Principles of Microeconomics Sem-1 (Ch. 1-4) PDF

CHAPTER Ten Principles of Economics 1 T he word economy comes from the Greek word oikonomos, which means “one who manages a household.” At first,...

CHAPTER Ten Principles of Economics 1 T he word economy comes from the Greek word oikonomos, which means “one who manages a household.” At first, this origin might seem peculiar. But in fact, households and economies have much in common. A household faces many decisions. It must decide which household members do which tasks and what each member receives in return: Who cooks dinner? Who does the laundry? Who gets the extra dessert at dinner? Who gets to drive the car? In short, a household must allocate its scarce resources (time, dessert, car mileage) among its various members, taking into account each member’s abilities, efforts, and desires. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 4 PART I InTRoduCTIon Like a household, a society faces many decisions. It must find some way to decide what jobs will be done and who will do them. It needs some people to grow food, other people to make clothing, and still others to design computer soft- ware. Once society has allocated people (as well as land, buildings, and machines) to various jobs, it must also allocate the goods and services they produce. It must decide who will eat caviar and who will eat potatoes. It must decide who will drive a Tesla and who will take the bus. The management of society’s resources is important because resources are scarcity scarce. Scarcity means that society has limited resources and therefore cannot the limited nature of produce all the goods and services people wish to have. Just as each member of society’s resources a household cannot get everything she wants, each individual in a society cannot attain the highest standard of living to which she might aspire. economics Economics is the study of how society manages its scarce resources. In most so- the study of how soci- cieties, resources are allocated not by an all-powerful dictator but through the com- ety manages its scarce bined choices of millions of households and firms. Economists, therefore, study resources how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people inter- act with one another. For instance, they examine how the multitude of buyers and sellers of a good together determine the price at which the good is sold and the quantity that is sold. Finally, economists analyze the forces and trends that affect the economy as a whole, including the growth in average income, the fraction of the population that cannot find work, and the rate at which prices are rising. The study of economics has many facets, but it is unified by several central ideas. In this chapter, we look at Ten Principles of Economics. Don’t worry if you don’t understand them all at first or if you aren’t completely convinced. We explore these ideas more fully in later chapters. The ten principles are introduced here to give you an overview of what economics is all about. Consider this chapter a “preview of coming attractions.” 1-1 How People Make Decisions There is no mystery to what an economy is. Whether we are talking about the economy of Los Angeles, the United States, or the whole world, an economy is just a group of people dealing with one another as they go about their lives. Because the behavior of an economy reflects the behavior of the individuals who make up the economy, we begin our study of economics with four principles about indi- vidual decision making. 1-1a Principle 1: People Face Trade-offs You may have heard the old saying, “There ain’t no such thing as a free lunch.” Grammar aside, there is much truth to this adage. To get something that we like, we usually have to give up something else that we also like. Making decisions requires trading off one goal against another. Consider a student who must decide how to allocate her most valuable resource—her time. She can spend all of her time studying economics, spend all of it studying psychology, or divide it between the two fields. For every hour she studies one subject, she gives up an hour she could have used studying the other. And for every hour she spends studying, she gives up an hour she could have spent napping, bike riding, watching TV, or working at her part-time job for some extra spending money. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 1 TEn PRInCIPlEs of EConomICs 5 Consider parents deciding how to spend their family income. They can buy food, clothing, or a family vacation. Or they can save some of the family income for retirement or the children’s college education. When they choose to spend an extra dollar on one of these goods, they have one less dollar to spend on some other good. When people are grouped into societies, they face different kinds of trade-offs. One classic trade-off is between “guns and butter.” The more a society spends on national defense (guns) to protect its shores from foreign aggressors, the less it can spend on consumer goods (butter) to raise the standard of living at home. Also important in modern society is the trade-off between a clean environment and a high level of income. Laws that require firms to reduce pollution raise the cost of producing goods and services. Because of these higher costs, the firms end up earn- ing smaller profits, paying lower wages, charging higher prices, or some combina- tion of these three. Thus, while pollution regulations yield the benefit of a cleaner environment and the improved health that comes with it, they come at the cost of reducing the incomes of the regulated firms’ owners, workers, and customers. Another trade-off society faces is between efficiency and equality. Efficiency efficiency means that society is getting the maximum benefits from its scarce resources. Equal- the property of society ity means that those benefits are distributed uniformly among society’s members. In getting the most it can other words, efficiency refers to the size of the economic pie, and equality refers to from its scarce resources how the pie is divided into individual slices. equality When government policies are designed, these two goals often conflict. Consider, the property of distribut- for instance, policies aimed at equalizing the distribution of economic well-being. ing economic prosperity Some of these policies, such as the welfare system or unemployment insurance, uniformly among the try to help the members of society who are most in need. Others, such as the in- members of society dividual income tax, ask the financially successful to contribute more than others to support the government. Though they achieve greater equality, these policies reduce efficiency. When the government redistributes income from the rich to the poor, it reduces the reward for working hard; as a result, people work less and produce fewer goods and services. In other words, when the government tries to cut the economic pie into more equal slices, the pie gets smaller. Recognizing that people face trade-offs does not by itself tell us what decisions they will or should make. A student should not abandon the study of psychology just because doing so would increase the time available for the study of economics. Society should not stop protecting the environment just because environmental reg- ulations reduce our material standard of living. The poor should not be ignored just because helping them distorts work incentives. Nonetheless, people are likely to make good decisions only if they understand the options that are available to them. Our study of economics, therefore, starts by acknowledging life’s trade-offs. 1-1b Principle 2: The Cost of Something Is What You Give Up to Get It Because people face trade-offs, making decisions requires comparing the costs and benefits of alternative courses of action. In many cases, however, the cost of an action is not as obvious as it might first appear. Consider the decision to go to college. The main benefits are intellectual enrich- ment and a lifetime of better job opportunities. But what are the costs? To answer this question, you might be tempted to add up the money you spend on tuition, books, room, and board. Yet this total does