Principles of Economics 3e PDF

Principles of Economics 3e SENIOR CONTRIBUTING AUTHORS DAVID SHAPIRO, PENNSYLVANIA STATE UNIVERSITY DANIEL MACDONALD, CALIFORNIA STATE UNIVERSITY, SAN BERNADINO STEVEN A. GREENLAW, UNIVERSITY OF MARY WASHINGTON OpenStax Rice University 6100 Main Street MS-375 Houston, Texas 77005 To learn more...

Principles of Economics 3e SENIOR CONTRIBUTING AUTHORS DAVID SHAPIRO, PENNSYLVANIA STATE UNIVERSITY DANIEL MACDONALD, CALIFORNIA STATE UNIVERSITY, SAN BERNADINO STEVEN A. GREENLAW, UNIVERSITY OF MARY WASHINGTON OpenStax Rice University 6100 Main Street MS-375 Houston, Texas 77005 To learn more about OpenStax, visit https://openstax.org. Individual print copies and bulk orders can be purchased through our website. ©2022 Rice University. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution 4.0 International License (CC BY 4.0). 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The future of education. openstax.org CONTENTS Preface 1 CHAPTER 1 Welcome to Economics! 9 Introduction 9 1.1 What Is Economics, and Why Is It Important? 10 1.2 Microeconomics and Macroeconomics 15 1.3 How Economists Use Theories and Models to Understand Economic Issues 16 1.4 How To Organize Economies: An Overview of Economic Systems 18 Key Terms 24 Key Concepts and Summary 24 Self-Check Questions 25 Review Questions 25 Critical Thinking Questions 26 CHAPTER 2 Choice in a World of Scarcity 27 Introduction to Choice in a World of Scarcity 27 2.1 How Individuals Make Choices Based on Their Budget Constraint 28 2.2 The Production Possibilities Frontier and Social Choices 34 2.3 Confronting Objections to the Economic Approach 39 Key Terms 43 Key Concepts and Summary 43 Self-Check Questions 44 Review Questions 44 Critical Thinking Questions 45 Problems 45 CHAPTER 3 Demand and Supply 47 Introduction to Demand and Supply 47 3.1 Demand, Supply, and Equilibrium in Markets for Goods and Services 48 3.2 Shifts in Demand and Supply for Goods and Services 54 3.3 Changes in Equilibrium Price and Quantity: The Four-Step Process 64 3.4 Price Ceilings and Price Floors 70 3.5 Demand, Supply, and Efficiency 74 Key Terms 78 Key Concepts and Summary 79 Self-Check Questions 80 Review Questions 81 Critical Thinking Questions 81 Problems 82 CHAPTER 4 Labor and Financial Markets 87 Introduction to Labor and Financial Markets 87 4.1 Demand and Supply at Work in Labor Markets 88 4.2 Demand and Supply in Financial Markets 96 4.3 The Market System as an Efficient Mechanism for Information 102 Key Terms 106 Key Concepts and Summary 106 Self-Check Questions 106 Review Questions 108 Critical Thinking Questions 108 Problems 108 CHAPTER 5 Elasticity 111 Introduction to Elasticity 111 5.1 Price Elasticity of Demand and Price Elasticity of Supply 112 5.2 Polar Cases of Elasticity and Constant Elasticity 117 5.3 Elasticity and Pricing 120 5.4 Elasticity in Areas Other Than Price 128 Key Terms 132 Key Concepts and Summary 132 Self-Check Questions 133 Review Questions 134 Critical Thinking Questions 135 Problems 135 CHAPTER 6 Consumer Choices 137 Introduction to Consumer Choices 137 6.1 Consumption Choices 138 6.2 How Changes in Income and Prices Affect Consumption Choices 145 6.3 Behavioral Economics: An Alternative Framework for Consumer Choice 151 Key Terms 154 Key Concepts and Summary 154 Self-Check Questions 155 Review Questions 155 Critical Thinking Questions 156 Problems 156 CHAPTER 7 Production, Costs, and Industry Structure 157 Introduction to Production, Costs, and Industry Structure 157 7.1 Explicit and Implicit Costs, and Accounting and Economic Profit 159 7.2 Production in the Short Run 161 7.3 Costs in the Short Run 165 7.4 Production in the Long Run 173 7.5 Costs in the Long Run 174 Key Terms 183 Key Concepts and Summary 183 Self-Check Questions 185 Review Questions 186 Critical Thinking Questions 186 Problems 187 Access for free at openstax.org CHAPTER 8 Perfect Competition 189 Introduction to Perfect Competition 189 8.1 Perfect Competition and Why It Matters 190 8.2 How Perfectly Competitive Firms Make Output Decisions 191 8.3 Entry and Exit Decisions in the Long Run 206 8.4 Efficiency in Perfectly Competitive Markets 208 Key Terms 211 Key Concepts and Summary 211 Self-Check Questions 212 Review Questions 213 Critical Thinking Questions 214 Problems 215 CHAPTER 9 Monopoly 217 Introduction to a Monopoly 217 9.1 How Monopolies Form: Barriers to Entry 219 9.2 How a Profit-Maximizing Monopoly Chooses Output and Price 223 Key Terms 234 Key Concepts and Summary 234 Self-Check Questions 235 Review Questions 235 Critical Thinking Questions 236 Problems 236 CHAPTER 10 Monopolistic Competition and Oligopoly 239 Introduction to Monopolistic Competition and Oligopoly 239 10.1 Monopolistic Competition 240 10.2 Oligopoly 248 Key Terms 255 Key Concepts and Summary 255 Self-Check Questions 256 Review Questions 257 Critical Thinking Questions 257 Problems 257 CHAPTER 11 Monopoly and Antitrust Policy 261 Introduction to Monopoly and Antitrust Policy 261 11.1 Corporate Mergers 262 11.2 Regulating Anticompetitive Behavior 268 11.3 Regulating Natural Monopolies 270 11.4 The Great Deregulation Experiment 273 Key Terms 276 Key Concepts and Summary 276 Self-Check Questions 277 Review Questions 278 Critical Thinking Questions 279 Problems 279 CHAPTER 12 Environmental Protection and Negative Externalities 283 Introduction to Environmental Protection and Negative Externalities 283 12.1 The Economics of Pollution 284 12.2 Command-and-Control Regulation 288 12.3 Market-Oriented Environmental Tools 289 12.4 The Benefits and Costs of U.S. Environmental Laws 292 12.5 International Environmental Issues 295 12.6 The Tradeoff between Economic Output and Environmental Protection 296 Key Terms 299 Key Concepts and Summary 299 Self-Check Questions 300 Review Questions 304 Critical Thinking Questions 305 Problems 305 CHAPTER 13 Positive Externalities and Public Goods 309 Introduction to Positive Externalities and Public Goods 309 13.1 Investments in Innovation 310 13.2 How Governments Can Encourage Innovation 315 13.3 Public Goods 318 Key Terms 323 Key Concepts and Summary 323 Self-Check Questions 323 Review Questions 325 Critical Thinking Questions 325 Problems 325 CHAPTER 14 Labor Markets and Income 327 Introduction to Labor Markets and Income 327 14.1 The Theory of Labor Markets 328 14.2 Wages and Employment in an Imperfectly Competitive Labor Market 333 14.3 Market Power on the Supply Side of Labor Markets: Unions 337 14.4 Bilateral Monopoly 344 14.5 Employment Discrimination 345 14.6 Immigration 352 Key Terms 355 Key Concepts and Summary 355 Self-Check Questions 356 Review Questions 358 Critical Thinking Questions 359 CHAPTER 15 Poverty and Economic Inequality 361 Introduction to Poverty and Economic Inequality 361 15.1 Drawing the Poverty Line 362 15.2 The Poverty Trap 365 15.3 The Safety Net 368 15.4 Income Inequality: Measurement and Causes 372 Access for free at openstax.org 15.5 Government Policies to Reduce Income Inequality 378 Key Terms 383 Key Concepts and Summary 383 Self-Check Questions 384 Review Questions 385 Critical Thinking Questions 386 Problems 387 CHAPTER 16 Information, Risk, and Insurance 389 Introduction to Information, Risk, and Insurance 389 16.1 The Problem of Imperfect Information and Asymmetric Information 390 16.2 Insurance and Imperfect Information 396 Key Terms 405 Key Concepts and Summary 405 Self-Check Questions 406 Review Questions 406 Critical Thinking Questions 407 Problems 407 CHAPTER 17 Financial Markets 409 Introduction to Financial Markets 409 17.1 How Businesses Raise Financial Capital 411 17.2 How Households Supply Financial Capital 415 17.3 How to Accumulate Personal Wealth 426 Key Terms 431 Key Concepts and Summary 432 Self-Check Questions 433 Review Questions 433 Critical Thinking Questions 434 Problems 434 CHAPTER 18 Public Economy 437 Introduction to Public Economy 437 18.1 Voter Participation and Costs of Elections 438 18.2 Special Interest Politics 440 18.3 Flaws in the Democratic System of Government 444 Key Terms 448 Key Concepts and Summary 448 Self-Check Questions 448 Review Questions 449 Critical Thinking Questions 449 Problems 450 CHAPTER 19 The Macroeconomic Perspective 451 Introduction to the Macroeconomic Perspective 451 19.1 Measuring the Size of the Economy: Gross Domestic Product 453 19.2 Adjusting Nominal Values to Real Values 462 19.3 Tracking Real GDP over Time 467 19.4 Comparing GDP among Countries 470 19.5 How Well GDP Measures the Well-Being of Society 472 Key Terms 476 Key Concepts and Summary 476 Self-Check Questions 477 Review Questions 478 Critical Thinking Questions 478 Problems 479 CHAPTER 20 Economic Growth 481 Introduction to Economic Growth 481 20.1 The Relatively Recent Arrival of Economic Growth 482 20.2 Labor Productivity and Economic Growth 485 20.3 Components of Economic Growth 491 20.4 Economic Convergence 496 Key Terms 501 Key Concepts and Summary 501 Self-Check Questions 502 Review Questions 503 Critical Thinking Questions 503 Problems 504 CHAPTER 21 Unemployment 505 Introduction to Unemployment 505 21.1 How Economists Define and Compute Unemployment Rate 506 21.2 Patterns of Unemployment 511 21.3 What Causes Changes in Unemployment over the Short Run 516 21.4 What Causes Changes in Unemployment over the Long Run 520 Key Terms 528 Key Concepts and Summary 528 Self-Check Questions 529 Review Questions 529 Critical Thinking Questions 531 Problems 531 CHAPTER 22 Inflation 533 Introduction to Inflation 533 22.1 Tracking Inflation 534 22.2 How to Measure Changes in the Cost of Living 538 22.3 How the U.S. and Other Countries Experience Inflation 543 22.4 The Confusion Over Inflation 547 22.5 Indexing and Its Limitations 552 Key Terms 555 Key Concepts and Summary 555 Self-Check Questions 556 Review Questions 557 Critical Thinking Questions 558 Access for free at openstax.org Problems 558 CHAPTER 23 The International Trade and Capital Flows 561 Introduction to the International Trade and Capital Flows 561 23.1 Measuring Trade Balances 563 23.2 Trade Balances in Historical and International Context 566 23.3 Trade Balances and Flows of Financial Capital 568 23.4 The National Saving and Investment Identity 571 23.5 The Pros and Cons of Trade Deficits and Surpluses 576 23.6 The Difference between Level of Trade and the Trade Balance 578 Key Terms 580 Key Concepts and Summary 580 Self-Check Questions 581 Review Questions 582 Critical Thinking Questions 583 Problems 583 CHAPTER 24 The Aggregate Demand/Aggregate Supply Model 585 Introduction to the Aggregate Supply–Aggregate Demand Model 585 24.1 Macroeconomic Perspectives on Demand and Supply 587 24.2 Building a Model of Aggregate Demand and Aggregate Supply 588 24.3 Shifts in Aggregate Supply 594 24.4 Shifts in Aggregate Demand 596 24.