Ten Principles of Economics PDF

2 part I Introduction The management of society’s resources is important because resources are scarce. scarcity Scar...

2 part I Introduction The management of society’s resources is important because resources are scarce. scarcity Scarcity means that society has limited resources and therefore cannot produce all the limited nature of the goods and services people wish to have. Just as each member of a household society’s resources 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 the study of how society societies, resources are allocated not by an all-powerful dictator but through the manages its scarce combined 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 interact with one another. For instance, they examine how the many 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 a sense 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, our first four principles concern individual 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, playing video games, or working at her part-time job for some extra spending money. Consider parents deciding how to spend their family income. They can buy food, clothing, or a family vacation. Or they can save some of their income for retirement or their 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 itself from foreign aggressors, the less it can spend on consumer goods (butter) to raise its standard of living. Also important Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch01_hr_001-016.indd 2 has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:08 am  CHAPTER 1 Ten Principles of Economics 3 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 earning smaller profits, paying lower wages, charging higher prices, or doing some combination of these three. Thus, while pollution regulations yield a cleaner environment and the improved health that comes with it, this benefit comes at the cost of reducing the well-being 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. the property of society Equality means that those benefits are distributed uniformly among society’s getting the most it can ­members. In other words, efficiency refers to the size of the economic pie, and from its scarce resources equality refers to how the pie is divided into individual slices. equality When government policies are designed, these two goals often conflict. Consider, the property of for instance, policies aimed at equalizing the distribution of economic well-being. distributing economic Some of these policies, such as the welfare system or unemployment insurance, try prosperity uniformly to help the members of society who are most in need. Others, such as the individual among the members income tax, ask the financially successful to contribute more than others to sup- of society port the government. Though these policies achieve greater equality, they 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 shrinks. 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 regulations would reduce our material standard of living. The government should not ignore the poor just because helping them would distort work incentives. Nonetheless, people are likely to make good decisions only if they understand the options available to them. Our study of economics, therefore, starts by acknowl- edging 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. This calculation has two problems. First, it includes some things that are not really costs of going to college. Even if you quit school, you need a place to sleep and food to eat. Room and board are costs of going to college only to the extent that they exceed the cost of living and eating at home or in your own apartment. Second, this calculation 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 and earning money. For most students, the earnings they give up to attend school are the largest cost of their education. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch01_hr_001-016.indd 3 has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:08 am  4 part I Introduction 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 take into account the opportunity up to obtain some item costs of each possible action. In fact, they usually do. College athletes who can earn millions dropping out of school and playing professional sports are well aware that their opportunity cost of attending college is very high. Not surprisingly, 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 systemati- people who systematically cally 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 product to make and sell to their objectives maximize profits. You will also encounter individuals who decide how much time to spend working and what goods and services to buy with the resulting income to achieve the highest possible level of satisfaction. Rational people know that decisions in life are rarely black and white but often involve shades of gray. At dinnertime, you don’t ask yourself “Should I fast or eat like a pig?” More likely, the question you face is “Should I take that extra spoon- ful 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 playing video games. Economists use the term marginal change marginal change to describe a small incremental adjustment to an existing plan of a small incremental action. Keep in mind that margin means “edge,” so marginal changes are adjust- adjustment to a plan ments around the edges of what you are doing. Rational people make decisions by of action comparing marginal benefits and marginal costs. For example, suppose you are considering watching a movie tonight. You pay $40 a month for a movie streaming service that gives you unlimited access to its film library, and you typically watch 8 movies a month. What cost should you take into account when deciding whether to stream another movie? You might at first think the answer is $40/8, or $5, which is the average cost of a movie. More relevant for your decision, however, is the marginal cost—the extra cost that you would incur by streaming another film. Here, the marginal cost is zero because you pay the same $40 for the service regardless of how many movies you stream. In other words, at the margin, streaming a movie is free. The only cost of watching a movie tonight is the time it takes away from other activities, such as working at a job or (better yet) reading this textbook. Thinking at the margin also works for business decisions. 