not truly represent what you give up to spend a year in college. There are two problems with this calculation. First, it includes some things that are not really costs of going to college. Even if you quit school, you need a place Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 6 PART I InTRoduCTIon to sleep and food to eat. Room and board are costs of going to college only to the extent that they are more expensive at college than elsewhere. Second, this calcu- lation ignores the largest cost of going to college—your time. When you spend a year listening to lectures, reading textbooks, and writing papers, you cannot spend that time working at a job. For most students, the earnings they give up to attend school are the single largest cost of their education. opportunity cost The opportunity cost of an item is what you give up to get that item. When whatever must be given making any decision, decision makers should be aware of the opportunity costs up to obtain some item that accompany each possible action. In fact, they usually are. College athletes who can earn millions if they drop out of school and play professional sports are well aware that their opportunity cost of attending college is very high. It is not surprising that they often decide that the benefit of a college education is not worth the cost. 1-1c Principle 3: Rational People Think at the Margin rational people Economists normally assume that people are rational. Rational people systemat- people who systematically ically and purposefully do the best they can to achieve their objectives, given the and purposefully do the available opportunities. As you study economics, you will encounter firms that best they can to achieve decide how many workers to hire and how much of their product to manufacture their objectives and sell to maximize profits. You will also encounter individuals who decide how much time to spend working and what goods and services to buy with the result- ing income to achieve the highest possible level of satisfaction. Rational people know that decisions in life are rarely black and white but usu- ally involve shades of gray. At dinnertime, the question you face is not “Should I fast or eat like a pig?” More likely, you will be asking yourself “Should I take that extra spoonful of mashed potatoes?” When exams roll around, your decision is not between blowing them off and studying 24 hours a day but whether to spend an extra hour reviewing your notes instead of watching TV. Economists use the marginal change term marginal change to describe a small incremental adjustment to an existing a small incremental plan of action. Keep in mind that margin means “edge,” so marginal changes are adjustment to a plan of adjustments around the edges of what you are doing. Rational people often make action decisions by comparing marginal benefits and marginal costs. For example, suppose you are considering calling a friend on your cell phone. You decide that talking with her for 10 minutes would give you a benefit that you value at about $7. Your cell phone service costs you $40 per month plus $0.50 per minute for whatever calls you make. You usually talk for 100 minutes a month, so your total monthly bill is $90 ($0.50 per minute times 100 minutes, plus the $40 fixed fee). Under these circumstances, should you make the call? You might be tempted to reason as follows: “Because I pay $90 for 100 minutes of calling each month, the average minute on the phone costs me $0.90. So a 10-minute call costs $9. Because that $9 cost is greater than the $7 benefit, I am going to skip the call.” That conclusion is wrong, however. Although the average cost of a 10-minute call is $9, the marginal cost—the amount your bill increases if you make the extra call—is only $5. You will make the right decision only by comparing the marginal benefit and the marginal cost. Because the marginal benefit of $7 is greater than the mar- ginal cost of $5, you should make the call. This is a principle that people innately understand: Cell phone users with unlimited minutes (that is, minutes that are free at the margin) are often prone to making long and frivolous calls. Thinking at the margin works for business decisions as well. Consider an airline deciding how much to charge passengers who fly standby. Suppose that flying a 200-seat plane across the United States costs the airline $100,000. In this case, the Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 1 TEn PRInCIPlEs of EConomICs 7 average cost of each seat is $100,000/200, which is $500. One might be tempted to conclude that the airline should never sell a ticket for less than $500. But a ratio- nal airline can increase its profits by thinking at the margin. Imagine that a plane is about to take off with 10 empty seats and a standby passenger waiting at the gate is willing to pay $300 for a seat. Should the airline sell the ticket? Of course it should. If the plane has empty seats, the cost of adding one more passenger is tiny. The average cost of flying a passenger is $500, but the marginal cost is merely the cost of the can of soda that the extra passenger will consume. As long as the standby passenger pays more than the marginal cost, selling the ticket is profitable. Marginal decision making can help explain some otherwise puzzling economic phenomena. Here is a classic question: Why is water so cheap, while diamonds are so expensive? Humans need water to survive, while diamonds are unneces- sary. Yet people are willing to pay much more for a diamond than for a cup of water. The reason is that a person’s willingness to pay for a good is based on the marginal benefit that an extra unit of the good would yield. The marginal bene- fit, in turn, depends on how many units a person already has. Water is essential, but the marginal benefit of an extra cup is small because water is plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so rare, BLEND IMAGES / ALAMY people consider the marginal benefit of an extra diamond to be large. A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost. This principle explains why people use their cell phones as much as they do, why airlines are willing to sell tickets below aver- age cost, and why people are willing to pay more for diamonds than for water. It “Is the marginal benefit can take some time to get used to the logic of marginal thinking, but the study of of this call greater than economics will give you ample opportunity to practice. the marginal cost?” 1-1d Principle 4: People Respond to Incentives An incentive is something (such as the prospect of a punishment or reward) that incentive induces a person to act. Because rational people make decisions by comparing something that induces a costs and benefits, they respond to incentives. You will see that incentives play person to act a central role in the study of economics. One economist went so far as to suggest that the entire field could be summarized as simply “People respond to incen- tives. The rest is commentary.” Incentives are key to analyzing how markets work. For example, when the price of an apple rises, people decide to eat fewer apples. At the same time, apple orchards decide to hire more workers and harvest more apples. In other words, a higher price in a market provides an incentive for buyers to consume less and an incentive for sellers to produce more. As we will see, the influence of prices on the behavior of consumers and producers is crucial to how a market economy allocates scarce resources. Public policymakers should never forget about incentives: Many policies change the costs or benefits that people face and, as a result, alter their behavior. A tax on gasoline, for instance, encourages people to drive smaller, more fuel-efficient cars. That is one reason people drive smaller cars in Europe, where gasoline taxes are high, than in the United States, where gasoline taxes are low. A higher gasoline tax also encourages people to carpool, take public transportation, and live closer to where they work. If the tax were larger, more people would be driving hybrid cars, and if it were large enough, they would switch to electric cars. When policymakers fail to consider how their policies affect incentives, they