macroeconomics and chapter 1 the economic perspective · 2018-03-21 · macroeconomics and the...

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Macroeconomics andthe Economic Perspective

LECTURE OBJECTIVES

• EMPHASIZE HOW MACROECONOMICS GREW OUT OF ATTEMPTS TO FINDSOLUTIONS TO ECONOMIC PROBLEMS SUCH AS THE GREAT DEPRESSION.(Lecture Note Module 1)

• INTRODUCE THE BASIC FACTS OF THE U.S. MACROECONOMY IN THE TWENTIETHCENTURY. (Lecture Note Module 1)

• EMPHASIZE THE FIVE CORE IDEAS OF ECONOMICS: TRADE-OFFS, INCENTIVES,EXCHANGE, INFORMATION, AND DISTRIBUTION. (Lecture Note Module 2)

• DEFINE MARKETS AND DESCRIBE THE PRINCIPAL MARKETS THAT MAKE UPTHE ECONOMY. (Lecture Note Module 3)

CHAPTER 1

4 | Chapter 1

I. MACROECONOMICS

A. Study of overall economy, not a particular industry

B. Aggregate economy: the general level of prices and employment

II. THE LEGACY OF THE GREAT DEPRESSION: THE COMMITMENT TO FULL EMPLOYMENT AND GROWTH

A. Macroeconomics developed in response to social and economic problems,especially the Great Depression.

B. Some facts about the Great Depression

1. 25 percent unemployed at the height of depression; high unemployment lastedfor all of the 1930s.

2. Stocks on the New York Stock Exchange lost 25 percent of their value.

3. Dow Industrial Average fell from 381 to 41 between September 1929 and July1932.

4. Bank runs and bank failures

5. Widespread poverty, especially among the elderly

6. Economic downturn worldwide

a. Economies were as interconnected as today.

b. Those countries that abandoned the gold standard recovered quicker and hadsmaller downturns.

7. The amount of physical capital, labor, and the level of technology were thesame in the early 1930s and late 1920s; however, in the 1930s they wentunused.

a. How was this possible?

b. Keynes’s answer: insufficient aggregate demand.

C. Post–World War II economic history

1. Fear of return of Great Depression after the war when the armed forcesreturned to civilian life

2. Government demand policies learned in Great Depression prevented a reoccur-rence of the Depression

3. Accountability of the government to get the economy going again

4. Kennedy tax cut of 1964 as natural experiment

5. Apparent trade-off between inflation and unemployment in the 1960s

a. Misery index = inflation + unemployment.

b. A measure of economic performance and well-being

6. Oil price shocks increased prices and inflation and slowed down productionand increased unemployment causing the stagflation of the 1970s. Stagflation:high inflation and high unemployment

ANNOTATEDCHAPTEROUTLINE

Macroeconomics and the Economic Perspective | 5

7. Rise of the misery index; Reagan defeats Carter.

8. Disinflation of the early 1980s and the return of the trade-off between inflationand unemployment

a. Fed focused on controlling money supply; interest rate rose dramatically.

b. Unemployment over 10 percent but inflation fell

9. Twin deficits of the mid- to late-1980s

a. Government budget deficit = government spending � tax revenue.

b. Trade deficit = exports � imports.

c. Trade debate: “Buy American” versus access to international markets inconsumer goods and capital or finance.

10. Slowdown of 1991, the rise of misery index; Clinton defeats Bush.

11. Rapid technological advance in computers and telecommunications improvesU.S. workers, productivity 1995–present. Large swings in government budgetdeficit: surplus in 2000 of $200 billion, tax increases, restraints on spendinggrowth, expanding economy boosted tax receipts

12. Financial crisis in Southeast Asia

13. Decade-long stagnation in Japan

14. Stubbornly high unemployment throughout Europe

15. Slowdown in late 2000; Bush inherits a much weaker economy, promptingcalls for the government to get the economy moving again. Bush tax cuts toencourage households to spend more to boost economy.

16. New challenges

a. Debates over unemployment, fiscal deficit and risks of deflation.

i. Recovery starting in late 2001 did not produce lasting job gains

1. Unemployment stubbornly high: jobless recovery

ii. Bush tax cuts and spending on the war on terrorism pushed gov’t budgetback into deficit

1. Over $300 billion

iii. Deflation: overall prices falling; negative inflation

1. The U.S. has not experienced this since Great Depression

III. THREE KEY GOALS OF MACROECONOMIC PERFORMANCE

A. Rapid growth

B. Full employment

1. Humphrey-Hawkins Act of 1978

2. All those willing, able and seeking work will find jobs.

C. Low inflation

6 | Chapter 1

IV. WHAT IS ECONOMICS?

A. Economics studies how the decision makers in the economy—the individuals,firms, governments, and other organizations—make choices.

1. Trade-offs are necessary because resources are scarce and decision makers areforced to make choices.

2. Incentives influence

a. How the agents in the economy make choices.

b. How decision makers respond to incentives.

3. Exchange: in a market economy, decisions about what is produced and howresources are used are determined through exchange in markets.

4. Information: the structure of markets and how well they function dependscritically on the information available to decision makers.

5. Distribution: markets determine how the goods and services produced by theeconomy are allocated to the members of society.