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. The average cost of each seat is $500 ($100,000/200). One might be tempted to conclude that the air- line should never sell a ticket for less than $500. But 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 and the small bit of jet fuel needed to carry the extra passenger’s weight. As long as the standby passenger pays more than the marginal cost, selling the ticket is profitable. Thus, a rational airline can increase profits by thinking at the margin. Marginal decision making can explain some otherwise puzzling phenom- ena. Here is a classic question: Why is water so cheap, while diamonds are so Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch01_hr_001-016.indd 4 has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:08 am  CHAPTER 1 Ten Principles of Economics 5 expensive? Humans need water to survive, while diamonds are unnecessary. Yet people are willing to pay much more for a dia- mond than for a cup of water. The reason is that a person’s will- REDPIXEL.PL/Shutterstock.com ingness to pay for a good is based on the marginal benefit that an extra unit of the good would yield. The marginal benefit, 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, the marginal benefit of an extra diamond is large. A rational decision maker takes an action if and only if the action’s marginal benefit exceeds its marginal cost. This principle Many movie streaming services set the explains why people use their movie streaming services as much ­marginal cost of a movie equal to zero. as they do, why airlines are willing to sell tickets below average cost, and why people pay more for diamonds than for water. It can take some time to get used to the logic of marginal thinking, but the study of economics will give you ample opportunity to practice. 1-1d Principle 4: People Respond to Incentives An incentive is something that induces a person to act, such as the prospect of a incentive punishment or reward. Because rational people make decisions by comparing costs something that induces a and benefits, they respond to incentives. You will see that incentives play a central person to act 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 incentives. The rest is commentary.” Incentives are key to analyzing how markets work. For example, when the price of apples 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, live closer to where they work, or switch to hybrid or electric cars. When policymakers fail to consider how their policies affect incentives, they often face unintended consequences. For example, consider public policy regard- ing auto safety. Today, all cars have seat belts, but this was not true 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 likelihood of surviving an auto accident rises. But that’s not the end of the story. The law also affects behavior by altering incen- tives. The relevant behavior here is the speed and care with which drivers operate 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, perhaps Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch01_hr_001-016.indd 5 has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:08 am  6 part I Introduction 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 attentively 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 by reducing the risk 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 specula- tion. 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 not only 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 policy, 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. QuickQuiz 1. Economics is best defined as the study of 3. A marginal change is one that a. how society manages its scarce resources. a. is not important for public policy. b. how to run a business most profitably. b. incrementally alters an existing plan. c. how to predict inflation, unemployment, and c. makes an outcome inefficient. stock prices. d. does not influence incentives. d. how the government can stop the harm from 4. Because people respond to incentives, unchecked self-interest. a. policymakers can alter outcomes by changing 2. Your opportunity cost of going to a movie is punishments or rewards. a. the price of the ticket. b. policies can have unintended consequences. b. the price of the ticket plus the cost of any soda c. society faces a trade-off between efficiency and and popcorn you buy at the theater. equality. c. the total cash expenditure needed to go to the d. All of the above. movie plus the value of your time. d. zero, as long as you enjoy the movie and consider it a worthwhile use of time and money. Answers at end of chapter. 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. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch01_hr_001-016.indd 6 has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:08 am  CHAPTER 1 Ten Principles of Economics 7 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 firms and Chinese firms pro- duce many of the same goods. Companies in the United States and China compete FROM THE WALL STREET JOURNAL - PERMISSION, 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 CARTOON FEATURES SYNDICATE one side wins and the other side loses. The opposite is true: Trade between two countries can make each country better off. To see why, consider how trade affects your family. When a member of your fam- ily 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 shopping because each family wants to buy the best goods at the lowest prices. In a sense, each family in an economy competes with all other families. Despite this competition, your family would not be better off isolating itself from “For $5 a week you can all other families. If it did, your family would need to grow its own food, sew its watch baseball without own clothes, and build its own home. Clearly, your family gains much from being being nagged to cut the able to trade with others. Trade allows each person to specialize in the activities she grass!” does best, whether it is farming, sewing, or home building. By trading with others, people can buy a greater variety of goods and services at lower cost. Like families, countries also benefit from being able to trade with one another. Trade allows countries to specialize in what they do best and to enjoy a greater 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 planners 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 well-being for the country as a whole. Most countries that once had centrally planned economies have abandoned the system and instead have adopted market economies. In a market economy, the market economy decisions of a central planner are replaced by the decisions of millions of firms and an economy that households. Firms decide whom to hire and what to make. Households decide allocates resources which firms to work for and what to buy with their incomes. These firms and through the decentralized households interact in the marketplace, where prices and self-interest guide their decisions of many firms decisions. and households as they At first glance, the success of market economies is puzzling. In a market economy, interact in markets for no one is looking out for the well-being of society as a whole. Free markets contain goods and services many buyers and sellers of numerous goods and services, and all of them are inter- ested primarily in their own well-being. Yet despite decentralized decision making and self-interested decision makers, market economies have proven remarkably successful in organizing economic activity to promote overall prosperity. 