often end up facing unintended consequences. For example, consider public policy regarding auto safety. Today, all cars have seat belts, but this was not true Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 8 PART I InTRoduCTIon 60 years ago. In 1965, Ralph Nader’s book Unsafe at Any Speed generated much public concern over auto safety. Congress responded with laws requiring seat belts as standard equipment on new cars. How does a seat belt law affect auto safety? The direct effect is obvious: When a person wears a seat belt, the probability of surviving an auto accident rises. But that’s not the end of the story because the law also affects behavior by altering incentives. The relevant behavior here is the speed and care with which drivers op- erate their cars. Driving slowly and carefully is costly because it uses the driver’s time and energy. When deciding how safely to drive, rational people compare, per- haps unconsciously, the marginal benefit from safer driving to the marginal cost. As a result, they drive more slowly and carefully when the benefit of increased safety is high. For example, when road conditions are icy, people drive more atten- tively and at lower speeds than they do when road conditions are clear. Consider how a seat belt law alters a driver’s cost–benefit calculation. Seat belts make accidents less costly because they reduce the likelihood of injury or death. In other words, seat belts reduce the benefits of slow and careful driving. People respond to seat belts as they would to an improvement in road conditions—by driving faster and less carefully. The result of a seat belt law, therefore, is a larger number of accidents. The decline in safe driving has a clear, adverse impact on pedestrians, who are more likely to find themselves in an accident but (unlike the drivers) don’t have the benefit of added protection. At first, this discussion of incentives and seat belts might seem like idle specu- lation. Yet in a classic 1975 study, economist Sam Peltzman argued that auto-safety laws have had many of these effects. According to Peltzman’s evidence, these laws give rise to fewer deaths per accident but also to more accidents. He con- cluded that the net result is little change in the number of driver deaths and an increase in the number of pedestrian deaths. Peltzman’s analysis of auto safety is an offbeat and controversial example of the general principle that people respond to incentives. When analyzing any pol- icy, we must consider not only the direct effects but also the less obvious indirect effects that work through incentives. If the policy changes incentives, it will cause people to alter their behavior. Describe an important trade-off you recently faced. Give an example of QuickQuiz some action that has both a monetary and nonmonetary opportunity cost. Describe an incentive your parents offered to you in an effort to influence your behavior. 1-2 How People Interact The first four principles discussed how individuals make decisions. As we go about our lives, many of our decisions affect not only ourselves but other people as well. The next three principles concern how people interact with one another. 1-2a Principle 5: Trade Can Make Everyone Better Off You may have heard on the news that the Chinese are our competitors in the world economy. In some ways, this is true because American and Chinese firms produce many of the same goods. Companies in the United States and China compete for the same customers in the markets for clothing, toys, solar panels, automobile tires, and many other items. Yet it is easy to be misled when thinking about competition among countries. Trade between the United States and China is not like a sports contest in which Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 1 TEn PRInCIPlEs of EConomICs 9 one side wins and the other side loses. In fact, the opposite is true: Trade between two countries can make each country better off. FROM THE WALL STREET JOURNAL - PERMISSION, To see why, consider how trade affects your family. When a member of your family looks for a job, she competes against members of other families who are looking for jobs. Families also compete against one another when they go shop- ping because each family wants to buy the best goods at the lowest prices. In a CARTOON FEATURES SYNDICATE sense, each family in an economy competes with all other families. Despite this competition, your family would not be better off isolating itself from all other families. If it did, your family would need to grow its own food, make its own clothes, and build its own home. Clearly, your family gains much from its ability to trade with others. Trade allows each person to specialize in the activities she does best, whether it is farming, sewing, or home building. By trad- ing with others, people can buy a greater variety of goods and services at lower “For $5 a week you can cost. watch baseball without Like families, countries also benefit from the ability to trade with one another. being nagged to cut the Trade allows countries to specialize in what they do best and to enjoy a greater grass!” variety of goods and services. The Chinese, as well as the French, Egyptians, and Brazilians, are as much our partners in the world economy as they are our competitors. 1-2b Principle 6: Markets Are Usually a Good Way to Organize Economic Activity The collapse of communism in the Soviet Union and Eastern Europe in the late 1980s and early 1990s was one of the last century’s most transformative events. Communist countries operated on the premise that government officials were in the best position to allocate the economy’s scarce resources. These central plan- ners decided what goods and services were produced, how much was produced, and who produced and consumed these goods and services. The theory behind central planning was that only the government could organize economic activity in a way that promoted economic well-being for the country as a whole. Most countries that once had centrally planned economies have abandoned the system and are instead developing market economies. In a market economy, the market economy decisions of a central planner are replaced by the decisions of millions of firms an economy that allocates and households. Firms decide whom to hire and what to make. Households resources through the decide which firms to work for and what to buy with their incomes. These firms decentralized decisions and households interact in the marketplace, where prices and self-interest guide of many firms and house- their decisions. holds as they interact in At first glance, the success of market economies is puzzling. In a market econ- markets for goods and omy, no one is looking out for the economic well-being of society as a whole. Free services markets contain many buyers and sellers of numerous goods and services, and all of them are interested primarily in their own well-being. Yet despite decentral- ized decision making and self-interested decision makers, market economies have proven remarkably successful in organizing economic activity to promote overall economic well-being. In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, economist Adam Smith made the most famous observation in all of economics: Households and firms interacting in markets act as if they are guided by an “in- visible hand” that leads them to desirable market outcomes. One of our goals in this book is to understand how this invisible hand works its magic. As you study economics, you will learn that prices are the instrument with which the invisible hand directs economic activity. In any market, buyers look at Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 10 PART I InTRoduCTIon the price when determining how much to demand, and sellers look at the price when deciding how much to supply. As a result of the decisions that buyers and sellers make, market prices reflect both the value of a good to society and the cost to society of making the good. Smith’s great insight was that prices adjust to guide these individual buyers and sellers to reach outcomes that, in many cases, maximize the well-being of society as a whole. Smith’s insight has an important corollary: When a