A production possibility frontier (PPF) shows the maximum possible output combinations of two goods or services an economy can achieve when all resources are fully and efficiently employed. Opportunity Cost and the PPF. Reallocating scarce resources from one product to another involves an opportunity cost.
The birth rate (technically, births/population rate) is the total number of live births per 1,000 of a population in a year or period.
Social capital is a form of economic and cultural capital in which social networks are central; transactions are marked by reciprocity, trust, and cooperation; and market agents produce goods and services not mainly for themselves, but for a common good.
Human capital: refers to the stock of knowledge, habits, social and personality attributes, including creativity, embodied in the ability to perform labor so as to produce economic value.
Gross domestic product (GDP) is a monetary measure of the market value of all final goods and services produced in a period (quarterly or yearly) of time.
Economic entity: any organization or unit in society can be an economic entity.
Gross national product (GNP) the total value of goods produced and services provided by a country during one year, equal to the gross domestic product plus the net income from foreign investments.
Gross national product (GNP) is the market value of all the products and services produced in one year by labor and property supplied by the citizens of a country.
Opportunity cost is the value (not a benefit) of the choice of a best alternative cost while making a decision.
Perfect competition: In economics, specifically general equilibrium theory, a perfect market is defined by several idealizing conditions, collectively called perfect competition.
Creative destruction: New combination of production factors work to displaced and eventually destroy the old structures.
• The fundamental lessons about individual decision making are that people face trade-offs 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.
• The fundamental lessons about interactions among people are that trade and interdependence can be mutually beneficial, that markets are usually a good way of coordinating economic activity among people, and that the government can potentially improve market outcomes by remedying a market failure or by promoting greater economic equality.
• The fundamental lessons about the economy as a whole are that productivity is the ultimate source of living standards, that growth in the quantity of money is the ultimate source of inflation, and that society faces a short-run trade-off between inflation and unemployment.
• Economists try to address their subject with a scientist’s objectivity. Like all scientists, they make appropriate assumptions and build simplified models to understand the world around them. Two simple economic models are the circular-flow diagram and the production possibilities frontier.
• The field of economics is divided into two subfields: microeconomics and macroeconomics. Microeconomists study decision making by households and firms and the interactions among households and firms in the marketplace. Macroeconomists study the forces and trends that affect the economy as a whole.
• A positive statement is an assertion about how the world is. A normative statement is an assertion about how the world ought to be. When economists make normative statements, they are acting more as policy advisers than as scientists.
• Economists who advise policymakers sometimes 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 the advice because of the many forces and constraints imposed by the political process.
• Each person consumes goods and services produced by many other people both in the United States and around the world. Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services.
• There are two ways to compare the ability of two people to produce a good. The person who can produce the good with the smaller quantity of inputs is said to have an absolute advantage in 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.
• Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage.
• 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.
• 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.
• 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.
• In addition to price, other determinants of how much consumers want to buy include income, the prices of substitutes and complements, tastes, expectations, and the number of buyers. If one of these factors changes, the demand curve shifts.
• 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 sup- plied rises. Therefore, the supply curve slopes upward.
• In addition to price, other determinants of how much producers want to sell include input prices, technology, expectations, and the number of sellers. If one of these factors changes, the supply curve shifts.
• The intersection of the supply and demand curves determines the market equilibrium. At the equilibrium price, the quantity demanded equals the quantity supplied.
• 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.
• 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 in which direction the curve shifts. Third, we compare the new equilibrium with the initial equilibrium.
• 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 consume and how much sellers choose to produce.
• The price elasticity of demand measures how much the quantity demanded responds to changes in the price. Demand tends to be more elastic if close substitutes are available, if the good is a luxury rather than a necessity, if the market is narrowly defined, or if buyers have substantial time to react to a price change.
• The price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. If quantity demanded moves proportionately less than the price, then the elasticity is less than 1 and demand is said to be inelastic. If quantity demanded moves proportionately more than the price, then the elasticity is greater than 1 and demand is said to be elastic.
