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ROGER A. ARNOLDCalifornia S t a t e Univers i ty

San Marcos

SOUTH-WESTERNCENGAGE Learning-

A u s t r a l i a • B r a z i l • C a n a d a • M e x i c o • S i n g a p o r e • S p a i n • U n i t e d K i n g d o m • U n i t e d S t a t e s

CONTENTS

INTRODUCTION TO ECONOMICS

PART 1 ECONOMICS: THE SCIENCE OF SCARCITY

CHAPTER 1: WHAT ECONOMICS IS ABOUT 1

mmA Definition of Economics 1

Goods and Bads 1 Resources 2 Scarcity and a Definition of Economics 2

Key Concepts in Economics 5Opportunity Cost 5 Opportunity Cost and Behavior 5 Benefits and Costs 6 DecisionsMade at the Margin 6 Efficiency 8 Economics Is About Incentives 10 UnintendedEffects 10 Exchange 12

The Market and Government 12

Ceteris Paribus and Theory 13Ceteris Paribus Thinking 13 What Is a Theory? 14

Economic Categories 17Positive and Normative Economics 17 Microeconomics and Macroeconomics 17

Chapter Summary 20

Key Terms and Concepts 21

Questions and Problems 21

APPENDIX A: WORKING WITH DIAGRAMS 23

Two-Variable Diagrams 23

Slope of a Line 24

Slope of a Line is Constant 25

Slope of a Curve 25

The 45-Degree Line 27

Pie Charts 27

Bar Graphs 28

Line Graphs 28

Appendix Summary 30


APPENDIX B: SHOULD YOU MAJOR IN ECONOMICS? 32

Five Myths About Economics and Being an Economics Major 33

What Awaits You as an Economics Major? 36

What Do Economists Do? 37

Places to Find More Information 39

Concluding Remarks 39

CONTENTS

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CHAPTER 2: PRODUCTION POSSIBILITIES FRONTIERFRAMEWORK 40

The Production Possibilities Frontier 40The Straight-Line PPF: Constant Opportunity Costs 40 The Bowed-Outward (Concave-Downward) PPF: Increasing Opportunity Costs 41 Law of Increasing OpportunityCosts 42 Economic Concepts in a PPF Framework 43

Specialization and Trade Can Move Us Beyond Our PPF 48A Simple Two-Person PPF Model 48On or Beyond the PPF? 51

Chapter Summary 52 -- '



Working with Numbers and Graphs 54

CHAPTER 3: SUPPLY AND DEMAND:THEORY 55

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What Is Demand? 55The Law of Demand 56 Four Ways to Represent the Law of Demand 56 Why DoesQuantity Demanded Go Down as Price Goes Up? 57 Individual Demand Curve andMarket Demand Curve 58 A Change in Quantity Demanded Versus a Change inDemand 59 What Factors Cause the Demand Curve to Shift? 61 MovementFactors and Shift Factors 64

Supply 65The Law of Supply 66 Why Most Supply Curves Are Upward Sloping 66 Changesin Supply Mean Shifts in Supply Curves 68 What Factors Cause the Supply Curve toShift? 68 A Change in Supply Versus a Change in Quantity Supplied 69

The Market: Putting Supply and Demand Together 70Supply and Demand at Work at an Auction 71 The Language of Supply and Demand:A Few Important Terms 71 Moving to Equilibrium: What Happens to Price WhenThere Is a Surplus or a Shortage? 72 Speed of Moving to Equilibrium 73 Movingto Equilibrium: Maximum and Minimum Prices 73 Equilibrium in Terms ofConsumers' and Producers' Surplus 75 What Can Change Equilibrium Price andQuantity? 76

Chapter Summary 82




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CHAPTER 4: PRICES: FREE, CONTROLLED, ANDRELATIVE 85

Price 85Price as a Rationing Device 85 Price as a Transmitter of Information 86

Price Controls 87Price Ceiling 87 Price Floor: Definition and Effects 89

Two Prices: Absolute and Relative 94Absolute (Money) Price and Relative Price 94 Taxes on Specific Goods and Relative PriceChanges 96