government prevents prices from adjusting naturally to supply and demand, it impedes the invisible hand’s ability to coordinate the decisions of the households and firms that make up an economy. This corollary explains why taxes adversely affect the allocation of resources: They distort prices and thus the decisions of households and firms. It also explains the great harm caused by policies that directly control prices, such as rent control. And it explains the failure of communism. In communist countries, prices were not determined in the marketplace but were dictated by central plan- ners. These planners lacked the necessary information about consumers’ tastes and producers’ costs, which in a market economy is reflected in prices. Central planners failed because they tried to run the economy with one hand tied behind their backs—the invisible hand of the marketplace. FY I Adam Smith and the Invisible Hand I t may be only a coincidence that Adam Smith’s great book The Wealth of Nations was published in 1776, the exact year in which American revolu- tionaries signed the Declaration of Independence. But the two documents It is not from the benevolence of the butcher, the brewer, or share a point of view that was prevalent at the time: Individuals are usu- the baker that we expect ally best left to their own devices, without the heavy hand of government our dinner, but from their guiding their actions. This political philosophy provides the intellectual regard to their own inter- basis for the market economy and for free society more generally. est. We address ourselves, not Why do decentralized market economies work so well? Is it because to their humanity but to their self-love, and never talk to them of our own people can be counted on to treat one another with love and kindness? necessities but of their advantages. Nobody but a beggar chooses to de- Not at all. Here is Adam Smith’s description of how people interact in a pend chiefly upon the benevolence of his fellow-citizens.... market economy: Every individual... neither intends to promote the public interest, nor knows how much he is promoting it.... He intends only his own Man has almost constant occasion for the help of his brethren, and it is gain, and he is in this, as in many other cases, led by an invisible hand in vain for him to expect it from their benevolence only. He will be more to promote an end which was no part of his intention. Nor is it always likely to prevail if he can interest their the worse for the society that it was no part of it. By pursuing his own self-love in his favour, and show interest he frequently promotes that of the society more effectually them that it is for their own advan- than when he really intends to promote it. tage to do for him what he requires of them.... Give me that which I Smith is saying that participants in the economy are motivated by want, and you shall have this which self-interest and that the “invisible hand” of the marketplace guides you want, is the meaning of every this self-interest into promoting general economic well-being. BETTMANN/CORBIS such offer; and it is in this manner Many of Smith’s insights remain at the center of modern econom- that we obtain from one another the ics. Our analysis in the coming chapters will allow us to express Smith’s far greater part of those good offices conclusions more precisely and to analyze more fully the strengths and Adam Smith which we stand in need of. weaknesses of the market’s invisible hand. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 1 TEn PRInCIPlEs of EConomICs 11 ADAM SMITH WOULD HAVE LOVED UBER CASE You have probably never lived in a centrally planned economy, but STUDY if you have ever tried to hail a cab in a major city, you have likely experienced a highly regulated market. In many cities, the local gov- ernment imposes strict controls in the market for taxis. The rules usually go well beyond regulation of insurance and safety. For example, the government may limit entry into the market by approving only a certain number of taxi medallions or permits. It may determine the prices that taxis are allowed to charge. The gov- ernment uses its police powers—that is, the threat of fines or jail time—to keep unauthorized drivers off the streets and to prevent all drivers from charging un- authorized prices. Recently, however, this highly controlled market has been invaded by a disrup- tive force: Uber. Launched in 2009, this company provides an app for smartphones RICHARD LEVINE / ALAMY that connects passengers and drivers. Because Uber cars do not roam the streets looking for taxi-hailing pedestrians, they are technically not taxis and so are not subject to the same regulations. But they offer much the same service. Indeed, rides from Uber cars are often more convenient. On a cold and rainy day, who wants to stand on the side of the road waiting for an empty cab to drive by? It is more pleas- ant to remain inside, use your smartphone to arrange for a ride, and stay warm and Technology can improve this dry until the car arrives. market. Uber cars often charge less than taxis, but not always. Uber allows drivers to raise their prices significantly when there is a surge in demand, such as during a sudden rainstorm or late on New Year’s Eve, when numerous tipsy partiers are looking for a safe way to get home. By contrast, regulated taxis are typically pre- vented from surge pricing. Not everyone is fond of Uber. Drivers of traditional taxis complain that this new competition eats into their source of income. This is hardly a surprise: Suppliers of goods and services usually dislike new competitors. But vigorous competition among producers makes a market work well for consumers. That is why economists love Uber. A 2014 survey of several dozen prominent economists asked whether car services such as Uber increased consumer well- being. Yes, said every single economist. The economists were also asked whether surge pricing increased consumer well-being. Yes, said 85 percent of them. Surge pricing makes consumers pay more at times, but because Uber drivers respond to incentives, it also increases the quantity of car services supplied when they are most needed. Surge pricing also helps allocate the services to those consum- ers who value them most highly and reduces the costs of searching and waiting for a car. If Adam Smith were alive today, he would surely have the Uber app on his phone. 1-2c Principle 7: Governments Can Sometimes Improve Market Outcomes If the invisible hand of the market is so great, why do we need government? One purpose of studying economics is to refine your view about the proper role and scope of government policy. property rights One reason we need government is that the invisible hand can work its magic the ability of an individ- only if the government enforces the rules and maintains the institutions that are ual to own and exercise key to a market economy. Most important, market economies need institutions control over scarce to enforce property rights so individuals can own and control scarce resources. resources Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 12 PART I InTRoduCTIon A farmer won’t grow food if she expects her crop to be stolen; a restaurant won’t serve meals unless it is assured that customers will pay before they leave; and a film company won’t produce movies if too many potential customers avoid paying by making illegal copies. We all rely on government-provided police and courts to enforce our rights over the things we produce—and the invisible hand counts on our ability to enforce those rights. Another reason we need government is that, although the invisible hand is powerful, it is not omnipotent. There are two broad rationales for a government to intervene in the economy and change the allocation of resources that people would choose on their own: to promote efficiency or to promote equality. That is, most policies aim either to enlarge the economic pie or to change how the pie is divided. Consider first the goal of efficiency. Although the invisible hand usually leads markets to allocate resources to maximize the size of the economic pie, market failure this is not always the case. Economists use the