V. THREE MAJOR MARKETS

A. Product market: goods and services bought and sold

B. Labor market: labor services bought and sold

C. Capital market: funds available for investment are raised and borrowed;capital goods refers to machinery and buildings

VI. MICROECONOMICS AND MACROECONOMICS

A. Microeconomics: study of the small—individual consumers, households, andfirms

B. Macroeconomics: study of the large—the economy overall

VII. THE SCIENCE OF ECONOMICS

A. Theory: a set of assumptions and the conclusions based on them, a logicalexercise

B. Models: words, equations, graphs that depict particular features of economy

C. Relationships between economic variables: connection between variables

1. Does one economic variable change when another economic variable changes?This is correlation.

2. Does one economic variable cause another economic variable to change? Thisis causation.


VIII. WHY ECONOMISTS DISAGREE

A. Positive economics: description of economy, how it works

B. Normative economics: weighing the benefits and costs of policies

C. Disagreement arises out of different models or estimates of quantitativerelationships or out of different values

8 | Chapter 1

LECTURE NOTE MODULE 1

THE COMMITMENT TO FULLEMPLOYMENT AND GROWTH

What Is Macroeconomics?PowerPoint 1.1.1

Macroeconomics is the study of the overall economy; not aparticular industry. We will look at the aggregate economy,that is, the general level of prices and employment in theUnited States.

The Great DepressionPowerPoint 1.1.2

The field of macroeconomics grew out of attempts to findsolutions to economic problems such as the Great Depres-sion. Some facts about the Great Depression: 25 percent ofthe workforce was unemployed at the height of the Depres-sion and high unemployment lasted for all of the 1930s. Thestock market crash of 1929 caused the N.Y. Stock Exchangeto lose 25 percent of its value. One index of stock prices, theDow Industrial Average, fell from 381 to 41 between Sep-tember 1929 and July 1932. The country was racked by arecord number of bank runs and bank failures. There waswidespread poverty, especially among the elderly. The eco-nomic downturn was worldwide since economies were inter-connected as they are today.

Recovery from the Great DepressionPowerPoint 1.1.3

Incredibly, the amount of physical capital and labor and thelevel of technology were the same in the 1930s as in the late1920s; however, something went wrong, and in the 1930sthey went unused. How was this possible? The English econ-omist John Maynard Keynes developed an answer andinvented the field of macroeconomics. The Great Depression,whatever its causes, was ultimately a problem of insufficientaggregate demand. Keynes argued that if the private econ-omy could not generate sufficient demand, it was the gov-ernment’s responsibility to do so.

Long-Term Effects of the Great DepressionPowerPoint 1.1.4

We owe many of the features of our present economy to thelessons learned by economists in the Great Depression: thecommitment by the government to policies that ensure fullemployment and economic growth; a Social Security sys-tem that ensures income for the elderly, the infirm, and theorphaned; the deposit insurance which guarantees householdsavings held in the banking system and ensures against bankruns; and the field of macroeconomics itself.

After the Great DepressionPowerPoint 1.1.5

Recent U.S. economic history has motivated new questions foreconomists and many new answers. Much has been learned bymacroeconomists as they have tried to understand and solvethe economic problems of the post-World War II economy.

Following the war, there was the fear of a revival of theGreat Depression once the armed forces returned to civilianlife. In response, the government enacted policies such as theFull-Employment Act of 1946 to prevent a reoccurrence ofthe 1930s. In this period, citizens began to hold their gov-ernment accountable for the economy’s performance whichis measured by stable prices, sustainable economic growth,and low unemployment.

Getting the Country Moving AgainPowerPoint 1.1.6

In the 1960s it appeared there was a stable trade-off betweeninflation and unemployment; if governments were willing totolerate slightly more inflation, there were policies that couldpredictably reduce unemployment. While true in the 1960s,the 1970s were to prove otherwise. An important policy ini-tiative started by President John F. Kennedy and passed in1964 during the Johnson administration was the so-calledKennedy tax cut of 1964, which enacted a tax cut along thelines spelled out by Keynes. It remains perhaps the mostfamous natural experiment in economic policy. Unemploy-ment fell and inflation rose moderately at first, as predicted.However, by the end of the decade, inflation was 6.2 percentafter starting the decade near 1 percent.

Stagflation PowerPoint 1.1.7

In the 1970s two oil price shocks increased consumer prices;inflation rose, production slowed, and unemploymentincreased, causing stagflation, a situation where both unem-ployment and inflation were high.

Government Deficits and Trade DeficitsPowerPoint 1.1.8

The early 1980s saw a steep disinflation, or reduction in therate of inflation, while unemployment rose to levels not seensince the Great Depression. Later in the decade during theReagan military buildup and following large tax cuts, thegovernment budget deficit and trade deficit both increasedto record levels. The government budget deficit = govern-ment spending � tax revenue while the trade deficit =exports � imports. The large trade deficit prompted a debateover the benefits of trade. Critics argued it was important to“Buy American” while others argued mutual trade allowedaccess to international markets in consumer goods and incapital or finance.