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation 600 24.6 Keynes’ Law and Say’s Law in the AD/AS Model 603 Key Terms 605 Key Concepts and Summary 605 Self-Check Questions 607 Review Questions 607 Critical Thinking Questions 608 Problems 609 CHAPTER 25 The Keynesian Perspective 613 Introduction to the Keynesian Perspective 613 25.1 Aggregate Demand in Keynesian Analysis 615 25.2 The Building Blocks of Keynesian Analysis 618 25.3 The Phillips Curve 622 25.4 The Keynesian Perspective on Market Forces 626 Key Terms 628 Key Concepts and Summary 628 Self-Check Questions 629 Review Questions 629 Critical Thinking Questions 630 CHAPTER 26 The Neoclassical Perspective 631 Introduction to the Neoclassical Perspective 631 26.1 The Building Blocks of Neoclassical Analysis 633 26.2 The Policy Implications of the Neoclassical Perspective 638 26.3 Balancing Keynesian and Neoclassical Models 645 Key Terms 647 Key Concepts and Summary 647 Self-Check Questions 647 Review Questions 648 Critical Thinking Questions 648 Problems 649 CHAPTER 27 Money and Banking 651 Introduction to Money and Banking 651 27.1 Defining Money by Its Functions 652 27.2 Measuring Money: Currency, M1, and M2 654 27.3 The Role of Banks 658 27.4 How Banks Create Money 663 Key Terms 667 Key Concepts and Summary 668 Self-Check Questions 669 Review Questions 669 Critical Thinking Questions 670 Problems 670 CHAPTER 28 Monetary Policy and Bank Regulation 671 Introduction to Monetary Policy and Bank Regulation 671 28.1 The Federal Reserve Banking System and Central Banks 672 28.2 Bank Regulation 675 28.3 How a Central Bank Executes Monetary Policy 677 28.4 Monetary Policy and Economic Outcomes 683 28.5 Pitfalls for Monetary Policy 687 Key Terms 695 Key Concepts and Summary 695 Self-Check Questions 696 Review Questions 697 Critical Thinking Questions 697 Problems 698 CHAPTER 29 Exchange Rates and International Capital Flows 699 Introduction to Exchange Rates and International Capital Flows 699 29.1 How the Foreign Exchange Market Works 700 29.2 Demand and Supply Shifts in Foreign Exchange Markets 708 29.3 Macroeconomic Effects of Exchange Rates 712 29.4 Exchange Rate Policies 715 Key Terms 722 Key Concepts and Summary 722 Self-Check Questions 723 Review Questions 724 Critical Thinking Questions 724 Problems 725 Access for free at openstax.org CHAPTER 30 Government Budgets and Fiscal Policy 727 Introduction to Government Budgets and Fiscal Policy 727 30.1 Government Spending 728 30.2 Taxation 731 30.3 Federal Deficits and the National Debt 734 30.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation 737 30.5 Automatic Stabilizers 741 30.6 Practical Problems with Discretionary Fiscal Policy 743 30.7 The Question of a Balanced Budget 746 Key Terms 748 Key Concepts and Summary 748 Self-Check Questions 749 Review Questions 751 Critical Thinking Questions 751 Problems 752 CHAPTER 31 The Impacts of Government Borrowing 753 Introduction to the Impacts of Government Borrowing 753 31.1 How Government Borrowing Affects Investment and the Trade Balance 754 31.2 Fiscal Policy and the Trade Balance 757 31.3 How Government Borrowing Affects Private Saving 760 31.4 Fiscal Policy, Investment, and Economic Growth 762 Key Terms 768 Key Concepts and Summary 768 Self-Check Questions 768 Review Questions 769 Critical Thinking Questions 769 Problems 770 CHAPTER 32 Macroeconomic Policy Around the World 771 Introduction to Macroeconomic Policy around the World 771 32.1 The Diversity of Countries and Economies across the World 772 32.2 Improving Countries’ Standards of Living 776 32.3 Causes of Unemployment around the World 781 32.4 Causes of Inflation in Various Countries and Regions 783 32.5 Balance of Trade Concerns 784 Key Terms 789 Key Concepts and Summary 789 Self-Check Questions 790 Review Questions 791 Critical Thinking Questions 791 Problems 791 CHAPTER 33 International Trade 793 Introduction to International Trade 793 33.1 Absolute and Comparative Advantage 794 33.2 What Happens When a Country Has an Absolute Advantage in All Goods 800 33.3 Intra-Industry Trade between Similar Economies 805 33.4 The Benefits of Reducing Barriers to International Trade 808 Key Terms 810 Key Concepts and Summary 810 Self-Check Questions 810 Review Questions 811 Critical Thinking Questions 812 Problems 812 CHAPTER 34 Globalization and Protectionism 815 Introduction to Globalization and Protectionism 815 34.1 Protectionism: An Indirect Subsidy from Consumers to Producers 816 34.2 International Trade and Its Effects on Jobs, Wages, and Working Conditions 823 34.3 Arguments in Support of Restricting Imports 826 34.4 How Governments Enact Trade Policy: Globally, Regionally, and Nationally 832 34.5 The Tradeoffs of Trade Policy 836 Key Terms 839 Key Concepts and Summary 839 Self-Check Questions 840 Review Questions 841 Critical Thinking Questions 842 Problems 843 Appendix A The Use of Mathematics in Principles of Economics 845 Appendix B Indifference Curves 863 Appendix C Present Discounted Value 877 Appendix D The Expenditure-Output Model 881 Appendix E How Open Market Operations Affect Balance Sheets in a Limited Reserves Environment 907 Answer Key 909 References 955 Index 977 Access for free at openstax.org  Preface 1 Preface Welcome to Principles of Economics 3e (Third Edition), an OpenStax resource. This textbook was written to increase student access to high-quality learning materials, maintaining highest standards of academic rigor at little to no cost. About OpenStax OpenStax is part of Rice University, which is a 501(c)(3) nonprofit charitable corporation. As an educational initiative, it's our mission to transform learning so that education works for every student. Through our partnerships with philanthropic organizations and our alliance with other educational resource companies, we're breaking down the most common barriers to learning. Because we believe that everyone should and can have access to knowledge. About OpenStax Resources Customization Principles of Economics 3e is licensed under a Creative Commons Attribution 4.0 International (CC BY) license, which means that you can distribute, remix, and build upon the content, as long as you provide attribution to OpenStax and its content contributors. 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If you reuse art from this text that does not have attribution provided, use the following attribution: Copyright Rice University, OpenStax, under CC-BY 4.0 license. Errata All OpenStax textbooks undergo a rigorous review process. However, like any professional-grade textbook, errors sometimes occur. In addition, economic data and related developments change frequently, and portions of the textbook may become out of date. Since our books are web based, we can make updates periodically when deemed pedagogically necessary. If you have a correction to suggest, submit it through the link on your book page on OpenStax.org. Subject matter experts review all errata suggestions. OpenStax is committed to remaining transparent about all updates, so you will also find a list of past and pending errata changes on your book page on OpenStax.org. Format You can access this textbook for free in web view or PDF through OpenStax.org, and for a low cost in print. About Principles of Economics 3e Principles of Economics 3e aligns to the topics and objectives of most introductory economics courses. Arranged in the traditional progression from microeconomics to macroeconomics, it allows flexibility in coverage and sequencing. The text uses conversational language and ample illustrations to explore economic theories, and provides a wide array of examples using both fictional and real-world scenarios. The third 2 Preface edition has been carefully and thoroughly updated to reflect current data and understanding, as well as to provide a deeper background in diverse contributors and their impacts on economic thought and analysis. Coverage and scope In response to faculty feedback and to ease transition to a new edition, Principles of Economics 3e retains the organization of the previous editions. The book covers the breadth of economics topics and also provides the necessary depth to ensure the course is manageable for instructors and students alike. We strove to balance theory and application, as well as the amount of calculation and mathematical examples. The book is organized into eight main parts: What is Economics? The first two chapters introduce students to the study of economics with a focus on making choices in a world of scarce resources. Supply and Demand, Chapters 3 and 4, introduces and explains the first analytical model in economics: supply, demand, and equilibrium, before showing applications in the markets for labor and finance. The Fundamentals of Microeconomic Theory, Chapters 5 through 10, begins the microeconomics portion of the text, presenting the theories of consumer behavior, production and costs, and the different models of market structure, including some simple game theory. Microeconomic Policy Issues, Chapters 11 through 18, covers the range of topics in applied micro, framed around the concepts of public goods and positive and negative