term market failure to refer to a a situation in which a situation in which the market on its own fails to produce an efficient allocation market left on its own of resources. As we will see, one possible cause of market failure is an exter- fails to allocate resources nality, which is the impact of one person’s actions on the well-being of a by- efficiently stander. The classic example of an externality is pollution. When the production of a good pollutes the air and creates health problems for those who live near externality the factories, the market left to its own devices may fail to take this cost into ac- the impact of one per- count. Another possible cause of market failure is market power, which refers to son’s actions on the the ability of a single person or firm (or a small group) to unduly influence mar- well-being of a bystander ket prices. For example, if everyone in town needs water but there is only one market power well, the owner of the well is not subject to the rigorous competition with which the ability of a single the invisible hand normally keeps self-interest in check; she may take advantage economic actor (or small of this opportunity by restricting the output of water so she can charge a higher group of actors) to have a price. In the presence of externalities or market power, well-designed public substantial influence on policy can enhance economic efficiency. market prices Now consider the goal of equality. Even when the invisible hand yields efficient outcomes, it can nonetheless leave sizable disparities in economic well-being. A market economy rewards people according to their ability to pro- duce things that other people are willing to pay for. The world’s best basketball player earns more than the world’s best chess player simply because people are willing to pay more to watch basketball than chess. The invisible hand does not ensure that everyone has sufficient food, decent clothing, and adequate health- care. This inequality may, depending on one’s political philosophy, call for gov- ernment intervention. In practice, many public policies, such as the income tax and the welfare system, aim to achieve a more equal distribution of economic well-being. To say that the government can improve on market outcomes does not mean that it always will. Public policy is made not by angels but by a political process that is far from perfect. Sometimes policies are designed simply to reward the politically powerful. Sometimes they are made by well-intentioned leaders who are not fully informed. As you study economics, you will become a better judge of when a government policy is justifiable because it promotes efficiency or equality and when it is not. Why is a country better off not isolating itself from all other countries? QuickQuiz Why do we have markets, and according to economists, what roles should government play in them? Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 1 TEn PRInCIPlEs of EConomICs 13 1-3 How the Economy as a Whole Works We started by discussing how individuals make decisions and then looked at how people interact with one another. All these decisions and interactions together make up “the economy.” The last three principles concern the workings of the economy as a whole. 1-3a Principle 8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services The differences in living standards around the world are staggering. In 2014, the average American had an income of about $55,000. In the same year, the average Mexican earned about $17,000, the average Chinese about $13,000, and the aver- age Nigerian only $6,000. Not surprisingly, this large variation in average income is reflected in various measures of quality of life. Citizens of high-income coun- tries have more TV sets, more cars, better nutrition, better healthcare, and a longer life expectancy than citizens of low-income countries. Changes in living standards over time are also large. In the United States, incomes have historically grown about 2 percent per year (after adjusting for changes in the cost of living). At this rate, average income doubles every 35 years. Over the past century, average U.S. income has risen about eightfold. What explains these large differences in living standards among countries and over time? The answer is surprisingly simple. Almost all variation in living stan- dards is attributable to differences in countries’ productivity—that is, the amount productivity of goods and services produced by each unit of labor input. In nations where the quantity of goods and workers can produce a large quantity of goods and services per hour, most peo- services produced from ple enjoy a high standard of living; in nations where workers are less produc- each unit of labor input tive, most people endure a more meager existence. Similarly, the growth rate of a nation’s productivity determines the growth rate of its average income. The fundamental relationship between productivity and living standards is sim- ple, but its implications are far-reaching. If productivity is the primary determinant of living standards, other explanations must be of secondary importance. For example, it might be tempting to credit labor unions or minimum-wage laws for the rise in living standards of American workers over the past century. Yet the real hero of American workers is their rising productivity. As another example, some commentators have claimed that increased competition from Japan and other countries explained the slow growth in U.S. incomes during the 1970s and 1980s. Yet the real villain was not competition from abroad but flagging productivity growth in the United States. The relationship between productivity and living standards also has profound implications for public policy. When thinking about how any policy will affect liv- ing standards, the key question is how it will affect our ability to produce goods and services. To boost living standards, policymakers need to raise productivity by ensuring that workers are well educated, have the tools they need to produce goods and services, and have access to the best available technology. 1-3b Principle 9: Prices Rise When the Government Prints Too Much Money In January 1921, a daily newspaper in Germany cost 0.30 marks. Less than two years later, in November 1922, the same newspaper cost 70,000,000 marks. All inflation other prices in the economy rose by similar amounts. This episode is one of his- an increase in the over- tory’s most spectacular examples of inflation, an increase in the overall level of all level of prices in the prices in the economy. economy Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  14 PART I InTRoduCTIon Although the United States has never experienced inflation even close to that of Germany in the 1920s, inflation has at times been an economic problem. During the 1970s, for instance, when the overall level of prices more than doubled, Presi- dent Gerald Ford called inflation “public enemy number one.” By contrast, infla- TRIBUNE MEDIA SERVICES, INC. ALL RIGHTS RESERVED. REPRINTED WITH PERMISSION. tion in the first decade of the 21st century ran about 2½ percent per year; at this rate, it would take almost 30 years for prices to double. Because high inflation imposes various costs on society, keeping inflation at a low level is a goal of eco- nomic policymakers around the world. What causes inflation? In almost all cases of large or persistent inflation, the culprit is growth in the quantity of money. When a government creates large quan- tities of the nation’s money, the value of the money falls. In Germany in the early 1920s, when prices were on average tripling every month, the quantity of money “Well it may have been was also tripling every month. Although less dramatic, the economic history of 68 cents when you got the United States points to a similar conclusion: The high inflation of the 1970s in line, but it’s 74 cents was associated with rapid growth in the quantity of money, and the return of low now!” inflation in the 1980s was associated with slower growth in the quantity of money. 