Getting the Economy Moving Again (II)PowerPoint 1.1.9

In 1991 the economy slowed down and Bill Clinton defeatedGeorge Bush for the White House. Then 1995 saw the begin-ning of a rapid technological advance in computers and tele-communications which improved U.S. workers’ productiv-ity. In 1997 a financial crisis in Southeast Asia shook worldasset markets. Japan, the world’s second largest economy, stillsuffers from a decade-long slowdown, and in Europe highunemployment, a leftover from the disinflation of the 1980s,remains a stubborn foe.

In late 2000 the U.S. economy started slowing down afterincreases in key interest rates, and George W. Bush inher-ited a much weaker economy; this has prompted calls forthe government to get the economy moving again.

From the late 1990s to the early years of the new centurythere were large swings in the government budget deficit.Tax increases, restraints on spending growth, and expandingeconomy boosted tax receipts during the 1990s so that by2000 the federal government was in surplus by $200 billion.Since 2001, tax cuts, a recession, and spending on the war onterrorism brought back high government deficits.

Several challenges face the U.S. economy today; namely,unemployment, the fiscal deficit, and risks of deflation. Therecovery starting in late 2001 did not produce lasting jobgains as unemployment remained stubbornly high. Somehave termed this a jobless recovery. The tax cuts pushed byPresident George W. Bush and spending on the war on ter-rorism pushed government budget back into a deficit over$300 billion. Last, there has been a fear that deflation, a situ-ation in which overall prices are falling (that is, negative infla-tion), may again arise in the United States; the last time oureconomy experienced deflation was the Great Depression.

Three Key Goals of Macroeconomic PerformancePowerPoint 1.1.10

Macroeconomic policy in the United States is dedicated tothree goals listed in the Humphrey-Hawkins Act of 1978:rapid growth, full employment, (which means that all thosewilling, able, and seeking work will find jobs), and lowinflation.


WHAT IS ECONOMICS?

What Is Economics? PowerPoint 1.2.1

Economics studies how the decision makers in the econ-omy—the individuals, firms, governments, and other orga-

nizations—make choices. Trade-offs are necessary becauseresources are scarce and decision makers are forced to makechoices. Incentives influence how the agents in the economymake choices and how decision makers respond to incen-tives. What is produced and how resources are used aredetermined through exchange in markets. The structure ofmarkets and how well they function depends critically onthe information available to decision makers. Markets deter-mine the distribution of goods, that is, how the goods andservices produced by the economy are allocated to membersof society.


THE THREE MAJOR MARKETS

The Three Major Markets PowerPoint 1.3.1

The economist’s concept of a market is any situation inwhich exchange takes place; it need not be a physical placeas many international currency trades take place in cyber-space now. Goods and services, capital and labor are allexchanged, bought and sold, on markets.

The product market is where goods and services boughtand sold, the labor market is where labor services boughtand sold, and the capital market is where funds availablefor investment are raised and borrowed. Note that we useanother term, capital goods, to refer to machinery andbuildings.

Microeconomics and MacroeconomicsPowerPoint 1.3.2

Microeconomics is the study of the small, that is, individualconsumers, households, and firms. Macroeconomics, on theother hand, is the study of the large, that is, the U.S. econ-omy overall.

The Science of Economics PowerPoint 1.3.3

In our study of economics we will make use of economictheory, which is a set of assumptions and the conclusionsbased on these assumptions. Conclusions must logically fol-low from the assumptions we make. We use economic mod-els, which are words, equations, and graphs that depict par-ticular features of economy. We will also be interested in therelationship between economic variables. The connectionbetween economic variables, such that when one variablechanges another economic variable changes, is called corre-lation. On the other hand, when one economic variablecauses another economic variable to change, we call thiscausation.


10 | Chapter 1

Why Economists Disagree PowerPoint 1.3.4

Some people may be confused by disagreements amongeconomists. After all, if economics is a science, how can twoeconomists disagree? Part of the solution to this can beunderstood by thinking about two different type’s economic

reasoning. Positive economics is the description of economyand how it works. On the other hand, normative economicsweighs the benefits and costs of policies. Economists need tobe clear on why they disagree highlighting the extent towhich disagreement arises out of different models or esti-mates of quantitative relationships or out of different values.

ALTERNATIVE PROBLEM

1. What is the difference between causation and correla-tion? Are there any good examples from economics toclarify this distinction?

SOLUTIONS

Review Questions

1. President Kennedy’s Council of Economic Advisersbelieved that inflation was the price they would payfor a lower unemployment rate. After the tax cut unem-ployment fell below 4 percent to 3.5 percent but thiswas accompanied by rising inflation from a 1 percentinflation rate in 1963 to 6.2 percent in 1969.

2. Stagflation is a situation of high unemployment andhigh inflation at the same time. The United States expe-rienced stagflation in the late 1970s.

3. During the late 1990s the U.S. economy experiencedboth low unemployment of 4 percent and low inflationunder 2 percent.

4. The key goals of macroeconomic policy are rapidgrowth, full employment, and low inflation.

5. Trade-offs are unavoidable because of scarcity.Scarcity forces us to make choices. We have to choosebetween alternatives, so there are things we must giveup. Incentives are important because economistsbelieve benefits or reduced costs motivate decisionmakers such as consumers, firms, and governments infavor of particular choices.