CONTENTS XI

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CHAPTER 5: SUPPLY, DEMAND, AND PRICE:APPLICATIONS 100

Application 1: Why Is It So Hard to Get Tickets to the Taping of The Big BangTheory 100

Application 2: Government, Easier Loans, and Housing Prices 102

Application 3: Southwest Airlines and the Price of an Aisle Seat 102

Application 4: Why Is Medical Care So Expensive? 103

Application 5: Why Do Colleges Use GPAs, ACTs, and SATs for Purposes ofAdmission? 106

Application 6 : Supply and Demand on a Freeway 106

Application 7: Are Renters Better Off? 108

Application 8: Do You Pay for Good Weather? 109

Application 9: College Superathletes 110

Application 10:10 a.m. Classes in College 112

Application 11: What Will Happen to the Price of Marijuana If the Purchase and Sale ofMarijuana Are Legalized? 113

Chapter Summary 115 \



MICROECONOMICS

PART 2 MICROECONOMIC FUNDAMENTALS

CHAPTER 6: ELASTICITY 118

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Elasticity: Part 1 118Price Elasticity of Demand 118 Elasticity Is Not Slope 120 From Perfecdy Elastic toPerfecdy Inelastic Demand 120 Price Elasticity of Demand and Total Revenue (TotalExpenditure) 123 Elastic Demand and Total Revenue 123

Elasticity: Part 2 127Price Elasticity of Demand Along a Straight-Line Demand Curve 127 Determinants of PriceElasticity of Demand 128

Other Elasticity Concepts 131Cross Elasticity of Demand 131 Income Elasticity of Demand 132 Price Elasticity ofSupply 133 Price Elasticity of Supply and Time 135

The Relationship Between Taxes and Elasticity 137Who Pays the Tax? 137 Elasticity and the Tax 138 Degree of Elasticity and TaxRevenue 138

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Chapter Summary 142




CHAPTER 7: CONSUMER CHOICE: MAXIMIZING UTILITYAND BEHAVIORAL ECONOMICS 145

Utility Theory 145Utility: Total and Marginal 145 Law of Diminishing Marginal Utility 146 The Solution to

' the Diamond-Water Paradox 148

Consumer Equilibrium and Demand 150Equating Marginal Utilities per Dollar 150 Maximizing Utility and the Law ofDemand 151 Should the Government Provide the Necessities of Life for Free? 151

Behavioral Economics 154Are People Willing to Reduce Others' Incomes? 154 Is $ 1 Always $ 1 ? 154Coffee Mugs and the Endowment Effect 156 Does the Endowment Effect Hold Only forNew Traders? 157

Chapter Summary 160




APPENDIX C: BUDGET CONSTRAINT AND INDIFFERENCECURVE ANALYSIS 162

The Budget Constraint 162Slope of the Budget Constraint 162 What Will Change the Budget Constraint? 162

Indifference Curves 162

Constructing an Indifference Curve 163

Characteristics of Indifference Curves 164

The Indifference Map and the Budget Constraint Come Together 167

From Indifference Curves to a Dennand Curve 168

Appendix Summary 169



CHAPTER 8: PRODUCTION AND COSTS 170

Why Firms Exist 170The Market and the Firm: Invisible Hand Versus Visible Hand 170 The Alchian and DemsetzAnswer 171 Shirking in a Team 171 Ronald Coase on Why Firms Exist 172 Markets:Outside and Inside the Firm 172

Two Sides to Every Business Firm 173More on Total Cost 173 Accounting Profit Versus Economic Profit 174 Zero EconomicProfit Is Not as Bad as It Sounds 174

CONTENTS xiii

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Production 175

Common Misconception About the Short Run and Long Run 176 Production in the ShortRun 176 Whose Marginal Productivity Are We Talking About? 177 Marginal PhysicalProduct and Marginal Cost 178 Average Productivity 180