1-3c Principle 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment Although a higher level of prices is, in the long run, the primary effect of increas- ing the quantity of money, the short-run story is more complex and controversial. Most economists describe the short-run effects of monetary injections as follows: Increasing the amount of money in the economy stimulates the overall level of spending and thus the demand for goods and services. Higher demand may over time cause firms to raise their prices, but in the meantime, it also encourages them to hire more workers and produce a larger quantity of goods and services. More hiring means lower unemployment. This line of reasoning leads to one final economy-wide trade-off: a short-run trade-off between inflation and unemployment. Although some economists still question these ideas, most accept that society faces a short-run trade-off between inflation and unemployment. This simply means that, over a period of a year or two, many economic policies push inflation and un- employment in opposite directions. Policymakers face this trade-off regardless of whether inflation and unemployment both start out at high levels (as they did in the early 1980s), at low levels (as they did in the late 1990s), or someplace in between. business cycle This short-run trade-off plays a key role in the analysis of the business cycle—the fluctuations in economic irregular and largely unpredictable fluctuations in economic activity, as measured activity, such as employ- by the production of goods and services or the number of people employed. ment and production Policymakers can exploit the short-run trade-off between inflation and un- employment using various policy instruments. By changing the amount that the government spends, the amount it taxes, and the amount of money it prints, pol- icymakers can influence the overall demand for goods and services. Changes in demand in turn influence the combination of inflation and unemployment that the economy experiences in the short run. Because these instruments of economic policy are potentially so powerful, how policymakers should use them to control the economy, if at all, is a subject of continuing debate. This debate heated up in the early years of Barack Obama’s presidency. In 2008 and 2009, the U.S. economy, as well as many other economies around the world, experi- enced a deep economic downturn. Problems in the financial system, caused by bad Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 1 TEn PRInCIPlEs of EConomICs 15 bets on the housing market, spilled over into the rest of the economy, causing incomes to fall and unemployment to soar. Policymakers responded in various ways to increase the overall demand for goods and services. President Obama’s first major initiative was a stimulus package of reduced taxes and increased government spending. At the same time, the nation’s central bank, the Federal Reserve, increased the supply of money. The goal of these policies was to reduce unemployment. Some feared, how- ever, that these policies might over time lead to an excessive level of inflation. List and briefly explain the three principles that describe how the econ- QuickQuiz omy as a whole works. 1-4 Conclusion You now have a taste of what economics is all about. In the coming chapters, we develop many specific insights about people, markets, and economies. Mastering these insights will take some effort, but it is not an overwhelming task. The field of economics is based on a few big ideas that can be applied in many different situations. Throughout this book, we will refer back to the Ten Principles of Economics high- lighted in this chapter and summarized in Table 1. Keep these building blocks in mind: Even the most sophisticated economic analysis is founded on the ten prin- ciples introduced here. TABLE 1 How People Make Decisions 1: People Face Trade-offs Ten Principles of 2: The Cost of Something Is What You Give Up to Get It Economics 3: Rational People Think at the Margin 4: People Respond to Incentives How People Interact 5: Trade Can Make Everyone Better Off 6: Markets Are Usually a Good Way to Organize Economic Activity 7: Governments Can Sometimes Improve Market Outcomes How the Economy as a Whole Works 8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services 9: Prices Rise When the Government Prints Too Much Money 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment CHAPTER QuickQuiz 1. Economics is best defined as the study of 2. Your opportunity cost of going to a movie is a. how society manages its scarce resources. a. the price of the ticket. b. how to run a business most profitably. b. the price of the ticket plus the cost of any soda c. how to predict inflation, unemployment, and stock and popcorn you buy at the theater. prices. c. the total cash expenditure needed to go to the d. how the government can stop the harm from movie plus the value of your time. unchecked self-interest. d. zero, as long as you enjoy the movie and consider it a worthwhile use of time and money. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 16 PART I InTRoduCTIon 3. A marginal change is one that 5. Governments may intervene in a market economy in a. is not important for public policy. order to b. incrementally alters an existing plan. a. protect property rights. c. makes an outcome inefficient. b. correct a market failure due to externalities. d. does not influence incentives. c. achieve a more equal distribution of income. 4. Adam Smith’s “invisible hand” refers to d. All of the above. a. the subtle and often hidden methods that busi- 6. If a nation has high and persistent inflation, the most nesses use to profit at consumers’ expense. likely explanation is b. the ability of free markets to reach desirable a. the central bank creating excessive amounts of outcomes, despite the self-interest of market money. participants. b. unions bargaining for excessively high wages. c. the ability of government regulation to benefit con- c. the government imposing excessive levels of taxation. sumers, even if the consumers are unaware of the d. firms using their monopoly power to enforce exces- regulations. sive price hikes. d. the way in which producers or consumers in unregulated markets impose costs on innocent bystanders. SUMMARY The fundamental lessons about individual decision way of coordinating economic activity among people, making are that people face trade-offs among alter- and that the government can potentially improve mar- native goals, that the cost of any action is measured ket outcomes by remedying a market failure or by pro- in terms of forgone opportunities, that rational people moting greater economic equality. make decisions by comparing marginal costs and mar- The fundamental lessons about the economy as a ginal benefits, and that people change their behavior in whole are that productivity is the ultimate source response to the incentives they face. of living standards, that growth in the quantity of The fundamental lessons about interactions among money is the ultimate source of inflation, and that people are that trade and interdependence can be society faces a short-run trade-off between inflation mutually beneficial, that markets are usually a good and unemployment. KEY CONCEPTS scarcity, p. 4 marginal change, p. 6 market power, p. 12 economics, p. 4 incentive, p. 7 productivity, p. 13 efficiency, p. 5 market economy, p. 9 inflation, p. 13 equality, p. 5 property rights, p. 11 business cycle, p. 14 opportunity cost, p. 6 market failure, p. 12 rational people, p. 6 externality, p. 12 QUESTIONS FOR REVIEW 1. Give three examples of important trade-offs that you 4. Why should policymakers think about incentives? face in your life. 5. Why isn’t trade among countries like a game with 2. What items would you include to figure out the some winners and some losers? opportunity cost of a vacation to Disney World? 6. What does the “invisible hand” of the marketplace 3. Water is necessary for life. Is the marginal benefit of a do? glass of water large or small? Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 1 TEn PRInCIPlEs of EConomICs 17 7. What are the two main causes of market failure? Give 9. What is inflation and what causes it? an example of each. 10. How are inflation and unemployment related in the 8. Why is productivity important? short run? PROBLEMS AND APPLICATIONS 1. Describe some of the trade-offs faced by each of the 7. Explain whether each of the following government following: activities is motivated by a concern about equality or a a. a family deciding whether to buy a new car concern about efficiency. In the case of efficiency, dis- b. a member of Congress deciding how much to cuss the type of market failure involved. spend on national parks a. regulating cable TV prices c. a company president deciding whether to open a b. providing some poor people with vouchers that new factory can be used to buy food d. a professor deciding how much to prepare for c. prohibiting smoking in public places class d. breaking up Standard Oil (which once owned e. a recent college graduate deciding whether to go 90 percent of all oil refineries) into several smaller to graduate school companies 2. You are trying to decide whether to take a vacation. e. imposing higher personal income tax rates on Most of the costs of the vacation (airfare, hotel, and people with higher incomes forgone wages) are measured in dollars, but the ben- f. instituting laws against driving while intoxicated efits of the vacation are psychological. How can you 8. Discuss each of the following statements from the compare the benefits to the costs? standpoints of equality and efficiency. 3. You were planning to spend Saturday working at your a. “Everyone in society should be guaranteed the part-time job, but a friend asks you to go skiing. What best healthcare possible.” is the true cost of going skiing? Now suppose you had b. “When workers are laid off, they should be able been planning to spend the day studying at the library. to collect unemployment benefits until they find a What is the cost of going skiing in this case? Explain. new job.” 4. You win $100 in a basketball pool. You have a choice 9. In what ways is your standard of living different from between spending the money now and putting it that of your parents or grandparents when they were away for a year in a bank account that pays 5 percent your age? Why have these changes occurred? interest. What is the opportunity cost of spending the 10. Suppose Americans decide to save more of their in- $100 now? comes. If banks lend this extra saving to businesses, 5. The company that you manage has invested $5 million which use the funds to build new factories, how might in developing a new product, but the development is this lead to faster growth in productivity? Who do you not quite finished. At a recent meeting, your salespeo- suppose benefits from the higher productivity? Is soci- ple report that the introduction of competing products ety getting a free lunch? has reduced the expected sales of your new product to 11. During the Revolutionary War, the American colonies $3 million. If it would cost $1 million to finish devel- could not raise enough tax revenue to fully fund the opment and make the product, should you go ahead war effort. To make up the difference, the colonies and do so? What is the most that you should pay to decided to print more money. Printing money to cover complete development? expenditures is sometimes referred to as an “inflation 6. A 1996 bill reforming the federal government’s anti- tax.” Who do you think is being “taxed” when more poverty programs limited many welfare recipients to money is printed? Why? only two years of benefits. a. How does this change affect the incentives for working? b. How might this change represent a trade-off To find additional study resources, visit cengagebrain.com, between equality and efficiency? and search for “Mankiw.” Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER Thinking Like an Economist 2 E very field of study has its own language and its own way of thinking. Mathematicians talk about axioms, integrals, and vector spaces. Psychologists talk about ego, id, and cognitive dissonance. Lawyers talk about venue, torts, and promissory estoppel. Economics is no different. Supply, demand, elasticity, comparative advantage, consumer surplus, deadweight loss—these terms are part of the economist’s lan- guage. In the coming chapters, you will encounter many new terms and some familiar words that economists use in specialized ways. At first, this new language may seem needlessly arcane. But as you will see, its value lies in its ability to provide you with a new and useful way of thinking about the world in which you live. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  20 PART I INTRODUCTION The purpose of this book is to help you learn the economist’s way of thinking. Just as you cannot become a mathematician, psychologist, or lawyer overnight, learning to think like an economist will take some time. Yet with a combination of theory, case studies, and examples of economics in the news, this book will give you ample opportunity to develop and practice this skill. Before delving into the substance and details of economics, it is helpful to have an overview of how economists approach the world. This chapter discusses the field’s methodology. What is distinctive about how economists confront a question? What does it mean to think like an economist? 2-1 The Economist as Scientist Economists try to address their subject with a scientist’s objectivity. They approach the study of the economy in much the same way a physicist approaches the study of matter and a biologist approaches the study of life: They devise theories, collect data, and then analyze these data in an attempt to verify or refute their theories. To beginners, the claim that economics is a science can seem odd. After all, © J.B. HANDELSMAN/ THE NEW YORKER COLLECTION/ economists do not work with test tubes or telescopes. The essence of science, however, is the scientific method—the dispassionate development and testing of theories about how the world works. This method of inquiry is as applicable to studying a nation’s economy as it is to studying the earth’s gravity or a species’ evolution. As Albert Einstein once put it, “The whole of science is nothing more WWW.CARTOONBANK.COM than the refinement of everyday thinking.” Although Einstein’s comment is as true for social sciences such as economics as it is for natural sciences such as physics, most people are not accustomed to look- ing at society through a scientific lens. Let’s discuss some of the ways economists apply the logic of science to examine how an economy works. “I’m a social scientist, 2-1a The Scientific Method: Observation, Michael. That means Theory, and More Observation I can’t explain electricity Isaac Newton, the famous 17th-century scientist and mathematician, allegedly or anything like that, became intrigued one day when he saw an apple fall from a tree. This observation but if you ever want motivated Newton to develop a theory of gravity that applies not only to an apple to know about people, falling to the earth but to any two objects in the universe. Subsequent testing of I’m your man.” Newton’s theory has shown that it works well in many circumstances (albeit not in all circumstances, as Einstein would later show). Because Newton’s theory has been so successful at explaining observation, it is still taught in undergraduate physics courses around the world. This interplay between theory and observation also occurs in economics. An economist might live in a country experiencing rapidly increasing prices and be moved by this observation to develop a theory of inflation. The theory might assert that high inflation arises when the government prints too much money. To test this theory, the economist could collect and analyze data on prices and money from many different countries. If growth in the quantity of money were completely unrelated to the rate of price increase, the economist would start to doubt the validity of this theory of inflation. If money growth and inflation were strongly correlated in international data, as in fact they are, the economist would become more confident in the theory. Although economists use theory and observation like other scientists, they face an obstacle that makes their task especially challenging: In economics, Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 2 THINkINg LIkE AN ECONOmIsT 21 conducting experiments is often impractical. Physicists studying gravity can drop many objects in their laboratories to generate data to test their theories. By contrast, economists studying inflation are not allowed to manipulate a nation’s monetary policy simply to generate useful data. Economists, like astronomers and evolutionary biologists, usually have to make do with whatever data the world happens to give them. To find a substitute for laboratory experiments, economists pay close attention to the natural experiments offered by history. When a war in the Middle East inter- rupts the supply of crude oil, for instance, oil prices skyrocket around the world. For consumers of oil and oil products, such an event depresses living standards. For economic policymakers, it poses a difficult choice about how best to respond. But for economic scientists, the event provides an opportunity to study the effects of a key natural resource on the world’s economies. Throughout this book, there- fore, we consider many historical episodes. These episodes are valuable to study because they give us insight into the economy of the past and, more important, because they allow us to illustrate and evaluate economic theories of the present. 