND
MARGINAL REVENUE FOR A
COMPETITIVE FIRM
QUANTITY TOTAL AVERAGE MARGINAL
(INGALLONS)PRICE REVENUE REVENUE REVENUE
(Q)(P)(TRH11549PH11547Q)(ARH11549TR/Q)(MRH11549 ?TR/?Q)
1 $6 $ 6 $6
$6
2612 6
6
368
6
4624 6
6
5630
6
666 6
6
7642
6
868 6
294 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
a78 How much revenue does the farm receive for the typical gallon of milk?
a78 How much additional revenue does the farm receive if it increases
production of milk by 1 gallon?
The last two columns in Table 14-1 answer these questions.
The fourth column in the table shows average revenue,which is total revenue
(from the third column) divided by the amount of output (from the first column).
Average revenue tells us how much revenue a firm receives for the typical unit
sold. In Table 14-1, you can see that average revenue equals $6, the price of a gal-
lon of milk. This illustrates a general lesson that applies not only to competitive
firms but to other firms as well. Total revenue is the price times the quantity
(PH11003Q), and average revenue is total revenue (PH11003 Q) divided by the quantity (Q).
Therefore, for all firms, average revenue equals the price of the good.
The fifth column shows marginal revenue,which is the change in total rev-
enue from the sale of each additional unit of output. In Table 14-1, marginal rev-
enue equals $6, the price of a gallon of milk. This result illustrates a lesson that
applies only to competitive firms. Total revenue is PH11003 Q,and Pis fixed for a com-
petitive firm. Therefore, when Qrises by 1 unit, total revenue rises by Pdollars. For
competitive firms, marginal revenue equals the price of the good.
QUICK QUIZ: When a competitive firm doubles the amount it sells, what
happens to the price of its output and its total revenue?
PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
The goal of a competitive firm is to maximize profit, which equals total revenue
minus total cost. We have just discussed the firm’s revenue, and in the last chapter
we discussed the firm’s costs. We are now ready to examine how the firm maxi-
mizes profit and how that decision leads to its supply curve.
A SIMPLE EXAMPLE OF PROFIT MAXIMIZATION
Let’s begin our analysis of the firm’s supply decision with the example in Table
14-2. In the first column of the table is the number of gallons of milk the Smith
Family Dairy Farm produces. The second column shows the farm’s total revenue,
which is $6 times the number of gallons. The third column shows the farm’s total
cost. Total cost includes fixed costs, which are $3 in this example, and variable
costs, which depend on the quantity produced.
The fourth column shows the farm’s profit, which is computed by subtracting
total cost from total revenue. If the farm produces nothing, it has a loss of $3. If it
produces 1 gallon, it has a profit of $1. If it produces 2 gallons, it has a profit of $4,
and so on. To maximize profit, the Smith Farm chooses the quantity that makes
profit as large as possible. In this example, profit is maximized when the farm pro-
duces 4 or 5 gallons of milk, when the profit is $7.
average revenue
total revenue divided by the quantity
sold
marginal revenue
the change in total revenue from an
additional unit sold
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 295
There is another way to look at the Smith Farm’s decision: The Smiths can find
the profit-maximizing quantity by comparing the marginal revenue and marginal
cost from each unit produced. The last two columns in Table 14-2 compute mar-
ginal revenue and marginal cost from the changes in total revenue and total cost.
The first gallon of milk the farm produces has a marginal revenue of $6 and a mar-
ginal cost of $2; hence, producing that gallon increases profit by $4 (from H11002$3 to
$1). The second gallon produced has a marginal revenue of $6 and a marginal cost
of $3, so that gallon increases profit by $3 (from $1 to $4). As long as marginal rev-
enue exceeds marginal cost, increasing the quantity produced raises profit. Once
the Smith Farm has reached 5 gallons of milk, however, the situation is very dif-
ferent. The sixth gallon would have marginal revenue of $6 and marginal cost of
$7, so producing it would reduce profit by $1 (from $7 to $6). As a result, the
Smiths would not produce beyond 5 gallons.
One of the Ten Principles of Economicsin Chapter 1 is that rational people think
at the margin. We now see how the Smith Family Dairy Farm can apply this prin-
ciple. If marginal revenue is greater than marginal cost—as it is at 1, 2, or 3 gal-
lons—the Smiths should increase the production of milk. If marginal revenue is
less than marginal cost—as it is at 6, 7, or 8 gallons—the Smiths should decrease
production. If the Smiths think at the margin and make incremental adjustments
to the level of production, they are naturally led to produce the profit-maximizing
quantity.
THE MARGINAL-COST CURVE AND THE
FIRM’S SUPPLY DECISION
To extend this analysis of profit maximization, consider the cost curves in Figure
14-1. These cost curves have the three features that, as we discussed in Chapter 13,
are thought to describe most firms: The marginal-cost curve (MC) is upward slop-
ing. The average-total-cost curve (ATC) is U-shaped. And the marginal-cost curve
Table 14-2
QUANTITY TOTAL MARGINAL MARGINAL
(INGALLONS)REVENUE TOTALCOST PROFIT REVENUE COST
(Q)(TR)(TC)(TRH11546TC)(MRH11549 ?TR/?Q)(MCH11549 ?TC/?Q)
0 $0 $3 H11002$3
$6 $2
1651
63
21284
64
318126
65
42477
66
5303
67
63606
68
74284
69
848471
PROFIT MAXIMIZATION: ANUMERICAL EXAMPLE
296 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
crosses the average-total-cost curve at the minimum of average total cost. The fig-
ure also shows a horizontal line at the market price (P). The price line is horizontal
because the firm is a price taker: The price of the firm’s output is the same regard-
less of the quantity that the firm decides to produce. Keep in mind that, for a com-
petitive firm, the firm’s price equals both its average revenue (AR) and its marginal
revenue (MR).
We can use Figure 14-1 to find the quantity of output that maximizes profit.
Imagine that the firm is producing at Q
1
. At this level of output, marginal revenue
is greater than marginal cost. That is, if the firm raised its level of production and
sales by 1 unit, the additional revenue (MR
1
) would exceed the additional costs
(MC
1
). Profit, which equals total revenue minus total cost, would increase. Hence,
if marginal revenue is greater than marginal cost, as it is at Q
1
, the firm can in-
crease profit by increasing production.
Asimilar argument applies when output is at Q
2
. In this case, marginal cost
is greater than marginal revenue. If the firm reduced production by 1 unit, the
costs saved (MC
2
) would exceed the revenue lost (MR
2
). Therefore, if marginal rev-
enue is less than marginal cost, as it is at Q
2
, the firm can increase profit by reduc-
ing production.
Where do these marginal adjustments to level of production end? Regardless
of whether the firm begins with production at a low level (such as Q
1
) or at a high
level (such as Q
2
), the firm will eventually adjust production until the quantity
produced reaches Q
MAX
. This analysis shows a general rule for profit maximiza-
tion: At the profit-maximizing level of output, marginal revenue and marginal cost are ex-
actly equal.
We can now see how the competitive firm decides the quantity of its good
tosupply to the market. Because a competitive firm is a price taker, its marginal
Quantity0
Costs
and
Revenue
MC
ATC
AVC
MC
2
MC
1
Q
1
Q
2
Q
MAX
P = MR
1
= MR
2
P = AR = MR
The firm maximizes
profit by producing
the quantity at which
marginal cost equals
marginal revenue.
Figure 14-1
PROFIT MAXIMIZATION FOR A
COMPETITIVE FIRM. This figure
shows the marginal-cost curve
(MC), the average-total-cost
curve (ATC), and the average-
variable-cost curve (AVC). It also
shows the market price (P),
which equals marginal revenue
(MR) and average revenue (AR).
At the quantity Q
1
, marginal
revenue MR
1
exceeds marginal
cost MC
1
, so raising production
increases profit. At the quantity
Q
2
, marginal cost MC
2
is above
marginal revenue MR
2
, so
reducing production increases
profit. The profit-maximizing
quantity Q
MAX
is found where the
horizontal price line intersects the
marginal-cost curve.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 297
revenue equals the market price. For any given price, the competitive firm’s profit-
maximizing quantity of output is found by looking at the intersection of the price
with the marginal-cost curve. In Figure 14-1, that quantity of output is Q
MAX
.
Figure 14-2 shows how a competitive firm responds to an increase in the price.
When the price is P
1
, the firm produces quantity Q
1
, which is the quantity that
equates marginal cost to the price. When the price rises to P
2
, the firm finds that
marginal revenue is now higher than marginal cost at the previous level of output,
so the firm increases production. The new profit-maximizing quantity is Q
2
, at
which marginal cost equals the new higher price. In essence, because the firm’s
marginal-cost curve determines the quantity of the good the firm is willing to supply at any
price, it is the competitive firm’s supply curve.
THE FIRM’S SHORT-RUN DECISION TO SHUT DOWN
So far we have been analyzing the question of how much a competitive firm will
produce. In some circumstances, however, the firm will decide to shut down and
not produce anything at all.
Here we should distinguish between a temporary shutdown of a firm and the
permanent exit of a firm from the market. Ashutdownrefers to a short-run decision
not to produce anything during a specific period of time because of current mar-
ket conditions. Exitrefers to a long-run decision to leave the market. The short-run
and long-run decisions differ because most firms cannot avoid their fixed costs in
the short run but can do so in the long run. That is, a firm that shuts down tem-
porarily still has to pay its fixed costs, whereas a firm that exits the market saves
both its fixed and its variable costs.
For example, consider the production decision that a farmer faces. The cost of
the land is one of the farmer’s fixed costs. If the farmer decides not to produce any
Quantity0
Price
MC
ATC
AVC
P
2
P
1
Q
1
Q
2
Figure 14-2
MARGINAL COSTAS THE
COMPETITIVE FIRM’S SUPPLY
CURVE. An increase in the price
from P
1
to P
2
leads to an increase
in the firm’s profit-maximizing
quantity from Q
1
to Q
2
. Because
the marginal-cost curve shows
the quantity supplied by the firm
at any given price, it is the firm’s
supply curve.
298 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
crops one season, the land lies fallow, and he cannot recover this cost. When mak-
ing the short-run decision whether to shut down for a season, the fixed cost of land
is said to be a sunk cost.By contrast, if the farmer decides to leave farming alto-
gether, he can sell the land. When making the long-run decision whether to exit the
market, the cost of land is not sunk. (We return to the issue of sunk costs shortly.)
Now let’s consider what determines a firm’s shutdown decision. If the firm
shuts down, it loses all revenue from the sale of its product. At the same time, it
saves the variable costs of making its product (but must still pay the fixed costs).
Thus, the firm shuts down if the revenue that it would get from producing is less than its
variable costs of production.
Asmall bit of mathematics can make this shutdown criterion more useful. If
TRstands for total revenue, and VCstands for variable costs, then the firm’s deci-
sion can be written as
Shut down if TRH11021VC.
The firm shuts down if total revenue is less than variable cost. By dividing both
sides of this inequality by the quantity Q,we can write it as
Shut down if TR/QH11021VC/Q.
Notice that this can be further simplified. TR/Qis total revenue divided by quan-
tity, which is average revenue. As we discussed previously, average revenue for
any firm is simply the good’s price P. Similarly, VC/Qis average variable cost
AVC. Therefore, the firm’s shutdown criterion is
Shut down if PH11021AVC.
That is, a firm chooses to shut down if the price of the good is less than the aver-
age variable cost of production. This criterion is intuitive: When choosing to pro-
duce, the firm compares the price it receives for the typical unit to the average
variable cost that it must incur to produce the typical unit. If the price doesn’t
cover the average variable cost, the firm is better off stopping production alto-
gether. The firm can reopen in the future if conditions change so that price exceeds
average variable cost.
We now have a full description of a competitive firm’s profit-maximizing
strategy. If the firm produces anything, it produces the quantity at which marginal
cost equals the price of the good. Yet if the price is less than average variable cost
at that quantity, the firm is better off shutting down and not producing anything.
These results are illustrated in Figure 14-3. The competitive firm’s short-run supply
curve is the portion of its marginal-cost curve that lies above average variable cost.
SPILT MILK AND OTHER SUNK COSTS
Sometime in your life, you have probably been told, “Don’t cry over spilt milk,” or
“Let bygones be bygones.” These adages hold a deep truth about rational decision-
making. Economists say that a cost is a sunk costwhen it has already been com-
mitted and cannot be recovered. In a sense, a sunk cost is the opposite of an
opportunity cost: An opportunity cost is what you have to give up if you choose to
sunk cost
a cost that has already been
committed and cannot be recovered
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 299
do one thing instead of another, whereas a sunk cost cannot be avoided, regardless
of the choices you make. Because nothing can be done about sunk costs, you can
ignore them when making decisions about various aspects of life, including busi-
ness strategy.
Our analysis of the firm’s shutdown decision is one example of the irrelevance
of sunk costs. We assume that the firm cannot recover its fixed costs by temporar-
ily stopping production. As a result, the firm’s fixed costs are sunk in the short run,
and the firm can safely ignore these costs when deciding how much to produce.
The firm’s short-run supply curve is the part of the marginal-cost curve that lies
above average variable cost, and the size of the fixed cost does not matter for this
supply decision.
The irrelevance of sunk costs explains how real businesses make decisions. In
the early 1990s, for instance, most of the major airlines reported large losses. In one
year, American Airlines, Delta, and USAir each lost more than $400 million. Yet de-
spite the losses, these airlines continued to sell tickets and fly passengers. At first,
this decision might seem surprising: If the airlines were losing money flying
planes, why didn’t the owners of the airlines just shut down their businesses?
To understand this behavior, we must acknowledge that many of the airlines’
costs are sunk in the short run. If an airline has bought a plane and cannot resell it,
then the cost of the plane is sunk. The opportunity cost of a flight includes only the
variable costs of fuel and the wages of pilots and flight attendants. As long as the
total revenue from flying exceeds these variable costs, the airlines should continue
operating. And, in fact, they did.
The irrelevance of sunk costs is also important for personal decisions. Imagine,
for instance, that you place a $10 value on seeing a newly released movie. You buy
a ticket for $7, but before entering the theater, you lose the ticket. Should you buy
another ticket? Or should you now go home and refuse to pay a total of $14 to see
the movie? The answer is that you should buy another ticket. The benefit of seeing
Quantity
MC
ATC
AVC
0
Costs
Firm
shuts
down if
P H11021 AVC
Firm’s short-run
supply curve
Figure 14-3
THE COMPETITIVE FIRM’S SHORT-
RUN SUPPLY CURVE. In the
short run, the competitive firm’s
supply curve is its marginal-cost
curve (MC) above average
variable cost (AVC). If the price
falls below average variable cost,
the firm is better off shutting
down.
300 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
the movie ($10) still exceeds the opportunity cost (the $7 for the second ticket).
The $7 you paid for the lost ticket is a sunk cost. As with spilt milk, there is no
point in crying about it.
CASE STUDY NEAR-EMPTY RESTAURANTS AND
OFF-SEASONMINIATURE GOLF
Have you ever walked into a restaurant for lunch and found it almost empty?
Why, you might have asked, does the restaurant even bother to stay open? It
might seem that the revenue from the few customers could not possibly cover
the cost of running the restaurant.
In making the decision whether to open for lunch, a restaurant owner must
keep in mind the distinction between fixed and variable costs. Many of a restau-
rant’s costs—the rent, kitchen equipment, tables, plates, silverware, and so on—
are fixed. Shutting down during lunch would not reduce these costs. In other
words, these costs are sunk in the short run. When the owner is deciding
whether to serve lunch, only the variable costs—the price of the additional food
and the wages of the extra staff—are relevant. The owner shuts down the
restaurant at lunchtime only if the revenue from the few lunchtime customers
fails to cover the restaurant’s variable costs.
An operator of a miniature-golf course in a summer resort community faces
a similar decision. Because revenue varies substantially from season to season,
the firm must decide when to open and when to close. Once again, the fixed
costs—the costs of buying the land and building the course—are irrelevant. The
miniature-golf course should be open for business only during those times of
year when its revenue exceeds its variable costs.
THE FIRM’S LONG-RUN DECISION TO
EXIT OR ENTER A MARKET
The firm’s long-run decision to exit the market is similar to its shutdown decision.
If the firm exits, it again will lose all revenue from the sale of its product, but now
it saves on both fixed and variable costs of production. Thus, the firm exits the mar-
ket if the revenue it would get from producing is less than its total costs.
We can again make this criterion more useful by writing it mathematically. If
TRstands for total revenue, and TCstands for total cost, then the firm’s criterion
can be written as
Exit if TR H11021TC.
The firm exits if total revenue is less than total cost. By dividing both sides of this
inequality by quantity Q,we can write it as
Exit if TR/Q H11021TC/Q.
We can simplify this further by noting that TR/Qis average revenue, which equals
the price P,and that TC/Qis average total cost ATC.Therefore, the firm’s exit cri-
terion is
STAYING OPEN CAN BE PROFITABLE, EVEN
WITH MANY TABLES EMPTY.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 301
Exit if P H11021ATC.
That is, a firm chooses to exit if the price of the good is less than the average total
cost of production.
Aparallel analysis applies to an entrepreneur who is considering starting a
firm. The firm will enter the market if such an action would be profitable, which
occurs if the price of the good exceeds the average total cost of production. The en-
try criterion is
Enter if PH11022ATC.
The criterion for entry is exactly the opposite of the criterion for exit.
We can now describe a competitive firm’s long-run profit-maximizing strat-
egy. If the firm is in the market, it produces the quantity at which marginal cost
equals the price of the good. Yet if the price is less than average total cost at that
quantity, the firm chooses to exit (or not enter) the market. These results are illus-
trated in Figure 14-4. The competitive firm’s long-run supply curve is the portion of its
marginal cost curve that lies above average total cost.
MEASURING PROFIT IN OUR GRAPH
FOR THE COMPETITIVE FIRM
As we analyze exit and entry, it is useful to be able to analyze the firm’s profit in
more detail. Recall that profit equals total revenue (TR) minus total cost (TC):
Profit H11005TRH11002TC.
Firm
exits
if
P H11021 ATC
Quantity
MC
ATC
0
Costs
Firm’s long-run
supply curve
Figure 14-4
THE COMPETITIVE FIRM’S LONG-
RUN SUPPLY CURVE. In the long
run, the competitive firm’s
supply curve is its marginal-cost
curve (MC) above average total
cost (ATC). If the price falls below
average total cost, the firm is
better off exiting the market.
302 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
We can rewrite this definition by multiplying and dividing the right-hand side
byQ:
Profit H11005(TR/QH11002TC/Q)H11003 Q.
But note that TR/Qis average revenue, which is the price P,and TC/Qis average
total cost ATC.Therefore,
Profit H11005(PH11002ATC)H11003 Q.
This way of expressing the firm’s profit allows us to measure profit in our graphs.
Panel (a) of Figure 14-5 shows a firm earning positive profit. As we have al-
ready discussed, the firm maximizes profit by producing the quantity at which
price equals marginal cost. Now look at the shaded rectangle. The height of the
rectangle is PH11002ATC,the difference between price and average total cost. The
INTHE1990S, MANY COUNTRIES THAT HAD
previously relied on communist theo-
ries of central planning tried to make
the transition to free-market capitalism.
According to this article, Poland suc-
ceeded because it encouraged free en-
try and exit, and Russia failed because
it didn’t.
Russia Is Not Poland,
and That’s Too Bad
BY MICHAEL M. WEINSTEIN
Put aside for a moment the frightening
crash of the ruble and the collapse of
Russia’s stock and bond markets last
week. They are symptoms of something
larger—a deformed economy in which
the Government sets business taxes
that few firms ever pay, enterprises
promise wages that employees never
see, loans go unpaid, people barter with
pots, pans and socks, and shady dealing
runs rampant.
It didn’t have to be this way. The
Russians need only look to Poland to be-
hold the better road untraveled. Poland
too began the decade saddled with pal-
try living standards bequeathed by a
sclerotic, centrally controlled economy
run by discredited Communists. It
reached out to the West for help creat-
ing monetary, budget, trade and legal
regimes, and unlike Russia it followed
through with sustained political will. It
now ranks among Europe’s fastest-
growing economies.
Key to Poland’s steady suc-
cess have been two policy decisions,
and discussing them helps to illuminate
by contrast what is going wrong with
Russia.
First, Poland adopted what might be
called the Balcerowicz rule, named after
Leszek Balcerowicz, the Finance Minis-
ter who masterminded Poland’s market
reforms. Mr. Balcerowicz invited thou-
sands of would-be entrepreneurs to sell,
within loose limits, anything they wanted
anywhere they wanted at whatever
price they wanted. Economists called
this liberalization. The Poles called it
competition.
The Balcerowicz rule helped break
the chokehold of Communist-dominated,
state-owned enterprises and Govern-
ment bureaucracies over economic ac-
tivity. Also, encouraging small start-ups
denies organized crime opportunities for
large prey.
When Poland broke away from
communism, Western economists had
wrung their hands trying to figure out
what to do with its sprawling state-
owned factories, which operated more
like social welfare agencies than produc-
tion units. The solution, it turned out,
was benign neglect. Rather than convert
factories, the Poles allowed them to
IN THE NEWS
Entry and Exit in
TransitionEconomies
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 303
width of the rectangle is Q,the quantity produced. Therefore, the area of the rec-
tangle is (PH11002ATC)H11003 Q,which is the firm’s profit.
Similarly, panel (b) of this figure shows a firm with losses (negative profit). In
this case, maximizing profit means minimizing losses, a task accomplished once
again by producing the quantity at which price equals marginal cost. Now con-
sider the shaded rectangle. The height of the rectangle is ATCH11002P, and the width
is Q.The area is (ATCH11002P)H11003 Q,which is the firm’s loss. Because a firm in this sit-
uation is not making enough revenue to cover its average total cost, the firm
would choose to exit the market.
QUICK QUIZ: How does the price faced by a profit-maximizing
competitive firm compare to its marginal cost? Explain. a78 When does a
profit-maximizing competitive firm decide to shut down?
shrivel. Workers peeled away to set up
retail shops and other small enterprises
largely free of Government interference.
The second major decision was
scarier. Poland forced insolvent firms
into bankruptcy, preventing them from
draining resources from productive parts
of the economy. That also ended a drain
on the Federal budget by firms that had
to be propped up by one disguised sub-
sidy or another.
There were moments when the
post-Communist Government in Russia
appeared headed in the same direction.
In early 1992, the Yeltsin Government
embraced the Balcerowicz rule. Rus-
sians were invited to take to the streets
and set up kiosks and curbside tables,
selling whatever they wanted at what-
ever price consumers would pay. But
then Communist antibodies, in the form
of the oligarchs who controlled the state-
owned factories and natural resources,
were activated. They detected foreign
tissue and attacked. Local government
buried the Balcerowicz rule, imposing li-
censing and other requirements and
eventually strangling start-ups. Professor
Marshall Goldman of Harvard points to
revealing comments by Viktor S. Cher-
nomyrdin, the off-again, on-again Prime
Minister whom President Boris N.
Yeltsin restored to his post last week.
Mr. Chernomyrdin observed that street
vendors were an unattractive, chaotic
blight on a proud country. The Russian
authorities cracked down.
The impact was severe. Anders
Aslund, a former adviser to the Russian
Government now at the Carnegie En-
dowment for International Peace, esti-
mates that since the middle of 1994, the
number of enterprises in Russia has
stagnated. In a typical Western econ-
omy, he estimates, there is 1 business
for every 10 residents. In Russia, the
ratio is 1 for every 55.
By snuffing out start-ups, Russia
lost the remarkable device by which
Poland drained workers out of worthless
factories into units that could produce
the goods that people wanted to buy.
Russia not only stifles start-ups; it
also props up incompetents. It tolerates
businesses that cannot pay taxes or
wages. They survive because of sys-
tems of barter and mutual forbearance of
loans and taxes. Suppliers engage in
round-robin lending by which everyone
owes money to someone and no one
ever pays up. That too throws a lifeline
to insolvent firms.
Russian factories continue to churn
out steel and other products that no one
needs. One measure of the deformity is
that Russia is littered with factories em-
ploying 10,000 or more workers. In the
United States, such factories are a rarity.
The effect is to keep alive concerns that
chew up $1.50 worth of resources in or-
der to turn out a product that is worth
only $1 to consumers. Economists call
this “negative value added.” Ordinary
folk call it economic suicide.
SOURCE:The New York Times,August 30, 1998,
Week in Review, p. 5.
304 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
THE SUPPLY CURVE IN A COMPETITIVE MARKET
Now that we have examined the supply decision of a single firm, we can discuss
the supply curve for a market. There are two cases to consider. First, we examine a
market with a fixed number of firms. Second, we examine a market in which the
number of firms can change as old firms exit the market and new firms enter. Both
cases are important, for each applies over a specific time horizon. Over short peri-
ods of time, it is often difficult for firms to enter and exit, so the assumption of a
fixed number of firms is appropriate. But over long periods of time, the number of
firms can adjust to changing market conditions.
THE SHORT RUN: MARKET SUPPLY WITH
A FIXED NUMBER OF FIRMS
Consider first a market with 1,000 identical firms. For any given price, each firm
supplies a quantity of output so that its marginal cost equals the price, as shown in
panel (a) of Figure 14-6. That is, as long as price is above average variable cost,
each firm’s marginal-cost curve is its supply curve. The quantity of output sup-
plied to the market equals the sum of the quantities supplied by each of the 1,000
individual firms. Thus, to derive the market supply curve, we add the quantity
supplied by each firm in the market. As panel (b) of Figure 14-6 shows, because the
(a) A Firm with Profits (b) A Firm with Losses
Quantity0
Price
Quantity0
Price
P = AR = MR
Profit
ATCMC
P
ATC
ATC
Q
(profit-maximizing quantity)
P = AR = MR
Loss
ATCMC
Q
(loss-minimizing quantity)
P
Figure 14-5
PROFITAS THE AREA BETWEEN PRICE AND AVERAGE TOTALCOST. The area of the
shaded box between price and average total cost represents the firm’s profit. The height of
this box is price minus average total cost (PH11002ATC), and the width of the box is the
quantity of output (Q). In panel (a), price is above average total cost, so the firm has
positive profit. In panel (b), price is less than average total cost, so the firm has losses.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 305
firms are identical, the quantity supplied to the market is 1,000 times the quantity
supplied by each firm.
THE LONG RUN: MARKET SUPPLY WITH ENTRY AND EXIT
Now consider what happens if firms are able to enter or exit the market. Let’s sup-
pose that everyone has access to the same technology for producing the good and
access to the same markets to buy the inputs into production. Therefore, all firms
and all potential firms have the same cost curves.
Decisions about entry and exit in a market of this type depend on the incen-
tives facing the owners of existing firms and the entrepreneurs who could start
new firms. If firms already in the market are profitable, then new firms will have
an incentive to enter the market. This entry will expand the number of firms, in-
crease the quantity of the good supplied, and drive down prices and profits. Con-
versely, if firms in the market are making losses, then some existing firms will exit
the market. Their exit will reduce the number of firms, decrease the quantity of the
good supplied, and drive up prices and profits. At the end of this process of entry and
exit, firms that remain in the market must be making zero economic profit.Recall that we
can write a firm’s profits as
Profit H11005(PH11002ATC)H11003 Q.
This equation shows that an operating firm has zero profit if and only if the price
of the good equals the average total cost of producing that good. If price is above
average total cost, profit is positive, which encourages new firms to enter. If price
(a) Individual Firm Supply
Quantity (firm)0
Price
MC
$2.00
1.00
100 200
(b) Market Supply
Quantity (market)0
Price
Supply
$2.00
1.00
100,000 200,000
Figure 14-6
MARKET SUPPLY WITH AFIXED NUMBER OF FIRMS. When the number of firms in the
market is fixed, the market supply curve, shown in panel (b), reflects the individual firms’
marginal-cost curves, shown in panel (a). Here, in a market of 1,000 firms, the quantity of
output supplied to the market is 1,000 times the quantity supplied by each firm.
306 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
is less than average total cost, profit is negative, which encourages some firms to
exit. The process of entry and exit ends only when price and average total cost are driven
to equality.
This analysis has a surprising implication. We noted earlier in the chapter that
competitive firms produce so that price equals marginal cost. We just noted that
free entry and exit forces price to equal average total cost. But if price is to equal
both marginal cost and average total cost, these two measures of cost must equal
each other. Marginal cost and average total cost are equal, however, only when the
firm is operating at the minimum of average total cost. Therefore, the long-run equi-
librium of a competitive market with free entry and exit must have firms operating at their
efficient scale.
Panel (a) of Figure 14-7 shows a firm in such a long-run equilibrium. In this
figure, price Pequals marginal cost MC,so the firm is profit-maximizing. Price
also equals average total cost ATC,so profits are zero. New firms have no incentive
to enter the market, and existing firms have no incentive to leave the market.
From this analysis of firm behavior, we can determine the long-run supply
curve for the market. In a market with free entry and exit, there is only one price
consistent with zero profit—the minimum of average total cost. As a result, the
long-run market supply curve must be horizontal at this price, as in panel (b) of
Figure 14-7. Any price above this level would generate profit, leading to entry and
an increase in the total quantity supplied. Any price below this level would gener-
ate losses, leading to exit and a decrease in the total quantity supplied. Eventually,
the number of firms in the market adjusts so that price equals the minimum of
(a) Firm’s Zero-Profit Condition
Quantity (firm)0
Price
P = minimum
ATC
(b) Market Supply
Quantity (market)
Price
0
Supply
MC
ATC
Figure 14-7
MARKET SUPPLY WITH ENTRY AND EXIT. Firms will enter or exit the market until profit is
driven to zero. Thus, in the long run, price equals the minimum of average total cost,
asshown in panel (a). The number of firms adjusts to ensure that all demand is satisfied
atthis price. The long-run market supply curve is horizontal at this price, as shown in
panel (b).
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 307
average total cost, and there are enough firms to satisfy all the demand at this
price.
WHY DO COMPETITIVE FIRMS STAY IN BUSINESS
IF THEY MAKE ZERO PROFIT?
At first, it might seem odd that competitive firms earn zero profit in the long run.
After all, people start businesses to make a profit. If entry eventually drives profit
to zero, there might seem to be little reason to stay in business.
To understand the zero-profit condition more fully, recall that profit equals to-
tal revenue minus total cost, and that total cost includes all the opportunity costs
of the firm. In particular, total cost includes the opportunity cost of the time and
money that the firm owners devote to the business. In the zero-profit equilibrium,
the firm’s revenue must compensate the owners for the time and money that they
expend to keep their business going.
Consider an example. Suppose that a farmer had to invest $1 million to open
his farm, which otherwise he could have deposited in a bank to earn $50,000 a year
in interest. In addition, he had to give up another job that would have paid him
$30,000 a year. Then the farmer’s opportunity cost of farming includes both the in-
terest he could have earned and the forgone wages—a total of $80,000. Even if his
profit is driven to zero, his revenue from farming compensates him for these op-
portunity costs.
Keep in mind that accountants and economists measure costs differently. As
we discussed in Chapter 13, accountants keep track of explicit costs but usually
miss implicit costs. That is, they measure costs that require an outflow of money
from the firm, but they fail to include opportunity costs of production that do not
involve an outflow of money. As a result, in the zero-profit equilibrium, economic
profit is zero, but accounting profit is positive. Our farmer’s accountant, for in-
stance, would conclude that the farmer earned an accounting profit of $80,000,
which is enough to keep the farmer in business.
“We’re a nonprofit organization—we don’t intend to be, but we are!”
308 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
A SHIFT IN DEMAND IN THE SHORT RUN AND LONG RUN
Because firms can enter and exit a market in the long run but not in the short run,
the response of a market to a change in demand depends on the time horizon. To
see this, let’s trace the effects of a shift in demand. This analysis will show how a
market responds over time, and it will show how entry and exit drive a market to
its long-run equilibrium.
Suppose the market for milk begins in long-run equilibrium. Firms are earn-
ing zero profit, so price equals the minimum of average total cost. Panel (a) of Fig-
ure 14-8 shows the situation. The long-run equilibrium is point A, the quantity
sold in the market is Q
1
, and the price is P
1
.
Now suppose scientists discover that milk has miraculous health benefits. As
a result, the demand curve for milk shifts outward from D
1
to D
2
, as in panel (b).
The short-run equilibrium moves from point Ato point B; as a result, the quantity
rises from Q
1
to Q
2
, and the price rises from P
1
to P
2
. All of the existing firms re-
spond to the higher price by raising the amount produced. Because each firm’s
supply curve reflects its marginal-cost curve, how much they each increase pro-
duction is determined by the marginal-cost curve. In the new, short-run equilib-
rium, the price of milk exceeds average total cost, so the firms are making positive
profit.
Over time, the profit in this market encourages new firms to enter. Some farm-
ers may switch to milk from other farm products, for example. As the number of
firms grows, the short-run supply curve shifts to the right from S
1
to S
2
, as in panel
(c), and this shift causes the price of milk to fall. Eventually, the price is driven back
down to the minimum of average total cost, profits are zero, and firms stop enter-
ing. Thus, the market reaches a new long-run equilibrium, point C. The price of
milk has returned to P
1
, but the quantity produced has risen to Q
3
. Each firm is
again producing at its efficient scale, but because more firms are in the dairy busi-
ness, the quantity of milk produced and sold is higher.
WHY THE LONG-RUN SUPPLY CURVE
MIGHT SLOPE UPWARD
So far we have seen that entry and exit can cause the long-run market supply
curve to be horizontal. The essence of our analysis is that there are a large number
of potential entrants, each of which faces the same costs. As a result, the long-run
market supply curve is horizontal at the minimum of average total cost. When the
demand for the good increases, the long-run result is an increase in the number of
firms and in the total quantity supplied, without any change in the price.
There are, however, two reasons that the long-run market supply curve might
slope upward. The first is that some resource used in production may be available
only in limited quantities. For example, consider the market for farm products.
Anyone can choose to buy land and start a farm, but the quantity of land is lim-
ited. As more people become farmers, the price of farmland is bid up, which raises
the costs of all farmers in the market. Thus, an increase in demand for farm prod-
ucts cannot induce an increase in quantity supplied without also inducing a rise in
farmers’ costs, which in turn means a rise in price. The result is a long-run market
supply curve that is upward sloping, even with free entry into farming.
Asecond reason for an upward-sloping supply curve is that firms may have
different costs. For example, consider the market for painters. Anyone can enter
Firm
(a) Initial Condition
Quantity (firm)0
Price
Market
Market
Quantity (market)
Long-run
supply
Price
0
Demand, D
1
Short-run supply, S
1
Firm
(b) Short-Run Response
Quantity (firm)0
Price
P
1
P
MC
ATC
MC
ATC
P
1
Profit
P
1
P
1
P
2
Firm
(c) Long-Run Response
Quantity (firm)0
Price
MC
ATC
A
Quantity (market)
Long-run
supply
Price
0
D
1
D
2
P
1
Q
1
Q
1
Q
2
P
2
A
B
Market
Quantity (market)
Price
0
P
1
P
2
Q
1
Q
2
Long-run
supply
Q
3
C
B
D
1
D
2
S
1
S
1
A
S
2
Figure 14-8
AN INCREASE IN DEMAND IN THE SHORT RUN AND LONG RUN. The market starts in a
long-run equilibrium, shown as point Ain panel (a). In this equilibrium, each firm makes
zero profit, and the price equals the minimum average total cost. Panel (b) shows what
happens in the short run when demand rises from D
1
to D
2
. The equilibrium goes from
point Ato point B, price rises from P
1
to P
2
, and the quantity sold in the market rises from
Q
1
to Q
2
. Because price now exceeds average total cost, firms make profits, which over
time encourage new firms to enter the market. This entry shifts the short-run supply curve
to the right from S
1
to S
2
, as shown in panel (c). In the new long-run equilibrium, point C,
price has returned to P
1
but the quantity sold has increased to Q
3
. Profits are again zero,
price is back to the minimum of average total cost, but the market has more firms to
satisfy the greater demand.
310 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
the market for painting services, but not everyone has the same costs. Costs vary
in part because some people work faster than others and in part because some
people have better alternative uses of their time than others. For any given price,
those with lower costs are more likely to enter than those with higher costs. To in-
crease the quantity of painting services supplied, additional entrants must be en-
couraged to enter the market. Because these new entrants have higher costs, the
price must rise to make entry profitable for them. Thus, the market supply curve
for painting services slopes upward even with free entry into the market.
Notice that if firms have different costs, some firms earn profit even in the long
run. In this case, the price in the market reflects the average total cost of the mar-
ginal firm—the firm that would exit the market if the price were any lower. This
firm earns zero profit, but firms with lower costs earn positive profit. Entry does
not eliminate this profit because would-be entrants have higher costs than firms al-
ready in the market. Higher-cost firms will enter only if the price rises, making the
market profitable for them.
IN COMPETITIVE MARKETS, STRONG DE-
mand leads to high prices and high
profits, which then lead to increased
entry, falling prices, and falling profits.
To economists, these market forces
areone reflection of the invisible hand
at work. To the business managers,
however, new entry and falling
profits can seem like a “problem of
overinvestment.”
In Some Industries, Executives
Foresee Tough Times Ahead;
A Key Culprit: High Profits
BY BERNARD WYSOCKI, JR.
MONTEREY, CALIF.—About 20 execu-
tives are huddled in a conference room
with a team of management consultants,
and the mood is surprisingly somber.
It’s a fine summer day, the stock
market is booming, the U.S. economy is
in great shape, and some of the com-
panies represented here are posting
stronger-than-expected profits. Best of
all, perhaps, these lucky executives are
just a chip shot away from the famed
Pebble Beach golf course. They ought to
be euphoric.
Instead, an undertone of concern is
evident among these executives from
Mobil Corp., Union Carbide Corp. and
other capital-intensive companies. In be-
tween golf, fine meals and cigars, they
hear a sobering message from their
hosts.
“I feel like the prophet of doom” is
the welcoming line of R. Duane Dickson,
a director of Mercer Management Con-
sulting and host of the meeting. “It’s our
belief that the downturn has started. I
can’t tell you how far it’s going to go. But
it could be a very ugly one.”
For two days, the executives and
their advisers discuss what they expect
in their industries between now and
2000: growing overcapacity, world-wide
product gluts, price wars, shakeouts,
and consolidations. . . .
One man who attended the Pebble
Beach meeting, Joseph Soviero, a Union
Carbide vice president, cites an odd but
basic problem in chemicals: the strong
profits of the past few years. “The prof-
itability that the industry sees during the
good times has always led to overinvest-
ing, and it has this time,” Mr. Soviero
says. He adds that the chemicals busi-
ness cycle is alive and has peaked. At
Union Carbide, he says, “we always talk
about the cycle” and try to manage it.
So far, demand isn’t a big problem.
In many industries, it is still growing
steadily, though slowly. What is develop-
ing is too much supply, stemming from
the recurring problem of overinvestment.
. . . The next few years will bring fierce
competition and falling prices.
SOURCE:The Wall Street Journal,August 7, 1997,
p.A1.
IN THE NEWS
Entry or Overinvestment?
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 311
Thus, for these two reasons, the long-run supply curve in a market may be up-
ward sloping rather than horizontal, indicating that a higher price is necessary to
induce a larger quantity supplied. Nonetheless, the basic lesson about entry and
exit remains true. Because firms can enter and exit more easily in the long run than in the
short run, the long-run supply curve is typically more elastic than the short-run supply
curve.
QUICK QUIZ: In the long run with free entry and exit, is the price in a
market equal to marginal cost, average total cost, both, or neither? Explain
with a diagram.
CONCLUSION: BEHIND THE SUPPLY CURVE
We have been discussing the behavior of competitive profit-maximizing firms. You
may recall from Chapter 1 that one of the Ten Principles of Economicsis that rational
people think at the margin. This chapter has applied this idea to the competitive
firm. Marginal analysis has given us a theory of the supply curve in a competitive
market and, as a result, a deeper understanding of market outcomes.
We have learned that when you buy a good from a firm in a competitive mar-
ket, you can be assured that the price you pay is close to the cost of producing that
good. In particular, if firms are competitive and profit-maximizing, the price of a
good equals the marginal cost of making that good. In addition, if firms can freely
enter and exit the market, the price also equals the lowest possible average total
cost of production.
Although we have assumed throughout this chapter that firms are price tak-
ers, many of the tools developed here are also useful for studying firms in less
competitive markets. In the next three chapters we will examine the behavior of
firms with market power. Marginal analysis will again be useful in analyzing these
firms, but it will have quite different implications.
a78 Because a competitive firm is a price taker, its revenue is
proportional to the amount of output it produces. The
price of the good equals both the firm’s average revenue
and its marginal revenue.
a78 To maximize profit, a firm chooses a quantity of output
such that marginal revenue equals marginal cost.
Because marginal revenue for a competitive firm equals
the market price, the firm chooses quantity so that price
equals marginal cost. Thus, the firm’s marginal cost
curve is its supply curve.
a78 In the short run when a firm cannot recover its fixed
costs, the firm will choose to shut down temporarily if
the price of the good is less than average variable cost.
In the long run when the firm can recover both fixed
and variable costs, it will choose to exit if the price is
less than average total cost.
a78 In a market with free entry and exit, profits are driven to
zero in the long run. In this long-run equilibrium, all
firms produce at the efficient scale, price equals the
minimum of average total cost, and the number of firms
adjusts to satisfy the quantity demanded at this price.
a78 Changes in demand have different effects over different
time horizons. In the short run, an increase in demand
raises prices and leads to profits, and a decrease in
Summary
312 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
demand lowers prices and leads to losses. But if firms
can freely enter and exit the market, then in the long run
the number of firms adjusts to drive the market back to
the zero-profit equilibrium.
competitive market, p. 292
average revenue, p. 294
marginal revenue, p. 294 sunk cost, p. 298
Key Concepts
1. What is meant by a competitive firm?
2. Draw the cost curves for a typical firm. For a given
price, explain how the firm chooses the level of output
that maximizes profit.
3. Under what conditions will a firm shut down
temporarily? Explain.
4. Under what conditions will a firm exit a market?
Explain.
5. Does a firm’s price equal marginal cost in the short run,
in the long run, or both? Explain.
6. Does a firm’s price equal the minimum of average total
cost in the short run, in the long run, or both? Explain.
7. Are market supply curves typically more elastic in the
short run or in the long run? Explain.
Questions for Review
1. What are the characteristics of a competitive market?
Which of the following drinks do you think is best
described by these characteristics? Why aren’t the
others?
a. tap water
b. bottled water
c. cola
d. beer
2. Your roommate’s long hours in Chem lab finally paid
off—she discovered a secret formula that lets people do
an hour’s worth of studying in 5 minutes. So far, she’s
sold 200 doses, and faces the following average-total-
cost schedule:
Q AVERAGETOTALCOST
199 $199
200 200
201 201
If a new customer offers to pay your roommate $300 for
one dose, should she make one more? Explain.
3. The licorice industry is competitive. Each firm produces
2 million strings of licorice per year. The strings have an
average total cost of $0.20 each, and they sell for $0.30.
a. What is the marginal cost of a string?
b. Is this industry in long-run equilibrium? Why or
why not?
4. You go out to the best restaurant in town and order a
lobster dinner for $40. After eating half of the lobster,
you realize that you are quite full. Your date wants you
to finish your dinner, because you can’t take it home
and because “you’ve already paid for it.” What should
you do? Relate your answer to the material in this
chapter.
5. Bob’s lawn-mowing service is a profit-maximizing,
competitive firm. Bob mows lawns for $27 each. His
total cost each day is $280, of which $30 is a fixed cost.
He mows 10 lawns a day. What can you say about Bob’s
short-run decision regarding shut down and his long-
run decision regarding exit?
6. Consider total cost and total revenue given in the table
below:
QUANTITY
012 3 4 5 6 7
Total cost $8 $9 $10 $11 $13 $19 $27 $37
Total revenue 0 8 16 24 32 40 48 56
a. Calculate profit for each quantity. How much
should the firm produce to maximize profit?
Problems and Applications
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 313
b. Calculate marginal revenue and marginal cost for
each quantity. Graph them. (Hint: Put the points
between whole numbers. For example, the marginal
cost between 2 and 3 should be graphed at 2 1/2.)
At what quantity do these curves cross? How does
this relate to your answer to part (a)?
c. Can you tell whether this firm is in a competitive
industry? If so, can you tell whether the industry is
in a long-run equilibrium?
7. From The Wall Street Journal(July 23, 1991): “Since
peaking in 1976, per capita beef consumption in the
United States has fallen by 28.6 percent . . . [and] the size
of the U.S. cattle herd has shrunk to a 30-year low.”
a. Using firm and industry diagrams, show the short-
run effect of declining demand for beef. Label the
diagram carefully and write out in words all of the
changes you can identify.
b. On a new diagram, show the long-run effect of
declining demand for beef. Explain in words.
8. “High prices traditionally cause expansion in an
industry, eventually bringing an end to high prices and
manufacturers’ prosperity.” Explain, using appropriate
diagrams.
9. Suppose the book-printing industry is competitive and
begins in a long-run equilibrium.
a. Draw a diagram describing the typical firm in the
industry.
b. Hi-Tech Printing Company invents a new process
that sharply reduces the cost of printing books.
What happens to Hi-Tech’s profits and the price of
books in the short run when Hi-Tech’s patent
prevents other firms from using the new
technology?
c. What happens in the long run when the patent
expires and other firms are free to use the
technology?
10. Many small boats are made of fiberglass, which is
derived from crude oil. Suppose that the price of oil
rises.
a. Using diagrams, show what happens to the cost
curves of an individual boat-making firm and to the
market supply curve.
b. What happens to the profits of boat makers in the
short run? What happens to the number of boat
makers in the long run?
11. Suppose that the U.S. textile industry is competitive,
and there is no international trade in textiles. In long-
run equilibrium, the price per unit of cloth is $30.
a. Describe the equilibrium using graphs for the entire
market and for an individual producer.
Now suppose that textile producers in other countries
are willing to sell large quantities of cloth in the United
States for only $25 per unit.
b. Assuming that U.S. textile producers have large
fixed costs, what is the short-run effect of these
imports on the quantity produced by an individual
producer? What is the short-run effect on profits?
Illustrate your answer with a graph.
c. What is the long-run effect on the number of U.S.
firms in the industry?
12. Suppose there are 1,000 hot pretzel stands operating in
New York City. Each stand has the usual U-shaped
average-total-cost curve. The market demand curve for
pretzels slopes downward, and the market for pretzels
is in long-run competitive equilibrium.
a. Draw the current equilibrium, using graphs for the
entire market and for an individual pretzel stand.
b. Now the city decides to restrict the number of
pretzel-stand licenses, reducing the number of
stands to only 800. What effect will this action have
on the market and on an individual stand that is
still operating? Use graphs to illustrate your
answer.
c. Suppose that the city decides to charge a license fee
for the 800 licenses. How will this affect the number
of pretzels sold by an individual stand, and the
stand’s profit? The city wants to raise as much
revenue as possible and also wants to ensure that
800 pretzel stands remain in the city. By how much
should the city increase the license fee? Show the
answer on your graph.
13. Assume that the gold-mining industry is competitive.
a. Illustrate a long-run equilibrium using diagrams for
the gold market and for a representative gold mine.
b. Suppose that an increase in jewelry demand
induces a surge in the demand for gold. Using your
diagrams, show what happens in the short run to
the gold market and to each existing gold mine.
c. If the demand for gold remains high, what would
happen to the price over time? Specifically, would
the new long-run equilibrium price be above,
below, or equal to the short-run equilibrium price in
part (b)? Is it possible for the new long-run
equilibrium price to be above the original long-run
equilibrium price? Explain.
14. (This problem is challenging.) The New York Times
(July1, 1994) reported on a Clinton administration
proposal to lift the ban on exporting oil from the
NorthSlope of Alaska. According to the article, the
administration said that “the chief effect of the ban has
314 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
been to provide California refiners with crude oil
cheaper than oil on the world market. . . . The ban
created a subsidy for California refiners that had not
been passed on to consumers.” Let’s use our analysis of
firm behavior to analyze these claims.
a. Draw the cost curves for a California refiner and for
a refiner in another part of the world. Assume that
the California refiners have access to inexpensive
Alaskan crude oil and that other refiners must buy
more expensive crude oil from the Middle East.
b. All of the refiners produce gasoline for the world
gasoline market, which has a single price. In the
long-run equilibrium, will this price depend on the
costs faced by California producers or the costs
faced by other producers? Explain. (Hint: California
cannot itself supply the entire world market.) Draw
new graphs that illustrate the profits earned by a
California refiner and another refiner.
c. In this model, is there a subsidy to California
refiners? Is it passed on to consumers?
315
IN THIS CHAPTER
YOU WILL . . .
See why monopolies
try to charge
different prices to
different customers
See how the
monopoly’s
decisions affect
economic well-being
Learn why some
markets have only
one seller
Analyze how a
monopoly
determines the
quantity to produce
and the price to
charge
Consider the
various public
policies aimed at
solving the problem
of monopoly
If you own a personal computer, it probably uses some version of Windows, the
operating system sold by the Microsoft Corporation. When Microsoft first de-
signed Windows many years ago, it applied for and received a copyright from the
government. The copyright gives Microsoft the exclusive right to make and sell
copies of the Windows operating system. So if a person wants to buy a copy of
Windows, he or she has little choice but to give Microsoft the approximately $50
that the firm has decided to charge for its product. Microsoft is said to have a mo-
nopoly in the market for Windows.
Microsoft’s business decisions are not well described by the model of firm
behavior we developed in Chapter 14. In that chapter, we analyzed competitive mar-
kets, in which there are many firms offering essentially identical products, so each
firm has little influence over the price it receives. By contrast, a monopoly such as
Microsoft has no close competitors and, therefore, can influence the market price of
its product. While a competitive firm is a price taker, a monopoly firm is a price maker.
MONOPOLY
316 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
In this chapter we examine the implications of this market power. We will see
that market power alters the relationship between a firm’s price and its costs. A
competitive firm takes the price of its output as given by the market and then
chooses the quantity it will supply so that price equals marginal cost. By contrast,
the price charged by a monopoly exceeds marginal cost. This result is clearly true
in the case of Microsoft’s Windows. The marginal cost of Windows—the extra cost
that Microsoft would incur by printing one more copy of the program onto some
floppy disks or a CD—is only a few dollars. The market price of Windows is many
times marginal cost.
It is perhaps not surprising that monopolies charge high prices for their prod-
ucts. Customers of monopolies might seem to have little choice but to pay what-
ever the monopoly charges. But, if so, why does a copy of Windows not cost $500?
Or $5,000? The reason, of course, is that if Microsoft set the price that high, fewer
people would buy the product. People would buy fewer computers, switch to
other operating systems, or make illegal copies. Monopolies cannot achieve any
level of profit they want, because high prices reduce the amount that their cus-
tomers buy. Although monopolies can control the prices of their goods, their prof-
its are not unlimited.
As we examine the production and pricing decisions of monopolies, we also
consider the implications of monopoly for society as a whole. Monopoly firms, like
competitive firms, aim to maximize profit. But this goal has very different ramifi-
cations for competitive and monopoly firms. As we first saw in Chapter 7, self-
interested buyers and sellers in competitive markets are unwittingly led by an
invisible hand to promote general economic well-being. By contrast, because
monopoly firms are unchecked by competition, the outcome in a market with a
monopoly is often not in the best interest of society.
One of the Ten Principles of Economics in Chapter 1 is that governments can
sometimes improve market outcomes. The analysis in this chapter will shed more
light on this principle. As we examine the problems that monopolies raise for so-
ciety, we will also discuss the various ways in which government policymakers
might respond to these problems. The U.S. government, for example, keeps a close
eye on Microsoft’s business decisions. In 1994, it prevented Microsoft from buying
Intuit, a software firm that sells the leading program for personal finance, on the
grounds that the combination of Microsoft and Intuit would concentrate too much
market power in one firm. Similarly, in 1998, the U.S. Justice Department objected
when Microsoft started integrating its Internet browser into its Windows operat-
ing system, claiming that this would impede competition from other companies,
such as Netscape. This concern led the Justice Department to file suit against
Microsoft, the final resolution of which was still unsettled as this book was going
to press.
WHY MONOPOLIES ARISE
Afirm is a monopoly if it is the sole seller of its product and if its product does not
have close substitutes. The fundamental cause of monopoly is barriers to entry:Amo-
nopoly remains the only seller in its market because other firms cannot enter
themarket and compete with it. Barriers to entry, in turn, have three main sources:
monopoly
a firm that is the sole seller of a
product without close substitutes
CHAPTER 15 MONOPOLY 317
CASE STUDY THE DEBEERS DIAMOND MONOPOLY
Aclassic example of a monopoly that arises from the ownership of a key re-
source is DeBeers, the South African diamond company. DeBeers controls about
80 percent of the world’s production of diamonds. Although the firm’s share of
the market is not 100 percent, it is large enough to exert substantial influence
over the market price of diamonds.
How much market power does DeBeers have? The answer depends in part
on whether there are close substitutes for its product. If people view emeralds,
rubies, and sapphires as good substitutes for diamonds, then DeBeers has rela-
tively little market power. In this case, any attempt by DeBeers to raise the price
of diamonds would cause people to switch to other gemstones. But if people
view these other stones as very different from diamonds, then DeBeers can ex-
ert substantial influence over the price of its product.
DeBeers pays for large amounts of advertising. At first, this decision might
seem surprising. If a monopoly is the sole seller of its product, why does it need
to advertise? One goal of the DeBeers ads is to differentiate diamonds from other
gems in the minds of consumers. When their slogan tells you that “a diamond
isforever,” you are meant to think that the same is not true of emeralds, rubies,
and sapphires. (And notice that the slogan is applied to all diamonds, not just
DeBeers diamonds—a sign of DeBeers’s monopoly position.) If the ads are
a78 Akey resource is owned by a single firm.
a78 The government gives a single firm the exclusive right to produce some
good or service.
a78 The costs of production make a single producer more efficient than a large
number of producers.
Let’s briefly discuss each of these.
MONOPOLY RESOURCES
The simplest way for a monopoly to arise is for a single firm to own a key resource.
For example, consider the market for water in a small town in the Old West. If
dozens of town residents have working wells, the competitive model discussed in
Chapter 14 describes the behavior of sellers. As a result, the price of a gallon of wa-
ter is driven to equal the marginal cost of pumping an extra gallon. But if there is
only one well in town and it is impossible to get water from anywhere else, then
the owner of the well has a monopoly on water. Not surprisingly, the monopolist
has much greater market power than any single firm in a competitive market. In
the case of a necessity like water, the monopolist could command quite a high
price, even if the marginal cost is low.
Although exclusive ownership of a key resource is a potential cause of mo-
nopoly, in practice monopolies rarely arise for this reason. Actual economies are
large, and resources are owned by many people. Indeed, because many goods are
traded internationally, the natural scope of their markets is often worldwide. There
are, therefore, few examples of firms that own a resource for which there are no
close substitutes.
“Rather than a monopoly, we like
to consider ourselves ‘the only
game in town.’”
318 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
successful, consumers will view diamonds as unique, rather than as one among
many gemstones, and this perception will give DeBeers greater market power.
GOVERNMENT-CREATED MONOPOLIES
In many cases, monopolies arise because the government has given one person or
firm the exclusive right to sell some good or service. Sometimes the monopoly
arises from the sheer political clout of the would-be monopolist. Kings, for exam-
ple, once granted exclusive business licenses to their friends and allies. At other
times, the government grants a monopoly because doing so is viewed to be in the
public interest. For instance, the U.S. government has given a monopoly to a com-
pany called Network Solutions, Inc., which maintains the database of all .com,
.net, and .org Internet addresses, on the grounds that such data need to be central-
ized and comprehensive.
The patent and copyright laws are two important examples of how the gov-
ernment creates a monopoly to serve the public interest. When a pharmaceutical
company discovers a new drug, it can apply to the government for a patent. If the
government deems the drug to be truly original, it approves the patent, which
gives the company the exclusive right to manufacture and sell the drug for 20
years. Similarly, when a novelist finishes a book, she can copyright it. The copy-
right is a government guarantee that no one can print and sell the work without
the author’s permission. The copyright makes the novelist a monopolist in the sale
of her novel.
The effects of patent and copyright laws are easy to see. Because these laws
give one producer a monopoly, they lead to higher prices than would occur under
competition. But by allowing these monopoly producers to charge higher prices
and earn higher profits, the laws also encourage some desirable behavior. Drug
companies are allowed to be monopolists in the drugs they discover in order to en-
courage pharmaceutical research. Authors are allowed to be monopolists in the
sale of their books to encourage them to write more and better books.
Thus, the laws governing patents and copyrights have benefits and costs. The
benefits of the patent and copyright laws are the increased incentive for creative
activity. These benefits are offset, to some extent, by the costs of monopoly pricing,
which we examine fully later in this chapter.
NATURAL MONOPOLIES
An industry is a natural monopoly when a single firm can supply a good or ser-
vice to an entire market at a smaller cost than could two or more firms. Anatural
monopoly arises when there are economies of scale over the relevant range of out-
put. Figure 15-1 shows the average total costs of a firm with economies of scale. In
this case, a single firm can produce any amount of output at least cost. That is, for
any given amount of output, a larger number of firms leads to less output per firm
and higher average total cost.
An example of a natural monopoly is the distribution of water. To provide wa-
ter to residents of a town, a firm must build a network of pipes throughout the
town. If two or more firms were to compete in the provision of this service, each
firm would have to pay the fixed cost of building a network. Thus, the average to-
tal cost of water is lowest if a single firm serves the entire market.
natural monopoly
a monopoly that arises because a
single firm can supply a good or
service to an entire market at a
smaller cost than could two or
more firms
CHAPTER 15 MONOPOLY 319
We saw other examples of natural monopolies when we discussed public
goods and common resources in Chapter 11. We noted in passing that some goods
in the economy are excludable but not rival. An example is a bridge used so infre-
quently that it is never congested. The bridge is excludable because a toll collector
can prevent someone from using it. The bridge is not rival because use of the
bridge by one person does not diminish the ability of others to use it. Because there
is a fixed cost of building the bridge and a negligible marginal cost of additional
users, the average total cost of a trip across the bridge (the total cost divided by the
number of trips) falls as the number of trips rises. Hence, the bridge is a natural
monopoly.
When a firm is a natural monopoly, it is less concerned about new entrants
eroding its monopoly power. Normally, a firm has trouble maintaining a monop-
oly position without ownership of a key resource or protection from the govern-
ment. The monopolist’s profit attracts entrants into the market, and these entrants
make the market more competitive. By contrast, entering a market in which an-
other firm has a natural monopoly is unattractive. Would-be entrants know that
they cannot achieve the same low costs that the monopolist enjoys because, after
entry, each firm would have a smaller piece of the market.
In some cases, the size of the market is one determinant of whether an indus-
try is a natural monopoly. Consider a bridge across a river. When the population is
small, the bridge may be a natural monopoly. Asingle bridge can satisfy the entire
demand for trips across the river at lowest cost. Yet as the population grows and
the bridge becomes congested, satisfying the entire demand may require two or
more bridges across the same river. Thus, as a market expands, a natural monop-
oly can evolve into a competitive market.
QUICK QUIZ: What are the three reasons that a market might have a
monopoly? a78 Give two examples of monopolies, and explain the reason
for each.
Quantity of Output
Average
total
cost
0
Cost
Figure 15-1
ECONOMIES OF SCALE AS A
CAUSE OF MONOPOLY. When a
firm’s average-total-cost curve
continually declines, the firm
haswhat is called a natural
monopoly. In this case, when
production is divided among
more firms, each firm produces
less, and average total cost rises.
As a result, a single firm can
produce any given amount at
thesmallest cost.
320 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
HOW MONOPOLIES MAKE PRODUCTION
AND PRICING DECISIONS
Now that we know how monopolies arise, we can consider how a monopoly firm
decides how much of its product to make and what price to charge for it. The
analysis of monopoly behavior in this section is the starting point for evaluating
whether monopolies are desirable and what policies the government might pursue
in monopoly markets.
MONOPOLY VERSUS COMPETITION
The key difference between a competitive firm and a monopoly is the monopoly’s
ability to influence the price of its output. Acompetitive firm is small relative to the
market in which it operates and, therefore, takes the price of its output as given by
market conditions. By contrast, because a monopoly is the sole producer in its market,
it can alter the price of its good by adjusting the quantity it supplies to the market.
One way to view this difference between a competitive firm and a monopoly
is to consider the demand curve that each firm faces. When we analyzed profit
maximization by competitive firms in Chapter 14, we drew the market price as a
horizontal line. Because a competitive firm can sell as much or as little as it wants
at this price, the competitive firm faces a horizontal demand curve, as in panel (a)
of Figure 15-2. In effect, because the competitive firm sells a product with many
Quantity of Output
Demand
(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve
0
Price
Quantity of Output0
Price
Demand
Figure 15-2
DEMAND CURVES FOR COMPETITIVE AND MONOPOLY FIRMS. Because competitive firms
are price takers, they in effect face horizontal demand curves, as in panel (a). Because a
monopoly firm is the sole producer in its market, it faces the downward-sloping market
demand curve, as in panel (b). As a result, the monopoly has to accept a lower price if it
wants to sell more output.
CHAPTER 15 MONOPOLY 321
perfect substitutes (the products of all the other firms in its market), the demand
curve that any one firm faces is perfectly elastic.
By contrast, because a monopoly is the sole producer in its market, its de-
mand curve is the market demand curve. Thus, the monopolist’s demand curve
slopes downward for all the usual reasons, as in panel (b) of Figure 15-2. If the mo-
nopolist raises the price of its good, consumers buy less of it. Looked at another way,
if the monopolist reduces the quantity of output it sells, the price of its output
increases.
The market demand curve provides a constraint on a monopoly’s ability to
profit from its market power. Amonopolist would prefer, if it were possible, to
charge a high price and sell a large quantity at that high price. The market demand
curve makes that outcome impossible. In particular, the market demand curve de-
scribes the combinations of price and quantity that are available to a monopoly
firm. By adjusting the quantity produced (or, equivalently, the price charged), the
monopolist can choose any point on the demand curve, but it cannot choose a
point off the demand curve.
What point on the demand curve will the monopolist choose? As with com-
petitive firms, we assume that the monopolist’s goal is to maximize profit. Because
the firm’s profit is total revenue minus total costs, our next task in explaining mo-
nopoly behavior is to examine a monopolist’s revenue.
A MONOPOLY’S REVENUE
Consider a town with a single producer of water. Table 15-1 shows how the mo-
nopoly’s revenue might depend on the amount of water produced.
The first two columns show the monopolist’s demand schedule. If the mo-
nopolist produces 1 gallon of water, it can sell that gallon for $10. If it produces
Table 15-1
QUANTITY
OF WATER PRICE TOTAL REVENUE AVERAGE REVENUE MARGINAL REVENUE
(Q)(P)(TRH11549PH11547Q)(ARH11549TR/Q)(MRH11549H9004TR/H9004Q)
0 gallons $11 $ 0 —
$10
1 10 10 $10
8
298 9
6
3824 8
4
47 7
2
5630 6
0
65 5
H110022
7428 4
H110024
834 3
AMONOPOLY’S TOTAL, AVERAGE, AND MARGINAL REVENUE
322 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
2 gallons, it must lower the price to $9 in order to sell both gallons. And if it
produces 3 gallons, it must lower the price to $8. And so on. If you graphed these
two columns of numbers, you would get a typical downward-sloping demand
curve.
The third column of the table presents the monopolist’s total revenue. It equals
the quantity sold (from the first column) times the price (from the second column).
The fourth column computes the firm’s average revenue, the amount of revenue the
firm receives per unit sold. We compute average revenue by taking the number
for total revenue in the third column and dividing it by the quantity of output
in the first column. As we discussed in Chapter 14, average revenue always
equalsthe price of the good. This is true for monopolists as well as for competitive
firms.
The last column of Table 15-1 computes the firm’s marginal revenue, the amount
of revenue that the firm receives for each additional unit of output. We compute
marginal revenue by taking the change in total revenue when output increases by
1 unit. For example, when the firm is producing 3 gallons of water, it receives total
revenue of $24. Raising production to 4 gallons increases total revenue to $28.
Thus, marginal revenue is $28 minus $24, or $4.
Table 15-1 shows a result that is important for understanding monopoly be-
havior: A monopolist’s marginal revenue is always less than the price of its good.For ex-
ample, if the firm raises production of water from 3 to 4 gallons, it will increase
total revenue by only $4, even though it will be able to sell each gallon for $7. For
a monopoly, marginal revenue is lower than price because a monopoly faces a
downward-sloping demand curve. To increase the amount sold, a monopoly firm
must lower the price of its good. Hence, to sell the fourth gallon of water, the mo-
nopolist must get less revenue for each of the first three gallons.
Marginal revenue is very different for monopolies from what it is for compet-
itive firms. When a monopoly increases the amount it sells, it has two effects on to-
tal revenue (P H11003 Q):
a78 The output effect: More output is sold, so Q is higher.
a78 The price effect: The price falls, so P is lower.
Because a competitive firm can sell all it wants at the market price, there is no price
effect. When it increases production by 1 unit, it receives the market price for that
unit, and it does not receive any less for the amount it was already selling. That is,
because the competitive firm is a price taker, its marginal revenue equals the price
of its good. By contrast, when a monopoly increases production by 1 unit, it must
reduce the price it charges for every unit it sells, and this cut in price reduces rev-
enue on the units it was already selling. As a result, a monopoly’s marginal rev-
enue is less than its price.
Figure 15-3 graphs the demand curve and the marginal-revenue curve for a
monopoly firm. (Because the firm’s price equals its average revenue, the demand
curve is also the average-revenue curve.) These two curves always start at the
same point on the vertical axis because the marginal revenue of the first unit sold
equals the price of the good. But, for the reason we just discussed, the monopolist’s
marginal revenue is less than the price of the good. Thus, a monopoly’s marginal-
revenue curve lies below its demand curve.
You can see in the figure (as well as in Table 15-1) that marginal revenue can
even become negative. Marginal revenue is negative when the price effect on
CHAPTER 15 MONOPOLY 323
revenue is greater than the output effect. In this case, when the firm produces an
extra unit of output, the price falls by enough to cause the firm’s total revenue to
decline, even though the firm is selling more units.
PROFIT MAXIMIZATION
Now that we have considered the revenue of a monopoly firm, we are ready to
examine how such a firm maximizes profit. Recall from Chapter 1 that one of
the Ten Principles of Economics is that rational people think at the margin. This
lesson is as true for monopolists as it is for competitive firms. Here we apply the
logic of marginal analysis to the monopolist’s problem of deciding how much to
produce.
Figure 15-4 graphs the demand curve, the marginal-revenue curve, and the
cost curves for a monopoly firm. All these curves should seem familiar: The de-
mand and marginal-revenue curves are like those in Figure 15-3, and the cost
curves are like those we introduced in Chapter 13 and used to analyze competitive
firms in Chapter 14. These curves contain all the information we need to determine
the level of output that a profit-maximizing monopolist will choose.
Suppose, first, that the firm is producing at a low level of output, such as Q
1
.
In this case, marginal cost is less than marginal revenue. If the firm increased pro-
duction by 1 unit, the additional revenue would exceed the additional costs, and
profit would rise. Thus, when marginal cost is less than marginal revenue, the firm
can increase profit by producing more units.
Quantity of Water
Price
$11
10
9
8
7
6
5
4
3
2
1
0
H110021
H110022
H110023
H110024
Demand
(average
revenue)
Marginal
revenue
12345 678
Figure 15-3
DEMAND AND MARGINAL-
REVENUE CURVES FOR A
MONOPOLY. The demand
curveshows how the quantity
affects the price of the good. The
marginal-revenue curve shows
how the firm’s revenue changes
when the quantity increases by
1unit. Because the price on all
units sold must fall if the
monopoly increases production,
marginal revenue is always less
than the price.
324 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
Asimilar argument applies at high levels of output, such as Q
2
. In this case,
marginal cost is greater than marginal revenue. If the firm reduced production by
1 unit, the costs saved would exceed the revenue lost. Thus, if marginal cost is
greater than marginal revenue, the firm can raise profit by reducing production.
In the end, the firm adjusts its level of production until the quantity reaches
Q
MAX
, at which marginal revenue equals marginal cost. Thus, the monopolist’s profit-
maximizing quantity of output is determined by the intersection of the marginal-revenue
curve and the marginal-cost curve. In Figure 15-4, this intersection occurs at point A.
You might recall from Chapter 14 that competitive firms also choose the quan-
tity of output at which marginal revenue equals marginal cost. In following this
rule for profit maximization, competitive firms and monopolies are alike. But there
is also an important difference between these types of firm: The marginal revenue
of a competitive firm equals its price, whereas the marginal revenue of a monop-
oly is less than its price. That is,
For a competitive firm: P H11005 MR H11005 MC.
For a monopoly firm: P > MR H11005 MC.
The equality of marginal revenue and marginal cost at the profit-maximizing
quantity is the same for both types of firm. What differs is the relationship of the
price to marginal revenue and marginal cost.
How does the monopoly find the profit-maximizing price for its product? The
demand curve answers this question, for the demand curve relates the amount
that customers are willing to pay to the quantity sold. Thus, after the monopoly
firm chooses the quantity of output that equates marginal revenue and marginal
Monopoly
price
QuantityQ
1
Q
2
Q
MAX
0
Costs and
Revenue
Demand
Average total cost
Marginal revenue
Marginal
cost
B
1. The intersection of the
marginal-revenue curve
and the marginal-cost
curve determines the
profit-maximizing
quantity . . .
A
2. . . . and then the demand
curve shows the price
consistent with this quantity.
Figure 15-4
PROFIT MAXIMIZATION FOR A
MONOPOLY. Amonopoly
maximizes profit by choosing the
quantity at which marginal
revenue equals marginal cost
(point A). It then uses the
demand curve to find the price
that will induce consumers to
buy that quantity (point B).
CHAPTER 15 MONOPOLY 325
cost, it uses the demand curve to find the price consistent with that quantity. In
Figure 15-4, the profit-maximizing price is found at point B.
We can now see a key difference between markets with competitive firms and
markets with a monopoly firm: In competitive markets, price equals marginal cost. In
monopolized markets, price exceeds marginal cost. As we will see in a moment, this
finding is crucial to understanding the social cost of monopoly.
A MONOPOLY’S PROFIT
How much profit does the monopoly make? To see the monopoly’s profit, recall
that profit equals total revenue (TR) minus total costs (TC):
Profit H11005 TR H11002 TC.
We can rewrite this as
Profit H11005(TR/Q H11002 TC/Q) H11003 Q.
TR/Q is average revenue, which equals the price P, and TC/Q is average total cost
ATC. Therefore,
Profit H11005(P H11002 ATC) H11003 Q.
This equation for profit (which is the same as the profit equation for competitive
firms) allows us to measure the monopolist’s profit in our graph.
Consider the shaded box in Figure 15-5. The height of the box (the segment
BC) is price minus average total cost, P – ATC, which is the profit on the typical
unit sold. The width of the box (the segment DC) is the quantity sold Q
MAX
. There-
fore, the area of this box is the monopoly firm’s total profit.
You may have noticed that we
have analyzed the price in a
monopoly market using the
market demand curve and the
firm’s cost curves. We have not
made any mention of the mar-
ket supply curve. By contrast,
when we analyzed prices in
competitive markets beginning
in Chapter 4, the two most im-
portant words were always sup-
ply and demand.
What happened to the sup-
ply curve? Although monopoly firms make decisions about
what quantity to supply (in the way described in this chapter),
a monopoly does not have a supply curve. A supply curve
tells us the quantity that firms choose to supply at any given
price. This concept makes sense when we are analyzing com-
petitive firms, which are price takers. But a monopoly firm is
a price maker, not a price taker. It is not meaningful to ask
what such a firm would produce at any price because the
firm sets the price at the same time it chooses the quantity
to supply.
Indeed, the monopolist’s decision about how much to
supply is impossible to separate from the demand curve it
faces. The shape of the demand curve determines the
shape of the marginal-revenue curve, which in turn deter-
mines the monopolist’s profit-maximizing quantity. In a com-
petitive market, supply decisions can be analyzed without
knowing the demand curve, but that is not true in a monop-
oly market. Therefore, we never talk about a monopoly’s
supply curve.
FYI
Why a
Monopoly Does
Not Have a
Supply Curve
326 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
CASE STUDY MONOPOLY DRUGS VERSUS GENERIC DRUGS
According to our analysis, prices are determined quite differently in monopo-
lized markets from the way they are in competitive markets. Anatural place to
test this theory is the market for pharmaceutical drugs because this market
takes on both market structures. When a firm discovers a new drug, patent laws
give the firm a monopoly on the sale of that drug. But eventually the firm’s
patent runs out, and any company can make and sell the drug. At that time, the
market switches from being monopolistic to being competitive.
What should happen to the price of a drug when the patent runs out?
Figure 15-6 shows the market for a typical drug. In this figure, the marginal cost
of producing the drug is constant. (This is approximately true for many drugs.)
During the life of the patent, the monopoly firm maximizes profit by produc-
ingthe quantity at which marginal revenue equals marginal cost and charging
a price well above marginal cost. But when the patent runs out, the profit
frommaking the drug should encourage new firms to enter the market. As the
market becomes more competitive, the price should fall to equal marginal cost.
Experience is, in fact, consistent with our theory. When the patent on a drug
expires, other companies quickly enter and begin selling so-called generic
products that are chemically identical to the former monopolist’s brand-name
product. And just as our analysis predicts, the price of the competitively pro-
duced generic drug is well below the price that the monopolist was charging.
The expiration of a patent, however, does not cause the monopolist to lose
all its market power. Some consumers remain loyal to the brand-name drug,
perhaps out of fear that the new generic drugs are not actually the same as the
drug they have been using for years. As a result, the former monopolist can
continue to charge a price at least somewhat above the price charged by its
new competitors.
Monopoly
price
Average
total
cost
QuantityQ
MAX
0
Costs and
Revenue
Demand
Marginal cost
Marginal revenue
B
C
E
D
Monopoly
profit
Average total cost
Figure 15-5
THE MONOPOLIST’S PROFIT.
The area of the box BCDE equals
the profit of the monopoly firm.
The height of the box (BC) is
price minus average total cost,
which equals profit per unit sold.
The width of the box (DC) is the
number of units sold.
CHAPTER 15 MONOPOLY 327
QUICK QUIZ: Explain how a monopolist chooses the quantity of output to
produce and the price to charge.
THE WELFARE COST OF MONOPOLY
Is monopoly a good way to organize a market? We have seen that a monopoly, in
contrast to a competitive firm, charges a price above marginal cost. From the stand-
point of consumers, this high price makes monopoly undesirable. At the same time,
however, the monopoly is earning profit from charging this high price. From the
standpoint of the owners of the firm, the high price makes monopoly very desirable.
Is it possible that the benefits to the firm’s owners exceed the costs imposed on con-
sumers, making monopoly desirable from the standpoint of society as a whole?
We can answer this question using the type of analysis we first saw in Chapter
7. As in that chapter, we use total surplus as our measure of economic well-being.
Recall that total surplus is the sum of consumer surplus and producer surplus.
Consumer surplus is consumers’ willingness to pay for a good minus the amount
they actually pay for it. Producer surplus is the amount producers receive for a
good minus their costs of producing it. In this case, there is a single producer: the
monopolist.
You might already be able to guess the result of this analysis. In Chapter 7 we
concluded that the equilibrium of supply and demand in a competitive market is
not only a natural outcome but a desirable one. In particular, the invisible hand of
the market leads to an allocation of resources that makes total surplus as large as
it can be. Because a monopoly leads to an allocation of resources different from
that in a competitive market, the outcome must, in some way, fail to maximize to-
tal economic well-being.
Price
during
patent life
Price after
patent
expires
QuantityMonopoly
quantity
Competitive
quantity
0
Costs and
Revenue
Demand
Marginal
cost
Marginal
revenue
Figure 15-6
THE MARKET FOR DRUGS.
When a patent gives a firm a
monopoly over the sale of a
drug,the firm charges the
monopoly price, which is well
above the marginal cost of
making the drug. When the
patent on a drug runs out, new
firms enter the market, making
itmore competitive. As a result,
the price falls from the monopoly
price to marginal cost.
328 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
THE DEADWEIGHT LOSS
We begin by considering what the monopoly firm would do if it were run by a
benevolent social planner. The social planner cares not only about the profit
earned by the firm’s owners but also about the benefits received by the firm’s con-
sumers. The planner tries to maximize total surplus, which equals producer sur-
plus (profit) plus consumer surplus. Keep in mind that total surplus equals the
value of the good to consumers minus the costs of making the good incurred by
the monopoly producer.
Figure 15-7 analyzes what level of output a benevolent social planner would
choose. The demand curve reflects the value of the good to consumers, as mea-
sured by their willingness to pay for it. The marginal-cost curve reflects the costs
of the monopolist. Thus, the socially efficient quantity is found where the demand curve
and the marginal-cost curve intersect. Below this quantity, the value to consumers ex-
ceeds the marginal cost of providing the good, so increasing output would raise to-
tal surplus. Above this quantity, the marginal cost exceeds the value to consumers,
so decreasing output would raise total surplus.
If the social planner were running the monopoly, the firm could achieve this ef-
ficient outcome by charging the price found at the intersection of the demand and
marginal-cost curves. Thus, like a competitive firm and unlike a profit-maximizing
monopoly, a social planner would charge a price equal to marginal cost. Because
this price would give consumers an accurate signal about the cost of producing the
good, consumers would buy the efficient quantity.
We can evaluate the welfare effects of monopoly by comparing the level of
output that the monopolist chooses to the level of output that a social planner
Quantity0
Price
Demand
(value to buyers)
Efficient
quantity
Marginal cost
Value to buyers
is greater than
cost to seller.
Value to buyers
is less than
cost to seller.
Cost
to
monopolist
Cost
to
monopolist
Value
to
buyers
Value
to
buyers
Figure 15-7
THE EFFICIENT LEVEL OF
OUTPUT. Abenevolent social
planner who wanted to maximize
total surplus in the market would
choose the level of output where
the demand curve and marginal-
cost curve intersect. Below this
level, the value of the good to the
marginal buyer (as reflected in
the demand curve) exceeds the
marginal cost of making the
good. Above this level, the value
to the marginal buyer is less than
marginal cost.
CHAPTER 15 MONOPOLY 329
would choose. As we have seen, the monopolist chooses to produce and sell the
quantity of output at which the marginal-revenue and marginal-cost curves in-
tersect; the social planner would choose the quantity at which the demand and
marginal-cost curves intersect. Figure 15-8 shows the comparison. The monopolist
produces less than the socially efficient quantity of output.
We can also view the inefficiency of monopoly in terms of the monopolist’s
price. Because the market demand curve describes a negative relationship between
the price and quantity of the good, a quantity that is inefficiently low is equivalent
to a price that is inefficiently high. When a monopolist charges a price above mar-
ginal cost, some potential consumers value the good at more than its marginal cost
but less than the monopolist’s price. These consumers do not end up buying the
good. Because the value these consumers place on the good is greater than the cost
of providing it to them, this result is inefficient. Thus, monopoly pricing prevents
some mutually beneficial trades from taking place.
Just as we measured the inefficiency of taxes with the deadweight-loss triangle
in Chapter 8, we can similarly measure the inefficiency of monopoly. Figure 15-8
shows the deadweight loss. Recall that the demand curve reflects the value to con-
sumers and the marginal-cost curve reflects the costs to the monopoly producer.
Thus, the area of the deadweight-loss triangle between the demand curve and the
marginal-cost curve equals the total surplus lost because of monopoly pricing.
The deadweight loss caused by monopoly is similar to the deadweight loss
caused by a tax. Indeed, a monopolist is like a private tax collector. As we saw in
Chapter 8, a tax on a good places a wedge between consumers’ willingness to pay
(as reflected in the demand curve) and producers’ costs (as reflected in the supply
curve). Because a monopoly exerts its market power by charging a price above
marginal cost, it places a similar wedge. In both cases, the wedge causes the quan-
tity sold to fall short of the social optimum. The difference between the two cases
is that the government gets the revenue from a tax, whereas a private firm gets the
monopoly profit.
Quantity0
Price
Efficient
quantity
Monopoly
price
Monopoly
quantity
Deadweight
loss
Demand
Marginal
revenue
Marginal cost
Figure 15-8
THE INEFFICIENCY OF
MONOPOLY. Because a
monopoly charges a price above
marginal cost, not all consumers
who value the good at more than
its cost buy it. Thus, the quantity
produced and sold by a
monopoly is below the socially
efficient level. The deadweight
loss is represented by the area of
the triangle between the demand
curve (which reflects the value of
the good to consumers) and the
marginal-cost curve (which
reflects the costs of the monopoly
producer).
330 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
THE MONOPOLY’S PROFIT: A SOCIAL COST?
It is tempting to decry monopolies for “profiteering” at the expense of the public.
And, indeed, a monopoly firm does earn a higher profit by virtue of its market
power. According to the economic analysis of monopoly, however, the firm’s profit
is not in itself necessarily a problem for society.
Welfare in a monopolized market, like all markets, includes the welfare of both
consumers and producers. Whenever a consumer pays an extra dollar to a producer
because of a monopoly price, the consumer is worse off by a dollar, and the producer
is better off by the same amount. This transfer from the consumers of the good to the
owners of the monopoly does not affect the market’s total surplus—the sum of con-
sumer and producer surplus. In other words, the monopoly profit itself does not
represent a shrinkage in the size of the economic pie; it merely represents a bigger
slice for producers and a smaller slice for consumers. Unless consumers are for some
reason more deserving than producers—a judgment that goes beyond the realm of
economic efficiency—the monopoly profit is not a social problem.
The problem in a monopolized market arises because the firm produces and
sells a quantity of output below the level that maximizes total surplus. The dead-
weight loss measures how much the economic pie shrinks as a result. This ineffi-
ciency is connected to the monopoly’s high price: Consumers buy fewer units
when the firm raises its price above marginal cost. But keep in mind that the profit
earned on the units that continue to be sold is not the problem. The problem stems
from the inefficiently low quantity of output. Put differently, if the high monopoly
price did not discourage some consumers from buying the good, it would raise
producer surplus by exactly the amount it reduced consumer surplus, leaving to-
tal surplus the same as could be achieved by a benevolent social planner.
There is, however, a possible exception to this conclusion. Suppose that a mo-
nopoly firm has to incur additional costs to maintain its monopoly position. For
example, a firm with a government-created monopoly might need to hire lobbyists
to convince lawmakers to continue its monopoly. In this case, the monopoly may
use up some of its monopoly profits paying for these additional costs. If so, the so-
cial loss from monopoly includes both these costs and the deadweight loss result-
ing from a price above marginal cost.
QUICK QUIZ: How does a monopolist’s quantity of output compare to the
quantity of output that maximizes total surplus?
PUBLIC POLICY TOWARD MONOPOLIES
We have seen that monopolies, in contrast to competitive markets, fail to allocate
resources efficiently. Monopolies produce less than the socially desirable quantity
of output and, as a result, charge prices above marginal cost. Policymakers in the
government can respond to the problem of monopoly in one of four ways:
a78 By trying to make monopolized industries more competitive
a78 By regulating the behavior of the monopolies
CHAPTER 15 MONOPOLY 331
a78 By turning some private monopolies into public enterprises
a78 By doing nothing at all
INCREASING COMPETITION WITH ANTITRUST LAWS
If Coca-Cola and Pepsico wanted to merge, the deal would be closely examined by
the federal government before it went into effect. The lawyers and economists in
the Department of Justice might well decide that a merger between these two large
soft drink companies would make the U.S. soft drink market substantially less
competitive and, as a result, would reduce the economic well-being of the country
as a whole. If so, the Justice Department would challenge the merger in court, and
if the judge agreed, the two companies would not be allowed to merge. It is pre-
cisely this kind of challenge that prevented software giant Microsoft from buying
Intuit in 1994.
The government derives this power over private industry from the antitrust
laws, a collection of statutes aimed at curbing monopoly power. The first and most
important of these laws was the Sherman Antitrust Act, which Congress passed in
1890 to reduce the market power of the large and powerful “trusts” that were
viewed as dominating the economy at the time. The Clayton Act, passed in 1914,
strengthened the government’s powers and authorized private lawsuits. As the
U.S. Supreme Court once put it, the antitrust laws are “a comprehensive charter of
economic liberty aimed at preserving free and unfettered competition as the rule
of trade.”
“But if we do merge with Amalgamated, we’ll have enough resources to fight the
anti-trust violation caused by the merger.”
332 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
The antitrust laws give the government various ways to promote competition.
They allow the government to prevent mergers, such as our hypothetical merger
between Coca-Cola and Pepsico. They also allow the government to break up com-
panies. For example, in 1984 the government split up AT&T, the large telecommu-
nications company, into eight smaller companies. Finally, the antitrust laws prevent
companies from coordinating their activities in ways that make markets less com-
petitive; we will discuss some of these uses of the antitrust laws in Chapter 16.
Antitrust laws have costs as well as benefits. Sometimes companies merge not
to reduce competition but to lower costs through more efficient joint production.
These benefits from mergers are sometimes called synergies. For example, many
U.S. banks have merged in recent years and, by combining operations, have been
able to reduce administrative staff. If antitrust laws are to raise social welfare, the
government must be able to determine which mergers are desirable and which are
not. That is, it must be able to measure and compare the social benefit from syner-
gies to the social costs of reduced competition. Critics of the antitrust laws are
skeptical that the government can perform the necessary cost-benefit analysis with
sufficient accuracy.
REGULATION
Another way in which the government deals with the problem of monopoly is by
regulating the behavior of monopolists. This solution is common in the case of nat-
ural monopolies, such as water and electric companies. These companies are not
allowed to charge any price they want. Instead, government agencies regulate
their prices.
What price should the government set for a natural monopoly? This question
is not as easy as it might at first appear. One might conclude that the price should
equal the monopolist’s marginal cost. If price equals marginal cost, customers will
buy the quantity of the monopolist’s output that maximizes total surplus, and the
allocation of resources will be efficient.
There are, however, two practical problems with marginal-cost pricing as a
regulatory system. The first is illustrated in Figure 15-9. Natural monopolies, by
definition, have declining average total cost. As we discussed in Chapter 13, when
average total cost is declining, marginal cost is less than average total cost. If regu-
lators are to set price equal to marginal cost, that price will be less than the firm’s
average total cost, and the firm will lose money. Instead of charging such a low
price, the monopoly firm would just exit the industry.
Regulators can respond to this problem in various ways, none of which is per-
fect. One way is to subsidize the monopolist. In essence, the government picks up
the losses inherent in marginal-cost pricing. Yet to pay for the subsidy, the govern-
ment needs to raise money through taxation, which involves its own deadweight
losses. Alternatively, the regulators can allow the monopolist to charge a price
higher than marginal cost. If the regulated price equals average total cost, the mo-
nopolist earns exactly zero economic profit. Yet average-cost pricing leads to dead-
weight losses, because the monopolist’s price no longer reflects the marginal cost
of producing the good. In essence, average-cost pricing is like a tax on the good the
monopolist is selling.
The second problem with marginal-cost pricing as a regulatory system (and
with average-cost pricing as well) is that it gives the monopolist no incentive to
CHAPTER 15 MONOPOLY 333
reduce costs. Each firm in a competitive market tries to reduce its costs because
lower costs mean higher profits. But if a regulated monopolist knows that regula-
tors will reduce prices whenever costs fall, the monopolist will not benefit from
lower costs. In practice, regulators deal with this problem by allowing monopolists
to keep some of the benefits from lower costs in the form of higher profit, a prac-
tice that requires some departure from marginal-cost pricing.
PUBLIC OWNERSHIP
The third policy used by the government to deal with monopoly is public owner-
ship. That is, rather than regulating a natural monopoly that is run by a private
firm, the government can run the monopoly itself. This solution is common in
many European countries, where the government owns and operates utilities such
as the telephone, water, and electric companies. In the United States, the govern-
ment runs the Postal Service. The delivery of ordinary First Class mail is often
thought to be a natural monopoly.
Economists usually prefer private to public ownership of natural monopolies.
The key issue is how the ownership of the firm affects the costs of production. Pri-
vate owners have an incentive to minimize costs as long as they reap part of the
benefit in the form of higher profit. If the firm’s managers are doing a bad job of
keeping costs down, the firm’s owners will fire them. By contrast, if the govern-
ment bureaucrats who run a monopoly do a bad job, the losers are the customers
and taxpayers, whose only recourse is the political system. The bureaucrats may
become a special-interest group and attempt to block cost-reducing reforms. Put
simply, as a way of ensuring that firms are well run, the voting booth is less reli-
able than the profit motive.
Average total
cost
Regulated
price
Quantity0
Loss
Price
Demand
Marginal cost
Average total cost
Figure 15-9
MARGINAL-COST PRICING FOR A
NATURAL MONOPOLY. Because
a natural monopoly has declining
average total cost, marginal cost
is less than average total cost.
Therefore, if regulators require a
natural monopoly to charge a
price equal to marginal cost,
pricewill be below average
totalcost, and the monopoly
willlosemoney.
334 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
DOING NOTHING
Each of the foregoing policies aimed at reducing the problem of monopoly has
drawbacks. As a result, some economists argue that it is often best for the govern-
ment not to try to remedy the inefficiencies of monopoly pricing. Here is the as-
sessment of economist George Stigler, who won the Nobel Prize for his work in
industrial organization, writing in the Fortune Encyclopedia of Economics:
Afamous theorem in economics states that a competitive enterprise economy
will produce the largest possible income from a given stock of resources. No real
economy meets the exact conditions of the theorem, and all real economies will
IN MANY CITIES, THE MASS TRANSIT SYSTEM
of buses and subways is a monopoly
run by the local government. But is this
the best system?
Man with a Van
BY JOHN TIERNEY
Vincent Cummins looks out from his van
with the wary eyes of a hardened crimi-
nal. It is quiet this evening in downtown
Brooklyn . . . too quiet. “Watch my back
for me!” he barks into the microphone of
his C.B. radio, addressing a fellow out-
law in a van who just drove by him on
Livingston Street. He looks left and right.
No police cars in sight. None of the
usual unmarked cars, either. Cummins
pauses for a second—he has heard on
the C.B. that cops have just busted two
other drivers—but he can’t stop himself.
“Watch my back!” he repeats into the
radio as he ruthlessly pulls over to the
curb.
Five seconds later, evil triumphs. A
middle-aged woman with a shopping bag
climbs into the van . . . and Cummins dri-
ves off with impunity! His new victim and
the other passengers laugh when asked
why they’re riding this illegal jitney. What
fool would pay $1.50 to stand on the bus
or subway when you’re guaranteed a
seat here for $1? Unlike bus drivers, the
van drivers make change and accept
bills, and the vans run more frequently at
every hour of the day. “It takes me an
hour to get home if I use the bus,” ex-
plains Cynthia Peters, a nurse born in
Trinidad. “When I’m working late, it’s
very scary waiting in the dark for the bus
and then walking the three blocks home.
With Vincent’s van, I get home in less
than half an hour. He takes me right to
the door and waits until I get inside.”
Cummins would prefer not to be an
outlaw. A native of Barbados, he has
been driving his van full time ever since
an injury forced him to give up his job as
a machinist. “I could be collecting dis-
ability,” he says, “but it’s better to
work.” He met Federal requirements to
run an interstate van service, then spent
years trying to get approval to operate in
the city. His application, which included
more than 900 supporting statements
from riders, business groups, and church
leaders, was approved by the City Taxi
and Limousine Commission as well as
by the Department of Transportation.
Mayor Giuliani supported him. But this
summer the City Council rejected his ap-
plication for a license, as it has rejected
most applications over the past four
years, which is why thousands of illegal
drivers in Brooklyn and Queens are
dodging the police.
IN THE NEWS
Public Transport and
Private Enterprise
VINCENT CUMMINS: OUTLAW ENTREPRENEUR
CHAPTER 15 MONOPOLY 335
fall short of the ideal economy—a difference called “market failure.” In my view,
however, the degree of “market failure” for the American economy is much
smaller than the “political failure” arising from the imperfections of economic
policies found in real political systems.
As this quotation makes clear, determining the proper role of the government in
the economy requires judgments about politics as well as economics.
QUICK QUIZ: Describe the ways policymakers can respond to the
inefficiencies caused by monopolies. List a potential problem with each of
these policy responses.
Council members claim they’re try-
ing to prevent vans from causing acci-
dents and traffic problems, although no
one who rides the vans takes these
protestations seriously. Vans with accred-
ited and insured drivers like Cummins are
no more dangerous or disruptive than
taxis. The only danger they pose is to the
public transit monopoly, whose union
leaders have successfully led the cam-
paign against them.
The van drivers have refuted two
modern urban myths: that mass transit
must lose money and that it must be a
public enterprise. Entrepreneurs like
Cummins are thriving today in other
cities—Seoul and Buenos Aires rely en-
tirely on private, profitable bus compa-
nies—and they once made New York the
world leader in mass transit. The first
horsecars and elevated trains were de-
veloped here by private companies. The
first subway was partly financed with a
loan from the city, but it was otherwise a
private operation, built and run quite
profitably with the fare set at a nickel—
the equivalent of less than a dollar today.
Eventually though, New York’s politi-
cians drove most private transit compa-
nies out of business by refusing to adjust
the fare for inflation. When the enter-
prises lost money in the 1920’s, Mayor
John Hylan offered to teach them efficient
management. If the city ran the subway,
he promised, it would make money while
preserving the nickel fare and freeing
New Yorkers from “serfdom” and “dicta-
torship” of the “grasping transportation
monopolies.” But expenses soared as
soon as government merged the private
systems into a true monopoly. The fare,
which remained a nickel through seven
decades of private transit, has risen 2,900
percent under public management—and
today the Metropolitan Transportation Au-
thority still manages to lose about $2 per
ride. Meanwhile, a jitney driver can pro-
vide better service at lower prices and still
make a profit.
“Transit could be profitable again if
entrepreneurs are given a chance,” says
Daniel B. Klein, an economist at Santa
Clara University in California and the co-
author of Curb Rights, a new book from
the Brookings Institution on mass transit.
“Government has demonstrated that it
has no more business producing transit
than producing cornflakes. It should con-
centrate instead on establishing new
rules to foster competition.” To encour-
age private operators to make a long-
term investment in regular service along
a route, the Brookings researchers rec-
ommend selling them exclusive “curb
rights” to pick up passengers waiting at
certain stops along the route. That way
part-time opportunists couldn’t swoop in
to steal regular customers from a long-
term operator. But to encourage compe-
tition, at other corners along the route
there should also be common stops
where passengers could be picked up by
any licensed jitney or bus.
Elements of this system already ex-
ist where jitneys have informally estab-
lished their own stops separate from the
regular buses, but the City Council is try-
ing to eliminate these competitors. Be-
sides denying licenses to new drivers
like Cummins, the Council has forbidden
veteran drivers with licenses to operate
on bus routes. Unless these restrictions
are overturned in court—a suit on the
drivers’ behalf has been filed by the Insti-
tute for Justice, a public-interest law firm
in Washington—the vans can compete
only by breaking the law. At this very mo-
ment, despite the best efforts of the po-
lice and the Transport Workers Union,
somewhere in New York a serial preda-
tor like Cummins is luring another unsus-
pecting victim. He may even be making
change for a $5 bill.
SOURCE: The New York Times Magazine,August 10,
1997, p. 22.
336 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
PRICE DISCRIMINATION
So far we have been assuming that the monopoly firm charges the same price to all
customers. Yet in many cases firms try to sell the same good to different customers
for different prices, even though the costs of producing for the two customers are
the same. This practice is called price discrimination.
Before discussing the behavior of a price-discriminating monopolist, we
should note that price discrimination is not possible when a good is sold in a com-
petitive market. In a competitive market, there are many firms selling the same
good at the market price. No firm is willing to charge a lower price to any cus-
tomer because the firm can sell all it wants at the market price. And if any firm
tried to charge a higher price to a customer, that customer would buy from another
firm. For a firm to price discriminate, it must have some market power.
A PARABLE ABOUT PRICING
To understand why a monopolist would want to price discriminate, let’s consider
a simple example. Imagine that you are the president of Readalot Publishing Com-
pany. Readalot’s best-selling author has just written her latest novel. To keep
things simple, let’s imagine that you pay the author a flat $2 million for the exclu-
sive rights to publish the book. Let’s also assume that the cost of printing the book
is zero. Readalot’s profit, therefore, is the revenue it gets from selling the book mi-
nus the $2 million it has paid to the author. Given these assumptions, how would
you, as Readalot’s president, decide what price to charge for the book?
Your first step in setting the price is to estimate what the demand for the book
is likely to be. Readalot’s marketing department tells you that the book will attract
two types of readers. The book will appeal to the author’s 100,000 die-hard fans.
These fans will be willing to pay as much as $30 for the book. In addition, the book
will appeal to about 400,000 less enthusiastic readers who will be willing to pay up
to $5 for the book.
What price maximizes Readalot’s profit? There are two natural prices to con-
sider: $30 is the highest price Readalot can charge and still get the 100,000 die-hard
fans, and $5 is the highest price it can charge and still get the entire market of
500,000 potential readers. It is a matter of simple arithmetic to solve Readalot’s
problem. At a price of $30, Readalot sells 100,000 copies, has revenue of $3 million,
and makes profit of $1 million. At a price of $5, it sells 500,000 copies, has revenue
of $2.5 million, and makes profit of $500,000. Thus, Readalot maximizes profit by
charging $30 and forgoing the opportunity to sell to the 400,000 less enthusiastic
readers.
Notice that Readalot’s decision causes a deadweight loss. There are 400,000
readers willing to pay $5 for the book, and the marginal cost of providing it to
them is zero. Thus, $2 million of total surplus is lost when Readalot charges the
higher price. This deadweight loss is the usual inefficiency that arises whenever a
monopolist charges a price above marginal cost.
Now suppose that Readalot’s marketing department makes an important dis-
covery: These two groups of readers are in separate markets. All the die-hard fans
live in Australia, and all the other readers live in the United States. Moreover, it is
price discrimination
the business practice of selling the
same good at different prices to
different customers
CHAPTER 15 MONOPOLY 337
difficult for readers in one country to buy books in the other. How does this dis-
covery affect Readalot’s marketing strategy?
In this case, the company can make even more profit. To the 100,000 Australian
readers, it can charge $30 for the book. To the 400,000 American readers, it can
charge $5 for the book. In this case, revenue is $3 million in Australia and $2 mil-
lion in the United States, for a total of $5 million. Profit is then $3 million, which is
substantially greater than the $1 million the company could earn charging the
same $30 price to all customers. Not surprisingly, Readalot chooses to follow this
strategy of price discrimination.
Although the story of Readalot Publishing is hypothetical, it describes accu-
rately the business practice of many publishing companies. Textbooks, for example,
are often sold at a lower price in Europe than in the United States. Even more im-
portant is the price differential between hardcover books and paperbacks. When a
publisher has a new novel, it initially releases an expensive hardcover edition and
later releases a cheaper paperback edition. The difference in price between these two
editions far exceeds the difference in printing costs. The publisher’s goal is just as in
our example. By selling the hardcover to die-hard fans and the paperback to less en-
thusiastic readers, the publisher price discriminates and raises its profit.
THE MORAL OF THE STORY
Like any parable, the story of Readalot Publishing is stylized. Yet, also like any
parable, it teaches some important and general lessons. In this case, there are three
lessons to be learned about price discrimination.
The first and most obvious lesson is that price discrimination is a rational
strategy for a profit-maximizing monopolist. In other words, by charging different
prices to different customers, a monopolist can increase its profit. In essence, a
price-discriminating monopolist charges each customer a price closer to his or her
willingness to pay than is possible with a single price.
The second lesson is that price discrimination requires the ability to separate
customers according to their willingness to pay. In our example, customers were
separated geographically. But sometimes monopolists choose other differences,
such as age or income, to distinguish among customers.
Acorollary to this second lesson is that certain market forces can prevent firms
from price discriminating. In particular, one such force is arbitrage, the process of
buying a good in one market at a low price and selling it in another market at a
higher price in order to profit from the price difference. In our example, suppose
that Australian bookstores could buy the book in the United States and resell it to
Australian readers. This arbitrage would prevent Readalot from price discriminat-
ing because no Australian would buy the book at the higher price.
The third lesson from our parable is perhaps the most surprising: Price dis-
crimination can raise economic welfare. Recall that a deadweight loss arises when
Readalot charges a single $30 price, because the 400,000 less enthusiastic readers
do not end up with the book, even though they value it at more than its marginal
cost of production. By contrast, when Readalot price discriminates, all readers end
up with the book, and the outcome is efficient. Thus, price discrimination can elim-
inate the inefficiency inherent in monopoly pricing.
Note that the increase in welfare from price discrimination shows up as higher
producer surplus rather than higher consumer surplus. In our example, consumers
338 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
are no better off for having bought the book: The price they pay exactly equals the
value they place on the book, so they receive no consumer surplus. The entire in-
crease in total surplus from price discrimination accrues to Readalot Publishing in
the form of higher profit.
THE ANALYTICS OF PRICE DISCRIMINATION
Let’s consider a bit more formally how price discrimination affects economic wel-
fare. We begin by assuming that the monopolist can price discriminate perfectly.
Perfect price discrimination describes a situation in which the monopolist knows ex-
actly the willingness to pay of each customer and can charge each customer a dif-
ferent price. In this case, the monopolist charges each customer exactly his
willingness to pay, and the monopolist gets the entire surplus in every transaction.
Figure 15-10 shows producer and consumer surplus with and without price
discrimination. Without price discrimination, the firm charges a single price above
marginal cost, as shown in panel (a). Because some potential customers who value
the good at more than marginal cost do not buy it at this high price, the monopoly
causes a deadweight loss. Yet when a firm can perfectly price discriminate, as
shown in panel (b), each customer who values the good at more than marginal cost
buys the good and is charged his willingness to pay. All mutually beneficial trades
take place, there is no deadweight loss, and the entire surplus derived from the
market goes to the monopoly producer in the form of profit.
(a) Monopolist with Single Price
Price
0 QuantityQuantity sold Quantity sold
(b) Monopolist with Perfect Price Discrimination
Price
0 Quantity
Monopoly
price
Profit
Profit
Deadweight
loss
Demand Demand
Marginal cost
Marginal
revenue
Consumer
surplus
Marginal cost
Figure 15-10
WELFARE WITH AND WITHOUT PRICE DISCRIMINATION. Panel (a) shows a monopolist
that charges the same price to all customers. Total surplus in this market equals the sum of
profit (producer surplus) and consumer surplus. Panel (b) shows a monopolist that can
perfectly price discriminate. Because consumer surplus equals zero, total surplus now
equals the firm’s profit. Comparing these two panels, you can see that perfect price
discrimination raises profit, raises total surplus, and lowers consumer surplus.
CHAPTER 15 MONOPOLY 339
In reality, of course, price discrimination is not perfect. Customers do not walk
into stores with signs displaying their willingness to pay. Instead, firms price dis-
criminate by dividing customers into groups: young versus old, weekday versus
weekend shoppers, Americans versus Australians, and so on. Unlike those in our
parable of Readalot Publishing, customers within each group differ in their will-
ingness to pay for the product, making perfect price discrimination impossible.
How does this imperfect price discrimination affect welfare? The analysis of
these pricing schemes is quite complicated, and it turns out that there is no general
answer to this question. Compared to the monopoly outcome with a single price,
imperfect price discrimination can raise, lower, or leave unchanged total surplus
in a market. The only certain conclusion is that price discrimination raises the mo-
nopoly’s profit—otherwise the firm would choose to charge all customers the
same price.
EXAMPLES OF PRICE DISCRIMINATION
Firms in our economy use various business strategies aimed at charging different
prices to different customers. Now that we understand the economics of price dis-
crimination, let’s consider some examples.
Movie Tickets Many movie theaters charge a lower price for children and
senior citizens than for other patrons. This fact is hard to explain in a competitive
market. In a competitive market, price equals marginal cost, and the marginal cost
of providing a seat for a child or senior citizen is the same as the marginal cost of
providing a seat for anyone else. Yet this fact is easily explained if movie theaters
have some local monopoly power and if children and senior citizens have a lower
“Would it bother you to hear how little I paid for this flight?”
340 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
WHAT ORGANIZATION IN OUR ECONOMY IS
most successful at exerting market
power and keeping prices away from
their competitive levels? Economist
Robert Barro reports on the first (and
only) annual competition to find the
most successful monopoly.
Let’s Play Monopoly
BY ROBERT J. BARRO
It’s almost the end of summer and time
for the first annual contest to choose the
best operating monopoly in America. The
contestants, selected by a panel of Har-
vard economists, are as follows:
1. The U.S. Postal Service
2. OPEC [Organization of Petroleum
Exporting Countries]
3. Almost any cable TV company
4. The Ivy League universities (for
administering financial aid to
students)
5. The NCAA [National Collegiate
Athletic Association] (for
administering payments to student-
athletes) . . .
Each contestant exhibits fine monopolis-
tic characteristics and is worthy of seri-
ous consideration for the award. The
U.S. Postal Service claims to be the
longest-running monopoly in America
and has the distinction of having its con-
trol over First Class mail prescribed (per-
haps) by the Constitution. The monopoly
has preserved large flows of revenues
and high wage rates despite studies
showing that private companies could
carry the mail more efficiently at much
lower cost.
On the other hand, the position of
the Postal Service has been eroded:
first, by successful competition on pack-
age delivery; second, by the recent entry
of express delivery services; and third,
and potentially most damaging, by the in-
troduction of the fax machine. Since
faxes are bound to supplant a substantial
fraction of First Class letters, the failure
to get Congress to classify a fax as First
Class mail and, hence, the exclusive do-
main of the post office shows a remark-
able loss of political muscle. Thus,
despite past glories, it is hard to be san-
guine about the long-term prospects of
the post office as a flourishing monopoly.
OPEC was impressive in generating
billions of dollars for its members from
1973 to the early 1980s. To understand
the functioning of this cartel it is impor-
tant to sort out the good guys from the
bad guys.
The good guys, like Saudi Arabia and
Kuwait, are the ones who have typically
held oil production below capacity and
thereby kept prices above the competitive
level. The bad guys, like Libya and Iraq
(when Iraq was allowed to produce oil),
are the ones who have produced as much
as they could and thereby kept prices low.
The good guys were responsible for
the vast expansion of oil revenues during
the blissful period after 1973. (Hence,
they were responsible for the consider-
able difficulties endured by oil con-
sumers.) But, unfortunately, these
countries could not keep the other
OPEC members in line and were also un-
able to exclude new producers or pre-
vent conservation by consumers. Thus,
oil prices plummeted in 1986. . . .
In any event, it is unclear that
OPEC qualifies for the contest: It is not
really American, and its members would
IN THE NEWS
The Best Monopolist
IS THE NCAA THE BEST MONOPOLIST?
CHAPTER 15 MONOPOLY 341
probably be arrested for price-fixing if
they ever held an official meeting in
America.
Most cable TV companies have
government-issued licenses that keep
competitors out. Thus, this business
supports the hypothesis (offered, I think,
by George Stigler) that private monopo-
lies are not sustainable for long unless
they have the weight of government be-
hind them.
The rapid escalation of prices and
the limitations on services seem, how-
ever, to be getting customers and their
congressional representatives progres-
sively more annoyed. Thus, it would not
be surprising if legislative action leads
soon to a deterioration of the cable com-
panies’ monopoly power. . . . This fear
about the future diminishes the claim of
this otherwise worthy contestant for the
first annual prize.
Officials of Ivy League universities
have been able to meet in semi-public fo-
rums to set rules that determine prices
of admission (tuition less financial aid) as
a function of applicant characteristics,
especially financial resources. In some
cases, the schools pooled information to
agree in advance on the right price to
charge a specific customer. Airlines and
other industries that wish to price dis-
criminate can only dream about this kind
of setup.
Moreover, the universities have
more or less successfully applied a high
moral tone to the process: Rich appli-
cants—especially smart rich applicants—
are charged more than the competitive
price for schooling in order to subsidize
the smart poor, but it is unclear why this
subsidy should come from the smart rich
rather than from taxpayers in general.
In any event, the universities’ envi-
able cartel position has been damaged
by the unenlightened Justice Depart-
ment, which argued that the price-setting
meetings were a violation of antitrust
laws. Since most of the universities in-
volved have agreed to stop these prac-
tices, it may be that future prices for
private higher education will come closer
to being competitively determined. . . .
The final contestant, the NCAA, has
been remarkably successful in holding
down “salaries” paid to college athletes.
It would be one thing merely to collude
to determine price ceilings (for example,
to restrict payments so that they not ex-
ceed tuition plus room and board and
some minor additional amount), but the
NCAA has also managed to monopolize
all the moral arguments.
Consider a poor ghetto resident
who can play basketball well, but not well
enough to make it to the NBA. If there
were no NCAA, this player might be able
legitimately to accumulate a significant
amount of cash during a four-year career.
But the NCAA ensures that the player
will remain poor after four years and,
moreover, has convinced most ob-
servers that it would be morally wrong
for the college to pay the player a com-
petitively determined wage for his or her
services.
For many economists, this interfer-
ence with competition—in a setting that
has no obvious reasons for market fail-
ure—is itself morally repugnant. But the
outrage is compounded here because
the transfer is clearly from poor ghetto
residents to rich colleges. Compare the
situation of contestant number 4, the Ivy
League universities, in which the transfer
from rich to poor students can readily be
supported on Robin Hood grounds.
The NCAA has the much more diffi-
cult task of defending a policy that pre-
vents many poor individuals from earning
money. Incredibly, this defense has been
so successful that it has even allowed
the organization to maintain the moral
high ground. When the NCAA maintains
its cartel by punishing schools that violate
the rules (by paying too much), almost no
one doubts that the evil entities are the
schools or people who paid the athletes,
rather than the cartel enforcers who pre-
vented the athletes from getting paid.
Given this extraordinary balancing act,
the decision of the panelists was straight-
forward and the NCAA is the clear and
deserving winner of the first annual prize
for best monopoly in America.
The panel of economists also con-
sidered briefly an award for the least effi-
cient monopoly in America. This choice
was, however, too easy. It goes to the
American Economic Association, which
has been a dismal failure at establishing
licensing requirements or other restric-
tions on entry into the economics pro-
fession. It is a sad state of affairs when
almost anyone can assume the title of
economist.
SOURCE: The Wall Street Journal,August 27, 1991,
p.A12.
342 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
willingness to pay for a ticket. In this case, movie theaters raise their profit by price
discriminating.
Airline Prices Seats on airplanes are sold at many different prices. Most air-
lines charge a lower price for a round-trip ticket between two cities if the traveler
stays over a Saturday night. At first this seems odd. Why should it matter to the
airline whether a passenger stays over a Saturday night? The reason is that this
rule provides a way to separate business travelers and personal travelers. Apas-
senger on a business trip has a high willingness to pay and, most likely, does not
want to stay over a Saturday night. By contrast, a passenger traveling for personal
reasons has a lower willingness to pay and is more likely to be willing to stay over
a Saturday night. Thus, the airlines can successfully price discriminate by charging
a lower price for passengers who stay over a Saturday night.
Discount Coupons Many companies offer discount coupons to the public
in newspapers and magazines. Abuyer simply has to clip out the coupon in order
to get $0.50 off his next purchase. Why do companies offer these coupons? Why
don’t they just cut the price of the product by $0.50?
The answer is that coupons allow companies to price discriminate. Companies
know that not all customers are willing to spend the time to clip out coupons.
Moreover, the willingness to clip coupons is related to the customer’s willingness
to pay for the good. Arich and busy executive is unlikely to spend her time clip-
ping discount coupons out of the newspaper, and she is probably willing to pay a
higher price for many goods. Aperson who is unemployed is more likely to clip
coupons and has a lower willingness to pay. Thus, by charging a lower price only
to those customers who clip coupons, firms can successfully price discriminate.
Financial Aid Many colleges and universities give financial aid to needy
students. One can view this policy as a type of price discrimination. Wealthy stu-
dents have greater financial resources and, therefore, a higher willingness to pay
than needy students. By charging high tuition and selectively offering financial
aid, schools in effect charge prices to customers based on the value they place on
going to that school. This behavior is similar to that of any price-discriminating
monopolist.
Quantity Discounts So far in our examples of price discrimination, the
monopolist charges different prices to different customers. Sometimes, however,
monopolists price discriminate by charging different prices to the same customer
for different units that the customer buys. For example, many firms offer lower
prices to customers who buy large quantities. Abakery might charge $0.50 for each
donut, but $5 for a dozen. This is a form of price discrimination because the
customer pays a higher price for the first unit bought than for the twelfth. Quan-
tity discounts are often a successful way of price discriminating because a cus-
tomer’s willingness to pay for an additional unit declines as the customer buys
more units.
QUICK QUIZ: Give two examples of price discrimination. a78 How does
perfect price discrimination affect consumer surplus, producer surplus, and
total surplus?
CHAPTER 15 MONOPOLY 343
CONCLUSION: THE PREVALENCE OF MONOPOLY
This chapter has discussed the behavior of firms that have control over the prices
they charge. We have seen that because monopolists produce less than the socially
efficient quantity and charge prices above marginal cost, they cause deadweight
losses. These inefficiencies can be mitigated through prudent public policies or, in
some cases, through price discrimination by the monopolist.
How prevalent are the problems of monopoly? There are two answers to this
question.
In one sense, monopolies are common. Most firms have some control over the
prices they charge. They are not forced to charge the market price for their goods,
because their goods are not exactly the same as those offered by other firms. A
Ford Taurus is not the same as a Toyota Camry. Ben and Jerry’s ice cream is not the
same as Breyer’s. Each of these goods has a downward-sloping demand curve,
which gives each producer some degree of monopoly power.
Yet firms with substantial monopoly power are quite rare. Few goods are truly
unique. Most have substitutes that, even if not exactly the same, are very similar.
Ben and Jerry can raise the price of their ice cream a little without losing all their
sales; but if they raise it very much, sales will fall substantially.
In the end, monopoly power is a matter of degree. It is true that many firms
have some monopoly power. It is also true that their monopoly power is usually
quite limited. In these cases, we will not go far wrong assuming that firms operate
in competitive markets, even if that is not precisely the case.
a78 Amonopoly is a firm that is the sole seller in its market.
Amonopoly arises when a single firm owns a key
resource, when the government gives a firm the exclusive
right to produce a good, or when a single firm can supply
the entire market at a smaller cost than many firms could.
a78 Because a monopoly is the sole producer in its market, it
faces a downward-sloping demand curve for its
product. When a monopoly increases production by 1
unit, it causes the price of its good to fall, which reduces
the amount of revenue earned on all units produced. As
a result, a monopoly’s marginal revenue is always
below the price of its good.
a78 Like a competitive firm, a monopoly firm maximizes
profit by producing the quantity at which marginal
revenue equals marginal cost. The monopoly then
chooses the price at which that quantity is demanded.
Unlike a competitive firm, a monopoly firm’s price
exceeds its marginal revenue, so its price exceeds
marginal cost.
a78 Amonopolist’s profit-maximizing level of output is
below the level that maximizes the sum of consumer
and producer surplus. That is, when the monopoly
charges a price above marginal cost, some consumers
who value the good more than its cost of production do
not buy it. As a result, monopoly causes deadweight
losses similar to the deadweight losses caused by taxes.
a78 Policymakers can respond to the inefficiency of
monopoly behavior in four ways. They can use the
antitrust laws to try to make the industry more
competitive. They can regulate the prices that the
monopoly charges. They can turn the monopolist into a
government-run enterprise. Or, if the market failure is
deemed small compared to the inevitable imperfections
of policies, they can do nothing at all.
a78 Monopolists often can raise their profits by charging
different prices for the same good based on a buyer’s
willingness to pay. This practice of price discrimination
can raise economic welfare by getting the good to some
Summary
344 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
consumers who otherwise would not buy it. In the
extreme case of perfect price discrimination, the
deadweight losses of monopoly are completely
eliminated. More generally, when price discrimination is
imperfect, it can either raise or lower welfare compared
to the outcome with a single monopoly price.
monopoly, p. 316 natural monopoly, p. 318 price discrimination, p. 336
Key Concepts
1. Give an example of a government-created monopoly. Is
creating this monopoly necessarily bad public policy?
Explain.
2. Define natural monopoly. What does the size of a
market have to do with whether an industry is a natural
monopoly?
3. Why is a monopolist’s marginal revenue less than the
price of its good? Can marginal revenue ever be
negative? Explain.
4. Draw the demand, marginal-revenue, and marginal-cost
curves for a monopolist. Show the profit-maximizing
level of output. Show the profit-maximizing price.
5. In your diagram from the previous question, show the
level of output that maximizes total surplus. Show the
deadweight loss from the monopoly. Explain your
answer.
6. What gives the government the power to regulate
mergers between firms? From the standpoint of the
welfare of society, give a good reason and a bad reason
that two firms might want to merge.
7. Describe the two problems that arise when regulators
tell a natural monopoly that it must set a price equal to
marginal cost.
8. Give two examples of price discrimination. In each case,
explain why the monopolist chooses to follow this
business strategy.
Questions for Review
1. Apublisher faces the following demand schedule for
the next novel by one of its popular authors:
PRICE QUANTITY DEMANDED
$100 0
90 100,000
80 200,000
70 300,000
60 400,000
50 500,000
40 600,000
30 700,000
20 800,000
10 900,000
0 1,000,000
The author is paid $2 million to write the book, and the
marginal cost of publishing the book is a constant $10
per book.
a. Compute total revenue, total cost, and profit at each
quantity. What quantity would a profit-maximizing
publisher choose? What price would it charge?
b. Compute marginal revenue. (Recall that MR H11005
H9004TR/H9004Q.) How does marginal revenue compare to
the price? Explain.
c. Graph the marginal-revenue, marginal-cost, and
demand curves. At what quantity do the marginal-
revenue and marginal-cost curves cross? What does
this signify?
d. In your graph, shade in the deadweight loss.
Explain in words what this means.
Problems and Applications
CHAPTER 15 MONOPOLY 345
e. If the author were paid $3 million instead of $2
million to write the book, how would this affect the
publisher’s decision regarding the price to charge?
Explain.
f. Suppose the publisher were not profit-maximizing
but were concerned with maximizing economic
efficiency. What price would it charge for the book?
How much profit would it make at this price?
2. Suppose that a natural monopolist were required by law
to charge average total cost. On a diagram, label the
price charged and the deadweight loss to society
relative to marginal-cost pricing.
3. Consider the delivery of mail. In general, what is the
shape of the average-total-cost curve? How might the
shape differ between isolated rural areas and densely
populated urban areas? How might the shape have
changed over time? Explain.
4. Suppose the Clean Springs Water Company has a
monopoly on bottled water sales in California. If the
price of tap water increases, what is the change in Clean
Springs’ profit-maximizing levels of output, price, and
profit? Explain in words and with a graph.
5. Asmall town is served by many competing
supermarkets, which have constant marginal cost.
a. Using a diagram of the market for groceries, show
the consumer surplus, producer surplus, and total
surplus.
b. Now suppose that the independent supermarkets
combine into one chain. Using a new diagram,
show the new consumer surplus, producer surplus,
and total surplus. Relative to the competitive
market, what is the transfer from consumers to
producers? What is the deadweight loss?
6. Johnny Rockabilly has just finished recording his latest
CD. His record company’s marketing department
determines that the demand for the CD is as follows:
PRICE NUMBER OF CDS
$24 10,000
22 20,000
20 30,000
18 40,000
16 50,000
14 60,000
The company can produce the CD with no fixed cost
and a variable cost of $5 per CD.
a. Find total revenue for quantity equal to 10,000,
20,000, and so on. What is the marginal revenue for
each 10,000 increase in the quantity sold?
b. What quantity of CDs would maximize profit?
What would the price be? What would the
profitbe?
c. If you were Johnny’s agent, what recording fee
would you advise Johnny to demand from the
record company? Why?
7. In 1969 the government charged IBM with
monopolizing the computer market. The government
argued (correctly) that a large share of all mainframe
computers sold in the United States were produced
byIBM. IBM argued (correctly) that a much smaller
share of the market for all types of computers
consistedof IBM products. Based on these facts, do
youthink that the government should have brought
suitagainst IBM for violating the antitrust laws?
Explain.
8. Acompany is considering building a bridge across a
river. The bridge would cost $2 million to build and
nothing to maintain. The following table shows the
company’s anticipated demand over the lifetime of the
bridge:
NUMBER OF CROSSINGS
PRICE (PER CROSSING)(IN THOUSANDS)
$8 0
7 100
6 200
5 300
4 400
3 500
2 600
1 700
0 800
a. If the company were to build the bridge, what
would be its profit-maximizing price? Would that
be the efficient level of output? Why or why not?
b. If the company is interested in maximizing profit,
should it build the bridge? What would be its profit
or loss?
c. If the government were to build the bridge, what
price should it charge?
d. Should the government build the bridge? Explain.
9. The Placebo Drug Company holds a patent on one of its
discoveries.
346 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
a. Assuming that the production of the drug involves
rising marginal cost, draw a diagram to illustrate
Placebo’s profit-maximizing price and quantity.
Also show Placebo’s profits.
b. Now suppose that the government imposes a tax
on each bottle of the drug produced. On a new
diagram, illustrate Placebo’s new price and
quantity. How does each compare to your answer
in part (a)?
c. Although it is not easy to see in your diagrams, the
tax reduces Placebo’s profit. Explain why this must
be true.
d. Instead of the tax per bottle, suppose that the
government imposes a tax on Placebo of $10,000
regardless of how many bottles are produced. How
does this tax affect Placebo’s price, quantity, and
profits? Explain.
10. Larry, Curly, and Moe run the only saloon in town.
Larry wants to sell as many drinks as possible without
losing money. Curly wants the saloon to bring in as
much revenue as possible. Moe wants to make the
largest possible profits. Using a single diagram of the
saloon’s demand curve and its cost curves, show the
price and quantity combinations favored by each of the
three partners. Explain.
11. For many years AT&T was a regulated monopoly,
providing both local and long-distance telephone
service.
a. Explain why long-distance phone service was
originally a natural monopoly.
b. Over the past two decades, many companies have
launched communication satellites, each of which
can transmit a limited number of calls. How did the
growing role of satellites change the cost structure
of long-distance phone service?
After a lengthy legal battle with the government, AT&T
agreed to compete with other companies in the long-
distance market. It also agreed to spin off its local phone
service into the “Baby Bells,” which remain highly
regulated.
c. Why might it be efficient to have competition in
long-distance phone service and regulated
monopolies in local phone service?
12. The Best Computer Company just developed a new
computer chip, on which it immediately acquires a
patent.
a. Draw a diagram that shows the consumer surplus,
producer surplus, and total surplus in the market
for this new chip.
b. What happens to these three measures of surplus if
the firm can perfectly price discriminate? What is
the change in deadweight loss? What transfers
occur?
13. Explain why a monopolist will always produce a
quantity at which the demand curve is elastic. (Hint: If
demand is inelastic and the firm raises its price, what
happens to total revenue and total costs?)
14. The “Big Three” American car companies are GM, Ford,
and Chrysler. If these were the only car companies in
the world, they would have much more monopoly
power. What action could the U.S. government take to
create monopoly power for these companies? (Hint: The
government took such an action in the 1980s.)
15. Singer Whitney Houston has a monopoly over a scarce
resource: herself. She is the only person who can
produce a Whitney Houston concert. Does this fact
imply that the government should regulate the prices of
her concerts? Why or why not?
16. Many schemes for price discriminating involve some
cost. For example, discount coupons take up time and
resources from both the buyer and the seller. This
question considers the implications of costly price
discrimination. To keep things simple, let’s assume that
our monopolist’s production costs are simply
proportional to output, so that average total cost and
marginal cost are constant and equal to each other.
a. Draw the cost, demand, and marginal-revenue
curves for the monopolist. Show the price the
monopolist would charge without price
discrimination.
b. In your diagram, mark the area equal to the
monopolist’s profit and call it X. Mark the area
equal to consumer surplus and call it Y. Mark the
area equal to the deadweight loss and call it Z.
c. Now suppose that the monopolist can perfectly
price discriminate. What is the monopolist’s profit?
(Give your answer in terms of X, Y, and Z.)
d. What is the change in the monopolist’s profit from
price discrimination? What is the change in total
surplus from price discrimination? Which change is
larger? Explain. (Give your answer in terms of X, Y,
and Z.)
e. Now suppose that there is some cost of price
discrimination. To model this cost, let’s assume that
the monopolist has to pay a fixed cost C in order to
price discriminate. How would a monopolist make
the decision whether to pay this fixed cost? (Give
your answer in terms of X, Y, Z, and C.)
CHAPTER 15 MONOPOLY 347
f. How would a benevolent social planner, who cares
about total surplus, decide whether the monopolist
should price discriminate? (Give your answer in
terms of X, Y, Z, and C.)
g. Compare your answers to parts (e) and (f). How
does the monopolist’s incentive to price
discriminate differ from the social planner’s? Is it
possible that the monopolist will price discriminate
even though it is not socially desirable?
IN THIS CHAPTER
YOU WILL . . .
Learn about the
prisoners’ dilemma
and how it applies
to oligopoly and
other issues
See what market
structures lie
between monopoly
and competition
Examine what
outcomes are
possible when a
market is an
oligopoly
Consider how the
antitrust laws try to
foster competition
in oligopolistic
markets
If you go to a store to buy tennis balls, it is likely that you will come home with one
of four brands: Wilson, Penn, Dunlop, or Spalding. These four companies make
almost all of the tennis balls sold in the United States. Together these firms deter-
mine the quantity of tennis balls produced and, given the market demand curve,
the price at which tennis balls are sold.
How can we describe the market for tennis balls? The previous two chapters
discussed two types of market structure. In a competitive market, each firm is so
small compared to the market that it cannot influence the price of its product and,
therefore, takes the price as given by market conditions. In a monopolized market,
a single firm supplies the entire market for a good, and that firm can choose any
price and quantity on the market demand curve.
The market for tennis balls fits neither the competitive nor the monopoly
model. Competition and monopoly are extreme forms of market structure. Com-
petition occurs when there are many firms in a market offering essentially iden-
tical products; monopoly occurs when there is only one firm in a market. It is
OLIGOPOLY
349
350 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
natural to start the study of industrial organization with these polar cases, for they
are the easiest cases to understand. Yet many industries, including the tennis ball
industry, fall somewhere between these two extremes. Firms in these industries
have competitors but, at the same time, do not face so much competition that they
are price takers. Economists call this situation imperfect competition.
In this chapter we discuss the types of imperfect competition and examine a
particular type called oligopoly.The essence of an oligopolistic market is that there
are only a few sellers. As a result, the actions of any one seller in the market can
have a large impact on the profits of all the other sellers. That is, oligopolistic firms
are interdependent in a way that competitive firms are not. Our goal in this chap-
ter is to see how this interdependence shapes the firms’ behavior and what prob-
lems it raises for public policy.
BETWEEN MONOPOLY AND PERFECT COMPETITION
The previous two chapters analyzed markets with many competitive firms and
markets with a single monopoly firm. In Chapter 14, we saw that the price in a
perfectly competitive market always equals the marginal cost of production. We
also saw that, in the long run, entry and exit drive economic profit to zero, so the
price also equals average total cost. In Chapter 15, we saw how firms with market
power can use that power to keep prices above marginal cost, leading to a positive
economic profit for the firm and a deadweight loss for society.
The cases of perfect competition and monopoly illustrate some important
ideas about how markets work. Most markets in the economy, however, include
elements of both these cases and, therefore, are not completely described by either
of them. The typical firm in the economy faces competition, but the competition is
not so rigorous as to make the firm exactly described by the price-taking firm ana-
lyzed in Chapter 14. The typical firm also has some degree of market power, but its
market power is not so great that the firm can be exactly described by the monop-
oly firm analyzed in Chapter 15. In other words, the typical firm in our economy
is imperfectly competitive.
There are two types of imperfectly competitive markets. An oligopolyis a
market with only a few sellers, each offering a product similar or identical to the
others. One example is the market for tennis balls. Another is the world market for
crude oil: Afew countries in the Middle East control much of the world’s oil re-
serves. Monopolistic competitiondescribes a market structure in which there are
many firms selling products that are similar but not identical. Examples include
the markets for novels, movies, CDs, and computer games. In a monopolistically
competitive market, each firm has a monopoly over the product it makes, but
many other firms make similar products that compete for the same customers.
Figure 16-1 summarizes the four types of market structure. The first question
to ask about any market is how many firms there are. If there is only one firm, the
market is a monopoly. If there are only a few firms, the market is an oligopoly. If
there are many firms, we need to ask another question: Do the firms sell identical
or differentiated products? If the many firms sell differentiated products, the mar-
ket is monopolistically competitive. If the many firms sell identical products, the
market is perfectly competitive.
oligopoly
a market structure in which only a
few sellers offer similar or identical
products
monopolistic competition
a market structure in which many
firms sell products that are similar
but not identical
CHAPTER 16 OLIGOPOLY 351
Reality, of course, is never as clear-cut as theory. In some cases, you may find
it hard to decide what structure best describes a market. There is, for instance, no
magic number that separates “few” from “many” when counting the number of
firms. (Do the approximately dozen companies that now sell cars in the United
States make this market an oligopoly or more competitive? The answer is open to
debate.) Similarly, there is no sure way to determine when products are differenti-
ated and when they are identical. (Are different brands of milk really the same?
Again, the answer is debatable.) When analyzing actual markets, economists have
to keep in mind the lessons learned from studying all types of market structure
and then apply each lesson as it seems appropriate.
Now that we understand how economists define the various types of market
structure, we can continue our analysis of them. In the next chapter we analyze
monopolistic competition. In this chapter we examine oligopoly.
QUICK QUIZ: Define oligopolyand monopolistic competitionand give an
example of each.
MARKETS WITH ONLY A FEW SELLERS
Because an oligopolistic market has only a small group of sellers, a key feature
ofoligopoly is the tension between cooperation and self-interest. The group of
oligopolists is best off cooperating and acting like a monopolist—producing a
? Tap water
? Cable TV
Monopoly
(Chapter 15)
? Novels
? Movies
? Wheat
? Milk
Monopolistic
Competition
(Chapter 17)
? Tennis balls
? Crude oil
Oligopoly
(Chapter 16)
Number of Firms?
Perfect
Competition
(Chapter 14)
Type of Products?
Identical
products
Differentiated
products
One
firm
Few
firms
Many
firms
Figure 16-1
THEFOURTYPES OFMARKET
STRUCTURE. Economists who
study industrial organization
divide markets into four types—
monopoly, oligopoly,
monopolistic competition, and
perfect competition.
352 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
small quantity of output and charging a price above marginal cost. Yet because
each oligopolist cares about only its own profit, there are powerful incentives at
work that hinder a group of firms from maintaining the monopoly outcome.
A DUOPOLY EXAMPLE
To understand the behavior of oligopolies, let’s consider an oligopoly with only
two members, called a duopoly.Duopoly is the simplest type of oligopoly. Oligop-
olies with three or more members face the same problems as oligopolies with only
two members, so we do not lose much by starting with the case of duopoly.
Imagine a town in which only two residents—Jack and Jill—own wells that
produce water safe for drinking. Each Saturday, Jack and Jill decide how many gal-
lons of water to pump, bring the water to town, and sell it for whatever price the
market will bear. To keep things simple, suppose that Jack and Jill can pump as
much water as they want without cost. That is, the marginal cost of water equals
zero.
Table 16-1 shows the town’s demand schedule for water. The first column
shows the total quantity demanded, and the second column shows the price. If the
two well owners sell a total of 10 gallons of water, water goes for $110 a gallon. If
they sell a total of 20 gallons, the price falls to $100 a gallon. And so on. If you
graphed these two columns of numbers, you would get a standard downward-
sloping demand curve.
The last column in Table 16-1 shows the total revenue from the sale of water.
Itequals the quantity sold times the price. Because there is no cost to pumping
water, the total revenue of the two producers equals their total profit.
Let’s now consider how the organization of the town’s water industry affects
the price of water and the quantity of water sold.
Table 16-1
THEDEMANDSCHEDULE
FORWATER
QUANTITY(INGALLONS)PRICE TOTALREVENUE(ANDTOTALPROFIT)
0 $120 $ 0
10 110 1,100
20 100 2,000
30 90 2,700
40 80 3,200
50 70 3,500
60 60 3,600
70 50 3,500
80 40 3,200
90 30 2,700
100 20 2,000
110 10 1,100
120 0 0
CHAPTER 16 OLIGOPOLY 353
COMPETITION, MONOPOLIES, AND CARTELS
Before considering the price and quantity of water that would result from the
duopoly of Jack and Jill, let’s discuss briefly the two market structures we already
understand: competition and monopoly.
Consider first what would happen if the market for water were perfectly
competitive. In a competitive market, the production decisions of each firm drive
price equal to marginal cost. In the market for water, marginal cost is zero. Thus,
under competition, the equilibrium price of water would be zero, and the equi-
librium quantity would be 120 gallons. The price of water would reflect the cost
of producing it, and the efficient quantity of water would be produced and
consumed.
Now consider how a monopoly would behave. Table 16-1 shows that total
profit is maximized at a quantity of 60 gallons and a price of $60 a gallon. Aprofit-
maximizing monopolist, therefore, would produce this quantity and charge this
price. As is standard for monopolies, price would exceed marginal cost. The result
would be inefficient, for the quantity of water produced and consumed would fall
short of the socially efficient level of 120 gallons.
What outcome should we expect from our duopolists? One possibility is that
Jack and Jill get together and agree on the quantity of water to produce and the
price to charge for it. Such an agreement among firms over production and price is
called collusion,and the group of firms acting in unison is called a cartel.Once a
cartel is formed, the market is in effect served by a monopoly, and we can apply
our analysis from Chapter 15. That is, if Jack and Jill were to collude, they would
agree on the monopoly outcome because that outcome maximizes the total profit
that the producers can get from the market. Our two producers would produce a
total of 60 gallons, which would be sold at a price of $60 a gallon. Once again, price
exceeds marginal cost, and the outcome is socially inefficient.
Acartel must agree not only on the total level of production but also on the
amount produced by each member. In our case, Jack and Jill must agree how to
split between themselves the monopoly production of 60 gallons. Each member of
the cartel will want a larger share of the market because a larger market share
means larger profit. If Jack and Jill agreed to split the market equally, each would
produce 30 gallons, the price would be $60 a gallon, and each would get a profit of
$1,800.
THE EQUILIBRIUM FOR AN OLIGOPOLY
Although oligopolists would like to form cartels and earn monopoly profits, often
that is not possible. As we discuss later in this chapter, antitrust laws prohibit ex-
plicit agreements among oligopolists as a matter of public policy. In addition,
squabbling among cartel members over how to divide the profit in the market
sometimes makes agreement among them impossible. Let’s therefore consider
what happens if Jack and Jill decide separately how much water to produce.
At first, one might expect Jack and Jill to reach the monopoly outcome on their
own, for this outcome maximizes their joint profit. In the absence of a binding
agreement, however, the monopoly outcome is unlikely. To see why, imagine that
Jack expects Jill to produce only 30 gallons (half of the monopoly quantity). Jack
would reason as follows:
collusion
an agreement among firms in a
market about quantities to produce
or prices to charge
cartel
a group of firms acting in unison
354 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
CARTELS ARE RARE, IN PART BECAUSE THE
antitrust laws make them illegal. As the
following article describes, however,
ocean shipping firms enjoy an unusual
exemption from these laws and, as a re-
sult, charge higher prices than they oth-
erwise would.
As U.S. Trade Grows, Shipping
Cartels Get a Bit More Scrutiny
BY ANNA WILDE MATTHEWS
RUTHERFORD, N.J.—Every two weeks, in
an unobtrusive office building here,
about 20 shipping-line managers gather
for their usual meeting. They sit around a
long conference table, exchange small
talk over bagels and coffee and then be-
gin discussing what they will charge to
move cargo across the Atlantic Ocean.
All very routine, except for one de-
tail: They don’t work for the same com-
pany. Each represents a different
shipping line, supposedly competing for
business. Under U.S. antitrust law, most
people doing this would end up in court.
But shipping isn’t like other busi-
nesses. Many of the world’s big shipping
lines, from Sea-Land Service Inc. of the
U.S. to A. P. Moller/Maersk Line of Den-
mark, are members of a little-noticed
cartel that for many decades has set
rates on tens of billions of dollars of
cargo.
Most U.S. consumer goods ex-
ported or imported by sea are affected
to some degree. The cartel—really a
series of cartels, one for each major
shipping route—can tell importers and
exporters when shipping contracts start
and when they end. They can favor one
port over another, enough to swing badly
needed trade away from an entire city.
And because the shipping industry has
an antitrust exemption from Congress,
all of this is legal.
“This is one of the last legalized
price-setting arrangements in exis-
tence,” says Robert Litan, a former
Justice Department antitrust official. Air-
lines and banks couldn’t do this, he says,
“but if you’re an ocean shipping line,
there’s nothing to stop you from price
fixing.”
You could call them the OPEC of
shipping, though not quite as powerful
because they can’t keep members from
building too many ships. To get more
business, some of the shipping cartels’
own members undercut cartel rates or
make special deals with big customers.
They also face the emergence of new
competitors, which are keeping rates
down in some markets.
Nonetheless, the industry is playing
a bigger role now in the U.S. economy
as American companies plunge more
deeply into world trade. Exports over the
seas have jumped 26% in the past two
years and 50% since the start of the
decade.
For consumers, the impact is hard
to measure. Transportation costs make
up 5% to 10% of the price of most
goods, and increases in shipping rates
are usually passed on to consumers. A
limited 1993 survey by the Agriculture
Department, examining $5 billion of U.S.
farm exports, concluded that the cartels
were raising ocean shipping rates as
much as 18%. A different report, by the
Federal Trade Commission in 1995,
found that when shipping lines broke
free of cartel rates, contract prices were
about 19% lower.
“The cartels’ whole makeup is anti-
consumer,” says John Taylor, a trans-
portation professor at Wayne State
University in Detroit. “They’re designed
to keep prices up.”
Some moves are afoot to change all
this. The U.S. Senate is considering a bill
that, for the first time in a decade, would
weaken the cartels, by reducing their
power to police their members. The bill,
sponsored by Sen. Kay Bailey Hutchison
of Texas, has the support of some other
high-ranking Republicans, including Ma-
jority Leader Trent Lott. . . .
For eight decades, shipping cartels
have been protected by Congress under
the Shipping Act of 1916, passed at the
behest of American shipping customers,
who thought cartels would guarantee re-
liable service. The law was revised sig-
nificantly only twice, in 1961 and 1984,
but both times the industry’s antitrust im-
munity was left intact.
The most recent major review
was done in 1991 by a congressional
commission. It heard more than 100
witnesses, produced a 250-page re-
port—and offered no conclusions or
recommendations. . . .
The real reasons for years of inac-
tion in Congress may be apathy and the
lobbying by various groups. Dockside la-
bor, for example, fears that secret con-
tracts would enable ship lines to divert
cargo to nonunion workers without the
union knowing it. David Butz, a Univer-
sity of Michigan economist who has
studied shipping, thinks voters aren’t
likely to weigh in; the cartels aren’t a hot
topic. “It’s below the radar screen,” he
says. “Consumers don’t realize the im-
pact they have.”
SOURCE:The Wall Street Journal,October 7, 1997,
p.A1.
IN THE NEWS
Modern Pirates
CHAPTER 16 OLIGOPOLY 355
“I could produce 30 gallons as well. In this case, a total of 60 gallons of water
would be sold at a price of $60 a gallon. My profit would be $1,800 (30 gallons H11003
$60 a gallon). Alternatively, I could produce 40 gallons. In this case, a total of 70
gallons of water would be sold at a price of $50 a gallon. My profit would be $2,000
(40 gallons H11003$50 a gallon). Even though total profit in the market would fall, my
profit would be higher, because I would have a larger share of the market.”
Of course, Jill might reason the same way. If so, Jack and Jill would each bring
40 gallons to town. Total sales would be 80 gallons, and the price would fall to $40.
Thus, if the duopolists individually pursue their own self-interest when deciding
how much to produce, they produce a total quantity greater than the monopoly
quantity, charge a price lower than the monopoly price, and earn total profit less
than the monopoly profit.
Although the logic of self-interest increases the duopoly’s output above the
monopoly level, it does not push the duopolists to reach the competitive alloca-
tion. Consider what happens when each duopolist is producing 40 gallons. The
price is $40, and each duopolist makes a profit of $1,600. In this case, Jack’s self-
interested logic leads to a different conclusion:
“Right now, my profit is $1,600. Suppose I increase my production to 50 gallons.
In this case, a total of 90 gallons of water would be sold, and the price would be $30
a gallon. Then my profit would be only $1,500. Rather than increasing production
and driving down the price, I am better off keeping my production at 40gallons.”
The outcome in which Jack and Jill each produce 40 gallons looks like some sort
of equilibrium. In fact, this outcome is called a Nash equilibrium(named after eco-
nomic theorist John Nash). ANash equilibriumis a situation in which economic
actors interacting with one another each choose their best strategy given the strate-
gies the others have chosen. In this case, given that Jill is producing 40 gallons, the
best strategy for Jack is to produce 40 gallons. Similarly, given that Jack is produc-
ing 40 gallons, the best strategy for Jill is to produce 40 gallons. Once they reach this
Nash equilibrium, neither Jack nor Jill has an incentive to make a different decision.
This example illustrates the tension between cooperation and self-interest. Oli-
gopolists would be better off cooperating and reaching the monopoly outcome. Yet
because they pursue their own self-interest, they do not end up reaching the mo-
nopoly outcome and maximizing their joint profit. Each oligopolist is tempted to
raise production and capture a larger share of the market. As each of them tries to
do this, total production rises, and the price falls.
At the same time, self-interest does not drive the market all the way to the
competitive outcome. Like monopolists, oligopolists are aware that increases in
the amount they produce reduce the price of their product. Therefore, they stop
short of following the competitive firm’s rule of producing up to the point where
price equals marginal cost.
In summary, when firms in an oligopoly individually choose production to maximize
profit, they produce a quantity of output greater than the level produced by monopoly and
less than the level produced by competition. The oligopoly price is less than the monopoly
price but greater than the competitive price (which equals marginal cost).
HOW THE SIZE OF AN OLIGOPOLY
AFFECTS THE MARKET OUTCOME
We can use the insights from this analysis of duopoly to discuss how the size of an
oligopoly is likely to affect the outcome in a market. Suppose, for instance, that
Nash equilibrium
a situation in which economic actors
interacting with one another each
choose their best strategy given the
strategies that all the other actors
have chosen
356 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
John and Joan suddenly discover water sources on their property and join Jack and
Jill in the water oligopoly. The demand schedule in Table 16-1 remains the same,
but now more producers are available to satisfy this demand. How would an in-
crease in the number of sellers from two to four affect the price and quantity of wa-
ter in the town?
If the sellers of water could form a cartel, they would once again try to maxi-
mize total profit by producing the monopoly quantity and charging the monopoly
price. Just as when there were only two sellers, the members of the cartel would
need to agree on production levels for each member and find some way to enforce
the agreement. As the cartel grows larger, however, this outcome is less likely.
Reaching and enforcing an agreement becomes more difficult as the size of the
group increases.
If the oligopolists do not form a cartel—perhaps because the antitrust laws
prohibit it—they must each decide on their own how much water to produce. To
see how the increase in the number of sellers affects the outcome, consider the de-
cision facing each seller. At any time, each well owner has the option to raise pro-
duction by 1 gallon. In making this decision, the well owner weighs two effects:
a78 The output effect:Because price is above marginal cost, selling 1 more gallon
of water at the going price will raise profit.
a78 The price effect:Raising production will increase the total amount sold, which
will lower the price of water and lower the profit on all the other gallons
sold.
If the output effect is larger than the price effect, the well owner will increase pro-
duction. If the price effect is larger than the output effect, the owner will not raise
production. (In fact, in this case, it is profitable to reduce production.) Each oli-
gopolist continues to increase production until these two marginal effects exactly
balance, taking the other firms’ production as given.
Now consider how the number of firms in the industry affects the marginal
analysis of each oligopolist. The larger the number of sellers, the less concerned
each seller is about its own impact on the market price. That is, as the oligopoly
grows in size, the magnitude of the price effect falls. When the oligopoly grows
very large, the price effect disappears altogether, leaving only the output effect. In
this extreme case, each firm in the oligopoly increases production as long as price
is above marginal cost.
We can now see that a large oligopoly is essentially a group of competitive
firms. Acompetitive firm considers only the output effect when deciding how
much to produce: Because a competitive firm is a price taker, the price effect is ab-
sent. Thus, as the number of sellers in an oligopoly grows larger, an oligopolistic market
looks more and more like a competitive market. The price approaches marginal cost, and the
quantity produced approaches the socially efficient level.
This analysis of oligopoly offers a new perspective on the effects of interna-
tional trade. Imagine that Toyota and Honda are the only automakers in Japan,
Volkswagen and Mercedes-Benz are the only automakers in Germany, and Ford
and General Motors are the only automakers in the United States. If these nations
prohibited trade in autos, each would have an auto oligopoly with only two mem-
bers, and the market outcome would likely depart substantially from the compet-
itive ideal. With international trade, however, the car market is a world market,
and the oligopoly in this example has six members. Allowing free trade increases
CHAPTER 16 OLIGOPOLY 357
CASE STUDY OPEC AND THE WORLD OIL MARKET
Our story about the town’s market for water is fictional, but if we change water
to crude oil, and Jack and Jill to Iran and Iraq, the story is quite close to being
true. Much of the world’s oil is produced by a few countries, mostly in the Mid-
dle East. These countries together make up an oligopoly. Their decisions about
how much oil to pump are much the same as Jack and Jill’s decisions about how
much water to pump.
The countries that produce most of the world’s oil have formed a cartel,
called the Organization of Petroleum Exporting Countries (OPEC). As origi-
nally formed in 1960, OPEC included Iran, Iraq, Kuwait, Saudi Arabia, and
Venezuela. By 1973, eight other nations had joined: Qatar, Indonesia, Libya,
theUnited Arab Emirates, Algeria, Nigeria, Ecuador, and Gabon. These coun-
tries control about three-fourths of the world’s oil reserves. Like any cartel,
OPEC tries to raise the price of its product through a coordinated reduction in
quantity produced. OPEC tries to set production levels for each of the member
countries.
The problem that OPEC faces is much the same as the problem that Jack
and Jill face in our story. The OPEC countries would like to maintain a high
price of oil. But each member of the cartel is tempted to increase production in
order to get a larger share of the total profit. OPEC members frequently agree to
reduce production but then cheat on their agreements.
OPEC was most successful at maintaining cooperation and high prices in
the period from 1973 to 1985. The price of crude oil rose from $2.64 a barrel in
1972 to $11.17 in 1974 and then to $35.10 in 1981. But in the early 1980s member
countries began arguing about production levels, and OPEC became ineffective
at maintaining cooperation. By 1986 the price of crude oil had fallen back to
$12.52 a barrel.
During the 1990s, the members of OPEC met about twice a year, but the car-
tel failed to reach and enforce agreement. The members of OPEC made produc-
tion decisions largely independently of one another, and the world market for
oil was fairly competitive. Throughout most of the decade, the price of crude
oil, adjusted for overall inflation, remained less than half the level OPEC had
achieved in 1981. In 1999, however, cooperation among oil-exporting nations
started to pick up (see the accompanying In the News box). Only time will tell
how persistent this renewed cooperation proves to be.
the number of producers from which each consumer can choose, and this
increased competition keeps prices closer to marginal cost. Thus, the theory
of oligopoly provides another reason, in addition to the theory of compara-
tive advantage discussed in Chapter 3, why all countries can benefit from free
trade.
OPEC: ANOTVERYCOOPERATIVECARTEL
QUICK QUIZ: If the members of an oligopoly could agree on a total
quantity to produce, what quantity would they choose? a78 If the oligopolists
do not act together but instead make production decisions individually, do
they produce a total quantity more or less than in your answer to the previous
question? Why?
358 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
GAME THEORY AND THE
ECONOMICS OF COOPERATION
As we have seen, oligopolies would like to reach the monopoly outcome, but do-
ing so requires cooperation, which at times is difficult to maintain. In this section
we look more closely at the problems people face when cooperation is desirable
but difficult. To analyze the economics of cooperation, we need to learn a little
about game theory.