externalities. Students explore competition and antitrust policies, environmental problems, poverty, income inequality, and other labor market issues. The text also covers information, risk and financial markets, as well as public economy. The Macroeconomic Perspective and Goals, Chapters 19 through 23, introduces a number of key concepts in macro: economic growth, unemployment and inflation, and international trade and capital flows. A Framework for Macroeconomic Analysis, Chapters 24 through 26, introduces the principal analytic model in macro, namely the aggregate demand/aggregate supply model. The model is then applied to the Keynesian and Neoclassical perspectives. The expenditure-output model is fully explained in a stand- alone appendix. Monetary and Fiscal Policy, Chapters 27 through 31, explains the role of money and the banking system, as well as monetary policy and financial regulation. Then the discussion switches to government deficits and fiscal policy. International Economics, Chapters 32 through 34, the final part of the text, introduces the international dimensions of economics, including international trade and protectionism. Changes to the third edition The revision process incorporated extensive feedback from faculty who have used the book in their courses. They advised that the third edition changes focus on currency updates, integration of newer perspectives and more diverse contributors, and relevance to students’ lives and careers. Current data and analysis: The authors have updated dozens of explanations, graphs, and tables containing financial, demographic, employment, and related economic data. The corresponding discussions provide context and interpretations of the data, including descriptions of change over time, cause-and-effect relationships, and balanced analysis of policies and opinions. Diverse perspectives and contributors: The third edition highlights the research and views of a broader group of economists. These include people from across the spectrum of economic thought, with a particular focus on those who take what are often considered non-traditional views of economic policy and government action. Examples include: Chapter 1: Esther Duflo, Abhijit Banerjee, and Michael Kremer regarding experimental analysis in development economics. Access for free at openstax.org  Preface 3 Chapter 4: Walter Williams and Thomas Sowell regarding the downsides of minimum wages. Chapter 13: Carlota Perez regarding employment shifts resulting from innovation; Mariana Mazzucato regarding government involvement in innovation; Elinor Ostrom and the “non-tragedy of the commons.” Chapter 14: William A. Darity Jr. on employment discrimination and market forces; Phyllis Ann Wallace and the EEOC. Chapter 19: Kate Raworth regarding concepts for expanding economic measures beyond GDP and similar metrics. Chapter 32: W. Arthur Lewis and the dual sector economy; Dambisa Moyo regarding the benefits and detriments of foreign aid. Relevance and engagement: In order to show the importance and application of economics in students’ lives and careers, the third edition directly addresses and expands topics likely to connect to various industries, issues, groups, and events. Brief references and deeply explored socio-political examples have been updated to showcase the critical—and sometimes unnoticed—ties between economic developments and topics relevant to students. Examples include education spending, the value of college degrees, discrimination, environmental policies, immigration policies, entrepreneurship and innovation, healthcare and insurance, and general financial literacy. Finally, the COVID-19 pandemic is referenced frequently to demonstrate its deep and evolving impacts on financial data, employment, and other aspects of the economy. FRED Data and Graphs: As in previous editions, the authors have included and referenced data from the Federal Reserve Economic Data (FRED). In some cases, interactive FRED graphs are embedded directly in the web view of the book; students may magnify and focus on specific time periods, analyze individual data points, and otherwise manipulate the graphs from within the OpenStax reading experience. In others cases (and in the PDF), links to the direct source of the FRED data are provided, and students are encouraged to explore the information and the overall FRED resources more thoroughly. Note that other data sources, such as the Bureau of Labor Statistics, U.S. Census Bureau, and World Bank, usually include links in the captions or credits; instructors and students can also explore those sites for more detailed investigations of the topics at hand. Updated art Principles of Economics 3e includes updated and redesigned art to clarify concepts and provide opportunities for graphical interpretation. Many graphs are shown with accompanying data tables and explanations of the drivers and consequences of change. 4 Preface Pedagogical foundation The narrative explanations and analysis presented in Principles of Economics 3e have been carefully crafted to provide a solid basis in economic concepts, flexibly approach skills and assess understanding, and deepen students’ engagement with the course materials. You will also find features that promote economic inquiry and explorations, including: Bring It Home: These explorations include a brief case study, specific to each chapter, which connects the chapter’s main topic to the real word. It is broken up into two parts: the first at the beginning of the chapter (in the intro module) and the second at chapter’s end, when students have learned what’s necessary to understand the case and “bring home” the chapter’s core concepts. Work It Out: These worked examples progress through an analytical or computational problem, and guide students step by step to find out how its solution is derived. Clear It Up: These boxes are deeper explanations of something in the main body of the text. Each Clear It Up starts with a question. The rest of the feature explains the answer. Questions for each level of learning Principles of Economics 3e offers flexibility in practice and assessment, and provides a range of opportunities to check understanding and encourage deeper thinking and application. Self-Checks are analytical self-assessment questions that appear at the end of each module. They “click to reveal” an answer in the web view so students can check their understanding before moving on to the next module. Self-Check questions are not simple look-up questions. They push the student to think beyond what is said in the text. Self-Check questions are designed for formative (rather than summative) Access for free at openstax.org  Preface 5 assessment. The questions and answers are explained so that students feel like they are being walked through the problem. Review Questions are simple recall questions from the chapter in open-response format (not multiple choice or true/false). The answers can be looked up in the text. Critical Thinking Questions are higher-level, conceptual questions that ask students to demonstrate their understanding by applying what they have learned in different contexts. Problems are exercises that give students additional practice working with the analytic and computational concepts in the module. OpenStax is retiring Principles of Microeconomics and Principles of Macroeconomics for AP textbooks because they are outdated. We recommend that Advanced Placement instructors and students use the college- level textbooks. About the Authors Senior contributing authors David Shapiro, Pennsylvania State University David Shapiro is Professor Emeritus of Economics, Demography, and Women’s, Gender, and Sexuality Studies at the Pennsylvania State University. He received a BA in economics and political science from the University of Michigan, and an MA as well as a PhD in economics from Princeton University. He began his academic career at Ohio State University in 1971, and moved to Penn State in 1980. His early research focused on women and youth in the United States labor market. Following a 1978–79 stint as a Fulbright professor at the University of Kinshasa in the Democratic Republic of the Congo, his research shifted focus to fertility in Kinshasa and more broadly, in sub-Saharan Africa. He has also received the top prize for teaching at both Ohio State and Penn State. Daniel MacDonald, California State University, San Bernardino Professor Daniel MacDonald is the Chair of the Economics Department at California State University, San Bernardino. He earned his BA in mathematics and economics from Seton Hall University in 2007 and his economics PhD from the University of Massachusetts Amherst in 2013. Macdonald conducts economic research in labor economics, public policy (housing), and the economic history of the U.S. Consulting. He is also the author of the weekly Inland Empire Economic Update newsletter (https://dpmacdonald.substack.com/), which he started in 2021. Steven A. Greenlaw, Professor Emeritus at University of Mary Washington Steven Greenlaw taught principles of economics for 39 years. In 1999, he received the Grellet C. Simpson Award for Excellence in Undergraduate Teaching at the University of Mary Washington. He is the author of Doing Economics: A Guide to Doing and Understanding Economic Research, as well as a variety of articles on economics pedagogy and instructional technology, published in the Journal of Economic Education, the International Review of Economic Education, and other outlets. He wrote the module on Quantitative Writing for Starting Point: Teaching and Learning Economics, the web portal on best practices in teaching economics. Steven Greenlaw lives in Alexandria, Virginia with his wife Kathy. Since retiring from full-time teaching, he has been doing faculty development work and other writing projects. Contributing authors Eric Dodge, Hanover College Cynthia Gamez, University of Texas at El Paso Andres