• 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 moves in the same direction as the price. For elastic demand curves, total revenue moves in the opposite direction as the price.
• 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 changes in the price of another good.
• 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.
• The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. If quantity supplied moves proportionately less than the price, then the elasticity is less than 1 and supply is said to be inelastic. If quantity supplied moves proportionately more than the price, then the elasticity is greater than 1 and supply is said to be elastic.
• 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.
• A price 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, then the price ceiling is binding, and the quantity demanded exceeds the quantity supplied. Because of the resulting shortage, sellers must in some way ration the good or service among buyers.
• A price 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, then the price floor is binding, and 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.
• 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.
• A tax 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 (that is, the division of the tax burden) does not depend on whether the tax is levied on buyers or sellers.
• The incidence of a tax depends on the price elasticities of supply and demand. Most of the burden falls on the side of the market that is less elastic because that side of the market cannot respond as easily to the tax by changing the quantity bought or sold.
• Consumer surplus equals buyers’ willingness to pay for a good minus the amount they actually pay, 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.
• 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.
• An allocation of resources that maximizes total surplus (the sum of consumer and producer surplus) is said to be efficient. Policymakers are often concerned with the efficiency, as well as the equality, of economic outcomes.
• The equilibrium of supply and demand maximizes total surplus. That is, the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently.
• Markets do not allocate resources efficiently in the presence of market failures such as market power or externalities.
• A tax 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 dead weight loss of the tax.
• Taxes have deadweight losses because they cause buyers to consume less and sellers to produce less, and these changes in behavior shrink 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.
• As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger. Because a tax reduces the size of the market, however, tax revenue does not con- tinually increase. It first rises with the size of a tax, but if the tax gets large enough, tax revenue starts to fall.
• The effects of free trade can be determined by comparing the domestic price before trade with the world price. A low 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.
• 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.
• A tariff—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.
• 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 merit in some cases, most economists believe that free trade is usually the better policy.
• When a transaction between a buyer and seller directly affects a third party, the effect is called an externality. If an activity yields negative externalities, such as pollution, the socially optimal quantity in a market is less than the equilibrium quantity. If an activity yields positive externalities, such as technology spillovers, the socially optimal quantity is greater than the equilibrium quantity.
• Governments pursue various policies to remedy the inefficiencies caused by externalities. Sometimes the government prevents socially inefficient activity by regulating behavior. Other times it internalizes an externality using corrective taxes. Another public policy is to issue permits. For example, the government could protect the environment by issuing a limited number of pollution permits. The result of this policy is similar to imposing corrective taxes on polluters.
• Those affected by externalities can sometimes solve the problem privately. For instance, when one business imposes 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.
• Goods differ in whether they are excludable and whether they are rival in consumption. A good is excludable if it is possible to prevent someone from using it. A good is rival in consumption if one person’s use of the good reduces others’ ability to use the same unit of the good. Markets work best for private goods, which are both excludable and rival in consumption. Markets do not work as well for other types of goods.
• Public goods are neither rival in consumption nor excludable. Examples of public goods include fireworks displays, national defense, and the discovery of fundamental knowledge. Because people are not charged for their use of the public good, they have an incentive to free ride, making private provision of the good untenable. Therefore, governments provide public goods, basing their decision about the quantity of each good on cost–benefit analysis.
• Common resources are rival in consumption 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 use various methods, such as regulations and corrective taxes, to limit the use of common resources.
• The U.S. government raises revenue using various taxes. The most important taxes for the federal government are personal income taxes and payroll taxes for social insurance. The most important taxes for state and local governments are sales taxes and property taxes.
• 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 dead weight loss that arises as taxes alter incentives and distort the allocation of resources. The second is the administrative burden of complying with the tax laws.
• 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 tax bills.
• When considering changes in the tax laws, policy- makers often face a trade-off between efficiency and equity. Much of the debate over tax policy arises because people give different weights to these two goals.