Game theoryis the study of how people behave in strategic situations. By
“strategic” we mean a situation in which each person, when deciding what actions
to take, must consider how others might respond to that action. Because the num-
ber of firms in an oligopolistic market is small, each firm must act strategically.
Each firm knows that its profit depends not only on how much it produces but
also on how much the other firms produce. In making its production decision,
each firm in an oligopoly should consider how its decision might affect the pro-
duction decisions of all the other firms.
Game theory is not necessary for understanding competitive or monopoly
markets. In a competitive market, each firm is so small compared to the market
that strategic interactions with other firms are not important. In a monopolized
market, strategic interactions are absent because the market has only one firm. But,
as we will see, game theory is quite useful for understanding the behavior of
oligopolies.
OPEC FAILED TO KEEP OIL PRICES HIGH
during most of the 1990s, but this
started to change in 1999.
An Oil Outsider Revives a Cartel
BY AGIS SALPUKAS
The price of crude oil has doubled since
early last year. Higher prices for gaso-
line, heating oil, and other products are
hitting every consumer’s pocketbook.
Is OPEC flexing its muscle again?
Not exactly. There’s a new cartel in town,
and after a shaky start two years ago, its
members have achieved—for now, at
least—the unity necessary to hold to
their production quotas. And that means
higher prices.
In a sense, this cartel is simply the
11 members of the Organization of Pe-
troleum Exporting Countries plus two—
Mexico and Norway. But the world’s
oil-producing and exporting nations are
wielding power this time around mainly
because of a shove not from the Middle
East but rather from Mexico—and espe-
cially from its persistent energy minister,
Luis K. Tellez. . . . Already, the price of
crude oil has more than doubled, to
$23.45 a barrel from $11 early this year.
Not that the coalition is home free.
Prices hit $24 a barrel last month, but
slipped back when traders thought they
saw hints of cracks in the cartel’s soli-
darity. After all, if one country breaks
ranks, the cartel’s tenuous grip on the
world market could crumble.
For the moment, though, there
seems little easing in the cartel’s united
front or in rising oil prices.
SOURCE:The New York Times,Money & Business
Section, October 24, 1999, p. 1.
IN THE NEWS
The Oil Cartel
MakesaComeback
game theory
the study of how people behave in
strategic situations
CHAPTER 16 OLIGOPOLY 359
Aparticularly important “game” is called the prisoners’dilemma.This game
provides insight into the difficulty of maintaining cooperation. Many times in life,
people fail to cooperate with one another even when cooperation would make
them all better off. An oligopoly is just one example. The story of the prisoners’
dilemma contains a general lesson that applies to any group trying to maintain co-
operation among its members.
THE PRISONERS’ DILEMMA
The prisoners’ dilemma is a story about two criminals who have been captured by
the police. Let’s call them Bonnie and Clyde. The police have enough evidence to
convict Bonnie and Clyde of the minor crime of carrying an unregistered gun, so
that each would spend a year in jail. The police also suspect that the two criminals
have committed a bank robbery together, but they lack hard evidence to convict
them of this major crime. The police question Bonnie and Clyde in separate rooms,
and they offer each of them the following deal:
“Right now, we can lock you up for 1 year. If you confess to the bank robbery
and implicate your partner, however, we’ll give you immunity and you can go
free. Your partner will get 20 years in jail. But if you both confess to the crime, we
won’t need your testimony and we can avoid the cost of a trial, so you will each
get an intermediate sentence of 8 years.”
If Bonnie and Clyde, heartless bank robbers that they are, care only about their
own sentences, what would you expect them to do? Would they confess or remain
silent? Figure 16-2 shows their choices. Each prisoner has two strategies: confess or
remain silent. The sentence each prisoner gets depends on the strategy he or she
chooses and the strategy chosen by his or her partner in crime.
Consider first Bonnie’s decision. She reasons as follows: “I don’t know what
Clyde is going to do. If he remains silent, my best strategy is to confess, since then
I’ll go free rather than spending a year in jail. If he confesses, my best strategy is
prisoners’ dilemma
a particular “game” between two
captured prisoners that illustrates
why cooperation is difficult to
maintain even when it is mutually
beneficial
Bonnie’s Decision
Confess
Confess
Bonnie gets 8 years
Clyde gets 8 years
Bonnie gets 20 years
Clyde goes free
Bonnie goes free
Clyde gets 20 years
Bonnie gets 1 year
Clyde gets 1 year
Remain Silent
Remain
Silent
Clyde’s
Decision
Figure 16-2
THEPRISONERS’ DILEMMA.In
this game between two criminals
suspected of committing a crime,
the sentence that each receives
depends both on his or her
decision whether to confess or
remain silent and on the decision
made by the other.
360 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
still to confess, since then I’ll spend 8 years in jail rather than 20. So, regardless of
what Clyde does, I am better off confessing.”
In the language of game theory, a strategy is called a dominant strategyif it is
the best strategy for a player to follow regardless of the strategies pursued by other
players. In this case, confessing is a dominant strategy for Bonnie. She spends less
time in jail if she confesses, regardless of whether Clyde confesses or remains
silent.
Now consider Clyde’s decision. He faces exactly the same choices as Bonnie,
and he reasons in much the same way. Regardless of what Bonnie does, Clyde can
reduce his time in jail by confessing. In other words, confessing is also a dominant
strategy for Clyde.
In the end, both Bonnie and Clyde confess, and both spend 8 years in jail. Yet,
from their standpoint, this is a terrible outcome. If they had bothremained silent,
both of them would have been better off, spending only 1 year in jail on the gun
charge. By each pursuing his or her own interests, the two prisoners together reach
an outcome that is worse for each of them.
To see how difficult it is to maintain cooperation, imagine that, before the po-
lice captured Bonnie and Clyde, the two criminals had made a pact not to confess.
Clearly, this agreement would make them both better off ifthey both live up to it,
because they would each spend only 1 year in jail. But would the two criminals in
fact remain silent, simply because they had agreed to? Once they are being ques-
tioned separately, the logic of self-interest takes over and leads them to confess.
Cooperation between the two prisoners is difficult to maintain, because coopera-
tion is individually irrational.
OLIGOPOLIES AS A PRISONERS’ DILEMMA
What does the prisoners’ dilemma have to do with markets and imperfect compe-
tition? It turns out that the game oligopolists play in trying to reach the monopoly
outcome is similar to the game that the two prisoners play in the prisoners’
dilemma.
Consider an oligopoly with two members, called Iran and Iraq. Both countries
sell crude oil. After prolonged negotiation, the countries agree to keep oil produc-
tion low in order to keep the world price of oil high. After they agree on produc-
tion levels, each country must decide whether to cooperate and live up to this
agreement or to ignore it and produce at a higher level. Figure 16-3 shows how the
profits of the two countries depend on the strategies they choose.
Suppose you are the president of Iraq. You might reason as follows: “I could
keep production low as we agreed, or I could raise my production and sell more
oil on world markets. If Iran lives up to the agreement and keeps its production
low, then my country earns profit of $60 billion with high production and $50 bil-
lion with low production. In this case, Iraq is better off with high production. If
Iran fails to live up to the agreement and produces at a high level, then my coun-
try earns $40 billion with high production and $30 billion with low production.
Once again, Iraq is better off with high production. So, regardless of what Iran
chooses to do, my country is better off reneging on our agreement and producing
at a high level.”
Producing at a high level is a dominant strategy for Iraq. Of course, Iran rea-
sons in exactly the same way, and so both countries produce at a high level. The
dominant strategy
a strategy that is best for a player in
a game regardless of the strategies
chosen by the other players
CHAPTER 16 OLIGOPOLY 361
result is the inferior outcome (from Iran and Iraq’s standpoint) with low profits for
each country.
This example illustrates why oligopolies have trouble maintaining monopoly
profits. The monopoly outcome is jointly rational for the oligopoly, but each oli-
gopolist has an incentive to cheat. Just as self-interest drives the prisoners in the
prisoners’ dilemma to confess, self-interest makes it difficult for the oligopoly to
maintain the cooperative outcome with low production, high prices, and monop-
oly profits.
OTHER EXAMPLES OF THE PRISONERS’ DILEMMA
We have seen how the prisoners’ dilemma can be used to understand the problem
facing oligopolies. The same logic applies to many other situations as well. Here
we consider three examples in which self-interest prevents cooperation and leads
to an inferior outcome for the parties involved.
Arms Races An arms race is much like the prisoners’ dilemma. To see this,
consider the decisions of two countries—the United States and the Soviet Union—
about whether to build new weapons or to disarm. Each country prefers to have
more arms than the other because a larger arsenal gives it more influence in world
affairs. But each country also prefers to live in a world safe from the other coun-
try’s weapons.
Figure 16-4 shows the deadly game. If the Soviet Union chooses to arm, the
United States is better off doing the same to prevent the loss of power. If the Soviet
Union chooses to disarm, the United States is better off arming because doing so
would make it more powerful. For each country, arming is a dominant strategy.
Thus, each country chooses to continue the arms race, resulting in the inferior out-
come in which both countries are at risk.
Iraq's Decision
High
Production
High Production
Iraq gets $40 billion
Iran gets $40 billion
Iraq gets $30 billion
Iran gets $60 billion
Iraq gets $60 billion
Iran gets $30 billion
Iraq gets $50 billion
Iran gets $50 billion
Low Production
Low
Production
Iran's
Decision
Figure 16-3
AN OLIGOPOLYGAME. In this
game between members of an
oligopoly, the profit that each
earns depends on both its
production decision and the
production decision of the other
oligopolist.
362 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
Throughout the era of the Cold War, the United States and the Soviet Union
attempted to solve this problem through negotiation and agreements over arms
control. The problems that the two countries faced were similar to those that oli-
gopolists encounter in trying to maintain a cartel. Just as oligopolists argue over
production levels, the United States and the Soviet Union argued over the amount
of arms that each country would be allowed. And just as cartels have trouble en-
forcing production levels, the United States and the Soviet Union each feared that
the other country would cheat on any agreement. In both arms races and oligopo-
lies, the relentless logic of self-interest drives the participants toward a noncoop-
erative outcome that is worse for each party.
Advertising When two firms advertise to attract the same customers, they
face a problem similar to the prisoners’ dilemma. For example, consider the deci-
sions facing two cigarette companies, Marlboro and Camel. If neither company ad-
vertises, the two companies split the market. If both advertise, they again split the
market, but profits are lower, since each company must bear the cost of advertis-
ing. Yet if one company advertises while the other does not, the one that advertises
attracts customers from the other.
Figure 16-5 shows how the profits of the two companies depend on their ac-
tions. You can see that advertising is a dominant strategy for each firm. Thus, both
firms choose to advertise, even though both firms would be better off if neither
firm advertised.
Atest of this theory of advertising occurred in 1971, when Congress passed a
law banning cigarette advertisements on television. To the surprise of many ob-
servers, cigarette companies did not use their considerable political clout to op-
pose the law. When the law went into effect, cigarette advertising fell, and the
profits of cigarette companies rose. The law did for the cigarette companies what
they could not do on their own: It solved the prisoners’ dilemma by enforcing the
cooperative outcome with low advertising and high profit.
Decision of the United States (U.S.)
Arm
Arm
U.S. at risk
USSR at risk
U.S. at risk and weak
USSR safe and powerful
U.S. safe and powerful
USSR at risk and weak
U.S. safe
USSR safe
Disarm
Disarm
Decision
of the
Soviet Union
(USSR)
Figure 16-4
ANARMS-RACEGAME. In this
game between two countries, the
safety and power of each country
depends on both its decision
whether to arm and the decision
made by the other country.
CHAPTER 16 OLIGOPOLY 363
Common Resources In Chapter 11 we saw that people tend to overuse
common resources. One can view this problem as an example of the prisoners’
dilemma.
Imagine that two oil companies—Exxon and Arco—own adjacent oil fields.
Under the fields is a common pool of oil worth $12 million. Drilling a well to re-
cover the oil costs $1 million. If each company drills one well, each will get half of
the oil and earn a $5 million profit ($6 million in revenue minus $1 million in
costs).
Because the pool of oil is a common resource, the companies will not use it ef-
ficiently. Suppose that either company could drill a second well. If one company
has two of the three wells, that company gets two-thirds of the oil, which yields a
profit of $6 million. Yet if each company drills a second well, the two companies
again split the oil. In this case, each bears the cost of a second well, so profit is only
$4 million for each company.
Figure 16-6 shows the game. Drilling two wells is a dominant strategy for each
company. Once again, the self-interest of the two players leads them to an inferior
outcome.
THE PRISONERS’ DILEMMA AND
THE WELFARE OF SOCIETY
The prisoners’ dilemma describes many of life’s situations, and it shows that co-
operation can be difficult to maintain, even when cooperation would make both
players in the game better off. Clearly, this lack of cooperation is a problem for
those involved in these situations. But is lack of cooperation a problem from the
standpoint of society as a whole? The answer depends on the circumstances.
In some cases, the noncooperative equilibrium is bad for society as well as
theplayers. In the arms-race game in Figure 16-4, both the United States and the
Marlboro's Decision
Advertise
Advertise
Marlboro gets $3
billion profit
Camel gets $3
billion profit
Camel gets $5
billion profit
Camel gets $2
billion profit
Camel gets $4
billion profit
Marlboro gets $2
billion profit
Marlboro gets $5
billion profit
Marlboro gets $4
billion profit
Don't Advertise
Don't
Advertise
Camel's
Decision
Figure 16-5
ANADVERTISINGGAME. In this
game between firms selling
similar products, the profit that
each earns depends on both its
own advertising decision and the
advertising decision of the other
firm.
364 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
Soviet Union end up at risk. In the common-resources game in Figure 16-6, the ex-
tra wells dug by Arco and Exxon are pure waste. In both cases, society would be
better off if the two players could reach the cooperative outcome.
By contrast, in the case of oligopolists trying to maintain monopoly profits,
lack of cooperation is desirable from the standpoint of society as a whole. The mo-
nopoly outcome is good for the oligopolists, but it is bad for the consumers of the
product. As we first saw in Chapter 7, the competitive outcome is best for society
because it maximizes total surplus. When oligopolists fail to cooperate, the quan-
tity they produce is closer to this optimal level. Put differently, the invisible hand
guides markets to allocate resources efficiently only when markets are competi-
tive, and markets are competitive only when firms in the market fail to cooperate
with one another.
Similarly, consider the case of the police questioning two suspects. Lack of co-
operation between the suspects is desirable, for it allows the police to convict more
criminals. The prisoners’ dilemma is a dilemma for the prisoners, but it can be a
boon to everyone else.
WHY PEOPLE SOMETIMES COOPERATE
The prisoners’ dilemma shows that cooperation is difficult. But is it impossible?
Not all prisoners, when questioned by the police, decide to turn in their partners
in crime. Cartels sometimes do manage to maintain collusive arrangements, de-
spite the incentive for individual members to defect. Very often, the reason that
players can solve the prisoners’ dilemma is that they play the game not once but
many times.
To see why cooperation is easier to enforce in repeated games, let’s return to
our duopolists, Jack and Jill. Recall that Jack and Jill would like to maintain the
monopoly outcome in which each produces 30 gallons, but self-interest drives
Exxon's Decision
Drill Two
Wells
Drill Two Wells
Exxon gets $4
million profit
Arco gets $4
million profit
Arco gets $6
million profit
Arco gets $3
million profit
Arco gets $5
million profit
Exxon gets $3
million profit
Exxon gets $6
million profit
Exxon gets $5
million profit
Drill One Well
Drill One
Well
Arco's
Decision
Figure 16-6
ACOMMON-RESOURCESGAME.
In this game between firms
pumping oil from a common
pool, the profit that each earns
depends on both the number of
wells it drills and the number of
wells drilled by the other firm.
CHAPTER 16 OLIGOPOLY 365
CASE STUDY THE PRISONERS’ DILEMMA TOURNAMENT
Imagine that you are playing a game of prisoners’ dilemma with a person being
“questioned” in a separate room. Moreover, imagine that you are going to play
not once but many times. Your score at the end of the game is the total number
of years in jail. You would like to make this score as small as possible. What
strategy would you play? Would you begin by confessing or remaining silent?
them to an equilibrium in which each produces 40 gallons. Figure 16-7 shows the
game they play. Producing 40 gallons is a dominant strategy for each player in this
game.
Imagine that Jack and Jill try to form a cartel. To maximize total profit, they
would agree to the cooperative outcome in which each produces 30 gallons. Yet, if
Jack and Jill are to play this game only once, neither has any incentive to live up to
this agreement. Self-interest drives each of them to renege and produce 40 gallons.
Now suppose that Jack and Jill know that they will play the same game every
week. When they make their initial agreement to keep production low, they can
also specify what happens if one party reneges. They might agree, for instance,
that once one of them reneges and produces 40 gallons, both of them will produce
40 gallons forever after. This penalty is easy to enforce, for if one party is produc-
ing at a high level, the other has every reason to do the same.
The threat of this penalty may be all that is needed to maintain cooperation.
Each person knows that defecting would raise his or her profit from $1,800 to
$2,000. But this benefit would last for only one week. Thereafter, profit would fall
to $1,600 and stay there. As long as the players care enough about future profits,
they will choose to forgo the one-time gain from defection. Thus, in a game of re-
peated prisoners’ dilemma, the two players may well be able to reach the cooper-
ative outcome.
Jack's Decision
Sell 40
Gallons
Sell 40 Gallons
Jack gets
$1,600 profit
Jill gets
$1,600 profit
Jill gets
$2,000 profit
Jill gets
$1,500 profit
Jill gets
$1,800 profit
Jack gets
$1,500 profit
Jack gets
$2,000 profit
Jack gets
$1,800 profit
Sell 30 Gallons
Sell 30
Gallons
Jill's
Decision
Figure 16-7
JACKANDJILL’S OLIGOPOLY
GAME. In this game between
Jack and Jill, the profit that each
earns from selling water depends
on both the quantity he or she
chooses to sell and the quantity
the other chooses to sell.
366 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
How would the other player’s actions affect your subsequent decisions about
confessing?
Repeated prisoners’ dilemma is quite a complicated game. To encourage
cooperation, players must penalize each other for not cooperating. Yet the strat-
egy described earlier for Jack and Jill’s water cartel—defect forever as soon as
the other player defects—is not very forgiving. In a game repeated many times,
a strategy that allows players to return to the cooperative outcome after a pe-
riod of noncooperation may be preferable.
To see what strategies work best, political scientist Robert Axelrod held a
tournament. People entered by sending computer programs designed to play
repeated prisoners’ dilemma. Each program then played the game against all
the other programs. The “winner” was the program that received the fewest
total years in jail.
The winner turned out to be a simple strategy called tit-for-tat.According to
tit-for-tat, a player should start by cooperating and then do whatever the other
player did last time. Thus, a tit-for-tat player cooperates until the other player
defects; he then defects until the other player cooperates again. In other words,
this strategy starts out friendly, penalizes unfriendly players, and forgives them
if warranted. To Axelrod’s surprise, this simple strategy did better than all the
more complicated strategies that people had sent in.
The tit-for-tat strategy has a long history. It is essentially the biblical strat-
egy of “an eye for an eye, a tooth for a tooth.” The prisoners’ dilemma tourna-
ment suggests that this may be a good rule of thumb for playing some of the
games of life.
QUICK QUIZ: Tell the story of the prisoners’ dilemma. Write down a table
showing the prisoners’ choices and explain what outcome is likely. a78 What
does the prisoners’ dilemma teach us about oligopolies?
PUBLIC POLICY TOWARD OLIGOPOLIES
One of the Ten Principles of Economicsin Chapter 1 is that governments can some-
times improve market outcomes. The application of this principle to oligopolistic
markets is, as a general matter, straightforward. As we have seen, cooperation
among oligopolists is undesirable from the standpoint of society as a whole, be-
cause it leads to production that is too low and prices that are too high. To move
the allocation of resources closer to the social optimum, policymakers should try
to induce firms in an oligopoly to compete rather than cooperate. Let’s consider
how policymakers do this and then examine the controversies that arise in this
area of public policy.
RESTRAINT OF TRADE AND THE ANTITRUST LAWS
One way that policy discourages cooperation is through the common law. Nor-
mally, freedom of contract is an essential part of a market economy. Businesses and
households use contracts to arrange mutually advantageous trades. In doing this,
CHAPTER 16 OLIGOPOLY 367
CASE STUDY AN ILLEGAL PHONE CALL
Firms in oligopolies have a strong incentive to collude in order to reduce pro-
duction, raise price, and increase profit. The great eighteenth-century economist
Adam Smith was well aware of this potential market failure. In The Wealth of
Nationshe wrote, “People of the same trade seldom meet together, but the con-
versation ends in a conspiracy against the public, or in some diversion to raise
prices.”
To see a modern example of Smith’s observation, consider the following ex-
cerpt of a phone conversation between two airline executives in the early 1980s.
The call was reported in The New York Timeson February 24, 1983. Robert Cran-
dall was president of American Airlines, and Howard Putnam was president of
Braniff Airways.
CRANDALL: I think it’s dumb as hell . . . to sit here and pound the @#$% out
of each other and neither one of us making a #$%& dime.
PUTNAM: Do you have a suggestion for me?
CRANDALL: Yes, I have a suggestion for you. Raise your $%*& fares
20percent. I’ll raise mine the next morning.
PUTNAM: Robert, we . . .
CRANDALL: You’ll make more money, and I will, too.
they rely on the court system to enforce contracts. Yet, for many centuries, judges
in England and the United States have deemed agreements among competitors to
reduce quantities and raise prices to be contrary to the public good. They therefore
refused to enforce such agreements.
The Sherman Antitrust Act of 1890 codified and reinforced this policy:
Every contract, combination in the form of trust or otherwise, or conspiracy, in
restraint of trade or commerce among the several States, or with foreign nations,
is declared to be illegal. . . . Every person who shall monopolize, or attempt to
monopolize, or combine or conspire with any person or persons to monopolize
any part of the trade or commerce among the several States, or with foreign
nations, shall be deemed guilty of a misdemeanor, and on conviction therefor,
shall be punished by fine not exceeding fifty thousand dollars, or by
imprisonment not exceeding one year, or by both said punishments, in the
discretion of the court.
The Sherman Act elevated agreements among oligopolists from an unenforceable
contract to a criminal conspiracy.
The Clayton Act of 1914 further strengthened the antitrust laws. According to
this law, if a person could prove that he was damaged by an illegal arrangement to
restrain trade, that person could sue and recover three times the damages he sus-
tained. The purpose of this unusual rule of triple damages is to encourage private
lawsuits against conspiring oligopolists.
Today, both the U.S. Justice Department and private parties have the authority
to bring legal suits to enforce the antitrust laws. As we discussed in Chapter 15,
these laws are used to prevent mergers that would lead to excessive market power
in any single firm. In addition, these laws are used to prevent oligopolists from act-
ing together in ways that would make their markets less competitive.
368 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
PUTNAM: We can’t talk about pricing!
CRANDALL: Oh @#$%, Howard. We can talk about any &*#@ thing we want
to talk about.
Putnam was right: The Sherman Antitrust Act prohibits competing executives
from even talking about fixing prices. When Howard Putnam gave a tape of this
conversation to the Justice Department, the Justice Department filed suit against
Robert Crandall.
Two years later, Crandall and the Justice Department reached a settlement
in which Crandall agreed to various restrictions on his business activities, in-
cluding his contacts with officials at other airlines. The Justice Department said
that the terms of settlement would “protect competition in the airline industry,
by preventing American and Crandall from any further attempts to monopolize
passenger airline service on any route through discussions with competitors
about the prices of airline services.”
CONTROVERSIES OVER ANTITRUST POLICY
Over time, much controversy has centered on the question of what kinds of
behavior the antitrust laws should prohibit. Most commentators agree that price-
fixing agreements among competing firms should be illegal. Yet the antitrust laws
BUSINESS EXECUTIVES ARE SUPPOSED TO
maximize their company’s profits, but
as the following article makes clear,
they have to play within the rules es-
tablished by the antitrust laws.
Jury Convicts Ex-Executives
in ADM Case
BY SCOTT KILMAN
CHICAGO—A federal jury found Michael
D. Andreas and two other former Archer-
Daniels-Midland Co. executives guilty in
a landmark price-fixing case.
The unanimous decision by the six-
woman, six-man jury, reached here after
a week of deliberations in the two-month
trial, is a blow to the Andreas family,
whose decades-long control of the De-
catur, Ill., grain-processing giant has
made it one of the Midwest’s wealthiest
and most politically influential families.
The verdicts also give the Justice
Department its biggest convictions in a
push against illegal global cartels. The
department has 30 grand juries around
the country considering international
price-fixing cases, and more are
expected. . . .
Mr. Andreas, who didn’t take the
stand in his defense, sat stone-faced as
U.S. District Judge Blanche M. Manning
read the verdict to the packed court-
room. Before the scandal, Mr. Andreas,
49 years old, was earning $1.3 million
annually as the No. 2 executive at
ADM and was being groomed to suc-
ceed his 80-year-old father, Dwayne
Andreas. . . .
The most prominent American exec-
utive ever convicted for international
price-fixing, the younger Mr. Andreas
faces sentencing on Jan. 7. Prosecutors
said they will seek the maximum sen-
tence of three years in prison for violat-
ing the Sherman Antitrust Act. The jury
determined that Mr. Andreas helped or-
ganize a cartel with four Asian compa-
nies to rig the $650 million world-wide
market for lysine, a fast-selling livestock-
feed additive that hastens the growth
of chickens and hogs. [Author’s note:
Andreas was eventually sentenced to
spend two years in prison.]
SOURCE:The Wall Street Journal,September 18,
1998, p. A3.
IN THE NEWS
The Short Step from
Millionaire Executive
toConvicted Felon
CHAPTER 16 OLIGOPOLY 369
have been used to condemn some business practices whose effects are not obvious.
Here we consider three examples.
Resale Price Maintenance One example of a controversial business
practice is resale price maintenance,also called fair trade.Imagine that Superduper
Electronics sells VCRs to retail stores for $300. If Superduper requires the retailers
to charge customers $350, it is said to engage in resale price maintenance. Any
retailer that charged less than $350 would have violated its contract with
Superduper.
At first, resale price maintenance might seem anticompetitive and, therefore,
detrimental to society. Like an agreement among members of a cartel, it prevents
the retailers from competing on price. For this reason, the courts have often
viewed resale price maintenance as a violation of the antitrust laws.
Yet some economists defend resale price maintenance on two grounds. First,
they deny that it is aimed at reducing competition. To the extent that Superduper
Electronics has any market power, it can exert that power through the wholesale
price, rather than through resale price maintenance. Moreover, Superduper has no
incentive to discourage competition among its retailers. Indeed, because a cartel of
retailers sells less than a group of competitive retailers, Superduper would be
worse off if its retailers were a cartel.
Second, economists believe that resale price maintenance has a legitimate goal.
Superduper may want its retailers to provide customers a pleasant showroom and
a knowledgeable sales force. Yet, without resale price maintenance, some cus-
tomers would take advantage of one store’s service to learn about the VCR’s spe-
cial features and then buy the VCR at a discount retailer that does not provide this
service. To some extent, good service is a public good among the retailers that sell
Superduper VCRs. As we discussed in Chapter 11, when one person provides a
public good, others are able to enjoy it without paying for it. In this case, discount
retailers would free ride on the service provided by other retailers, leading to less
service than is desirable. Resale price maintenance is one way for Superduper to
solve this free-rider problem.
The example of resale price maintenance illustrates an important principle:
Business practices that appear to reduce competition may in fact have legitimate purposes.
This principle makes the application of the antitrust laws all the more difficult. The
economists, lawyers, and judges in charge of enforcing these laws must determine
what kinds of behavior public policy should prohibit as impeding competition and
reducing economic well-being. Often that job is not easy.
Predatory Pricing Firms with market power normally use that power to
raise prices above the competitive level. But should policymakers ever be con-
cerned that firms with market power might charge prices that are too low? This
question is at the heart of a second debate over antitrust policy.
Imagine that a large airline, call it Coyote Air, has a monopoly on some route.
Then Roadrunner Express enters and takes 20 percent of the market, leaving Coy-
ote with 80 percent. In response to this competition, Coyote starts slashing its fares.
Some antitrust analysts argue that Coyote’s move could be anticompetitive: The
price cuts may be intended to drive Roadrunner out of the market so Coyote can
recapture its monopoly and raise prices again. Such behavior is called predatory
pricing.
Although predatory pricing is a common claim in antitrust suits, some econo-
mists are skeptical of this argument and believe that predatory pricing is rarely,
370 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
CASE STUDY THE MICROSOFT CASE
The most important and controversial antitrust case in recent years has been the
U.S. government’s suit against the Microsoft Corporation, filed in 1998. Cer-
tainly, the case did not lack drama. It pitted one of the world’s richest men (Bill
Gates) against one of the world’s most powerful regulatory agencies (the U.S.
and perhaps never, a profitable business strategy. Why? For a price war to drive
out a rival, prices have to be driven below cost. Yet if Coyote starts selling cheap
tickets at a loss, it had better be ready to fly more planes, because low fares will at-
tract more customers. Roadrunner, meanwhile, can respond to Coyote’s predatory
move by cutting back on flights. As a result, Coyote ends up bearing more than
80percent of the losses, putting Roadrunner in a good position to survive the price
war. As in the old Roadrunner–Coyote cartoons, the predator suffers more than
theprey.
Economists continue to debate whether predatory pricing should be a concern
for antitrust policymakers. Various questions remain unresolved. Is predatory
pricing ever a profitable business strategy? If so, when? Are the courts capable of
telling which price cuts are competitive and thus good for consumers and which
are predatory? There are no easy answers.
Tying Athird example of a controversial business practice is tying.Suppose
that Makemoney Movies produces two new films—Star Wars and Hamlet. If
Makemoney offers theaters the two films together at a single price, rather than
separately, the studio is said to be tying its two products.
When the practice of tying movies was challenged in the courts, the U.S.
Supreme Court banned the practice. The Court reasoned as follows: Imagine that
Star Warsis a blockbuster, whereas Hamletis an unprofitable art film. Then the
studio could use the high demand for Star Warsto force theaters to buy Hamlet.It
seemed that the studio could use tying as a mechanism for expanding its market
power.
Many economists, however, are skeptical of this argument. Imagine that the-
aters are willing to pay $20,000 for Star Warsand nothing for Hamlet.Then the
most that a theater would pay for the two movies together is $20,000—the same as
it would pay for Star Warsby itself. Forcing the theater to accept a worthless movie
as part of the deal does not increase the theater’s willingness to pay. Makemoney
cannot increase its market power simply by bundling the two movies together.
Why, then, does tying exist? One possibility is that it is a form of price dis-
crimination. Suppose there are two theaters. City Theater is willing to pay $15,000
for Star Warsand $5,000 for Hamlet.Country Theater is just the opposite: It is will-
ing to pay $5,000 for Star Warsand $15,000 for Hamlet.If Makemoney charges sep-
arate prices for the two films, its best strategy is to charge $15,000 for each film,
and each theater chooses to show only one film. Yet if Makemoney offers the two
movies as a bundle, it can charge each theater $20,000 for the movies. Thus, if dif-
ferent theaters value the films differently, tying may allow the studio to increase
profit by charging a combined price closer to the buyers’ total willingness to pay.
Tying remains a controversial business practice. The Supreme Court’s argu-
ment that tying allows a firm to extend its market power to other goods is not well
founded, at least in its simplest form. Yet economists have proposed more elabo-
rate theories for how tying can impede competition. Given our current economic
knowledge, it is unclear whether tying has adverse effects for society as a whole.
CHAPTER 16 OLIGOPOLY 371
Justice Department). Testifying for the government was a prominent economist
(MIT professor Franklin Fisher). Testifying for Microsoft was an equally promi-
nent economist (MIT professor Richard Schmalensee). At stake was the future
of one of the world’s most valuable companies (Microsoft) in one of the econ-
omy’s fastest growing industries (computer software).
Acentral issue in the Microsoft case involved tying—in particular, whether
Microsoft should be allowed to integrate its Internet browser into its Windows
operating system. The government claimed that Microsoft was bundling these
two products together to expand the market power it had in the market for
computer operating systems into an unrelated market (for Internet browsers).
Allowing Microsoft to incorporate such products into its operating system, the
government argued, would deter new software companies such as Netscape
from entering the market and offering new products.
Microsoft responded by pointing out that putting new features into old
products is a natural part of technological progress. Cars today include stereos
and air-conditioners, which were once sold separately, and cameras come with
built-in flashes. The same is true with operating systems. Over time, Microsoft
has added many features to Windows that were previously stand-alone prod-
ucts. This has made computers more reliable and easier to use because con-
sumers can be confident that the pieces work together. The integration of
Internet technology, Microsoft argued, was the natural next step.
One point of disagreement concerned the extent of Microsoft’s market
power. Noting that more than 80 percent of new personal computers used a
Microsoft operating system, the government argued that the company had sub-
stantial monopoly power, which it was trying to expand. Microsoft replied that
the software market is always changing and that Microsoft’s Windows was
constantly being challenged by competitors, such as the Apple Mac and Linux
operating systems. It also argued that the low price it charged for Windows—
about $50, or only 3 percent of the price of a typical computer—was evidence
that its market power was severely limited.
As this book was going to press, the final outcome of the Microsoft case was
yet to be resolved. In November 1999 the trial judge issued a ruling in which he
found that Microsoft had great monopoly power and that it had illegally abused
that power. But many questions were still unanswered. Would the trial court’s
decision hold up on appeal? If so, what remedy would the government seek?
Would it try to regulate future design changes in the Windows operating sys-
tem? Would it try to break up Microsoft into a group of smaller, more com-
petitive companies? The answers to these questions will shape the software
industry for years to come.
QUICK QUIZ: What kind of agreement is illegal for businesses to make?
a78 Why are the antitrust laws controversial?
CONCLUSION
Oligopolies would like to act like monopolies, but self-interest drives them closer
to competition. Thus, oligopolies can end up looking either more like monopolies
or more like competitive markets, depending on the number of firms in the
“ME? AMONOPOLIST? NOWJUSTWAITA
MINUTE. . .”
372 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
oligopoly and how cooperative the firms are. The story of the prisoners’ dilemma
shows why oligopolies can fail to maintain cooperation, even when cooperation is
in their best interest.
Policymakers regulate the behavior of oligopolists through the antitrust laws.
The proper scope of these laws is the subject of ongoing controversy. Although
price fixing among competing firms clearly reduces economic welfare and should
be illegal, some business practices that appear to reduce competition may have le-
gitimate if subtle purposes. As a result, policymakers need to be careful when they
use the substantial powers of the antitrust laws to place limits on firm behavior.
a78 Oligopolists maximize their total profits by forming a
cartel and acting like a monopolist. Yet, if oligopolists
make decisions about production levels individually, the
result is a greater quantity and a lower price than under
the monopoly outcome. The larger the number of firms
in the oligopoly, the closer the quantity and price will be
to the levels that would prevail under competition.
a78 The prisoners’ dilemma shows that self-interest can
prevent people from maintaining cooperation, even
when cooperation is in their mutual interest. The logic
of the prisoners’ dilemma applies in many situations,
including arms races, advertising, common-resource
problems, and oligopolies.
a78 Policymakers use the antitrust laws to prevent
oligopolies from engaging in behavior that reduces
competition. The application of these laws can be
controversial, because some behavior that may seem to
reduce competition may in fact have legitimate business
purposes.
Summary
oligopoly, p. 350
monopolistic competition, p. 350
collusion, p. 353
cartel, p. 353
Nash equilibrium, p. 355
game theory, p. 358
prisoners’ dilemma, p. 359
dominant strategy, p. 360
Key Concepts
1. If a group of sellers could form a cartel, what quantity
and price would they try to set?
2. Compare the quantity and price of an oligopoly to those
of a monopoly.
3. Compare the quantity and price of an oligopoly to those
of a competitive market.
4. How does the number of firms in an oligopoly affect the
outcome in its market?
5. What is the prisoners’ dilemma, and what does it have
to do with oligopoly?
6. Give two examples other than oligopoly to show how
the prisoners’ dilemma helps to explain behavior.
7. What kinds of behavior do the antitrust laws prohibit?
8. What is resale price maintenance, and why is it
controversial?
Questions for Review
CHAPTER 16 OLIGOPOLY 373
1. The New York Times(Nov. 30, 1993) reported that “the
inability of OPEC to agree last week to cut production
has sent the oil market into turmoil . . . [leading to] the
lowest price for domestic crude oil since June 1990.”
a. Why were the members of OPEC trying to agree to
cut production?
b. Why do you suppose OPEC was unable to agree on
cutting production? Why did the oil market go into
“turmoil” as a result?
c. The newspaper also noted OPEC’s view “that
producing nations outside the organization, like
Norway and Britain, should do their share and cut
production.” What does the phrase “do their share”
suggest about OPEC’s desired relationship with
Norway and Britain?
2. Alarge share of the world supply of diamonds comes
from Russia and South Africa. Suppose that the
marginal cost of mining diamonds is constant at $1,000
per diamond, and the demand for diamonds is
described by the following schedule:
PRICE QUANTITY
$8,000 5,000
7,000 6,000
6,000 7,000
5,000 8,000
4,000 9,000
3,000 10,000
2,000 11,000
1,000 12,000
a. If there were many suppliers of diamonds, what
would be the price and quantity?
b. If there were only one supplier of diamonds, what
would be the price and quantity?
c. If Russia and South Africa formed a cartel, what
would be the price and quantity? If the countries
split the market evenly, what would be South
Africa’s production and profit? What would
happen to South Africa’s profit if it increased its
production by 1,000 while Russia stuck to the cartel
agreement?
d. Use your answer to part (c) to explain why cartel
agreements are often not successful.
3. This chapter discusses companies that are oligopolists in
the market for the goods they sell. Many of the same
ideas apply to companies that are oligopolists in the
market for the inputs they buy.
a. If sellers who are oligopolists try to increase the
price of goods they sell, what is the goal of buyers
who are oligopolists?
b. Major league baseball team owners have an
oligopoly in the market for baseball players. What
is the owners’ goal regarding players’ salaries?
Why is this goal difficult to achieve?
c. Baseball players went on strike in 1994 because
they would not accept the salary cap that the
owners wanted to impose. If the owners were
already colluding over salaries, why did the owners
feel the need for a salary cap?
4. Describe several activities in your life in which game
theory could be useful. What is the common link among
these activities?
5. Consider trade relations between the United States and
Mexico. Assume that the leaders of the two countries
believe the payoffs to alternative trade policies are as
follows:
a. What is the dominant strategy for the United
States? For Mexico? Explain.
b. Define Nash equilibrium.What is the Nash
equilibrium for trade policy?
c. In 1993 the U.S. Congress ratified the North
American Free Trade Agreement (NAFTA), in
which the United States and Mexico agreed to
reduce trade barriers simultaneously. Do the
perceived payoffs as shown here justify this
approach to trade policy?
d. Based on your understanding of the gains from
trade (discussed in Chapters 3 and 9), do you think
that these payoffs actually reflect a nation’s welfare
under the four possible outcomes?
United States Decision
Low
Tariffs
Low Tariffs
U.S. gains
$25 billion
Mexico gains
$25 billion
Mexico gains
$10 billion
Mexico gains
$30 billion
Mexico gains
$20 billion
U.S. gains
$30 billion
U.S. gains
$10 billion
U.S. gains
$20 billion
High Tariffs
High
Tarrifs
Mexico's
Decision
'
Problems and Applications
374 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
6. Suppose that you and a classmate are assigned a project
on which you will receive one combined grade. You
each want to receive a good grade, but you also want to
do as little work as possible. The decision box and
payoffs are as follows:
Assume that having fun is your normal state, but
having no fun is as unpleasant as receiving a grade that
is two letters lower.
a. Write out the decision box that combines the letter
grade and the amount of fun you have into a single
payoff for each outcome.
b. If neither you nor your classmate knows how much
work the other person is doing, what is the likely
outcome? Does it matter whether you are likely to
work with this person again? Explain your answer.
7. The chapter states that the ban on cigarette advertising
on television in 1971 increased the profits of cigarette
companies. Could the ban still be good public policy?
Explain your answer.
8. Acase study in the chapter describes a phone
conversation between the presidents of American
Airlines and Braniff Airways. Let’s analyze the game
between the two companies. Suppose that each
company can charge either a high price for tickets or a
low price. If one company charges $100, it earns low
profits if the other company charges $100 also, and high
profits if the other company charges $200. On the other
hand, if the company charges $200, it earns very low
profits if the other company charges $100, and medium
profits if the other company charges $200 also.
a. Draw the decision box for this game.
b. What is the Nash equilibrium in this game?
Explain.
c. Is there an outcome that would be better than
theNash equilibrium for both airlines? How
couldit be achieved? Who would lose if it were
achieved?
9. Farmer Jones and Farmer Smith graze their cattle on
thesame field. If there are 20 cows grazing in the
field,each cow produces $4,000 of milk over its
lifetime.If there are more cows in the field, then each
cow can eat less grass, and its milk production falls.
With 30 cows on the field, each produces $3,000 of milk;
with 40 cows, each produces $2,000 of milk. Cows cost
$1,000 apiece.
a. Assume that Farmer Jones and Farmer Smith can
each purchase either 10 or 20 cows, but that neither
knows how many the other is buying when she
makes her purchase. Calculate the payoffs of each
outcome.
b. What is the likely outcome of this game? What
would be the best outcome? Explain.
c. There used to be more common fields than there are
today. Why? (For more discussion of this topic,
reread Chapter 11.)
10. Little Kona is a small coffee company that is considering
entering a market dominated by Big Brew. Each
company’s profit depends on whether Little Kona
entersand whether Big Brew sets a high price or a low
price:
Big Brew threatens Little Kona by saying, “If you enter,
we’re going to set a low price, so you had better stay
out.” Do you think Little Kona should believe the
threat? Why or why not? What do you think Little Kona
should do?
11. Jeff and Steve are playing tennis. Every point comes
down to whether Steve guesses correctly whether
Jeffwill hit the ball to Steve’s left or right. The
outcomesare:
Big Brew
Enter
High Price
Brew makes
$3 million
Kona makes
$2 million
Kona loses
$1 million
Kona makes
zero
Kona makes
zero
Brew makes
$1 million
Brew makes
$7 million
Brew makes
$2 million
Low Price
Don't
Enter
Little
Kona
Your Decision
Work
Work
You get A grade,
no fun
Classmate gets
A grade, no fun
Classmate gets B
grade, no fun
Classmate gets
B grade, fun
Classmate gets
D grade, fun
You get B grade,
fun
You get B grade,
no fun
You get D grade,
fun
Shirk
Shirk
Classmate's
Decision
CHAPTER 16 OLIGOPOLY 375
Does either player have a dominant strategy? If Jeff
chooses a particular strategy (Left or Right) and sticks
with it, what will Steve do? So, can you think of a better
strategy for Jeff to follow?
Steve Guesses
Left
Left
Steve wins
point
Jeff wins
point
Jeff wins
point
Steve wins
point
Right
Right
Jeff
Hits
Jeff loses
point
Steve loses
point
Steve loses
point
Jeff loses
point
IN THIS CHAPTER
YOU WILL . . .
Examine the debate
over the role of
brand names
Consider the
desirability of
outcomes in
monopolistically
competitive
markets
Analyze competition
among firms that
sell differentiated
products
Compare the
outcome under
monopolistic
competition and
under perfect
competition
Examine the debate
over the effects of
advertising
You walk into a bookstore to buy a book to read during your next vacation. On the
store’s shelves you find a John Grisham mystery, a Stephen King thriller, a Danielle
Steel romance, a Frank McCourt memoir, and many other choices. When you pick
out a book and buy it, what kind of market are you participating in?
On the one hand, the market for books seems competitive. As you look over
the shelves at your bookstore, you find many authors and many publishers vying
for your attention. Abuyer in this market has thousands of competing products
from which to choose. And because anyone can enter the industry by writing and
publishing a book, the book business is not very profitable. For every highly paid
novelist, there are hundreds of struggling ones.
On the other hand, the market for books seems monopolistic. Because each
book is unique, publishers have some latitude in choosing what price to charge.
The sellers in this market are price makers rather than price takers. And, indeed,
the price of books greatly exceeds marginal cost. The price of a typical hardcover
MONOPOLISTIC COMPETITION
377
378 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
novel, for instance, is about $25, whereas the cost of printing one additional copy
of the novel is less than $5.
In this chapter we examine markets that have some features of competi-
tionand some features of monopoly. This market structure is called monopolistic
competition. Monopolistic competition describes a market with the following
attributes:
a78 Many sellers:There are many firms competing for the same group of
customers.
a78 Product differentiation:Each firm produces a product that is at least slightly
different from those of other firms. Thus, rather than being a price taker, each
firm faces a downward-sloping demand curve.
a78 Free entry:Firms can enter (or exit) the market without restriction. Thus,
thenumber of firms in the market adjusts until economic profits are driven
to zero.
Amoment’s thought reveals a long list of markets with these attributes: books,
CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, and
so on.
Monopolistic competition, like oligopoly, is a market structure that lies be-
tween the extreme cases of competition and monopoly. But oligopoly and monop-
olistic competition are quite different. Oligopoly departs from the perfectly
competitive ideal of Chapter 14 because there are only a few sellers in the market.
The small number of sellers makes rigorous competition less likely, and it makes
strategic interactions among them vitally important. By contrast, under monopo-
listic competition, there are many sellers, each of which is small compared to the
market. Amonopolistically competitive market departs from the perfectly com-
petitive ideal because each of the sellers offers a somewhat different product.
COMPETITION WITH DIFFERENTIATED PRODUCTS
To understand monopolistically competitive markets, we first consider the de-
cisions facing an individual firm. We then examine what happens in the long
run as firms enter and exit the industry. Next, we compare the equilibrium un-
der monopolistic competition to the equilibrium under perfect competition that
we examined in Chapter 14. Finally, we consider whether the outcome in a mo-
nopolistically competitive market is desirable from the standpoint of society as a
whole.
THE MONOPOLISTICALLY COMPETITIVE
FIRM IN THE SHORT RUN
Each firm in a monopolistically competitive market is, in many ways, like a mo-
nopoly. Because its product is different from those offered by other firms, it faces a
monopolistic competition
a market structure in which many
firms sell products that are similar
but not identical
CHAPTER 17 MONOPOLISTIC COMPETITION 379
downward-sloping demand curve. (By contrast, a perfectly competitive firm faces
a horizontal demand curve at the market price.) Thus, the monopolistically com-
petitive firm follows a monopolist’s rule for profit maximization: It chooses the
quantity at which marginal revenue equals marginal cost and then uses its de-
mand curve to find the price consistent with that quantity.
Figure 17-1 shows the cost, demand, and marginal-revenue curves for two
typical firms, each in a different monopolistically competitive industry. In both
panels of this figure, the profit-maximizing quantity is found at the intersection of
the marginal-revenue and marginal-cost curves. The two panels in this figure
show different outcomes for the firm’s profit. In panel (a), price exceeds average
total cost, so the firm makes a profit. In panel (b), price is below average total cost.
In this case, the firm is unable to make a positive profit, so the best the firm can do
is to minimize its losses.
All this should seem familiar. Amonopolistically competitive firm chooses its
quantity and price just as a monopoly does. In the short run, these two types of
market structure are similar.
THE LONG-RUN EQUILIBRIUM
The situations depicted in Figure 17-1 do not last long. When firms are mak-
ingprofits, as in panel (a), new firms have an incentive to enter the market. This
QuantityProfit-
maximizing
quantity
Loss-
minimizing
quantity
0
Price
Price
Demand
Demand
MR
ATC
(a) Firm Makes Profit
Quantity0
Price
Price
Average
total cost
Average
total cost
(b) Firm Makes Losses
MR
Profit
Losses
MC
ATC
MC
Figure 17-1
MONOPOLISTIC COMPETITORS IN THE SHORT RUN. Monopolistic competitors, like
monopolists, maximize profit by producing the quantity at which marginal revenue
equals marginal cost. The firm in panel (a) makes a profit because, at this quantity, price is
above average total cost. The firm in panel (b) makes losses because, at this quantity, price
is less than average total cost.
380 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
entry increases the number of products from which customers can choose and,
therefore,reduces the demand faced by each firm already in the market. In other
words,profit encourages entry, and entry shifts the demand curves faced by the
incumbent firms to the left. As the demand for incumbent firms’ products falls,
these firms experience declining profit.
Conversely, when firms are making losses, as in panel (b), firms in the market
have an incentive to exit. As firms exit, customers have fewer products from which
to choose. This decrease in the number of firms expands the demand faced by
those firms that stay in the market. In other words, losses encourage exit, and exit
shifts the demand curves of the remaining firms to the right. As the demand for
the remaining firms’ products rises, these firms experience rising profit (that is, de-
clining losses).
This process of entry and exit continues until the firms in the market are mak-
ing exactly zero economic profit. Figure 17-2 depicts the long-run equilibrium.
Once the market reaches this equilibrium, new firms have no incentive to enter,
and existing firms have no incentive to exit.
Notice that the demand curve in this figure just barely touches the average-
total-cost curve. Mathematically, we say the two curves are tangentto each other.
These two curves must be tangent once entry and exit have driven profit to zero.
Because profit per unit sold is the difference between price (found on the demand
curve) and average total cost, the maximum profit is zero only if these two curves
touch each other without crossing.
CHAPTER 17 MONOPOLISTIC COMPETITION 381
To sum up, two characteristics describe the long-run equilibrium in a monop-
olistically competitive market:
a78 As in a monopoly market, price exceeds marginal cost. This conclusion arises
because profit maximization requires marginal revenue to equal marginal
cost and because the downward sloping demand curve makes marginal
revenue less than the price.
a78 As in a competitive market, price equals average total cost. This conclusion
arises because free entry and exit drive economic profit to zero.
The second characteristic shows how monopolistic competition differs from mo-
nopoly. Because a monopoly is the sole seller of a product without close substi-
tutes, it can earn positive economic profit, even in the long run. By contrast,
because there is free entry into a monopolistically competitive market, the eco-
nomic profit of a firm in this type of market is driven to zero.
MONOPOLISTIC VERSUS PERFECT COMPETITION
Figure 17-3 compares the long-run equilibrium under monopolistic competition to
the long-run equilibrium under perfect competition. (Chapter 14 discussed the
equilibrium with perfect competition.) There are two noteworthy differences be-
tween monopolistic and perfect competition: excess capacity and the markup.
Excess Capacity As we have just seen, entry and exit drive each firm in a
monopolistically competitive market to a point of tangency between its demand
Profit-maximizing
quantity
Quantity
Price
0
P = ATC
Demand
MR
ATC
MC
Figure 17-2
AMONOPOLISTIC COMPETITOR
IN THE LONG RUN.In a
monopolistically competitive
market, if firms are making
profit, new firms enter, and the
demand curves for the incumbent
firms shift to the left. Similarly, if
firms are making losses, old firms
exit, and the demand curves of
the remaining firms shift to the
right. Because of these shifts in
demand, a monopolistically
competitive firm eventually finds
itself in the long-run equilibrium
shown here. In this long-run
equilibrium, price equals average
total cost, and the firm earns zero
profit.
382 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
and average-total-cost curves. Panel (a) of Figure 17-3 shows that the quantity of
output at this point is smaller than the quantity that minimizes average total cost.
Thus, under monopolistic competition, firms produce on the downward-sloping
portion of their average-total-cost curves. In this way, monopolistic competition
contrasts starkly with perfect competition. As panel (b) of Figure 17-3 shows, free
entry in competitive markets drives firms to produce at the minimum of average
total cost.
The quantity that minimizes average total cost is called the efficient scaleof the
firm. In the long run, perfectly competitive firms produce at the efficient scale,
whereas monopolistically competitive firms produce below this level. Firms are
said to have excess capacityunder monopolistic competition. In other words, a mo-
nopolistically competitive firm, unlike a perfectly competitive firm, could increase
the quantity it produces and lower the average total cost of production.
Markup over Marginal Cost Asecond difference between perfect com-
petition and monopolistic competition is the relationship between price and mar-
ginal cost. For a competitive firm, such as that shown in panel (b) of Figure 17-3,
price equals marginal cost. For a monopolistically competitive firm, such as that
shown in panel (a), price exceeds marginal cost, because the firm always has some
market power.
QuantityQuantity
produced
Efficient
scale
Quantity produced =
Efficient scale
0
Price
P
Demand
(a) Monopolistically Competitive Firm
Quantity0
Price
P = MC P = MR
(demand
curve)
Marginal
cost
(b) Perfectly Competitive Firm
Markup
Excess capacity
MC
ATC
MC
ATC
MR
Figure 17-3
MONOPOLISTIC VERSUS PERFECT COMPETITION. Panel (a) shows the long-run
equilibrium in a monopolistically competitive market, and panel (b) shows the long-run
equilibrium in a perfectly competitive market. Two differences are notable. (1) The
perfectly competitive firm produces at the efficient scale, where average total cost is
minimized. By contrast, the monopolistically competitive firm produces at less than the
efficient scale. (2) Price equals marginal cost under perfect competition, but price is above
marginal cost under monopolistic competition.
CHAPTER 17 MONOPOLISTIC COMPETITION 383
How is this markup over marginal cost consistent with free entry and zero
profit? The zero-profit condition ensures only that price equals average total
cost. It does not ensure that price equals marginal cost. Indeed, in the long-run
equilibrium, monopolistically competitive firms operate on the declining por-
tion of their average-total-cost curves, so marginal cost is below average to-
talcost.Thus, for price to equal average total cost, price must be above marginal
cost.
In this relationship between price and marginal cost, we see a key behavioral
difference between perfect competitors and monopolistic competitors. Imagine
that you were to ask a firm the following question: “Would you like to see another
customer come through your door ready to buy from you at your current price?”
Aperfectly competitive firm would answer that it didn’t care. Because price ex-
actly equals marginal cost, the profit from an extra unit sold is zero. By contrast, a
monopolistically competitive firm is always eager to get another customer. Be-
cause its price exceeds marginal cost, an extra unit sold at the posted price means
more profit. According to an old quip, monopolistically competitive markets are
those in which sellers send Christmas cards to the buyers.
MONOPOLISTIC COMPETITION AND
THE WELFARE OF SOCIETY
Is the outcome in a monopolistically competitive market desirable from the stand-
point of society as a whole? Can policymakers improve on the market outcome?
There are no simple answers to these questions.
One source of inefficiency is the markup of price over marginal cost. Because
of the markup, some consumers who value the good at more than the marginal
cost of production (but less than the price) will be deterred from buying it. Thus, a
monopolistically competitive market has the normal deadweight loss of monopoly
pricing. We first saw this type of inefficiency when we discussed monopoly in
Chapter 15.
Although this outcome is clearly undesirable compared to the first-best out-
come of price equal to marginal cost, there is no easy way for policymakers to fix
the problem. To enforce marginal-cost pricing, policymakers would need to regu-
late all firms that produce differentiated products. Because such products are so
common in the economy, the administrative burden of such regulation would be
overwhelming.
Moreover, regulating monopolistic competitors would entail all the problems
of regulating natural monopolies. In particular, because monopolistic competitors
are making zero profits already, requiring them to lower their prices to equal mar-
ginal cost would cause them to make losses. To keep these firms in business, the
government would need to help them cover these losses. Rather than raising taxes
to pay for these subsidies, policymakers may decide it is better to live with the
inefficiency of monopolistic pricing.
Another way in which monopolistic competition may be socially inefficient is
that the number of firms in the market may not be the “ideal” one. That is, there
may be too much or too little entry. One way to think about this problem is in
terms of the externalities associated with entry. Whenever a new firm considers en-
tering the market with a new product, it considers only the profit it would make.
Yet its entry would also have two external effects:
384 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
a78 The product-variety externality:Because consumers get some consumer surplus
from the introduction of a new product, entry of a new firm conveys a
positive externality on consumers.
a78 The business-stealing externality:Because other firms lose customers and
profits from the entry of a new competitor, entry of a new firm imposes a
negative externality on existing firms.
Thus, in a monopolistically competitive market, there are both positive and nega-
tive externalities associated with the entry of new firms. Depending on which ex-
ternality is larger, a monopolistically competitive market could have either too few
or too many products.
Both of these externalities are closely related to the conditions for monopolis-
tic competition. The product-variety externality arises because a new firm would
offer a product different from those of the existing firms. The business-stealing ex-
ternality arises because firms post a price above marginal cost and, therefore, are
always eager to sell additional units. Conversely, because perfectly competitive
firms produce identical goods and charge a price equal to marginal cost, neither of
these externalities exists under perfect competition.
In the end, we can conclude only that monopolistically competitive markets
do not have all the desirable welfare properties of perfectly competitive markets.
That is, the invisible hand does not ensure that total surplus is maximized under
monopolistic competition. Yet because the inefficiencies are subtle, hard to mea-
sure, and hard to fix, there is no easy way for public policy to improve the market
outcome.
QUICK QUIZ: List the three key attributes of monopolistic competition.
a78 Draw and explain a diagram to show the long-run equilibrium in a
monopolistically competitive market. How does this equilibrium differ from
that in a perfectly competitive market?
As we have seen, monopolisti-
cally competitive firms produce
a quantity of output below the
level that minimizes average to-
tal cost. By contrast, firms in
perfectly competitive markets
are driven to produce at the
quantity that minimizes average
total cost. This comparison be-
tween perfect and monopolistic
competition has led some
economists in the past to ar-
gue that the excess capacity of
monopolistic competitors was a source of inefficiency.
Today economists understand that the excess capac-
ity of monopolistic competitors is not directly relevant for
evaluating economic welfare. There is no reason that soci-
ety should want all firms to produce at the minimum of
average total cost. For example, consider a publishing firm.
Producing a novel might take a fixed cost of $50,000 (the
author’s time) and variable costs of $5 per book (the cost of
printing). In this case, the average total cost of a book de-
clines as the number of books increases because the fixed
cost gets spread over more and more units. The average to-
tal cost is minimized by printing an infinite number of books.
But in no sense is infinity the right number of books for so-
ciety to produce.
In short, monopolistic competitors do have excess ca-
pacity, but this fact tells us little about the desirability of the
market outcome.
FYI
Is Excess
Capacity a
Social Problem?
CHAPTER 17 MONOPOLISTIC COMPETITION 385
ADVERTISING
It is nearly impossible to go through a typical day in a modern economy without
being bombarded with advertising. Whether you are reading a newspaper, watch-
ing television, or driving down the highway, some firm will try to convince you to
buy its product. Such behavior is a natural feature of monopolistic competition.
When firms sell differentiated products and charge prices above marginal cost,
each firm has an incentive to advertise in order to attract more buyers to its partic-
ular product.
The amount of advertising varies substantially across products. Firms that sell
highly differentiated consumer goods, such as over-the-counter drugs, perfumes,
soft drinks, razor blades, breakfast cereals, and dog food, typically spend between
10 and 20 percent of revenue for advertising. Firms that sell industrial products,
such as drill presses and communications satellites, typically spend very little on
advertising. And firms that sell homogeneous products, such as wheat, peanuts, or
crude oil, spend nothing at all. For the economy as a whole, spending on advertis-
ing comprises about 2 percent of total firm revenue, or more than $100 billion.
Advertising takes many forms. About one-half of advertising spending is for
space in newspapers and magazines, and about one-third is for commercials on
television and radio. The rest is spent on various other ways of reaching cus-
tomers, such as direct mail, billboards, and the Goodyear blimp.
THE DEBATE OVER ADVERTISING
Is society wasting the resources it devotes to advertising? Or does advertising
serve a valuable purpose? Assessing the social value of advertising is difficult and
often generates heated argument among economists. Let’s consider both sides of
the debate.
The Critique of Advertising Critics of advertising argue that firms ad-
vertise in order to manipulate people’s tastes. Much advertising is psychological
rather than informational. Consider, for example, the typical television commercial
for some brand of soft drink. The commercial most likely does not tell the viewer
about the product’s price or quality. Instead, it might show a group of happy peo-
ple at a party on a beach on a beautiful sunny day. In their hands are cans of the
soft drink. The goal of the commercial is to convey a subconscious (if not subtle)
message: “You too can have many friends and be happy, if only you drink our
product.” Critics of advertising argue that such a commercial creates a desire that
otherwise might not exist.
Critics also argue that advertising impedes competition. Advertising often
tries to convince consumers that products are more different than they truly are.
By increasing the perception of product differentiation and fostering brand loyalty,
advertising makes buyers less concerned with price differences among similar
goods. With a less elastic demand curve, each firm charges a larger markup over
marginal cost.
The Defense of Advertising Defenders of advertising argue that firms
use advertising to provide information to customers. Advertising conveys the
386 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
CASE STUDY ADVERTISING AND THE PRICE OF EYEGLASSES
What effect does advertising have on the price of a good? On the one hand, ad-
vertising might make consumers view products as being more different than
they otherwise would. If so, it would make markets less competitive and firms’
demand curves less elastic, and this would lead firms to charge higher prices.
On the other hand, advertising might make it easier for consumers to find the
firms offering the best prices. In this case, it would make markets more com-
petitive and firms’ demand curves more elastic, and this would lead to lower
prices.
In an article published in the Journal of Law and Economicsin 1972, economist
Lee Benham tested these two views of advertising. In the United States during
the 1960s, the various state governments had vastly different rules about adver-
tising by optometrists. Some states allowed advertising for eyeglasses and eye
examinations. Many states, however, prohibited it. For example, the Florida law
read as follows:
It is unlawful for any person, firm, or corporation to . . . advertise either
directly or indirectly by any means whatsoever any definite or indefinite price
or credit terms on prescriptive or corrective lens, frames, complete
prescriptive or corrective glasses, or any optometric service. . . . This section is
passed in the interest of public health, safety, and welfare, and its provisions
shall be liberally construed to carry out its objects and purposes.
Professional optometrists enthusiastically endorsed these restrictions on
advertising.
Benham used the differences in state law as a natural experiment to test
thetwo views of advertising. The results were striking. In those states that pro-
hibited advertising, the average price paid for a pair of eyeglasses was $33.
(This number is not as low as it seems, for this price is from 1963, when all
prices were much lower than they are today. To convert 1963 prices into to-
day’sdollars, you can multiply them by 5.) In those states that did not restrict
prices of the goods being offered for sale, the existence of new products, and the
locations of retail outlets. This information allows customers to make better
choices about what to buy and, thus, enhances the ability of markets to allocate re-
sources efficiently.
Defenders also argue that advertising fosters competition. Because advertising
allows customers to be more fully informed about all the firms in the market, cus-
tomers can more easily take advantage of price differences. Thus, each firm has
less market power. In addition, advertising allows new firms to enter more easily,
because it gives entrants a means to attract customers from existing firms.
Over time, policymakers have come to accept the view that advertising can
make markets more competitive. One important example is the regulation of cer-
tain professions, such as lawyers, doctors, and pharmacists. In the past, these
groups succeeded in getting state governments to prohibit advertising in their
fields on the grounds that advertising was “unprofessional.” In recent years, how-
ever, the courts have concluded that the primary effect of these restrictions on ad-
vertising was to curtail competition. They have, therefore, overturned many of the
laws that prohibit advertising by members of these professions.
CHAPTER 17 MONOPOLISTIC COMPETITION 387
advertising, the average price was $26. Thus, advertising reduced average
prices by more than 20 percent. In the market for eyeglasses, and probably in
many other markets as well, advertising fosters competition and leads to lower
prices for consumers.
ADVERTISING AS A SIGNAL OF QUALITY
Many types of advertising contain little apparent information about the product
being advertised. Consider a firm introducing a new breakfast cereal. Atypical ad-
vertisement might have some highly paid actor eating the cereal and exclaiming
how wonderful it tastes. How much information does the advertisement really
provide?
The answer is: more than you might think. Defenders of advertising argue that
even advertising that appears to contain little hard information may in fact tell
consumers something about product quality. The willingness of the firm to spend
a large amount of money on advertising can itself be a signalto consumers about
the quality of the product being offered.
Consider the problem facing two firms—Post and Kellogg. Each company has
just come up with a recipe for a new cereal, which it would sell for $3 a box. To
keep things simple, let’s assume that the marginal cost of making cereal is zero, so
the $3 is all profit. Each company knows that if it spends $10 million on advertis-
ing, it will get 1 million consumers to try its new cereal. And each company knows
that if consumers like the cereal, they will buy it not once but many times.
First consider Post’s decision. Based on market research, Post knows that its
cereal is only mediocre. Although advertising would sell one box to each of 1 mil-
lion consumers, the consumers would quickly learn that the cereal is not very
good and stop buying it. Post decides it is not worth paying $10 million in adver-
tising to get only $3 million in sales. So it does not bother to advertise. It sends its
cooks back to the drawing board to find another recipe.
Kellogg, on the other hand, knows that its cereal is great. Each person who
tries it will buy a box a month for the next year. Thus, the $10 million in advertis-
ing will bring in $36 million in sales. Advertising is profitable here because Kellogg
has a good product that consumers will buy repeatedly. Thus, Kellogg chooses to
advertise.
Now that we have considered the behavior of the two firms, let’s consider the
behavior of consumers. We began by asserting that consumers are inclined to try a
new cereal that they see advertised. But is this behavior rational? Should a con-
sumer try a new cereal just because the seller has chosen to advertise it?
In fact, it may be completely rational for consumers to try new products that
they see advertised. In our story, consumers decide to try Kellogg’s new cereal be-
cause Kellogg advertises. Kellogg chooses to advertise because it knows that its ce-
real is quite good, while Post chooses not to advertise because it knows that its
cereal is only mediocre. By its willingness to spend money on advertising, Kellogg
signals to consumers the quality of its cereal. Each consumer thinks, quite sensibly,
“Boy, if the Kellogg Company is willing to spend so much money advertising this
new cereal, it must be really good.”
What is most surprising about this theory of advertising is that the content of
the advertisement is irrelevant. Kellogg signals the quality of its product by its
willingness to spend money on advertising. What the advertisements say is not as
388 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
important as the fact that consumers know ads are expensive. By contrast, cheap
advertising cannot be effective at signaling quality to consumers. In our example,
if an advertising campaign cost less than $3 million, both Post and Kellogg would
use it to market their new cereals. Because both good and mediocre cereals would
be advertised, consumers could not infer the quality of a new cereal from the
factthat it is advertised. Over time, consumers would learn to ignore such cheap
advertising.
This theory can explain why firms pay famous actors large amounts of money
to make advertisements that, on the surface, appear to convey no information at
all. The information is not in the advertisement’s content, but simply in its exis-
tence and expense.
BRAND NAMES
Advertising is closely related to the existence of brand names. In many markets,
there are two types of firms. Some firms sell products with widely recognized
brand names, while other firms sell generic substitutes. For example, in a typical
drugstore, you can find Bayer aspirin on the shelf next to a generic aspirin. In a
typical grocery store, you can find Pepsi next to less familiar colas. Most often, the
firm with the brand name spends more on advertising and charges a higher price
for its product.
Just as there is disagreement about the economics of advertising, there is dis-
agreement about the economics of brand names. Let’s consider both sides of the
debate.
Critics of brand names argue that brand names cause consumers to perceive
differences that do not really exist. In many cases, the generic good is almost in-
distinguishable from the brand-name good. Consumers’ willingness to pay more
for the brand-name good, these critics assert, is a form of irrationality fostered by
advertising. Economist Edward Chamberlin, one of the early developers of the
theory of monopolistic competition, concluded from this argument that brand
names were bad for the economy. He proposed that the government discourage
CHAPTER 17 MONOPOLISTIC COMPETITION 389
CASE STUDY BRAND NAMES UNDER COMMUNISM
Defenders of brand names get some support for their view from experiences in
the former Soviet Union. When the Soviet Union adhered to the principles of
communism, central planners in the government replaced the invisible hand of
the marketplace. Yet, just like consumers living in an economy with free mar-
kets, Soviet central planners learned that brand names were useful in helping to
ensure product quality.
In an article published in the Journal of Political Economyin 1960, Marshall
Goldman, an expert on the Soviet economy, described the Soviet experience:
In the Soviet Union, production goals have been set almost solely in
quantitative or value terms, with the result that, in order to meet the plan,
quality is often sacrificed. . . . Among the methods adopted by the Soviets to
deal with this problem, one is of particular interest to us—intentional product
differentiation. . . . In order to distinguish one firm from similar firms in the
same industry or ministry, each firm has its own name. Whenever it is
their use by refusing to enforce the exclusive trademarks that companies use to
identify their products.
More recently, economists have defended brand names as a useful way for
consumers to ensure that the goods they buy are of high quality. There are two re-
lated arguments. First, brand names provide consumers informationabout quality
when quality cannot be easily judged in advance of purchase. Second, brand
names give firms an incentiveto maintain high quality, because firms have a finan-
cial stake in maintaining the reputation of their brand names.
To see how these arguments work in practice, consider a famous brand name:
McDonald’s hamburgers. Imagine that you are driving through an unfamiliar
town and want to stop for lunch. You see a McDonald’s and a local restaurant next
to it. Which do you choose? The local restaurant may in fact offer better food at
lower prices, but you have no way of knowing that. By contrast, McDonald’s of-
fers a consistent product across many cities. Its brand name is useful to you as a
way of judging the quality of what you are about to buy.
The McDonald’s brand name also ensures that the company has an incentive
to maintain quality. For example, if some customers were to become ill from bad
food sold at a McDonald’s, the news would be disastrous for the company.
McDonald’s would lose much of the valuable reputation that it has built up with
years of expensive advertising. As a result, it would lose sales and profit not just in
the outlet that sold the bad food but in its many outlets throughout the country.
Bycontrast, if some customers were to become ill from bad food at a local restau-
rant, that restaurant might have to close down, but the lost profits would be
muchsmaller. Hence, McDonald’s has a greater incentive to ensure that its food
issafe.
The debate over brand names thus centers on the question of whether con-
sumers are rational in preferring brand names over generic substitutes. Critics of
brand names argue that brand names are the result of an irrational consumer re-
sponse to advertising. Defenders of brand names argue that consumers have good
reason to pay more for brand-name products because they can be more confident
in the quality of these products.
390 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
physically possible, it is obligatory that the firm identify itself on the good or
packaging with a “production mark.”
Goldman quotes the analysis of a Soviet marketing expert:
This [trademark] makes it easy to establish the actual producer of the product
in case it is necessary to call him to account for the poor quality of his goods.
For this reason, it is one of the most effective weapons in the battle for the
quality of products. . . . The trademark makes it possible for the consumer to
select the good which he likes. . . . This forces other firms to undertake
measures to improve the quality of their own product in harmony with the
demands of the consumer.
BRAND NAMES CONVEY INFORMATION TO
consumers about the goods that firms
are offering. Establishing a brand
name—and ensuring that it conveys
the right information—is an important
strategy for many businesses, including
TV networks.
A TV Season When
Image Is Everything
BY STUART ELLIOTT
A marketing blitz to promote fall tele-
vision programming, estimated at a rec-
ord $400 million to $500 million, has
been inundating America with a barrage
of branding.
Branding is a shorthand term along
Madison Avenue for attempts to create
or burnish an identity or image, just as
Coca-Cola seeks to distinguish itself
from Pepsi-Cola. For the 1996–97
prime-time broadcast television season,
which officially began this week, viewers
have been swamped by the torrent of
teasing practically since the 1995–96
season ended in May.
At the center of those efforts is the
most ambitious push ever by the broad-
cast networks to brand themselves and
many of the blocks of programming they
offer—a marked departure from the
past, when they would promote only
specific shows.
“The perception was that people
watched shows, not networks,” said
Bob Bibb, who with Lewis Goldstein
jointly heads marketing for WB, a fledg-
ling network owned by Time Warner, Inc.,
and based in Burbank, California.
“But that was when there were only
three networks, three choices,” Mr. Bibb
added, “and it was easy to find the
shows you liked.”
WB has been presenting a sassy
singing cartoon character named Michi-
gan J. Frog as its “spokesphibian,” per-
sonifying the entire lineup of the
“Dubba-dubba-WB”—as he insists upon
calling the network.
“It’s not a frog, it’s an attitude,” Mr.
Bibb said, “a consistency from show to
show.”
In television, an intrinsic part of
branding is selecting shows that seem
related and might appeal to a certain au-
dience segment. It means “developing
an overall packaging of the network to
build a relationship with viewers, so they
will come to expect certain things from
us,” said Alan Cohen, executive vice
president for the ABC-TV unit of the
Walt Disney Company in New York.
That, he said, means defining the
network so that “when you’re watching
ABC, you’ll know you’re watching
ABC”—and to accomplish it in a way
that appeals to the primary ABC audi-
ence of youngish urbanites and families
with children.
SOURCE:The New York Times,September 20, 1996,
p. D1.
IN THE NEWS
TV Networks as
BrandNames
AN ATTITUDE, NOT JUST A FROG
CHAPTER 17 MONOPOLISTIC COMPETITION 391
Goldman notes that “these arguments are clear enough and sound as if they
might have been written by a bourgeois apologist.”
QUICK QUIZ: How might advertising make markets less competitive?
How might it make markets more competitive? a78 Give the arguments for
and against brand names.
CONCLUSION
Monopolistic competition is true to its name: It is a hybrid of monopoly and com-
petition. Like a monopoly, each monopolistic competitor faces a downward-
sloping demand curve and, as a result, charges a price above marginal cost. As in
a competitive market, however, there are many firms, and entry and exit drive the
profit of each monopolistic competitor toward zero. Because monopolistically
competitive firms produce differentiated products, each firm advertises in order to
attract customers to its own brand. To some extent, advertising manipulates con-
sumers’ tastes, promotes irrational brand loyalty, and impedes competition. To a
larger extent, advertising provides information, establishes brand names of reli-
able quality, and fosters competition.
The theory of monopolistic competition seems to describe many markets in
the economy. It is somewhat disappointing, therefore, that the theory does not
yield simple and compelling advice for public policy. From the standpoint of the
economic theorist, the allocation of resources in monopolistically competitive mar-
kets is not perfect. Yet, from the standpoint of a practical policymaker, there may
be little that can be done to improve it.
a78 Amonopolistically competitive market is characterized
by three attributes: many firms, differentiated products,
and free entry.
a78 The equilibrium in a monopolistically competitive
market differs from that in a perfectly competitive
market in two related ways. First, each firm has excess
capacity. That is, it operates on the downward-sloping
portion of the average-total-cost curve. Second, each
firm charges a price above marginal cost.
a78 Monopolistic competition does not have all the
desirable properties of perfect competition. There is the
standard deadweight loss of monopoly caused by the
markup of price over marginal cost. In addition, the
number of firms (and thus the variety of products) can
be too large or too small. In practice, the ability of
policymakers to correct these inefficiencies is limited.
a78 The product differentiation inherent in monopolistic
competition leads to the use of advertising and brand
names. Critics of advertising and brand names argue
that firms use them to take advantage of consumer
irrationality and to reduce competition. Defenders of
advertising and brand names argue that firms use them
to inform consumers and to compete more vigorously
on price and product quality.
Summary
monopolistic competition, p. 378
Key Concepts
392 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
1. Describe the three attributes of monopolistic
competition. How is monopolistic competition like
monopoly? How is it like perfect competition?
2. Draw a diagram depicting a firm in a monopolistically
competitive market that is making profits. Now show
what happens to this firm as new firms enter the
industry.
3. Draw a diagram of the long-run equilibrium in a
monopolistically competitive market. How is price
related to average total cost? How is price related to
marginal cost?
4. Does a monopolistic competitor produce too much or
too little output compared to the most efficient level?
What practical considerations make it difficult for
policymakers to solve this problem?
5. How might advertising reduce economic well-being?
How might advertising increase economic well-being?
6. How might advertising with no apparent informational
content in fact convey information to consumers?
7. Explain two benefits that might arise from the existence
of brand names.
Questions for Review
1. Classify the following markets as perfectly competitive,
monopolistic, or monopolistically competitive, and
explain your answers.
a. wooden #2 pencils
b. bottled water
c. copper
d. local telephone service
e. peanut butter
f. lipstick
2. What feature of the product being sold distinguishes a
monopolistically competitive firm from a monopolistic
firm?
3. The chapter states that monopolistically competitive
firms could increase the quantity they produce and
lower the average total cost of production. Why don’t
they do so?
4. Sparkle is one firm of many in the market for
toothpaste, which is in long-run equilibrium.
a. Draw a diagram showing Sparkle’s demand curve,
marginal-revenue curve, average-total-cost curve,
and marginal-cost curve. Label Sparkle’s profit-
maximizing output and price.
b. What is Sparkle’s profit? Explain.
c. On your diagram, show the consumer surplus
derived from the purchase of Sparkle toothpaste.
Also show the deadweight loss relative to the
efficient level of output.
d. If the government forced Sparkle to produce
theefficient level of output, what would happen
tothe firm? What would happen to Sparkle’s
customers?
5. Do monopolistically competitive markets typically have
the optimal number of products? Explain.
6. Complete the table below by filling in YES, NO, or
MAYBE for each type of market structure.
Problems and Applications
PERFECT MONOPOLISTIC
DO FIRMS:COMPETITION COMPETITION MONOPOLY
Make differentiated products?
Have excess capacity?
Advertise?
Pick Qso that MRH11005MC?
Pick Qso that PH11005MC?
Earn economic profits in long-run equilibrium?
Face a downward-sloping demand curve?
Have MRless than price?
Face the entry of other firms?
Exit in the long run if profits are less than zero?
CHAPTER 17 MONOPOLISTIC COMPETITION 393
7. The chapter says that monopolistically competitive
firms may send Christmas cards to their customers.
What do they accomplish by this? Explain in words and
with a diagram.
8. If you were thinking of entering the ice-cream business,
would you try to make ice cream that is just like one of
the existing brands? Explain your decision using the
ideas of this chapter.
9. Describe three commercials that you have seen on TV.
Inwhat ways, if any, were each of these commercials
socially useful? In what ways were they socially
wasteful? Did the commercials affect the likelihood of
your buying the product, and why?
10. For each of the following pairs of firms, explain which
firm would be more likely to engage in advertising.
a. a family-owned farm or a family-owned restaurant
b. a manufacturer of forklifts or a manufacturer
ofcars
c. a company that invented a very reliable watch or a
company that invented a less reliable watch that
costs the same amount to make
11. Twenty years ago the market for chicken was perfectly
competitive. Then Frank Perdue began marketing
chicken under his name.
a. How do you suppose Perdue created a brand name
for chicken? What did he gain from doing so?
b. What did society gain from having brand-name
chicken? What did society lose?
12. The makers of Tylenol pain reliever do a lot of
advertising and have very loyal customers. In contrast,
the makers of generic acetaminophen do no advertising,
and their customers shop only for the lowest price.
Assume that the marginal costs of Tylenol and generic
acetaminophen are the same and constant.
a. Draw a diagram showing Tylenol’s demand,
marginal-revenue, and marginal-cost curves. Label
Tylenol’s price and markup over marginal cost.
b. Repeat part (a) for a producer of generic
acetaminophen. How do the diagrams differ?
Which company has the bigger markup? Explain.
c. Which company has the bigger incentive for careful
quality control? Why?
IN THIS CHAPTER
YOU WILL . . .
Examine how a
change in the
supply of one factor
alters the earnings
of all the factors
Learn why
equilibrium wages
equal the value of
the marginal
product of labor
Analyze the labor
demand of
competitive, profit-
maximizing firms
Consider the
household decisions
that lie behind
labor supply
Consider how the
other factors of
production—land
and capital—are
compensated
When you finish school, your income will be determined largely by what kind of
job you take. If you become a computer programmer, you will earn more than if
you become a gas station attendant. This fact is not surprising, but it is not obvious
why it is true. No law requires that computer programmers be paid more than gas
station attendants. No ethical principle says that programmers are more deserv-
ing. What then determines which job will pay you the higher wage?
Your income, of course, is a small piece of a larger economic picture. In 1999
the total income of all U.S. residents was about $8 trillion. People earned this in-
come in various ways. Workers earned about three-fourths of it in the form of
wages and fringe benefits. The rest went to landowners and to the owners of capi-
tal—the economy’s stock of equipment and structures—in the form of rent, profit,
and interest. What determines how much goes to workers? To landowners? To the
owners of capital? Why do some workers earn higher wages than others, some
THE MARKETS FOR THE
FACTORS OF PRODUCTION
397
398 PART SIX THE ECONOMICS OF LABOR MARKETS
landowners higher rental income than others, and some capital owners greater
profit than others? Why, in particular, do computer programmers earn more than
gas station attendants?
The answers to these questions, like most in economics, hinge on supply and
demand. The supply and demand for labor, land, and capital determine the prices
paid to workers, landowners, and capital owners. To understand why some peo-
ple have higher incomes than others, therefore, we need to look more deeply at
the markets for the services they provide. That is our job in this and the next two
chapters.
This chapter provides the basic theory for the analysis of factor markets. As
you may recall from Chapter 2, the factors of production are the inputs used to
produce goods and services. Labor, land, and capital are the three most important
factors of production. When a computer firm produces a new software program, it
uses programmers’ time (labor), the physical space on which its offices sit (land),
and an office building and computer equipment (capital). Similarly, when a gas
station sells gas, it uses attendants’ time (labor), the physical space (land), and the
gas tanks and pumps (capital).
Although in many ways factor markets resemble the goods markets we have
analyzed in previous chapters, they are different in one important way: The de-
mand for a factor of production is a derived demand. That is, a firm’s demand for a
factor of production is derived from its decision to supply a good in another mar-
ket. The demand for computer programmers is inextricably tied to the supply of
computer software, and the demand for gas station attendants is inextricably tied
to the supply of gasoline.
In this chapter we analyze factor demand by considering how a competitive,
profit-maximizing firm decides how much of any factor to buy. We begin our
analysis by examining the demand for labor. Labor is the most important factor of
production, for workers receive most of the total income earned in the U.S. econ-
omy. Later in the chapter, we see that the lessons we learn about the labor market
apply directly to the markets for the other factors of production.
The basic theory of factor markets developed in this chapter takes a large step
toward explaining how the income of the U.S. economy is distributed among
workers, landowners, and owners of capital. Chapter 19 will build on this analysis
to examine in more detail why some workers earn more than others. Chapter 20
will examine how much inequality results from this process and then consider
what role the government should and does play in altering the distribution of
income.
THE DEMAND FOR LABOR
Labor markets, like other markets in the economy, are governed by the forces of
supply and demand. This is illustrated in Figure 18-1. In panel (a) the supply and
demand for apples determine the price of apples. In panel (b) the supply and de-
mand for apple pickers determine the price, or wage, of apple pickers.
As we have already noted, labor markets are different from most other mar-
kets because labor demand is a derived demand. Most labor services, rather than
factors of production
the inputs used to produce goods and
services
CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 399
being final goods ready to be enjoyed by consumers, are inputs into the produc-
tion of other goods. To understand labor demand, we need to focus on the firms
that hire the labor and use it to produce goods for sale. By examining the link be-
tween the production of goods and the demand for labor, we gain insight into the
determination of equilibrium wages.
THE COMPETITIVE PROFIT-MAXIMIZING FIRM
Let’s look at how a typical firm, such as an apple producer, decides the quantity of
labor to demand. The firm owns an apple orchard and each week must decide
how many apple pickers to hire to harvest its crop. After the firm makes its hiring
decision, the workers pick as many apples as they can. The firm then sells the ap-
ples, pays the workers, and keeps what is left as profit.
We make two assumptions about our firm. First, we assume that our firm is
competitive both in the market for apples (where the firm is a seller) and in the
market for apple pickers (where the firm is a buyer). Recall from Chapter 14 that a
competitive firm is a price taker. Because there are many other firms selling apples
and hiring apple pickers, a single firm has little influence over the price it gets for
apples or the wage it pays apple pickers. The firm takes the price and the wage as
given by market conditions. It only has to decide how many workers to hire and
how many apples to sell.
Second, we assume that the firm is profit-maximizing. Thus, the firm does not
directly care about the number of workers it has or the number of apples it pro-
duces. It cares only about profit, which equals the total revenue from the sale of
Quantity of
Apples
0
Price of
Apples
P
Q
Demand
Supply
Demand
Supply
Quantity of
Apple Pickers
0
Wage of
Apple
Pickers
L
W
(a) The Market for Apples (b) The Market for Apple Pickers
Figure 18-1
THE VERSATILITY OF SUPPLY AND DEMAND. The basic tools of supply and demand
apply to goods and to labor services. Panel (a) shows how the supply and demand
for apples determine the price of apples. Panel (b) shows how the supply and demand for
apple pickers determine the wage of apple pickers.
400 PART SIX THE ECONOMICS OF LABOR MARKETS
apples minus the total cost of producing them. The firm’s supply of apples and its
demand for workers are derived from its primary goal of maximizing profit.
THE PRODUCTION FUNCTION AND THE
MARGINAL PRODUCT OF LABOR
To make its hiring decision, the firm must consider how the size of its workforce
affects the amount of output produced. In other words, it must consider how the
number of apple pickers affects the quantity of apples it can harvest and sell. Ta-
ble 18-1 gives a numerical example. In the first column is the number of workers.
In the second column is the quantity of apples the workers harvest each week.
These two columns of numbers describe the firm’s ability to produce. As we
noted in Chapter 13, economists use the term production function to describe the
relationship between the quantity of the inputs used in production and the quan-
tity of output from production. Here the “input” is the apple pickers and the “out-
put” is the apples. The other inputs—the trees themselves, the land, the firm’s
trucks and tractors, and so on—are held fixed for now. This firm’s production
function shows that if the firm hires 1 worker, that worker will pick 100 bushels
of apples per week. If the firm hires 2 workers, the two workers together will pick
180 bushels per week, and so on.
Figure 18-2 graphs the data on labor and output presented in Table 18-1. The
number of workers is on the horizontal axis, and the amount of output is on the
vertical axis. This figure illustrates the production function.
One of the Ten Principles of Economics introduced in Chapter 1 is that rational
people think at the margin. This idea is the key to understanding how firms decide
what quantity of labor to hire. To take a step toward this decision, the third column
in Table 18-1 gives the marginal product of labor, the increase in the amount of
output from an additional unit of labor. When the firm increases the number of
workers from 1 to 2, for example, the amount of apples produced rises from 100 to
180 bushels. Therefore, the marginal product of the second worker is 80 bushels.
Table 18-1
VALUEOFTHE
MARGINALPRODUCT MARGINALPRODUCT MARGINAL
LABOR OUTPUT OFLABOR OFLABOR WAGE PROFIT
L Q MPLH11549 ?Q/?L ?PROFITH11549
(NUMBEROFWORKERS)(BUSHELSPERWEEK)(BUSHELSPERWEEK) VMPLH11549PH11547MPL W VMPLH11546W
00
100 $1,000 $500 $500
110
80 800 500 300
218
60 600 500 100
324
40 400 500 H11002100
4 280
20 200 500 H11002300
5 300
HOW THE COMPETITIVE FIRM DECIDES HOW MUCH LABOR TO HIRE
production function
the relationship between the quantity
of inputs used to make a good and
the quantity of output of that good
marginal product
of labor
the increase in the amount of output
from an additional unit of labor
CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 401
Notice that as the number of workers increases, the marginal product of labor
declines. As you may recall from Chapter 13, this property is called diminishing
marginal product.At first, when only a few workers are hired, they pick apples
from the best trees in the orchard. As the number of workers increases, additional
workers have to pick from the trees with fewer apples. Hence, as more and more
workers are hired, each additional worker contributes less to the production of
apples. For this reason, the production function in Figure 18-2 becomes flatter as
the number of workers rises.
THE VALUE OF THE MARGINAL PRODUCT
AND THE DEMAND FOR LABOR
Our profit-maximizing firm is concerned more with money than with apples. As a
result, when deciding how many workers to hire, the firm considers how much
profit each worker would bring in. Because profit is total revenue minus total cost,
the profit from an additional worker is the worker’s contribution to revenue minus
the worker’s wage.
To find the worker’s contribution to revenue, we must convert the marginal
product of labor (which is measured in bushels of apples) into the value of the mar-
ginal product (which is measured in dollars). We do this using the price of apples.
To continue our example, if a bushel of apples sells for $10 and if an additional
worker produces 80 bushels of apples, then the worker produces $800 of revenue.
The value of the marginal product of any input is the marginal product of
that input multiplied by the market price of the output. The fourth column in Ta-
ble 18-1 shows the value of the marginal product of labor in our example, assum-
ing the price of apples is $10 per bushel. Because the market price is constant for a
competitive firm, the value of the marginal product (like the marginal product it-
self) diminishes as the number of workers rises.
diminishing marginal
product
the property whereby the marginal
product of an input declines as the
quantity of the input increases
Quantity of
Apple Pickers
0
Quantity
of Apples
300
280
240
180
100
Production
function
12345
Figure 18-2
THE PRODUCTION FUNCTION.
The production function is the
relationship between the inputs
into production (apple pickers)
and the output from production
(apples). As the quantity of the
input increases, the production
function gets flatter, reflecting the
property of diminishing marginal
product.
value of the marginal
product
the marginal product of an input
times the price of the output
402 PART SIX THE ECONOMICS OF LABOR MARKETS
Now consider how many workers the firm will hire. Suppose that the market
wage for apple pickers is $500 per week. In this case, the first worker that the firm
hires is profitable: The first worker yields $1,000 in revenue, or $500 in profit. Sim-
ilarly, the second worker yields $800 in additional revenue, or $300 in profit. The
third worker produces $600 in additional revenue, or $100 in profit. After the third
worker, however, hiring workers is unprofitable. The fourth worker would yield
only $400 of additional revenue. Because the worker’s wage is $500, hiring the
fourth worker would mean a $100 reduction in profit. Thus, the firm hires only
three workers.
It is instructive to consider the firm’s decision graphically. Figure 18-3 graphs
the value of the marginal product. This curve slopes downward because the mar-
ginal product of labor diminishes as the number of workers rises. The figure also
includes a horizontal line at the market wage. To maximize profit, the firm hires
workers up to the point where these two curves cross. Below this level of employ-
ment, the value of the marginal product exceeds the wage, so hiring another
worker would increase profit. Above this level of employment, the value of the
marginal product is less than the wage, so the marginal worker is unprofitable.
Thus, a competitive, profit-maximizing firm hires workers up to the point where the value
of the marginal product of labor equals the wage.
Having explained the profit-maximizing hiring strategy for a competitive
firm, we can now offer a theory of labor demand. Recall that a firm’s labor demand
curve tells us the quantity of labor that a firm demands at any given wage. We
have just seen in Figure 18-3 that the firm makes that decision by choosing the
quantity of labor at which the value of the marginal product equals the wage. As a
result, the value-of-marginal-product curve is the labor demand curve for a competitive,
profit-maximizing firm.
0 Quantity of
Apple Pickers
Value
of the
Marginal
Product
Market
wage
Profit-maximizing quantity
Value of marginal product
(demand curve for labor)
Figure 18-3
THE VALUE OF THE MARGINAL
PRODUCT OF LABOR. This figure
shows how the value of the
marginal product (the marginal
product times the price of the
output) depends on the number
of workers. The curve slopes
downward because of
diminishing marginal product.
For a competitive, profit-
maximizing firm, this value-of-
marginal-product curve is also
the firm’s labor demand curve.
CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 403
WHAT CAUSES THE LABOR DEMAND CURVE TO SHIFT?
We now understand the labor demand curve: It is nothing more than a reflection
of the value of marginal product of labor. With this insight in mind, let’s consider
a few of the things that might cause the labor demand curve to shift.
The Output Price The value of the marginal product is marginal product
times the price of the firm’s output. Thus, when the output price changes, the
value of the marginal product changes, and the labor demand curve shifts. An in-
crease in the price of apples, for instance, raises the value of the marginal product
of each worker that picks apples and, therefore, increases labor demand from the
firms that supply apples. Conversely, a decrease in the price of apples reduces the
value of the marginal product and decreases labor demand.
Technological Change Between 1968 and 1998, the amount of output
a typical U.S. worker produced in an hour rose by 57 percent. Why? The most
In Chapter 14 we saw how
a competitive, profit-maximizing
firm decides how much of its
output to sell: It chooses the
quantity of output at which the
price of the good equals the
marginal cost of production. We
have just seen how such a firm
decides how much labor to
hire: It chooses the quantity of
labor at which the wage equals
the value of the marginal prod-
uct. Because the production
function links the quantity of inputs to the quantity of output,
you should not be surprised to learn that the firm’s decision
about input demand is closely linked to its decision about
output supply. In fact, these two decisions are two sides of
the same coin.
To see this relationship more fully, let’s consider how
the marginal product of labor (MPL) and marginal cost (MC)
are related. Suppose an additional worker costs $500 and
has a marginal product of 50 bushels of apples. In this
case, producing 50 more bushels costs $500; the marginal
cost of a bushel is $500/50, or $10. More generally, if W
is the wage, and an extra unit of labor produces MPL units
of output, then the marginal cost of a unit of output is
MC H11005 W/MPL.
This analysis shows that diminishing marginal product
is closely related to increasing marginal cost. When our ap-
ple orchard grows crowded with workers, each additional
worker adds less to the production of apples (MPL falls).
Similarly, when the apple firm is producing a large quantity
of apples, the orchard is already crowded with workers, so it
is more costly to produce an additional bushel of apples
(MC rises).
Now consider our criterion for profit maximization. We
determined earlier that a profit-maximizing firm chooses the
quantity of labor so that the value of the marginal product
(P H11003 MPL) equals the wage (W). We can write this mathe-
matically as
P H11003 MPL H11005 W.
If we divide both sides of this equation by MPL, we obtain
P H11005 W/MPL.
We just noted that W/MPL equals marginal cost MC. There-
fore, we can substitute to obtain
P H11005 MC.
This equation states that the price of the firm’s output is
equal to the marginal cost of producing a unit of output.
Thus, when a competitive firm hires labor up to the point at
which the value of the marginal product equals the wage, it
also produces up to the point at which the price equals mar-
ginal cost. Our analysis of labor demand in this chapter is
just another way of looking at the production decision we
first saw in Chapter 14.
FYI
Input Demand
and Output
Supply: Two
Sides of the
Same Coin
404 PART SIX THE ECONOMICS OF LABOR MARKETS
important reason is technological progress: Scientists and engineers are constantly
figuring out new and better ways of doing things. This has profound implications
for the labor market. Technological advance raises the marginal product of labor,
which in turn increases the demand for labor. Such technological advance explains
persistently rising employment in face of rising wages: Even though wages (ad-
justed for inflation) increased by 62 percent over these three decades, firms
nonetheless increased by 72 percent the number of workers they employed.
The Supply of Other Factors The quantity available of one factor of
production can affect the marginal product of other factors. A fall in the supply of
ladders, for instance, will reduce the marginal product of apple pickers and thus
the demand for apple pickers. We consider this linkage among the factors of pro-
duction more fully later in the chapter.
QUICK QUIZ: Define marginal product of labor and value of the marginal
product of labor. a78 Describe how a competitive, profit-maximizing firm
decides how many workers to hire.
THE SUPPLY OF LABOR
Having analyzed labor demand in detail, let’s turn to the other side of the market
and consider labor supply. A formal model of labor supply is included in Chapter
21, where we develop the theory of household decisionmaking. Here we discuss
briefly and informally the decisions that lie behind the labor supply curve.
THE TRADEOFF BETWEEN WORK AND LEISURE
One of the Ten Principles of Economics in Chapter 1 is that people face tradeoffs.
Probably no tradeoff is more obvious or more important in a person’s life than the
tradeoff between work and leisure. The more hours you spend working, the fewer
hours you have to watch TV, have dinner with friends, or pursue your favorite
hobby. The tradeoff between labor and leisure lies behind the labor supply curve.
Another one of the Ten Principles of Economics is that the cost of something is
what you give up to get it. What do you give up to get an hour of leisure? You give
up an hour of work, which in turn means an hour of wages. Thus, if your wage is
$15 per hour, the opportunity cost of an hour of leisure is $15. And when you get a
raise to $20 per hour, the opportunity cost of enjoying leisure goes up.
The labor supply curve reflects how workers’ decisions about the labor–leisure
tradeoff respond to a change in that opportunity cost. An upward-sloping labor
supply curve means that an increase in the wage induces workers to increase the
quantity of labor they supply. Because time is limited, more hours of work means
that workers are enjoying less leisure. That is, workers respond to the increase in
the opportunity cost of leisure by taking less of it.
It is worth noting that the labor supply curve need not be upward sloping.
Imagine you got that raise from $15 to $20 per hour. The opportunity cost of
CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 405
leisure is now greater, but you are also richer than you were before. You might
decide that with your extra wealth you can now afford to enjoy more leisure;
in this case, your labor supply curve would slope backwards. In Chapter 21, we
discuss this possibility in terms of conflicting effects on your labor-supply deci-
sion (called income and substitution effects). For now, we ignore the possibility of
backward-sloping labor supply and assume that the labor supply curve is upward
sloping.
WHAT CAUSES THE LABOR SUPPLY CURVE TO SHIFT?
The labor supply curve shifts whenever people change the amount they want to
work at a given wage. Let’s now consider some of the events that might cause such
a shift.
Changes in Tastes In 1950, 34 percent of women were employed at paid
jobs or looking for work. In 1998, the number had risen to 60 percent. There are, of
course, many explanations for this development, but one of them is changing
tastes, or attitudes toward work. A generation or two ago, it was the norm for
women to stay at home while raising children. Today, family sizes are smaller, and
more mothers choose to work. The result is an increase in the supply of labor.
Changes in Alternative Opportunities The supply of labor in any
one labor market depends on the opportunities available in other labor markets. If
the wage earned by pear pickers suddenly rises, some apple pickers may choose to
switch occupations. The supply of labor in the market for apple pickers falls.
Immigration Movements of workers from region to region, or country to
country, is an obvious and often important source of shifts in labor supply. When
immigrants come to the United States, for instance, the supply of labor in the
United States increases and the supply of labor in the immigrants’ home countries
contracts. In fact, much of the policy debate about immigration centers on its effect
on labor supply and, thereby, equilibrium in the labor market.
QUICK QUIZ: Who has a greater opportunity cost of enjoying leisure—a
janitor or a brain surgeon? Explain. Can this help explain why doctors work
such long hours?
EQUILIBRIUM IN THE LABOR MARKET
So far we have established two facts about how wages are determined in compet-
itive labor markets:
a78 The wage adjusts to balance the supply and demand for labor.
a78 The wage equals the value of the marginal product of labor.
406 PART SIX THE ECONOMICS OF LABOR MARKETS
At first, it might seem surprising that the wage can do both these things at once. In
fact, there is no real puzzle here, but understanding why there is no puzzle is an
important step to understanding wage determination.
Figure 18-4 shows the labor market in equilibrium. The wage and the quantity
of labor have adjusted to balance supply and demand. When the market is in this
equilibrium, each firm has bought as much labor as it finds profitable at the equi-
librium wage. That is, each firm has followed the rule for profit maximization: It
has hired workers until the value of the marginal product equals the wage. Hence,
the wage must equal the value of marginal product of labor once it has brought
supply and demand into equilibrium.
This brings us to an important lesson: Any event that changes the supply or de-
mand for labor must change the equilibrium wage and the value of the marginal product by
the same amount, because these must always be equal. To see how this works, let’s con-
sider some events that shift these curves.
SHIFTS IN LABOR SUPPLY
Suppose that immigration increases the number of workers willing to pick apples.
As Figure 18-5 shows, the supply of labor shifts to the right from S
1
to S
2
. At the
initial wage W
1
, the quantity of labor supplied now exceeds the quantity de-
manded. This surplus of labor puts downward pressure on the wage of apple pick-
ers, and the fall in the wage from W
1
to W
2
in turn makes it profitable for firms to
hire more workers. As the number of workers employed in each apple orchard
rises, the marginal product of a worker falls, and so does the value of the marginal
product. In the new equilibrium, both the wage and the value of the marginal
product of labor are lower than they were before the influx of new workers.
Wage
(price of
labor)
Equilibrium
wage, W
0 Quantity of
Labor
Equilibrium
employment, L
Supply
Demand
Figure 18-4
EQUILIBRIUM IN A LABOR
MARKET. Like all prices, the
price of labor (the wage) depends
on supply and demand. Because
the demand curve reflects the
value of the marginal product of
labor, in equilibrium workers
receive the value of their
marginal contribution to the
production of goods and services.
CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 407
An episode from Israel illustrates how a shift in labor supply can alter the
equilibrium in a labor market. During most of the 1980s, many thousands of Pale-
stinians regularly commuted from their homes in the Israeli-occupied West Bank
and Gaza Strip to jobs in Israel, primarily in the construction and agriculture
industries. In 1988, however, political unrest in these occupied areas induced the
Israeli government to take steps that, as a by-product, reduced this supply of
workers. Curfews were imposed, work permits were checked more thoroughly,
and a ban on overnight stays of Palestinians in Israel was enforced more rigor-
ously. The economic impact of these steps was exactly as theory predicts: The
number of Palestinians with jobs in Israel fell by half, while those who continued
to work in Israel enjoyed wage increases of about 50 percent. With a reduced num-
ber of Palestinian workers in Israel, the value of the marginal product of the re-
maining workers was much higher.
SHIFTS IN LABOR DEMAND
Now suppose that an increase in the popularity of apples causes their price to rise.
This price increase does not change the marginal product of labor for any given
number of workers, but it does raise the value of the marginal product. With a
higher price of apples, hiring more apple pickers is now profitable. As Figure 18-6
shows, when the demand for labor shifts to the right from D
1
to D
2
, the equilib-
rium wage rises from W
1
to W
2
, and equilibrium employment rises from L
1
to L
2
.
Once again, the wage and the value of the marginal product of labor move
together.
This analysis shows that prosperity for firms in an industry is often linked
to prosperity for workers in that industry. When the price of apples rises, apple
Wage
(price of
labor)
W
2
W
1
0 Quantity of
Labor
L
2
L
1
Supply, S
1
Demand
2. . . . reduces
the wage . . .
3. . . . and raises employment.
1. An increase in
labor supply . . .
S
2
Figure 18-5
ASHIFT IN LABOR SUPPLY.
When labor supply increases
from S
1
to S
2
, perhaps because of
an immigration of new workers,
the equilibrium wage falls from
W
1
to W
2
. At this lower wage,
firms hire more labor, so
employment rises from L
1
to L
2
.
The change in the wage reflects a
change in the value of the
marginal product of labor: With
more workers, the added output
from an extra worker is smaller.
408 PART SIX THE ECONOMICS OF LABOR MARKETS
CASE STUDY PRODUCTIVITY AND WAGES
One of the Ten Principles of Economics in Chapter 1 is that our standard of living
depends on our ability to produce goods and services. We can now see how this
principle works in the market for labor. In particular, our analysis of labor de-
mand shows that wages equal productivity as measured by the value of the
marginal product of labor. Put simply, highly productive workers are highly
paid, and less productive workers are less highly paid.
This lesson is key to understanding why workers today are better off than
workers in previous generations. Table 18-2 presents some data on growth in
productivity and growth in wages (adjusted for inflation). From 1959 to 1997,
productivity as measured by output per hour of work grew about 1.8 percent
per year; at this rate, productivity doubles about every 40 years. Over this pe-
riod, wages grew at a similar rate of 1.7 percent per year.
producers make greater profit, and apple pickers earn higher wages. When the
price of apples falls, apple producers earn smaller profit, and apple pickers earn
lower wages. This lesson is well known to workers in industries with highly
volatile prices. Workers in oil fields, for instance, know from experience that their
earnings are closely linked to the world price of crude oil.
From these examples, you should now have a good understanding of how
wages are set in competitive labor markets. Labor supply and labor demand to-
gether determine the equilibrium wage, and shifts in the supply or demand curve
for labor cause the equilibrium wage to change. At the same time, profit maxi-
mization by the firms that demand labor ensures that the equilibrium wage always
equals the value of the marginal product of labor.
Wage
(price of
labor)
W
1
W
2
0 Quantity of
Labor
L
1
L
2
Supply
Demand, D
1
2. . . . increases
the wage . . .
3. . . . and increases employment.
1. An increase in
labor demand . . .
D
2
Figure 18-6
ASHIFT IN LABOR DEMAND.
When labor demand increases
from D
1
to D
2
, perhaps because of
an increase in the price of the
firms’ output, the equilibrium
wage rises from W
1
to W
2
, and
employment rises from L
1
to L
2
.
Again, the change in the wage
reflects a change in the value of
the marginal product of labor:
With a higher output price, the
added output from an extra
worker is more valuable.
CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 409
Table 18-2 also shows that, beginning around 1973, growth in productivity
slowed from 2.9 to 1.1 percent per year. This 1.8 percentage-point slowdown in
productivity coincided with a slowdown in wage growth of 1.9 percentage
points. Because of this productivity slowdown, workers in the 1980s and 1990s
did not experience the same rapid growth in living standards that their parents
enjoyed. A slowdown of 1.8 percentage points might not seem large, but accu-
mulated over many years, even a small change in a growth rate is significant. If
productivity and wages had grown at the same rate since 1973 as they did pre-
viously, workers’ earnings would now be about 50 percent higher than they are.
The link between productivity and wages also sheds light on international
experience. Table 18-3 presents some data on productivity growth and wage
growth for a representative group of countries, ranked in order of their produc-
tivity growth. Although these international data are far from precise, a close link
between the two variables is apparent. In South Korea, Hong Kong, and Singa-
pore, productivity has grown rapidly, and so have wages. In Mexico, Argentina,
and Iran, productivity has fallen, and so have wages. The United States falls
about in the middle of the distribution: By international standards, U.S. pro-
ductivity growth and wage growth have been neither exceptionally bad nor ex-
ceptionally good.
What causes productivity and wages to vary so much over time and across
countries? A complete answer to this question requires an analysis of long-run
economic growth, a topic beyond the scope of this chapter. We can, however,
briefly note three key determinants of productivity:
a78 Physical capital: When workers work with a larger quantity of equipment
and structures, they produce more.
a78 Human capital: When workers are more educated, they produce more.
a78 Technological knowledge: When workers have access to more sophisticated
technologies, they produce more.
Physical capital, human capital, and technological knowledge are the ulti-
mate sources of most of the differences in productivity, wages, and standards of
living.
Table 18-2
PRODUCTIVITY AND WAGE
GROWTH IN THE UNITED STATES
GROWTHRATE GROWTHRATE
TIMEPERIOD OFPRODUCTIVITY OFREALWAGES
1959–1997 1.8 1.7
1959–1973 2.9 2.9
1973–1997 1.1 1.0
SOURCE: Economic Report of the President 1999, table B-49, p. 384. Growth in productivity is measured here
as the annualized rate of change in output per hour in the nonfarm business sector. Growth in real
wages is measured as the annualized change in compensation per hour in the nonfarm business sector
divided by the implicit price deflator for that sector. These productivity data measure average
productivity—the quantity of output divided by the quantity of labor—rather than marginal
productivity, but average and marginal productivity are thought to move closely together.
410 PART SIX THE ECONOMICS OF LABOR MARKETS
QUICK QUIZ: How does an immigration of workers affect labor supply,
labor demand, the marginal product of labor, and the equilibrium wage?
THE OTHER FACTORS OF PRODUCTION:
LAND AND CAPITAL
We have seen how firms decide how much labor to hire and how these decisions
determine workers’ wages. At the same time that firms are hiring workers, they
are also deciding about other inputs to production. For example, our apple-
producing firm might have to choose the size of its apple orchard and the number
of ladders to make available to its apple pickers. We can think of the firm’s factors
of production as falling into three categories: labor, land, and capital.
The meaning of the terms labor and land is clear, but the definition of capital is
somewhat tricky. Economists use the term capital to refer to the stock of equip-
ment and structures used for production. That is, the economy’s capital represents
the accumulation of goods produced in the past that are being used in the present
to produce new goods and services. For our apple firm, the capital stock includes
the ladders used to climb the trees, the trucks used to transport the apples, the
buildings used to store the apples, and even the trees themselves.
EQUILIBRIUM IN THE MARKETS FOR LAND AND CAPITAL
What determines how much the owners of land and capital earn for their con-
tribution to the production process? Before answering this question, we need to
Table 18-3
PRODUCTIVITY AND WAGE
GROWTH AROUND THE WORLD
GROWTHRATE GROWTHRATE
COUNTRY OFPRODUCTIVITY OFREALWAGES
South Korea 8.5 7.9
Hong Kong 5.5 4.9
Singapore 5.3 5.0
Indonesia 4.0 4.4
Japan 3.6 2.0
India 3.1 3.4
United Kingdom 2.4 2.4
United States 1.7 0.5
Brazil 0.4 H110022.4
Mexico H110020.2 H110023.0
Argentina H110020.9 H110021.3
Iran H110021.4 H110027.9
SOURCE: World Development Report 1994, table 1, pp. 162–163, and table 7, pp. 174–175. Growth in
productivity is measured here as the annualized rate of change in gross national product per person
from 1980 to 1992. Growth in wages is measured as the annualized change in earnings per employee in
manufacturing from 1980 to 1991.
capital
the equipment and structures used to
produce goods and services
CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 411
distinguish between two prices: the purchase price and the rental price. The pur-
chase price of land or capital is the price a person pays to own that factor of pro-
duction indefinitely. The rental price is the price a person pays to use that factor for
a limited period of time. It is important to keep this distinction in mind because, as
we will see, these prices are determined by somewhat different economic forces.
Having defined these terms, we can now apply the theory of factor demand
we developed for the labor market to the markets for land and capital. The wage
is, after all, simply the rental price of labor. Therefore, much of what we have
learned about wage determination applies also to the rental prices of land and cap-
ital. As Figure 18-7 illustrates, the rental price of land, shown in panel (a), and the
rental price of capital, shown in panel (b), are determined by supply and demand.
Moreover, the demand for land and capital is determined just like the demand for
labor. That is, when our apple-producing firm is deciding how much land and
how many ladders to rent, it follows the same logic as when deciding how many
workers to hire. For both land and capital, the firm increases the quantity hired un-
til the value of the factor’s marginal product equals the factor’s price. Thus, the de-
mand curve for each factor reflects the marginal productivity of that factor.
We can now explain how much income goes to labor, how much goes to
landowners, and how much goes to the owners of capital. As long as the firms
using the factors of production are competitive and profit-maximizing, each fac-
tor’s rental price must equal the value of the marginal product for that factor.
Labor, land, and capital each earn the value of their marginal contribution to the produc-
tion process.
Now consider the purchase price of land and capital. The rental price and the
purchase price are obviously related: Buyers are willing to pay more to buy a piece
of land or capital if it produces a valuable stream of rental income. And, as we
Quantity of
Land
0
Rental
Price of
Land
P
Q
Demand
Supply
Demand
Supply
Quantity of
Capital
0
Rental
Price of
Capital
Q
P
(a) The Market for Land (b) The Market for Capital
Figure 18-7
THE MARKETS FOR LAND AND CAPITAL. Supply and demand determine the
compensation paid to the owners of land, as shown in panel (a), and the compensation
paid to the owners of capital, as shown in panel (b). The demand for each factor, in turn,
depends on the value of the marginal product of that factor.
412 PART SIX THE ECONOMICS OF LABOR MARKETS
have just seen, the equilibrium rental income at any point in time equals the value
of that factor’s marginal product. Therefore, the equilibrium purchase price of a
piece of land or capital depends on both the current value of the marginal product
and the value of the marginal product expected to prevail in the future.
LINKAGES AMONG THE FACTORS OF PRODUCTION
We have seen that the price paid to any factor of production—labor, land, or capi-
tal—equals the value of the marginal product of that factor. The marginal product
of any factor, in turn, depends on the quantity of that factor that is available. Be-
cause of diminishing returns, a factor in abundant supply has a low marginal
product and thus a low price, and a factor in scarce supply has a high marginal
product and a high price. As a result, when the supply of a factor falls, its equilib-
rium factor price rises.
When the supply of any factor changes, however, the effects are not limited to
the market for that factor. In most situations, factors of production are used to-
gether in a way that makes the productivity of each factor dependent on the quan-
tities of the other factors available to be used in the production process. As a result,
a change in the supply of any one factor alters the earnings of all the factors.
For example, suppose that a hurricane destroys many of the ladders that
workers use to pick apples from the orchards. What happens to the earnings of the
various factors of production? Most obviously, the supply of ladders falls and,
Labor income is an easy con-
cept to understand: It is the
paycheck that workers get from
their employers. The income
earned by capital, however, is
less obvious.
In our analysis, we have
been implicitly assuming that
households own the economy’s
stock of capital—ladders, drill
presses, warehouses, etc.—
and rent it to the firms that use
it. Capital income, in this case,
is the rent that households receive for the use of their capi-
tal. This assumption simplified our analysis of how capital
owners are compensated, but it is not entirely realistic. In
fact, firms usually own the capital they use and, therefore,
they receive the earnings from this capital.
These earnings from capital, however, eventually get
paid to households. Some of the earnings are paid in the
form of interest to those households who have lent money
to firms. Bondholders and bank depositors are two exam-
ples of recipients of interest. Thus, when you receive inter-
est on your bank account, that income is part of the econ-
omy’s capital income.
In addition, some of the earnings from capital are paid
to households in the form of dividends. Dividends are pay-
ments by a firm to the firm’s stockholders. A stockholder is
a person who has bought a share in the ownership of the
firm and, therefore, is entitled to share in the firm’s profits.
A firm does not have to pay out all of its earnings to
households in the form of interest and dividends. Instead, it
can retain some earnings within the firm and use these
earnings to buy additional capital. Although these retained
earnings do not get paid to the firm’s stockholders, the
stockholders benefit from them nonetheless. Because re-
tained earnings increase the amount of capital the firm
owns, they tend to increase future earnings and, thereby,
the value of the firm’s stock.
These institutional details are interesting and impor-
tant, but they do not alter our conclusion about the income
earned by the owners of capital. Capital is paid according to
the value of its marginal product, regardless of whether this
income gets transmitted to households in the form of inter-
est or dividends or whether it is kept within firms as re-
tained earnings.
FYI
What Is
Capital Income?
CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 413
CASE STUDY THE ECONOMICS OF THE BLACK DEATH
In fourteenth-century Europe, the bubonic plague wiped out about one-third of
the population within a few years. This event, called the Black Death, provides a
grisly natural experiment to test the theory of factor markets that we have just
developed. Consider the effects of the Black Death on those who were lucky
enough to survive. What do you think happened to the wages earned by work-
ers and the rents earned by landowners?
To answer this question, let’s examine the effects of a reduced population
on the marginal product of labor and the marginal product of land. With a
smaller supply of workers, the marginal product of labor rises. (This is simply
diminishing marginal product working in reverse.) Thus, we would expect the
Black Death to raise wages.
Because land and labor are used together in production, a smaller supply of
workers also affects the market for land, the other major factor of production in
medieval Europe. With fewer workers available to farm the land, an additional
unit of land produced less additional output. In other words, the marginal
product of land fell. Thus, we would expect the Black Death to lower rents.
In fact, both predictions are consistent with the historical evidence. Wages
approximately doubled during this period, and rents declined 50 percent or
more. The Black Death led to economic prosperity for the peasant classes and
reduced incomes for the landed classes.
therefore, the equilibrium rental price of ladders rises. Those owners who were
lucky enough to avoid damage to their ladders now earn a higher return when
they rent out their ladders to the firms that produce apples.
Yet the effects of this event do not stop at the ladder market. Because there are
fewer ladders with which to work, the workers who pick apples have a smaller
marginal product. Thus, the reduction in the supply of ladders reduces the de-
mand for the labor of apple pickers, and this causes the equilibrium wage to fall.
This story shows a general lesson: An event that changes the supply of any
factor of production can alter the earnings of all the factors. The change in earnings
of any factor can be found by analyzing the impact of the event on the value of the
marginal product of that factor.
WORKERS WHO SURVIVED THE PLAGUE
WERE LUCKY IN MORE WAYS THAN ONE.
QUICK QUIZ: What determines the income of the owners of land and
capital? a78 How would an increase in the quantity of capital affect the
incomes of those who already own capital? How would it affect the incomes
of workers?
CONCLUSION
This chapter explained how labor, land, and capital are compensated for the roles
they play in the production process. The theory developed here is called the neo-
classical theory of distribution. According to the neoclassical theory, the amount paid
to each factor of production depends on the supply and demand for that factor.
414 PART SIX THE ECONOMICS OF LABOR MARKETS
The demand, in turn, depends on that particular factor’s marginal productivity. In
equilibrium, each factor of production earns the value of its marginal contribution
to the production of goods and services.
The neoclassical theory of distribution is widely accepted. Most economists
begin with the neoclassical theory when trying to explain how the U.S. economy’s
$8 trillion of income is distributed among the economy’s various members. In the
following two chapters, we consider the distribution of income in more detail. As
you will see, the neoclassical theory provides the framework for this discussion.
Even at this point you can use the theory to answer the question that began
this chapter: Why are computer programmers paid more than gas station atten-
dants? It is because programmers can produce a good of greater market value than
can a gas station attendant. People are willing to pay dearly for a good computer
game, but they are willing to pay little to have their gas pumped and their wind-
shield washed. The wages of these workers reflect the market prices of the goods
they produce. If people suddenly got tired of using computers and decided to
spend more time driving, the prices of these goods would change, and so would
the equilibrium wages of these two groups of workers.
a78 The economy’s income is distributed in the markets for
the factors of production. The three most important
factors of production are labor, land, and capital.
a78 The demand for factors, such as labor, is a derived
demand that comes from firms that use the factors to
produce goods and services. Competitive, profit-
maximizing firms hire each factor up to the point at
which the value of the marginal product of the factor
equals its price.
a78 The supply of labor arises from individuals’ tradeoff
between work and leisure. An upward-sloping labor
supply curve means that people respond to an increase
in the wage by enjoying less leisure and working more
hours.
a78 The price paid to each factor adjusts to balance the
supply and demand for that factor. Because factor
demand reflects the value of the marginal product of
that factor, in equilibrium each factor is compensated
according to its marginal contribution to the production
of goods and services.
a78 Because factors of production are used together, the
marginal product of any one factor depends on the
quantities of all factors that are available. As a result, a
change in the supply of one factor alters the equilibrium
earnings of all the factors.
Summary
factors of production, p. 398
production function, p. 400
marginal product of labor, p. 400
diminishing marginal product, p. 401
value of the marginal product, p. 401
capital, p. 410
Key Concepts
1. Explain how a firm’s production function is related
to its marginal product of labor, how a firm’s
marginal product of labor is related to the value
of its marginal product, and how a firm’s value
of marginal product is related to its demand for
labor.
Questions for Review
CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 415
2. Give two examples of events that could shift the
demand for labor.
3. Give two examples of events that could shift the supply
of labor.
4. Explain how the wage can adjust to balance the supply
and demand for labor while simultaneously equaling
the value of the marginal product of labor.
5. If the population of the United States suddenly grew
because of a large immigration, what would happen to
wages? What would happen to the rents earned by the
owners of land and capital?
1. Suppose that the president proposes a new law aimed at
reducing heath care costs: All Americans are to be
required to eat one apple daily.
a. How would this apple-a-day law affect the demand
and equilibrium price of apples?
b. How would the law affect the marginal product
and the value of the marginal product of apple
pickers?
c. How would the law affect the demand and
equilibrium wage for apple pickers?
2. Henry Ford once said: “It is not the employer who pays
wages—he only handles the money. It is the product
that pays wages.” Explain.
3. Show the effect of each of the following events on the
market for labor in the computer manufacturing
industry.
a. Congress buys personal computers for all American
college students.
b. More college students major in engineering and
computer science.
c. Computer firms build new manufacturing plants.
4. Your enterprising uncle opens a sandwich shop that
employs 7 people. The employees are paid $6 per hour,
and a sandwich sells for $3. If your uncle is maximizing
his profit, what is the value of the marginal product of
the last worker he hired? What is that worker’s
marginal product?
5. Imagine a firm that hires two types of workers—some
with computer skills and some without. If technology
advances, so that computers become more useful to the
firm, what happens to the marginal product of the two
types? What happens to equilibrium wages? Explain,
using appropriate diagrams.
6. Suppose a freeze in Florida destroys part of the Florida
orange crop.
a. Explain what happens to the price of oranges and
the marginal product of orange pickers as a result
of the freeze. Can you say what happens to the
demand for orange pickers? Why or why not?
b. Suppose the price of oranges doubles and the
marginal product falls by 30 percent. What happens
to the equilibrium wage of orange pickers?
c. Suppose the price of oranges rises by 30 percent
and the marginal product falls by 50 percent.
What happens to the equilibrium wage of orange
pickers?
7. During the 1980s and 1990s the United States
experienced a significant inflow of capital from other
countries. For example, Toyota, BMW, and other
foreign car companies built auto plants in the United
States.
a. Using a diagram of the U.S. capital market, show
the effect of this inflow on the rental price of capital
in the United States and on the quantity of capital
in use.
b. Using a diagram of the U.S. labor market, show the
effect of the capital inflow on the average wage
paid to U.S. workers.
8. Suppose that labor is the only input used by a perfectly
competitive firm that can hire workers for $50 per day.
The firm’s production function is as follows:
DAYS OFLABOR UNITSOFOUTPUT
00
17
213
319
425
528
62
Each unit of output sells for $10. Plot the firm’s demand
for labor. How many days of labor should the firm hire?
Show this point on your graph.
Problems and Applications
416 PART SIX THE ECONOMICS OF LABOR MARKETS
9. (This question is challenging.) In recent years some
policymakers have proposed requiring firms to give
workers certain fringe benefits. For example, in 1993
President Clinton proposed requiring firms to provide
health insurance to their workers. Let’s consider the
effects of such a policy on the labor market.
a. Suppose that a law required firms to give each
worker $3 of fringe benefits for every hour that the
worker is employed by the firm. How does this law
affect the marginal profit that a firm earns from
each worker? How does the law affect the demand
curve for labor? Draw your answer on a graph with
the cash wage on the vertical axis.
b. If there is no change in labor supply, how would
this law affect employment and wages?
c. Why might the labor supply curve shift in response
to this law? Would this shift in labor supply raise or
lower the impact of the law on wages and
employment?
d. As Chapter 6 discussed, the wages of some
workers, particularly the unskilled and
inexperienced, are kept above the equilibrium level
by minimum-wage laws. What effect would a
fringe-benefit mandate have for these workers?
10. (This question is challenging.) This chapter has assumed
that labor is supplied by individual workers acting
competitively. In some markets, however, the supply of
labor is determined by a union of workers.
a. Explain why the situation faced by a labor union
may resemble the situation faced by a monopoly
firm.
b. The goal of a monopoly firm is to maximize profits.
Is there an analogous goal for labor unions?
c. Now extend the analogy between monopoly firms
and unions. How do you suppose that the wage set
by a union compares to the wage in a competitive
market? How do you suppose employment differs
in the two cases?
d. What other goals might unions have that make
unions different from monopoly firms?
IN THIS CHAPTER
YOU WILL . . .
Consider why it is
difficult to measure
the impact of
discrimination on
wages
See when market
forces can and
cannot provide a
natural remedy for
discrimination
Consider the debate
over comparable
worth as a system
for setting wages
Examine why in
some occupations a
few superstars earn
tremendous
incomes
Examine how wages
compensate for
differences in job
characteristics
Learn and compare
the human-capital
and signaling
theories of
education
Learn why wages
rise above the level
that balances
supply and demand
In the United States today, the typical physician earns about $200,000 a year, the
typical police officer about $50,000, and the typical farmworker about $20,000.
These examples illustrate the large differences in earnings that are so common in
our economy. These differences explain why some people live in mansions, ride in
limousines, and vacation on the French Riviera, while other people live in small
apartments, ride the bus, and vacation in their own back yards.
Why do earnings vary so much from person to person? Chapter 18, which de-
veloped the basic neoclassical theory of the labor market, offers an answer to this
question. There we saw that wages are governed by labor supply and labor de-
mand. Labor demand, in turn, reflects the marginal productivity of labor. In equi-
librium, each worker is paid the value of his or her marginal contribution to the
economy’s production of goods and services.
EARNINGS AND
DISCRIMINATION
417
418 PART SIX THE ECONOMICS OF LABOR MARKETS
This theory of the labor market, though widely accepted by economists, is
only the beginning of the story. To understand the wide variation in earnings that
we observe, we must go beyond this general framework and examine more pre-
cisely what determines the supply and demand for different types of labor. That is
our goal in this chapter.
SOME DETERMINANTS OF EQUILIBRIUM WAGES
Workers differ from one another in many ways. Jobs also have differing character-
istics—both in terms of the wage they pay and in terms of their nonmonetary at-
tributes. In this section we consider how the characteristics of workers and jobs
affect labor supply, labor demand, and equilibrium wages.
COMPENSATING DIFFERENTIALS
When a worker is deciding whether to take a job, the wage is only one of many job
attributes that the worker takes into account. Some jobs are easy, fun, and safe; oth-
ers are hard, dull, and dangerous. The better the job as gauged by these nonmon-
etary characteristics, the more people there are who are willing to do the job at any
“On the one hand, I know I could make more money if I
left public service for the privatesector, but, on the other
hand, I couldn’t chop off heads.”
CHAPTER 19 EARNINGS AND DISCRIMINATION 419
given wage. In other words, the supply of labor for easy, fun, and safe jobs is
greater than the supply of labor for hard, dull, and dangerous jobs. As a result,
“good” jobs will tend to have lower equilibrium wages than “bad” jobs.
For example, imagine you are looking for a summer job in the local beach
community. Two kinds of jobs are available. You can take a job as a beach-badge
checker, or you can take a job as a garbage collector. The beach-badge checkers
take leisurely strolls along the beach during the day and check to make sure the
tourists have bought the required beach permits. The garbage collectors wake up
before dawn to drive dirty, noisy trucks around town to pick up garbage. Which
job would you want? Most people would prefer the beach job if the wages were
the same. To induce people to become garbage collectors, the town has to offer
higher wages to garbage collectors than to beach-badge checkers.
Economists use the term compensating differential to refer to a difference in
wages that arises from nonmonetary characteristics of different jobs. Compensat-
ing differentials are prevalent in the economy. Here are some examples:
a78 Coal miners are paid more than other workers with similar levels of
education. Their higher wage compensates them for the dirty and dangerous
nature of coal mining, as well as the long-term health problems that coal
miners experience.
a78 Workers who work the night shift at factories are paid more than similar
workers who work the day shift. The higher wage compensates them for
having to work at night and sleep during the day, a lifestyle that most people
find undesirable.
a78 Professors are paid less than lawyers and doctors, who have similar amounts
of education. Professors’ lower wages compensate them for the great
intellectual and personal satisfaction that their jobs offer. (Indeed, teaching
economics is so much fun that it is surprising that economics professors get
paid anything at all!)
HUMAN CAPITAL
As we discussed in the previous chapter, the word capital usually refers to the econ-
omy’s stock of equipment and structures. The capital stock includes the farmer’s
tractor, the manufacturer’s factory, and the teacher’s blackboard. The essence of cap-
ital is that it is a factor of production that itself has been produced.
There is another type of capital that, while less tangible than physical capital,
is just as important to the economy’s production. Human capital is the accumula-
tion of investments in people. The most important type of human capital is educa-
tion. Like all forms of capital, education represents an expenditure of resources at
one point in time to raise productivity in the future. But, unlike an investment in
other forms of capital, an investment in education is tied to a specific person, and
this linkage is what makes it human capital.
Not surprisingly, workers with more human capital on average earn more
than those with less human capital. College graduates in the United States, for ex-
ample, earn about twice as much as those workers who end their education with a
high school diploma. This large difference has been documented in many coun-
tries around the world. It tends to be even larger in less developed countries,
where educated workers are in scarce supply.
compensating differential
a difference in wages that arises
to offset the nonmonetary
characteristics of different jobs
human capital
the accumulation of investments in
people, such as education and on-the-
job training
420 PART SIX THE ECONOMICS OF LABOR MARKETS
CASE STUDY THE INCREASING VALUE OF SKILLS
“The rich get richer, and the poor get poorer.” Like many adages, this one is not
always true, but recently it has been. Many studies have documented that the
earnings gap between workers with high skills and workers with low skills has
increased over the past two decades.
Table 19-1 presents data on the average earnings of college graduates and of
high school graduates without any additional education. These data show the
increase in the financial reward from education. In 1978, a man on average
earned 66 percent more with a college degree than without one; by 1998, this
figure had risen to 118 percent. For woman, the reward for attending college
rose from a 55 percent increase in earnings to a 98 percent increase. The incen-
tive to stay in school is as great today as it has ever been.
Why has the gap in earnings between skilled and unskilled workers risen in
recent years? No one knows for sure, but economists have proposed two hy-
potheses to explain this trend. Both hypotheses suggest that the demand for
skilled labor has risen over time relative to the demand for unskilled labor. The
shift in demand has led to a corresponding change in wages, which in turn has
led to greater inequality.
The first hypothesis is that international trade has altered the relative de-
mand for skilled and unskilled labor. In recent years, the amount of trade with
other countries has increased substantially. Imports into the United States have
risen from 5 percent of total U.S. production in 1970 to 13 percent in 1998. Ex-
ports from the United States have risen from 6 percent in 1970 to 11 percent in
1998. Because unskilled labor is plentiful and cheap in many foreign countries,
It is easy to see why education raises wages from the perspective of supply
and demand. Firms—the demanders of labor—are willing to pay more for the
highly educated because highly educated workers have higher marginal products.
Workers—the suppliers of labor—are willing to pay the cost of becoming educated
only if there is a reward for doing so. In essence, the difference in wages between
highly educated workers and less educated workers may be considered a com-
pensating differential for the cost of becoming educated.
Table 19-1
AVERAGE ANNUAL EARNINGS BY
EDUCATIONAL ATTAINMENT.
College graduates have always
earned more than workers
without the benefit of college, but
the salary gap grew even larger
during the 1980s and 1990s.
1978 1998
MEN High school, no college $31,847 $28,742
College graduates $52,761 $62,588
Percent extra for college grads H1100166% H11001118%
WOMEN High school, no college $14,953 $17,898
College graduates $23,170 $35,431
Percent extra for college grads H1100155% H1100198%
NOTE:Earnings data are adjusted for inflation and are expressed in 1998 dollars. Data apply to workers
age 18 and over.
SOURCE:U.S. Census Bureau.
CHAPTER 19 EARNINGS AND DISCRIMINATION 421
the United States tends to import goods produced with unskilled labor and ex-
port goods produced with skilled labor. Thus, when international trade ex-
pands, the domestic demand for skilled labor rises, and the domestic demand
for unskilled labor falls.
The second hypothesis is that changes in technology have altered the rela-
tive demand for skilled and unskilled labor. Consider, for instance, the intro-
duction of computers. Computers raise the demand for skilled workers who
can use the new machines and reduce the demand for the unskilled workers
whose jobs are replaced by the computers. For example, many companies now
rely more on computer databases, and less on filing cabinets, to keep business
records. This change raises the demand for computer programmers and reduces
the demand for filing clerks. Thus, as more firms begin to use computers, the
demand for skilled labor rises, and the demand for unskilled labor falls.
Economists have found it difficult to gauge the validity of these two hy-
potheses. It is possible, of course, that both are true: Increasing international
trade and technological change may share responsibility for the increasing in-
equality we have observed in recent decades.
ABILITY, EFFORT, AND CHANCE
Why do major league baseball players get paid more than minor league players?
Certainly, the higher wage is not a compensating differential. Playing in the major
leagues is not a less pleasant task than playing in the minor leagues; in fact, the op-
posite is true. The major leagues do not require more years of schooling or more
experience. To a large extent, players in the major leagues earn more just because
they have greater natural ability.
Natural ability is important for workers in all occupations. Because of hered-
ity and upbringing, people differ in their physical and mental attributes. Some
people are strong, others weak. Some people are smart, others less so. Some peo-
ple are outgoing, others awkward in social situations. These and many other per-
sonal characteristics determine how productive workers are and, therefore, play a
role in determining the wages they earn.
Closely related to ability is effort. Some people work hard; others are lazy. We
should not be surprised to find that those who work hard are more productive and
earn higher wages. To some extent, firms reward workers directly by paying peo-
ple on the basis of what they produce. Salespeople, for instance, are often paid as
a percentage of the sales they make. At other times, hard work is rewarded less di-
rectly in the form of a higher annual salary or a bonus.
Chance also plays a role in determining wages. If a person attended a trade
school to learn how to repair televisions with vacuum tubes and then found this
skill made obsolete by the invention of solid-state electronics, he or she would end
up earning a low wage compared to others with similar years of training. The low
wage of this worker is due to chance—a phenomenon that economists recognize
but do not shed much light on.
How important are ability, effort, and chance in determining wages? It is hard
to say, because ability, effort, and chance are hard to measure. But indirect evi-
dence suggests that they are very important. When labor economists study wages,
they relate a worker’s wage to those variables that can be measured—years of
schooling, years of experience, age, and job characteristics. Although all of these
422 PART SIX THE ECONOMICS OF LABOR MARKETS
CASE STUDY THE BENEFITS OF BEAUTY
People differ in many ways. One difference is in how attractive they are. The ac-
tor Mel Gibson, for instance, is a handsome man. In part for this reason, his
movies attract large audiences. Not surprisingly, the large audiences mean a
large income for Mr. Gibson.
How prevalent are the economic benefits of beauty? Labor economists Daniel
Hamermesh and Jeff Biddle tried to answer this question in a study published in
the December 1994 issue of the American Economic Review. Hamermesh and Bid-
dle examined data from surveys of individuals in the United States and Canada.
The interviewers who conducted the survey were asked to rate each respondent’s
physical appearance. Hamermesh and Biddle then examined how much the
wages of the respondents depended on the standard determinants—education,
experience, and so on—and how much they depended on physical appearance.
Hamermesh and Biddle found that beauty pays. People who are deemed to
be more attractive than average earn 5 percent more than people of average
looks. People of average looks earn 5 to 10 percent more than people considered
less attractive than average. Similar results were found for men and women.
What explains these differences in wages? There are several ways to inter-
pret the “beauty premium.”
One interpretation is that good looks are themselves a type of innate ability
determining productivity and wages. Some people are born with the attributes
of a movie star; other people are not. Good looks are useful in any job in which
workers present themselves to the public—such as acting, sales, and waiting on
tables. In this case, an attractive worker is more valuable to the firm than an un-
attractive worker. The firm’s willingness to pay more to attractive workers re-
flects its customers’ preferences.
A second interpretation is that reported beauty is an indirect measure of
other types of ability. How attractive a person appears depends on more than
just heredity. It also depends on dress, hairstyle, personal demeanor, and other
attributes that a person can control. Perhaps a person who successfully projects
an attractive image in a survey interview is more likely to be an intelligent per-
son who succeeds at other tasks as well.
Athird interpretation is that the beauty premium is a type of discrimina-
tion, a topic to which we return later.
measured variables affect a worker’s wage as theory predicts, they account for less
than half of the variation in wages in our economy. Because so much of the varia-
tion in wages is left unexplained, omitted variables, including ability, effort, and
chance, must play an important role.
GOOD LOOKS PAY.
AN ALTERNATIVE VIEW OF EDUCATION: SIGNALING
Earlier we discussed the human-capital view of education, according to which
schooling raises workers’ wages because it makes them more productive. Al-
though this view is widely accepted, some economists have proposed an alterna-
tive theory, which emphasizes that firms use educational attainment as a way of
sorting between high-ability and low-ability workers. According to this alternative
CHAPTER 19 EARNINGS AND DISCRIMINATION 423
CASE STUDY HUMAN CAPITAL, NATURAL ABILITY, AND
COMPULSORY SCHOOL ATTENDANCE
Does attending school increase wages because it increases productivity, or does
it only appear to increase productivity because high-ability people are more
likely to stay in school? This question is important both for judging the various
theories of education and for evaluating alternative education policies.
If economists could conduct controlled experiments like laboratory scien-
tists, it would be easy to answer this question. We could choose some experi-
mental subjects from the school-age population and then randomly divide them
into various groups. For each group we could require a different amount of
school attendance. By comparing the difference in the educational attainment
and the difference in subsequent wages of the various groups, we could see
whether education does in fact increase productivity. Because the groups would
be chosen randomly, we could be sure that the difference in wages was not at-
tributable to a difference in natural ability.
Although conducting such an experiment might seem difficult, the laws of
the United States inadvertently provide a natural experiment that is quite simi-
lar. All students in the United States are required by law to attend school, but
the laws vary from state to state. Some states allow students to drop out at age
view, when people earn a college degree, for instance, they do not become more
productive, but they do signaltheir high ability to prospective employers. Because
it is easier for high-ability people to earn a college degree than it is for low-ability
people, more high-ability people get college degrees. As a result, it is rational for
firms to interpret a college degree as a signal of ability.
The signaling theory of education is similar to the signaling theory of adver-
tising discussed in Chapter 17. In the signaling theory of advertising, the adver-
tisement itself contains no real information, but the firm signals the quality of its
product to consumers by its willingness to spend money on advertising. In the
signaling theory of education, schooling has no real productivity benefit, but the
worker signals his innate productivity to employers by his willingness to spend
years at school. In both cases, an action is being taken not for its intrinsic benefit
but because the willingness to take that action conveys private information to
someone observing it.
Thus, we now have two views of education: the human-capital theory and the
signaling theory. Both views can explain why more educated workers tend to earn
more than less educated workers. According to the human-capital view, education
makes workers more productive; according to the signaling view, education is cor-
related with natural ability. But the two views have radically different predictions
for the effects of policies that aim to increase educational attainment. According to
the human-capital view, increasing educational levels for all workers would raise
all workers’ productivity and thereby their wages. According to the signaling
view, education does not enhance productivity, so raising all workers’ educational
levels would not affect wages.
Most likely, truth lies somewhere between these two extremes. The benefits to
education are probably a combination of the productivity-enhancing effects of hu-
man capital and the productivity-revealing effects of signaling. The open question
is the relative size of these two effects.
424 PART SIX THE ECONOMICS OF LABOR MARKETS
16, while others require attendance until age 17 or 18. Moreover, the laws have
changed over time. Between 1970 and 1980, for instance, Wyoming reduced the
school-attendance age from 17 to 16, while Washington raised it from 16 to 18.
This variation across states and over time provides data with which to study the
effects of compulsory school attendance.
Even within a state, school-attendance laws have different effects on differ-
ent people. Students start attending school at different ages, depending on the
month of the year in which they were born. Yet all students can drop out as
soon as they reach the minimum legal age; they are not required to finish out
the school year. As a result, those who start school at a relatively young age are
required to spend more time in school than those who start school at a relatively
old age. This variation across students within a state also provides a way to
study the effects of compulsory attendance.
In an article published in the November 1991 issue of the Quarterly Journal of
Economics, labor economists Joshua Angrist and Alan Krueger used this natural
experiment to study the relationship between schooling and wages. Because the
duration of each student’s compulsory schooling depends on his or her state of
residence and month of birth, and not on natural ability, it was possible to isolate
the productivity-enhancing effect of education from the ability-signaling effect.
According to Angrist and Krueger’s research, those students who were required
to finish more school did earn significantly higher subsequent wages than those
with lower requirements. This finding indicates that education does raise a
worker’s productivity, as the human-capital theory suggests.
Although establishing the benefits of compulsory schooling is useful, it does
not by itself tell us whether these laws are desirable. That policy judgment re-
quires a more complete analysis of the costs and benefits. At the very least, we
would need to compare the benefits of schooling to the opportunity cost—the
wages that the student could have earned by dropping out. In addition, requir-
ing a student to stay in school may have external effects on others in society. On
the one hand, compulsory school attendance may reduce crime rates, for young
dropouts are at high risk of engaging in criminal activity. On the other hand, stu-
dents who stay in school only because they are required to do so may interfere
with the learning of other students who are more committed to their educations.
THE SUPERSTAR PHENOMENON
Although most actors earn very little and often have to take jobs as waiters to
support themselves, actor Robin Williams earned $23 million in 1997. Similarly,
although most people who play football do it for free as a hobby, Brett Favre earned
$6.75 million as a pro quarterback. Robin Williams and Brett Favre are superstars in
their fields, and their great public appeal is reflected in astronomical incomes.
Why do Robin Williams and Brett Favre earn so much? It is not surprising that
there are differences in incomes within occupations. Good carpenters earn more
than mediocre carpenters, and good plumbers earn more than mediocre plumbers.
People vary in ability and effort, and these differences lead to differences in in-
come. Yet the best carpenters and plumbers do not earn the many millions that are
common among the best actors and athletes. What explains the difference?
To understand the tremendous incomes of Robin Williams and Brett Favre, we
must examine the special features of the markets in which they sell their services.
Superstars arise in markets that have two characteristics:
CHAPTER 19 EARNINGS AND DISCRIMINATION 425
a78 Every customer in the market wants to enjoy the good supplied by the best
producer.
a78 The good is produced with a technology that makes it possible for the best
producer to supply every customer at low cost.
If Robin Williams is the funniest actor around, then everyone will want to see his
next movie; seeing twice as many movies by an actor half as funny is not a good
substitute. Moreover, it is possible for everyone to enjoy the comedy of Robin
Williams. Because it is easy to make multiple copies of a film, Robin Williams can
provide his service to millions of people simultaneously. Similarly, because foot-
ball games are broadcast on television, millions of fans can enjoy the extraordinary
athletic skills of Brett Favre.
We can now see why there are no superstar carpenters and plumbers. Other
things equal, everyone prefers to employ the best carpenter, but a carpenter, unlike
a movie actor, can provide his services to only a limited number of customers. Al-
though the best carpenter will be able to command a somewhat higher wage than
the average carpenter, the average carpenter will still be able to earn a good living.
ABOVE-EQUILIBRIUM WAGES:
MINIMUM-WAGE LAWS, UNIONS, AND EFFICIENCY WAGES
Most analyses of wage differences among workers are based on the equilibrium
model of the labor market—that is, wages are assumed to adjust to balance labor
supply and labor demand. But this assumption does not always apply. For some
workers, wages are set above the level that brings supply and demand into equi-
librium. Let’s consider three reasons why this might be so.
One reason for above-equilibrium wages is minimum-wage laws, as we first
saw in Chapter 6. Most workers in the economy are not affected by these laws be-
cause their equilibrium wages are well above the legal minimum. But for some
workers, especially the least skilled and experienced, minimum-wage laws raise
wages above the level they would earn in an unregulated labor market.
A second reason that wages might rise above their equilibrium level is the
market power of labor unions. Aunion is a worker association that bargains with
employers over wages and working conditions. Unions often raise wages above
the level that would prevail without a union, perhaps because they can threaten to
withhold labor from the firm by calling a strike. Studies suggest that union work-
ers earn about 10 to 20 percent more than similar nonunion workers.
Athird reason for above-equilibrium wages is suggested by the theory of effi-
ciency wages.This theory holds that a firm can find it profitable to pay high wages
because doing so increases the productivity of its workers. In particular, high
wages may reduce worker turnover, increase worker effort, and raise the quality
of workers who apply for jobs at the firm. If this theory is correct, then some firms
may choose to pay their workers more than they would normally earn.
Above-equilibrium wages, whether caused by minimum-wage laws, unions,
or efficiency wages, have similar effects on the labor market. In particular, pushing
a wage above the equilibrium level raises the quantity of labor supplied and re-
duces the quantity of labor demanded. The result is a surplus of labor, or unem-
ployment. The study of unemployment and the public policies aimed to deal with
it is usually considered a topic within macroeconomics, so it goes beyond the
scope of this chapter. But it would be a mistake to ignore these issues completely
union
a worker association that bargains
with employers over wages and
working conditions
strike
the organized withdrawal of labor
from a firm by a union
efficiency wages
above-equilibrium wages paid by
firms in order to increase worker
productivity
426 PART SIX THE ECONOMICS OF LABOR MARKETS
when analyzing earnings. Although most wage differences can be understood
while maintaining the assumption of equilibrium in the labor market, above-
equilibrium wages play a role in some cases.
QUICK QUIZ: Define compensating differential and give an example.
a78 Give two reasons why more educated workers earn more than less
educated workers.
THE ECONOMICS OF DISCRIMINATION
Another source of differences in wages is discrimination. Discrimination occurs
when the marketplace offers different opportunities to similar individuals who
differ only by race, ethnic group, sex, age, or other personal characteristics. Dis-
crimination reflects some people’s prejudice against certain groups in society. Al-
though discrimination is an emotionally charged topic that often generates heated
debate, economists try to study the topic objectively in order to separate myth
from reality.
MEASURING LABOR-MARKET DISCRIMINATION
How much does discrimination in labor markets affect the earnings of different
groups of workers? This question is important, but answering it is not easy.
It might seem natural to gauge the amount of discrimination in labor markets
by looking at the average wages of different groups. For instance, in recent years
the wage of the average black worker in the United States has been about 20 per-
cent less than the wage of the average white worker. The wage of the average fe-
male worker has been about 30 percent less than the wage of the average male
worker. These wage differentials are sometimes presented in political debate as ev-
idence that many employers discriminate against blacks and women.
Yet there is an obvious problem with this approach. Even in a labor market free
of discrimination, different people have different wages. People differ in the
amount of human capital they have and in the kinds of work they are able and will-
ing to do. The wage differences we observe in the economy are, to a large extent, at-
tributable to the determinants of equilibrium wages we discussed in the preceding
section. Simply observing differences in wages among broad groups—whites and
blacks, men and women—says little about the prevalence of discrimination.
Consider, for example, the role of human capital. About 80 percent of white
male workers have a high school diploma, and 25 percent have a college degree.
By contrast, only 67 percent of black male workers have a high school diploma,
and only 12 percent have a college degree. Thus, at least some of the difference be-
tween the wages of whites and the wages of blacks can be traced to differences in
educational attainment. Similarly, among white workers, 25 percent of men have a
college degree, whereas only 19 percent of women have a college degree, indicat-
ing that some of the difference between the wages of men and women is attribut-
able to educational attainment.
discrimination
the offering of different opportunities
to similar individuals who differ only
by race, ethnic group, sex, age, or
other personal characteristics
CHAPTER 19 EARNINGS AND DISCRIMINATION 427
In fact, human capital is probably even more important in explaining wage
differentials than the foregoing numbers suggest. For many years, public schools
in predominantly black areas have been of lower quality—as measured by expen-
diture, class size, and so on—than public schools in predominantly white areas.
Similarly, for many years, schools directed girls away from science and math
courses, even though these subjects may have had greater value in the market-
place than some of the alternatives. If we could measure the quality as well as the
quantity of education, the differences in human capital among these groups would
seem even larger.
Human capital acquired in the form of job experience can also help explain
wage differences. In particular, women tend to have less job experience on average
than men. One reason is that female labor-force participation has increased over the
past several decades. Because of this historic change, the average female worker to-
day is younger than the average male worker. In addition, women are more likely
to interrupt their careers to raise children. For both reasons, the experience of the
average female worker is less than the experience of the average male worker.
Yet another source of wage differences is compensating differentials. Some an-
alysts have suggested that women take more pleasant jobs on average than men
and that this fact explains some of the earnings differential between men and
women. For example, women are more likely to be secretaries, and men are more
likely to be truck drivers. The relative wages of secretaries and truck drivers de-
pend in part on the working conditions of each job. Because these nonmonetary as-
pects are hard to measure, it is difficult to gauge the practical importance of
compensating differentials in explaining the wage differences that we observe.
In the end, the study of wage differences among groups does not establish any
clear conclusion about the prevalence of discrimination in U.S. labor markets.
Most economists believe that some of the observed wage differentials are attribut-
able to discrimination, but there is no consensus about how much. The only con-
clusion about which economists are in consensus is a negative one: Because the
differences in average wages among groups in part reflect differences in human capital and
job characteristics, they do not by themselves say anything about how much discrimination
there is in the labor market.
Of course, differences in human capital among groups of workers may them-
selves reflect discrimination. The inferior schools historically available to black
students, for instance, may be traced to prejudice on the part of city councils and
school boards. But this kind of discrimination occurs long before the worker enters
the labor market. In this case, the disease is political, even if the symptom is
economic.
DISCRIMINATION BY EMPLOYERS
Let’s now turn from measurement to the economic forces that lie behind discrimi-
nation in labor markets. If one group in society receives a lower wage than another
group, even after controlling for human capital and job characteristics, who is to
blame for this differential?