6. Exchange is voluntary so if the exchange makes oneof the parties worse off, that party will not enter intoit. Therefore, when voluntary exchange takes place,both sides of the exchange are better off (or at least noworse off).

7. Information can be freely shared. Standard goodscannot be freely shared; if I eat my slice of cake, youcan’t. With regard to information, my use of the infor-mation that the sky is blue does not prevent you fromusing that information too.

If information is imperfect, people may wish toprotect themselves against the dangers of the unknown.They may be willing, in other words, to buy insuranceto cover the bad outcomes they cannot foresee.

There is a flip side to the relationship betweenimperfect information and insurance; imperfect infor-mation may also hinder the market for insurance. Take,for example, automobile insurance that covers againsttheft. Consumers who buy such insurance know thatthe insurer will compensate them if their car is stolen.This may lead them to take fewer precautions to pro-tect their car and as a consequence have their cars

stolen more often. Insurers have imperfect informationabout how well their customers will protect their carsonce they are insured against theft. Since insurers knowthese incentives exist, they may offer less of this typeof insurance than the market wants.

8. Steps to improve equity by softening the way marketsdistribute income often blunt economic incentives andresult in less production with the same inputs; that is,the result is inefficient. For example, while welfarepayments provide an important safety net for the poor,the taxation required to finance welfare may discour-age work and savings. If the government takes 1 out ofevery 2 or 3 dollars that an individual earns, that indi-vidual may not be inclined to work as much. If thegovernment takes 1 out of 2 or 3 dollars a person earnsfrom interest on savings, the person may decide tospend more and save less.

9. The goods market, the labor market, and the capitalmarket: When we buy goods and services as consumers,we are participating in the goods market. When anindividual gets a job, she is a supplier in the labormarket. When we save, we are suppliers of loanablefunds in the capital market.

10. Microeconomics: the performance of the U.S. computerchip industry and the price of electricity in Californiathe summer of 2001. Macroeconomics: unemploymentin the United States and the U.S. trade balance.

Problems

1. On June 23, 2005, the front page of the New York Timeshad news of the Chinese takeover offer for a U.S. oilcompany, an example of capital inflows from China tothe United States. Also mentioned elsewhere in the news-paper was the sudden fall in Treasury bill rates which isrelated to the cost of borrowing funds for consumers,households, and firms.

2. The U.S. unemployment rate in May 2005 was 5.1 per-cent. From May 2004 to May 2005 inflation was2.8 percent.

3. In the 1980s and 1990s the two deficits were the federalgovernment deficit and the U.S. trade deficit. Duringthe 1990s the government budget deficit shrank as taxesincreased, restraints were placed on the growth of gov-ernment spending, and the booming stock marketincreased capital gains tax receipts. In the 1990s thetrade deficit continued, however. In the last five years,the federal government budget has returned to deficit,the result of tax cuts, extra spending on the war on ter-rorism, and the slump in the economy in 2001 whichreduced tax receipts and required higher governmentspending. At the same time the U.S. trade deficit hasslid to a record deficit as U.S. imports far exceedexports.


12 | Chapter 1

Swedes who have the same income levels, educationlevels, access to health care, and so on. It would be inter-esting to see, after controlling for these variables, whetherpeople who live in Sweden live longer.

9. This disagreement concerns both positive and norma-tive economics and is the type of issue that makes eco-nomics interesting. Disagreements about positive eco-nomics center on such problems as which models of themacroeconomy are relevant for studying the U.S. econ-omy in 2000. Disagreements about normative econom-ics revolve around such questions as whether one thinksinflation is worse than slowing down the economy.

SOLUTION TO ALTERNATIVE PROBLEM

1. Correlation means that when one thing happens, someother thing tends to happen. Causation means there issome systematic relationship between the two events orsome reason why when the first thing happens, the sec-ond thing tends to happen. Just because two things tendto happen together does not mean one causes the other;they could both be caused by some third thing and sotend to happen together. To take a simple example fromeconomics, U.S. GDP, which is the total value of all ofthe final goods produced within the borders of the UnitedStates, increases (virtually) every year. A second variable,total cumulative rainfall since 1900, also increases everyyear since every year the United States gets rained on(if you doubt this, ask someone living in Seattle). Sinceboth of these variables increase every year, they are cor-related; they tend to happen together. On the other hand,neither variable causes the other. Cumulative rainfall doesnot in any meaningful way cause U.S. GDP to rise andU.S. GDP, of course, has no causal effect on the weather.There is no systematic way in which causation mightwork between these two variables. These two variablesare both caused by a third variable which is, of course,time.

4. (a) An increase in tuition costs reduces the incentive togo to college since alternatives may now be moreattractive.

(b) A fall in the interest rate on student loans raises theincentive to go to college because the borrowingcosts of a student loan are lower.

(c) A rise in wages for unskilled jobs reduces the incen-tive to go to college since one of the alternatives togoing to college has become more attractive.

(d) An increase in incomes of college graduates raisesthe incentive to go to college since the rewards to aearning a college degree are higher.

5. (a) Macroeconomic(b) Microeconomic(c) Microeconomic(d) Macroeconomic(e) Microeconomic(f) Both micro and macro: Micro since the oil industry

is just one industry in the U.S. economy. Macrosince the price of oil is a major component of trans-portation costs which in turn feed into the price ofvirtually every other good produced in the UnitedStates.