Jauregui, Columbus State University Diane Keenan, Cerritos College Amyaz Moledina, The College of Wooster Craig Richardson, Winston-Salem State University Ralph Sonenshine, American University 6 Preface Reviewers Bryan Aguiar, Northwest Arkansas Community College Basil Al Hashimi, Mesa Community College Emil Berendt, Mount St. Mary's University Zena Buser, Adams State University Douglas Campbell, The University of Memphis Sanjukta Chaudhuri, University of Wisconsin - Eau Claire Xueyu Cheng, Alabama State University Robert Cunningham, Alma College Rosa Lea Danielson, College of DuPage Steven Deloach, Elon University Michael Enz, Framingham State University Debbie Evercloud, University of Colorado Denver Reza Ghorashi, Stockton University Robert Gillette, University of Kentucky Shaomin Huang, Lewis-Clark State College George Jones, University of Wisconsin-Rock County Charles Kroncke, College of Mount St. Joseph Teresa Laughlin, Palomar Community College Carlos Liard-Muriente, Central Connecticut State University Heather Luea, Kansas State University Steven Lugauer, University of Notre Dame William Mosher, Nashua Community College Michael Netta, Hudson County Community College Nick Noble, Miami University Joe Nowakowski, Muskingum University Shawn Osell, University of Wisconsin-Superior Mark Owens, Middle Tennessee State University Sonia Pereira, Barnard College Jennifer Platania, Elon University Robert Rycroft, University of Mary Washington Adrienne Sachse, Florida State College at Jacksonville Hans Schumann, Texas A&M University Gina Shamshak, Goucher College Chris Warburton, John Jay College of Criminal Justice, CUNY Mark Witte, Northwestern University Answers to Questions in the Book Students can find answers to Self-Checks in the Answer Key. 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To access the technology options for your text, visit your book page on OpenStax.org. Access for free at openstax.org Welcome to Economics! 1 FIGURE 1.1 Do You Use Facebook? Economics is greatly impacted by how well information travels through society. Today, social media giants Twitter, Facebook, and Instagram are major forces on the information super highway. (Credit: modification of "Social Media Mixed Icons - Banner" by Blogtrepreneur/Flickr, CC BY 2.0) CHAPTER OBJECTIVES In this chapter, you will learn about: What Is Economics, and Why Is It Important? Microeconomics and Macroeconomics How Economists Use Theories and Models to Understand Economic Issues How Economies Can Be Organized: An Overview of Economic Systems Introduction BRING IT HOME Information Overload in the Information Age To post or not to post? Every day we are faced with a myriad of decisions, from what to have for breakfast, to which show to stream, to the more complex—“Should I double major and add possibly another semester of study to my education?” Our response to these choices depends on the information we have available at any given moment. Economists call this “imperfect” because we rarely have all the data we need to make perfect decisions. Despite the lack of perfect information, we still make hundreds of decisions a day. Streams, sponsors, and social media are altering the process by which we make choices, how we spend our time, which movies we see, which products we buy, and more. Whether they read the reviews or just check the ratings, it's unlikely for Americans to make many significant decisions without these information streams. As you will see in this course, what happens in economics is affected by how well and how fast information disseminates through a society, such as how quickly information travels through Facebook. “Economists love nothing better than when deep and liquid markets operate under conditions of perfect information,” says Jessica Irvine, National Economics Editor for News Corp Australia. This leads us to the topic of this chapter, an introduction to the world of making decisions, processing information, 10 1 Welcome to Economics! and understanding behavior in markets —the world of economics. Each chapter in this book will start with a discussion about current (or sometimes past) events and revisit it at chapter’s end—to “bring home” the concepts in play. What is economics and why should you spend your time learning it? After all, there are other disciplines you could be studying, and other ways you could be spending your time. As the Bring it Home feature just mentioned, making choices is at the heart of what economists study, and your decision to take this course is as much as economic decision as anything else. Economics is probably not what you think. It is not primarily about money or finance. It is not primarily about business. It is not mathematics. What is it then? It is both a subject area and a way of viewing the world. 1.1 What Is Economics, and Why Is It Important? LEARNING OBJECTIVES By the end of this section, you will be able to: Discuss the importance of studying economics Explain the relationship between production and division of labor Evaluate the significance of scarcity Economics is the study of how humans make decisions in the face of scarcity. These can be individual decisions, family decisions, business decisions or societal decisions. If you look around carefully, you will see that scarcity is a fact of life. Scarcity means that human wants for goods, services and resources exceed what is available. Resources, such as labor, tools, land, and raw materials are necessary to produce the goods and services we want but they exist in limited supply. Of course, the ultimate scarce resource is time- everyone, rich or poor, has just 24 expendable hours in the day to earn income to acquire goods and services, for leisure time, or for sleep. At any point in time, there is only a finite amount of resources available. Think about it this way: In 2015 the labor force in the United States contained over 158 million workers, according to the U.S. Bureau of Labor Statistics. The total land area was 3,794,101 square miles. While these are certainly large numbers, they are not infinite. Because these resources are limited, so are the numbers of goods and services we produce with them. Combine this with the fact that human wants seem to be virtually infinite, and you can see why scarcity is a problem. Introduction to FRED Data is very important in economics because it describes and measures the issues and problems that economics seek to understand. A variety of government agencies publish economic and social data. For this course, we will generally use data from the St. Louis Federal Reserve Bank's FRED database. FRED is very user friendly. It allows you to display data in tables or charts, and you can easily download it into spreadsheet form if you want to use the data for other purposes. The FRED website (https://openstax.org/l/FRED/) includes data on nearly 400,000 domestic and international variables over time, in the following broad categories: Money, Banking & Finance Population, Employment, & Labor Markets (including Income Distribution) National Accounts (Gross Domestic Product & its components), Flow of Funds, and International Accounts Production & Business Activity (including Business Cycles) Prices & Inflation (including the Consumer Price Index, the Producer Price Index, and the Employment Cost Index) International Data from other nations U.S. Regional Data Academic Data (including Penn World Tables & NBER Macrohistory database) For more information about how to use FRED, see the variety of videos (https://openstax.org/l/FRED_intro) on Access for free at openstax.org  1.1 What Is Economics, and Why Is It Important? 11 YouTube starting with this introduction. FIGURE 1.2 Scarcity of Resources People experiencing homelessness are a stark reminder that scarcity of resources is real. (Credit: "Pittsburgh Homeless" by "daveyinn"/Flickr Creative Commons, CC BY 2.0) If you still do not believe that scarcity is a problem, consider the following: Does everyone require food to eat? Does everyone need a decent place to live? Does everyone have access to healthcare? In every country in the world, there are people who are hungry, homeless (for example, those who call park benches their beds, as Figure 1.2 shows), and in need of healthcare, just to focus on a few critical goods and services. Why is this the case? It is because of scarcity. Let’s delve into the concept of scarcity a little deeper, because it is crucial to understanding economics. The Problem of Scarcity Think about all the things you consume: food, shelter, clothing, transportation, healthcare, and entertainment. How do you acquire those items? You do not produce them yourself. You buy them. How do you afford the things you buy? You work for pay. If you do not, someone else does on your behalf. Yet most of us never have enough income to buy all the things we want. This is because of scarcity. So how do we solve it? LINK IT UP Visit this website (http://openstax.org/l/drought) to read about how the United States is dealing with scarcity in resources. Every society, at every level, must make choices about how to use its resources. Families must decide whether to spend their money on a new car or a fancy vacation. Towns must choose whether to put more of the budget into police and fire protection or into the school system. Nations must decide whether to devote more funds to national defense or to protecting the environment. In most cases, there just isn’t enough money in the budget to do everything. How do we use our limited resources the best way possible, that is, to obtain the most goods and services we can? There are a couple of options. First, we could each produce everything we each consume. Alternatively, we could each produce some of what we want to consume, and “trade” for the rest of what we want. Let’s explore these options. Why do we not each just produce all of the things we consume? Think back to pioneer days, when individuals knew how to do so much more than we do today, from building their homes, to growing their crops, to hunting for food, to repairing their equipment. Most of us do not know how to do all—or any—of those things, but it is not because we could not learn. Rather, we do not have to. The reason why is something called the division and specialization of labor, a production innovation first put forth by Adam Smith (Figure 1.3) in his book, The Wealth of Nations. 