The answer is not obvious. It might seem natural to blame employers for dis-
criminatory wage differences. After all, employers make the hiring decisions that de-
termine labor demand and wages. If some groups of workers earn lower wages than
they should, then it seems that employers are responsible. Yet many economists are
428 PART SIX THE ECONOMICS OF LABOR MARKETS
CASE STUDY SEGREGATED STREETCARS AND
THE PROFIT MOTIVE
In the early twentieth century, streetcars in many southern cities were segre-
gated by race. White passengers sat in the front of the streetcars, and black pas-
sengers sat in the back. What do you suppose caused and maintained this
discriminatory practice? And how was this practice viewed by the firms that
ran the streetcars?
In a 1986 article in the Journal of Economic History, economic historian Jen-
nifer Roback looked at these questions. Roback found that the segregation of
races on streetcars was the result of laws that required such segregation. Before
these laws were passed, racial discrimination in seating was rare. It was far
more common to segregate smokers and nonsmokers.
Moreover, the firms that ran the streetcars often opposed the laws requiring
racial segregation. Providing separate seating for different races raised the
firms’ costs and reduced their profit. One railroad company manager com-
plained to the city council that, under the segregation laws, “the company has
to haul around a good deal of empty space.”
Here is how Roback describes the situation in one southern city:
The railroad company did not initiate the segregation policy and was not at
all eager to abide by it. State legislation, public agitation, and a threat to
arrest the president of the railroad were all required to induce them to
separate the races on their cars. . . . There is no indication that the
management was motivated by belief in civil rights or racial equality. The
evidence indicates their primary motives were economic; separation was
skeptical of this easy answer. They believe that competitive, market economies pro-
vide a natural antidote to employer discrimination. That antidote is called the profit
motive.
Imagine an economy in which workers are differentiated by their hair color.
Blondes and brunettes have the same skills, experience, and work ethic. Yet, be-
cause of discrimination, employers prefer not to hire workers with blonde hair.
Thus, the demand for blondes is lower than it otherwise would be. As a result,
blondes earn a lower wage than brunettes.
How long can this wage differential persist? In this economy, there is an easy
way for a firm to beat out its competitors: It can hire blonde workers. By hiring
blondes, a firm pays lower wages and thus has lower costs than firms that hire
brunettes. Over time, more and more “blonde” firms enter the market to take ad-
vantage of this cost advantage. The existing “brunette” firms have higher costs
and, therefore, begin to lose money when faced with the new competitors. These
losses induce the brunette firms to go out of business. Eventually, the entry of
blonde firms and the exit of brunette firms cause the demand for blonde workers
to rise and the demand for brunette workers to fall. This process continues until
the wage differential disappears.
Put simply, business owners who care only about making money are at an ad-
vantage when competing against those who also care about discriminating. As a
result, firms that do not discriminate tend to replace those that do. In this way,
competitive markets have a natural remedy for employer discrimination.
CHAPTER 19 EARNINGS AND DISCRIMINATION 429
costly. . . . Officials of the company may or may not have disliked blacks,
but they were not willing to forgo the profits necessary to indulge such
prejudice.
The story of southern streetcars illustrates a general lesson: Business owners are
usually more interested in making profit than in discriminating against a par-
ticular group. When firms engage in discriminatory practices, the ultimate
source of the discrimination often lies not with the firms themselves but else-
where. In this particular case, the streetcar companies segregated whites and
blacks because discriminatory laws, which the companies opposed, required
them to do so.
DISCRIMINATION BY CUSTOMERS AND GOVERNMENTS
Although the profit motive is a strong force acting to eliminate discriminatory
wage differentials, there are limits to its corrective abilities. Here we consider two
of the most important limits: customer preferences and government policies.
To see how customer preferences for discrimination can affect wages, consider
again our imaginary economy with blondes and brunettes. Suppose that restau-
rant owners discriminate against blondes when hiring waiters. As a result, blonde
waiters earn lower wages than brunette waiters. In this case, a restaurant could
open up with blonde waiters and charge lower prices. If customers only cared
about the quality and price of their meals, the discriminatory firms would be dri-
ven out of business, and the wage differential would disappear.
On the other hand, it is possible that customers prefer being served by brunette
waiters. If this preference for discrimination is strong, the entry of blonde restau-
rants need not succeed in eliminating the wage differential between brunettes and
blondes. That is, if customers have discriminatory preferences, a competitive mar-
ket is consistent with a discriminatory wage differential. An economy with such
discrimination would contain two types of restaurants. Blonde restaurants hire
blondes, have lower costs, and charge lower prices. Brunette restaurants hire
brunettes, have higher costs, and charge higher prices. Customers who did not care
about the hair color of their waiters would be attracted to the lower prices at the
blonde restaurants. Bigoted customers would go to the brunette restaurants. They
would pay for their discriminatory preference in the form of higher prices.
Another way for discrimination to persist in competitive markets is for the
government to mandate discriminatory practices. If, for instance, the government
passed a law stating that blondes could wash dishes in restaurants but could not
work as waiters, then a wage differential could persist in a competitive market.
The example of segregated streetcars in the foregoing case study is one example of
government-mandated discrimination. More recently, before South Africa aban-
doned its system of apartheid, blacks were prohibited from working in some jobs.
Discriminatory governments pass such laws to suppress the normal equalizing
force of free and competitive markets.
To sum up: Competitive markets contain a natural remedy for employer discrimina-
tion. The entry of firms that care only about profit tends to eliminate discriminatory wage
differentials. These wage differentials persist in competitive markets only when customers
are willing to pay to maintain the discriminatory practice or when the government man-
dates it.
430 PART SIX THE ECONOMICS OF LABOR MARKETS
CASE STUDY DISCRIMINATION IN SPORTS
As we have seen, measuring discrimination is often difficult. To determine
whether one group of workers is discriminated against, a researcher must cor-
rect for differences in the productivity between that group and other workers in
the economy. Yet, in most firms, it is difficult to measure a particular worker’s
contribution to the production of goods and services.
One type of firm in which such corrections are easier is the sports team. Pro-
fessional teams have many objective measures of productivity. In baseball, for
instance, we can measure a player’s batting average, the frequency of home
runs, the number of stolen bases, and so on.
Studies of sports teams suggest that racial discrimination is, in fact, common
and that much of the blame lies with customers. One study, published in the Jour-
nal of Labor Economicsin 1988, examined the salaries of basketball players. It found
that black players earned 20 percent less than white players of comparable ability.
The study also found that attendance at basketball games was larger for teams
WHY DOES THE AVERAGE FEMALE WORKER
earn less than the average male
worker? In the following article, econo-
mist June O’Neill offers some answers
to this question.
The Shrinking Pay Gap
BY JUNE ELLENOFF O’NEILL
“Fifty-nine cents,” the popular button
said, a symbol of the stubborn fact that
throughout the post–World War II period,
women’s wages hovered at around 60
percent of men’s, despite an increasing
proportion of women working outside
the home. This gender gap did not de-
cline through the 1960s and the 1970s
despite the rise of the feminist move-
ment, equal pay and employment legisla-
tion, and affirmative action.
But starting in the Reagan years, the
gender gap in wages began to decline
dramatically. By some measures the ratio
of women’s earnings to men’s rose to
nearly 80 percent; and even this number,
I believe, overstates the gender gap be-
tween men and women with similar skills
and training. Why did this dramatic nar-
rowing in relative wages happen?
The answer has less to do with poli-
tics or protests than with the realities of
the labor market. Although basic skills
are acquired in school, it is in the labor
market where specialized skills are de-
veloped that bring higher wages. During
the three decades following World War II
women entered the labor market in
record numbers. But many of the new
entrants had been out of the labor force
for considerable periods of time, raising
their children. These women diluted the
skill level of the rapidly expanding group
of employed women. This was the main
reason why the gender gap in pay did
not narrow during the postwar years.
Today’s working women, particularly
those younger than forty, are much more
nearly equal to men in work experience
than were their mothers. Through delayed
marriage, low fertility, and an increasing
tendency for mothers of young children to
work, women have acquired many more
years of continuous work experience than
was true in the past. (Close to 60 percent
of married women with children under age
six are now in the labor force; in 1960, the
proportion was only 19 percent.)
And the work experience gained by
these younger women is likely to have an
even greater impact on their future earn-
ings because their work experience has
been more correctly anticipated. Many in-
vestment choices affecting careers are
made at younger ages: years of school-
ing, subjects in school, other professional
training. In the past, women were much
less likely than men to invest in lengthy
training because they assumed they
would not be working enough years to
justify it.
In fact, the National Longitudinal
Surveys found that even in the late
1960s less than 30 percent of young
IN THE NEWS
Men, Women, and Wages
CHAPTER 19 EARNINGS AND DISCRIMINATION 431
with a greater proportion of white players. One interpretation of these facts is that
customer discrimination makes black players less profitable than white players
for team owners. In the presence of such customer discrimination, a discrimina-
tory wage gap can persist, even if team owners care only about profit.
A similar situation once existed for baseball players. A study using data
from the late 1960s showed that black players earned less than comparable
white players. Moreover, fewer fans attended games pitched by blacks than
games pitched by whites, even though black pitchers had better records than
white pitchers. Studies of more recent salaries in baseball, however, have found
no evidence of discriminatory wage differentials.
Another study, published in the Quarterly Journal of Economics in 1990, ex-
amined the market prices of old baseball cards. This study found similar evi-
dence of discrimination. The cards of black hitters sold for 10 percent less than
the cards of comparable white hitters. The cards of black pitchers sold for 13
percent less than the cards of comparable white pitchers. These results suggest
customer discrimination among baseball fans.
women anticipated that they would be
working at age thirty-five, yet when this
group actually reached thirty-five, more
than 70 percent of them were in the labor
force. Their underestimation of future
work activity surely influenced their early
career preparations (or lack thereof).
More recent survey data show a dra-
matic change in expectations. The vast
majority of young women now report an
intention to work at age thirty-five.
Those changing work expectations
are reflected in rising female enrollments
in higher education. In 1960, women re-
ceived 35 percent of all bachelor’s de-
grees in the U.S.; by the 1980s, they
received somewhat more than half of
them. In 1968, women received 8 per-
cent of the medical degrees, 3 percent
of the MBAs, and 4 percent of the law
degrees granted that year. In 1986, they
received 31 percent of the medical de-
grees and MBAs and 39 percent of the
law degrees. This recent trend in school-
ing is likely to reinforce the rise in work
experience and contribute to continuing
increases in the relative earnings of
women workers. . . .
Despite the advances of the past
decade, women still earn less than men.
The hourly earnings of women were 74
percent of the earnings of men in 1992
when ages twenty-five to sixty-four are
considered, up from 62 percent in 1979.
At ages twenty-five to thirty-four, where
women’s skills have increased the most,
the ratio is 87 percent.
Economist Barbara Bergmann and
others attribute the pay gap to “wide-
spread, severe, ongoing discrimination by
employers and fellow workers.” But dis-
crimination cannot be directly measured.
Instead, researchers estimate the extent
to which differences in productivity ap-
pear to explain the gap and then attribute
the rest to discrimination. Such a conclu-
sion is premature, however, when pro-
ductivity differences are not accurately
measured, which is usually the case.
For example, data are seldom avail-
able on lifetime patterns of work experi-
ence, and even less material is available
on factors bearing on work expectations
and the intensity and nature of work in-
vestments. As these are still the key
sources of skill differences between men
and women, there is considerable room
for interpretation and disagreement.
When earnings comparisons are re-
stricted to men and women more similar
in their experience and life situations, the
measured earnings differentials are typi-
cally quite small. For example, among
people twenty-seven to thirty-three who
have never had a child, the earnings of
women in the National Longitudinal Sur-
vey of Youth are close to 98 percent of
men’s. . . .
It is true that women and men still do
not have the same earnings. But I believe
that the differential is largely due to con-
tinuing gender differences in the priority
placed on market work vs. family respon-
sibilities. Until family roles are more equal,
women are not likely to have the same
pattern of market work and earnings as
men. Technology has reduced the burden
of housework, but child care remains a
responsibility that is harder to shift to the
market.
SOURCE: The Wall Street Journal, October 7, 1994,
p.A10.
432 PART SIX THE ECONOMICS OF LABOR MARKETS
THE DEBATE OVER COMPARABLE WORTH
Should engineers get paid more than librarians? This question is at the heart of the
debate over comparable worth,a doctrine whereby jobs deemed comparable should
be paid the same wage.
Advocates of comparable worth point out that traditionally male occupations
have higher wages than traditionally female occupations. They believe that these oc-
cupational differences are discriminatory against women. Even if women were paid
the same as men for the same type of work, the gender gap in wages would persist
until comparable occupations were paid similar wages. Comparable-worth advo-
cates want jobs rated according to a set of impartial criteria—education, experience,
responsibility, working conditions, and so on. Under this system, comparably rated
jobs would pay the same wage. Alibrarian with a master’s degree, ten years of ex-
perience, and a 40-hour workweek, for instance, would be paid the same as an engi-
neer with a master’s degree, ten years of experience, and a 40-hour workweek.
Most economists are critical of comparable-worth proposals. They argue that
a competitive market is the best mechanism for setting wages. It would be nearly
impossible, they claim, to measure all of the factors that are relevant for determin-
ing the right wage for any job. Moreover, the fact that traditionally female occupa-
tions pay less than traditionally male occupations is not by itself evidence of
discrimination. Women have in the past spent more time than men raising chil-
dren. Women are, therefore, more likely to choose occupations that offer flexible
hours and other working conditions compatible with child-rearing. To some ex-
tent, the gender gap in wages is a compensating differential.
Economists also point out that comparable-worth proposals would have an
important unintended side effect. Comparable-worth advocates want the wages in
traditionally female occupations to be raised by legal decree. Such a policy would
have many of the effects of a minimum wage, which we first discussed in Chapter
6. In particular, when the wage is forced to rise above the equilibrium level, the
quantity of labor supplied to these occupations would rise, and the quantity de-
manded would fall. The result would be higher unemployment in traditionally fe-
male occupations. In this way, a comparable-worth law could adversely affect
some members of groups that the policy is aimed at helping.
QUICK QUIZ: Why is it hard to establish whether a group of workers is
being discriminated against? a78 Explain how profit-maximizing firms tend to
eliminate discriminatory wage differentials. a78 How might a discriminatory
wage differential persist?
CONCLUSION
In competitive markets, workers earn a wage equal to the value of their marginal
contribution to the production of goods and services. There are, however, many
things that affect the value of the marginal product. Firms pay more for workers
who are more talented, more diligent, more experienced, and more educated be-
cause these workers are more productive. Firms pay less to those workers against
whom customers discriminate because these workers contribute less to revenue.
comparable worth
a doctrine according to which jobs
deemed comparable should be paid
the same wage
CHAPTER 19 EARNINGS AND DISCRIMINATION 433
The theory of the labor market we have developed in the last two chapters ex-
plains why some workers earn higher wages than other workers. The theory does
not say that the resulting distribution of income is equal, fair, or desirable in any
way. That is the topic we take up in Chapter 20.
OVER THE PAST SEVERALYEARS, THE IDEAOF
comparable worth—sometimes called
pay equity—has made a comeback
among some political leaders.
Labor and Women Push for Equal
Pay for Equivalent Work
BY MARY LEONARD
WASHINGTON—Nobody says men and
women shouldn’t get equal pay for doing
the same job. But what’s brewing now is
a big push nationally by the president,
organized labor, and women’s rights
groups to level the gender playing field
on wages for different but equivalent
work.
In a strategy session today, Senator
Tom Harkin, an Iowa Democrat who has
been the lonely champion for pay-equity
legislation since 1996, will meet with John
Podesta, the president’s chief of staff,
and other officials on ways the White
House can boost his bill this year. Yester-
day, the AFL-CIO launched a nationwide
campaign to pass comparable-worth bills
in 24 states, including Massachusetts.
What’s going on here? Trying to de-
termine comparable salaries for jobs tra-
ditionally held by men and women is an
old idea, discredited by some economists
as unwieldy, if not downright dumb. They
wonder who can and will decide the eco-
nomic value of a riveter versus a nurse,
the comparable pay for a probation offi-
cer and a librarian, the equivalent pay for
an auto mechanic and a secretary.
Many see pay equity, even if it is dif-
ficult to enforce, as the only remedy for
wage discrimination, a problem that per-
sists for women, even as they have
earned advanced degrees, climbed the
corporate ladder, and plopped their chil-
dren in day care while pursuing full-time
jobs in large numbers. . . .
“For too long, working women have
been seething while politicians have re-
mained silent,” said Karen Nussbaum,
director of the AFL-CIO’s Working
Women’s department. “Pay equity can
right a long-standing wrong.” . . .
Diana Furchtgott-Roth, a resident fel-
low at the American Enterprise Institute,
says there are plenty of reasons why men
and women earn different wages—senior-
ity, job risk, and market demand for cer-
tain skills—that have nothing to do with
discrimination and would not be erased by
“cockeyed” pay-equity laws. She said
when you compare men and women with
the same qualifications doing the same
jobs, women earn 95 percent of men’s
salaries.
“Comparable worth is certainly mak-
ing a comeback,” Furchtgott-Roth said,
“and I believe it’s because feminists who
supported Clinton through the Lewinsky
mess are demanding a political payoff. I
don’t see any Republican support for
these proposals.”
SOURCE: The Boston Globe, February 25, 1999, pp.
A1, A22.
IN THE NEWS
The Recent Push for
Comparable Worth
a78 Workers earn different wages for many reasons. To
some extent, wage differentials compensate workers for
job attributes. Other things equal, workers in hard,
unpleasant jobs get paid more than workers in easy,
pleasant jobs.
a78 Workers with more human capital get paid more than
workers with less human capital. The return to
accumulating human capital is high and has increased
over the past decade.
a78 Although years of education, experience, and job
characteristics affect earnings as theory predicts,
thereismuch variation in earnings that cannot
beexplained by things that economists can
measure.Theunexplained variation in earnings is
Summary
434 PART SIX THE ECONOMICS OF LABOR MARKETS
largely attributable to natural ability, effort, and
chance.
a78 Some economists have suggested that more educated
workers earn higher wages not because education raises
productivity but because workers with high natural
ability use education as a way to signal their high ability
to employers. If this signaling theory were correct, then
increasing the educational attainment of all workers
would not raise the overall level of wages.
a78 Wages are sometimes pushed above the level that brings
supply and demand into balance. Three reason for
above-equilibrium wages are minimum-wage laws,
unions, and efficiency wages.
a78 Some differences in earnings are attributable to
discrimination on the basis of race, sex, or other factors.
Measuring the amount of discrimination is difficult,
however, because one must correct for differences in
human capital and job characteristics.
a78 Competitive markets tend to limit the impact of
discrimination on wages. If the wages of a group of
workers are lower than those of another group for
reasons not related to marginal productivity, then
nondiscriminatory firms will be more profitable than
discriminatory firms. Profit-maximizing behavior,
therefore, can act to reduce discriminatory wage
differentials. Discrimination can persist in competitive
markets if customers are willing to pay more to
discriminatory firms or if the government passes laws
requiring firms to discriminate.
compensating differential, p. 419
human capital, p. 419
union, p. 425
strike, p. 425
efficiency wages, p. 425
discrimination, p. 426
comparable worth, p. 432
Key Concepts
1. Why do coal miners get paid more than other workers
with similar amounts of education?
2. In what sense is education a type of capital?
3. How might education raise a worker’s wage without
raising the worker’s productivity?
4. What conditions lead to economic superstars? Would you
expect to see superstars in dentistry? In music? Explain.
5. Give three reasons why a worker’s wage might be
above the level that balances supply and demand.
6. What difficulties arise in deciding whether a group
ofworkers has a lower wage because of
discrimination?
7. Do the forces of economic competition tend to
exacerbate or ameliorate discrimination on the basis of
race?
8. Give an example of how discrimination might persist in
a competitive market.
Questions for Review
1. College students sometimes work as summer interns for
private firms or the government. Many of these
positions pay little or nothing.
a. What is the opportunity cost of taking such a job?
b. Explain why students are willing to take these jobs.
c. If you were to compare the earnings later in life of
workers who had worked as interns and those who
had taken summer jobs that paid more, what would
you expect to find?
2. As explained in Chapter 6, a minimum-wage law
distorts the market for low-wage labor. To reduce this
distortion, some economists advocate a two-tiered
minimum-wage system, with a regular minimum wage
for adult workers and a lower, “sub-minimum” wage
Problems and Applications
CHAPTER 19 EARNINGS AND DISCRIMINATION 435
for teenage workers. Give two reasons why a single
minimum wage might distort the labor market for
teenage workers more than it would the market for
adult workers.
3. Abasic finding of labor economics is that workers who
have more experience in the labor force are paid more
than workers who have less experience (holding
constant the amount of formal education). Why might
this be so? Some studies have also found that experience
at the same job (called “job tenure”) has an extra
positive influence on wages. Explain.
4. At some colleges and universities, economics professors
receive higher salaries than professors in some other
fields.
a. Why might this be true?
b. Some other colleges and universities have a policy
of paying equal salaries to professors in all fields.
At some of these schools, economics professors
have lighter teaching loads than professors in some
other fields. What role do the differences in
teaching loads play?
5. Sara works for Steve, whom she hates because of his
snobbish attitude. Yet when she looks for other jobs, the
best she can do is find a job paying $10,000 less than her
current salary. Should she take the job? Analyze Sara’s
situation from an economic point of view.
6. Imagine that someone were to offer you a choice: You
could spend four years studying at the world’s best
university, but you would have to keep your attendance
there a secret. Or you could be awarded an official
degree from the world’s best university, but you
couldn’t actually attend. Which choice do you think
would enhance your future earnings more? What does
your answer say about the debate over signaling versus
human capital in the role of education?
7. When recording devices were first invented almost 100
years ago, musicians could suddenly supply their music
to large audiences at low cost. How do you suppose this
event affected the income of the best musicians? How
do you suppose it affected the income of average
musicians?
8. Alan runs an economic consulting firm. He hires
primarily female economists because, he says, “they will
work for less than comparable men because women
have fewer job options.” Is Alan’s behavior admirable or
despicable? If more employers were like Alan, what
would happen to the wage differential between men
and women?
9. Acase study in this chapter described how customer
discrimination in sports seems to have an important
effect on players’ earnings. Note that this is possible
because sports fans know the players’ characteristics,
including their race. Why is this knowledge important
for the existence of discrimination? Give some specific
examples of industries where customer discrimination is
and is not likely to influence wages.
10. Suppose that all young women were channeled into
careers as secretaries, nurses, and teachers; at the same
time, young men were encouraged to consider these
three careers and many others as well.
a. Draw a diagram showing the combined labor
market for secretaries, nurses, and teachers. Draw a
diagram showing the combined labor market for all
other fields. In which market is the wage higher?
Do men or women receive higher wages on
average?
b. Now suppose that society changed and encouraged
both young women and young men to consider a
wide range of careers. Over time, what effect would
this change have on the wages in the two markets
you illustrated in part (a)? What effect would the
change have on the average wages of men and
women?
11. Economist June O’Neill argues that “until family roles
are more equal, women are not likely to have the same
pattern of market work and earnings as men.” What
does she mean by the “pattern” of market work? How
do these characteristics of jobs and careers affect
earnings?
12. This chapter considers the economics of discrimination
by employers, customers, and governments. Now
consider discrimination by workers. Suppose that some
brunette workers did not like working with blonde
workers. Do you think this worker discrimination could
explain lower wages for blonde workers? If such a wage
differential existed, what would a profit-maximizing
entrepreneur do? If there were many such
entrepreneurs, what would happen over time?
IN THIS CHAPTER
YOU WILL . . .
See how political
philosophers view
the government’s
role in
redistributing
income
Examine the degree
of economic
inequality in our
society
Consider some
problems that arise
when measuring
economic inequality
Consider the
various policies
aimed at helping
poor families
escape poverty
“The only difference between the rich and other people,” Mary Colum once said to
Ernest Hemingway, “is that the rich have more money.” Maybe so. But this claim
leaves many questions unanswered. The gap between rich and poor is a fascinat-
ing and important topic of study—for the comfortable rich, for the struggling poor,
and for the aspiring and worried middle class.
From the previous two chapters you should have some understanding about
why different people have different incomes. Aperson’s earnings depend on the
supply and demand for that person’s labor, which in turn depend on natural abil-
ity, human capital, compensating differentials, discrimination, and so on. Because
labor earnings make up about three-fourths of the total income in the U.S. econ-
omy, the factors that determine wages are also largely responsible for determining
how the economy’s total income is distributed among the various members of so-
ciety. In other words, they determine who is rich and who is poor.
INCOME INEQUALITY
AND POVERTY
437
438 PART SIX THE ECONOMICS OF LABOR MARKETS
In this chapter we discuss the distribution of income. As we shall see, this
topic raises some fundamental questions about the role of economic policy. One of
the Ten Principles of Economicsin Chapter 1 is that governments can sometimes im-
prove market outcomes. This possibility is particularly important when consider-
ing the distribution of income. The invisible hand of the marketplace acts to
allocate resources efficiently, but it does not necessarily ensure that resources are
allocated fairly. As a result, many economists—though not all—believe that the
government should redistribute income to achieve greater equality. In doing so,
however, the government runs into another of the Ten Principles of Economics:Peo-
ple face tradeoffs. When the government enacts policies to make the distribution
of income more equitable, it distorts incentives, alters behavior, and makes the al-
location of resources less efficient.
Our discussion of the distribution of income proceeds in three steps. First, we
assess how much inequality there is in our society. Second, we consider some dif-
ferent views about what role the government should play in altering the distribu-
tion of income. Third, we discuss various public policies aimed at helping society’s
poorest members.
THE MEASUREMENT OF INEQUALITY
We begin our study of the distribution of income by addressing four questions of
measurement:
a78 How much inequality is there in our society?
a78 How many people live in poverty?
“As far as I’m concerned, they can do what they want with the
minimum wage, just as long as they keep their hands off the
maximum wage.”
CHAPTER 20 INCOME INEQUALITY AND POVERTY 439
a78 What problems arise in measuring the amount of inequality?
a78 How often do people move among income classes?
These measurement questions are the natural starting point from which to discuss
public policies aimed at changing the distribution of income.
U.S. INCOME INEQUALITY
There are various ways to describe the distribution of income in the economy.
Table 20-1 presents a particularly simple way. It shows the percentage of families
that fall into each of seven income categories. You can use this table to find where
your family lies in the income distribution.
For examining differences in the income distribution over time or across coun-
tries, economists find it more useful to present the income data as in Table 20-2. To
see how to interpret this table, consider the following thought experiment. Imag-
ine that you lined up all the families in the economy according to their annual in-
come. Then you divided the families into five equal groups: the bottom fifth, the
second fifth, the middle fifth, the fourth fifth, and the top fifth. Next you computed
the share of total income that each group of families received. In this way, you
could produce the numbers in Table 20-2.
These numbers give us a way of gauging how the economy’s total income is dis-
tributed. If income were equally distributed across all families, each one-fifth of fam-
ilies would receive one-fifth (20 percent) of income. If all income were concentrated
among just a few families, the top fifth would receive 100 percent, and the other
fifths would receive 0 percent. The actual economy, of course, is between these two
extremes. The table shows that in 1998 the bottom fifth of all families received 4.2
percent of all income, and the top fifth of all families received 47.3 percent of all in-
come. In other words, even though the top and bottom fifths include the same num-
ber of families, the top fifth has about ten times as much income as the bottom fifth.
The last column in Table 20-2 shows the share of total income received by the
very richest families. In 1998, the top 5 percent of families received 20.7 percent of
total income. Thus, the total income of the richest 5 percent of families was greater
than the total income of the poorest 40 percent.
Table 20-2 also shows the distribution of income in various years beginning in
1935. At first glance, the distribution of income appears to have been remarkably
stable over time. Throughout the past several decades, the bottom fifth of families
Table 20-1
THE DISTRIBUTION OF INCOME IN
THE UNITED STATES: 1998
ANNUAL FAMILY INCOME PERCENT OF FAMILIES
Less than $15,000 11.7%
$15,000-$24,999 12.3
$25,000-$34,999 12.7
$35,000-$49,999 16.8
$50,000-$74,999 21.5
$75,000-$99,999 11.7
$100,000 and over 13.3
Source: U.S. Bureau of the Census.
440 PART SIX THE ECONOMICS OF LABOR MARKETS
CASE STUDY THE WOMEN’S MOVEMENT AND
THEINCOMEDISTRIBUTION
Over the past several decades, there has been a dramatic change in women’s
role in the economy. The percentage of women who hold jobs has risen from
about 32 percent in the 1950s to about 54 percent in the 1990s. As full-time
homemakers have become less common, a woman’s earnings have become a
more important determinant of the total income of a typical family.
Although the women’s movement has led to more equality between men
and women in access to education and jobs, it has also led to less equality in fam-
ily incomes. The reason is that the rise in women’s labor-force participation has
not been the same across all income groups. In particular, the women’s move-
ment has had its greatest impact on women from high-income households.
Women from low-income households have long had high rates of participation
in the labor force, even in the 1950s, and their behavior has changed much less.
In essence, the women’s movement has changed the behavior of the wives
of high-income men. In the 1950s, a male executive or physician was likely to
marry a woman who would stay at home and raise the children. Today, the wife
of a male executive or physician is more likely to be an executive or physician
herself. The result is that rich households have become even richer, a pattern
that raises inequality in family incomes.
has received about 4 to 5 percent of income, while the top fifth has received about
40 to 50 percent of income. Closer inspection of the table reveals some trends in the
degree of inequality. From 1935 to 1970, the distribution gradually became more
equal. The share of the bottom fifth rose from 4.1 to 5.5 percent, and the share of
the top fifth fell from 51.7 percent to 40.9 percent. In more recent years, this trend
has reversed itself. From 1970 to 1998, the share of the bottom fifth fell from 5.5
percent to 4.2 percent, and the share of the top fifth rose from 40.9 to 47.3 percent.
In Chapter 19 we discussed some of the reasons for this recent increase in in-
equality. Increases in international trade with low-wage countries and changes in
technology have tended to reduce the demand for unskilled labor and raise the de-
mand for skilled labor. As a result, the wages of unskilled workers have fallen rel-
ative to the wages of skilled workers, and this change in relative wages has
increased inequality in family incomes.
Table 20-2
INCOME INEQUALITY IN THE
UNITED STATES. This table
shows the percent of total before-
tax income received by families
in each fifth of the income
distribution and by those
familiesin the top 5 percent.
BOTTOM SECOND MIDDLE FOURTH TOP TOP
YEAR FIFTH FIFTH FIFTH FIFTH FIFTH 5 PERCENT
1998 4.2% 9.9% 15.7% 23.0% 47.3% 20.7%
1990 4.6 10.8 16.6 23.8 44.3 17.4
1980 5.2 11.5 17.5 24.3 41.5 15.3
1970 5.5 12.2 17.6 23.8 40.9 15.6
1960 4.8 12.2 17.8 24.0 41.3 15.9
1950 4.5 12.0 17.4 23.4 42.7 17.3
1935 4.1 9.2 14.1 20.9 51.7 26.5
Source: U.S. Bureau of the Census.
CHAPTER 20 INCOME INEQUALITY AND POVERTY 441
As this example shows, there are social as well as economic determinants of
the distribution of income. Moreover, the simplistic view that “income inequal-
ity is bad” can be misleading. Increasing the opportunities available to women
was surely a good change for society, even if one effect was greater inequality in
family incomes. When evaluating any change in the distribution of income, pol-
icymakers must look at the reasons for that change before deciding whether it
presents a problem for society.
CASE STUDY INCOME INEQUALITY AROUND THE WORLD
How does the amount of income inequality in the United States compare to that
in other countries? This question is interesting, but answering it is problematic.
For many countries, data are not available. Even when they are, not every coun-
try in the world collects data in the same way; for example, some countries col-
lect data on individual incomes, whereas other countries collect data on family
incomes. As a result, whenever we find a difference between two countries, we
can never be sure whether it reflects a true difference in the economies or
merely a difference in the way data are collected.
With this warning in mind, consider Table 20-3, which compares the income
distribution of the United States to that of seven other countries. The countries
EQUALITY FOR WOMEN HAS MEANT
LESS EQUALITY FOR FAMILY INCOMES.
Table 20-3
COUNTRY BOTTOM FIFTH SECOND FIFTH MIDDLE FIFTH FOURTH FIFTH TOP FIFTH
Germany 9.0% 13.5% 17.5% 22.9% 37.1%
Canada 7.5 12.9 17.2 23.0 39.3
Russia 7.4 12.6 17.7 24.2 38.2
United Kingdom 7.1 12.8 17.2 23.1 39.8
China 5.5 9.8 14.9 22.3 47.5
United States 4.8 10.5 16.0 23.5 45.2
Chile 3.5 6.6 10.9 18.1 61.0
Brazil 2.5 5.7 9.9 17.7 64.2
INCOME INEQUALITY AROUND THE WORLD. This table shows the percent of total before-
tax income received by families in each fifth of the income distribution.
Source: World Development Report: 1998/99,pp. 198–199.
442 PART SIX THE ECONOMICS OF LABOR MARKETS
are ranked from the most equal to the most unequal. On the top of the list is
Germany, where the richest fifth of the population has income only about 4 times
that of the poorest fifth. On the bottom of the list is Brazil, where the richest
fifthhas income about 25 times that of the poorest fifth. Although all countries
have substantial inequality in income, the degree of inequality is not the same
everywhere.
When countries are ranked by inequality, the United States ends up slightly
behind the middle of the pack. Compared to other economically advanced
countries, such as Germany and Canada, the United States has substantial in-
equality. But the United States has a more equal income distribution than many
developing countries, such as Chile and Brazil.
THE POVERTY RATE
Acommonly used gauge of the distribution of income is the poverty rate. The
poverty rate is the percentage of the population whose family income falls below
an absolute level called the poverty line. The poverty line is set by the federal gov-
ernment at roughly three times the cost of providing an adequate diet. This line is
adjusted every year to account for changes in the level of prices, and it depends on
family size.
To get some idea about what the poverty rate tells us, consider the data for
1998. In that year, the median family had an income of $47,469, and the poverty
line for a family of four was $16,660. The poverty rate was 12.7 percent. In other
words, 12.7 percent of the population were members of families with incomes be-
low the poverty line for their family size.
Figure 20-1 shows the poverty rate since 1959, when the official data begin. You
can see that the poverty rate fell from 22.4 percent in 1959 to a low of 11.1 percent in
1973. This decline is not surprising, for average income in the economy (adjusted
poverty line
an absolute level of income set by the
federal government for each family
size below which a family is deemed
to be in poverty
Percent of the
Population
below Poverty
Line
1960 1965 1970 1975 1980 1985 1990 1995 1998
0
5
10
15
20
25
Poverty rate
Figure 20-1
THE POVERTY RATE. The
poverty rate shows the percentage
of the population with incomes
below an absolute level called the
poverty line.
Source: U.S. Bureau of the Census.
poverty rate
the percentage of the population
whose family income falls below an
absolute level called the poverty line
CHAPTER 20 INCOME INEQUALITY AND POVERTY 443
for inflation) rose more than 50 percent during this period. Because the poverty line
is an absolute rather than a relative standard, more families are pushed above the
poverty line as economic growth pushes the entire income distribution upward. As
John F. Kennedy once put it, a rising tide lifts all boats.
Since the early 1970s, however, the economy’s rising tide has left some boats
behind. Despite continued (although somewhat slower) growth in average in-
come, the poverty rate has not declined. This lack of progress in reducing poverty
in recent years is closely related to the increasing inequality we saw in Table 20-2.
Although economic growth has raised the income of the typical family, the in-
crease in inequality has prevented the poorest families from sharing in this greater
economic prosperity.
Poverty is an economic malady that affects all groups within the population,
but it does not affect all groups with equal frequency. Table 20-4 shows the poverty
rates for several groups, and it reveals three striking facts:
a78 Poverty is correlated with race. Blacks and Hispanics are about three times
more likely to live in poverty than are whites.
a78 Poverty is correlated with age. Children are more likely than average to be
members of poor families, and the elderly are less likely than average to be
poor.
a78 Poverty is correlated with family composition. Families headed by a female
adult and without a husband present are more than twice as likely to live in
poverty as the average family.
These three facts have described U.S. society for many years, and they show which
people are most likely to be poor. These effects also work together: Among black
and Hispanic children in female-headed households, more than half live in poverty.
PROBLEMS IN MEASURING INEQUALITY
Although data on the income distribution and the poverty rate help to give us
some idea about the degree of inequality in our society, interpreting these data is
not as straightforward as it might first appear. The data are based on households’
Table 20-4
WHO IS POOR? This table
shows that the poverty rate varies
greatly among different groups
within the population.
GROUP POVERTY RATE
All persons 12.7%
White, not Hispanic 8.2
Black 26.1
Hispanic 25.6
Asian, Pacific Islander 12.5
Children (under age 18) 18.9
Elderly (over age 64) 10.5
Female household, no husband present 33.1
Source: U.S. Bureau of the Census. Data are for 1998.
444 PART SIX THE ECONOMICS OF LABOR MARKETS
annual incomes. What people care about, however, is not their incomes but their
ability to maintain a good standard of living. For various reasons, data on the in-
come distribution and the poverty rate give an incomplete picture of inequality in
living standards. We examine these reasons below.
In-Kind Transfers Measurements of the distribution of income and the
poverty rate are based on families’ money income. Through various government
programs, however, the poor receive many nonmonetary items, including food
stamps, housing vouchers, and medical services. Transfers to the poor given in the
form of goods and services rather than cash are called in-kind transfers. Standard
measurements of the degree of inequality do not take account of these in-kind
transfers.
Because in-kind transfers are received mostly by the poorest members of soci-
ety, the failure to include in-kind transfers as part of income greatly affects the
measured poverty rate. According to a study by the Census Bureau, if in-kind
transfers were included in income at their market value, the number of families in
poverty would be about 10 percent lower than the standard data indicate.
The important role of in-kind transfers makes evaluating changes in poverty
more difficult. Over time, as public policies to help the poor evolve, the composi-
tion of assistance between cash and in-kind transfers changes. Some of the fluctu-
ations in the measured poverty rate, therefore, reflect the form of government
assistance rather than the true extent of economic deprivation.
The Economic Life Cycle Incomes vary predictably over people’s lives.
Ayoung worker, especially one in school, has a low income. Income rises as the
worker gains maturity and experience, peaks at around age 50, and then falls
sharply when the worker retires at around age 65. This regular pattern of income
variation is called the life cycle.
Because people can borrow and save to smooth out life cycle changes in in-
come, their standard of living in any year depends more on lifetime income than
on that year’s income. The young often borrow, perhaps to go to school or to buy
a house, and then repay these loans later when their incomes rise. People have
their highest saving rates when they are middle-aged. Because people can save in
anticipation of retirement, the large declines in incomes at retirement need not lead
to similar declines in the standard of living.
This normal life cycle pattern causes inequality in the distribution of annual
income, but it does not represent true inequality in living standards. To gauge
the inequality of living standards in our society, the distribution of lifetime in-
comes is more relevant than the distribution of annual incomes. Unfortunately,
data on lifetime incomes are not readily available. When looking at any data on
inequality, however, it is important to keep the life cycle in mind. Because a per-
son’s lifetime income smooths out the highs and lows of the life cycle, lifetime in-
comes are surely more equally distributed across the population than are annual
incomes.
Transitory versus Permanent Income Incomes vary over people’s
lives not only because of predictable life cycle variation but also because of ran-
dom and transitory forces. One year a frost kills off the Florida orange crop, and
Florida orange growers see their incomes fall temporarily. At the same time, the
in-kind transfers
transfers to the poor given in the
form of goods and services rather
than cash
life cycle
the regular pattern of income
variation over a person’s life
CHAPTER 20 INCOME INEQUALITY AND POVERTY 445
Florida frost drives up the price of oranges, and California orange growers see
their incomes temporarily rise. The next year the reverse might happen.
Just as people can borrow and lend to smooth out life cycle variation in in-
come, they can also borrow and lend to smooth out transitory variation in income.
When California orange growers experience a good year, they would be foolish to
spend all of their additional income. Instead, they save some of it, knowing that
their good fortune is unlikely to persist. Similarly, the Florida orange growers re-
spond to their temporarily low incomes by drawing down their savings or by bor-
rowing. To the extent that a family saves and borrows to buffer itself from
transitory changes in income, these changes do not affect its standard of living. A
family’s ability to buy goods and services depends largely on its permanent in-
come, which is its normal, or average, income.
To gauge inequality of living standards, the distribution of permanent income
is more relevant than the distribution of annual income. Although permanent in-
come is hard to measure, it is an important concept. Because permanent income
excludes transitory changes in income, permanent income is more equally distrib-
uted than is current income.
permanent income
a person’s normal income
HOW MANY PEOPLE LIVE IN POVERTY? THE
answer is a topic of continuing debate.
Devising New Math
to Define Poverty
BY LOUIS UCHITELLE
The Census Bureau has begun to revise
its definition of what constitutes poverty
in the United States, experimenting with
a formula that would drop millions of
more families below the poverty line.
The bureau’s new approach would
in effect raise the income threshold for
living above poverty to $19,500 for a
family of four, from the $16,600 now
considered sufficient. Suddenly, 46 mil-
lion Americans, or 17 percent of the pop-
ulation, would be recognized as officially
below the line, not the 12.7 percent an-
nounced last month, the lowest in nearly
a decade. . . .
Fixing a poverty line has always been
a subjective endeavor. The current for-
mula was created for President Lyndon B.
Johnson to keep score on his “war on
poverty” and has remained unchanged
since 1965 except for adjustments for in-
flation. . . . The Census Bureau’s new Ex-
perimental Measures are an effort to
determine what poor people must spend
on food, clothing, housing, and life’s little
extras.
“There is no scientific way to set a
new poverty line,” said Rebecca M.
Blank, dean of the School of Social Pol-
icy at the University of Michigan. “What
there is here are a set of judgment calls,
now being made, about what is needed
to lift people to a socially acceptable
standard of living.” . . .
Ordinary Americans, in opinion polls,
draw the poverty line above $20,000,
saying it takes at least that much, if not
more, to “get along in their community,”
to “live decently,” or to avoid hardship.
But a higher threshold means gov-
ernment spending would rise to pay for
benefits tied to the poverty level, like
food stamps and Head Start. That would
require an incursion into the budget sur-
plus that neither Republicans nor De-
mocrats seek.
Not surprising, the White House,
which would have to authorize a change
in the poverty formula, is proceeding
cautiously. “We have at least a couple of
years more work to do,” an Administra-
tion official said, passing the decision for
redefining poverty to the next adminis-
tration.
SOURCE:The New York Times,October 18, 1999,
pp.A1, A14.
IN THE NEWS
Measuring Poverty
446 PART SIX THE ECONOMICS OF LABOR MARKETS
ECONOMIC MOBILITY
People sometimes speak of “the rich” and “the poor” as if these groups consisted
of the same families year after year. In fact, this is not at all the case. Economic mo-
bility, the movement of people among income classes, is substantial in the U.S.
economy. Movements up the income ladder can be due to good luck or hard work,
and movements down the ladder can be due to bad luck or laziness. Some of this
mobility reflects transitory variation in income, while some reflects more persis-
tent changes in income.
Because economic mobility is so great, many of those below the poverty line
are there only temporarily. Poverty is a long-term problem for relatively few fam-
ilies. In a typical ten-year period, about one in four families falls below the poverty
line in at least one year. Yet fewer than 3 percent of families are poor for eight or
more years. Because it is likely that the temporarily poor and the persistently poor
face different problems, policies that aim to combat poverty need to distinguish
between these groups.
Another way to gauge economic mobility is the persistence of economic suc-
cess from generation to generation. Economists who have studied this topic find
substantial mobility. If a father earns 20 percent above his generation’s average in-
come, his son will most likely earn 8 percent above his generation’s average in-
come. There is almost no correlation between the income of a grandfather and the
income of a grandson. There is much truth to the old saying, “From shirtsleeves to
shirtsleeves in three generations.”
One result of this great economic mobility is that the U.S. economy is filled
with self-made millionaires (as well as with heirs who squandered the fortunes
they inherited). According to estimates for 1996, about 2.7 million households in
the United States had net worth (assets minus debts) that exceeded $1 million.
These households represented the richest 2.8 percent of the population. About four
out of five of these millionaires made their money on their own, such as by start-
ing and building a business or by climbing the corporate ladder. Only one in five
millionaires inherited their fortunes.
QUICK QUIZ: What does the poverty rate measure? a78 Describe three
potential problems in interpreting the measured poverty rate.
THE POLITICAL PHILOSOPHY
OF REDISTRIBUTING INCOME
We have just seen how the economy’s income is distributed and have considered
some of the problems in interpreting measured inequality. This discussion was pos-
itivein the sense that it merely described the world as it is. We now turn to the nor-
mative question facing policymakers: What should the government do about
economic inequality?
This question is not just about economics. Economic analysis alone cannot tell
us whether policymakers should try to make our society more egalitarian. Our
views on this question are, to a large extent, a matter of political philosophy. Yet
CHAPTER 20 INCOME INEQUALITY AND POVERTY 447
because the government’s role in redistributing income is central to so many de-
bates over economic policy, here we digress from economic science to consider a
bit of political philosophy.
UTILITARIANISM
A prominent school of thought in political philosophy is utilitarianism. The
founders of utilitarianism are the English philosophers Jeremy Bentham (1748–1832)
and John Stuart Mill (1806–1873). To a large extent, the goal of utilitarians is to ap-
ply the logic of individual decisionmaking to questions concerning morality and
public policy.
The starting point of utilitarianism is the notion of utility—the level of happi-
ness or satisfaction that a person receives from his or her circumstances. Utility is
a measure of well-being and, according to utilitarians, is the ultimate objective of
all public and private actions. The proper goal of the government, they claim, is to
maximize the sum of utility of everyone in society.
The utilitarian case for redistributing income is based on the assumption of di-
minishing marginal utility. It seems reasonable that an extra dollar of income to a
poor person provides that person with more additional utility than does an extra
dollar to a rich person. In other words, as a person’s income rises, the extra well-
being derived from an additional dollar of income falls. This plausible assumption,
together with the utilitarian goal of maximizing total utility, implies that the gov-
ernment should try to achieve a more equal distribution of income.
The argument is simple. Imagine that Peter and Paul are the same, except that
Peter earns $80,000 and Paul earns $20,000. In this case, taking a dollar from Peter
to pay Paul will reduce Peter’s utility and raise Paul’s utility. But, because of di-
minishing marginal utility, Peter’s utility falls by less than Paul’s utility rises.
Thus, this redistribution of income raises total utility, which is the utilitarian’s
objective.
At first, this utilitarian argument might seem to imply that the government
should continue to redistribute income until everyone in society has exactly the
same income. Indeed, that would be the case if the total amount of income—
$100,000 in our example—were fixed. But, in fact, it is not. Utilitarians reject com-
plete equalization of incomes because they accept one of the Ten Principles of
Economicspresented in Chapter 1: People respond to incentives.
To take from Peter to pay Paul, the government must pursue policies that re-
distribute income, such as the U.S. federal income tax and welfare system. Under
these policies, people with high incomes pay high taxes, and people with low in-
comes receive income transfers. Yet, as we have seen in Chapters 8 and 12, taxes
distort incentives and cause deadweight losses. If the government takes away ad-
ditional income a person might earn through higher income taxes or reduced
transfers, both Peter and Paul have less incentive to work hard. As they work less,
society’s income falls, and so does total utility. The utilitarian government has to
balance the gains from greater equality against the losses from distorted incen-
tives. To maximize total utility, therefore, the government stops short of making
society fully egalitarian.
Afamous parable sheds light on the utilitarian’s logic. Imagine that Peter and
Paul are thirsty travelers trapped at different places in the desert. Peter’s oasis has
much water; Paul’s has little. If the government could transfer water from one oasis
utilitarianism
the political philosophy according to
which the government should choose
policies to maximize the total utility
of everyone in society
utility
a measure of happiness or
satisfaction
448 PART SIX THE ECONOMICS OF LABOR MARKETS
to the other without cost, it would maximize total utility from water by equalizing
the amount in the two places. But suppose that the government has only a leaky
bucket. As it tries to move water from one place to the other, some of the water is
lost in transit. In this case, a utilitarian government might still try to move some wa-
ter from Peter to Paul, depending on how thirsty Paul is and how leaky the bucket
is. But, with only a leaky bucket at its disposal, a utilitarian government will not try
to reach complete equality.
LIBERALISM
Asecond way of thinking about inequality might be called liberalism. Philoso-
pher John Rawls develops this view in his book ATheory of Justice.This book was
first published in 1971, and it quickly became a classic in political philosophy.
Rawls begins with the premise that a society’s institutions, laws, and policies
should be just. He then takes up the natural question: How can we, the members
of society, ever agree on what justice means? It might seem that every person’s
point of view is inevitably based on his or her particular circumstances—whether
he or she is talented or less talented, diligent or lazy, educated or less educated,
born to a wealthy family or a poor one. Could we ever objectivelydetermine what
a just society would be?
To answer this question, Rawls proposes the following thought experiment.
Imagine that before any of us is born, we all get together for a meeting to design
the rules that govern society. At this point, we are all ignorant about the station in
life each of us will end up filling. In Rawls’s words, we are sitting in an “original
position” behind a “veil of ignorance.” In this original position, Rawls argues, we
can choose a just set of rules for society because we must consider how those rules
will affect every person. As Rawls puts it, “Since all are similarly situated and no
one is able to design principles to favor his particular conditions, the principles of
justice are the result of fair agreement or bargain.” Designing public policies and
institutions in this way allows us to be objective about what policies are just.
Rawls then considers what public policy designed behind this veil of igno-
rance would try to achieve. In particular, he considers what income distribution a
person would consider just if that person did not know whether he or she would
end up at the top, bottom, or middle of the distribution. Rawls argues that a per-
son in the original position would be especially concerned about the possibility of
being at the bottomof the income distribution. In designing public policies, there-
fore, we should aim to raise the welfare of the worst-off person in society. That is,
rather than maximizing the sum of everyone’s utility, as a utilitarian would do,
Rawls would maximize the minimum utility. Rawls’s rule is called the maximin
criterion.
Because the maximin criterion emphasizes the least fortunate person in soci-
ety, it justifies public policies aimed at equalizing the distribution of income. By
transferring income from the rich to the poor, society raises the well-being of the
least fortunate. The maximin criterion would not, however, lead to a completely
egalitarian society. If the government promised to equalize incomes completely,
people would have no incentive to work hard, society’s total income would fall
substantially, and the least fortunate person would be worse off. Thus, the max-
imin criterion still allows disparities in income, because such disparities can im-
prove incentives and thereby raise society’s ability to help the poor. Nonetheless,
liberalism
the political philosophy according to
which the government should choose
policies deemed to be just, as
evaluated by an impartial observer
behind a “veil of ignorance”
maximin criterion
the claim that the government should
aim to maximize the well-being of
the worst-off person in society
CHAPTER 20 INCOME INEQUALITY AND POVERTY 449
INVESTOR WARREN BUFFETT’S $36 BILLION
make him one of the world’s richest
men. Here is how Buffett explained
his personal philosophy to an audi-
enceof college students at the Univer-
sity of Washington. He is responding
to a question about the importance
of “giving back to your community.”
Notice the echoes of Rawls’s veil of
ignorance.
Buffett’s Answer
I know in my own case that 99%-plus [of
my wealth] will go back to society, just
because we’ve been treated extraordi-
narily well by society.
I’m lucky. I don’t run fast, but I’m
wired in a particular way that I thrive in a
big capitalist economy with a lot of ac-
tion. . . . If I had been born some time
ago I would’ve been some animal’s
lunch. . . .
Let me suggest another way to
think about this. Let’s say that it was 24
hours before you were born, and a genie
appeared and said, “You look like a win-
ner. I have enormous confidence in you,
and what I’m going to do is let you set
the rules for society into which you will
be born. You can set the economic rules
and the social rules, and whatever rules
you set will apply during your lifetime and
your children’s lifetime.”
And you’ll say, “Well, that’s nice,
but what’s the catch?”
And the genie says, “Here’s the
catch. You don’t know if you’re going to
be born rich or poor, black or white, male
or female, able-bodied or infirm, intelli-
gent or retarded.” So all you know is
that you’re going to get one ball out of a
barrel with, say, 5.8 billion balls in it [each
ball representing one of the 5.8 billion
people on earth]. You’re going to partici-
pate in what I call the ovarian lottery. It’s
the most important thing that will happen
to you in your life, but you have no con-
trol over it. It’s going to determine far
more than your grades at school or any-
thing else that happens to you.
Now, what rules do you want to
have? I’m not going to tell you the rules,
and nobody will tell you; you have to
make them up for yourself. But they will
affect how you think about what you do
in your will and things of that sort.
You’re going to want to have a sys-
tem that turns out more and more goods
and services. You’ve got a great quantity
of people out there, and you want them
to live pretty well, and you want your
kids to live better than you did, and you
want your grandchildren to live better
than your kids. You’re going to want a
system that keeps Bill Gates and Andy
Grove and Jack Welch [heads of Mi-
crosoft, Intel, and General Electric] work-
ing long, long after they don’t need to
work. You’re going to want the most able
people working more than 12 hours a
day. So you’ve got to have a system that
gives them an incentive to turn out the
goods and services.
But you’re also going to want a
system that takes care of the bad balls,
the ones that aren’t lucky. If you have a
system that is turning out enough goods
and services, you can take care of them.
You don’t want people worrying about be-
ing sick in their old age, or fearful about
going home at night. You want a system
where people are free of fear to some
extent.
So you’ll try to design something,
assuming you have the goods and ser-
vices to solve that sort of thing. You’ll
want equality of opportunity—namely a
good public school system—to make
you feel that every piece of talent out
there will get the same shot at contribut-
ing. And your tax system will follow from
your reasoning on that. And what you do
with the money you make is another
thing to think about. As you work
through that, everybody comes up with
something a little different. I just suggest
that you play that little game.
SOURCE:Fortune,July 20, 1998, pp. 62–64.
IN THE NEWS
A Rawlsian Billionaire
WARREN BUFFETT
450 PART SIX THE ECONOMICS OF LABOR MARKETS
because Rawls’s philosophy puts weight on only the least fortunate members of
society, it calls for more income redistribution than does utilitarianism.
Rawls’s views are controversial, but the thought experiment he proposes has
much appeal. In particular, this thought experiment allows us to consider the re-
distribution of income as a form of social insurance.That is, from the perspective of
the original position behind the veil of ignorance, income redistribution is like an
insurance policy. Homeowners buy fire insurance to protect themselves from the
risk of their housing burning down. Similarly, when we as a society choose policies
that tax the rich to supplement the incomes of the poor, we are all insuring our-
selves against the possibility that we might have been a member of a poor family.
Because people dislike risk, we should be happy to have been born into a society
that provides us this insurance.
It is not at all clear, however, that rational people behind the veil of ignorance
would truly be so averse to risk as to follow the maximin criterion. Indeed, be-
cause a person in the original position might end up anywhere in the distribution
of outcomes, he or she might treat all possible outcomes equally when designing
public policies. In this case, the best policy behind the veil of ignorance would be
to maximize the average utility of members of society, and the resulting notion of
justice would be more utilitarian than Rawlsian.
LIBERTARIANISM
Athird view of inequality is called libertarianism. The two views we have con-
sidered so far—utilitarianism and liberalism—both view the total income of soci-
ety as a shared resource that a social planner can freely redistribute to achieve
some social goal. By contrast, libertarians argue that society itself earns no in-
come—only individual members of society earn income. According to libertarians,
the government should not take from some individuals and give to others in order
to achieve any particular distribution of income.
For instance, philosopher Robert Nozick writes the following in his famous
1974 book Anarchy, State and Utopia:
We are not in the position of children who have been given portions of pie by
someone who now makes last minute adjustments to rectify careless cutting.
There is no centraldistribution, no person or group entitled to control all the
resources, jointly deciding how they are to be doled out. What each person gets,
he gets from others who give to him in exchange for something, or as a gift. In a
free society, diverse persons control different resources, and new holdings arise
out of the voluntary exchanges and actions of persons.
Whereas utilitarians and liberals try to judge what amount of inequality is desir-
able in a society, Nozick denies the validity of this very question.
The libertarian alternative to evaluating economic outcomesis to evaluate the
processby which these outcomes arise. When the distribution of income is achieved
unfairly—for instance, when one person steals from another—the government has
the right and duty to remedy the problem. But, as long as the process determining
the distribution of income is just, the resulting distribution is fair, no matter how
unequal.
Nozick criticizes Rawls’s liberalism by drawing an analogy between the dis-
tribution of income in society and the distribution of grades in a course. Suppose
you were asked to judge the fairness of the grades in the economics course you are
libertarianism
the political philosophy according
to which the government should
punish crimes and enforce voluntary
agreements but not redistribute
income
CHAPTER 20 INCOME INEQUALITY AND POVERTY 451
now taking. Would you imagine yourself behind a veil of ignorance and choose a
grade distribution without knowing the talents and efforts of each student? Or
would you ensure that the process of assigning grades to students is fair without
regard for whether the resulting distribution is equal or unequal? For the case of
grades at least, the libertarian emphasis on process over outcomes is compelling.
Libertarians conclude that equality of opportunities is more important than
equality of incomes. They believe that the government should enforce individual
rights to ensure that everyone has the same opportunity to use his or her talents
and achieve success. Once these rules of the game are established, the government
has no reason to alter the resulting distribution of income.
QUICK QUIZ: Pam earns more than Pauline. Someone proposes taxing
Pam in order to supplement Pauline’s income. How would a utilitarian, a
liberal, and a libertarian evaluate this proposal?
POLICIES TO REDUCE POVERTY
As we have just seen, political philosophers hold various views about what role the
government should take in altering the distribution of income. Political debate
among the larger population of voters reflects a similar disagreement. Despite these
continuing debates, however, most people believe that, at the very least, the gov-
ernment should try to help those most in need. According to a popular metaphor,
the government should provide a “safety net” to prevent any citizen from falling
too far.
Poverty is one of the most difficult problems that policymakers face. Poor fam-
ilies are more likely than the overall population to experience homelessness, drug
dependency, domestic violence, health problems, teenage pregnancy, illiteracy, un-
employment, and low educational attainment. Members of poor families are both
more likely to commit crimes and more likely to be victims of crimes. Although it
is hard to separate the causes of poverty from the effects, there is no doubt that
poverty is associated with various economic and social ills.
Suppose that you were a policymaker in the government, and your goal was
to reduce the number of people living in poverty. How would you achieve this
goal? Here we consider some of the policy options that you might consider. Al-
though each of these options does help some people escape poverty, none of them
is perfect, and deciding which is best is not easy.
MINIMUM-WAGE LAWS
Laws setting a minimum wage that employers can pay workers are a perennial
source of debate. Advocates view the minimum wage as a way of helping the
working poor without any cost to the government. Critics view it as hurting those
it is intended to help.
The minimum wage is easily understood using the tools of supply and demand,
as we first saw in Chapter 6. For workers with low levels of skill and experience, a
452 PART SIX THE ECONOMICS OF LABOR MARKETS
high minimum wage forces the wage above the level that balances supply and de-
mand. It therefore raises the cost of labor to firms and reduces the quantity of labor
that those firms demand. The result is higher unemployment among those groups of
workers affected by the minimum wage. Although those workers who remain em-
ployed benefit from a higher wage, those who might have been employed at a lower
wage are worse off.
The magnitude of these effects depends crucially on the elasticity of demand.
Advocates of a high minimum wage argue that the demand for unskilled labor is
relatively inelastic, so that a high minimum wage depresses employment only
slightly. Critics of the minimum wage argue that labor demand is more elastic, es-
pecially in the long run when firms can adjust employment and production more
fully. They also note that many minimum-wage workers are teenagers from
middle-class families, so that a high minimum wage is imperfectly targeted as a
policy for helping the poor.
WELFARE
One way to raise the living standards of the poor is for the government to supple-
ment their incomes. The primary way in which the government does this is
through the welfare system. Welfare is a broad term that encompasses various
government programs. Temporary Assistance for Needy Families (formerly called
Aid to Families with Dependent Children) is a program that assists families where
there are children but no adult able to support the family. In a typical family re-
ceiving such assistance, the father is absent, and the mother is at home raising
small children. Another welfare program is Supplemental Security Income (SSI),
which provides assistance to the poor who are sick or disabled. Note that for both
of these welfare programs, a poor person cannot qualify for assistance simply by
having a low income. He or she must also establish some additional “need,” such
as small children or a disability.
A common criticism of welfare programs is that they create incentives for
people to become “needy.” For example, these programs may encourage families
to break up, for many families qualify for financial assistance only if the father
is absent. The programs may also encourage illegitimate births, for many poor,
single women qualify for assistance only if they have children. Because poor,
single mothers are such an important part of the poverty problem and because
welfare programs seem to raise the number of poor, single mothers, critics of the
welfare system assert that these policies exacerbate the very problems they are
supposed to cure. As a result of these arguments, the welfare system was re-
vised in a 1996 law that limited the amount of time recipients could stay on
welfare.
How severe are these potential problems with the welfare system? No one
knows for sure. Proponents of the welfare system point out that being a poor, sin-
gle mother on welfare is a difficult existence at best, and they are skeptical that
many people would be encouraged to pursue such a life if it were not thrust upon
them. Moreover, trends over time do not support the view that the decline of the
two-parent family is largely a symptom of the welfare system, as the system’s
critics sometimes claim. Since the early 1970s, welfare benefits (adjusted for infla-
tion) have declined, yet the percentage of children living with only one parent has
risen.
welfare
government programs that
supplement the incomes of the needy
CHAPTER 20 INCOME INEQUALITY AND POVERTY 453
NEGATIVE INCOME TAX
Whenever the government chooses a system to collect taxes, it affects the distribu-
tion of income. This is clearly true in the case of a progressive income tax, whereby
high-income families pay a larger percentage of their income in taxes than do low-
income families. As we discussed in Chapter 12, equity across income groups is an
important criterion in the design of a tax system.
MANY ANTIPOVERTY PROGRAMS ARE TAR-
geted at poor areas of the country. Econ-
omist Edward Glaeser presents the case
against this geographic approach.
Help Poor People,
Not Poor Places
BY EDWARD L. GLAESER
President Clinton’s six-city “New Mar-
kets” tour earlier this summer signaled a
renewed focus on the problems of the
poor. But while the president’s concern is
appreciated by all of us who care about
the islands of poverty in America’s sea of
affluence, his proposals are fundamen-
tally flawed. They may still help some of
the poor, but also risk repeating some of
the worst mistakes of the Johnson era.
The trouble with the president’s rec-
ommendations is that they violate the
first economic rule of urban poverty pol-
icy: Programs should be person-based,
not place-based.
Economists have long argued that
place-based programs are a mistake.
They strongly prefer person-based poli-
cies that create transfers, entitlements,
or relief from regulation on the basis of
personal characteristics. Examples of
person-based policies include the Earned
Income Tax Credit and the GI Bill.
Place-based policies, on the other
hand, give transfers or other government
support on the basis of location. Exam-
ples of such policies are housing proj-
ects and enterprise zones. President
Clinton’s recent Rural Housing and Eco-
nomic Development Assistance for Ken-
tucky or the new Empowerment Zone
Grant for East St. Louis, Ill., are quintes-
sential place-based policies.
The problem with place-based pro-
grams is that they create incentives to
keep the poor in the ghetto. By subsidiz-
ing the place, not the person living there,
these policies make it more attractive for
the poor to stay in high-poverty areas.
Indeed, current research shows that
supposedly benevolent pro-poor housing
and transfer policies play a major role in
herding the poor into inner cities.
It’s hard to see the logic in artificially
limiting migration and concentrating the
poor in areas with low productivity.
Movement out of low-productivity, high-
unemployment areas is one reason that
unemployment rates in the U.S. stay
low. Moreover, flight from the ghettos
has enabled many African-Americans to
avoid the social costs of the inner city,
and black-white segregation in the U.S.
has declined substantially because of it.
Place-based programs also suffer
from the fact that their benefits go dis-
proportionately to property owners in the
targeting areas—and not to the intended
beneficiaries. If the government offers
tax credits to firms that invest in a poor
region, for instance, then firms will locate
there, pushing up property values and
rents. But the benefits of increased eco-
nomic activity will evaporate as higher
housing costs eat away the planned ben-
efits to the needy. . . .
If place-based policies are so bad,
why are they so popular? A cynic might
say that the residents of wealthy sub-
urbs prefer that the poor remain in ghet-
tos. A more practical explanation is that
we have place-based politicians who
lobby for place-based policies. . . .
A wise alternative to such faulty
place-based poverty assistance would
be a program that offers tax credits to
companies that employ the disadvan-
taged. This would be a less distortionary
means of assisting the poor.
SOURCE:The Wall Street Journal,August 12, 1999,
p.A22.
IN THE NEWS
Should the Government Try
to Help Poor Regions?
454 PART SIX THE ECONOMICS OF LABOR MARKETS
Many economists have advocated supplementing the income of the poor us-
ing a negative income tax. According to this policy, every family would report its
income to the government. High-income families would pay a tax based on their
incomes. Low-income families would receive a subsidy. In other words, they
would “pay” a “negative tax.”
For example, suppose the government used the following formula to compute
a family’s tax liability:
Taxes owed H11005(1/3 of income) H11002$10,000.
In this case, a family that earned $60,000 would pay $10,000 in taxes, and a family
that earned $90,000 would pay $20,000 in taxes. A family that earned $30,000
would owe nothing. And a family that earned $15,000 would “owe” H11002$5,000. In
other words, the government would send this family a check for $5,000.
Under a negative income tax, poor families would receive financial assistance
without having to demonstrate need. The only qualification required to receive as-
sistance would be a low income. Depending on one’s point of view, this feature
can be either an advantage or a disadvantage. On the one hand, a negative income
tax does not encourage illegitimate births and the breakup of families, as critics of
the welfare system believe current policy does. On the other hand, a negative in-
come tax would subsidize those who are simply lazy and, in some people’s eyes,
undeserving of government support.
One actual tax provision that works much like a negative income tax is the
Earned Income Tax Credit. This credit allows poor working families to receive in-
come tax refunds greater than the taxes they paid during the year. Because the
Earned Income Tax Credit applies only to the working poor, it does not discourage
recipients from working, as other antipoverty programs are claimed to do. For the
same reason, however, it also does not help alleviate poverty due to unemploy-
ment, sickness, or other inability to work.
IN-KIND TRANSFERS
Another way to help the poor is to provide them directly with some of the goods
and services they need to raise their living standards. For example, charities pro-
vide the needy with food, shelter, and toys at Christmas. The government gives
poor families food stamps,which are government vouchers that can be used to buy
food at stores; the stores then redeem the vouchers for money. The government
also gives many poor people health care through a program called Medicaid.
Is it better to help the poor with these in-kind transfers or with direct cash
payments? There is no clear answer.
Advocates of in-kind transfers argue that such transfers ensure that the poor
get what they need most. Among the poorest members of society, alcohol and drug
addiction is more common than it is in society as a whole. By providing the poor
with food and shelter, society can be more confident that it is not helping to sup-
port such addictions. This is one reason why in-kind transfers are more politically
popular than cash payments to the poor.
Advocates of cash payments argue that in-kind transfers are inefficient and
disrespectful. The government does not know what goods and services the poor
need most. Many of the poor are ordinary people down on their luck. Despite their
negative income tax
a tax system that collects revenue
from high-income households and
gives transfers to low-income
households
CHAPTER 20 INCOME INEQUALITY AND POVERTY 455
misfortune, they are in the best position to decide how to raise their own living
standards. Rather than giving the poor in-kind transfers of goods and services that
they may not want, it may be better to give them cash and allow them to buy what
they think they need most.
ANTIPOVERTY PROGRAMS AND WORK INCENTIVES
Many policies aimed at helping the poor can have the unintended effect of dis-
couraging the poor from escaping poverty on their own. To see why, consider the
following example. Suppose that a family needs an income of $15,000 to maintain
a reasonable standard of living. And suppose that, out of concern for the poor, the
government promises to guarantee every family that income. Whatever a family
earns, the government makes up the difference between that income and $15,000.
What effect would you expect this policy to have?
The incentive effects of this policy are obvious: Any person who would make
under $15,000 by working has no incentive to find and keep a job. For every dollar
that the person would earn, the government would reduce the income supplement
by a dollar. In effect, the government taxes 100 percent of additional earnings.
Aneffective marginal tax rate of 100 percent is surely a policy with a large dead-
weight loss.
The adverse effects of this high effective tax rate can persist over time. Aper-
son discouraged from working loses the on-the-job training that a job might offer.
In addition, his or her children miss the lessons learned by observing a parent with
a full-time job, and this may adversely affect their own ability to find and hold
ajob.
Although the antipoverty program we have been discussing is hypothetical, it
is not as unrealistic as it might first appear. Welfare, Medicaid, food stamps, and
the Earned Income Tax Credit are all programs aimed at helping the poor, and they
are all tied to family income. As a family’s income rises, the family becomes ineli-
gible for these programs. When all these programs are taken together, it is com-
mon for families to face effective marginal tax rates that are very high. Sometimes
the effective marginal tax rates even exceed 100 percent, so that poor families are
worse off when they earn more. By trying to help the poor, the government dis-
courages those families from working. According to critics of antipoverty pro-
grams, these programs alter work attitudes and create a “culture of poverty.”
It might seem that there is an easy solution to this problem: Reduce benefits to
poor families more gradually as their incomes rise. For example, if a poor family
loses 30 cents of benefits for every dollar it earns, then it faces an effective marginal
tax rate of 30 percent. Although this effective tax reduces work effort to some ex-
tent, it does not eliminate the incentive to work completely.
The problem with this solution is that it greatly increases the cost of programs
to combat poverty. If benefits are phased out gradually as a poor family’s income
rises, then families just above the poverty level will also be eligible for substantial
benefits. The more gradual the phase-out, the more families are eligible, and the
greater the cost of the program. Thus, policymakers face a tradeoff between bur-
dening the poor with high effective marginal tax rates and burdening taxpayers
with costly programs to reduce poverty.
There are various other ways to try to reduce the work disincentive of anti-
poverty programs. One is to require any person collecting benefits to accept a
456 PART SIX THE ECONOMICS OF LABOR MARKETS
government-provided job—a system sometimes called workfare. Another possi-
bility is to provide benefits for only a limited period of time. This route was taken
in a 1996 welfare reform bill. Advocates of time limits point to the falling poverty
rate in the late 1990s as evidence supporting this approach. Critics argue that time
limits are cruel to the least fortunate members of society and that the falling
poverty rate in the late 1990s is due more to a strong economy than to welfare
reform.
QUICK QUIZ: List three policies aimed at helping the poor, and discuss the
pros and cons of each.
CONCLUSION
People have long reflected on the distribution of income in society. Plato, the ancient
Greek philosopher, concluded that in an ideal society the income of the richest
IN1996 THEU.S. WELFARE SYSTEM UNDER-
went a major reform, including the en-
actment of time limits on benefits. In the
following opinion column, economist
Gary Becker evaluates the change in
policy.
Guess What?
Welfare Reform Works
BY GARY S. BECKER
The welfare reform act of 1996 is one of
the most revolutionary pieces of legisla-
tion since the welfare state began half a
century ago. Contrary to the predictions
of many skeptics, this law has been re-
markably successful—helped, to be
sure, by the strong economy of the past
several years.
The success of earlier reforms by a
few states led to a bipartisan effort by a
Republican Congress and President
Clinton to “end welfare as we know it”
by forcing recipients in all states to look
for work. The 1996 law limits families to
two years of welfare income during any
one spell and caps the total time on wel-
fare over a mother’s lifetime at five
years.
The number of recipients rose
sharply from the early 1960s, to a peak
in 1993, when over 4 million American
families were on welfare. In that year, an
incredible 1 million residents of New
York City alone were receiving welfare,
up from 250,000 in 1960.
Wisconsin, Massachusetts, New
Jersey, and a few other states decided in
the late 1980s that this upward trend in
welfare was unacceptable and could be
reversed. They introduced reforms that
discouraged women from having children
while on welfare. More important, they
dropped the assumption that most
women on welfare are not capable of
getting and holding jobs, and put pres-
sure on them to find employment to help
support their families.
These states managed to cut their
welfare populations while at the same
time improving the economic situation of
single-parent families. Recently, a careful
evaluation of the Massachusetts reforms
by economists M. Anne Hill and Thomas
J. Main of the City University of New
York concluded that they not only greatly
reduced that state’s welfare caseload
but also encouraged more young women
to finish high school and sharpen their
economic skills.
What worked in Massachusetts and
other pioneering states was applica-
ble throughout the nation, but the re-
assessment of federal welfare policy
IN THE NEWS
Welfare Reform
CHAPTER 20 INCOME INEQUALITY AND POVERTY 457
person would be no more than four times the income of the poorest person. Al-
though the measurement of inequality is difficult, it is clear that our society has
much more inequality than Plato recommended.
One of the Ten Principles of Economics discussed in Chapter 1 is that govern-
ments can sometimes improve market outcomes. There is little consensus, how-
ever, about how this principle should be applied to the distribution of income.
Philosophers and policymakers today do not agree on how much income inequal-
ity is desirable, or even whether public policy should aim to alter the distribution
of income. Much of public debate reflects this disagreement. Whenever taxes are
raised, for instance, lawmakers argue over how much of the tax hike should fall on
the rich, the middle class, and the poor.
Another of the Ten Principles of Economics is that people face tradeoffs. This
principle is important to keep in mind when thinking about economic inequality.
Policies that penalize the successful and reward the unsuccessful reduce the in-
centive to succeed. Thus, policymakers face a tradeoff between equality and effi-
ciency. The more equally the pie is divided, the smaller the pie becomes. This is the
one lesson concerning the distribution of income about which almost everyone
agrees.
was opposed by many intellectuals.
Some members of President Clinton’s
team quit after the 1996 federal law,
over what they considered a betrayal of
the welfare state. They argued that most
women forced off welfare would become
homeless or destitute, since they sup-
posedly are too mentally or physically
handicapped or lacking in requisite skills
to obtain and hold jobs.
However, this law has been highly
successful in reversing the large growth
in the number of welfare recipients in the
United States. Most mothers forced off
welfare found work and provide financial
support for their children.
Certainly, the huge decline—by over
40 percent—in the number of single
mothers on welfare from the 1993 peak
is partly due to the booming economy of
the past seven years. However, most of
this decline took place in the two years
after the passage of the 1996 act. The
study of Massachusetts’ experience
cited earlier confirms the importance of
the new approach to welfare, since the
authors’ research attributes more than
one-third of the decline in that state’s
welfare role since 1995 to the reforms
and not simply to its buoyant economy.
The federal law recognizes that the
number of families in need of assistance
always rises sharply during bad eco-
nomic times. This is why each welfare
spell is allowed to last up to two years,
and mothers with dependent children
can have multiple spells, up to a total of
five years over their lifetimes. It further
acknowledges that some women are
handicapped and unable to work. What it
aims to discourage is the attraction of
welfare to able-bodied women during
good times when jobs are available.
The act also recognizes that many
poor working mothers will not earn
enough to provide a decent standard of
living for their families. Children of un-
married working mothers continue to be
eligible for Medicaid and food stamps,
and they benefit from the earned-income
tax credit that is available only to poorer
working parents with children.
One of the most important, if hardest
to document, gains from taking families
off welfare is their greater self-respect
when they provide for themselves. Moth-
ers on welfare convey the impression to
their children that it is normal to live off
government handouts. In such an environ-
ment, it is difficult for children to place a
high value on doing well at school and
preparing for work by seeking out training
on jobs and in schools.
Welfare reform has been a resound-
ing success in inducing unmarried moth-
ers to find jobs. This revolutionary
approach to welfare is based on the ap-
preciation that the vast majority of fami-
lies do much better when treated as
responsible adults and offered effective
incentives to help themselves.
SOURCE:Business Week,May 24, 1999, p. 18.
458 PART SIX THE ECONOMICS OF LABOR MARKETS
a78 Data on the distribution of income show wide disparity
in our society. The richest fifth of families earns about
ten times as much income as the poorest fifth.
a78 Because in-kind transfers, the economic life cycle,
transitory income, and economic mobility are so
important for understanding variation in income, it is
difficult to gauge the degree of inequality in our society
using data on the distribution of income in a single year.
When these factors are taken into account, they tend to
suggest that economic well-being is more equally
distributed than is annual income.
a78 Political philosophers differ in their views about the role
of government in altering the distribution of income.
Utilitarians (such as John Stuart Mill) would choose the
distribution of income to maximize the sum of utility of
everyone in society. Liberals (such as John Rawls) would
determine the distribution of income as if we were
behind a “veil of ignorance” that prevented us from
knowing our own stations in life. Libertarians (such as
Robert Nozick) would have the government enforce
individual rights to ensure a fair process but then not be
concerned about inequality in the resulting distribution
of income.
a78 Various policies aim to help the poor—minimum-wage
laws, welfare, negative income taxes, and in-kind
transfers. Although each of these policies helps some
families escape poverty, they also have unintended side
effects. Because financial assistance declines as income
rises, the poor often face effective marginal tax rates that
are very high. Such high effective tax rates discourage
poor families from escaping poverty on their own.
Summary
poverty rate, p. 442
poverty line, p. 442
in-kind transfers, p. 444
life cycle, p. 444
permanent income, p. 445
utilitarianism, p. 447
utility, p. 447
liberalism, p. 448
maximin criterion, p. 448
libertarianism, p. 450
welfare, p. 452
negative income tax, p. 454
Key Concepts
1. Does the richest fifth of the U.S. population earn two,
four, or ten times the income of the poorest fifth?
2. How does the extent of income inequality in the United
States compare to that of other nations around the world?
3. What groups in the population are most likely to live in
poverty?
4. When gauging the amount of inequality, why do
transitory and life cycle variations in income cause
difficulties?
5. How would a utilitarian, a liberal, and a libertarian
determine how much income inequality is permissible?
6. What are the pros and cons of in-kind (rather than cash)
transfers to the poor?
7. Describe how antipoverty programs can discourage the
poor from working. How might you reduce this
disincentive? What are the disadvantages with your
proposed policy?
Questions for Review
1. Table 20-2 shows that income inequality in the United
States has increased during the past 20 years. Some
factors contributing to this increase were discussed in
Chapter 19. What are they?
2. Table 20-4 shows that the percentage of children in
families with income below the poverty line is almost
twice the percentage of the elderly in such families.
How might the allocation of government money across
Problems and Applications
CHAPTER 20 INCOME INEQUALITY AND POVERTY 459
different social programs have contributed to this
phenomenon? (Hint: See Chapter 12.)
3. Economists often view life cycle variation in income as
one form of transitory variation in income around
people’s lifetime, or permanent, income. In this sense,
how does your current income compare to your
permanent income? Do you think your current income
accurately reflects your standard of living?
4. The chapter discusses the importance of economic
mobility.
a. What policies might the government pursue to
increase economic mobility withina generation?
b. What policies might the government pursue to
increase economic mobility acrossgenerations?
c. Do you think we should reduce spending on
current welfare programs in order to increase
spending on programs that enhance economic
mobility? What are some of the advantages and
disadvantages of doing so?
5. Consider two communities. In one community, ten
families have incomes of $100 each and ten families
have incomes of $20 each. In the other community, ten
families have incomes of $200 each and ten families
have incomes of $22 each.
a. In which community is the distribution of income
more unequal? In which community is the problem
of poverty likely to be worse?
b. Which distribution of income would Rawls prefer?
Explain.
c. Which distribution of income do you prefer?
Explain.
6. The chapter uses the analogy of a “leaky bucket” to
explain one constraint on the redistribution of income.
a. What elements of the U.S. system for redistributing
income create the leaks in the bucket? Be specific.
b. Do you think that Republicans or Democrats
generally believe that the bucket used for
redistributing income is more leaky? How does that
belief affect their views about the amount of income
redistribution that the government should
undertake?
7. Suppose there are two possible income distributions in a
society of ten people. In the first distribution, nine people
would have incomes of $30,000 and one person would
have an income of $10,000. In the second distribution, all
ten people would have incomes of $25,000.
a. If the society had the first income distribution, what
would be the utilitarian argument for redistributing
income?
b. Which income distribution would Rawls consider
more equitable? Explain.
c. Which income distribution would Nozick consider
more equitable? Explain.
8. The poverty rate would be substantially lower if the
market value of in-kind transfers were added to family
income. The government spends more money on
Medicaid than on any other in-kind transfer, with
expenditures per recipient family amounting to roughly
$5,000 annually.
a. If the government gave each recipient family a
check for this amount instead of enrolling them in
the Medicaid program, do you think that most of
these families would spend that much to purchase
health insurance? (Recall that the poverty line is
below $15,000 for a family of four.) Why?
b. How does your answer to part (a) affect your view
about whether we should determine the poverty
rate by valuing in-kind transfers at the price the
government pays for them? Explain.
c. How does your answer to part (a) affect your view
about whether we should provide assistance to the
poor in the form of cash transfers or in-kind
transfers? Explain.
9. Suppose that a family’s tax liability equaled its income
multiplied by one-half, minus $10,000. Under this
system, some families would pay taxes to the
government, and some families would receive money
from the government through a “negative income tax.”
a. Consider families with pre-tax incomes of $0,
$10,000, $20,000, $30,000, and $40,000. Make a table
showing pre-tax income, taxes paid to the
government or money received from the
government, and after-tax income for each family.
b. What is the marginal tax rate in this system? (See
Chapter 12 if you need to review the definition of
marginal tax rate.) What is the maximum amount of
income at which a family receivesmoney from the
government?
c. Now suppose that the tax schedule is changed, so
that a family’s tax liability equals its income
multiplied by one-quarter, minus $10,000. What is
the marginal tax rate in this new system? What is
the maximum amount of income at which a family
receives money from the government?
d. What is the main advantage of each of the tax
schedules discussed here?
10. John and Jeremy are utilitarians. John believes that labor
supply is highly elastic, whereas Jeremy believes that
460 PART SIX THE ECONOMICS OF LABOR MARKETS
labor supply is quite inelastic. How do you suppose
their views about income redistribution differ?
11. Do you agree or disagree with each of the following
statements? What do your views imply for public
policies, such as taxes on inheritance?
a. “Every parent has the right to work hard and save
in order to give his or her children a better life.”
b. “No child should be disadvantaged by the sloth or
bad luck of his or her parents.”
IN THIS CHAPTER
YOU WILL . . .
Decompose the
impact of a price
change into an
income effect and a
substitution effect
Apply the theory of
consumer choice to
four questions
about household
behavior
Analyze how a
consumer’s optimal
choices are
determined
See how a budget
constraint
represents the
choices a consumer
can afford
Learn how
indifference curves
can be used to
represent a
consumer’s
preferences
See how a consumer
responds to
changes in income
and changes
in prices
When you walk into a store, you are confronted with thousands of goods that you
might buy. Of course, because your financial resources are limited, you cannot buy
everything that you want. You therefore consider the prices of the various goods
being offered for sale and buy a bundle of goods that, given your resources, best
suits your needs and desires.
In this chapter we develop the theory that describes how consumers make de-
cisions about what to buy. So far throughout this book, we have summarized con-
sumers’ decisions with the demand curve. As we discussed in Chapters 4 through
7, the demand curve for a good reflects consumers’ willingness to pay for it. When
the price of a good rises, consumers are willing to pay for fewer units, so the quan-
tity demanded falls. We now look more deeply at the decisions that lie behind the
demand curve. The theory of consumer choice presented in this chapter provides
THE THEORY OF
CONSUMER CHOICE
463
464 PART SEVEN ADVANCED TOPIC
a more complete understanding of demand, just as the theory of the competitive
firm in Chapter 14 provides a more complete understanding of supply.
One of the Ten Principles of Economics discussed in Chapter 1 is that people face
tradeoffs. The theory of consumer choice examines the tradeoffs that people face in
their role as consumers. When a consumer buys more of one good, he can afford
less of other goods. When he spends more time enjoying leisure and less time
working, he has lower income and can afford less consumption. When he spends
more of his income in the present and saves less of it, he must accept a lower level
of consumption in the future. The theory of consumer choice examines how con-
sumers facing these tradeoffs make decisions and how they respond to changes in
their environment.
After developing the basic theory of consumer choice, we apply it to several
questions about household decisions. In particular, we ask:
a78 Do all demand curves slope downward?
a78 How do wages affect labor supply?
a78 How do interest rates affect household saving?
a78 Do the poor prefer to receive cash or in-kind transfers?
At first, these questions might seem unrelated. But, as we will see, we can use the
theory of consumer choice to address each of them.
THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN AFFORD
Most people would like to increase the quantity or quality of the goods they con-
sume—to take longer vacations, drive fancier cars, or eat at better restaurants. Peo-
ple consume less than they desire because their spending is constrained, or limited,
by their income. We begin our study of consumer choice by examining this link be-
tween income and spending.
To keep things simple, we examine the decision facing a consumer who buys
only two goods: Pepsi and pizza. Of course, real people buy thousands of different
kinds of goods. Yet assuming there are only two goods greatly simplifies the prob-
lem without altering the basic insights about consumer choice.
We first consider how the consumer’s income constrains the amount he
spends on Pepsi and pizza. Suppose that the consumer has an income of $1,000 per
month and that he spends his entire income each month on Pepsi and pizza. The
price of a pint of Pepsi is $2, and the price of a pizza is $10.
Table 21-1 shows some of the many combinations of Pepsi and pizza that the
consumer can buy. The first line in the table shows that if the consumer spends all
his income on pizza, he can eat 100 pizzas during the month, but he would not be
able to buy any Pepsi at all. The second line shows another possible consumption
bundle: 90 pizzas and 50 pints of Pepsi. And so on. Each consumption bundle in
the table costs exactly $1,000.
Figure 21-1 graphs the consumption bundles that the consumer can choose.
The vertical axis measures the number of pints of Pepsi, and the horizontal axis
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 465
measures the number of pizzas. Three points are marked on this figure. At point A,
the consumer buys no Pepsi and consumes 100 pizzas. At point B, the consumer
buys no pizza and consumes 500 pints of Pepsi. At point C, the consumer buys
50pizzas and 250 pints of Pepsi. Point C, which is exactly at the middle of the line
from Ato B, is the point at which the consumer spends an equal amount ($500) on
Pepsi and pizza. Of course, these are only three of the many combinations of Pepsi
and pizza that the consumer can choose. All the points on the line from Ato B are
possible. This line, called the budget constraint,shows the consumption bundles
that the consumer can afford. In this case, it shows the tradeoff between Pepsi and
pizza that the consumer faces.
Table 21-1
THE CONSUMER’S
OPPORTUNITIES. This table
shows what the consumer can
afford if his income is $1,000, the
price of Pepsi is $2, and the price
of pizza is $10.
NUMBER SPENDING SPENDING TOTAL
PINTSOFPEPSI OFPIZZAS ONPEPSI ONPIZZA SPENDING
0 100 $ 0 $1,000 $1,000
50 90 100 900 1,000
100 80 200 800 1,000
150 70 300 700 1,000
200 60 400 600 1,000
250 50 500 500 1,000
300 40 600 400 1,000
350 30 700 300 1,000
400 20 800 200 1,000
450 10 900 100 1,000
500 0 1,000 0 1,000
100 Quantity
of Pizza
Quantity
of Pepsi
0
250
50
500
B
C
A
Consumer’s
budget constraint
Figure 21-1
THE CONSUMER’S BUDGET
CONSTRAINT. The budget
constraint shows the various
bundles of goods that the
consumer can afford for a given
income. Here the consumer buys
bundles of Pepsi and pizza. The
more Pepsi he buys, the less
pizza he can afford.
budget constraint
the limit on the consumption
bundles that a consumer can afford
466 PART SEVEN ADVANCED TOPIC
The slope of the budget constraint measures the rate at which the consumer
can trade one good for the other. Recall from the appendix to Chapter 2 that the
slope between two points is calculated as the change in the vertical distance di-
vided by the change in the horizontal distance (“rise over run”). From point Ato
point B, the vertical distance is 500 pints, and the horizontal distance is 100 pizzas.
Thus, the slope is 5 pints per pizza. (Actually, because the budget constraint slopes
downward, the slope is a negative number. But for our purposes we can ignore the
minus sign.)
Notice that the slope of the budget constraint equals the relative price of the two
goods—the price of one good compared to the price of the other. Apizza costs 5
times as much as a pint of Pepsi, so the opportunity cost of a pizza is 5 pints of
Pepsi. The budget constraint’s slope of 5 reflects the tradeoff the market is offering
the consumer: 1 pizza for 5 pints of Pepsi.
QUICK QUIZ: Draw the budget constraint for a person with income of
$1,000 if the price of Pepsi is $5 and the price of pizza is $10. What is the slope
of this budget constraint?
PREFERENCES: WHAT THE CONSUMER WANTS
Our goal in this chapter is to see how consumers make choices. The budget con-
straint is one piece of the analysis: It shows what combination of goods the con-
sumer can afford given his income and the prices of the goods. The consumer’s
choices, however, depend not only on his budget constraint but also on his prefer-
ences regarding the two goods. Therefore, the consumer’s preferences are the next
piece of our analysis.
REPRESENTING PREFERENCES WITH
INDIFFERENCE CURVES
The consumer’s preferences allow him to choose among different bundles of Pepsi
and pizza. If you offer the consumer two different bundles, he chooses the bundle
that best suits his tastes. If the two bundles suit his tastes equally well, we say that
the consumer is indifferent between the two bundles.
Just as we have represented the consumer’s budget constraint graphically, we
can also represent his preferences graphically. We do this with indifference curves.
An indifference curveshows the bundles of consumption that make the consumer
equally happy. In this case, the indifference curves show the combinations of Pepsi
and pizza with which the consumer is equally satisfied.
Figure 21-2 shows two of the consumer’s many indifference curves. The con-
sumer is indifferent among combinations A, B, and C, because they are all on the
same curve. Not surprisingly, if the consumer’s consumption of pizza is reduced,
say from point A to point B, consumption of Pepsi must increase to keep him
equally happy. If consumption of pizza is reduced again, from point B to point C,
the amount of Pepsi consumed must increase yet again.
indifference curve
a curve that shows consumption
bundles that give the consumer the
same level of satisfaction
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 467
The slope at any point on an indifference curve equals the rate at which the
consumer is willing to substitute one good for the other. This rate is called the
marginal rate of substitution(MRS). In this case, the marginal rate of substitution
measures how much Pepsi the consumer requires in order to be compensated for
a one-unit reduction in pizza consumption. Notice that because the indifference
curves are not straight lines, the marginal rate of substitution is not the same at all
points on a given indifference curve. The rate at which a consumer is willing to
trade one good for the other depends on the amounts of the goods he is already
consuming. That is, the rate at which a consumer is willing to trade pizza for Pepsi
depends on whether he is more hungry or more thirsty, which in turn depends on
how much pizza and Pepsi he has.
The consumer is equally happy at all points on any given indifference curve,
but he prefers some indifference curves to others. Because he prefers more con-
sumption to less, higher indifference curves are preferred to lower ones. In Fig-
ure21-2, any point on curve I
2
is preferred to any point on curve I
1
.
Aconsumer’s set of indifference curves gives a complete ranking of the con-
sumer’s preferences. That is, we can use the indifference curves to rank any two
bundles of goods. For example, the indifference curves tell us that point D is pre-
ferred to point Abecause point D is on a higher indifference curve than point A.
(That conclusion may be obvious, however, because point D offers the consumer
both more pizza and more Pepsi.) The indifference curves also tell us that point D
is preferred to point C because point D is on a higher indifference curve. Even
though point D has less Pepsi than point C, it has more than enough extra pizza to
make the consumer prefer it. By seeing which point is on the higher indifference
curve, we can use the set of indifference curves to rank any combinations of Pepsi
and pizza.
Quantity
of Pizza
Quantity
of Pepsi
0
C
B
1
A
D
Indifference
curve, I
1
I
2
MRS
Figure 21-2
THE CONSUMER’S PREFERENCES.
The consumer’s preferences are
represented with indifference
curves, which show the
combinations of Pepsi and pizza
that make the consumer equally
satisfied. Because the consumer
prefers more of a good, points
on a higher indifference curve
(I
2
here) are preferred to points on
a lower indifference curve (I
1
).
The marginal rate of substitution
(MRS) shows the rate at which
the consumer is willing to trade
Pepsi for pizza.
marginal rate of
substitution
the rate at which a consumer is
willing to trade one good for another
468 PART SEVEN ADVANCED TOPIC
FOUR PROPERTIES OF INDIFFERENCE CURVES
Because indifference curves represent a consumer’s preferences, they have certain
properties that reflect those preferences. Here we consider four properties that de-
scribe most indifference curves:
a78 Property 1: Higher indifference curves are preferred to lower ones. Consumers
usually prefer more of something to less of it. (That is why we call this
something a “good” rather than a “bad.”) This preference for greater
quantities is reflected in the indifference curves. As Figure 21-2 shows, higher
indifference curves represent larger quantities of goods than lower
indifference curves. Thus, the consumer prefers being on higher indifference
curves.
a78 Property 2: Indifference curves are downward sloping. The slope of an
indifference curve reflects the rate at which the consumer is willing to
substitute one good for the other. In most cases, the consumer likes both
goods. Therefore, if the quantity of one good is reduced, the quantity of the
other good must increase in order for the consumer to be equally happy. For
this reason, most indifference curves slope downward.
a78 Property 3: Indifference curves do not cross. To see why this is true, suppose that
two indifference curves did cross, as in Figure 21-3. Then, because point Ais
on the same indifference curve as point B, the two points would make the
consumer equally happy. In addition, because point B is on the same
indifference curve as point C, these two points would make the consumer
equally happy. But these conclusions imply that points Aand C would also
make the consumer equally happy, even though point C has more of both
goods. This contradicts our assumption that the consumer always prefers
more of both goods to less. Thus, indifference curves cannot cross.
Quantity
of Pizza
Quantity
of Pepsi
0
C
A
B
Figure 21-3
THE IMPOSSIBILITY OF
INTERSECTING INDIFFERENCE
CURVES. Asituation like this
can never happen. According to
these indifference curves, the
consumer would be equally
satisfied at points A, B, and C,
even though point C has more of
both goods than point A.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 469
a78 Property 4: Indifference curves are bowed inward. The slope of an indifference
curve is the marginal rate of substitution—the rate at which the consumer is
willing to trade off one good for the other. The marginal rate of substitution
(MRS) usually depends on the amount of each good the consumer is
currently consuming. In particular, because people are more willing to trade
away goods that they have in abundance and less willing to trade away
goods of which they have little, the indifference curves are bowed inward. As
an example, consider Figure 21-4. At point A, because the consumer has a lot
of Pepsi and only a little pizza, he is very hungry but not very thirsty. To
induce the consumer to give up 1 pizza, the consumer has to be given 6 pints
of Pepsi: The marginal rate of substitution is 6 pints per pizza. By contrast, at
point B, the consumer has little Pepsi and a lot of pizza, so he is very thirsty
but not very hungry. At this point, he would be willing to give up 1 pizza to
get 1 pint of Pepsi: The marginal rate of substitution is 1 pint per pizza. Thus,
the bowed shape of the indifference curve reflects the consumer’s greater
willingness to give up a good that he already has in large quantity.
TWO EXTREME EXAMPLES OF INDIFFERENCE CURVES
The shape of an indifference curve tells us about the consumer’s willingness to
trade one good for the other. When the goods are easy to substitute for each other,
the indifference curves are less bowed; when the goods are hard to substitute, the
indifference curves are very bowed. To see why this is true, let’s consider the ex-
treme cases.
Perfect Substitutes Suppose that someone offered you bundles of nick-
els and dimes. How would you rank the different bundles?
Quantity
of Pizza
Quantity
of Pepsi
14
8
4
3
023 67
Indifference
curve
1
1
A
B
MRS = 6
MRS = 1
Figure 21-4
BOWED INDIFFERENCE CURVES.
Indifference curves are usually
bowed inward. This shape
implies that the marginal rate of
substitution (MRS) depends on
the quantity of the two goods the
consumer is consuming. At point
A, the consumer has little pizza
and much Pepsi, so he requires a
lot of extra Pepsi to induce him to
give up one of the pizzas: The
marginal rate of substitution is
6 pints of Pepsi per pizza. At
point B, the consumer has much
pizza and little Pepsi, so he
requires only a little extra Pepsi
to induce him to give up one of
the pizzas: The marginal rate of
substitution is 1 pint of Pepsi per
pizza.
470 PART SEVEN ADVANCED TOPIC
Most likely, you would care only about the total monetary value of each bun-
dle. If so, you would judge a bundle based on the number of nickels plus twice the
number of dimes. In other words, you would always be willing to trade 1 dime for
2 nickels, regardless of the number of nickels and dimes in the bundle. Your mar-
ginal rate of substitution between nickels and dimes would be a fixed number—2.
We can represent your preferences over nickels and dimes with the indiffer-
ence curves in panel (a) of Figure 21-5. Because the marginal rate of substitution is
constant, the indifference curves are straight lines. In this extreme case of straight
indifference curves, we say that the two goods are perfect substitutes.
Perfect Complements Suppose now that someone offered you bundles
of shoes. Some of the shoes fit your left foot, others your right foot. How would
you rank these different bundles?
In this case, you might care only about the number of pairs of shoes. In other
words, you would judge a bundle based on the number of pairs you could assem-
ble from it. Abundle of 5 left shoes and 7 right shoes yields only 5 pairs. Getting 1
more right shoe has no value if there is no left shoe to go with it.
We can represent your preferences for right and left shoes with the indiffer-
ence curves in panel (b) of Figure 21-5. In this case, a bundle with 5 left shoes and
5 right shoes is just as good as a bundle with 5 left shoes and 7 right shoes. It is also
just as good as a bundle with 7 left shoes and 5 right shoes. The indifference
curves, therefore, are right angles. In this extreme case of right-angle indifference
curves, we say that the two goods are perfect complements.
In the real world, of course, most goods are neither perfect substitutes (like
nickels and dimes) nor perfect complements (like right shoes and left shoes). More
Dimes123 750
Nickels
6
4
2
(a) Perfect Substitutes
Right Shoes0
Left
Shoes
7
5
(b) Perfect Complements
I
1
I
2
I
3
I
1
I
2
Figure 21-5
PERFECT SUBSTITUTES AND PERFECT COMPLEMENTS. When two goods are easily
substitutable, such as nickels and dimes, the indifference curves are straight lines, as
shown in panel (a). When two goods are strongly complementary, such as left shoes and
right shoes, the indifference curves are right angles, as shown in panel (b).
perfect substitutes
two goods with straight-line
indifference curves
perfect complements
two goods with right-angle
indifference curves
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 471
typically, the indifference curves are bowed inward, but not so bowed as to be-
come right angles.
QUICK QUIZ: Draw some indifference curves for Pepsi and pizza. Explain
the four properties of these indifference curves.
OPTIMIZATION: WHAT THE CONSUMER CHOOSES
The goal of this chapter is to understand how a consumer makes choices. We have
the two pieces necessary for this analysis: the consumer’s budget constraint and
the consumer’s preferences. Now we put these two pieces together and consider
the consumer’s decision about what to buy.
THE CONSUMER’S OPTIMAL CHOICES
Consider once again our Pepsi and pizza example. The consumer would like to
end up with the best possible combination of Pepsi and pizza—that is, the combi-
nation on the highest possible indifference curve. But the consumer must also end
up on or below his budget constraint, which measures the total resources available
to him.
Figure 21-6 shows the consumer’s budget constraint and three of his many in-
difference curves. The highest indifference curve that the consumer can reach (I
2
in
the figure) is the one that just barely touches the budget constraint. The point at
which this indifference curve and the budget constraint touch is called the opti-
mum. The consumer would prefer point A, but he cannot afford that point because
We have used indifference
curves to represent the con-
sumer’s preferences. Another
common way to represent pref-
erences is with the concept of
utility. Utility is an abstract mea-
sure of the satisfaction or happi-
ness that a consumer receives
from a bundle of goods. Econo-
mists say that a consumer
prefers one bundle of goods to
another if the first provides
more utility than the second.
Indifference curves and utility are closely related. Be-
cause the consumer prefers points on higher indifference
curves, bundles of goods on higher indifference curves pro-
vide higher utility. Because the consumer is equally happy
with all points on the same indifference curve, all these
bundles provide the same utility. Indeed, you can think of an
indifference curve as an “equal-utility” curve. The slope of
the indifference curve (the marginal rate of substitution) re-
flects the marginal utility generated by one good compared
to the marginal utility generated by the other good.
When economists discuss the theory of consumer
choice, they might express the theory using different words.
One economist might say that the goal of the consumer is to
maximize utility. Another might say that the goal of the con-
sumer is to end up on the highest possible indifference
curve. In essence, these are two ways of saying the same
thing.
FYI
Utility: An
Alternative
Way to
Represent a
Consumer’s
Preferences
472 PART SEVEN ADVANCED TOPIC
it lies above his budget constraint. The consumer can afford point B, but that point
is on a lower indifference curve and, therefore, provides the consumer less satis-
faction. The optimum represents the best combination of consumption of Pepsi
and pizza available to the consumer.
Notice that, at the optimum, the slope of the indifference curve equals the
slope of the budget constraint. We say that the indifference curve is tangent to the
budget constraint. The slope of the indifference curve is the marginal rate of sub-
stitution between Pepsi and pizza, and the slope of the budget constraint is the
relative price of Pepsi and pizza. Thus, the consumer chooses consumption of the two
goods so that the marginal rate of substitution equals the relative price.
In Chapter 7 we saw how market prices reflect the marginal value that con-
sumers place on goods. This analysis of consumer choice shows the same result in
another way. In making his consumption choices, the consumer takes as given the
relative price of the two goods and then chooses an optimum at which his mar-
ginal rate of substitution equals this relative price. The relative price is the rate at
which the market is willing to trade one good for the other, whereas the marginal
rate of substitution is the rate at which the consumer is willing to trade one good for
the other. At the consumer’s optimum, the consumer’s valuation of the two goods
(as measured by the marginal rate of substitution) equals the market’s valuation
(as measured by the relative price). As a result of this consumer optimization, mar-
ket prices of different goods reflect the value that consumers place on those goods.
HOW CHANGES IN INCOME AFFECT
THE CONSUMER’S CHOICES
Now that we have seen how the consumer makes the consumption decision, let’s
examine how consumption responds to changes in income. To be specific, suppose
Quantity
of Pizza
Quantity
of Pepsi
0
Optimum
A
B
Budget constraint
I
1
I
2
I
3
Figure 21-6
THE CONSUMER’S OPTIMUM.
The consumer chooses the point
on his budget constraint that lies
on the highest indifference curve.
At this point, called the optimum,
the marginal rate of substitution
equals the relative price of the
two goods. Here the highest
indifference curve the consumer
can reach is I
2
. The consumer
prefers point A, which lies on
indifference curve I
3
, but the
consumer cannot afford this
bundle of Pepsi and pizza. By
contrast, point B is affordable, but
because it lies on a lower
indifference curve, the consumer
does not prefer it.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 473
that income increases. With higher income, the consumer can afford more of both
goods. The increase in income, therefore, shifts the budget constraint outward,
as in Figure 21-7. Because the relative price of the two goods has not changed,
theslope of the new budget constraint is the same as the slope of the initial budget
constraint. That is, an increase in income leads to a parallel shift in the budget
constraint.
The expanded budget constraint allows the consumer to choose a better com-
bination of Pepsi and pizza. In other words, the consumer can now reach a higher
indifference curve. Given the shift in the budget constraint and the consumer’s
preferences as represented by his indifference curves, the consumer’s optimum
moves from the point labeled “initial optimum” to the point labeled “new opti-
mum.”
Notice that, in Figure 21-7, the consumer chooses to consume more Pepsi and
more pizza. Although the logic of the model does not require increased consump-
tion of both goods in response to increased income, this situation is the most com-
mon one. As you may recall from Chapter 4, if a consumer wants more of a good
when his income rises, economists call it a normal good.The indifference curves
in Figure 21-7 are drawn under the assumption that both Pepsi and pizza are nor-
mal goods.
Figure 21-8 shows an example in which an increase in income induces the con-
sumer to buy more pizza but less Pepsi. If a consumer buys less of a good when his
income rises, economists call it an inferior good.Figure 21-8 is drawn under the
assumption that pizza is a normal good and Pepsi is an inferior good.
Although most goods are normal goods, there are some inferior goods in the
world. One example is bus rides. High-income consumers are more likely to own
cars and less likely to ride the bus than low-income consumers. Bus rides, there-
fore, are an inferior good.
Quantity
of Pizza
Quantity
of Pepsi
0
New optimum
New budget constraint
I
1
I
2
2. . . . raising pizza consumption . . .
3. . . . and
Pepsi
consumption.
Initial
budget
constraint
Initial
optimum
1. An increase in income shifts the
budget constraint outward . . .
Figure 21-7
AN INCREASE IN INCOME.
When the consumer’s income
rises, the budget constraint shifts
out. If both goods are normal
goods, the consumer responds to
the increase in income by buying
more of both of them. Here the
consumer buys more pizza and
more Pepsi.
normal good
a good for which an increase in
income raises the quantity demanded
inferior good
a good for which an increase in
income reduces the quantity
demanded
474 PART SEVEN ADVANCED TOPIC
HOW CHANGES IN PRICES AFFECT
THE CONSUMER’S CHOICES
Let’s now use this model of consumer choice to consider how a change in the price
of one of the goods alters the consumer’s choices. Suppose, in particular, that the
price of Pepsi falls from $2 to $1 a pint. It is no surprise that the lower price ex-
pands the consumer’s set of buying opportunities. In other words, a fall in the
price of any good shifts the budget constraint outward.
Figure 21-9 considers more specifically how the fall in price affects the budget
constraint. If the consumer spends his entire $1,000 income on pizza, then the price
of Pepsi is irrelevant. Thus, point A in the figure stays the same. Yet if the con-
sumer spends his entire income of $1,000 on Pepsi, he can now buy 1,000 rather
than only 500 pints. Thus, the end point of the budget constraint moves from point
B to point D.
Notice that in this case the outward shift in the budget constraint changes its
slope. (This differs from what happened previously when prices stayed the same
but the consumer’s income changed.) As we have discussed, the slope of the bud-
get constraint reflects the relative price of Pepsi and pizza. Because the price of
Pepsi has fallen to $1 from $2, while the price of pizza has remained $10, the con-
sumer can now trade a pizza for 10 rather than 5 pints of Pepsi. As a result, the
new budget constraint is more steeply sloped.
How such a change in the budget constraint alters the consumption of both
goods depends on the consumer’s preferences. For the indifference curves drawn
in this figure, the consumer buys more Pepsi and less pizza.
Quantity
of Pizza
Quantity
of Pepsi
0
Initial
optimum
New optimum
Initial
budget
constraint
New budget constraint
I
1
I
2
1. When an increase in income shifts the
budget constraint outward . . .
3. . . . but
Pepsi
consumption
falls, making
Pepsi an
inferior good.
2. . . . pizza consumption rises, making pizza a normal good . . .
Figure 21-8
AN INFERIOR GOOD. Agood is
an inferior good if the consumer
buys less of it when his income
rises. Here Pepsi is an inferior
good: When the consumer’s
income increases and the budget
constraint shifts outward, the
consumer buys more pizza but
less Pepsi.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 475
INCOME AND SUBSTITUTION EFFECTS
The impact of a change in the price of a good on consumption can be decomposed
into two effects: an income effectand a substitution effect.To see what these two
effects are, consider how our consumer might respond when he learns that the
price of Pepsi has fallen. He might reason in the following ways:
a78 “Great news! Now that Pepsi is cheaper, my income has greater purchasing
power. I am, in effect, richer than I was. Because I am richer, I can buy both
more Pepsi and more pizza.” (This is the income effect.)
a78 “Now that the price of Pepsi has fallen, I get more pints of Pepsi for every
pizza that I give up. Because pizza is now relatively more expensive, I should
buy less pizza and more Pepsi.” (This is the substitution effect.)
Which statement do you find more compelling?
In fact, both of these statements make sense. The decrease in the price of Pepsi
makes the consumer better off. If Pepsi and pizza are both normal goods, the con-
sumer will want to spread this improvement in his purchasing power over both
goods. This income effect tends to make the consumer buy more pizza and more
Pepsi. Yet, at the same time, consumption of Pepsi has become less expensive rela-
tive to consumption of pizza. This substitution effect tends to make the consumer
choose more Pepsi and less pizza.
Now consider the end result of these two effects. The consumer certainly buys
more Pepsi, because the income and substitution effects both act to raise purchases
of Pepsi. But it is ambiguous whether the consumer buys more pizza, because the
Quantity
of Pizza
100
Quantity
of Pepsi
1,000
500
0
B
D
A
New optimum
I
1
I
2
Initial optimum
New budget constraint
Initial
budget
constraint
1. A fall in the price of Pepsi rotates
the budget constraint outward . . .
3. . . . and
raising Pepsi
consumption.
2. . . . reducing pizza consumption . . .
Figure 21-9
ACHANGE IN PRICE. When the
price of Pepsi falls, the
consumer’s budget constraint
shifts outward and changes
slope. The consumer moves from
the initial optimum to the new
optimum, which changes his
purchases of both Pepsi and
pizza. In this case, the quantity of
Pepsi consumed rises, and the
quantity of pizza consumed falls.
income effect
the change in consumption that
results when a price change moves
the consumer to a higher or lower
indifference curve
substitution effect
the change in consumption that
results when a price change moves
the consumer along a given
indifference curve to a point with a
new marginal rate of substitution
476 PART SEVEN ADVANCED TOPIC
income and substitution effects work in opposite directions. This conclusion is
summarized in Table 21-2.
We can interpret the income and substitution effects using indifference curves.
The income effect is the change in consumption that results from the movement to a higher
indifference curve. The substitution effect is the change in consumption that results from
being at a point on an indifference curve with a different marginal rate of substitution.
Figure 21-10 shows graphically how to decompose the change in the con-
sumer’s decision into the income effect and the substitution effect. When the price
Table 21-2
GOOD INCOMEEFFECT SUBSTITUTIONEFFECT TOTALEFFECT
Pepsi Consumer is richer, Pepsi is relatively cheaper, so Income and substitution effects act in
so he buys more Pepsi. consumer buys more Pepsi. same direction, so consumer buys
more Pepsi.
Pizza Consumer is richer, Pizza is relatively more Income and substitution effects act in
so he buys more pizza. expensive, so consumer opposite directions, so the total effect
buys less pizza. on pizza consumption is ambiguous.
INCOME AND SUBSTITUTION EFFECTS WHEN THE PRICE OF PEPSI FALLS
Quantity
of Pizza
Quantity
of Pepsi
0
Income
effect
Substitution
effect
B
A
C New optimum
I
1
I
2
Initial optimum
New budget constraint
Initial
budget
constraint
Substitution effect
Income effect
Figure 21-10
INCOME AND SUBSTITUTION
EFFECTS. The effect of a change
in price can be broken down into
an income effect and a substitu-
tion effect. The substitution
effect—the movement along an
indifference curve to a point with
a different marginal rate of
substitution—is shown here as
the change from point Ato
point B along indifference
curve I
1
. The income effect—the
shift to a higher indifference
curve—is shown here as the
change from point B on
indifference curve I
1
to point C on
indifference curve I
2
.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 477
of Pepsi falls, the consumer moves from the initial optimum, point A, to the new
optimum, point C. We can view this change as occurring in two steps. First, the
consumer moves along the initial indifference curve I
1
from point Ato point B. The
consumer is equally happy at these two points, but at point B, the marginal rate of
substitution reflects the new relative price. (The dashed line through point B
reflects the new relative price by being parallel to the new budget constraint.)
Next, the consumer shifts to the higher indifference curve I
2
by moving from
point B to point C. Even though point B and point C are on different indiffer-
ence curves, they have the same marginal rate of substitution. That is, the slope
of the indifference curve I
1
at point B equals the slope of the indifference curve I
2
at point C.
Although the consumer never actually chooses point B, this hypothetical point
is useful to clarify the two effects that determine the consumer’s decision. Notice
that the change from point Ato point B represents a pure change in the marginal
rate of substitution without any change in the consumer’s welfare. Similarly, the
change from point B to point C represents a pure change in welfare without any
change in the marginal rate of substitution. Thus, the movement from A to B
shows the substitution effect, and the movement from B to C shows the income
effect.
DERIVING THE DEMAND CURVE
We have just seen how changes in the price of a good alter the consumer’s budget
constraint and, therefore, the quantities of the two goods that he chooses to buy.
The demand curve for any good reflects these consumption decisions. Recall that
a demand curve shows the quantity demanded of a good for any given price. We
can view a consumer’s demand curve as a summary of the optimal decisions that
arise from his budget constraint and indifference curves.
For example, Figure 21-11 considers the demand for Pepsi. Panel (a) shows
that when the price of a pint falls from $2 to $1, the consumer’s budget constraint
shifts outward. Because of both income and substitution effects, the consumer in-
creases his purchases of Pepsi from 50 to 150 pints. Panel (b) shows the demand
curve that results from this consumer’s decisions. In this way, the theory of con-
sumer choice provides the theoretical foundation for the consumer’s demand
curve, which we first introduced in Chapter 4.
Although it is comforting to know that the demand curve arises naturally
from the theory of consumer choice, this exercise by itself does not justify devel-
oping the theory. There is no need for a rigorous, analytic framework just to estab-
lish that people respond to changes in prices. The theory of consumer choice is,
however, very useful. As we see in the next section, we can use the theory to delve
more deeply into the determinants of household behavior.
QUICK QUIZ: Draw a budget constraint and indifference curves for Pepsi
and pizza. Show what happens to the budget constraint and the consumer’s
optimum when the price of pizza rises. In your diagram, decompose the
change into an income effect and a substitution effect.
478 PART SEVEN ADVANCED TOPIC
FOUR APPLICATIONS
Now that we have developed the basic theory of consumer choice, let’s use it to
shed light on four questions about how the economy works. These four questions
might at first seem unrelated. But because each question involves household
decisionmaking, we can address it with the model of consumer behavior we have
just developed.
DO ALL DEMAND CURVES SLOPE DOWNWARD?
Normally, when the price of a good rises, people buy less of it. Chapter 4 called
this usual behavior the law of demand. This law is reflected in the downward slope
of the demand curve.
As a matter of economic theory, however, demand curves can sometimes slope
upward. In other words, consumers can sometimes violate the law of demand and
buy more of a good when the price rises. To see how this can happen, consider Fig-
ure 21-12. In this example, the consumer buys two goods—meat and potatoes. Ini-
tially, the consumer’s budget constraint is the line from point A to point B. The
optimum is point C. When the price of potatoes rises, the budget constraint shifts
inward and is now the line from point Ato point D. The optimum is now point E.
Quantity
of Pizza
50 1500
50 Demand
(a) The Consumer’s Optimum
Quantity
of Pepsi
0
Price of
Pepsi
$2
1
(b) The Demand Curve for Pepsi
Quantity
of Pepsi
150
B
A
B
A
I
1
I
2
New budget constraint
Initial budget
constraint
Figure 21-11
DERIVING THE DEMAND CURVE. Panel (a) shows that when the price of Pepsi falls from
$2 to $1, the consumer’s optimum moves from point Ato point B, and the quantity of
Pepsi consumed rises from 50 to 150 pints. The demand curve in panel (b) reflects this
relationship between the price and the quantity demanded.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 479
Notice that a rise in the price of potatoes has led the consumer to buy a larger
quantity of potatoes.
Why is the consumer responding in a seemingly perverse way? The reason is
that potatoes here are a strongly inferior good. When the price of potatoes rises,
the consumer is poorer. The income effect makes the consumer want to buy less
meat and more potatoes. At the same time, because the potatoes have become
more expensive relative to meat, the substitution effect makes the consumer want
to buy more meat and less potatoes. In this particular case, however, the income ef-
fect is so strong that it exceeds the substitution effect. In the end, the consumer re-
sponds to the higher price of potatoes by buying less meat and more potatoes.
Economists use the term Giffen goodto describe a good that violates the law
of demand. (The term is named for economist Robert Giffen, who first noted this
possibility.) In this example, potatoes are a Giffen good. Giffen goods are inferior
goods for which the income effect dominates the substitution effect. Therefore,
they have demand curves that slope upward.
Economists disagree about whether any Giffen good has ever been discovered.
Some historians suggest that potatoes were in fact a Giffen good during the Irish
potato famine of the nineteenth century. Potatoes were such a large part of peo-
ple’s diet that when the price of potatoes rose, it had a large income effect. People
responded to their reduced living standard by cutting back on the luxury of meat
and buying more of the staple food of potatoes. Thus, it is argued that a higher
price of potatoes actually raised the quantity of potatoes demanded.
Whether or not this historical account is true, it is safe to say that Giffen goods
are very rare. The theory of consumer choice does allow demand curves to slope
upward. Yet such occurrences are so unusual that the law of demand is as reliable
a law as any in economics.
Quantity
of Meat
A
Quantity of
Potatoes
0
E
C
I
2
I
1
Initial budget constraint
New budget
constraint
D
B
2. . . . which
increases
potato
consumption
if potatoes
are a Giffen
good.
Optimum with low
price of potatoes
Optimum with high
price of potatoes
1. An increase in the price of
potatoes rotates the budget
constraint inward . . .
Figure 21-12
AGIFFEN GOOD. In this
example, when the price of
potatoes rises, the consumer’s
optimum shifts from point C
to point E. In this case, the
consumer responds to a higher
price of potatoes by buying less
meat and more potatoes.
Giffen good
a good for which an increase in the
price raises the quantity demanded
480 PART SEVEN ADVANCED TOPIC
HOW DO WAGES AFFECT LABOR SUPPLY?
So far we have used the theory of consumer choice to analyze how a person de-
cides how to allocate his income between two goods. We can use the same theory
to analyze how a person decides to allocate his time between work and leisure.
Consider the decision facing Sally, a freelance software designer. Sally is
awake for 100 hours per week. She spends some of this time enjoying leisure—rid-
ing her bike, watching television, studying economics, and so on. She spends the
rest of this time at her computer developing software. For every hour she spends
developing software, she earns $50, which she spends on consumption goods.
Thus, her wage ($50) reflects the tradeoff Sally faces between leisure and con-
sumption. For every hour of leisure she gives up, she works one more hour and
gets $50 of consumption.
Figure 21-13 shows Sally’s budget constraint. If she spends all 100 hours en-
joying leisure, she has no consumption. If she spends all 100 hours working, she
earns a weekly consumption of $5,000 but has no time for leisure. If she works a
normal 40-hour week, she enjoys 60 hours of leisure and has weekly consumption
of $2,000.
Figure 21-13 uses indifference curves to represent Sally’s preferences for con-
sumption and leisure. Here consumption and leisure are the two “goods” between
which Sally is choosing. Because Sally always prefers more leisure and more con-
sumption, she prefers points on higher indifference curves to points on lower ones.
At a wage of $50 per hour, Sally chooses a combination of consumption and leisure
represented by the point labeled “optimum.” This is the point on the budget con-
straint that is on the highest possible indifference curve, which is curve I
2
.
Now consider what happens when Sally’s wage increases from $50 to $60 per
hour. Figure 21-14 shows two possible outcomes. In each case, the budget con-
straint, shown in the left-hand graph, shifts outward from BC
1
to BC
2
. In the
process, the budget constraint becomes steeper, reflecting the change in relative
Hours of Leisure0
2,000
$5,000
60
Consumption
100
Optimum
I
3
I
2
I
1
Figure 21-13
THE WORK-LEISURE DECISION.
This figure shows Sally’s budget
constraint for deciding how
much to work, her indifference
curves for consumption and
leisure, and her optimum.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 481
price: At the higher wage, Sally gets more consumption for every hour of leisure
that she gives up.
Sally’s preferences, as represented by her indifference curves, determine the
resulting responses of consumption and leisure to the higher wage. In both panels,
Hours of
Leisure
0
Consumption
(a) For a person with these preferences . . .
Hours of Labor
Supplied
0
Wage
. . . the labor supply curve slopes upward.
Hours of
Leisure
0
Consumption
(b) For a person with these preferences . . .
Hours of Labor
Supplied
0
Wage
. . . the labor supply curve slopes backward.
I
1
I
2
BC
2
BC
1
I
1
I
2
BC
2
BC
1
1. When the wage rises . . .
2. . . . hours of leisure increase . . . 3. . . . and hours of labor decrease.
2. . . . hours of leisure decrease . . . 3. . . . and hours of labor increase.
1. When the wage rises . . .
Labor
supply
Labor
supply
Figure 21-14
AN INCREASE IN THE WAGE. The two panels of this figure show how a person might
respond to an increase in the wage. The graphs on the left show the consumer’s initial
budget constraint BC
1
and new budget constraint BC
2
, as well as the consumer’s optimal
choices over consumption and leisure. The graphs on the right show the resulting labor
supply curve. Because hours worked equal total hours available minus hours of leisure,
any change in leisure implies an opposite change in the quantity of labor supplied. In
panel (a), when the wage rises, consumption rises and leisure falls, resulting in a labor
supply curve that slopes upward. In panel (b), when the wage rises, both consumption
and leisure rise, resulting in a labor supply curve that slopes backward.
482 PART SEVEN ADVANCED TOPIC
CASE STUDY INCOME EFFECTS ON LABOR SUPPLY:
HISTORICAL TRENDS, LOTTERY WINNERS,
AND THE CARNEGIE CONJECTURE
The idea of a backward-sloping labor supply curve might at first seem like a mere
theoretical curiosity, but in fact it is not. Evidence indicates that the labor supply
curve, considered over long periods of time, does in fact slope backward. Ahun-
dred years ago many people worked six days a week. Today five-day workweeks
are the norm. At the same time that the length of the workweek has been falling,
the wage of the typical worker (adjusted for inflation) has been rising.
Here is how economists explain this historical pattern: Over time, advances
in technology raise workers’ productivity and, thereby, the demand for labor.
The increase in labor demand raises equilibrium wages. As wages rise, so does
the reward for working. Yet rather than responding to this increased incentive
by working more, most workers choose to take part of their greater prosperity
in the form of more leisure. In other words, the income effect of higher wages
dominates the substitution effect.
Further evidence that the income effect on labor supply is strong comes
from a very different kind of data: winners of lotteries. Winners of large prizes
consumption rises. Yet the response of leisure to the change in the wage is differ-
ent in the two cases. In panel (a), Sally responds to the higher wage by enjoying
less leisure. In panel (b), Sally responds by enjoying more leisure.
Sally’s decision between leisure and consumption determines her supply of
labor, for the more leisure she enjoys the less time she has left to work. In each
panel, the right-hand graph in Figure 21-14 shows the labor supply curve implied
by Sally’s decision. In panel (a), a higher wage induces Sally to enjoy less leisure
and work more, so the labor supply curve slopes upward. In panel (b), a higher
wage induces Sally to enjoy more leisure and work less, so the labor supply curve
slopes “backward.”
At first, the backward-sloping labor supply curve is puzzling. Why would a
person respond to a higher wage by working less? The answer comes from con-
sidering the income and substitution effects of a higher wage.
Consider first the substitution effect. When Sally’s wage rises, leisure becomes
more costly relative to consumption, and this encourages Sally to substitute con-
sumption for leisure. In other words, the substitution effect induces Sally to work
harder in response to higher wages, which tends to make the labor supply curve
slope upward.
Now consider the income effect. When Sally’s wage rises, she moves to a
higher indifference curve. She is now better off than she was. As long as con-
sumption and leisure are both normal goods, she tends to want to use this increase
in well-being to enjoy both higher consumption and greater leisure. In other
words, the income effect induces her to work less, which tends to make the labor
supply curve slope backward.
In the end, economic theory does not give a clear prediction about whether an
increase in the wage induces Sally to work more or less. If the substitution effect is
greater than the income effect for Sally, she works more. If the income effect is
greater than the substitution effect, she works less. The labor supply curve, there-
fore, could be either upward or backward sloping.
“NO MORE 9-TO-5 FOR ME.”
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 483
in the lottery see large increases in their incomes and, as a result, large outward
shifts in their budget constraints. Because the winners’ wages have not
changed, however, the slopes of their budget constraints remain the same. There
is, therefore, no substitution effect. By examining the behavior of lottery win-
ners, we can isolate the income effect on labor supply.
The results from studies of lottery winners are striking. Of those winners
who win more than $50,000, almost 25 percent quit working within a year, and
another 9 percent reduce the number of hours they work. Of those winners who
win more than $1 million, almost 40 percent stop working. The income effect on
labor supply of winning such a large prize is substantial.
Similar results were found in a study, published in the May 1993 issue of the
Quarterly Journal of Economics, of how receiving a bequest affects a person’s la-
bor supply. The study found that a single person who inherits more than
$150,000 is four times as likely to stop working as a single person who inherits
less than $25,000. This finding would not have surprised the nineteenth-century
industrialist Andrew Carnegie. Carnegie warned that “the parent who leaves
his son enormous wealth generally deadens the talents and energiesof the son,
and tempts him to lead a less useful and less worthy life than he otherwise
would.” That is, Carnegie viewed the income effect on labor supply to be sub-
stantial and, from his paternalistic perspective, regrettable. During his life and
at his death, Carnegie gave much of his vast fortune to charity.
HOW DO INTEREST RATES AFFECT HOUSEHOLD SAVING?
An important decision that every person faces is how much income to consume to-
day and how much to save for the future. We can use the theory of consumer
choice to analyze how people make this decision and how the amount they save
depends on the interest rate their savings will earn.
Consider the decision facing Sam, a worker planning ahead for retirement. To
keep things simple, let’s divide Sam’s life into two periods. In the first period, Sam
is young and working. In the second period, he is old and retired. When young,
Sam earns a total of $100,000. He divides this income between current consump-
tion and saving. When he is old, Sam will consume what he has saved, including
the interest that his savings have earned.
Suppose that the interest rate is 10 percent. Then for every dollar that Sam
saves when young, he can consume $1.10 when old. We can view “consumption
when young” and “consumption when old” as the two goods that Sam must
choose between. The interest rate determines the relative price of these two goods.
Figure 21-15 shows Sam’s budget constraint. If he saves nothing, he consumes
$100,000 when young and nothing when old. If he saves everything, he consumes
nothing when young and $110,000 when old. The budget constraint shows these
and all the intermediate possibilities.
Figure 21-15 uses indifference curves to represent Sam’s preferences for con-
sumption in the two periods. Because Sam prefers more consumption in both pe-
riods, he prefers points on higher indifference curves to points on lower ones.
Given his preferences, Sam chooses the optimal combination of consumption in
both periods of life, which is the point on the budget constraint that is on the high-
est possible indifference curve. At this optimum, Sam consumes $50,000 when
young and $55,000 when old.
484 PART SEVEN ADVANCED TOPIC
Now consider what happens when the interest rate increases from 10 percent
to 20 percent. Figure 21-16 shows two possible outcomes. In both cases, the budget
constraint shifts outward and becomes steeper. At the new higher interest rate,
Sam gets more consumption when old for every dollar of consumption that he
gives up when young.
The two panels show different preferences for Sam and the resulting response
to the higher interest rate. In both cases, consumption when old rises. Yet the re-
sponse of consumption when young to the change in the interest rate is different
in the two cases. In panel (a), Sam responds to the higher interest rate by con-
suming less when young. In panel (b), Sam responds by consuming more when
young.
Sam’s saving, of course, is his income when young minus the amount he con-
sumes when young. In panel (a), consumption when young falls when the interest
rate rises, so saving must rise. In panel (b), Sam consumes more when young, so
saving must fall.
The case shown in panel (b) might at first seem odd: Sam responds to an in-
crease in the return to saving by saving less. Yet this behavior is not as peculiar as
it might seem. We can understand it by considering the income and substitution
effects of a higher interest rate.
Consider first the substitution effect. When the interest rate rises, consumption
when old becomes less costly relative to consumption when young. Therefore, the
substitution effect induces Sam to consume more when old and less when young.
In other words, the substitution effect induces Sam to save more.
Now consider the income effect. When the interest rate rises, Sam moves to a
higher indifference curve. He is now better off than he was. As long as consump-
tion in both periods consists of normal goods, he tends to want to use this increase
in well-being to enjoy higher consumption in both periods. In other words, the in-
come effect induces him to save less.
Consumption
when Young
0
55,000
$110,000
$50,000
Consumption
when Old
100,000
Optimum
I
3
I
2
I
1
Budget
constraint
Figure 21-15
THE CONSUMPTION-SAVING
DECISION. This figure shows
the budget constraint for a person
deciding how much to consume
in the two periods of his life, the
indifference curves representing
his preferences, and the
optimum.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 485
The end result, of course, depends on both the income and substitution effects.
If the substitution effect of a higher interest rate is greater than the income effect,
Sam saves more. If the income effect is greater than the substitution effect, Sam
saves less. Thus, the theory of consumer choice says that an increase in the interest
rate could either encourage or discourage saving.
Although this ambiguous result is interesting from the standpoint of economic
theory, it is disappointing from the standpoint of economic policy. It turns out that
an important issue in tax policy hinges in part on how saving responds to interest
rates. Some economists have advocated reducing the taxation of interest and other
capital income, arguing that such a policy change would raise the after-tax interest
rate that savers can earn and would thereby encourage people to save more. Other
economists have argued that because of offsetting income and substitution effects,
such a tax change might not increase saving and could even reduce it. Unfortu-
nately, research has not led to a consensus about how interest rates affect saving.
As a result, there remains disagreement among economists about whether changes
in tax policy aimed to encourage saving would, in fact, have the intended effect.
DO THE POOR PREFER TO RECEIVE CASH
OR IN-KIND TRANSFERS?
Paul is a pauper. Because of his low income, he has a meager standard of liv-
ing. The government wants to help. It can either give Paul $1,000 worth of food
0
(a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving
Consumption
when Old
I
1
I
2
BC
1
BC
2
0
I
1
I
2
BC
1
BC
2
Consumption
when Old
Consumption
when Young
1. A higher interest rate rotates
the budget constraint outward . . .
1. A higher interest rate rotates
the budget constraint outward . . .
2. . . . resulting in lower
consumption when young
and, thus, higher saving.
2. . . . resulting in higher
consumption when young
and, thus, lower saving.
Consumption
when Young
Figure 21-16
AN INCREASE IN THE INTEREST RATE. In both panels, an increase in the interest rate
shifts the budget constraint outward. In panel (a), consumption when young falls, and
consumption when old rises. The result is an increase in saving when young. In panel (b),
consumption in both periods rises. The result is a decrease in saving when young.
486 PART SEVEN ADVANCED TOPIC
(perhaps by issuing him food stamps) or simply give him $1,000 in cash. What
does the theory of consumer choice have to say about the comparison between
these two policy options?
Figure 21-17 shows how the two options might work. If the government gives
Paul cash, then the budget constraint shifts outward. He can divide the extra cash
Cash Transfer In-Kind Transfer
Nonfood
Consumption
0
$1,000
Cash Transfer
(a) The Constraint Is Not Binding
(b) The Constraint Is Binding
0
$1,000
In-Kind Transfer
Food
A
B
I
2
I
1
BC
1
BC
2
(with $1,000 cash)
A
B
C
I
2
I
1
BC
1
BC
2
(with $1,000 food stamps)
Food
Nonfood
Consumption
Nonfood
Consumption
0
$1,000
0
$1,000
Food
A
B
I
2
I
1
BC
1
BC
2
(with $1,000 cash)
A
B
I
2
I
1
BC
1
BC
2
(with $1,000 food stamps)
Food
Nonfood
Consumption
I
3
Figure 21-17
CASH VERSUS IN-KIND TRANSFERS. Both panels compare a cash transfer and a similar
in-kind transfer of food. In panel (a), the in-kind transfer does not impose a binding
constraint, and the consumer ends up on the same indifference curve under the two
policies. In panel (b), the in-kind transfer imposes a binding constraint, and the consumer
ends up on a lower indifference curve with the in-kind transfer than with the cash
transfer.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 487
between food and nonfood consumption however he pleases. By contrast, if the
government gives Paul an in-kind transfer of food, then his new budget constraint
is more complicated. The budget constraint has again shifted out. But now the
budget constraint has a kink at $1,000 of food, for Paul must consume at least that
amount in food. That is, even if Paul spends all his money on nonfood consump-
tion, he still consumes $1,000 in food.
The ultimate comparison between the cash transfer and in-kind transfer de-
pends on Paul’s preferences. In panel (a), Paul would choose to spend at least
$1,000 on food even if he receives a cash transfer. Therefore, the constraint im-
posed by the in-kind transfer is not binding. In this case, his consumption moves
from point Ato point B regardless of the type of transfer. That is, Paul’s choice be-
tween food and nonfood consumption is the same under the two policies.
In panel (b), however, the story is very different. In this case, Paul would pre-
fer to spend less than $1,000 on food and spend more on nonfood consumption.
The cash transfer allows him discretion to spend the money as he pleases, and he
consumes at point B. By contrast, the in-kind transfer imposes the binding con-
straint that he consume at least $1,000 of food. His optimal allocation is at the kink,
point C. Compared to the cash transfer, the in-kind transfer induces Paul to con-
sume more food and less of other goods. The in-kind transfer also forces Paul to
end up on a lower (and thus less preferred) indifference curve. Paul is worse off
than if he had the cash transfer.
Thus, the theory of consumer choice teaches a simple lesson about cash versus
in-kind transfers. If an in-kind transfer of a good forces the recipient to consume
more of the good than he would on his own, then the recipient prefers the cash
transfer. If the in-kind transfer does not force the recipient to consume more of the
good than he would on his own, then the cash and in-kind transfer have exactly
the same effect on the consumption and welfare of the recipient.
QUICK QUIZ: Explain how an increase in the wage can potentially
decrease the amount that a person wants to work.
CONCLUSION: DO PEOPLE
REALLY THINK THIS WAY?
The theory of consumer choice describes how people make decisions. As we have
seen, it has broad applicability. It can explain how a person chooses between Pepsi
and pizza, work and leisure, consumption and saving, and on and on.
At this point, however, you might be tempted to treat the theory of consumer
choice with some skepticism. After all, you are a consumer. You decide what to
buy every time you walk into a store. And you know that you do not decide by
writing down budget constraints and indifference curves. Doesn’t this knowledge
about your own decisionmaking provide evidence against the theory?
The answer is no. The theory of consumer choice does not try to present a lit-
eral account of how people make decisions. It is a model. And, as we first dis-
cussed in Chapter 2, models are not intended to be completely realistic.
The best way to view the theory of consumer choice is as a metaphor for how
consumers make decisions. No consumer (except an occasional economist) goes
488 PART SEVEN ADVANCED TOPIC
through the explicit optimization envisioned in the theory. Yet consumers are
aware that their choices are constrained by their financial resources. And, given
those constraints, they do the best they can to achieve the highest level of satisfac-
tion. The theory of consumer choice tries to describe this implicit, psychological
process in a way that permits explicit, economic analysis.
The proof of the pudding is in the eating. And the test of a theory is in its ap-
plications. In the last section of this chapter we applied the theory of consumer
choice to four practical issues about the economy. If you take more advanced
courses in economics, you will see that this theory provides the framework for
much additional analysis.
a78 Aconsumer’s budget constraint shows the possible
combinations of different goods he can buy given his
income and the prices of the goods. The slope of the
budget constraint equals the relative price of the goods.
a78 The consumer’s indifference curves represent his
preferences. An indifference curve shows the various
bundles of goods that make the consumer equally
happy. Points on higher indifference curves are
preferred to points on lower indifference curves. The
slope of an indifference curve at any point is the
consumer’s marginal rate of substitution—the rate at
which the consumer is willing to trade one good for the
other.
a78 The consumer optimizes by choosing the point on his
budget constraint that lies on the highest indifference
curve. At this point, the slope of the indifference curve
(the marginal rate of substitution between the goods)
equals the slope of the budget constraint (the relative
price of the goods).
a78 When the price of a good falls, the impact on the
consumer’s choices can be broken down into an income
effect and a substitution effect. The income effect is the
change in consumption that arises because a lower price
makes the consumer better off. The substitution effect is
the change in consumption that arises because a price
change encourages greater consumption of the good
that has become relatively cheaper. The income effect is
reflected in the movement from a lower to a higher
indifference curve, whereas the substitution effect is
reflected by a movement along an indifference curve to
a point with a different slope.
a78 The theory of consumer choice can be applied in many
situations. It can explain why demand curves can
potentially slope upward, why higher wages could
either increase or decrease the quantity of labor
supplied, why higher interest rates could either increase
or decrease saving, and why the poor prefer cash to
in-kind transfers.
Summary
budget constraint, p. 465
indifference curve, p. 466
marginal rate of substitution, p. 467
perfect substitutes, p. 470
perfect complements, p. 470
normal good, p. 473
inferior good, p. 473
income effect, p. 475
substitution effect, p. 475
Giffen good, p. 479
Key Concepts
1. Aconsumer has income of $3,000. Wine costs $3 a glass,
and cheese costs $6 a pound. Draw the consumer’s
budget constraint. What is the slope of this budget
constraint?
Questions for Review
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 489
2. Draw a consumer’s indifference curves for wine and
cheese. Describe and explain four properties of these
indifference curves.
3. Pick a point on an indifference curve for wine and
cheese and show the marginal rate of substitution. What
does the marginal rate of substitution tell us?
4. Show a consumer’s budget constraint and indifference
curves for wine and cheese. Show the optimal
consumption choice. If the price of wine is $3 a glass
and the price of cheese is $6 a pound, what is the
marginal rate of substitution at this optimum?
5. Aperson who consumes wine and cheese gets a raise, so
his income increases from $3,000 to $4,000. Show what
happens if both wine and cheese are normal goods.
Now show what happens if cheese is an inferior good.
6. The price of cheese rises from $6 to $10 a pound, while
the price of wine remains $3 a glass. For a consumer
with a constant income of $3,000, show what happens to
consumption of wine and cheese. Decompose the
change into income and substitution effects.
7. Can an increase in the price of cheese possibly induce a
consumer to buy more cheese? Explain.
8. Suppose a person who buys only wine and cheese is
given $1,000 in food stamps to supplement his $1,000
income. The food stamps cannot be used to buy wine.
Might the consumer be better off with $2,000 in income?
Explain in words and with a diagram.
1. Jennifer divides her income between coffee and
croissants (both of which are normal goods). An early
frost in Brazil causes a large increase in the price of
coffee in the United States.
a. Show the effect of the frost on Jennifer’s budget
constraint.
b. Show the effect of the frost on Jennifer’s optimal
consumption bundle assuming that the substitution
effect outweighs the income effect for croissants.
c. Show the effect of the frost on Jennifer’s optimal
consumption bundle assuming that the income
effect outweighs the substitution effect for
croissants.
2. Compare the following two pairs of goods:
a78 Coke and Pepsi
a78 Skis and ski bindings
In which case do you expect the indifference curves to
be fairly straight, and in which case do you expect the
indifference curves to be very bowed? In which case will
the consumer respond more to a change in the relative
price of the two goods?
3. Mario consumes only cheese and crackers.
a. Could cheese and crackers both be inferior goods
for Mario? Explain.
b. Suppose that cheese is a normal good for Mario
whereas crackers are an inferior good. If the price of
cheese falls, what happens to Mario’s consumption
of crackers? What happens to his consumption of
cheese? Explain.
4. Jim buys only milk and cookies.
a. In 2001, Jim earns $100, milk costs $2 per quart, and
cookies cost $4 per dozen. Draw Jim’s budget
constraint.
b. Now suppose that all prices increase by 10 percent
in 2002 and that Jim’s salary increases by 10 percent
as well. Draw Jim’s new budget constraint. How
would Jim’s optimal combination of milk and
cookies in 2002 compare to his optimal combination
in 2001?
5. Consider your decision about how many hours to
work.
a. Draw your budget constraint assuming that you
pay no taxes on your income. On the same
diagram, draw another budget constraint assuming
that you pay a 15 percent tax.
b. Show how the tax might lead to more hours of
work, fewer hours, or the same number of hours.
Explain.
6. Sarah is awake for 100 hours per week. Using one
diagram, show Sarah’s budget constraints if she earns
$6 per hour, $8 per hour, and $10 per hour. Now draw
indifference curves such that Sarah’s labor supply curve
is upward sloping when the wage is between $6 and $8
per hour, and backward sloping when the wage is
between $8 and $10 per hour.
7. Draw the indifference curve for someone deciding how
much to work. Suppose the wage increases. Is it possible
that the person’s consumption would fall? Is this
Problems and Applications
490 PART SEVEN ADVANCED TOPIC
plausible? Discuss. (Hint: Think about income and
substitution effects.)
8. Suppose you take a job that pays $30,000 and set some
of this income aside in a savings account that pays an
annual interest rate of 5 percent. Use a diagram with a
budget constraint and indifference curves to show how
your consumption changes in each of the following
situations. To keep things simple, assume that you pay
no taxes on your income.
a. Your salary increases to $40,000.
b. The interest rate on your bank account rises to
8 percent.
9. As discussed in the text, we can divide an individual’s
life into two hypothetical periods: “young” and “old.”
Suppose that the individual earns income only when
young and saves some of that income to consume when
old. If the interest rate on savings falls, can you tell what
happens to consumption when young? Can you tell
what happens to consumption when old? Explain.
10. Suppose that your state gives each town $5 million in
aid per year. The way in which the money is spent is
currently unrestricted, but the governor has proposed
that towns be required to spend the entire $5 million on
education. You can illustrate the effect of this proposal
on your town’s spending on education using a budget
constraint and indifference-curve diagram. The two
goods are education and noneducation spending.
a. Draw your town’s budget constraint under the
existing policy, assuming that your town’s only
source of revenue besides the state aid is a property
tax that yields $10 million. On the same diagram,
draw the budget constraint under the governor’s
proposal.
b. Would your town spend more on education under
the governor’s proposal than under the existing
policy? Explain.
c. Now compare two towns—Youngsville and
Oldsville—with the same revenue and the same
state aid. Youngsville has a large school-age
population, and Oldsville has a large elderly
population. In which town is the governor’s
proposal most likely to increase education
spending? Explain.
11. (This problem is challenging.) The welfare system
provides income to some needy families. Typically, the
maximum payment goes to families that earn no
income; then, as families begin to earn income, the
welfare payment declines gradually and eventually
disappears. Let’s consider the possible effects of this
program on a family’s labor supply.
a. Draw a budget constraint for a family assuming
that the welfare system did not exist. On the same
diagram, draw a budget constraint that reflects the
existence of the welfare system.
b. Adding indifference curves to your diagram, show
how the welfare system could reduce the number of
hours worked by the family. Explain, with reference
to both the income and substitution effects.
c. Using your diagram from part (b), show the effect
of the welfare system on the well-being of the
family.
12. (This problem is challenging.) Suppose that an
individual owed no taxes on the first $10,000 she earned
and 15 percent of any income she earned over $10,000.
(This is a simplified version of the actual U.S. income
tax.) Now suppose that Congress is considering two
ways to reduce the tax burden: a reduction in the tax
rate and an increase in the amount on which no tax is
owed.
a. What effect would a reduction in the tax rate have
on the individual’s labor supply if she earned
$30,000 to start? Explain in words using the income
and substitution effects. You do not need to use a
diagram.
b. What effect would an increase in the amount on
which no tax is owed have on the individual’s labor
supply? Again, explain in words using the income
and substitution effects.
13. (This problem is challenging.) Consider a person
deciding how much to consume and how much to save
for retirement. This person has particular preferences:
Her lifetime utility depends on the lowest level of
consumption during the two periods of her life. That is,
Utility H11005Minimum {consumption when young,
consumption when old}.
a. Draw this person’s indifference curves. (Hint:
Recall that indifference curves show the
combinations of consumption in the two periods
that yield the same level of utility.)
b. Draw the budget constraint and the optimum.
c. When the interest rate increases, does this person
save more or less? Explain your answer using
income and substitution effects.
IN THIS CHAPTER
YOU WILL . . .
Consider whether
GDP is a good
measure of
economic well-being
See the breakdown
of GDP into its four
major components
Consider why an
economy’s total
income equals its
total expenditure
Learn how gross
domestic product
(GDP) is defined and
calculated
Learn the
distinction between
real GDP and
nominal GDP
When you finish school and start looking for a full-time job, your experience will,
to a large extent, be shaped by prevailing economic conditions. In some years,
firms throughout the economy are expanding their production of goods and ser-
vices, employment is rising, and jobs are easy to find. In other years, firms are cut-
ting back on production, employment is declining, and finding a good job takes a
long time. Not surprisingly, any college graduate would rather enter the labor
force in a year of economic expansion than in a year of economic contraction.
Because the condition of the overall economy profoundly affects all of us,
changes in economic conditions are widely reported by the media. Indeed, it is hard
to pick up a newspaper without seeing some newly reported statistic about the
economy. The statistic might measure the total income of everyone in the economy
(GDP), the rate at which average prices are rising (inflation), the percentage of the
labor force that is out of work (unemployment), total spending at stores (retail
MEASURING A NATION’S
INCOME
493
494 PART EIGHT THE DATA OF MACROECONOMICS
sales), or the imbalance of trade between the United States and the rest of the world
(the trade deficit). All these statistics are macroeconomic.Rather than telling us about
a particular household or firm, they tell us something about the entire economy.
As you may recall from Chapter 2, economics is divided into two branches:
microeconomics and macroeconomics. Microeconomicsis the study of how indi-
vidual households and firms make decisions and how they interact with one
another in markets. Macroeconomicsis the study of the economy as a whole. The
goal of macroeconomics is to explain the economic changes that affect many
households, firms, and markets at once. Macroeconomists address diverse ques-
tions: Why is average income high in some countries while it is low in others? Why
do prices rise rapidly in some periods of time while they are more stable in other
periods? Why do production and employment expand in some years and contract
in others? What, if anything, can the government do to promote rapid growth in
incomes, low inflation, and stable employment? These questions are all macroeco-
nomic in nature because they concern the workings of the entire economy.
Because the economy as a whole is just a collection of many households and
many firms interacting in many markets, microeconomics and macroeconomics
are closely linked. The basic tools of supply and demand, for instance, are as cen-
tral to macroeconomic analysis as they are to microeconomic analysis. Yet study-
ing the economy in its entirety raises some new and intriguing challenges.
In this chapter and the next one, we discuss some of the data that economists
and policymakers use to monitor the performance of the overall economy. These
data reflect the economic changes that macroeconomists try to explain. This chap-
ter considers gross domestic product, or simply GDP, which measures the total
income of a nation. GDPis the most closely watched economic statistic because it
is thought to be the best single measure of a society’s economic well-being.
THE ECONOMY’S INCOME AND EXPENDITURE
If you were to judge how a person is doing economically, you might first look at
his or her income. Aperson with a high income can more easily afford life’s neces-
sities and luxuries. It is no surprise that people with higher incomes enjoy higher
standards of living—better housing, better health care, fancier cars, more opulent
vacations, and so on.
The same logic applies to a nation’s overall economy. When judging whether the
economy is doing well or poorly, it is natural to look at the total income that every-
one in the economy is earning. That is the task of gross domestic product (GDP).
GDPmeasures two things at once: the total income of everyone in the econo-
my and the total expenditure on the economy’s output of goods and services. The
reason that GDPcan perform the trick of measuring both total income and total
expenditure is that these two things are really the same. For an economy as a whole,
income must equal expenditure.
Why is this true? The reason that an economy’s income is the same as its expen-
diture is simply that every transaction has two parties: a buyer and a seller. Every
dollar of spending by some buyer is a dollar of income for some seller. Suppose, for
instance, that Karen pays Doug $100 to mow her lawn. In this case, Doug is a seller
of a service, and Karen is a buyer. Doug earns $100, and Karen spends $100. Thus,
microeconomics
the study of how households and
firms make decisions and how they
interact in markets
macroeconomics
the study of economy-wide
phenomena, including inflation,
unemployment, and economic
growth
CHAPTER 22 MEASURING A NATION’S INCOME 495
the transaction contributes equally to the economy’s income and to its expenditure.
GDP, whether measured as total income or total expenditure, rises by $100.
Another way to see the equality of income and expenditure is with the circular-
flow diagram in Figure 22-1. (You may recall this circular-flow diagram from
Chapter 2.) This diagram describes all the transactions between households and
firms in a simple economy. In this economy, households buy goods and services
from firms; these expenditures flow through the markets for goods and services.
The firms in turn use the money they receive from sales to pay workers’ wages,
landowners’ rent, and firm owners’ profit; this income flows through the markets
for the factors of production. In this economy, money continuously flows from
households to firms and then back to households.
We can compute GDPfor this economy in one of two ways: by adding up the
total expenditure by households or by adding up the total income (wages, rent,
and profit) paid by firms. Because all expenditure in the economy ends up as
someone’s income, GDPis the same regardless of how we compute it.