6. (a) Capital market(b) Labor market(c) Product market(d) Labor market(e) Product market(f) Capital market

7. It seems unlikely that using cat litter results in longer-lived cats. These two events, cat litter use and longerlives, are correlated, but there is no reason to believe onecauses the other. They are both related to some thirdthing. Cats that live in homes are likely to use cat litterand are also likely to live longer since they are shelteredfrom the rough and tumble world of the alley.

8. This information does not prove that if an Indian movedto Sweden, he would live longer. Income, access to healthcare, infant nutrition, sanitation, and many other factorsaffect life expectancy. One might compare Indians and

Instructor’s Manual forStiglitz and Walsh’sPrinciples ofMicroeconomicsFOURTH EDITION

Instructor’s Manual forStiglitz and Walsh’sPrinciples ofMicroeconomicsFOURTH EDITION

Gerald McIntyreOCCIDENTAL COLLEGE

W • W • NORTON & COMPANY • NEW YORK • LONDONB

Copyright © 2006, 2002, 1997, 1993 by W. W. Norton & Company, Inc.

All rights reserved

Printed in the United States of America

ISBN 13: 978-0-393-92805-1 (pbk.)

ISBN 10: 0-393-92805-5 (pbk.)

W. W. Norton & Company, Inc., 500 Fifth Avenue, New York, N.Y. 10110

www.wwnorton.comW. W. Norton & Company Ltd., Castle House, 75/76 Wells Street, London W1T 3QT

1 2 3 4 5 6 7 8 9 0

v

CONTENTS

Preface vii

Part One: Introduction

Chapter 1 | Modern Economics 3

Chapter 2 | Thinking Like an Economist 11

Part Two: Perfect Markets

Chapter 3 | Demand, Supply, and Price 23

Chapter 4 | Using Demand and Supply 35

Chapter 5 | The Consumption Decision 45

Chapter 6 | The Firm’s Costs 59

Chapter 7 | The Competitive Firm 71

Chapter 8 | Labor Markets 79

Chapter 9 | Capital Markets 87

Chapter 10 | The Efficiency of Competitive Markets 97

Part Three: Imperfect Markets

Chapter 11 | Introduction to Imperfect Markets 107

Chapter 12 | Monopoly, Monopolistic Competition, and Oligopoly 117

Chapter 13 | Government Policies toward Competition 133

Chapter 14 | Strategic Behavior 143

Chapter 15 | Imperfect Information in the Product Market 159

Chapter 16 | Imperfections in the Labor Market 169

Part Four: Issues in Public Policy

Chapter 17 | The Public Sector 179

Chapter 18 | Environmental Economics 195

Chapter 19 | International Trade and Trade Policy 205

Chapter 20 | Technological Change 223

Chapter 21 | A Student’s Guide to Investing 233

For each chapter of the fourth edition of Principles of Microeconomics by Stiglitz and Walsh the following ancillary materialsare provided:

• A list of Lecture Objectives, so instructors can easily identify the main themes of the chapter at a glance.

• A short outline of the entire chapter for quick reference, which is designed to serve as a lecture outline.

• A Lecture Note Module for each chapter objective, which is a complete lecture in a ready-to-deliver form.

• A series of PowerPoint storyboards or slides for each lecture objective that follow the chapter outline and LectureNote Modules. These slides include most of the graphs and tables from the text.

• Solutions to all of the review questions found at the end of the chapter.

• Solutions to all problems found at the end of the chapter.

• A set of additional or parallel problems (and solutions) similar to the problems found at the end of the chapter.

I hope instructors find these ancillaries a useful adjunct to their courses and that students find these materials helpful inlearning the principles of economics. I would like to thank W. W. Norton for its assistance and patience.

Jerry McIntyreLos Angeles, CAAugust 2005

PREFACE

PART ONEINTRODUCTION

CHAPTER 1

3

Modern Economics

LECTURE OBJECTIVES

• ANSWER THE QUESTION: WHAT IS ECONOMICS AND WHAT ARE MARKETS? (Lecture Note Module 3)

• IDENTIFY THE KEY CONCEPTS THAT DEFINE THE CORE IDEAS OF ECONOMICS.(Lecture Note Module 3)

• IDENTIFY THE THREE MAJOR MARKETS. (Lecture Note Module 4)

• DISCRIMINATE BETWEEN THE TWO BRANCHES OF ECONOMICS.(Lecture Note Module 5)

• EXPLAIN WHY ECONOMICS IS CALLED A SCIENCE AND WHY ECONOMISTS OFTEN DISAGREE. (Lecture Note Modules 6 and 7)

4 | Chapter 1

ANNOTATEDCHAPTEROUTLINE

I. INTRODUCTION

A. Technology has transformed many things.

1. How we shop, pay bills, travel, communicate, and collect information

2. How firms produce: computerized assembly lines and robots

3. Information technology (IT)

B. The old economy is still live and kicking.

1. IT makes up less than 10% of the economy.

2. Technologies change but economic laws do not.

C. Economics from today’s headlines

1. Bill to curb music piracy: battle between music companies and consumers

a. It does not cost more to music companies to share files so why should con-sumers pay companies for files?

b. Without the ability to earn profit, music companies have less of an incentiveto seek out, record, and promote new music. The role of property rights andthe right to charge for the use of their property will play an important role asnew information technologies make trading such property easier.