• The goal of firms is to maximize profit, which equals total revenue minus total cost.
• 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 at the firm rather than taking another job, are implicit. Economic profit takes both explicit and implicit costs into account, whereas accounting profit considers only explicit costs.
• A firm’s costs reflect its production process. A typical firm’s production function gets flatter as the quantity of an 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.
• A firm’s total costs can be divided into 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 change when the firm alters the quantity of output produced.
• 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 rises if output increases by 1 unit.
• 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 rises as output increases further. The marginal-cost curve always crosses the average- total-cost curve at the minimum of average total cost.
• A firm’s costs often depend on the time horizon 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.
• 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.
• To maximize profit, a firm chooses a quantity of out- put 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.
• 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.
• In a market with free entry and exit, profit is 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.
• 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 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
• A monopoly is a firm that is the sole seller in its market. A monopoly 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 lower cost than many firms could.
• 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.
• Like a competitive firm, a monopoly firm maximizes profit by producing the quantity at which marginal revenue equals marginal cost. The monopoly then sets 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.
• A monopolist’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 dead- weight losses similar to those caused by taxes.
• A monopolist can often increase 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 consumers who would otherwise not buy it. In the extreme case of perfect price discrimination, the dead- weight loss of monopoly is completely eliminated and the entire surplus in the market goes to the monopoly producer. More generally, when price discrimination is imperfect, it can either raise or lower welfare compared to the outcome with a single monopoly price.
• 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.
• A monopolistically competitive market is characterized by three attributes: many firms, differentiated products, and free entry and exit.
• The long-run equilibrium in a monopolistically competitive market differs from that in a perfectly competitive market in two related ways. First, each firm in a monopolistically competitive market has excess capacity. That is, it chooses a quantity that puts it on the downward-sloping portion of the average- total-cost curve. Second, each firm charges a price above marginal cost.
• 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.
• 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 manipulate consumers’ tastes 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.
• 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 perfect competition.
• 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, common-resource problems, and oligopolies.
• 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 can appear to reduce com- petition may in fact have legitimate business purposes.
• 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.
• 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 factor’s marginal product equals its price.
• The supply of labor arises from individuals’ trade- off between work and leisure. An upward-sloping labor-supply curve means that people respond to an increase in the wage by working more hours and enjoying less leisure.
• 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.
• 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.
• Workers earn different wages for many reasons. One reason is that wage differentials play a role compensating workers for job attributes. Other things being equal, workers in hard, unpleasant jobs are paid more than workers in easy, pleasant jobs.
• Workers with more human capital are paid more than workers with less human capital. The return to accumulating human capital is high and has increased over the past several decades.
• Although years of education, experience, and job characteristics affect earnings as theory predicts, much variation in earnings cannot be explained by things that economists can easily measure. The unexplained variation in earnings is largely attributable to natural ability, effort, and chance.
• 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 is correct, then increasing the educational attainment of all workers would not raise the overall level of wages.
• Wages are sometimes pushed above the level that brings supply and demand into balance. Three explanations of above-equilibrium wages are mini- mum-wage laws, unions, and efficiency wages.
• Some differences in earnings are attributable to discrimination based on 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.
• 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 reduce discriminatory wage differentials. Discrimination persists in competitive markets, however, if customers are willing to pay more to discriminatory firms or if the government passes laws requiring firms to discriminate.
• Data on the distribution of income show a wide disparity in U.S. society. The richest fifth of families earns more than twelve times as much income as the poorest fifth.
• 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 other factors are taken into account, they tend to suggest that economic well-being is more equally distributed than is annual income.
• 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 that maximizes 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 stations in life. Libertarians (such as Robert Nozick) would have the government enforce individual rights to ensure a fair process but then would not be concerned about inequality in the resulting distribution of income.
• Various policies aim to help the poor—minimum-wage laws, welfare, negative income taxes, and in-kind transfers. While these policies help alleviate poverty, they also have unintended side effects. Because financial assistance declines as income rises, the poor often face very high effective marginal tax rates, which discourage poor families from escaping poverty on their own.