The actual economy is, of course, more complicated than the one illustrated in
Figure 22-1. In particular, households do not spend all of their income. Households
pay some of their income to the government in taxes, and they save and invest
some of their income for use in the future. In addition, households do not buy all
Spending
(= GDP)
Goods and
services
bought
Revenue
(= GDP)
Goods
and services
sold
Labor, land,
and capital
Income (= GDP)
H11005Flow of goods
and services
H11005Flow of dollars
Inputs for
production
Wages, rent,
and profit
(= GDP)
FIRMS HOUSEHOLDS
MARKETS FOR
FACTORS OF
PRODUCTION
MARKETS FOR
GOODS AND
SERVICES
Figure 22-1
THE CIRCULAR-FLOW DIAGRAM.
Households buy goods and
services from firms, and firms use
their revenue from sales to pay
wages to workers, rent to
landowners, and profit to firm
owners. GDPequals the total
amount spent by households in
the market for goods and
services. It also equals the total
wages, rent, and profit paid by
firms in the markets for the
factors of production.
496 PART EIGHT THE DATA OF MACROECONOMICS
goods and services produced in the economy. Some goods and services are bought
by governments, and some are bought by firms that plan to use them in the future
to produce their own output. Yet, regardless of whether a household, government,
or firm buys a good or service, the transaction has a buyer and seller. Thus, for the
economy as a whole, expenditure and income are always the same.
QUICK QUIZ: What two things does gross domestic product measure?
How can it measure two things at once?
THE MEASUREMENT OF GROSS
DOMESTIC PRODUCT
Now that we have discussed the meaning of gross domestic product in general
terms, let’s be more precise about how this statistic is measured. Here is a defini-
tion of GDP:
a78 Gross domestic product (GDP)is the market value of all final goods and
services produced within a country in a given period of time.
This definition might seem simple enough. But, in fact, many subtle issues arise
when computing an economy’s GDP. Let’s therefore consider each phrase in this
definition with some care.
“GDP IS THE MARKET VALUE . . .”
You have probably heard the adage, “You can’t compare apples and oranges.” Yet
GDPdoes exactly that. GDPadds together many different kinds of products into a
single measure of the value of economic activity. To do this, it uses market prices.
Because market prices measure the amount people are willing to pay for different
goods, they reflect the value of those goods. If the price of an apple is twice the price
of an orange, then an apple contributes twice as much to GDPas does an orange.
“OF ALL . . .”
GDPtries to be comprehensive. It includes all items produced in the economy and
sold legally in markets. GDP measures the market value of not just apples and
oranges, but also pears and grapefruit, books and movies, haircuts and health care,
and on and on.
GDPalso includes the market value of the housing services provided by the
economy’s stock of housing. For rental housing, this value is easy to calculate—the
rent equals both the tenant’s expenditure and the landlord’s income. Yet many
people own the place where they live and, therefore, do not pay rent. The govern-
ment includes this owner-occupied housing in GDPby estimating its rental value.
That is, GDPis based on the assumption that the owner, in effect, pays rent to him-
self, so the rent is included both in his expenditure and in his income.
There are some products, however, that GDP excludes because measuring
them is so difficult. GDPexcludes items produced and sold illicitly, such as illegal
gross domestic product
(GDP)
the market value of all final goods
and services produced within a
country in a given period of time
CHAPTER 22 MEASURING A NATION’S INCOME 497
drugs. It also excludes most items that are produced and consumed at home and,
therefore, never enter the marketplace. Vegetables you buy at the grocery store are
part of GDP; vegetables you grow in your garden are not.
These exclusions from GDPcan at times lead to paradoxical results. For exam-
ple, when Karen pays Doug to mow her lawn, that transaction is part of GDP. If
Karen were to marry Doug, the situation would change. Even though Doug may
continue to mow Karen’s lawn, the value of the mowing is now left out of GDP
because Doug’s service is no longer sold in a market. Thus, when Karen and Doug
marry, GDPfalls.
“FINAL . . .”
When International Paper makes paper, which Hallmark then uses to make a
greeting card, the paper is called an intermediate good, and the card is called a final
good. GDPincludes only the value of final goods. The reason is that the value of
intermediate goods is already included in the prices of the final goods. Adding the
market value of the paper to the market value of the card would be double count-
ing. That is, it would (incorrectly) count the paper twice.
An important exception to this principle arises when an intermediate good is
produced and, rather than being used, is added to a firm’s inventory of goods to be
used or sold at a later date. In this case, the intermediate good is taken to be “final”
for the moment, and its value as inventory investment is added to GDP. When the
inventory of the intermediate good is later used or sold, the firm’s inventory invest-
ment is negative, and GDPfor the later period is reduced accordingly.
“GOODS AND SERVICES . . .”
GDP includes both tangible goods (food, clothing, cars) and intangible services
(haircuts, housecleaning, doctor visits). When you buy a CD by your favorite
singing group, you are buying a good, and the purchase price is part of GDP.
When you pay to hear a concert by the same group, you are buying a service, and
the ticket price is also part of GDP.
“PRODUCED . . .”
GDPincludes goods and services currently produced. It does not include transac-
tions involving items produced in the past. When General Motors produces and
sells a new car, the value of the car is included in GDP. When one person sells a
used car to another person, the value of the used car is not included in GDP.
“WITHIN A COUNTRY . . .”
GDPmeasures the value of production within the geographic confines of a coun-
try. When a Canadian citizen works temporarily in the United States, his produc-
tion is part of U.S. GDP. When an American citizen owns a factory in Haiti, the
production at his factory is not part of U.S. GDP. (It is part of Haiti’s GDP.) Thus,
items are included in a nation’s GDPif they are produced domestically, regardless
of the nationality of the producer.
498 PART EIGHT THE DATA OF MACROECONOMICS
“. . . IN A GIVEN PERIOD OF TIME.”
GDPmeasures the value of production that takes place within a specific interval of
time. Usually that interval is a year or a quarter (three months). GDPmeasures the
economy’s flow of income and expenditure during that interval.
When the government reports the GDP for a quarter, it usually presents
GDP“at an annual rate.” This means that the figure reported for quarterly GDPis
the amount of income and expenditure during the quarter multiplied by 4. The
government uses this convention so that quarterly and annual figures on GDPcan
be compared more easily.
In addition, when the government reports quarterly GDP, it presents the data
after they have been modified by a statistical procedure called seasonal adjustment.
The unadjusted data show clearly that the economy produces more goods and
services during some times of year than during others. (As you might guess,
December’s Christmas shopping season is a high point.) When monitoring the
When the U.S. Department
of Commerce computes the
nation’s GDP every three
months, it also computes vari-
ous other measures of income
to get a more complete picture
of what’s happening in the econ-
omy. These other measures dif-
fer from GDP by excluding or
including certain categories of
income. What follows is a brief
description of five of these
income measures, ordered from
largest to smallest.
a78 Gross national product (GNP) is the total income
earned by a nation’s permanent residents (called
nationals). It differs from GDP by including income that
our citizens earn abroad and excluding income that for-
eigners earn here. For example, when a Canadian citi-
zen works temporarily in the United States, his
production is part of U.S. GDP, but it is not part of U.S.
GNP. (It is part of Canada’s GNP.) For most countries,
including the United States, domestic residents are
responsible for most domestic production, so GDP and
GNP are quite close.
a78 Net national product (NNP) is the total income of a
nation’s residents (GNP) minus losses from depreciation.
Depreciation is the wear and tear on the economy’s
stock of equipment and structures, such as trucks rust-
ing and lightbulbs burning out. In the national income
accounts prepared by the Department of Commerce,
depreciation is called the “consumption of fixed capital.”
a78 National income is the total income earned by a
nation’s residents in the production of goods and ser-
vices. It differs from net national product by excluding
indirect business taxes (such as sales taxes) and
including business subsidies. NNP and national income
also differ because of a “statistical discrepancy” that
arises from problems in data collection.
a78 Personal income is the income that households and
noncorporate businesses receive. Unlike national
income, it excludes retained earnings, which is income
that corporations have earned but have not paid out to
their owners. It also subtracts corporate income taxes
and contributions for social insurance (mostly Social
Security taxes). In addition, personal income includes
the interest income that households receive from their
holdings of government debt and the income that
households receive from government transfer pro-
grams, such as welfare and Social Security.
a78 Disposable personal income is the income that house-
holds and noncorporate businesses have leftafter sat-
isfying all their obligations to the government. It equals
personal income minus personal taxes and certain non-
tax payments (suchastraffic tickets).
Although the various measures of income differ in detail,
they almost always tell the same story about economic con-
ditions. When GDP is growing rapidly, these other measures
of income are usually growing rapidly. And when GDP is
falling, these other measures are usually falling as well. For
monitoring fluctuations in the overall economy, it does not
matter much which measure of income we use.
FYI
Other Measures
of Income
CHAPTER 22 MEASURING A NATION’S INCOME 499
condition of the economy, economists and policymakers often want to look
beyond these regular seasonal changes. Therefore, government statisticians adjust
the quarterly data to take out the seasonal cycle. The GDPdata reported in the
news are always seasonally adjusted.
Now let’s repeat the definition of GDP:
a78 Gross domestic product (GDP) is the market value of all final goods and
services produced within a country in a given period of time.
It should be apparent that GDPis a sophisticated measure of the value of economic
activity. In advanced courses in macroeconomics, you will learn more of the sub-
tleties that arise in its calculation. But even now you can see that each phrase in
this definition is packed with meaning.
QUICK QUIZ: Which contributes more to GDP—the production of a pound
of hamburger or the production of a pound of caviar? Why?
THE COMPONENTS OF GDP
Spending in the economy takes many forms. At any moment, the Smith family
may be having lunch at Burger King; General Motors may be building a car facto-
ry; the Navy may be procuring a submarine; and British Airways may be buying
an airplane from Boeing. GDPincludes all of these various forms of spending on
domestically produced goods and services.
To understand how the economy is using its scarce resources, economists are
often interested in studying the composition of GDPamong various types of spend-
ing. To do this, GDP(which we denote as Y) is divided into four components: con-
sumption (C), investment (I), government purchases (G), and net exports (NX):
Y H11005C H11001IH11001G H11001NX.
This equation is an identity—an equation that must be true by the way the vari-
ables in the equation are defined. In this case, because each dollar of expenditure
included in GDPis placed into one of the four components of GDP, the total of the
four components must be equal to GDP.
We have just seen an example of each component. Consumptionis spending
by households on goods and services, such as the Smiths’ lunch at Burger King.
Investmentis the purchase of capital equipment, inventories, and structures, such
as the General Motors factory. Investment also includes expenditure on new hous-
ing. (By convention, expenditure on new housing is the one form of household
spending categorized as investment rather than consumption.) Government pur-
chasesinclude spending on goods and services by local, state, and federal govern-
ments, such as the Navy’s purchase of a submarine. Net exports equal the
purchases of domestically produced goods by foreigners (exports) minus the
domestic purchases of foreign goods (imports). Adomestic firm’s sale to a buyer in
another country, such as the Boeing sale to British Airways, increases net exports.
The “net” in “net exports” refers to the fact that imports are subtracted from
exports. This subtraction is made because imports of goods and services are
consumption
spending by households on goods
and services, with the exception of
purchases of new housing
investment
spending on capital equipment,
inventories, and structures,
including household purchases of
new housing
government purchases
spending on goods and services by
local, state, and federal governments
net exports
spending on domestically produced
goods by foreigners (exports) minus
spending on foreign goods by
domestic residents (imports)
500 PART EIGHT THE DATA OF MACROECONOMICS
included in other components of GDP. For example, suppose that a household
buys a $30,000 car from Volvo, the Swedish carmaker. That transaction increases
consumption by $30,000 because car purchases are part of consumer spending. It
also reduces net exports by $30,000 because the car is an import. In other words,
net exports include goods and services produced abroad (with a minus sign)
because these goods and services are included in consumption, investment, and
government purchases (with a plus sign). Thus, when a domestic household, firm,
or government buys a good or service from abroad, the purchase reduces net
exports—but because it also raises consumption, investment, or government pur-
chases, it does not affect GDP.
The meaning of “government purchases” also requires a bit of clarification.
When the government pays the salary of an Army general, that salary is part of
government purchases. But what happens when the government pays a Social
Security benefit to one of the elderly? Such government spending is called a trans-
fer payment because it is not made in exchange for a currently produced good or
service. From a macroeconomic standpoint, transfer payments are like a tax rebate.
Like taxes, transfer payments alter household income, but they do not reflect the
economy’s production. Because GDP is intended to measure income from (and
expenditure on) the production of goods and services, transfer payments are not
counted as part of government purchases.
Table 22-1 shows the composition of U.S. GDPin 1998. In this year, the GDPof
the United States was about $8.5 trillion. If we divide this number by the 1998 U.S.
population of 270 million, we find that GDPper person—the amount of expendi-
ture for the average American—was $31,522. Consumption made up about two-
thirds of GDP, or $21,511 per person. Investment was $5,063 per person.
Government purchases were $5,507 per person. Net exports were –$559 per per-
son. This number is negative because Americans earned less from selling to for-
eigners than they spent on foreign goods.
QUICK QUIZ: List the four components of expenditure. Which is the largest?
REAL VERSUS NOMINAL GDP
As we have seen, GDPmeasures the total spending on goods and services in all
markets in the economy. If total spending rises from one year to the next, one of
two things must be true: (1) the economy is producing a larger output of goods
Table 22-1
GDPAND ITS COMPONENTS.
This table shows total GDPfor
the U.S. economy in 1998 and the
breakdown of GDPamong its
four components. When reading
this table, recall the identity
Y H11005C H11001IH11001G H11001NX.
TOTAL PERCENT
(IN BILLIONS)PERPERSON OFTOTAL
Gross domestic product, Y $8,511 $31,522 100%
Consumption, C 5,808 21,511 68
Investment, I 1,367 5,063 16
Government purchases, G 1,487 5,507 18
Net exports, NX H11002151 H11002559 H110022
SOURCE: U.S. Department of Commerce.
CHAPTER 22 MEASURING A NATION’S INCOME 501
and services, or (2) goods and services are being sold at higher prices. When
studying changes in the economy over time, economists want to separate these
two effects. In particular, they want a measure of the total quantity of goods and
services the economy is producing that is not affected by changes in the prices of
those goods and services.
To do this, economists use a measure called real GDP. Real GDP answers a
hypothetical question: What would be the value of the goods and services pro-
duced this year if we valued these goods and services at the prices that prevailed
in some specific year in the past? By evaluating current production using prices
that are fixed at past levels, real GDPshows how the economy’s overall produc-
tion of goods and services changes over time.
To see more precisely how real GDPis constructed, let’s consider an example.
A NUMERICAL EXAMPLE
Table 22-2 shows some data for an economy that produces only two goods—hot
dogs and hamburgers. The table shows the quantities of the two goods produced
and their prices in the years 2001, 2002, and 2003.
Table 22-2
PRICES ANDQUANTITIES
YEAR PRICEOF HOTDOGS QUANTITY OFHOTDOGS PRICEOF HAMBURGERS QUANTITY OFHAMBURGERS
2001 $1 100 $2 50
2002 2 150 3 100
2003 3 200 4 150
YEAR CALCULATINGNOMINALGDP
2001 ($1 per hot dog H11003100 hot dogs) H11001($2 per hamburger H1100350 hamburgers) H11005$200
2002 ($2 per hot dog H11003150 hot dogs) H11001($3 per hamburger H11003100 hamburgers) H11005$600
2003 ($3 per hot dog H11003200 hot dogs) H11001($4 per hamburger H11003150 hamburgers) H11005$1,200
YEAR CALCULATINGREALGDP (BASEYEAR 2001)
2001 ($1 per hot dog H11003100 hot dogs) H11001($2 per hamburger H1100350 hamburgers) H11005$200
2002 ($1 per hot dog H11003150 hot dogs) H11001($2 per hamburger H11003100 hamburgers) H11005$350
2003 ($1 per hot dog H11003200 hot dogs) H11001($2 per hamburger H11003150 hamburgers) H11005$500
YEAR CALCULATING THEGDP DEFLATOR
2001 ($200/$200) H11003100 H11005100
2002 ($600/$350) H11003100 H11005171
2003 ($1,200/$500) H11003100 H11005240
REAL AND NOMINAL GDP. This table shows how to calculate real GDP, nominal GDP,
and the GDPdeflator for a hypothetical economy that produces only hot dogs and
hamburgers.
502 PART EIGHT THE DATA OF MACROECONOMICS
To compute total spending in this economy, we would multiply the quantities
of hot dogs and hamburgers by their prices. In the year 2001, 100 hot dogs are sold
at a price of $1 per hot dog, so expenditure on hot dogs equals $100. In the same
year, 50 hamburgers are sold for $2 per hamburger, so expenditure on hamburgers
also equals $100. Total expenditure in the economy—the sum of expenditure on
hot dogs and expenditure on hamburgers—is $200. This amount, the production
of goods and services valued at current prices, is called nominal GDP.
The table shows the calculation of nominal GDP for these three years. Total
spending rises from $200 in 2001 to $600 in 2002 and then to $1,200 in 2003. Part of
this rise is attributable to the increase in the quantities of hot dogs and hamburgers,
and part is attributable to the increase in the prices of hot dogs and hamburgers.
To obtain a measure of the amount produced that is not affected by changes in
prices, we use real GDP,which is the production of goods and services valued at
constant prices. We calculate real GDPby first choosing one year as a base year. We
then use the prices of hot dogs and hamburgers in the base year to compute the
value of goods and services in all of the years. In other words, the prices in the
base year provide the basis for comparing quantities in different years.
Suppose that we choose 2001 to be the base year in our example. We can then
use the prices of hot dogs and hamburgers in 2001 to compute the value of goods
and services produced in 2001, 2002, and 2003. Table 22-2 shows these calculations.
To compute real GDPfor 2001, we use the prices of hot dogs and hamburgers in
2001 (the base year) and the quantities of hot dogs and hamburgers produced in
2001. (Thus, for the base year, real GDPalways equals nominal GDP.) To compute
real GDPfor 2002, we use the prices of hot dogs and hamburgers in 2001 (the base
year) and the quantities of hot dogs and hamburgers produced in 2002. Similarly,
to compute real GDPfor 2003, we use the prices in 2001 and the quantities in 2003.
When we find that real GDPhas risen from $200 in 2001 to $350 in 2002 and then
to $500 in 2003, we know that the increase is attributable to an increase in the quan-
tities produced, because the prices are being held fixed at base-year levels.
To sum up: Nominal GDP uses current prices to place a value on the economy’s pro-
duction of goods and services. Real GDP uses constant base-year prices to place a value on
the economy’s production of goods and services. Because real GDPis not affected by
changes in prices, changes in real GDPreflect only changes in the amounts being
produced. Thus, real GDPis a measure of the economy’s production of goods and
services.
Our goal in computing GDPis to gauge how well the overall economy is per-
forming. Because real GDPmeasures the economy’s production of goods and ser-
vices, it reflects the economy’s ability to satisfy people’s needs and desires. Thus,
real GDP is a better gauge of economic well-being than is nominal GDP. When
economists talk about the economy’s GDP, they usually mean real GDPrather than
nominal GDP. And when they talk about growth in the economy, they measure
that growth as the percentage change in real GDPfrom one period to another.
THE GDP DEFLATOR
As we have just seen, nominal GDPreflects both the prices of goods and services
and the quantities of goods and services the economy is producing. By contrast, by
holding prices constant at base-year levels, real GDPreflects only the quantities
produced. From these two statistics, we can compute a third, called the GDP defla-
tor, which reflects the prices of goods and services but not the quantities produced.
nominal GDP
the production of goods and services
valued at current prices
real GDP
the production of goods and services
valued at constant prices
CHAPTER 22 MEASURING A NATION’S INCOME 503
CASE STUDY REAL GDP OVER RECENT HISTORY
Now that we know how real GDPis defined and measured, let’s look at what this
macroeconomic variable tells us about the recent history of the United States. Fig-
ure 22-2 shows quarterly data on real GDPfor the U.S. economy since 1970.
The GDP deflatoris calculated as follows:
GDPdeflator H11005H11003100.
Because nominal GDPand real GDPmust be the same in the base year, the GDP
deflator for the base year always equals 100. The GDP deflator for subsequent
years measures the rise in nominal GDPfrom the base year that cannot be attrib-
utable to a rise in real GDP.
The GDPdeflator measures the current level of prices relative to the level of
prices in the base year. To see why this is true, consider a couple of simple exam-
ples. First, imagine that the quantities produced in the economy rise over time but
prices remain the same. In this case, both nominal and real GDPrise together, so
the GDPdeflator is constant. Now suppose, instead, that prices rise over time but
the quantities produced stay the same. In this second case, nominal GDPrises but
real GDPremains the same, so the GDPdeflator rises as well. Notice that, in both
cases, the GDPdeflator reflects what’s happening to prices, not quantities.
Let’s now return to our numerical example in Table 22-2. The GDPdeflator is
computed at the bottom of the table. For year 2001, nominal GDPis $200, and real
GDPis $200, so the GDPdeflator is 100. For the year 2002, nominal GDPis $600,
and real GDPis $350, so the GDPdeflator is 171. Because the GDPdeflator rose in
year 2002 from 100 to 171, we can say that the price level increased by 71 percent.
The GDPdeflator is one measure that economists use to monitor the average
level of prices in the economy. We examine another—the consumer price index—in
the next chapter, where we also describe the differences between the two measures.
Nominal GDP
Real GDP
GDP deflator
a measure of the price level
calculated as the ratio of nominal
GDP to real GDP times 100
Billions of
1992 Dollars
3,000
4,000
5,000
6,000
$8,000
$7,000
1970 1975 1980 1985 1990 20001995
Figure 22-2
REAL GDP IN THE UNITED
STATES. This figure shows
quarterly data on real GDPfor
the U.S. economy since 1970.
Recessions—periods of falling
real GDP—are marked with the
shaded vertical bars.
SOURCE: U.S. Department of Commerce.
504 PART EIGHT THE DATA OF MACROECONOMICS
The most obvious feature of these data is that real GDPgrows over time.
The real GDPof the U.S. economy in 1999 was more than twice its 1970 level.
Put differently, the output of goods and services produced in the United States
has grown on average about 3 percent per year since 1970. This continued
growth in real GDP enables the typical American to enjoy greater economic
prosperity than his or her parents and grandparents did.
Asecond feature of the GDPdata is that growth is not steady. The upward
climb of real GDP is occasionally interrupted by periods during which GDP
declines, called recessions. Figure 22-2 marks recessions with shaded vertical
bars. (There is no ironclad rule for when the official business cycle dating com-
mittee will declare that a recession has occurred, but a good rule of thumb is
two consecutive quarters of falling real GDP.) Recessions are associated not only
with lower incomes but also with other forms of economic distress: rising
unemployment, falling profits, increased bankruptcies, and so on.
Much of macroeconomics is aimed at explaining the long-run growth
and short-run fluctuations in real GDP. As we will see in the coming chap-
ters, we need different models for these two purposes. Because the short-run
fluctuations represent deviations from the long-run trend, we first examine the
behavior of the economy in the long run. In particular, Chapters 24 through 30
examine how key macroeconomic variables, including real GDP, are deter-
mined in the long run. We then build on this analysis to explain short-run fluc-
tuations in Chapters 31 through 33.
QUICK QUIZ: Define real and nominal GDP. Which is a better measure of
economic well-being? Why?
GDP AND ECONOMIC WELL-BEING
Earlier in this chapter, GDPwas called the best single measure of the economic well-
being of a society. Now that we know what GDPis, we can evaluate this claim.
As we have seen, GDPmeasures both the economy’s total income and the econ-
omy’s total expenditure on goods and services. Thus, GDPper person tells us the
income and expenditure of the average person in the economy. Because most people
would prefer to receive higher income and enjoy higher expenditure, GDPper per-
son seems a natural measure of the economic well-being of the average individual.
Yet some people dispute the validity of GDPas a measure of well-being. When
Senator Robert Kennedy was running for president in 1968, he gave a moving cri-
tique of such economic measures:
[Gross domestic product] does not allow for the health of our children, the
quality of their education, or the joy of their play. It does not include the beauty
of our poetry or the strength of our marriages, the intelligence of our public
debate or the integrity of our public officials. It measures neither our courage,
nor our wisdom, nor our devotion to our country. It measures everything, in
short, except that which makes life worthwhile, and it can tell us everything
about America except why we are proud that we are Americans.
CHAPTER 22 MEASURING A NATION’S INCOME 505
Much of what Robert Kennedy said is correct. Why then do we care about GDP?
The answer is that a large GDPdoes in fact help us to lead a good life. GDP
does not measure the health of our children, but nations with larger GDP can
afford better health care for their children. GDPdoes not measure the quality of
their education, but nations with larger GDP can afford better educational sys-
tems. GDPdoes not measure the beauty of our poetry, but nations with larger GDP
can afford to teach more of their citizens to read and to enjoy poetry. GDPdoes not
take account of our intelligence, integrity, courage, wisdom, or devotion to coun-
try, but all of these laudable attributes are easier to foster when people are less con-
cerned about being able to afford the material necessities of life. In short, GDPdoes
not directly measure those things that make life worthwhile, but it does measure
our ability to obtain the inputs into a worthwhile life.
GDP measures the value of the econ-
omy’s output of goods and services.
What do you think we would learn if,
instead, we measured the weight of the
economy’s output?
From Greenspan, a (Truly)
Weighty Idea
BY DAVID WESSEL
Having weighed the evidence carefully,
Federal Reserve Chairman Alan
Greenspan wants you to know that the
U.S. economy is getting lighter.
Literally.
When he refers to “downsizing” in
this instance, Mr. Greenspan means that
a dollar’s worth of the goods and ser-
vices produced in the mighty U.S. econ-
omy weighs a lot less than it used to,
even after adjusting for inflation.
A modern 10-story office building,
he says, weighs less than a 10-story
building erected in the late 19th century.
With synthetic fibers, clothes weigh less.
And the electronics revolution has pro-
duced televisions so light they can be
worn on the wrist.
By conventional measures, the [real]
gross domestic product—the value of all
goods and services produced in the
nation—is five times as great as it was
50 years ago. Yet “the physical weight
of our gross domestic product is evi-
dently only modestly higher than it was
50 or 100 years ago,” Mr. Greenspan
told an audience in Dallas recently.
When you think about it, it’s not so
surprising that the economy is getting
lighter. An ever-growing proportion of
the U.S. GDP consists of things that
don’t weigh anything at all—lawyers’
services, psychotherapy, e-mail, online
information.
But Mr. Greenspan has a way of
making the obvious sound profound.
Only “a small fraction” of the nation’s
economic growth in the past several
decades “represents growth in the ton-
nage of physical materials—oil, coal,
ores, wood, raw chemicals,” he has
observed. “The remainder represents
new insights into how to rearrange those
physical materials to better serve human
needs.” . . .
The incredible shrinking GDP helps
explain why American workers can pro-
duce more for each hour of work than
ever before. . . . [It] also helps explain
why there is so much international trade
these days. “The . . . downsizing of out-
put,” Mr. Greenspan said recently,
“meant that products were easier and
hence less costly to move, and most
especially across national borders.” . . .
“The world of 1948 was vastly dif-
ferent,” Mr. Greenspan observed a few
years back. “The quintessential model of
industry might in those days was the
array of vast, smoke-encased integrated
steel mills . . . on the shores of Lake
Michigan. Output was things, big physi-
cal things.”
Today, one exemplar of U.S. eco-
nomic might is Microsoft Corp., with its
almost weightless output. “Virtually
unimaginable a half-century ago was the
extent to which concepts and ideas
would substitute for physical resources
and human brawn in the production of
goods and services,” he has said.
Of course, one thing Made in the
U.S. is heavier than it used to be: peo-
ple. The National Institutes of Health
says 22.3% of Americans are obese, up
from 12.8% in the early 1960. But Mr.
Greenspan doesn’t talk about that.
SOURCE: The Wall Street Journal, May 20, 1999,
p.B1.
IN THE NEWS
GDP Lightens Up
506 PART EIGHT THE DATA OF MACROECONOMICS
CASE STUDY INTERNATIONAL DIFFERENCES IN GDP AND THE
QUALITY OF LIFE
One way to gauge the usefulness of GDPas a measure of economic well-being
is to examine international data. Rich and poor countries have vastly different
levels of GDPper person. If a large GDPleads to a higher standard of living,
then we should observe GDP to be strongly correlated with measures of the
quality of life. And, in fact, we do.
Table 22-3 shows 12 of the world’s most populous countries ranked in order
of GDPper person. The table also shows life expectancy (the expected life span
at birth) and literacy (the percentage of the adult population that can read).
These data show a clear pattern. In rich countries, such as the United States,
Japan, and Germany, people can expect to live into their late seventies, and
almost all of the population can read. In poor countries, such as Nigeria,
Bangladesh, and Pakistan, people typically live only until their fifties or early
sixties, and only about half of the population is literate.
Although data on other aspects of the quality of life are less complete, they
tell a similar story. Countries with low GDP per person tend to have more
infants with low birth weight, higher rates of infant mortality, higher rates of
GDPis not, however, a perfect measure of well-being. Some things that con-
tribute to a good life are left out of GDP. One is leisure. Suppose, for instance, that
everyone in the economy suddenly started working every day of the week, rather
than enjoying leisure on weekends. More goods and services would be produced,
and GDPwould rise. Yet, despite the increase in GDP, we should not conclude that
everyone would be better off. The loss from reduced leisure would offset the gain
from producing and consuming a greater quantity of goods and services.
Because GDPuses market prices to value goods and services, it excludes the
value of almost all activity that takes place outside of markets. In particular, GDP
omits the value of goods and services produced at home. When a chef prepares a
delicious meal and sells it at his restaurant, the value of that meal is part of GDP.
But if the chef prepares the same meal for his spouse, the value he has added to the
raw ingredients is left out of GDP. Similarly, child care provided in day care cen-
ters is part of GDP, whereas child care by parents at home is not. Volunteer work
also contributes to the well-being of those in society, but GDPdoes not reflect these
contributions.
Another thing that GDPexcludes is the quality of the environment. Imagine
that the government eliminated all environmental regulations. Firms could then
produce goods and services without considering the pollution they create, and
GDP might rise. Yet well-being would most likely fall. The deterioration in the
quality of air and water would more than offset the gains from greater production.
GDPalso says nothing about the distribution of income. Asociety in which
100 people have annual incomes of $50,000 has GDPof $5 million and, not sur-
prisingly, GDPper person of $50,000. So does a society in which 10 people earn
$500,000 and 90 suffer with nothing at all. Few people would look at those two sit-
uations and call them equivalent. GDP per person tells us what happens to the
average person, but behind the average lies a large variety of personal experiences.
In the end, we can conclude that GDPis a good measure of economic well-
being for most—but not all—purposes. It is important to keep in mind what GDP
includes and what it leaves out.
GDPREFLECTS THE FACTORY’S
PRODUCTION, BUT NOT THE HARM THAT IT
INFLICTS ON THE ENVIRONMENT.
CHAPTER 22 MEASURING A NATION’S INCOME 507
Table 22-3
GDP, LIFE EXPECTANCY, AND
LITERACY. The table shows
GDPper person and two
measures of the quality of life for
12 major countries.
REALGDP PER LIFE ADULT
COUNTRY PERSON, 1997 EXPECTANCY LITERACY
United States $29,010 77 years 99%
Japan 24,070 80 99
Germany 21,260 77 99
Mexico 8,370 72 90
Brazil 6,480 67 84
Russia 4,370 67 99
Indonesia 3,490 65 85
China 3,130 70 83
India 1,670 63 53
Pakistan 1,560 64 41
Bangladesh 1,050 58 39
Nigeria 920 50 59
Source: Human Development Report 1999, United Nations.
Measuring a nation’s gross domestic
product is never easy, but it becomes
especially difficult when people have
every incentive to hide their economic
activities from the eyes of government.
The Russian Economy:
Notes from Underground
BY MICHAEL R. GORDON
If you want to know what is happening in
the Russian economy, it helps to think
about bread. Government statistics show
that people are eating more bread and
bakeries are selling less. Or consider vod-
ka. Distillers are able to produce far more
vodka than is officially being sold. But giv-
en the well-deserved Russian fondness for
vodka there is every reason to think the
distilleries are operating at full capacity.
The Russian Government’s top
number crunchers say the contradictions
are easy to explain: high taxes, govern-
ment red tape, and the simple desire to
sock away some extra cash have driven
much of Russia’s economic activity
underground.
For the last six years, the Russian
economy has been going down, down,
down. But as President Boris N. Yeltsin
tries to deliver the growth he has
promised, economists are taking a clos-
er look at the murky but vibrant shadow
economy. It includes everything from
small businesses that never report their
sales to huge companies that understate
their production to avoid taxes.
Government experts insist that if the
shadow economy is taken into account,
the overall economy is finally starting to
grow. In turn, Mr. Yeltsin’s critics com-
plain that the new calculations are more
propaganda than economics. . . .
There is no question that measuring
economic activity in a former Communist
country on the road to capitalism is a
frustratingly elusive task.
“There is a serious problem with
post-socialist statistics,” said Yegor T.
Gaidar, the former Prime Minister and
pro-reform director of the Institute of
Economic Problems of the Transitional
Period.
“Seven years ago to report an
increase in the amount of production
was to become a Hero of Socialist
Labor,” he said. “Now it is to get addi-
tional visits from the tax collector.”
SOURCE: The New York Times, May 18, 1997, Week
in Review, p. 4.
IN THE NEWS
Hidden GDP
508 PART EIGHT THE DATA OF MACROECONOMICS
maternal mortality, higher rates of child malnutrition, and less common access
to safe drinking water. In countries with low GDPper person, fewer school-age
children are actually in school, and those who are in school must learn with
fewer teachers per student. These countries also tend to have fewer televisions,
fewer telephones, fewer paved roads, and fewer households with electricity.
International data leave no doubt that a nation’s GDPis closely associated with
its citizens’ standard of living.
QUICK QUIZ: Why should policymakers care about GDP?
CONCLUSION
This chapter has discussed how economists measure the total income of a nation.
Measurement is, of course, only a starting point. Much of macroeconomics is
aimed at revealing the long-run and short-run determinants of a nation’s gross
domestic product. Why, for example, is GDPhigher in the United States and Japan
than in India and Nigeria? What can the governments of the poorest countries do
to promote more rapid growth in GDP? Why does GDPin the United States rise
rapidly in some years and fall in others? What can U.S. policymakers do to reduce
the severity of these fluctuations in GDP? These are the questions we will take up
shortly.
At this point, it is important to acknowledge the importance of just measuring
GDP. We all get some sense of how the economy is doing as we go about our lives.
But the economists who study changes in the economy and the policymakers who
formulate economic policies need more than this vague sense—they need concrete
data on which to base their judgments. Quantifying the behavior of the economy
with statistics such as GDPis, therefore, the first step to developing a science of
macroeconomics.
a78 Because every transaction has a buyer and a seller, the
total expenditure in the economy must equal the total
income in the economy.
a78 Gross domestic product (GDP) measures an economy’s
total expenditure on newly produced goods and
services and the total income earned from the
production of these goods and services. More precisely,
GDPis the market value of all final goods and services
produced within a country in a given period of time.
a78 GDPis divided among four components of expenditure:
consumption, investment, government purchases, and
net exports. Consumption includes spending on goods
and services by households, with the exception of
purchases of new housing. Investment includes
spending on new equipment and structures, including
households’ purchases of new housing. Government
purchases include spending on goods and services by
local, state, and federal governments. Net exports equal
the value of goods and services produced domestically
and sold abroad (exports) minus the value of goods and
services produced abroad and sold domestically
(imports).
a78 Nominal GDPuses current prices to value the
economy’s production of goods and services. Real GDP
uses constant base-year prices to value the economy’s
production of goods and services. The GDPdeflator—
Summary
CHAPTER 22 MEASURING A NATION’S INCOME 509
calculated from the ratio of nominal to real GDP—
measures the level of prices in the economy.
a78 GDPis a good measure of economic well-being because
people prefer higher to lower incomes. But it is not a
perfect measure of well-being. For example, GDP
excludes the value of leisure and the value of a clean
environment.
Key Concepts
microeconomics, p. 494
macroeconomics, p. 494
gross domestic product (GDP), p. 496
consumption, p. 499
investment, p. 499
government purchases, p. 499
net exports, p. 499
nominal GDP, p. 502
real GDP, p. 502
GDPdeflator, p. 503
Questions for Review
1. Explain why an economy’s income must equal its
expenditure.
2. Which contributes more to GDP—the production of an
economy car or the production of a luxury car? Why?
3. Afarmer sells wheat to a baker for $2. The baker uses
the wheat to make bread, which is sold for $3. What is
the total contribution of these transactions to GDP?
4. Many years ago Peggy paid $500 to put together a
record collection. Today she sold her albums at a garage
sale for $100. How does this sale affect current GDP?
5. List the four components of GDP. Give an example of
each.
6. Why do economists use real GDPrather than nominal
GDPto gauge economic well-being?
7. In the year 2001, the economy produces 100 loaves of
bread that sell for $2 each. In the year 2002, the economy
produces 200 loaves of bread that sell for $3 each.
Calculate nominal GDP, real GDP, and the GDPdeflator
for each year. (Use 2001 as the base year.) By what
percentage does each of these three statistics rise from
one year to the next?
8. Why is it desirable for a country to have a large GDP?
Give an example of something that would raise GDP
and yet be undesirable.
Problems and Applications
1. What components of GDP(if any) would each of the
following transactions affect? Explain.
a. Afamily buys a new refrigerator.
b. Aunt Jane buys a new house.
c. Ford sells a Thunderbird from its inventory.
d. You buy a pizza.
e. California repaves Highway 101.
f. Your parents buy a bottle of French wine.
g. Honda expands its factory in Marysville, Ohio.
2. The “government purchases” component of GDPdoes
not include spending on transfer payments such as
Social Security. Thinking about the definition of GDP,
explain why transfer payments are excluded.
3. Why do you think households’ purchases of new
housing are included in the investment component of
GDPrather than the consumption component? Can you
think of a reason why households’ purchases of new
cars should also be included in investment rather than
in consumption? To what other consumption goods
might this logic apply?
4. As the chapter states, GDPdoes not include the value of
used goods that are resold. Why would including such
transactions make GDPa less informative measure of
economic well-being?
5. Below are some data from the land of milk and honey.
PRICE QUANTITY PRICEOF QUANTITY
YEAR OFMILK OFMILK HONEY OFHONEY
2001 $1 100 qts. $2 50 qts.
2002 $1 200 $2 100
2003 $2 200 $4 100
510 PART EIGHT THE DATA OF MACROECONOMICS
a. Compute nominal GDP, real GDP, and the GDP
deflator for each year, using 2001 as the base year.
b. Compute the percentage change in nominal GDP,
real GDP, and the GDPdeflator in 2002 and 2003
from the preceding year. For each year, identify the
variable that does not change. Explain in words
why your answer makes sense.
c. Did economic well-being rise more in 2002 or 2003?
Explain.
6. Consider the following data on U.S. GDP:
NOMINALGDP GDP DEFLATOR
YEAR (IN BILLIONS)(BASEYEAR 1992)
1996 7,662 110
1997 8,111 112
a. What was the growth rate of nominal GDPbetween
1996 and 1997? (Note: The growth rate is the
percentage change from one period to the next.)
b. What was the growth rate of the GDPdeflator
between 1996 and 1997?
c. What was real GDPin 1996 measured in 1992
prices?
d. What was real GDPin 1997 measured in 1992
prices?
e. What was the growth rate of real GDPbetween
1996 and 1997?
f. Was the growth rate of nominal GDPhigher or
lower than the growth rate of real GDP? Explain.
7. If prices rise, people’s income from selling goods
increases. The growth of real GDPignores this gain,
however. Why, then, do economists prefer real GDPas a
measure of economic well-being?
8. Revised estimates of U.S. GDPare usually released by
the government near the end of each month. Go to a
library and find a newspaper article that reports on the
most recent release. Discuss the recent changes in real
and nominal GDPand in the components of GDP.
(Alternatively, you can get the data at www.bea.doc.gov,
the Web site of the U.S. Bureau of Economic Analysis.)
9. One day Barry the Barber, Inc., collects $400 for haircuts.
Over this day, his equipment depreciates in value by
$50. Of the remaining $350, Barry sends $30 to the
government in sales taxes, takes home $220 in wages,
and retains $100 in his business to add new equipment
in the future. From the $220 that Barry takes home, he
pays $70 in income taxes. Based on this information,
compute Barry’s contribution to the following measures
of income:
a. gross domestic product
b. net national product
c. national income
d. personal income
e. disposable personal income
10. Goods and services that are not sold in markets, such as
food produced and consumed at home, are generally
not included in GDP. Can you think of how this might
cause the numbers in the second column of Table 22-3 to
be misleading in a comparison of the economic well-
being of the United States and India? Explain.
11. Until the early 1990s, the U.S. government emphasized
GNPrather than GDPas a measure of economic well-
being. Which measure should the government prefer if
it cares about the total income of Americans? Which
measure should it prefer if it cares about the total
amount of economic activity occurring in the United
States?
12. The participation of women in the U.S. labor force has
risen dramatically since 1970.
a. How do you think this rise affected GDP?
b. Now imagine a measure of well-being that includes
time spent working in the home and taking leisure.
How would the change in this measure of well-
being compare to the change in GDP?
c. Can you think of other aspects of well-being that
are associated with the rise in women’s labor force
participation? Would it be practical to construct a
measure of well-being that includes these aspects?
511
IN THIS CHAPTER
YOU WILL . . .
Learn the
distinction between
real and nominal
interest rates
Compare the CPI
and the GDP
deflator as
measures of the
overall price level
Learn how the
consumer price
index (CPI) is
constructed
Consider why the
CPI is an imperfect
measure of the cost
of living
See how to use a
price index to
compare dollar
figures from
different times
In 1931, as the U.S. economy was suffering through the Great Depression, famed
baseball player Babe Ruth earned $80,000. At the time, this salary was extraordi-
nary, even among the stars of baseball. According to one story, a reporter asked
Ruth whether he thought it was right that he made more than President Herbert
Hoover, who had a salary of only $75,000. Ruth replied, “I had a better year.”
Today the average baseball player earns more than 10 times Ruth’s 1931 salary,
and the best players can earn 100 times as much. At first, this fact might lead you
to think that baseball has become much more lucrative over the past six decades.
But, as everyone knows, the prices of goods and services have also risen. In 1931,
a nickel would buy an ice-cream cone, and a quarter would buy a ticket at the local
movie theater. Because prices were so much lower in Babe Ruth’s day than they
are in ours, it is not clear whether Ruth enjoyed a higher or lower standard of liv-
ing than today’s players.
MEASURING THE
COST OF LIVING
512 PART EIGHT THE DATA OF MACROECONOMICS
In the preceding chapter we looked at how economists use gross domestic
product (GDP) to measure the quantity of goods and services that the economy is
producing. This chapter examines how economists measure the overall cost of liv-
ing. To compare Babe Ruth’s salary of $80,000 to salaries from today, we need to
find some way of turning dollar figures into meaningful measures of purchasing
power. That is exactly the job of a statistic called the consumer price index.After see-
ing how the consumer price index is constructed, we discuss how we can use such
a price index to compare dollar figures from different points in time.
The consumer price index is used to monitor changes in the cost of living over
time. When the consumer price index rises, the typical family has to spend more
dollars to maintain the same standard of living. Economists use the term inflation
to describe a situation in which the economy’s overall price level is rising. The
inflation rateis the percentage change in the price level from the previous period.
As we will see in the coming chapters, inflation is a closely watched aspect of
macroeconomic performance and is a key variable guiding macroeconomic policy.
This chapter provides the background for that analysis by showing how econo-
mists measure the inflation rate using the consumer price index.
THE CONSUMER PRICE INDEX
The consumer price index (CPI)is a measure of the overall cost of the goods and
services bought by a typical consumer. Each month the Bureau of Labor Statistics,
which is part of the Department of Labor, computes and reports the consumer
price index. In this section we discuss how the consumer price index is calculated
and what problems arise in its measurement. We also consider how this index
compares to the GDPdeflator, another measure of the overall level of prices, which
we examined in the preceding chapter.
HOW THE CONSUMER PRICE INDEX IS CALCULATED
When the Bureau of Labor Statistics calculates the consumer price index and the
inflation rate, it uses data on the prices of thousands of goods and services. To see
exactly how these statistics are constructed, let’s consider a simple economy in
which consumers buy only two goods—hot dogs and hamburgers. Table 23-1
shows the five steps that the Bureau of Labor Statistics follows.
1. Fix the Basket.The first step in computing the consumer price index is to
determine which prices are most important to the typical consumer. If the
typical consumer buys more hot dogs than hamburgers, then the price of hot
dogs is more important than the price of hamburgers and, therefore, should
be given greater weight in measuring the cost of living. The Bureau of Labor
Statistics sets these weights by surveying consumers and finding the basket
of goods and services that the typical consumer buys. In the example in the
table, the typical consumer buys a basket of 4 hot dogs and 2 hamburgers.
consumer price
index (CPI)
a measure of the overall cost of
thegoods and services bought
byatypical consumer
CHAPTER 23 MEASURING THE COST OF LIVING 513
2. Find the Prices.The second step in computing the consumer price index is to
find the prices of each of the goods and services in the basket for each point
in time. The table shows the prices of hot dogs and hamburgers for three
different years.
3. Compute the Basket’s Cost.The third step is to use the data on prices
tocalculate the cost of the basket of goods and services at different times.
Thetable shows this calculation for each of the three years. Notice that only
the prices in this calculation change. By keeping the basket of goods the
same(4hot dogs and 2 hamburgers), we are isolating the effects of price
changes from the effect of any quantity changes that might be occurring
atthe same time.
4. Choose a Base Year and Compute the Index.The fourth step is to designate
oneyear as the base year, which is the benchmark against which other years
arecompared. To calculate the index, the price of the basket of goods and
Table 23-1
CALCULATING THE CONSUMER
PRICE INDEX AND THE INFLATION
RATE: AN EXAMPLE. This table
shows how to calculate the
consumer price index and the
inflation rate for a hypothetical
economy in which consumers
buy only hot dogs and
hamburgers.
STEP1: SURVEYCONSUMERSTODETERMINEAFIXEDBASKETOFGOODS
4 hot dogs, 2 hamburgers
STEP2: FINDTHEPRICEOFEACHGOODINEACHYEAR
YEAR PRICEOFHOTDOGS PRICEOFHAMBURGERS
2001 $1 $2
2002 2 3
2003 3 4
STEP3: COMPUTETHECOSTOFTHEBASKETOFGOODSINEACHYEAR
2001 ($1 per hot dog H110034 hot dogs) H11001($2 per hamburger H110032 hamburgers) H11005$8
2002 ($2 per hot dog H110034 hot dogs) H11001($3 per hamburger H110032 hamburgers) H11005$14
2003 ($3 per hot dog H110034 hot dogs) H11001($4 per hamburger H110032 hamburgers) H11005$20
STEP4: CHOOSEONEYEARASABASEYEAR(2001) ANDCOMPUTETHECONSUMER
PRICEINDEXINEACHYEAR
2001 ($8/$8) H11003100 H11005100
2002 ($14/$8) H11003100 H11005175
2003 ($20/$8) H11003100 H11005250
STEP5: USETHECONSUMERPRICEINDEXTOCOMPUTETHEINFLATIONRATEFROM
PREVIOUSYEAR
2002 (175 H11002100)/100 H11003100 H1100575%
2003 (250 H11002175)/175 H11003100 H1100543%
514 PART EIGHT THE DATA OF MACROECONOMICS
services in each year is divided by the price of the basket in the base year,
and this ratio is then multiplied by 100. The resulting number is the
consumer price index.
In the example in the table, the year 2001 is the base year. In this year,
thebasket of hot dogs and hamburgers costs $8. Therefore, the price of the
basket in all years is divided by $8 and multiplied by 100. The consumer
price index is 100 in 2001. (The index is always 100 in the base year.) The
consumer price index is 175 in 2002. This means that the price of the basket
in 2002 is 175 percent of its price in the base year. Put differently, a basket
ofgoods that costs $100 in the base year costs $175 in 2002. Similarly, the
consumer price indexis 250 in 2003, indicating that the price level in 2003
is250 percent of the price level in the base year.
5. Compute the Inflation Rate.The fifth and final step is to use the consumer price
index to calculate the inflation rate,which is the percentage change in the
price index from the preceding period. That is, the inflation rate between two
consecutive years is computed as follows:
inflation rate
the percentage change in the price
index from the preceding period
When constructing the con-
sumer price index, the Bureau
of Labor Statistics tries to
include all the goods and ser-
vices that the typical consumer
buys. Moreover, it tries to
weight these goods and ser-
vices according to how much
consumers buy of each item.
Figure 23-1 shows the
breakdown of consumer spend-
ing into the major categories of
goods and services. By far the
largest category is housing, which makes up 40 percent of
the typical consumer’s budget. This category includes the
cost of shelter (30 percent), fuel and other utilities (5 per-
cent), and household furnishings and operation (5 percent).
The next largest category, at 17 percent, is transportation,
which includes spending on cars, gasoline, buses, subways,
and so on. The next category, at 16 percent, is food and
beverages; this includes food at home (9 percent), food
away from home (6 percent), and alcoholic beverages (1 per-
cent). Next are medical care at 6 percent, recreation at 6
percent, apparel at 5 percent, and education and communi-
cation at 5 percent. This last category includes, for exam-
ple, college tuition and personal computers.
Also included in the figure, at 5 percent of spending, is
a category for other goods and services. This is a catchall
for things consumers buy that do not naturally fit into the
other categories, such as cigarettes, haircuts, and funeral
expenses.
FYI
What Is in the
CPI’s Basket?
16%
Food and
beverages
17%
Transportation
Other goods
and services
Medical care
Apparel
Recreation
5%
6%
5%
5%
6%
40%
Housing
Education and
communication
Figure 23-1
THE TYPICAL BASKET OF GOODS AND SERVICES. This
figure shows how the typical consumer divides his
spending among various categories of goods and services.
The Bureau of Labor Statistics calls each percentage the
“relative importance” of the category.
SOURCE:Bureau of Labor Statistics.
CHAPTER 23 MEASURING THE COST OF LIVING 515
Inflation rate in year 2 H11005H11003100.
In our example, the inflation rate is 75 percent in 2002 and 43 percent in 2003.
Although this example simplifies the real world by including only two goods,
it shows how the Bureau of Labor Statistics (BLS) computes the consumer price
index and the inflation rate. The BLS collects and processes data on the prices of
thousands of goods and services every month and, by following the five foregoing
steps, determines how quickly the cost of living for the typical consumer is rising.
When the bureau makes its monthly announcement of the consumer price index,
you can usually hear the number on the evening television news or see it in the
next day’s newspaper.
In addition to the consumer price index for the overall economy, the BLS cal-
culates several other price indexes. It reports the index for specific regions within
the country (such as Boston, New York, and Los Angeles) and for some narrow
categories of goods and services (such as food, clothing, and energy). It also calcu-
lates the producer price index,which measures the cost of a basket of goods and
services bought by firms rather than consumers. Because firms eventually pass on
their costs to consumers in the form of higher consumer prices, changes in the pro-
ducer price index are often thought to be useful in predicting changes in the con-
sumer price index.
PROBLEMS IN MEASURING THE COST OF LIVING
The goal of the consumer price index is to measure changes in the cost of living. In
other words, the consumer price index tries to gauge how much incomes must rise
in order to maintain a constant standard of living. The consumer price index, how-
ever, is not a perfect measure of the cost of living. Three problems with the index
are widely acknowledged but difficult to solve.
The first problem is called substitution bias.When prices change from one year
to the next, they do not all change proportionately: Some prices rise by more than
others. Consumers respond to these differing price changes by buying less of the
goods whose prices have risen by large amounts and by buying more of the goods
whose prices have risen less or perhaps even have fallen. That is, consumers sub-
stitute toward goods that have become relatively less expensive. Yet the consumer
price index is computed assuming a fixed basket of goods. By not taking into
account the possibility of consumer substitution, the index overstates the increase
in the cost of living from one year to the next.
Let’s consider a simple example. Imagine that in the base year, apples are
cheaper than pears, and so consumers buy more apples than pears. When the
Bureau of Labor Statistics constructs the basket of goods, it will include more
apples than pears. Suppose that next year pears are cheaper than apples. Con-
sumers will naturally respond to the price changes by buying more pears and few-
er apples. Yet, when computing the consumer price index, the Bureau of Labor
Statistics uses a fixed basket, which in essence assumes that consumers continue
buying the now expensive apples in the same quantities as before. For this reason,
the index will measure a much larger increase in the cost of living than consumers
actually experience.
CPI in year 2H11002CPI in year 1
CPI in year 1
producer price index
a measure of the cost of a basket of
goods and services bought by firms
516 PART EIGHT THE DATA OF MACROECONOMICS
The second problem with the consumer price index is the introduction of new
goods.When a new good is introduced, consumers have more variety from which
to choose. Greater variety, in turn, makes each dollar more valuable, so consumers
need fewer dollars to maintain any given standard of living. Yet because the con-
sumer price index is based on a fixed basket of goods and services, it does not
reflect this change in the purchasing power of the dollar.
Again, let’s consider an example. When VCRs were introduced, consumers
were able to watch their favorite movies at home. Compared to going to a movie
theater, the convenience is greater and the cost is less. Aperfect cost-of-living index
would reflect the introduction of the VCR with a decrease in the cost of living. The
consumer price index, however, did not decrease in response to the introduction of
the VCR. Eventually, the Bureau of Labor Statistics did revise the basket of goods
BEHIND EVERY MACROECONOMIC STATISTIC
are thousands of individual pieces of
data on the economy. This article fol-
lows some of the people who collect
these data.
Is the CPI Accurate?
Ask the Federal Sleuths
Who Get the Numbers
BY CHRISTINA DUFF
TRENTON, N.J.—The hospital’s finance
director is relentlessly unhelpful, but she
is still no match for Sabina Bloom, gov-
ernment gumshoe.
Mrs. Bloom wants to know the
exact prices of some hospital services.
“Nothing’s changed,” the woman says.
“Well, do you have the ledger?” Mrs.
Bloom asks. “We haven’t changed any
prices,” the woman insists. Mrs.
Bloom’s fast talk finally pries the woman
from behind her desk, and she gets the
numbers. It turns out that a semiprivate
surgery recovery room now costs
$753.80 a day—or $0.04 less than a
month ago.
Chalk up another small success for
Mrs. Bloom, one of about 300 Bureau of
Labor Statistics employees who gather
the information that is fed into the
monthly Consumer Price Index. . . .
Mrs. Bloom’s travails sometimes
read like a detective novel. Each month,
she covers 900 miles in her beat-up Geo
Prizm (three accidents in the past 18
months) to visit about 150 sites. Her
mission: to record the prices of certain
items, time and again. If prices change,
she needs to find out why. Each month,
some 90,000 prices are shipped to
Washington, plugged into a computer,
scrutinized, aggregated, adjusted for
seasonal ups or downs, and then spit
out as the monthly CPI report.
Choosing what to price—for ex-
ample, the “regular” or “fancy” baby
parakeet—can seem arbitrary. After con-
sulting surveys that track consumer buy-
ing habits, the labor statistics bureau
selects popular stores and item cate-
gories—say, women’s tops. The price-
taker then asks a store employee to help
zero in on an item of the price-taker’s
choosing. They narrow to the size of the
top, its style (short-sleeve, long-sleeve,
tank, or turtleneck), and so on; items
that generate the most revenue in a cat-
egory have the best chance of getting
picked.
Shoppers know that relying on
employees for anything can be chancy.
At a downtown Chicago department
store (the government doesn’t disclose
IN THE NEWS
Shopping for the CPI
THE INTRODUCTION OF NEW PRODUCTS
BIASES THECPI.
CHAPTER 23 MEASURING THE COST OF LIVING 517
to include VCRs, and subsequently the index reflected changes in VCR prices. But
the reduction in the cost of living associated with the initial introduction of the
VCR never showed up in the index.
The third problem with the consumer price index is unmeasured quality change.
If the quality of a good deteriorates from one year to the next, the value of a dollar
falls, even if the price of the good stays the same. Similarly, if the quality rises from
one year to the next, the value of a dollar rises. The Bureau of Labor Statistics does
its best to account for quality change. When the quality of a good in the basket
changes—for example, when a car model has more horsepower or gets better gas
mileage from one year to the next—the BLS adjusts the price of the good to
account for the quality change. It is, in essence, trying to compute the price of a
basket of goods of constant quality. Despite these efforts, changes in quality
remain a problem, because quality is so hard to measure.
names) price-taker Mary Ann Latter
squints at a sale sign above an ivory
shell blouse. “Save 45%–60% when you
take an additional 30% off permanently
reduced merchandise. Markdown taken
at register,” the sign says.
Confused, Ms. Latter asks a clerk
to scan the item. There is a pause. “It’s
30 percent off,” she says, just before
the lunch-hour rush.
“I know,” Ms. Latter says, “but can
you scan it just to make sure?” Under
her breath, she mumbles, “So helpful.”
Downstairs in the jewelry depart-
ment, Ms. Latter tries to price the one
18-inch silver necklace left, but there is
no tag. “Do I have to look it up now?”
moans the employee behind the counter.
Ms. Latter watches her wait on several
customers, then asks again: “Could you
find it?” The harried saleswoman throws
on the counter a thick notebook with a
dizzying array of jewelry sketches. Ms.
Latter finally locates a silver weave that
looks about right.
When the exact item can’t be found,
price-takers must substitute. That can be
difficult. Consider a haircut: If the stylist
leaves, his fill-in must have about the
same experience; a newer stylist, for
example, might charge less. This frigid
winter afternoon, Ms. Latter needs to
substitute a coat because clothing items
rarely remain on the racks for more than
a couple months. It must be a lightweight
swing coat of less than half wool. After
digging through heavy winter wear, trying
to locate tags in three departments on
two floors, she gives up. It is off season
anyway, so she will have to wait months
to choose a substitute.
Making it harder for price detectives
to grasp the true cost of living is that the
master list of 207 categories they
price—called the market basket—is
updated only once every ten years. Cel-
lular phones? Too new to be priced
because they don’t fit into any of the cat-
egories set up in the 1980s. They proba-
bly will be included when the new
categories arrive [next year].
Some changes within these cate-
gories are made every five years. So
within “new cars,” for example, if
domestic autos overtake imports in a
big way, price-takers might examine
more Fords and fewer Toyotas. But that
doesn’t happen often enough, critics
say. Ms. Latter, a city-dwelling Genera-
tion X’er, continually must price “Always
Twenty-One” girdles, yet ignore the new,
popular WonderBras behind her. . . .
Ms. Latter’s colleague in suburban
Chicago, Sheila Ward, must ignore the
hoopla over Tickle Me Elmo and instead
price a GI Joe Extreme doll with “paint-
ed, molded hair.” Reliance on outdated
goods, says Mrs. Ward, “would be one
of the criticisms of us.” She recalls a
music store owner who became frustrat-
ed because she kept seeking prices on a
guitar he could never imagine playing—
much less selling. He finally threw her
out of his shop, screaming, “The
damned government! Is this what I’m
paying taxes for?”
Price-takers can’t do much about
these problems. What they can do is
interrogate. At a simple restaurant, Mrs.
Ward asks if food portions have
changed. The owner says they haven’t.
But she remembers that the price of
bacon has been climbing, and asks again
about his BLT. Suddenly, he recalls that
he has cut the number of bacon slices
from three to two. And that is a very dif-
ferent sandwich.
SOURCE:The Wall Street Journal,January 16, 1997,
p.A1.
518 PART EIGHT THE DATA OF MACROECONOMICS
There is still much debate among economists about how severe these mea-
surement problems are and what should be done about them. The issue is impor-
tant because many government programs use the consumer price index to adjust
for changes in the overall level of prices. Recipients of Social Security, for instance,
get annual increases in benefits that are tied to the consumer price index. Some
economists have suggested modifying these programs to correct for the measure-
ment problems. For example, most studies conclude that the consumer price index
overstates inflation by about 1 percentage point per year (although recent
improvements in the CPI have reduced this upward bias somewhat). In response
to these findings, Congress could change the Social Security program so that ben-
efits increased every year by the measured inflation rate minus 1 percentage point.
Such a change would provide a crude way of offsetting the measurement prob-
lems and, at the same time, reduce government spending by billions of dollars
each year.
ALTHOUGH THE CONSUMER PRICE INDEX
may overstate the true rate of inflation
facing the typical consumer, it may
understate inflation for certain types of
consumers. In particular, according to
some economists, the elderly have
experienced more rapid cost-of-living
increases than the general population.
Prices That
Don’t Fit the Profile:
Is Index Mismatched to
Retirees’ Reality?
BY LAURA CASTANEDA
Low inflation, a driving force behind the
nation’s economic boom, is having the
perverse effect of making life harder for
millions of elderly Americans.
That is because increases in Social
Security payments are based on an infla-
tion index—the Consumer Price Index
for Urban Wage Earners and Clerical
Workers—that may not accurately
reflect their expenses.
Based on that index, monthly Social
Security payments will rise an average of
1.3 percent next year. But the costs that
drain the resources of many retired
people—notably medical treatment, pre-
scription drugs, and special housing—
are rising faster than consumer prices in
general. . . .
Now the Bureau of Labor Statistics,
which calculates the indexes, has
devised an experimental index that does
track some spending habits of older
Americans, and it has shown a widening
gap between cost increases for them
and those for the general population.
Between December 1982 and Septem-
ber 1998, the experimental index rose
73.9 percent, while the official index
rose 63.5 percent, said Patrick Jack-
man, an economist at the bureau. . . .
The official index “is understating
the true rate of inflation for the elderly,”
said Dean Baker, an economist at the
Economic Policy Institute, an indepen-
dent research organization in Washing-
ton, and the disparity is likely to get
worse over time.
But Mr. Baker, the author of
“Getting Prices Right: The Battle Over
the Consumer Price Index,” said older
people’s higher spending on some
goods and services was not the only
reason. The official index also considers
price declines for consumer goods that
they rarely buy, like television sets and
computers.
While Congress balks at the cost,
he added, a separate CPI for the elderly
“would be the way to go” to correct the
problem.
SOURCE:The New York Times,Business Section,
November 8, 1998, p. 10.
IN THE NEWS
ACPI for Senior Citizens
CHAPTER 23 MEASURING THE COST OF LIVING 519
THE GDP DEFLATOR VERSUS THE CONSUMER PRICE INDEX
In the preceding chapter, we examined another measure of the overall level of
prices in the economy—the GDPdeflator. The GDPdeflator is the ratio of nominal
GDPto real GDP. Because nominal GDPis current output valued at current prices
and real GDP is current output valued at base-year prices, the GDP deflator
reflects the current level of prices relative to the level of prices in the base year.
Economists and policymakers monitor both the GDP deflator and the con-
sumer price index to gauge how quickly prices are rising. Usually, these two sta-
tistics tell a similar story. Yet there are two important differences that can cause
them to diverge.
The first difference is that the GDPdeflator reflects the prices of all goods and
services produced domestically,whereas the consumer price index reflects the prices
of all goods and services bought by consumers.For example, suppose that the price
of an airplane produced by Boeing and sold to the Air Force rises. Even though the
plane is part of GDP, it is not part of the basket of goods and services bought by a
typical consumer. Thus, the price increase shows up in the GDPdeflator but not in
the consumer price index.
As another example, suppose that Volvo raises the price of its cars. Because
Volvos are made in Sweden, the car is not part of U.S. GDP. But U.S. consumers
buy Volvos, and so the car is part of the typical consumer’s basket of goods.
Hence, a price increase in an imported consumption good, such as a Volvo, shows
up in the consumer price index but not in the GDPdeflator.
This first difference between the consumer price index and the GDPdeflator
is particularly important when the price of oil changes. Although the United
States does produce some oil, much of the oil we use is imported from the
Middle East. As a result, oil and oil products such as gasoline and heating oil
comprise a much larger share of consumer spending than they do of GDP. When
the price of oil rises, the consumer price index rises by much more than does the
GDPdeflator.
The second and more subtle difference between the GDPdeflator and the con-
sumer price index concerns how various prices are weighted to yield a single
number for the overall level of prices. The consumer price index compares the
price of a fixedbasket of goods and services to the price of the basket in the base
year. Only occasionally does the Bureau of Labor Statistics change the basket of
goods. By contrast, the GDP deflator compares the price of currently produced
goods and services to the price of the same goods and services in the base year.
Thus, the group of goods and services used to compute the GDPdeflator changes
automatically over time. This difference is not important when all prices are
changing proportionately. But if the prices of different goods and services are
changing by varying amounts, the way we weight the various prices matters for
the overall inflation rate.
Figure 23-2 shows the inflation rate as measured by both the GDPdeflator and
the consumer price index for each year since 1965. You can see that sometimes the
two measures diverge. When they do diverge, it is possible to go behind these
numbers and explain the divergence with the two differences we have discussed.
The figure shows, however, that divergence between these two measures is the
exception rather than the rule. In the late 1970s, both the GDPdeflator and the con-
sumer price index show high rates of inflation. In the late 1980s and 1990s, both
measures show low rates of inflation.
520 PART EIGHT THE DATA OF MACROECONOMICS
QUICK QUIZ: Explain briefly what the consumer price index is trying to
measure and how it is constructed.
CORRECTING ECONOMIC VARIABLES FOR THE
EFFECTS OF INFLATION
The purpose of measuring the overall level of prices in the economy is to permit
comparison between dollar figures from different points in time. Now that we
know how price indexes are calculated, let’s see how we might use such an index
to compare a dollar figure from the past to a dollar figure in the present.
DOLLAR FIGURES FROM DIFFERENT TIMES
We first return to the issue of Babe Ruth’s salary. Was his salary of $80,000 in 1931
high or low compared to the salaries of today’s players?
To answer this question, we need to know the level of prices in 1931 and the
level of prices today. Part of the increase in baseball salaries just compensates play-
ers for the higher level of prices today. To compare Ruth’s salary to those of today’s
players, we need to inflate Ruth’s salary to turn 1931 dollars into today’s dollars.
Aprice index determines the size of this inflation correction.
1965
Percent
per Year
15
CPI
GDP deflator
10
5
0
1970 1975 1980 1985 1990 19981995
Figure 23-2
TWO MEASURES OF INFLATION.
This figure shows the inflation
rate—the percentage change in
the level of prices—as measured
by the GDPdeflator and the
consumer price index using
annual data since 1965. Notice
that the two measures of inflation
generally move together.
SOURCE:U.S. Department of Labor; U.S.
Department of Commerce.
”The price may seem a little high,
but youhave to remember that’s
in today’sdollars.”
CHAPTER 23 MEASURING THE COST OF LIVING 521
CASE STUDY MR. INDEX GOES TO HOLLYWOOD
What was the most popular movie of all time? The answer might surprise you.
Movie popularity is usually gauged by box office receipts. By that measure,
Titanic is the No. 1 movie of all time, followed by Star Wars, Star Wars: The
Phantom Menace, and ET. But this ranking ignores an obvious but important
fact: Prices, including the price of movie tickets, have been rising over time.
Whenwe correct box office receipts for the effects of inflation, the story is very
different.
Table 23-2 shows the top ten movies of all time, ranked by inflation-
adjusted box office receipts. The No. 1 movie is Gone with the Wind,which was
released in 1939 and is well ahead of Titanic.In the 1930s, before everyone had
televisions in their homes, about 90 million Americans went to the cinema each
week, compared to about 25 million today. But the movies from that era rarely
show up in popularity rankings because ticket prices were only a quarter. Scar-
lett and Rhett fare a lot better once we correct for the effects of inflation.
Government statistics show a consumer price index of 15.2 for 1931 and 166
for 1999. Thus, the overall level of prices has risen by a factor of 10.9 (which equals
166/15.2). We can use these numbers to measure Ruth’s salary in 1999 dollars. The
calculation is as follows:
Salary in 1999 dollars H11005Salary in 1931 dollars H11003
H11005$80,000 H11003
H11005$873,684.
We find that Babe Ruth’s 1931 salary is equivalent to a salary today of just under
$1 million. That is not a bad income, but it is less than the salary of the average
baseball player today, and it is far less than the amount paid to today’s baseball
superstars. Chicago Cubs hitter Sammy Sosa, for instance, was paid about $10 mil-
lion in 1999.
Let’s also examine President Hoover’s 1931 salary of $75,000. To translate that
figure into 1999 dollars, we again multiply the ratio of the price levels in the two
years. We find that Hoover’s salary is equivalent to $75,000 H11003 (166/15.2), or
$819,079, in 1999 dollars. This is well above President Clinton’s salary of $200,000
(and even above the $400,000 salary that, according to recent legislation, will be
paid to Clinton’s successor). It seems that President Hoover did have a pretty good
year after all.
166
15.2
Price level in 1999
Price level in 1931
INDEXATION
As we have just seen, price indexes are used to correct for the effects of inflation
when comparing dollar figures from different times. This type of correction shows
up in many places in the economy. When some dollar amount is automatically
corrected for inflation by law or contract, the amount is said to be indexedfor
inflation.
indexation
the automatic correction of a dollar
amount for the effects of inflation
bylaw or contract
“FRANKLY, MY DEAR, I DON’T CARE MUCH
FOR THE EFFECTS OF INFLATION.”
522 PART EIGHT THE DATA OF MACROECONOMICS
For example, many long-term contracts between firms and unions include
partial or complete indexation of the wage to the consumer price index. Such a
provision is called a cost-of-living allowance,or COLA. ACOLAautomatically raises
the wage when the consumer price index rises.
Indexation is also a feature of many laws. Social Security benefits, for example,
are adjusted every year to compensate the elderly for increases in prices. The
brackets of the federal income tax—the income levels at which the tax rates
change—are also indexed for inflation. There are, however, many ways in which
the tax system is not indexed for inflation, even when perhaps it should be. We
discuss these issues more fully when we discuss the costs of inflation later in
thisbook.
REAL AND NOMINAL INTEREST RATES
Correcting economic variables for the effects of inflation is particularly important,
and somewhat tricky, when we look at data on interest rates. When you deposit
your savings in a bank account, you will earn interest on your deposit. Converse-
ly, when you borrow from a bank to pay your tuition, you will pay interest on your
student loan. Interest represents a payment in the future for a transfer of money in
the past. As a result, interest rates always involve comparing amounts of money at
different points in time. To fully understand interest rates, we need to know how
to correct for the effects of inflation.
Let’s consider an example. Suppose that Sally Saver deposits $1,000 in a bank
account that pays an annual interest rate of 10 percent. After a year passes, Sally
has accumulated $100 in interest. Sally then withdraws her $1,100. Is Sally $100
richer than she was when she made the deposit a year earlier?
The answer depends on what we mean by “richer.” Sally does have $100 more
than she had before. In other words, the number of dollars has risen by 10 percent.
But if prices have risen at the same time, each dollar now buys less than it did a
year ago. Thus, her purchasing power has not risen by 10 percent. If the inflation
Table 23-2
THE MOST POPULAR MOVIES OF
ALL TIME, INFLATION ADJUSTED
YEAROF TOTALDOMESTICGROSS
FILM RELEASE (INMILLIONSOF1999 DOLLARS)
1. Gone with the Wind 1939 $920
2. Star Wars 1977 798
3. The Sound of Music 1965 638
4. Titanic 1997 601
5. E.T. The Extra-Terrestrial 1982 601
6. The Ten Commandments 1956 587
7. Jaws 1975 574
8. Doctor Zhivago 1965 543
9. The Jungle Book 1967 485
10. Snow White and the Seven Dwarfs 1937 476
SOURCE:The Movie Times, online Web site (www.the-movie-times.com).
CHAPTER 23 MEASURING THE COST OF LIVING 523
rate was 4 percent, then the amount of goods she can buy has increased by only
6 percent. And if the inflation rate was 15 percent, then the price of goods has
increased proportionately more than the number of dollars in her account. In that
case, Sally’s purchasing power has actually fallen by 5 percent.
The interest rate that the bank pays is called the nominal interest rate,and the
interest rate corrected for inflation is called thereal interest rate.We can write the
relationship among the nominal interest rate, the real interest rate, and inflation as
follows:
Real interest rate H11005Nominal interest rateH11002 Inflation rate.
The real interest rate is the difference between the nominal interest rate and the
rate of inflation. The nominal interest rate tells you how fast the number of dollars
in your bank account rises over time. The real interest rate tells you how fast the
purchasing power of your bank account rises over time.
Figure 23-3 shows real and nominal interest rates since 1965. The nominal
interest rate is the interest rate on three-month Treasury bills. The real interest rate
is computed by subtracting inflation—the percentage change in the consumer
price index—from this nominal interest rate.
You can see that real and nominal interest rates do not always move together.
For example, in the late 1970s, nominal interest rates were high. But because infla-
tion was very high, real interest rates were low. Indeed, in some years, real interest
rates were negative, for inflation eroded people’s savings more quickly than nom-
inal interest payments increased them. By contrast, in the late 1990s, nominal inter-
est rates were low. But because inflation was also low, real interest rates were
relatively high. In the coming chapters, when we study the causes and effects of
nominal interest rate
the interest rate as usually reported
without a correction for the effects
ofinflation
real interest rate
the interest rate corrected for the
effects of inflation
1965
Interest Rates
(percent
per year)
15
Real interest rate
10
5
0
H110025
1970 1975 1980 1985 1990 1995 1998
Nominal interest rate
Figure 23-3
REAL AND NOMINAL
INTEREST RATES. This figure
shows nominal and real interest
rates using annual data since
1965. The nominal interest rate
is the rate on a three-month
Treasury bill. The real interest
rate is the nominal interest rate
minus the inflation rate as
measured by the consumer price
index. Notice that nominal and
real interest rates often do not
move together.
SOURCE:U.S. Department of Labor;
U.S.Department of Treasury.
524 PART EIGHT THE DATA OF MACROECONOMICS
changes in interest rates, it will be important for us to keep in mind the distinction
between real and nominal interest rates.
QUICK QUIZ: Henry Ford paid his workers $5 a day in 1914. If the
consumer price index was 10 in 1914 and 166 in 1999, how much was the Ford
paycheck worth in 1999 dollars?
CONCLUSION
“Anickel ain’t worth a dime anymore,” baseball player Yogi Berra once quipped.
Indeed, throughout recent history, the real values behind the nickel, the dime, and
the dollar have not been stable. Persistent increases in the overall level of prices
have been the norm. Such inflation reduces the purchasing power of each unit of
money over time. When comparing dollar figures from different times, it is impor-
tant to keep in mind that a dollar today is not the same as a dollar 20 years ago or,
most likely, 20 years from now.
This chapter has discussed how economists measure the overall level of prices
in the economy and how they use price indexes to correct economic variables for
the effects of inflation. This analysis is only a starting point. We have not yet exam-
ined the causes and effects of inflation or how inflation interacts with other eco-
nomic variables. To do that, we need to go beyond issues of measurement. Indeed,
that is our next task. Having explained how economists measure macroeconomic
quantities and prices in the past two chapters, we are now ready to develop the
models that explain long-run and short-run movements in these variables.
Summary
a78 The consumer price index shows the cost of a basket of
goods and services relative to the cost of the same
basket in the base year. The index is used to measure the
overall level of prices in the economy. The percentage
change in the consumer price index measures the
inflation rate.
a78 The consumer price index is an imperfect measure of the
cost of living for three reasons. First, it does not take
into account consumers’ ability to substitute toward
goods that become relatively cheaper over time. Second,
it does not take into account increases in the purchasing
power of the dollar due to the introduction of new
goods. Third, it is distorted by unmeasured changes in
the quality of goods and services. Because of these
measurement problems, the CPI overstates annual
inflation by about 1 percentage point.
a78 Although the GDPdeflator also measures the overall
level of prices in the economy, it differs from the
consumer price index because it includes goods and
services produced rather than goods and services
consumed. As a result, imported goods affect the
consumer price index but not the GDPdeflator. In
addition, whereas the consumer price index uses a
fixedbasket of goods, the GDPdeflator automatically
changes the group of goods and services over time as
the composition of GDPchanges.
a78 Dollar figures from different points in time do not
represent a valid comparison of purchasing power. To
compare a dollar figure from the past to a dollar figure
today, the older figure should be inflated using a price
index.
CHAPTER 23 MEASURING THE COST OF LIVING 525
a78 Various laws and private contracts use price indexes to
correct for the effects of inflation. The tax laws, however,
are only partially indexed for inflation.
a78 Acorrection for inflation is especially important when
looking at data on interest rates. The nominal interest
rate is the interest rate usually reported; it is the rate at
which the number of dollars in a savings account
increases over time. By contrast, the real interest rate
takes into account changes in the value of the dollar
over time. The real interest rate equals the nominal
interest rate minus the rate of inflation.
consumer price index (CPI), p. 512
inflation rate, p. 514
producer price index, p. 515
indexation, p. 521
nominal interest rate, p. 523
real interest rate, p. 523
1. Which do you think has a greater effect on the consumer
price index: a 10 percent increase in the price of chicken
or a 10 percent increase in the price of caviar? Why?
2. Describe the three problems that make the consumer
price index an imperfect measure of the cost of living.
3. If the price of a Navy submarine rises, is the consumer
price index or the GDPdeflator affected more? Why?
4. Over a long period of time, the price of a candy bar rose
from $0.10 to $0.60. Over the same period, the consumer
price index rose from 150 to 300. Adjusted for overall
inflation, how much did the price of the candy bar
change?
5. Explain the meaning of nominal interest rateand real
interest rate.How are they related?
Key Concepts
Questions for Review
1. Suppose that people consume only three goods, as
shown in this table:
TENNIS TENNIS
BALLS RACQUETS GATORADE
2001 price $2 $40 $1
2001 quantity 100 10 200
2002 price $2 $60 $2
2002 quantity 100 10 200
a. What is the percentage change in the price of each
of the three goods? What is the percentage change
in the overall price level?
b. Do tennis racquets become more or less expensive
relative to Gatorade? Does the well-being of some
people change relative to the well-being of others?
Explain.
2. Suppose that the residents of Vegopia spend all of their
income on cauliflower, broccoli, and carrots. In 2001
they buy 100 heads of cauliflower for $200, 50 bunches
of broccoli for $75, and 500 carrots for $50. In 2002 they
buy 75 heads of cauliflower for $225, 80 bunches of
broccoli for $120, and 500 carrots for $100. If the base
year is 2001, what is the CPI in both years? What is the
inflation rate in 2002?
3. From 1947 to 1997 the consumer price index in the
United States rose 637 percent. Use this fact to adjust
each of the following 1947 prices for the effects of
inflation. Which items cost less in 1997 than in 1947 after
adjusting for inflation? Which items cost more?
ITEM 1947 PRICE 1997 PRICE
University of Iowa tuition $130 $2,470
Gallon of gasoline $0.23 $1.22
Three-minute phone call
from New York to L.A. $2.50 $0.45
One-day hospital stay in
intensive care unit $35 $2,300
McDonald’s hamburger $0.15 $0.59
Problems and Applications
526 PART EIGHT THE DATA OF MACROECONOMICS
4. Beginning in 1994, environmental regulations have
required that gasoline contain a new additive to reduce
air pollution. This requirement raised the cost of
gasoline. The Bureau of Labor Statistics (BLS) decided
that this increase in cost represented an improvement in
quality.
a. Given this decision, did the increased cost of
gasoline raise the CPI?
b. What is the argument in favor of the BLS’s
decision? What is the argument for a different
decision?
5. Which of the problems in the construction of the CPI
might be illustrated by each of the following situations?
Explain.
a. the invention of the Sony Walkman
b. the introduction of air bags in cars
c. increased personal computer purchases in response
to a decline in their price
d. more scoops of raisins in each package of Raisin
Bran
e. greater use of fuel-efficient cars after gasoline prices
increase
6. The New York Timescost $0.15 in 1970 and $0.75 in 1999.
The average wage in manufacturing was $3.35 per hour
in 1970 and $13.84 in 1999.
a. By what percentage did the price of a newspaper
rise?
b. By what percentage did the wage rise?
c. In each year, how many minutes does a worker
have to work to earn enough to buy a newspaper?
d. Did workers’ purchasing power in terms of
newspapers rise or fall?
7. The chapter explains that Social Security benefits are
increased each year in proportion to the increase in the
CPI, even though most economists believe that the CPI
overstates actual inflation.
a. If the elderly consume the same market basket as
other people, does Social Security provide the
elderly with an improvement in their standard of
living each year? Explain.
b. In fact, the elderly consume more health care than
younger people, and health care costs have risen
faster than overall inflation. What would you do to
determine whether the elderly are actually better
off from year to year?
8. How do you think the basket of goods and services you
buy differs from the basket bought by the typical U.S.
household? Do you think you face a higher or lower
inflation rate than is indicated by the CPI? Why?
9. Income tax brackets were not indexed until 1985. When
inflation pushed up people’s nominal incomes during
the 1970s, what do you think happened to real tax
revenue? (Hint: This phenomenon was known as
“bracket creep.”)
10. When deciding how much of their income to save for
retirement, should workers consider the real or the
nominal interest rate that their savings will earn?
Explain.
11. Suppose that a borrower and a lender agree on the
nominal interest rate to be paid on a loan. Then inflation
turns out to be higher than they both expected.
a. Is the real interest rate on this loan higher or lower
than expected?
b. Does the lender gain or lose from this unexpectedly
high inflation? Does the borrower gain or lose?
c. Inflation during the 1970s was much higher than
most people had expected when the decade began.
How did this affect homeowners who obtained
fixed-rate mortgages during the 1960s? How did
itaffect the banks who lent the money?
Examine how a
country’s policies
influence its
productivity growth
Consider why
productivity is the
key determinant
of a country’s
standard of living
IN THIS CHAPTER
YOU WILL . . .
See how economic
growth differs
around the world
Analyze the factors
that determine
a country’s
productivityWhen you travel around the world, you see tremendous variation in the standard
of living. The average person in a rich country, such as the United States, Japan, or
Germany, has an income more than ten times as high as the average person in a
poor country, such as India, Indonesia, or Nigeria. These large differences in
income are reflected in large differences in the quality of life. Richer countries have
more automobiles, more telephones, more televisions, better nutrition, safer hous-
ing, better health care, and longer life expectancy.
Even within a country, there are large changes in the standard of living over
time. In the United States over the past century, average income as measured by
real GDPper person has grown by about 2 percent per year. Although 2 percent
might seem small, this rate of growth implies that average income doubles every
35 years. Because of this growth, average income today is about eight times as high
as average income a century ago. As a result, the typical American enjoys much
PRODUCTION AND GROWTH
529
530 PART NINE THE REAL ECONOMY IN THE LONG RUN
greater economic prosperity than did his or her parents, grandparents, and great-
grandparents.
Growth rates vary substantially from country to country. In some East Asian
countries, such as Singapore, South Korea, and Taiwan, average income has risen
about 7 percent per year in recent decades. At this rate, average income doubles
every ten years. These countries have, in the length of one generation, gone from
being among the poorest in the world to being among the richest. By contrast, in
some African countries, such as Chad, Ethiopia, and Nigeria, average income has
been stagnant for many years.
What explains these diverse experiences? How can the rich countries be sure
to maintain their high standard of living? What policies should the poor countries
pursue to promote more rapid growth in order to join the developed world? These
are among the most important questions in macroeconomics. As economist Robert
Lucas put it, “The consequences for human welfare in questions like these are sim-
ply staggering: Once one starts to think about them, it is hard to think about any-
thing else.”
In the previous two chapters we discussed how economists measure macro-
economic quantities and prices. In this chapter we start studying the forces that
determine these variables. As we have seen, an economy’s gross domestic product
(GDP) measures both the total income earned in the economy and the total expen-
diture on the economy’s output of goods and services. The level of real GDPis a
good gauge of economic prosperity, and the growth of real GDPis a good gauge of
economic progress. Here we focus on the long-run determinants of the level and
growth of real GDP. Later in this book we study the short-run fluctuations of real
GDParound its long-run trend.
We proceed here in three steps. First, we examine international data on real
GDPper person. These data will give you some sense of how much the level and
growth of living standards vary around the world. Second, we examine the role of
productivity—the amount of goods and services produced for each hour of a work-
er’s time. In particular, we see that a nation’s standard of living is determined by
the productivity of its workers, and we consider the factors that determine a
nation’s productivity. Third, we consider the link between productivity and the
economic policies that a nation pursues.
ECONOMIC GROWTH AROUND THE WORLD
As a starting point for our study of long-run growth, let’s look at the experiences
of some of the world’s economies. Table 24-1 shows data on real GDPper person
for 13 countries. For each country, the data cover about a century of history. The
first and second columns of the table present the countries and time periods. (The
time periods differ somewhat from country to country because of differences in
data availability.) The third and fourth columns show estimates of real GDPper
person about a century ago and for a recent year.
The data on real GDPper person show that living standards vary widely from
country to country. Income per person in the United States, for instance, is about 8
times that in China and about 15 times that in India. The poorest countries have
average levels of income that have not been seen in the United States for many
CHAPTER 24 PRODUCTION AND GROWTH 531
decades. The typical citizen of China in 1997 had about as much real income as the
typical American in 1870. The typical person in Pakistan in 1997 had about one-
half the real income of a typical American a century ago.
The last column of the table shows each country’s growth rate. The growth
rate measures how rapidly real GDP per person grew in the typical year. In the
United States, for example, real GDPper person was $3,188 in 1870 and $28,740 in
1997. The growth rate was 1.75 percent per year. This means that if real GDPper
person, beginning at $3,188, were to increase by 1.75 percent for each of 127 years,
it would end up at $28,740. Of course, real GDPper person did not actually rise
exactly 1.75 percent every year: Some years it rose by more and other years by less.
The growth rate of 1.75 percent per year ignores short-run fluctuations around the
long-run trend and represents an average rate of growth for real GDPper person
over many years.
The countries in Table 24-1 are ordered by their growth rate from the most to
the least rapid. Japan tops the list, with a growth rate of 2.82 percent per year. A
hundred years ago, Japan was not a rich country. Japan’s average income was only
somewhat higher than Mexico’s, and it was well behind Argentina’s. To put the
issue another way, Japan’s income in 1890 was less than India’s income in 1997.
But because of its spectacular growth, Japan is now an economic superpower, with
average income only slightly behind that of the United States. At the bottom of the
list of countries is Bangladesh, which has experienced growth of only 0.78 percent
per year over the past century. As a result, the typical resident of Bangladesh con-
tinues to live in abject poverty.
Because of differences in growth rates, the ranking of countries by income
changes substantially over time. As we have seen, Japan is a country that has risen
Table 24-1
REALGDP PERPERSON REALGDP PERPERSON GROWTHRATE
COUNTRY PERIOD ATBEGINNING OFPERIOD
a
AT END OFPERIOD
a
PER YEAR
Japan 1890–1997 $1,196 $23,400 2.82%
Brazil 1900–1997 619 6,240 2.41
Mexico 1900–1997 922 8,120 2.27
Germany 1870–1997 1,738 21,300 1.99
Canada 1870–1997 1,890 21,860 1.95
China 1900–1997 570 3,570 1.91
Argentina 1900–1997 1,824 9,950 1.76
United States 1870–1997 3,188 28,740 1.75
Indonesia 1900–1997 708 3,450 1.65
India 1900–1997 537 1,950 1.34
United Kingdom 1870–1997 3,826 20,520 1.33
Pakistan 1900–1997 587 1,590 1.03
Bangladesh 1900–1997 495 1,050 0.78
a
Real GDPis measured in 1997 dollars.
SOURCE:Robert J. Barro and Xavier Sala-i-Martin, Economic Growth(New York: McGraw-Hill, 1995), tables 10.2 and 10.3; World Development Report
1998/99,table 1; and author’s calculations.
THE VARIETY OF GROWTH EXPERIENCES
532 PART NINE THE REAL ECONOMY IN THE LONG RUN
relative to others. One country that has fallen behind is the United Kingdom. In
1870, the United Kingdom was the richest country in the world, with average
income about 20 percent higher than that of the United States and about twice that
of Canada. Today, average income in the United Kingdom is below average
income in its two former colonies.
These data show that the world’s richest countries have no guarantee they will
stay the richest and that the world’s poorest countries are not doomed forever to
remain in poverty. But what explains these changes over time? Why do some
countries zoom ahead while others lag behind? These are precisely the questions
that we take up next.
QUICK QUIZ: What is the approximate growth rate of real GDPper person
in the United States? Name a country that has had faster growth and a country
that has had slower growth.
PRODUCTIVITY: ITS ROLE AND DETERMINANTS
Explaining the large variation in living standards around the world is, in one
sense, very easy. As we will see, the explanation can be summarized in a single
word—productivity. But, in another sense, the international variation is deeply
It may be tempting to dismiss
differences in growth rates as
insignificant. If one country
grows at 1 percent while anoth-
er grows at 3 percent, so what?
What difference can 2 percent
make?
The answer is: a big differ-
ence. Even growth rates that
seem small when written in per-
centage terms seem large after
they are compounded for many
years. Compounding refers to
the accumulation of a growth
rate over a period of time.
Consider an example. Suppose that two college gradu-
ates—Jerry and Elaine—both take their first jobs at the age
of 22 earning $30,000 a year. Jerry lives in an economy
where all incomes grow at 1 percent per year, while Elaine
lives in one where incomes grow at 3 percent per year.
Straightforward calculations show what happens. Forty
years later, when both are 62 years old, Jerry earns
$45,000 a year, while Elaine earns $98,000. Because of
that difference of 2 percentage points in the growth rate,
Elaine’s salary is more than twice Jerry’s.
An old rule of thumb, called the rule of 70, is helpful in
understanding growth rates and the effects of compounding.
According to the rule of 70, if some variable grows at a rate
of x percent per year, then that variable doubles in approxi-
mately 70/x years. In Jerry’s economy, incomes grow at 1
percent per year, so it takes about 70 years for incomes to
double. In Elaine’s economy, incomes grow at 3 percent per
year, so it takes about 70/3, or 23, years for incomes to
double.
The rule of 70 applies not only to a growing economy
but also to a growing savings account. Here is an example:
In 1791, Ben Franklin died and left $5,000 to be invested
for a period of 200 years to benefit medical students and
scientific research. If this money had earned 7 percent per
year (which would, in fact, have been very possible to do),
the investment would have doubled in value every 10 years.
Over 200 years, it would have doubled 20 times. At the end
of 200 years of compounding, the investment would have
been worth 2
20
H11003$5,000, which is about $5 billion. (In fact,
Franklin’s $5,000 grew to only $2 million over 200 years
because some of the money was spent along the way.)
As these examples show, growth rates compounded
over many years can lead to some spectacular results. That
is probably why Albert Einstein once called compounding
“the greatest mathematical discovery of all time.”
FYI
The Magic of
Compounding
and the
Rule of 70
CHAPTER 24 PRODUCTION AND GROWTH 533
puzzling. To explain why incomes are so much higher in some countries than in
others, we must look at the many factors that determine a nation’s productivity.
WHY PRODUCTIVITY IS SO IMPORTANT
Let’s begin our study of productivity and economic growth by developing a sim-
ple model based loosely on Daniel DeFoe’s famous novel Robinson Crusoe. Robin-
son Crusoe, as you may recall, is a sailor stranded on a desert island. Because
Crusoe lives alone, he catches his own fish, grows his own vegetables, and makes
his own clothes. We can think of Crusoe’s activities—his production and con-
sumption of fish, vegetables, and clothing—as being a simple economy. By exam-
ining Crusoe’s economy, we can learn some lessons that also apply to more
complex and realistic economies.
What determines Crusoe’s standard of living? The answer is obvious. If Cru-
soe is good at catching fish, growing vegetables, and making clothes, he lives well.
If he is bad at doing these things, he lives poorly. Because Crusoe gets to consume
only what he produces, his living standard is tied to his productive ability.
The term productivityrefers to the quantity of goods and services that a work-
er can produce for each hour of work. In the case of Crusoe’s economy, it is easy to
see that productivity is the key determinant of living standards and that growth in
productivity is the key determinant of growth in living standards. The more fish
Crusoe can catch per hour, the more he eats at dinner. If Crusoe finds a better place
to catch fish, his productivity rises. This increase in productivity makes Crusoe
better off: He could eat the extra fish, or he could spend less time fishing and
devote more time to making other goods he enjoys.
The key role of productivity in determining living standards is as true for
nations as it is for stranded sailors. Recall that an economy’s gross domestic prod-
uct (GDP) measures two things at once: the total income earned by everyone in the
economy and the total expenditure on the economy’s output of goods and ser-
vices. The reason why GDPcan measure these two things simultaneously is that,
for the economy as a whole, they must be equal. Put simply, an economy’s income
is the economy’s output.
Like Crusoe, a nation can enjoy a high standard of living only if it can produce
a large quantity of goods and services. Americans live better than Nigerians
because American workers are more productive than Nigerian workers. The
Japanese have enjoyed more rapid growth in living standards than Argentineans
because Japanese workers have experienced more rapidly growing productivity.
Indeed, one of the Ten Principles of Economicsin Chapter 1 is that a country’s stan-
dard of living depends on its ability to produce goods and services.
Hence, to understand the large differences in living standards we observe
across countries or over time, we must focus on the production of goods and ser-
vices. But seeing the link between living standards and productivity is only the
first step. It leads naturally to the next question: Why are some economies so much
better at producing goods and services than others?
HOW PRODUCTIVITY IS DETERMINED
Although productivity is uniquely important in determining Robinson Crusoe’s
standard of living, many factors determine Crusoe’s productivity. Crusoe will be
productivity
the amount of goods and services
produced from each hour of a
worker’s time
534 PART NINE THE REAL ECONOMY IN THE LONG RUN
better at catching fish, for instance, if he has more fishing poles, if he has been
trained in the best fishing techniques, if his island has a plentiful fish supply, and
if he invents a better fishing lure. Each of these determinants of Crusoe’s pro-
ductivity—which we can call physical capital, human capital, natural resources, and
technological knowledge—has a counterpart in more complex and realistic
economies. Let’s consider each of these factors in turn.
Physical Capital Workers are more productive if they have tools with
which to work. The stock of equipment and structures that are used to produce
goods and services is called physical capital, or just capital. For example, when
woodworkers make furniture, they use saws, lathes, and drill presses. More tools
allow work to be done more quickly and more accurately. That is, a worker with
only basic hand tools can make less furniture each week than a worker with
sophisticated and specialized woodworking equipment.
As you may recall from Chapter 2, the inputs used to produce goods and ser-
vices—labor, capital, and so on—are called the factors of production.An important
feature of capital is that it is a produced factor of production. That is, capital is an
input into the production process that in the past was an output from the produc-
tion process. The woodworker uses a lathe to make the leg of a table. Earlier the
lathe itself was the output of a firm that manufactures lathes. The lathe manu-
facturer in turn used other equipment to make its product. Thus, capital is a factor
of production used to produce all kinds of goods and services, including more
capital.
Human Capital A second determinant of productivity is human capital.
Human capitalis the economist’s term for the knowledge and skills that workers
acquire through education, training, and experience. Human capital includes the
skills accumulated in early childhood programs, grade school, high school, col-
lege, and on-the-job training for adults in the labor force.
Although education, training, and experience are less tangible than lathes,
bulldozers, and buildings, human capital is like physical capital in many ways.
Like physical capital, human capital raises a nation’s ability to produce goods and
services. Also like physical capital, human capital is a produced factor of pro-
duction. Producing human capital requires inputs in the form of teachers, libraries,
and student time. Indeed, students can be viewed as “workers” who have the im-
portant job of producing the human capital that will be used in future production.
Natural Resources A third determinant of productivity is natural
resources. Natural resources are inputs into production that are provided by
nature, such as land, rivers, and mineral deposits. Natural resources take two
forms: renewable and nonrenewable. A forest is an example of a renewable
resource. When one tree is cut down, a seedling can be planted in its place to be
harvested in the future. Oil is an example of a nonrenewable resource. Because oil
is produced by nature over many thousands of years, there is only a limited sup-
ply. Once the supply of oil is depleted, it is impossible to create more.
Differences in natural resources are responsible for some of the differences in
standards of living around the world. The historical success of the United States
was driven in part by the large supply of land well suited for agriculture. Today,
some countries in the Middle East, such as Kuwait and Saudi Arabia, are rich
physical capital
the stock of equipment and
structures that are used to produce
goods and services
human capital
the knowledge and skills that
workers acquire through education,
training, and experience
natural resources
the inputs into the production of
goods and services that are provided
by nature, such as land, rivers, and
mineral deposits
CHAPTER 24 PRODUCTION AND GROWTH 535
simply because they happen to be on top of some of the largest pools of oil in the
world.
Although natural resources can be important, they are not necessary for an
economy to be highly productive in producing goods and services. Japan, for
instance, is one of the richest countries in the world, despite having few natural
resources. International trade makes Japan’s success possible. Japan imports many
of the natural resources it needs, such as oil, and exports its manufactured goods
to economies rich in natural resources.
Technological Knowledge Afourth determinant of productivity is tech-
nological knowledge—the understanding of the best ways to produce goods and
services. Ahundred years ago, most Americans worked on farms, because farm
technology required a high input of labor in order to feed the entire population.
Today, thanks to advances in the technology of farming, a small fraction of the
population can produce enough food to feed the entire country. This technological
change made labor available to produce other goods and services.
Technological knowledge takes many forms. Some technology is common
knowledge—after it becomes used by one person, everyone becomes aware of it.
For example, once Henry Ford successfully introduced production in assembly
lines, other carmakers quickly followed suit. Other technology is proprietary—it is
known only by the company that discovers it. Only the Coca-Cola Company, for
instance, knows the secret recipe for making its famous soft drink. Still other tech-
nology is proprietary for a short time. When a pharmaceutical company discovers
a new drug, the patent system gives that company a temporary right to be the
technological knowledge
society’s understanding of the best
ways to produce goods and services
Economists often use a pro-
duction function to describe the
relationship between the quan-
tity of inputs used in production
and the quantity of output from
production. For example, sup-
pose Y denotes the quantity of
output, L the quantity of labor,
K the quantity of physical capi-
tal, H the quantity of human
capital, and N the quantity of
natural resources. Then we
might write
YH11005A F(L, K, H, N),
where F( ) is a function that shows how the inputs are com-
bined to produce output. A is a variable that reflects the
available production technology. As technology improves, A
rises, so the economy produces more output from any given
combination of inputs.
Many production functions have a property called con-
stant returns to scale. If a production function has constant
returns to scale, then a doubling of all the inputs causes the
amount of output to double as well. Mathematically, we
write that a production function has constant returns to
scale if, for any positive number x,
xY H11005 AF(xL, xK, xH, xN).
A doubling of all inputs is represented in this equation by
x = 2. The right-hand side shows the inputs doubling, and
the left-hand side shows output doubling.
Production functions with constant returns to scale
have an interesting implication. To see what it is, set x =
1/L. Then the equation above becomes
Y/L H11005 AF(1, K/L, H/L, N/L).
Notice that Y/L is output per worker, which is a measure of
productivity. This equation says that productivity depends on
physical capital per worker (K/L), human capital per worker
(H/L), and natural resources per worker (N/L). Productivity
also depends on the state of technology, as reflected by the
variable A. Thus, this equation provides a mathematical
summary of the four determinants of productivity we have
just discussed.
FYI
The Production
Function
536 PART NINE THE REAL ECONOMY IN THE LONG RUN
CASE STUDY ARE NATURAL RESOURCES
A LIMIT TO GROWTH?
The world’s population is far larger today than it was a century ago, and many
people are enjoying a much higher standard of living. Aperennial debate con-
cerns whether this growth in population and living standards can continue in
the future.
Many commentators have argued that natural resources provide a limit to
how much the world’s economies can grow. At first, this argument might seem
hard to ignore. If the world has only a fixed supply of nonrenewable natural
resources, how can population, production, and living standards continue to
grow over time? Eventually, won’t supplies of oil and minerals start to run out?
When these shortages start to occur, won’t they stop economic growth and, per-
haps, even force living standards to fall?
Despite the apparent appeal of such arguments, most economists are less
concerned about such limits to growth than one might guess. They argue that
technological progress often yields ways to avoid these limits. If we compare
the economy today to the economy of the past, we see various ways in which
the use of natural resources has improved. Modern cars have better gas
mileage. New houses have better insulation and require less energy to heat and
cool them. More efficient oil rigs waste less oil in the process of extraction. Recy-
cling allows some nonrenewable resources to be reused. The development of
alternative fuels, such as ethanol instead of gasoline, allows us to substitute
renewable for nonrenewable resources.
Fifty years ago, some conservationists were concerned about the excessive
use of tin and copper. At the time, these were crucial commodities: Tin was used
to make many food containers, and copper was used to make telephone wire.
Some people advocated mandatory recycling and rationing of tin and copper so
that supplies would be available for future generations. Today, however, plastic
has replaced tin as a material for making many food containers, and phone calls
often travel over fiber-optic cables, which are made from sand. Technological
progress has made once crucial natural resources less necessary.
But are all these efforts enough to permit continued economic growth? One
way to answer this question is to look at the prices of natural resources. In a
market economy, scarcity is reflected in market prices. If the world were run-
ning out of natural resources, then the prices of those resources would be rising
exclusive manufacturer of this particular drug. When the patent expires, however,
other companies are allowed to make the drug. All these forms of technological
knowledge are important for the economy’s production of goods and services.
It is worthwhile to distinguish between technological knowledge and human
capital. Although they are closely related, there is an important difference. Tech-
nological knowledge refers to society’s understanding about how the world
works. Human capital refers to the resources expended transmitting this under-
standing to the labor force. To use a relevant metaphor, knowledge is the quality of
society’s textbooks, whereas human capital is the amount of time that the popula-
tion has devoted to reading them. Workers’ productivity depends on both the
quality of textbooks they have available and the amount of time they have spent
studying them.
CHAPTER 24 PRODUCTION AND GROWTH 537
over time. But, in fact, the opposite is more nearly true. The prices of most nat-
ural resources (adjusted for overall inflation) are stable or falling. It appears that
our ability to conserve these resources is growing more rapidly than their sup-
plies are dwindling. Market prices give no reason to believe that natural
resources are a limit to economic growth.
QUICK QUIZ: List and describe four determinants of a country’s
productivity.
ECONOMIC GROWTH AND PUBLIC POLICY
So far, we have determined that a society’s standard of living depends on its abili-
ty to produce goods and services and that its productivity depends on physical
capital, human capital, natural resources, and technological knowledge. Let’s now
turn to the question faced by policymakers around the world: What can govern-
ment policy do to raise productivity and living standards?
THE IMPORTANCE OF SAVING AND INVESTMENT
Because capital is a produced factor of production, a society can change the
amount of capital it has. If today the economy produces a large quantity of new
capital goods, then tomorrow it will have a larger stock of capital and be able to
produce more of all types of goods and services. Thus, one way to raise future pro-
ductivity is to invest more current resources in the production of capital.
One of the Ten Principles of Economicspresented in Chapter 1 is that people face
tradeoffs. This principle is especially important when considering the accumula-
tion of capital. Because resources are scarce, devoting more resources to producing
capital requires devoting fewer resources to producing goods and services for cur-
rent consumption. That is, for society to invest more in capital, it must consume
less and save more of its current income. The growth that arises from capital accu-
mulation is not a free lunch: It requires that society sacrifice consumption of goods
and services in the present in order to enjoy higher consumption in the future.
TECHNOLOGICAL PROGRESS LEADS TO
NEW PRODUCTS, SUCH AS THIS HYBRID
ELECTRIC/GAS-POWERED CAR, THAT
REDUCE OUR DEPENDENCE ON
NONRENEWABLE RESOURCES.
538 PART NINE THE REAL ECONOMY IN THE LONG RUN
The next chapter examines in more detail how the economy’s financial mar-
kets coordinate saving and investment. It also examines how government policies
influence the amount of saving and investment that takes place. At this point it is
important to note that encouraging saving and investment is one way that a gov-
ernment can encourage growth and, in the long run, raise the economy’s standard
of living.
To see the importance of investment for economic growth, consider Figure
24-1, which displays data on 15 countries. Panel (a) shows each country’s growth
rate over a 31-year period. The countries are ordered by their growth rates, from
most to least rapid. Panel (b) shows the percentage of GDP that each country
devotes to investment. The correlation between growth and investment, although
not perfect, is strong. Countries that devote a large share of GDP to investment,
such as Singapore and Japan, tend to have high growth rates. Countries that
devote a small share of GDPto investment, such as Rwanda and Bangladesh, tend
to have low growth rates. Studies that examine a more comprehensive list of coun-
tries confirm this strong correlation between investment and growth.
There is, however, a problem in interpreting these data. As the appendix
to Chapter 2 discussed, a correlation between two variables does not establish
whichvariable is the cause and which is the effect. It is possible that high invest-
ment causes high growth, but it is also possible that high growth causes high
(a) Growth Rate 1960–1991 (b) Investment 1960–1991
South Korea
Singapore
Japan
Israel
Canada
Brazil
West Germany
Mexico
United Kingdom
Nigeria
United States
India
Bangladesh
Chile
Rwanda
South Korea
Singapore
Japan
Israel
Canada
Brazil
West Germany
Mexico
United Kingdom
Nigeria
United States
India
Bangladesh
Chile
Rwanda
Investment (percent of GDP)Growth Rate (percent)
01234567 0 10203040
Figure 24-1
GROWTH AND INVESTMENT. Panel (a) shows the growth rateof GDPper person for
15countries over the period from 1960 to 1991. Panel (b) shows the percentage of GDP
that each country devoted to investment over this period. The figure shows that
investment and growth are positively correlated.
CHAPTER 24 PRODUCTION AND GROWTH 539
investment. (Or, perhaps, high growth and high investment are both caused by a
third variable that has been omitted from the analysis.) The data by themselves
cannot tell us the direction of causation. Nonetheless, because capital accumula-
tion affects productivity so clearly and directly, many economists interpret these
data as showing that high investment leads to more rapid economic growth.
DIMINISHING RETURNS AND THE CATCH-UP EFFECT
Suppose that a government, convinced by the evidence in Figure 24-1, pursues
policies that raise the nation’s saving rate—the percentage of GDP devoted to
saving rather than consumption. What happens? With the nation saving more,
fewer resources are needed to make consumption goods, and more resources are
available to make capital goods. As a result, the capital stock increases, leading to
rising productivity and more rapid growth in GDP. But how long does this higher
rate of growth last? Assuming that the saving rate remains at its new higher level,
does the growth rate of GDPstay high indefinitely or only for a period of time?
The traditional view of the production process is that capital is subject to
diminishing returns:As the stock of capital rises, the extra output produced from
an additional unit of capital falls. In other words, when workers already have a
large quantity of capital to use in producing goods and services, giving them an
additional unit of capital increases their productivity only slightly. Because of
diminishing returns, an increase in the saving rate leads to higher growth only for
a while. As the higher saving rate allows more capital to be accumulated, the ben-
efits from additional capital become smaller over time, and so growth slows down.
In the long run, the higher saving rate leads to a higher level of productivity and income,
but not to higher growth in these variables.Reaching this long run, however, can take
quite a while. According to studies of international data on economic growth,
increasing the saving rate can lead to substantially higher growth for a period of
several decades.
The diminishing returns to capital has another important implication: Other
things equal, it is easier for a country to grow fast if it starts out relatively poor.
This effect of initial conditions on subsequent growth is sometimes called the
catch-up effect.In poor countries, workers lack even the most rudimentary tools
and, as a result, have low productivity. Small amounts of capital investment would
substantially raise these workers’ productivity. By contrast, workers in rich coun-
tries have large amounts of capital with which to work, and this partly explains
their high productivity. Yet with the amount of capital per worker already so high,
additional capital investment has a relatively small effect on productivity. Studies
of international data on economic growth confirm this catch-up effect: Controlling
for other variables, such as the percentage of GDP devoted to investment, poor
countries do tend to grow faster than rich countries.
This catch-up effect can help explain some of the puzzling results in Figure 24-1.
Over this 31-year period, the United States and South Korea devoted a similar
share of GDP to investment. Yet the United States experienced only mediocre
growth of about 2 percent, while Korea experienced spectacular growth of more
than 6 percent. The explanation is the catch-up effect. In 1960, Korea had GDPper
person less than one-tenth the U.S. level, in part because previous investment had
been so low. With a small initial capital stock, the benefits to capital accumulation
were much greater in Korea, and this gave Korea a higher subsequent growth rate.
diminishing returns
the property whereby the benefit
from an extra unit of an input
declines as the quantity of the
input increases
catch-up effect
the property whereby countries
that start off poor tend to grow
morerapidly than countries
that start off rich
540 PART NINE THE REAL ECONOMY IN THE LONG RUN
This catch-up effect shows up in other aspects of life. When a school gives an
end-of-year award to the “Most Improved” student, that student is usually one
who began the year with relatively poor performance. Students who began the
year not studying find improvement easier than students who always worked
hard. Note that it is good to be “Most Improved,” given the starting point, but it is
even better to be “Best Student.” Similarly, economic growth over the last several
decades has been much more rapid in South Korea than in the United States, but
GDPper person is still higher in the United States.
INVESTMENT FROM ABROAD
So far we have discussed how policies aimed at increasing a country’s saving rate
can increase investment and, thereby, long-term economic growth. Yet saving by
domestic residents is not the only way for a country to invest in new capital. The
other way is investment by foreigners.
Investment from abroad takes several forms. Ford Motor Company might
build a car factory in Mexico. Acapital investment that is owned and operated by
a foreign entity is called foreign direct investment.Alternatively, an American might
buy stock in a Mexican corporation (that is, buy a share in the ownership of the
corporation); the Mexican corporation can use the proceeds from the stock sale to
build a new factory. An investment that is financed with foreign money but oper-
ated by domestic residents is called foreign portfolio investment.In both cases, Amer-
icans provide the resources necessary to increase the stock of capital in Mexico.
That is, American saving is being used to finance Mexican investment.
When foreigners invest in a country, they do so because they expect to earn a
return on their investment. Ford’s car factory increases the Mexican capital stock
and, therefore, increases Mexican productivity and Mexican GDP. Yet Ford takes
some of this additional income back to the United States in the form of profit. Sim-
ilarly, when an American investor buys Mexican stock, the investor has a right to
a portion of the profit that the Mexican corporation earns.
Investment from abroad, therefore, does not have the same effect on all mea-
sures of economic prosperity. Recall that gross domestic product (GDP) is the
income earned within a country by both residents and nonresidents, whereas
gross national product (GNP) is the income earned by residents of a country both
at home and abroad. When Ford opens its car factory in Mexico, some of the
income the factory generates accrues to people who do not live in Mexico. As a
result, foreign investment in Mexico raises the income of Mexicans (measured by
GNP) by less than it raises the production in Mexico (measured by GDP).
Nonetheless, investment from abroad is one way for a country to grow. Even
though some of the benefits from this investment flow back to the foreign owners,
this investment does increase the economy’s stock of capital, leading to higher pro-
ductivity and higher wages. Moreover, investment from abroad is one way for
poor countries to learn the state-of-the-art technologies developed and used in
richer countries. For these reasons, many economists who advise governments in
less developed economies advocate policies that encourage investment from
abroad. Often this means removing restrictions that governments have imposed
on foreign ownership of domestic capital.
An organization that tries to encourage the flow of investment to poor coun-
tries is the World Bank. This international organization obtains funds from the
CHAPTER 24 PRODUCTION AND GROWTH 541
world’s advanced countries, such as the United States, and uses these resources to
make loans to less developed countries so that they can invest in roads, sewer sys-
tems, schools, and other types of capital. It also offers the countries advice about
how the funds might best be used. The World Bank, together with its sister orga-
nization, the International Monetary Fund, was set up after World War II. One les-
son from the war was that economic distress often leads to political turmoil,
international tensions, and military conflict. Thus, every country has an interest in
promoting economic prosperity around the world. The World Bank and the Inter-
national Monetary Fund are aimed at achieving that common goal.
EDUCATION
Education—investment in human capital—is at least as important as investment
in physical capital for a country’s long-run economic success. In the United States,
each year of schooling raises a person’s wage on average by about 10 percent. In
less developed countries, where human capital is especially scarce, the gap
between the wages of educated and uneducated workers is even larger. Thus, one
way in which government policy can enhance the standard of living is to provide
good schools and to encourage the population to take advantage of them.
Investment in human capital, like investment in physical capital, has an
opportunity cost. When students are in school, they forgo the wages they could
have earned. In less developed countries, children often drop out of school at an
early age, even though the benefit of additional schooling is very high, simply
because their labor is needed to help support the family.
Some economists have argued that human capital is particularly important for
economic growth because human capital conveys positive externalities. An exter-
nalityis the effect of one person’s actions on the well-being of a bystander. An edu-
cated person, for instance, might generate new ideas about how best to produce
goods and services. If these ideas enter society’s pool of knowledge, so everyone
can use them, then the ideas are an external benefit of education. In this case, the
return to schooling for society is even greater than the return for the individual.
This argument would justify the large subsidies to human-capital investment that
we observe in the form of public education.
One problem facing some poor countries is the brain drain—the emigration of
many of the most highly educated workers to rich countries, where these workers
can enjoy a higher standard of living. If human capital does have positive exter-
nalities, then this brain drain makes those people left behind poorer than they oth-
erwise would be. This problem offers policymakers a dilemma. On the one hand,
the United States and other rich countries have the best systems of higher educa-
tion, and it would seem natural for poor countries to send their best students
abroad to earn higher degrees. On the other hand, those students who have spent
time abroad may choose not to return home, and this brain drain will reduce the
poor nation’s stock of human capital even further.
PROPERTY RIGHTS AND POLITICAL STABILITY
Another way in which policymakers can foster economic growth is by protecting
property rights and promoting political stability. As we first noted when we
542 PART NINE THE REAL ECONOMY IN THE LONG RUN
discussed economic interdependence in Chapter 3, production in market
economies arises from the interactions of millions of individuals and firms. When
you buy a car, for instance, you are buying the output of a car dealer, a car manu-
facturer, a steel company, an iron ore mining company, and so on. This division of
production among many firms allows the economy’s factors of production to be
used as effectively as possible. To achieve this outcome, the economy has to coor-
dinate transactions among these firms, as well as between firms and consumers.
Market economies achieve this coordination through market prices. That is, mar-
ket prices are the instrument with which the invisible hand of the marketplace
brings supply and demand into balance.
An important prerequisite for the price system to work is an economy-wide
respect for property rights. Property rights refer to the ability of people to exercise
authority over the resources they own. Amining company will not make the effort
to mine iron ore if it expects the ore to be stolen. The company mines the ore only
if it is confident that it will benefit from the ore’s subsequent sale. For this reason,
courts serve an important role in a market economy: They enforce property rights.
Through the criminal justice system, the courts discourage direct theft. In addition,
through the civil justice system, the courts ensure that buyers and sellers live up to
their contracts.
Although those of us in developed countries tend to take property rights for
granted, those living in less developed countries understand that lack of property
rights can be a major problem. In many countries, the system of justice does not
work well. Contracts are hard to enforce, and fraud often goes unpunished.
In more extreme cases, the government not only fails to enforce property rights
but actually infringes upon them. To do business in some countries, firms are
expected to bribe powerful government officials. Such corruption impedes the
coordinating power of markets. It also discourages domestic saving and invest-
ment from abroad.
One threat to property rights is political instability. When revolutions and
coups are common, there is doubt about whether property rights will be respected
in the future. If a revolutionary government might confiscate the capital of some
businesses, as was often true after communist revolutions, domestic residents have
less incentive to save, invest, and start new businesses. At the same time, foreign-
ers have less incentive to invest in the country. Even the threat of revolution can act
to depress a nation’s standard of living.
Thus, economic prosperity depends in part on political prosperity. Acountry
with an efficient court system, honest government officials, and a stable constitu-
tion will enjoy a higher economic standard of living than a country with a poor
court system, corrupt officials, and frequent revolutions and coups.
FREE TRADE
Some of the world’s poorest countries have tried to achieve more rapid economic
growth by pursuing inward-oriented policies.These policies are aimed at raising pro-
ductivity and living standards within the country by avoiding interaction with the
rest of the world. As we discussed in Chapter 9, domestic firms sometimes claim
they need protection from foreign competition in order to compete and grow. This
infant-industry argument, together with a general distrust of foreigners, has at
CHAPTER 24 PRODUCTION AND GROWTH 543
times led policymakers in less developed countries to impose tariffs and other
trade restrictions.
Most economists today believe that poor countries are better off pursuing
outward-oriented policies that integrate these countries into the world economy.
Chapters 3 and 9 showed how international trade can improve the economic well-
being of a country’s citizens. Trade is, in some ways, a type of technology. When a
country exports wheat and imports steel, the country benefits in the same way as
if it had invented a technology for turning wheat into steel. Acountry that elimi-
nates trade restrictions will, therefore, experience the same kind of economic
growth that would occur after a major technological advance.
The adverse impact of inward orientation becomes clear when one considers
the small size of many less developed economies. The total GDP of Argentina,
for instance, is about that of Philadelphia. Imagine what would happen if the
Philadelphia City Council were to prohibit city residents from trading with people
living outside the city limits. Without being able to take advantage of the gains
from trade, Philadelphia would need to produce all the goods it consumes.
It would also have to produce all its own capital goods, rather than importing
state-of-the-art equipment from other cities. Living standards in Philadelphia
would fall immediately, and the problem would likely only get worse over time.
This is precisely what happened when Argentina pursued inward-oriented poli-
cies throughout much of the twentieth century. By contrast, countries pursuing
outward-oriented policies, such as South Korea, Singapore, and Taiwan, have
enjoyed high rates of economic growth.
The amount that a nation trades with others is determined not only by gov-
ernment policy but also by geography. Countries with good natural seaports find
trade easier than countries without this resource. It is not a coincidence that many
of the world’s major cities, such as New York, San Francisco, and Hong Kong, are
located next to oceans. Similarly, because landlocked countries find international
trade more difficult, they tend to have lower levels of income than countries with
easy access to the world’s waterways.
THE CONTROL OF POPULATION GROWTH
Acountry’s productivity and living standard are determined in part by its popu-
lation growth. Obviously, population is a key determinant of a country’s labor
force. It is no surprise, therefore, that countries with large populations (such as the
United States and Japan) tend to produce greater GDPthan countries with small
populations (such as Luxembourg and the Netherlands). But total GDP is not a
good measure of economic well-being. For policymakers concerned about living
standards, GDPper person is more important, for it tells us the quantity of goods
and services available for the typical individual in the economy.
How does growth in the number of people affect the amount of GDPper per-
son? Standard theories of economic growth predict that high population growth
reduces GDPper person. The reason is that rapid growth in the number of work-
ers forces the other factors of production to be spread more thinly. In particular,
when population growth is rapid, equipping each worker with a large quantity of
capital is more difficult. Asmaller quantity of capital per worker leads to lower
productivity and lower GDPper worker.
544 PART NINE THE REAL ECONOMY IN THE LONG RUN
This problem is most apparent in the case of human capital. Countries with
high population growth have large numbers of school-age children. This places
a larger burden on the educational system. It is not surprising, therefore, that
educational attainment tends to be low in countries with high population
growth.
The differences in population growth around the world are large. In devel-
oped countries, such as the United States and western Europe, the population has
risen about 1 percent per year in recent decades, and it is expected to rise even
more slowly in the future. By contrast, in many poor African countries, population
growth is about 3 percent per year. At this rate, the population doubles every
23years.
Reducing the rate of population growth is widely thought to be one way less
developed countries can try to raise their standards of living. In some countries,
this goal is accomplished directly with laws regulating the number of children
families may have. China, for instance, allows only one child per family; couples
who violate this rule are subject to substantial fines. In countries with greater
You may have heard economics
called “the dismal science.”
The field was pinned with this
label many years ago be-
cause of a theory proposed
by Thomas Robert Malthus
(1766–1834), an English min-
ister and early economic
thinker. In a famous book
called An Essay on the Princi-
ple of Population as It Affects
the Future Improvement of
Society, Malthus offered what
may be history’s most chilling forecast. Malthus argued that
an ever increasing population would continually strain soci-
ety’s ability to provide for itself. As a result, mankind was
doomed to forever live in poverty.
Malthus’s logic was very simple. He began by noting
that “food is necessary to the existence of man” and that
“the passion between the sexes is necessary and will
remain nearly in its present state.” He concluded that “the
power of population is infinitely greater than the power in the
earth to produce subsistence for man.” According to
Malthus, the only check on population growth was “misery
and vice.” Attempts by charities or governments to alleviate
poverty were counterproductive, he argued, because they
merely allowed the poor to have more children, placing even
greater strains on society’s productive capabilities.
Fortunately, Malthus’s dire forecast was far off the
mark. Although the world population has increased about
sixfold over the past two centuries, living standards around
the world are on average much
higher. As a result of economic
growth, chronic hunger and malnu-
trition are less common now than
they were in Malthus’s day.
Famines occur from time to time,
but they are more often the result
of an unequal income distribution
or political instability than an inad-
equate production of food.
Where did Malthus go wrong?
He failed to appreciate that growth
in mankind’s ingenuity would
exceed growth in population. New
ideas about how to produce and even the kinds of goods to
produce have led to greater prosperity than Malthus—or
anyone else of his era—ever imagined. Pesticides, fertiliz-
ers, mechanized farm equipment, and new crop varieties
have allowed each farmer to feed ever greater numbers of
people. The wealth-enhancing effects of technological
progress have exceeded whatever wealth-diminishing
effects might be attributed to population growth.
Indeed, some economists now go so far as to suggest
that population growth may even have helped mankind
achieve higher standards of living. If there are more people,
then there are more scientists, inventors, and engineers to
contribute to technological progress, which benefits every-
one. Perhaps world population growth, rather than being a
source of economic deprivation as Malthus predicted, has
actually been an engine of technological progress and eco-
nomic prosperity.
THOMAS MALTHUS
FYI
Thomas
Malthus on
Population
Growth
CHAPTER 24 PRODUCTION AND GROWTH 545
CASE STUDY THE PRODUCTIVITY SLOWDOWN
From 1959 to 1973, productivity, as measured by output per hour worked in
U.S. businesses, grew at a rate of 3.2 percent per year. From 1973 to 1998, pro-
ductivity grew by only 1.3 percent per year. Not surprisingly, this slowdown in
productivity growth has been reflected in reduced growth in real wages and
family incomes. It is also reflected in a general sense of economic anxiety.
freedom, the goal of reduced population growth is accomplished less directly by
increasing awareness of birth control techniques.
The final way in which a country can influence population growth is to apply
one of the Ten Principles of Economics:People respond to incentives. Bearing a child,
like any decision, has an opportunity cost. When the opportunity cost rises, people
will choose to have smaller families. In particular, women with the opportunity to
receive good education and desirable employment tend to want fewer children
than those with fewer opportunities outside the home. Hence, policies that foster
equal treatment of women are one way for less developed economies to reduce the
rate of population growth.
RESEARCH AND DEVELOPMENT
The primary reason that living standards are higher today than they were a cen-
tury ago is that technological knowledge has advanced. The telephone, the tran-
sistor, the computer, and the internal combustion engine are among the thousands
of innovations that have improved the ability to produce goods and services.
Although most technological advance comes from private research by firms
and individual inventors, there is also a public interest in promoting these efforts.
To a large extent, knowledge is a public good: Once one person discovers an idea,
the idea enters society’s pool of knowledge, and other people can freely use it. Just
as government has a role in providing a public good such as national defense, it
also has a role in encouraging the research and development of new technologies.
The U.S. government has long played a role in the creation and dissemination
of technological knowledge. Acentury ago, the government sponsored research
about farming methods and advised farmers how best to use their land. More
recently, the U.S. government has, through the Air Force and NASA, supported
aerospace research; as a result, the United States is a leading maker of rockets and
planes. The government continues to encourage advances in knowledge with
research grants from the National Science Foundation and the National Institutes
of Health and with tax breaks for firms engaging in research and development.
Yet another way in which government policy encourages research is through
the patent system. When a person or firm invents a new product, such as a new
drug, the inventor can apply for a patent. If the product is deemed truly original,
the government awards the patent, which gives the inventor the exclusive right to
make the product for a specified number of years. In essence, the patent gives the
inventor a property right over his invention, turning his new idea from a public
good into a private good. By allowing inventors to profit from their inventions—
even if only temporarily—the patent system enhances the incentive for individu-
als and firms to engage in research.
546 PART NINE THE REAL ECONOMY IN THE LONG RUN
Because it has accumulated over so many years, this fall in productivity growth
of 1.9 percentage points has had a large effect on incomes. If this slowdown had
not occurred, the income of the average American would today be about 60 per-
cent higher.
The slowdown in economic growth has been one of the most important
problems facing economic policymakers. Economists are often asked what
caused the slowdown and what can be done to reverse it. Unfortunately, despite
much research on these questions, the answers remain elusive.
Two facts are well established. First, the slowdown in productivity growth
is a worldwide phenomenon. Sometime in the mid-1970s, economic growth
slowed not only in the United States but also in other industrial countries,
including Canada, France, Germany, Italy, Japan, and the United Kingdom.
Although some of these countries have had more rapid growth than the United
States, all of them have had slow growth compared to their own past experi-
ence. To explain the slowdown in U.S. growth, therefore, it seems necessary to
look beyond our borders.
Second, the slowdown cannot be traced to those factors of production that
are most easily measured. Economists can measure directly the quantity of
physical capital that workers have available. They can also measure human cap-
ital in the form of years of schooling. It appears that the slowdown in produc-
tivity is not primarily attributable to reduced growth in these inputs.
Technology appears to be one of the few remaining culprits. That is, having
ruled out most other explanations, many economists attribute the slowdown in
economic growth to a slowdown in the creation of new ideas about how to pro-
duce goods and services. Because the quantity of “ideas” is hard to measure,
this explanation is difficult to confirm or refute.
In some ways, it is odd to say that the last 25 years have been a period of
slow technological progress. This period has witnessed the spread of computers
across the economy—an historic technological revolution that has affected
almost every industry and almost every firm. Yet, for some reason, this change
has not yet been reflected in more rapid economic growth. As economist Robert
Solow put it, “You can see the computer age everywhere but in the productivity
statistics.”
What does the future of economic growth hold? An optimistic scenario is
that the computer revolution will rejuvenate economic growth once these new
machines are integrated into the economy and their potential is fully under-
stood. Economic historians note that the discovery of electricity took many
decades to have a large impact on productivity and living standards because
people had to figure out the best ways to use the new resource. Perhaps the
computer revolution will have a similar delayed effect. Some observers believe
this may be starting to happen already, for productivity growth did pick up a bit
in the late 1990s. It is still too early to say, however, whether this change will
persist.
A more pessimistic scenario is that, after a period of rapid scientific and
technological advance, we have entered a new phase of slower growth in
knowledge, productivity, and incomes. Data from a longer span of history seem
to support this conclusion. Figure 24-2 shows the average growth of real GDP
per person in the developed world going back to 1870. The productivity slow-
down is apparent in the last two entries: Around 1970, the growth rate slowed
from 3.7 to 2.2 percent. But compared to earlier periods of history, the anomaly
CHAPTER 24 PRODUCTION AND GROWTH 547
is not the slow growth of recent years but rather the rapid growth during the
1950s and 1960s. Perhaps the decades after World War II were a period of
unusually rapid technological advance, and growth has slowed down simply
because technological progress has returned to a more normal rate.
Growth Rate
(percent
per year)
1.0
1.5
2.0
2.5
3.0
3.5
4.0
1870–
1890
1890–
1910
1910–
1930
1930–
1950
1950–
1970
1970–
1990
0
Figure 24-2
THE GROWTH IN REAL GDP
PER PERSON. This figure shows
the average growth rate of real
GDPper person for 16 advanced
economies, including the major
countries of Europe, Canada,
the United States, Japan, and
Australia. Notice that the growth
rate rose substantially after 1950
and then fell after 1970.
SOURCE:Robert J. Barro and Xavier Sala-i-
Martin, Economic Growth(New York:
McGraw-Hill, 1995), p. 6.
QUICK QUIZ: Describe three ways in which a government policymaker
can try to raise the growth in living standards in a society. Are there any
drawbacks to these policies?
CONCLUSION:
THE IMPORTANCE OF LONG-RUN GROWTH
In this chapter we have discussed what determines the standard of living in a
nation and how policymakers can endeavor to raise the standard of living through
policies that promote economic growth. Most of this chapter is summarized in one
of the Ten Principles of Economics: A country’s standard of living depends on its
ability to produce goods and services. Policymakers who want to encourage
growth in standards of living must aim to increase their nation’s productive ability
by encouraging rapid accumulation of the factors of production and ensuring that
these factors are employed as effectively as possible.
548 PART NINE THE REAL ECONOMY IN THE LONG RUN
Economists differ in their views of the role of government in promoting eco-
nomic growth. At the very least, government can lend support to the invisible
hand by maintaining property rights and political stability. More controversial is
whether government should target and subsidize specific industries that might be
ECONOMIST JEFFREY SACHS HAS BEEN A
prominent adviser to governments
seeking to reform their economies and
raise economic growth. He has also
been a critic of the World Bank and the
International Monetary Fund (IMF), the
international policy organizations that
dispense advice and money to strug-
gling countries. Here Sachs discusses
how the countries of Africa can escape
their continuing poverty.
Growth in Africa: It Can Be Done
BY JEFFREY SACHS
In the old story, the peasant goes to
the priest for advice on saving his dy-
ing chickens. The priest recommends
prayer, but the chickens continue to
die. The priest then recommends music
for the chicken coop, but the deaths
continue unabated. Pondering again,
the priest recommends repainting the
chicken coop in bright colors. Finally, all
the chickens die. “What a shame,” the
priest tells the peasant. “I had so many
more good ideas.”
Since independence, African coun-
tries have looked to donor nations—
often their former colonial rulers—and to
the international finance institutions for
guidance on growth. Indeed, since the
onset of the African debt crises of the
1980s, the guidance has become a kind
of economic receivership, with the poli-
cies of many African nations decided in a
seemingly endless cycle of meetings
with the IMF, the World Bank, donors,
and creditors.
What a shame. So many good
ideas, so few results. Output per head
fell 0.7 percent between 1978 and 1987,
and 0.6 percent during 1987–1994.
Some growth is estimated for 1995 but
only at 0.6 percent—far below the faster-
growing developing countries. . . .
The IMF and World Bank would be
absolved of shared responsibility for
slow growth if Africa were structurally
incapable of growth rates seen in other
parts of the world or if the continent’s
low growth were an impenetrable mys-
tery. But Africa’s growth rates are
not huge mysteries. The evidence on
cross-country growth suggests that
Africa’s chronically low growth can be
explained by standard economic vari-
ables linked to identifiable (and remedi-
able) policies. . . .
Studies of cross-country growth
show that per capita growth is related to:
? the initial income level of the coun-
try, with poorer countries tending to
grow faster than richer countries;
? the extent of overall market orienta-
tion, including openness to trade,
domestic market liberalization,
private rather than state owner-
ship, protection of private property
rights, and low marginal tax rates;
? the national saving rate, which in
turn is strongly affected by the gov-
ernment’s own saving rate; and
? the geographic and resource struc-
ture of the economy. . . .
These four factors can account
broadly for Africa’s long-term growth
predicament. While it should have grown
faster than other developing areas
because of relatively low income per
head (and hence larger opportunity for
“catch-up” growth), Africa grew more
slowly. This was mainly because of much
IN THE NEWS
A Solution to
Africa’s Problems
CHAPTER 24 PRODUCTION AND GROWTH 549
especially important for technological progress. There is no doubt that these issues
are among the most important in economics. The success of one generation’s poli-
cymakers in learning and heeding the fundamental lessons about economic
growth determines what kind of world the next generation will inherit.
higher trade barriers; excessive tax
rates; lower saving rates; and adverse
structural conditions, including an unusu-
ally high incidence of inaccessibility to
the sea (15 of 53 countries are land-
locked). . . .
If the policies are largely to blame,
why, then, were they adopted? The his-
torical origins of Africa’s antimarket ori-
entation are not hard to discern. After
almost a century of colonial depreda-
tions, African nations understandably if
erroneously viewed open trade and for-
eign capital as a threat to national sover-
eignty. As in Sukarno’s Indonesia,
Nehru’s India, and Peron’s Argentina,
“self sufficiency” and “state leader-
ship,” including state ownership of much
of industry, became the guideposts of
the economy. As a result, most of Africa
went into a largely self-imposed eco-
nomic exile. . . .
Adam Smith in 1755 famously
remarked that “little else is requisite to
carry a state to the highest degrees of
opulence from the lowest barbarism, but
peace, easy taxes, and tolerable admin-
istration of justice.” A growth agenda
need not be long and complex. Take his
points in turn.
Peace, of course, is not so easily
guaranteed, but the conditions for peace
on the continent are better than today’s
ghastly headlines would suggest. Sev-
eral of the large-scale conflicts that have
ravaged the continent are over or nearly
so. . . . The ongoing disasters, such as in
Liberia, Rwanda and Somalia, would be
better contained if the West were willing
to provide modest support to African-
based peacekeeping efforts.
“Easy taxes” are well within the
ambit of the IMF and World Bank. But
here, the IMF stands guilty of neglect, if
not malfeasance. African nations need
simple, low taxes, with modest revenue
targets as a share of GDP. Easy taxes
are most essential in international trade,
since successful growth will depend,
more than anything else, on economic
integration with the rest of the world.
Africa’s largely self-imposed exile from
world markets can end quickly by cutting
import tariffs and ending export taxes on
agricultural exports. Corporate tax rates
should be cut from rates of 40 percent
and higher now prevalent in Africa, to
rates between 20 percent and 30 per-
cent, as in the outward-oriented East
Asian economies. . . .
Adam Smith spoke of a “tolerable”
administration of justice, not perfect jus-
tice. Market liberalization is the primary
key to strengthening the rule of law. Free
trade, currency convertibility and auto-
matic incorporation of business vastly
reduce the scope for official corruption
and allow the government to focus on
the real public goods—internal public
order, the judicial system, basic pub-
lic health and education, and monetary
stability. . . .
All of this is possible only if the gov-
ernment itself has held its own spending
to the necessary minimum. The Asian
economies show how to function with
government spending of 20 percent of
GDP or less (China gets by with just 13
percent). Education can usefully absorb
around 5 percent of GDP; health, an-
other 3 percent; public administration,
2 percent; the army and police, 3 per-
cent. Government investment spending
can be held to 5 percent of GDP but only
if the private sector is invited to pro-
vide infrastructure in telecommunica-
tions, port facilities, and power. . . .
This fiscal agenda excludes many
popular areas for government spending.
There is little room for transfers or social
spending beyond education and health
(though on my proposals, these would
get a hefty 8 percent of GDP). Subsidies
to publicly owned companies or market-
ing boards should be scrapped. Food
and housing subsidies for urban workers
cannot be financed. And, notably, inter-
est payments on foreign debt are not
budgeted for. This is because most
bankrupt African states need a fresh
start based on deep debt-reduction,
which should be implemented in con-
junction with far-reaching domestic
reforms.
Source: Economist,June 29, 1996, pp. 19–21.
550 PART NINE THE REAL ECONOMY IN THE LONG RUN
a78 Economic prosperity, as measured by GDPper person,
varies substantially around the world. The average
income in the world’s richest countries is more than ten
times that in the world’s poorest countries. Because
growth rates of real GDPalso vary substantially, the
relative positions of countries can change dramatically
over time.
a78 The standard of living in an economy depends on the
economy’s ability to produce goods and services.
Productivity, in turn, depends on the amounts of
physical capital, human capital, natural resources, and
technological knowledge available to workers.
a78 Government policies can influence the economy’s
growth rate in many ways: encouraging saving and
investment, encouraging investment from abroad,
fostering education, maintaining property rights and
political stability, allowing free trade, controlling
population growth, and promoting the research and
development of new technologies.
a78 The accumulation of capital is subject to diminishing
returns: The more capital an economy has, the less
additional output the economy gets from an extra unit
of capital. Because of diminishing returns, higher saving
leads to higher growth for a period of time, but growth
eventually slows down as the economy approaches a
higher level of capital, productivity, and income. Also
because of diminishing returns, the return to capital is
especially high in poor countries. Other things equal,
these countries can grow faster because of the catch-up
effect.
Summary
productivity, p. 533
physical capital, p. 534
human capital, p. 534
natural resources, p. 534
technological knowledge, p. 535
diminishing returns, p. 539
catch-up effect, p. 539
Key Concepts
1. What does the level of a nation’s GDPmeasure? What
does the growth rate of GDPmeasure? Would you
rather live in a nation with a high level of GDPand a
low growth rate, or in a nation with a low level and a
high growth rate?
2. List and describe four determinants of productivity.
3. In what way is a college degree a form of capital?
4. Explain how higher saving leads to a higher standard of
living. What might deter a policymaker from trying to
raise the rate of saving?
5. Does a higher rate of saving lead to higher growth
temporarily or indefinitely?
6. Why would removing a trade restriction, such as a tariff,
lead to more rapid economic growth?
7. How does the rate of population growth influence the
level of GDPper person?
8. Describe two ways in which the U.S. government tries
to encourage advances in technological knowledge.
Questions for Review
1. Most countries, including the United States, import
substantial amounts of goods and services from other
countries. Yet the chapter says that a nation can enjoy a
high standard of living only if it can produce a large
quantity of goods and services itself. Can you reconcile
these two facts?
2. List the capital inputs necessary to produce each of the
following:
a. cars
b. high school educations
c. plane travel
d. fruits and vegetables
Problems and Applications
CHAPTER 24 PRODUCTION AND GROWTH 551
3. U.S. income per person today is roughly eight times
what it was a century ago. Many other countries have
also experienced significant growth over that period.
What are some specific ways in which your standard of
living differs from that of your great-grandparents?
4. The chapter discusses how employment has declined
relative to output in the farm sector. Can you think of
another sector of the economy where the same
phenomenon has occurred more recently? Would you
consider the change in employment in this sector to
represent a success or a failure from the standpoint of
society as a whole?
5. Suppose that society decided to reduce consumption
and increase investment.
a. How would this change affect economic growth?
b. What groups in society would benefit from this
change? What groups might be hurt?
6. Societies choose what share of their resources to devote
to consumption and what share to devote to investment.
Some of these decisions involve private spending;
others involve government spending.
a. Describe some forms of private spending that
represent consumption, and some forms that
represent investment.
b. Describe some forms of government spending that
represent consumption, and some forms that
represent investment.
7. What is the opportunity cost of investing in capital? Do
you think a country can “over-invest” in capital? What
is the opportunity cost of investing in human capital?
Do you think a country can “over-invest” in human
capital? Explain.
8. Suppose that an auto company owned entirely by
German citizens opens a new factory in South Carolina.
a. What sort of foreign investment would this
represent?
b. What would be the effect of this investment on U.S.
GDP? Would the effect on U.S. GNPbe larger or
smaller?
9. In the 1980s Japanese investors made significant direct
and portfolio investments in the United States. At the
time, many Americans were unhappy that this
investment was occurring.
a. In what way was it better for the United States to
receive this Japanese investment than not to receive
it?
b. In what way would it have been better still for
Americans to have done this investment?
10. In the countries of South Asia in 1992, only 56 young
women were enrolled in secondary school for every 100
young men. Describe several ways in which greater
educational opportunities for young women could lead
to faster economic growth in these countries.
11. International data show a positive correlation between
political stability and economic growth.
a. Through what mechanism could political stability
lead to strong economic growth?
b. Through what mechanism could strong economic
growth lead to political stability?
IN THIS CHAPTER
YOU WILL . . .
Consider how
government budget
deficits affect the
U.S. economy
Develop a model of
the supply and
demand for loanable
funds in financial
markets
Learn about some of
the important
financial
institutions in the
U.S. economy
Consider how the
financial system is
related to key
macroeconomic
variables
Use the loanable-
funds model to
analyze various
government policies
Imagine that you have just graduated from college (with a degree in economics, of
course) and you decide to start your own business—an economic forecasting firm.
Before you make any money selling your forecasts, you have to incur substantial
costs to set up your business. You have to buy computers with which to make your
forecasts, as well as desks, chairs, and filing cabinets to furnish your new office.
Each of these items is a type of capital that your firm will use to produce and sell
its services.
How do you obtain the funds to invest in these capital goods? Perhaps you are
able to pay for them out of your past savings. More likely, however, like most en-
trepreneurs, you do not have enough money of your own to finance the start of
your business. As a result, you have to get the money you need from other sources.
SAVING, INVESTMENT, AND
THE FINANCIAL SYSTEM
553
554 PART NINE THE REAL ECONOMY IN THE LONG RUN
There are various ways for you to finance these capital investments. You could
borrow the money, perhaps from a bank or from a friend or relative. In this case,
you would promise not only to return the money at a later date but also to pay in-
terest for the use of the money. Alternatively, you could convince someone to pro-
vide the money you need for your business in exchange for a share of your future
profits, whatever they might happen to be. In either case, your invest-
ment in computers and office equipment is being financed by someone else’s
saving.
The financial systemconsists of those institutions in the economy that help to
match one person’s saving with another person’s investment. As we discussed in
the previous chapter, saving and investment are key ingredients to long-run
economic growth: When a country saves a large portion of its GDP, more resources
are available for investment in capital, and higher capital raises a country’s
productivity and living standard. The previous chapter, however, did not explain
how the economy coordinates saving and investment. At any time, some people
want to save some of their income for the future, and others want to borrow in or-
der to finance investments in new and growing businesses. What brings these
two groups of people together? What ensures that the supply of funds from
thosewhowant to save balances the demand for funds from those who want to
invest?
This chapter examines how the financial system works. First, we discuss the
large variety of institutions that make up the financial system in our economy. Sec-
ond, we discuss the relationship between the financial system and some key
macroeconomic variables—notably saving and investment. Third, we develop a
model of the supply and demand for funds in financial markets. In the model, the
interest rate is the price that adjusts to balance supply and demand. The model
shows how various government policies affect the interest rate and, thereby, soci-
ety’s allocation of scarce resources.
FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY
At the broadest level, the financial system moves the economy’s scarce resources
from savers (people who spend less than they earn) to borrowers (people who
spend more than they earn). Savers save for various reasons—to put a child
through college in several years or to retire comfortably in several decades. Simi-
larly, borrowers borrow for various reasons—to buy a house in which to live or to
start a business with which to make a living. Savers supply their money to the fi-
nancial system with the expectation that they will get it back with interest at a later
date. Borrowers demand money from the financial system with the knowledge
that they will be required to pay it back with interest at a later date.
The financial system is made up of various financial institutions that help co-
ordinate savers and borrowers. As a prelude to analyzing the economic forces that
drive the financial system, let’s discuss the most important of these institutions. Fi-
nancial institutions can be grouped into two categories—financial markets and fi-
nancial intermediaries. We consider each category in turn.
financial system
the group of institutions in the
economy that help to match one
person’s saving with another
person’s investment
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 555
FINANCIAL MARKETS
Financial marketsare the institutions through which a person who wants to save
can directly supply funds to a person who wants to borrow. The two most impor-
tant financial markets in our economy are the bond market and the stock market.
The Bond Market When Intel, the giant maker of computer chips, wants to
borrow to finance construction of a new factory, it can borrow directly from the
public. It does this by selling bonds. Abond is a certificate of indebtedness that
specifies the obligations of the borrower to the holder of the bond. Put simply, a
bond is an IOU. It identifies the time at which the loan will be repaid, called the
date of maturity,and the rate of interest that will be paid periodically until the loan
matures. The buyer of a bond gives his or her money to Intel in exchange for this
promise of interest and eventual repayment of the amount borrowed (called the
principal). The buyer can hold the bond until maturity or can sell the bond at an
earlier date to someone else.
There are literally millions of different bonds in the U.S. economy. When large
corporations, the federal government, or state and local governments need to bor-
row to finance the purchase of a new factory, a new jet fighter, or a new school,
they usually do so by issuing bonds. If you look at The Wall Street Journal or the
business section of your local newspaper, you will find a listing of the prices and
interest rates on some of the most important bond issues. Although these bonds
differ in many ways, three characteristics of bonds are most important.
The first characteristic is a bond’s term—the length of time until the bond ma-
tures. Some bonds have short terms, such as a few months, while others have
terms as long as 30 years. (The British government has even issued a bond that
never matures, called a perpetuity.This bond pays interest forever, but the princi-
pal is never repaid.) The interest rate on a bond depends, in part, on its term. Long-
term bonds are riskier than short-term bonds because holders of long-term bonds
have to wait longer for repayment of principal. If a holder of a long-term bond
needs his money earlier than the distant date of maturity, he has no choice but to
sell the bond to someone else, perhaps at a reduced price. To compensate for this
risk, long-term bonds usually pay higher interest rates than short-term bonds.
The second important characteristic of a bond is its credit risk—the probability
that the borrower will fail to pay some of the interest or principal. Such a failure to
pay is called a default.Borrowers can (and sometimes do) default on their loans by
declaring bankruptcy. When bond buyers perceive that the probability of default
is high, they demand a higher interest rate to compensate them for this risk. Be-
cause the U.S. government is considered a safe credit risk, government bonds tend
to pay low interest rates. By contrast, financially shaky corporations raise money
by issuing junk bonds, which pay very high interest rates. Buyers of bonds can
judge credit risk by checking with various private agencies, such as Standard &
Poor’s, which rate the credit risk of different bonds.
The third important characteristic of a bond is its tax treatment—the way in
which the tax laws treat the interest earned on the bond. The interest on most
bonds is taxable income, so that the bond owner has to pay a portion of the inter-
est in income taxes. By contrast, when state and local governments issue bonds,
called municipal bonds,the bond owners are not required to pay federal income tax
on the interest income. Because of this tax advantage, bonds issued by state and
financial markets
financial institutions through
which savers can directly
provide funds to borrowers
bond
a certificate of indebtedness
556 PART NINE THE REAL ECONOMY IN THE LONG RUN
local governments pay a lower interest rate than bonds issued by corporations or
the federal government.
The Stock Market Another way for Intel to raise funds to build a new
semiconductor factory is to sell stock in the company. Stockrepresents ownership
in a firm and is, therefore, a claim to the profits that the firm makes. For example,
if Intel sells a total of 1,000,000 shares of stock, then each share represents owner-
ship of 1/1,000,000 of the business.
The sale of stock to raise money is called equity finance, whereas the sale of
bonds is called debt finance. Although corporations use both equity and debt fi-
nance to raise money for new investments, stocks and bonds are very different.
The owner of shares of Intel stock is a part owner of Intel; the owner of an Intel
bond is a creditor of the corporation. If Intel is very profitable, the stockholders en-
joy the benefits of these profits, whereas the bondholders get only the interest on
their bonds. And if Intel runs into financial difficulty, the bondholders are paid
what they are due before stockholders receive anything at all. Compared to bonds,
stocks offer the holder both higher risk and potentially higher return.
After a corporation issues stock by selling shares to the public, these shares
trade among stockholders on organized stock exchanges. In these transactions, the
corporation itself receives no money when its stock changes hands. The most im-
portant stock exchanges in the U.S. economy are the New York Stock Exchange,
the American Stock Exchange, and NASDAQ (National Association of Securities
Dealers Automated Quotation system). Most of the world’s countries have their
own stock exchanges on which the shares of local companies trade.
The prices at which shares trade on stock exchanges are determined by the
supply and demand for the stock in these companies. Because stock represents
ownership in a corporation, the demand for a stock (and thus its price) reflects
people’s perception of the corporation’s future profitability. When people become
optimistic about a company’s future, they raise their demand for its stock and
thereby bid up the price of a share of stock. Conversely, when people come to ex-
pect a company to have little profit or even losses, the price of a share falls.
Various stock indexes are available to monitor the overall level of stock prices.
Astock index is computed as an average of a group of stock prices. The most fa-
mous stock index is the Dow Jones Industrial Average, which has been computed
regularly since 1896. It is now based on the prices of the stocks of 30 major U.S.
companies, such as General Motors, General Electric, Microsoft, Coca-Cola, AT&T,
and IBM. Another well-known stock index is the Standard & Poor’s 500 Index,
which is based on the prices of 500 major companies. Because stock prices reflect
expected profitability, these stock indexes are watched closely as possible indica-
tors of future economic conditions.