2. Internet drug trade proves to be a bitter pill for Canada

a. Buyers in Florida or the United States in general can buy less expensive drugsin Canada more easily due to the Internet.

b. This leads to shortages in Canada.

3. Intel cancels two chip projects: Intel with $2 billion sunk in plant pulls plug on anew line of computer chips. Firms are concerned about costs but economicsshows which costs are important and whether some costs are not.

4. Oracle bids for PeopleSoft to be tested in court

a. The U.S. Justice Department sues to block takeover.

b. Why does government try to ensure competition?

c. What are the advantages of competition?

d. What tools does the government use to promote competition?

5. FASB proposes expensing stock options

a. Many tech companies reward employees with stock options, an opportunity tobuy shares of stock at a set price.

b. If a company does well, the price rises and employees gain. Employees havean incentive to work hard and help the company succeed.

c. FASB argues that options must be expensed—deducted from revenues whichreduces profit.

Modern Economics | 5

II. WHAT IS ECONOMICS?

A. Economics studies how individuals, firms, the government, and other organizations make choices and how those choices determine society’suse of its resources.

B. Trade-offs

1. All choices involve trade-offs: How to spend your weekly budget—pizza, CDs,movies, books, and so on. There is no such thing as a free lunch.

2. Trade-offs stem from scarcity: limited money, time, and resources.

C. Incentives: the rewards and costs that stem from making choices

1. All decision makers, consumers, businesses, and governments respond toincentives.

2. Prices affect incentives, both rewards and costs.

D. Exchange: trade of goods and services

1. Voluntary exchange in markets determines which goods and services to produce.

2. Voluntary exchange means both parties get something they want; e.g., workerswant income, and firms want certain jobs done.

3. A market: any situation in which exchange takes place

a. It need not be a physical location.

b. With competition, consumers have alternatives.

4. The United States is a mixed economy; government plays a critical role.

E. Information: needed to make informed choices

1. Information is like other goods or services: firms and institutions specialize inthe purchase and sale of information.

2. Information is unlike other goods and services: the seller of a car lets you testdrive it, but a seller of information cannot let you see the information.

3. Information can shape whole markets:

a. The market for used cars

b. The stock and security markets

c. The insurance market

F. Distribution: the market determines who gets which goods.

a. Some view the distribution of wealth with unease.

b. Government programs soften the distributional impact of markets but alsoblunt economic incentives: the trade-off between equity and efficiency.

III. THE THREE MAJOR MARKETS

A. The product market: where final goods and services are exchanged

6 | Chapter 1

B. The labor market: where workers sell labor and firms hire workers

C. The capital market: where households, firms, and government save (lend) andraise (borrow) funds. Capital is plant, machinery, and equipment.

IV. THE TWO BRANCHES OF ECONOMICS

A. Microeconomics: the study of specific goods and services, industries,individuals, and firms.

B. Macroeconomics: the study of the behavior of the overall economy.

V. THE SCIENCE OF ECONOMICS

A. Economics is a social science.

B. Economists construct theories from assumptions or hypotheses and theconclusions derived from them

1. Theories are logical exercises.

2. Economists use the theory of perfect competition even where it only holdsapproximately.

C. Economists use models to test theories; models are abstractions.

D. Discovering and interpreting relationships

1. Economists seek to understand the relationships among variables.

2. Variables can be measured and may change.

E. Causation and correlation

1. Correlation: when one variable changes another tends to change

2. Causation: when changing one variable “causes” another variable to change,when changing the first necessarily changes the second. For example, in the1970s imports of cars from Japan rose while U.S. auto production fell.

a. These variables are correlated.

b. Was there causation? No; both were related to a third thing—higher oilprices pushed U.S. consumers away from “gas-guzzling” U.S. cars towardmore fuel-efficient Japanese cars.

VI. WHY ECONOMISTS DISAGREE

A. Differences usually fall into two categories:

1. How the economy operates (positive economics), e.g., differences over whichmodel to use

2. How to evaluate the consequences of policies (normative economics), e.g.,differences in assessments of the quantitative magnitudes of the analysis

B. Different values lead economists to disagree about the policies that government should pursue.

determine society’s use of its scarce resources. There are fiveimportant core ideas that economics stresses: trade-offs, in-centives, exchange, information, and distribution.

Trade-Offs PowerPoint 1.3.2

In a market economy and a democratic society, consumersmake choices about what they will buy and how they willlive their lives. This is a good thing. However, all choices in-volve trade-offs. Take, for example, your decision on how tospend your weekly budget: how much money should youspend on pizza, CDs, movies, books, and so on? There is nosuch thing as a free lunch. Trade-offs stem from scarcity. Weall have limited money and time, and society as a whole haslimited resources.

Incentives PowerPoint 1.3.3

All decision makers, consumers, businesses, and govern-ments respond to incentives. Incentives are the rewards andcosts that stem from making choices. In the economy, priceaffects incentives as it indicates both rewards and costs in anexchange.