12 1 Welcome to Economics! FIGURE 1.3 Adam Smith Adam Smith introduced the idea of dividing labor into discrete tasks. (Credit: "Adam Smith" by Cadell and Davies (1811), John Horsburgh (1828), or R.C. Bell (1872)/Wikimedia Commons, Public Domain) The Division of and Specialization of Labor The formal study of economics began when Adam Smith (1723–1790) published his famous book The Wealth of Nations in 1776. Many authors had written on economics in the centuries before Smith, but he was the first to address the subject in a comprehensive way. In the first chapter, Smith introduces the concept of division of labor, which means that the way one produces a good or service is divided into a number of tasks that different workers perform, instead of all the tasks being done by the same person. To illustrate division of labor, Smith counted how many tasks went into making a pin: drawing out a piece of wire, cutting it to the right length, straightening it, putting a head on one end and a point on the other, and packaging pins for sale, to name just a few. Smith counted 18 distinct tasks that different people performed—all for a pin, believe it or not! Modern businesses divide tasks as well. Even a relatively simple business like a restaurant divides the task of serving meals into a range of jobs like top chef, sous chefs, less-skilled kitchen help, servers to wait on the tables, a greeter at the door, janitors to clean up, and a business manager to handle paychecks and bills—not to mention the economic connections a restaurant has with suppliers of food, furniture, kitchen equipment, and the building where it is located. A complex business like a large manufacturing factory, such as the shoe factory (Figure 1.4), or a hospital can have hundreds of job classifications. FIGURE 1.4 Division of Labor Workers on an assembly line are an example of the divisions of labor. (Credit: "Red Wing Shoe Factory Tour" by Nina Hale/Flickr Creative Commons, CC BY 2.0) Access for free at openstax.org  1.1 What Is Economics, and Why Is It Important? 13 Why the Division of Labor Increases Production When we divide and subdivide the tasks involved with producing a good or service, workers and businesses can produce a greater quantity of output. In his observations of pin factories, Smith noticed that one worker alone might make 20 pins in a day, but that a small business of 10 workers (some of whom would need to complete two or three of the 18 tasks involved with pin-making), could make 48,000 pins in a day. How can a group of workers, each specializing in certain tasks, produce so much more than the same number of workers who try to produce the entire good or service by themselves? Smith offered three reasons. First, specialization in a particular small job allows workers to focus on the parts of the production process where they have an advantage. (In later chapters, we will develop this idea by discussing comparative advantage.) People have different skills, talents, and interests, so they will be better at some jobs than at others. The particular advantages may be based on educational choices, which are in turn shaped by interests and talents. Only those with medical degrees qualify to become doctors, for instance. For some goods, geography affects specialization. For example, it is easier to be a wheat farmer in North Dakota than in Florida, but easier to run a tourist hotel in Florida than in North Dakota. If you live in or near a big city, it is easier to attract enough customers to operate a successful dry cleaning business or movie theater than if you live in a sparsely populated rural area. Whatever the reason, if people specialize in the production of what they do best, they will be more effective than if they produce a combination of things, some of which they are good at and some of which they are not. Second, workers who specialize in certain tasks often learn to produce more quickly and with higher quality. This pattern holds true for many workers, including assembly line laborers who build cars, stylists who cut hair, and doctors who perform heart surgery. In fact, specialized workers often know their jobs well enough to suggest innovative ways to do their work faster and better. A similar pattern often operates within businesses. In many cases, a business that focuses on one or a few products (sometimes called its “core competency”) is more successful than firms that try to make a wide range of products. Third, specialization allows businesses to take advantage of economies of scale, which means that for many goods, as the level of production increases, the average cost of producing each individual unit declines. For example, if a factory produces only 100 cars per year, each car will be quite expensive to make on average. However, if a factory produces 50,000 cars each year, then it can set up an assembly line with huge machines and workers performing specialized tasks, and the average cost of production per car will be lower. The ultimate result of workers who can focus on their preferences and talents, learn to do their specialized jobs better, and work in larger organizations is that society as a whole can produce and consume far more than if each person tried to produce all of their own goods and services. The division and specialization of labor has been a force against the problem of scarcity. Trade and Markets Specialization only makes sense, though, if workers can use the pay they receive for doing their jobs to purchase the other goods and services that they need. In short, specialization requires trade. You do not have to know anything about electronics or sound systems to play music—you just buy an iPod or MP3 player, download the music, and listen. You do not have to know anything about artificial fibers or the construction of sewing machines if you need a jacket—you just buy the jacket and wear it. You do not need to know anything about internal combustion engines to operate a car—you just get in and drive. Instead of trying to acquire all the knowledge and skills involved in producing all of the goods and services that you wish to consume, the market allows you to learn a specialized set of skills and then use the pay you receive to buy the goods and services you need or want. This is how our modern society has evolved into a strong economy. 14 1 Welcome to Economics! Why Study Economics? FIGURE 1.5 Esther Duflo, Abhijit Banerjee, and Michael Kremer Esther Duflo, Abhijit Banerjee (both from Massachusetts Institute of Technology), and Michael Kremer (University of Chicago) were awarded the Nobel Prize for groundbreaking work in which they established experimental methods to understand poverty and outcomes of initiatives to address it. (Credit: modification of work by U.S. Embassy Sweden/Wikimedia Commons, CC BY 2.0; Financial Times/Wikimedia Commons, CC BY 2.0; U.S. Embassy Sweden/Flickr Creative Commons, CC BY 2.0) Now that you have an overview on what economics studies, let’s quickly discuss why you are right to study it. Economics is not primarily a collection of facts to memorize, although there are plenty of important concepts to learn. Instead, think of economics as a collection of questions to answer or puzzles to work. Most importantly, economics provides the tools to solve those puzzles. Consider the complex and critical issue of education barriers on national and regional levels, which affect millions of people and result in widespread poverty and inequality. Governments, aid organizations, and wealthy individuals spend billions of dollars each year trying to address these issues. Nations announce the revitalization of their education programs; tech companies donate devices and infrastructure, and celebrities and charities build schools and sponsor students. Yet the problems remain, sometimes almost as pronounced as they were before the intervention. Why is that the case? In 2019, three economists—Esther Duflo, Abhijit Banerjee, and Michael Kremer—were awarded the Nobel Prize for their work to answer those questions. They worked diligently to break the widespread problems into smaller pieces, and experimented with small interventions to test success. The award citation credited their work with giving the world better tools and information to address poverty and improve education. Esther Duflo, who is the youngest person and second woman to win the Nobel Prize in Economics, said, "We believed that like the war on cancer, the war on poverty was not going to be won in one major battle, but in a series of small triumphs.... This work and the culture of learning that it fostered in governments has led to real improvement in the lives of hundreds of millions of poor people.” As you can see, economics affects far more than business. For example: Virtually every major problem facing the world today, from global warming, to world poverty, to the conflicts in Syria, Afghanistan, and Somalia, has an economic dimension. If you are going to be part of solving those problems, you need to be able to understand them. Economics is crucial. It is hard to overstate the importance of economics to good citizenship. You need to be able to vote intelligently on budgets, regulations, and laws in general. When the U.S. government came close to a standstill at the end of 2012 due to the “fiscal cliff,” what were the issues? Did you know? A basic understanding of economics makes you a well-rounded thinker. When you read articles about economic issues, you will understand and be able to evaluate the writer’s argument. When you hear Access for free at openstax.org  1.2 Microeconomics and Macroeconomics 15 classmates, co-workers, or political candidates talking about economics, you will be able to distinguish between common sense and nonsense. You will find new ways of thinking about current events and about personal and business decisions, as well as current events and politics. The study of economics does not dictate the answers, but it can illuminate the different choices. 