FINANCIAL INTERMEDIARIES
Financial intermediariesare financial institutions through which savers can indi-
rectly provide funds to borrowers. The term intermediaryreflects the role of these
institutions in standing between savers and borrowers. Here we consider two of
the most important financial intermediaries—banks and mutual funds.
stock
a claim to partial ownership in a firm
THENEWYORKSTOCKEXCHANGE
financial intermediaries
financial institutions through which
savers can indirectly provide funds
to borrowers
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 557
Banks
If the owner of a small grocery store wants to finance an expansion of his business,
he probably takes a strategy quite different from Intel. Unlike Intel, a small grocer
Most daily newspapers include
stock tables, which contain in-
formation about recent trading
in the stocks of several thou-
sand companies. Here is the
kind of information these ta-
bles usually provide:
a78 Price. The single most im-
portant piece of informa-
tion about a stock is the
price of a share. The
newspaper usually pre-
sents several prices. The
“last” or “closing” price is the price of the last trans-
action that occurred before the stock exchange closed
the previous day. Many newspapers also give the “high”
and “low” prices over the past day of trading and,
sometimes, over the past year as well.
a78 Volume. Most newspapers present the number of
shares sold during the past day of trading. This figure is
called the daily volume.
a78 Dividend. Corporations pay out some of their profits to
their stockholders; this amount is called the dividend.
(Profits not paid out are called retained earnings and
are used by the corporation for additional investment.)
Newspapers often report the dividend paid over the pre-
vious year for each share of stock. They sometimes
report the dividend yield, which is the dividend ex-
pressed as a percentage of the stock’s price.
a78 Price-earnings ratio. A corporation’s earnings, or profit,
is the amount of revenue it receives for the sale of its
products minus its costs of production as measured by
its accountants. Earnings per share is the company’s
total earnings divided by the number of shares of stock
outstanding. Companies use some of their earnings to
pay dividends to stockholders; the rest is kept in the
firm to make new investments. The price–earnings
ratio, often called the P/E, is the price of a corpora-
tion’s stock divided by the amount the corporation
earned per share over the past year. Historically, the
typical price–earnings ratio is about 15. A higher P/E in-
dicates that a corporation’s stock is expensive relative
to its recent earnings; this might indicate either that
people expect earnings to rise in the future or that the
stock is overvalued. Conversely, a lower P/E indicates
that a corporation’s stock is cheap relative to its recent
earnings; this might indicate either that people expect
earnings to fall or that the stock is undervalued.
Why does the newspaper report all these data every day?
Many people who invest their savings in stock follow these
numbers closely when deciding which stocks to buy and sell.
By contrast, other stockholders follow a buy-and-hold strat-
egy: They buy the stock of well-run companies, hold it for
long periods of time, and do not respond to the daily fluctu-
ations reported in the paper.
Name of
company
Symbol for
company’s stock
52 Weeks
Hi Lo Stock Sym Div
Yld
% PE
Vol
100s Hi Lo Close
Net
Chg
26
3
/16
12
7
/8
75
7
/16
22
1
/2
23
7
/16
6
7
/8
47
5
/16
9
3
/4
CslFnl
Coastcast
CocaCola
CCFemsa ADR
TOPrS
PAR
KO
KOF
2.09
.64
.12e
8.6
...
1.3
.9
...
17
40
...
59
171
39384
2121
24
1
/4
11
3
/8
51
13
13
/16
23
13
/16
10
7
/8
49
3
/4
12
7
/8
24
1
/4
11
3
/8
51
13
3
/4
+
1
/16
+
3
/8
+1
1
/16
+
1
/16
Dividend
amount
Dividend
yield
Price–
earnings
ratio
Trading volume over
the previous day
Highest and
lowest price over
the previous day
Last price at which
the stock traded
Change in
closing price
from the
day before
Highest and lowest
price of the stock
over the past year
FYI
How to Read
the Newspaper’s
Stock Tables
558 PART NINE THE REAL ECONOMY IN THE LONG RUN
would find it difficult to raise funds in the bond and stock markets. Most buyers of
stocks and bonds prefer to buy those issued by larger, more familiar companies.
The small grocer, therefore, most likely finances his business expansion with a loan
from a local bank.
Banks are the financial intermediaries with which people are most familiar. A
primary job of banks is to take in deposits from people who want to save and use
these deposits to make loans to people who want to borrow. Banks pay depositors
interest on their deposits and charge borrowers slightly higher interest on their
loans. The difference between these rates of interest covers the banks’ costs and re-
turns some profit to the owners of the banks.
Besides being financial intermediaries, banks play a second important role in
the economy: They facilitate purchases of goods and services by allowing people
to write checks against their deposits. In other words, banks help create a special
asset that people can use as a medium of exchange.Amedium of exchange is an item
that people can easily use to engage in transactions. Abank’s role in providing a
medium of exchange distinguishes it from many other financial institutions.
Stocks and bonds, like bank deposits, are a possible store of valuefor the wealth that
people have accumulated in past saving, but access to this wealth is not as easy,
cheap, and immediate as just writing a check. For now, we ignore this second
roleof banks, but we will return to it when we discuss the monetary system in
Chapter 27.
Mutual Funds Afinancial intermediary of increasing importance in the U.S.
economy is the mutual fund. Amutual fund is an institution that sells shares to
the public and uses the proceeds to buy a selection, or portfolio,of various types of
stocks, bonds, or both stocks and bonds. The shareholder of the mutual fund ac-
cepts all the risk and return associated with the portfolio. If the value of the port-
folio rises, the shareholder benefits; if the value of the portfolio falls, the
shareholder suffers the loss.
The primary advantage of mutual funds is that they allow people with small
amounts of money to diversify. Buyers of stocks and bonds are well advised to
heed the adage: Don’t put all your eggs in one basket. Because the value of any
single stock or bond is tied to the fortunes of one company, holding a single kind
of stock or bond is very risky. By contrast, people who hold a diverse portfolio of
stocks and bonds face less risk because they have only a small stake in each com-
pany. Mutual funds make this diversification easy. With only a few hundred dol-
lars, a person can buy shares in a mutual fund and, indirectly, become the part
owner or creditor of hundreds of major companies. For this service, the company
mutual fund
an institution that sells shares
to the public and uses the proceeds
to buy a portfolio of stocks and bonds
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 559
operating the mutual fund charges shareholders a fee, usually between 0.5 and 2.0
percent of assets each year.
Asecond advantage claimed by mutual fund companies is that mutual funds
give ordinary people access to the skills of professional money managers. The
managers of most mutual funds pay close attention to the developments and
prospects of the companies in which they buy stock. These managers buy the stock
of those companies that they view as having a profitable future and sell the stock
of companies with less promising prospects. This professional management, it is
argued, should increase the return that mutual fund depositors earn on their sav-
ings.
Financial economists, however, are often skeptical of this second argument.
With thousands of money managers paying close attention to each company’s
prospects, the price of a company’s stock is usually a good reflection of the com-
pany’s true value. As a result, it is hard to “beat the market” by buying good stocks
and selling bad ones. In fact, mutual funds called index funds, which buy all the
stocks in a given stock index, perform somewhat better on average than mutual
funds that take advantage of active management by professional money man-
agers. The explanation for the superior performance of index funds is that they
keep costs low by buying and selling very rarely and by not having to pay the
salaries of the professional money managers.
SUMMING UP
The U.S. economy contains a large variety of financial institutions. In addition to
the bond market, the stock market, banks, and mutual funds, there are also pen-
sion funds, credit unions, insurance companies, and even the local loan shark.
These institutions differ in many ways. When analyzing the macroeconomic role
of the financial system, however, it is more important to keep in mind the similar-
ity of these institutions than the differences. These financial institutions all serve
the same goal—directing the resources of savers into the hands of borrowers.
QUICK QUIZ: What is stock? What is a bond? How are they different?
How are they similar?
SAVING AND INVESTMENT
IN THE NATIONAL INCOME ACCOUNTS
Events that occur within the financial system are central to understanding devel-
opments in the overall economy. As we have just seen, the institutions that make
up this system—the bond market, the stock market, banks, and mutual funds—
have the role of coordinating the economy’s saving and investment. And as we
saw in the previous chapter, saving and investment are important determinants of
long-run growth in GDPand living standards. As a result, macroeconomists need
to understand how financial markets work and how various events and policies
affect them.
560 PART NINE THE REAL ECONOMY IN THE LONG RUN
As a starting point for an analysis of financial markets, we discuss in this sec-
tion the key macroeconomic variables that measure activity in these markets. Our
emphasis here is not on behavior but on accounting. Accountingrefers to how var-
ious numbers are defined and added up. Apersonal accountant might help an in-
dividual add up his income and expenses. Anational income accountant does the
same thing for the economy as a whole. The national income accounts include, in
particular, GDPand the many related statistics.
The rules of national income accounting include several important identities.
Recall that an identityis an equation that must be true because of the way the vari-
ables in the equation are defined. Identities are useful to keep in mind, for they
clarify how different variables are related to one another. Here we consider some
accounting identities that shed light on the macroeconomic role of financial
markets.
SOME IMPORTANT IDENTITIES
Recall that gross domestic product (GDP) is both total income in an economy
andthe total expenditure on the economy’s output of goods and services. GDP
THE U.S. STOCK MARKET EXPERIENCED A
quadrupling of stock prices during the
1990s. The following article tries to ex-
plain this remarkable boom. It suggests
that people bid up stock prices because
they came to view stocks as less risky
than they previously thought.
Are Stocks Overvalued?
Not a Chance
BY JAMES K. GLASSMAN
AND KEVIN A. HASSETT
The Dow Jones Industrial Average has
returned more than 200 percent over
the past five years, and the past three
have set an all-time record. So it’s
hardly surprising that many observers
worry the stock market is overvalued.
One of the most popular measures of
valuation, the ratio of a stock’s price to
its earnings per share, P/E, is close to
an all-time high. The P/E of the average
stock on the Dow is 22.5, meaning that
it costs $22.50 to buy $1 in profits—or,
conversely, that an investor’s return
(earnings divided by price) is just 4.4
percent, vs. 5.9 percent for long-term
Treasury bonds.
Yet Warren Buffett, chairman of
Berkshire Hathaway Corp. and the
most successful large-scale investor of
our time, told shareholders in a March
14 letter that “there is no reason to
think of stocks as generally overval-
ued” as long as interest rates remain
low and businesses continue to oper-
ate as profitably as they have in recent
years. Investors were buoyed by this
statement, even though Mr. Buffett
provided no analysis to back up his as-
sertion.
Mr. Buffett is right—and we have
the numbers and the theory to back him
up. Worries about overvaluation, we be-
lieve, are based on a serious and wide-
spread misunderstanding of the returns
and risks associated with equities. We
are not so foolish as to predict the short-
term course of stocks, but we are not re-
luctant to state that, based on modest
assumptions about interest rates and
profit levels, current P/E levels give us
no great concern—nor would levels as
much as twice as high.
The fact is that if you hold stocks in-
stead of bonds the amount of money
flowing into your pockets will be higher
over time. Why? Both bonds and stocks
provide their owners with a flow of cash
over time. For bonds, the arithmetic is
simple: If you buy a $10,000 bond paying
6 percent interest today, you’ll receive
$600 every year. For equities, the math
is more complicated: Assume that a
stock currently yields 2 percent, or $2
for each share priced at $100. Say you
own 100 shares; total dividend payments
are $200—much lower than for bonds.
IN THE NEWS
The Stock Market Boom
of the 1990s
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 561
(denoted as Y) is divided into four components of expenditure: consumption (C),
investment (I), government purchases (G), and net exports (NX). We write
YH11005CH11001IH11001GH11001NX.
This equation is an identity because every dollar of expenditure that shows up on
the left-hand side also shows up in one of the four components on the right-hand
side. Because of the way each of the variables is defined and measured, this equa-
tion must always hold.
In this chapter, we simplify our analysis by assuming that the economy we are
examining is closed. A closed economy is one that does not interact with other
economies. In particular, a closed economy does not engage in international trade
in goods and services, nor does it engage in international borrowing and lending.
Of course, actual economies are open economies—that is, they interact with other
economies around the world. (We will examine the macroeconomics of open
economies later in this book.) Nonetheless, assuming a closed economy is a useful
simplification by which we can learn some lessons that apply to all economies.
Moreover, this assumption applies perfectly to the world economy (inasmuch as
interplanetary trade is not yet common).
But wait. There is a big difference.
Profits grow over time. If that dividend
should increase with profits, say at a
rate of 5 percent annually, then, by the
30th year, your annual dividend payment
will be over $800, or one-third more than
the bond is yielding. The price of the
stock almost certainly will have risen
as well.
By this simple exercise, we can see
that stocks—even with their profits
growing at a moderate 5 percent—will
return far more than bonds over long pe-
riods. Over the past 70 years, stocks
have annually returned 4.8 percent-
age points more than long-term U.S.
Treasury bonds and 6.8 points more
than Treasury bills, according to Ibbot-
son Associates Inc., a Chicago research
firm.
But isn’t that extra reward—what
economists call the “equity premium”—
merely the bonus paid by the market to
investors who accept higher risk, since
returns for stocks are so much more un-
certain than for bonds? To this question,
we respond: What extra risk?
In his book “Stocks for the Long
Run,” Jeremy J. Siegel of the University
of Pennsylvania concludes: “It is widely
known that stock returns, on average,
exceed bonds in the long run. But it is lit-
tle known that in the long run, the risks in
stocks are less than those found in
bonds or even bills!” Mr. Siegel looked
at every 20-year holding period from
1802 to 1992 and found that the worst
real return for stocks was an annual av-
erage of 1.2 percent and the best was
an annual average of 12.6 percent. For
long-term bonds, the range was minus
3.1 percent to plus 8.8 percent; for T-
bills, minus 3.0 percent to plus 8.3 per-
cent.
Based on these findings, it would
seem that there should be no need for
an equity risk premium at all—and that
the correct valuation for the stock mar-
ket would be one that equalizes the
present value of cash flow between
stocks and bonds in the long run. Think
of the market as offering you two assets,
one that will pay you $1,000 over the
next 30 years in a steady stream and
another that, just as surely, will pay you
the $1,000, but the cash flow will vary
from year to year. Assuming you’re in-
vesting for the long term, you will value
them about the same. . . .
Allow us now to suggest a hypothe-
sis about the huge returns posted by the
stock market over the past few years:
As mutual funds have advertised the re-
duction of risk acquired by taking the
long view, the risk premium required by
shareholders has gradually drifted down.
Since Siegel’s results suggest that the
correct risk premium might be zero, this
drift downward—and the corresponding
trend toward higher stock prices—may
not be over. . . . In the current environ-
ment, we are very comfortable both in
holding stocks and in saying that pundits
who claim the market is overvalued are
foolish.
Source: The Wall Street Journal,Monday, March 30,
1998, p. A18.
562 PART NINE THE REAL ECONOMY IN THE LONG RUN
Because a closed economy does not engage in international trade, imports and
exports are exactly zero. Therefore, net exports (NX) are also zero. In this case, we
can write
YH11005CH11001IH11001G.
This equation states that GDPis the sum of consumption, investment, and gov-
ernment purchases. Each unit of output sold in a closed economy is consumed, in-
vested, or bought by the government.
To see what this identity can tell us about financial markets, subtract Cand G
from both sides of this equation. We obtain
YH11002 CH11002 GH11005I.
The left-hand side of this equation (YH11002 CH11002 G) is the total income in the economy
that remains after paying for consumption and government purchases: This
amount is called national saving, or just saving, and is denoted S. Substituting
Sfor YH11002 CH11002 G,we can write the last equation as
SH11005I.
This equation states that saving equals investment.
To understand the meaning of national saving, it is helpful to manipulate the
definition a bit more. Let Tdenote the amount that the government collects from
households in taxes minus the amount it pays back to households in the form of
transfer payments (such as Social Security and welfare). We can then write na-
tional saving in either of two ways:
SH11005YH11002 CH11002 G
or
SH11005(YH11002 TH11002 C) H11001(TH11002 G).
These equations are the same, because the two T’s in the second equation cancel
each other, but each reveals a different way of thinking about national saving. In
particular, the second equation separates national saving into two pieces: private
saving (YH11002 TH11002 C) and public saving (TH11002 G).
Consider each of these two pieces. Private savingis the amount of income that
households have left after paying their taxes and paying for their consumption. In
particular, because households receive income of Y, pay taxes of T, and spend Con
consumption, private saving is YH11002 TH11002 C.Public savingis the amount of tax reve-
nue that the government has left after paying for its spending. The government re-
ceives T in tax revenue and spends G on goods and services. If T exceeds G, the
government runs a budget surplusbecause it receives more money than it spends.
This surplus of T H11002 G represents public saving. If the government spends more
than it receives in tax revenue, then Gis larger than T. In this case, the government
runs a budget deficit,and public saving TH11002 Gis a negative number.
Now consider how these accounting identities are related to financial markets.
The equation SH11005Ireveals an important fact: For the economy as a whole, saving must
national saving (saving)
the total income in the
economy that remains after
paying for consumption and
government purchases
private saving
the income that households
have left after paying for taxes
and consumption
public saving
the tax revenue that the government
has left after paying for its spending
budget surplus
an excess of tax revenue over
government spending
budget deficit
a shortfall of tax revenue from
government spending
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 563
be equal to investment.Yet this fact raises some important questions: What mecha-
nisms lie behind this identity? What coordinates those people who are deciding
how much to save and those people who are deciding how much to invest? The
answer is: the financial system. The bond market, the stock market, banks, mutual
funds, and other financial markets and intermediaries stand between the two sides
of the SH11005Iequation. They take in the nation’s saving and direct it to the nation’s
investment.
THE MEANING OF SAVING AND INVESTMENT
The terms saving and investment can sometimes be confusing. Most people use
these terms casually and sometimes interchangeably. By contrast, the macroecon-
omists who put together the national income accounts use these terms carefully
and distinctly.
Consider an example. Suppose that Larry earns more than he spends and de-
posits his unspent income in a bank or uses it to buy a bond or some stock from a
corporation. Because Larry’s income exceeds his consumption, he adds to the na-
tion’s saving. Larry might think of himself as “investing” his money, but a macro-
economist would call Larry’s act saving rather than investment.
In the language of macroeconomics, investment refers to the purchase of new
capital, such as equipment or buildings. When Moe borrows from the bank to
build himself a new house, he adds to the nation’s investment. Similarly, when the
USING SOME OFYOUR INCOME TOBUYSTOCK? MOST PEOPLE CALLTHIS INVESTING.
MACROECONOMISTS CALLIT SAVING.
564 PART NINE THE REAL ECONOMY IN THE LONG RUN
Curly Corporation sells some stock and uses the proceeds to build a new factory,
it also adds to the nation’s investment.
Although the accounting identity SH11005Ishows that saving and investment are
equal for the economy as a whole, this does not have to be true for every individ-
ual household or firm. Larry’s saving can be greater than his investment, and he
can deposit the excess in a bank. Moe’s saving can be less than his investment, and
he can borrow the shortfall from a bank. Banks and other financial institutions
make these individual differences between saving and investment possible by al-
lowing one person’s saving to finance another person’s investment.
QUICK QUIZ: Define private saving, public saving, national saving,and
investment.How are they related?
THE MARKET FOR LOANABLE FUNDS
Having discussed some of the important financial institutions in our economy and
the macroeconomic role of these institutions, we are ready to build a model of fi-
nancial markets. Our purpose in building this model is to explain how financial
markets coordinate the economy’s saving and investment. The model also gives us
a tool with which we can analyze various government policies that influence sav-
ing and investment.
To keep things simple, we assume that the economy has only one financial
market, called the market for loanable funds.All savers go to this market to de-
posit their saving, and all borrowers go to this market to get their loans. Thus, the
term loanable fundsrefers to all income that people have chosen to save and lend
out, rather than use for their own consumption. In the market for loanable funds,
there is one interest rate, which is both the return to saving and the cost of bor-
rowing.
The assumption of a single financial market, of course, is not literally true. As
we have seen, the economy has many types of financial institutions. But, as we dis-
cussed in Chapter 2, the art in building an economic model is simplifying the
world in order to explain it. For our purposes here, we can ignore the diversity of
financial institutions and assume that the economy has a single financial market.
SUPPLY AND DEMAND FOR LOANABLE FUNDS
The economy’s market for loanable funds, like other markets in the economy, is
governed by supply and demand. To understand how the market for loanable
funds operates, therefore, we first look at the sources of supply and demand in
that market.
The supply of loanable funds comes from those people who have some extra
income they want to save and lend out. This lending can occur directly, such as
when a household buys a bond from a firm, or it can occur indirectly, such as when
a household makes a deposit in a bank, which in turn uses the funds to make
loans. In both cases, saving is the source of the supply of loanable funds.
market for loanable funds
the market in which those who
want to save supply funds and
those who want to borrow to
invest demand funds
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 565
The demand for loanable funds comes from households and firms who wish
to borrow to make investments. This demand includes families taking out mort-
gages to buy homes. It also includes firms borrowing to buy new equipment or
build factories. In both cases, investment is the source of the demand for loanable
funds.
The interest rate is the price of a loan. It represents the amount that borrowers
pay for loans and the amount that lenders receive on their saving. Because a high
interest rate makes borrowing more expensive, the quantity of loanable funds de-
manded falls as the interest rate rises. Similarly, because a high interest rate makes
saving more attractive, the quantity of loanable funds supplied rises as the interest
rate rises. In other words, the demand curve for loanable funds slopes downward,
and the supply curve for loanable funds slopes upward.
Figure 25-1 shows the interest rate that balances the supply and demand for
loanable funds. In the equilibrium shown, the interest rate is 5 percent, and the
quantity of loanable funds demanded and the quantity of loanable funds supplied
both equal $1,200 billion. The adjustment of the interest rate to the equilibrium
level occurs for the usual reasons. If the interest rate were lower than the equilib-
rium level, the quantity of loanable funds supplied would be less than the quan-
tity of loanable funds demanded. The resulting shortage of loanable funds would
encourage lenders to raise the interest rate they charge. Conversely, if the interest
rate were higher than the equilibrium level, the quantity of loanable funds sup-
plied would exceed the quantity of loanable funds demanded. As lenders com-
peted for the scarce borrowers, interest rates would be driven down. In this way,
“Whoops! There go those darned interest rates again!”
566 PART NINE THE REAL ECONOMY IN THE LONG RUN
the interest rate approaches the equilibrium level at which the supply and demand
for loanable funds exactly balance.
Recall that economists distinguish between the real interest rate and the nom-
inal interest rate. The nominal interest rate is the interest rate as usually reported—
the monetary return to saving and cost of borrowing. The real interest rate is the
nominal interest rate corrected for inflation; it equals the nominal interest rate mi-
nus the inflation rate. Because inflation erodes the value of money over time, the
real interest rate more accurately reflects the real return to saving and cost of bor-
rowing. Therefore, the supply and demand for loanable funds depend on the real
(rather than nominal) interest rate, and the equilibrium in Figure 25-1 should be in-
terpreted as determining the real interest rate in the economy. For the rest of this
chapter, when you see the term interest rate,you should remember that we are talk-
ing about the real interest rate.
This model of the supply and demand for loanable funds shows that financial
markets work much like other markets in the economy. In the market for milk, for
instance, the price of milk adjusts so that the quantity of milk supplied balances
the quantity of milk demanded. In this way, the invisible hand coordinates the be-
havior of dairy farmers and the behavior of milk drinkers. Once we realize that
saving represents the supply of loanable funds and investment represents the de-
mand, we can see how the invisible hand coordinates saving and investment.
When the interest rate adjusts to balance supply and demand in the market for
loanable funds, it coordinates the behavior of people who want to save (the sup-
pliers of loanable funds) and the behavior of people who want to invest (the de-
manders of loanable funds).
We can now use this analysis of the market for loanable funds to examine var-
ious government policies that affect the economy’s saving and investment. Be-
cause this model is just supply and demand in a particular market, we analyze any
policy using the three steps discussed in Chapter 4. First, we decide whether the
policy shifts the supply curve or the demand curve. Second, we determine the di-
rection of the shift. Third, we use the supply-and-demand diagram to see how the
equilibrium changes.
Loanable Funds
(in billions of dollars)
0
Interest
Rate
5%
Supply
Demand
$1,200
Figure 25-1
THE MARKET FOR LOANABLE
FUNDS. The interest rate in the
economy adjusts to balance the
supply and demand for loanable
funds. The supply of loanable
funds comes from national
saving, including both private
saving and public saving.
The demand for loanable
funds comes from firms and
households that want to borrow
for purposes of investment.
Herethe equilibrium interest
rateis 5percent, and $1,200
billion of loanable funds are
supplied and demanded.
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 567
Imagine that someone offered
to give you $100 today or
$100 in ten years. Which
would you choose? This is an
easy question. Getting $100
today is clearly better, because
you can always deposit the
money in a bank, still have it in
ten years, and earn interest
along the way. The lesson:
Money today is more valuable
than the same amount of
money in the future.
Now consider a harder
question: Imagine that someone offered you $100 today or
$200 in ten years. Which would you choose? To answer
this question, you need some way to compare sums of
money from different points in time. Economists do this
with a concept called present value. The present value of
any future sum of money is the amount today that would
be needed, at current interest rates, to produce that fu-
ture sum.
To learn how to use the concept of present value, let’s
work through a couple of simple problems:
Question: If you put $100 in a bank account today,
how much will it be worth in N years? That is, what will be
the future value of this $100?
Answer: Let’s use r to denote the interest rate ex-
pressed in decimal form (so an interest rate of 5 percent
means r H11005 0.05). If interest is paid each year, and if the in-
terest paid remains in the bank account to earn more in-
terest (a process called compounding), the $100 will
become (1 H11001 r) H11003 $100 after one year, (1 H11001r) H11003 (1 H11001r) H11003
$100 after two years, (1 H11001 r) H11003 (1 H11001 r) H11003 (1 H11001 r) H11003 $100
after three years, and so on. After N years, the $100 be-
comes (1 H11001r)
N
H11003 $100. For example, if we are investing at
an interest rate of 5 percent for ten years, then the future
value of the $100 will be (1.05)
10
H11003 $100, which is $163.
Question: Now suppose you are going to be paid $200
in N years. What is the present value of this future pay-
ment? That is, how much would you have to deposit in a
bank right now to yield $200 in N years?
Answer: To answer this question, just turn the previous
answer on its head. In the last question, we computed a fu-
ture value from a present value by multiplying by the factor
(1 H11001 r)
N
. To compute a present value from a future value,
we divide by the factor (1 H11001 r)
N
. Thus, the present value of
$200 in N years is $200/(1 H11001 r)
N
. If that amount is de-
posited in a bank today, after N years it would become
(1 H11001 r)
N
H11003 [$200/(1 H11001 r)
N
], which is $200. For instance, if
the interest rate is 5 percent, the present value of $200 in
ten years is $200/(1.05)
10
, which is $123.
This illustrates the general formula: If r is the interest rate,
then an amount X to be received in N years has present
value of X/(1 H11001 r)
N
.
Let’s now return to our earlier question: Should you
choose $100 today or $200 in ten years? We can infer
from our calculation of present value that if the interest
rate is 5 percent, you should prefer the $200 in ten years.
The future $200 has a present value of $123, which is
greater than $100. You are, therefore, better off waiting for
the future sum.
Notice that the answer to our question depends on the
interest rate. If the interest rate were 8 percent, then the
$200 in ten years would have a present value of $200/
(1.08)
10
, which is only $93. In this case, you should take
the $100 today. Why should the interest rate matter for
your choice? The answer is that the higher the interest rate,
the more you can earn by depositing your money at the
bank, so the more attractive getting $100 today becomes.
The concept of present value is useful in many appli-
cations, including the decisions that companies face when
evaluating investment projects. For instance, imagine that
General Motors is thinking about building a new automobile
factory. Suppose that the factory will cost $100 million to-
day and will yield the company $200 million in ten years.
Should General Motors undertake the project? You can see
that this decision is exactly like the one we have been
studying. To make its decision, the company will compare
the present value of the $200 million return to the $100
million cost.
The company’s decision, therefore, will depend on the
interest rate. If the interest rate is 5 percent, then the
present value of the $200 million return from the factory is
$123 million, and the company will choose to pay the $100
million cost. By contrast, if the interest rate is 8 percent,
then the present value of the return is only $93 million, and
the company will decide to forgo the project. Thus, the con-
cept of present value helps explain why investment—and
thus the quantity of loanable funds demanded—declines
when the interest rate rises.
Here is another application of present value: Suppose
you win a million-dollar lottery, but the prize is going to be
paid out as $20,000 a year for 50 years. How much is the
prize really worth? After performing 50 calculations similar
to those above (one calculation for each payment) and
adding up the results, you would learn that the present
value of this prize at a 7 percent interest rate is only
$276,000. This is one way that state lotteries make
money—by selling tickets in the present, and paying out
prizes in the future.
FYI
Present
Value
568 PART NINE THE REAL ECONOMY IN THE LONG RUN
POLICY 1: TAXES AND SAVING
American families save a smaller fraction of their incomes than their counterparts
in many other countries, such as Japan and Germany. Although the reasons for
these international differences are unclear, many U.S. policymakers view the low
level of U.S. saving as a major problem. One of the Ten Principles of Economics in
Chapter 1 is that a country’s standard of living depends on its ability to produce
goods and services. And, as we discussed in the preceding chapter, saving is an
important long-run determinant of a nation’s productivity. If the United States
could somehow raise its saving rate to the level that prevails in other countries, the
growth rate of GDPwould increase, and over time, U.S. citizens would enjoy a
higher standard of living.
Another of the Ten Principles of Economicsis that people respond to incentives.
Many economists have used this principle to suggest that the low saving rate in
the United States is at least partly attributable to tax laws that discourage saving.
The U.S. federal government, as well as many state governments, collects revenue
by taxing income, including interest and dividend income. To see the effects of this
policy, consider a 25-year-old individual who saves $1,000 and buys a 30-year
bond that pays an interest rate of 9 percent. In the absence of taxes, the $1,000
grows to $13,268 when the individual reaches age 55. Yet if that interest is taxed at
a rate of, say, 33 percent, then the after-tax interest rate is only 6 percent. In this
case, the $1,000 grows to only $5,743 after 30 years. The tax on interest income sub-
stantially reduces the future payoff from current saving and, as a result, reduces
the incentive for people to save.
In response to this problem, many economists and lawmakers have proposed
changing the tax code to encourage greater saving. In 1995, for instance, when
Congressman Bill Archer of Texas became chairman of the powerful House Ways
and Means Committee, he proposed replacing the current income tax with a
consumption tax. Under a consumption tax, income that is saved would not be
taxed until the saving is later spent; in essence, a consumption tax is like the sales
taxes that many states now use to collect revenue. Amore modest proposal is to
expand eligibility for special accounts, such as Individual Retirement Accounts,
that allow people to shelter some of their saving from taxation. Let’s consider the
effect of such a saving incentive on the market for loanable funds, as illustrated in
Figure 25-2.
First, which curve would this policy affect? Because the tax change would al-
ter the incentive for households to save at any given interest rate,it would affect the
quantity of loanable funds supplied at each interest rate. Thus, the supply of loan-
able funds would shift. The demand for loanable funds would remain the same,
because the tax change would not directly affect the amount that borrowers want
to borrow at any given interest rate.
Second, which way would the supply curve shift? Because saving would be
taxed less heavily than under current law, households would increase their saving
by consuming a smaller fraction of their income. Households would use this addi-
tional saving to increase their deposits in banks or to buy more bonds. The supply
of loanable funds would increase, and the supply curve would shift to the right
from S
1
to S
2
, as shown in Figure 25-2.
Finally, we can compare the old and new equilibria. In the figure, the increased
supply of loanable funds reduces the interest rate from 5 percent to 4 percent. The
lower interest rate raises the quantity of loanable funds demanded from $1,200
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 569
billion to $1,600 billion. That is, the shift in the supply curve moves the market
equilibrium along the demand curve. With a lower cost of borrowing, households
and firms are motivated to borrow more to finance greater investment. Thus, if a
change in the tax laws encouraged greater saving, the result would be lower interest rates
and greater investment.
Although this analysis of the effects of increased saving is widely accepted
among economists, there is less consensus about what kinds of tax changes should
be enacted. Many economists endorse tax reform aimed at increasing saving in or-
der to stimulate investment and growth. Yet others are skeptical that these tax
changes would have much effect on national saving. These skeptics also doubt the
equity of the proposed reforms. They argue that, in many cases, the benefits of the
tax changes would accrue primarily to the wealthy, who are least in need of tax re-
lief. We examine this debate more fully in the final chapter of this book.
POLICY 2: TAXES AND INVESTMENT
Suppose that Congress passed a law giving a tax reduction to any firm building a
new factory. In essence, this is what Congress does when it institutes an investment
tax credit,which it does from time to time. Let’s consider the effect of such a law on
the market for loanable funds, as illustrated in Figure 25-3.
First, would the law affect supply or demand? Because the tax credit would
reward firms that borrow and invest in new capital, it would alter investment at
any given interest rate and, thereby, change the demand for loanable funds. By
contrast, because the tax credit would not affect the amount that households save
at any given interest rate, it would not affect the supply of loanable funds.
Loanable Funds
(in billions of dollars)
0
Interest
Rate
4%
5%
Supply, S
1
S
2
$1,200 $1,600
2. ...which
reduces the
equilibrium
interest rate...
3. ...and raises the equilibrium
quantity of loanable funds.
Demand
1. Tax incentives for
saving increase the
supply of loanable
funds...
Figure 25-2
AN INCREASE IN THE SUPPLYOF
LOANABLE FUNDS. Achange
in the tax laws to encourage
Americans to save more would
shift the supply of loanable funds
to the right from S
1
to S
2
. As a
result, the equilibrium interest
rate would fall, and the lower
interest rate would stimulate
investment. Here the equilibrium
interest rate falls from 5 percent
to 4 percent, and the equilibrium
quantity of loanable funds saved
and invested rises from $1,200
billion to $1,600 billion.
570 PART NINE THE REAL ECONOMY IN THE LONG RUN
Second, which way would the demand curve shift? Because firms would have
an incentive to increase investment at any interest rate, the quantity of loanable
funds demanded would be higher at any given interest rate. Thus, the demand
curve for loanable funds would move to the right, as shown by the shift from D
1
to
D
2
in the figure.
Third, consider how the equilibrium would change. In Figure 25-3, the in-
creased demand for loanable funds raises the interest rate from 5 percent to 6 per-
cent, and the higher interest rate in turn increases the quantity of loanable funds
supplied from $1,200 billion to $1,400 billion, as households respond by increasing
the amount they save. This change in household behavior is represented here as a
movement along the supply curve. Thus, if a change in the tax laws encouraged
greater investment, the result would be higher interest rates and greater saving.
POLICY 3:
GOVERNMENT BUDGET DEFICITS AND SURPLUSES
Throughout the 1980s and 1990s, one of the most pressing policy issues was the
size of the government budget deficit. Recall that a budget deficit is an excess of
government spending over tax revenue. Governments finance budget deficits by
borrowing in the bond market, and the accumulation of past government borrow-
ing is called the government debt.In the 1980s and 1990s, the U.S. federal govern-
ment ran large budget deficits, resulting in a rapidly growing government debt. As
a result, much public debate centered on the effects of these deficits both on the al-
location of the economy’s scarce resources and on long-term economic growth.
Loanable Funds
(in billions of dollars)
0
Interest
Rate
5%
6%
$1,200 $1,400
1. An investment
tax credit
increases the
demand for
loanable funds...
2. ...which
raises the
equilibrium
interest rate...
3. ...and raises the equilibrium
quantity of loanable funds.
Supply
Demand, D
1
D
2
Figure 25-3
AN INCREASE IN THE DEMAND
FOR LOANABLE FUNDS. If the
passage of an investment tax
credit encouraged U.S. firms
to invest more, the demand for
loanable funds would increase.
As a result, the equilibrium
interest rate would rise, and
thehigher interest rate would
stimulate saving. Here, when the
demand curve shifts from D
1
to
D
2
, the equilibrium interest rate
rises from 5 percent to 6 percent,
and the equilibrium quantity
ofloanable funds saved and
invested rises from $1,200 billion
to $1,400 billion.
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 571
We can analyze the effects of a budget deficit by following our three steps in
the market for loanable funds, which is illustrated in Figure 25-4. First, which
curve shifts when the budget deficit rises? Recall that national saving—the source
of the supply of loanable funds—is composed of private saving and public saving.
Achange in the government budget deficit represents a change in public saving
and, thereby, in the supply of loanable funds. Because the budget deficit does not
influence the amount that households and firms want to borrow to finance invest-
ment at any given interest rate, it does not alter the demand for loanable funds.
Second, which way does the supply curve shift? When the government runs a
budget deficit, public saving is negative, and this reduces national saving. In other
words, when the government borrows to finance its budget deficit, it reduces the
supply of loanable funds available to finance investment by households and firms.
Thus, a budget deficit shifts the supply curve for loanable funds to the left from
S
1
to S
2
, as shown in Figure 25-4.
Third, we can compare the old and new equilibria. In the figure, when the
budget deficit reduces the supply of loanable funds, the interest rate rises from
5 percent to 6 percent. This higher interest rate then alters the behavior of the
households and firms that participate in the loan market. In particular, many
demanders of loanable funds are discouraged by the higher interest rate. Fewer
families buy new homes, and fewer firms choose to build new factories. The fall in
investment because of government borrowing is called crowding outand is repre-
sented in the figure by the movement along the demand curve from a quantity of
$1,200 billion in loanable funds to a quantity of $800 billion. That is, when the gov-
ernment borrows to finance its budget deficit, it crowds out private borrowers
who are trying to finance investment.
Loanable Funds
(in billions of dollars)
0
Interest
Rate
$800 $1,200
3. ...and reduces the equilibrium
quantity of loanable funds.
S
2
2. ...which
raises the
equilibrium
interest rate...
Supply, S
1
Demand
5%
6%
1. A budget deficit
decreases the
supply of loanable
funds...
Figure 25-4
THE EFFECT OF AGOVERNMENT
BUDGET DEFICIT. When the
government spends more than
it receives in tax revenue, the
resulting budget deficit lowers
national saving. The supply of
loanable funds decreases, and
the equilibrium interest rate rises.
Thus, when thegovernment
borrows to finance its budget
deficit, it crowds out households
and firmswho otherwise would
borrow to finance investment.
Here, when the supply shifts
from S
1
to S
2
, the equilibrium
interest rate rises from 5 percent
to 6 percent, and the equilibrium
quantity of loanable funds saved
and invested falls from $1,200
billion to $800 billion.
crowding out
a decrease in investment that results
from government borrowing
572 PART NINE THE REAL ECONOMY IN THE LONG RUN
CASE STUDY THE DEBATE OVER THE BUDGET SURPLUS
Our analysis shows why, other things being the same, budget surpluses are bet-
ter for economic growth than budget deficits. Making economic policy, how-
ever, is not as simple as this observation may make it sound. Agood example
occurred in the late 1990s, when the U.S. government found itself with a budget
surplus, and much debate centered on what to do with it.
Many policymakers favored leaving the budget surplus alone, rather than
dissipating it with a spending increase or tax cut. They based their conclusion
on the analysis we have just seen: Using the surplus to retire some of the gov-
ernment debt would stimulate private investment and economic growth.
Other policymakers took a different view. Some thought the surplus should
be used to increase government spending on infrastructure and education be-
cause, they argued, the return to these public investments is greater than the
typical return to private investment. Some thought taxes should be cut, arguing
that lower tax rates would distort decisionmaking less and lead to a more effi-
cient allocation of resources; they also cautioned that without such a tax cut,
Thus, the most basic lesson about budget deficits follows directly from their ef-
fects on the supply and demand for loanable funds: When the government reduces
national saving by running a budget deficit, the interest rate rises, and investment falls.
Because investment is important for long-run economic growth, government bud-
get deficits reduce the economy’s growth rate.
Government budget surpluses work just the opposite as budget deficits. When
government collects more in tax revenue than it spends, its saves the difference by
retiring some of the outstanding government debt. This budget surplus, or public
saving, contributes to national saving. Thus, a budget surplus increases the supply of
loanable funds, reduces the interest rate, and stimulates investment.Higher investment,
in turn, means greater capital accumulation and more rapid economic growth.
“Our debt-reduction
plan is simple, but it
willrequire a great
dealof money.”
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 573
Congress would be tempted to spend the surplus on “pork barrel” projects of
dubious value.
As this book was going to press, the debate over the budget surplus was
still raging. There is room for reasonable people to disagree. The right policy
depends on how valuable you view private investment, how valuable you view
public investment, how distortionary you view taxation, and how reliable you
view the political process.
CASE STUDY THE HISTORY OF U.S. GOVERNMENT DEBT
How indebted is the U.S. government? The answer to this question varies sub-
stantially over time. Figure 25-5 shows the debt of the U.S. federal government
expressed as a percentage of U.S. GDP. It shows that the government debt has
fluctuated from zero in 1836 to 107 percent of GDPin 1945. In recent years, gov-
ernment debt has been about 50 percent of GDP.
The behavior of the debt–GDPratio is one gauge of what’s happening with
the government’s finances. Because GDP is a rough measure of the govern-
ment’s tax base, a declining debt–GDPratio indicates that the government in-
debtedness is shrinking relative to its ability to raise tax revenue. This suggests
that the government is, in some sense, living within its means. By contrast, a ris-
ing debt–GDPratio means that the government indebtedness is increasing rela-
tive to its ability to raise tax revenue. It is often interpreted as meaning that
fiscal policy—government spending and taxes—cannot be sustained forever at
current levels.
Throughout history, the primary cause of fluctuations in government
debtis war. When wars occur, government spending on national defense rises
Percent
of GDP
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990
Revolutionary
War
2010
Civil
War World War I
World War II
0
20
40
60
80
100
120
Figure 25-5
THE U.S. GOVERNMENT DEBT.
The debt of the U.S. federal
government, expressed here as
a percentage of GDP, has varied
substantially throughout history.
Itreached its highest level after
thelarge expenditures of World
War II, but then declined through-
out the 1950s and 1960s. It began
rising again in the early 1980s
when Ronald Reagan’s taxcuts
were not accompanied bysimilar
cuts in government spending.
Itthen stabilized andeven
declined slightly inthelate1990s.
Source: U.S. Department of Treasury; U.S.
Department of Commerce; and T. S. Berry,
“Production and Population since 1789,”
Bostwick Paper No. 6, Richmond, 1988.
574 PART NINE THE REAL ECONOMY IN THE LONG RUN
substantially to pay for soldiers and military equipment. Taxes typically rise as
well but by much less than the increase in spending. The result is a budget
deficit and increasing government debt. When the war is over, government
spending declines, and the debt–GDPratio starts declining as well.
There are two reasons to believe that debt financing of war is an appro-
priate policy. First, it allows the government to keep tax rates smooth over time.
Without debt financing, tax rates would have to rise sharply during wars, and
as we saw in Chapter 8, this would cause a substantial decline in economic
efficiency. Second, debt financing of wars shifts part of the cost of wars to fu-
ture generations, who will have to pay off the government debt. This is argu-
ably a fair distribution of the burden, for future generations get some of the
benefit when one generation fights a war to defend the nation against foreign
aggressors.
One large increase in government debt that cannot be explained by war is
the increase that occurred beginning around 1980. When President Ronald Rea-
gan took office in 1981, he was committed to smaller government and lower
taxes. Yet he found cutting government spending to be more difficult politically
than cutting taxes. The result was the beginning of a period of large budget
deficits that continued not only through Reagan’s time in office but also for
many years thereafter. As a result, government debt rose from 26 percent of
GDPin 1980 to 50 percent of GDPin 1993.
As we discussed earlier, government budget deficits reduce national sav-
ing, investment, and long-run economic growth, and this is precisely why the
rise in government debt during the 1980s troubled so many economists. Policy-
makers from both political parties accepted this basic argument and viewed
persistent budget deficits as an important policy problem. When Bill Clinton
moved into the Oval Office in 1993, deficit reduction was his first major goal.
Similarly, when the Republicans took control of Congress in 1995, deficit reduc-
tion was high on their legislative agenda. Both of these efforts substantially re-
duced the size of the government budget deficit, and it eventually turned into a
small surplus. As a result, by the late 1990s, the debt–GDPratio was declining
once again.
QUICK QUIZ: If more Americans adopted a “live for today” approach to
life, how would this affect saving, investment, and the interest rate?
CONCLUSION
“Neither a borrower nor a lender be,” Polonius advises his son in Shake-
speare’s Hamlet. If everyone followed this advice, this chapter would have been
unnecessary.
Few economists would agree with Polonius. In our economy, people borrow
and lend often, and usually for good reason. You may borrow one day to start your
own business or to buy a home. And people may lend to you in the hope that the
interest you pay will allow them to enjoy a more prosperous retirement. The fi-
nancial system has the job of coordinating all this borrowing and lending activity.
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 575
In many ways, financial markets are like other markets in the economy. The
price of loanable funds—the interest rate—is governed by the forces of supply and
demand, just as other prices in the economy are. And we can analyze shifts in sup-
ply or demand in financial markets as we do in other markets. One of the Ten Prin-
ciples of Economicsintroduced in Chapter 1 is that markets are usually a good way
to organize economic activity. This principle applies to financial markets as well.
When financial markets bring the supply and demand for loanable funds into bal-
ance, they help allocate the economy’s scarce resources to their most efficient use.
In one way, however, financial markets are special. Financial markets, unlike
most other markets, serve the important role of linking the present and the future.
Those who supply loanable funds—savers—do so because they want to convert
some of their current income into future purchasing power. Those who demand
loanable funds—borrowers—do so because they want to invest today in order to
have additional capital in the future to produce goods and services. Thus, well-
functioning financial markets are important not only for current generations but
also for future generations who will inherit many of the resulting benefits.
a78 The U.S. financial system is made up of many types of
financial institutions, such as the bond market, the stock
market, banks, and mutual funds. All these institutions
act to direct the resources of households who want to
save some of their income into the hands of households
and firms who want to borrow.
a78 National income accounting identities reveal some
important relationships among macroeconomic
variables. In particular, for a closed economy, national
saving must equal investment. Financial institutions are
the mechanism through which the economy matches
one person’s saving with another person’s investment.
a78 The interest rate is determined by the supply and
demand for loanable funds. The supply of loanable
funds comes from households who want to save some
of their income and lend it out. The demand for
loanable funds comes from households and firms who
want to borrow for investment. To analyze how any
policy or event affects the interest rate, one must
consider how it affects the supply and demand for
loanable funds.
a78 National saving equals private saving plus public
saving. Agovernment budget deficit represents negative
public saving and, therefore, reduces national saving
and the supply of loanable funds available to finance
investment. When a government budget deficit crowds
out investment, it reduces the growth of productivity
and GDP.
Summary
financial system, p. 554
financial markets, p. 555
bond, p. 555
stock, p. 556
financial intermediaries, p. 556
mutual fund, p. 558
national saving (saving), p. 562
private saving, p. 562
public saving, p. 562
budget surplus, p. 562
budget deficit, p. 562
market for loanable funds, p. 564
crowding out, p. 571
Key Concepts
1. What is the role of the financial system? Name and
describe two markets that are part of the financial
system in our economy. Name and describe two
financial intermediaries.
Questions for Review
576 PART NINE THE REAL ECONOMY IN THE LONG RUN
2. Why is it important for people who own stocks and
bonds to diversify their holdings? What type of financial
institution makes diversification easier?
3. What is national saving? What is private saving? What
is public saving? How are these three variables related?
4. What is investment? How is it related to national
saving?
5. Describe a change in the tax code that might increase
private saving. If this policy were implemented, how
would it affect the market for loanable funds?
6. What is a government budget deficit? How does it affect
interest rates, investment, and economic growth?
1. For each of the following pairs, which bond would you
expect to pay a higher interest rate? Explain.
a. a bond of the U.S. government or a bond of an
eastern European government
b. a bond that repays the principal in 2005 or a bond
that repays the principal in 2025
c. a bond from Coca-Cola or a bond from a software
company you run in your garage
d. a bond issued by the federal government or a bond
issued by New York State
2. Look up in a newspaper the stock of two companies you
know something about (perhaps as a customer). What is
the price–earnings ratio for each company? Why do you
think they differ? If you were to buy one of these stocks,
which would you choose? Why?
3. Theodore Roosevelt once said, “There is no moral
difference between gambling at cards or in lotteries or
on the race track and gambling in the stock market.”
What social purpose do you think is served by the
existence of the stock market?
4. Use the Internet to look at the Web site for a mutual
fund company, such as Vanguard (www.vanguard.com).
Compare the return on an actively managed mutual
fund with the return on an index fund. What explains
the difference in these returns?
5. Declines in stock prices are sometimes viewed as
harbingers of future declines in real GDP. Why do you
suppose that might be true?
6. When the Russian government defaulted on its debt to
foreigners in 1998, interest rates rose on bonds issued by
many other developing countries. Why do you suppose
this happened?
7. Many workers hold large amounts of stock issued by
the firms at which they work. Why do you suppose
companies encourage this behavior? Why might a
person notwant to hold stock in the company where
heworks?
8. Your roommate says that he buys stock only in
companies that everyone believes will experience big
increases in profits in the future. How do you suppose
the price–earnings ratio of these companies compares
tothe price–earnings ratio of other companies? What
might be the disadvantage of buying stock in these
companies?
9. Explain the difference between saving and investment
as defined by a macroeconomist. Which of the following
situations represent investment? Saving? Explain.
a. Your family takes out a mortgage and buys a new
house.
b. You use your $200 paycheck to buy stock in AT&T.
c. Your roommate earns $100 and deposits it in her
account at a bank.
d. You borrow $1,000 from a bank to buy a car to use
in your pizza delivery business.
10. Suppose GDPis $8 trillion, taxes are $1.5 trillion, private
saving is $0.5 trillion, and public saving is $0.2 trillion.
Assuming this economy is closed, calculate consump-
tion, government purchases, national saving, and
investment.
11. Suppose that Intel is considering building a new chip-
making factory.
a. Assuming that Intel needs to borrow money in the
bond market, why would an increase in interest
rates affect Intel’s decision about whether to build
the factory?
b. If Intel has enough of its own funds to finance the
new factory without borrowing, would an increase
in interest rates still affect Intel’s decision about
whether to build the factory? Explain.
12. Suppose the government borrows $20 billion more next
year than this year.
a. Use a supply-and-demand diagram to analyze this
policy. Does the interest rate rise or fall?
b. What happens to investment? To private saving? To
public saving? To national saving? Compare the
Problems and Applications
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 577
size of the changes to the $20 billion of extra
government borrowing.
c. How does the elasticity of supply of loanable
fundsaffect the size of these changes? (Hint: See
Chapter5 to review the definition of elasticity.)
d. How does the elasticity of demand for loanable
funds affect the size of these changes?
e. Suppose households believe that greater
government borrowing today implies higher
taxesto pay off the government debt in the future.
What does this belief do to private saving and the
supply of loanable funds today? Does it increase
ordecrease the effects you discussed in parts
(a)and(b)?
13. Over the past ten years, new computer technology has
enabled firms to reduce substantially the amount of
inventories they hold for each dollar of sales. Illustrate
the effect of this change on the market for loanable
funds. (Hint: Expenditure on inventories is a type of
investment.) What do you think has been the effect on
investment in factories and equipment?
14. “Some economists worry that the aging populations of
industrial countries are going to start running down
their savings just when the investment appetite of
emerging economies is growing” (Economist,May 6,
1995). Illustrate the effect of these phenomena on the
world market for loanable funds.
15. This chapter explains that investment can be increased
both by reducing taxes on private saving and by
reducing the government budget deficit.
a. Why is it difficult to implement both of these
policies at the same time?
b. What would you need to know about private
saving in order to judge which of these two policies
would be a more effective way to raise investment?
IN THIS CHAPTER
YOU WILL . . .
Examine how
unemployment
results when firms
choose to pay
efficiency wages
Consider how
unemployment can
result from
minimum-wage laws
Learn about the
data used to
measure the amount
of unemployment
Consider how
unemployment
arises from the
process of job
search
See how
unemployment can
arise from
bargaining between
firms and unions
Losing a job can be the most distressing economic event in a person’s life. Most
people rely on their labor earnings to maintain their standard of living, and many
people get from their work not only income but also a sense of personal accom-
plishment. Ajob loss means a lower living standard in the present, anxiety about
the future, and reduced self-esteem. It is not surprising, therefore, that politicians
campaigning for office often speak about how their proposed policies will help
create jobs.
In the preceding two chapters we have seen some of the forces that determine
the level and growth of a country’s standard of living. Acountry that saves and in-
vests a high fraction of its income, for instance, enjoys more rapid growth in its
capital stock and its GDP than a similar country that saves and invests less. An
even more obvious determinant of a country’s standard of living is the amount of
unemployment it typically experiences. People who would like to work but cannot
UNEMPLOYMENT
AND ITS NATURAL RATE
579
580 PART NINE THE REAL ECONOMY IN THE LONG RUN
find a job are not contributing to the economy’s production of goods and services.
Although some degree of unemployment is inevitable in a complex economy with
thousands of firms and millions of workers, the amount of unemployment varies
substantially over time and across countries. When a country keeps its workers as
fully employed as possible, it achieves a higher level of GDPthan it would if it left
many of its workers standing idle.
This chapter begins our study of unemployment. The problem of unemploy-
ment is usefully divided into two categories—the long-run problem and the short-
run problem. The economy’s natural rate of unemploymentrefers to the amount of
unemployment that the economy normally experiences. Cyclical unemployment
refers to the year-to-year fluctuations in unemployment around its natural rate,
and it is closely associated with the short-run ups and downs of economic activity.
Cyclical unemployment has its own explanation, which we defer until we study
short-run economic fluctuations later in this book. In this chapter we discuss the
determinants of an economy’s natural rate of unemployment. As we will see, the
designation natural does not imply that this rate of unemployment is desirable.
Nor does it imply that it is constant over time or impervious to economic policy. It
merely means that this unemployment does not go away on its own even in the
long run.
We begin the chapter by looking at some of the relevant facts that describe un-
employment. In particular, we examine three questions: How does the govern-
ment measure the economy’s rate of unemployment? What problems arise in
interpreting the unemployment data? How long are the unemployed typically
without work?
We then turn to the reasons why economies always experience some unem-
ployment and the ways in which policymakers can help the unemployed. We dis-
cuss four explanations for the economy’s natural rate of unemployment: job
search, minimum-wage laws, unions, and efficiency wages. As we will see, long-
run unemployment does not arise from a single problem that has a single solution.
Instead, it reflects a variety of related problems. As a result, there is no easy way
for policymakers to reduce the economy’s natural rate of unemployment and, at
the same time, to alleviate the hardships experienced by the unemployed.
IDENTIFYING UNEMPLOYMENT
We begin this chapter by examining more precisely what the term unemployment
means. We consider how the government measures unemployment, what prob-
lems arise in interpreting the unemployment data, and how long the typical spell
of unemployment lasts.
HOW IS UNEMPLOYMENT MEASURED?
Measuring unemployment is the job of the Bureau of Labor Statistics (BLS), which
is part of the Department of Labor. Every month the BLS produces data on unem-
ployment and on other aspects of the labor market, such as types of employment,
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 581
length of the average workweek, and the duration of unemployment. These data
come from a regular survey of about 60,000 households, called the Current Popu-
lation Survey.
Based on the answers to survey questions, the BLS places each adult (aged six-
teen and older) in each surveyed household into one of three categories:
a78 Employed
a78 Unemployed
a78 Not in the labor force
A person is considered employed if he or she spent most of the previous week
working at a paid job. Aperson is unemployed if he or she is on temporary layoff,
is looking for a job, or is waiting for the start date of a new job. Aperson who fits
neither of the first two categories, such as a full-time student, homemaker, or re-
tiree, is not in the labor force. Figure 26-1 shows this breakdown for 1998.
Once the BLS has placed all the individuals covered by the survey in a cate-
gory, it computes various statistics to summarize the state of the labor market. The
BLS defines the labor force as the sum of the employed and the unemployed:
Labor force H11005Number employed H11001number of unemployed
Adult
population
(205.2 million)
Labor force
(137.7 million)
Employed
(131.5 million)
Not in labor force
(67.5 million)
Unemployed (6.2 million)
Figure 26-1
THE BREAKDOWN OF THE
POPULATION IN 1998. The
Bureau of Labor Statistics
divides the adult population
intothree categories: employed,
unemployed, and not in the
laborforce.
SOURCE:Bureau of Labor Statistics.
labor force
the total number of workers,
including both the employed
andtheunemployed
582 PART NINE THE REAL ECONOMY IN THE LONG RUN
The BLS defines the unemployment rate as the percentage of the labor force that
is unemployed:
Unemployment rate H11005H11003 100.
The BLS computes unemployment rates for the entire adult population and for
more narrow groups—blacks, whites, men, women, and so on.
The BLS uses the same survey to produce data on labor-force participation.
The labor-force participation ratemeasures the percentage of the total adult pop-
ulation of the United States that is in the labor force:
Labor-force participation rate H11005H11003 100.
This statistic tells us the fraction of the population that has chosen to participate in
the labor market. The labor-force participation rate, like the unemployment rate, is
computed both for the entire adult population and for more narrow groups.
To see how these data are computed, consider the figures for 1998. In that year,
131.5 million people were employed, and 6.2 million people were unemployed.
The labor force was
Labor force H11005131.5 H110016.2 H11005137.7 million.
The unemployment rate was
Unemployment rate H11005(6.2/137.7) H11003100 H110054.5 percent.
Because the adult population was 205.2 million, the labor-force participation
ratewas
Labor-force participation rate H11005(137.7/205.2) H11003100 H1100567.1 percent.
Hence, in 1998, two-thirds of the U.S. adult population were participating in the
labor market, and 4.5 percent of those labor-market participants were with-
out work.
Table 26-1 shows the statistics on unemployment and labor-force participation
for various groups within the U.S. population. Three comparisons are most appar-
ent. First, women have lower rates of labor-force participation than men, but once
in the labor force, women have similar rates of unemployment. Second, blacks
have similar rates of labor-force participation as whites, and they have much
higher rates of unemployment. Third, teenagers have lower rates of labor-force
participation and much higher rates of unemployment than the overall popula-
tion. More generally, these data show that labor-market experiences vary widely
among groups within the economy.
The BLS data on the labor market also allow economists and policymakers to
monitor changes in the economy over time. Figure 26-2 shows the unemployment
rate in the United States since 1960. The figure shows that the economy always has
some unemployment and that the amount changes from year to year. The normal
rate of unemployment around which the unemployment rate fluctuates is called
the natural rate of unemployment, and the deviation of unemployment from its
Labor force
Adult population
Number of unemployed
Labor force
unemployment rate
the percentage of the labor force
thatis unemployed
labor-force
participation rate
the percentage of the adult
population that is in the labor force
natural rate of
unemployment
the normal rate of unemployment
around which the unemployment
rate fluctuates
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 583
natural rate is called cyclical unemployment. In the figure, the natural rate is
shown as a horizontal line at 5.5 percent, which is a rough estimate of the natural
rate for the U.S. economy during this period. Later in this book we discuss
UNEMPLOYMENT LABOR-FORCE
DEMOGRAPHIC GROUP RATE PARTICIPATION RATE
ADULTS (AGES 20 AND OVER)
White, male 3.2% 77.2%
White, female 3.4 59.7
Black, male 7.4 72.5
Black, female 7.9 64.8
TEENAGERS (AGES 16–19)
White, male 14.1 56.6
White, female 10.9 55.4
Black, male 30.1 40.7
Black, female 25.3 42.5
SOURCE:Bureau of Labor Statistics.
Table 26-1
THE LABOR-MARKET
EXPERIENCES OF VARIOUS
DEMOGRAPHIC GROUPS.
This table shows the
unemployment rate and
thelabor-force participation
rateof various groups in the
U.S.population for 1998.
10
8
6
4
2
0
1970 19751960 1965 1980 1985 1990 2000
Percent of
Labor Force
1995
Natural rate of
unemployment
Unemployment rate
Figure 26-2
UNEMPLOYMENT RATE SINCE 1960. This graph uses annual data onthe unemployment
rate to show the fraction of the labor force without a job.
Source: U.S. Department of Labor.
cyclical unemployment
the deviation of unemployment from
its natural rate
584 PART NINE THE REAL ECONOMY IN THE LONG RUN
CASE STUDY LABOR-FORCE PARTICIPATION
OF MEN AND WOMEN IN THE U.S. ECONOMY
Women’s role in American society has changed dramatically over the past cen-
tury. Social commentators have pointed to many causes for this change. In part,
it is attributable to new technologies such as the washing machine, clothes
dryer, refrigerator, freezer, and dishwasher, which have reduced the amount of
time required to complete routine household tasks. In part, it is attributable to
improved birth control, which has reduced the number of children born to the
typical family. And, of course, this change in women’s role is also partly at-
tributable to changing political and social attitudes. Together these develop-
ments have had a profound impact on society in general and on the economy in
particular.
Nowhere is that impact more obvious than in data on labor-force participa-
tion. Figure 26-3 shows the labor-force participation rates of men and women in
the United States since 1950. Just after World War II, men and women had very
different roles in society. Only 33 percent of women were working or looking for
work, in contrast to 87 percent of men. Over the past several decades, the dif-
ference between the participation rates of men and women has gradually di-
minished, as growing numbers of women have entered the labor force and
some men have left it. Data for 1998 show that 60 percent of women were in the
labor force, in contrast to 75 percent of men. As measured by labor-force partic-
ipation, men and women are now playing a more equal role in the economy.
The increase in women’s labor-force participation is easy to understand, but
the fall in men’s may seem puzzling. There are several reasons for this decline.
short-run economic fluctuations, including the year-to-year fluctuations in unem-
ployment around its natural rate. In the rest of this chapter, however, we ignore the
short-run fluctuations and examine why unemployment is a chronic problem for
market economies.
MORE WOMEN ARE WORKING
NOW THAN EVER BEFORE.
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 585
First, young men now stay in school longer than their fathers and grandfathers
did. Second, older men now retire earlier and live longer. Third, with more
women employed, more fathers now stay at home to raise their children. Full-
time students, retirees, and stay-at-home fathers are all counted as out of the
labor force.
DOES THE UNEMPLOYMENT RATE MEASURE
WHAT WE WANT IT TO?
Measuring the amount of unemployment in the economy might seem straightfor-
ward. In fact, it is not. Whereas it is easy to distinguish between a person with a
full-time job and a person who is not working at all, it is much harder to distin-
guish between a person who is unemployed and a person who is not in the labor
force.
Movements into and out of the labor force are, in fact, very common. More
than one-third of the unemployed are recent entrants into the labor force. These
entrants include young workers looking for their first jobs, such as recent college
graduates. They also include, in greater numbers, older workers who had previ-
ously left the labor force but have now returned to look for work. Moreover, not all
unemployment ends with the job seeker finding a job. Almost half of all spells of
unemployment end when the unemployed person leaves the labor force.
Because people move into and out of the labor force so often, statistics on un-
employment are difficult to interpret. On the one hand, some of those who report
being unemployed may not, in fact, be trying hard to find a job. They may be
calling themselves unemployed because they want to qualify for a government
100
80
60
40
20
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995'98
Labor-Force
Participation
Rate (in percent)
Women
Men
Figure 26-3
LABOR-FORCE PARTICIPATION
RATES FOR MEN AND WOMEN
SINCE 1950. This figure shows
the percentage of adult men and
women who are members of the
labor force. It shows that over
the past several decades, women
have entered the labor force, and
men have left it.
SOURCE: U.S. Department of Labor.
586 PART NINE THE REAL ECONOMY IN THE LONG RUN
program that financially assists the unemployed or because they are actually
working and being paid “under the table.” It may be more realistic to view these
individuals as out of the labor force or, in some cases, employed. On the other
hand, some of those who report being out of the labor force may, in fact, want to
work. These individuals may have tried to find a job but have given up after an
unsuccessful search. Such individuals, called discouraged workers, do not show
up in unemployment statistics, even though they are truly workers without jobs.
According to most estimates, adding discouraged workers would increase the
measured unemployment rate by about one-half of one percentage point.
There is no easy way to fix the unemployment rate as reported by the BLS to
make it a more reliable indicator of conditions in the labor market. In the end, it is
best to view the reported unemployment rate as a useful but imperfect measure of
joblessness.
HOW LONG ARE THE UNEMPLOYED WITHOUT WORK?
In judging how serious the problem of unemployment is, one question to consider
is whether unemployment is typically a short-term or long-term condition. If un-
employment is short-term, one might conclude that it is not a big problem. Work-
ers may require a few weeks between jobs to find the openings that best suit their
tastes and skills. Yet if unemployment is long-term, one might conclude that it is a
serious problem. Workers unemployed for many months are more likely to suffer
economic and psychological hardship.
Because the duration of unemployment can affect our view about how big a
problem unemployment is, economists have devoted much energy to studying
data on the duration of unemployment spells. In this work, they have uncovered a
result that is important, subtle, and seemingly contradictory: Most spells of unem-
ployment are short, and most unemployment observed at any given time is long-term.
To see how this statement can be true, consider an example. Suppose that you
visited the government’s unemployment office every week for a year to survey the
unemployed. Each week you find that there are four unemployed workers. Three
of these workers are the same individuals for the whole year, while the fourth per-
son changes every week. Based on this experience, would you say that unemploy-
ment is typically short-term or long-term?
Some simple calculations help answer this question. In this example, you meet
a total of 55 unemployed people; 52 of them are unemployed for one week, and
three are unemployed for the full year. This means that 52/55, or 95 percent, of un-
employment spells end in one week. Thus, most spells of unemployment are short.
Yet consider the total amount of unemployment. The three people unemployed for
one year (52 weeks) make up a total of 156 weeks of unemployment. Together with
the 52 people unemployed for one week, this makes 208 weeks of unemployment.
In this example, 156/208, or 75 percent, of unemployment is attributable to those
individuals who are unemployed for a full year. Thus, most unemployment ob-
served at any given time is long-term.
This subtle conclusion implies that economists and policymakers must be
careful when interpreting data on unemployment and when designing policies to
help the unemployed. Most people who become unemployed will soon find jobs.
Yet most of the economy’s unemployment problem is attributable to the relatively
few workers who are jobless for long periods of time.
discouraged workers
individuals who would like to work
but have given up looking for a job
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 587
WHY ARE THERE ALWAYS SOME PEOPLE UNEMPLOYED?
We have discussed how the government measures the amount of unemployment,
the problems that arise in interpreting unemployment statistics, and the findings
of labor economists on the duration of unemployment. You should now have a
good idea about what unemployment is.
This discussion, however, has not explained why economies experience un-
employment. In most markets in the economy, prices adjust to bring quantity sup-
plied and quantity demanded into balance. In an ideal labor market, wages would
adjust to balance the quantity of labor supplied and the quantity of labor de-
manded. This adjustment of wages would ensure that all workers are always fully
employed.
Of course, reality does not resemble this ideal. There are always some workers
without jobs, even when the overall economy is doing well. In other words, the
unemployment rate never falls to zero; instead, it fluctuates around the natural
rate of unemployment. To understand this natural rate, we now examine the rea-
sons why actual labor markets depart from the ideal of full employment.
To preview our conclusions, we will find that there are four ways to explain
unemployment in the long run. The first explanation is that it takes time for work-
ers to search for the jobs that are best suited for them. The unemployment that re-
sults from the process of matching workers and jobs is sometimes called frictional
unemployment,and it is often thought to explain relatively short spells of unem-
ployment.
The next three explanations for unemployment suggest that the number of
jobs available in some labor markets may be insufficient to give a job to everyone
who wants one. This occurs when the quantity of labor supplied exceeds the quan-
tity demanded. Unemployment of this sort is sometimes called structural unem-
ployment,and it is often thought to explain longer spells of unemployment. As we
will see, this kind of unemployment results when wages are, for some reason, set
above the level that brings supply and demand into equilibrium. We will examine
three possible reasons for an above-equilibrium wage: minimum-wage laws,
unions, and efficiency wages.
QUICK QUIZ: How is the unemployment rate measured? a78How might
the unemployment rate overstate the amount of joblessness? How might it
understate it?
JOB SEARCH
One reason why economies always experience some unemployment is job search.
Job searchis the process of matching workers with appropriate jobs. If all workers
and all jobs were the same, so that all workers were equally well suited for all jobs,
job search would not be a problem. Laid-off workers would quickly find new
jobs that were well suited for them. But, in fact, workers differ in their tastes and
skills, jobs differ in their attributes, and information about job candidates and job
frictional unemployment
unemployment that results because
it takes time for workers to search
forthe jobs that best suit their
tastesandskills
structural unemployment
unemployment that results because
the number of jobs available in
somelabor markets is insufficient
toprovide a job for everyone
whowantsone
job search
the process by which workers
findappropriate jobs given
theirtastes and skills
588 PART NINE THE REAL ECONOMY IN THE LONG RUN
vacancies is disseminated slowly among the many firms and households in the
economy.
WHY SOME FRICTIONAL UNEMPLOYMENT IS INEVITABLE
Frictional unemployment is often the result of changes in the demand for labor
among different firms. When consumers decide that they prefer Compaq over Dell
computers, Compaq increases employment, and Dell lays off workers. The former
Dell workers must now search for new jobs, and Compaq must decide which new
workers to hire for the various jobs that have opened up. The result of this transi-
tion is a period of unemployment.
Similarly, because different regions of the country produce different goods,
employment can rise in one region while it falls in another. Consider, for instance,
what happens when the world price of oil falls. Oil-producing firms in Texas re-
spond to the lower price by cutting back on production and employment. At the
same time, cheaper gasoline stimulates car sales, so auto-producing firms in
Michigan raise production and employment. Changes in the composition of de-
mand among industries or regions are called sectoral shifts.Because it takes time for
workers to search for jobs in the new sectors, sectoral shifts temporarily cause un-
employment.
Frictional unemployment is inevitable simply because the economy is always
changing. Acentury ago, the four industries with the largest employment in the
United States were cotton goods, woolen goods, men’s clothing, and lumber. To-
day, the four largest industries are autos, aircraft, communications, and electrical
components. As this transition took place, jobs were created in some firms, and
jobs were destroyed in others. The end result of this process has been higher pro-
ductivity and higher living standards. But, along the way, workers in declining in-
dustries found themselves out of work and searching for new jobs.
Data show that at least 10 percent of U.S. manufacturing jobs are destroyed
every year. In addition, more than 3 percent of workers leave their jobs in a typical
month, sometimes because they realize that the jobs are not a good match for their
tastes and skills. Many of these workers, especially younger ones, find new jobs
at higher wages. This churning of the labor force is normal in a well-functioning
and dynamic market economy, but the result is some amount of frictional
unemployment.
PUBLIC POLICY AND JOB SEARCH
Even if some frictional unemployment is inevitable, the precise amount is not. The
faster information spreads about job openings and worker availability, the more
rapidly the economy can match workers and firms. The Internet, for instance, may
help facilitate job search and reduce frictional unemployment. In addition, public
policy may play a role. If policy can reduce the time it takes unemployed workers
to find new jobs, it can reduce the economy’s natural rate of unemployment.
Government programs try to facilitate job search in various ways. One way is
through government-run employment agencies, which give out information about
job vacancies. Another way is through public training programs, which aim to
ease the transition of workers from declining to growing industries and to help
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 589
disadvantaged groups escape poverty. Advocates of these programs believe that
they make the economy operate more efficiently by keeping the labor force more
fully employed, and that they reduce the inequities inherent in a constantly chang-
ing market economy.
Critics of these programs question whether the government should get in-
volved with the process of job search. They argue that it is better to let the private
market match workers and jobs. In fact, most job search in our economy takes
place without intervention by the government. Newspaper ads, job newsletters,
college placement offices, headhunters, and word of mouth all help spread infor-
mation about job openings and job candidates. Similarly, much worker education
is done privately, either through schools or through on-the-job training. These crit-
ics contend that the government is no better—and most likely worse—at dissemi-
nating the right information to the right workers and deciding what kinds of
worker training would be most valuable. They claim that these decisions are best
made privately by workers and employers.
UNEMPLOYMENT INSURANCE
One government program that increases the amount of frictional unemployment,
without intending to do so, is unemployment insurance. This program is de-
signed to offer workers partial protection against job loss. The unemployed who
quit their jobs, were fired for cause, or just entered the labor force are not eligible.
Benefits are paid only to the unemployed who were laid off because their previous
employers no longer needed their skills. Although the terms of the program vary
over time and across states, a typical American worker covered by unemployment
insurance receives 50 percent of his or her former wages for 26 weeks.
While unemployment insurance reduces the hardship of unemployment, it
also increases the amount of unemployment. The explanation is based on one of
the Ten Principles of Economicsin Chapter 1: People respond to incentives. Because
unemployment benefits stop when a worker takes a new job, the unemployed de-
vote less effort to job search and are more likely to turn down unattractive job of-
fers. In addition, because unemployment insurance makes unemployment less
onerous, workers are less likely to seek guarantees of job security when they ne-
gotiate with employers over the terms of employment.
Many studies by labor economists have examined the incentive effects of un-
employment insurance. One study examined an experiment run by the state of Illi-
nois in 1985. When unemployed workers applied to collect unemployment
insurance benefits, the state randomly selected some of them and offered each a
$500 bonus if they found new jobs within 11 weeks. This group was then com-
pared to a control group not offered the incentive. The average spell of unemploy-
ment for the group offered the bonus was 7 percent shorter than the average spell
for the control group. This experiment shows that the design of the unemployment
insurance system influences the effort that the unemployed devote to job search.
Several other studies examined search effort by following a group of workers
over time. Unemployment insurance benefits, rather than lasting forever, usually
run out after six months or a year. These studies found that when the unemployed
become ineligible for benefits, the probability of their finding a new job rises
markedly. Thus, receiving unemployment insurance benefits does reduce the
search effort of the unemployed.
unemployment insurance
a government program that partially
protects workers’incomes when
theybecome unemployed
590 PART NINE THE REAL ECONOMY IN THE LONG RUN
MANY EUROPEAN COUNTRIES HAVE UN-
employment insurance that is far more
generous than that offered to U.S.
workers, and some economists believe
that these programs explain the high
European unemployment rates. The
following article discusses the recent
debate over unemployment insurance
in Germany.
For Germany,
Benefits Are Also a Burden
BY ELIZABETH NEUFFER
BERLIN—They grumble and grouse as
they wait for their benefit checks at a
local unemployment office here—about
the lack of jobs, about the stupidity of
German politicians, about how outra-
geously high taxes are.
What today’s unemployed Germans
don’t complain about is this: the size of
their benefit checks.
“I get unemployment benefits, I
make some money working on the black
market, I make a living,” says Michael
Steinbach, a 30-year-old electrician who
sports a well-ironed shirt, fashionable
glasses, and a briefcase as he waits his
turn at the Prenzlauer Berg unemploy-
ment office. “For now, it’s comfortable.”
Germany’s social welfare system
takes good care of the jobless, with ini-
tial average monthly checks of nearly
$900 per month for someone married—
and the prospect, for those who know
how to work the system, of remaining on
benefits for life. So blatantly do people
abuse this system that Chancellor Hel-
mut Kohl once critically described his
country as “Leisurepark Germany.” . . .
Now—partly because . . . such gen-
erous benefits are seriously straining the
nation’s economy—questions are being
raised about whether one way to combat
unemployment is to reform the social
welfare system itself. . . .
Combating unemployment, always a
hot topic here, leapt back into public de-
bate last week, after the German Labor
office released figures showing that job-
lessness inched up to 11.7 percent in
September, the fifth consecutive post-
war record. . . .
The unease here also stems from
memories of when Germany last faced
such levels of joblessness: 1933, when
the unemployed were so desperate they
begged in the streets for spare change,
relied on soup kitchens for meals, and
ushered the Nazis into power.
Postwar Germany’s reaction was to
create a massive welfare state, designed
to squelch social unrest through social
benevolence. “It’s more important to
have modestly happy people on benefits
than poverty and all its side effects such
as a high crime rate as in the United
States,” said Heiner Geissler, a leading
figure in the ruling CDU party.
It is becoming increasingly clear,
though, that preserving benefits has
trapped Germany in something of a vi-
cious circle.
The nation’s high-cost social welfare
system is one reason its labor costs are
among the highest in the world: Both
employees and employers must pay
generously into the system, so they
need higher wages and profits. More
than half of a worker’s paycheck goes to
taxes. Employer/employee-funded taxes
this year alone totaled 52.8 billion
deutsche marks, or nearly $30 billion.
But high labor costs are a major
reason companies are now fleeing for
cheaper, neighboring Poland—meaning
job losses for Germany. At the same
time, unemployment benefits have be-
come something of a velvet coffin for the
unemployed, discouraging them from
taking jobs. Until recently, workers who
worked part-time were effectively penal-
ized, as they would receive less unem-
ployment benefits if they were laid off.
And generous unemployment bene-
fits mean there is no incentive to take
part-time or low-paid work—a strategy
adopted to fight unemployment in
other countries, including the United
States. . . .
These benefits are so good that ex-
ploiting them is something of a national
sport. In a recent, and not uncommon,
conversation overheard in a Berlin cafe,
a woman bragged about how she was
using her Sozialhilfe to pay for a vacation
in Italy. Some Germans even register in
several districts, knowing it’s unlikely
they will be caught for receiving multiple
benefits.
Not surprisingly, more than 60 per-
cent of Germany’s unemployed are long-
term unemployed.
“People are used to, and heavily
rely on, ‘Father State,’ ” said Dieter
Hundt, president of the Confederation of
Germany Employers’ Association. “We
are a bit spoiled by a too tightly woven
social net, which doesn’t encourage the
individual enough to improve his own
situation.”
SOURCE:The Boston Globe,October 12, 1997, p. F1.
IN THE NEWS
German Unemployment
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 591
Even though unemployment insurance reduces search effort and raises unem-
ployment, we should not necessarily conclude that the policy is a bad one. The
program does achieve its primary goal of reducing the income uncertainty that
workers face. In addition, when workers turn down unattractive job offers, they
have the opportunity to look for jobs that better suit their tastes and skills. Some
economists have argued that unemployment insurance improves the ability of the
economy to match each worker with the most appropriate job.
The study of unemployment insurance shows that the unemployment rate is
an imperfect measure of a nation’s overall level of economic well-being. Most
economists agree that eliminating unemployment insurance would reduce the
amount of unemployment in the economy. Yet economists disagree on whether
economic well-being would be enhanced or diminished by this change in policy.
QUICK QUIZ: How would an increase in the world price of oil affect the
amount of frictional unemployment? Is this unemployment undesirable?
What public policies might affect the amount of unemployment caused by this
price change?
MINIMUM-WAGE LAWS
Having seen how frictional unemployment results from the process of matching
workers and jobs, let’s now examine how structural unemployment results when
the number of jobs is insufficient for the number of workers.
To understand structural unemployment, we begin by reviewing how un-
employment arises from minimum-wage laws—a topic we first analyzed in
Chapter 6. Although minimum wages are not the predominant reason for unem-
ployment in our economy, they have an important effect on certain groups with
particularly high unemployment rates. Moreover, the analysis of minimum wages
is a natural place to start because, as we will see, it can be used to understand some
of the other reasons for structural unemployment.
Figure 26-4 reviews the basic economics of a minimum wage. When a
minimum-wage law forces the wage to remain above the level that balances sup-
ply and demand, it raises the quantity of labor supplied and reduces the quantity
of labor demanded compared to the equilibrium level. There is a surplus of labor.
Because there are more workers willing to work than there are jobs, some workers
are unemployed.
Because we discussed minimum-wage laws extensively in Chapter 6, we will
not discuss them further here. It is, however, important to note why minimum-
wage laws are not a predominant reason for unemployment: Most workers in the
economy have wages well above the legal minimum. Minimum-wage laws are
binding most often for the least skilled and least experienced members of the labor
force, such as teenagers. It is only among these workers that minimum-wage laws
explain the existence of unemployment.
Although Figure 26-4 is drawn to show the effects of a minimum-wage law, it
also illustrates a more general lesson: If the wage is kept above the equilibrium level for
any reason, the result is unemployment.Minimum-wage laws are just one reason why
592 PART NINE THE REAL ECONOMY IN THE LONG RUN
wages may be “too high.” In the remaining two sections of this chapter, we con-
sider two other reasons why wages may be kept above the equilibrium level—
unions and efficiency wages. The basic economics of unemployment in these cases
is the same as that shown in Figure 26-4, but these explanations of unemployment
can apply to many more of the economy’s workers.
At this point, however, we should stop and notice that the structural unem-
ployment that arises from an above-equilibrium wage is, in an important sense,
different from the frictional unemployment that arises from the process of job
search. The need for job search is not due to the failure of wages to balance labor
supply and labor demand. When job search is the explanation for unemployment,
workers are searchingfor the jobs that best suit their tastes and skills. By contrast,
when the wage is above the equilibrium level, the quantity of labor supplied ex-
ceeds the quantity of labor demanded, and workers are unemployed because they
are waitingfor jobs to open up.
QUICK QUIZ: Draw the supply curve and the demand curve for a labor
market in which the wage is fixed above the equilibrium level. Show the
quantity of labor supplied, the quantity demanded, and the amount of
unemployment.
UNIONS AND COLLECTIVE BARGAINING
A union is a worker association that bargains with employers over wages and
working conditions. Whereas only 16 percent of U.S. workers now belong to
W
E
Quantity of
Labor
L
E
0
Surplus of labor H11005
Unemployment
Labor
supply
Labor
demand
Wage
Minimum
wage
L
D
L
S
Figure 26-4
UNEMPLOYMENT FROM A
WAGE ABOVE THE EQUILIBRIUM
LEVEL. In this labor market,
the wage atwhich supply and
demand balance is W
E
. At this
equilibrium wage, the quantity of
labor supplied and the quantity
of labor demanded both equal L
E
.
By contrast, if the wage is forced
to remain above the equilibrium
level, perhaps because of a
minimum-wage law, the quantity
of labor supplied rises to L
S
,and
the quantity of labor demanded
falls to L
D
.The resulting surplus
of labor, L
S
–L
D
,represents
unemployment.
union
a worker association that bargains
with employers over wages and
working conditions
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 593
unions, unions played a much larger role in the U.S. labor market in the past. In
the 1940s and 1950s, when unions were at their peak, about a third of the U.S. labor
force was unionized. Moreover, unions continue to play a large role in many
European countries. In Sweden and Denmark, for instance, more than three-
fourths of workers belong to unions.
THE ECONOMICS OF UNIONS
Aunion is a type of cartel. Like any cartel, a union is a group of sellers acting to-
gether in the hope of exerting their joint market power. Most workers in the U.S.
economy discuss their wages, benefits, and working conditions with their em-
ployers as individuals. By contrast, workers in a union do so as a group. The
process by which unions and firms agree on the terms of employment is called col-
lective bargaining.
When a union bargains with a firm, it asks for higher wages, better benefits,
and better working conditions than the firm would offer in the absence of a union.
If the union and the firm do not reach agreement, the union can organize a with-
drawal of labor from the firm, called a strike.Because a strike reduces production,
sales, and profit, a firm facing a strike threat is likely to agree to pay higher wages
than it otherwise would. Economists who study the effects of unions typically find
that union workers earn about 10 to 20 percent more than similar workers who do
not belong to unions.
When a union raises the wage above the equilibrium level, it raises the quan-
tity of labor supplied and reduces the quantity of labor demanded, resulting in un-
employment. Those workers who remain employed are better off, but those who
were previously employed and are now unemployed at the higher wage are worse
off. Indeed, unions are often thought to cause conflict between different groups of
workers—between the insiders who benefit from high union wages and the out-
siderswho do not get the union jobs.
The outsiders can respond to their status in one of two ways. Some of them
remain unemployed and wait for the chance to become insiders and earn the high
union wage. Others take jobs in firms that are not unionized. Thus, when unions
raise wages in one part of the economy, the supply of labor increases in other parts
of the economy. This increase in labor supply, in turn, reduces wages in industries
that are not unionized. In other words, workers in unions reap the benefit of col-
lective bargaining, while workers not in unions bear some of the cost.
The role of unions in the economy depends in part on the laws that govern
union organization and collective bargaining. Normally, explicit agreements
among members of a cartel are illegal. If firms that sell a common product were to
agree to set a high price for that product, the agreement would be a “conspiracy in
restraint of trade.” The government would prosecute these firms in civil and crim-
inal court for violating the antitrust laws. By contrast, unions are exempt from
these laws. The policymakers who wrote the antitrust laws believed that workers
needed greater market power as they bargained with employers. Indeed, various
laws are designed to encourage the formation of unions. In particular, the Wagner
Act of 1935 prevents employers from interfering when workers try to organize
unions and requires employers to bargain with unions in good faith. The National
Labor Relations Board (NLRB) is the government agency that enforces workers’
right to unionize.
collective bargaining
the process by which unions
andfirms agree on the
termsofemployment
strike
the organized withdrawal of
laborfrom a firm by a union
594 PART NINE THE REAL ECONOMY IN THE LONG RUN
Legislation affecting the market power of unions is a perennial topic of politi-
cal debate. State lawmakers sometimes debate right-to-work laws,which give work-
ers in a unionized firm the right to choose whether to join the union. In the absence
of such laws, unions can insist during collective bargaining that firms make union
membership a requirement for employment. In recent years, lawmakers in Wash-
ington have debated a proposed law that would prevent firms from hiring perma-
nent replacements for workers who are on strike. This law would make strikes
more costly for firms and, thereby, would increase the market power of unions.
These and similar policy decisions will help determine the future of the union
movement.
ARE UNIONS GOOD OR BAD FOR THE ECONOMY?
Economists disagree about whether unions are good or bad for the economy as a
whole. Let’s consider both sides of the debate.
Critics of unions argue that unions are merely a type of cartel. When unions
raise wages above the level that would prevail in competitive markets, they reduce
the quantity of labor demanded, cause some workers to be unemployed, and re-
duce the wages in the rest of the economy. The resulting allocation of labor is, crit-
ics argue, both inefficient and inequitable. It is inefficient because high union
wages reduce employment in unionized firms below the efficient, competitive
level. It is inequitable because some workers benefit at the expense of other
workers.
“Gentlemen, nothing stands in the way of a final accord except that management
wants profit maximization and the union wants more moola.”
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 595
SOMEDAY YOU MAY FACE THE DECISION
about whether to vote for or against a
union in your workplace. The follow-
ing article discusses some issues you
might consider.
On Payday,
Union Jobs Stack Up Very Well
BY DAVID CAY JOHNSTON
With the teamsters’ success in their
two-week strike against United Parcel
Service, and with the A.F.L.-C.I.O. train-
ing thousands of union organizers in a
drive to reverse a quarter-century of de-
clining membership, millions of workers
will be asked over the next few years
whether they want a union to represent
them.
It is a complicated question, the an-
swer to which rests on a jumble of deter-
minations: Do you favor collective action
or individual initiative? Do you trust the
union’s leaders? Do you want somebody
else speaking for you in dealings with
your employer? Do you think you will be
dismissed if you sign a union card—or
that the company will send your job over-
seas if a union is organized?
But in one regard, the choice is sim-
ple—and it is not the choice that most
workers have made during the labor
movement’s recent decades in the eco-
nomic wilderness.
From a pocketbook perspective,
workers are absolutely better off joining
a union. Economists across the political
spectrum agree. Turning a nonunion job
into a union job very likely will have a big-
ger effect on lifetime finances than all the
advice employees will ever read about in-
vesting their 401(k) plans, buying a
home or otherwise making more of what
they earn.
Here is how the equation works,
said Prof. Richard B. Freeman of Harvard
University: “For an existing worker in a
firm, if you can carry out an organizing
drive, it is all to your benefit. If there are
going to be losers, they are people who
might have gotten a job in the future, the
shareholders whose profits will go down,
the managers because there will be less
profit to distribute to them in pay and,
maybe, consumers will pay a little more
for the product. But as a worker, it is aw-
fully hard to see why you wouldn’t want a
union.”
Overall, union workers are paid
about 20 percent more than nonunion
workers, and their fringe benefits are
typically worth two to four times as
much, economists with a wide array of
views have found. The financial advan-
tage is even greater for workers with lit-
tle formal education and training and for
women, blacks, and Hispanic workers.
Moreover, 85 percent of union
members have health insurance, com-
pared with 57 percent of nonunion
workers, said Barry Bluestone, a labor-
friendly economics professor at the Uni-
versity of Massachusetts.
The conclusion draws no argument
even from Prof. Leo Troy of Rutgers Uni-
versity, who is widely known in academic
circles and among union leaders for his
hostility to organized labor. “From a
standpoint of wages and fringe bene-
fits,” Professor Troy said, “the answer is
yes, you are better off in a union.”
His objections to unions concern
how they reduce profits for owners and
distort investment decisions in ways that
slow the overall growth of the econ-
omy—not how they affect workers who
bargain collectively. Professor Troy
points out that he belongs to a union
himself—the American Association of
University Professors.
Donald R. Deere, an economist at
the Bush School of Government and
Public Service at Texas A & M University,
studied the wage differential for compa-
rable union and nonunion workers be-
tween 1974 and 1996, a period when
union membership fell to 15 percent of
American workers from 22 percent.
In every educational and age cate-
gory that he studied, Professor Deere
found that union members increased
their wage advantage over nonunion
workers during those years. Last year,
he estimates, unionized workers with
less than a high school education earned
22 percent more than their nonunion
counterparts. The differential declined as
education levels rose, reaching 10 per-
cent for college graduates.
“It makes sense to belong to a
union,” Professor Deere said, “so long
as you don’t lose your job in the long
term.”
Source: The New York Times,Money & Business
Section, August 31, 1997, p. 1.
IN THE NEWS
Should You Join a Union?
596 PART NINE THE REAL ECONOMY IN THE LONG RUN
Advocates of unions contend that unions are a necessary antidote to the mar-
ket power of the firms that hire workers. The extreme case of this market power is
the “company town,” where a single firm does most of the hiring in a geographic
region. In a company town, if workers do not accept the wages and working con-
ditions that the firm offers, they have little choice but to move or stop working. In
the absence of a union, therefore, the firm could use its market power to pay lower
wages and offer worse working conditions than would prevail if it had to com-
pete with other firms for the same workers. In this case, a union may balance the
firm’s market power and protect the workers from being at the mercy of the firm
owners.
Advocates of unions also claim that unions are important for helping firms re-
spond efficiently to workers’ concerns. Whenever a worker takes a job, the worker
and the firm must agree on many attributes of the job in addition to the wage:
hours of work, overtime, vacations, sick leave, health benefits, promotion sched-
ules, job security, and so on. By representing workers’ views on these issues,
unions allow firms to provide the right mix of job attributes. Even if unions have
the adverse effect of pushing wages above the equilibrium level and causing un-
employment, they have the benefit of helping firms keep a happy and productive
workforce.
In the end, there is no consensus among economists about whether unions are
good or bad for the economy. Like many institutions, their influence is probably
beneficial in some circumstances and adverse in others.
QUICK QUIZ: How does a union in the auto industry affect wages and
employment at General Motors and Ford? How does it affect wages and
employment in other industries?
THE THEORY OF EFFICIENCY WAGES
Afourth reason why economies always experience some unemployment—in ad-
dition to job search, minimum-wage laws, and unions—is suggested by the theory
of efficiency wages. According to this theory, firms operate more efficiently if
wages are above the equilibrium level. Therefore, it may be profitable for firms to
keep wages high even in the presence of a surplus of labor.
In some ways, the unemployment that arises from efficiency wages is similar
to the unemployment that arises from minimum-wage laws and unions. In all
three cases, unemployment is the result of wages above the level that balances the
quantity of labor supplied and the quantity of labor demanded. Yet there is also
an important difference. Minimum-wage laws and unions prevent firms from
lowering wages in the presence of a surplus of workers. Efficiency-wage theory
states that such a constraint on firms is unnecessary in many cases because firms
may be better off keeping wages above the equilibrium level.
Why should firms want to keep wages high? In some ways, this decision
seems odd, for wages are a large part of firms’ costs. Normally, we expect profit-
maximizing firms to want to keep costs—and therefore wages—as low as possible.
efficiency wages
above-equilibrium wages paid
byfirms in order to increase
workerproductivity
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 597
The novel insight of efficiency-wage theory is that paying high wages might be
profitable because they might raise the efficiency of a firm’s workers.
There are several types of efficiency-wage theory. Each type suggests a differ-
ent explanation for why firms may want to pay high wages. Let’s now consider
four of these types.
WORKER HEALTH
The first and simplest type of efficiency-wage theory emphasizes the link between
wages and worker health. Better paid workers eat a more nutritious diet, and
workers who eat a better diet are healthier and more productive. Afirm may find
it more profitable to pay high wages and have healthy, productive workers than to
pay lower wages and have less healthy, less productive workers.
This type of efficiency-wage theory is not relevant for firms in rich countries
such as the United States. In these countries, the equilibrium wages for most
workers are well above the level needed for an adequate diet. Firms are not
concerned that paying equilibrium wages would place their workers’ health in
jeopardy.
This type of efficiency-wage theory is more relevant for firms in less devel-
oped countries where inadequate nutrition is a more common problem. Unem-
ployment is high in the cities of many poor African countries, for example. In these
countries, firms may fear that cutting wages would, in fact, adversely influence
their workers’ health and productivity. In other words, concern over nutrition may
explain why firms do not cut wages despite a surplus of labor.
WORKER TURNOVER
Asecond type of efficiency-wage theory emphasizes the link between wages and
worker turnover. Workers quit jobs for many reasons—to take jobs in other firms,
to move to other parts of the country, to leave the labor force, and so on. The fre-
quency with which they quit depends on the entire set of incentives they face, in-
cluding the benefits of leaving and the benefits of staying. The more a firm pays its
workers, the less often its workers will choose to leave. Thus, a firm can reduce
turnover among its workers by paying them a high wage.
Why do firms care about turnover? The reason is that it is costly for firms to
hire and train new workers. Moreover, even after they are trained, newly hired
workers are not as productive as experienced workers. Firms with higher
turnover, therefore, will tend to have higher production costs. Firms may find it
profitable to pay wages above the equilibrium level in order to reduce worker
turnover.
WORKER EFFORT
A third type of efficiency-wage theory emphasizes the link between wages
and worker effort. In many jobs, workers have some discretion over how hard to
work. As a result, firms monitor the efforts of their workers, and workers caught
598 PART NINE THE REAL ECONOMY IN THE LONG RUN
shirking their responsibilities are fired. But not all shirkers are caught immediately
because monitoring workers is costly and imperfect. A firm can respond to this
problem by paying wages above the equilibrium level. High wages make workers
more eager to keep their jobs and, thereby, give workers an incentive to put for-
ward their best effort.
This particular type of efficiency-wage theory is similar to the old Marxist idea
of the “reserve army of the unemployed.” Marx thought that employers benefited
from unemployment because the threat of unemployment helped to discipline
those workers who had jobs. In the worker-effort variant of efficiency-wage theory,
unemployment fills a similar role. If the wage were at the level that balanced sup-
ply and demand, workers would have less reason to work hard because if they
were fired, they could quickly find new jobs at the same wage. Therefore, firms
raise wages above the equilibrium level, causing unemployment and providing an
incentive for workers not to shirk their responsibilities.
WORKER QUALITY
A fourth and final type of efficiency-wage theory emphasizes the link between
wages and worker quality. When a firm hires new workers, it cannot perfectly
gauge the quality of the applicants. By paying a high wage, the firm attracts a bet-
ter pool of workers to apply for its jobs.
To see how this might work, consider a simple example. Waterwell Company
owns one well and needs one worker to pump water from the well. Two workers,
Bill and Ted, are interested in the job. Bill, a proficient worker, is willing to work
for $10 per hour. Below that wage, he would rather start his own lawn-mowing
business. Ted, a complete incompetent, is willing to work for anything above $2
per hour. Below that wage, he would rather sit on the beach. Economists say that
Bill’s reservation wage—the lowest wage he would accept—is $10, and Ted’s reser-
vation wage is $2.
What wage should the firm set? If the firm were interested in minimizing
labor costs, it would set the wage at $2 per hour. At this wage, the quantity of
workers supplied (one) would balance the quantity demanded. Ted would take
the job, and Bill would not apply for it. Yet suppose Waterwell knows that only
one of these two applicants is competent, but it does not know whether it is Bill or
Ted. If the firm hires the incompetent worker, he will damage the well, causing
the firm huge losses. In this case, the firm has a better strategy than paying the
DILBERT
?
By Scott Adams
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 599
equilibrium wage of $2 and hiring Ted. It can offer $10 per hour, inducing both Bill
and Ted to apply for the job. By choosing randomly between these two applicants
and turning the other away, the firm has a fifty-fifty chance of hiring the compe-
tent one. By contrast, if the firm offers any lower wage, it is sure to hire the incom-
petent worker.
In many situations in life, in-
formation is asymmetric: One
person in a transaction knows
more about what is going on
than the other person. This
possibility raises a variety of
interesting problems for eco-
nomic theory. Some of these
problems were highlighted in
our description of the theory of
efficiency wages. These prob-
lems, however, go beyond the
study of unemployment.
The worker-quality variant
of efficiency-wage theory illus-
trates a general principle called adverse selection. Adverse
selection arises when one person knows more about the at-
tributes of a good than another and, as a result, the unin-
formed person runs the risk of being sold a good of low
quality. In the case of worker quality, for instance, workers
have better information about their own abilities than firms
do. When a firm cuts the wage it pays, the selection of work-
ers changes in a way that is adverse to the firm.
Adverse selection arises in many other circumstances.
Here are two examples:
a78 Sellers of used cars know their vehicles’ defects,
whereas buyers often do not. Because owners of the
worst cars are more likely to sell them than are the
owners of the best cars, buyers are correctly apprehen-
sive about getting a “lemon.” As a result, many people
avoid buying cars in the used car market.
a78 Buyers of health insurance know more about their own
health problems than do insurance companies. Be-
cause people with greater hidden health problems are
more likely to buy health insurance than are other peo-
ple, the price of health insurance reflects the costs of a
sicker-than-average person. As a result, people with av-
erage health problems are discouraged by the high
price from buying health insurance.
In each case, the market for the product—used cars or
health insurance—does not work as well as it might be-
cause of the problem of adverse selection.
Similarly, the worker-effort variant of efficiency-wage
theory illustrates a general phenomenon called moral haz-
ard. Moral hazard arises when one person, called the agent,
is performing some task on behalf of another person, called
the principal. Because the principal cannot perfectly monitor
the agent’s behavior, the agent tends to undertake less ef-
fort than the principal considers desirable. The term moral
hazard refers to the risk of dishonest or otherwise inappro-
priate behavior by the agent. In such a situation, the princi-
pal tries various ways to encourage the agent to act more
responsibly.
In an employment relationship, the firm is the principal
and the worker is the agent. The moral-hazard problem is
the temptation of imperfectly monitored workers to shirk
their responsibilities. According to the worker-effort variant
of efficiency-wage theory, the principal can encourage the
agent not to shirk by paying a wage above the equilibrium
level because then the agent has more to lose if caught
shirking. In this way, high wages reduce the problem of
moral hazard.
Moral hazard arises in many other situations. Here are
some examples:
a78 A homeowner with fire insurance buys too few fire ex-
tinguishers. The reason is that the homeowner bears
the cost of the extinguisher while the insurance com-
pany receives much of the benefit.
a78 A babysitter allows children to watch more television
than the parents of the children prefer. The reason is
that more educational activities require more energy
from the babysitter, even though they are beneficial for
the children.
a78 A family lives near a river with a high risk of flooding.
The reason it continues to live there is that the family
enjoys the scenic views, and the government will bear
part of the cost when it provides disaster relief after
aflood.
Can you identify the principal and the agent in each of these
three situations? How do you think the principal in each
case might solve the problem of moral hazard?
FYI
The Economics
of Asymmetric
Information
600 PART NINE THE REAL ECONOMY IN THE LONG RUN
CASE STUDY HENRY FORD AND THE VERY GENEROUS
$5-A-DAY WAGE
Henry Ford was an industrial visionary. As founder of the Ford Motor Com-
pany, he was responsible for introducing modern techniques of production.
Rather than building cars with small teams of skilled craftsmen, Ford built cars
on assembly lines in which unskilled workers were taught to perform the same
simple tasks over and over again. The output of this assembly process was the
Model T Ford, one of the most famous early automobiles.
In 1914, Ford introduced another innovation: the $5 workday. This might
not seem like much today, but back then $5 was about twice the going wage. It
was also far above the wage that balanced supply and demand. When the new
$5-a-day wage was announced, long lines of job seekers formed outside the
Ford factories. The number of workers willing to work at this wage far ex-
ceeded the number of workers Ford needed.
Ford’s high-wage policy had many of the effects predicted by efficiency-
wage theory. Turnover fell, absenteeism fell, and productivity rose. Workers
were so much more efficient that Ford’s production costs were lower even
though wages were higher. Thus, paying a wage above the equilibrium level
This story illustrates a general phenomenon. When a firm faces a surplus of
workers, it might seem profitable to reduce the wage it is offering. But by reducing
the wage, the firm induces an adverse change in the mix of workers. In this case,
at a wage of $10, Waterwell has two workers applying for one job. But if Waterwell
responds to this labor surplus by reducing the wage, the competent worker (who
has better alternative opportunities) will not apply. Thus, it is profitable for the
firm to pay a wage above the level that balances supply and demand.
WORKERS OUTSIDE AN EARLY FORD FACTORY
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 601
was profitable for the firm. Henry Ford himself called the $5-a-day wage “one
of the finest cost-cutting moves we ever made.”
Historical accounts of this episode are also consistent with efficiency-wage
theory. An historian of the early Ford Motor Company wrote, “Ford and his as-
sociates freely declared on many occasions that the high-wage policy turned out
to be good business. By this they meant that it had improved the discipline of
the workers, given them a more loyal interest in the institution, and raised their
personal efficiency.”
Why did it take Henry Ford to introduce this efficiency wage? Why were
other firms not already taking advantage of this seemingly profitable business
strategy? According to some analysts, Ford’s decision was closely linked to his
use of the assembly line. Workers organized in an assembly line are highly in-
terdependent. If one worker is absent or works slowly, other workers are less
able to complete their own tasks. Thus, while assembly lines made production
more efficient, they also raised the importance of low worker turnover, high
worker quality, and high worker effort. As a result, paying efficiency wages
may have been a better strategy for the Ford Motor Company than for other
businesses at the time.
QUICK QUIZ: Give four explanations for why firms might find it
profitable to pay wages above the level that balances quantity of labor
supplied and quantity of labor demanded.
CONCLUSION
In this chapter we discussed the measurement of unemployment and the reasons
why economies always experience some degree of unemployment. We have seen
how job search, minimum-wage laws, unions, and efficiency wages can all help ex-
plain why some workers do not have jobs. Which of these four explanations for the
natural rate of unemployment are the most important for the U.S. economy and
other economies around the world? Unfortunately, there is no easy way to tell.
Economists differ in which of these explanations of unemployment they consider
most important.
The analysis of this chapter yields an important lesson: Although the economy
will always have some unemployment, its natural rate is not immutable. Many
events and policies can change the amount of unemployment the economy typi-
cally experiences. As the information revolution changes the process of job search,
as Congress adjusts the minimum wage, as workers form or quit unions, and as
firms alter their reliance on efficiency wages, the natural rate of unemployment
evolves. Unemployment is not a simple problem with a simple solution. But how
we choose to organize our society can profoundly influence how prevalent a prob-
lem it is.
602 PART NINE THE REAL ECONOMY IN THE LONG RUN
a78 The unemployment rate is the percentage of those who
would like to work who do not have jobs. The Bureau of
Labor Statistics calculates this statistic monthly based on
a survey of thousands of households.
a78 The unemployment rate is an imperfect measure of
joblessness. Some people who call themselves
unemployed may actually not want to work, and some
people who would like to work have left the labor force
after an unsuccessful search.
a78 In the U.S. economy, most people who become
unemployed find work within a short period of time.
Nonetheless, most unemployment observed at any
given time is attributable to the few people who are
unemployed for long periods of time.
a78 One reason for unemployment is the time it takes for
workers to search for jobs that best suit their tastes and
skills. Unemployment insurance is a government policy
that, while protecting workers’ incomes, increases the
amount of frictional unemployment.
a78 Asecond reason why our economy always has some
unemployment is minimum-wage laws. By raising the
wage of unskilled and inexperienced workers above the
equilibrium level, minimum-wage laws raise the
quantity of labor supplied and reduce the quantity
demanded. The resulting surplus of labor represents
unemployment.
a78 Athird reason for unemployment is the market power
of unions. When unions push the wages in unionized
industries above the equilibrium level, they create a
surplus of labor.
a78 Afourth reason for unemployment is suggested by the
theory of efficiency wages. According to this theory,
firms find it profitable to pay wages above the
equilibrium level. High wages can improve worker
health, lower worker turnover, increase worker effort,
and raise worker quality.
Summary
labor force, p. 581
unemployment rate, p. 582
labor-force participation rate, p. 582
natural rate of unemployment, p. 582
cyclical unemployment, p. 583
discouraged workers, p. 586
frictional unemployment, p. 587
structural unemployment, p. 587
job search, p. 587
unemployment insurance, p. 589
union, p. 592
collective bargaining, p. 593
strike, p. 593
efficiency wages, p. 596
Key Concepts
1. What are the three categories into which the Bureau of
Labor Statistics divides everyone? How does it compute
the labor force, the unemployment rate, and the labor-
force participation rate?
2. Is unemployment typically short-term or long-term?
Explain.
3. Why is frictional unemployment inevitable? How might
the government reduce the amount of frictional
unemployment?
4. Are minimum-wage laws a better explanation for
structural unemployment among teenagers or among
college graduates? Why?
5. How do unions affect the natural rate of
unemployment?
6. What claims do advocates of unions make to argue that
unions are good for the economy?
7. Explain four ways in which a firm might increase its
profits by raising the wages itpays.
Questions for Review
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 603
1. The Bureau of Labor Statistics announced that in
December 1998, of all adult Americans, 138,547,000 were
employed, 6,021,000 were unemployed, and 67,723,000
were not in the labor force. How big was the labor
force? What was the labor-force participation rate?
Whatwas the unemployment rate?
2. As shown in Figure 26-3, the overall labor-force
participation rate of men declined between 1970 and
1990. This overall decline reflects different patterns
fordifferent age groups, however, as shown in the
following table.
MEN MEN MEN
ALLMEN 16–24 25–54 55 AND OVER
1970 80% 69% 96% 56%
1990 76 72 93 40
Which group experienced the largest decline? Given this
information, what factor may have played an important
role in the decline in overall male labor-force
participation over this period?
3. The labor-force participation rate of women increased
sharply between 1970 and 1990, as shown in Figure 26-3.
As with men, however, there were different patterns for
different age groups, as shown in this table.
ALL WOMEN WOMEN WOMEN WOMEN
WOMEN 25-54 25-34 35-44 45-54
1970 43% 50% 45% 51% 54%
1990 58 74 74 77 71
Why do you think that younger women experienced
abigger increase in labor-force participation than
olderwomen?
4. Between 1997 and 1998, total U.S. employment
increased by 2.1 million workers, but the number of
unemployed workers declined by only 0.5 million.
Howare these numbers consistent with each other?
Why might one expect a reduction in the number of
people counted as unemployed to be smaller than the
increase in the number of people employed?
5. Are the following workers more likely to experience
short-term or long-term unemployment? Explain.
a. a construction worker laid off because of
badweather
b. a manufacturing worker who loses her job at a
plant in an isolated area
c. a stagecoach-industry worker laid off because of
competition from railroads
d. a short-order cook who loses his job when a new
restaurant opens across the street
e. an expert welder with little formal education who
loses her job when the company installs automatic
welding machinery
6. Using a diagram of the labor market, show the effect of
an increase in the minimum wage on the wage paid to
workers, the number of workers supplied, the number
of workers demanded, and the amount of
unemployment.
7. Do you think that firms in small towns or cities have
more market power in hiring? Do you think that firms
generally have more market power in hiring today than
50 years ago, or less? How do you think this change
over time has affected the role of unions in the
economy? Explain.
8. Consider an economy with two labor markets, neither of
which is unionized. Now suppose a union is established
in one market.
a. Show the effect of the union on the market in which
it is formed. In what sense is the quantity of labor
employed in this market an inefficient quantity?
b. Show the effect of the union on the nonunionized
market. What happens to the equilibrium wage in
this market?
9. It can be shown that an industry’s demand for labor will
become more elastic when the demand for the
industry’s product becomes more elastic. Let’s consider
the implications of this fact for the U.S. automobile
industry and the auto workers’ union (the UAW).
a. What happened to the elasticity of demand for
American cars when the Japanese developed
astrong auto industry? What happened to the
elasticity of demand for American autoworkers?
Explain.
b. As the chapter explains, a union generally faces
atradeoff in deciding how much to raise wages,
because a bigger increase is better for workers
whoremain employed but also results in a greater
reduction in employment. How did the rise in auto
imports from Japan affect the wage-employment
tradeoff faced by the UAW?
Problems and Applications
604 PART NINE THE REAL ECONOMY IN THE LONG RUN
c. Do you think the growth of the Japanese auto
industry increased or decreased the gap between
the competitive wage and the wage chosen by the
UAW? Explain.
10. Some workers in the economy are paid a flat salary and
some are paid by commission. Which compensation
scheme would require more monitoring by supervisors?
In which case do firms have an incentive to pay more
than the equilibrium level (as in the worker-effort
variant of efficiency-wage theory)? What factors do you
think determine the type of compensation firms choose?
11. Each of the following situations involves moral hazard.
In each case, identify the principal and the agent, and
explain why there is asymmetric information. How does
the action described reduce the problem of moral
hazard?
a. Landlords require tenants to pay security deposits.
b. Firms compensate top executives with options to
buy company stock at a given price in the future.
c. Car insurance companies offer discounts to
customers who install antitheft devices in their cars.
12. Suppose that the Live-Long-and-Prosper Health
Insurance Company charges $5,000 annually for a
family insurance policy. The company’s president
suggests that the company raise the annual price to
$6,000 in order to increase its profits. If the firm
followed this suggestion, what economic problem might
arise? Would the firm’s pool of customers tend to
become more or less healthy on average? Would the
company’s profits necessarily increase?
13. (This problem is challenging.) Suppose that Congress
passes a law requiring employers to provide employees
some benefit (such as health care) that raises the cost of
an employee by $4 per hour.
a. What effect does this employer mandate have on
the demand for labor? (In answering this and the
following questions, be quantitative when you can.)
b. If employees place a value on this benefit exactly
equal to its cost, what effect does this employer
mandate have on the supply of labor?
c. If the wage is free to balance supply and demand,
how does this law affect the wage and the level of
employment? Are employers better or worse off?
Are employees better or worse off?
d. If a minimum-wage law prevents the wage from
balancing supply and demand, how does the
employer mandate affect the wage, the level of
employment, and the level of unemployment? Are
employers better or worse off? Are employees
better or worse off?
e. Now suppose that workers do not value the
mandated benefit at all. How does this alternative
assumption change your answers to parts (b), (c),
and (d) above?
607
IN THIS CHAPTER
YOU WILL . . .
Examine how the
banking system
helps determine the
supply of money
Consider the nature
of money and its
functions in the
economy
Learn about the
Federal Reserve
System
Examine the tools
used by the Federal
Reserve to alter the
supply of money
When you walk into a restaurant to buy a meal, you get something of value—a full
stomach. To pay for this service, you might hand the restaurateur several worn-out
pieces of greenish paper decorated with strange symbols, government buildings,
and the portraits of famous dead Americans. Or you might hand him a single
piece of paper with the name of a bank and your signature. Whether you pay by
cash or check, the restaurateur is happy to work hard to satisfy your gastronomi-
cal desires in exchange for these pieces of paper which, in and of themselves, are
worthless.
To anyone who has lived in a modern economy, this social custom is not at all
odd. Even though paper money has no intrinsic value, the restaurateur is confi-
dent that, in the future, some third person will accept it in exchange for something
that the restaurateur does value. And that third person is confident that some
fourth person will accept the money, with the knowledge that yet a fifth person
will accept the money . . . and so on. To the restaurateur and to other people in our
society, your cash or check represents a claim to goods and services in the future.
THE MONETARY SYSTEM
608 PART TEN MONEY AND PRICES IN THE LONG RUN
The social custom of using money for transactions is extraordinarily useful in
a large, complex society. Imagine, for a moment, that there was no item in the
economy widely accepted in exchange for goods and services. People would have
to rely on barter—the exchange of one good or service for another—to obtain the
things they need. To get your restaurant meal, for instance, you would have to
offer the restaurateur something of immediate value. You could offer to wash
some dishes, clean his car, or give him your family’s secret recipe for meat loaf. An
economy that relies on barter will have trouble allocating its scarce resources
efficiently. In such an economy, trade is said to require the double coincidence of
wants—the unlikely occurrence that two people each have a good or service that
the other wants.
The existence of money makes trade easier. The restaurateur does not care
whether you can produce a valuable good or service for him. He is happy to accept
your money, knowing that other people will do the same for him. Such a conven-
tion allows trade to be roundabout. The restaurateur accepts your money and uses
it to pay his chef; the chef uses her paycheck to send her child to day care; the day
care center uses this tuition to pay a teacher; and the teacher hires you to mow his
lawn. As money flows from person to person in the economy, it facilitates produc-
tion and trade, thereby allowing each person to specialize in what he or she does
best and raising everyone’s standard of living.
In this chapter we begin to examine the role of money in the economy. We dis-
cuss what money is, the various forms that money takes, how the banking system
helps create money, and how the government controls the quantity of money in
circulation. Because money is so important in the economy, we devote much effort
in the rest of this book to learning how changes in the quantity of money affect
various economic variables, including inflation, interest rates, production, and em-
ployment. Consistent with our long-run focus in the previous three chapters, in the
next chapter we will examine the long-run effects of changes in the quantity of
money. The short-run effects of monetary changes are a more complex topic, which
we will take up later in the book. This chapter provides the background for all of
this further analysis.
THE MEANING OF MONEY
What is money? This might seem like an odd question. When you read that bil-
lionaire Bill Gates has a lot of money, you know what that means: He is so rich that
he can buy almost anything he wants. In this sense, the term money is used to mean
wealth.
Economists, however, use the word in a more specific sense: Moneyis the set
of assets in the economy that people regularly use to buy goods and services from
other people. The cash in your wallet is money because you can use it to buy a
meal at a restaurant or a shirt at a clothing store. By contrast, if you happened to
own most of Microsoft Corporation, as Bill Gates does, you would be wealthy, but
this asset is not considered a form of money. You could not buy a meal or a shirt
with this wealth without first obtaining some cash. According to the economist’s
definition, money includes only those few types of wealth that are regularly
accepted by sellers in exchange for goods and services.
money
the set of assets in an economy that
people regularly use to buy goods
and services from other people
CHAPTER 27 THE MONETARY SYSTEM 609
THE FUNCTIONS OF MONEY
Money has three functions in the economy: It is a medium of exchange, a unit of ac-
count, and a store of value. These three functions together distinguish money from
other assets, such as stocks, bonds, real estate, art, and even baseball cards. Let’s
examine each of these functions of money in turn.
Amedium of exchangeis an item that buyers give to sellers when they pur-
chase goods and services. When you buy a shirt at a clothing store, the store gives
you the shirt, and you give the store your money. This transfer of money from
buyer to seller allows the transaction to take place. When you walk into a store,
you are confident that the store will accept your money for the items it is selling
because money is the commonly accepted medium of exchange.
Aunit of accountis the yardstick people use to post prices and record debts.
When you go shopping, you might observe that a shirt costs $20 and a hamburger
costs $2. Even though it would be accurate to say that the price of a shirt is 10 ham-
burgers and the price of a hamburger is 1/10 of a shirt, prices are never quoted in
this way. Similarly, if you take out a loan from a bank, the size of your future loan
repayments will be measured in dollars, not in a quantity of goods and services.
When we want to measure and record economic value, we use money as the unit
of account.
Astore of valueis an item that people can use to transfer purchasing power
from the present to the future. When a seller accepts money today in exchange for
a good or service, that seller can hold the money and become a buyer of another
good or service at another time. Of course, money is not the only store of value in
the economy, for a person can also transfer purchasing power from the present to
the future by holding other assets. The term wealth is used to refer to the total of all
stores of value, including both money and nonmonetary assets.
Economists use the term liquidityto describe the ease with which an asset can
be converted into the economy’s medium of exchange. Because money is the econ-
omy’s medium of exchange, it is the most liquid asset available. Other assets vary
widely in their liquidity. Most stocks and bonds can be sold easily with small cost,
so they are relatively liquid assets. By contrast, selling a house, a Rembrandt paint-
ing, or a 1948 Joe DiMaggio baseball card requires more time and effort, so these
assets are less liquid.
When people decide in what form to hold their wealth, they have to balance
the liquidity of each possible asset against the asset’s usefulness as a store of value.
Money is the most liquid asset, but it is far from perfect as a store of value. When
prices rise, the value of money falls. In other words, when goods and services be-
come more expensive, each dollar in your wallet can buy less. This link between
the price level and the value of money will turn out to be important for under-
standing how money affects the economy.
THE KINDS OF MONEY
When money takes the form of a commodity with intrinsic value, it is called com-
modity money. The term intrinsic value means that the item would have value
even if it were not used as money. One example of commodity money is gold.
Gold has intrinsic value because it is used in industry and in the making of jewelry.
Although today we no longer use gold as money, historically gold has been a
common form of money because it is relatively easy to carry, measure, and verify
medium of exchange
an item that buyers give to sellers
when they want to purchase goods
and services
unit of account
the yardstick people use to post
prices and record debts
store of value
an item that people can use to
transfer purchasing power from the
present to the future
liquidity
the ease with which an asset can be
converted into the economy’s
medium of exchange
commodity money
money that takes the form of a
commodity with intrinsic value
for impurities. When an economy uses gold as money (or uses paper money that
is convertible into gold on demand), it is said to be operating under a gold standard.
610 PART TEN MONEY AND PRICES IN THE LONG RUN
THE ROLE OF SOCIAL CUSTOM IN THE MON-
etary system is most apparent in for-
eign cultures with customs very
different from our own. The following
article describes the money on the is-
land of Yap. As you read the article, ask
yourself whether Yap is using a type of
commodity money, a type of fiat
money, or something in between.
Fixed Assets, or Why a Loan
in Yap Is Hard to Roll Over
BY ART PINE
YAP, MICRONESIA—On this tiny South Pa-
cific island, life is easy and the currency
is hard.
Elsewhere, the world’s troubled
monetary system creaks along; floating
exchange rates wreak havoc on currency
markets, and devaluations are common-
place. But on Yap the currency is as
solid as a rock. In fact, it is rock. Lime-
stone to be precise.
For nearly 2,000 years the Yapese
have used large stone wheels to pay for
major purchases, such as land, canoes
and permissions to marry. Yap is a U.S.
trust territory, and the dollar is used in
grocery stores and gas stations. But re-
liance on stone money, like the island’s
ancient caste system and the traditional
dress of loincloths and grass skirts,
continues.
Buying property with stones is
“much easier than buying it with U.S.
dollars,” says John Chodad, who re-
cently purchased a building lot with a 30-
inch stone wheel. “We don’t know the
value of the U.S. dollar.” . . .
Stone wheels don’t make good
pocket money, so for small transactions,
Yapese use other forms of currency,
such as beer. Beer is proffered as pay-
ment for all sorts of odd jobs, including
construction. The 10,000 people on Yap
consume 40,000 to 50,000 cases a
year, mostly of Budweiser. . . .
The people of Yap have been using
stone money ever since a Yapese war-
rior named Anagumang first brought the
huge stones from limestone caverns on
neighboring Palau, some 1,500 to 2,000
years ago. Inspired by the moon, he
fashioned the stone into large circles.
The rest is history.
Yapese lean the stone wheels
against their houses or prop up rows of
them in village “banks.” Most of the
stones are 2 1/2 to 5 feet in diameter,
but some are as much as 12 feet across.
Each has a hole in the center so it can be
slipped onto the trunk of a fallen betel
nut tree and carried. It takes 20 men to
lift some stones.
By custom, the stones are worth-
less when broken. You never hear peo-
ple on Yap musing about wanting a piece
of the rock. Rather than risk a broken
stone—or back—Yapese tend to leave
the larger stones where they are and
make a mental accounting that the own-
ership has been transferred—much as
gold bars used in international transac-
tions change hands without leaving the
vaults of the New York Federal Reserve
Bank. . . .
There are some decided advan-
tages to using massive stones for
money. They are immune to black-
market trading, for one thing, and they
pose formidable obstacles to pick-
pockets. In addition, there aren’t any
sterile debates about how to stabilize the
Yapese monetary system. With only
6,600 stone wheels remaining on the
island, the money supply stays put. . . .
Meanwhile, Yap’s stone money may
be about to take on international signifi-
cance. Just yesterday, Washington re-
ceived notice that Tosiho Nakayama, the
president of Micronesia, plans to bring a
stone disk when he visits the United
States next month. It will be flown by Air
Force jet.
Officials say Mr. Nakayama intends
the stone as Micronesia’s symbolic con-
tribution toward reducing the U.S. bud-
get deficit.
SOURCE: The Wall Street Journal, March 29, 1984,
p.A1.
IN THE NEWS
Money on the Island of Yap
MONEY ON THE ISLAND OF YAP: NOT EXACTLY
POCKET CHANGE
CHAPTER 27 THE MONETARY SYSTEM 611
Another example of commodity money is cigarettes. In prisoner-of-war camps
during World War II, prisoners traded goods and services with one another using
cigarettes as the store of value, unit of account, and medium of exchange. Simi-
larly, as the Soviet Union was breaking up in the late 1980s, cigarettes started re-
placing the ruble as the preferred currency in Moscow. In both cases, even
nonsmokers were happy to accept cigarettes in an exchange, knowing that they
could use the cigarettes to buy other goods and services.
Money without intrinsic value is called fiat money.Afiat is simply an order or
decree, and fiat money is established as money by government decree. For exam-
ple, compare the paper dollars in your wallet (printed by the U.S. government)
and the paper dollars from a game of Monopoly (printed by the Parker Brothers
game company). Why can you use the first to pay your bill at a restaurant but not
the second? The answer is that the U.S. government has decreed its dollars to be
valid money. Each paper dollar in your wallet reads: “This note is legal tender for
all debts, public and private.”
Although the government is central to establishing and regulating a system of
fiat money (by prosecuting counterfeiters, for example), other factors are also re-
quired for the success of such a monetary system. To a large extent, the acceptance
of fiat money depends as much on expectations and social convention as on gov-
ernment decree. The Soviet government in the 1980s never abandoned the ruble as
the official currency. Yet the people of Moscow preferred to accept cigarettes (or
even American dollars) in exchange for goods and services, because they were
more confident that these alternative monies would be accepted by others in the
future.
MONEY IN THE U.S. ECONOMY
As we will see, the quantity of money circulating in the economy, called the money
stock, has a powerful influence on many economic variables. But before we con-
sider why that is true, we need to ask a preliminary question: What is the quantity
of money? In particular, suppose you were given the task of measuring how much
money there is in the U.S. economy. What would you include in your measure?
The most obvious asset to include is currency—the paper bills and coins in the
hands of the public. Currency is clearly the most widely accepted medium of ex-
change in our economy. There is no doubt that it is part of the money stock.
Yet currency is not the only asset that you can use to buy goods and services.
Many stores also accept personal checks. Wealth held in your checking account is
almost as convenient for buying things as wealth held in your wallet. To mea-
sure the money stock, therefore, you might want to include demand deposits—
balances in bank accounts that depositors can access on demand simply by writing
a check.
Once you start to consider balances in checking accounts as part of the money
stock, you are led to consider the large variety of other accounts that people hold
at banks and other financial institutions. Bank depositors usually cannot write
checks against the balances in their savings accounts, but they can easily transfer
funds from savings into checking accounts. In addition, depositors in money mar-
ket mutual funds can often write checks against their balances. Thus, these other
accounts should plausibly be part of the U.S. money stock.
fiat money
money without intrinsic value
that is used as money because
of government decree
currency
the paper bills and coins in the
hands of the public
demand deposits
balances in bank accounts that
depositors can access on demand
by writing a check
“Gee, these new twenties look
just like Monopoly money.”
612 PART TEN MONEY AND PRICES IN THE LONG RUN
CASE STUDY WHERE IS ALL THE CURRENCY?
One puzzle about the money stock of the U.S. economy concerns the amount of
currency. In 1998 there was about $460 billion of currency outstanding. To put
this number in perspective, we can divide it by 205 million, the number of
adults (age sixteen and over) in the United States. This calculation implies that
the average adult holds about $2,240 of currency. Most people are surprised to
learn that our economy has so much currency because they carry far less than
this in their wallets.
Who is holding all this currency? No one knows for sure, but there are two
plausible explanations.
The first explanation is that much of the currency is being held abroad. In
foreign countries without a stable monetary system, people often prefer U.S.
dollars to domestic assets. It is, in fact, not unusual to see U.S. dollars being
used overseas as the medium of exchange, unit of account, and store of value.
The second explanation is that much of the currency is being held by drug
dealers, tax evaders, and other criminals. For most people in the U.S. economy,
In a complex economy such as ours, it is not easy to draw a line between assets
that can be called “money” and assets that cannot. The coins in your pocket are
clearly part of the money stock, and the Empire State Building clearly is not, but
there are many assets in between these extremes for which the choice is less clear.
Therefore, various measures of the money stock are available for the U.S. economy.
Table 27-1 shows the two most important, designated M1 and M2. Each of these
measures uses a slightly different criterion for distinguishing monetary and non-
monetary assets.
For our purposes in this book, we need not dwell on the differences between
the various measures of money. The important point is that the money stock for the
U.S. economy includes not just currency but also deposits in banks and other finan-
cial institutions that can be readily accessed and used to buy goods and services.
Table 27-1
TWO MEASURES OF THE MONEY
STOCK FOR THE U.S. ECONOMY.
The two most widely followed
measures of the money stock
areM1 and M2.
MEASURE AMOUNTIN1998 WHAT’SINCLUDED
M1 $1,092 billion Currency
Traveler’s checks
Demand deposits
Other checkable deposits
M2 $4,412 billion Everything in M1
Savings deposits
Small time deposits
Money market mutual funds
Afew minor categories
SOURCE:Federal Reserve.
CHAPTER 27 THE MONETARY SYSTEM 613
currency is not a particularly good way to hold wealth. Not only can currency
be lost or stolen, but it also does not earn interest, whereas a bank deposit does.
Thus, most people hold only small amounts of currency. By contrast, criminals
may avoid putting their wealth in banks, because a bank deposit gives police a
paper trail with which to trace their illegal activities. For criminals, currency
may be the best store of value available.
QUICK QUIZ: List and describe the three functions of money.
THE FEDERAL RESERVE SYSTEM
Whenever an economy relies on a system of fiat money, as the U.S. economy does,
some agency must be responsible for regulating the system. In the United States,
that agency is the Federal Reserve,often simply called the Fed.If you look at the
top of a dollar bill, you will see that it is called a “Federal Reserve Note.” The Fed
is an example of a central bank—an institution designed to oversee the banking
system and regulate the quantity of money in the economy. Other major central
It might seem natural to in-
clude credit cards as part of
the economy’s stock of money.
After all, people use credit
cards to make many of
their purchases. Aren’t credit
cards, therefore, a medium of
exchange?
Although at first this argu-
ment may seem persuasive,
credit cards are excluded from
all measures of the quantity of
money. The reason is that
credit cards are not really a
method of payment but a method of deferring payment.
When you buy a meal with a credit card, the bank that is-
sued the card pays the restaurant what it is due. At a later
date, you will have to repay the bank (perhaps with interest).
When the time comes to pay your credit card bill, you will
probably do so by writing a check against your checking ac-
count. The balance in this checking account is part of the
economy’s stock of money.
Notice that credit cards are very different from debit
cards, which automatically withdraw funds from a bank
account to pay for
items bought. Rather
than allowing the user
to postpone payment
for a purchase, a
debit card allows the
user immediate ac-
cess to deposits in a
bank account. In this
sense, a debit card is
more similar to a
check than to a credit
card. The account balances that lie behind debit cards are
included in measures of the quantity of money.
Even though credit cards are not considered a form of
money, they are nonetheless important for analyzing the
monetary system. People who have credit cards can pay
many of their bills all at once at the end of the month, rather
than sporadically as they make purchases. As a result, peo-
ple who have credit cards probably hold less money on
average than people who do not have credit cards. Thus, the
introduction and increased popularity of credit cards may
reduce the amount of money that people choose to hold.
IS THIS MONEY?
Federal Reserve (Fed)
the central bank of the United States
FYI
Credit Cards,
Debit Cards,
and Money
central bank
an institution designed to oversee
the banking system and regulate the
quantity of money in the economy
614 PART TEN MONEY AND PRICES IN THE LONG RUN
banks around the world include the Bank of England, the Bank of Japan, and the
European Central Bank.
THE FED’S ORGANIZATION
The Federal Reserve was created in 1914, after a series of bank failures in 1907 con-
vinced Congress that the United States needed a central bank to ensure the health
of the nation’s banking system. Today, the Fed is run by its Board of Governors,
which has seven members appointed by the president of the United States and
confirmed by the Senate. The governors have 14-year terms. Just as federal judges
are given lifetime appointments to insulate them from politics, Fed governors are
given long terms to give them independence from short-term political pressures
when they formulate monetary policy.
Among the seven members of the Board of Governors, the most important is
the chairman. The chairman directs the Fed staff, presides over board meetings,
and testifies regularly about Fed policy in front of congressional committees. The
president appoints the chairman to a four-year term. As this book was going to
press, the chairman of the Fed was Alan Greenspan, who was originally appointed
in 1987 by President Reagan and later reappointed by Presidents Bush and
Clinton.
The Federal Reserve System is made up of the Federal Reserve Board in Wash-
ington, D.C., and 12 regional Federal Reserve Banks located in major cities around
the country. The presidents of the regional banks are chosen by each bank’s board
of directors, whose members are typically drawn from the region’s banking and
business community.
The Fed has two related jobs. The first job is to regulate banks and ensure the
health of the banking system. This task is largely the responsibility of the regional
Federal Reserve Banks. In particular, the Fed monitors each bank’s financial con-
dition and facilitates bank transactions by clearing checks. It also acts as a bank’s
bank. That is, the Fed makes loans to banks when banks themselves want to bor-
row. When financially troubled banks find themselves short of cash, the Fed acts
as a lender of last resort—a lender to those who cannot borrow anywhere else—in
order to maintain stability in the overall banking system.
The Fed’s second and more important job is to control the quantity of money
that is made available in the economy, called the money supply. Decisions by
policymakers concerning the money supply constitute monetary policy.At the
Federal Reserve, monetary policy is made by the Federal Open Market Committee
(FOMC). The FOMC meets about every six weeks in Washington, D.C., to discuss
the condition of the economy and consider changes in monetary policy.
THE FEDERAL OPEN MARKET COMMITTEE
The Federal Open Market Committee is made up of the seven members of the
Board of Governors and five of the 12 regional bank presidents. All 12 regional
presidents attend each FOMC meeting, but only five get to vote. The five with vot-
ing rights rotate among the 12 regional presidents over time. The president of the
New York Fed always gets a vote, however, because New York is the traditional
money supply
the quantity of money available
in the economy
monetary policy
the setting of the money supply by
policymakers in the central bank
CHAPTER 27 THE MONETARY SYSTEM 615
financial center of the U.S. economy and because all Fed purchases and sales of
government bonds are conducted at the New York Fed’s trading desk.
Through the decisions of the FOMC, the Fed has the power to increase or de-
crease the number of dollars in the economy. In simple metaphorical terms, you
can imagine the Fed printing up dollar bills and dropping them around the coun-
try by helicopter. Similarly, you can imagine the Fed using a giant vacuum cleaner
to suck dollar bills out of people’s wallets. Although in practice the Fed’s methods
for changing the money supply are more complex and subtle than this, the
helicopter-vacuum metaphor is a good first approximation to the meaning of
monetary policy.
We discuss later in this chapter how the Fed actually changes the money sup-
ply, but it is worth noting here that the Fed’s primary tool is open-market opera-
tions—the purchase and sale of U.S. government bonds. (Recall that a U.S.
government bond is a certificate of indebtedness of the federal government.) If the
FOMC decides to increase the money supply, the Fed creates dollars and uses
them to buy government bonds from the public in the nation’s bond markets.
After the purchase, these dollars are in the hands of the public. Thus, an open-
market purchase of bonds by the Fed increases the money supply. Conversely, if
the FOMC decides to decrease the money supply, the Fed sells government bonds
from its portfolio to the public in the nation’s bond markets. After the sale, the dol-
lars it receives for the bonds are out of the hands of the public. Thus, an open-
market sale of bonds by the Fed decreases the money supply.
The Fed is an important institution because changes in the money supply can
profoundly affect the economy. One of the Ten Principles of Economics in Chapter 1
is that prices rise when the government prints too much money. Another of the
Ten Principles of Economics is that society faces a short-run tradeoff between infla-
tion and unemployment. The power of the FOMC rests on these principles. For
reasons we discuss more fully in the coming chapters, the FOMC’s policy deci-
sions have an important influence on the economy’s rate of inflation in the long
run and the economy’s employment and production in the short run. Indeed, the
chairman of the Federal Reserve has been called the second most powerful person
in the United States.
QUICK QUIZ: What are the primary responsibilities of the Federal
Reserve? If the Fed wants to increase the supply of money, how does it
usuallydo it?
BANKS AND THE MONEY SUPPLY
So far we have introduced the concept of “money” and discussed how the Federal
Reserve controls the supply of money by buying and selling government bonds in
open-market operations. Although this explanation of the money supply is correct,
it is not complete. In particular, it omits the central role that banks play in the mon-
etary system.
616 PART TEN MONEY AND PRICES IN THE LONG RUN
Recall that the amount of money you hold includes both currency (the bills in
your wallet and coins in your pocket) and demand deposits (the balance in your
checking account). Because demand deposits are held in banks, the behavior of
banks can influence the quantity of demand deposits in the economy and, there-
fore, the money supply. This section examines how banks affect the money supply
and how they complicate the Fed’s job of controlling the money supply.
THE SIMPLE CASE OF 100-PERCENT-RESERVE BANKING
To see how banks influence the money supply, it is useful to imagine first a world
without any banks at all. In this simple world, currency is the only form of money.
To be concrete, let’s suppose that the total quantity of currency is $100. The supply
of money is, therefore, $100.
Now suppose that someone opens a bank, appropriately called First National
Bank. First National Bank is only a depository institution—that is, it accepts de-
posits but does not make loans. The purpose of the bank is to give depositors a
safe place to keep their money. Whenever a person deposits some money, the bank
keeps the money in its vault until the depositor comes to withdraw it or writes a
check against his or her balance. Deposits that banks have received but have not
loaned out are called reserves.In this imaginary economy, all deposits are held as
reserves, so this system is called 100-percent-reserve banking.
We can express the financial position of First National Bank with a T-account,
which is a simplified accounting statement that shows changes in a bank’s assets
and liabilities. Here is the T-account for First National Bank if the economy’s entire
$100 of money is deposited in the bank:
FIRST NATIONALBANK
ASSETS LIABILITIES
Reserves $100.00 Deposits $100.00
”I’ve heard a lot about money, and now I’d like to try some.”
reserves
deposits that banks have received but
have not loaned out
CHAPTER 27 THE MONETARY SYSTEM 617
On the left-hand side of the T-account are the bank’s assets of $100 (the reserves it
holds in its vaults). On the right-hand side of the T-account are the bank’s liabili-
ties of $100 (the amount it owes to its depositors). Notice that the assets and liabil-
ities of First National Bank exactly balance.
Now consider the money supply in this imaginary economy. Before First Na-
tional Bank opens, the money supply is the $100 of currency that people are hold-
ing. After the bank opens and people deposit their currency, the money supply is
the $100 of demand deposits. (There is no longer any currency outstanding, for it
is all in the bank vault.) Each deposit in the bank reduces currency and raises de-
mand deposits by exactly the same amount, leaving the money supply unchanged.
Thus, if banks hold all deposits in reserve, banks do not influence the supply of money.
MONEY CREATION WITH FRACTIONAL-RESERVE BANKING
Eventually, the bankers at First National Bank may start to reconsider their policy
of 100-percent-reserve banking. Leaving all that money sitting idle in their vaults
seems unnecessary. Why not use some of it to make loans? Families buying
houses, firms building new factories, and students paying for college would all be
happy to pay interest to borrow some of that money for a while. Of course, First
National Bank has to keep some reserves so that currency is available if depositors
want to make withdrawals. But if the flow of new deposits is roughly the same as
the flow of withdrawals, First National needs to keep only a fraction of its deposits
in reserve. Thus, First National adopts a system called fractional-reserve banking.
The fraction of total deposits that a bank holds as reserves is called the reserve
ratio. This ratio is determined by a combination of government regulation and
bank policy. As we discuss more fully later in the chapter, the Fed places a mini-
mum on the amount of reserves that banks hold, called a reserve requirement. In ad-
dition, banks may hold reserves above the legal minimum, called excess reserves, so
they can be more confident that they will not run short of cash. For our purpose
here, we just take reserve ratio as given and examine what fractional-reserve bank-
ing means for the money supply.
Let’s suppose that First National has a reserve ratio of 10 percent. This means
that it keeps 10 percent of its deposits in reserve and loans out the rest. Now let’s
look again at the bank’s T-account:
FIRST NATIONALBANK
ASSETS LIABILITIES
Reserves $10.00 Deposits $100.00
Loans 90.00
First National still has $100 in liabilities because making the loans did not alter the
bank’s obligation to its depositors. But now the bank has two kinds of assets: It has
$10 of reserves in its vault, and it has loans of $90. (These loans are liabilities of the
people taking out the loans but they are assets of the bank making the loans, be-
cause the borrowers will later repay the bank.) In total, First National’s assets still
equal its liabilities.
Once again consider the supply of money in the economy. Before First
National makes any loans, the money supply is the $100 of deposits in the bank.
fractional-reserve banking
a banking system in which banks
hold only a fraction of deposits
as reserves
reserve ratio
the fraction of deposits that
banks hold as reserves
618 PART TEN MONEY AND PRICES IN THE LONG RUN
Yet when First National makes these loans, the money supply increases. The
depositors still have demand deposits totaling $100, but now the borrowers hold
$90 in currency. The money supply (which equals currency plus demand deposits)
equals $190. Thus, when banks hold only a fraction of deposits in reserve, banks create
money.
At first, this creation of money by fractional-reserve banking may seem too
good to be true because it appears that the bank has created money out of thin air.
To make this creation of money seem less miraculous, note that when First Na-
tional Bank loans out some of its reserves and creates money, it does not create any
wealth. Loans from First National give the borrowers some currency and thus the
ability to buy goods and services. Yet the borrowers are also taking on debts, so
the loans do not make them any richer. In other words, as a bank creates the as-
set of money, it also creates a corresponding liability for its borrowers. At the end
of this process of money creation, the economy is more liquid in the sense that
there is more of the medium of exchange, but the economy is no wealthier than
before.
THE MONEY MULTIPLIER
The creation of money does not stop with First National Bank. Suppose the bor-
rower from First National uses the $90 to buy something from someone who then
deposits the currency in Second National Bank. Here is the T-account for Second
National Bank:
SECOND NATIONALBANK
ASSETS LIABILITIES
Reserves $ 9.00 Deposits $90.00
Loans 81.00
After the deposit, this bank has liabilities of $90. If Second National also has a re-
serve ratio of 10 percent, it keeps assets of $9 in reserve and makes $81 in loans.
In this way, Second National Bank creates an additional $81 of money. If this $81
is eventually deposited in Third National Bank, which also has a reserve ratio of
10percent, this bank keeps $8.10 in reserve and makes $72.90 in loans. Here is the
T-account for Third National Bank:
THIRD NATIONALBANK
ASSETS LIABILITIES
Reserves $ 8.10 Deposits $81.00
Loans 72.90
The process goes on and on. Each time that money is deposited and a bank loan is
made, more money is created.
CHAPTER 27 THE MONETARY SYSTEM 619
How much money is eventually created in this economy? Let’s add it up:
Original deposit H11005$ 100.00
First National lending H11005$ 90.00[H11005.9 H11003$100.00]
Second National lendingH11005$ 81.00[H11005.9 H11003$90.00]
Third National lending H11005$ 72.90[H11005.9 H11003$81.00]
??
Total money supply H11005$1,000.00
It turns out that even though this process of money creation can continue forever,
it does not create an infinite amount of money. If you laboriously add the infinite
sequence of numbers in the foregoing example, you find the $100 of reserves gen-
erates $1,000 of money. The amount of money the banking system generates with
each dollar of reserves is called the money multiplier.In this imaginary economy,
where the $100 of reserves generates $1,000 of money, the money multiplier is 10.
What determines the size of the money multiplier? It turns out that the answer
is simple: The money multiplier is the reciprocal of the reserve ratio. If R is the reserve
ratio for all banks in the economy, then each dollar of reserves generates 1/R dol-
lars of money. In our example, R H110051/10, so the money multiplier is 10.
This reciprocal formula for the money multiplier makes sense. If a bank holds
$1,000 in deposits, then a reserve ratio of 1/10 (10 percent) means that the bank
must hold $100 in reserves. The money multiplier just turns this idea around: If the
banking system as a whole holds a total of $100 in reserves, it can have only $1,000
in deposits. In other words, if R is the ratio of reserves to deposits at each bank
(that is, the reserve ratio), then the ratio of deposits to reserves in the banking sys-
tem (that is, the money multiplier) must be 1/R.
This formula shows how the amount of money banks create depends on the
reserve ratio. If the reserve ratio were only 1/20 (5 percent), then the banking sys-
tem would have 20 times as much in deposits as in reserves, implying a money
multiplier of 20. Each dollar of reserves would generate $20 of money. Similarly, if
the reserve ratio were 1/5 (20 percent), deposits would be 5 times reserves, the
money multiplier would be 5, and each dollar of reserves would generate $5 of
money. Thus, the higher the reserve ratio, the less of each deposit banks loan out, and the
smaller the money multiplier. In the special case of 100-percent-reserve banking, the
reserve ratio is 1, the money multiplier is 1, and banks do not make loans or create
money.
THE FED’S TOOLS OF MONETARY CONTROL
As we have already discussed, the Federal Reserve is responsible for controlling
the supply of money in the economy. Now that we understand how fractional-
reserve banking works, we are in a better position to understand how the Fed car-
ries out this job. Because banks create money in a system of fractional-reserve
banking, the Fed’s control of the money supply is indirect. When the Fed decides
to change the money supply, it must consider how its actions will work through
the banking system.
The Fed has three tools in its monetary toolbox: open-market operations,
reserve requirements, and the discount rate. Let’s discuss how the Fed uses each of
these tools.
money multiplier
the amount of money the
banking system generates
with each dollar of reserves
620 PART TEN MONEY AND PRICES IN THE LONG RUN
Open-Market Operations As we noted earlier, the Fed conducts open-
market operationswhen it buys or sells government bonds from the public. To in-
crease the money supply, the Fed instructs its bond traders at the New York Fed to
buy bonds in the nation’s bond markets. The dollars the Fed pays for the bonds in-
crease the number of dollars in circulation. Some of these new dollars are held as
currency, and some are deposited in banks. Each new dollar held as currency in-
creases the money supply by exactly $1. Each new dollar deposited in a bank in-
creases the money supply to an even greater extent because it increases reserves
and, thereby, the amount of money that the banking system can create.
To reduce the money supply, the Fed does just the opposite: It sells govern-
ment bonds to the public in the nation’s bond markets. The public pays for these
bonds with its holdings of currency and bank deposits, directly reducing the
amount of money in circulation. In addition, as people make withdrawals from
banks, banks find themselves with a smaller quantity of reserves. In response,
banks reduce the amount of lending, and the process of money creation reverses
itself.
Open-market operations are easy to conduct. In fact, the Fed’s purchases and
sales of government bonds in the nation’s bond markets are similar to the transac-
tions that any individual might undertake for his own portfolio. (Of course, when
an individual buys or sells a bond, money changes hands, but the amount of
money in circulation remains the same.) In addition, the Fed can use open-market
operations to change the money supply by a small or large amount on any day
without major changes in laws or bank regulations. Therefore, open-market oper-
ations are the tool of monetary policy that the Fed uses most often.
Reserve Requirements The Fed also influences the money supply with
reserve requirements,which are regulations on the minimum amount of reserves
that banks must hold against deposits. Reserve requirements influence how much
money the banking system can create with each dollar of reserves. An increase in
reserve requirements means that banks must hold more reserves and, therefore,
can loan out less of each dollar thatis deposited; as a result, it raises the reserve ra-
tio, lowers the money multiplier, and decreases the money supply. Conversely, a
decrease in reserve requirements lowers the reserve ratio, raises the money multi-
plier, and increases the money supply.
The Fed uses changes in reserve requirements only rarely because frequent
changes would disrupt the business of banking. When the Fed increases reserve
requirements, for instance, some banks find themselves short of reserves, even
though they have seen no change in deposits. As a result, they have to curtail lend-
ing until they build their level of reserves to the new required level.
The Discount Rate The third tool in the Fed’s toolbox is the discount rate,
the interest rate on the loans that the Fed makes to banks. Abank borrows from the
Fed when it has too few reserves to meet reserve requirements. This might occur
because the bank made too many loans or because it has experienced recent with-
drawals. When the Fed makes such a loan to a bank, the banking system has more
reserves than it otherwise would, and these additional reserves allow the banking
system to create more money.
The Fed can alter the money supply by changing the discount rate. Ahigher
discount rate discourages banks from borrowing reserves from the Fed. Thus, an
increase in the discount rate reduces the quantity of reserves in the banking
open-market operations
the purchase and sale of U.S.
government bonds by the Fed
reserve requirements
regulations on the minimum amount
of reserves that banks must hold
against deposits
discount rate
the interest rate on the loans that the
Fed makes to banks
CHAPTER 27 THE MONETARY SYSTEM 621
system, which in turn reduces the money supply. Conversely, a lower discount
rate encourages bank borrowing from the Fed, increases the quantity of reserves,
and increases the money supply.
The Fed uses discount lending not only to control the money supply but also
to help financial institutions when they are in trouble. For example, in 1984, ru-
mors circulated that Continental Illinois National Bank had made a large number
of bad loans, and these rumors induced many depositors to withdraw their de-
posits. As part of an effort to save the bank, the Fed acted as a lender of last resort
and loaned Continental Illinois more than $5 billion. Similarly, when the stock
market crashed on October 19, 1987, many Wall Street brokerage firms found
themselves temporarily in need of funds to finance the high volume of stock trad-
ing. The next morning, before the stock market opened, Fed Chairman Alan
Greenspan announced the Fed’s “readiness to serve as a source of liquidity to sup-
port the economic and financial system.” Many economists believe that
Greenspan’s reaction to the stock crash was an important reason why it had so few
repercussions.
PROBLEMS IN CONTROLLING THE MONEY SUPPLY
The Fed’s three tools—open-market operations, reserve requirements, and the dis-
count rate—have powerful effects on the money supply. Yet the Fed’s control of
the money supply is not precise. The Fed must wrestle with two problems, each
of which arises because much of the money supply is created by our system of
fractional-reserve banking.
The first problem is that the Fed does not control the amount of money that
households choose to hold as deposits in banks. The more money households de-
posit, the more reserves banks have, and the more money the banking system can
create. And the less money households deposit, the less reserves banks have, and
the less money the banking system can create. To see why this is a problem, sup-
pose that one day people begin to lose confidence in the banking system and,
therefore, decide to withdraw deposits and hold more currency. When this hap-
pens, the banking system loses reserves and creates less money. The money supply
falls, even without any Fed action.
The second problem of monetary control is that the Fed does not control the
amount that bankers choose to lend. When money is deposited in a bank, it creates
more money only when the bank loans it out. Because banks can choose to hold
excess reserves instead, the Fed cannot be sure how much money the banking sys-
tem will create. For instance, suppose that one day bankers become more cautious
about economic conditions and decide to make fewer loans and hold greater re-
serves. In this case, the banking system creates less money than it otherwise
would. Because of the bankers’ decision, the money supply falls.