• A consumer’s budget constraint shows the possible combinations of different goods she can buy given her income and the prices of the goods. The slope of the budget constraint equals the relative price of the goods.
• The consumer’s indifference curves represent her 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.
• The consumer optimizes by choosing the point on her 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), and the consumer’s valuation of the two goods (measured by the marginal rate of substitution) equals the market’s valuation (measured by the relative price).
• 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.
• The theory of consumer choice can be applied in many situations. It explains why demand curves can potentially slope upward, why higher wages could either increase or decrease the quantity of labor supplied, and why higher interest rates could either increase or decrease saving.
• In many economic transactions, information is asymmetric. When there are hidden actions, principals may be concerned that agents suffer from the problem of moral hazard. When there are hidden characteristics, buyers may be concerned about the problem of adverse selection among the sellers. Private markets sometimes deal with asymmetric information with signaling and screening.
• Although government policy can sometimes improve market outcomes, governments are themselves imperfect institutions. The Condorcet paradox shows that majority rule fails to produce transitive preferences for society, and Arrow’s impossibility theorem shows that no voting system will be perfect. In many situations, democratic institutions will produce the outcome desired by the median voter, regardless of the preferences of the rest of the electorate. Moreover, the individuals who set government policy may be motivated by self-interest rather than the national interest.
• The study of psychology and economics reveals that human decision making is more complex than is assumed in conventional economic theory. People are not always rational, they care about the fairness of economic outcomes (even to their own detriment), and they can be inconsistent over time.
• Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy.
• 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, GDP is the market value of all final goods and services produced within a country in a given period of time.
• GDP is 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 business capital, residential capital, and inventories. 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 (ex- ports) minus the value of goods and services produced abroad and sold domestically (imports).
• Nominal GDP uses current prices to value the econ- omy’s production of goods and services. Real GDP uses constant base-year prices to value the economy’s production of goods and services. The GDP deflator— calculated from the ratio of nominal to real GDP— measures the level of prices in the economy.
• GDP is a good measure of economic well-being be- cause 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.
• The consumer price index (CPI) 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 CPI measures the inflation rate.
• The CPI 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 true inflation.
• Like the CPI, the GDP deflator measures the overall level of prices in the economy. The two price indexes usually move together, but there are important differences. The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed. As a result, imported goods affect the CPI but not the GDP deflator. In addition, while the CPI uses a fixed basket of goods, the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.
• Dollar figures from different times 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.
• 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.
• A correction 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.
• Economic prosperity, as measured by GDP per 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 GDP also vary substantially, the relative positions of countries can change dramatically over time.
• The standard of living in an economy depends on the economy’s ability to produce goods and services. Productivity, in turn, depends on the physical capital, human capital, natural resources, and technological knowledge available to workers.
• Government policies can try to influence the economy’s growth rate in many ways: by encouraging saving and investment, encouraging investment from abroad, fostering education, promoting good health, maintaining property rights and political stability, allowing free trade, and promoting the research and development of new technologies.
• 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. As a result, although higher saving leads to higher growth for a period of time, growth eventually slows down as capital, productivity, and income rise. Also because of diminishing returns, the return to capital is especially high in poor countries. Other things being equal, these countries can grow faster because of the catch-up effect.
• Population growth has a variety of effects on economic growth. On the one hand, more rapid population growth may lower productivity by stretching the supply of natural resources and by reducing the amount of capital available for each worker. On the other hand, a larger population may enhance the rate of technological progress because there are more scientists and engineers.
• 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 that want to save some of their income into the hands of households and firms that want to borrow.
• 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.
• The interest rate is determined by the supply and demand for loanable funds. The supply of loanable funds comes from households that want to save some of their income and lend it out. The demand for loanable funds comes from households and firms that 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.
• National saving equals private saving plus public saving. A government 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.
