CHAPTER 1 TEN PRINCIPLES OF ECONOMICS In the 1980s and 1990s, for example, much debate in the United States centered on the governments 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 students education) and physical capital(the firms factory). Because lower investment today means lower productivity in the future, government budget deficits are generally thought to de- press growth in living standard 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 inflation prices in the economy an increase in the overall level of Although the United States has never experienced inflation even close to that prices in the economy 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 原人 " Well it may have been 68 cents when you got in line, but it's 74 cents now!
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 government 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 depress 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 history’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!
PART ONE NTRODUCTION 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 nations 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 tity of mon PRINCIPLE 10: SOCIETY FACES A SHORT-RUN TRADEOFF BETWEEN NFLATION 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 Phillips curve between inflation and unemployment is called the Phillips curve, after the ec a curve that shows the short-run mist who first examined this relationship tradeoff between inflation and 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 ily until prices have fully adjusted to the change The tradeoff between inflation and unemployment is only temporary, but it an 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
14 PART ONE INTRODUCTION 20 years for prices to double. Because high inflation imposes various costs on society, 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 government 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 dramatic, 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 ridding 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 economist 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 inflation 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 workers. Thus, the reduction in the quantity of money raises unemployment temporarily 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 understanding 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 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 Table 1-1 HOw peop MAKE DECISIONS TEN PRINCIPLES OF ECONOMI #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 HOw PEOPLE InteRaCt #5: Trade Can Make Everyone Better Off #6: Markets Are Usually a Good Way to Organize #7: Governments Can Sometimes Improve Market HOw THE ECONOMY #8: A Countrys Standard of Living Depends on Its AS A WHOLE WORKS Ability to Produce Goods and Services #9: Prices rise when the government prints too #10: Society Faces a 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. Mastering 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 different 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 HOW PEOPLE #1: People Face Tradeoffs MAKE DECISIONS #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 HOW PEOPLE INTERACT #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 HOW THE ECONOMY #8: A Country’s Standard of Living Depends on Its AS A WHOLE WORKS 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
PART ONE NTRODUCTION Summary The fundamental lessons about individual markets are usually a good way of coordinating trade decisionmaking are that people face tradeoffs among among people, and that the government can potentially alternative goals, that the cost of any action is measured improve market outcomes if there is some market in terms of forgone opportunities, that rational people failure or if the market outcome is inequitable nake decisions by comparing marginal costs ar The fundamental lessons about the economy as a whole marginal benefits, and that people change their behavior are that productivity is the ultimate source of living in response to the incentives they face tandards, that money growth is the ultimate source of The fundamental lessons about interactions among inflation, and that society faces a short-run tradeoff people are that trade can be mutually beneficial, that between inflation and unemployment Key concepts scarcity, p. 4 marginal changes, I productivity, P. 12 economics,p4 narket economy, p. 9 inflation, p. 13 efficiency, p 5 market failure, p. 11 Phillips curve, p. 14 equity, p 5 eternality, p. 11 opportunity cost, p.6 market power, p. 11 Questions for Review Give three examples of important tradeoffs that you face 6. What does the "invisible hand"of the marketplace do? 7. Explain the two main causes of market failure and give 2. What is the opportunity cost of seeing a movie? an example of each 3. Water is necessary for life. Is the marginal benefit of a 8. Why is productivity important? glass of water large or small? 9. What is inflation and what causes it? Why should policymakers think about incentives? 10. How are inflation and unemployment related in the 5. Why isnt trade among countries like a game with some Problems and Applications 1. Describe some of the tradeoffs faced by the following: is the true cost of going skiing? Now suppose that you a. a family deciding whether to buy a new car had been planning to spend the day studying at the b. a member of Congress deciding how much to library. What is the cost of going skiing in this case spend on national parks c. a company president deciding whether to open a 4. You win $100 in a basketball pool. You have a choice between spending the money now or putting it away d. a professor deciding how much to prepare for class for a year in a bank account that pays 5 percent interest. 2. You are trying to decide whether to take a vacation What is the opportunity cost of spending the $100 now? Most of the costs of the vacation(airfare, hotel, forgone 5. The company that you manage has invested $5 million n developing a new product, but the development is vacation are psychological. How can you compare the not quite finished. At a recent meeting, your salespeople benefits to the costs? report that the introduction of competing products has 3. You were planning to spend Saturday working at your reduced the expected sales of your new produc part-time job, but a friend asks you to go sking. What S3 million If it would cost $1 million to finish
16 PART ONE INTRODUCTION ◆ 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. ◆ 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. ◆ 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 development and make the product, should you go b. How would your decisions about CDs affect some thead and do so? What is the most that you should pay of your other decisions, such as how many CD to complete development? players to make or cassette tapes to produce How 6. Three managers of the Magic Potion Company are might some of your other decisions about the discussing a possible increase in production. Each economy change your views about CDs? suggests a way to make this decision 1. Explain whether each of the following government activities is motivated by a concern about equity or a HARRY: We should examine whether our oncern about efficiency. In the case of efficiency, discuss companys productivity--gallons of the type of market failure involved potion per worker--would rise or fall a. regulating cable-TV prices RON: We should examine whether our average b. providing some poor people with vouchers that car costcost per worker--would rise or fall be used to buy food HERMIONE: We should examine whether the extra c. prohibiting smoking in public places revenue from selling the additional potion d. breaking up Standard Oil (which once owned 90 percent of all oil refineries) into several smaller would be greater or smaller than the extra companes e. imposing higher personal income tax rates on people with higher incomes Who do you think is right? Why? f. instituting laws against driving while intoxicated 7. The Social Security system provides income for people 12. Discuss each of the following statements from the over age 65. If a recipient of Social Security decides to stand points of equity and efficiency. work and earn some income, the amount he or she a."Everyone in society should be guaranteed the best receives in Social Security benefits is typically reduced a. How does the provision of Social Security affect health care possible. b."When workers are laid off, they should be able to peoples incentive to save while working? collect unemployment benefits until they find a b. How does the reduction in benefits associated with new job. higher earnings affect peoples incentive to work 13. In what ways is your standard of living different from 8. A recent bill reforming the governments antipoverty that of your parents or grand parents when they were your age? Why have these changes occurred? programs limited many welfare recipients to only two years of benefits 14. Suppose Americans decide to save more of their a. How does this change affect the incentives for incomes. If banks lend this extra saving to businesses, which use the funds to build new factories, how might b. How might this change represent a tradeoff this lead to faster growth in productivity? who do you etween equity and efficiency suppose benefits from the higher productivity? Is 9. Your roommate is a better cook than you are, but you an clean more quickly than your roommate can. If you 15. Suppose that when everyone wakes up tomorrow, they roommate did all of the cooking and you did all of the discover that the government has given them an cleaning, would your chores take you more or less time additional amount of money equal to the amount they than if you divided each task evenly? Give a similar Iready had. Explain what effect this doubling of the example of how specialization and trade can make two noney supply will likely have on the following: countries both better of the total amount spent on goods and services b. the quantity of goods and services purchased if 10. Suppose the United States adopted central planning for ices are sticky its economy, and you became the chief planner. Among c. the prices of goods and services if prices can adjust the millions of decisions that you need to make for next compact discs to produce, what 16. Imagine that you are a policymaker trying to decide whether to reduce the rate of inflation To make ar artists to record, and who should receive the discs a. To make these decisions intelligently, what elligent decision, what would you need to know information would you need about the compact about inflation, unemployment, and the tradeoff between them? disc industry? What information would you need about each of the people in the United States?
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?