Hence, in a system of fractional-reserve banking, the amount of money in the
economy depends in part on the behavior of depositors and bankers. Because
theFed cannot control or perfectly predict this behavior, it cannot perfectly control
the money supply. Yet, if the Fed is vigilant, these problems need not be large. The
Fed collects data on deposits and reserves from banks every week, so it is quickly
aware of any changes in depositor or banker behavior. It can, therefore, respond to
these changes and keep the money supply close to whatever level it chooses.
622 PART TEN MONEY AND PRICES IN THE LONG RUN
CASE STUDY BANK RUNS AND THE MONEY SUPPLY
Although you have probably never witnessed a bank run in real life, you may
have seen one depicted in movies such as Mary Poppins or It’s a Wonderful Life.
Abank run occurs when depositors suspect that a bank may go bankrupt and,
therefore, “run” to the bank to withdraw their deposits.
Bank runs are a problem for banks under fractional-reserve banking. Be-
cause a bank holds only a fraction of its deposits in reserve, it cannot satisfy
withdrawal requests from all depositors. Even if the bank is in fact solvent
(meaning that its assets exceed its liabilities), it will not have enough cash on
hand to allow all depositors immediate access to all of their money. When a run
occurs, the bank is forced to close its doors until some bank loans are repaid or
until some lender of last resort (such as the Fed) provides it with the currency it
needs to satisfy depositors.
Bank runs complicate the control of the money supply. An important exam-
ple of this problem occurred during the Great Depression in the early 1930s. Af-
ter a wave of bank runs and bank closings, households and bankers became
more cautious. Households withdrew their deposits from banks, preferring to
hold their money in the form of currency. This decision reversed the process of
money creation, as bankers responded to falling reserves by reducing bank
loans. At the same time, bankers increased their reserve ratios so that they
would have enough cash on hand to meet their depositors’ demands in any fu-
ture bank runs. The higher reserve ratio reduced the money multiplier, which
also reduced the money supply. From 1929 to 1933, the money supply fell by 28
percent, even without the Federal Reserve taking any deliberate contractionary
action. Many economists point to this massive fall in the money supply to ex-
plain the high unemployment and falling prices that prevailed during this pe-
riod. (In future chapters we examine the mechanisms by which changes in the
money supply affect unemployment and prices.)
Today, bank runs are not a major problem for the banking system or the
Fed. The federal government now guarantees the safety of deposits at most
banks, primarily through the Federal Deposit Insurance Corporation (FDIC).
Depositors do not run on their banks because they are confident that, even
if their bank goes bankrupt, the FDIC will make good on the deposits. The
ANOT-SO-WONDERFUL
BANK RUN
CHAPTER 27 THE MONETARY SYSTEM 623
policy of government deposit insurance has costs: Bankers whose deposits
are guaranteed may have too little incentive to avoid bad risks when making
loans. (This behavior is an example of a phenomenon, introduced in the pre-
ceding chapter, called moral hazard.) But one benefit of deposit insurance is a
more stable banking system. As a result, most people see bank runs only in the
movies.
QUICK QUIZ: Describe how banks create money. a78If the Fed wanted
touse all three of its policy tools to decrease the money supply, what
woulditdo?
CONCLUSION
Some years ago, a book made the best-seller list with the title Secrets of the Temple:
How the Federal Reserve Runs the Country. Although no doubt an exaggeration, this
title did highlight the important role of the monetary system in our daily lives.
Whenever we buy or sell anything, we are relying on the extraordinarily useful so-
cial convention called “money.” Now that we know what money is and what de-
termines its supply, we can discuss how changes in the quantity of money affect
the economy. We begin to address that topic in the next chapter.
a78 The term money refers to assets that people regularly use
to buy goods and services.
a78 Money serves three functions. As a medium of
exchange, it provides the item used to make
transactions. As a unit of account, it provides the way in
which prices and other economic values are recorded.
As a store of value, it provides a way of transferring
purchasing power from the present to the future.
a78 Commodity money, such as gold, is money that has
intrinsic value: It would be valued even if it were not
used as money. Fiat money, such as paper dollars, is
money without intrinsic value: It would be worthless if
it were not used as money.
a78 In the U.S. economy, money takes the form of currency
and various types of bank deposits, such as checking
accounts.
a78 The Federal Reserve, the central bank of the United
States, is responsible for regulating the U.S. monetary
system. The Fed chairman is appointed by the president
and confirmed by Congress every four years. The
chairman is the lead member of the Federal Open
Market Committee, which meets about every six weeks
to consider changes in monetary policy.
a78 The Fed controls the money supply primarily through
open-market operations: The purchase of government
bonds increases the money supply, and the sale of
government bonds decreases the money supply. The
Fed can also expand the money supply by lowering
reserve requirements or decreasing the discount rate,
and it can contract the money supply by raising reserve
requirements or increasing the discount rate.
a78 When banks loan out some of their deposits, they
increase the quantity of money in the economy.
Becauseof this role of banks in determining the
moneysupply, the Fed’s control of the money supply
isimperfect.
Summary
624 PART TEN MONEY AND PRICES IN THE LONG RUN
money, p. 608
medium of exchange, p. 609
unit of account, p. 609
store of value, p. 609
liquidity, p. 609
commodity money, p. 609
fiat money, p. 611
currency, p. 611
demand deposits, p. 611
Federal Reserve (Fed), p. 613
central bank, p. 613
money supply, p. 614
monetary policy, p. 614
reserves, p. 616
fractional-reserve banking, p. 617
reserve ratio, p. 617
money multiplier, p. 619
open-market operations, p. 620
reserve requirements, p. 620
discount rate, p. 620
Key Concepts
1. What distinguishes money from other assets in the
economy?
2. What is commodity money? What is fiat money? Which
kind do we use?
3. What are demand deposits, and why should they be
included in the stock of money?
4. Who is responsible for setting monetary policy in the
United States? How is this group chosen?
5. If the Fed wants to increase the money supply with
open-market operations, what does it do?
6. Why don’t banks hold 100 percent reserves? How is the
amount of reserves banks hold related to the amount of
money the banking system creates?
7. What is the discount rate? What happens to the money
supply when the Fed raises the discount rate?
8. What are reserve requirements? What happens to the
money supply when the Fed raises reserve
requirements?
9. Why can’t the Fed control the money supply perfectly?
Questions for Review
1. Which of the following are money in the U.S. economy?
Which are not? Explain your answers by discussing
each of the three functions of money.
a. a U.S. penny
b. a Mexican peso
c. a Picasso painting
d. a plastic credit card
2. Every month Yankee magazine includes a “Swopper’s
[sic] Column” of offers to barter goods and services.
Here is an example: “Will swop custom-designed
wedding gown and up to 6 bridesmaids’ gowns for
2round-trip plane tickets and 3 nights’ lodging in the
countryside of England.” Why would it be difficult to
run our economy using a “Swopper’s Column” instead
of money? In light of your answer, why might the Yankee
“Swopper’s Column” exist?
3. What characteristics of an asset make it useful as a
medium of exchange? As a store of value?
4. Consider how the following situations would affect the
economy’s monetary system.
a. Suppose that the people on Yap discovered an easy
way to make limestone wheels. How would this
development affect the usefulness of stone wheels
as money? Explain.
b. Suppose that someone in the United States
discovered an easy way to counterfeit $100 bills.
How would this development affect the U.S.
monetary system? Explain.
5. Your uncle repays a $100 loan from Tenth National Bank
by writing a $100 check from his TNB checking account.
Use T-accounts to show the effect of this transaction on
your uncle and on TNB. Has your uncle’s wealth
changed? Explain.
6. Beleaguered State Bank (BSB) holds $250 million in
deposits and maintains a reserve ratio of 10 percent.
a. Show a T-account for BSB.
b. Now suppose that BSB’s largest depositor
withdraws $10 million in cash from her account.
IfBSB decides to restore its reserve ratio by
reducing the amount of loans outstanding,
showitsnew T-account.
Problems and Applications
CHAPTER 27 THE MONETARY SYSTEM 625
c. Explain what effect BSB’s action will have on
otherbanks.
d. Why might it be difficult for BSB to take the action
described in part (b)? Discuss another way for BSB
to return to its original reserve ratio.
7. You take $100 you had kept under your pillow and
deposit it in your bank account. If this $100 stays in the
banking system as reserves and if banks hold reserves
equal to 10 percent of deposits, by how much does the
total amount of deposits in the banking system increase?
By how much does the money supply increase?
8. The Federal Reserve conducts a $10 million open-
market purchase of government bonds. If the required
reserve ratio is 10 percent, what is the largest possible
increase in the money supply that could result? Explain.
What is the smallest possible increase? Explain.
9. Suppose that the T-account for First National Bank is as
follows:
ASSETS LIABILITIES
Reserves $100,000 Deposits $500,000
Loans 400,000
a. If the Fed requires banks to hold 5 percent of
deposits as reserves, how much in excess reserves
does First National now hold?
b. Assume that all other banks hold only the required
amount of reserves. If First National decides to
reduce its reserves to only the required amount,
byhow much would the economy’s money
supplyincrease?
10. Suppose that the reserve requirement for checking
deposits is 10 percent and that banks do not hold any
excess reserves.
a. If the Fed sells $1 million of government bonds,
what is the effect on the economy’s reserves and
money supply?
b. Now suppose the Fed lowers the reserve
requirement to 5 percent, but banks choose to hold
another 5 percent of deposits as excess reserves.
Why might banks do so? What is the overall change
in the money multiplier and the money supply as a
result of these actions?
11. Assume that the banking system has total reserves of
$100 billion. Assume also that required reserves are 10
percent of checking deposits, and that banks hold no
excess reserves and households hold no currency.
a. What is the money multiplier? What is the money
supply?
b. If the Fed now raises required reserves to 20 percent
of deposits, what is the change in reserves and the
change in the money supply?
12. (This problem is challenging.) The economy of
Elmendyn contains 2,000 $1 bills.
a. If people hold all money as currency, what is the
quantity of money?
b. If people hold all money as demand deposits and
banks maintain 100 percent reserves, what is the
quantity of money?
c. If people hold equal amounts of currency and
demand deposits and banks maintain 100 percent
reserves, what is the quantity of money?
d. If people hold all money as demand deposits and
banks maintain a reserve ratio of 10 percent, what is
the quantity of money?
e. If people hold equal amounts of currency and
demand deposits and banks maintain a reserve
ratio of 10 percent, what is the quantity of money?
627
IN THIS CHAPTER
YOU WILL . . .
Consider the various
costs that inflation
imposes on society
See why some
countries print so
much money that
they experience
hyperinflation
See why inflation
results from rapid
growth in the money
supply
Learn the meaning
of the classical
dichotomy and
monetary neutrality
Examine how the
nominal interest
rate responds to the
inflation rate
Although today you need a dollar or two to buy yourself an ice-cream cone, life
was very different 60 years ago. In one Trenton, New Jersey, candy store (run, inci-
dentally, by this author’s grandmother in the 1930s), ice-cream cones came in two
sizes. A cone with a small scoop of ice cream cost three cents. Hungry customers
could buy a large scoop for a nickel.
You are probably not surprised at the increase in the price of ice cream. In our
economy, most prices tend to rise over time. This increase in the overall level of
prices is called inflation. Earlier in the book we examined how economists measure
the inflation rate as the percentage change in the consumer price index, the GDP
deflator, or some other index of the overall price level. These price indexes show
that, over the past 60 years, prices have risen on average about 5 percent per year.
MONEY GROWTH
AND INFLATION
628 PART TEN MONEY AND PRICES IN THE LONG RUN
Accumulated over so many years, a 5 percent annual inflation rate leads to an
18-fold increase in the price level.
Inflation may seem natural and inevitable to a person who grew up in the
United States during the second half of the twentieth century, but in fact it is not
inevitable at all. There were long periods in the nineteenth century during which
most prices fell—a phenomenon called deflation. The average level of prices in the
U.S. economy was 23 percent lower in 1896 than in 1880, and this deflation was a
major issue in the presidential election of 1896. Farmers, who had accumulated
large debts, were suffering when the fall in crop prices reduced their incomes and
thus their ability to pay off their debts. They advocated government policies to re-
verse the deflation.
Although inflation has been the norm in more recent history, there has been
substantial variation in the rate at which prices rise. During the 1990s, prices rose
at an average rate of about 2 percent per year. By contrast, in the 1970s, prices rose
by 7 percent per year, which meant a doubling of the price level over the decade.
The public often views such high rates of inflation as a major economic problem.
In fact, when President Jimmy Carter ran for reelection in 1980, challenger Ronald
Reagan pointed to high inflation as one of the failures of Carter’s economic policy.
International data show an even broader range of inflation experiences.
Germany after World War I experienced a spectacular example of inflation. The
price of a newspaper rose from 0.3 marks in January 1921 to 70,000,000 marks less
than two years later. Other prices rose by similar amounts. An extraordinarily high
rate of inflation such as this is called hyperinflation. The German hyperinflation had
such an adverse effect on the German economy that it is often viewed as one con-
tributor to the rise of Nazism and, as a result, World War II. Over the past 50 years,
with this episode still in mind, German policymakers have been extraordinarily
averse to inflation, and Germany has had much lower inflation than the United
States.
What determines whether an economy experiences inflation and, if so, how
much? This chapter answers this question by developing the quantity theory of
money. Chapter 1 summarized this theory as one of the Ten Principles of Economics:
Prices rise when the government prints too much money. This insight has a long
and venerable tradition among economists. The quantity theory was discussed by
the famous eighteenth-century philosopher David Hume and has been advocated
more recently by the prominent economist Milton Friedman. This theory of infla-
tion can explain both moderate inflations, such as those we have experienced in
the United States, and hyperinflations, such as those experienced in interwar Ger-
many and, more recently, in some Latin American countries.
After developing a theory of inflation, we turn to a related question: Why is in-
flation a problem? At first glance, the answer to this question may seem obvious:
Inflation is a problem because people don’t like it. In the 1970s, when the United
States experienced a relatively high rate of inflation, opinion polls placed inflation
as the most important issue facing the nation. President Ford echoed this senti-
ment in 1974 when he called inflation “public enemy number one.” Ford briefly
wore a “WIN” button on his lapel—for “Whip Inflation Now.”
But what, exactly, are the costs that inflation imposes on a society? The answer
may surprise you. Identifying the various costs of inflation is not as straightfor-
ward as it first appears. As a result, although all economists decry hyperinflation,
some economists argue that the costs of moderate inflation are not nearly as large
as the general public believes.
CHAPTER 28 MONEY GROWTH AND INFLATION 629
THE CLASSICAL THEORY OF INFLATION
We begin our study of inflation by developing the quantity theory of money. This
theory is often called “classical” because it was developed by some of the earliest
thinkers about economic issues. Most economists today rely on this theory to ex-
plain the long-run determinants of the price level and the inflation rate.
THE LEVEL OF PRICES AND THE VALUE OF MONEY
Suppose we observe over some period of time the price of an ice-cream cone rising
from a nickel to a dollar. What conclusion should we draw from the fact that peo-
ple are willing to give up so much more money in exchange for a cone? It is possi-
ble that people have come to enjoy ice cream more (perhaps because some chemist
has developed a miraculous new flavor). Yet that is probably not the case. It is
more likely that people’s enjoyment of ice cream has stayed roughly the same and
that, over time, the money used to buy ice cream has become less valuable. Indeed,
the first insight about inflation is that it is more about the value of money than
about the value of goods.
This insight helps point the way toward a theory of inflation. When the con-
sumer price index and other measures of the price level rise, commentators are
often tempted to look at the many individual prices that make up these price
indexes: “The CPI rose by 3 percent last month, led by a 20 percent rise in the
price of coffee and a 30 percent rise in the price of heating oil.” Although this ap-
proach does contain some interesting information about what’s happening in the
”So what’s it going to be? The same size as last year or the same price as last year?”
630 PART TEN MONEY AND PRICES IN THE LONG RUN
economy, it also misses a key point: Inflation is an economy-wide phenomenon
that concerns, first and foremost, the value of the economy’s medium of exchange.
The economy’s overall price level can be viewed in two ways. So far, we have
viewed the price level as the price of a basket of goods and services. When the
price level rises, people have to pay more for the goods and services they buy. Al-
ternatively, we can view the price level as a measure of the value of money. A rise
in the price level means a lower value of money because each dollar in your wal-
let now buys a smaller quantity of goods and services.
It may help to express these ideas mathematically. Suppose P is the price level
as measured, for instance, by the consumer price index or the GDP deflator. Then
P measures the number of dollars needed to buy a basket of goods and services.
Now turn this idea around: The quantity of goods and services that can be bought
with $1 equals 1/P. In other words, if P is the price of goods and services mea-
sured in terms of money, 1/P is the value of money measured in terms of goods
and services. Thus, when the overall price level rises, the value of money falls.
MONEY SUPPLY, MONEY DEMAND,
AND MONETARY EQUILIBRIUM
What determines the value of money? The answer to this question, like many in
economics, is supply and demand. Just as the supply and demand for bananas de-
termines the price of bananas, the supply and demand for money determines the
value of money. Thus, our next step in developing the quantity theory of money is
to consider the determinants of money supply and money demand.
First consider money supply. In the preceding chapter we discussed how the
Federal Reserve, together with the banking system, determines the supply of
money. When the Fed sells bonds in open-market operations, it receives dollars in
exchange and contracts the money supply. When the Fed buys government bonds,
it pays out dollars and expands the money supply. In addition, if any of these dol-
lars are deposited in banks who then hold them as reserves, the money multiplier
swings into action, and these open-market operations can have an even greater ef-
fect on the money supply. For our purposes in this chapter, we ignore the compli-
cations introduced by the banking system and simply take the quantity of money
supplied as a policy variable that the Fed controls directly and completely.
Now consider money demand. There are many factors that determine the
quantity of money people demand, just as there are many determinants of the
quantity demanded of other goods and services. How much money people choose
to hold in their wallets, for instance, depends on how much they rely on credit
cards and on whether an automatic teller machine is easy to find. And, as we will
emphasize in Chapter 32, the quantity of money demanded depends on the inter-
est rate that a person could earn by using the money to buy an interest-bearing
bond rather than leaving it in a wallet or low-interest checking account.
Although many variables affect the demand for money, one variable stands
out in importance: the average level of prices in the economy. People hold money
because it is the medium of exchange. Unlike other assets, such as bonds or stocks,
people can use money to buy the goods and services on their shopping lists. How
much money they choose to hold for this purpose depends on the prices of those
goods and services. The higher prices are, the more money the typical transaction
requires, and the more money people will choose to hold in their wallets and
CHAPTER 28 MONEY GROWTH AND INFLATION 631
checking accounts. That is, a higher price level (a lower value of money) increases
the quantity of money demanded.
What ensures that the quantity of money the Fed supplies balances the quan-
tity of money people demand? The answer, it turns out, depends on the time hori-
zon being considered. Later in this book we will examine the short-run answer,
and we will see that interest rates play a key role. In the long run, however, the an-
swer is different and much simpler. In the long run, the overall level of prices adjusts
to the level at which the demand for money equals the supply. If the price level is above
the equilibrium level, people will want to hold more money than the Fed has cre-
ated, so the price level must fall to balance supply and demand. If the price level is
below the equilibrium level, people will want to hold less money than the Fed has
created, and the price level must rise to balance supply and demand. At the equi-
librium price level, the quantity of money that people want to hold exactly bal-
ances the quantity of money supplied by the Fed.
Figure 28-1 illustrates these ideas. The horizontal axis of this graph shows the
quantity of money. The left-hand vertical axis shows the value of money, 1/P, and
the right-hand vertical axis shows the price level, P. Notice that the price-level axis
on the right is inverted: A low price level is shown near the top of this axis, and a
high price level is shown near the bottom. This inverted axis illustrates that when
the value of money is high (as shown near the top of the left axis), the price level is
low (as shown near the top of the right axis).
The two curves in this figure are the supply and demand curves for money.
The supply curve is vertical because the Fed has fixed the quantity of money avail-
able. The demand curve for money is downward sloping, indicating that when the
value of money is low (and the price level is high), people demand a larger quan-
tity of it to buy goods and services. At the equilibrium, shown in the figure as
point A, the quantity of money demanded balances the quantity of money sup-
plied. This equilibrium of money supply and money demand determines the value
of money and the price level.
Quantity fixed
by the Fed
Quantity of
Money
Value of
Money, 1/P
Price
Level, P
A
Money supply
0
1
(Low)
(High)
(High)
(Low)
1
/2
1
/4
3
/4
1
1.33
2
4
Equilibrium
value of
money
Equilibrium
price level
Money
demand
Figure 28-1
HOW THE SUPPLY AND DEMAND
FOR MONEY DETERMINE THE
EQUILIBRIUM PRICE LEVEL.
The horizontal axis shows the
quantity of money. The left
vertical axis shows the value of
money, and the right vertical axis
shows the price level. The supply
curve for money is vertical
because the quantity of money
supplied is fixed by the Fed.
The demand curve for money
is downward sloping because
people want to hold a larger
quantity of money when
each dollar buys less. At the
equilibrium, point A, the value
of money (on the left axis) and
the price level (on the right
axis) have adjusted to bring the
quantity of money supplied
and the quantity of money
demanded into balance.
632 PART TEN MONEY AND PRICES IN THE LONG RUN
THE EFFECTS OF A MONETARY INJECTION
Let’s now consider the effects of a change in monetary policy. To do so, imagine
that the economy is in equilibrium and then, suddenly, the Fed doubles the supply
of money by printing some dollar bills and dropping them around the country
from helicopters. (Or, less dramatically and more realistically, the Fed could inject
money into the economy by buying some government bonds from the public in
open-market operations.) What happens after such a monetary injection? How
does the new equilibrium compare to the old one?
Figure 28-2 shows what happens. The monetary injection shifts the supply
curve to the right from MS
1
to MS
2
, and the equilibrium moves from point A to
point B. As a result, the value of money (shown on the left axis) decreases from 1/2
to 1/4, and the equilibrium price level (shown on the right axis) increases from
2 to 4. In other words, when an increase in the money supply makes dollars more
plentiful, the result is an increase in the price level that makes each dollar less
valuable.
This explanation of how the price level is determined and why it might change
over time is called the quantity theory of money.According to the quantity theory,
the quantity of money available in the economy determines the value of money,
and growth in the quantity of money is the primary cause of inflation. As econo-
mist Milton Friedman once put it, “Inflation is always and everywhere a monetary
phenomenon.”
A BRIEF LOOK AT THE ADJUSTMENT PROCESS
So far we have compared the old equilibrium and the new equilibrium after an in-
jection of money. How does the economy get from the old to the new equilibrium?
Quantity of
Money
Value of
Money, 1/P
Price
Level, P
A
B
Money
demand
0
1
(Low)
(High)
(High)
(Low)
1
/2
1
/4
3
/4
1
1.33
2
4
M
1
MS
1
M
2
MS
2
2. …decreases
the value of
money…
3. …and
increases
the price
level.
1. An increase
in the money
supply...
Figure 28-2
AN INCREASE IN THE
MONEY SUPPLY. When the Fed
increases the supply of money,
the money supply curve shifts
from MS
1
to MS
2
. The value of
money (on the left axis) and the
price level (on the right axis)
adjust to bring supply and
demand back into balance. The
equilibrium moves from point
A to point B. Thus, when an
increase in the money supply
makes dollars more plentiful, the
price level increases, making each
dollar less valuable.
quantity theory of money
a theory asserting that the quantity
of money available determines the
price level and that the growth rate
in the quantity of money available
determines the inflation rate
CHAPTER 28 MONEY GROWTH AND INFLATION 633
A complete answer to this question requires an understanding of short-run
fluctuations in the economy, which we examine later in this book. Yet, even now, it
is instructive to consider briefly the adjustment process that occurs after a change
in money supply.
The immediate effect of a monetary injection is to create an excess supply
of money. Before the injection, the economy was in equilibrium (point A in Fig-
ure 28-2). At the prevailing price level, people had exactly as much money as they
wanted. But after the helicopters drop the new money and people pick it up off the
streets, people have more dollars in their wallets than they want. At the prevailing
price level, the quantity of money supplied now exceeds the quantity demanded.
People try to get rid of this excess supply of money in various ways. They
might buy goods and services with their excess holdings of money. Or they might
use this excess money to make loans to others by buying bonds or by depositing
the money in a bank savings account. These loans allow other people to buy goods
and services. In either case, the injection of money increases the demand for
goods and services.
The economy’s ability to supply goods and services, however, has not
changed. As we saw in Chapter 24, the economy’s production is determined by the
available labor, physical capital, human capital, natural resources, and techno-
logical knowledge. None of these is altered by the injection of money.
Thus, the greater demand for goods and services causes the prices of goods
and services to increase. The increase in the price level, in turn, increases the quan-
tity of money demanded because people are using more dollars for every transac-
tion. Eventually, the economy reaches a new equilibrium (point B in Figure 28-2) at
which the quantity of money demanded again equals the quantity of money sup-
plied. In this way, the overall price level for goods and services adjusts to bring
money supply and money demand into balance.
THE CLASSICAL DICHOTOMY AND MONETARY NEUTRALITY
We have seen how changes in the money supply lead to changes in the average
level of prices of goods and services. How do these monetary changes affect other
important macroeconomic variables, such as production, employment, real wages,
and real interest rates? This question has long intrigued economists. Indeed, the
great philosopher David Hume wrote about it in the eighteenth century. The an-
swer we give today owes much to Hume’s analysis.
Hume and his contemporaries suggested that all economic variables should be
divided into two groups. The first group consists of nominal variables—variables
measured in monetary units. The second group consists of real variables—vari-
ables measured in physical units. For example, the income of corn farmers is a
nominal variable because it is measured in dollars, whereas the quantity of corn
they produce is a real variable because it is measured in bushels. Similarly, nomi-
nal GDP is a nominal variable because it measures the dollar value of the econ-
omy’s output of goods and services, while real GDP is a real variable because it
measures the total quantity of goods and services produced. This separation of
variables into these groups is now called the classical dichotomy. (Adichotomy is a
division into two groups, and classical refers to the earlier economic thinkers.)
Application of the classical dichotomy is somewhat tricky when we turn
to prices. Prices in the economy are normally quoted in terms of money and,
nominal variables
variables measured in
monetaryunits
real variables
variables measured in physical units
classical dichotomy
the theoretical separation of nominal
and real variables
634 PART TEN MONEY AND PRICES IN THE LONG RUN
therefore, are nominal variables. For instance, when we say that the price of corn
is $2 a bushel or that the price of wheat is $1 a bushel, both prices are nominal vari-
ables. But what about a relative price—the price of one thing compared to another?
In our example, we could say that the price of a bushel of corn is two bushels of
wheat. Notice that this relative price is no longer measured in terms of money.
When comparing the prices of any two goods, the dollar signs cancel, and the re-
sulting number is measured in physical units. The lesson is that dollar prices are
nominal variables, whereas relative prices are real variables.
This lesson has several important applications. For instance, the real wage (the
dollar wage adjusted for inflation) is a real variable because it measures the rate at
which the economy exchanges goods and services for each unit of labor. Similarly,
the real interest rate (the nominal interest rate adjusted for inflation) is a real vari-
able because it measures the rate at which the economy exchanges goods and ser-
vices produced today for goods and services produced in the future.
Why bother separating variables into these two groups? Hume suggested that
the classical dichotomy is useful in analyzing the economy because different forces
influence real and nominal variables. In particular, he argued, nominal variables
are heavily influenced by developments in the economy’s monetary system,
whereas the monetary system is largely irrelevant for understanding the determi-
nants of important real variables.
Notice that Hume’s idea was implicit in our earlier discussions of the real
economy in the long run. In previous chapters, we examined how real GDP, sav-
ing, investment, real interest rates, and unemployment are determined without
any mention of the existence of money. As explained in that analysis, the econ-
omy’s production of goods and services depends on productivity and factor sup-
plies, the real interest rate adjusts to balance the supply and demand for loanable
funds, the real wage adjusts to balance the supply and demand for labor, and un-
employment results when the real wage is for some reason kept above its equilib-
rium level. These important conclusions have nothing to do with the quantity of
money supplied.
Changes in the supply of money, according to Hume, affect nominal variables
but not real variables. When the central bank doubles the money supply, the price
level doubles, the dollar wage doubles, and all other dollar values double. Real
variables, such as production, employment, real wages, and real interest rates, are
unchanged. This irrelevance of monetary changes for real variables is called mone-
tary neutrality.
An analogy sheds light on the meaning of monetary neutrality. Recall that, as
the unit of account, money is the yardstick we use to measure economic transac-
tions. When a central bank doubles the money supply, all prices double, and the
value of the unit of account falls by half. A similar change would occur if the gov-
ernment were to reduce the length of the yard from 36 to 18 inches: As a result of
the new unit of measurement, all measured distances (nominal variables) would
double, but the actual distances (real variables) would remain the same. The dollar,
like the yard, is merely a unit of measurement, so a change in its value should not
have important real effects.
Is this conclusion of monetary neutrality a realistic description of the world in
which we live? The answer is: not completely. A change in the length of the yard
from 36 to 18 inches would not matter much in the long run, but in the short run it
would certainly lead to confusion and various mistakes. Similarly, most econo-
mists today believe that over short periods of time—within the span of a year or
monetary neutrality
the proposition that changes in
themoney supply do not affect
realvariables
CHAPTER 28 MONEY GROWTH AND INFLATION 635
two—there is reason to think that monetary changes do have important effects on
real variables. Hume himself also doubted that monetary neutrality would apply
in the short run. (We will turn to the study of short-run nonneutrality in Chap-
ters 31 to 33, and this topic will shed light on the reasons why the Fed changes the
supply of money over time.)
Most economists today accept Hume’s conclusion as a description of the econ-
omy in the long run. Over the course of a decade, for instance, monetary changes
have important effects on nominal variables (such as the price level) but only neg-
ligible effects on real variables (such as real GDP). When studying long-run
changes in the economy, the neutrality of money offers a good description of how
the world works.
VELOCITY AND THE QUANTITY EQUATION
We can obtain another perspective on the quantity theory of money by consider-
ing the following question: How many times per year is the typical dollar bill used
to pay for a newly produced good or service? The answer to this question is given
by a variable called the velocity of money. In physics, the term velocity refers to the
speed at which an object travels. In economics, the velocity of money refers to
the speed at which the typical dollar bill travels around the economy from wallet
to wallet.
To calculate the velocity of money, we divide the nominal value of output
(nominal GDP) by the quantity of money. If P is the price level (the GDP deflator),
Y the quantity of output (real GDP), and M the quantity of money, then velocity is
VH11005 (PH11003 Y)/M.
To see why this makes sense, imagine a simple economy that produces only pizza.
Suppose that the economy produces 100 pizzas in a year, that a pizza sells for
$10, and that the quantity of money in the economy is $50. Then the velocity of
money is
VH11005 ($10 H11003 100)/$50
H11005 20.
In this economy, people spend a total of $1,000 per year on pizza. For this $1,000 of
spending to take place with only $50 of money, each dollar bill must change hands
on average 20 times per year.
With slight algebraic rearrangement, this equation can be rewritten as
MH11003 VH11005PH11003 Y.
This equation states that the quantity of money (M) times the velocity of money
(V) equals the price of output (P) times the amount of output (Y). It is called the
quantity equation because it relates the quantity of money (M) to the nominal
value of output (PH11003 Y). The quantity equation shows that an increase in the quan-
tity of money in an economy must be reflected in one of the other three variables:
velocity of money
the rate at which money
changeshands
quantity equation
the equation MH11003 V H11005PH11003 Y, which
relates the quantity of money, the
velocity of money, and the dollar
value of the economy’s output of
goods and services
636 PART TEN MONEY AND PRICES IN THE LONG RUN
The price level must rise, the quantity of output must rise, or the velocity of money
must fall.
In many cases, it turns out that the velocity of money is relatively stable. For
example, Figure 28-3 shows nominal GDP, the quantity of money (as measured by
M2), and the velocity of money for the U.S. economy since 1960. Although the ve-
locity of money is not exactly constant, it has not changed dramatically. By con-
trast, the money supply and nominal GDP during this period have increased more
than tenfold. Thus, for some purposes, the assumption of constant velocity may be
a good approximation.
We now have all the elements necessary to explain the equilibrium price level
and inflation rate. Here they are:
1. The velocity of money is relatively stable over time.
2. Because velocity is stable, when the Fed changes the quantity of money (M),
it causes proportionate changes in the nominal value of output (PH11003 Y).
3. The economy’s output of goods and services (Y) is primarily determined by
factor supplies (labor, physical capital, human capital, and natural resources)
and the available production technology. In particular, because money is
neutral, money does not affect output.
4. With output (Y) determined by factor supplies and technology, when the
Fed alters the money supply (M) and induces proportional changes in
the nominal value of output (PH11003 Y), these changes are reflected in
changes in the price level (P).
5. Therefore, when the Fed increases the money supply rapidly, the result is a
high rate of inflation.
These five steps are the essence of the quantity theory of money.
Indexes
(1960 = 100)
1,500
1,000
500
0
1960 1965 1970 1975 1980 1985 1990 1995 2000
Velocity
M2
Nominal GDP
Figure 28-3
NOMINAL GDP, THE
QUANTITY OF MONEY, AND
THE VELOCITY OF MONEY. This
figure shows the nominal value
of output as measured by
nominal GDP, the quantity of
money as measured by M2,
and the velocity of money as
measured by their ratio. For
comparability, all three series
have been scaled to equal 100 in
1960. Notice that nominal GDP
and the quantity of money have
grown dramatically over this
period, while velocity has been
relatively stable.
SOURCE: U.S. Department of Commerce;
Federal Reserve Board.
CHAPTER 28 MONEY GROWTH AND INFLATION 637
CASE STUDY MONEY AND PRICES DURING
FOURHYPERINFLATIONS
Although earthquakes can wreak havoc on a society, they have the beneficial
by-product of providing much useful data for seismologists. These data can
shed light on alternative theories and, thereby, help society predict and deal
with future threats. Similarly, hyperinflations offer monetary economists a nat-
ural experiment they can use to study the effects of money on the economy.
Hyperinflations are interesting in part because the changes in the money
supply and price level are so large. Indeed, hyperinflation is generally defined
(a) Austria (b) Hungary
Money supply
Price level
Index
(Jan. 1921 = 100)
Index
(July 1921 = 100)
(c) Germany
Price level
1
Index
(Jan. 1921 = 100)
(d) Poland
100,000,000,000,000
1,000,000
10,000,000,000
1,000,000,000,000
100,000,000
10,000
100
100,000
10,000
1,000
100
19251924192319221921
Money supply
Money
supply
Price level
100,000
10,000
1,000
100
19251924192319221921
19251924192319221921
Price level
Money
supply
Index
(Jan. 1921 = 100)
100
10,000,000
100,000
1,000,000
10,000
1,000
19251924192319221921
Figure 28-4
MONEY AND PRICES DURING FOUR HYPERINFLATIONS. This figure shows the quantity
of money and the price level during four hyperinflations. (Note that these variables are
graphed on logarithmic scales. This means that equal vertical distances on the graph
represent equal percentage changes in the variable.) In each case, the quantity of money
and the price level move closely together. The strong association between these two
variables is consistent with the quantity theory of money, which states that growth in
the money supply is the primary cause of inflation.
SOURCE: Adapted from Thomas J. Sargent, “The End of Four Big Inflations,” in Robert Hall, ed., Inflation, Chicago:
University of Chicago Press, 1983, pp. 41-93.
638 PART TEN MONEY AND PRICES IN THE LONG RUN
THE INFLATION TAX
If inflation is so easy to explain, why do countries experience hyperinflation? That
is, why do the central banks of these countries choose to print so much money that
its value is certain to fall rapidly over time?
The answer is that the governments of these countries are using money cre-
ation as a way to pay for their spending. When the government wants to build
roads, pay salaries to police officers, or give transfer payments to the poor or el-
derly, it first has to raise the necessary funds. Normally, the government does this
by levying taxes, such as income and sales taxes, and by borrowing from the pub-
lic by selling government bonds. Yet the government can also pay for spending by
simply printing the money it needs.
When the government raises revenue by printing money, it is said to levy an
inflation tax. The inflation tax is not exactly like other taxes, however, because no
one receives a bill from the government for this tax. Instead, the inflation tax is
more subtle. When the government prints money, the price level rises, and the dol-
lars in your wallet are less valuable. Thus, the inflation tax is like a tax on everyone
who holds money.
The importance of the inflation tax varies from country to country and over
time. In the United States in recent years, the inflation tax has been a trivial source
of revenue: It has accounted for less than 3 percent of government revenue. Dur-
ing the 1770s, however, the Continental Congress of the fledgling United States re-
lied heavily on the inflation tax to pay for military spending. Because the new
government had a limited ability to raise funds through regular taxes or borrow-
ing, printing dollars was the easiest way to pay the American soldiers. As the
quantity theory predicts, the result was a high rate of inflation: Prices measured in
terms of the continental dollar rose more than 100-fold over a few years.
Almost all hyperinflations follow the same pattern as the hyperinflation dur-
ing the American Revolution. The government has high spending, inadequate tax
revenue, and limited ability to borrow. As a result, it turns to the printing press
to pay for its spending. The massive increases in the quantity of money lead to
inflation tax
the revenue the government
raisesbycreating money
as inflation that exceeds 50 percent per month. This means that the price level in-
creases more than 100-fold over the course of a year.
The data on hyperinflation show a clear link between the quantity of money
and the price level. Figure 28-4 graphs data from four classic hyperinflations
that occurred during the 1920s in Austria, Hungary, Germany, and Poland. Each
graph shows the quantity of money in the economy and an index of the price
level. The slope of the money line represents the rate at which the quantity of
money was growing, and the slope of the price line represents the inflation rate.
The steeper the lines, the higher the rates of money growth or inflation.
Notice that in each graph the quantity of money and the price level are al-
most parallel. In each instance, growth in the quantity of money is moderate at
first, and so is inflation. But over time, the quantity of money in the economy
starts growing faster and faster. At about the same time, inflation also takes off.
Then when the quantity of money stabilizes, the price level stabilizes as well.
These episodes illustrate well one of the Ten Principles of Economics: Prices rise
when the government prints too much money.
CHAPTER 28 MONEY GROWTH AND INFLATION 639
massive inflation. The inflation ends when the government institutes fiscal
reforms—such as cuts in government spending—that eliminate the need for the
inflation tax.
THE FISHER EFFECT
According to the principle of monetary neutrality, an increase in the rate of money
growth raises the rate of inflation but does not affect any real variable. An impor-
tant application of this principle concerns the effect of money on interest rates. In-
terest rates are important variables for macroeconomists to understand because
they link the economy of the present and the economy of the future through their
effects on saving and investment.
To understand the relationship between money, inflation, and interest rates,
recall from Chapter 23 the distinction between the nominal interest rate and the
real interest rate. The nominal interest rate is the interest rate you hear about at your
bank. If you have a savings account, for instance, the nominal interest rate tells you
how fast the number of dollars in your account will rise over time. The real interest
rate corrects the nominal interest rate for the effect of inflation in order to tell you
how fast the purchasing power of your savings account will rise over time. The
real interest rate is the nominal interest rate minus the inflation rate:
Real interest rate H11005 Nominal interest rate H11002 Inflation rate.
WHENEVER GOVERNMENTS FIND THEM-
selves short of cash, they are tempted to
solve the problem simply by printing
some more. In 1998, Russian policy-
makers found this temptation hard to
resist, and the inflation rate rose to
more than 100 percent per year.
Russia’s New Leaders Plan to Pay
Debts by Printing Money
BY MICHAEL WINES
MOSCOW—Russia’s new Communist-
influenced Government indicated today
that it plans to satisfy old debts and bail
out old friends by printing new rubles, a
decision that drew a swift and strong re-
action from President Boris N. Yeltsin’s
old capitalist allies.
The deputy head of the central bank
said today that the bank intends to bail
out many of the nation’s bankrupt finan-
cial institutions by buying back their
multibillion-ruble portfolios of Govern-
ment bonds and Treasury bills. The Gov-
ernment temporarily froze $40 billion
worth of notes when the fiscal crisis
erupted last month because it lacked
the money to pay investors who hold
them.
Asked by the Reuters news service
how the near-broke Government would
find the money to pay off the banks,
the deputy, Andrei Kozlov, replied,
“Emissions, of course, emissions.”
“Emissions” is a euphemism for printing
money.
Hours later in Washington, Deputy
Treasury Secretary Lawrence H. Sum-
mers told a House subcommittee that
Russia was heading toward a return
of the four-digit inflation rates that sav-
aged consumers and almost toppled Mr.
Yeltsin’s Government in 1993.
Russia’s new leaders cannot repeal
“basic economic laws,” he said.
SOURCE: The New York Times, September 18, 1998,
p. A3.
IN THE NEWS
Russia Turns to
the Inflation Tax
640 PART TEN MONEY AND PRICES IN THE LONG RUN
For example, if the bank posts a nominal interest rate of 7 percent per year and the
inflation rate is 3 percent per year, then the real value of the deposits grows by 4
percent per year.
We can rewrite this equation to show that the nominal interest rate is the sum
of the real interest rate and the inflation rate:
Nominal interest rate H11005 Real interest rate H11001 Inflation rate.
This way of looking at the nominal interest rate is useful because different eco-
nomic forces determine each of the two terms on the right-hand side of this equa-
tion. As we discussed in Chapter 25, the supply and demand for loanable funds
determine the real interest rate. And, according to the quantity theory of money,
growth in the money supply determines the inflation rate.
Let’s now consider how the growth in the money supply affects interest rates.
In the long run over which money is neutral, a change in money growth should
not affect the real interest rate. The real interest rate is, after all, a real variable. For
the real interest rate not to be affected, the nominal interest rate must adjust one-
for-one to changes in the inflation rate. Thus, when the Fed increases the rate of money
growth, the result is both a higher inflation rate and a higher nominal interest rate. This
adjustment of the nominal interest rate to the inflation rate is called the Fisher
effect, after economist Irving Fisher (1867-1947), who first studied it.
The Fisher effect is, in fact, crucial for understanding changes over time in the
nominal interest rate. Figure 28-5 shows the nominal interest rate and the inflation
rate in the U.S. economy since 1960. The close association between these two vari-
ables is clear. The nominal interest rate rose from the early 1960s through the 1970s
because inflation was also rising during this time. Similarly, the nominal interest
rate fell from the early 1980s through the 1990s because the Fed got inflation under
control.
Fisher effect
the one-for-one adjustment
ofthenominal interest rate to
theinflationrate
Percent
(per year)
1960 1965 1970 1975 1980 1985 1990 1995
Inflation
Nominal interest rate
0
3
6
9
12
15
Figure 28-5
THE NOMINAL INTEREST RATE
AND THE INFLATION RATE.
This figure uses annual data since
1960 to show the nominal interest
rate on three-month Treasury
bills and the inflation rate as
measured by the consumer price
index. The close association
between these two variables is
evidence for the Fisher effect:
When the inflation rate rises, so
does the nominal interest rate.
SOURCE: U.S. Department of Treasury;
U.S. Department of Labor.
CHAPTER 28 MONEY GROWTH AND INFLATION 641
QUICK QUIZ: The government of a country increases the growth rate
of the money supply from 5 percent per year to 50 percent per year. What
happens to prices? What happens to nominal interest rates? Why might the
government be doing this?
THE COSTS OF INFLATION
In the late 1970s, when the U.S. inflation rate reached about 10 percent per year, in-
flation dominated debates over economic policy. And even though inflation was
low during the 1990s, inflation remained a closely watched macroeconomic vari-
able. One 1996 study found that inflation was the economic term mentioned most
often in U.S. newspapers (far ahead of second-place finisher unemployment and
third-place finisher productivity).
Inflation is closely watched and widely discussed because it is thought to be a
serious economic problem. But is that true? And if so, why?
A FALL IN PURCHASING POWER? THE INFLATION FALLACY
If you ask the typical person why inflation is bad, he will tell you that the answer
is obvious: Inflation robs him of the purchasing power of his hard-earned dollars.
When prices rise, each dollar of income buys fewer goods and services. Thus, it
might seem that inflation directly lowers living standards.
Yet further thought reveals a fallacy in this answer. When prices rise, buyers of
goods and services pay more for what they buy. At the same time, however, sellers
of goods and services get more for what they sell. Because most people earn their
incomes by selling their services, such as their labor, inflation in incomes goes
hand in hand with inflation in prices. Thus, inflation does not in itself reduce people’s
real purchasing power.
People believe the inflation fallacy because they do not appreciate the princi-
ple of monetary neutrality. A worker who receives an annual raise of 10 percent
tends to view that raise as a reward for her own talent and effort. When an infla-
tion rate of 6 percent reduces the real value of that raise to only 4 percent, the
worker might feel that she has been cheated of what is rightfully her due. In fact,
as we discussed in Chapter 24, real incomes are determined by real variables, such
as physical capital, human capital, natural resources, and the available production
technology. Nominal incomes are determined by those factors and the overall
price level. If the Fed were to lower the inflation rate from 6 percent to zero, our
worker’s annual raise would fall from 10 percent to 4 percent. She might feel less
robbed by inflation, but her real income would not rise more quickly.
If nominal incomes tend to keep pace with rising prices, why then is inflation
a problem? It turns out that there is no single answer to this question. Instead,
economists have identified several costs of inflation. Each of these costs shows
some way in which persistent growth in the money supply does, in fact, have
some effect on real variables.
642 PART TEN MONEY AND PRICES IN THE LONG RUN
SHOELEATHER COSTS
As we have discussed, inflation is like a tax on the holders of money. The tax itself
is not a cost to society: It is only a transfer of resources from households to the gov-
ernment. Yet, as we first saw in Chapter 8, most taxes give people an incentive to
alter their behavior to avoid paying the tax, and this distortion of incentives causes
deadweight losses for society as a whole. Like other taxes, the inflation tax also
causes deadweight losses because people waste scarce resources trying to avoid it.
How can a person avoid paying the inflation tax? Because inflation erodes the
real value of the money in your wallet, you can avoid the inflation tax by holding
less money. One way to do this is to go to the bank more often. For example, rather
than withdrawing $200 every four weeks, you might withdraw $50 once a week.
By making more frequent trips to the bank, you can keep more of your wealth in
your interest-bearing savings account and less in your wallet, where inflation
erodes its value.
The cost of reducing your money holdings is called the shoeleather cost of
inflation because making more frequent trips to the bank causes your shoes to
wear out more quickly. Of course, this term is not to be taken literally: The actual
cost of reducing your money holdings is not the wear and tear on your shoes but
the time and convenience you must sacrifice to keep less money on hand than you
would if there were no inflation.
The shoeleather costs of inflation may seem trivial. And, in fact, they are in the
U.S. economy, which has had only moderate inflation in recent years. But this cost
is magnified in countries experiencing hyperinflation. Here is a description of one
person’s experience in Bolivia during its hyperinflation (as reported in the August
13, 1985, issue of The Wall Street Journal, p. 1):
When Edgar Miranda gets his monthly teacher’s pay of 25 million pesos, he
hasn’t a moment to lose. Every hour, pesos drop in value. So, while his wife
rushes to market to lay in a month’s supply of rice and noodles, he is off with the
rest of the pesos to change them into black-market dollars.
Mr. Miranda is practicing the First Rule of Survival amid the most out-of-
control inflation in the world today. Bolivia is a case study of how runaway
inflation undermines a society. Price increases are so huge that the figures build
up almost beyond comprehension. In one six-month period, for example, prices
soared at an annual rate of 38,000 percent. By official count, however, last year’s
inflation reached 2,000 percent, and this year’s is expected to hit 8,000 percent—
though other estimates range many times higher. In any event, Bolivia’s rate
dwarfs Israel’s 370 percent and Argentina’s 1,100 percent—two other cases of
severe inflation.
It is easier to comprehend what happens to the 38-year-old Mr. Miranda’s
pay if he doesn’t quickly change it into dollars. The day he was paid 25 million
pesos, a dollar cost 500,000 pesos. So he received $50. Just days later, with the rate
at 900,000 pesos, he would have received $27.
As this story shows, the shoeleather costs of inflation can be substantial. With the
high inflation rate, Mr. Miranda does not have the luxury of holding the local
money as a store of value. Instead, he is forced to convert his pesos quickly into
goods or into U.S. dollars, which offer a more stable store of value. The time and
effort that Mr. Miranda expends to reduce his money holdings are a waste of
shoeleather costs
the resources wasted when inflation
encourages people to reduce their
money holdings
CHAPTER 28 MONEY GROWTH AND INFLATION 643
resources. If the monetary authority pursued a low-inflation policy, Mr. Miranda
would be happy to hold pesos, and he could put his time and effort to more
productive use. In fact, shortly after this article was written, the Bolivian inflation
rate was reduced substantially with more restrictive monetary policy.
WHENEVER GOVERNMENTS TURN TO THE
printing press to finance substantial
amounts of spending, the result is hy-
perinflation. As residents of Serbia
learned in the early 1990s, life under
such circumstances is far from easy.
Special, Today Only: 6 Million
Dinars for a Snickers Bar
BY ROGER THUROW
BELGRADE, YUGOSLAVIA—At the Luna
boutique, a Snickers bar costs 6 million
dinars. Or at least it does until manager
Tihomir Nikolic reads the overnight fax
from his boss.
“Raise prices 99 percent,” the doc-
ument tersely orders. It would be an
even 100 percent except that the com-
puters at the boutique, which would be
considered a dime store in other parts
of the world, can’t handle three-digit
changes.
So for the second time in three
days, Mr. Nikolic sets about raising
prices. He jams a mop across the door
frame to keep customers from getting
away with a bargain. The computer spits
out the new prices on perforated paper.
The manager and two assistants rip
the paper into tags and tape them to the
shelves. They used to put the prices
directly on the goods, but there were so
many stickers it was getting difficult to
read the labels.
After four hours, the mop is re-
moved from the door. The customers
wander in, rub their eyes and squint at
the tags, counting the zeros. Mr. Nikolic
himself squints as the computer prints
another price, this one for a video
recorder.
“Is that billions?” he asks himself. It
is: 20,391,560,223 dinars, to be precise.
He points to his T-shirt, which is embla-
zoned with the words “Far Out,” the
name of a fruit juice he once sold. He
suggests it is an ideal motto for Serbia’s
bizarre economic situation. “It fits the
craziness,” he says.
How else would you describe it?
Since the international community im-
posed economic sanctions, the inflation
rate has been at least 10 percent daily.
This translates to an annual rate in the
quadrillions—so high as to be meaning-
less. In Serbia, one U.S. dollar will get
you 10 million dinars at the Hyatt hotel,
12 million from the shady money chang-
ers on Republic Square, and 17 million
from a bank run by Belgrade’s under-
world. Serbs complain that the dinar is
as worthless as toilet paper. But for the
moment, at least, there is plenty of toilet
paper to go around.
The government mint, hidden in the
park behind the Belgrade racetrack, is
said to be churning out dinars 24 hours a
day, furiously trying to keep up with the
inflation that is fueled, in turn, by its own
nonstop printing. The government, which
believes in throwing around money to
damp dissent, needs dinars to pay work-
ers for not working at closed factories
and offices. It needs them to buy the har-
vest from the farmers. It needs them to
finance its smuggling forays and other
ways to evade the sanctions, bringing
in everything from oil to Mr. Nikolic’s
Snickers bars. It also needs them to sup-
ply brother Serbs fighting in Bosnia-
Herzegovina and Croatia.
The money changers, whose finger-
tips detect the slightest change in paper
quality, insist that the mint is even con-
tracting out to private printers to meet
demand.
“We’re experts. They can’t fool
us,” says one of the changers as he
hands over 800 million worth of 5-million-
dinar bills. “These,” he notes confi-
dently, “are fresh from the mint.” He
says he got them from a private bank,
which got them from the central bank,
which got them from the mint—an un-
holy circuit linking the black market with
the Finance Ministry. “It’s collective lu-
nacy,” the money changer says, laughing
wickedly.
SOURCE: The Wall Street Journal,August 4, 1993,
p. A1.
IN THE NEWS
The Hyperinflation in Serbia
644 PART TEN MONEY AND PRICES IN THE LONG RUN
MENU COSTS
Most firms do not change the prices of their products every day. Instead, firms of-
ten announce prices and leave them unchanged for weeks, months, or even years.
One survey found that the typical U.S. firm changes its prices about once a year.
Firms change prices infrequently because there are costs of changing prices.
Costs of price adjustment are called menu costs, a term derived from a restaurant’s
cost of printing a new menu. Menu costs include the cost of deciding on new
prices, the cost of printing new price lists and catalogs, the cost of sending these
new price lists and catalogs to dealers and customers, the cost of advertising the
new prices, and even the cost of dealing with customer annoyance over price
changes.
Inflation increases the menu costs that firms must bear. In the current U.S.
economy, with its low inflation rate, annual price adjustment is an appropriate
business strategy for many firms. But when high inflation makes firms’ costs rise
rapidly, annual price adjustment is impractical. During hyperinflations, for exam-
ple, firms must change their prices daily or even more often just to keep up with
all the other prices in the economy.
RELATIVE-PRICE VARIABILITY
AND THE MISALLOCATION OF RESOURCES
Suppose that the Eatabit Eatery prints a new menu with new prices every January
and then leaves its prices unchanged for the rest of the year. If there is no inflation,
Eatabit’s relative prices—the prices of its meals compared to other prices in the
economy—would be constant over the course of the year. By contrast, if the infla-
tion rate is 12 percent per year, Eatabit’s relative prices will automatically fall by 1
percent each month. The restaurant’s relative prices (that is, its prices compared
with others in the economy) will be high in the early months of the year, just after
it has printed a new menu, and low in the later months. And the higher the infla-
tion rate, the greater is this automatic variability. Thus, because prices change only
once in a while, inflation causes relative prices to vary more than they otherwise
would.
Why does this matter? The reason is that market economies rely on relative
prices to allocate scarce resources. Consumers decide what to buy by comparing
the quality and prices of various goods and services. Through these decisions, they
determine how the scarce factors of production are allocated among industries and
firms. When inflation distorts relative prices, consumer decisions are distorted,
and markets are less able to allocate resources to their best use.
INFLATION-INDUCED TAX DISTORTIONS
Almost all taxes distort incentives, cause people to alter their behavior, and lead
to a less efficient allocation of the economy’s resources. Many taxes, however,
become even more problematic in the presence of inflation. The reason is that
lawmakers often fail to take inflation into account when writing the tax laws.
menu costs
the costs of changing prices
CHAPTER 28 MONEY GROWTH AND INFLATION 645
Economists who have studied the tax code conclude that inflation tends to raise
the tax burden on income earned from savings.
One example of how inflation discourages saving is the tax treatment of capital
gains—the profits made by selling an asset for more than its purchase price. Sup-
pose that in 1980 you used some of your savings to buy stock in Microsoft Corpo-
ration for $10 and that in 2000 you sold the stock for $50. According to the tax law,
you have earned a capital gain of $40, which you must include in your income
when computing how much income tax you owe. But suppose the overall price
level doubled from 1980 to 2000. In this case, the $10 you invested in 1980 is equiv-
alent (in terms of purchasing power) to $20 in 2000. When you sell your stock for
$50, you have a real gain (an increase in purchasing power) of only $30. The tax
code, however, does not take account of inflation and assesses you a tax on a gain
of $40. Thus, inflation exaggerates the size of capital gains and inadvertently in-
creases the tax burden on this type of income.
Another example is the tax treatment of interest income. The income tax treats
the nominal interest earned on savings as income, even though part of the nominal
interest rate merely compensates for inflation. To see the effects of this policy, con-
sider the numerical example in Table 28-1. The table compares two economies,
both of which tax interest income at a rate of 25 percent. In Economy 1, inflation is
zero, and the nominal and real interest rates are both 4 percent. In this case, the
25 percent tax on interest income reduces the real interest rate from 4 percent to
3 percent. In Economy 2, the real interest rate is again 4 percent, but the inflation
rate is 8 percent. As a result of the Fisher effect, the nominal interest rate is 12 per-
cent. Because the income tax treats this entire 12 percent interest as income, the
government takes 25 percent of it, leaving an after-tax nominal interest rate of only
9 percent and an after-tax real interest rate of only 1 percent. In this case, the
25 percent tax on interest income reduces the real interest rate from 4 percent to
1 percent. Because the after-tax real interest rate provides the incentive to save,
saving is much less attractive in the economy with inflation (Economy 2) than in
the economy with stable prices (Economy 1).
Table 28-1
HOW INFLATION RAISES THE
TAX BURDEN ON SAVING.
In the presence of zero inflation, a
25 percent tax on interest income
reduces the real interest rate from
4 percent to 3 percent. In the
presence of 8 percent inflation,
the same tax reduces the real
interest rate from 4 percent to
1 percent.
ECONOMY 1ECONOMY 2
(PRICE STABILITY)(INFLATION)
Real interest rate 4% 4%
Inflation rate 0 8
Nominal interest rate
(real interest rate H11001 inflation rate) 4 12
Reduced interest due to 25 percent tax
(.25 H11003 nominal interest rate) 1 3
After-tax nominal interest rate
(.75 H11003 nominal interest rate) 3 9
After-tax real interest rate
(after-tax nominal interest
rate H11002 inflation rate) 3 1
646 PART TEN MONEY AND PRICES IN THE LONG RUN
The taxes on nominal capital gains and on nominal interest income are two
examples of how the tax code interacts with inflation. There are many others.
Because of these inflation-induced tax changes, higher inflation tends to discour-
age people from saving. Recall that the economy’s saving provides the resources
for investment, which in turn is a key ingredient to long-run economic growth.
Thus, when inflation raises the tax burden on saving, it tends to depress the econ-
omy’s long-run growth rate. There is, however, no consensus among economists
about the size of this effect.
One solution to this problem, other than eliminating inflation, is to index the
tax system. That is, the tax laws could be rewritten to take account of the effects of
inflation. In the case of capital gains, for example, the tax code could adjust the
purchase price using a price index and assess the tax only on the real gain. In the
case of interest income, the government could tax only real interest income by ex-
cluding that portion of the interest income that merely compensates for inflation.
To some extent, the tax laws have moved in the direction of indexation. For exam-
ple, the income levels at which income tax rates change are adjusted automatically
each year based on changes in the consumer price index. Yet many other aspects of
the tax laws—such as the tax treatment of capital gains and interest income—are
not indexed.
In an ideal world, the tax laws would be written so that inflation would not
alter anyone’s real tax liability. In the world in which we live, however, tax laws
are far from perfect. More complete indexation would probably be desirable, but
it would further complicate a tax code that many people already consider too
complex.
CONFUSION AND INCONVENIENCE
Imagine that we took a poll and asked people the following question: “This year
the yard is 36 inches. How long do you think it should be next year?” Assum-
ing we could get people to take us seriously, they would tell us that the yard
should stay the same length—36 inches. Anything else would just complicate life
needlessly.
What does this finding have to do with inflation? Recall that money, as the
economy’s unit of account, is what we use to quote prices and record debts. In
other words, money is the yardstick with which we measure economic transac-
tions. The job of the Federal Reserve is a bit like the job of the Bureau of Stan-
dards—to ensure the reliability of a commonly used unit of measurement. When
the Fed increases the money supply and creates inflation, it erodes the real value
of the unit of account.
It is difficult to judge the costs of the confusion and inconvenience that arise
from inflation. Earlier we discussed how the tax code incorrectly measures real in-
comes in the presence of inflation. Similarly, accountants incorrectly measure
firms’ earnings when prices are rising over time. Because inflation causes dollars
at different times to have different real values, computing a firm’s profit—the dif-
ference between its revenue and costs—is more complicated in an economy with
inflation. Therefore, to some extent, inflation makes investors less able to sort out
successful from unsuccessful firms, which in turn impedes financial markets in
their role of allocating the economy’s saving to alternative types of investment.
CHAPTER 28 MONEY GROWTH AND INFLATION 647
CASE STUDY THE WIZARD OF OZ
ANDTHEFREE-SILVERDEBATE
As a child, you probably saw the movie The Wizard of Oz, based on a children’s
book written in 1900. The movie and book tell the story of a young girl,
Dorothy, who finds herself lost in a strange land far from home. You probably
did not know, however, that the story is actually an allegory about U.S. mone-
tary policy in the late nineteenth century.
From 1880 to 1896, the price level in the U.S. economy fell by 23 percent.
Because this event was unanticipated, it led to a major redistribution of
A SPECIAL COST OF UNEXPECTED INFLATION:
ARBITRARY REDISTRIBUTIONS OF WEALTH
So far, the costs of inflation we have discussed occur even if inflation is steady and
predictable. Inflation has an additional cost, however, when it comes as a surprise.
Unexpected inflation redistributes wealth among the population in a way that has
nothing to do with either merit or need. These redistributions occur because many
loans in the economy are specified in terms of the unit of account—money.
Consider an example. Suppose that Sam Student takes out a $20,000 loan at a
7 percent interest rate from Bigbank to attend college. In ten years, the loan will
come due. After his debt has compounded for ten years at 7 percent, Sam will owe
Bigbank $40,000. The real value of this debt will depend on inflation over the
decade. If Sam is lucky, the economy will have a hyperinflation. In this case, wages
and prices will rise so high that Sam will be able to pay the $40,000 debt out of
pocket change. By contrast, if the economy goes through a major deflation, then
wages and prices will fall, and Sam will find the $40,000 debt a greater burden
than he anticipated.
This example shows that unexpected changes in prices redistribute wealth
among debtors and creditors. A hyperinflation enriches Sam at the expense of Big-
bank because it diminishes the real value of the debt; Sam can repay the loan in
less valuable dollars than he anticipated. Deflation enriches Bigbank at Sam’s ex-
pense because it increases the real value of the debt; in this case, Sam has to repay
the loan in more valuable dollars than he anticipated. If inflation were predictable,
then Bigbank and Sam could take inflation into account when setting the nominal
interest rate. (Recall the Fisher effect.) But if inflation is hard to predict, it imposes
risk on Sam and Bigbank that both would prefer to avoid.
This cost of unexpected inflation is important to consider together with an-
other fact: Inflation is especially volatile and uncertain when the average rate of in-
flation is high. This is seen most simply by examining the experience of different
countries. Countries with low average inflation, such as Germany in the late twen-
tieth century, tend to have stable inflation. Countries with high average inflation,
such as many countries in Latin America, tend also to have unstable inflation.
There are no known examples of economies with high, stable inflation. This rela-
tionship between the level and volatility of inflation points to another cost of in-
flation. If a country pursues a high-inflation monetary policy, it will have to bear
not only the costs of high expected inflation but also the arbitrary redistributions
of wealth associated with unexpected inflation.
648 PART TEN MONEY AND PRICES IN THE LONG RUN
wealth. Most farmers in the western part of the country were debtors. Their
creditors were the bankers in the east. When the price level fell, it caused the
real value of these debts to rise, which enriched the banks at the expense of the
farmers.
According to populist politicians of the time, the solution to the farmers’
problem was the free coinage of silver. During this period, the United States
was operating with a gold standard. The quantity of gold determined the
money supply and, thereby, the price level. The free-silver advocates wanted
silver, as well as gold, to be used as money. If adopted, this proposal would
have increased the money supply, pushed up the price level, and reduced the
real burden of the farmers’ debts.
The debate over silver was heated, and it was central to the politics of the
1890s. A common election slogan of the populists was “We Are Mortgaged. All
But Our Votes.” One prominent advocate of free silver was William Jennings
Bryan, the Democratic nominee for president in 1896. He is remembered in part
for a speech at the Democratic party’s nominating convention in which he said,
“You shall not press down upon the brow of labor this crown of thorns. You
shall not crucify mankind upon a cross of gold.” Rarely since then have politi-
cians waxed so poetic about alternative approaches to monetary policy.
Nonetheless, Bryan lost the election to Republican William McKinley, and the
United States remained on the gold standard.
L. Frank Baum, the author of the book The Wonderful Wizard of Oz, was a
midwestern journalist. When he sat down to write a story for children, he made
the characters represent protagonists in the major political battle of his time.
Although modern commentators on the story differ somewhat in the inter-
pretation they assign to each character, there is no doubt that the story high-
lights the debate over monetary policy. Here is how economic historian Hugh
Rockoff, writing in the August 1990 issue of the Journal of Political Economy,
interprets the story:
DOROTHY: Traditional American values
TOTO: Prohibitionist party, also called the
Teetotalers
SCARECROW: Farmers
TIN WOODSMAN: Industrial workers
COWARDLY LION: William Jennings Bryan
MUNCHKINS: Citizens of the east
WICKED WITCH OF THE EAST: Grover Cleveland
WICKED WITCH OF THE WEST: William McKinley
WIZARD: Marcus Alonzo Hanna, chairman of the
Republican party
OZ: Abbreviation for ounce of gold
YELLOW BRICK ROAD: Gold standard
In the end of Baum’s story, Dorothy does find her way home, but it is not by just
following the yellow brick road. After a long and perilous journey, she learns
that the wizard is incapable of helping her or her friends. Instead, Dorothy
finally discovers the magical power of her silver slippers. (When the book was
made into a movie in 1939, Dorothy’s slippers were changed from silver to ruby.
Apparently, the Hollywood filmmakers were not aware that they were telling a
story about nineteenth-century monetary policy.)
Although the populists lost the debate over the free coinage of silver, they
did eventually get the monetary expansion and inflation that they wanted. In
1898 prospectors discovered gold near the Klondike River in the Canadian
Yukon. Increased supplies of gold also arrived from the mines of South Africa.
As a result, the money supply and the price level started to rise in the United
States and other countries operating on the gold standard. Within 15 years,
prices in the United States were back to the levels that had prevailed in the
1880s, and farmers were better able to handle their debts.
QUICK QUIZ: List and describe six costs of inflation.
CONCLUSION
This chapter discussed the causes and costs of inflation. The primary cause of in-
flation is simply growth in the quantity of money. When the central bank creates
money in large quantities, the value of money falls quickly. To maintain stable
prices, the central bank must maintain strict control over the money supply.
The costs of inflation are more subtle. They include shoeleather costs, menu
costs, increased variability of relative prices, unintended changes in tax liabilities,
confusion and inconvenience, and arbitrary redistributions of wealth. Are these
costs, in total, large or small? All economists agree that they become huge during
hyperinflation. But their size for moderate inflation—when prices rise by less than
10 percent per year—is more open to debate.
Although this chapter presented many of the most important lessons about in-
flation, the discussion is incomplete. When the Fed reduces the rate of money
growth, prices rise less rapidly, as the quantity theory suggests. Yet as the economy
makes the transition to this lower inflation rate, the change in monetary policy will
have disruptive effects on production and employment. That is, even though mon-
etary policy is neutral in the long run, it has profound effects on real variables in
CHAPTER 28 MONEY GROWTH AND INFLATION 649
AN EARLY DEBATE OVER
MONETARY POLICY
650 PART TEN MONEY AND PRICES IN THE LONG RUN
the short run. Later in this book we will examine the reasons for short-run mone-
tary nonneutrality in order to enhance our understanding of the causes and costs
of inflation.
AS WE HAVE SEEN, UNEXPECTED CHANGES
in the price level redistribute wealth
among debtors and creditors. This
would no longer be true if debt con-
tracts were written in real, rather than
nominal, terms. In 1997 the U.S. Trea-
sury started issuing bonds with a
return indexed to the price level. In
the following article, written a few
months before the policy was imple-
mented, two prominent economists
discuss the merits of this policy.
Inflation Fighters
for the Long Term
BY JOHN Y. CAMPBELL
AND ROBERT J. SHILLER
Treasury Secretary Robert Rubin an-
nounced on Thursday that the govern-
ment plans to issue inflation-indexed
bonds—that is, bonds whose interest
and principal payments are adjusted
upward for inflation, guaranteeing their
real purchasing power in the future.
This is a historic moment. Econo-
mists have been advocating such
bonds for many long and frustrating
years. Index bonds were first called for
in 1822 by the economist Joseph
Lowe. In the 1870s, they were cham-
pioned by the British economist Wil-
liam Stanley Jevons. In the early part of
this century, the legendary Irving
Fisher made a career of advocating
them.
In recent decades, economists of
every political stripe—from Milton
Friedman to James Tobin, Alan Blinder
to Alan Greenspan—have supported
them. Yet, because there was little
public clamor for such an investment,
the government never issued indexed
bonds.
Let’s hope this lack of interest
does not continue now that they will
become available. The success of the
indexed bonds depends on whether the
public understands them—and buys
them. Until now, inflation has made
government bonds a risky investment.
In 1966, when the inflation rate was
only 3 percent, if someone had bought
a 30-year government bond yielding
5 percent, he would have expected
that by now his investment would be
worth 180 percent of its original value.
However, after years of higher-than-
expected inflation, the investment is
worth only 85 percent of its original
value.
Because inflation has been mod-
est in recent years, many people today
are not worried about how it will affect
their savings. This complacency is dan-
gerous: Even a low rate of inflation can
seriously erode savings over long peri-
ods of time.
Imagine that you retire today with a
pension invested in Treasury bonds
that pay a fixed $10,000 each year,
IN THE NEWS
How to Protect Your Savings
from Inflation
a78 The overall level of prices in an economy adjusts to
bring money supply and money demand into balance.
When the central bank increases the supply of money, it
causes the price level to rise. Persistent growth in the
quantity of money supplied leads to continuing
inflation.
a78 The principle of monetary neutrality asserts that
changes in the quantity of money influence nominal
variables but not real variables. Most economists believe
that monetary neutrality approximately describes the
behavior of the economy in the long run.
Summary
CHAPTER 28 MONEY GROWTH AND INFLATION 651
regardless of inflation. If there is no in-
flation, in 20 years the pension will have
the same purchasing power that it does
today. But if there is an inflation rate of
only 3 percent per year, in 20 years
your pension will be worth only $5,540
in today’s dollars. Five percent inflation
over 20 years will cut your purchasing
power to $3,770, and 10 percent will
reduce it to a pitiful $1,390. Which
of these scenarios is likely? No one
knows. Inflation ultimately depends on
the people who are elected and ap-
pointed as guardians of our money
supply.
At a time when Americans are liv-
ing longer and planning for several
decades of retirement, the insidious ef-
fects of inflation should be of serious
concern. For this reason alone, the cre-
ation of inflation-indexed bonds, with
their guarantee of a safe return over
long periods of time, is a welcome de-
velopment.
No other investment offers this
kind of safety. Conventional govern-
ment bonds make payments that are
fixed in dollar terms; but investors
should be concerned about purchasing
power, not about the number of dollars
they receive. Money market funds
make dollar payments that increase
with inflation to some degree, since
short-term interest rates tend to rise
with inflation. But many other factors
also influence interest rates, so the real
income from a money market fund is
not secure.
The stock market offers a high rate
of return on average, but it can fall as
well as rise. Investors should remem-
ber the bear market of the 1970s as
well as the bull market of the 1980s
and 1990s.
Inflation-indexed government bonds
have been issued in Britain for 15
years, in Canada for five years, and in
many other countries, including Aus-
tralia, New Zealand, and Sweden. In
Britain, which has the world’s largest in-
dexed-bond market, the bonds have of-
fered a yield 3 to 4 percent higher than
the rate of inflation. In the United
States, a safe long-term return of this
sort should make indexed bonds an im-
portant part of retirement savings.
We expect that financial insti-
tutions will take advantage of the new
inflation-indexed bonds and offer in-
novative new products. Indexed-bond
funds will probably appear first, but in-
dexed annuities and even indexed mort-
gages—monthly payments would be
adjusted for inflation—should also be-
come available. [Author’s note: Since
this article was written, some of these
indexed products have been intro-
duced, but their use is not yet wide-
spread.]
Although the Clinton administration
may not get much credit for it today,
the decision to issue inflation-indexed
bonds is an accomplishment that histo-
rians decades hence will single out for
special recognition.
SOURCE: The New York Times, May 18, 1996, p. 19.
a78 A government can pay for some of its spending simply
by printing money. When countries rely heavily on this
“inflation tax,” the result is hyperinflation.
a78 One application of the principle of monetary neutrality
is the Fisher effect. According to the Fisher effect, when
the inflation rate rises, the nominal interest rate rises by
the same amount, so that the real interest rate remains
the same.
a78 Many people think that inflation makes them poorer
because it raises the cost of what they buy. This view is
a fallacy, however, because inflation also raises nominal
incomes.
a78 Economists have identified six costs of inflation:
shoeleather costs associated with reduced money
holdings, menu costs associated with more frequent
adjustment of prices, increased variability of relative
prices, unintended changes in tax liabilities due to
nonindexation of the tax code, confusion and
inconvenience resulting from a changing unit of
account, and arbitrary redistributions of wealth between
debtors and creditors. Many of these costs are large
during hyperinflation, but the size of these costs for
moderate inflation is less clear.
652 PART TEN MONEY AND PRICES IN THE LONG RUN
quantity theory of money, p. 632
nominal variables, p. 633
real variables, p. 633
classical dichotomy, p. 633
monetary neutrality, p. 634
velocity of money, p. 635
quantity equation, p. 635
inflation tax, p. 638
Fisher effect, p. 640
shoeleather costs, p. 642
menu costs, p. 644
Key Concepts
1. Explain how an increase in the price level affects the real
value of money.
2. According to the quantity theory of money, what is the
effect of an increase in the quantity of money?
3. Explain the difference between nominal and real
variables, and give two examples of each. According to
the principle of monetary neutrality, which variables are
affected by changes in the quantity of money?
4. In what sense is inflation like a tax? How does thinking
about inflation as a tax help explain hyperinflation?
5. According to the Fisher effect, how does an increase in
the inflation rate affect the real interest rate and the
nominal interest rate?
6. What are the costs of inflation? Which of these costs do
you think are most important for the U.S. economy?
7. If inflation is less than expected, who benefits—debtors
or creditors? Explain.
Questions for Review
1. Suppose that this year’s money supply is $500 billion,
nominal GDP is $10 trillion, and real GDP is $5 trillion.
a. What is the price level? What is the velocity of
money?
b. Suppose that velocity is constant and the
economy’s output of goods and services rises by
5 percent each year. What will happen to nominal
GDP and the price level next year if the Fed keeps
the money supply constant?
c. What money supply should the Fed set next year if
it wants to keep the price level stable?
d. What money supply should the Fed set next year if
it wants inflation of 10 percent?
2. Suppose that changes in bank regulations expand the
availability of credit cards, so that people need to hold
less cash.
a. How does this event affect the demand for money?
b. If the Fed does not respond to this event, what will
happen to the price level?
c. If the Fed wants to keep the price level stable, what
should it do?
3. It is often suggested that the Federal Reserve try to
achieve zero inflation. If we assume that velocity is
constant, does this zero-inflation goal require that the
rate of money growth equal zero? If yes, explain why. If
no, explain what the rate of money growth should
equal.
4. The economist John Maynard Keynes wrote: “Lenin is
said to have declared that the best way to destroy the
capitalist system was to debauch the currency. By a
continuing process of inflation, governments can
confiscate, secretly and unobserved, an important part
of the wealth of their citizens.” Justify Lenin’s assertion.
5. Suppose that a country’s inflation rate increases sharply.
What happens to the inflation tax on the holders of
money? Why is wealth that is held in savings accounts
not subject to a change in the inflation tax? Can you
think of any way in which holders of savings accounts
are hurt by the increase in the inflation rate?
6. Hyperinflations are extremely rare in countries whose
central banks are independent of the rest of the
government. Why might this be so?
Problems and Applications
CHAPTER 28 MONEY GROWTH AND INFLATION 653
7. Let’s consider the effects of inflation in an economy
composed only of two people: Bob, a bean farmer, and
Rita, a rice farmer. Bob and Rita both always consume
equal amounts of rice and beans. In 2000, the price of
beans was $1, and the price of rice was $3.
a. Suppose that in 2001 the price of beans was $2 and
the price of rice was $6. What was inflation? Was
Bob better off, worse off, or unaffected by the
changes in prices? What about Rita?
b. Now suppose that in 2001 the price of beans was $2
and the price of rice was $4. What was inflation?
Was Bob better off, worse off, or unaffected by the
changes in prices? What about Rita?
c. Finally, suppose that in 2001 the price of beans
was $2 and the price of rice was $1.50. What
was inflation? Was Bob better off, worse off,
or unaffected by the changes in prices?
What about Rita?
d. What matters more to Bob and Rita—the overall
inflation rate or the relative price of rice and beans?
8. If the tax rate is 40 percent, compute the before-tax real
interest rate and the after-tax real interest rate in each of
the following cases:
a. The nominal interest rate is 10 percent and the
inflation rate is 5 percent.
b. The nominal interest rate is 6 percent and the
inflation rate is 2 percent.
c. The nominal interest rate is 4 percent and the
inflation rate is 1 percent.
9. What are your shoeleather costs of going to the bank?
How might you measure these costs in dollars? How do
you think the shoeleather costs of your college president
differ from your own?
10. Recall that money serves three functions in the
economy. What are those functions? How does inflation
affect the ability of money to serve each of these
functions?
11. Suppose that people expect inflation to equal 3 percent,
but in fact prices rise by 5 percent. Describe how this
unexpectedly high inflation rate would help or hurt the
following:
a. the government
b. a homeowner with a fixed-rate mortgage
c. a union worker in the second year of a labor
contract
d. a college that has invested some of its endowment
in government bonds
12. Explain one harm associated with unexpected inflation
that is not associated with expected inflation. Then
explain one harm associated with both expected and
unexpected inflation.
13. Explain whether the following statements are true, false,
or uncertain.
a. “Inflation hurts borrowers and helps lenders,
because borrowers must pay a higher rate of
interest.”
b. “If prices change in a way that leaves the overall
price level unchanged, then no one is made better
or worse off.”
c. “Inflation does not reduce the purchasing power of
most workers.”
IN THIS CHAPTER
YOU WILL . . .
Learn the meaning of
the nominal exchange
rate and the real
exchange rate
Examine purchasing-
power parity as
a theory of how
exchange rates
are determined
Consider why net
exports must always
equal net foreign
investment
Learn how net
exports measure the
international flow of
goods and services
Learn how net foreign
investment measures
the international
flow of capital
See how saving,
domestic investment,
and net foreign
investment are
related
When you decide to buy a car, you may compare the latest models offered by Ford
and Toyota. When you take your next vacation, you may consider spending it on
a beach in Florida or in Mexico. When you start saving for your retirement, you
may choose between a mutual fund that buys stock in U.S. companies and one that
buys stock in foreign companies. In all of these cases, you are participating not just
in the U.S. economy but in economies around the world.
There are clear benefits to being open to international trade: Trade allows peo-
ple to produce what they produce best and to consume the great variety of goods
and services produced around the world. Indeed, one of the Ten Principles of Eco-
nomicshighlighted in Chapter 1 is that trade can make everyone better off. Chap-
ters 3 and 9 examined the gains from trade more fully. We learned that
international trade can raise living standards in all countries by allowing each
OPEN-ECONOMY
MACROECONOMICS:
BASIC CONCEPTS
657
658 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
country to specialize in producing those goods and services in which it has a com-
parative advantage.
So far our development of macroeconomics has largely ignored the economy’s
interaction with other economies around the world. For most questions in macro-
economics, international issues are peripheral. For instance, when we discussed
the natural rate of unemployment in Chapter 26 and the causes of inflation in
Chapter 28, the effects of international trade could safely be ignored. Indeed, to
keep their analysis simple, macroeconomists often assume a closed economy—an
economy that does not interact with other economies.
Yet some new macroeconomic issues arise in an open economy—an economy
that interacts freely with other economies around the world. This chapter and the
next one, therefore, provide an introduction to open-economy macroeconomics.
We begin in this chapter by discussing the key macroeconomic variables that de-
scribe an open economy’s interactions in world markets. You may have noticed
mention of these variables—exports, imports, the trade balance, and exchange
rates—when reading the newspaper or watching the nightly news. Our first job is
to understand what these data mean. In the next chapter we develop a model to
explain how these variables are determined and how they are affected by various
government policies.
THE INTERNATIONAL FLOWS
OF GOODS AND CAPITAL
An open economy interacts with other economies in two ways: It buys and sells
goods and services in world product markets, and it buys and sells capital assets
in world financial markets. Here we discuss these two activities and the close rela-
tionship between them.
THE FLOW OF GOODS: EXPORTS, IMPORTS,
AND NET EXPORTS
As we first noted in Chapter 3, exportsare domestically produced goods and ser-
vices that are sold abroad, and imports are foreign-produced goods and services
that are sold domestically. When Boeing, the U.S. aircraft manufacturer, builds a
plane and sells it to Air France, the sale is an export for the United States and an
import for France. When Volvo, the Swedish car manufacturer, makes a car and
sells it to a U.S. resident, the sale is an import for the United States and an export
for Sweden.
The net exportsof any country are the value of its exports minus the value of
its imports. The Boeing sale raises U.S. net exports, and the Volvo sale reduces U.S.
net exports. Because net exports tell us whether a country is, in total, a seller or a
buyer in world markets for goods and services, net exports are also called the
trade balance. If net exports are positive, exports are greater than imports, indi-
cating that the country sells more goods and services abroad than it buys from
other countries. In this case, the country is said to run a trade surplus. If net
closed economy
an economy that does not interact
with other economies in the world
open economy
an economy that interacts freely with
other economies around the world
exports
goods and services that are produced
domestically and sold abroad
imports
goods and services that are produced
abroad and sold domestically
net exports
the value of a nation’s exports minus
the value of its imports, also called
the trade balance
trade balance
the value of a nation’s exports minus
the value of its imports, also called
net exports
trade surplus
an excess of exports over imports
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 659
CASE STUDY THE INCREASING OPENNESS
OF THE U.S. ECONOMY
Perhaps the most dramatic change in the U.S. economy over the past five
decades has been the increasing importance of international trade and finance.
This change is illustrated in Figure 29-1, which shows the total value of goods
and services exported to other countries and imported from other countries ex-
pressed as a percentage of gross domestic product. In the 1950s exports of goods
and services averaged less than 5 percent of GDP. Today they are more than
twice that level and still rising. Imports of goods and services have risen by a
similar amount.
exports are negative, exports are less than imports, indicating that the country sells
fewer goods and services abroad than it buys from other countries. In this case, the
country is said to run a trade deficit. If net exports are zero, its exports and im-
ports are exactly equal, and the country is said to have balanced trade.
In the next chapter we develop a theory that explains an economy’s trade bal-
ance, but even at this early stage it is easy to think of many factors that might in-
fluence a country’s exports, imports, and net exports. Those factors include the
following:
a78 The tastes of consumers for domestic and foreign goods
a78 The prices of goods at home and abroad
a78 The exchange rates at which people can use domestic currency to buy foreign
currencies
a78 The incomes of consumers at home and abroad
a78 The cost of transporting goods from country to country
a78 The policies of the government toward international trade
As these variables change over time, so does the amount of international trade.
“But we’re not just talking about buying a car—we’re talking
aboutconfrontingthiscountry’s trade deficit withJapan.”
trade deficit
an excess of imports over exports
balanced trade
a situation in which exports
equalimports
660 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
This increase in international trade is partly due to improvements in trans-
portation. In 1950 the average merchant ship carried less than 10,000 tons of
cargo; today, many ships carry more than 100,000 tons. The long-distance jet
was introduced in 1958, and the wide-body jet in 1967, making air transport far
cheaper. Because of these developments, goods that once had to be produced lo-
cally can now be traded around the world. Cut flowers, for instance, are now
grown in Israel and flown to the United States to be sold. Fresh fruits and veg-
etables that can grow only in summer can now be consumed in winter as well,
because they can be shipped to the United States from countries in the southern
hemisphere.
The increase in international trade has also been influenced by advances in
telecommunications, which have allowed businesses to reach overseas cus-
tomers more easily. For example, the first transatlantic telephone cable was not
laid until 1956. As recently as 1966, the technology allowed only 138 simultane-
ous conversations between North America and Europe. Today, communications
satellites permit more than 1 million conversations to occur at the same time.
Technological progress has also fostered international trade by changing the
kinds of goods that economies produce. When bulky raw materials (such as
steel) and perishable goods (such as foodstuffs) were a large part of the world’s
output, transporting goods was often costly and sometimes impossible. By con-
trast, goods produced with modern technology are often light and easy to trans-
port. Consumer electronics, for instance, have low weight for every dollar of
value, which makes them easy to produce in one country and sell in another. An
even more extreme example is the film industry. Once a studio in Hollywood
makes a movie, it can send copies of the film around the world at almost zero
cost. And, indeed, movies are a major export of the United States.
The government’s trade policies have also been a factor in increasing inter-
national trade. As we discussed in Chapters 3 and 9, economists have long be-
lieved that free trade between countries is mutually beneficial. Over time,
policymakers around the world have come to accept these conclusions. Inter-
national agreements, such as the North American Free Trade Agreement
(NAFTA) and the General Agreement on Tariffs and Trade (GATT), have grad-
ually lowered trade barriers, such as tariffs and import quotas. The pattern of
INTERNATIONAL TRADE IS
INCREASINGLY IMPORTANT
FOR THE U.S. ECONOMY.
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 661
increasing trade illustrated in Figure 29-1 is a phenomenon that most econo-
mists and policymakers endorse and encourage.
THE FLOW OF CAPITAL: NET FOREIGN INVESTMENT
So far we have been discussing how residents of an open economy participate in
world markets for goods and services. In addition, residents of an open economy
participate in world financial markets. AU.S. resident with $20,000 could use that
money to buy a car from Toyota, but he could instead use that money to buy stock
in the Toyota corporation. The first transaction would represent a flow of goods,
whereas the second would represent a flow of capital.
The term net foreign investment refers to the purchase of foreign assets by
domestic residents minus the purchase of domestic assets by foreigners. When a
U.S. resident buys stock in Telmex, the Mexican phone company, the purchase
raises U.S. net foreign investment. When a Japanese resident buys a bond issued
by the U.S. government, the purchase reduces U.S. net foreign investment.
Recall that foreign investment takes two forms. If McDonald’s opens up a fast
food outlet in Russia, that is an example of foreign direct investment.Alternatively,
if an American buys stock in a Russian corporation, that is an example of foreign
portfolio investment.In the first case, the American owner is actively managing the
investment, whereas in the second case the American owner has a more passive
role. In both cases, U.S. residents are buying assets located in another country, so
both purchases increase U.S. net foreign investment.
We develop a theory to explain net foreign investment in the next chapter.
Here, let’s consider briefly some of the more important variables that influence net
foreign investment:
a78 The real interest rates being paid on foreign assets
a78 The real interest rates being paid on domestic assets
Percent
of GDP
Exports
Imports
0
5
10
15
1950 1955 1960 1965 1970 1975 1980 19901985 20001995
Figure 29-1
THE INTERNATIONALIZATION
OF THE U.S. ECONOMY. This
figure shows exports and imports
of the U.S. economy
asapercentage of U.S. gross
domestic product since 1950.
Thesubstantial increases over
time show the increasing
importance of international
tradeand finance.
SOURCE: U.S. Department of Commerce.
net foreign investment
the purchase of foreign assets
bydomestic residents minus
thepurchase of domestic
assetsbyforeigners
662 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
a78 The perceived economic and political risks of holding assets abroad
a78 The government policies that affect foreign ownership of domestic assets
For example, consider U.S. investors deciding whether to buy Mexican govern-
ment bonds or U.S. government bonds. (Recall that a bond is, in effect, an IOU of
the issuer.) To make this decision, U.S. investors compare the real interest rates
offered on the two bonds. The higher a bond’s real interest rate, the more attractive
it is. While making this comparison, however, U.S. investors must also take into
account the risk that one of these governments might defaulton its debt (that is,
not pay interest or principal when it is due), as well as any restrictions that the
WHEN YOU HEAR ABOUT A FACTORY BEING
built in Asia or Latin America, have you
ever wondered who is financing that
project? The answer might surprise you.
The World’s New Financier Is You
BY EDWARD WYATT
Investors flocked to Eastern Europe after
the Berlin Wall fell in 1989, eager to
scoop up bargains in what they were
sure would be a quick economic revival.
A year later, the technology boom drew
their money to the Far East. Then Latin
America heated up—that is, until the
Mexican peso went bust, which sent
investors scurrying back to the Pacific
Rim. Russia got sexy as an investment
early [in 1997], and more recently South
America has had allure.
Billions of dollars are sloshing back
and forth over the globe with seemingly
little rhyme or reason, chasing invest-
ments in once-obscure markets from
Santiago to Kuala Lumpur. But there is at
least some method to the madness—de-
spite occasional debacles like the recent
Bre-X gold mining fraud, in which mutual
fund managers poured scads of money
into what amounted to little more than
holes in the ground in Borneo.
To begin with, foreign stock and
bond markets are growing much faster
than those in America, providing much
higher returns to investors. In 1970, for-
eign markets accounted for only a third
of the value of the world’s stock and
bond markets, with the United States
alone accounting for the other two-
thirds. But by last year, they had grown
to nearly 60 percent of the total.
Stock markets in newly emerging
economies like those of Turkey, Ar-
gentina, and South Africa now account
for 14 percent of the world’s total stock
market value, up from 4 percent 10
years ago.
Investors have flocked to them as
global economic trends have shifted
since the end of the cold war. Central-
ized, state-planned economies have
been scuttled for ones favoring private
ownership of industry. With the trans-
formation, the resulting vibrant new
economies no longer need to rely on
international development agencies or
giant New York banks for foreign invest-
ment, as they did in the 1970s and
1980s; instead, much of their seed capi-
tal since 1990 has come from a sur-
prising source: millions of average
Americans who invest in mutual funds.
“This is a trend that has been led by
America, which pushed the international
lending agencies to encourage the de-
velopment of private enterprise, to open
up these markets and get the hands of
government out of industrial ownership,”
said J. Mark Mobius, who oversees sev-
eral Templeton mutual funds that invest
in emerging markets. “That led to the
development of capital markets—bond
markets and stock markets—in many of
these countries, and now to people like
me trying to invest all the money that is
flowing into our mutual funds.” . . .
And these days, when the finance
minister of a developing country wants
to encourage foreigners to invest in his
country, he is less likely to court the
World Bank or the Agency for Interna-
tional Development than someone like
Mr. Mobius.
SOURCE:The New York Times,May 25, 1997, Week
in Review, p. 3.
IN THE NEWS
It’s the 21st Century,
Do You Know Where
Your Capital Is?
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 663
Mexican government has imposed, or might impose in the future, on foreign
investors in Mexico.
THE EQUALITY OF NET EXPORTS
AND NET FOREIGN INVESTMENT
We have seen that an open economy interacts with the rest of the world in two
ways—in world markets for goods and services and in world financial markets.
Net exports and net foreign investment each measure a type of imbalance in these
markets. Net exports measure an imbalance between a country’s exports and its
imports. Net foreign investment measures an imbalance between the amount of
foreign assets bought by domestic residents and the amount of domestic assets
bought by foreigners.
An important but subtle fact of accounting states that, for an economy as a
whole, these two imbalances must offset each other. That is, net foreign investment
(NFI) always equals net exports (NX):
NFIH11005NX.
This equation holds because every transaction that affects one side of this equation
must also affect the other side by exactly the same amount. This equation is an
identity—an equation that must hold because of the way the variables in the equa-
tion are defined and measured.
To see why this accounting identity is true, consider an example. Suppose that
Boeing, the U.S. aircraft maker, sells some planes to a Japanese airline. In this sale,
a U.S. company gives planes to a Japanese company, and a Japanese company
gives yen to a U.S. company. Notice that two things have occurred simultaneously.
The United States has sold to a foreigner some of its output (the planes), and this
sale increases U.S. net exports. In addition, the United States has acquired some
foreign assets (the yen), and this acquisition increases U.S. net foreign investment.
Although Boeing most likely will not hold on to the yen it has acquired in this
sale, any subsequent transaction will preserve the equality of net exports and net
foreign investment. For example, Boeing may exchange its yen for dollars with a
U.S. mutual fund that wants the yen to buy stock in Sony Corporation, the Japan-
ese maker of consumer electronics. In this case, Boeing’s net export of planes
equals the mutual fund’s net foreign investment in Sony stock. Hence, NXand NFI
rise by an equal amount.
Alternatively, Boeing may exchange its yen for dollars with another U.S. com-
pany that wants to buy computers from Toshiba, the Japanese computer maker. In
this case, U.S. imports (of computers) exactly offset U.S. exports (of planes). The
sales by Boeing and Toshiba together affect neither U.S. net exports nor U.S. net
foreign investment. That is, NXand NFIare the same as they were before these
transactions took place.
The equality of net exports and net foreign investment follows from the fact
that every international transaction is an exchange. When a seller country transfers
a good or service to a buyer country, the buyer country gives up some asset to pay
for this good or service. The value of that asset equals the value of the good or ser-
vice sold. When we add everything up, the net value of goods and services sold by
a country (NX) must equal the net value of assets acquired (NFI). The international
664 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
flow of goods and services and the international flow of capital are two sides of
thesame coin.
SAVING, INVESTMENT, AND THEIR RELATIONSHIP
TO THE INTERNATIONAL FLOWS
Anation’s saving and investment are, as we have seen in Chapters 24 and 25, cru-
cial to its long-run economic growth. Let’s therefore consider how these variables
are related to the international flows of goods and capital, as measured by net
exports and net foreign investment. We can do this most easily with the help of
some simple mathematics.
As you may recall, the term net exportsfirst appeared earlier in the book when
we discussed the components of gross domestic product. The economy’s gross
domestic product (Y) is divided among four components: consumption (C),
investment (I), government purchases (G), and net exports (NX). We write
this as
YH11005CH11001IH11001GH11001NX.
WILL THE WORLD’SDEVELOPING COUN -
tries, such as those in Latin America,
flood the world’s industrial countries
with cheap exports while refusing to
import goods from the industrial coun-
tries? Willthe developing countries use
the world’s saving to finance invest-
ment and growth, leaving the indus-
trial countries with insufficient funds
for their own capital accumulation?
Some people fear that both of these out-
comes might occur. But an accounting
identity, and economist Paul Krugman,
tell us not to worry.
Fantasy Economics
BY PAUL KRUGMAN
Reports by international organizations
are usually greeted with well deserved
yawns. Occasionally, however, such a
report is a leading indicator of a sea
change in opinion.
A few weeks ago, the World Eco-
nomic Forum—which every year draws
an unmatched assemblage of the world’s
political and business elite to its confer-
ence in Davos, Switzerland—released
its annual report on international compet-
itiveness. The report made headlines be-
cause it demoted Japan and declared
America the world’s most competitive
economy.
The revealing part of the report,
however, is not its more or less mean-
ingless competitiveness rankings but its
introduction, which offers what seems to
be a very clear vision of the global eco-
nomic future.
That vision, shared by many power-
ful people, is compelling and alarming. It
is also nonsense. And the fact that this
nonsense is being taken seriously by
many people who believe themselves to
be sophisticated about economics is it-
self an ominous portent for the world
economy.
The report finds that the spread
of modern technology to newly in-
dustrializing nations is deindustrializing
high-wage nations: Capital is flowing to
the Third World and low-cost produc-
ers in these countries are flooding
world markets with cheap manufactured
goods.
The report predicts that these
trends will accelerate, that service jobs
will soon begin to follow the lost jobs in
manufacturing and that the future of the
high-wage nations offers a bleak choice
between declining wages and rising un-
employment.
This vision resonates with many
people. Yet as a description of what has
IN THE NEWS
Flows between
the Developing South
andtheIndustrial North
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 665
Total expenditure on the economy’s output of goods and services is the sum of
expenditure on consumption, investment, government purchases, and net exports.
Because each dollar of expenditure is placed into one of these four components,
this equation is an accounting identity: It must be true because of the way the vari-
ables are defined and measured.
Recall that national saving is the income of the nation that is left after paying
for current consumption and government purchases. National saving (S) equals
YH11002 CH11002 G.If we rearrange the above equation to reflect this fact, we obtain
YH11002 CH11002 GH11005IH11001NX
SH11005IH11001NX.
Because net exports (NX) also equal net foreign investment (NFI), we can write
this equation as
S H11005 I H11001 NFI
SavingH11005
Domestic
H11001
Net foreign
investment investment.
actually happened in recent years, it is al-
most completely untrue.
Rapidly growing Third World econ-
omies have indeed increased their ex-
ports of manufactured goods. But today
these exports absorb only about 1 per-
cent of First World income. Moreover,
Third World nations have also increased
their imports.
Overall, the effect of Third World
growth on the number of industrial jobs
in Western nations has been minimal:
Growing exports to the newly industrial-
izing countries have created about as
many jobs as growing imports have
displaced.
What about capital flows? The num-
bers sound impressive. Last year, $24
billion flowed to Mexico, $11 billion to
China. The total movement of capital
from advanced to developing nations
was about $60 billion. But though this
sounds like a lot, it is pocket change in a
world economy that invests more than
$4 trillion a year.
In other words, if the vision of a
Western economy battered by low-wage
competition is meant to describe today’s
world, it is a fantasy with hardly any ba-
sis in reality.
Even if the vision does not describe
the present, might it describe the future?
Well, growing exports of manufactured
goods from South to North will lead to a
net loss of northern industrial jobs only if
they are not matched by growth in ex-
ports from North to South.
The authors of the report evidently
envision a future of large-scale Third
World trade surpluses. But it is an un-
avoidable fact of accounting that a coun-
try that runs a trade surplus must also
be a net investor in other countries. So
large-scale deindustrialization can take
place only if low-wage nations are major
exporters of capital to high-wage na-
tions. This seems unlikely. In any case, it
contradicts the rest of the story, which
predicts huge capital flows into low-wage
nations.
Thus, the vision offered by the
world competitiveness report conflicts
not only with the facts but with itself. Yet
it is a vision that a growing number of the
world’s most influential men and women
seem to share. That is a dangerous
trend.
Not everyone who worries about
low-wage competition is a protectionist.
Indeed, the authors of the world compet-
itiveness report would surely claim to be
champions of free trade. Nonetheless,
the fact that such ideas have become re-
spectable . . . suggests that the intellec-
tual consensus that has kept world trade
relatively free, and that has allowed hun-
dreds of millions of people in the Third
World to get their first taste of prosper-
ity, may be unraveling.
SOURCE:The New York Times,September 26, 1994,
p.A17.
666 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
CASE STUDY ARE U.S. TRADE DEFICITS
A NATIONAL PROBLEM?
You may have heard the press call the United States “the world’s largest
debtor.” The nation earned that description by borrowing heavily in world fi-
nancial markets during the 1980s and 1990s to finance large trade deficits. Why
did the United States do this, and should this event give Americans reason to
worry?
To answer these questions, let’s see what these macroeconomic accounting
identities tell us about the U.S. economy. Panel (a) of Figure 29-2 shows national
saving and domestic investment as a percentage of GDP since 1960. Panel (b)
shows net foreign investment as a percentage of GDP. Notice that, as the identi-
ties require, net foreign investment always equals national saving minus do-
mestic investment.
The figure shows a dramatic change beginning in the early 1980s. Before
1980, national saving and domestic investment were very close, and so net for-
eign investment was small. Yet after 1980, national saving fell dramatically, in
part because of increased government budget deficits and in part because of a
fall in private saving. Because this fall in saving did not coincide with a similar
fall in domestic investment, net foreign investment became a large negative
number, indicating that foreigners were buying more assets in the United States
than Americans were buying abroad. Put simply, the United States was going
into debt.
As we have seen, accounting identities require that net exports must equal
net foreign investment. Thus, when net foreign investment became negative,
net exports became negative as well. The United States ran a trade deficit:
This equation shows that a nation’s saving must equal its domestic investment
plus its net foreign investment. In other words, when U.S. citizens save a dollar of
their income for the future, that dollar can be used to finance accumulation of do-
mestic capital or it can be used to finance the purchase of capital abroad.
This equation should look somewhat familiar. Earlier in the book, when we
analyzed the role of the financial system, we considered this identity for the spe-
cial case of a closed economy. In a closed economy, net foreign investment is zero
(NFIH110050), so saving equals investment (SH11005I). By contrast, an open economy has
two uses for its saving: domestic investment and net foreign investment.
As before, we can view the financial system as standing between the two sides
of this identity. For example, suppose the Smith family decides to save some of its
income for retirement. This decision contributes to national saving, the left-hand
side of our equation. If the Smiths deposit their saving in a mutual fund, the mu-
tual fund may use some of the deposit to buy stock issued by General Motors,
which uses the proceeds to build a factory in Ohio. In addition, the mutual fund
may use some of the Smiths’ deposit to buy stock issued by Toyota, which uses the
proceeds to build a factory in Osaka. These transactions show up on the right-
hand side of the equation. From the standpoint of U.S. accounting, the General
Motors expenditure on a new factory is domestic investment, and the purchase of
Toyota stock by a U.S. resident is net foreign investment. Thus, all saving in the
U.S. economy shows up as investment in the U.S. economy or as U.S. net foreign
investment.
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 667
Imports of goods and services exceeded exports. In 1998, the trade deficit was
$151 billion, or about 1.8 percent of GDP.
Are these trade deficits a problem for the U.S. economy? Most economists
believe that they are not a problem in themselves, but perhaps are a symptom
of a problem—reduced national saving. Reduced national saving is potentially
a problem because it means that the nation is putting away less to provide for
its future. Once national saving has fallen, however, there is no reason to de-
plore the resulting trade deficits. If national saving fell without inducing a trade
deficit, investment in the United States would have to fall. This fall in invest-
ment, in turn, would adversely affect the growth in the capital stock, labor
Percent
of GDP
20
18
16
14
12
10
1960 1965 199519901985198019751970
National saving
Domestic investment
Percent
of GDP
4
H110024
H110023
H110022
H110021
0
1
2
3
Net foreign
investment
(a) National Saving and Domestic Investment (as a percentage of GDP)
(b) Net Foreign Investment (as a percentage of GDP)
2000
1960 1965 199519901985198019751970 2000
Figure 29-2
NATIONAL SAVING,
DOMESTIC INVESTMENT, AND
NET FOREIGN INVESTMENT.
Panel (a) shows national saving
and domestic investment as
apercentage of GDP. Panel
(b)shows net foreign investment
as a percentage of GDP. You can
see from the figure that national
saving has been lower since 1980
than it was before 1980. This fall
in national saving has been
reflected primarily in reduced net
foreign investment rather than in
reduced domestic investment.
SOURCE:U.S. Department of Commerce.
668 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
productivity, and real wages. In other words, given the fact that U.S. citizens are
not saving much, it is better to have foreigners invest in the U.S. economy than
no one at all.
QUICK QUIZ: Define net exportsand net foreign investment.Explain how
they are related.
THE PRICES FOR INTERNATIONAL TRANSACTIONS:
REAL AND NOMINAL EXCHANGE RATES
So far we have discussed measures of the flow of goods and services and the flow
of capital across a nation’s border. In addition to these quantity variables, macro-
economists also study variables that measure the prices at which these interna-
tional transactions take place. Just as the price in any market serves the important
role of coordinating buyers and sellers in that market, international prices help co-
ordinate the decisions of consumers and producers as they interact in world mar-
kets. Here we discuss the two most important international prices—the nominal
and real exchange rates.
NOMINAL EXCHANGE RATES
The nominal exchange rateis the rate at which a person can trade the currency of
one country for the currency of another. For example, if you go to a bank, you
might see a posted exchange rate of 80 yen per dollar. If you give the bank one U.S.
dollar, it will give you 80 Japanese yen; and if you give the bank 80 Japanese yen,
it will give you one U.S. dollar. (In actuality, the bank will post slightly different
prices for buying and selling yen. The difference gives the bank some profit for of-
fering this service. For our purposes here, we can ignore these differences.)
An exchange rate can always be expressed in two ways. If the exchange rate is
80 yen per dollar, it is also 1/80 ( H110050.0125) dollar per yen. Throughout this book,
we always express the nominal exchange rate as units of foreign currency per U.S.
dollar, such as 80 yen per dollar.
If the exchange rate changes so that a dollar buys more foreign currency, that
change is called an appreciationof the dollar. If the exchange rate changes so that
a dollar buys less foreign currency, that change is called a depreciationof the dol-
lar. For example, when the exchange rate rises from 80 to 90 yen per dollar, the dol-
lar is said to appreciate. At the same time, because a Japanese yen now buys less of
the U.S. currency, the yen is said to depreciate. When the exchange rate falls from
80 to 70 yen per dollar, the dollar is said to depreciate, and the yen is said to ap-
preciate.
At times you may have heard the media report that the dollar is either
“strong” or “weak.” These descriptions usually refer to recent changes in the nom-
inal exchange rate. When a currency appreciates, it is said to strengthenbecause it
can then buy more foreign currency. Similarly, when a currency depreciates, it is
said to weaken.
nominal exchange rate
the rate at which a person can trade
the currency of one country for the
currency of another
appreciation
an increase in the value of a currency
as measured by the amount of foreign
currency it can buy
depreciation
a decrease in the value of a currency
as measured by the amount of foreign
currency it can buy
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 669
For any country, there are many nominal exchange rates. The U.S. dollar can
be used to buy Japanese yen, British pounds, French francs, Mexican pesos, and so
on. When economists study changes in the exchange rate, they often use indexes
that average these many exchange rates. Just as the consumer price index turns the
many prices in the economy into a single measure of the price level, an exchange
rate index turns these many exchange rates into a single measure of the interna-
tional value of the currency. So when economists talk about the dollar appreciating
or depreciating, they often are referring to an exchange rate index that takes into
account many individual exchange rates.
REAL EXCHANGE RATES
The real exchange rate is the rate at which a person can trade the goods and ser-
vices of one country for the goods and services of another. For example, suppose
that you go shopping and find that a case of German beer is twice as expensive as
a case of American beer. We would then say that the real exchange rate is 1/2 case
of German beer per case of American beer. Notice that, like the nominal exchange
rate, we express the real exchange rate as units of the foreign item per unit of the
domestic item. But in this instance the item is a good rather than a currency.
Real and nominal exchange rates are closely related. To see how, consider an
example. Suppose that a bushel of American rice sells for $100, and a bushel of
Japanese rice sells for 16,000 yen. What is the real exchange rate between American
and Japanese rice? To answer this question, we must first use the nominal ex-
change rate to convert the prices into a common currency. If the nominal exchange
rate is 80 yen per dollar, then a price for American rice of $100 per bushel is equiv-
alent to 8,000 yen per bushel. American rice is half as expensive as Japanese rice.
The real exchange rate is 1/2 bushel of Japanese rice per bushel of American rice.
We can summarize this calculation for the real exchange rate with the follow-
ing formula:
Real exchange rate H11005 .
Using the numbers in our example, the formula applies as follows:
Real exchange rate H11005
H11005
H110051/2 bushel of Japanese rice per bushel of American rice.
Thus, the real exchange rate depends on the nominal exchange rate and on the
prices of goods in the two countries measured in the local currencies.
Why does the real exchange rate matter? As you might guess, the real ex-
change rate is a key determinant of how much a country exports and imports.
When Uncle Ben’s, Inc., is deciding whether to buy U.S. rice or Japanese rice to put
into its boxes, for example, it will ask which rice is cheaper. The real exchange rate
8,000 yen per bushel of American rice
16,000 yen per bushel of Japanese rice
(80 yen per dollar)H11003($100 per bushel of American rice)
16,000 yen per bushel of Japanese rice
Nominal exchange rateH11003Domestic price
Foreign price
real exchange rate
the rate at which a person can trade
the goods and services of one country
for the goods and services of another
670 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
gives the answer. As another example, imagine that you are deciding whether to
take a seaside vacation in Miami, Florida, or in Cancun, Mexico. You might ask
your travel agent the price of a hotel room in Miami (measured in dollars), the
price of a hotel room in Cancun (measured in pesos), and the exchange rate be-
tween pesos and dollars. If you decide where to vacation by comparing costs, you
are basing your decision on the real exchange rate.
When studying an economy as a whole, macroeconomists focus on overall
prices rather than the prices of individual items. That is, to measure the real ex-
change rate, they use price indexes, such as the consumer price index, which mea-
sure the price of a basket of goods and services. By using a price index for a U.S.
basket (P), a price index for a foreign basket (P*), and the nominal exchange rate
between the U.S. dollar and foreign currencies (e), we can compute the overall real
exchange rate between the United States and other countries as follows:
Real exchange rate H11005(eH11003 P)/P*.
This real exchange rate measures the price of a basket of goods and services avail-
able domestically relative to a basket of goods and services available abroad.
As we examine more fully in the next chapter, a country’s real exchange rate is
a key determinant of its net exports of goods and services. Adepreciation (fall) in
the U.S. real exchange rate means that U.S. goods have become cheaper relative to
foreign goods. This change encourages consumers both at home and abroad to buy
more U.S. goods and fewer goods from other countries. As a result, U.S. exports
rise, and U.S. imports fall, and both of these changes raise U.S. net exports. Con-
versely, an appreciation (rise) in the U.S. real exchange rate means that U.S. goods
have become more expensive compared to foreign goods, so U.S. net exports fall.
QUICK QUIZ: Define nominal exchange rateand real exchange rate,and
explain how they are related. a78If the nominal exchange rate goes from 100 to
120 yen per dollar, has the dollar appreciated or depreciated?
A FIRST THEORY OF EXCHANGE-RATE
DETERMINATION: PURCHASING-POWER PARITY
Exchange rates vary substantially over time. In 1970, a U.S. dollar could be used to
buy 3.65 German marks or 627 Italian lira. In 1998, a U.S. dollar bought 1.76 Ger-
man marks or 1,737 Italian lira. In other words, over this period the value of the
dollar fell by more than half compared to the mark, while it more than doubled
compared to the lira.
What explains these large and opposite changes? Economists have developed
many models to explain how exchange rates are determined, each emphasizing
just some of the many forces at work. Here we develop the simplest theory of ex-
change rates, called purchasing-power parity.This theory states that a unit of any
given currency should be able to buy the same quantity of goods in all countries.
Many economists believe that purchasing-power parity describes the forces that
determine exchange rates in the long run. We now consider the logic on which this
purchasing-power parity
a theory of exchange rates whereby a
unit of any given currency should
beable to buy the same quantity
ofgoods in all countries
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 671
long-run theory of exchange rates is based, as well as the theory’s implications and
limitations.
THE BASIC LOGIC OF PURCHASING-POWER PARITY
The theory of purchasing-power parity is based on a principle called the law of one
price.This law asserts that a good must sell for the same price in all locations. Oth-
erwise, there would be opportunities for profit left unexploited. For example, sup-
pose that coffee beans sold for less in Seattle than in Boston. Aperson could buy
coffee in Seattle for, say, $4 a pound and then sell it in Boston for $5 a pound, mak-
ing a profit of $1 per pound from the difference in price. The process of taking ad-
vantage of differences in prices in different markets is called arbitrage. In our
example, as people took advantage of this arbitrage opportunity, they would in-
crease the demand for coffee in Seattle and increase the supply in Boston. The price
of coffee would rise in Seattle (in response to greater demand) and fall in Boston
(in response to greater supply). This process would continue until, eventually, the
prices were the same in the two markets.
Now consider how the law of one price applies to the international market-
place. If a dollar (or any other currency) could buy more coffee in the United States
than in Japan, international traders could profit by buying coffee in the United
States and selling it in Japan. This export of coffee from the United States to Japan
Some of the currencies men-
tioned in this chapter, such as
the French franc, the German
mark, and the Italian lira, are in
the process of disappearing.
Many European nations have
decided to give up their na-
tional currencies and start us-
ing a new common currency
called the euro. A newly formed
European Central Bank, with
representatives from all of the
participating countries, issues
the euro and controls the quantity in circulation, much as
the Federal Reserve controls the quantity of dollars in the
U.S. economy.
Why are these countries adopting a common currency?
One benefit of a common currency is that it makes trade
easier. Imagine that each of the 50 U.S. states had a dif-
ferent currency. Every time you crossed a state border you
would need to change your money and perform the kind of
exchange-rate calculations discussed in the text. This would
be inconvenient, and it might deter you from buying goods
and services outside your own state. The countries of
Europe decided
that as their
economies be-
came more inte-
grated, it would
be better to
avoid this incon-
venience.
There are,
however, costs
of choosing a
common cur-
rency. If the na-
tions of Europe
have only one
money, they can
have only one monetary policy. If they disagree about what
monetary policy is best, they will have to reach some kind of
agreement, rather than each going its own way. Because
adopting a single money has both benefits and costs, there
is debate among economists about whether Europe’s recent
adoption of the euro was a good decision. Only time will tell
what effect the decision will have.
FYI
The Euro
672 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
would drive up the U.S. price of coffee and drive down the Japanese price. Con-
versely, if a dollar could buy more coffee in Japan than in the United States, traders
could buy coffee in Japan and sell it in the United States. This import of coffee into
the United States from Japan would drive down the U.S. price of coffee and drive
up the Japanese price. In the end, the law of one price tells us that a dollar must
buy the same amount of coffee in all countries.
This logic leads us to the theory of purchasing-power parity. According to this
theory, a currency must have the same purchasing power in all countries. That is,
a U.S. dollar must buy the same quantity of goods in the United States and Japan,
and a Japanese yen must buy the same quantity of goods in Japan and the United
States. Indeed, the name of this theory describes it well. Paritymeans equality, and
purchasing powerrefers to the value of money. Purchasing-power paritystates that a
unit of all currencies must have the same real value in every country.
IMPLICATIONS OF PURCHASING-POWER PARITY
What does the theory of purchasing-power parity say about exchange rates? It tells
us that the nominal exchange rate between the currencies of two countries de-
pends on the price levels in those countries. If a dollar buys the same quantity of
goods in the United States (where prices are measured in dollars) as in Japan
(where prices are measured in yen), then the number of yen per dollar must reflect
the prices of goods in the United States and Japan. For example, if a pound of cof-
fee costs 500 yen in Japan and $5 in the United States, then the nominal exchange
rate must be 100 yen per dollar (500 yen/$5 H11005100 yen per dollar). Otherwise, the
purchasing power of the dollar would not be the same in the two countries.
To see more fully how this works, it is helpful to use just a bit of mathematics.
Suppose that Pis the price of a basket of goods in the United States (measured in
dollars), P*is the price of a basket of goods in Japan (measured in yen), and eis the
nominal exchange rate (the number of yen a dollar can buy). Now consider the
quantity of goods a dollar can buy at home and abroad. At home, the price level is
P, so the purchasing power of $1 at home is 1/P.Abroad, a dollar can be exchanged
into eunits of foreign currency, which in turn have purchasing power e/P*.For the
purchasing power of a dollar to be the same in the two countries, it must be the
case that
1/PH11005e/P*.
With rearrangement, this equation becomes
1 H11005eP/P*.
Notice that the left-hand side of this equation is a constant, and the right-hand side
is the real exchange rate. Thus, if the purchasing power of the dollar is always the same
at home and abroad, then the real exchange rate—the relative price of domestic and foreign
goods—cannot change.
To see the implication of this analysis for the nominal exchange rate, we can
rearrange the last equation to solve for the nominal exchange rate:
eH11005P*/P.
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 673
CASE STUDY THE NOMINAL EXCHANGE RATE
DURING A HYPERINFLATION
Macroeconomists can only rarely conduct controlled experiments. Most often,
they must glean what they can from the natural experiments that history gives
them. One natural experiment is hyperinflation—the high inflation that arises
when a government turns to the printing press to pay for large amounts of gov-
ernment spending. Because hyperinflations are so extreme, they illustrate some
basic economic principles with clarity.
Consider the German hyperinflation of the early 1920s. Figure 29-3 shows
the German money supply, the German price level, and the nominal exchange
rate (measured as U.S. cents per German mark) for that period. Notice that
these series move closely together. When the supply of money starts growing
quickly, the price level also takes off, and the German mark depreciates. When
the money supply stabilizes, so does the price level and the exchange rate.
The pattern shown in this figure appears during every hyperinflation. It
leaves no doubt that there is a fundamental link among money, prices, and the
nominal exchange rate. The quantity theory of money discussed in the previous
chapter explains how the money supply affects the price level. The theory of
purchasing-power parity discussed here explains how the price level affects the
nominal exchange rate.
That is, the nominal exchange rate equals the ratio of the foreign price level (mea-
sured in units of the foreign currency) to the domestic price level (measured in
units of the domestic currency). According to the theory of purchasing-power parity, the
nominal exchange rate between the currencies of two countries must reflect the different
price levels in those countries.
Akey implication of this theory is that nominal exchange rates change when
price levels change. As we saw in the preceding chapter, the price level in any
country adjusts to bring the quantity of money supplied and the quantity of
money demanded into balance. Because the nominal exchange rate depends on
the price levels, it also depends on the money supply and money demand in each
country. When a central bank in any country increases the money supply and
causes the price level to rise, it also causes that country’s currency to depreciate
relative to other currencies in the world. In other words, when the central bank prints
large quantities of money, that money loses value both in terms of the goods and services it
can buy and in terms of the amount of other currencies it can buy.
We can now answer the question that began this section: Why has the U.S. dol-
lar lost value compared to the German mark and gained value compared to the
Italian lira? The answer is that Germany has pursued a less inflationary monetary
policy than the United States, and Italy has pursued a more inflationary monetary
policy. From 1970 to 1998, inflation in the United States was 5.3 percent per year.
By contrast, inflation was 3.5 percent in Germany, and 9.6 percent in Italy. As U.S.
prices rose relative to German prices, the value of the dollar fell relative to the
mark. Similarly, as U.S. prices fell relative to Italian prices, the value of the dollar
rose relative to the lira.
674 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
LIMITATIONS OF PURCHASING-POWER PARITY
Purchasing-power parity provides a simple model of how exchange rates are de-
termined. For understanding many economic phenomena, the theory works well.
In particular, it can explain many long-term trends, such as the depreciation of the
U.S. dollar against the German mark and the appreciation of the U.S. dollar
against the Italian lira. It can also explain the major changes in exchange rates that
occur during hyperinflations.
Yet the theory of purchasing-power parity is not completely accurate. That is,
exchange rates do not always move to ensure that a dollar has the same real value
in all countries all the time. There are two reasons why the theory of purchasing-
power parity does not always hold in practice.
The first reason is that many goods are not easily traded. Imagine, for instance,
that haircuts are more expensive in Paris than in New York. International travelers
might avoid getting their haircuts in Paris, and some haircutters might move from
New York to Paris. Yet such arbitrage would probably be too limited to eliminate
the differences in prices. Thus, the deviation from purchasing-power parity might
persist, and a dollar (or franc) would continue to buy less of a haircut in Paris than
in New York.
The second reason that purchasing-power parity does not always hold is that
even tradable goods are not always perfect substitutes when they are produced in
different countries. For example, some consumers prefer German beer, and others
prefer American beer. Moreover, consumer tastes for beer change over time. If Ger-
man beer suddenly becomes more popular, the increase in demand will drive up
10,000,000,000
1,000,000,000,000,000
100,000
1
.00001
.0000000001
1921 1922 1923 1924
Exchange rate
Money supply
Price level
1925
Indexes
(Jan. 1921 H11005 100)
Figure 29-3
MONEY, PRICES, AND THE
NOMINAL EXCHANGE RATE
DURING THE GERMAN
HYPERINFLATION. This figure
shows the money supply, the
price level, and the exchange rate
(measured as U.S. cents per
mark) for the German
hyperinflation from January 1921
to December 1924. Notice how
similarly these three variables
move. When the quantity of
money started growing quickly,
the price level followed, and the
mark depreciated relative to the
dollar. When the German central
bank stabilized the money
supply, the price level and
exchange rate stabilized as well.
SOURCE:Adapted from Thomas J. Sargent,
“The End of Four Big Inflations,” in Robert
Hall, ed., Inflation(Chicago: University of
Chicago Press, 1983), pp. 41–93.
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 675
CASE STUDY THE HAMBURGER STANDARD
When economists apply the theory of purchasing-power parity to explain ex-
change rates, they need data on the prices of a basket of goods available in dif-
ferent countries. One analysis of this sort is conducted by The Economist, an
international newsmagazine. The magazine occasionally collects data on a bas-
ket of goods consisting of “two all beef patties, special sauce, lettuce, cheese,
pickles, onions, on a sesame seed bun.” It’s called the “Big Mac” and is sold by
McDonald’s around the world.
Once we have the prices of Big Macs in two countries denominated in the
local currencies, we can compute the exchange rate predicted by the theory of
purchasing-power parity. The predicted exchange rate is the one that makes the
cost of the Big Mac the same in the two countries. For instance, if the price of a
Big Mac is $2 in the United States and 200 yen in Japan, purchasing-power par-
ity would predict an exchange rate of 100 yen per dollar.
How well does purchasing-power parity work when applied using Big Mac
prices? Here are some examples from an Economist article published on April 3,
1999, when the price of a Big Mac was $2.43 in the United States:
PRICE OF PREDICTED ACTUAL
COUNTRY ABIG MAC EXCHANGE RATE EXCHANGE RATE
Italy 4,500 lira 1,852 lira/$ 1,799 lira/$
Japan 294 yen 121 yen/$ 120 yen/$
Russia 33.5 rubles 13.8 rubles/$ 24.7 rubles/$
Germany 4.95 marks 2.04 marks/$ 1.82 marks/$
Brazil 2.95 reals 1.21 reals/$ 1.73 reals/$
Britain 1.90 pounds 0.78 pound/$ 0.62 pound/$
You can see that the predicted and actual exchange rates are not exactly the
same. After all, international arbitrage in Big Macs is not easy. Yet the two
exchange rates are usually in the same ballpark. Purchasing-power parity is not
the price of German beer. As a result, a dollar (or a mark) might then buy more
beer in the United States than in Germany. But despite this difference in prices in
the two markets, there might be no opportunity for profitable arbitrage because
consumers do not view the two beers as equivalent.
Thus, both because some goods are not tradable and because some tradable
goods are not perfect substitutes with their foreign counterparts, purchasing-
power parity is not a perfect theory of exchange-rate determination. For these rea-
sons, real exchange rates fluctuate over time. Nonetheless, the theory of
purchasing-power parity does provide a useful first step in understanding ex-
change rates. The basic logic is persuasive: As the real exchange rate drifts from the
level predicted by purchasing-power parity, people have greater incentive to move
goods across national borders. Even if the forces of purchasing-power parity do
not completely fix the real exchange rate, they provide a reason to expect that
changes in the real exchange rate are most often small or temporary. As a result,
large and persistent movements in nominal exchange rates typically reflect
changes in price levels at home and abroad.
INTHEUNITED STATESTHE PRICE OF
ABIG MAC IS $2.43; IN JAPAN IT IS
294 YEN.
676 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
a precise theory of exchange rates, but it often provides a reasonable first
approximation.
QUICK QUIZ: Over the past 20 years, Spain has had high inflation, and
Japan has had low inflation. What do you predict has happened to the number
of Spanish pesetas a person can buy with a Japanese yen?
CONCLUSION
The purpose of this chapter has been to develop some basic concepts that macro-
economists use to study open economies. You should now understand why a na-
tion’s net exports must equal its net foreign investment, and why national saving
must equal domestic investment plus net foreign investment. You should also un-
derstand the meaning of the nominal and real exchange rates, as well as the impli-
cations and limitations of purchasing-power parity as a theory of how exchange
rates are determined.
The macroeconomic variables defined here offer a starting point for analyzing
an open economy’s interactions with the rest of the world. In the next chapter we
develop a model that can explain what determines these variables. We can then
discuss how various events and policies affect a country’s trade balance and the
rate at which nations make exchanges in world markets.
a78 Net exports are the value of domestic goods and
services sold abroad minus the value of foreign goods
and services sold domestically. Net foreign investment
is the acquisition of foreign assets by domestic residents
minus the acquisition of domestic assets by foreigners.
Because every international transaction involves an
exchange of an asset for a good or service, an economy’s
net foreign investment always equals its net exports.
a78 An economy’s saving can be used either to finance
investment at home or to buy assets abroad. Thus,
national saving equals domestic investment plus net
foreign investment.
a78 The nominal exchange rate is the relative price of the
currency of two countries, and the real exchange rate
isthe relative price of the goods and services of two
countries. When the nominal exchange rate changes so
that each dollar buys more foreign currency, the dollar is
said to appreciateor strengthen.When the nominal
exchange rate changes so that each dollar buys less
foreign currency, the dollar is said to depreciateor weaken.
a78 According to the theory of purchasing-power parity, a
dollar (or a unit of any other currency) should be able to
buy the same quantity of goods in all countries. This
theory implies that the nominal exchange rate between
the currencies of two countries should reflect the price
levels in those countries. As a result, countries with
relatively high inflation should have depreciating
currencies, and countries with relatively low inflation
should have appreciating currencies.
Summary
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 677
closed economy, p. 658
open economy, p. 658
exports, p. 658
imports, p. 658
net exports, p. 658
trade balance, p. 658
trade surplus, p. 658
trade deficit, p. 659
balanced trade, p. 659
net foreign investment, p. 661
nominal exchange rate, p. 668
appreciation, p. 668
depreciation, p. 668
real exchange rate, p. 669
purchasing-power parity, p. 670
Key Concepts
1. Define net exports and net foreign investment. Explain
how and why they are related.
2. Explain the relationship among saving, investment, and
net foreign investment.
3. If a Japanese car costs 500,000 yen, a similar American
car costs $10,000, and a dollar can buy 100 yen, what are
the nominal and real exchange rates?
4. Describe the economic logic behind the theory of
purchasing-power parity.
5. If the Fed started printing large quantities of U.S.
dollars, what would happen to the number of Japanese
yen a dollar could buy?
Questions for Review
1. How would the following transactions affect U.S.
exports, imports, and net exports?
a. An American art professor spends the summer
touring museums in Europe.
b. Students in Paris flock to see the latest Arnold
Schwarzenegger movie.
c. Your uncle buys a new Volvo.
d. The student bookstore at Oxford University sells a
pair of Levi’s 501 jeans.
e. ACanadian citizen shops at a store in northern
Vermont to avoid Canadian sales taxes.
2. International trade in each of the following products has
increased over time. Suggest some reasons why this
might be so.
a. wheat
b. banking services
c. computer software
d. automobiles
3. Describe the difference between foreign direct
investment and foreign portfolio investment. Who is
more likely to engage in foreign direct investment—a
corporation or an individual investor? Who is more
likely to engage in foreign portfolio investment?
4. How would the following transactions affect U.S. net
foreign investment? Also, state whether each involves
direct investment or portfolio investment.
a. An American cellular phone company establishes
an office in the Czech Republic.
b. Harrod’s of London sells stock to the General
Electric pension fund.
c. Honda expands its factory in Marysville, Ohio.
d. AFidelity mutual fund sells its Volkswagen stock to
a French investor.
5. Holding national saving constant, does an increase in
net foreign investment increase, decrease, or have no
effect on a country’s accumulation of domestic capital?
6. The business section of most major newspapers contains
a table showing U.S. exchange rates. Find such a table
and use it to answer the following questions.
a. Does this table show nominal or real exchange
rates? Explain.
b. What are the exchange rates between the United
States and Canada and between the United States
and Japan? Calculate the exchange rate between
Canada and Japan.
c. If U.S. inflation exceeds Japanese inflation over
thenext year, would you expect the U.S. dollar
toappreciate or depreciate relative to the
Japaneseyen?
7. Would each of the following groups be happy or
unhappy if the U.S. dollar appreciated? Explain.
Problems and Applications
678 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
a. Dutch pension funds holding U.S. government
bonds
b. U.S. manufacturing industries
c. Australian tourists planning a trip to the United
States
d. an American firm trying to purchase property
overseas
8. What is happening to the U.S. real exchange rate in each
of the following situations? Explain.
a. The U.S. nominal exchange rate is unchanged, but
prices rise faster in the United States than abroad.
b. The U.S. nominal exchange rate is unchanged, but
prices rise faster abroad than in the United States.
c. The U.S. nominal exchange rate declines, and prices
are unchanged in the United States and abroad.
d. The U.S. nominal exchange rate declines, and prices
rise faster abroad than in the United States.
9. List three goods for which the law of one price is likely
to hold, and three goods for which it is not. Justify your
choices.
10. Acan of soda costs $0.75 in the United States and 12
pesos in Mexico. What would the peso-dollar exchange
rate be if purchasing-power parity holds? If a monetary
expansion caused all prices in Mexico to double, so that
soda rose to 24 pesos, what would happen to the peso-
dollar exchange rate?
11. Assume that American rice sells for $100 per bushel,
Japanese rice sells for 16,000 yen per bushel, and the
nominal exchange rate is 80 yen per dollar.
a. Explain how you could make a profit from this
situation. What would be your profit per bushel of
rice? If other people exploit the same opportunity,
what would happen to the price of rice in Japan
and the price of rice in the United States?
b. Suppose that rice is the only commodity in the
world. What would happen to the real exchange
rate between the United States and Japan?
12. Acase study in the chapter analyzed purchasing-power
parity for several countries using the price of a Big Mac.
Here are data for a few more countries:
PRICE OF PREDICTED ACTUAL
COUNTRY ABIG MAC EXCHANGE RATE EXCHANGE RATE
South Korea 3,000 won _____ won/$ 1,218 won/$
Spain 375 pesetas _____ pesetas/$ 155 pesetas/$
Mexico 19.9 pesos _____ pesos/$ 9.54 pesos/$
Netherlands 5.45 guilders _____ guilders/$ 2.05 guilders/$
a. For each country, compute the predicted exchange
rate of the local currency per U.S. dollar. (Recall that
the U.S. price of a Big Mac was $2.43.) How well
does the theory of purchasing-power parity explain
exchange rates?
b. According to purchasing-power parity, what is the
predicted exchange rate between the South Korean
won and Spanish peseta? What is the actual
exchange rate?
c. Which of these countries offers the cheapest Big
Mac? Why do you think that might be the case?
IN THIS CHAPTER
YOU WILL . . .
Use the model
to analyze
political instability
and capital flight
Use the model
to analyze the
macroeconomic
effects of trade
policies
Build a model to
explain an open
economy’s trade
balance and
exchange rate
Use the model
to analyze the
effects of
government
budget deficits
Over the past decade, the United States has persistently imported more goods and
services than it has exported. That is, U.S. net exports have been negative. Al-
though economists debate whether these trade deficits are a problem for the U.S.
economy, the nation’s business community has a strong opinion. Many business
leaders claim that the trade deficits reflect unfair competition: Foreign firms are al-
lowed to sell their products in U.S. markets, they contend, while foreign govern-
ments impede U.S. firms from selling U.S. products abroad.
Imagine that you are the president and you want to end these trade deficits.
What should you do? Should you try to limit imports, perhaps by imposing a
quota on the import of cars from Japan? Or should you try to influence the nation’s
trade deficit in some other way?
To understand what factors determine a country’s trade balance and how
government policies can affect it, we need a macroeconomic theory of the open
A MACROECONOMIC THEORY
OF THE OPEN ECONOMY
679
680 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
economy. The preceding chapter introduced some of the key macroeconomic vari-
ables that describe an economy’s relationship with other economies—including
net exports, net foreign investment, and the real and nominal exchange rates. This
chapter develops a model that shows what forces determine these variables and
how these variables are related to one another.
To develop this macroeconomic model of an open economy, we build on our
previous analysis in two important ways. First, the model takes the economy’s
GDP as given. We assume that the economy’s output of goods and services, as
measured by real GDP, is determined by the supplies of the factors of production
and by the available production technology that turns these inputs into output.
Second, the model takes the economy’s price level as given. We assume the price
level adjusts to bring the supply and demand for money into balance. In other
words, this chapter takes as a starting point the lessons learned in Chapters 24 and
28 about the determination of the economy’s output and price level.
The goal of the model in this chapter is to highlight those forces that determine
the economy’s trade balance and exchange rate. In one sense, the model is simple:
It merely applies the tools of supply and demand to an open economy. Yet the
model is also more complicated than others we have seen because it involves look-
ing simultaneously at two related markets—the market for loanable funds and the
market for foreign-currency exchange. After we develop this model of the open
economy, we use it to examine how various events and policies affect the econ-
omy’s trade balance and exchange rate. We will then be able to determine the gov-
ernment policies that are most likely to reverse the trade deficits that the U.S.
economy has experienced over the past decade.
SUPPLY AND DEMAND FOR LOANABLE FUNDS
AND FOR FOREIGN-CURRENCY EXCHANGE
To understand the forces at work in an open economy, we focus on supply and de-
mand in two markets. The first is the market for loanable funds, which coordinates
the economy’s saving and investment (including its net foreign investment). The
second is the market for foreign-currency exchange, which coordinates people
who want to exchange the domestic currency for the currency of other countries.
In this section we discuss supply and demand in each of these markets. In the next
section we put these markets together to explain the overall equilibrium for an
open economy.
THE MARKET FOR LOANABLE FUNDS
When we first analyzed the role of the financial system in Chapter 25, we made the
simplifying assumption that the financial system consists of only one market,
called the market for loanable funds.All savers go to this market to deposit their sav-
ing, and all borrowers go to this market to get their loans. In this market, there is
one interest rate, which is both the return to saving and the cost of borrowing.
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 681
To understand the market for loanable funds in an open economy, the place to
start is the identity discussed in the preceding chapter:
S H11005 I H11001 NFI
Saving H11005 Domestic investment H11001 Net foreign investment.
Whenever a nation saves a dollar of its income, it can use that dollar to finance the
purchase of domestic capital or to finance the purchase of an asset abroad. The two
sides of this identity represent the two sides of the market for loanable funds. The
supply of loanable funds comes from national saving (S). The demand for loanable
funds comes from domestic investment (I) and net foreign investment (NFI). Note
that the purchase of a capital asset adds to the demand for loanable funds, regard-
less of whether that asset is located at home or abroad. Because net foreign invest-
ment can be either positive or negative, it can either add to or subtract from the
demand for loanable funds that arises from domestic investment.
As we learned in our earlier discussion of the market for loanable funds, the
quantity of loanable funds supplied and the quantity of loanable funds demanded
depend on the real interest rate. A higher real interest rate encourages people to
save and, therefore, raises the quantity of loanable funds supplied. A higher inter-
est rate also makes borrowing to finance capital projects more costly; thus, it dis-
courages investment and reduces the quantity of loanable funds demanded.
In addition to influencing national saving and domestic investment, the real
interest rate in a country affects that country’s net foreign investment. To see why,
consider two mutual funds—one in the United States and one in Germany—de-
ciding whether to buy a U.S. government bond or a German government bond.
The mutual funds would make this decision in part by comparing the real interest
rates in the United States and Germany. When the U.S. real interest rate rises, the
U.S. bond becomes more attractive to both mutual funds. Thus, an increase in
the U.S. real interest rate discourages Americans from buying foreign assets and
encourages foreigners to buy U.S. assets. For both reasons, a high U.S. real interest
rate reduces U.S. net foreign investment.
We represent the market for loanable funds on the familiar supply-and-
demand diagram in Figure 30-1. As in our earlier analysis of the financial system,
the supply curve slopes upward because a higher interest rate increases the quan-
tity of loanable funds supplied, and the demand curve slopes downward because
a higher interest rate decreases the quantity of loanable funds demanded. Unlike
the situation in our previous discussion, however, the demand side of the market
now represents the behavior of both domestic investment and net foreign invest-
ment. That is, in an open economy, the demand for loanable funds comes not only
from those who want to borrow funds to buy domestic capital goods but also from
those who want to borrow funds to buy foreign assets.
The interest rate adjusts to bring the supply and demand for loanable funds
into balance. If the interest rate were below the equilibrium level, the quantity of
loanable funds supplied would be less than the quantity demanded. The resulting
shortage of loanable funds would push the interest rate upward. Conversely, if the
interest rate were above the equilibrium level, the quantity of loanable funds sup-
plied would exceed the quantity demanded. The surplus of loanable funds would
drive the interest rate downward. At the equilibrium interest rate, the supply of
loanable funds exactly balances the demand. That is, at the equilibrium interest rate,
682 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
the amount that people want to save exactly balances the desired quantities of domestic in-
vestment and net foreign investment.
THE MARKET FOR FOREIGN-CURRENCY EXCHANGE
The second market in our model of the open economy is the market for foreign-
currency exchange. Participants in this market trade U.S. dollars in exchange for
foreign currencies. To understand the market for foreign-currency exchange, we
begin with another identity from the last chapter:
NFI H11005 NX
Net foreign investment H11005 Net exports.
This identity states that the imbalance between the purchase and sale of capital as-
sets abroad (NFI) equals the imbalance between exports and imports of goods and
services (NX). When U.S. net exports are positive, for instance, foreigners are buy-
ing more U.S. goods and services than Americans are buying foreign goods and
services. What are Americans doing with the foreign currency they are getting
from this net sale of goods and services abroad? They must be adding to their
holdings of foreign assets, which means U.S. net foreign investment is positive.
Conversely, if U.S. net exports are negative, Americans are spending more on for-
eign goods and services than they are earning from selling abroad; this trade
deficit must be financed by selling American assets abroad, so U.S. net foreign in-
vestment is negative as well.
Our model of the open economy assumes that the two sides of this identity
represent the two sides of the market for foreign-currency exchange. Net foreign
investment represents the quantity of dollars supplied for the purpose of buying
assets abroad. For example, when a U.S. mutual fund wants to buy a Japanese
Equilibrium
quantity
Quantity of
Loanable Funds
Real
Interest
Rate
Equilibrium
real interest
rate
Supply of loanable funds
(from national saving)
Demand for loanable
funds (for domestic
investment and net
foreign investment)
Figure 30-1
THE MARKET FOR
LOANABLE FUNDS. The interest
rate in an open economy, as in a
closed economy, is determined by
the supply and demand for
loanable funds. National saving
is the source of the supply of
loanable funds. Domestic
investment and net foreign
investment are the sources of the
demand for loanable funds. At
the equilibrium interest rate,
the amount that people want to
save exactly balances the amount
that people want to borrow for
the purpose of buying domestic
capital and foreign assets.
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 683
government bond, it needs to change dollars into yen, so it supplies dollars in the
market for foreign-currency exchange. Net exports represent the quantity of dol-
lars demanded for the purpose of buying U.S. net exports of goods and services.
For example, when a Japanese airline wants to buy a plane made by Boeing,
it needs to change its yen into dollars, so it demands dollars in the market for
foreign-currency exchange.
What price balances the supply and demand in the market for foreign-
currency exchange? The answer is the real exchange rate. As we saw in the pre-
ceding chapter, the real exchange rate is the relative price of domestic and foreign
goods and, therefore, is a key determinant of net exports. When the U.S. real ex-
change rate appreciates, U.S. goods become more expensive relative to foreign
goods, making U.S. goods less attractive to consumers both at home and abroad.
As a result, exports from the United States fall, and imports into the United States
rise. For both reasons, net exports fall. Hence, an appreciation of the real exchange
rate reduces the quantity of dollars demanded in the market for foreign-currency
exchange.
Figure 30-2 shows supply and demand in the market for foreign-currency ex-
change. The demand curve slopes downward for the reason we just discussed:
A higher real exchange rate makes U.S. goods more expensive and reduces the
quantity of dollars demanded to buy those goods. The supply curve is vertical
because the quantity of dollars supplied for net foreign investment does not
depend on the real exchange rate. (As discussed earlier, net foreign investment
depends on the real interest rate. When discussing the market for foreign-currency
exchange, we take the real interest rate and net foreign investment as given.)
The real exchange rate adjusts to balance the supply and demand for dollars
just as the price of any good adjusts to balance supply and demand for that good.
If the real exchange rate were below the equilibrium level, the quantity of dollars
supplied would be less than the quantity demanded. The resulting shortage of dol-
lars would push the value of the dollar upward. Conversely, if the real exchange
Equilibrium
quantity
Quantity of Dollars Exchanged
into Foreign Currency
Real
Exchange
Rate
Equilibrium
real exchange
rate
Supply of dollars
(from net foreign investment)
Demand for dollars
(for net exports)
Figure 30-2
THE MARKET FOR FOREIGN-
CURRENCY EXCHANGE. The real
exchange rate is determined by
the supply and demand for
foreign-currency exchange. The
supply of dollars to be exchanged
into foreign currency comes from
net foreign investment. Because
net foreign investment does not
depend on the real exchange rate,
the supply curve is vertical. The
demand for dollars comes from
net exports. Because a lower real
exchange rate stimulates net
exports (and thus increases the
quantity of dollars demanded to
pay for these net exports), the
demand curve is downward
sloping. At the equilibrium real
exchange rate, the number of
dollars people supply to buy
foreign assets exactly balances
the number of dollars people
demand to buy net exports.
684 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
rate were above the equilibrium level, the quantity of dollars supplied would ex-
ceed the quantity demanded. The surplus of dollars would drive the value of the
dollar downward. At the equilibrium real exchange rate, the demand for dollars by for-
eigners arising from the U.S. net exports of goods and services exactly balances the supply
of dollars from Americans arising from U.S. net foreign investment.
At this point, it is worth noting that the division of transactions between “sup-
ply” and “demand” in this model is somewhat artificial. In our model, net exports
are the source of the demand for dollars, and net foreign investment is the source
of the supply. Thus, when a U.S. resident imports a car made in Japan, our model
treats that transaction as a decrease in the quantity of dollars demanded (because
net exports fall) rather than an increase in the quantity of dollars supplied. Simi-
larly, when a Japanese citizen buys a U.S. government bond, our model treats that
transaction as a decrease in the quantity of dollars supplied (because net foreign
investment falls) rather than an increase in the quantity of dollars demanded. This
use of language may seem somewhat unnatural at first, but it will prove useful
when analyzing the effects of various policies.
QUICK QUIZ: Describe the sources of supply and demand in the market
for loanable funds and the market for foreign-currency exchange.
EQUILIBRIUM IN THE OPEN ECONOMY
So far we have discussed supply and demand in two markets—the market for
loanable funds and the market for foreign-currency exchange. Let’s now consider
how these markets are related to each other.
An alert reader of this book
might ask: Why are we develop-
ing a theory of the exchange
rate here? Didn’t we already do
that in the preceding chapter?
As you may recall, the pre-
ceding chapter developed a
theory of the exchange rate
called purchasing-power parity.
This theory asserts that a dol-
lar (or any other currency) must
buy the same quantity of goods
and services in every country.
As a result, the real exchange rate is fixed, and all changes
in the nominal exchange rate between two currencies reflect
changes in the price levels in the two countries.
The model of the exchange rate developed here is re-
lated to the theory of purchasing-power parity. According to
the theory of purchasing-power parity, international trade re-
sponds quickly to international price differences. If goods
were cheaper in one country than in another, they would be
exported from the first country and imported into the sec-
ond until the price difference disappeared. In other words,
the theory of purchasing-power parity assumes that net ex-
ports are highly responsive to small changes in the real ex-
change rate. If net exports were in fact so responsive, the
demand curve in Figure 30-2 would be horizontal.
Thus, the theory of purchasing-power parity can be
viewed as a special case of the model considered here. In
that special case, the demand curve for foreign-currency ex-
change, rather than being downward sloping, is horizontal at
the level of the real exchange rate that ensures parity of
purchasing power at home and abroad. That special case is
a good place to start when studying exchange rates, but it is
far from the end of the story.
This chapter, therefore, concentrates on the more real-
istic case in which the demand curve for foreign-currency ex-
change is downward sloping. This allows for the possibility
that the real exchange rate changes over time, as in fact it
sometimes does in the real world.
FYI
Purchasing-
Power Parity as
a Special Case
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 685
NET FOREIGN INVESTMENT:
THE LINK BETWEEN THE TWO MARKETS
We begin by recapping what we’ve learned so far in this chapter. We have been
discussing how the economy coordinates four important macroeconomic vari-
ables: national saving (S), domestic investment (I), net foreign investment (NFI),
and net exports (NX). Keep in mind the following identities:
SH11005IH11001NFI
and
NFIH11005NX.
In the market for loanable funds, supply comes from national saving, demand
comes from domestic investment and net foreign investment, and the real interest
rate balances supply and demand. In the market for foreign-currency exchange,
supply comes from net foreign investment, demand comes from net exports, and
the real exchange rate balances supply and demand.
Net foreign investment is the variable that links these two markets. In the mar-
ket for loanable funds, net foreign investment is a piece of demand. A person who
wants to buy an asset abroad must finance this purchase by borrowing in the mar-
ket for loanable funds. In the market for foreign-currency exchange, net foreign in-
vestment is the source of supply. A person who wants to buy an asset in another
country must supply dollars in order to exchange them for the currency of that
country.
The key determinant of net foreign investment, as we have discussed, is the
real interest rate. When the U.S. interest rate is high, owning U.S. assets is more
attractive, and U.S. net foreign investment is low. Figure 30-3 shows this negative
0 Net Foreign
Investment
Net foreign investment
is negative.
Net foreign investment
is positive.
Real
Interest
Rate
Figure 30-3
HOW NET FOREIGN INVESTMENT
DEPENDS ON THE INTEREST RATE.
Because a higher domestic real
interest rate makes domestic
assets more attractive, it reduces
net foreign investment. Note the
position of zero on the horizontal
axis: Net foreign investment can
be either positive or negative.
686 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
relationship between the interest rate and net foreign investment. This net-foreign-
investment curve is the link between the market for loanable funds and the mar-
ket for foreign-currency exchange.
SIMULTANEOUS EQUILIBRIUM IN TWO MARKETS
We can now put all the pieces of our model together in Figure 30-4. This figure
shows how the market for loanable funds and the market for foreign-currency
(a) The Market for Loanable Funds (b) Net Foreign Investment
Net foreign
investment,
NFI
Real
Interest
Rate
Real
Interest
Rate
(c) The Market for Foreign-Currency Exchange
Quantity of
Dollars
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
r
1
r
1
E
1
Supply
Supply
Demand
Demand
Figure 30-4
THE REAL EQUILIBRIUM IN AN OPEN ECONOMY. In panel (a), the supply and demand for
loanable funds determine the real interest rate. In panel (b), the interest rate determines
net foreign investment, which provides the supply of dollars in the market for foreign-
currency exchange. In panel (c), the supply and demand for dollars in the market for
foreign-currency exchange determine the real exchange rate.
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 687
exchange jointly determine the important macroeconomic variables of an open
economy.
Panel (a) of the figure shows the market for loanable funds (taken from Fig-
ure 30-1). As before, national saving is the source of the supply of loanable funds.
Domestic investment and net foreign investment are the source of the demand for
loanable funds. The equilibrium real interest rate (r
1
) brings the quantity of loan-
able funds supplied and the quantity of loanable funds demanded into balance.
Panel (b) of the figure shows net foreign investment (taken from Figure 30-3).
It shows how the interest rate from panel (a) determines net foreign investment.
A higher interest rate at home makes domestic assets more attractive, and this in
turn reduces net foreign investment. Therefore, the net-foreign-investment curve
in panel (b) slopes downward.
Panel (c) of the figure shows the market for foreign-currency exchange (taken
from Figure 30-2). Because net foreign investment must be paid for with foreign
currency, the quantity of net foreign investment from panel (b) determines the sup-
ply of dollars to be exchanged into foreign currencies. The real exchange rate does
not affect net foreign investment, so the supply curve is vertical. The demand for
dollars comes from net exports. Because a depreciation of the real exchange rate in-
creases net exports, the demand curve for foreign-currency exchange slopes down-
ward. The equilibrium real exchange rate (E
1
) brings into balance the quantity of
dollars supplied and the quantity of dollars demanded in the market for foreign-
currency exchange.
The two markets shown in Figure 30-4 determine two relative prices—the real
interest rate and the real exchange rate. The real interest rate determined in panel
(a) is the price of goods and services in the present relative to goods and services
in the future. The real exchange rate determined in panel (c) is the price of domes-
tic goods and services relative to foreign goods and services. These two relative
prices adjust simultaneously to balance supply and demand in these two markets.
As they do so, they determine national saving, domestic investment, net foreign
investment, and net exports. In a moment, we will use this model to see how
all these variables change when some policy or event causes one of these curves
to shift.
QUICK QUIZ: In the model of the open economy just developed, two
markets determine two relative prices. What are the markets? What are the
two relative prices?
HOW POLICIES AND EVENTS
AFFECT AN OPEN ECONOMY
Having developed a model to explain how key macroeconomic variables are de-
termined in an open economy, we can now use the model to analyze how changes
in policy and other events alter the economy’s equilibrium. As we proceed, keep in
mind that our model is just supply and demand in two markets—the market for
loanable funds and the market for foreign-currency exchange. When using the
model to analyze any event, we can apply the three steps outlined in Chapter 4.
688 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
First, we determine which of the supply and demand curves the event affects.
Second, we determine which way the curves shift. Third, we use the supply-and-
demand diagrams to examine how these shifts alter the economy’s equilibrium.