Costs of Production: Total, Average, Marginal 183The A VC and A TC Curves in Relation to the MC Curve 184 Tying Short-Run Production toCosts 187 One More Cost Concept: Sunk Cost 189

Production and Costs in the Long Run 193Long-Run Average Total Cost Curve 193 Economies of Scale, Diseconomies of Scale, andConstant Returns to Scale 194 Why Economies of Scale? 195 Why Diseconomies ofScale? 195 Minimum Efficient Scale and Number of Firms in an Industry 196

Shifts in Cost Curves 196

Taxes 196 Input Prices 196 Technology 196

Chapter Summary 199




PART 3 PRODUCT MARKETS AND POLICIES

CHAPTER 9: PERFECT COMPETITION 202

The Theory of Perfect Competition 202A Perfectly Competitive Firm Is a Price Taker 203 The Demand Curve for a PerfectlyCompetitive Firm Is Horizontal 203 Common Misconceptions About DemandCurves 204 The Marginal Revenue Curve of a Perfectly Competitive Firm Is the Same as ItsDemand Curve 205 Theory and Real-World Markets 206

Perfect Competition in the Short Run 206What Level of Output Does the Profit-Maximizing Fitm Produce? 206 The PerfectlyCompetitive Firm and Resource Allocative Efficiency 207 To Produce or Not toProduce: That Is the Question 208 Common Misconceptions over the ShutdownDecision 210 The Perfectly Competitive Firm's Short-Run Supply Curve 211 FromFirm to Market (Industry) Supply Curve 211 Why Is the Market Supply Curve UpwardSloping? 212

Perfect Competition in the Long Run 214The Conditions of Long-Run Competitive Equilibrium 214 The Perfectly Competitive Firmand Productive Efficiency 216 Industry Adjustment to an Increase in Demand 216 Profitfrom Two Perspectives 219 Industry Adjustment to a Decrease in Demand 220 Difference:in Costs, Differences in Profits: Now You See It, Now You Don't 220 Profit andDiscrimination 223

Topics for Analysis in the Theory of Perfect Competition 223Do Higher Costs Mean Higher Prices? 223 Will the Perfectly Competitive FirmAdvertise? 224 Supplier-Set Price Versus Market-Determined Price: Collusion orCompetition? 225

Chapter Summary 226




xiv CONTENTS

CHAPTER 10: MONOPOLY 229

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The Theory of Monopoly 229Barriers to Entry: A Key to Understanding Monopoly 229 What Is the Difference Between aGovernment Monopoly and a Market Monopoly? 231

Monopoly Pricing and Output Decisions 232The Monopolist's Demand and Marginal Revenue 232 The Monopolist's Demand andMarginal Revenue Curves Are Not the Same 233 Price and Output for a Profit-MaximizingMonopolist 233 Comparing the Demand Curve in Perfect Competition with the DemandCurve in Monopoly 235 If a Firm Maximizes Revenue, Does It Automatically MaximizeProfit Too? 235^

Perfect Competition and Monopoly 237Price, Marginal Revenue, and Marginal Cost 237 Monopoly, Perfect Competition, andConsumers' Surplus 237 Monopoly or Nothing? 238

The Case Against Monopoly 239The Deadweight Loss of Monopoly 239 Rent Seeking 240 X-Inefficiency 241

Price Discrimination 241Types of Price Discrimination 241 Why a Monopolist Wants to PriceDiscriminate 242 Conditions of Price Discrimination 242 About Price Discrimination:Does Your Lower Price Mean My Higher Price? 242 Moving to P = MC Through PriceDiscrimination 242 Coupons and Price Discrimination 244