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: Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch01_hr_001-016.indd 7 has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:08 am  8 part I Introduction Households and firms interacting in markets act as if they are guided by an “invis- ible 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 the price when deciding how much to demand, and sellers look at the price when deciding how much to supply. As a result of these decisions, 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 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 problems caused by policies that 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 planners. These planners lacked the necessary information about consumers’ tastes and producers’ costs, which in a market economy is reflected in prices. Central plan- ners failed because they tried to run the economy with one hand tied behind their backs—the invisible hand of the marketplace. 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 revo- lutionaries signed the Declaration of Independence. But the two docu- the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. ments share a point of view that was prevalent at the time: Individuals It is not from the benevolence of the butcher, the brewer, or the are usually best left to their own devices, without the heavy hand of baker that we expect our dinner, but from their regard to their own government directing their actions. This political philosophy provides interest. We address ourselves, not to their humanity but to their the intellectual foundation for the market economy and for a free society self-love, and never talk to them of our own necessities but of their more generally. advantages. Nobody but a beggar chooses to depend chiefly upon Why do decentralized market economies work well? Is it because the benevolence of his fellow-citizens.... people can be counted on to treat one another with love and kindness? Every individual... neither intends to promote the public inter- Not at all. Here is Adam Smith’s description of how people interact in a est, nor knows how much he is promoting it.... He intends only market economy: his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his inten- Photographs Division[ LC-USZ62-17407] Man has almost constant occa- tion. Nor is it always the worse for the society that it was no part of sion for the help of his brethren, it. By pursuing his own interest he frequently promotes that of the Library of Congress Prints and and it is in vain for him to expect society more effectually than when he really intends to promote it. it from their benevolence only. He will be more likely to prevail if he Smith is saying that participants in the economy are motivated by self- can interest their self-love in his interest and that the “invisible hand” of the marketplace guides this favour, and show them that it is self-interest into promoting general economic well-being. for their own advantage to do for Many of Smith’s insights remain at the center of modern econom- him what he requires of them.... ics. Our analysis in the coming chapters will allow us to express Smith’s Give me that which I want, and you conclusions more precisely and to analyze more fully the strengths and Adam Smith. shall have this which you want, is weaknesses of the market’s invisible hand. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch01_hr_001-016.indd 8 has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:08 am  CHAPTER 1 Ten Principles of Economics 9 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 per- mits. It may determine the prices that taxis are allowed to charge. The government uses its police p ­ owers—that is, the threat of fines or jail time—to keep unauthor- ized drivers off the streets and prevent drivers from charging unauthorized prices. Richard Levine/Alamy Stock Photo In 2009, however, this highly controlled market was invaded by a disruptive force: Uber, a company that provides a smartphone app to connect 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 pleasant to remain inside, use your smartphone to arrange a ride, and stay warm and dry until the car arrives. Uber cars often charge less than taxis, but not always. Uber’s prices rise signifi- Technology can improve cantly when there is a surge in demand, such as during a sudden rainstorm or late this market. on New Year’s Eve, when numerous tipsy partiers are looking for a safe way to get home. By contrast, regulated taxis are typically prevented from surge pricing. Not everyone is fond of Uber. Drivers of traditional taxis complain that this new competition cuts into their source of income. This is hardly a surprise: Suppliers of goods and services often 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. Every single economist said “Yes.” 