GOVERNMENT BUDGET DEFICITS
When we first discussed the supply and demand for loanable funds earlier in the
book, we examined the effects of government budget deficits, which occur when
government spending exceeds government revenue. Because a government bud-
get deficit represents negative public saving, it reduces national saving (the sum of
public and private saving). Thus, a government budget deficit reduces the supply
of loanable funds, drives up the interest rate, and crowds out investment.
Now let’s consider the effects of a budget deficit in an open economy. First,
which curve in our model shifts? As in a closed economy, the initial impact of the
budget deficit is on national saving and, therefore, on the supply curve for loan-
able funds. Second, which way does this supply curve shift? Again as in a closed
economy, a budget deficit represents negative public saving, so it reduces national
saving and shifts the supply curve for loanable funds to the left. This is shown as
the shift from S
1
to S
2
in panel (a) of Figure 30-5.
Our third and final step is to compare the old and new equilibria. Panel (a)
shows the impact of a U.S. budget deficit on the U.S. market for loanable funds.
With fewer funds available for borrowers in U.S. financial markets, the interest
rate rises from r
1
to r
2
to balance supply and demand. Faced with a higher interest
rate, borrowers in the market for loanable funds choose to borrow less. This
change is represented in the figure as the movement from point A to point B along
the demand curve for loanable funds. In particular, households and firms reduce
their purchases of capital goods. As in a closed economy, budget deficits crowd out
domestic investment.
In an open economy, however, the reduced supply of loanable funds has addi-
tional effects. Panel (b) shows that the increase in the interest rate from r
1
to r
2
re-
duces net foreign investment. [This fall in net foreign investment is also part of the
decrease in the quantity of loanable funds demanded in the movement from point
A to point B in panel (a).] Because saving kept at home now earns higher rates of
return, investing abroad is less attractive, and domestic residents buy fewer for-
eign assets. Higher interest rates also attract foreign investors, who want to earn
the higher returns on U.S. assets. Thus, when budget deficits raise interest rates,
both domestic and foreign behavior cause U.S. net foreign investment to fall.
Panel (c) shows how budget deficits affect the market for foreign-currency ex-
change. Because net foreign investment is reduced, people need less foreign cur-
rency to buy foreign assets, and this induces a leftward shift in the supply curve
for dollars from S
1
to S
2
. The reduced supply of dollars causes the real exchange
rate to appreciate from E
1
to E
2
. That is, the dollar becomes more valuable com-
pared to foreign currencies. This appreciation, in turn, makes U.S. goods more ex-
pensive compared to foreign goods. Because people both at home and abroad
switch their purchases away from the more expensive U.S. goods, exports from the
United States fall, and imports into the United States rise. For both reasons, U.S.
net exports fall. Hence, in an open economy, government budget deficits raise real inter-
est rates, crowd out domestic investment, cause the dollar to appreciate, and push the trade
balance toward deficit.
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 689
An important example of this lesson occurred in the United States in the 1980s.
Shortly after Ronald Reagan was elected president in 1980, the fiscal policy of
the U.S. federal government changed dramatically. The president and Congress
enacted large cuts in taxes, but they did not cut government spending by nearly as
(a) The Market for Loanable Funds (b) Net Foreign Investment
Real
Interest
Rate
Real
Interest
Rate
(c) The Market for Foreign-Currency Exchange
Quantity of
Dollars
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
r
1
r
1
E
1
E
2
Demand
Demand
r
2
r
2
NFI
S
1
S
2
S
2 S
1
B
A
1. A budget deficit reduces
the supply of loanable funds . . .
2. . . . which
increases
the real
interest
rate . . .
4. The decrease
in net foreign
investment reduces
the supply of dollars
to be exchanged
into foreign
currency . . .
5. . . . which
causes the
real exchange
rate to
appreciate.
3. . . . which in
turn reduces
net foreign
investment.
Figure 30-5
THE EFFECTS OF A GOVERNMENT BUDGET DEFICIT. When the government runs a budget
deficit, it reduces the supply of loanable funds from S
1
to S
2
in panel (a). The interest rate
rises from r
1
to r
2
to balance the supply and demand for loanable funds. In panel (b), the
higher interest rate reduces net foreign investment. Reduced net foreign investment, in
turn, reduces the supply of dollars in the market for foreign-currency exchange from S
1
to
S
2
in panel (c). This fall in the supply of dollars causes the real exchange rate to appreciate
from E
1
to E
2
. The appreciation of the exchange rate pushes the trade balance toward
deficit.
690 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
much, so the result was a large budget deficit. Our model of the open economy
predicts that such a policy should lead to a trade deficit, and in fact it did, as we
saw in a case study in the preceding chapter. The budget deficit and trade deficit
during this period were so closely related in both theory and practice that they
earned the nickname the twin deficits. We should not, however, view these twins as
identical, for many factors beyond fiscal policy can influence the trade deficit.
TRADE POLICY
A trade policy is a government policy that directly influences the quantity of
goods and services that a country imports or exports. As we saw in Chapter 9,
trade policy takes various forms. One common trade policy is a tariff, a tax on im-
ported goods. Another is an import quota, a limit on the quantity of a good that can
be produced abroad and sold domestically. Trade policies are common throughout
the world, although sometimes they are disguised. For example, the U.S. govern-
ment has often pressured Japanese automakers to reduce the number of cars they
sell in the United States. These so-called “voluntary export restrictions” are not re-
ally voluntary and, in essence, are a form of import quota.
Let’s consider the macroeconomic impact of trade policy. Suppose that the U.S.
auto industry, concerned about competition from Japanese automakers, convinces
the U.S. government to impose a quota on the number of cars that can be imported
from Japan. In making their case, lobbyists for the auto industry assert that the
trade restriction would shrink the size of the U.S. trade deficit. Are they right? Our
model, as illustrated in Figure 30-6, offers an answer.
The first step in analyzing the trade policy is to determine which curve shifts.
The initial impact of the import restriction is, not surprisingly, on imports. Because
net exports equal exports minus imports, the policy also affects net exports. And
because net exports are the source of demand for dollars in the market for foreign-
currency exchange, the policy affects the demand curve in this market.
The second step is to determine which way this demand curve shifts. Because
the quota restricts the number of Japanese cars sold in the United States, it reduces
imports at any given real exchange rate. Net exports, which equal exports minus
imports, will therefore rise for any given real exchange rate. Because foreigners
need dollars to buy U.S. net exports, there is an increased demand for dollars in
the market for foreign-currency exchange. This increase in the demand for dollars
is shown in panel (c) of Figure 30-6 as the shift from D
1
to D
2
.
The third step is to compare the old and new equilibria. As we can see in panel
(c), the increase in the demand for dollars causes the real exchange rate to appreci-
ate from E
1
to E
2
. Because nothing has happened in the market for loanable funds
in panel (a), there is no change in the real interest rate. Because there is no change
in the real interest rate, there is also no change in net foreign investment, shown in
panel (b). And because there is no change in net foreign investment, there can be
no change in net exports, even though the import quota has reduced imports.
The reason why net exports can stay the same while imports fall is explained
by the change in the real exchange rate: When the dollar appreciates in value in the
market for foreign-currency exchange, domestic goods become more expensive
relative to foreign goods. This appreciation encourages imports and discourages
exports—and both of these changes work to offset the direct increase in net exports
trade policy
a government policy that directly
influences the quantity of goods
and services that a country
imports or exports
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 691
due to the import quota. In the end, an import quota reduces both imports and
exports, but net exports (exports minus imports) are unchanged.
We have thus come to a surprising implication: Trade policies do not affect the
trade balance. That is, policies that directly influence exports or imports do not alter
(a) The Market for Loanable Funds (b) Net Foreign Investment
Real
Interest
Rate
Real
Interest
Rate
(c) The Market for Foreign-Currency Exchange
Quantity of
Dollars
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
r
1
r
1
Supply
Supply
Demand
NFI
D
2
D
1
3. Net exports,
however, remain
the same.
2. . . . and
causes the
real exchange
rate to
appreciate.
E
1
E
2
1. An import
quota increases
the demand for
dollars . . .
Figure 30-6
THE EFFECTS OF AN IMPORT QUOTA. When the U.S. government imposes a quota on the
import of Japanese cars, nothing happens in the market for loanable funds in panel (a) or
to net foreign investment in panel (b). The only effect is a rise in net exports (exports
minus imports) for any given real exchange rate. As a result, the demand for dollars in the
market for foreign-currency exchange rises, as shown by the shift from D
1
to D
2
in panel
(c). This increase in the demand for dollars causes the value of the dollar to appreciate
from E
1
to E
2
. This appreciation of the dollar tends to reduce net exports, offsetting the
direct effect of the import quota on the trade balance.
692 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
net exports. This conclusion seems less surprising if one recalls the accounting
identity:
NXH11005NFIH11005SH11002 I.
Net exports equal net foreign investment, which equals national saving minus
domestic investment. Trade policies do not alter the trade balance because they do
not alter national saving or domestic investment. For given levels of national
saving and domestic investment, the real exchange rate adjusts to keep the trade
balance the same, regardless of the trade policies the government puts in place.
Although trade policies do not affect a country’s overall trade balance, these
policies do affect specific firms, industries, and countries. When the U.S. govern-
ment imposes an import quota on Japanese cars, General Motors has less competi-
tion from abroad and will sell more cars. At the same time, because the dollar has
appreciated in value, Boeing, the U.S. aircraft maker, will find it harder to compete
with Airbus, the European aircraft maker. U.S. exports of aircraft will fall, and U.S.
imports of aircraft will rise. In this case, the import quota on Japanese cars will in-
crease net exports of cars and decrease net exports of planes. In addition, it will
increase net exports from the United States to Japan and decrease net exports from
the United States to Europe. The overall trade balance of the U.S. economy, how-
ever, stays the same.
The effects of trade policies are, therefore, more microeconomic than macro-
economic. Although advocates of trade policies sometimes claim (incorrectly) that
these policies can alter a country’s trade balance, they are usually more motivated
by concerns about particular firms or industries. One should not be surprised, for
instance, to hear an executive from General Motors advocating import quotas for
Japanese cars. Economists almost always oppose such trade policies. As we saw in
Chapters 3 and 9, free trade allows economies to specialize in doing what they do
best, making residents of all countries better off. Trade restrictions interfere with
these gains from trade and, thus, reduce overall economic well-being.
POLITICAL INSTABILITY AND CAPITAL FLIGHT
In 1994 political instability in Mexico, including the assassination of a prominent
political leader, made world financial markets nervous. People began to view
Mexico as a much less stable country than they had previously thought. They
decided to pull some of their assets out of Mexico in order to move these funds to
the United States and other “safe havens.” Such a large and sudden movement of
funds out of a country is called capital flight. To see the implications of capital
flight for the Mexican economy, we again follow our three steps for analyzing a
change in equilibrium, but this time we apply our model of the open economy
from the perspective of Mexico rather than the United States.
Consider first which curves in our model capital flight affects. When investors
around the world observe political problems in Mexico, they decide to sell some of
their Mexican assets and use the proceeds to buy U.S. assets. This act increases
Mexican net foreign investment and, therefore, affects both markets in our model.
Most obviously, it affects the net-foreign-investment curve, and this in turn influ-
ences the supply of pesos in the market for foreign-currency exchange. In addition,
because the demand for loanable funds comes from both domestic investment and
net foreign investment, capital flight affects the demand curve in the market for
loanable funds.
capital flight
a large and sudden reduction in
the demand for assets located
in acountry
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 693
Now consider which way these curves shift. When net foreign investment in-
creases, there is greater demand for loanable funds to finance these purchases.
Thus, as panel (a) of Figure 30-7 shows, the demand curve for loanable funds shifts
to the right from D
1
to D
2
. In addition, because net foreign investment is higher for
(a) The Market for Loanable Funds in Mexico (b) Mexican Net Foreign Investment
Real
Interest
Rate
Real
Interest
Rate
(c) The Market for Foreign-Currency Exchange
Quantity of
Pesos
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
r
1
r
1
D
1
D
2
E
2
E
1
Demand
r
2
r
2
S
1
S
2
Supply
NFI
2
NFI
1
1. An increase
in net foreign
investment . . .
3. . . . which
increases
the interest
rate.
2. . . . increases the demand
for loanable funds . . .
4. At the same
time, the increase
in net foreign
investment
increases the
supply of pesos . . .
5. . . . which
causes the
peso to
depreciate.
Figure 30-7
THE EFFECTS OF CAPITAL FLIGHT. If people decide that Mexico is a risky place to keep
their savings, they will move their capital to safer havens such as the United States,
resulting in an increase in Mexican net foreign investment. Consequently, the demand for
loanable funds in Mexico rises from D
1
to D
2
, as shown in panel (a), and this drives up the
Mexican real interest rate from r
1
to r
2
. Because net foreign investment is higher for any
interest rate, that curve also shifts to the right from NFI
1
to NFI
2
in panel (b). At the same
time, in the market for foreign-currency exchange, the supply of pesos rises from S
1
to S
2
,
as shown in panel (c). This increase in the supply of pesos causes the peso to depreciate
from E
1
to E
2
, so the peso becomes less valuable compared to other currencies.
694 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
any interest rate, the net-foreign-investment curve also shifts to the right from NFI
1
to NFI
2
, as in panel (b).
To see the effects of capital flight on the economy, we compare the old and new
equilibria. Panel (a) of Figure 30-7 shows that the increased demand for loanable
funds causes the interest rate in Mexico to rise from r
1
to r
2
. Panel (b) shows that
Mexican net foreign investment increases. (Although the rise in the interest rate
does make Mexican assets more attractive, this development only partly offsets
the impact of capital flight on net foreign investment.) Panel (c) shows that the
increase in net foreign investment raises the supply of pesos in the market for
foreign-currency exchange from S
1
to S
2
. That is, as people try to get out of Mexi-
can assets, there is a large supply of pesos to be converted into dollars. This in-
crease in supply causes the peso to depreciate from E
1
to E
2
. Thus, capital flight from
Mexico increases Mexican interest rates and decreases the value of the Mexican peso in the
market for foreign-currency exchange. This is exactly what was observed in 1994.
From November 1994 to March 1995, the interest rate on short-term Mexican gov-
ernment bonds rose from 14 percent to 70 percent, and the peso depreciated in
value from 29 to 15 U.S. cents per peso.
Although capital flight has its largest impact on the country from which capi-
tal is fleeing, it also affects other countries. When capital flows out of Mexico into
the United States, for instance, it has the opposite effect on the U.S. economy as it
has on the Mexican economy. In particular, the rise in Mexican net foreign invest-
ment coincides with a fall in U.S. net foreign investment. As the peso depreciates
in value and Mexican interest rates rise, the dollar appreciates in value and U.S. in-
terest rates fall. The size of this impact on the U.S. economy is small, however, be-
cause the economy of the United States is so large compared to that of Mexico.
The events that we have been describing in Mexico could happen to any econ-
omy in the world, and in fact they do from time to time. In 1997, the world learned
that the banking systems of several Asian economies, including Thailand, South
Korea, and Indonesia, were at or near the point of bankruptcy, and this news in-
duced capital to flee from these nations. In 1998, the Russian government de-
faulted on its debt, inducing international investors to take whatever money they
could and run. In each of these cases of capital flight, the results were much as our
model predicts: rising interest rates and a falling currency.
Could capital flight ever happen in the United States? Although the U.S. econ-
omy has long been viewed as a safe economy in which to invest, political devel-
opments in the United States have at times induced small amounts of capital
flight. For example, the September 22, 1995, issue of The New York Times reported
that on the previous day, “House Speaker Newt Gingrich threatened to send the
United States into default on its debt for the first time in the nation’s history, to
force the Clinton administration to balance the budget on Republican terms”
(p. A1). Even though most people believed such a default was unlikely, the effect
of the announcement was, in a small way, similar to that experienced by Mexico in
1994. Over the course of that single day, the interest rate on a 30-year U.S. govern-
ment bond rose from 6.46 percent to 6.55 percent, and the exchange rate fell from
102.7 to 99.0 yen per dollar. Thus, even the stable U.S. economy is potentially sus-
ceptible to the effects of capital flight.
QUICK QUIZ: Suppose that Americans decided to spend a smaller fraction
of their incomes. What would be the effect on saving, investment, interest
rates, the real exchange rate, and the trade balance?
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 695
CONCLUSION
International economics is a topic of increasing importance. More and more,
American citizens are buying goods produced abroad and producing goods to be
sold overseas. Through mutual funds and other financial institutions, they borrow
and lend in world financial markets. As a result, a full analysis of the U.S. economy
requires an understanding of how the U.S. economy interacts with other econo-
mies in the world. This chapter has provided a basic model for thinking about the
macroeconomics of open economies.
Although the study of international economics is valuable, we should be care-
ful not to exaggerate its importance. Policymakers and commentators are often
quick to blame foreigners for problems facing the U.S. economy. By contrast, econ-
omists more often view these problems as homegrown. For example, politicians
often discuss foreign competition as a threat to American living standards. Econo-
mists are more likely to lament the low level of national saving. Low saving im-
pedes growth in capital, productivity, and living standards, regardless of whether
the economy is open or closed. Foreigners are a convenient target for politicians
because blaming foreigners provides a way to avoid responsibility without insult-
ing any domestic constituency. Whenever you hear popular discussions of inter-
national trade and finance, therefore, it is especially important to try to separate
myth from reality. The tools you have learned in the past two chapters should help
in that endeavor.
a78 To analyze the macroeconomics of open economies, two
markets are central—the market for loanable funds and
the market for foreign-currency exchange. In the market
for loanable funds, the interest rate adjusts to balance
the supply of loanable funds (from national saving) and
the demand for loanable funds (from domestic
investment and net foreign investment). In the market
for foreign-currency exchange, the real exchange rate
adjusts to balance the supply of dollars (for net foreign
investment) and the demand for dollars (for net
exports). Because net foreign investment is part of the
demand for loanable funds and provides the supply of
dollars for foreign-currency exchange, it is the variable
that connects these two markets.
a78 A policy that reduces national saving, such as a
government budget deficit, reduces the supply of
loanable funds and drives up the interest rate. The
higher interest rate reduces net foreign investment,
which reduces the supply of dollars in the market for
foreign-currency exchange. The dollar appreciates, and
net exports fall.
a78 Although restrictive trade policies, such as tariffs or
quotas on imports, are sometimes advocated as a way to
alter the trade balance, they do not necessarily have that
effect. A trade restriction increases net exports for a
given exchange rate and, therefore, increases the
demand for dollars in the market for foreign-currency
exchange. As a result, the dollar appreciates in value,
making domestic goods more expensive relative to
foreign goods. This appreciation offsets the initial
impact of the trade restriction on net exports.
a78 When investors change their attitudes about holding
assets of a country, the ramifications for the country’s
economy can be profound. In particular, political
instability can lead to capital flight, which tends to
increase interest rates and cause the currency to
depreciate.
Summary
696 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
THIS ARTICLE DESCRIBES HOW CAPITAL IS
flowing from China into the United
States. Can you predict what would
happen to the U.S. economy if these
capital flows stopped?
China, of All Places,
Sends Capital to U.S.
BYCRAIGS. SMITH
SHANGHAI, CHINA—A giant, developing
nation bordered by an economic quag-
mire is an unlikely source of capital for
the world’s industrialized powers. But
China, with fat trade surpluses and bulg-
ing foreign-exchange reserves, is buying
U.S. government securities, especially
Treasury bonds and bonds issued by
Fannie Mae and Freddie Mac.
That’s good for America. Such in-
vestments add liquidity to the U.S. hous-
ing market and help hold down U.S.
interest rates. And China is likely to con-
tinue to buy a lot of U.S. debt for years
to come.
Thanks to high domestic savings, a
continuing inflow of foreign investment
and tight controls on domestic spending,
China is awash in capital. Last year’s
capital surplus . . . reached an estimated
$67 billion.
China squirrels more than half of
that away into foreign reserves, which
are invested abroad. Chinese companies
funnel much of the rest directly overseas
through bank transfers—sometimes
skirting Chinese capital restrictions to
doso. So while the financial crisis has
transformed the rest of East Asia into a
capital-sucking hole, China has become
a gushing fountain of capital.
This isn’t the first time a developing
country has sent abroad funds that could
IN THE NEWS
How the Chinese Help
American Home Buyers
THEIR SAVING HELPS US GET
CHEAP MORTGAGES.
trade policy, p. 690 capital flight, p. 692
Key Concepts
1. Describe supply and demand in the market for loanable
funds and the market for foreign-currency exchange.
How are these markets linked?
2. Why are budget deficits and trade deficits sometimes
called the twin deficits?
3. Suppose that a textile workers’ union encourages people
to buy only American-made clothes. What would this
policy do to the trade balance and the real exchange
rate? What is the impact on the textile industry? What is
the impact on the auto industry?
4. What is capital flight? When a country experiences
capital flight, what is the effect on its interest rate and
exchange rate?
Questions for Review
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 697
be used productively at home. Often,
such money was fleeing instability, as
it was in Latin America in the 1980s,
Russia in the 1990s, and Africa in both
decades.
Usually, however, developing coun-
tries invest their capital in their own
growing economies. And some Chinese
officials believe that’s what China should
be doing, too. One former Chinese cen-
tral bank official calls it “scandalous”
that a country of poor peasants is financ-
ing investment of an industrialized power
such as the United States.
Others complain that China isn’t
even getting good returns on its invest-
ments. It pays an average of 7 to 8 per-
cent on its $130 billion foreign debt but
earns only about 5 percent on the $140
billion of its reserves invested abroad.
That’s partly because yields on U.S.
debt—widely considered the safest se-
curities in the world—are relatively low.
But China has good reasons to
send some of its capital overseas. Its in-
vestment in fixed assets as a percentage
of its gross domestic product was an ex-
traordinarily high 34 percent in 1996, the
latest year for which figures are avail-
able. It’s doubtful that China could in-
crease that ratio without wasting money
or fueling inflation. Thailand’s ratio was
40 percent and Korea’s 37 percent
before their overspending undermined
those nations’ economies. . . .
“They’re already investing as much
as they can absorb,” says Andy Xie, an
economist for Morgan Stanley Dean
Witter & Co. in Hong Kong.
Yet while investment is constrained,
savings keep growing. The percentage
of working-age people in the population
has climbed to 62 percent from 51 per-
cent in the past 30 years. And those
workers, often allowed only one child on
which to spend, are hitting their peak
saving years. With consumption low, the
pileup of money pushes capital offshore.
The result: Chinese capital is
spreading everywhere. The country is
a big buyer of oil fields, for example,
having pledged more than $8 billion for
concessions in Sudan, Venezuela, Iraq
and Kazakstan. Mainland capital also has
poured into Hong Kong, where it helped
inflate property prices before East Asia’s
crisis began letting out some of that air.
The capital surplus has even allowed
China to help its neighbors when they
got into trouble: Beijing pledged $1 bil-
lion to the International Monetary Fund
bailouts in Thailand and Indonesia. Most
of the money, though, goes into U.S.
Treasury bonds. China won’t say how
much, but estimates run as high as
40percent.
And China’s central bank, like 50
others around the world, lends money to
Fannie Mae and Freddie Mac, which use
the funds to buy mortgage loans that
banks and others extend to ordinary
Americans. The flood of money keeps
the market liquid and reduces the rates
that U.S. home buyers pay.
SOURCE: The Wall Street Journal, March 30, 1998,
The Outlook, p. 1.
1. Japan generally runs a significant trade surplus. Do you
think this is most related to high foreign demand for
Japanese goods, low Japanese demand for foreign
goods, a high Japanese saving rate relative to Japanese
investment, or structural barriers against imports into
Japan? Explain your answer.
2. An article in The New York Times (Apr. 14, 1995)
regarding a decline in the value of the dollar reported
that “the president was clearly determined to signal that
the United States remains solidly on a course of deficit
reduction, which should make the dollar more attractive
to investors.” Would deficit reduction in fact raise the
value of the dollar? Explain.
3. Suppose that Congress passes an investment tax credit,
which subsidizes domestic investment. How does this
policy affect national saving, domestic investment, net
foreign investment, the interest rate, the exchange rate,
and the trade balance?
4. The chapter notes that the rise in the U.S. trade deficit
during the 1980s was due largely to the rise in the U.S.
budget deficit. On the other hand, the popular press
sometimes claims that the increased trade deficit
resulted from a decline in the quality of U.S. products
relative to foreign products.
a. Assume that U.S. products did decline in relative
quality during the 1980s. How did this affect net
exports at any given exchange rate?
b. Use a three-panel diagram to show the effect of this
shift in net exports on the U.S. real exchange rate
and trade balance.
Problems and Applications
698 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
c. Is the claim in the popular press consistent with the
model in this chapter? Does a decline in the quality
of U.S. products have any effect on our standard of
living? (Hint: When we sell our goods to foreigners,
what do we receive in return?)
5. An economist discussing trade policy in The New
Republic wrote: “One of the benefits of the United States
removing its trade restrictions [is] the gain to U.S.
industries that produce goods for export. Export
industries would find it easier to sell their goods
abroad—even if other countries didn’t follow our
example and reduce their trade barriers.” Explain in
words why U.S. export industries would benefit from a
reduction in restrictions on imports to the United States.
6. Suppose the French suddenly develop a strong taste for
California wines. Answer the following questions in
words and using a diagram.
a. What happens to the demand for dollars in the
market for foreign-currency exchange?
b. What happens to the value of dollars in the market
for foreign-currency exchange?
c. What happens to the quantity of net exports?
7. A senator renounces her past support for protectionism:
“The U.S. trade deficit must be reduced, but import
quotas only annoy our trading partners. If we subsidize
U.S. exports instead, we can reduce the deficit by
increasing our competitiveness.” Using a three-panel
diagram, show the effect of an export subsidy on net
exports and the real exchange rate. Do you agree with
the senator?
8. Suppose that real interest rates increase across Europe.
Explain how this development will affect U.S. net
foreign investment. Then explain how it will affect U.S.
net exports by using a formula from the chapter and by
using a diagram. What will happen to the U.S. real
interest rate and real exchange rate?
9. Suppose that Americans decide to increase their saving.
a. If the elasticity of U.S. net foreign investment with
respect to the real interest rate is very high, will this
increase in private saving have a large or small
effect on U.S. domestic investment?
b. If the elasticity of U.S. exports with respect to the
real exchange rate is very low, will this increase in
private saving have a large or small effect on the
U.S. real exchange rate?
10. Over the past decade, some of Japanese saving has been
used to finance American investment. That is, American
net foreign investment in Japan has been negative.
a. If the Japanese decided they no longer wanted to
buy U.S. assets, what would happen in the U.S.
market for loanable funds? In particular, what
would happen to U.S. interest rates, U.S. saving,
and U.S. investment?
b. What would happen in the market for foreign-
currency exchange? In particular, what would
happen to the value of the dollar and the U.S.
trade balance?
11. In 1998 the Russian government defaulted on its debt
payments, leading investors worldwide to raise their
preference for U.S. government bonds, which are
considered very safe. What effect do you think this
“flight to safety” had on the U.S. economy? Be sure
to note the impact on national saving, domestic
investment, net foreign investment, the interest rate,
the exchange rate, and the trade balance.
12. Suppose that U.S. mutual funds suddenly decide to
invest more in Canada.
a. What happens to Canadian net foreign investment,
Canadian saving, and Canadian domestic
investment?
b. What is the long-run effect on the Canadian
capital stock?
c. How will this change in the capital stock affect the
Canadian labor market? Does this U.S. investment
in Canada make Canadian workers better off or
worse off?
d. Do you think this will make U.S. workers better off
or worse off? Can you think of any reason why the
impact on U.S. citizens generally may be different
from the impact on U.S. workers?
IN THIS CHAPTER
YOU WILL . . .
See how shifts in
aggregate demand or
aggregate supply can
cause booms and
recessions
Use the model of
aggregate demand
and aggregate supply
to explain economic
fluctuations
Learn three key facts
about short-run
economic
fluctuations
Consider how the
economy in the
short run differs from
the economy in
the long run
Economic activity fluctuates from year to year. In most years, the production of
goods and services rises. Because of increases in the labor force, increases in the
capital stock, and advances in technological knowledge, the economy can produce
more and more over time. This growth allows everyone to enjoy a higher standard
of living. On average over the past 50 years, the production of the U.S. economy as
measured by real GDPhas grown by about 3 percent per year.
In some years, however, this normal growth does not occur. Firms find them-
selves unable to sell all of the goods and services they have to offer, so they cut
back on production. Workers are laid off, unemployment rises, and factories are
left idle. With the economy producing fewer goods and services, real GDP and
other measures of income fall. Such a period of falling incomes and rising
AGGREGATE DEMAND
AND AGGREGATE SUPPLY
701
702 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
unemployment is called a recessionif it is relatively mild and a depressionif it is
more severe.
What causes short-run fluctuations in economic activity? What, if anything,
can public policy do to prevent periods of falling incomes and rising unemploy-
ment? When recessions and depressions occur, how can policymakers reduce their
length and severity? These are the questions that we take up in this and the next
two chapters.
The variables that we study in the coming chapters are largely those we have
already seen. They include GDP, unemployment, interest rates, exchange rates,
and the price level. Also familiar are the policy instruments of government spend-
ing, taxes, and the money supply. What differs in the next few chapters is the time
horizon of our analysis. Our focus in the previous seven chapters has been on the
behavior of the economy in the long run. Our focus now is on the economy’s short-
run fluctuations around its long-run trend.
Although there remains some debate among economists about how to analyze
short-run fluctuations, most economists use the model of aggregate demand and
aggregate supply. Learning how to use this model for analyzing the short-run effects
of various events and policies is the primary task ahead. This chapter introduces
the model’s two key pieces—the aggregate-demand curve and the aggregate-
supply curve. After getting a sense of the overall structure of the model in this
chapter, we examine the pieces of the model in more detail in the next two
chapters.
THREE KEY FACTS
ABOUT ECONOMIC FLUCTUATIONS
Short-run fluctuations in economic activity occur in all countries and in all times
throughout history. As a starting point for understanding these year-to-year fluc-
tuations, let’s discuss some of their most important properties.
FACT 1: ECONOMIC FLUCTUATIONS ARE
IRREGULAR AND UNPREDICTABLE
Fluctuations in the economy are often called the business cycle. As this term sug-
gests, economic fluctuations correspond to changes in business conditions. When
real GDP grows rapidly, business is good. Firms find that customers are plentiful
and that profits are growing. On the other hand, when real GDP falls, businesses
have trouble. In recessions, most firms experience declining sales and profits.
The term business cycle is somewhat misleading, however, because it seems to
suggest that economic fluctuations follow a regular, predictable pattern. In fact,
economic fluctuations are not at all regular, and they are almost impossible to pre-
dict with much accuracy. Panel (a) of Figure 31-1 shows the real GDP of the U.S.
economy since 1965. The shaded areas represent times of recession. As the figure
shows, recessions do not come at regular intervals. Sometimes recessions are close
recession
a period of declining real incomes
and rising unemployment
depression
a severe recession
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 703
Billions of
1992 Dollars
Real GDP
(a) Real GDP
Billions of
1992 Dollars
Investment spending
(b) Investment Spending
Percent of
Labor Force
Unemployment rate
(c) Unemployment Rate
300
400
500
600
700
800
900
1,000
$1,100
2,500
3,000
3,500
4,000
4,500
5,000
5,500
6,000
6,500
$7,000
0
2
4
6
8
10
12
1965 1970 1975 1980 1985 1990 1995
1965 1970 1975 1980 1985 1990 1995
1965 1970 1975 1980 1985 1990 1995
Figure 31-1
ALOOK AT SHORT-RUN
ECONOMIC FLUCTUATIONS.
This figure shows real GDPin
panel (a), investment spending
in panel (b), and unemployment
in panel (c) for the U.S. economy
using quarterly data since 1965.
Recessions are shown as the
shaded areas. Notice that real
GDPand investment spending
decline during recessions, while
unemployment rises.
SOURCE:U.S. Department of Commerce;
U.S. Department of Labor.
704 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
together, such as the recessions of 1980 and 1982. Sometimes the economy goes
many years without a recession.
FACT 2: MOST MACROECONOMIC
QUANTITIES FLUCTUATE TOGETHER
Real GDPis the variable that is most commonly used to monitor short-run changes
in the economy because it is the most comprehensive measure of economic activ-
ity. Real GDPmeasures the value of all final goods and services produced within a
given period of time. It also measures the total income (adjusted for inflation) of
everyone in the economy.
It turns out, however, that for monitoring short-run fluctuations, it does
not really matter which measure of economic activity one looks at. Most macroeco-
nomic variables that measure some type of income, spending, or production fluc-
tuate closely together. When real GDP falls in a recession, so do personal
income, corporate profits, consumer spending, investment spending, industrial
production, retail sales, home sales, auto sales, and so on. Because recessions are
economy-wide phenomena, they show up in many sources of macroeconomic data.
Although many macroeconomic variables fluctuate together, they fluctuate by
different amounts. In particular, as panel (b) of Figure 31-1 shows, investment
spending varies greatly over the business cycle. Even though investment averages
about one-seventh of GDP, declines in investment account for about two-thirds of
the declines in GDPduring recessions. In other words, when economic conditions
deteriorate, much of the decline is attributable to reductions in spending on new
factories, housing, and inventories.
“You’re fired. Pass it on.”
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 705
FACT 3: AS OUTPUT FALLS, UNEMPLOYMENT RISES
Changes in the economy’s output of goods and services are strongly correlated
with changes in the economy’s utilization of its labor force. In other words, when
real GDP declines, the rate of unemployment rises. This fact is hardly surprising:
When firms choose to produce a smaller quantity of goods and services, they lay
off workers, expanding the pool of unemployed.
Panel (c) of Figure 31-1 shows the unemployment rate in the U.S. economy
since 1965. Once again, recessions are shown as the shaded areas in the figure. The
figure shows clearly the impact of recessions on unemployment. In each of the re-
cessions, the unemployment rate rises substantially. When the recession ends and
real GDPstarts to expand, the unemployment rate gradually declines. The unem-
ployment rate never approaches zero; instead, it fluctuates around its natural rate
of about 5 percent.
QUICK QUIZ: List and discuss three key facts about economic fluctuations.
EXPLAINING SHORT-RUN
ECONOMIC FLUCTUATIONS
Describing the regular patterns that economies experience as they fluctuate over
time is easy. Explaining what causes these fluctuations is more difficult. Indeed,
compared to the topics we have studied in previous chapters, the theory of eco-
nomic fluctuations remains controversial. In this and the next two chapters, we de-
velop the model that most economists use to explain short-run fluctuations in
economic activity.
HOW THE SHORT RUN DIFFERS FROM THE LONG RUN
In previous chapters we developed theories to explain what determines most im-
portant macroeconomic variables in the long run. Chapter 24 explained the level
and growth of productivity and real GDP. Chapter 25 explained how the real in-
terest rate adjusts to balance saving and investment. Chapter 26 explained why
there is always some unemployment in the economy. Chapters 27 and 28 ex-
plained the monetary system and how changes in the money supply affect the
price level, the inflation rate, and the nominal interest rate. Chapters 29 and 30 ex-
tended this analysis to open economies in order to explain the trade balance and
the exchange rate.
All of this previous analysis was based on two related ideas—the classical di-
chotomy and monetary neutrality. Recall that the classical dichotomy is the sepa-
ration of variables into real variables (those that measure quantities or relative
prices) and nominal variables (those measured in terms of money). According to
classical macroeconomic theory, changes in the money supply affect nominal vari-
ables but not real variables. As a result of this monetary neutrality, Chapters 24, 25,
706 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
and 26 were able to examine the determinants of real variables (real GDP, the real
interest rate, and unemployment) without introducing nominal variables (the
money supply and the price level).
Do these assumptions of classical macroeconomic theory apply to the world in
which we live? The answer to this question is of central importance to under-
standing how the economy works: Most economists believe that classical theory de-
scribes the world in the long run but not in the short run. Beyond a period of several
years, changes in the money supply affect prices and other nominal variables but
do not affect real GDP, unemployment, or other real variables. When studying
year-to-year changes in the economy, however, the assumption of monetary neu-
trality is no longer appropriate. Most economists believe that, in the short run, real
and nominal variables are highly intertwined. In particular, changes in the money
supply can temporarily push output away from its long-run trend.
To understand the economy in the short run, therefore, we need a new model.
To build this new model, we rely on many of the tools we have developed in pre-
vious chapters, but we have to abandon the classical dichotomy and the neutrality
of money.
THE BASIC MODEL OF ECONOMIC FLUCTUATIONS
Our model of short-run economic fluctuations focuses on the behavior of two vari-
ables. The first variable is the economy’s output of goods and services, as mea-
sured by real GDP. The second variable is the overall price level, as measured by
the CPI or the GDPdeflator. Notice that output is a real variable, whereas the price
level is a nominal variable. Hence, by focusing on the relationship between these
two variables, we are highlighting the breakdown of the classical dichotomy.
We analyze fluctuations in the economy as a whole with the model of aggre-
gate demand and aggregate supply,which is illustrated in Figure 31-2. On the ver-
tical axis is the overall price level in the economy. On the horizontal axis is the
overall quantity of goods and services. The aggregate-demand curveshows the
quantity of goods and services that households, firms, and the government want
to buy at each price level. The aggregate-supply curve shows the quantity of
goods and services that firms produce and sell at each price level. According to
this model, the price level and the quantity of output adjust to bring aggregate de-
mand and aggregate supply into balance.
It may be tempting to view the model of aggregate demand and aggregate
supply as nothing more than a large version of the model of market demand and
market supply, which we introduced in Chapter 4. Yet in fact this model is quite
different. When we consider demand and supply in a particular market—ice
cream, for instance—the behavior of buyers and sellers depends on the ability of
resources to move from one market to another. When the price of ice cream rises,
the quantity demanded falls because buyers will use their incomes to buy prod-
ucts other than ice cream. Similarly, a higher price of ice cream raises the quantity
supplied because firms that produce ice cream can increase production by hiring
workers away from other parts of the economy. This microeconomic substitution
from one market to another is impossible when we are analyzing the economy as
a whole. After all, the quantity that our model is trying to explain—real GDP—
measures the total quantity produced in all of the economy’s markets. To under-
stand why the aggregate-demand curve is downward sloping and why the
model of aggregate
demand and
aggregate supply
the model that most economists
use to explain short-run
fluctuations in economic activity
around its long-run trend
aggregate-demand curve
a curve that shows the quantity of
goods and services that households,
firms, and the government want to
buy at each price level
aggregate-supply curve
a curve that shows the quantity of
goods and services that firms choose
to produce and sell at each price level
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 707
aggregate-supply curve is upward sloping, we need a macroeconomic theory.
Developing such a theory is our next task.
QUICK QUIZ: How does the economy’s behavior in the short run differ
from its behavior in the long run? a78Draw the model of aggregate demand
and aggregate supply. What variables are on the two axes?
THE AGGREGATE-DEMAND CURVE
The aggregate-demand curve tells us the quantity of all goods and services de-
manded in the economy at any given price level. As Figure 31-3 illustrates, the
aggregate-demand curve is downward sloping. This means that, other things
equal, a fall in the economy’s overall level of prices (from, say, P
1
to P
2
) tends to
raise the quantity of goods and services demanded (from Y
1
to Y
2
).
WHY THE AGGREGATE-DEMAND CURVE
SLOPES DOWNWARD
Why does a fall in the price level raise the quantity of goods and services de-
manded? To answer this question, it is useful to recall that GDP(which we denote
as Y) is the sum of consumption (C), investment (I), government purchases (G),
and net exports (NX):
Equilibrium
output
Quantity of
Output
Price
Level
0
Equilibrium
price level
Aggregate
supply
Aggregate
demand
Figure 31-2
AGGREGATE DEMAND
AND AGGREGATE SUPPLY.
Economists use the model of
aggregate demand and aggregate
supply to analyze economic
fluctuations. On the vertical
axis is the overall level of prices.
On the horizontal axis is the
economy’s total output of
goods and services. Output
and the price level adjust
to the point at which
the aggregate-supply
and aggregate-demand
curves intersect.
708 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
Y H11005C H11001IH11001G H11001NX.
Each of these four components contributes to the aggregate demand for goods and
services. For now, we assume that government spending is fixed by policy. The
other three components of spending—consumption, investment, and net ex-
ports—depend on economic conditions and, in particular, on the price level. To un-
derstand the downward slope of the aggregate-demand curve, therefore, we must
examine how the price level affects the quantity of goods and services demanded
for consumption, investment, and net exports.
The Price Level and Consumption: The Wealth Effect Con-
sider the money that you hold in your wallet and your bank account. The nominal
value of this money is fixed, but its real value is not. When prices fall, these dollars
are more valuable because then they can be used to buy more goods and services.
Thus, a decrease in the price level makes consumers feel more wealthy, which in turn en-
courages them to spend more. The increase in consumer spending means a larger quantity
of goods and services demanded.
The Price Level and Investment: The Interest-Rate Effect
As we discussed in Chapter 28, the price level is one determinant of the quantity
of money demanded. The lower the price level, the less money households need to
hold to buy the goods and services they want. When the price level falls, therefore,
households try to reduce their holdings of money by lending some of it out. For in-
stance, a household might use its excess money to buy interest-bearing bonds. Or
it might deposit its excess money in an interest-bearing savings account, and the
bank would use these funds to make more loans. In either case, as households try
to convert some of their money into interest-bearing assets, they drive down
Quantity of
Output
Price
Level
0
Aggregate
demand
P
1
Y
1
Y
2
P
2
1. A decrease
in the price
level . . .
2. . . . increases the quantity of
goods and services demanded.
Figure 31-3
THE AGGREGATE-DEMAND
CURVE. Afall in the price level
from P
1
to P
2
increases the
quantity of goods and services
demanded from Y
1
to Y
2
. There
are three reasons for this negative
relationship. As the price level
falls, real wealth rises, interest
rates fall, and the exchange rate
depreciates. These effects
stimulate spending on
consumption, investment, and
net exports. Increased spending
on these components of output
means a larger quantity of goods
and services demanded.
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 709
interest rates. Lower interest rates, in turn, encourage borrowing by firms that
want to invest in new plants and equipment and by households who want to in-
vest in new housing. Thus, a lower price level reduces the interest rate, encourages
greater spending on investment goods, and thereby increases the quantity of goods and
services demanded.
The Price Level and Net Exports: The Exchange-Rate Ef-
fect As we have just discussed, a lower price level in the United States lowers
the U.S. interest rate. In response, some U.S. investors will seek higher returns by
investing abroad. For instance, as the interest rate on U.S. government bonds falls,
a mutual fund might sell U.S. government bonds in order to buy German govern-
ment bonds. As the mutual fund tries to move assets overseas, it increases the sup-
ply of dollars in the market for foreign-currency exchange. The increased supply
of dollars causes the dollar to depreciate relative to other currencies. Because each
dollar buys fewer units of foreign currencies, foreign goods become more expen-
sive relative to domestic goods. This change in the real exchange rate (the relative
price of domestic and foreign goods) increases U.S. exports of goods and services
and decreases U.S. imports of goods and services. Net exports, which equal ex-
ports minus imports, also increase. Thus, when a fall in the U.S. price level causes U.S.
interest rates to fall, the real exchange rate depreciates, and this depreciation stimulates
U.S. net exports and thereby increases the quantity of goods and services demanded.
Summary There are, therefore, three distinct but related reasons why a fall in
the price level increases the quantity of goods and services demanded: (1) Con-
sumers feel wealthier, which stimulates the demand for consumption goods. (2)
Interest rates fall, which stimulates the demand for investment goods. (3) The ex-
change rate depreciates, which stimulates the demand for net exports. For all three
reasons, the aggregate-demand curve slopes downward.
It is important to keep in mind that the aggregate-demand curve (like all de-
mand curves) is drawn holding “other things equal.” In particular, our three ex-
planations of the downward-sloping aggregate-demand curve assume that the
money supply is fixed. That is, we have been considering how a change in the
price level affects the demand for goods and services, holding the amount of
money in the economy constant. As we will see, a change in the quantity of money
shifts the aggregate-demand curve. At this point, just keep in mind that the
aggregate-demand curve is drawn for a given quantity of money.
WHY THE AGGREGATE-DEMAND CURVE MIGHT SHIFT
The downward slope of the aggregate-demand curve shows that a fall in the price
level raises the overall quantity of goods and services demanded. Many other fac-
tors, however, affect the quantity of goods and services demanded at a given price
level. When one of these other factors changes, the aggregate-demand curve shifts.
Let’s consider some examples of events that shift aggregate demand. We can
categorize them according to which component of spending is most directly
affected.
Shifts Arising from Consumption Suppose Americans suddenly be-
come more concerned about saving for retirement and, as a result, reduce their
current consumption. Because the quantity of goods and services demanded at
710 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
any price level is lower, the aggregate-demand curve shifts to the left. Conversely,
imagine that a stock market boom makes people feel wealthy and less concerned
about saving. The resulting increase in consumer spending means a greater quan-
tity of goods and services demanded at any given price level, so the aggregate-
demand curve shifts to the right.
Thus, any event that changes how much people want to consume at a given
price level shifts the aggregate-demand curve. One policy variable that has this
effect is the level of taxation. When the government cuts taxes, it encourages
people to spend more, so the aggregate-demand curve shifts to the right. When
thegovernment raises taxes, people cut back on their spending, and the aggregate-
demand curve shifts to the left.
Shifts Arising from Investment Any event that changes how much
firms want to invest at a given price level also shifts the aggregate-demand curve.
For instance, imagine that the computer industry introduces a faster line of
computers, and many firms decide to invest in new computer systems. Because
the quantity of goods and services demanded at any price level is higher, the
aggregate-demand curve shifts to the right. Conversely, if firms become pes-
simistic about future business conditions, they may cut back on investment spend-
ing, shifting the aggregate-demand curve to the left.
Tax policy can also influence aggregate demand through investment. As we
saw in Chapter 25, an investment tax credit (a tax rebate tied to a firm’s investment
spending) increases the quantity of investment goods that firms demand at any
given interest rate. It therefore shifts the aggregate-demand curve to the right.
Therepeal of an investment tax credit reduces investment and shifts the aggregate-
demand curve to the left.
Another policy variable that can influence investment and aggregate demand
is the money supply. As we discuss more fully in the next chapter, an increase
in the money supply lowers the interest rate in the short run. This makes borrow-
ing less costly, which stimulates investment spending and thereby shifts the
aggregate-demand curve to the right. Conversely, a decrease in the money supply
raises the interest rate, discourages investment spending, and thereby shifts the
aggregate-demand curve to the left. Many economists believe that throughout U.S.
history changes in monetary policy have been an important source of shifts in ag-
gregate demand.
Shifts Arising from Government Purchases The most direct way
that policymakers shift the aggregate-demand curve is through government pur-
chases. For example, suppose Congress decides to reduce purchases of new
weapons systems. Because the quantity of goods and services demanded at any
price level is lower, the aggregate-demand curve shifts to the left. Conversely, if
state governments start building more highways, the result isagreater quantity of
goods and services demanded at any price level, so the aggregate-demand curve
shifts to the right.
Shifts Arising from Net Exports Any event that changes net exports
for a given price level also shifts aggregate demand. For instance, when Europe ex-
periences a recession, it buys fewer goods from the United States. This reduces
U.S. net exports and shifts the aggregate-demand curve for the U.S. economy to
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 711
the left. When Europe recovers from its recession, it starts buying U.S. goods again,
shifting the aggregate-demand curve to the right.
Net exports sometimes change because of movements in the exchange rate.
Suppose, for instance, that international speculators bid up the value of the U.S.
dollar in the market for foreign-currency exchange. This appreciation of the dollar
would make U.S. goods more expensive compared to foreign goods, which would
depress net exports and shift the aggregate-demand curve to the left. Conversely,
a depreciation of the dollar stimulates net exports and shifts the aggregate-
demand curve to the right.
Summary In the next chapter we analyze the aggregate-demand curve in
more detail. There we examine more precisely how the tools of monetary and fis-
cal policy can shift aggregate demand and whether policymakers should use these
tools for that purpose. At this point, however, you should have some idea about
why the aggregate-demand curve slopes downward and what kinds of events and
policies can shift this curve. Table 31-1 summarizes what we have learned so far.
Table 31-1
THE AGGREGATE-DEMAND
CURVE: SUMMARY
WHYDOESTHEAGGREGATE-DEMANDCURVESLOPEDOWNWARD?
1. The Wealth Effect: Alower price level increases real wealth, which encourages
spending on consumption.
2. The Interest-Rate Effect: Alower price level reduces the interest rate, which
encourages spending on investment.
3. The Exchange-Rate Effect: Alower price level causes the real exchange rate to
depreciate, which encourages spending on net exports.
WHYMIGHTTHEAGGREGATE-DEMANDCURVESHIFT?
1. Shifts Arising from Consumption: An event that makes consumers spend more
at a given price level (a tax cut, a stock market boom) shifts the aggregate-
demand curve to the right. An event that makes consumers spend less at a
given price level (a tax hike, a stock market decline) shifts the aggregate-
demand curve to the left.
2. Shifts Arising from Investment: An event that makes firms invest more at a
given price level (optimism about the future, a fall in interest rates due to an
increase in the money supply) shifts the aggregate-demand curve to the
right. An event that makes firms invest less at a given price level (pessimism
about the future, a rise in interest rates due to a decrease in the money
supply) shifts the aggregate-demand curve to the left.
3. Shifts Arising from Government Purchases: An increase in government
purchases of goods and services (greater spending on defense or highway
construction) shifts the aggregate-demand curve to the right. Adecrease
in government purchases on goods and services (a cutback in defense or
highway spending) shifts the aggregate-demand curve to the left.
4. Shifts Arising from Net Exports: An event that raises spending on net exports
at a given price level (a boom overseas, an exchange-rate depreciation) shifts
the aggregate-demand curve to the right. An event that reduces spending on
net exports at a given price level (a recession overseas, an exchange-rate
appreciation) shifts the aggregate-demand curve to the left.
712 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
QUICK QUIZ: Explain the three reasons why the aggregate-demand curve
slopes downward. a78Give an example of an event that would shift the
aggregate-demand curve. Which way would this event shift the curve?
THE AGGREGATE-SUPPLY CURVE
The aggregate-supply curve tells us the total quantity of goods and services that
firms produce and sell at any given price level. Unlike the aggregate-demand
curve, which is always downward sloping, the aggregate-supply curve shows a
relationship that depends crucially on the time horizon being examined. In the long
run, the aggregate-supply curve is vertical, whereas in the short run, the aggregate-supply
curve is upward sloping. To understand short-run economic fluctuations, and
how the short-run behavior of the economy deviates from its long-run behavior,
we need to examine both the long-run aggregate-supply curve and the short-run
aggregate-supply curve.
WHY THE AGGREGATE-SUPPLY CURVE
IS VERTICAL IN THE LONG RUN
What determines the quantity of goods and services supplied in the long run? We
implicitly answered this question earlier in the book when we analyzed the
process of economic growth. In the long run, an economy’s production of goods and ser-
vices (its real GDP) depends on its supplies of labor, capital, and natural resources and on
the available technology used to turn these factors of production into goods and services.
Because the price level does not affect these long-run determinants of real GDP, the
long-run aggregate-supply curve is vertical, as in Figure 31-4. In other words, in
the long run, the economy’s labor, capital, natural resources, and technology de-
termine the total quantity of goods and services supplied, and this quantity sup-
plied is the same regardless of what the price level happens to be.
The vertical long-run aggregate-supply curve is, in essence, just an application
of the classical dichotomy and monetary neutrality. As we have already discussed,
classical macroeconomic theory is based on the assumption that real variables do
not depend on nominal variables. The long-run aggregate-supply curve is consis-
tent with this idea because it implies that the quantity of output (a real variable)
does not depend on the level of prices (a nominal variable). As noted earlier, most
economists believe that this principle works well when studying the economy
over a period of many years, but not when studying year-to-year changes. Thus,
the aggregate-supply curve is vertical only in the long run.
One might wonder why supply curves for specific goods and services can be
upward sloping if the long-run aggregate-supply curve is vertical. The reason is
that the supply of specific goods and services depends on relative prices—the prices
of those goods and services compared to other prices in the economy. For example,
when the price of ice cream rises, suppliers of ice cream increase their production,
taking labor, milk, chocolate, and other inputs away from the production of other
goods, such as frozen yogurt. By contrast, the economy’s overall production of
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 713
goods and services is limited by its labor, capital, natural resources, and tech-
nology. Thus, when all prices in the economy rise together, there is no change in
the overall quantity of goods and services supplied.
WHY THE LONG-RUN AGGREGATE-
SUPPLY CURVE MIGHT SHIFT
The position of the long-run aggregate-supply curve shows the quantity of goods
and services predicted by classical macroeconomic theory. This level of production
is sometimes called potential output or full-employment output. To be more accurate,
we call it the natural rate of output because it shows what the economy produces
when unemployment is at its natural, or normal, rate. The natural rate of output is
the level of production toward which the economy gravitates in the long run.
Any change in the economy that alters the natural rate of output shifts the
long-run aggregate-supply curve. Because output in the classical model depends
on labor, capital, natural resources, and technological knowledge, we can catego-
rize shifts in the long-run aggregate-supply curve as arising from these sources.
Shifts Arising from Labor Imagine that an economy experiences an in-
crease in immigration from abroad. Because there would be a greater number of
workers, the quantity of goods and services supplied would increase. As a result,
the long-run aggregate-supply curve would shift to the right. Conversely, if many
workers left the economy to go abroad, the long-run aggregate-supply curve
would shift to the left.
The position of the long-run aggregate-supply curve also depends on the nat-
ural rate of unemployment, so any change in the natural rate of unemployment
shifts the long-run aggregate-supply curve. For example, if Congress were to raise
Quantity of
Output
Natural rate
of output
Price
Level
0
Long-run
aggregate
supply
P
2
1. A change
in the price
level . . .
2. . . . does not affect
the quantity of goods
and services supplied
in the long run.
P
1
Figure 31-4
THE LONG-RUN AGGREGATE-
SUPPLY CURVE. In the long run,
the quantity of output supplied
depends on the economy’s
quantities of labor, capital, and
natural resources and on the
technology for turning these
inputs into output. The quantity
supplied does not depend on the
overall price level.As a result, the
long-run aggregate-supply curve
is vertical at the natural rate of
output.
714 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
the minimum wage substantially, the natural rate of unemployment would rise,
and the economy would produce a smaller quantity of goods and services. As a
result, the long-run aggregate-supply curve would shift to the left. Conversely, if
a reform of the unemployment insurance system were to encourage unemployed
workers to search harder for new jobs, the natural rate of unemployment would
fall, and the long-run aggregate-supply curve would shift to the right.
Shifts Arising from Capital An increase in the economy’s capital stock
increases productivity and, thereby, the quantity of goods and services supplied.
As a result, the long-run aggregate-supply curve shifts to the right. Conversely, a
decrease in the economy’s capital stock decreases productivity and the quantity of
goods and services supplied, shifting the long-run aggregate-supply curve to the
left.
Notice that the same logic applies regardless of whether we are discussing
physical capital or human capital. An increase either in the number of machines or
in the number of college degrees will raise the economy’s ability to produce goods
and services. Thus, either would shift the long-run aggregate-supply curve to
the right.
Shifts Arising from Natural Resources An economy’s production
depends on its natural resources, including its land, minerals, and weather. Adis-
covery of a new mineral deposit shifts the long-run aggregate-supply curve to the
right. A change in weather patterns that makes farming more difficult shifts the
long-run aggregate-supply curve to the left.
In many countries, important natural resources are imported from abroad.
Achange in the availability of these resources can also shift the aggregate-supply
curve. As we discuss later in this chapter, events occurring in the world oil market
have historically been an important source of shifts in aggregate supply.
Shifts Arising from Technological Knowledge Perhaps the most
important reason that the economy today produces more than it did a generation
ago is that our technological knowledge has advanced. The invention of the com-
puter, for instance, has allowed us to produce more goods and services from any
given amounts of labor, capital, and natural resources. As a result, it has shifted the
long-run aggregate-supply curve to the right.
Although not literally technological, there are many other events that act like
changes in technology. As Chapter 9 explains, opening up international trade has
effects similar to inventing new production processes, so it also shifts the long-
run aggregate-supply curve to the right. Conversely, if the government passed
new regulations preventing firms from using some production methods, perhaps
because they were too dangerous for workers, the result would be a leftward shift
in the long-run aggregate-supply curve.
Summary The long-run aggregate-supply curve reflects the classical model of
the economy we developed in previous chapters. Any policy or event that raised
real GDP in previous chapters can now be viewed as increasing the quantity of
goods and services supplied and shifting the long-run aggregate-supply curve to
the right. Any policy or event that lowered real GDPin previous chapters can now
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 715
be viewed as decreasing the quantity of goods and services supplied and shifting
the long-run aggregate-supply curve to the left.
A NEW WAY TO DEPICT
LONG-RUN GROWTH AND INFLATION
Having introduced the economy’s aggregate-demand curve and the long-run
aggregate-supply curve, we now have a new way to describe the economy’s long-
run trends. Figure 31-5 illustrates the changes that occur in the economy from
decade to decade. Notice that both curves are shifting. Although there are many
forces that govern the economy in the long run and can in principle cause such
shifts, the two most important in practice are technology and monetary policy.
Technological progress enhances the economy’s ability to produce goods and ser-
vices, and this continually shifts the long-run aggregate-supply curve to the right.
At the same time, because the Fed increases the money supply over time, the
aggregate-demand curve also shifts to the right. As the figure illustrates, the result
is trend growth in output (as shown by increasing Y) and continuing inflation (as
shown by increasing P). This is just another way of representing the classical
analysis of growth and inflation we conducted in Chapters 24 and 28.
The purpose of developing the model of aggregate demand and aggregate
supply, however, is not to dress our long-run conclusions in new clothing. Instead,
Quantity of
Output
Y
1980
AD
1980
Y
1990
AD
1990
Y
2000
Aggregate
Demand, AD
2000
Price
Level
0
Long-run
aggregate
supply,
LRAS
1980
LRAS
1990
LRAS
2000
P
1980
1. In the long run,
technological
progress shifts
long-run aggregate
supply . . .
4. . . . and
ongoing inflation.
3. . . . leading to growth
in output . . .
P
1990
P
2000
2. . . . and growth in the
money supply shifts
aggregate demand . . .
Figure 31-5
LONG-RUN GROWTH AND
INFLATION IN THE MODEL OF
AGGREGATE DEMAND AND
AGGREGATE SUPPLY. As the
economy becomes better able to
produce goods and services over
time, primarily because of
technological progress, the long-
run aggregate-supply curve shifts
to the right. At the same time, as
the Fed increases the money
supply, the aggregate-demand
curve also shifts to the right. In
this figure, output grows from
Y
1980
to Y
1990
and then to Y
2000
, and
the price level rises from P
1980
to
P
1990
and then to P
2000
. Thus, the
model of aggregate demand and
aggregate supply offers a new
way to describe the classical
analysis of growth and inflation.
716 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
it is to provide a framework for short-run analysis, as we will see in a moment. As
we develop the short-run model, we keep the analysis simple by not showing the
continuing growth and inflation depicted in Figure 31-5. But always remember
that long-run trends provide the background for short-run fluctuations. Short-run
fluctuations in output and the price level should be viewed as deviations from the continu-
ing long-run trends.
WHY THE AGGREGATE-SUPPLY CURVE
SLOPES UPWARD IN THE SHORT RUN
We now come to the key difference between the economy in the short run and
in the long run: the behavior of aggregate supply. As we have already discussed,
the long-run aggregate-supply curve is vertical. By contrast, in the short run, the
aggregate-supply curve is upward sloping, as shown in Figure 31-6. That is, over
a period of a year or two, an increase in the overall level of prices in the economy
tends to raise the quantity of goods and services supplied, and a decrease in the
level of prices tends to reduce the quantity of goods and services supplied.
What causes this positive relationship between the price level and output?
Macroeconomists have proposed three theories for the upward slope of the short-
run aggregate-supply curve. In each theory, a specific market imperfection causes
the supply side of the economy to behave differently in the short run than it does
in the long run. Although each of the following theories will differ in detail, they
share a common theme: The quantity of output supplied deviates from its long-
run, or “natural,” level when the price level deviates from the price level that
people expected. When the price level rises above the expected level, output rises
above its natural rate, and when the price level falls below the expected level, out-
put falls below its natural rate.
Quantity of
Output
Price
Level
0
Short-run
aggregate
supply
Y
2
Y
1
1. A decrease
in the price
level . . .
2. . . . reduces the quantity
of goods and services
supplied in the short run.
P
1
P
2
Figure 31-6
THE SHORT-RUN AGGREGATE-
SUPPLY CURVE. In the short run,
a fall in the price level from P
1
to
P
2
reduces the quantity of output
supplied from Y
1
to Y
2
. This
positive relationship could be
due to misperceptions, sticky
wages, or sticky prices. Over
time, perceptions, wages, and
prices adjust, so this positive
relationship is only temporary.
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 717
The Misperceptions Theory One approach to the short-run aggregate-
supply curve is the misperceptions theory. According to this theory, changes in the
overall price level can temporarily mislead suppliers about what is happening in
the individual markets in which they sell their output. As a result of these short-
run misperceptions, suppliers respond to changes in the level of prices, and this
response leads to an upward-sloping aggregate-supply curve.
To see how this might work, suppose the overall price level falls below the
level that people expected. When suppliers see the prices of their products fall,
they may mistakenly believe that their relative prices have fallen. For example,
wheat farmers may notice a fall in the price of wheat before they notice a fall in the
prices of the many items they buy as consumers. They may infer from this obser-
vation that the reward to producing wheat is temporarily low, and they may re-
spond by reducing the quantity of wheat they supply. Similarly, workers may
notice a fall in their nominal wages before they notice a fall in the prices of the
goods they buy. They may infer that the reward to working is temporarily low and
respond by reducing the quantity of labor they supply. In both cases, a lower price
level causes misperceptions about relative prices, and these misperceptions induce sup-
pliers to respond to the lower price level by decreasing the quantity of goods and services
supplied.
The Sticky-Wage Theory Asecond explanation of the upward slope of
the short-run aggregate-supply curve is the sticky-wage theory. According to this
theory, the short-run aggregate-supply curve slopes upward because nominal
wages are slow to adjust, or are “sticky,” in the short run. To some extent, the slow
adjustment of nominal wages is attributable to long-term contracts between work-
ers and firms that fix nominal wages, sometimes for as long as three years. In ad-
dition, this slow adjustment may be attributable to social norms and notions of
fairness that influence wage setting and that change only slowly over time.
To see what sticky nominal wages mean for aggregate supply, imagine that a
firm has agreed in advance to pay its workers a certain nominal wage based on
what it expected the price level to be. If the price level P falls below the level that
was expected and the nominal wage remains stuck at W, then the real wage W/P
rises above the level the firm planned to pay. Because wages are a large part of a
firm’s production costs, a higher real wage means that the firm’s real costs have
risen. The firm responds to these higher costs by hiring less labor and producing
a smaller quantity of goods and services. In other words, because wages do not ad-
just immediately to the price level, a lower price level makes employment and produc-
tion less profitable, which induces firms to reduce the quantity of goods and services
supplied.
The Sticky-Price Theory Recently, some economists have advocated a
third approach to the short-run aggregate-supply curve, called the sticky-price the-
ory. As we just discussed, the sticky-wage theory emphasizes that nominal wages
adjust slowly over time. The sticky-price theory emphasizes that the prices of
some goods and services also adjust sluggishly in response to changing economic
conditions. This slow adjustment of prices occurs in part because there are costs to
adjusting prices, called menu costs. These menu costs include the cost of printing
and distributing catalogs and the time required to change price tags. As a result of
these costs, prices as well as wages may be sticky in the short run.
718 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
To see the implications of sticky prices for aggregate supply, suppose that each
firm in the economy announces its prices in advance based on the economic con-
ditions it expects to prevail. Then, after prices are announced, the economy expe-
riences an unexpected contraction in the money supply, which (as we have
learned) will reduce the overall price level in the long run. Although some firms
reduce their prices immediately in response to changing economic conditions,
other firms may not want to incur additional menu costs and, therefore, may tem-
porarily lag behind. Because these lagging firms have prices that are too high, their
sales decline. Declining sales, in turn, cause these firms to cut back on production
and employment. In other words, because not all prices adjust instantly to changing
conditions, an unexpected fall in the price level leaves some firms with higher-than-desired
prices, and these higher-than-desired prices depress sales and induce firms to reduce the
quantity of goods and services they produce.
Summary There are three alternative explanations for the upward slope of the
short-run aggregate-supply curve: (1) misperceptions, (2) sticky wages, and (3)
sticky prices. Economists debate which of these theories is correct. For our pur-
poses in this book, however, the similarities of the theories are more important
than the differences. All three theories suggest that output deviates from its nat-
ural rate when the price level deviates from the price level that people expected.
We can express this mathematically as follows:
H11005H11001a
H20898
H11002
H20899
where a is a number that determines how much output responds to unexpected
changes in the price level.
Notice that each of the three theories of short-run aggregate supply empha-
sizes a problem that is likely to be only temporary. Whether the upward slope of
the aggregate-supply curve is attributable to misperceptions, sticky wages, or
sticky prices, these conditions will not persist forever. Eventually, as people adjust
their expectations, misperceptions are corrected, nominal wages adjust, and prices
become unstuck. In other words, the expected and actual price levels are equal
in the long run, and the aggregate-supply curve is vertical rather than upward
sloping.
WHY THE SHORT-RUN AGGREGATE-SUPPLY
CURVE MIGHT SHIFT
The short-run aggregate-supply curve tells us the quantity of goods and services
supplied in the short run for any given level of prices. We can think of this curve
as similar to the long-run aggregate-supply curve but made upward sloping by
thepresence of misperceptions, sticky wages, and sticky prices. Thus, when think-
Expected
price level
Actual
price level
Natural rate of
output
Quantity of
output supplied
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 719
ing about what shifts the short-run aggregate-supply curve, we have to consider
all those variables that shift the long-run aggregate-supply curve plus a new
variable—the expected price level—that influences misperceptions, sticky wages,
and sticky prices.
Let’s start with what we know about the long-run aggregate-supply curve. As
we discussed earlier, shifts in the long-run aggregate-supply curve normally arise
from changes in labor, capital, natural resources, or technological knowledge.
These same variables shift the short-run aggregate-supply curve. For example,
when an increase in the economy’s capital stock increases productivity, both the
long-run and short-run aggregate-supply curves shift to the right. When an in-
crease in the minimum wage raises the natural rate of unemployment, both the
long-run and short-run aggregate-supply curves shift to the left.
The important new variable that affects the position of the short-run
aggregate-supply curve is people’s expectation of the price level. As we have dis-
cussed, the quantity of goods and services supplied depends, in the short run, on
misperceptions, sticky wages, and sticky prices. Yet perceptions, wages, and prices
are set on the basis of expectations of the price level. So when expectations change,
the short-run aggregate-supply curve shifts.
To make this idea more concrete, let’s consider a specific theory of aggregate
supply—the sticky-wage theory. According to this theory, when people expect the
price level to be high, they tend to set wages high. High wages raise firms’ costs
and, for any given actual price level, reduce the quantity of goods and services that
firms supply. Thus, when the expected price level rises, wages rise, costs rise, and
firms choose to supply a smaller quantity of goods and services at any given actual
price level. Thus, the short-run aggregate-supply curve shifts to the left. Con-
versely, when the expected price level falls, wages fall, costs fall, firms increase
production, and the short-run aggregate-supply curve shifts to the right.
Asimilar logic applies in each theory of aggregate supply. The general lesson
is the following: An increase in the expected price level reduces the quantity of goods and
services supplied and shifts the short-run aggregate-supply curve to the left. A decrease in
the expected price level raises the quantity of goods and services supplied and shifts the
short-run aggregate-supply curve to the right. As we will see in the next section, this
influence of expectations on the position of the short-run aggregate-supply curve
plays a key role in reconciling the economy’s behavior in the short run with its be-
havior in the long run. In the short run, expectations are fixed, and the economy
finds itself at the intersection of the aggregate-demand curve and the short-run
aggregate-supply curve. In the long run, expectations adjust, and the short-
run aggregate-supply curve shifts. This shift ensures that the economy eventually
finds itself at the intersection of the aggregate-demand curve and the long-run
aggregate-supply curve.
You should now have some understanding about why the short-run
aggregate-supply curve slopes upward and what events and policies can cause
this curve to shift. Table 31-2 summarizes our discussion.
QUICK QUIZ: Explain why the long-run aggregate-supply curve is
vertical. a78Explain three theories for why the short-run aggregate-supply
curve is upward sloping.
720 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
TWO CAUSES OF ECONOMIC FLUCTUATIONS
Now that we have introduced the model of aggregate demand and aggregate sup-
ply, we have the basic tools we need to analyze fluctuations in economic activity.
In the next two chapters we will refine our understanding of how to use these
tools. But even now we can use what we have learned about aggregate demand
and aggregate supply to examine the two basic causes of short-run fluctuations.
Figure 31-7 shows an economy in long-run equilibrium. Equilibrium output
and the price level are determined by the intersection of the aggregate-demand
curve and the long-run aggregate-supply curve, shown as point Ain the figure. At
this point, output is at its natural rate. The short-run aggregate-supply curve
passes through this point as well, indicating that perceptions, wages, and prices
Table 31-2
THE SHORT-RUN
AGGREGATE-SUPPLY
CURVE:SUMMARY
WHYDOESTHESHORT-RUNAGGREGATE-SUPPLYCURVESLOPEUPWARD?
1. The Misperceptions Theory: An unexpectedly low price level leads some
suppliers to think their relative prices have fallen, which induces a fall
in production.
2. The Sticky-Wage Theory: An unexpectedly low price level raises the real wage,
which causes firms to hire fewer workers and produce a smaller quantity of
goods and services.
3. The Sticky-Price Theory: An unexpectedly low price level leaves some firms
with higher-than-desired prices, which depresses their sales and leads them
to cut back production.
WHYMIGHTTHESHORT-RUNAGGREGATE-SUPPLYCURVESHIFT?
1. Shifts Arising from Labor: An increase in the quantity of labor available
(perhaps due to a fall in the natural rate of unemployment) shifts the
aggregate-supply curve to the right. Adecrease in the quantity of labor
available (perhaps due to a rise in the natural rate of unemployment) shifts
the aggregate-supply curve to the left.
2. Shifts Arising from Capital: An increase in physical or human capital shifts the
aggregate-supply curve to the right. Adecrease in physical or human capital
shifts the aggregate-supply curve to the left.
3. Shifts Arising from Natural Resources: An increase in the availability of natural
resources shifts the aggregate-supply curve to the right. Adecrease in the
availability of natural resources shifts the aggregate-supply curve to the left.
4. Shifts Arising from Technology: An advance in technological knowledge shifts
the aggregate-supply curve to the right. Adecrease in the available
technology (perhaps due to government regulation) shifts the aggregate-
supply curve to the left.
5. Shifts Arising from the Expected Price Level: Adecrease in the expected price
level shifts the short-run aggregate-supply curve to the right. An increase
in the expected price level shifts the short-run aggregate-supply curve
to the left.
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 721
have fully adjusted to this long-run equilibrium. That is, when an economy is in its
long-run equilibrium, perceptions, wages, and prices must have adjusted so that
the intersection of aggregate demand with short-run aggregate supply is the same
as the intersection of aggregate demand with long-run aggregate supply.
THE EFFECTS OF A SHIFT IN AGGREGATE DEMAND
Suppose that for some reason a wave of pessimism suddenly overtakes the econ-
omy. The cause might be a scandal in the White House, a crash in the stock market,
or the outbreak of a war overseas. Because of this event, many people lose confi-
dence in the future and alter their plans. Households cut back on their spending
and delay major purchases, and firms put off buying new equipment.
What is the impact of such a wave of pessimism on the economy? Such an
event reduces the aggregate demand for goods and services. That is, for any given
price level, households and firms now want to buy a smaller quantity of goods
and services. As Figure 31-8 shows, the aggregate-demand curve shifts to the left
from AD
1
to AD
2
.
In this figure we can examine the effects of the fall in aggregate demand. In the
short run, the economy moves along the initial short-run aggregate-supply curve
AS
1
, going from point Ato point B. As the economy moves from point Ato pointB,
output falls from Y
1
to Y
2
, and the price level falls from P
1
to P
2
. The falling level of
output indicates that the economy is in a recession. Although not shown in the
figure, firms respond to lower sales and production by reducing employment.
Thus, the pessimism that caused the shift in aggregate demand is, to some extent,
self-fulfilling: Pessimism about the future leads to falling incomes and rising
unemployment.
Natural rate
of output
Quantity of
Output
Price
Level
0
Equilibrium
price
Short-run
aggregate
supply
Long-run
aggregate
supply
Aggregate
demand
A
Figure 31-7
THE LONG-RUN EQUILIBRIUM.
The long-run equilibrium of
the economy is found where the
aggregate-demand curve crosses
the long-run aggregate-supply
curve (point A). When the
economy reaches this long-run
equilibrium, perceptions, wages,
and prices will have adjusted so
that the short-run aggregate-
supply curve crosses this
point as well.
722 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
What should policymakers do when faced with such a recession? One possi-
bility is to take action to increase aggregate demand. As we noted earlier, an in-
crease in government spending or an increase in the money supply would increase
the quantity of goods and services demanded at any price and, therefore, would
shift the aggregate-demand curve to the right. If policymakers can act with suffi-
cient speed and precision, they can offset the initial shift in aggregate demand, re-
turn the aggregate-demand curve back to AD
1
, and bring the economy back to
point A. (The next chapter discusses in more detail the ways in which monetary
and fiscal policy influence aggregate demand, as well as some of the practical dif-
ficulties in using these policy instruments.)
Even without action by policymakers, the recession will remedy itself over a
period of time. Because of the reduction in aggregate demand, the price level falls.
Eventually, expectations catch up with this new reality, and the expected price
level falls as well. Because the fall in the expected price level alters perceptions,
wages, and prices, it shifts the short-run aggregate-supply curve to the right from
AS
1
to AS
2
in Figure 31-8. This adjustment of expectations allows the economy
over time to approach point C, where the new aggregate demand-curve (AD
2
)
crosses the long-run aggregate-supply curve.
In the new long-run equilibrium, point C, output is back to its natural rate.
Even though the wave of pessimism has reduced aggregate demand, the price
level has fallen sufficiently (to P
3
) to offset the shift in the aggregate-demand
curve. Thus, in the long run, the shift in aggregate demand is reflected fully in the
price level and not at all in the level of output. In other words, the long-run effect
of a shift in aggregate demand is a nominal change (the price level is lower) but
not a real change (output is the same).
Quantity of
Output
Price
Level
0
Short-run aggregate
supply, AS
1
Long-run
aggregate
supply
Aggregate
demand, AD
1
A
B
C
P
1
P
2
P
3
Y
1
Y
2
AD
2
AS
2
1. A decrease in
aggregate demand . . .
2. . . . causes output to fall in the short run . . .
3. . . . but over
time, the short-run
aggregate-supply
curve shifts . . .
4. . . . and output returns
to its natural rate.
Figure 31-8
ACONTRACTION IN AGGREGATE
DEMAND. Afall in aggregate
demand, which might be due to a
wave of pessimism in the
economy, is represented with a
leftward shift in the aggregate-
demand curve from AD
1
to AD
2
.
The economy moves from point
Ato point B. Output falls from Y
1
to Y
2
, and the price level falls
from P
1
to P
2
. Over time, as
perceptions, wages, and prices
adjust, the short-run aggregate-
supply curve shifts to the right
from AS
1
to AS
2
, and the
economy reaches point C, where
the new aggregate-demand curve
crosses the long-run aggregate-
supply curve. The price level
falls to P
3
, and output returns
to its natural rate, Y
1
.
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 723
CASE STUDY TWO BIG SHIFTS IN AGGREGATE DEMAND:
THE GREAT DEPRESSION AND WORLD WAR II
At the beginning of this chapter we established three key facts about economic
fluctuations by looking at data since 1965. Let’s now take a longer look at U.S.
economic history. Figure 31-9 shows data on real GDPgoing back to 1900. Most
short-run economic fluctuations are hard to see in this figure; they are dwarfed
by the 25-fold rise in GDP over the past century. Yet two episodes jump out as
being particularly significant—the large drop in real GDPin the early 1930s and
the large increase in real GDPin the early 1940s. Both of these events are attrib-
utable to shifts in aggregate demand.
The economic calamity of the early 1930s is called the Great Depression, and
it is by far the largest economic downturn in U.S. history. Real GDP fell by
27 percent from 1929 to 1933, and unemployment rose from 3 percent to 25
To sum up, this story about shifts in aggregate demand has two important
lessons:
a78 In the short run, shifts in aggregate demand cause fluctuations in the
economy’s output of goods and services.
a78 In the long run, shifts in aggregate demand affect the overall price level but
do not affect output.
Real GDP
(billions of
1992 dollars)
1900 1910 1920 1930 1940 1950 19901960 20001970 1980
8,000
4,000
2,000
1,000
500
250
The Great
Depression
The World War II
Boom
Real GDP
Figure 31-9
U.S. REAL GDP SINCE 1900.
Over the course of U.S. economic
history, two fluctuations stand
out as being especially large.
During the early 1930s, the
economy went through the Great
Depression, when the production
of goods and services
plummeted. During the early
1940s, the United States entered
World War II, and the economy
experienced rapidly rising
production. Both of these events
are usually explained by large
shifts in aggregate demand.
NOTE:Real GDPis graphed here using a proportional scale. This means that equal distances on the vertical axis
represent equal percentage changes. For example, the distance between 1,000 and 2,000 (a 100 percent increase) is
the same as the distance between 2,000 and 4,000 (a 100 percent increase). With such a scale,stable growth—say,
3 percent per year—would show up as an upward-sloping straight line.
SOURCE:U.S. Department of Commerce.
724 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
percent. At the same time, the price level fell by 22 percent over these four years.
Many other countries experienced similar declines in output and prices during
this period.
Economic historians continue to debate the causes of the Great Depression,
but most explanations center on a large decline in aggregate demand. What
caused aggregate demand to contract? Here is where the disagreement arises.
Many economists place primary blame on the decline in the money supply:
From 1929 to 1933, the money supply fell by 28 percent. As you may recall from
our discussion of the monetary system in Chapter 27, this decline in the money
supply was due to problems in the banking system. As households withdrew
their money from financially shaky banks and bankers became more cau-
tious and started holding greater reserves, the process of money creation under
fractional-reserve banking went into reverse. The Fed, meanwhile, failed to off-
set this fall in the money multiplier with expansionary open-market operations.
As a result, the money supply declined. Many economists blame the Fed’s fail-
ure to act for the Great Depression’s severity.
Other economists have suggested alternative reasons for the collapse in
aggregate demand. For example, stock prices fell about 90 percent during this
period, depressing household wealth and thereby consumer spending. In addi-
tion, the banking problems may have prevented some firms from obtaining the
financing they wanted for investment projects, and this would have depressed
investment spending. Of course, all of these forces may have acted together to
contract aggregate demand during the Great Depression.
The second significant episode in Figure 31-9—the economic boom of the
early 1940s—is easier to explain. The obvious cause of this event is World War
II. As the United States entered the war overseas, the federal government had to
devote more resources to the military. Government purchases of goods and
services increased almost fivefold from 1939 to 1944. This huge expansion in
aggregate demand almost doubled the economy’s production of goods and
services and led to a 20 percent increase in the price level (although widespread
government price controls limited the rise in prices). Unemployment fell from
17 percent in 1939 to about 1 percent in 1944—the lowest level in U.S. history.
WARS: ONE WAY TO STIMULATE AGGREGATE DEMAND
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 725
THE EFFECTS OF A SHIFT IN AGGREGATE SUPPLY
Imagine once again an economy in its long-run equilibrium. Now suppose that
suddenly some firms experience an increase in their costs of production. For ex-
ample, bad weather in farm states might destroy some crops, driving up the cost
AS WE HAVE SEEN, WHEN PEOPLE CHANGE
their perceptions and spending, they
shift the aggregate-demand curve and
cause short-run fluctuations in the
economy. According to the following
article, such a shift occurred in 1996,
just as the presidential campaign of that
year was getting under way.
Consumers Get the Credit
for Expanding Economy
BYRICHARDW. STEVENSON
WASHINGTON—President Clinton claims
the credit for himself, and analysts cite
an array of other possible factors, but
the most important source of the econ-
omy’s remarkable resilience and vibrancy
this year appears to be the consumer.
For most of this year, Americans
have spent prodigiously on homes, cars,
refrigerators, and dinners out, carrying
forward an aging economic expansion
that as recently as January seemed in
danger of expiring. In the process, they
have largely ignored warning signs that
they are becoming overextended.
The consumer spending spree was
a major force in the surprisingly robust
economic data released Friday, econo-
mists said. The Labor Department es-
timated that the economy created
239,000 jobs in June, far more than
expected, making that month the fifth
consecutive one with strong employ-
ment gains. The unemployment rate now
stands at 5.3 percent, the lowest in six
years, and economic growth is so rapid
that it has revived fears of inflation.
Among the industries showing the
biggest gains was retailing, which added
75,000 jobs in June, nearly half of them
in what the government classifies as eat-
ing and drinking places. Job growth was
also strong at car dealers, gas stations,
hotels, and stores selling building materi-
als, garden supplies, and home furnish-
ings. Employment in construction was up
by 23,000, reflecting in part the contin-
ued upward strength of home building.
Just how long consumers can carry
on with their free-spending ways, how-
ever, remains an open question and one
that is critical to policymakers at the Fed-
eral Reserve as they decide whether to
raise interest rates to keep the economy
from accelerating enough to generate in-
creased inflation.
Some economists believe that con-
sumers have amassed so much debt
that they will be forced to rein in their
spending for the rest of the year, result-
ing in a slackening of economic growth.
Credit card delinquencies in the first
quarter were at their highest level since
1981, and personal bankruptcies were
up 15 percent from the first three
months of 1995. . . .
Most economists also agree that
the surge in spending this year has been
driven in large part by temporary fac-
tors—including low interest rates, higher-
than-expected tax refunds, and rebates
from automakers—that have been re-
versed or phased out. . . .
One wild card in assessing the
course of consumer spending is the
stock market, which has been making
relatively affluent consumers feel flush
with its continued boom. Economists
have grappled for years with the ques-
tion of the extent to which paper gains
on stock market investments lead con-
sumers to spend more, and they still do
not agree on an answer. But they said it
was relatively clear that the bull market
of recent years—and the fact that more
and more Americans invest in the market
through retirement plans and mutual
funds—has provided some impetus to
consumers to spend more.
SOURCE: The New York Times, July 8, 1996, p. D3.
IN THE NEWS
How Consumers Shift
Aggregate Demand
CONSUMERS: AGGREGATE-DEMAND SHIFTERS
726 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
of producing food products. Or a war in the Middle East might interrupt the ship-
ping of crude oil, driving up the cost of producing oil products.
What is the macroeconomic impact of such an increase in production costs?
For any given price level, firms now want to supply a smaller quantity of goods
and services. Thus, as Figure 31-10 shows, the short-run aggregate-supply curve
shifts to the left from AS
1
to AS
2
. (Depending on the event, the long-run aggregate-
supply curve might also shift. To keep things simple, however, we will assume
that it does not.)
In this figure we can trace the effects of the leftward shift in aggregate supply.
In the short run, the economy moves along the existing aggregate-demand curve,
going from point Ato point B. The output of the economy falls from Y
1
to Y
2
, and
the price level rises from P
1
to P
2
. Because the economy is experiencing both stag-
nation (falling output) and inflation (rising prices), such an event is sometimes
called stagflation.
What should policymakers do when faced with stagflation? As we will discuss
more fully later in this book, there are no easy choices. One possibility is to do
nothing. In this case, the output of goods and services remains depressed at Y
2
for
a while. Eventually, however, the recession will remedy itself as perceptions,
wages, and prices adjust to the higher production costs. A period of low output
and high unemployment, for instance, puts downward pressure on workers’
wages. Lower wages, in turn, increase the quantity of output supplied. Over time,
as the short-run aggregate-supply curve shifts back toward AS
1
, the price level
falls, and the quantity of output approaches its natural rate. In the long run, the
economy returns to point A, where the aggregate-demand curve crosses the long-
run aggregate-supply curve.
Alternatively, policymakers who control monetary and fiscal policy might
attempt to offset some of the effects of the shift in the short-run aggregate-supply
stagflation
a period of falling output
and rising prices
Quantity of
Output
Price
Level
0
Aggregate demand
A
B
Y
1
Y
2
3. . . . and
the price
level to rise.
2. . . . causes output to fall . . .
1. An adverse shift in the short-
run aggregate-supply curve . . .
Short-run
aggregate
supply, AS
1
Long-run
aggregate
supply
P
2
P
1
AS
2
Figure 31-10
AN ADVERSE SHIFT IN
AGGREGATE SUPPLY. When
some event increases firms’ costs,
the short-run aggregate-supply
curve shifts to the left from AS
1
to
AS
2
. The economy moves from
point Ato point B. The result is
stagflation: Output falls from Y
1
to Y
2
, and the price level rises
from P
1
to P
2
.
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 727
CASE STUDY OIL AND THE ECONOMY
Some of the largest economic fluctuations in the U.S. economy since 1970 have
originated in the oil fields of the Middle East. Crude oil is a key input into the
production of many goods and services, and much of the world’s oil comes
from Saudi Arabia, Kuwait, and other Middle Eastern countries. When some
event (usually political in origin) reduces the supply of crude oil flowing from
this region, the price of oil rises around the world. U.S. firms that produce gaso-
line, tires, and many other products experience rising costs. The result is a left-
ward shift in the aggregate-supply curve, which in turn leads to stagflation.
curve by shifting the aggregate-demand curve. This possibility is shown in Fig-
ure 31-11. In this case, changes in policy shift the aggregate-demand curve to the
right from AD
1
to AD
2
—exactly enough to prevent the shift in aggregate supply
from affecting output. The economy moves directly from point Ato point C. Out-
put remains at its natural rate, and the price level rises from P
1
to P
3
. In this case,
policymakers are said to accommodate the shift in aggregate supply because they
allow the increase in costs to affect the level of prices permanently.
To sum up, this story about shifts in aggregate supply has two important
implications:
a78 Shifts in aggregate supply can cause stagflation—a combination of recession
(falling output) and inflation (rising prices).
a78 Policymakers who can influence aggregate demand cannot offset both of
these adverse effects simultaneously.
Quantity of
Output
Natural rate
of output
Price
Level
0
Short-run
aggregate
supply, AS
1
Long-run
aggregate
supply
Aggregate demand, AD
1
A
C
P
2
P
3
P
1
AS
2
3. . . . which
causes the
price level
to rise
further . . .
4. . . . but keeps output
at its natural rate.
2. . . . policymakers can
accommodate the shift
by expanding aggregate
demand . . .
1. When short-run aggregate
supply falls . . .
AD
2
Figure 31-11
ACCOMMODATING AN ADVERSE
SHIFT IN AGGREGATE SUPPLY.
Faced with an adverse shift in
aggregate supply from AS
1
to
AS
2
, policymakers who can
influence aggregate demand
might try to shift the aggregate-
demand curve to the right from
AD
1
to AD
2
. The economy would
move from point Ato point C.
This policy would prevent the
supply shift from reducing
output in the short run, but the
price level would permanently
rise from P
1
to P
3
.
728 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
The first episode of this sort occurred in the mid-1970s. The countries with
large oil reserves got together as members of OPEC, the Organization of Petro-
leum Exporting Countries. OPEC was a cartel—a group of sellers that attempts
to thwart competition and reduce production in order to raise prices. And, in-
deed, oil prices rose substantially. From 1973 to 1975, oil approximately doubled
in price. Oil-importing countries around the world experienced simultaneous
inflation and recession. The U.S. inflation rate as measured by the CPI exceeded
10 percent for the first time in decades. Unemployment rose from 4.9 percent in
1973 to 8.5 percent in 1975.
Almost the same thing happened again a few years later. In the late 1970s,
the OPEC countries again restricted the supply of oil to raise the price. From
1978 to 1981, the price of oil more than doubled. Once again, the result was
stagflation. Inflation, which had subsided somewhat after the first OPEC event,
again rose above 10 percent per year. But because the Fed was not willing to ac-
commodate such a large rise in inflation, a recession was soon to follow. Unem-
ployment rose from about 6 percent in 1978 and 1979 to about 10 percent a few
years later.
The world market for oil can also be a source of favorable shifts in aggre-
gate supply. In 1986 squabbling broke out among members of OPEC. Member
countries reneged on their agreements to restrict oil production. In the world
market for crude oil, prices fell by about half. This fall in oil prices reduced costs
to U.S. firms, which shifted the aggregate-supply curve to the right. As a result,
the U.S. economy experienced the opposite of stagflation: Output grew rapidly,
unemployment fell, and the inflation rate reached its lowest level in many
years.
In recent years, the world market for oil has been relatively quiet. The only
exception has been a brief period during 1990, just before the Persian Gulf War,
when oil prices temporarily spiked up out of fear that a long military conflict
might disrupt oil production. Yet this recent tranquillity does not mean that the
United States no longer needs to worry about oil prices. Political troubles in
the Middle East (or greater cooperation among the members of OPEC) could
always send oil prices higher. The macroeconomic result of a large rise in oil
prices could easily resemble the stagflation of the 1970s.
QUICK QUIZ: Suppose that the election of a popular presidential candidate
suddenly increases people’s confidence in the future. Use the model of
aggregate demand and aggregate supply to analyze the effect on the economy.
CONCLUSION: THE ORIGINS OF AGGREGATE
DEMAND AND AGGREGATE SUPPLY
This chapter has achieved two goals. First, we have discussed some of the impor-
tant facts about short-run fluctuations in economic activity. Second, we have in-
troduced a basic model to explain those fluctuations, called the model of aggregate
demand and aggregate supply. In the next two chapters we look at each piece of
CHANGES IN MIDDLE EASTERN OIL
PRODUCTION ARE ONE SOURCE OF
U.S. ECONOMIC FLUCTUATIONS.
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 729
this model in more detail in order to understand more fully what causes fluctua-
tions in the economy and how policymakers might respond to these fluctuations.
Now that we have a preliminary understanding of this model, it is worthwhile
to step back from it and consider its history. How did this model of short-run fluc-
tuations develop? The answer is that this model, to a large extent, is a by-product
of the Great Depression of the 1930s. Economists and policymakers at the time
were puzzled about what had caused this calamity and were uncertain about how
to deal with it.
In 1936, economist John Maynard Keynes published a book titled The General
Theory of Employment, Interest, and Money, which attempted to explain short-run
economic fluctuations in general and the Great Depression in particular. Keynes’s
primary message was that recessions and depressions can occur because of inade-
quate aggregate demand for goods and services. Keynes had long been a critic of
classical economic theory—the theory we examined in Chapters 24 through 30—
because it could explain only the long-run effects of policies. Afew years before of-
fering The General Theory, Keynes had written the following about classical
economics:
The long run is a misleading guide to current affairs. In the long run we are all
dead. Economists set themselves too easy, too useless a task if in tempestuous
seasons they can only tell us when the storm is long past, the ocean will be flat.
Keynes’s message was aimed at policymakers as well as economists. As the
world’s economies suffered with high unemployment, Keynes advocated policies
to increase aggregate demand, including government spending on public works.
In the next chapter we examine in detail how policymakers can try to use the tools
of monetary and fiscal policy to influence aggregate demand. The analysis in the
next chapter, as well as in this one, owes much to the legacy of John Maynard
Keynes.
a78 All societies experience short-run economic fluctuations
around long-run trends. These fluctuations are irregular
and largely unpredictable. When recessions do occur,
real GDPand other measures of income, spending, and
production fall, and unemployment rises.
a78 Economists analyze short-run economic fluctuations
using the model of aggregate demand and aggregate
supply. According to this model, the output of goods
and services and the overall level of prices adjust to
balance aggregate demand and aggregate supply.
a78 The aggregate-demand curve slopes downward for
three reasons. First, a lower price level raises the real
value of households’ money holdings, which stimulates
consumer spending. Second, a lower price level reduces
the quantity of money households demand; as
households try to convert money into interest-bearing
assets, interest rates fall, which stimulates investment
spending. Third, as a lower price level reduces interest
rates, the dollar depreciates in the market for foreign-
currency exchange, which stimulates net exports.
a78 Any event or policy that raises consumption,
investment, government purchases, or net exports at a
given price level increases aggregate demand. Any
event or policy that reduces consumption, investment,
government purchases, or net exports at a given price
level decreases aggregate demand.
a78 The long-run aggregate-supply curve is vertical. In the
long run, the quantity of goods and services supplied
depends on the economy’s labor, capital, natural
resources, and technology, but not on the overall
level of prices.
Summary
730 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
a78 Three theories have been proposed to explain the
upward slope of the short-run aggregate-supply curve.
According to the misperceptions theory, an unexpected
fall in the price level leads suppliers to mistakenly
believe that their relative prices have fallen, which
induces them to reduce production. According to the
sticky-wage theory, an unexpected fall in the price level
temporarily raises real wages, which induces firms to
reduce employment and production. According to the
sticky-price theory, an unexpected fall in the price level
leaves some firms with prices that are temporarily too
high, which reduces their sales and causes them to cut
back production. All three theories imply that output
deviates from its natural rate when the price level
deviates from the price level that people expected.
a78 Events that alter the economy’s ability to produce
output, such as changes in labor, capital, natural
resources, or technology, shift the short-run aggregate-
supply curve (and may shift the long-run aggregate-
supply curve as well). In addition, the position of
the short-run aggregate-supply curve depends on the
expected price level.
a78 One possible cause of economic fluctuations is a shift in
aggregate demand. When the aggregate-demand curve
shifts to the left, for instance, output and prices fall in
the short run. Over time, as a change in the expected
price level causes perceptions, wages, and prices to
adjust, the short-run aggregate-supply curve shifts to
the right, and the economy returns to its natural rate of
output at a new, lower price level.
a78 Asecond possible cause of economic fluctuations is a
shift in aggregate supply. When the aggregate-supply
curve shifts to the left, the short-run effect is falling
output and rising prices—a combination called
stagflation. Over time, as perceptions, wages, and
prices adjust, the price level falls back to its original
level, and output recovers.
recession, p. 702
depression, p. 702
model of aggregate demand and
aggregate supply, p. 706
aggregate-demand curve, p. 706
aggregate-supply curve, p. 706
stagflation, p. 726
Key Concepts
1. Name two macroeconomic variables that decline when
the economy goes into a recession. Name one
macroeconomic variable that rises during a recession.
2. Draw a diagram with aggregate demand, short-run
aggregate supply, and long-run aggregate supply. Be
careful to label the axes correctly.
3. List and explain the three reasons why the aggregate-
demand curve is downward sloping.
4. Explain why the long-run aggregate-supply curve is
vertical.
5. List and explain the three theories for why the short-run
aggregate-supply curve is upward sloping.
6. What might shift the aggregate-demand curve to the
left? Use the model of aggregate demand and aggregate
supply to trace through the effects of such a shift.
7. What might shift the aggregate-supply curve to the left?
Use the model of aggregate demand and aggregate
supply to trace through the effects of such a shift.
Questions for Review
1. Why do you think that investment is more variable over
the business cycle than consumer spending? Which
category of consumer spending do you think would be
most volatile: durable goods (such as furniture and car
Problems and Applications
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 731
purchases), nondurable goods (such as food and
clothing), or services (such as haircuts and medical
care)? Why?
2. Suppose that the economy is undergoing a recession
because of a fall in aggregate demand.
a. Using an aggregate-demand/aggregate-supply
diagram, depict the current state of the economy.
b. What is happening to the unemployment rate?
c. “Capacity utilization” is a measure of how
intensively the capital stock is being used. In a
recession, is capacity utilization above or below its
long-run average? Explain.
3. Explain whether each of the following events will
increase, decrease, or have no effect on long-run
aggregate supply.
a. The United States experiences a wave of
immigration.
b. Congress raises the minimum wage to $10 per hour.
c. Intel invents a new and more powerful
computer chip.
d. Asevere hurricane damages factories along the
east coast.
4. In Figure 31-8, how does the unemployment rate at
points B and C compare to the unemployment rate
at point A? Under the sticky-wage explanation of the
short-run aggregate-supply curve, how does the real
wage at points B and C compare to the real wage at
point A?
5. Explain why the following statements are false.
a. “The aggregate-demand curve slopes downward
because it is the horizontal sum of the demand
curves for individual goods.”
b. “The long-run aggregate-supply curve is vertical
because economic forces do not affect long-run
aggregate supply.”
c. “If firms adjusted their prices every day, then the
short-run aggregate-supply curve would be
horizontal.”
d. “Whenever the economy enters a recession, its
long-run aggregate-supply curve shifts to the left.”
6. For each of the three theories for the upward slope of
the short-run aggregate-supply curve, carefully explain
the following:
a. how the economy recovers from a recession and
returns to its long-run equilibrium without any
policy intervention
b. what determines the speed of that recovery
7. Suppose the Fed expands the money supply, but
because the public expects this Fed action, it
simultaneously raises its expectation of the price level.
What will happen to output and the price level in the
short run? Compare this result to the outcome if the Fed
expanded the money supply but the public didn’t
change its expectation of the price level.
8. Suppose that the economy is currently in a recession. If
policymakers take no action, how will the economy
evolve over time? Explain in words and using an
aggregate-demand/aggregate-supply diagram.
9. Suppose workers and firms suddenly believe that
inflation will be quite high over the coming year.
Suppose also that the economy begins in long-run
equilibrium, and the aggregate-demand curve does not
shift.
a. What happens to nominal wages? What happens to
real wages?
b. Using an aggregate-demand/aggregate-supply
diagram, show the effect of the change in
expectations on both the short-run and long-run
levels of prices and output.
c. Were the expectations of high inflation accurate?
Explain.
10. Explain whether each of the following events shifts the
short-run aggregate-supply curve, the aggregate-
demand curve, both, or neither. For each event that does
shift a curve, use a diagram to illustrate the effect on the
economy.
a. Households decide to save a larger share of their
income.
b. Florida orange groves suffer a prolonged period of
below-freezing temperatures.
c. Increased job opportunities overseas cause many
people to leave the country.
11. For each of the following events, explain the short-run
and long-run effects on output and the price level,
assuming policymakers take no action.
a. The stock market declines sharply, reducing
consumers’ wealth.
b. The federal government increases spending on
national defense.
c. Atechnological improvement raises productivity.
d. Arecession overseas causes foreigners to buy fewer
U.S. goods.
12. Suppose that firms become very optimistic about future
business conditions and invest heavily in new capital
equipment.
a. Use an aggregate-demand/aggregate-supply
diagram to show the short-run effect of this
optimism on the economy. Label the new levels of
732 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
prices and real output. Explain in words why the
aggregate quantity of output supplied changes.
b. Now use the diagram from part (a) to show the
new long-run equilibrium of the economy. (For
now, assume there is no change in the long-run
aggregate-supply curve.) Explain in words why the
aggregate quantity of output demanded changes
between the short run and the long run.
c. How might the investment boom affect the long-
run aggregate-supply curve? Explain.
13. In 1939, with the U.S. economy not fully recovered from
the Great Depression, President Roosevelt proclaimed
that Thanksgiving Day would fall a week earlier than
usual so that the shopping period before Christmas
would be lengthened. Explain this decision, using the
model of aggregate demand and aggregate supply.
IN THIS CHAPTER
YOU WILL . . .
Analyze how fiscal
policy affects
interest rates and
aggregate demand
Learn the theory of
liquidity preference
as a short-run theory
of the interest rate
Analyze how
monetary policy
affects interest
rates and aggregate
demand
Discuss the debate
over whether
policymakers should
try to stabilize
the economy
Imagine that you are a member of the Federal Open Market Committee, which sets
monetary policy. You observe that the president and Congress have agreed to cut
government spending. How should the Fed respond to this change in fiscal pol-
icy? Should it expand the money supply, contract the money supply, or leave the
money supply the same?
To answer this question, you need to consider the impact of monetary and fis-
cal policy on the economy. In the preceding chapter we saw how to explain short-
run economic fluctuations using the model of aggregate demand and aggregate
supply. When the aggregate-demand curve or the aggregate-supply curve shifts,
the result is fluctuations in the economy’s overall output of goods and services and
in its overall level of prices. As we noted in the previous chapter, monetary and
THE INFLUENCE OF
MONETARY AND FISCAL POLICY
ON AGGREGATE DEMAND
733
734 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
fiscal policy can each influence aggregate demand. Thus, a change in one of these
policies can lead to short-run fluctuations in output and prices. Policymakers will
want to anticipate this effect and, perhaps, adjust the other policy in response.
In this chapter we examine in more detail how the government’s tools of mon-
etary and fiscal policy influence the position of the aggregate-demand curve. We
have previously discussed the long-run effects of these policies. In Chapters 24 and
25 we saw how fiscal policy affects saving, investment, and long-run economic
growth. In Chapters 27 and 28 we saw how the Fed controls the money supply and
how the money supply affects the price level in the long run. We now see how
these policy tools can shift the aggregate-demand curve and, in doing so, affect
short-run economic fluctuations.
As we have already learned, many factors influence aggregate demand be-
sides monetary and fiscal policy. In particular, desired spending by households
and firms determines the overall demand for goods and services. When desired
spending changes, aggregate demand shifts. If policymakers do not respond, such
shifts in aggregate demand cause short-run fluctuations in output and employ-
ment. As a result, monetary and fiscal policymakers sometimes use the policy
levers at their disposal to try to offset these shifts in aggregate demand and
thereby stabilize the economy. Here we discuss the theory behind these policy ac-
tions and some of the difficulties that arise in using this theory in practice.
HOW MONETARY POLICY
INFLUENCES AGGREGATE DEMAND
The aggregate-demand curve shows the total quantity of goods and services de-
manded in the economy for any price level. As you may recall from the preceding
chapter, the aggregate-demand curve slopes downward for three reasons:
a78 The wealth effect:Alower price level raises the real value of households’
money holdings, and higher real wealth stimulates consumer spending.
a78 The interest-rate effect:Alower price level lowers the interest rate as people try
to lend out their excess money holdings, and the lower interest rate
stimulates investment spending.
a78 The exchange-rate effect:When a lower price level lowers the interest rate,
investors move some of their funds overseas and cause the domestic
currency to depreciate relative to foreign currencies. This depreciation makes
domestic goods cheaper compared to foreign goods and, therefore,
stimulates spending on net exports.
These three effects should not be viewed as alternative theories. Instead, they oc-
cur simultaneously to increase the quantity of goods and services demanded when
the price level falls and to decrease it when the price level rises.
Although all three effects work together in explaining the downward slope of
the aggregate-demand curve, they are not of equal importance. Because money
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 735
holdings are a small part of household wealth, the wealth effect is the least impor-
tant of the three. In addition, because exports and imports represent only a small
fraction of U.S. GDP, the exchange-rate effect is not very large for the U.S. econ-
omy. (This effect is much more important for smaller countries because smaller
countries typically export and import a higher fraction of their GDP.) For the U.S.
economy, the most important reason for the downward slope of the aggregate-demand
curve is the interest-rate effect.
To understand how policy influences aggregate demand, therefore, we exam-
ine the interest-rate effect in more detail. Here we develop a theory of how the in-
terest rate is determined, called the theory of liquidity preference. After we
develop this theory, we use it to understand the downward slope of the aggregate-
demand curve and how monetary policy shifts this curve. By shedding new light
on the aggregate-demand curve, the theory of liquidity preference expands our
understanding of short-run economic fluctuations.
THE THEORY OF LIQUIDITY PREFERENCE
In his classic book, The General Theory of Employment, Interest, and Money, John
Maynard Keynes proposed the theory of liquidity preference to explain what fac-
tors determine the economy’s interest rate. The theory is, in essence, just an appli-
cation of supply and demand. According to Keynes, the interest rate adjusts to
balance the supply anddemand for money.
You may recall from Chapter 23 that economists distinguish between two in-
terest rates: The nominal interest rateis the interest rate as usually reported, and the
real interest rateis the interest rate corrected for the effects of inflation. Which in-
terest rate are we now trying to explain? The answer is both. In the analysis that
follows, we hold constant the expected rate of inflation. (This assumption is rea-
sonable for studying the economy in the short run, as we are now doing). Thus,
when the nominal interest rate rises or falls, the real interest rate that people ex-
pect to earn rises or falls as well. For the rest of this chapter, when we refer to
changes in the interest rate, you should envision the real and nominal interest
rates moving in the same direction.
Let’s now develop the theory of liquidity preference by considering the sup-
ply and demand for money and how each depends on the interest rate.
Money Supply The first piece of the theory of liquidity preference is the sup-
ply of money. As we first discussed in Chapter 27, the money supply in the U.S.
economy is controlled by the Federal Reserve. The Fed alters the money supply
primarily by changing the quantity of reserves in the banking system through the
purchase and sale of government bonds in open-market operations. When the Fed
buys government bonds, the dollars it pays for the bonds are typically deposited
in banks, and these dollars are added to bank reserves. When the Fed sells gov-
ernment bonds, the dollars it receives for the bonds are withdrawn from the bank-
ing system, and bank reserves fall. These changes in bank reserves, in turn, lead to
changes in banks’ ability to make loans and create money. In addition to these
open-market operations, the Fed can alter the money supply by changing reserve
requirements (the amount of reserves banks must hold against deposits) or the
discount rate (the interest rate at which banks can borrow reserves from the Fed).
theory of liquidity
preference
Keynes’s theory that the interest rate
adjusts to bring money supply and
money demand into balance
736 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
These details of monetary control are important for the implementation of Fed
policy, but they are not crucial in this chapter. Our goal here is to examine how
changes in the money supply affect the aggregate demand for goods and services.
For this purpose, we can ignore the details of how Fed policy is implemented and
simply assume that the Fed controls the money supply directly. In other words, the
quantity of money supplied in the economy is fixed at whatever level the Fed
decides to set it.
Because the quantity of money supplied is fixed by Fed policy, it does not de-
pend on other economic variables. In particular, it does not depend on the interest
rate. Once the Fed has made its policy decision, the quantity of money supplied is
the same, regardless of the prevailing interest rate. We represent a fixed money
supply with a vertical supply curve, as in Figure 32-1.
Money Demand The second piece of the theory of liquidity preference is the
demand for money. As a starting point for understanding money demand, recall
that any asset’s liquidityrefers to the ease with which that asset is converted into
the economy’s medium of exchange. Money is the economy’s medium of ex-
change, so it is by definition the most liquid asset available. The liquidity of money
explains the demand for it: People choose to hold money instead of other assets
that offer higher rates of return because money can be used to buy goods and ser-
vices.
Although many factors determine the quantity of money demanded, the one
emphasized by the theory of liquidity preference is the interest rate. The reason is
that the interest rate is the opportunity cost of holding money. That is, when you
hold wealth as cash in your wallet, instead of as an interest-bearing bond, you lose
the interest you could have earned. An increase in the interest rate raises the cost
of holding money and, as a result, reduces the quantity of money demanded. Ade-
crease in the interest rate reduces the cost of holding money and raises the quan-
tity demanded. Thus, as shown in Figure 32-1, the money-demand curve slopes
downward.
Quantity of
Money
Interest
Rate
Equilibrium
interest
rate
0
Money
demand
Quantity fixed
by the Fed
Money
supply
r
1
r
2
M
d
1
M
d
2
Figure 32-1
EQUILIBRIUMINTHE
MONEYMARKET. According to
the theory of liquidity preference,
the interest rate adjusts to bring
the quantity of money supplied
and the quantity of money
demanded into balance. If the
interest rate is above the
equilibrium level (such as at r
1
),
the quantity of money people
want to hold (M
d
1
) is less than the
quantity the Fed has created, and
this surplus of money puts
downward pressure on the
interest rate. Conversely, ifthe
interest rate is below the
equilibrium level (such as at r
2
),
the quantity of money people
want to hold (M
d
2
) is greater than
the quantity the Fed has created,
and this shortage of money puts
upward pressure onthe interest
rate. Thus, the forces of supply
and demand inthe market for
money push theinterest rate
toward the equilibrium interest
rate, at which people are content
holdingthe quantity of
moneythe Fed has created.
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 737
Equilibrium in the Money Market According to the theory of
liquidity preference, the interest rate adjusts to balance the supply and demand
formoney. There is one interest rate, called the equilibrium interest rate,at which
thequantity of money demanded exactly balances the quantity ofmoney sup-
plied. If the interest rate is at any other level, people will try toadjust their portfo-
lios of assets and, as a result, drive the interest rate toward the equilibrium.
For example, suppose that the interest rate is above the equilibrium level,
suchas r
1
in Figure 32-1. In this case, the quantity of money that people want
tohold, M
d
1
, is less than the quantity of money that the Fed has supplied. Those
people whoare holding the surplus of money will try to get rid of it by buy-
ing interest-bearing bonds or by depositing it in an interest-bearing bank ac-
count.Because bond issuers and banks prefer to pay lower interest rates, they
respond to this surplus of money by lowering the interest rates they offer. As the
interest rate falls, people become more willing to hold money until, at the equilib-
rium interest rate, people are happy to hold exactly the amount of money the Fed
has supplied.
Conversely, at interest rates below the equilibrium level, such as r
2
in Fig-
ure 32-1, the quantity of money that people want to hold, M
d
2
, is greater than the
quantity of money that the Fed has supplied. As a result, people try to increase
their holdings of money by reducing their holdings of bonds and other interest-
bearing assets. As people cut back on their holdings of bonds, bond issuers find
that they have to offer higher interest rates to attract buyers. Thus, the interest rate
rises and approaches the equilibrium level.
THE DOWNWARD SLOPE OF
THE AGGREGATE-DEMAND CURVE
Having seen how the theory of liquidity preference explains the economy’s equi-
librium interest rate, we now consider its implications for the aggregate demand
for goods and services. As a warm-up exercise, let’s begin by using the theory to
reexamine a topic we already understand—the interest-rate effect and the down-
ward slope of the aggregate-demand curve. In particular, suppose that the overall
level of prices in the economy rises. What happens to the interest rate that balances
the supply and demand for money, and how does that change affect the quantity
of goods and services demanded?
As we discussed in Chapter 28, the price level is one determinant of the quan-
tity of money demanded. At higher prices, more money is exchanged every time a
good or service is sold. As a result, people will choose to hold a larger quantity of
money. That is, a higher price level increases the quantity of money demanded
forany given interest rate. Thus, an increase in the price level from P
1
to P
2
shifts
themoney-demand curve to the right from MD
1
to MD
2
, as shown in panel (a) of
Figure 32-2.
Notice how this shift in money demand affects the equilibrium in the money
market. For a fixed money supply, the interest rate must rise to balance money
supply and money demand. The higher price level has increased the amount of
money people want to hold and has shifted the money demand curve to the right.
Yet the quantity of money supplied is unchanged, so the interest rate must rise
from r
1
to r
2
to discourage the additional demand.
738 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
This increase in the interest rate has ramifications not only for the money mar-
ket but also for the quantity of goods and services demanded, as shown in panel
(b). At a higher interest rate, the cost of borrowing and the return to saving are
greater. Fewer households choose to borrow to buy a new house, and those who
do buy smaller houses, so the demand for residential investment falls. Fewer firms
choose to borrow to build new factories and buy new equipment, so business in-
vestment falls. Thus, when the price level rises from P
1
to P
2
, increasing money de-
mand from MD
1
to MD
2
and raising the interest rate from r
1
to r
2
, the quantity of
goods and services demanded falls from Y
1
to Y
2
.
Quantity
of Money
Quantity fixed
by the Fed
0
Interest
Rate
r
2
r
1
Money demand at
price level P
2
, MD
2
Money demand at
price level P
1
, MD
1
Money
supply
(a) The Money Market
(b) The Aggregate-Demand Curve
3. . . . which
increases the
equilibrium
interest rate . . .
2. . . . increases the
demand for money . . .
Quantity
of Output
0
Price
Level
Aggregate
demand
P
2
Y
2
Y
1
P
1
4. . . . which in turn reduces the quantity
of goods and services demanded.
1. An
increase
in the price
level . . .
Figure 32-2
THEMONEYMARKETAND
THESLOPEOFTHE
AGGREGATE-DEMANDCURVE.
An increase in the price level
from P
1
to P
2
shifts the money-
demand curve to the right, as in
panel (a). This increase in money
demand causes the interest rate
to rise from r
1
to r
2
. Because
theinterest rate is the cost of
borrowing, the increase in the
interest rate reduces the quantity
of goods and services demanded
from Y
1
to Y
2
. This negative
relationship between the price
level and quantity demanded is
represented with a downward-
sloping aggregate-demand curve,
as in panel (b).
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 739
Hence, this analysis of the interest-rate effect can be summarized in three
steps: (1) Ahigher price level raises money demand. (2) Higher money demand
leads to a higher interest rate. (3) Ahigher interest rate reduces the quantity of
goods and services demanded.
Of course, the same logic works in reverse as well: Alower price level reduces
money demand, which leads to a lower interest rate, and this in turn increases the
quantity of goods and services demanded. The end result of this analysis is a neg-
ative relationship between the price level and the quantity of goods and services
demanded, which is illustrated with a downward-sloping aggregate-demand
curve.
At this point, we should pause
and reflect on a seemingly awk-
ward embarrassment of riches.
It might appear as if we now
have two theories for how in-
terest rates are determined.
Chapter 25 said that the inter-
est rate adjusts to balance the
supply and demand for loan-
able funds (that is, national
saving and desired invest-
ment). By contrast, we just es-
tablished here that the interest
rate adjusts to balance the supply and demand for money.
How can we reconcile these two theories?
To answer this question, we must again consider the
differences between the long-run and short-run behavior of
the economy. Three macroeconomic variables are of central
importance: the economy’s output of goods and services,
the interest rate, and the price level. According to the clas-
sical macroeconomic theory we developed in Chapters 24,
25, and 28, these variables are determined as follows:
1. Output is determined by the supplies of capital and
labor and the available production technology for
turning capital and labor into output. (We call this the
natural rate of output.)
2. For any given level of output, the interest rate adjusts
to balance the supply and demand for loanable funds.
3. The price level adjusts to balance the supply and
demand for money. Changes in the supply of money
lead to proportionate changes in the price level.
These are three of the essential propositions of classical
economic theory. Most economists believe that these
propositions do a good job of describing how the economy
works in the long run.
Yet these propositions do not hold in the short run. As
we discussed in the preceding chapter, many prices are
slow to adjust to changes in the money supply; this is re-
flected in a short-run aggregate-supply curve that is upward
sloping rather than vertical. As a result, the overall price
level cannot, by itself, balance the supply and demand for
money in the short run. This stickiness of the price level
forces the interest rate to move in order to bring the money
market into equilibrium. These changes in the interest rate,
in turn, affect the aggregate demand for goods and ser-
vices. As aggregate demand fluctuates, the economy’s out-
put of goods and services moves away from the level
determined by factor supplies and technology.
For issues concerning the short run, then, it is best to
think about the economy as follows:
1. The price level is stuck at some level (based on
previously formed expectations) and, in the short run,
is relatively unresponsive to changing economic
conditions.
2. For any given price level, the interest rate adjusts to
balance the supply and demand for money.
3. The level of output responds to the aggregate demand
for goods and services, which is in part determined by
the interest rate that balances the money market.
Notice that this precisely reverses the order of analysis
used to study the economy in the long run.
Thus, the different theories of the interest rate are use-
ful for different purposes. When thinking about the long-run
determinants of interest rates, it is best to keep in mind the
loanable-funds theory. This approach highlights the impor-
tance of an economy’s saving propensities and investment
opportunities. By contrast, when thinking about the short-
run determinants of interest rates, it is best to keep in mind
the liquidity-preference theory. This theory highlights the im-
portance of monetary policy.
FYI
Interest Rates
in the Long Run
and the
ShortRun
740 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
CHANGES IN THE MONEY SUPPLY
So far we have used the theory of liquidity preference to explain more fully how
the total quantity of goods and services demanded in the economy changes as the
price level changes. That is, we have examined movements along the downward-
sloping aggregate-demand curve. The theory also sheds light, however, on some
of the other events that alter the quantity of goods and services demanded. When-
ever the quantity of goods and services demanded changes for a given price level,
the aggregate-demand curve shifts.
One important variable that shifts the aggregate-demand curve is monetary
policy. To see how monetary policy affects the economy in the short run, suppose
that the Fed increases the money supply by buying government bonds in open-
market operations. (Why the Fed might do this will become clear later after we un-
derstand the effects of such a move.) Let’s consider how this monetary injection
influences the equilibrium interest rate for a given price level. This will tell us what
the injection does to the position of the aggregate-demand curve.
As panel (a) of Figure 32-3 shows, an increase in the money supply shifts the
money-supply curve to the right from MS
1
to MS
2
. Because the money-demand
curve has not changed, the interest rate falls from r
1
to r
2
to balance money supply
and money demand. That is, the interest rate must fall to induce people to hold the
additional money the Fed has created.
Once again, the interest rate influences the quantity of goods and services de-
manded, as shown in panel (b) of Figure 32-3. The lower interest rate reduces the
cost of borrowing and the return to saving. Households buy more and larger
houses, stimulating the demand for residential investment. Firms spend more on
new factories and new equipment, stimulating business investment. As a result,
the quantity of goods and services demanded at a given price level, P
–
, rises from
Y
1
to Y
2
. Of course, there is nothing special about P
–
:The monetary injection raises
the quantity of goods and services demanded at every price level. Thus, the entire
aggregate-demand curve shifts to the right.
To sum up: When the Fed increases the money supply, it lowers the interest rate and
increases the quantity of goods and services demanded for any given price level, shifting the
aggregate-demand curve to the right. Conversely, when the Fed contracts the money sup-
ply, it raises the interest rate and reduces the quantity of goods and services demanded for
any given price level, shifting the aggregate-demand curve to the left.
THE ROLE OF INTEREST-RATE TARGETS IN FED POLICY
How does the Federal Reserve affect the economy? Our discussion here and ear-
lier in the book has treated the money supply as the Fed’s policy instrument. When
the Fed buys government bonds in open-market operations, it increases the money
supply and expands aggregate demand. When the Fed sells government bonds in
open-market operations, it decreases the money supply and contracts aggregate
demand.
Often discussions of Fed policy treat the interest rate, rather than the money
supply, as the Fed’s policy instrument. Indeed, in recent years, the Federal Reserve
has conducted policy by setting a target for the federal funds rate—the interest rate
that banks charge one another for short-term loans. This target is reevaluated
every six weeks at meetings of the Federal Open Market Committee (FOMC). The
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 741
FOMC has chosen to set a target for the federal funds rate (rather than for the
money supply, as it has done at times in the past) in part because the money sup-
ply is hard to measure with sufficient precision.
The Fed’s decision to target an interest rate does not fundamentally alter our
analysis of monetary policy. The theory of liquidity preference illustrates an im-
portant principle: Monetary policy can be described either in terms of the money sup-
ply or in terms of the interest rate.When the FOMC sets a target for the federal funds
rate of, say, 6 percent, the Fed’s bond traders are told: “Conduct whatever open-
market operations are necessary to ensure that the equilibrium interest rate equals
MS
2
Money
supply,
MS
1
Y
1
Aggregate
demand, AD
1
Y
2
P
Money demand
at price level P
AD
2
Quantity
of Money
0
Interest
Rate
r
1
r
2
(a) The Money Market
(b) The Aggregate-Demand Curve
Quantity
of Output
0
Price
Level
3. . . . which increases the quantity of goods
and services demanded at a given price level.
2. . . . the
equilibrium
interest rate
falls . . .
1. When the Fed
increases the
money supply . . .
Figure 32-3
AMONETARYINJECTION.In
panel (a), an increase in the
money supply from MS
1
to MS
2
reduces the equilibrium interest
rate from r
1
to r
2
. Because the
interest rate is the cost of
borrowing, the fall in the interest
rate raises the quantity of goods
and services demanded at a given
price level from Y
1
to Y
2
. Thus,
inpanel (b), the aggregate-
demand curve shifts to the
rightfrom AD
1
to AD
2
.
742 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
CASE STUDY WHY THE FED WATCHES THE STOCK MARKET
(AND VICE VERSA)
“Irrational exuberance.” That was how Federal Reserve Chairman Alan
Greenspan once described the booming stock market of the late 1990s. He is
right that the market was exuberant: Average stock prices increased about four-
fold during this decade. Whether this rise was irrational, however, is more open
to debate.
Regardless of how we view the booming market, it does raise an important
question: How should the Fed respond to stock-market fluctuations? The Fed
6 percent.” In other words, when the Fed sets a target for the interest rate, it com-
mits itself to adjusting the money supply in order to make the equilibrium in the
money market hit that target.
As a result, changes in monetary policy can be viewed either in terms of a
changing target for the interest rate or in terms of a change in the money supply.
When you read in the newspaper that “the Fed has lowered the federal funds rate
from 6 to 5 percent,” you should understand that this occurs only because the
Fed’s bond traders are doing what it takes to make it happen. To lower the federal
funds rate, the Fed’s bond traders buy government bonds, and this purchase
increases the money supply and lowers the equilibrium interest rate (just as in
Figure 32-3). Similarly, when the FOMC raises the target for the federal funds rate,
the bond traders sell government bonds, and this sale decreases the money supply
and raises the equilibrium interest rate.
The lessons from all this are quite simple: Changes in monetary policy that
aim to expand aggregate demand can be described either as increasing the money
supply or as lowering the interest rate. Changes in monetary policy that aim to
contract aggregate demand can be described either as decreasing the money sup-
ply or as raising the interest rate.
“Ray Brown on bass, Elvin Jones on drums, and Alan Greenspan on interest rates.”
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 743
has no reason to care about stock prices in themselves, but it does have the job
of monitoring and responding to developments in the overall economy, and the
stock market is a piece of that puzzle. When the stock market booms, house-
holds become wealthier, and this increased wealth stimulates consumer spend-
ing. In addition, a rise in stock prices makes it more attractive for firms to sell
new shares of stock, and this stimulates investment spending. For both reasons,
a booming stock market expands the aggregate demand for goods and services.
As we discuss more fully later in the chapter, one of the Fed’s goals is to sta-
bilize aggregate demand, for greater stability in aggregate demand means
greater stability in output and the price level. To do this, the Fed might respond
to a stock-market boom by keeping the money supply lower and interest rates
higher than it otherwise would. The contractionary effects of higher interest
rates would offset the expansionary effects of higher stock prices. In fact, this
analysis does describe Fed behavior: Real interest rates were kept high by his-
torical standards during the “irrationally exuberant” stock-market boom of the
late 1990s.
The opposite occurs when the stock market falls. Spending on consumption
and investment declines, depressing aggregate demand and pushing the econ-
omy toward recession. To stabilize aggregate demand, the Fed needs to increase
the money supply and lower interest rates. And, indeed, that is what it typically
does. For example, on October 19, 1987, the stock market fell by 22.6 percent—
its biggest one-day drop in history. The Fed responded to the market crash by
NEWSPAPERS ARE FILLED WITHSTORIES
about monetary policymakers adjust-
ing the money supply and interest rates
in response to changing economic con-
ditions. Here’s an example.
European Banks, Acting in
Unison, Cut Interest Rate:
11 Nations Decide That Growth,
Not Inflation, Is Top Concern
BY EDMUND L. ANDREWS
FRANKFURT, DEC. 3—In the most coordi-
nated action yet toward European mone-
tary union, 11 nations simultaneously cut
their interest rates today to a nearly uni-
form level.
The move came a month before the
nations adopt the euro as a single cur-
rency and marked a drastic shift in policy.
As recently as two months ago, Euro-
pean central bankers had adamantly re-
sisted demands from political leaders to
lower rates because they were intent on
establishing the credibility of the euro
and the fledgling European Central Bank
in world markets.
But today, citing signs that the
global economic slowdown has begun
to chill Europe, the central banks of
the 11 euro-zone nations reduced their
benchmark interest rates by at least
three-tenths of a percent. The cuts are
intended to help bolster the European
economies by making it cheaper for
businesses and consumers to borrow.
“We are deaf to political pressure,
but we are not blind to facts and argu-
ments,” Hans Tietmeyer, the president
of Germany’s central bank, the Bundes-
bank, said. . . .
In announcing the decision, Mr. Tiet-
meyer said today that the central bank-
ers had acted in response to mounting
evidence that European growth rates
would be significantly slower next year
than they had predicted as recently as
last summer.
SOURCE: The New York Times, December 4, 1998,
p.A1.
IN THE NEWS
European Central Bankers
Expand Aggregate Demand
744 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
QUICK QUIZ: Use the theory of liquidity preference to explain how a de
crease in the money supply affects the equilibrium interest rate. How does this
change in monetary policy affect the aggregate-demand curve?
HOW FISCAL POLICY
INFLUENCES AGGREGATE DEMAND
The government can influence the behavior of the economy not only with mone-
tary policy but also with fiscal policy. Fiscal policy refers to the government’s
choices regarding the overall level of government purchases or taxes. Earlier in the
book we examined how fiscal policy influences saving, investment, and growth in
the long run. In the short run, however, the primary effect of fiscal policy is on the
aggregate demand for goods and services.
CHANGES IN GOVERNMENT PURCHASES
When policymakers change the money supply or the level of taxes, they shift the
aggregate-demand curve by influencing the spending decisions of firms or house-
holds. By contrast, when the government alters its own purchases of goods and
services, it shifts the aggregate-demand curve directly.
Suppose, for instance, that the U.S. Department of Defense places a $20 billion
order for new fighter planes with Boeing, the large aircraft manufacturer. This or-
der raises the demand for the output produced by Boeing, which induces the com-
pany to hire more workers and increase production. Because Boeing is part of the
economy, the increase in the demand for Boeing planes means an increase in the
total quantity of goods and services demanded at each price level. As a result, the
aggregate-demand curve shifts to the right.
By how much does this $20 billion order from the government shift the
aggregate-demand curve? At first, one might guess that the aggregate-demand
curve shifts to the right by exactly $20 billion. It turns out, however, that this is not
increasing the money supply and lowering interest rates. The federal funds rate
fell from 7.7 percent at the beginning of October to 6.6 percent at the end of the
month. In part because of the Fed’s quick action, the economy avoided a reces-
sion.
While the Fed keeps an eye on the stock market, stock-market participants
also keep an eye on the Fed. Because the Fed can influence interest rates and
economic activity, it can alter the value of stocks. For example, when the Fed
raises interest rates by reducing the money supply, it makes owning stocks less
attractive for two reasons. First, a higher interest rate means that bonds, the
alternative to stocks, are earning a higher return. Second, the Fed’s tightening of
monetary policy risks pushing the economy into a recession, which reduces
profits. As a result, stock prices often fall when the Fed raises interest rates.
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 745
right. There are two macroeconomic effects that make the size of the shift in ag-
gregate demand differ from the change in government purchases. The first—the
multiplier effect—suggests that the shift in aggregate demand could be largerthan
$20 billion. The second—the crowding-out effect—suggests that the shift in aggre-
gate demand could be smallerthan $20 billion. We now discuss each of these effects
in turn.
THE MULTIPLIER EFFECT
When the government buys $20 billion of goods from Boeing, that purchase has
repercussions. The immediate impact of the higher demand from the government
is to raise employment and profits at Boeing. Then, as the workers see higher earn-
ings and the firm owners see higher profits, they respond to this increase in in-
come by raising their own spending on consumer goods. As a result, the
government purchase from Boeing raises the demand for the products of many
other firms in the economy. Because each dollar spent by the government can raise
the aggregate demand for goods and services by more than a dollar, government
purchases are said to have a multiplier effecton aggregate demand.
This multiplier effect continues even after this first round. When consumer
spending rises, the firms that produce these consumer goods hire more people and
experience higher profits. Higher earnings and profits stimulate consumer spend-
ing once again, and so on. Thus, there is positive feedback as higher demand leads
to higher income, which in turn leads to even higher demand. Once all these ef-
fects are added together, the total impact on the quantity of goods and services
demanded can be much larger than the initial impulse from higher government
spending.
Figure 32-4 illustrates the multiplier effect. The increase in government pur-
chases of $20 billion initially shifts the aggregate-demand curve to the right from
AD
1
to AD
2
by exactly $20 billion. But when consumers respond by increasing
their spending, the aggregate-demand curve shifts still further to AD
3
.
This multiplier effect arising from the response of consumer spending can be
strengthened by the response of investment to higher levels of demand. For in-
stance, Boeing might respond to the higher demand for planes by deciding to buy
more equipment or build another plant. In this case, higher government demand
spurs higher demand for investment goods. This positive feedback from demand
to investment is sometimes called the investment accelerator.
A FORMULA FOR THE SPENDING MULTIPLIER
Alittle high school algebra permits us to derive a formula for the size of the mul-
tiplier effect that arises from consumer spending. An important number in this for-
mula is the marginal propensity to consume(MPC)—the fraction of extra income that
a household consumes rather than saves. For example, suppose that the marginal
propensity to consume is 3/4. This means that for every extra dollar that a house-
hold earns, the household spends $0.75 (3/4 of the dollar) and saves $0.25. With an
MPCof 3/4, when the workers and owners of Boeing earn $20 billion from the
government contract, they increase their consumer spending by 3/4H11003 $20 billion,
or $15 billion.
multiplier effect
the additional shifts in aggregate
demand that result when
expansionary fiscal policy
increasesincome and thereby
increases consumer spending
746 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
To gauge the impact on aggregate demand of a change in government pur-
chases, we follow the effects step-by-step. The process begins when the govern-
ment spends $20 billion, which implies that national income (earnings and profits)
also rises by this amount. This increase in income in turn raises consumer spend-
ing by MPC H11003 $20 billion, which in turn raises the income for the workers and
owners of the firms that produce the consumption goods. This second increase in
income again raises consumer spending, this time by MPCH11003 (MPCH11003 $20 billion).
These feedback effects go on and on.
To find the total impact on the demand for goods and services, we add up all
these effects:
Change in government purchasesH11005 $20 billion
First change in consumption H11005 MPC H11003$20 billion
Second change in consumption H11005MPC
2
H11003$20 billion
Third change in consumption H11005MPC
3
H11003$20 billion
??
Total change in demand H11005
(1 H11001MPCH11001MPC
2
H11001MPC
3
H11001
· · ·
)H11003$20 billion.
Here, “. . .” represents an infinite number of similar terms. Thus, we can write the
multiplier as follows:
Quantity of
Output
Price
Level
0
Aggregate demand, AD
1
$20 billion
AD
2
AD
3
1. An increase in government purchases
of $20 billion initially increases aggregate
demand by $20 billion . . .
2. . . . but the multiplier
effect can amplify the
shift in aggregate
demand.
Figure 32-4
THEMULTIPLIEREFFECT.An
increase in government
purchases of $20 billion can
shiftthe aggregate-demand
curveto the right by more than
$20 billion. This multiplier
effectarises because increases
inaggregate income
stimulateadditional
spendingbyconsumers.
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 747
Multiplier H110051 H11001MPCH11001MPC
2
H11001MPC
3
H11001
· · · ·
This multiplier tells us the demand for goods and services that each dollar of gov-
ernment purchases generates.
To simplify this equation for the multiplier, recall from math class that this ex-
pression is an infinite geometric series. For xbetween H110021 and H110011,
1 H11001xH11001x
2
H11001x
3
H11001
· · ·
H110051/(1H11002 x).
In our case, xH11005MPC.Thus,
Multiplier H110051/(1H11002 MPC).
For example, if MPCis 3/4, the multiplier is 1/(1H11002 3/4), which is 4. In this case,
the $20 billion of government spending generates $80 billion of demand for goods
and services.
This formula for the multiplier shows an important conclusion: The size of the
multiplier depends on the marginal propensity to consume. Whereas an MPCof
3/4 leads to a multiplier of 4, an MPCof 1/2 leads to a multiplier of only 2. Thus,
a larger MPCmeans a larger multiplier. To see why this is true, remember that the
multiplier arises because higher income induces greater spending on consump-
tion. The larger the MPCis, the greater is this induced effect on consumption, and
the larger is the multiplier.
OTHER APPLICATIONS OF THE MULTIPLIER EFFECT
Because of the multiplier effect, a dollar of government purchases can generate
more than a dollar of aggregate demand. The logic of the multiplier effect, how-
ever, is not restricted to changes in government purchases. Instead, it applies to
any event that alters spending on any component of GDP—consumption, invest-
ment, government purchases, or net exports.
For example, suppose that a recession overseas reduces the demand for U.S.
net exports by $10 billion. This reduced spending on U.S. goods and services de-
presses U.S. national income, which reduces spending by U.S. consumers. If the
marginal propensity to consume is 3/4 and the multiplier is 4, then the $10 billion
fall in net exports means a $40 billion contraction in aggregate demand.
As another example, suppose that a stock-market boom increases households’
wealth and stimulates their spending on goods and services by $20 billion. This ex-
tra consumer spending increases national income, which in turn generates even
more consumer spending. If the marginal propensity to consume is 3/4 and the
multiplier is 4, then the initial impulse of $20 billion in consumer spending trans-
lates into an $80 billion increase in aggregate demand.
The multiplier is an important concept in macroeconomics because it shows
how the economy can amplify the impact of changes in spending. Asmall initial
change in consumption, investment, government purchases, or net exports can
end up having a large effect on aggregate demand and, therefore, the economy’s
production of goods and services.
748 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
THE CROWDING-OUT EFFECT
The multiplier effect seems to suggest that when the government buys $20 billion
of planes from Boeing, the resulting expansion in aggregate demand is necessarily
larger than $20 billion. Yet another effect is working in the opposite direction.
While an increase in government purchases stimulates the aggregate demand for
goods and services, it also causes the interest rate to rise, and a higher interest rate
reduces investment spending and chokes off aggregate demand. The reduction in
aggregate demand that results when a fiscal expansion raises the interest rate is
called the crowding-out effect.
To see why crowding out occurs, let’s consider what happens in the money
market when the government buys planes from Boeing. As we have discussed,
this increase in demand raises the incomes of the workers and owners of this firm
(and, because of the multiplier effect, of other firms as well). As incomes rise,
households plan to buy more goods and services and, as a result, choose to hold
more of their wealth in liquid form. That is, the increase in income caused by the
fiscal expansion raises the demand for money.
The effect of the increase in money demand is shown in panel (a) of Fig-
ure 32-5. Because the Fed has not changed the money supply, the vertical supply
curve remains the same. When the higher level of income shifts the money-
demand curve to the right from MD
1
to MD
2
, the interest rate must rise from r
1
to
r
2
to keep supply and demand in balance.
The increase in the interest rate, in turn, reduces the quantity of goods and ser-
vices demanded. In particular, because borrowing is more expensive, the demand
for residential and business investment goods declines. That is, as the increase in
government purchases increases the demand for goods and services, it may also
crowd out investment. This crowding-out effect partially offsets the impact of gov-
ernment purchases on aggregate demand, as illustrated in panel (b) of Figure 32-5.
The initial impact of the increase in government purchases is to shift the aggregate-
demand curve from AD
1
to AD
2
, but once crowding out takes place, the aggregate-
demand curve drops back to AD
3
.
To sum up: When the government increases its purchases by $20 billion, the aggre-
gate demand for goods and services could rise by more or less than $20 billion, depending
on whether the multiplier effect or the crowding-out effect is larger.
CHANGES IN TAXES
The other important instrument of fiscal policy, besides the level of government
purchases, is the level of taxation. When the government cuts personal income
taxes, for instance, it increases households’ take-home pay. Households will save
some of this additional income, but they will also spend some of it on consumer
goods. Because it increases consumer spending, the tax cut shifts the aggregate-
demand curve to the right. Similarly, a tax increase depresses consumer spending
and shifts the aggregate-demand curve to the left.
The size of the shift in aggregate demand resulting from a tax change is also af-
fected by the multiplier and crowding-out effects. When the government cuts taxes
and stimulates consumer spending, earnings and profits rise, which further stim-
ulates consumer spending. This is the multiplier effect. At the same time, higher
income leads to higher money demand, which tends to raise interest rates. Higher
crowding-out effect
the offset in aggregate demand that
results when expansionary fiscal
policy raises the interest rate and
thereby reduces investment spending
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 749
interest rates make borrowing more costly, which reduces investment spending.
This is the crowding-out effect. Depending on the size of the multiplier and
crowding-out effects, the shift in aggregate demand could be larger or smaller than
the tax change that causes it.
In addition to the multiplier and crowding-out effects, there is another impor-
tant determinant of the size of the shift in aggregate demand that results from a tax
change: households’ perceptions about whether the tax change is permanent or
temporary. For example, suppose that the government announces a tax cut of
$1,000 per household. In deciding how much of this $1,000 to spend, households
must ask themselves how long this extra income will last. If households expect the
Quantity
of Money
Quantity fixed
by the Fed
0
Interest
Rate
r
2
r
1
Money demand, MD
1
Money
supply
(a) The Money Market
3. . . . which
increases
the
equilibrium
interest
rate . . .
2. . . . the increase in
spending increases
money demand . . .
MD
2
Quantity
of Output
0
Price
Level
Aggregate demand, AD
1
(b) The Shift in Aggregate Demand
4. . . . which in turn
partly offsets the
initial increase in
aggregate demand.
AD
2
AD
3
$20 billion
1. When an
increase in
government
purchases
increases
aggregate
demand . . .
Figure 32-5
THECROWDING-OUTEFFECT.
Panel (a) shows the money
market. When the government
increases its purchases of goods
and services, the resulting
increase in income raises the
demand for money from MD
1
toMD
2
, and this causes the
equilibrium interest rate to rise
from r
1
to r
2
. Panel (b) shows the
effects on aggregate demand.
Theinitial impact of the increase
in government purchases shifts
the aggregate-demand curve
from AD
1
to AD
2
. Yet, because
theinterest rate is the cost of
borrowing, the increase in the
interest rate tends to reduce
thequantity of goods and
services demanded, particularly
for investment goods. This
crowding out of investment
partially offsets the impact of
thefiscal expansion on
aggregatedemand. In the end,
the aggregate-demand curve
shifts only to AD
3
.
750 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
tax cut to be permanent, they will view it as adding substantially to their financial
resources and, therefore, increase their spending by a large amount. In this case,
the tax cut will have a large impact on aggregate demand. By contrast, if house-
holds expect the tax change to be temporary, they will view it as adding only
slightly to their financial resources and, therefore, will increase their spending by
only a small amount. In this case, the tax cut will have a small impact on aggregate
demand.
An extreme example of a temporary tax cut was the one announced in 1992. In
that year, President George Bush faced a lingering recession and an upcoming re-
election campaign. He responded to these circumstances by announcing a reduc-
tion in the amount of income tax that the federal government was withholding
from workers’ paychecks. Because legislated income tax rates did not change,
however, every dollar of reduced withholding in 1992 meant an extra dollar of
taxes due on April 15, 1993, when income tax returns for 1992 were to be filed.
Thus, Bush’s “tax cut” actually represented only a short-term loan from the gov-
ernment. Not surprisingly, the impact of the policy on consumer spending and ag-
gregate demand was relatively small.
QUICK QUIZ: Suppose that the government reduces spending on highway
construction by $10 billion. Which way does the aggregate-demand curve
shift? Explain why the shift might be larger than $10 billion. Explain why
theshift might be smaller than $10 billion.
INTHE1990S, JAPANEXPERIENCEDALONG
and deep recession. As the decade was
coming to a close, it looked like an end
might be in sight, in part because the
government was using fiscal policy to
expand aggregate demand.
The Land of the Rising Outlook:
Public Spending May Have
Reversed Japan’s Downturn
BY SHERYL WUDUNN
NAKANOJOMACHI, JAPAN—Bulldozers and
tall cranes are popping up around the
country like bamboo shoots after a
spring rain, and this is raising hopes that
Japan may finally be close to lifting itself
out of recession.
No other country has ever poured
as much money—more than $830 billion
the last 12 months alone—into eco-
nomic revival as has Japan, and much of
that money is now sloshing around the
country and creating a noticeable impact.
Here in this village in central Japan, as in
much of the country, construction crews
are busy again, small companies are get-
ting loans again, and some people are
feeling a tad more confident.
Japanese leaders have traditionally
funneled money into brick-and-mortar
projects to stimulate the economy, so
the signs of life these days are inter-
preted by most experts as just a tempo-
rary comeback, not a self-sustaining
recovery. There have been many false
starts the last eight years, but the econ-
omy has always sunk back, this time
into the deepest recession since World
War II.
To the pessimists Japan is like a ve-
hicle being towed away along the road
by all that deficit spending; they doubt its
engine will start without an overhaul.
Whatever the reasons for the move-
ment, whatever the concerns for the fu-
ture, though, the passengers throughout
Japan seem relieved that at least the ve-
hicle may be going forward again.
SOURCE:The New York Times,March 11, 1999, p. C1.
IN THE NEWS
Japan Tries a
Fiscal Stimulus
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 751
USING POLICY TO STABILIZE THE ECONOMY
We have seen how monetary and fiscal policy can affect the economy’s aggregate
demand for goods and services. These theoretical insights raise some important
policy questions: Should policymakers use these instruments to control aggregate
demand and stabilize the economy? If so, when? If not, why not?
THE CASE FOR ACTIVE STABILIZATION POLICY
Let’s return to the question that began this chapter: When the president and Con-
gress cut government spending, how should the Federal Reserve respond? As
we have seen, government spending is one determinant of the position of the
aggregate-demand curve. When the government cuts spending, aggregate demand
will fall, which will depress production and employment in the short run. If the
Federal Reserve wants to prevent this adverse effect of the fiscal policy, it can act
to expand aggregate demand by increasing the money supply. Amonetary expan-
sion would reduce interest rates, stimulate investment spending, and expand ag-
gregate demand. If monetary policy responds appropriately, the combined
changes in monetary and fiscal policy could leave the aggregate demand for goods
and services unaffected.
This analysis is exactly the sort followed by members of the Federal Open
Market Committee. They know that monetary policy is an important determinant
So far our discussion of fis-
cal policy has stressed how
changes in government pur-
chases and changes in taxes in-
fluence the quantity of goods
and services demanded. Most
economists believe that the
short-run macroeconomic ef-
fects of fiscal policy work
primarily through aggregate
demand. Yet fiscal policy can
potentially also influence the
quantity of goods and ser-
vicessupplied.
For instance, consider the effects of tax changes on
aggregate supply. One of the Ten Principles of Economics in
Chapter 1 is that people respond to incentives. When gov-
ernment policymakers cut tax rates, workers get to keep
more of each dollar they earn, so they have a greater incen-
tive to work and produce goods and services. If they
respond to this incentive, the quantity of goods and ser-
vices supplied will be greater at each price level, and the
aggregate-supply curve will shift to the right. Some econo-
mists, called supply-siders, have argued that the influence
of tax cuts on aggregate supply is very large. Indeed, as we
discussed in Chapter 8, some supply-siders claim the influ-
ence is so large that a cut in tax rates will actually increase
tax revenue by increasing worker effort. Most economists,
however, believe that the supply-side effects of tax cuts are
much smaller.
Like changes in taxes, changes in government pur-
chases can also potentially affect aggregate supply.
Suppose, for instance, that the government increases ex-
penditure on a form of government-provided capital, such as
roads. Roads are used by private businesses to make de-
liveries to their customers; an increase in the quantity of
roads increases these businesses’ productivity. Hence,
when the government spends more on roads, it increases
the quantity of goods and services supplied at any given
price level and, thus, shifts the aggregate-supply curve to
the right. This effect on aggregate supply is probably more
important in the long run than in the short run, however, be-
cause it would take some time for the government to build
the new roads and put them into use.
FYI
How Fiscal
Policy Might
Affect
Aggregate
Supply
752 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
of aggregate demand. They also know that there are other important determinants
as well, including fiscal policy set by the president and Congress. As a result,
theFed’s Open Market Committee watches the debates over fiscal policy with a
keeneye.
This response of monetary policy to the change in fiscal policy is an example
of a more general phenomenon: the use of policy instruments to stabilize aggre-
gate demand and, as a result, production and employment. Economic stabilization
has been an explicit goal of U.S. policy since the Employment Act of 1946. This act
states that “it is the continuing policy and responsibility of the federal government
to . . . promote full employment and production.” In essence, the government has
chosen to hold itself accountable for short-run macroeconomic performance.
The Employment Act has two implications. The first, more modest, implica-
tion is that the government should avoid being a cause of economic fluctuations.
Thus, most economists advise against large and sudden changes in monetary and
fiscal policy, for such changes are likely to cause fluctuations in aggregate demand.
Moreover, when large changes do occur, it is important that monetary and fiscal
policymakers be aware of and respond to the other’s actions.
The second, more ambitious, implication of the Employment Act is that the
government should respond to changes in the private economy in order to stabi-
lize aggregate demand. The act was passed not long after the publication of John
Maynard Keynes’s The General Theory of Employment, Interest, and Money.As we
discussed in the preceding chapter, The General Theoryhas been one the most in-
fluential books ever written about economics. In it, Keynes emphasized the key
role of aggregate demand in explaining short-run economic fluctuations. Keynes
claimed that the government should actively stimulate aggregate demand when
aggregate demand appeared insufficient to maintain production at its full-
employment level.
Keynes (and his many followers) argued that aggregate demand fluctuates be-
cause of largely irrational waves of pessimism and optimism. He used the term
“animal spirits” to refer to these arbitrary changes in attitude. When pessimism
reigns, households reduce consumption spending, and firms reduce investment
spending. The result is reduced aggregate demand, lower production, and higher
unemployment. Conversely, when optimism reigns, households and firms in-
crease spending. The result is higher aggregate demand, higher production, and
inflationary pressure. Notice that these changes in attitude are, to some extent, self-
fulfilling.
In principle, the government can adjust its monetary and fiscal policy in re-
sponse to these waves of optimism and pessimism and, thereby, stabilize the econ-
omy. For example, when people are excessively pessimistic, the Fed can expand
the money supply to lower interest rates and expand aggregate demand. When
they are excessively optimistic, it can contract the money supply to raise interest
rates and dampen aggregate demand. Former Fed Chairman William McChesney
Martin described this view of monetary policy very simply: “The Federal Re-
serve’s job is to take away the punch bowl just as the party gets going.”
CASE STUDY KEYNESIANS IN THE WHITE HOUSE
When a reporter asked President John F. Kennedy in 1961 why he advocated a
tax cut, Kennedy replied, “To stimulate the economy. Don’t you remember your
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 753
Economics 101?” Kennedy’s policy was, in fact, based on the analysis of fiscal
policy we have developed in this chapter. His goal was to enact a tax cut, which
would raise consumer spending, expand aggregate demand, and increase the
economy’s production and employment.
In choosing this policy, Kennedy was relying on his team of economic ad-
visers. This team included such prominent economists as James Tobin and
Robert Solow, each of whom would later win a Nobel Prize for his contributions
to economics. As students in the 1940s, these economists had closely studied
John Maynard Keynes’s General Theory,which then was only a few years old.
When the Kennedy advisers proposed cutting taxes, they were putting
Keynes’s ideas into action.
Although tax changes can have a potent influence on aggregate demand,
they have other effects as well. In particular, by changing the incentives that
people face, taxes can alter the aggregate supply of goods and services. Part of
the Kennedy proposal was an investment tax credit, which gives a tax break to
firms that invest in new capital. Higher investment would not only stimulate
aggregate demand immediately but would also increase the economy’s pro-
ductive capacity over time. Thus, the short-run goal of increasing production
through higher aggregate demand was coupled with a long-run goal of in-
creasing production through higher aggregate supply. And, indeed, when the
tax cut Kennedy proposed was finally enacted in 1964, it helped usher in a pe-
riod of robust economic growth.
Since the 1964 tax cut, policymakers have from time to time proposed using
fiscal policy as a tool for controlling aggregate demand. As we discussed earlier,
President Bush attempted to speed recovery from a recession by reducing tax
withholding. Similarly, when President Clinton moved into the Oval Office in
1993, one of his first proposals was a “stimulus package” of increased govern-
ment spending. His announced goal was to help the U.S. economy recover more
quickly from the recession it had just experienced. In the end, however, the
stimulus package was defeated. Many in Congress (and many economists) con-
sidered the Clinton proposal too late to be of much help, for the economy was
already recovering as Clinton took office. Moreover, deficit reduction to en-
courage long-run economic growth was considered a higher priority than a
short-run expansion in aggregate demand.