1.2 Microeconomics and Macroeconomics LEARNING OBJECTIVES By the end of this section, you will be able to: Describe microeconomics Describe macroeconomics Contrast monetary policy and fiscal policy Economics is concerned with the well-being of all people, including those with jobs and those without jobs, as well as those with high incomes and those with low incomes. Economics acknowledges that production of useful goods and services can create problems of environmental pollution. It explores the question of how investing in education helps to develop workers’ skills. It probes questions like how to tell when big businesses or big labor unions are operating in a way that benefits society as a whole and when they are operating in a way that benefits their owners or members at the expense of others. It looks at how government spending, taxes, and regulations affect decisions about production and consumption. It should be clear by now that economics covers considerable ground. We can divide that ground into two parts: Microeconomics focuses on the actions of individual agents within the economy, like households, workers, and businesses. Macroeconomics looks at the economy as a whole. It focuses on broad issues such as growth of production, the number of unemployed people, the inflationary increase in prices, government deficits, and levels of exports and imports. Microeconomics and macroeconomics are not separate subjects, but rather complementary perspectives on the overall subject of the economy. To understand why both microeconomic and macroeconomic perspectives are useful, consider the problem of studying a biological ecosystem like a lake. One person who sets out to study the lake might focus on specific topics: certain kinds of algae or plant life; the characteristics of particular fish or snails; or the trees surrounding the lake. Another person might take an overall view and instead consider the lake's ecosystem from top to bottom; what eats what, how the system stays in a rough balance, and what environmental stresses affect this balance. Both approaches are useful, and both examine the same lake, but the viewpoints are different. In a similar way, both microeconomics and macroeconomics study the same economy, but each has a different viewpoint. Whether you are scrutinizing lakes or economics, the micro and the macro insights should blend with each other. In studying a lake, the micro insights about particular plants and animals help to understand the overall food chain, while the macro insights about the overall food chain help to explain the environment in which individual plants and animals live. In economics, the micro decisions of individual businesses are influenced by whether the macroeconomy is healthy. For example, firms will be more likely to hire workers if the overall economy is growing. In turn, macroeconomy's performance ultimately depends on the microeconomic decisions that individual households and businesses make. Microeconomics What determines how households and individuals spend their budgets? What combination of goods and services will best fit their needs and wants, given the budget they have to spend? How do people decide whether to work, and if so, whether to work full time or part time? How do people decide how much to save for the future, or whether they should borrow to spend beyond their current means? What determines the products, and how many of each, a firm will produce and sell? What determines the 16 1 Welcome to Economics! prices a firm will charge? What determines how a firm will produce its products? What determines how many workers it will hire? How will a firm finance its business? When will a firm decide to expand, downsize, or even close? In the microeconomics part of this book, we will learn about the theory of consumer behavior, the theory of the firm, how markets for labor and other resources work, and how markets sometimes fail to work properly. Macroeconomics What determines the level of economic activity in a society? In other words, what determines how many goods and services a nation actually produces? What determines how many jobs are available in an economy? What determines a nation’s standard of living? What causes the economy to speed up or slow down? What causes firms to hire more workers or to lay them off? Finally, what causes the economy to grow over the long term? We can determine an economy's macroeconomic health by examining a number of goals: growth in the standard of living, low unemployment, and low inflation, to name the most important. How can we use government macroeconomic policy to pursue these goals? A nation's central bank conducts monetary policy, which involves policies that affect bank lending, interest rates, and financial capital markets. For the United States, this is the Federal Reserve. A nation's legislative body determines fiscal policy, which involves government spending and taxes. For the United States, this is the Congress and the executive branch, which originates the federal budget. These are the government's main tools. Americans tend to expect that government can fix whatever economic problems we encounter, but to what extent is that expectation realistic? These are just some of the issues that we will explore in the macroeconomic chapters of this book. 1.3 How Economists Use Theories and Models to Understand Economic Issues LEARNING OBJECTIVES By the end of this section, you will be able to: Interpret a circular flow diagram Explain the importance of economic theories and models Describe goods and services markets and labor markets FIGURE 1.6 John Maynard Keynes One of the most influential economists in modern times was John Maynard Keynes. (Credit: “John Maynard Keynes” by IMF/Wikimedia Commons, Public Domain) John Maynard Keynes (1883–1946), one of the greatest economists of the twentieth century, pointed out that economics is not just a subject area but also a way of thinking. Keynes (Figure 1.6) famously wrote in the introduction to a fellow economist’s book: “[Economics] is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions.” In other words, economics teaches you how to think, not what to think. LINK IT UP Watch this video (http://openstax.org/l/Keynes) about John Maynard Keynes and his influence on economics. Access for free at openstax.org  1.3 How Economists Use Theories and Models to Understand Economic Issues 17 Economists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline. They analyze issues and problems using economic theories that are based on particular assumptions about human behavior. These assumptions tend to be different than the assumptions an anthropologist or psychologist might use. A theory is a simplified representation of how two or more variables interact with each other. The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done well, this enables the analyst to understand the issue and any problems around it. A good theory is simple enough to understand, while complex enough to capture the key features of the object or situation you are studying. Sometimes economists use the term model instead of theory. Strictly speaking, a theory is a more abstract representation, while a model is a more applied or empirical representation. We use models to test theories, but for this course we will use the terms interchangeably. For example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Companies often build models of their new products, which are more rough and unfinished than the final product, but can still demonstrate how the new product will work. A good model to start with in economics is the circular flow diagram (Figure 1.7). It pictures the economy as consisting of two groups—households and firms—that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees. FIGURE 1.7 The Circular Flow Diagram The circular flow diagram shows how households and firms interact in the goods and services market, and in the labor market. The direction of the arrows shows that in the goods and services market, households receive goods and services and pay firms for them. In the labor market, households provide labor and receive payment from firms through wages, salaries, and benefits. Firms produce and sell goods and services to households in the market for goods and services (or product market). Arrow “A” indicates this. Households pay for goods and services, which becomes the revenues to firms. Arrow “B” indicates this. Arrows A and B represent the two sides of the product market. Where do households obtain the income to buy goods and services? They provide the labor and other resources (e.g., land, capital, raw materials) firms need to produce goods and services in the market for inputs (or factors of production). Arrow “C” indicates this. In return, firms pay for the inputs (or resources) they use in the form of wages and other factor payments. Arrow “D” indicates this. Arrows “C” and “D” represent the two sides of the factor market. Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for revenues. The outer circle shows this, and represents the two sides of the product market (for example, the market for goods and 18 1 Welcome to Economics! services) in which households demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries, and benefits. The inner circle shows this and represents the two sides of the labor market in which households supply and firms demand. This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports). Economists carry a set of theories in their heads like a carpenter carries around a toolkit. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the theory to derive insights about the issue or problem. Economists express theories as diagrams, graphs, or even as mathematical equations. (Do not worry. In this course, we will mostly use graphs.) Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve. We explain both micro and macroeconomics in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn a number of others. 1.4 How To Organize Economies: An Overview of Economic Systems LEARNING OBJECTIVES By the end of this section, you will be able to: Contrast traditional economies, command economies, and market economies Explain gross domestic product (GDP) Assess the importance and effects of globalization Think about what a complex system a modern economy is. It includes all production of goods and services, all buying and selling, all employment. The economic life of every individual is interrelated, at least to a small extent, with the economic lives of thousands or even millions of other individuals. Who organizes and coordinates this system? Who ensures that, for example, the number of televisions a society provides is the same as the amount it needs and wants? Who ensures that the right number of employees work in the electronics industry? Who ensures that televisions are produced in the best way possible? How does it all get done? There are at least three ways that societies organize an economy. The first is the traditional economy, which is the oldest economic system and is used in parts of Asia, Africa, and South America. Traditional economies organize their economic affairs the way they have always done (i.e., tradition). Occupations stay in the family. Most families are farmers who grow the crops using traditional methods. What you produce is what you consume. Because tradition drives the way of life, there is little economic progress or development. Access for free at openstax.org  1.4 How To Organize Economies: An Overview of Economic Systems 19 FIGURE 1.8 A Command Economy Ancient Egypt was an example of a command economy. (Credit: "Pyramids at Giza" by Jay Bergesen/Flickr Creative Commons, CC BY 2.0) Command economies are very different. In a command economy, economic effort is devoted to goals passed down from a ruler or ruling class. Ancient Egypt was a good example: a large part of economic life was devoted to building pyramids, like those in Figure 1.8, for the pharaohs. Medieval manor life is another example: the lord provided the land for growing crops and protection in the event of war. In return, vassals provided labor and soldiers to do the lord’s bidding. In the last century, communism emphasized command economies. In a command economy, the government decides what goods and services will be produced and what prices it will charge for them. The government decides what methods of production to use and sets wages for workers. The government provides many necessities like healthcare and education for free. Currently, Cuba and North Korea have command economies. FIGURE 1.9 A Market Economy Nothing says “market” more than The New York Stock Exchange. (Credit: work by Erik Drost/Flickr Creative Commons, CC BY 2.0) Although command economies have a very centralized structure for economic decisions, market economies have a very decentralized structure. A market is an institution that brings together buyers and sellers of goods or services, who may be either individuals or businesses. The New York Stock Exchange (Figure 1.9) is a prime example of a market which brings buyers and sellers together. In a market economy, decision-making is decentralized. Market economies are based on private enterprise: the private individuals or groups of private individuals own and operate the means of production (resources and businesses). Businesses supply goods and services based on demand. (In a command economy, by contrast, the government owns resources and businesses.) Supply of goods and services depends on what the demands are. A person’s income is based on their ability to convert resources (especially labor) into something that society values. The more society values the person’s output, the higher the income (think Lady Gaga or LeBron James). In this scenario, market forces, not governments, determine economic decisions. Most economies in the real world are mixed. They combine elements of command and market (and even traditional) systems. The U.S. economy is positioned toward the market-oriented end of the spectrum. Many countries in Europe and Latin America, while primarily market-oriented, have a greater degree of government 20 1 Welcome to Economics! involvement in economic decisions than the U.S. economy. China and Russia, while over the past several decades have moved more in the direction of having a market-oriented system, remain closer to the command economy end of the spectrum. The Heritage Foundation provides perspective on countries’ economic freedom, as the following Clear It Up feature discusses. CLEAR IT UP What countries are considered economically free? Who is in control of economic decisions? Are people free to do what they want and to work where they want? Are businesses free to produce when they want and what they choose, and to hire and fire as they wish? Are banks free to choose who will receive loans, or does the government control these kinds of choices? Each year, researchers at the Heritage Foundation and the Wall Street Journal look at 50 different categories of economic freedom for countries around the world. They give each nation a score based on the extent of economic freedom in each category. Note that while the Heritage Foundation/WSJ index is widely cited by an array of scholars and publications, it should be regarded as only one viewpoint. Some experts indicate that the index’s category choices and scores are politically biased. However, the index and others like it provide a useful resource for critical discussion of economic freedom. The 2016 Heritage Foundation’s Index of Economic Freedom report ranked 178 countries around the world: Table 1.1 lists some examples of the most free and the least free countries. Although technically not a separate country, Hong Kong has been granted a degree of autonomy such that, for purposes of measuring economic statistics, it is often treated as a separate country. Several additional countries were not ranked because of extreme instability that made judgments about economic freedom impossible. These countries include Afghanistan, Iraq, Libya, Syria, Somalia, and Yemen. The assigned rankings are inevitably based on estimates, yet even these rough measures can be useful for discerning trends. In 2015, 101 of the 178 included countries shifted toward greater economic freedom, although 77 of the countries shifted toward less economic freedom. In recent decades, the overall trend has been a higher level of economic freedom around the world. Most Economic Freedom Least Economic Freedom 1. Hong Kong 167. Timor-Leste 2. Singapore 168. Democratic Republic of Congo 3. New Zealand 169. Argentina 4. Switzerland 170. Equatorial Guinea 5. Australia 171. Iran 6. Canada 172. Republic of Congo 7. Chile 173. Eritrea 8. Ireland 174. Turkmenistan TABLE 1.1 Economic Freedoms, 2016 (Source: The Heritage Foundation, 2016 Index of Economic Freedom, Country Rankings, http://www.heritage.org/index/ranking) Access for free at openstax.org  1.4 How To Organize Economies: An Overview of Economic Systems 21 Most Economic Freedom Least Economic Freedom 9. Estonia 175. Zimbabwe 10. United Kingdom 176. Venezuela 11. United States 177. Cuba 12. Denmark 178. North Korea TABLE 1.1 Economic Freedoms, 2016 (Source: The Heritage Foundation, 2016 Index of Economic Freedom, Country Rankings, http://www.heritage.org/index/ranking) Regulations: The Rules of the Game Markets and government regulations are always entangled. There is no such thing as an absolutely free market. Regulations always define the “rules of the game” in the economy. Economies that are primarily market-oriented have fewer regulations—ideally just enough to maintain an even playing field for participants. At a minimum, these laws govern matters like safeguarding private property against theft, protecting people from violence, enforcing legal contracts, preventing fraud, and collecting taxes. Conversely, even the most command-oriented economies operate using markets. How else would buying and selling occur? The government heavily regulates decisions of what to produce and prices to charge. Heavily regulated economies often have underground economies (or black markets), which are markets where the buyers and sellers make transactions without the government’s approval. The question of how to organize economic institutions is typically not a straightforward choice between all market or all government, but instead involves a balancing act over the appropriate combination of market freedom and government rules. FIGURE 1.10 Globalization Cargo ships are one mode of transportation for shipping goods in the global economy. (Credit: "Cargo Ship" by Raul Valdez/Flickr Creative Commons, CC BY 2.0) The Rise of Globalization Recent decades have seen a trend toward globalization, which is the expanding cultural, political, and economic connections between people around the world. One measure of this is the increased buying and selling of goods, services, and assets across national borders—in other words, international trade and financial capital flows. Globalization has occurred for a number of reasons. Improvements in shipping, as illustrated by the container 22 1 Welcome to Economics! ship in Figure 1.10, and air cargo have driven down transportation costs. Innovations in computing and telecommunications have made it easier and cheaper to manage long-distance economic connections of production and sales. Many valuable