Exchange PowerPoint 1.3.4

The trade of goods and services is known as exchange. Oureconomy is based on voluntary exchange in markets. Volun-tary exchange means that both parties get something theywant: a worker wants income and a firm wants a certain jobdone, for example. A market is not necessarily a physicalplace but any situation in which an exchange takes place. Inthe past markets were located physically; you (or your agent)had to be physically present in order to buy at an auction.Now the Internet auction site eBay allows you to be half aworld away and still buy something. Though our economydepends on the market to deliver a vast amount of goods andservices, inputs, labor, and capital to those who want them,our economy is a mixed economy where the governmentplays a critical role.

Information PowerPoint 1.3.5

Information plays a crucial role in any economy; making in-formed choices requires information. In a way, informationis like any other good or service. There are firms and institu-tions that specialize in the purchase and sale of information.On the other hand, information differs from other goods. Aseller of a car lets you test drive it, but a seller of informa-tion cannot let you see the information. In some marketsinformation is so crucial it shapes the whole market, forexample, the market for used cars, the market for stocks andother assets, and the market for insurance.



MODERN ECONOMICS

Technology and Economic Laws PowerPoint 1.1.1

In the past ten years technology has seemed to transformeverything: how we shop, pay bills, travel, communicate,and collect information. It has also changed how firms pro-duce, from computerized assembly lines and robots to pop-upads on Web pages and Internet job search programs. Thesechanges reflect a revolution in information technology (IT).While these changes are obvious, the old economy is stillalive and kicking. Recent studies conclude that IT makes upless than 10% of the economy. The lesson is that while tech-nologies change economic laws do not.


THE STORY OF COMPUTERS AND THE INTERNET

The World Wide Web and the InternetPowerPoint 1.2.1

The Internet was developed by the Defense Department’sAdvanced Research Projects Agency (DARPA) to allow re-searchers to exchange information; e-mail came much later.The World Wide Web was developed in 1990, and the vastamount of information available on the Web was finallymade navigable by the development of the browser in 1995.With the rise of the Internet, Microsoft recognized that itsdominance was being challenged.

The Government and the Computer IndustryPowerPoint 1.2.2

The government played an important role in the rise of thecomputer industry. It funded basic research all along. TheCensus Bureau bought the first UNIVAC and is now playinga role in ensuring fair competition with the antitrust caseagainst Microsoft.


WHAT IS ECONOMICS?

What Is Economics? PowerPoint 1.3.1

Economics studies how individuals, firms, the government,and other organizations make choices and how those choices

of assumptions or hypotheses and the conclusions derivedfrom them. Theories (whether economic or otherwise) arelogical exercises from assumptions to conclusions.

Economic Modeling PowerPoint 1.6.2

Economists use models to test theories. Models are abstrac-tions of social reality that focus on the essential part of thetheory. For instance, economists may use the theory of perfector pure competition even where it holds only approximately.

Discovering and Interpreting RelationshipsPowerPoint 1.6.3

Economists seek to understand the relationships among eco-nomic variables which can be measured and may changewith economic circumstances.

Causation and CorrelationPowerPoint 1.6.4

It is important for economists to understand when two eco-nomic variables are correlated—when there is a patternedrelationship between them—and when one economic vari-able causes another. For example, if the government lowerstaxes, does output increase? Do lower taxes cause highergrowth or are taxes and growth just inversely correlated withno causal relationship?


WHY ECONOMISTS DISAGREE

Why Economists DisagreePowerPoint 1.7.1

Economists often disagree (that’s one reason it’s fun to studyeconomics). Most often economists disagree about publicpolicy, what the government should do. Their differencesusually fall into one of two categories: differences about howthe economy operates (positive economics) and differencesabout how to evaluate the consequences of policies (norma-tive economics), such as differences over assessing the quan-titative magnitudes of the analysis. These differences arisebecause economists like everyone have different values lead-ing them to disagree about government policies and evenabout how the economy operates.

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Distribution PowerPoint 1.3.6

The distribution of goods is determined by the market; thatis, who gets what is mediated by the buying and selling ofgoods. Some view the uneven distribution of wealth in oureconomy with unease, and there are government programsthat attempt to even it out. However, efforts to soften the dis-tributional impact of markets often blunts economic incen-tives. There is a trade-off between equity and efficiency.


THE THREE MAJOR MARKETS

The Three Major Markets PowerPoint 1.4.1

There are three major markets in any economy: the productmarket, where final goods and services are exchanged; thelabor market, where workers sell labor and firms hire work-ers; and the capital market, where households, firms, andgovernment save and raise funds (capital is plant, machin-ery, and equipment).


THE TWO BRANCHES OF ECONOMICS

The Two Branches of EconomicsPowerPoint 1.5.1

There are two branches of economics: microeconomics whichis the study of the small, that is, the study of specific goodsand services, industries, individuals, and firms, and macro-economics which is the study of the large, that is, the behav-ior of the overall economy.


THE SCIENCE OF ECONOMICS

The Science of Economics PowerPoint 1.6.1

Economics is a social science and as such has adopted manyof the principles of the sciences. Economic theory consists


individuals. Macroeconomic issues include unemploy-ment, inflation, economic growth, and the balance oftrade. The general difference between the two is thatmacroeconomics looks at the economy as a whole whilemicroeconomics looks at the behavior of the units thatmake up the economy.