Chapter Summary 248




CHAPTER 11: MONOPOLISTIC COMPETITION, OLIGOPOLY,AND GAME THEORY 251

economics 24/7The Theory of Monopolistic Competition 251

The Monopolistic Competitor's Demand Curve 251 The Relationship Between Price andMarginal Revenue for a Monopolistic Competitor 252 Output, Price, and Marginal Costfor the Monopolistic Competitor 252 Will There Be Profits in the Long Run? 252 ExcessCapacity: What Is It, and Is It "Good" or "Bad"? 253 The Monopolistic Competitor and TwoTypes of Efficiency 254

Oligopoly: Assumptions and Real-World Behavior 255The Concentration Ratio 256

Price and Output Under the Cartel Theory 256The Cartel Theory 256

Game Theory, Oligopoly, and Contestable Markets 259Prisoner's Dilemma 260 Oligopoly Firms' Cartels and the Prisoner's Dilemma 262 AreMarkets Contestable? 263

A Review of Market Structures 264

Applications of Game Theory 264Grades and Partying 264 The Arms Race 266 Speed Limit Laws 267 The Fear of Guiltas an Enforcement Mechanism 268

Chapter Summary 271




CONTENTS xv

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CHAPTER 12: GOVERNMENT AND PRODUCT MARKETS:ANTITRUST AND REGULATION 273

Antitrust 273Antitrust Acts 273 Unsettled Points in Antitrust Policy 276 Antitrust andMergers 278 Common Misconceptions About Antitrust Policy 278 NetworkMonopolies 279

Regulation 281The Case of Natural Monopoly 281 Regulating the Natural Monopoly 282 RegulatingIndustries That Are Not Natural Monopolies 284 Theories of Regulation 284 The Costsand Benefits of Regulation 285 Some Effects of Regulation Are Unintended 286Deregulation 286

Chapter Summary 288




PART 4 FACTOR MARKETS AND RELATED ISSUES

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CHAPTER 13: FACTOR MARKETS: WITH EMPHASISON THE LABOR MARKET 291

Factor Markets 291

The Demand for a Factor 291 Marginal Revenue Product: Two Ways to CalculateIt 292 The MRP Curve Is the Firm's Factor Demand Curve 292 Value MarginalProduct 293 An Important Question: Is MRP = VMP. 294 Marginal Factor Cost:The Firm's Factor Supply Curve 295 How Many Units of a Factor Should a FirmBuy? 295 When There Is More Than One Factor, How Much of Each Factor Should theFirm Buy? 296

The Labor Market 297Shifts in a Firm's MRP, or Factor Demand, Curve 298 Market Demand for Labor 299The Elasticity of Demand for Labor 300 Market Supply of Labor 301 An Individual'sSupply of Labor 302 Shifts in the Labor Supply Curve 303 Putting Supply and DemandTogether 304 Why Do Wage Rates Differ? 304 Why Demand and Supply Differ Among

1 Labor Markets 305 Why Did You Choose Your Major? 306 Marginal ProductivityTheory 307

Labor Markets and Information 310Screening Potential Employees 310 Promoting from Within 310 Discrimination or anInformation^Problem? 310

Chapter Summary 313




CHAPTER 14: WAGES, UNIONS, AND LABOR 315

Objectives of Labor Unions 315Employment for All Members 315 Maximizing the Total Wage Bill 315 MaximizingIncome for a Limited Number of Union Members 316 Wage-Employment Trade-Off 316

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Practices of Labor Unions 317Affecting Elasticity of Demand for Union Labor 317 Affecting the Demand for UnionLabor 318 Affecting the Supply of Union Labor 318 Affecting Wages Direcdy: CollectiveBargaining 319 Strikes 320

Effects of Labor Unions 321The Case of Monopsony 321 Unions'Effects on Wages 322 Unions'Effects onPrices 324 Unions' Effects on Productivity and Efficiency: Two Views 324

Chapter Summary 328




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CHAPTER 15: THE DISTRIBUTION OF INCOME ANDPOVERTY 330

Some Facts About Income Distribution 330Who Are the Rich and How Rich Are They? 330 The Effect of Age on the IncomeDistribution 331 A Simple Equation 333