• Because savings can earn interest, a sum of money today is more valuable than the same sum of money in the future. A person can compare sums from different times using the concept of present value. The present value of any future sum is the amount that would be needed today, given prevailing interest rates, to produce that future sum.
• Because of diminishing marginal utility, most people are risk averse. Risk-averse people can reduce risk by buying insurance, diversifying their holdings, and choosing a portfolio with lower risk and lower return.
• The value of an asset equals the present value of the cash flows the owner will receive. For a share of stock, these cash flows include the stream of dividends and the final sale price. According to the efficient markets hypothesis, financial markets process available information rationally, so a stock price always equals the best estimate of the value of the underlying business. Some economists question the efficient markets hypothesis, however, and believe that irrational psychological factors also influence asset prices.
• 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.
• 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 and therefore are not counted as unemployed.
• 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.
• One reason for unemployment is the time it takes workers to search for jobs that best suit their tastes and skills. This frictional unemployment is increased as a result of unemployment insurance, a government pol- icy designed to protect workers’ incomes.
• A second reason 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.
• A third 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.
• A fourth reason for unemployment is suggested by the theory of efficiency wages. According to this theory, firms find it profitable to pay wages above the equi- librium level. High wages can improve worker health, lower worker turnover, raise worker quality, and increase worker effort.
• The term money refers to assets that people regularly use to buy goods and services.
• Money serves three functions. As a medium of exchange, it is the item used to make transactions. As a unit of account, it provides the way to record prices and other economic values. As a store of value, it offers a way to transfer purchasing power from the present to the future.
• 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.
• In the U.S. economy, money takes the form of currency and various types of bank deposits, such as checking accounts.
• The Federal Reserve, the central bank of the United States, is responsible for regulating the U.S. monetary system. The Fed chair is appointed by the president and confirmed by Congress every 4 years. The chair is the head of the Federal Open Market Committee, which meets about every 6 weeks to consider changes in monetary policy.
• Bank depositors provide resources to banks by depositing their funds into bank accounts. These deposits are part of a bank’s liabilities. Bank owners also provide resources (called bank capital) for the bank. Because of leverage (the use of borrowed funds for investment), a small change in the value of a bank’s assets can lead to a large change in the value of the bank’s capital. To protect depositors, bank regulators require banks to hold a certain minimum amount of capital.
• 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 also uses other tools to control the money supply. It can expand the money supply by decreasing the discount rate, increasing its lending to banks, lowering reserve requirements, or decreasing the interest rate on reserves. It can contract the money supply by increasing the discount rate, decreasing its lending to banks, raising reserve requirements, or increasing the interest rate on reserves.
• When individuals deposit money in banks and banks loan out some of these deposits, the quantity of money in the economy increases. Because the banking system influences the money supply in this way, the Fed’s control of the money supply is imperfect.
• The Federal Reserve has in recent years set monetary policy by choosing a target for the federal funds rate, a short-term interest rate at which banks make loans to one another. As the Fed achieves its target, it adjusts the money supply.
• 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.
• 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.
• 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.
• 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.
• 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.
• 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.
• Net exports are the value of domestic goods and services sold abroad (exports) minus the value of foreign goods and services sold domestically (imports). Net capital outflow is the acquisition of foreign assets by domestic residents (capital outflow) minus the acquisition of domestic assets by foreigners (capital inflow). Because every international transaction involves an exchange of an asset for a good or service, an economy’s net capital outflow always equals its net exports.
• 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 capital outflow.
• The nominal exchange rate is the relative price of the currency of two countries, and the real exchange rate is the 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 appreciate or strengthen. When the nominal exchange rate changes so that each dollar buys less foreign currency, the dollar is said to depreciate or weaken.
• 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.
• Two markets are central to the macroeconomics of open economies: the market for loanable funds and the market for foreign-currency exchange. In the market for loanable funds, the real interest rate adjusts to balance the supply of loanable funds (from national saving) and the demand for loanable funds (for domestic investment and net capital outflow). In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (from net capital outflow) and the demand for dollars (for net exports). Because net capital outflow is part of the demand for loanable funds and because it provides the supply of dollars for foreign-currency exchange, it is the variable that connects these two markets.