JOHNMAYNARDKEYNES
AVISIONARYANDTWODISCIPLES
JOHNF. KENNEDY BILLCLINTON
754 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
THE CASE AGAINST ACTIVE STABILIZATION POLICY
Some economists argue that the government should avoid active use of monetary
and fiscal policy to try to stabilize the economy. They claim that these policy in-
struments should be set to achieve long-run goals, such as rapid economic growth
and low inflation, and that the economy should be left to deal with short-run fluc-
tuations on its own. Although these economists may admit that monetary and fis-
cal policy can stabilize the economy in theory, they doubt whether it can do so in
practice.
The primary argument against active monetary and fiscal policy is that these
policies affect the economy with a substantial lag. As we have seen, monetary pol-
icy works by changing interest rates, which in turn influence investment spending.
But many firms make investment plans far in advance. Thus, most economists be-
lieve that it takes at least six months for changes in monetary policy to have much
effect on output and employment. Moreover, once these effects occur, they can last
for several years. Critics of stabilization policy argue that because of this lag, the
Fed should not try to fine-tune the economy. They claim that the Fed often reacts
too late to changing economic conditions and, as a result, ends up being a cause of
rather than a cure for economic fluctuations. These critics advocate a passive mon-
etary policy, such as slow and steady growth in the money supply.
Fiscal policy also works with a lag, but unlike the lag in monetary policy, the
lag in fiscal policy is largely attributable to the political process. In the United
States, most changes in government spending and taxes must go through congres-
sional committees in both the House and the Senate, be passed by both legislative
bodies, and then be signed by the president. Completing this process can take
months and, in some cases, years. By the time the change in fiscal policy is passed
and ready to implement, the condition of the economy may well have changed.
These lags in monetary and fiscal policy are a problem in part because
economic forecasting is so imprecise. If forecasters could accurately predict the
condition of the economy a year in advance, then monetary and fiscal policymak-
ers could look ahead when making policy decisions. In this case, policymakers
could stabilize the economy, despite the lags they face. In practice, however, major
recessions and depressions arrive without much advance warning. The best
policymakers can do at any time is to respond to economic changes as they
occur.
AUTOMATIC STABILIZERS
All economists—both advocates and critics of stabilization policy—agree that the
lags in implementation render policy less useful as a tool for short-run stabiliza-
tion. The economy would be more stable, therefore, if policymakers could find a
way to avoid some of these lags. In fact, they have. Automatic stabilizers are
changes in fiscal policy that stimulate aggregate demand when the economy goes
into a recession without policymakers having to take any deliberate action.
The most important automatic stabilizer is the tax system. When the economy
goes into a recession, the amount of taxes collected by the government falls auto-
matically because almost all taxes are closely tied to economic activity. The per-
sonal income tax depends on households’ incomes, the payroll tax depends on
workers’ earnings, and the corporate income tax depends on firms’ profits. Be-
automatic stabilizers
changes in fiscal policy that
stimulate aggregate demand
whenthe economy goes into a
recession without policymakers
having to take any deliberate action
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 755
cause incomes, earnings, and profits all fall in a recession, the government’s tax
revenue falls as well. This automatic tax cut stimulates aggregate demand and,
thereby, reduces the magnitude of economic fluctuations.
Government spending also acts as an automatic stabilizer. In particular, when
the economy goes into a recession and workers are laid off, more people apply for
unemployment insurance benefits, welfare benefits, and other forms of income
support. This automatic increase in government spending stimulates aggregate
demand at exactly the time when aggregate demand is insufficient to maintain full
employment. Indeed, when the unemployment insurance system was first enacted
in the 1930s, economists who advocated this policy did so in part because of its
power as an automatic stabilizer.
The automatic stabilizers in the U.S. economy are not sufficiently strong to
prevent recessions completely. Nonetheless, without these automatic stabilizers,
output and employment would probably be more volatile than they are. For this
reason, many economists oppose a constitutional amendment that would require
the federal government always to run a balanced budget, as some politicians have
proposed. When the economy goes into a recession, taxes fall, government spend-
ing rises, and the government’s budget moves toward deficit. If the government
faced a strict balanced-budget rule, it would be forced to look for ways to raise
taxes or cut spending in a recession. In other words, a strict balanced-budget rule
would eliminate the automatic stabilizers inherent in our current system of taxes
and government spending.
QUICK QUIZ: Suppose a wave of negative “animal spirits” overruns the
economy, and people become pessimistic about the future. What happens
toaggregate demand? If the Fed wants to stabilize aggregate demand, how
should it alter the money supply? If it does this, what happens to the interest
rate? Why might the Fed choose not to respond in this way?
CONCLUSION
Before policymakers make any change in policy, they need to consider all the ef-
fects of their decisions. Earlier in the book we examined classical models of the
economy, which describe the long-run effects of monetary and fiscal policy. There
we saw how fiscal policy influences saving, investment, the trade balance, and
long-run growth, and how monetary policy influences the price level and the in-
flation rate.
In this chapter we examined the short-run effects of monetary and fiscal pol-
icy. We saw how these policy instruments can change the aggregate demand for
goods and services and, thereby, alter the economy’s production and employment
in the short run. When Congress reduces government spending in order to balance
the budget, it needs to consider both the long-run effects on saving and growth
and the short-run effects on aggregate demand and employment. When the Fed
reduces the growth rate of the money supply, it must take into account the long-
run effect on inflation as well as the short-run effect on production. In the next
chapter we discuss the transition between the short run and the long run more
756 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
fully, and we see that policymakers often face a tradeoff between long-run and
short-run goals.
CLOSELY RELATED TO THE QUESTION OF
whether monetary and fiscal policy
should be used to stabilize the econ-
omy is the question of who should set
monetary and fiscal policy. In the
United States, monetary policy is made
by a central bank that operates free of
mostpolitical pressures. As this opin-
ion column discusses, some members
ofCongress want to reduce the Fed’s
independence.
Don’t Tread on the Fed
BY MARTIN AND KATHLEEN FELDSTEIN
We and most other economists give very
high marks to the Federal Reserve for the
way it has managed monetary policy in
recent years. Fed officials have very suc-
cessfully carried out their responsibility to
reduce the rate of inflation and have done
so without interrupting the economic ex-
pansion that began back in 1991.
Despite that excellent record, there
are influential figures in Congress who
are planning to introduce legislation that
would weaken the Federal Reserve’s abil-
ity to continue to make sound monetary
policy decisions. That legislation would
give Congress and the president more
influence over Federal Reserve policy,
making monetary policy responsive to
political pressures. If that happened, the
risk of higher inflation and of increased
cyclical volatility would become much
greater.
To achieve the good economic per-
formance of the past five years, the Fed
had to raise interest rates several times
in 1994 and, more recently, has had to
avoid political calls for easier money
to speed up the pace of economic activ-
ity. Looking ahead, the economy may
slow in the next year. If it does, you can
expect to hear members of Congress
and maybe the White House urging the
Fed to lower interest rates in order
to maintain economic momentum. But
we’re betting that, even if the economy
does slow, the inflationary pressures are
building and will force the Fed to raise in-
terest rates by early in the new year.
If the Fed does raise interest rates
in order to prevent a rise in inflation, the
increased political pressure on the Fed
may find popular support. There is always
public resistance to higher interest rates,
which make borrowing more expensive
for both businesses and homeowners.
Moreover, the purpose of higher interest
rates would be to slow the growth of
spending in order to prevent an overheat-
ing of demand. That too will meet popular
opposition. It is, in part, because good
economic policy is not always popular in
the short run that it is important for the
IN THE NEWS
The Independence of the
Federal Reserve
a78 In developing a theory of short-run economic
fluctuations, Keynes proposed the theory of liquidity
preference to explain the determinants of the interest
rate. According to this theory, the interest rate adjusts to
balance the supply and demand for money.
a78 An increase in the price level raises money demand and
increases the interest rate that brings the money market
into equilibrium. Because the interest rate represents
thecost of borrowing, a higher interest rate reduces
investment and, thereby, the quantity of goods and
services demanded. The downward-sloping aggregate-
demand curve expresses this negative relationship
between the price level and the quantity demanded.
a78 Policymakers can influence aggregate demand with
monetary policy. An increase in the money supply
reduces the equilibrium interest rate for any given
pricelevel. Because a lower interest rate stimulates
investment spending, the aggregate-demand curve
Summary
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 757
Fed to be sheltered from short-run po-
litical pressures.
The Fed is an independent agency
that reports to Congress but doesn’t
take orders from anyone. Monetary pol-
icy and short-term interest rates are
determined by the Federal Open Market
Committee (the FOMC), which consists
of the 7 governors of the Fed plus the 12
presidents of the regional Federal Re-
serve Banks. The regional presidents
vote on an alternating basis but all partic-
ipate in the deliberations.
A key to the independence of the
Fed’s actions lies in the manner that ap-
pointments are made within the system.
Although the 7 Federal Reserve gover-
nors are appointed by the president and
confirmed by the Senate, each of the 12
Federal Reserve presidents is selected
by the local board of a regional Federal
Reserve Bank rather than being respon-
sive to Washington. These regional pres-
idents often serve for many years.
Frequently they are long-term employees
of the Federal Reserve system who have
risen through the ranks. And many are
professional economists with expertise in
monetary economics. But whatever their
backgrounds, they are not political ap-
pointees or friends of elected politicians.
Their allegiance is to the goal of sound
monetary policy, including both macro-
economic performance and supervision
of the banking system.
The latest challenge to Fed indepen-
dence would be to deny these Federal
Reserve presidents the power to vote on
monetary policy. This bad idea, explicitly
proposed by Senator Paul Sarbanes, a
powerful Democrat on the Senate Bank-
ing Committee, would mean shifting all of
the authority to the 7 governors. Be-
cause at least one governor’s term ends
every two years, a president who spends
eight years in the White House would
beable to appoint a majority of the Board
of Governors and could thus control
monetary policy. An alternative bad
idea, proposed by Representative Henry
Gonzalez, a key Democrat on the House
Banking Committee, would take away
the independence of the Fed by hav-
ing the regional Fed presidents ap-
pointedby the president subject to Sen-
ate confirmation.
Either approach would inevitably
mean more politicalization of Federal
Reserve policy. In an economy that is
starting to overheat, the temptation
would be to resist raising interest rates
and to risk an acceleration of inflation. In
the long run, that would mean volatile in-
terest rates and less stability in the over-
all economy.
Ironically, such a move toward cut-
ting the independence of the Federal
Reserve is just counter to developments
in other countries. Experience around the
world has confirmed that the indepen-
dence of central banks such as our Fed
is the key to sound monetary policy.
It would be a serious mistake for the
United States to move in the opposite
direction.
SOURCE:The Boston Globe,November 12, 1996,
p.D4.
shifts to the right. Conversely, a decrease in the money
supply raises the equilibrium interest rate for any
givenprice level and shifts the aggregate-demand
curveto the left.
a78 Policymakers can also influence aggregate demand with
fiscal policy. An increase in government purchases or
acut in taxes shifts the aggregate-demand curve to
theright. Adecrease in government purchases or an
increase in taxes shifts the aggregate-demand curve
tothe left.
a78 When the government alters spending or taxes, the
resulting shift in aggregate demand can be larger or
smaller than the fiscal change. The multiplier effect
tends to amplify the effects of fiscal policy on aggregate
demand. The crowding-out effect tends to dampen the
effects of fiscal policy on aggregate demand.
a78 Because monetary and fiscal policy can influence
aggregate demand, the government sometimes uses
these policy instruments in an attempt to stabilize the
economy. Economists disagree about how active the
government should be in this effort. According to
advocates of active stabilization policy, changes in
attitudes by households and firms shift aggregate
demand; if the government does not respond, the result
is undesirable and unnecessary fluctuations in output
and employment. According to critics of active
stabilization policy, monetary and fiscal policy work
with such long lags that attempts at stabilizing the
economy often end up being destabilizing.
758 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
theory of liquidity preference,
p. 735
multiplier effect, p. 745
crowding-out effect, p. 748
automatic stabilizers, p. 754
Key Concepts
1. What is the theory of liquidity preference? How does it
help explain the downward slope of the aggregate-
demand curve?
2. Use the theory of liquidity preference to explain how a
decrease in the money supply affects the aggregate-
demand curve.
3. The government spends $3 billion to buy police cars.
Explain why aggregate demand might increase by more
than $3 billion. Explain why aggregate demand might
increase by less than $3 billion.
4. Suppose that survey measures of consumer confidence
indicate a wave of pessimism is sweeping the country.
Ifpolicymakers do nothing, what will happen to
aggregate demand? What should the Fed do if it wants
to stabilize aggregate demand? If the Fed does nothing,
what might Congress do to stabilize aggregate demand?
5. Give an example of a government policy that acts as
anautomatic stabilizer. Explain why this policy has
thiseffect.
Questions for Review
1. Explain how each of the following developments would
affect the supply of money, the demand for money, and
the interest rate. Illustrate your answers with diagrams.
a. The Fed’s bond traders buy bonds in open-market
operations.
b. An increase in credit card availability reduces the
cash people hold.
c. The Federal Reserve reduces banks’ reserve
requirements.
d. Households decide to hold more money to use for
holiday shopping.
e. Awave of optimism boosts business investment
and expands aggregate demand.
f. An increase in oil prices shifts the short-run
aggregate-supply curve to the left.
2. Suppose banks install automatic teller machines on
every block and, by making cash readily available,
reduce the amount of money people want to hold.
a. Assume the Fed does not change the money supply.
According to the theory of liquidity preference,
what happens to the interest rate? What happens to
aggregate demand?
b. If the Fed wants to stabilize aggregate demand,
how should it respond?
3. Consider two policies—a tax cut that will last for only
one year, and a tax cut that is expected to be permanent.
Which policy will stimulate greater spending by
consumers? Which policy will have the greater impact
on aggregate demand? Explain.
4. The interest rate in the United States fell sharply during
1991. Many observers believed this decline showed that
monetary policy was quite expansionary during the
year. Could this conclusion be incorrect? (Hint: The
United States hit the bottom of a recession in 1991.)
5. In the early 1980s, new legislation allowed banks to pay
interest on checking deposits, which they could not do
previously.
a. If we define money to include checking deposits,
what effect did this legislation have on money
demand? Explain.
b. If the Federal Reserve had maintained a constant
money supply in the face of this change, what
would have happened to the interest rate? What
would have happened to aggregate demand and
aggregate output?
c. If the Federal Reserve had maintained a constant
market interest rate (the interest rate on
nonmonetary assets) in the face of this change,
Problems and Applications
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 759
what change in the money supply would have been
necessary? What would have happened to
aggregate demand and aggregate output?
6. This chapter explains that expansionary monetary
policy reduces the interest rate and thus stimulates
demand for investment goods. Explain how such a
policy also stimulates the demand for net exports.
7. Suppose economists observe that an increase in
government spending of $10 billion raises the total
demand for goods and services by $30 billion.
a. If these economists ignore the possibility of
crowding out, what would they estimate the
marginal propensity to consume (MPC) to be?
b. Now suppose the economists allow for crowding
out. Would their new estimate of the MPC be larger
or smaller than their initial one?
8. Suppose the government reduces taxes by $20 billion,
that there is no crowding out, and that the marginal
propensity to consume is 3/4.
a. What is the initial effect of the tax reduction on
aggregate demand?
b. What additional effects follow this initial effect?
What is the total effect of the tax cut on aggregate
demand?
c. How does the total effect of this $20 billion tax cut
compare to the total effect of a $20 billion increase
in government purchases? Why?
9. Suppose government spending increases. Would the
effect on aggregate demand be larger if the Federal
Reserve took no action in response, or if the Fed were
committed to maintaining a fixed interest rate? Explain.
10. In which of the following circumstances is expansionary
fiscal policy more likely to lead to a short-run increase
in investment? Explain.
a. when the investment accelerator is large, or when it
is small?
b. when the interest sensitivity of investment is large,
or when it is small?
11. Assume the economy is in a recession. Explain how each
of the following policies would affect consumption and
investment. In each case, indicate any direct effects, any
effects resulting from changes in total output, any effects
resulting from changes in the interest rate, and the
overall effect. If there are conflicting effects making the
answer ambiguous, say so.
a. an increase in government spending
b. a reduction in taxes
c. an expansion of the money supply
12. For various reasons, fiscal policy changes automatically
when output and employment fluctuate.
a. Explain why tax revenue changes when the
economy goes into a recession.
b. Explain why government spending changes when
the economy goes into a recession.
c. If the government were to operate under a strict
balanced-budget rule, what would it have to do in
arecession? Would that make the recession more
orless severe?
13. Recently, some members of Congress have proposed a
law that would make price stability the sole goal of
monetary policy. Suppose such a law were passed.
a. How would the Fed respond to an event that
contracted aggregate demand?
b. How would the Fed respond to an event that
caused an adverse shift in short-run aggregate
supply?
In each case, is there another monetary policy that
would lead to greater stability in output?
IN THIS CHAPTER
YOU WILL . . .
See how
policymakers’
credibility might
affect the cost of
reducing inflation
See how supply
shocks can shift
the inflation–
unemployment
tradeoff
Learn why
policymakers face a
short-run tradeoff
between inflation
and unemployment
Consider why
the inflation–
unemployment
tradeoff disappears
in the long run
Consider the short-
run cost of reducing
the rate of inflation
Two closely watched indicators of economic performance are inflation and unem-
ployment. When the Bureau of Labor Statistics releases data on these variables
each month, policymakers are eager to hear the news. Some commentators have
added together the inflation rate and the unemployment rate to produce a misery
index,which purports to measure the health of the economy.
How are these two measures of economic performance related to each other?
Earlier in the book we discussed the long-run determinants of unemployment and
the long-run determinants of inflation. We saw that the natural rate of unemploy-
ment depends on various features of the labor market, such as minimum-wage
laws, the market power of unions, the role of efficiency wages, and the effective-
ness of job search. By contrast, the inflation rate depends primarily on growth in
THE SHORT-RUN TRADEOFF
BETWEEN INFLATION
AND UNEMPLOYMENT
761
762 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
the money supply, which a nation’s central bank controls. In the long run, there-
fore, inflation and unemployment are largely unrelated problems.
In the short run, just the opposite is true. One of the Ten Principles of Economics
discussed in Chapter 1 is that society faces a short-run tradeoff between inflation
and unemployment. If monetary and fiscal policymakers expand aggregate de-
mand and move the economy up along the short-run aggregate-supply curve, they
can lower unemployment for awhile, but only at the cost of higher inflation. If pol-
icymakers contract aggregate demand and move the economy down the short-run
aggregate-supply curve, they can lower inflation, but only at the cost of temporar-
ily higher unemployment.
In this chapter we examine this tradeoff more closely. The relationship be-
tween inflation and unemployment is a topic that has attracted the attention of
some of the most important economists of the last half century. The best way to un-
derstand this relationship is to see how thinking about it has evolved over time. As
we will see, the history of thought regarding inflation and unemployment since
the 1950s is inextricably connected to the history of the U.S. economy. These two
histories will show why the tradeoff between inflation and unemployment holds
in the short run, why it does not hold in the long run, and what issues it raises for
economic policymakers.
THE PHILLIPS CURVE
The short-run relationship between inflation and unemployment is often called the
Phillips curve.We begin our story with the discovery of the Phillips curve and its
migration to America.
ORIGINS OF THE PHILLIPS CURVE
In 1958, economist A. W. Phillips published an article in the British journal Eco-
nomicathat would make him famous. The article was titled “The Relationship be-
tween Unemployment and the Rate of Change of Money Wages in the United
Kingdom, 1861–1957.” In it, Phillips showed a negative correlation between the
rate of unemployment and the rate of inflation. That is, Phillips showed that years
with low unemployment tend to have high inflation, and years with high unem-
ployment tend to have low inflation. (Phillips examined inflation in nominal
wages rather than inflation in prices, but for our purposes that distinction is not
important. These two measures of inflation usually move together.) Phillips con-
cluded that two important macroeconomic variables—inflation and unemploy-
ment—were linked in a way that economists had not previously appreciated.
Although Phillips’s discovery was based on data for the United Kingdom, re-
searchers quickly extended his finding to other countries. Two years after Phillips
published his article, economists Paul Samuelson and Robert Solow published an
article in the American Economic Reviewcalled “Analytics of Anti-Inflation Policy”
in which they showed a similar negative correlation between inflation and un-
employment in data for the United States. They reasoned that this correlation
CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 763
arose because low unemployment was associated with high aggregate demand,
which in turn puts upward pressure on wages and prices throughout the economy.
Samuelson and Solow dubbed the negative association between inflation and un-
employment the Phillips curve.Figure 33-1 shows an example of a Phillips curve
like the one found by Samuelson and Solow.
As the title of their paper suggests, Samuelson and Solow were interested in
the Phillips curve because they believed that it held important lessons for policy-
makers. In particular, they suggested that the Phillips curve offers policymakers a
menu of possible economic outcomes. By altering monetary and fiscal policy to in-
fluence aggregate demand, policymakers could choose any point on this curve.
Point Aoffers high unemployment and low inflation. Point B offers low unem-
ployment and high inflation. Policymakers might prefer both low inflation and
low unemployment, but the historical data as summarized by the Phillips curve
indicate that this combination is impossible. According to Samuelson and Solow,
policymakers face a tradeoff between inflation and unemployment, and the
Phillips curve illustrates that tradeoff.
AGGREGATE DEMAND, AGGREGATE SUPPLY,
AND THE PHILLIPS CURVE
The model of aggregate demand and aggregate supply provides an easy explana-
tion for the menu of possible outcomes described by the Phillips curve. The Phillips
curve simply shows the combinations of inflation and unemployment that arise in the
shortrun as shifts in the aggregate-demand curve move the economy along the short-run
aggregate-supply curve.As we saw in Chapter 31, an increase in the aggregate de-
mand for goods and services leads, in the short run, to a larger output of goods
and services and a higher price level. Larger output means greater employment
Phillips curve
a curve that shows the short-run
tradeoff between inflation and
unemployment
Unemployment
Rate (percent)
047
Inflation
Rate
(percent
per year)
B
A
6
2
Phillips curve
Figure 33-1
THEPHILLIPSCURVE. The
Phillips curve illustrates
anegative association between
the inflation rate and the
unemployment rate. At
pointA,inflation is low and
unemployment is high. At
pointB, inflation is high
andunemployment is low.
764 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
and, thus, a lower rate of unemployment. In addition, whatever the previous
year’s price level happens to be, the higher the price level in the current year, the
higher the rate of inflation. Thus, shifts in aggregate demand push inflation and
unemployment in opposite directions in the short run—a relationship illustrated
by the Phillips curve.
To see more fully how this works, let’s consider an example. To keep the num-
bers simple, imagine that the price level (as measured, for instance, by the con-
sumer price index) equals 100 in the year 2000. Figure 33-2 shows two possible
outcomes that might occur in year 2001. Panel (a) shows the two outcomes using
the model of aggregate demand and aggregate supply. Panel (b) illustrates the
same two outcomes using the Phillips curve.
In panel (a) of the figure, we can see the implications for output and the price
level in the year 2001. If the aggregate demand for goods and services is relatively
low, the economy experiences outcome A. The economy produces output of 7,500,
and the price level is 102. By contrast, if aggregate demand is relatively high, the
economy experiences outcome B. Output is 8,000, and the price level is 106. Thus,
higher aggregate demand moves the economy to an equilibrium with higher out-
put and a higher price level.
Quantity
of Output
8,0007,5000
106
102
Short-run
aggregate
supply
(a) The Model of Aggregate Demand and Aggregate Supply
Unemployment
Rate (percent)
0
Inflation
Rate
(percent
per year)
Price
Level
(b) The Phillips Curve
4
(output is
8,000)
7
(output is
7,500)
B
A
6
2
Phillips curve
A
B
Low aggregate
demand
High
aggregate demand
(unemployment
is 7%)
(unemployment
is 4%)
Figure 33-2
HOWTHEPHILLIPSCURVEISRELATEDTOTHEMODELOFAGGREGATEDEMAND
ANDAGGREGATESUPPLY. This figure assumes a price level of 100 for the year 2000 and
charts possible outcomes for the year 2001. Panel (a) shows the model of aggregate
demand and aggregate supply. If aggregate demand is low, the economy is at point A;
output is low (7,500), and the price level is low (102). If aggregate demand is high, the
economy is at point B; output is high (8,000), and the price level is high (106). Panel (b)
shows the implications for the Phillips curve. Point A, which arises when aggregate
demand is low, has high unemployment (7percent) and low inflation (2 percent). Point B,
which arises when aggregate demand is high, has low unemployment (4 percent) and
high inflation (6 percent).
CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 765
In panel (b) of the figure, we can see what these two possible outcomes mean
for unemployment and inflation. Because firms need more workers when they
produce a greater output of goods and services, unemployment is lower in out-
come B than in outcome A. In this example, when output rises from 7,500 to 8,000,
unemployment falls from 7 percent to 4 percent. Moreover, because the price level
is higher at outcome B than at outcome A, the inflation rate (the percentage change
in the price level from the previous year) is also higher. In particular, since the
price level was 100 in year 2000, outcome Ahas an inflation rate of 2 percent, and
outcome B has an inflation rate of 6 percent. Thus, we can compare the two possi-
ble outcomes for the economy either in terms of output and the price level (using
the model of aggregate demand and aggregate supply) or in terms of unemploy-
ment and inflation (using the Phillips curve).
As we saw in the preceding chapter, monetary and fiscal policy can shift
theaggregate-demand curve. Therefore, monetary and fiscal policy can move the
economy along the Phillips curve. Increases in the money supply, increases in
government spending, or cuts in taxes expand aggregate demand and move the
economy to a point on the Phillips curve with lower unemployment and higher
inflation. Decreases in the money supply, cuts in government spending, or in-
creases in taxes contract aggregate demand and move the economy to a point
onthe Phillips curve with lower inflation and higher unemployment. In this sense,
the Phillips curve offers policymakers a menu of combinations of inflation and
unemployment.
QUICK QUIZ: Draw the Phillips curve. Use the model of aggregate
demand and aggregate supply to show how policy can move the economy
from a point on this curve with high inflation to a point with low inflation.
SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF EXPECTATIONS
The Phillips curve seems to offer policymakers a menu of possible inflation-
unemployment outcomes. But does this menu remain stable over time? Is the
Phillips curve a relationship on which policymakers can rely? Economists took up
these questions in the late 1960s, shortly after Samuelson and Solow had intro-
duced the Phillips curve into the macroeconomic policy debate.
THE LONG-RUN PHILLIPS CURVE
In 1968 economist Milton Friedman published a paper in the American Economic
Review,based on an address he had recently given as president of the American
Economic Association. The paper, titled “The Role of Monetary Policy,” contained
sections on “What Monetary Policy Can Do” and “What Monetary Policy Cannot
Do.” Friedman argued that one thing monetary policy cannot do, other than for
only a short time, is pick a combination of inflation and unemployment on the
Phillips curve. At about the same time, another economist, Edmund Phelps, also
766 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
published a paper denying the existence of a long-run tradeoff between inflation
and unemployment.
Friedman and Phelps based their conclusions on classical principles of macro-
economics, which we discussed in Chapters 24 through 30. Recall that classical
theory points to growth in the money supply as the primary determinant of infla-
tion. But classical theory also states that monetary growth does not have real ef-
fects—it merely alters all prices and nominal incomes proportionately. In
particular, monetary growth does not influence those factors that determine the
economy’s unemployment rate, such as the market power of unions, the role of ef-
ficiency wages, or the process of job search. Friedman and Phelps concluded that
there is no reason to think the rate of inflation would, in the long run,be related to
the rate of unemployment.
Here, in his own words, is Friedman’s view about what the Fed can hope to
accomplish in the long run:
The monetary authority controls nominal quantities—directly, the quantity of its
own liabilities [currency plus bank reserves]. In principle, it can use this control
to peg a nominal quantity—an exchange rate, the price level, the nominal level of
national income, the quantity of money by one definition or another—or to peg
the change in a nominal quantity—the rate of inflation or deflation, the rate of
ACCORDINGTOTHEPHILLIPSCURVE, WHEN
unemployment falls to low levels,
wages and prices start to rise more
quickly. The following article illustrates
this link between labor-market condi-
tions and inflation.
Tighter Labor Market
Widens Inflation Fears
BY ROBERT D. HERSHEY, JR.
REMINGTON, VA.—Trinity Packaging’s plant
here recently hired a young man for a hot,
entry-level job feeding plastic scrap onto
a conveyor belt. The pay was OK for un-
skilled labor—a good $3 or so above the
federal minimum of $4.25 an hour—but
the new worker lasted only one shift.
“He worked Friday night and then
just told the supervisor that this work’s
too hard—and we haven’t seen him
since,” said Pat Roe, a personnel director
for the Trinity Packaging Corporation, a
producer of plastic bags for supermarkets
and other users. “Three years ago he’d
have probably stuck it out.”
This is just one of the many ex-
amples of how a growing number of com-
panies these days are facing something
they have not seen for many years: a tight
labor market in which many workers can
be much more choosy about their job.
Breaking a sweat can be reason enough
to quit in search of better opportunities.
“This summer’s been extremely
difficult, with unemployment so low,”
said Eleanor J. Brown, proprietor of a
small temporary-help agency in nearby
Culpeper, which supplies workers to
Trinity Packaging. “It’s hard to find, espe-
cially, industrial workers and laborers.”
From iron mines near Lake Superior
to retailers close to Puget Sound to con-
struction contractors around Atlanta, a
wide range of employers in many parts of
the country are grappling with an inability
to fill their ranks with qualified workers.
These areas of virtually full employment
hold important implications for household
incomes, financial markets, and political
campaigns as well as business profitabil-
ity itself.
So far, the tightening labor market
has generated only scattered—and in
most cases modest—pay increases.
Most companies, unable to pass on
higher costs by raising prices because of
intense competition from foreign and
domestic rivals, are working even harder
to keep a lid on labor costs, in part by
adopting novel ways of coupling pay to
profits.
“The overriding need is for expense
control,” said Kenneth T. Mayland, chief
IN THE NEWS
The Effects of
Low Unemployment
CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 767
growth or decline in nominal national income, the rate of growth of the quantity
of money. It cannot use its control over nominal quantities to peg a real
quantity—the real rate of interest, the rate of unemployment, the level of real
national income, the real quantity of money, the rate of growth of real national
income, or the rate of growth of the real quantity of money.
These views have important implications for the Phillips curve. In particular, they
imply that monetary policymakers face a long-run Phillips curve that is vertical, as
in Figure 33-3. If the Fed increases the money supply slowly, the inflation rate is
low, and the economy finds itself at point A. If the Fed increases the money supply
quickly, the inflation rate is high, and the economy finds itself at point B. In either
case, the unemployment rate tends toward its normal level, called the natural rate
of unemployment.The vertical long-run Phillips curve illustrates the conclusion that
unemployment does not depend on money growth and inflation in the long run.
The vertical long-run Phillips curve is, in essence, one expression of the classi-
cal idea of monetary neutrality. As you may recall, we expressed this idea in Chap-
ter 31 with a vertical long-run aggregate-supply curve. Indeed, as Figure 33-4
illustrates, the vertical long-run Phillips curve and the vertical long-run aggregate-
supply curve are two sides of the same coin. In panel (a) of this figure, an increase
in the money supply shifts the aggregate-demand curve to the right from AD
1
financial economist at Keycorp, a Cleve-
land bank, “at a time when revenue
growth is constrained.”
But with unemployment already at a
low 5.5 percent and the economy looking
stronger than expected this summer,
more analysts are worried that it may be
only a matter of time before wage pres-
sures begin to build again as they did in
the late 1980s. . . .
The labor shortages are wide-
spread and include both skilled and
unskilled jobs. Among the hardest oc-
cupations to fill are computer analyst
and programmer, aerospace engineer,
construction trades worker, and various
types of salespeople. But even fast
food establishments in the St. Louis
area and elsewhere have resorted to
signing bonuses as well as premium pay
and more generous benefits to attract
applicants. . . .
So far, upward pressure on pay is
relatively modest, a phenomenon that
economists say is surprising in light of an
uninterrupted business expansion that is
now five and a half years old.
“We have less wage pressure
than, historically, anyone would have
guessed,” said Stuart G. Hoffman, chief
economist at PNC Bank in Pittsburgh.
But wages have already crept up
a bit and could accelerate even if the
economy slackens from its recent rapid
growth pace. And if the economy
maintains significant momentum, some
analysts say, all bets are off. If growth
continues another six months at above
2.5 percent or so, Mark Zandi, chief
economist for Regional Financial Associ-
ates, said, “we’ll be looking at wage infla-
tion right square in the eye.” . . .
[Author’s note: In fact, wage inflation did
rise. The rate of increase in compensation
per hour paid by U.S. businesses rose
from 1.8 percent in 1994 to 4.4 percent in
1998. But thanks to a fall in world com-
modity prices and a surge in productivity
growth, higher wage inflation didn’t trans-
late into higher price inflation. A case
study later in this chapter considers these
events in more detail.]
One worker who has taken advan-
tage of the current environment is Clyde
Long, a thirty-year-old who switched jobs
to join Trinity Packaging in May. He had
been working about two miles away at
Ross Industries, which makes food-
processing equipment, and quit without
having anything else lined up.
In a week, Mr. Long had hired on at
Trinity where, as a press operator, he now
earns $8.55 an hour—$1.25 more than at
his old job—with better benefits and train-
ing as well. “It’s a whole lot better here,”
he said.
SOURCE:The New York Times,September 5, 1996,
p.D1.
768 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
toAD
2
. As a result of this shift, the long-run equilibrium moves from point Ato
point B. The price level rises from P
1
to P
2
, but because the aggregate-supply curve
is vertical, output remains the same. In panel (b), more rapid growth in the money
supply raises the inflation rate by moving the economy from point Ato point B.
But because the Phillips curve is vertical, the rate of unemployment is the same at
these two points. Thus, the vertical long-run aggregate-supply curve and the ver-
tical long-run Phillips curve both imply that monetary policy influences nominal
variables (the price level and the inflation rate) but not real variables (output and
unemployment). Regardless of the monetary policy pursued by the Fed, output
and unemployment are, in the long run, at their natural rates.
What is so “natural” about the natural rate of unemployment? Friedman and
Phelps used this adjective to describe the unemployment rate toward which the
economy tends to gravitate in the long run. Yet the natural rate of unemployment
is not necessarily the socially desirable rate of unemployment. Nor is the natural
rate of unemployment constant over time. For example, suppose that a newly
formed union uses its market power to raise the real wages of some workers above
the equilibrium level. The result is a surplus of workers and, therefore, a higher
natural rate of unemployment. This unemployment is “natural” not because it is
good but because it is beyond the influence of monetary policy. More rapid money
growth would not reduce the market power of the union or the level of unem-
ployment; it would lead only to more inflation.
Although monetary policy cannot influence the natural rate of unemploy-
ment, other types of policy can. To reduce the natural rate of unemployment,
policymakers should look to policies that improve the functioning of the labor
market. Earlier in the book we discussed how various labor-market policies, such
as minimum-wage laws, collective-bargaining laws, unemployment insurance,
and job-training programs, affect the natural rate of unemployment. Apolicy
change that reduced the natural rate of unemployment would shift the long-run
Unemployment
Rate
0 Natural rate of
unemployment
Inflation
Rate
B
Long-run
Phillips curve
High
inflation
Low
inflation
A
2. . . . but unemployment
remains at its natural rate
in the long run.
1. When the
Fed increases
the growth rate
of the money
supply, the
rate of inflation
increases . . .
Figure 33-3
THELONG-RUNPHILLIPSCURVE.
According to Friedman and
Phelps, there is no tradeoff
between inflation and
unemployment in the long run.
Growth in the money supply
determines the inflation rate.
Regardless of the inflation
rate,the unemployment rate
gravitates toward its natural
rate.As a result, the long-run
Phillips curve is vertical.
CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 769
Phillips curve to the left. In addition, because lower unemployment means more
workers are producing goods and services, the quantity of goods and services
supplied would be larger at any given price level, and the long-run aggregate-
supply curve would shift to the right. The economy could then enjoy lower unem-
ployment and higher output for any given rate of money growth and inflation.
EXPECTATIONS AND THE SHORT-RUN PHILLIPS CURVE
At first, the denial by Friedman and Phelps of a long-run tradeoff between infla-
tion and unemployment might not seem persuasive. Their argument was based on
an appeal to theory.By contrast, the negative correlation between inflation and un-
employment documented by Phillips, Samuelson, and Solow was based on data.
Why should anyone believe that policymakers faced a vertical Phillips curve when
the world seemed to offer a downward-sloping one? Shouldn’t the findings of
Phillips, Samuelson, and Solow lead us to reject the classical conclusion of mone-
tary neutrality?
Quantity
of Output
Natural rate
of output
Natural rate of
unemployment
0
Price
Level
P
2
P
1
Aggregate
demand, AD
1
Long-run aggregate
supply
Long-run Phillips
curve
(a) The Model of Aggregate Demand and Aggregate Supply
Unemployment
Rate
0
Inflation
Rate
(b) The Phillips Curve
2. . . . raises
the price
level . . .
1. An increase in
the money supply
increases aggregate
demand . . .
B
A
AD
2
B
A
4. . . . but leaves output and unemployment
at their natural rates.
3. . . . and
increases the
inflation rate . . .
Figure 33-4
HOWTHELONG-RUNPHILLIPSCURVEISRELATEDTOTHEMODELOFAGGREGATE
DEMANDANDAGGREGATESUPPLY. Panel (a) shows the model of aggregate demand and
aggregate supply with a vertical aggregate-supply curve. When expansionary monetary
policy shifts the aggregate-demand curve to the right from AD
1
to AD
2
, the equilibrium
moves from point Ato pointB. The price level rises from P
1
to P
2
, while output remains
the same. Panel (b) shows the long-run Phillips curve, which is vertical at the natural
rate of unemployment. Expansionary monetary policy moves the economy from
lower inflation (point A) to higher inflation (point B) without changing the rate of
unemployment.
770 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
Friedman and Phelps were well aware of these questions, and they offered
a way to reconcile classical macroeconomic theory with the finding of a down-
ward-sloping Phillips curve in data from the United Kingdom and the United
States. They claimed that a negative relationship between inflation and unem-
ployment holds in the short run but that it cannot be used by policymakers in the
long run. In other words, policymakers can pursue expansionary monetary policy
to achieve lower unemployment for a while, but eventually unemployment re-
turns to its natural rate, and more expansionary monetary policy leads only to
higher inflation.
Friedman and Phelps reasoned as we did in Chapter 31 when we explained
the difference between the short-run and long-run aggregate-supply curves. (In
fact, the discussion in that chapter drew heavily on the legacy of Friedman and
Phelps.) As you may recall, the short-run aggregate-supply curve is upward
sloping, indicating that an increase in the price level raises the quantity of goods
and services that firms supply. By contrast, the long-run aggregate-supply curve is
vertical, indicating that the price level does not influence quantity supplied in the
long run. Chapter 31 presented three theories to explain the upward slope of
the short-run aggregate-supply curve: misperceptions about relative prices,
sticky wages, and sticky prices. Because perceptions, wages, and prices adjust to
changing economic conditions over time, the positive relationship between the
price level and quantity supplied applies in the short run but not in the long
run. Friedman and Phelps applied this same logic to the Phillips curve. Just as
the aggregate-supply curve slopes upward only in the short run, the tradeoff
between inflationand unemployment holds only in the short run. And just as
the long-run aggregate-supply curve is vertical, the long-run Phillips curve is
also vertical.
To help explain the short-run and long-run relationship between inflation and
unemployment, Friedman and Phelps introduced a new variable into the analysis:
expected inflation.Expected inflation measures how much people expect the overall
price level to change. As we discussed in Chapter 31, the expected price level af-
fects the perceptions of relative prices that people form and the wages and prices
that they set. As a result, expected inflation is one factor that determines the posi-
tion of the short-run aggregate-supply curve. In the short run, the Fed can take ex-
pected inflation (and thus the short-run aggregate-supply curve) as already
determined. When the money supply changes, the aggregate-demand curve shifts,
and the economy moves along a given short-run aggregate-supply curve. In the
short run, therefore, monetary changes lead to unexpected fluctuations in output,
prices, unemployment, and inflation. In this way, Friedman and Phelps explained
the Phillips curve that Phillips, Samuelson, and Solow had documented.
Yet the Fed’s ability to create unexpected inflation by increasing the money
supply exists only in the short run. In the long run, people come to expect what-
ever inflation rate the Fed chooses to produce. Because perceptions, wages, and
prices will eventually adjust to the inflation rate, the long-run aggregate-supply
curve is vertical. In this case, changes in aggregate demand, such as those due to
changes in the money supply, do not affect the economy’s output of goods and
services. Thus, Friedman and Phelps concluded that unemployment returns to its
natural rate in the long run.
The analysis of Friedman and Phelps can be summarized in the following
equation (which is, in essence, another expression of the aggregate-supply equa-
tion we saw in Chapter 31):
CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 771
H11005H11002a
H20898
H11002
H20899
.
This equation relates the unemployment rate to the natural rate of unemployment,
actual inflation, and expected inflation. In the short run, expected inflation is
given. As a result, higher actual inflation is associated with lower unemployment.
(How much unemployment responds to unexpected inflation is determined by the
size of a,a number that in turn depends on the slope of the short-run aggregate-
supply curve.) In the long run, however, people come to expect whatever inflation
the Fed produces. Thus, actual inflation equals expected inflation, and unemploy-
ment is at its natural rate.
This equation implies there is no stable short-run Phillips curve. Each short-
run Phillips curve reflects a particular expected rate of inflation. (To be precise, if
you graph the equation, you’ll find that the short-run Phillips curve intersects the
long-run Phillips curve at the expected rate of inflation.) Whenever expected in-
flation changes, the short-run Phillips curve shifts.
According to Friedman and Phelps, it is dangerous to view the Phillips curve
as a menu of options available to policymakers. To see why, imagine an economy
at its natural rate of unemployment with low inflation and low expected inflation,
shown in Figure 33-5 as point A. Now suppose that policymakers try to take ad-
vantage of the tradeoff between inflation and unemployment by using monetary
or fiscal policy to expand aggregate demand. In the short run when expected in-
flation is given, the economy goes from point Ato point B. Unemployment falls be-
low its natural rate, and inflation rises above expected inflation. Over time, people
get used to this higher inflation rate, and they raise their expectations of inflation.
When expected inflation rises, firms and workers start taking higher inflation into
Expected
inflation
Actual
inflation
Natural rate of
unemployment
Unemployment
rate
Unemployment
Rate
0 Natural rate of
unemployment
Inflation
Rate
C
B
Long-run
Phillips curve
A
Short-run Phillips curve
with high expected
inflation
Short-run Phillips curve
with low expected
inflation
1. Expansionary policy moves
the economy up along the
short-run Phillips curve . . .
2. . . . but in the long run, expected
inflation rises, and the short-run
Phillips curve shifts to the right.
Figure 33-5
HOWEXPECTEDINFLATION
SHIFTSTHESHORT-RUN
PHILLIPSCURVE. The higher the
expected rate of inflation, the
higher the short-run tradeoff
between inflation and
unemployment. At point A,
expected inflation and actual
inflation are both low, and
unemployment is at its natural
rate. If the Fed pursues an
expansionary monetary policy,
the economy moves from point A
to point B in the short run. At
point B, expected inflation is still
low, but actual inflation is high.
Unemployment is below its
natural rate. In the long run,
expected inflation rises, and the
economy moves to point C. At
point C, expected inflation and
actual inflation are both high,
andunemployment is back
toitsnatural rate.
772 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
account when setting wages and prices. The short-run Phillips curve then shifts to
the right, as shown in the figure. The economy ends up at point C, with higher in-
flation than at point Abut with the same level of unemployment.
Thus, Friedman and Phelps concluded that policymakers do face a tradeoff be-
tween inflation and unemployment, but only a temporary one. If policymakers use
this tradeoff, they lose it.
THE NATURAL EXPERIMENT
FOR THE NATURAL-RATE HYPOTHESIS
Friedman and Phelps had made a bold prediction in 1968: If policymakers try to
take advantage of the Phillips curve by choosing higher inflation in order to re-
duce unemployment, they will succeed at reducing unemployment only tem-
porarily. This view—that unemployment eventually returns to its natural rate,
regardless of the rate of inflation—is called the natural-rate hypothesis. Afew
years after Friedman and Phelps proposed this hypothesis, monetary and fiscal
policymakers inadvertently created a natural experiment to test it. Their labora-
tory was the U.S. economy.
Before we see the outcome of this test, however, let’s look at the data that
Friedman and Phelps had when they made their prediction in 1968. Figure 33-6
shows the unemployment rate and the inflation rate for the period from 1961 to
1968. These data trace out a Phillips curve. As inflation rose over these eight years,
unemployment fell. The economic data from this era seemed to confirm the trade-
off between inflation and unemployment.
The apparent success of the Phillips curve in the 1960s made the prediction of
Friedman and Phelps all the more bold. In 1958 Phillips had suggested a negative
natural-rate hypothesis
the claim that unemployment
eventually returns to its normal,
ornatural, rate, regardless of
therateof inflation
Unemployment
Rate (percent)
Inflation Rate
(percent per year)
1968
1966
1961
1962
1963
1967
1965
1964
123456789100
2
4
6
8
10
Figure 33-6
THEPHILLIPSCURVE
INTHE1960S. This figure uses
annual data from1961 to 1968 on
the unemployment rate and on
the inflation rate (as measured by
theGDPdeflator) to show the
negative relationship between
inflation and unemployment.
SOURCE:U.S. Department of Labor;
U.S.Department of Commerce.
CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 773
association between inflation and unemployment. In 1960 Samuelson and Solow
had showed it existed in U.S. data. Another decade of data had confirmed the re-
lationship. To some economists at the time, it seemed ridiculous to claim that the
Phillips curve would break down once policymakers tried to use it.
But, in fact, that is exactly what happened. Beginning in the late 1960s, the
government followed policies that expanded the aggregate demand for goods and
services. In part, this expansion was due to fiscal policy: Government spending
rose as the Vietnam War heated up. In part, it was due to monetary policy: Because
the Fed was trying to hold down interest rates in the face of expansionary fiscal
policy, the money supply (as measured by M2) rose about 13 percent per year dur-
ing the period from 1970 to 1972, compared to 7 percent per year in the early 1960s.
As a result, inflation stayed high (about 5 to 6 percent per year in the late 1960s and
early 1970s, compared to about 1 to 2 percent per year in the early 1960s). But, as
Friedman and Phelps had predicted, unemployment did not stay low.
Figure 33-7 displays the history of inflation and unemployment from 1961 to
1973. It shows that the simple negative relationship between these two variables
started to break down around 1970. In particular, as inflation remained high in the
early 1970s, people’s expectations of inflation caught up with reality, and the un-
employment rate reverted to the 5 percent to 6 percent range that had prevailed in
the early 1960s. Notice that the history illustrated in Figure 33-7 closely resembles
the theory of a shifting short-run Phillips curve shown in Figure 33-5. By 1973,
policymakers had learned that Friedman and Phelps were right: There is no trade-
off between inflation and unemployment in the long run.
QUICK QUIZ: Draw the short-run Phillips curve and the long-run Phillips
curve. Explain why they are different.
Unemployment
Rate (percent)
Inflation Rate
(percent per year)
1973
1966
1972
1971
1961
1962
1963
1967
1968
1969
1970
1965
1964
123456789100
2
4
6
8
10
Figure 33-7
THEBREAKDOWNOF
THEPHILLIPSCURVE. This
figure shows annual data
from 1961 to 1973 on the
unemployment rate and on the
inflation rate (as measured by
theGDPdeflator). Notice that the
Phillips curve of the 1960s breaks
down in the early 1970s.
SOURCE: U.S. Department of Labor;
U.S.Department of Commerce.
774 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
SHIFTS IN THE PHILLIPS CURVE:
THE ROLE OF SUPPLY SHOCKS
Friedman and Phelps had suggested in 1968 that changes in expected inflation
shift the short-run Phillips curve, and the experience of the early 1970s convinced
most economists that Friedman and Phelps were right. Within a few years,
INTHE1960S AND 1970S, POLICYMAKERS
learned that high expected inflation
shifts the short-run Phillips curve out-
ward, making actual inflation more
likely. In the 1990s, the opposite oc-
curred, as expected inflation fell and
helped keep actual inflation low.
The Virtuous Circle
of Low Inflation
BY JACOB M. SCHLESINGER
Why does inflation remain so low?
Some experts credit greater cor-
porate efficiency. Others cite a growing
labor force. Luck, in the form of cheap oil
and a strong dollar, helps. But the raging
economic debate often overlooks one
simple answer: because inflation remains
so low. In other words, it isn’t just a mat-
ter of mathematical formulas such as a
Phillips-curve tradeoff between inflation
and jobs; it also is the nebulous matter of
mass psychology. The economy may be
entering a phase in which low inflation is
no longer considered a lucky, transitory
phenomenon but an integral part of its
fabric. And if enough executives, suppli-
ers, consumers and workers believe it
will last, they will act in ways that help
make it last.
“For the past couple of years, peo-
ple were expecting inflation to rise, but
it hasn’t,” says Janet Yellen, the chief
White House economist and former Fed-
eral Reserve governor. “Slowly, people
are being convinced that inflation is
down and it’s going to stay down,
[which] is helpful in keeping inflation
down. Inflationary expectations feed
directly into wage bargaining and price
setting.”
This substantial exorcising of the
inflationary specter flows partly from
the Fed’s new credibility: a widespread
belief that it is committed to keeping
prices relatively stable and knows how to
do so. . . .
A widely cited measure of public
attitudes, the University of Michigan’s
Survey of Consumers, is reflecting two
significant changes this year, says
Richard Curtin, its director. First, long-
term inflation expectations—the pre-
dicted annual inflation rate for the next
five to 10 years—have slipped below
3% for the first time since the survey
began asking the question nearly two
decades ago. Second, long-term inflation
expectations now nearly equal short-
term expectations. . . .
This outlook eases inflationary pres-
sures in many ways. Recall the 1970s,
Ms. Yellen says, “when expectations of
future inflation led workers to demand
wage increases that would compensate
them for expected inflation, and firms to
give wage increases believing they could
pass on price increases.” . . .
“In the 1970s and 1980s, we had
price increases baked into our projec-
tions,” says Warren L. Batts, chairman
of both Premark International Inc. and
Tupperware Corp. and head of the
National Association of Manufacturers.
“We thought we could charge our cus-
tomers [more], and therefore we could
pay our suppliers. [Now], you know you
can’t charge, so you don’t pay.”
Of course, inflationary fears aren’t
completely cured, as last week’s stock
and bond market jitters show. Rampant
inflation in the 1970s shattered the no-
tion that America was immune to the
problem. Remaining traces of apprehen-
sion may not be all bad. “The moment
we become complacent about infla-
tion,” says Deputy Treasury Secretary
Lawrence Summers, “is the moment we
will start to have an inflation problem.”
SOURCE:The Wall Street Journal,August 18, 1997,
p.A1.
IN THE NEWS
The Benefits of Low
Expected Inflation
CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 775
however, the economics profession would turn its attention to a different source of
shifts in the short-run Phillips curve: shocks to aggregate supply.
This time, the shift in focus came not from two American economics professors
but from a group of Arab sheiks. In 1974, the Organization of Petroleum Exporting
Countries (OPEC) began to exert its market power as a cartel in the world oil mar-
ket in order to increase its members’ profits. The countries of OPEC, such as Saudi
Arabia, Kuwait, and Iraq, restricted the amount of crude oil they pumped and sold
on world markets. Within a few years, this reduction in supply caused the price of
oil to almost double.
Alarge increase in the world price of oil is an example of a supply shock.
Asupply shockis an event that directly affects firms’ costs of production and thus
the prices they charge; it shifts the economy’s aggregate-supply curve and, as a re-
sult, the Phillips curve. For example, when an oil price increase raises the cost of
producing gasoline, heating oil, tires, and many other products, it reduces the
quantity of goods and services supplied at any given price level. As panel (a) of
Figure 33-8 shows, this reduction in supply is represented by the leftward shift in
the aggregate-supply curve from AS
1
to AS
2
. The price level rises from P
1
to P
2
, and
output falls from Y
1
to Y
2
. The combination of rising prices and falling output is
sometimes called stagflation.
supply shock
an event that directly alters
firms’costs and prices, shifting
theeconomy’s aggregate-supply
curve and thus the Phillips curve
Quantity
of Output
0
Price
Level
P
2
P
1
Aggregate
demand
(a) The Model of Aggregate Demand and Aggregate Supply
Unemployment
Rate
0
Inflation
Rate
(b) The Phillips Curve
3. . . . and
raises
the price
level . . .
B
A
AS
2
Aggregate
supply, AS
1
B
A
1. An adverse
shift in aggregate
supply . . .
2. . . . lowers output . . .
4. . . . giving policymakers
a less favorable tradeoff
between unemployment
and inflation.
Y
2
Y
1
PC
2
Phillips curve, PC
1
Figure 33-8
ANADVERSESHOCKTOAGGREGATESUPPLY. Panel (a) shows the model of aggregate
demand and aggregate supply. When the aggregate-supply curve shifts to the left from
AS
1
to AS
2
, the equilibrium moves from point Ato point B. Output falls from Y
1
to Y
2
, and
the price level rises from P
1
to P
2
. Panel(b) shows the short-run tradeoff between inflation
and unemployment. The adverseshift in aggregate supply moves the economy from a
point with lower unemployment and lower inflation (point A) to a point with higher
unemployment andhigher inflation (pointB). The short-run Phillips curve shifts to the
right from PC
1
toPC
2
. Policymakers now face a worse tradeoff between inflation and
unemployment.
776 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
This shift in aggregate supply is associated with a similar shift in the short-run
Phillips curve, shown in panel (b). Because firms need fewer workers to produce
the smaller output, employment falls and unemployment rises. Because the price
level is higher, the inflation rate—the percentage change in the price level from the
previous year—is also higher. Thus, the shift in aggregate supply leads to higher
unemployment and higher inflation. The short-run tradeoff between inflation and
unemployment shifts to the right from PC
1
to PC
2
.
Confronted with an adverse shift in aggregate supply, policymakers face a dif-
ficult choice between fighting inflation and fighting unemployment. If they con-
tract aggregate demand to fight inflation, they will raise unemployment further. If
they expand aggregate demand to fight unemployment, they will raise inflation
further. In other words, policymakers face a less favorable tradeoff between infla-
tion and unemployment than they did before the shift in aggregate supply: They
have to live with a higher rate of inflation for a given rate of unemployment, a
higher rate of unemployment for a given rate of inflation, or some combination of
higher unemployment and higher inflation.
An important question is whether this adverse shift in the Phillips curve is
temporary or permanent. The answer depends on how people adjust their expec-
tations of inflation. If people view the rise in inflation due to the supply shock as a
temporary aberration, expected inflation does not change, and the Phillips curve
will soon revert to its former position. But if people believe the shock will lead to
a new era of higher inflation, then expected inflation rises, and the Phillips curve
remains at its new, less desirable position.
In the United States during the 1970s, expected inflation did rise substantially.
This rise in expected inflation is partly attributable to the decision of the Fed to
“Remember the good old days when all the economy needed was a little fine-tuning?”
CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 777
accommodate the supply shock with higher money growth. (As we saw in Chap-
ter 31, policymakers are said to accommodatean adverse supply shock when they
respond to it by increasing aggregate demand.) Because of this policy decision, the
recession that resulted from the supply shock was smaller than it otherwise might
have been, but the U.S. economy faced an unfavorable tradeoff between inflation
and unemployment for many years. The problem was compounded in 1979, when
OPEC once again started to exert its market power, more than doubling the price
of oil. Figure 33-9 shows inflation and unemployment in the U.S. economy during
this period.
In 1980, after two OPEC supply shocks, the U.S. economy had an inflation rate
of more than 9 percent and an unemployment rate of about 7 percent. This combi-
nation of inflation and unemployment was not at all near the tradeoff that seemed
possible in the 1960s. (In the 1960s, the Phillips curve suggested that an unem-
ployment rate of 7 percent would be associated with an inflation rate of only 1 per-
cent. Inflation of more than 9 percent was unthinkable.) With the misery index in
1980 near an historic high, the public was widely dissatisfied with the performance
of the economy. Largely because of this dissatisfaction, President Jimmy Carter lost
his bid for reelection in November 1980 and was replaced by Ronald Reagan.
Something had to be done, and soon it would be.
QUICK QUIZ: Give an example of a favorable shock to aggregate supply.
Use the model of aggregate demand and aggregate supply to explain the
effects of such a shock. How does it affect the Phillips curve?
Unemployment
Rate (percent)
Inflation Rate
(percent per year)
1972
1975
1981
1976
1978
1979
1980
1973
1974
1977
123456789100
2
4
6
8
10
Figure 33-9
THESUPPLYSHOCKS
OFTHE1970S. This figure
shows annual datafrom 1972 to
1981 on theunemployment rate
and ontheinflation rate (as
measuredbytheGDPdeflator).
In the periods 1973–1975 and
1978–1981, increases in world
oilprices led to higher inflation
and higher unemployment.
SOURCE:U.S. Department of Labor;
U.S.Department of Commerce.
778 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
THE COST OF REDUCING INFLATION
In October 1979, as OPEC was imposing adverse supply shocks on the world’s
economies for the second time in a decade, Fed Chairman Paul Volcker decided
that the time for action had come. Volcker had been appointed chairman by Presi-
dent Carter only two months earlier, and he had taken the job knowing that infla-
tion had reached unacceptable levels. As guardian of the nation’s monetary
system, he felt he had little choice but to pursue a policy of disinflation—a reduc-
tion in the rate of inflation. Volcker had no doubt that the Fed could reduce infla-
tion through its ability to control the quantity of money. But what would be the
short-run cost of disinflation? The answer to this question was much less certain.
THE SACRIFICE RATIO
To reduce the inflation rate, the Fed has to pursue contractionary monetary policy.
Figure 33-10 shows some of the effects of such a decision. When the Fed slows the
rate at which the money supply is growing, it contracts aggregate demand. The fall
in aggregate demand, in turn, reduces the quantity of goods and services that
firms produce, and this fall in production leads to a fall in employment. The econ-
omy begins at point Ain the figure and moves along the short-run Phillips curve
to point B, which has lower inflation and higher unemployment. Over time, as
people come to understand that prices are rising more slowly, expected inflation
WHENPAULVOLCKERBECAME
FEDCHAIRMAN, INFLATIONWAS
WIDELYVIEWEDASONEOFTHE
NATION’SFOREMOSTPROBLEMS.
Unemployment
Rate
0 Natural rate of
unemployment
Inflation
Rate
A
B
Long-run
Phillips curve
C
Short-run Phillips curve
with high expected
inflation
Short-run Phillips curve
with low expected
inflation
1. Contractionary policy moves
the economy down along the
short-run Phillips curve . . .
2. . . . but in the long run, expected
inflation falls, and the short-run
Phillips curve shifts to the left.
Figure 33-10
DISINFLATIONARYMONETARY
POLICYINTHESHORTRUN
ANDLONGRUN. When the Fed
pursues contractionary monetary
policy to reduce inflation, the
economy moves along a short-
run Phillips curve from point Ato
point B. Over time, expected
inflation falls, and the short-run
Phillips curve shifts downward.
When the economy reaches point
C, unemployment is back at its
natural rate.
CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 779
falls, and the short-run Phillips curve shifts downward. The economy moves from
point B to point C. Inflation is lower, and unemployment is back at its natural rate.
Thus, if a nation wants to reduce inflation, it must endure a period of high un-
employment and low output. In Figure 33-10, this cost is represented by the move-
ment of the economy through point B as it travels from point Ato point C. The size
of this cost depends on the slope of the Phillips curve and how quickly expecta-
tions of inflation adjust to the new monetary policy.
Many studies have examined the data on inflation and unemployment in or-
der to estimate the cost of reducing inflation. The findings of these studies are of-
ten summarized in a statistic called the sacrifice ratio. The sacrifice ratio is the
number of percentage points of annual output lost in the process of reducing in-
flation by 1 percentage point. Atypical estimate of the sacrifice ratio is 5. That is,
for each percentage point that inflation is reduced, 5 percent of annual output
must be sacrificed in the transition.
Such estimates surely must have made Paul Volcker apprehensive as he con-
fronted the task of reducing inflation. Inflation was running at almost 10 percent
per year. To reach moderate inflation of, say, 4 percent per year would mean re-
ducing inflation by 6 percentage points. If each percentage point cost 5 percent of
the economy’s annual output, then reducing inflation by 6 percentage points
would require sacrificing 30 percent of annual output.
According to studies of the Phillips curve and the cost of disinflation, this sac-
rifice could be paid in various ways. An immediate reduction in inflation would
depress output by 30 percent for a single year, but that outcome was surely too
harsh even for an inflation hawk like Paul Volcker. It would be better, many ar-
gued, to spread out the cost over several years. If the reduction in inflation took
place over 5 years, for instance, then output would have to average only 6 percent
below trend during that period to add up to a sacrifice of 30 percent. An even more
gradual approach would be to reduce inflation slowly over a decade, so that out-
put would have to be only 3 percent below trend. Whatever path was chosen,
however, it seemed that reducing inflation would not be easy.
RATIONAL EXPECTATIONS AND THE POSSIBILITY OF
COSTLESS DISINFLATION
Just as Paul Volcker was pondering how costly reducing inflation might be, a
group of economics professors was leading an intellectual revolution that would
challenge the conventional wisdom on the sacrifice ratio. This group included
such prominent economists as Robert Lucas, Thomas Sargent, and Robert Barro.
Their revolution was based on a new approach to economic theory and policy
called rational expectations.According to the theory of rational expectations, peo-
ple optimally use all the information they have, including information about gov-
ernment policies, when forecasting the future.
This new approach has had profound implications for many areas of macro-
economics, but none is more important than its application to the tradeoff between
inflation and unemployment. As Friedman and Phelps had first emphasized, ex-
pected inflation is an important variable that explains why there is a tradeoff be-
tween inflation and unemployment in the short run but not in the long run. How
quickly the short-run tradeoff disappears depends on how quickly expectations
adjust. Proponents of rational expectations built on the Friedman–Phelps analysis
sacrifice ratio
the number of percentage points
ofannual output lost in the
processof reducing inflation
by1percentage point
rational expectations
the theory according to which
peopleoptimally use all the
information they have,
includinginformation about
government policies, when
forecasting the future
780 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
to argue that when economic policies change, people adjust their expectations of
inflation accordingly. Studies of inflation and unemployment that tried to estimate
the sacrifice ratio had failed to take account of the direct effect of the policy regime
on expectations. As a result, estimates of the sacrifice ratio were, according to the
rational-expectations theorists, unreliable guides for policy.
In a 1981 paper titled “The End of Four Big Inflations,” Thomas Sargent de-
scribed this new view as follows:
An alternative “rational expectations” view denies that there is any inherent
momentum to the present process of inflation. This view maintains that firms
and workers have now come to expect high rates of inflation in the future and
that they strike inflationary bargains in light of these expectations. However, it is
held that people expect high rates of inflation in the future precisely because the
government’s current and prospective monetary and fiscal policies warrant those
expectations. . . . An implication of this view is that inflation can be stopped
much more quickly than advocates of the “momentum” view have indicated and
that their estimates of the length of time and the costs of stopping inflation in
terms of foregone output are erroneous. . . . This is not to say that it would be
easy to eradicate inflation. On the contrary, it would require more than a few
temporary restrictive fiscal and monetary actions. It would require a change in
the policy regime. . . . How costly such a move would be in terms of foregone
output and how long it would be in taking effect would depend partly on how
resolute and evident the government’s commitment was.
According to Sargent, the sacrifice ratio could be much smaller than suggested by
previous estimates. Indeed, in the most extreme case, it could be zero. If the
government made a credible commitment to a policy of low inflation, people
would be rational enough to lower their expectations of inflation immediately. The
short-run Phillips curve would shift downward, and the economy would reach
low inflation quickly without the cost of temporarily high unemployment and low
output.
THE VOLCKER DISINFLATION
As we have seen, when Paul Volcker faced the prospect of reducing inflation from
its peak of about 10 percent, the economics profession offered two conflicting pre-
dictions. One group of economists offered estimates of the sacrifice ratio and con-
cluded that reducing inflation would have great cost in terms of lost output and
high unemployment. Another group offered the theory of rational expectations
and concluded that reducing inflation could be much less costly and, perhaps,
could even have no cost at all. Who was right?
Figure 33-11 shows inflation and unemployment from 1979 to 1987. As you
can see, Volcker did succeed at reducing inflation. Inflation came down from al-
most 10 percent in 1981 and 1982 to about 4 percent in 1983 and 1984. Credit for
this reduction in inflation goes completely to monetary policy. Fiscal policy at this
time was acting in the opposite direction: The increases in the budget deficit dur-
ing the Reagan administration were expanding aggregate demand, which tends to
raise inflation. The fall in inflation from 1981 to 1984 is attributable to the tough
anti-inflation policies of Fed Chairman Paul Volcker.
CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 781
The figure shows that the Volcker disinflation did come at the cost of high
unemployment. In 1982 and 1983, the unemployment rate was about 10 percent—
almost twice its level when Paul Volcker was appointed Fed chairman. At the same
time, the production of goods and services as measured by real GDPwas well
below its trend level. (See Figure 31-1 in Chapter 31.) The Volcker disinflation
produced the deepest recession in the United States since the Great Depression of
the 1930s.
Does this experience refute the possibility of costless disinflation as suggested
by the rational-expectations theorists? Some economists have argued that the an-
swer to this question is a resounding yes. Indeed, the pattern of disinflation shown
in Figure 33-11 is very similar to the pattern predicted in Figure 33-10. To make the
transition from high inflation (point Ain both figures) to low inflation (point C),
the economy had to experience a painful period of high unemployment (point B).
Yet there are two reasons not to reject the conclusions of the rational-
expectations theorists so quickly. First, even though the Volcker disinflation did
impose a cost of temporarily high unemployment, the cost was not as large as
many economists had predicted. Most estimates of the sacrifice ratio based on the
Volcker disinflation are smaller than estimates that had been obtained from previ-
ous data. Perhaps Volcker’s tough stand on inflation did have some direct effect on
expectations, as the rational-expectations theorists claimed.
Second, and more important, even though Volcker announced that he would
aim monetary policy to lower inflation, much of the public did not believe him.
Because few people thought Volcker would reduce inflation as quickly as he did,
expected inflation did not fall, and the short-run Phillips curve did not shift down
as quickly as it might have. Some evidence for this hypothesis comes from the
Unemployment
Rate (percent)
Inflation Rate
(percent per year)
1979
1980
1983
1981
1982
1984
1986
1987
1985
123456789100
2
4
6
8
10
A
B
C
Figure 33-11
THEVOLCKERDISINFLATION.
This figure shows annual
datafrom 1979 to 1987 on
theunemployment rate and
ontheinflation rate (as
measuredbythe GDPdeflator).
The reduction in inflation during
thisperiod came at the cost of
very high unemployment in
1982and 1983. Note that the
points labeled A, B, and C in
thisfigure correspond roughly
tothe points in Figure 33-10.
SOURCE:U.S. Department of Labor;
U.S.Department of Commerce.
782 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
forecasts made by commercial forecasting firms: Their forecasts of inflation fell
more slowly in the 1980s than did actual inflation. Thus, the Volcker disinflation
does not necessarily refute the rational-expectations view that credible disinflation
can be costless. It does show, however, that policymakers cannot count on people
immediately believing them when they announce a policy of disinflation.
THE GREENSPAN ERA
Since the OPEC inflation of the 1970s and the Volcker disinflation of the 1980s, the
U.S. economy has experienced relatively mild fluctuations in inflation and unem-
ployment. Figure 33-12 shows inflation and unemployment from 1984 to 1999.
This period is called the Greenspan era, after Alan Greenspan who in 1987 fol-
lowed Paul Volcker as chairman of the Federal Reserve.
This period began with a favorable supply shock. In 1986, OPEC members
started arguing over production levels, and their long-standing agreement to re-
strict supply broke down. Oil prices fell by about half. As the figure shows, this fa-
vorable supply shock led to falling inflation and falling unemployment.
Since then, the Fed has been careful to avoid repeating the policy mistakes of
the 1960s, when excessive aggregate demand pushed unemployment below the
natural rate and raised inflation. When unemployment fell and inflation rose in
1989 and 1990, the Fed raised interest rates and contracted aggregate demand,
leading to a small recession in 1991. Unemployment then rose above most esti-
mates of the natural rate, and inflation fell once again.
Unemployment
Rate (percent)
Inflation Rate
(percent per year)
1984
1991
1985
1992
1986
1993
1994
1988
1987
1995
1996
1997
1998
1999
1989
1990
123456789100
2
4
6
8
10
Figure 33-12
THEGREENSPANERA. This
figure shows annual datafrom
1984 to 1999 on the
unemployment rate and on
theinflation rate (as measured
bythe GDPdeflator).
Duringmost of this period,
AlanGreenspan has been
chairman of the Federal
Reserve.Fluctuations in
inflationand unemployment
have been relatively small.
SOURCE:U.S. Department of Labor;
U.S.Department of Commerce.
FEDCHAIRMANALANGREENSPAN
HASPRESIDEDOVERAPERIODOFLOW
INFLATIONANDRELATIVETRANQUILLITY
INTHEECONOMY.
CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 783
CASE STUDY WHY WERE INFLATION AND UNEMPLOYMENT
SO LOW AT THE END OF THE 1990S?
As the twentieth century drew to a close, the U.S. economy was experiencing
some of the lowest rates of inflation and unemployment in many years. In 1999,
for instance, unemployment had fallen to 4.2 percent, while inflation was
running a mere 1.3 percent per year. As measured by these two important
macroeconomic variables, the United States was enjoying a period of unusual
prosperity.
Some observers argued that this experience cast doubt on the theory of the
Phillips curve. Indeed, the combination of low inflation and low unemployment
might seem to suggest that there was no longer a tradeoff between these
twovariables. Yet most economists took a less radical view of events. As we
havediscussed throughout this chapter, the short-run tradeoff between infla-
tion andunemployment shifts over time. In the 1990s, this tradeoff shifted left-
ward, allowing the economy to enjoy low unemployment and low inflation
simultaneously.
What caused this favorable shift in the short-run Phillips curve? Part of the
answer lies in a fall in expected inflation. Under Paul Volcker and Alan
Greenspan, the Fed pursued a policy aimed at reducing inflation and keeping it
low. Over time, as this policy succeeded, the Fed gained credibility with the
public that it would continue to fight inflation as necessary. The increased cred-
ibility lowered inflation expectations, which shifted the short-run Phillips curve
to the left.
In addition to this shift from reduced expected inflation, many economists
believe that the U.S. economy experienced some favorable supply shocks
during this period. (Recall that a favorable supply shock shifts the short-run
aggregate-supply curve to the right, raising output and reducing prices. It
therefore reduces both unemployment and inflation and shifts the short-run
Phillips curve to the left.) Here are three events that may get credit for the
favorable shift to aggregate supply:
The rest of the 1990s witnessed a period of economic prosperity. Inflation
gradually drifted downward, approaching zero by the end of the decade. Unem-
ployment also drifted downward, leading many observers to believe that the nat-
ural rate of unemployment had fallen. Part of the credit for this good economic
performance goes to Alan Greenspan and his colleagues at the Federal Reserve, for
low inflation can be achieved only with prudent monetary policy. But as the fol-
lowing case study discusses, good luck in the form of favorable supply shocks is
also part of the story.
What does the future hold? Macroeconomists are notoriously bad at fore-
casting, but several lessons of the past are clear. First, as long as the Fed remains
vigilant in its control over the money supply and, thereby, aggregate demand,
there is no reason to allow inflation to heat up needlessly, as it did in the late 1960s.
Second, the possibility always exists for the economy to experience adverse shocks
to aggregate supply, as it did in the 1970s. If that unfortunate development occurs,
policymakers will have little choice but to confront a less desirable tradeoff
between inflation and unemployment.
784 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
a78 Declining Commodity Prices.In the late 1990s, the prices of many basic
commodities fell on world markets. This fall in commodity prices, in turn,
was partly due to a deep recession in Japan and other Asianeconomies,
which reduced the demand for these products. Because commodities are
an important input into production, the fall in their prices reduced
producers’ costs and acted as a favorable supply shock for the U.S.
economy.
a78 Labor-Market Changes.Some economists believe that the aging of the large
baby-boom generation born after World War II has caused fundamental
changes in the labor market. Because older workers are typically in more
stable jobs than younger workers, an increase in the average age of the
laborforce may reduce the economy’s natural rate of unemployment.
a78 Technological Advance.Some economists think the U.S. economy has
entered aperiod of more rapid technological progress. Advances in
information technology, such as the Internet, have been profound and
have influenced many parts of the economy. Such technological advance
increases productivity and, therefore, is a type of favorable supply shock.
Economists debate which of these explanations of the shifting Phillips curve is
most plausible. In the end, the complete story may contain elements of each.
Keep in mind that none of these hypotheses denies the fundamental lesson
of the Phillips curve—that policymakers who control aggregate demand always
face a short-run tradeoff between inflation and unemployment. Yet the 1990s
remind us that this short-run tradeoff changes over time, sometimes in ways
that are hard to predict.
QUICK QUIZ: What is the sacrifice ratio? How might the credibility of the
Fed’s commitment to reduce inflation affect the sacrifice ratio?
CONCLUSION
This chapter has examined how economists’ thinking about inflation and unem-
ployment has evolved over time. We have discussed the ideas of many of the best
economists of the twentieth century: from the Phillips curve of Phillips, Samuel-
son, and Solow, to the natural-rate hypothesis of Friedman and Phelps, to the
rational-expectations theory of Lucas, Sargent, and Barro. Four of this group have
already won Nobel prizes for their work in economics, and more are likely to be so
honored in the years to come.
Although the tradeoff between inflation and unemployment has generated
much intellectual turmoil over the past 40 years, certain principles have developed
that today command consensus. Here is how Milton Friedman expressed the rela-
tionship between inflation and unemployment in 1968:
There is always a temporary tradeoff between inflation and unemployment;
thereis no permanent tradeoff. The temporary tradeoff comes not from inflation
perse, but from unanticipated inflation, which generally means, from a rising
CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 785
rate of inflation. The widespread belief that there is a permanent tradeoff is a
sophisticated version of the confusion between “high” and “rising” that we all
recognize in simpler forms. Arising rate of inflation may reduce unemployment,
a high rate will not.
But how long, you will say, is “temporary”? . . . I can at most venture a
personal judgment, based on some examination of the historical evidence, that
the initial effects of a higher and unanticipated rate of inflation last for something
like two to five years.
Today, more than 30 years later, this statement still summarizes the view of most
macroeconomists.
a78 The Phillips curve describes a negative relationship
between inflation and unemployment. By expanding
aggregate demand, policymakers can choose a point on
the Phillips curve with higher inflation and lower
unemployment. By contracting aggregate demand,
policymakers can choose a point on the Phillips curve
with lower inflation and higher unemployment.
a78 The tradeoff between inflation and unemployment
described by the Phillips curve holds only in the short
run. In the long run, expected inflation adjusts to
changes in actual inflation, and the short-run Phillips
curve shifts. As a result, the long-run Phillips curve is
vertical at the natural rate of unemployment.
a78 The short-run Phillips curve also shifts because of
shocks to aggregate supply. An adverse supply shock,
such as the increase in world oil prices during the 1970s,
gives policymakers a less favorable tradeoff between
inflation and unemployment. That is, after an adverse
supply shock, policymakers have to accept a higher rate
of inflation for any given rate of unemployment, or a
higher rate of unemployment for any given rate of
inflation.
a78 When the Fed contracts growth in the money supply to
reduce inflation, it moves the economy along the short-
run Phillips curve, which results in temporarily high
unemployment. The cost of disinflation depends on
how quickly expectations of inflation fall. Some
economists argue that a credible commitment to low
inflation can reduce the cost of disinflation by inducing
a quick adjustment of expectations.
Summary
Phillips curve, p. 763
natural-rate hypothesis, p. 772
supply shock, p. 775
sacrifice ratio, p. 779
rational expectations, p. 779
Key Concepts
1. Draw the short-run tradeoff between inflation and
unemployment. How might the Fed move the economy
from one point on this curve to another?
2. Draw the long-run tradeoff between inflation and
unemployment. Explain how the short-run and long-
run tradeoffs are related.
3. What’s so natural about the natural rate of
unemployment? Why might the natural rate
ofunemployment differ across countries?
4. Suppose a drought destroys farm crops and drives up
the price of food. What is the effect on the short-run
tradeoff between inflation and unemployment?
5. The Fed decides to reduce inflation. Use the Phillips
curve to show the short-run and long-run effects
ofthispolicy. How might the short-run costs be
reduced?
Questions for Review
786 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
1. Suppose the natural rate of unemployment is 6 percent.
On one graph, draw two Phillips curves that can be
used to describe the four situations listed below. Label
the point that shows the position of the economy in each
case:
a. Actual inflation is 5 percent and expected inflation
is 3 percent.
b. Actual inflation is 3 percent and expected inflation
is 5 percent.
c. Actual inflation is 5 percent and expected inflation
is 5 percent.
d. Actual inflation is 3 percent and expected inflation
is 3 percent.
2. Illustrate the effects of the following developments on
both the short-run and long-run Phillips curves. Give
the economic reasoning underlying your answers.
a. a rise in the natural rate of unemployment
b. a decline in the price of imported oil
c. a rise in government spending
d. a decline in expected inflation
3. Suppose that a fall in consumer spending causes a
recession.
a. Illustrate the changes in the economy using both an
aggregate-supply/aggregate-demand diagram and
a Phillips-curve diagram. What happens to inflation
and unemployment in the short run?
b. Now suppose that over time expected inflation
changes in the same direction that actual inflation
changes. What happens to the position of the short-
run Phillips curve? After the recession is over, does
the economy face a better or worse set of inflation–
unemployment combinations?
4. Suppose the economy is in a long-run equilibrium.
a. Draw the economy’s short-run and long-run
Phillips curves.
b. Suppose a wave of business pessimism reduces
aggregate demand. Show the effect of this shock on
your diagram from part (a). If the Fed undertakes
expansionary monetary policy, can it return the
economy to its original inflation rate and original
unemployment rate?
c. Now suppose the economy is back in long-run
equilibrium, and then the price of imported oil
rises. Show the effect of this shock with a new
diagram like that in part (a). If the Fed undertakes
expansionary monetary policy, can it return the
economy to its original inflation rate and original
unemployment rate? If the Fed undertakes
contractionary monetary policy, can it return the
economy to its original inflation rate and original
unemployment rate? Explain why this situation
differs from that in part (b).
5. Suppose the Federal Reserve believed that the natural
rate of unemployment was 6 percent when the actual
natural rate was 5.5 percent. If the Fed based its policy
decisions on its belief, what would happen to the
economy?
6. The price of oil fell sharply in 1986 and again in 1998.
a. Show the impact of such a change in both the
aggregate-demand/aggregate-supply diagram and
in the Phillips-curve diagram. What happens to
inflation and unemployment in the short run?
b. Do the effects of this event mean there is no short-
run tradeoff between inflation and unemployment?
Why or why not?
7. Suppose the Federal Reserve announced that it would
pursue contractionary monetary policy in order to
reduce the inflation rate. Would the following
conditions make the ensuing recession more or less
severe? Explain.
a. Wage contracts have short durations.
b. There is little confidence in the Fed’s determination
to reduce inflation.
c. Expectations of inflation adjust quickly to actual
inflation.
8. Some economists believe that the short-run Phillips
curve is relatively steep and shifts quickly in response to
changes in the economy. Would these economists be
more or less likely to favor contractionary policy in
order to reduce inflation than economists who had the
opposite views?
9. Imagine an economy in which all wages are set in three-
year contracts. In this world, the Fed announces a
disinflationary change in monetary policy to begin
immediately. Everyone in the economy believes the
Fed’s announcement. Would this disinflation be
costless? Why or why not? What might the Fed do to
reduce the cost of disinflation?
10. Given the unpopularity of inflation, why don’t elected
leaders always support efforts to reduce inflation?
Economists believe that countries can reduce the cost
Problems and Applications
CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 787
ofdisinflation by letting their central banks make
decisions about monetary policy without interference
from politicians. Why might this be so?
11. Suppose Federal Reserve policymakers accept the
theory of the short-run Phillips curve and the natural-
rate hypothesis and want to keep unemployment close
to its natural rate. Unfortunately, because the natural
rate of unemployment can change over time, they aren’t
certain about the value of the natural rate. What
macroeconomic variables do you think they should look
at when conducting monetary policy?
IN THIS CHAPTER
YOU WILL . . .
Consider whether
the tax laws should
be reformed to
encourage saving
Consider whether the
central bank should
aim for zero inflation
Consider whether
policymakers should
try to stabilize
the economy
Consider whether
monetary policy
should be made by
rule rather than
by discretion
Consider whether
fiscal policymakers
should reduce the
government debt
It is hard to open up the newspaper without finding some politician or editorial
writer advocating a change in economic policy. The president should use the bud-
get surplus to reduce government debt, or he should use it to increase government
spending. The Federal Reserve should cut interest rates to stimulate a flagging
economy, or it should avoid such moves in order not to risk higher inflation. Con-
gress should reform the tax system to promote faster economic growth, or it
should reform the tax system to achieve a more equal distribution of income. Eco-
nomic issues are central to the continuing political debate in the United States and
other countries around the world. It is no surprise that when Bill Clinton first ran
for president in 1992, his chief strategist posted a sign to remind the staff of the
central campaign issue: “The economy, stupid.”
The previous dozen chapters have developed the tools that economists use
when analyzing the behavior of the economy as a whole and the impact of policies
FIVE DEBATES OVER
MACROECONOMIC POLICY
791
792 PART THIRTEEN FINAL THOUGHTS
on the economy. This final chapter presents both sides in five leading debates over
macroeconomic policy. The knowledge you have accumulated in this course pro-
vides the background with which we can discuss these important, unsettled is-
sues. It should help you choose a side in these debates or, at least, help you see
why choosing a side is so difficult.
SHOULD MONETARY AND FISCAL POLICYMAKERS
TRY TO STABILIZE THE ECONOMY?
In Chapters 31, 32, and 33, we saw how changes in aggregate demand and aggre-
gate supply can lead to short-run fluctuations in production and employment. We
also saw how monetary and fiscal policy can shift aggregate demand and, thereby,
influence these fluctuations. But even if policymakers caninfluence short-run eco-
nomic fluctuations, does that mean they should?Our first debate concerns whether
monetary and fiscal policymakers should use the tools at their disposal in an at-
tempt to smooth the ups and downs of the business cycle.
PRO: POLICYMAKERS SHOULD TRY
TO STABILIZE THE ECONOMY
Left on their own, economies tend to fluctuate. When households and firms be-
come pessimistic, for instance, they cut back on spending, and this reduces the ag-
gregate demand for goods and services. The fall in aggregate demand, in turn,
reduces the production of goods and services. Firms lay off workers, and the un-
employment rate rises. Real GDPand other measures of income fall. Rising unem-
ployment and falling income help confirm the pessimism that initially generated
the economic downturn.
Such a recession has no benefit for society—it represents a sheer waste of re-
sources. Workers who become unemployed because of inadequate aggregate de-
mand would rather be working. Business owners whose factories are left idle
during a recession would rather be producing valuable goods and services and
selling them at a profit.
There is no reason for society to suffer through the booms and busts of the
business cycle. The development of macroeconomic theory has shown policy-
makers how to reduce the severity of economic fluctuations. By “leaning against
the wind” of economic change, monetary and fiscal policy can stabilize aggregate
demand and, thereby, production and employment. When aggregate demand is
inadequate to ensure full employment, policymakers should boost government
spending, cut taxes, and expand the money supply. When aggregate demand
is excessive, risking higher inflation, policymakers should cut government
spending, raise taxes, and reduce the money supply. Such policy actions put
macroeconomic theory to its best use by leading to a more stable economy, which
benefits everyone.
CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 793
CON: POLICYMAKERS SHOULD NOT TRY
TO STABILIZE THE ECONOMY
Although monetary and fiscal policy can be used to stabilize the economy in the-
ory, there are substantial obstacles to the use of such policies in practice.
One problem is that monetary and fiscal policy do not affect the economy im-
mediately but instead work with a long lag. Monetary policy affects aggregate de-
mand by changing interest rates, which in turn affect spending, especially
residential and business investment. But many households and firms set their
spending plans in advance. As a result, it takes time for changes in interest rates to
alter the aggregate demand for goods and services. Many studies indicate that
changes in monetary policy have little effect on aggregate demand until about six
months after the change is made.
Fiscal policy works with a lag because of the long political process that gov-
erns changes in spending and taxes. To make any change in fiscal policy, a bill
must go through congressional committees, pass both the House and the Senate,
and be signed by the president. It can take years to propose, pass, and implement
a major change in fiscal policy.
Because of these long lags, policymakers who want to stabilize the economy
need to look ahead to economic conditions that are likely to prevail when their ac-
tions will take effect. Unfortunately, economic forecasting is highly imprecise, in
part because macroeconomics is such a primitive science and in part because the
shocks that cause economic fluctuations are intrinsically unpredictable. Thus,
when policymakers change monetary or fiscal policy, they must rely on educated
guesses about future economic conditions.
All too often, policymakers trying to stabilize the economy do just the oppo-
site. Economic conditions can easily change between the time when a policy action
begins and when it takes effect. Because of this, policymakers can inadvertently
794 PART THIRTEEN FINAL THOUGHTS
exacerbate rather than mitigate the magnitude of economic fluctuations. Some
economists have claimed that many of the major economic fluctuations in history,
including the Great Depression of the 1930s, can be traced to destabilizing policy
actions.
One of the first rules taught to physicians is “do no harm.” The human body
has natural restorative powers. Confronted with a sick patient and an uncertain
diagnosis, often a doctor should do nothing but leave the patient’s body to its own
devices. Intervening in the absence of reliable knowledge merely risks making
matters worse.
The same can be said about treating an ailing economy. It might be desirable if
policymakers could eliminate all economic fluctuations, but that is not a realistic
goal given the limits of macroeconomic knowledge and the inherent un-
predictability of world events. Economic policymakers should refrain from inter-
vening often with monetary and fiscal policy and be content if they do no harm.
QUICK QUIZ: Explain why monetary and fiscal policy work with a lag.
Why do these lags matter in the choice between active and passive policy?
SHOULD MONETARY POLICY BE MADE BY RULE
RATHER THAN BY DISCRETION?
As we first discussed in Chapter 27, the Federal Open Market Committee sets
monetary policy in the United States. The committee meets about every six
weeks to evaluate the state of the economy. Based on this evaluation and fore-
casts of future economic conditions, it chooses whether to raise, lower, or leave un-
changed the level of short-term interest rates. The Fed then adjusts the money
supply to reach that interest-rate target until the next meeting, when the target is
reevaluated.
The Federal Open Market Committee operates with almost complete discre-
tion over how to conduct monetary policy. The laws that created the Fed give the
institution only vague recommendations about what goals it should pursue. And
they do not tell the Fed how to pursue whatever goals it might choose. Once mem-
bers are appointed to the Federal Open Market Committee, they have little man-
date but to “do the right thing.”
Some economists are critical of this institutional design. Our second debate
over macroeconomic policy, therefore, focuses on whether the Federal Reserve
should have its discretionary powers reduced and, instead, be committed to fol-
lowing a rule for how it conducts monetary policy.
PRO: MONETARY POLICY SHOULD BE MADE BY RULE
Discretion in the conduct of monetary policy has two problems. The first is that it
does not limit incompetence and abuse of power. When the government sends
CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 795
police into a community to maintain civic order, it gives them strict guidelines
about how to carry out their job. Because police have great power, allowing them
to exercise that power in whatever way they want would be dangerous. Yet when
the government gives central bankers the authority to maintain economic order,
it gives them no guidelines. Monetary policymakers are allowed undisciplined
discretion.
As an example of abuse of power, central bankers are sometimes tempted to
use monetary policy to affect the outcome of elections. Suppose that the vote for
the incumbent president is based on economic conditions at the time he is up for
reelection. A central banker sympathetic to the incumbent might be tempted to
pursue expansionary policies just before the election to stimulate production and
employment, knowing that the resulting inflation will not show up until after the
election. Thus, to the extent that central bankers ally themselves with politicians,
discretionary policy can lead to economic fluctuations that reflect the electoral cal-
endar. Economists call such fluctuations the political business cycle.
The second, more subtle, problem with discretionary monetary policy is that
it might lead to more inflation than is desirable. Central bankers, knowing that
there is no long-run tradeoff between inflation and unemployment, often an-
nounce that their goal is zero inflation. Yet they rarely achieve price stability.
Why? Perhaps it is because, once the public forms expectations of inflation,
policymakers face a short-run tradeoff between inflation and unemployment.
They are tempted to renege on their announcement of price stability in order to
achieve lower unemployment. This discrepancy between announcements (what
policymakers say they are going to do) and actions (what they subsequently in
fact do) is called the time inconsistency of policy.Because policymakers are so often
time inconsistent, people are skeptical when central bankers announce their in-
tentions to reduce the rate of inflation. As a result, people always expect more
inflation than monetary policymakers claim they are trying to achieve. Higher ex-
pectations of inflation, in turn, shift the short-run Phillips curve upward, making
the short-run tradeoff between inflation and unemployment less favorable than it
otherwise might be.
One way to avoid these two problems with discretionary policy is to commit
the central bank to a policy rule. For example, suppose that Congress passed a law
requiring the Fed to increase the money supply by exactly 3 percent per year. (Why
3 percent? Because real GDP grows on average about 3 percent per year and be-
cause money demand grows with real GDP, 3 percent growth in the money supply
is roughly the rate necessary to produce long-run price stability.) Such a law would
eliminate incompetence and abuse of power on the part of the Fed, and it would
make the political business cycle impossible. In addition, policy could no longer be
time inconsistent. People would now believe the Fed’s announcement of low in-
flation because the Fed would be legally required to pursue a low-inflation mone-
tary policy. With low expected inflation, the economy would face a more favorable
short-run tradeoff between inflation and unemployment.
Other rules for monetary policy are also possible. Amore active rule might al-
low some feedback from the state of the economy to changes in monetary policy.
For example, a more active rule might require the Fed to increase monetary growth
by 1 percentage point for every percentage point that unemployment rises above
its natural rate. Regardless of the precise form of the rule, committing the Fed to
some rule would yield advantages by limiting incompetence, abuse of power, and
time inconsistency in the conduct of monetary policy.
796 PART THIRTEEN FINAL THOUGHTS
CON: MONETARY POLICY SHOULD NOT BE MADE BY RULE
Although there may be pitfalls with discretionary monetary policy, there is also an
important advantage to it: flexibility. The Fed has to confront various circum-
stances, not all of which can be foreseen. In the 1930s banks failed in record num-
bers. In the 1970s the price of oil skyrocketed around the world. In October 1987
the stock market fell by 22 percent in a single day. The Fed must decide how to re-
spond to these shocks to the economy. Adesigner of a policy rule could not possi-
bly consider all the contingencies and specify in advance the right policy response.
It is better to appoint good people to conduct monetary policy and then give them
the freedom to do the best they can.
Moreover, the alleged problems with discretion are largely hypothetical. The
practical importance of the political business cycle, for instance, is far from clear.
In some cases, just the opposite seems to occur. For example, President Jimmy
Carter appointed Paul Volcker to head the Federal Reserve in 1979. Nonetheless, in
DURING THE 1990S, MANY CENTRAL BANKS
around the world adopted inflation
targeting as a rule—or at least as a
rough guide—for setting monetary
policy. Brazil is a recent example.
Brazil to Use Inflation Data for
Managing Interest Rates
BY PETER FRITSCH
RIO DE JANEIRO—Brazil’s Central Bank
will adopt in late June a formal process
for managing interest rates based on
predefined inflation targets for the fol-
lowing 30 months, according to the
bank’s president, Arminio Fraga.
In an interview, Mr. Fraga said the
Central Bank is in the process of work-
ing out the details of an “inflation target-
ing” regime for managing interest rates
and the economy. Inflation targeting—
a system used by other countries with
free-floating currencies such as Britain,
Canada, and New Zealand—is fairly sim-
ple: If prices are rising faster than expec-
tations, interest rates are lifted to cool
off the economy. If prices are falling or
steady, rates are cut. . . .
Once in place, Brazil’s new policy
will look like the Bank of England’s.
Britain’s central bank hitched interest-
rate policy to a more visible price anchor
after the inflationary shock of the
pound’s severe weakening in 1992. To-
day, the United Kingdom targets annual
inflation at 2.5% over a two-year horizon
and adjusts short-term interest rates
when its price forecasts wander from
that goal by more than a percentage
point.
In general, outside observers like
the simplicity of this policy. “The ad-
vantage of targeting inflation is that
the Central Bank is less likely to
micromanage than if it is trying to target
the level of interest rates or the cur-
rency,” says Morgan Stanley Dean Wit-
ter & Co. economist Ernest W. Brown.
The downside of setting explicit targets
is that a hard-to-predict economy without
price controls like Brazil’s is apt to miss
its inflation targets from time to time, and
miss them publicly.
That causes some to worry about
the Brazilian Central Bank’s lack of inde-
pendence. Brazil’s Central Bank reports
to the Finance Ministry, and thus to the
president. What if missing—or hitting—
an inflation target clashes with other ad-
ministration goals, such as reducing
unemployment? “Inflation targeting goes
in the right direction of trying to insulate
the Central Bank from politics,” says
J. P. Morgan & Co. economist Marcelo
Carvalho. “Still, introducing inflation tar-
geting without proper formal Central
Bank independence risks just pouring
old wine into new bottles.”
SOURCE:The Wall Street Journal,May 22, 1999,
p.A8.
IN THE NEWS
Inflation Targeting
CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 797
October of that year Volcker moved to contract monetary policy to combat the
high rate of inflation that he had inherited from his predecessor. The predictable
result of Volcker’s decision was a recession, and the predictable result of the reces-
sion was a decline in Carter’s popularity. Rather than using monetary policy to
help the president who had appointed him, Volcker helped to ensure Carter’s de-
feat by Ronald Reagan in the November 1980 election.
The practical importance of time inconsistency is also far from clear. Although
most people are skeptical of central-bank announcements, central bankers can
achieve credibility over time by backing up their words with actions. In the 1990s,
the Fed achieved and maintained a low rate of inflation, despite the ever present
temptation to take advantage of the short-run tradeoff between inflation and un-
employment. This experience shows that low inflation does not require that the
Fed be committed to a policy rule.
Any attempt to replace discretion with a rule must confront the difficult task
of specifying a precise rule. Despite much research examining the costs and bene-
fits of alternative rules, economists have not reached a consensus about what a
good rule would be. Until there is a consensus, society has little choice but to give
central bankers discretion to conduct monetary policy as they see fit.
QUICK QUIZ: Give an example of a monetary policy rule. Why might
your rule be better than discretionary policy? Why might it be worse?
SHOULD THE CENTRAL BANK
AIM FOR ZERO INFLATION?
One of the Ten Principles of Economicsdiscussed in Chapter 1, and developed more
fully in Chapter 28, is that prices rise when the government prints too much
money. Another of the Ten Principles of Economics discussed in Chapter 1, and de-
veloped more fully in Chapter 33, is that society faces a short-run tradeoff between
inflation and unemployment. Put together, these two principles raise a question
for policymakers: How much inflation should the central bank be willing to toler-
ate? Our third debate is whether zero is the right target for the inflation rate.
PRO: THE CENTRAL BANK SHOULD
AIM FOR ZERO INFLATION
Inflation confers no benefit on society, but it imposes several real costs. As we dis-
cussed in Chapter 28, economists have identified six costs of inflation:
a78 Shoeleather costs associated with reduced money holdings
a78 Menu costs associated with more frequent adjustment of prices
a78 Increased variability of relative prices
a78 Unintended changes in tax liabilities due to nonindexation of the tax code
798 PART THIRTEEN FINAL THOUGHTS
a78 Confusion and inconvenience resulting from a changing unit of account
a78 Arbitrary redistributions of wealth associated with dollar-denominated debts
Some economists argue that these costs are small, at least for moderate rates of in-
flation, such as the 3 percent inflation experienced in the United States during the
1990s. But other economists claim these costs can be substantial, even for moder-
ate inflation. Moreover, there is no doubt that the public dislikes inflation. When
inflation heats up, opinion polls identify inflation as one of the nation’s leading
problems.
Of course, the benefits of zero inflation have to be weighed against the costs of
achieving it. Reducing inflation usually requires a period of high unemployment
and low output, as illustrated by the short-run Phillips curve. But this disinfla-
tionary recession is only temporary. Once people come to understand that policy-
makers are aiming for zero inflation, expectations of inflation will fall, and the
short-run tradeoff will improve. Because expectations adjust, there is no tradeoff
between inflation and unemployment in the long run.
Reducing inflation is, therefore, a policy with temporary costs and permanent
benefits. That is, once the disinflationary recession is over, the benefits of zero in-
flation would persist into the future. If policymakers are farsighted, they should be
willing to incur the temporary costs for the permanent benefits. This is precisely
the calculation made by Paul Volcker in the early 1980s, when he tightened mone-
tary policy and reduced inflation from about 10 percent in 1980 to about 4 percent
in 1983. Although in 1982 unemployment reached its highest level since the Great
Depression, the economy eventually recovered from the recession, leaving a legacy
of low inflation. Today Volcker is considered a hero among central bankers.
Moreover, the costs of reducing inflation need not be as large as some econo-
mists claim. If the Fed announces a credible commitment to zero inflation, it can
directly influence expectations of inflation. Such a change in expectations can im-
prove the short-run tradeoff between inflation and unemployment, allowing the
economy to reach lower inflation at a reduced cost. The key to this strategy is cred-
ibility: People must believe that the Fed is actually going to carry through on its
announced policy. Congress could help in this regard by passing legislation that
made price stability the Fed’s primary goal. Such a law would make it less costly
to achieve zero inflation without reducing any of the resulting benefits.
One advantage of a zero-inflation target is that zero provides a more natural
focal point for policymakers than any other number. Suppose, for instance, that the
Fed were to announce that it would keep inflation at 3 percent—the rate experi-
enced during the 1990s. Would the Fed really stick to that 3 percent target? If
events inadvertently pushed inflation up to 4 or 5 percent, why wouldn’t they just
raise the target? There is, after all, nothing special about the number 3. By contrast,
zero is the only number for the inflation rate at which the Fed can claim that it
achieved price stability and fully eliminated the costs of inflation.
CON: THE CENTRAL BANK SHOULD NOT
AIM FOR ZERO INFLATION
Although price stability may be desirable, the benefits of zero inflation compared
to moderate inflation are small, whereas the costs of reaching zero inflation are
CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 799
large. Estimates of the sacrifice ratio suggest that reducing inflation by 1 percent-
age point requires giving up about 5 percent of one year’s output. Reducing infla-
tion from, say, 4 percent to zero requires a loss of 20 percent of a year’s output. At
the current level of gross domestic product of about $9 trillion, this cost translates
into $1.8 trillion of lost output, which is about $6,500 per person. Although people
might dislike inflation, it is not at all clear that they would (or should) be willing
to pay this much to get rid of it.
The social costs of disinflation are even larger than this $6,500 figure suggests,
for the lost income is not spread equitably over the population. When the econ-
omy goes into recession, all incomes do not fall proportionately. Instead, the
fall in aggregate income is concentrated on those workers who lose their jobs.
The vulnerable workers are often those with the least skills and experience.
Hence, much of the cost of reducing inflation is borne by those who can least af-
ford to pay it.
Although economists can list several costs of inflation, there is no professional
consensus that these costs are substantial. The shoeleather costs, menu costs, and
others that economists have identified do not seem great, at least for moderate
rates of inflation. It is true that the public dislikes inflation, but the public may be
misled into believing the inflation fallacy—the view that inflation erodes living
standards. Economists understand that living standards depend on productivity,
not monetary policy. Because inflation in nominal incomes goes hand in hand with
inflation in prices, reducing inflation would not cause real incomes to rise more
rapidly.
Moreover, policymakers can reduce many of the costs of inflation without ac-
tually reducing inflation. They can eliminate the problems associated with the
nonindexed tax system by rewriting the tax laws to take account of the effects of
inflation. They can also reduce the arbitrary redistributions of wealth between
creditors and debtors caused by unexpected inflation by issuing indexed govern-
ment bonds, as in fact the Clinton administration did in 1997. Such an act insulates
holders of government debt from inflation. In addition, by setting an example, it
might encourage private borrowers and lenders to write debt contracts indexed for
inflation.
Reducing inflation might be desirable if it could be done at no cost, as some
economists argue is possible. Yet this trick seems hard to carry out in practice.
When economies reduce their rate of inflation, they almost always experience a pe-
riod of high unemployment and low output. It is risky to believe that the central
bank could achieve credibility so quickly as to make disinflation painless.
Indeed, a disinflationary recession can potentially leave permanent scars on
the economy. Firms in all industries reduce their spending on new plants and
equipment substantially during recessions, making investment the most volatile
component of GDP. Even after the recession is over, the smaller stock of capital re-
duces productivity, incomes, and living standards below the levels they otherwise
would have achieved. In addition, when workers become unemployed in reces-
sions, they lose valuable job skills. Even after the economy has recovered, their
value as workers is diminished. Some economists have argued that the high un-
employment in many European economies during the past decade is the aftermath
of the disinflations of the 1980s.
Why should policymakers put the economy through a costly, inequitable dis-
inflationary recession to achieve zero inflation, which may have only modest ben-
efits? Economist Alan Blinder, whom Bill Clinton appointed to be vice chairman of
800 PART THIRTEEN FINAL THOUGHTS
the Federal Reserve, argued forcefully in his book Hard Heads, Soft Hearts that
policymakers should not make this choice:
The costs that attend the low and moderate inflation rates experienced in the
United States and in other industrial countries appear to be quite modest—more
like a bad cold than a cancer on society. . . . As rational individuals, we do not
volunteer for a lobotomy to cure a head cold. Yet, as a collectivity, we routinely
prescribe the economic equivalent of lobotomy (high unemployment) as a cure
for the inflationary cold.
Blinder concludes that it is better to learn to live with moderate inflation.
QUICK QUIZ: Explain the costs and benefits of reducing inflation to zero.
Which are temporary and which are permanent?
SHOULD FISCAL POLICYMAKERS
REDUCE THE GOVERNMENT DEBT?
Perhaps the most persistent macroeconomic debate in recent years has been over
the finances of the federal government. Throughout most of the 1980s and 1990s,
the U.S. federal government spent more than it collected in tax revenue and fi-
nanced this budget deficit by issuing government debt. When we studied financial
markets in Chapter 25, we saw how budget deficits affect saving, investment, and
interest rates.
This situation reversed itself in the late 1990s, when a combination of tax hikes,
spending cuts, and strong economic growth eliminated the government’s budget
deficit and even produced a small budget surplus. Our fourth debate concerns
whether fiscal policymakers should use this budget surplus to reduce the govern-
ment debt. The alternative is to eliminate the budget surplus by cutting taxes or
increasing spending.
PRO: POLICYMAKERS SHOULD
REDUCE THE GOVERNMENT DEBT
The U.S. federal government is far more indebted today than it was two decades
ago. In 1980, the federal debt was $710 billion; in 1999, it was $3.7 trillion. If we di-
vide today’s debt by the size of the population, we learn that each person’s share
of the government debt is about $14,000.
The most direct effect of the government debt is to place a burden on future
generations of taxpayers. When these debts and accumulated interest come due,
future taxpayers will face a difficult choice. They can pay higher taxes, enjoy less
government spending, or both, in order to make resources available to pay off the
debt and accumulated interest. Or they can delay the day of reckoning and put the
government into even deeper debt by borrowing once again to pay off the old debt
and interest. In essence, when the government runs a budget deficit and issues
government debt, it allows current taxpayers to pass the bill for some of their
“MY SHARE OF THE GOVERNMENT DEBT
IS $14,000.”
CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 801
government spending on to future taxpayers. Inheriting such a large debt cannot
help but lower the living standard of future generations.
In addition to this direct effect, budget deficits also have various macroeco-
nomic effects. Because budget deficits represent negativepublic saving, they lower
national saving (the sum of private and public saving). Reduced national saving
causes real interest rates to rise and investment to fall. Reduced investment leads
over time to a smaller stock of capital. Alower capital stock reduces labor produc-
tivity, real wages, and the economy’s production of goods and services. Thus,
when the government increases its debt, future generations are born into an econ-
omy with lower incomes as well as higher taxes.
There are, nevertheless, situations in which running a budget deficit is justifi-
able. Throughout history, the most common cause of increased government debt is
war. When a military conflict raises government spending temporarily, it is rea-
sonable to finance this extra spending by borrowing. Otherwise, taxes during
wartime would have to rise precipitously. Such high tax rates would greatly dis-
tort the incentives faced by those who are taxed, leading to large deadweight
losses. In addition, such high tax rates would be unfair to current generations of
taxpayers, who already have to make the sacrifice of fighting the war.
Similarly, it is reasonable to allow a rise in government debt during a tempo-
rary downturn in economic activity. When the economy goes into a recession, tax
revenue falls automatically, because the income tax and the payroll tax are levied
on measures of income. If the government tried to balance its budget during a re-
cession, it would have to raise taxes or cut spending at a time of high unemploy-
ment. Such a policy would tend to depress aggregate demand at precisely the time
it needed to be stimulated and, therefore, would tend to increase the magnitude of
economic fluctuations.
The rise in government debt during the 1980s and 1990s, however, cannot be
justified by appealing to war or recession. During this period, the United States
avoided major military conflict and major economic downturn. Nonetheless, the
government consistently ran a budget deficit, largely because the president and
Congress found it easier to increase government spending than to increase taxes.
As a result, government debt as a percentage of annual gross domestic product in-
creased from 26 percent in 1980 to 50 percent in 1995, before falling back a bit to
44 percent in 1999. It is hard to see any rationale for this rise in government debt.
If the U.S. government had been operating with a balanced budget since 1980,
today’s college graduates would be entering an economy that promised them
greater economic prosperity.
It’s now time to reverse the effects of this policy mistake. A combination of
fiscal prudence and good luck left the U.S. government with a budget surplus in
the late 1990s and projected surpluses for subsequent years. We should use these
surpluses to repay some of the debt that the government has accumulated. Com-
pared to the alternative of cutting taxes or increasing spending, repaying the debt
would mean greater national saving, investment, and economic growth.
CON: POLICYMAKERS SHOULD NOT
REDUCE THE GOVERNMENT DEBT
The problem of government debt is often exaggerated. Although the government
debt does represent a tax burden on younger generations, it is not large compared
to the average person’s lifetime income. The debt of the U.S. federal government is
802 PART THIRTEEN FINAL THOUGHTS
about $14,000 per person. Aperson who works 40 years for $25,000 a year will earn
$1 million over his lifetime. His share of the government debt represents less than
2 percent of his lifetime resources.
Moreover, it is misleading to view the effects of government debt in isolation.
The government debt is just one piece of a large picture of how the government
chooses to raise and spend money. In making these decisions over fiscal policy,
policymakers affect different generations of taxpayers in many ways. The govern-
ment’s budget deficit or surplus should be considered together with these other
policies.
For example, suppose the government uses the budget surplus to pay off the
government debt instead of using it to pay for increased spending on education.
Does this policy make young generations better off? The government debt will be
smaller when they enter the labor force, which means a smaller tax burden. Yet if
they are less well educated than they could be, their productivity and incomes will
be lower. Many estimates of the return to schooling (the increase in a worker’s
wage that results from an additional year in school) find that it is quite large. Re-
ducing the government debt rather than funding more education spending could,
all things considered, make future generations worse off.
Single-minded concern about the government debt is also dangerous because
it draws attention away from various other policies that redistribute income across
generations. For example, in the 1960s and 1970s, the U.S. federal government
raised Social Security benefits for the elderly. It financed this higher spending by
increasing the payroll tax on the working-age population. This policy redistributed
income away from younger generations toward older generations, even though
it did not affect the government debt. Thus, government debt is only a small
piece of the larger issue of how government policy affects the welfare of different
generations.
To some extent, the adverse effects of government debt can be reversed by
forward-looking parents. Suppose a parent is worried about the impact of the
government debt on his children. The parent can offset the impact simply by sav-
ing and leaving a larger bequest. The bequest would enhance the children’s ability
to bear the burden of future taxes. Some economists claim that people do in fact
behave this way. If this were true, higher private saving by parents would offset
the public dissaving of budget deficits, and deficits would not affect the economy.
Most economists doubt that parents are so farsighted, but some people probably
do act this way, and anyone could. Deficits give people the opportunity to con-
sume at the expense of their children, but deficits do not require them to do so. If
the government debt actually represented a great problem facing future genera-
tions, some parents would help to solve it.
Critics of budget deficits sometimes assert that the government debt cannot
continue to rise forever, but in fact it can. Just as a bank officer evaluating a loan
application would compare a person’s debts to his income, we should judge the
burden of the government debt relative to the size of the nation’s income. Popula-
tion growth and technological progress cause the total income of the U.S. economy
to grow over time. As a result, the nation’s ability to pay the interest on the gov-
ernment debt grows over time as well. As long as the government debt grows
more slowly than the nation’s income, there is nothing to prevent the government
debt from growing forever.
Some numbers can put this into perspective. The real output of the U.S. econ-
omy grows on average about 3 percent per year. If the inflation rate is 2 percent per
CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 803
WHEN POLICYMAKERS FACE GOVERNMENT
budget surpluses, they have three op-
tions: cutting taxes, increasing spend-
ing, or reducing the government debt.
Choosing is not easy.
Lawmakers Discover
That Surpluses
Can Be as Vexing as Deficits
BY DAVID WESSEL AND GREG HITT
WASHINGTON—It took politicians 15 con-
tentious years to eliminate the biggest
federal budget deficits since World
War II. Now, they are having nearly as
much difficulty deciding what to do with
the roughly $3 trillion in surpluses pro-
jected over the next 10 years.
The sudden emergence of a budget
windfall larger than anticipated just six
months ago is forcing into fast-forward
a longstanding debate over fiscal policy
and the role of government.
On the surface, lawmakers face a
simple multiple-choice question: Should
the surplus be saved, spent, or devoted
to tax cuts? But at its core, the debate
is about profound issues that were
long suppressed by the deficit-reduction
imperative:
How big should government be?
DoAmericans prefer to pay less in
taxes or have government do more?
How much should younger workers sac-
rifice to support baby-boomer parents
and grandparents in retirement, and how
much should baby-boomers set aside in
advance? How much should government
interfere with the workings of the market
to spread the benefits of today’s pros-
perity? Is paying off debt incurred in the
1980s and 1990s more or less important
than raising spending on education and
health or lowering taxes?
With something less than unanimity,
Republicans make the case for bigger
tax cuts and smaller government. “Re-
publicans believe it’s a matter of principle
to return excess tax money in Wash-
ington to the families and workers who
sent it here,” House Ways and Means
Chairman Bill Archer, a Texas Republi-
can, said on the floor of the House of
Representatives during last week’s tax-
cut debate. “Republicans believe that
Americans have the right to keep more
of what they earn.”
Where Republicans see an over-
taxed populace, however, liberal Democ-
rats in Congress see “unmet needs.”
“The question,” says Rep. Barney
Frank, a Massachusetts Democrat, “is
not whether the surplus should be spent
according to people’s wishes. Of course
it should. The question is whether it
should be spent on private goods or
public goods.” . . .
The public is split, but a new Wall
Street Journal/NBC News poll suggests
that the GOP is having trouble selling
its call for tax cuts. . . . Asked to pick
just one option for using the surplus, 46
percent of the 1,007 respondents opted
for spending on social programs such as
education or a prescription-drug benefit
for Medicare recipients, 22 percent
picked paying down the federal debt, and
only 20 percent picked tax cuts. (The
rest picked defense or didn’t make a
choice.)
“We are not in a period like the
late 1970s when people really despised
government,” says Republican pollster
Robert Teeter, who conducted the poll
with Democrat Peter Hart. “The elec-
torate is saying there are serious le-
gitimate issues that the government
should address, and they are willing to
use some of their money to do it,” Mr.
Teeter adds. . . .
Fed Chairman Greenspan continues
to preach the virtues of debt reduction.
Although he doesn’t admit to as much,
he sees virtue in gridlock. If Congress
and Mr. Clinton can get appropriations
bills enacted this year, but agree on
nothing else, then the surplus will auto-
matically go to reducing the government
debt.
SOURCE:The Wall Street Journal,July 29, 1999,
p.A1.
IN THE NEWS
The Budget Surplus
804 PART THIRTEEN FINAL THOUGHTS
year, then nominal income grows at a rate of 5 percent per year. The government
debt, therefore, can rise by 5 percent per year without increasing the ratio of debt
to income. In 1999 the federal government debt was $3.7 trillion; 5 percent of this
figure is $165 billion. As long as the federal budget deficit is smaller than $165 bil-
lion, the policy is sustainable. There will never be any day of reckoning that forces
the budget deficits to end or the economy to collapse.
If moderate budget deficits are sustainable, there is no need for the govern-
ment to maintain budget surpluses. Let’s put this excess of revenue over spending
to better use. The government could use these funds to pay for valuable govern-
ment programs, such as increased funding for education. Or it could use them to
finance a tax cut. In the late 1990s taxes reached an historic high as a percentage of
GDP, so there is every reason to suppose that the deadweight losses of taxation
reached an historic high as well. If all these taxes aren’t needed for current spend-
ing, the government should return the money to the people who earned it.
QUICK QUIZ: Explain how reducing the government debt makes future
generations better off. What fiscal policy might improve the lives of future
generations more than reducing the government debt?
SHOULD THE TAX LAWS BE REFORMED TO
ENCOURAGE SAVING?
Anation’s standard of living depends on its ability to produce goods and services.
This was one of the Ten Principles of Economicsin Chapter 1. As we saw in Chapter
24, a nation’s productive capability, in turn, is determined largely by how much it
saves and invests for the future. Our fifth debate is whether policymakers should
reform the tax laws to encourage greater saving and investment.
PRO: THE TAX LAWS SHOULD BE
REFORMED TO ENCOURAGE SAVING
A nation’s saving rate is a key determinant of its long-run economic prosperity.
When the saving rate is higher, more resources are available for investment in new
plant and equipment. Alarger stock of plant and equipment, in turn, raises labor
productivity, wages, and incomes. It is, therefore, no surprise that international
data show a strong correlation between national saving rates and measures of eco-
nomic well-being.
Another of the Ten Principles of Economicspresented in Chapter 1 is that people
respond to incentives. This lesson should apply to people’s decisions about how
much to save. If a nation’s laws make saving attractive, people will save a higher
fraction of their incomes, and this higher saving will lead to a more prosperous
future.
Unfortunately, the U.S. tax system discourages saving by taxing the return to
saving quite heavily. For example, consider a 25-year-old worker who saves $1,000
CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 805
of her income to have a more comfortable retirement at the age of 70. If she buys a
bond that pays an interest rate of 10 percent, the $1,000 will accumulate at the end
of 45 years to $72,900 in the absence of taxes on interest. But suppose she faces a
marginal tax rate on interest income of 40 percent, which is typical of many work-
ers once federal and state income taxes are added together. In this case, her after-
tax interest rate is only 6 percent, and the $1,000 will accumulate at the end of 45
years to only $13,800. That is, accumulated over this long span of time, the tax rate
on interest income reduces the benefit of saving $1,000 from $72,900 to $13,800—
or by about 80 percent.
The tax code further discourages saving by taxing some forms of capital in-
come twice. Suppose a person uses some of his saving to buy stock in a corpora-
tion. When the corporation earns a profit from its capital investments, it first pays
tax on this profit in the form of the corporate income tax. If the corporation pays
out the rest of the profit to the stockholder in the form of dividends, the stock-
holder pays tax on this income a second time in the form of the individual income
tax. This double taxation substantially reduces the return to the stockholder,
thereby reducing the incentive to save.
The tax laws again discourage saving if a person wants to leave his accumu-
lated wealth to his children (or anyone else) rather than consuming it during his
lifetime. Parents can bequeath some money to their children without tax, but if the
bequest becomes large, the inheritance tax rate can be as high as 55 percent. To a
large extent, concern about national saving is motivated by a desire to ensure eco-
nomic prosperity for future generations. It is odd, therefore, that the tax laws dis-
courage the most direct way in which one generation can help the next.
In addition to the tax code, many other policies and institutions in our society
reduce the incentive for households to save. Some government benefits, such as
welfare and Medicaid, are means-tested; that is, the benefits are reduced for those
who in the past have been prudent enough to save some of their income. Colleges
and universities grant financial aid as a function of the wealth of the students and
their parents. Such a policy is like a tax on wealth and, as such, discourages stu-
dents and parents from saving.
There are various ways in which the tax code could provide an incentive to
save, or at least reduce the disincentive that households now face. Already the tax
laws give preferential treatment to some types of retirement saving. When a tax-
payer puts income into an Individual Retirement Account (IRA), for instance, that
income and the interest it earns are not taxed until the funds are withdrawn at re-
tirement. The tax code gives a similar tax advantage to retirement accounts that go
by other names, such as 401(k), 403(b), Keogh, and profit-sharing plans. There are,
however, limits to who is eligible to use these plans and, for those who are eligible,
limits on the amount that can be put in them. Moreover, because there are penal-
ties for withdrawal before retirement age, these retirement plans provide little in-
centive for other types of saving, such as saving to buy a house or pay for college.
Asmall step to encourage greater saving would be to expand the ability of house-
holds to use such tax-advantaged savings accounts.
Amore comprehensive approach would be to reconsider the entire basis by
which the government collects revenue. The centerpiece of the U.S. tax system is
the income tax. A dollar earned is taxed the same whether it is spent or saved.
An alternative advocated by many economists is a consumption tax. Under a
consumption tax, a household pays taxes only on the basis of what it spends.
Income that is saved is exempt from taxation until the saving is later withdrawn
806 PART THIRTEEN FINAL THOUGHTS
and spent on consumption goods. In essence, a consumption tax puts all sav-
ing automatically into a tax-advantaged savings account, much like an IRA. A
switch from income to consumption taxation would greatly increase the incentive
tosave.
CON: THE TAX LAWS SHOULD
NOT BE REFORMED TO ENCOURAGE SAVING
Increasing saving may be desirable, but it is not the only goal of tax policy. Policy-
makers also must be sure to distribute the tax burden fairly. The problem with pro-
posals to increase the incentive to save is that they increase the tax burden on those
who can least afford it.
It is an undeniable fact that high-income households save a greater fraction of
their income than low-income households. As a result, any tax change that favors
people who save will also tend to favor people with high income. Policies such
as tax-advantaged retirement accounts may seem appealing, but they lead to a
less egalitarian society. By reducing the tax burden on the wealthy who can take
advantage of these accounts, they force the government to raise the tax burden on
the poor.
Moreover, tax policies designed to encourage saving may not be effective at
achieving that goal. Many studies have found that saving is relatively inelastic—
that is, the amount of saving is not very sensitive to the rate of return on saving.
If this is indeed the case, then tax provisions that raise the effective return by
reducing the taxation of capital income will further enrich the wealthy without
inducing them to save more than they otherwise would.
Economic theory does not give a clear prediction about whether a higher
rate of return would increase saving. The outcome depends on the relative size
of two conflicting effects, called the substitution effect and the income effect. On
the one hand, a higher rate of return raises the benefit of saving: Each dollar
saved today produces more consumption in the future. This substitution effect
tends to raise saving. On the other hand, a higher rate of return lowers the need
forsaving: Ahousehold has to save less to achieve any target level of consumption
in the future. This income effect tends to reduce saving. If the substitution and
income effects approximately cancel each other, as some studies suggest, then
saving will not change when lower taxation of capital income raises the rate of
return.
There are other ways to raise national saving than by giving tax breaks to the
rich. National saving is the sum of private and public saving. Instead of trying to
alter the tax code to encourage greater private saving, policymakers can simply
raise public saving by increasing the budget surplus, perhaps by raising taxes on
the wealthy. This offers a direct way of raising national saving and increasing pros-
perity for future generations.
Indeed, once public saving is taken into account, tax provisions to encourage
saving might backfire. Tax changes that reduce the taxation of capital income
reduce government revenue and, thereby, lead to a budget deficit. To increase na-
tional saving, such a change in the tax code must stimulate private saving by more
than it reduces public saving. If this is not the case, so-called saving incentives can
potentially make matters worse.
CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 807
QUICK QUIZ: Give three examples of how our society discourages saving.
What are the drawbacks of eliminating these disincentives?
CONCLUSION
This chapter has considered five debates over macroeconomic policy. For each, it
began with a controversial proposition and then offered the arguments pro and
con. If you find it hard to choose a side in these debates, you may find some com-
fort in the fact that you are not alone. The study of economics does not always
make it easy to choose among alternative policies. Indeed, by clarifying the in-
evitable tradeoffs that policymakers face, it can make the choice more difficult.
Difficult choices, however, have no right to seem easy. When you hear politi-
cians or commentators proposing something that sounds too good to be true, it
probably is. If they sound like they are offering you a free lunch, you should look
for the hidden price tag. Few if any policies come with benefits but no costs. By
helping you see through the fog of rhetoric so common in political discourse, the
study of economics should make you a better participant in our national debates.
a78 Advocates of active monetary and fiscal policy view the
economy as inherently unstable and believe that policy
can manage aggregate demand to offset the inherent
instability. Critics of active monetary and fiscal policy
emphasize that policy affects the economy with a lag
and that our ability to forecast future economic
conditions is poor. As a result, attempts to stabilize the
economy can end up being destabilizing.
a78 Advocates of rules for monetary policy argue that
discretionary policy can suffer from incompetence,
abuse of power, and time inconsistency. Critics of rules
for monetary policy argue that discretionary policy is
more flexible in responding to changing economic
circumstances.
a78 Advocates of a zero-inflation target emphasize that
inflation has many costs and few if any benefits.
Moreover, the cost of eliminating inflation—depressed
output and employment—is only temporary. Even this
cost can be reduced if the central bank announces a
credible plan to reduce inflation, thereby directly
lowering expectations of inflation. Critics of a zero-
inflation target claim that moderate inflation imposes
only small costs on society, whereas the recession
necessary to reduce inflation is quite costly.
a78 Advocates of reducing the government debt argue that
the debt imposes a burden on future generations by
raising their taxes and lowering their incomes. Critics of
reducing the government debt argue that the debt is
only one small piece of fiscal policy. Single-minded
concern about the debt can obscure the many ways in
which the government’s tax and spending decisions
affect different generations.
a78 Advocates of tax incentives for saving point out that our
society discourages saving in many ways, such as by
heavily taxing the income from capital and by reducing
benefits for those who have accumulated wealth. They
endorse reforming the tax laws to encourage saving,
perhaps by switching from an income tax to a
consumption tax. Critics of tax incentives for saving
argue that many proposed changes to stimulate saving
would primarily benefit the wealthy, who do not need a
tax break. They also argue that such changes might have
only a small effect on private saving. Raising public
saving by increasing the government’s budget surplus
would provide a more direct and equitable way to
increase national saving.
Summary
808 PART THIRTEEN FINAL THOUGHTS
1. What causes the lags in the effect of monetary and fiscal
policy on aggregate demand? What are the implications
of these lags for the debate over active versus passive
policy?
2. What might motivate a central banker to cause a
political business cycle? What does the political business
cycle imply for the debate over policy rules?
3. Explain how credibility might affect the cost of reducing
inflation.
4. Why are some economists against a target of zero
inflation?
5. Explain two ways in which a government budget deficit
hurts a future worker.
6. What are two situations in which most economists view
a budget deficit as justifiable?
7. Give an example of how the government might hurt
young generations, even while reducing the
government debt they inherit.
8. Some economists say that the government can continue
running a budget deficit forever. How is that possible?
9. Some income from capital is taxed twice. Explain.
10. Give an example, other than tax policy, of how our
society discourages saving.
11. What adverse effect might be caused by tax incentives
toraise saving?
Questions for Review
1. The chapter suggests that the economy, like the human
body, has “natural restorative powers.”
a. Illustrate the short-run effect of a fall in aggregate
demand using an aggregate-demand/aggregate-
supply diagram. What happens to total output,
income, and employment?
b. If the government does not use stabilization policy,
what happens to the economy over time? Illustrate
on your diagram. Does this adjustment generally
occur in a matter of months or a matter of years?
c. Do you think the “natural restorative powers” of
the economy mean that policymakers should be
passive in response to the business cycle?
2. Policymakers who want to stabilize the economy must
decide how much to change the money supply,
government spending, or taxes. Why is it difficult for
policymakers to choose the appropriate strength of their
actions?
3. Suppose that people suddenly wanted to hold more
money balances.
a. What would be the effect of this change on the
economy if the Federal Reserve followed a rule of
increasing the money supply by 3 percent per year?
Illustrate your answer with a money-market
diagram and an aggregate-demand/aggregate-
supply diagram.
b. What would be the effect of this change on the
economy if the Fed followed a rule of increasing
themoney supply by 3 percent per year plus
1percentage point for every percentage point
thatunemployment rises above its normal level?
Illustrate your answer.
c. Which of the foregoing rules better stabilizes
theeconomy? Would it help to allow the Fed to
respond to predicted unemployment instead of
current unemployment? Explain.
4. Some economists have proposed that the Fed use the
following rule for choosing its target for the federal
funds interest rate (r):
rH110052% H11001 π H110011/2 (yH11002 y*)/y*H110011/2 (π H11002 π*),
where π is the average of the inflation rate over the
pastyear, yis real GDPas recently measured, y*is an
estimate of the natural rate of output, and π*is the Fed’s
goal for inflation.
a. Explain the logic that might lie behind this rule for
setting interest rates. Would you support the Fed’s
use of this rule?
b. Some economists advocate such a rule for monetary
policy but believe π and yshould be the forecastsof
future values of inflation and output. What are the
advantages of using forecasts instead of actual
values? What are the disadvantages?
5. The problem of time inconsistency applies to fiscal
policy as well as to monetary policy. Suppose the
Problems and Applications
CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 809
government announced a reduction in taxes on income
from capital investments, like new factories.
a. If investors believed that capital taxes would
remain low, how would the government’s action
affect the level of investment?
b. After investors have responded to the announced
tax reduction, does the government have an
incentive to renege on its policy? Explain.
c. Given your answer to part (b), would investors
believe the government’s announcement? What
canthe government do to increase the credibility
ofannounced policy changes?
d. Explain why this situation is similar to the time
inconsistency problem faced by monetary
policymakers.
6. Chapter 2 explains the difference between positive
analysis and normative analysis. In the debate about
whether the central bank should aim for zero inflation,
which areas of disagreement involve positive statements
and which involve normative judgments?
7. Why are the benefits of reducing inflation permanent
and the costs temporary? Why are the costs of
increasing inflation permanent and the benefits
temporary? Use Phillips-curve diagrams in your
answer.
8. Suppose the federal government cuts taxes and
increases spending, raising the budget deficit to
12percent of GDP. If nominal GDPis rising 7 percent
per year, are such budget deficits sustainable forever?
Explain. If budget deficits of this size are maintained for
20 years, what is likely to happen to your taxes and your
children’s taxes in the future? Can you do something
today to offset this future effect?
9. Explain how each of the following policies redistributes
income across generations. Is the redistribution from
young to old, or from old to young?
a. an increase in the budget deficit
b. more generous subsidies for education loans
c. greater investments in highways and bridges
d. indexation of Social Security benefits to inflation
10. Surveys suggest that most people are opposed to budget
deficits, but these same people elected representatives
who in the 1980s and 1990s passed budgets with
significant deficits. Why might the opposition to budget
deficits be stronger in principle than in practice?
11. The chapter says that budget deficits reduce the income
of future generations, but can boost output and income
during a recession. Explain how both of these
statements can be true.
12. What is the fundamental tradeoff that society faces if it
chooses to save more?
13. Suppose the government reduced the tax rate on income
from savings.
a. Who would benefit from this tax reduction most
directly?
b. What would happen to the capital stock over time?
What would happen to the capital available to each
worker? What would happen to productivity?
What would happen to wages?
c. In light of your answer to part (b), who might
benefit from this tax reduction in the long run?
ability-to-pay principle—the idea that
taxes should be levied on a person
according to how well that person
can shoulder the burden
absolute advantage—the comparison
among producers of a good accord-
ing to their productivity
accounting profit—total revenue mi-
nus total explicit cost
aggregate-demand curve—a curve that
shows the quantity of goods and
services that households, firms, and
the government want to buy at each
price level
aggregate-supply curve—a curve that
shows the quantity of goods and
services that firms choose to pro-
duce and sell at each price level
appreciation—an increase in the value
of a currency as measured by the
amount of foreign currency it can
buy
automatic stabilizers—changes in fis-
cal policy that stimulate aggregate
demand when the economy goes
into a recession without policymak-
ers having to take any deliberate
action
average fixed cost—fixed costs
divided by the quantity of output
average revenue—total revenue
divided by the quantity sold
average tax rate—total taxes paid
divided by total income
average total cost—total cost divided
by the quantity of output
average variable cost—variable costs
divided by the quantity of output
balanced trade—a situation in which
exports equal imports
benefits principle—the idea that peo-
ple should pay taxes based on the
benefits they receive from govern-
ment services
bond—a certificate of indebtedness
budget constraint—the limit on the
consumption bundles that a con-
sumer can afford
budget deficit—a shortfall of tax rev-
enue from government spending
budget surplus—an excess of govern-
ment receipts over government
spending
capital—the equipment and structures
used to produce goods and services
capital flight—a large and sudden
reduction in the demand for assets
located in a country
cartel—a group of firms acting in
unison
catch-up effect—the property whereby
countries that start off poor tend to
grow more rapidly than countries
that start off rich
central bank—an institution designed
to oversee the banking system and
regulate the quantity of money in
the economy
ceteris paribus—a Latin phrase, trans-
lated as “other things being equal,”
used as a reminder that all variables
other than the ones being studied
are assumed to be constant
circular-flow diagram—a visual model
of the economy that shows how dol-
lars flow through markets among
households and firms
classical dichotomy—the theoretical
separation of nominal and real
variables
closed economy—an economy that
does not interact with other
economies in the world
Coase theorem—the proposition that if
private parties can bargain without
cost over the allocation of resources,
they can solve the problem of exter-
nalities on their own
collective bargaining—the process by
which unions and firms agree on
the terms of employment
collusion—an agreement among firms
in a market about quantities to pro-
duce or prices to charge
commodity money—money that takes
the form of a commodity with in-
trinsic value
common resources—goods that are
rival but not excludable
comparable worth—a doctrine accord-
ing to which jobs deemed compara-
ble should be paid the same wage
comparative advantage—the compari-
son among producers of a good ac-
cording to their opportunity cost
compensating differential—a differ-
ence in wages that arises to offset
the nonmonetary characteristics of
different jobs
competitive market—a market with
many buyers and sellers trading
identical products so that each
buyer and seller is a price taker
complements—two goods for which
an increase in the price of one leads
to a decrease in the demand for the
other
constant returns to scale—the prop-
erty whereby long-run average total
cost stays the same as the quantity
of output changes
consumer price index (CPI)—a mea-
sure of the overall cost of the goods
and services bought by a typical
consumer
consumer surplus—a buyer’s willing-
ness to pay minus the amount the
buyer actually pays
consumption—spending by house-
holds on goods and services, with
the exception of purchases of new
housing
cost—the value of everything a seller
must give up to produce a good
cost-benefit analysis—a study that
compares the costs and benefits to
society of providing a public good
cross-price elasticity of demand—a
measure of how much the quantity
demanded of one good responds to
a change in the price of another
good, computed as the percentage
change in quantity demanded of the
first good divided by the percentage
change in the price
crowding out—a decrease in invest-
ment that results from government
borrowing
crowding-out effect—the offset in ag-
gregate demand that results when
expansionary fiscal policy raises the
interest rate and thereby reduces in-
vestment spending
currency—the paper bills and coins in
the hands of the public
cyclical unemployment—the devia-
tion of unemployment from its
natural rate
deadweight loss—the fall in total
surplus that results from a market
distortion, such as a tax
demand curve—a graph of the rela-
tionship between the price of a good
and the quantity demanded
demand deposits—balances in bank
accounts that depositors can access
on demand by writing a check
demand schedule—a table that shows
the relationship between the price
of a good and the quantity
demanded
GLOSSARY
811
depreciation—a decrease in the value
of a currency as measured by the
amount of foreign currency it can
buy
depression—a severe recession
diminishing marginal product—the
property whereby the marginal
product of an input declines as the
quantity of the input increases
diminishing returns—the property
whereby the benefit from an extra
unit of an input declines as the
quantity of the input increases
discount rate—the interest rate on the
loans that the Fed makes to banks
discouraged workers—individuals
who would like to work but have
given up looking for a job
discrimination—the offering of differ-
ent opportunities to similar individ-
uals who differ only by race, ethnic
group, sex, age, or other personal
characteristics
diseconomies of scale—the property
whereby long-run average total
cost rises as the quantity of output
increases
dominant strategy—a strategy that is
best for a player in a game regard-
less of the strategies chosen by the
other players
economic profit—total revenue minus
total cost, including both explicit
and implicit costs
economics—the study of how society
manages its scarce resources
economies of scale—the property
whereby long-run average total
cost falls as the quantity of output
increases
efficiency—the property of society
getting the most it can from its
scarce resources
efficiency wages—above-equilibrium
wages paid by firms in order to in-
crease worker productivity
efficient scale—the quantity of output
that minimizes average total cost
elasticity—a measure of the respon-
siveness of quantity demanded
or quantity supplied to one of its
determinants
equilibrium—a situation in which
supply and demand have been
brought into balance
equilibrium price—the price that bal-
ances supply and demand
equilibrium quantity—the quantity
supplied and the quantity de-
manded when the price has ad-
justed to balance supply and
demand
equity—the property of distributing
economic prosperity fairly among
the members of society
excludability—the property of a good
whereby a person can be prevented
from using it
explicit costs—input costs that re-
quire an outlay of money by the
firm
exports—goods and services that are
produced domestically and sold
abroad
externality—the impact of one per-
son’s actions on the well-being of a
bystander
factors of production—the inputs used
to produce goods and services
Federal Reserve (Fed)—the central
bank of the United States
fiat money—money without intrinsic
value that is used as money because
of government decree
financial intermediaries—financial
institutions through which savers
can indirectly provide funds to
borrowers
financial markets—financial institu-
tions through which savers can di-
rectly provide funds to borrowers
financial system—the group of institu-
tions in the economy that help to
match one person’s saving with
another person’s investment
Fisher effect—the one-for-one adjust-
ment of the nominal interest rate to
the inflation rate
fixed costs—costs that do not vary
with the quantity of output
produced
fractional-reserve banking—a bank-
ing system in which banks hold
only a fraction of deposits as
reserves
free rider—a person who receives the
benefit of a good but avoids paying
for it
frictional unemployment—unemploy-
ment that results because it takes
time for workers to search for the
jobs that best suit their tastes and
skills
game theory—the study of how people
behave in strategic situations
GDP deflator—a measure of the
price level calculated as the ratio
of nominal GDP to real GDP times
100
Giffen good—a good for which an
increase in the price raises the
quantity demanded
government purchases—spending on
goods and services by local, state,
and federal governments
gross domestic product (GDP)—the
market value of all final goods and
services produced within a country
in a given period of time
horizontal equity—the idea that tax-
payers with similar abilities to pay
taxes should pay the same amount
human capital—the accumulation of
investments in people, such as edu-
cation and on-the-job training
implicit costs—input costs that do not
require an outlay of money by the
firm
import quota—a limit on the quantity
of a good that can be produced
abroad and sold domestically
imports—goods and services that
are produced abroad and sold
domestically
in-kind transfers—transfers to the
poor given in the form of goods and
services rather than cash
income effect—the change in con-
sumption that results when a price
change moves the consumer to a
higher or lower indifference curve
income elasticity of demand—a mea-
sure of how much the quantity de-
manded of a good responds to a
change in consumers’ income, com-
puted as the percentage change in
quantity demanded divided by the
percentage change in income
indexation—the automatic correction
of a dollar amount for the effects of
inflation by law or contract
indifference curve—a curve that
shows consumption bundles that
give the consumer the same level of
satisfaction
inferior good—a good for which, other
things equal, an increase in income
leads to a decrease in demand
812 GLOSSARY
inflation—an increase in the overall
level of prices in the economy
inflation rate—the percentage change
in the price index from the preced-
ing period
inflation tax—the revenue the govern-
ment raises by creating money
internalizing an externality—altering
incentives so that people take ac-
count of the external effects of their
actions
investment—spending on capital
equipment, inventories, and struc-
tures, including household pur-
chases of new housing
job search—the process by which
workers find appropriate jobs given
their tastes and skills
labor force—the total number of work-
ers, including both the employed
and the unemployed
labor-force participation rate—the
percentage of the adult population
that is in the labor force
law of demand—the claim that, other
things equal, the quantity de-
manded of a good falls when the
price of the good rises
law of supply—the claim that, other
things equal, the quantity supplied
of a good rises when the price of the
good rises
law of supply and demand—the claim
that the price of any good adjusts to
bring the supply and demand for
that good into balance
liberalism—the political philosophy
according to which the government
should choose policies deemed
to be just, as evaluated by an impar-
tial observer behind a “veil of
ignorance”
libertarianism—the political philoso-
phy according to which the govern-
ment should punish crimes and
enforce voluntary agreements but
not redistribute income
life cycle—the regular pattern of
income variation over a person’s
life
liquidity—the ease with which an
asset can be converted into the
economy’s medium of exchange
lump-sum tax—a tax that is the same
amount for every person
macroeconomics—the study of econ-
omy-wide phenomena, including
inflation, unemployment, and eco-
nomic growth
marginal changes—small incremental
adjustments to a plan of action
marginal cost—the increase in total
cost that arises from an extra unit of
production
marginal product—the increase in out-
put that arises from an additional
unit of input
marginal product of labor—the in-
crease in the amount of output from
an additional unit of labor
marginal rate of substitution—the rate
at which a consumer is willing to
trade one good for another
marginal revenue—the change in total
revenue from an additional unit
sold
marginal tax rate—the extra taxes
paid on an additional dollar of
income
market—a group of buyers and sellers
of a particular good or service
market economy—an economy that
allocates resources through the
decentralized decisions of many
firms and households as they in-
teract in markets for goods and
services
market failure—a situation in which a
market left on its own fails to allo-
cate resources efficiently
market for loanable funds—the mar-
ket in which those who want to
save supply funds and those who
want to borrow to invest demand
funds
market power—the ability of a single
economic actor (or small group of
actors) to have a substantial influ-
ence on market prices
maximin criterion—the claim that the
government should aim to maxi-
mize the well-being of the worst-off
person in society
medium of exchange—an item that
buyers give to sellers when they
want to purchase goods and
services
menu costs—the costs of changing
prices
microeconomics—the study of how
households and firms make deci-
sions and how they interact in
markets
model of aggregate demand and
aggregate supply—the model that
most economists use to explain
short-run fluctuations in economic
activity around its long-run trend
monetary neutrality—the proposition
that changes in the money supply
do not affect real variables
monetary policy—the setting of the
money supply by policymakers in
the central bank
money—the set of assets in an econ-
omy that people regularly use to
buy goods and services from other
people
money multiplier—the amount of
money the banking system gener-
ates with each dollar of reserves
money supply—the quantity of money
available in the economy
monopolistic competition—a market
structure in which many firms sell
products that are similar but not
identical
monopoly—a firm that is the sole
seller of a product without close
substitutes
multiplier effect—the additional shifts
in aggregate demand that result
when expansionary fiscal policy
increases income and thereby in-
creases consumer spending
mutual fund—an institution that sells
shares to the public and uses the
proceeds to buy a portfolio of stocks
and bonds
Nash equilibrium—a situation in
which economic actors interacting
with one another each choose their
best strategy given the strategies
that all the other actors have chosen
national saving (saving)—the total in-
come in the economy that remains
after paying for consumption and
government purchases
natural monopoly—a monopoly that
arises because a single firm can sup-
ply a good or service to an entire
market at a smaller cost than could
two or more firms
natural-rate hypothesis—the claim
that unemployment eventually re-
turns to its normal, or natural, rate,
regardless of the rate of inflation
natural rate of unemployment—the
normal rate of unemployment
around which the unemployment
rate fluctuates
GLOSSARY 813
natural resources—the inputs into the
production of goods and services
that are provided by nature, such as
land, rivers, and mineral deposits
negative income tax—a tax system
that collects revenue from high-
income households and gives trans-
fers to low-income households
net exports—the value of a nation’s ex-
ports minus the value of its imports,
also called the trade balance
net foreign investment—the purchase
of foreign assets by domestic resi-
dents minus the purchase of domes-
tic assets by foreigners
nominal exchange rate—the rate
at which a person can trade the
currency of one country for the cur-
rency of another
nominal GDP—the production of
goods and services valued at cur-
rent prices
nominal interest rate—the interest rate
as usually reported without a cor-
rection for the effects of inflation
nominal variables—variables mea-
sured in monetary units
normal good—a good for which, other
things equal, an increase in income
leads to an increase in demand
normative statements—claims that at-
tempt to prescribe how the world
should be
oligopoly—a market structure in
which only a few sellers offer simi-
lar or identical products
open economy—an economy that in-
teracts freely with other economies
around the world
open-market operations—the pur-
chase and sale of U.S. government
bonds by the Fed
opportunity cost—whatever must be
given up to obtain some item
perfect complements—two goods
with right-angle indifference curves
perfect substitutes—two goods with
straight-line indifference curves
permanent income—a person’s nor-
mal income
Phillips curve—a curve that shows the
short-run tradeoff between inflation
and unemployment
physical capital—the stock of equip-
ment and structures that are used to
produce goods and services
Pigovian tax—a tax enacted to correct
the effects of a negative externality
positive statements—claims that at-
tempt to describe the world as it is
poverty line—an absolute level of in-
come set by the federal government
for each family size below which a
family is deemed to be in poverty
poverty rate—the percentage of the
population whose family income
falls below an absolute level called
the poverty line
price ceiling—a legal maximum on the
price at which a good can be sold
price discrimination—the business
practice of selling the same good
at different prices to different
customers
price elasticity of demand—a mea-
sure of how much the quantity
demanded of a good responds to
a change in the price of that good,
computed as the percentage change
in quantity demanded divided by
the percentage change in price
price elasticity of supply—a measure
of how much the quantity supplied
of a good responds to a change in
the price of that good, computed as
the percentage change in quantity
supplied divided by the percentage
change in price
price floor—a legal minimum on the
price at which a good can be sold
prisoners’dilemma—a particular
“game” between two captured pris-
oners that illustrates why coopera-
tion is difficult to maintain even
when it is mutually beneficial
private goods—goods that are both
excludable and rival
private saving—the income that
households have left after paying
for taxes and consumption
producer price index—a measure of
the cost of a basket of goods and
services bought by firms
producer surplus—the amount a seller
is paid for a good minus the seller’s
cost
production function—the relationship
between quantity of inputs used to
make a good and the quantity of
output of that good
production possibilities frontier—a
graph that shows the combinations
of output that the economy can pos-
sibly produce given the available
factors of production and the avail-
able production technology
productivity—the amount of goods
and services produced from each
hour of a worker’s time
profit—total revenue minus total cost
progressive tax—a tax for which
high-income taxpayers pay a larger
fraction of their income than do
low-income taxpayers
proportional tax—a tax for which
high-income and low-income tax-
payers pay the same fraction of
income
public goods—goods that are neither
excludable nor rival
public saving—the tax revenue that
the government has left after paying
for its spending
purchasing-power parity—a theory of
exchange rates whereby a unit of
any given currency should be able
to buy the same quantity of goods
in all countries
quantity demanded—the amount of a
good that buyers are willing and
able to purchase
quantity equation—the equation M H11003
V H11005 P H11003 Y, which relates the quan-
tity of money, the velocity of money,
and the dollar value of the econ-
omy’s output of goods and services
quantity supplied—the amount of a
good that sellers are willing and
able to sell
quantity theory of money—a theory
asserting that the quantity of money
available determines the price level
and that the growth rate in the
quantity of money available deter-
mines the inflation rate
rational expectations—the theory ac-
cording to which people optimally
use all the information they have,
including information about gov-
ernment policies, when forecasting
the future
real exchange rate—the rate at which a
person can trade the goods and
services of one country for the
goods and services of another
real GDP—the production of goods
and services valued at constant
prices
real interest rate—the interest rate
corrected for the effects of inflation
814 GLOSSARY
real variables—variables measured in
physical units
recession—a period of declining real
incomes and rising unemployment
regressive tax—a tax for which high-
income taxpayers pay a smaller
fraction of their income than do
low-income taxpayers
reserve ratio—the fraction of deposits
that banks hold as reserves
reserve requirements—regulations
on the minimum amount of re-
serves that banks must hold against
deposits
reserves—deposits that banks have
received but have not loaned out
rivalry—the property of a good
whereby one person’s use dimin-
ishes other people’s use
sacrifice ratio—the number of percent-
age points of annual output lost in
the process of reducing inflation by
1 percentage point
scarcity—the limited nature of soci-
ety’s resources
shoeleather costs—the resources
wasted when inflation encourages
people to reduce their money
holdings
shortage—a situation in which quan-
tity demanded is greater than
quantity supplied
stagflation—a period of falling output
and rising prices
stock—a claim to partial ownership in
a firm
store of value—an item that people
can use to transfer purchasing
power from the present to the
future
strike—the organized withdrawal of
labor from a firm by a union
structural unemployment—unem-
ployment that results because the
number of jobs available in some
labor markets is insufficient to pro-
vide a job for everyone who wants
one
substitutes—two goods for which an
increase in the price of one leads to
an increase in the demand for the
other
substitution effect—the change in
consumption that results when a
price change moves the consumer
along a given indifference curve to
a point with a new marginal rate of
substitution
sunk cost—a cost that has already been
committed and cannot be recovered
supply curve—a graph of the relation-
ship between the price of a good
and the quantity supplied
supply schedule—a table that shows
the relationship between the
price of a good and the quantity
supplied
supply shock—an event that directly
alters firms’ costs and prices, shift-
ing the economy’s aggregate-supply
curve and thus the Phillips curve
surplus—a situation in which quantity
supplied is greater than quantity
demanded
tariff—a tax on goods produced
abroad and sold domestically
tax incidence—the study of who bears
the burden of taxation
technological knowledge—society’s
understanding of the best ways to
produce goods and services
theory of liquidity preference—
Keynes’s theory that the interest
rate adjusts to bring money supply
and money demand into balance
total cost—the market value of the
inputs a firm uses in production
total revenue (for a firm)—the amount
a firm receives for the sale of its
output
total revenue (in a market)—the
amount paid by buyers and re-
ceived by sellers of a good, com-
puted as the price of the good times
the quantity sold
trade balance—the value of a nation’s
exports minus the value of its im-
ports, also called net exports
trade deficit—an excess of imports
over exports
trade policy—a government policy
that directly influences the quantity
of goods and services that a country
imports or exports
trade surplus—an excess of exports
over imports
Tragedy of the Commons—a parable
that illustrates why common
resources get used more than is
desirable from the standpoint of
society as a whole
transaction costs—the costs that par-
ties incur in the process of agreeing
and following through on a bargain
unemployment insurance—a govern-
ment program that partially pro-
tects workers’ incomes when they
become unemployed
unemployment rate—the percent-
age of the labor force that is
unemployed
union—a worker association that bar-
gains with employers over wages
and working conditions
unit of account—the yardstick people
use to post prices and record debts
utilitarianism—the political philoso-
phy according to which the govern-
ment should choose policies to
maximize the total utility of every-
one in society
utility—a measure of happiness or
satisfaction
value of the marginal product—the
marginal product of an input times
the price of the output
variable costs—costs that do vary with
the quantity of output produced
velocity of money—the rate at which
money changes hands
vertical equity—the idea that tax-
payers with a greater ability to
pay taxes should pay larger
amounts
welfare—government programs that
supplement the incomes of the
needy
welfare economics—the study of how
the allocation of resources affects
economic well-being
willingness to pay—the maximum
amount that a buyer will pay for
a good
world price—the price of a good that
prevails in the world market for
that good
GLOSSARY 815
曼昆经济学原理（Principles of Economics）：[曼昆经济学原理].Mankiw.Principles.of.Economics
| 课件名称： | 曼昆经济学原理（Principles of Economics） |
| 课件分类： | 经济 |
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