Measuring Income Equality 334 •The Lorenz Curve 334 The Gini Coefficient 335 A Limitation of the GiniCoefficient 337 Common Misconceptions About Income Inequality 337

Why Income Inequality Exists 338Factors Contributing to Income Inequality 338 Income Differences: Some Are Voluntary,Some Are Not 340

Poverty 342What Is Poverty? 342 Limitations of the Official Poverty Income Statistics 342 Who Arethe Poor? 342 What Is the Justification for Government Redistributing Income? 343

Chapter Summary 344




CHAPTER 16: INTEREST, RENT, AND PROFIT 347

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Interest 347Loanable Funds: Demand and Supply 347 The Price for Loanable Funds and theReturn on Capital Goods Tend to Equality 349 Why Do Interest RatesDiffer? 349 Nominal and Real Interest Rates 350 Present Value: What IsSomething Tomorrow Worth Today? 351

Rent 354David Ricardo, the Price of Grain, and Land Rent 354 The Supply Curve of Land Can BeUpward Sloping 356 Economic Rent and Other Factors of Production 356 Economic Rentand Baseball Players: Perspective Matters 357 Competing for Artificial and Real Rents 357 DoPeople Overestimate Their Worth to Others, or Are They Simply Seeking Economic Rent? 358

Profit 358Theories of Profit 358 What Is Entrepreneurship? 360 What a Microwave Oven, an OilChange, and an Errand Runner Have in Common 361 Profit and Loss as Signals 361

Chapter Summary 363Key Terms and Concepts 363Questions and Problems 363Working with Numbers and Graphs 364

CONTENTS XVII

PART 5 MARKET FAILURE, PUBLIC CHOICE, ANDSPECIAL-INTEREST-GROUP POLITICS

CHAPTER 17: MARKET FAILURE: EXTERNALITIES, PUBLICGOODS, AND ASYMMETRIC INFORMATION 365

Externalities 365Costs and Benefits of Activities 365 Marginal Costs and Benefits of Activities 366 SocialOptimality, or Efficiency, Conditions 367 Three Categories of Activities 367 Externalitiesin Consumption and in Production 367 Diagram of a Negative Externality 367Diagram of a Positive Externality 369

Internalizing Externalities 371Persuasion 371 Taxes and Subsidies 371 Assigning Property Rights 372 VoluntaryAgreements 372 Combining Property Rights Assignments and Voluntary Agreements 373Beyond Internalizing: Setting Regulations 374

Dealing with a Negative Externality in the Environment 375Is No Pollution Worse Than Some Pollution? 375 Government Standards or PollutionPermits 375

Public Goods: Excludable and Nonexcludable 377Goods 377 The Free Rider 378 Nonexcludable Versus Nonrivalrous 378

Asymmetric Information 381Asymmetric Information in a Product Market 381 Asymmetric Information in aFactor Market 382 Is There Market Failure? 382-x Adverse Selection 383 MoralHazard 384

Chapter Summary 386




CHAPTER 18: PUBLIC CHOICE AND SPECIAL-INTEREST-GROUP POLITICS 390

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Public Choice Theory 390

The Political Market 391Moving Toward the Middle: The Median Voter Model 391 What Does the Theory Predict? 392

Voters and Rational Ignorance 394The Costs and Benefits of Voting 394 Rational Ignorance 395

More About Voting 397Example 1: Voting for a Nonexcludable Public Good 397 Example 2: Voting and Efficiency 398

Special Interest Groups 399Information and Lobbying Efforts 399 Congressional Districts as Special InterestGroups 399 Public Interest Talk, Special Interest Legislation 400 Rent Seeking 400Bringing About Transfers 401 Information, Rational Ignorance, and Seeking Transfers 402