• 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 capital outflow, which reduces the supply of dollars in the market for foreign-currency exchange. The dollar appreciates, and net exports fall.
• 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 any 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.
• 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.
• All societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. When recessions occur, real GDP and other measures of income, spending, and production fall, while unemployment rises.
• Classical economic theory is based on the assumption that nominal variables such as the money supply and the price level do not influence real variables such as output and employment. Most economists believe that this assumption is accurate in the long run but not in the short run. 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.
• The aggregate-demand curve slopes downward for three reasons. The first is the wealth effect: A lower price level raises the real value of households’ money holdings, which stimulates consumer spending. The second is the interest-rate effect: 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. The third is the exchange-rate effect: As a lower price level reduces interest rates, the dollar depreciates in the market for foreign-currency exchange, which stimulates net exports.
• 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.
• 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.
• Three theories have been proposed to explain the upward slope of the short-run aggregate-supply curve. 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. 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. All three theories imply that output deviates from its natural level when the actual price level deviates from the price level that people expected.
• 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.
• 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 wages, prices, and perceptions to adjust, the short-run aggregate-supply curve shifts to the right. This shift returns the economy to its natural level of output at a new, lower price level.
• A second possible cause of economic fluctuations is a shift in aggregate supply. When the short-run aggregate-supply curve shifts to the left, the effect is falling output and rising prices—a combination called stagflation. Over time, as wages, prices, and perceptions adjust, the short-run aggregate-supply curve shifts back to the right, returning the price level and output to their original levels.
• 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.
• 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 rep- resents the cost 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.
• Policymakers can influence aggregate demand with monetary policy. An increase in the money supply reduces the equilibrium interest rate for any given price level. Because a lower interest rate stimulates investment spending, the aggregate-demand curve shifts to the right. Conversely, a decrease in the money supply raises the equilibrium interest rate for any given price level and shifts the aggregate-demand curve to the left.
• Policymakers can also influence aggregate demand with fiscal policy. An increase in government purchases or a cut in taxes shifts the aggregate-demand curve to the right. A decrease in government purchases or an increase in taxes shifts the aggregate-demand curve to the left.
• When the government alters spending or taxes, the resulting shift in aggregate demand can be larger or smaller than the fiscal change. The multiplier ef- fect 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.
• 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 de- mand; if the government does not respond, the result is undesirable and unnecessary fluctuations in output and employment. According to critics of active stabi- lization policy, monetary and fiscal policy work with such long lags that attempts at stabilizing the econ- omy often end up being destabilizing.
• 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.
• The trade-off 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.
• The short-run Phillips curve also shifts because of shocks to aggregate supply. An adverse supply shock, such as an increase in world oil prices, gives policy- makers a less favorable trade-off 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.
• 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.
• Advocates of active monetary and fiscal policies 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 policies 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.
• Advocates of increased government spending to fight recessions argue that because tax cuts may be saved rather than spent, direct government spending does more to increase aggregate demand, which is key to promoting production and employment. Critics of spending hikes argue that tax cuts can expand both aggregate demand and aggregate supply and that hasty increases in government spending may lead to wasteful public projects.
• Advocates of rules for monetary policy argue that discretionary policy can suffer from incompetence, the 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.
• 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. The critics also point out several ways in which moderate inflation may be helpful to an economy.
• Advocates of a balanced government budget argue that budget deficits impose an unjustifiable burden on future generations by raising their taxes and low- ering their incomes. Critics of a balanced government budget argue that the deficit is only one small piece of fiscal policy. Single-minded concern about the budget deficit can obscure the many ways in which policy, including various spending programs, affects different generations.
• Advocates of tax incentives for saving point out that our society discourages saving in many ways, such as by heavily taxing capital income 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 decreasing the government’s budget deficit would provide a more direct and equitable way to increase national saving.