products and services in the modern economy can take the form of information—for example: computer software; financial advice; travel planning; music, books and movies; and blueprints for designing a building. These products and many others can be transported over telephones and computer networks at ever-lower costs. Finally, international agreements and treaties between countries have encouraged greater trade. Table 1.2 presents one measure of globalization. It shows the percentage of domestic economic production that was exported for a selection of countries from 2010 to 2015, according to an entity known as The World Bank. Exports are the goods and services that one produces domestically and sells abroad. Imports are the goods and services that one produces abroad and then sells domestically. Gross domestic product (GDP) measures the size of total production in an economy. Thus, the ratio of exports divided by GDP measures what share of a country’s total economic production is sold in other countries. Country 2010 2011 2012 2013 2014 2015 Higher Income Countries United States 12.4 13.6 13.6 13.5 13.5 12.6 Belgium 76.2 81.4 82.2 82.8 84.0 84.4 Canada 29.1 30.7 30.0 30.1 31.7 31.5 France 26.0 27.8 28.1 28.3 29.0 30.0 Middle Income Countries Brazil 10.9 11.9 12.6 12.6 11.2 13.0 Mexico 29.9 31.2 32.6 31.7 32.3 35.3 South Korea 49.4 55.7 56.3 53.9 50.3 45.9 Lower Income Countries Chad 36.8 38.9 36.9 32.2 34.2 29.8 China 29.4 28.5 27.3 26.4 23.9 22.4 India 22.0 23.9 24.0 24.8 22.9 - Nigeria 25.3 31.3 31.4 18.0 18.4 - TABLE 1.2 The Extent of Globalization (exports/GDP) (Source: http://databank.worldbank.org/data/) In recent decades, the export/GDP ratio has generally risen, both worldwide and for the U.S. economy. Interestingly, the share of U.S. exports in proportion to the U.S. economy is well below the global average, in part because large economies like the United States can contain more of the division of labor inside their national borders. However, smaller economies like Belgium, Korea, and Canada need to trade across their borders with other countries to take full advantage of division of labor, specialization, and economies of scale. In this sense, the enormous U.S. economy is less affected by globalization than most other countries. Access for free at openstax.org  1.4 How To Organize Economies: An Overview of Economic Systems 23 Table 1.2 indicates that many medium and low income countries around the world, like Mexico and China, have also experienced a surge of globalization in recent decades. If an astronaut in orbit could put on special glasses that make all economic transactions visible as brightly colored lines and look down at Earth, the astronaut would see the planet covered with connections. Despite the rise in globalization over the last few decades, in recent years we've seen significant pushback against globalization from people across the world concerned about loss of jobs, loss of political sovereignty, and increased economic inequality. Prominent examples of this pushback include the 2016 vote in Great Britain to exit the European Union (i.e. Brexit), and the election of Donald J. Trump for President of the United States. Hopefully, you now have an idea about economics. Before you move to any other chapter of study, be sure to read the very important appendix to this chapter called The Use of Mathematics in Principles of Economics. It is essential that you learn more about how to read and use models in economics. BRING IT HOME Information Overload in the Information Age The world provides nearly instant access to a wealth of information. Consider that as recently as the late 1970s, the Farmer’s Almanac, along with the Weather Bureau of the U.S. Department of Agriculture, were the primary sources American farmers used to determine when to plant and harvest their crops. Today, these decisions are driven by data. Farmers access detailed data streams driven by global positioning systems, historical rainfall patterns, and complex weather monitoring services. They combine this information with crop yield data and soil quality measurements from prior years. Maximizing production efficiently can mean the difference between a farm that remains profitable and one that may need to sell its land, and data helps eliminate guesswork. Information helps us make decisions as simple as what to wear today to how many reporters the media should send to cover an event. Each of these decisions is an economic decision. After all, resources are scarce. If the media send ten reporters to cover an announcement, they are not available to cover other stories or complete other tasks. Information provides the necessary knowledge to make the best possible decisions on how to utilize scarce resources. Welcome to the world of economics! 24 1 Key Terms Key Terms circular flow diagram a diagram that views the economy as consisting of households and firms interacting in a goods and services market and a labor market command economy an economy where economic decisions are passed down from government authority and where the government owns the resources division of labor the way in which different workers divide required tasks to produce a good or service economics the study of how humans make choices under conditions of scarcity economies of scale when the average cost of producing each individual unit declines as total output increases exports products (goods and services) made domestically and sold abroad fiscal policy economic policies that involve government spending and taxes globalization the trend in which buying and selling in markets have increasingly crossed national borders goods and services market a market in which firms are sellers of what they produce and households are buyers gross domestic product (GDP) measure of the size of total production in an economy imports products (goods and services) made abroad and then sold domestically labor market the market in which households sell their labor as workers to business firms or other employers macroeconomics the branch of economics that focuses on broad issues such as growth, unemployment, inflation, and trade balance market interaction between potential buyers and sellers; a combination of demand and supply market economy an economy where economic decisions are decentralized, private individuals own resources, and businesses supply goods and services based on demand microeconomics the branch of economics that focuses on actions of particular agents within the economy, like households, workers, and business firms model see theory monetary policy policy that involves altering the level of interest rates, the availability of credit in the economy, and the extent of borrowing private enterprise system where private individuals or groups of private individuals own and operate the means of production (resources and businesses) scarcity when human wants for goods and services exceed the available supply specialization when workers or firms focus on particular tasks for which they are well-suited within the overall production process theory a representation of an object or situation that is simplified while including enough of the key features to help us understand the object or situation traditional economy typically an agricultural economy where things are done the same as they have always been done underground economy a market where the buyers and sellers make transactions in violation of one or more government regulations Key Concepts and Summary 1.1 What Is Economics, and Why Is It Important? Economics seeks to solve the problem of scarcity, which is when human wants for goods and services exceed the available supply. A modern economy displays a division of labor, in which people earn income by specializing in what they produce and then use that income to purchase the products they need or want. The division of labor allows individuals and firms to specialize and to produce more for several reasons: a) It allows the agents to focus on areas of advantage due to natural factors and skill levels; b) It encourages the agents to learn and invent; c) It allows agents to take advantage of economies of scale. Division and specialization of labor only work when individuals can purchase what they do not produce in markets. Learning about economics helps you understand the major problems facing the world today, prepares you to be a good citizen, and helps you become a well-rounded thinker. Access for free at openstax.org  1 Self-Check Questions 25 1.2 Microeconomics and Macroeconomics Microeconomics and macroeconomics are two different perspectives on the economy. The microeconomic perspective focuses on parts of the economy: individuals, firms, and industries. The macroeconomic perspective looks at the economy as a whole, focusing on goals like growth in the standard of living, unemployment, and inflation. Macroeconomics has two types of policies for pursuing these goals: monetary policy and fiscal policy. 1.3 How Economists Use Theories and Models to Understand Economic Issues Economists analyze problems differently than do other disciplinary experts. The main tools economists use are economic theories or models. A theory is not an illustration of the answer to a problem. Rather, a theory is a tool for determining the answer. 1.4 How To Organize Economies: An Overview of Economic Systems We can organize societies as traditional, command, or market-oriented economies. Most societies are a mix. The last few decades have seen globalization evolve as a result of growth in commercial and financial networks that cross national borders, making businesses and workers from different economies increasingly interdependent. Self-Check Questions 1. What is scarcity? Can you think of two causes of scarcity? 2. Residents of the town of Smithfield like to consume hams, but each ham requires 10 people to produce it and takes a month. If the town has a total of 100 people, what is the maximum am