2-1b The Role of Assumptions If you ask a physicist how long it would take a marble to fall from the top of a ten-story building, he will likely answer the question by assuming that the mar- ble falls in a vacuum. Of course, this assumption is false. In fact, the building is surrounded by air, which exerts friction on the falling marble and slows it down. Yet the physicist will point out that the friction on the marble is so small that its effect is negligible. Assuming the marble falls in a vacuum simplifies the problem without substantially affecting the answer. Economists make assumptions for the same reason: Assumptions can sim- plify the complex world and make it easier to understand. To study the effects of international trade, for example, we might assume that the world consists of only two countries and that each country produces only two goods. In reality, there are numerous countries, each of which produces thousands of different types of goods. But by considering a world with only two countries and two goods, we can focus our thinking on the essence of the problem. Once we understand inter- national trade in this simplified imaginary world, we are in a better position to understand international trade in the more complex world in which we live. The art in scientific thinking—whether in physics, biology, or economics— is deciding which assumptions to make. Suppose, for instance, that instead of dropping a marble from the top of the building, we were dropping a beach ball of the same weight. Our physicist would realize that the assumption of no fric- tion is less accurate in this case: Friction exerts a greater force on the beach ball because it is much larger than a marble. The assumption that gravity works in a vacuum is reasonable when studying a falling marble but not when studying a falling beach ball. Similarly, economists use different assumptions to answer different questions. Suppose that we want to study what happens to the economy when the govern- ment changes the number of dollars in circulation. An important piece of this analysis, it turns out, is how prices respond. Many prices in the economy change infrequently: The newsstand prices of magazines, for instance, change only once every few years. Knowing this fact may lead us to make different assumptions when studying the effects of the policy change over different time horizons. For studying the short-run effects of the policy, we may assume that prices do not change much. We may even make the extreme and artificial assumption that Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 22 PART I INTRODUCTION all prices are completely fixed. For studying the long-run effects of the policy, however, we may assume that all prices are completely flexible. Just as a physicist uses different assumptions when studying falling marbles and falling beach balls, economists use different assumptions when studying the short-run and long-run effects of a change in the quantity of money. 2-1c Economic Models High school biology teachers teach basic anatomy with plastic replicas of the human body. These models have all the major organs—the heart, the liver, the kidneys, and so on—which allow teachers to show their students very simply how the important parts of the body fit together. Because these plastic models are stylized and omit many details, no one would mistake one of them for a real person. Despite this lack of realism—indeed, because of this lack of realism— studying these models is useful for learning how the human body works. Economists also use models to learn about the world, but unlike plastic manikins, their models mostly consist of diagrams and equations. Like a biology teacher’s plastic model, economic models omit many details to allow us to see what is truly important. Just as the biology teacher’s model does not include all the body’s muscles and capillaries, an economist’s model does not include every feature of the economy. As we use models to examine various economic issues throughout this book, you will see that all the models are built with assumptions. Just as a physicist begins the analysis of a falling marble by assuming away the existence of friction, economists assume away many details of the economy that are irrelevant to the question at hand. All models—in physics, biology, and economics—simplify real- ity to improve our understanding of it. 2-1d Our First Model: The Circular-Flow Diagram The economy consists of millions of people engaged in many activities—buying, sell- ing, working, hiring, manufacturing, and so on. To understand how the economy works, we must find some way to simplify our thinking about all these activities. In other words, we need a model that explains, in general terms, how the economy is organized and how participants in the economy interact with one another. circular-flow diagram Figure 1 presents a visual model of the economy called a circular-flow diagram. a visual model of the In this model, the economy is simplified to include only two types of decision economy that shows makers—firms and households. Firms produce goods and services using inputs, how dollars flow through such as labor, land, and capital (buildings and machines). These inputs are called markets among the factors of production. Households own the factors of production and consume households and firms all the goods and services that the firms produce. Households and firms interact in two types of markets. In the markets for goods and services, households are buyers, and firms are sellers. In particular, households buy the output of goods and services that firms produce. In the markets for the fac- tors of production, households are sellers, and firms are buyers. In these markets, households provide the inputs that firms use to produce goods and services. The circular-flow diagram offers a simple way of organizing the economic transac- tions that occur between households and firms in the economy. The two loops of the circular-flow diagram are distinct but related. The inner loop represents the flows of inputs and outputs. The households sell the use of their labor, land, and capital to the firms in the markets for the factors of pro- duction. The firms then use these factors to produce goods and services, which in turn are sold to households in the markets for goods and services. The outer Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203  CHAPTER 2 THINkINg LIkE AN ECONOmIsT 23 FIGURE 1 MARKETS Revenue FOR Spending The Circular Flow GOODS AND SERVICES This diagram is a schematic representa- Goods Firms sell Goods and tion of the organization of the economy. and services Households buy services Decisions are made by households and sold bought firms. Households and firms interact in the markets for goods and services (where households are buyers and firms are sellers) FIRMS HOUSEHOLDS and in the markets for the factors of Produce and sell Buy and consume production (where firms are buyers and goods and services goods and servic