Chapter Summary 406

- Key Terms and Concepts 408



XVIII CONTENTS

PART 6 GOVERNMENT AND MARKETS

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CHAPTER 19: THE ECONOMIC CASE FOR AND AGAINST >GOVERNMENT: FIVE TOPICS CONSIDERED 410

Economics and Government 410

The Economic Case For Government 411Government Can Remove Individuals from a Prisoner's Dilemma Setting 411 Externalities 415Nonexcludable Public Goods 416 The Case for Smaller or Larger Government 418

The Economic Case Against Government 418Unintended Effects of Government Actions 418 Government as TransferMechanism 420 Economic Growth Versus Transfers 423 Following the Leader inPushing for Transfers 424 Divisive Society: A NonExcludable Public Bad 425

Chapter Summary 428



1 THE GLOBAL ECONOMY

PART 7 INTERNATIONAL ECONOMICS AND GLOBALIZATION

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CHAPTER 20: INTERNATIONAL TRADE 430

International Trade Theory 430How Countries Know What to Trade 430 Common Misconception About How MuchWe Can Consume 434 How Countries Know When They Have a ComparativeAdvantage 433

Trade Restrictions 436The Distributional Effects of International Trade 436 Consumers' and Producers'Surpluses 436 The Benefits and Costs of Trade Restrictions 437 Why NationsSometimes Restrict Trade 440

Chapter Summary 444




CHAPTER 21: INTERNATIONAL FINANCE 448

The Balance of Payments 448Current Account 449 Capital Account 452 Official Reserve Account 453 StatisticalDiscrepancy 453 What the Balance of Payments Equals 454

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The Foreign Exchange Market 455The Demand for Goods 455 The Demand for and Supply of Currencies 456

Flexible Exchange Rates 458The Equilibrium Exchange Rate 458 Changes in the Equilibrium ExchangeRate 459 Factors That Affect the Equilibrium Exchange Rate 459

Fixed Exchange Rates 462Fixed Exchange Rates and Overvalued/Undervalued Currency 462 What Is So BadAbout an Overvalued Dollar? 463 Government Involvement in a Fixed Exchange RateSystem 464 Options Under a Fixed Exchange Rate System 465The Gold Standard 466

Fixed Exchange Rates Versus Flexible Exchange Rates 468Promoting International Trade 468Optimal Currency Areas 469

The Current International Monetary System 470

Chapter Summary 472




ECONOMICS

PART 8 FINANCIAL MATTERS

CHAPTER 22: STOCKS, BONDS, FUTURES, AND OPTIONS 477

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Financial Markets 477

Stocks 477Where Are Stocks Bought and Sold? 478 The Dow Jones Industrial Average (DJIA) 478How the Stock Market Works 480 Why Do People Buy Stock? 481 How to Buy and SellStock 482 Buying Stocks or Buying the Market 482 How to Read the StockMarket Page 483

Bonds 485The Components of a Bond 485 Bond Ratings 485 Bond Prices and Yields(or Interest Rates) 486 Common Misconceptions About the Coupon Rate and Yield(Interest Rate) 487 Types of Bonds 487 How to Read the Bond Market Page 488Risk and Return 489

Futures and Options 489Futures 489 Options 491

Chapter Summary 493




XX CONTENTS

WEB CHAPTER

PART 9 WEB CHAPTER

CHAPTER 23: AGRICULTURE: PROBLEMS, POLICIES, ANDUNINTENDED EFFECTS

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Agriculture: The IssuesA Few Facts Agriculture and Income Inelasticity Agriculture and Price Inelasticity PriceVariability and Futures Contracts Can Bad Weather Be Good for Farmers?

Agricultural PoliciesPrice Supports Restricting Supply Target Prices and Deficiency Payments ProductionFlexibility Contract Payments, (Fixed) Direct Payments, and CountercyclicalPayments Nonrecourse Commodity Loans

Chapter Summary

Key Terms and Concepts

Questions and Problems

Working with Numbers and Graphs

SELF-TEST APPENDIX 496GLOSSARY 510INDEX 519

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