8. A model is a theoretical construct designed to mirrorthe essential characteristics of the particular phenomenaunder study. Economists use models to study the work-ings of the economy and to make predictions about howthe economy will respond to changes.

9. If one variable causes another, then changing onevariable will necessarily change the other; this impliesthat the two variables are correlated. However, if achange in one variable only leads to a predictable changein the other variable, then the two are correlated but itcannot be said that the change in one variable causedthe change in the other. An example of correlation is thetotal rainfall since 1900 in the United States and U.S.per capita income. Over time both of these variables in-crease, but total rainfall does not in any meaningful wayaffect per capita income in the United States, so there isno causation. Both are related to a third variable—time.An example of causation is the consumer price indexand the aggregate amount of transactions money (cashand checking account balances) in the United States.Over time both have increased and there is a causal rela-tionship: The more money in circulation, the higher theprice level.

Problems

1. (a) Reduces the incentives to go to college.(b) Increases the incentives.(c) Reduces the incentives if some of those going to

college might be attracted to low-skilled jobs.(d) Increases the incentives.

2. (a) Macroeconomic; (b) Microeconomic;(c) Microeconomic; (d) Macroeconomic;(e) Microeconomic; (f) Macroeconomic.

3. (a) Capital; (b) Labor; (c) Product; (d) Labor;(e) Product; (f) Capital.

4. The correlation between cat litter use and cat lifeexpectancy does not imply causation. It could be thatonly indoor cats use cat litter. Thus, it could be arguedthat the cat faces less danger and is likely to live longerif it is an indoor cat. To test this, you could collect dataon the death rates of outdoor cats that use a litter boxand outdoor cats that do not.

5. Once again, correlation does not imply causation.Lifestyle, climate, and heredity are factors that influencelife expectancy. If it is true that the Swedish environ-ment is less hostile compared to the Indian environment,then one can expect to live longer in Sweden than in

ALTERNATIVE PROBLEMS1. What is a market?2. How are goods produced?3. What determines production?4. Who decides who gets what in a market economy?

SOLUTIONS

Review Questions

1. Trade-offs are unavoidable because resources are scarceand we must make choices. Economists believe that alleconomic agents, consumers, business firms, and thegovernment respond to incentives by changing thedecisions they make.

2. After a voluntary exchange, both parties are better off orthey would not have made the exchange.

3. Information can be used by many people without a re-duction in the information available. This is not true forice cream; if Joe eats one scoop of ice cream, there isless ice cream for Carl. Imperfect information affectsthe market for insurance since the insurer does notknow perfectly what kind of risk the potential policy-holder represents and how the ownership of the insurancemay affect the policyholder’s behavior in the future. Forexample, someone with car insurance that covers thewhole value of the car if stolen may be less likely totake precautions to keep it from being stolen.

4. Government programs to promote equity, that is, tosoften the disparity of income, such as generous unem-ployment benefits, may discourage workers from seekingand finding jobs. This may mean greater unemploymentfor a longer period of time, which reduces the economy’sefficiency. That is, programs to support incomes dampenone of the incentives to work.

5. In a mixed economy, there is a mix between public andprivate policymaking. In general, the U.S. governmentsets the legal structure under which private firms andindividuals operate. It regulates businesses to ensurethat they do not mislead customers, that they are carefulabout the safety of their employees, and that they do notpollute the air and water. The government providesgoods and services for national defense, builds roads,and prints money. Government programs provide forthe elderly through Social Security and Medicare. Thegovernment helps those who have suffered some sort ofdislocation and attempts to provide support for the poorthrough welfare programs.

6. Firms sell goods to households in the product market.Firms hire labor, and households sell labor in the labormarket. Firms invest in capital goods, and householdsinvest and borrow money in the capital market.

7. Microeconomic issues include the behavior anddecision-making processes of firms, households, and

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profit; the Chicago commodities market, where buyersand sellers of goods meet to coordinate current andfuture delivery as well as to shift risk; the markets forautos, steel, and so on. Exchange in daily lives in theUnited States is clearly market dependent.

2. What is produced is balanced by the cost to the produceror supplier and the consumers’ willingness to pay. Howgoods are produced, what inputs are used, what techniquewill be employed is determined by the relative cost ofdifferent inputs and alternative production processes.

3. Production is determined by consumers’ relative willing-ness to pay—how many other goods they are willing togive up, and the costs of production.

4. All the individual agents participating in a market, theconsumer, the business firm, and sometimes the govern-ment, interact to decide who gets what in a marketeconomy.

India. To test this, you would need to compare groupsof individuals whose characteristics were nearly identi-cal, place them in comparable environments within thetwo countries, and compare their average life spans.

6. This is a disagreement in normative economics. Bothsides to this debate agreed on how the economy oper-ates (which is positive economics). That is, they agreedthat the Fed could slow down the economy. The partici-pants of this debate disagreed on what ought to be done,which is a normative question.

SOLUTIONS TO ALTERNATIVE PROBLEMS

1. A market is a situation in which exchanges occur, forexample, a farmer’s market, where goods or money maybe exchanged for other goods; a stock exchange, wherecapital is exchanged for the right to share in corporate

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