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 consumers 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. One reason we need government is that the invisible hand can work its magic only if the government enforces the rules and maintains the institutions that are key to a market economy. Most important, market economies need institutions to enforce ­property rights so individuals can own and control scarce resources. A farmer won’t property rights grow food if she expects her crop to be stolen; a restaurant won’t serve meals unless it is the ability of an assured that customers will pay before they leave; and a film company won’t produce individual to own and movies if too many potential customers avoid paying by making illegal copies. We all exercise control over rely on government-provided police and courts to enforce our rights over the things scarce resources 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 pow- erful, it is not omnipotent. There are two broad rationales for a government to Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch01_hr_001-016.indd 9 has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:08 am  10 part I Introduction 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, this is not market failure always the case. Economists use the term market failure to refer to a situation in a situation in which a which the market on its own fails to produce an efficient allocation of resources. market left on its own As we will see, one possible cause of market failure is an externality, which is fails to allocate resources the impact of one person’s actions on the well-being of a bystander. The classic efficiently example of an externality is pollution. When the production of a good pollutes the air and creates health problems for those who live near the factories, the market externality on its own may fail to take this cost into account. Another possible cause of market the impact of one failure is market power, which refers to the ability of a single person or firm (or a person’s actions on the small group of them) to unduly influence market prices. For example, if everyone well-being of a bystander in town needs water but there is only one well, the owner of the well does not face market power the rigorous competition with which the invisible hand normally keeps self-interest the ability of a single in check; she may take advantage of this opportunity by restricting the output of economic actor (or small water so she can charge a higher price. In the presence of externalities or market group of actors) to have a power, well-designed public policy can enhance economic efficiency. substantial influence on Now consider the goal of equality. Even when the invisible hand yields efficient market prices outcomes, it can nonetheless leave sizable disparities in economic well-being. A market economy rewards people according to their ability to produce 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 healthcare. This inequality may, depending on one’s political philosophy, call for government intervention. In prac- tice, 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 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 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. QuickQuiz 5. International trade benefits a nation when c. the ability of government regulation to benefit a. its revenue from selling abroad exceeds its consumers even if the consumers are unaware of outlays from buying abroad. the regulations. b. its trading partners experience reduced economic d. the way in which producers or consumers in well-being. unregulated markets impose costs on innocent c. all nations are specializing in producing what bystanders. they do best. 7. Governments may intervene in a market economy in d. no domestic jobs are lost because of trade. order to 6. Adam Smith’s “invisible hand” refers to a. protect property rights. a. the subtle and often hidden methods that b. correct a market failure due to externalities. businesses use to profit at consumers’ expense. c. achieve a more equal distribution of income. b. the ability of free markets to reach desirable d. All of the above. outcomes, despite the self-interest of market participants. Answers at end of chapter. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch01_hr_001-016.indd 10 has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:08 am  CHAPTER 1 Ten Principles of Economics 11 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 2017, the average American earned about $60,000. In the same year, the average German earned about $51,000, the average Chinese about $17,000, and the average 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 countries have more computers, more cars, better nutrition, better healthcare, and a longer life expec- tancy than do 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 people services produced from enjoy a high standard of living; in nations where workers are less productive, most each unit of labor input people endure a more meager existence. Similarly, the growth rate of a nation’s productivity determines the growth rate of its average income. The relationship between productivity and living standards is simple, but its implications are far-reaching. If productivity is the primary determinant of living standards, other explanations must be less important. For example, it might be tempting to credit labor unions or minimum-wage laws for the rise in living stan- dards 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 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 2 years later, in November 1922, the same newspaper cost 70,000,000 marks. All other inflation prices in the economy rose by similar amounts. This episode is one of history’s an increase in the overall most spectacular examples of inflation, an increase in the overall level of prices in level of prices in the the economy. economy Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch01_hr_001-016.indd 11 has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 10:08 am  12 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 a problem. During the 1970s, TRIBUNE MEDIA SERVICES, INC. ALL RIGHTS the overall level of prices more than doubled, and President Gerald Ford called RESERVED. REPRINTED WITH PERMISSION. inflation “public enemy number one.” By contrast, inflation in the two decades of the 21st century has run about 2 percent per year; at this rate, it takes 35 years for prices to double. Because high inflation imposes various costs on society, keeping inflation at a reasonable rate is a goal of economic 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 quantities of the nation’s money, the value of the money falls. In Germany in the early 1920s, when prices were on average tripling every month, the quantity of “Well it may have been money was also tripling every month. Although less dramatic, the economic his- 68 cents when you got tory of the United States points to a similar conclusion: The high inflation of the in line, but it’s 74 cents 1970s was associated with rapid growth in the quantity of money, and the return now!” of low 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 While an increase in the quantity of money primarily raises prices in the long run, the short-run story is more complex. Most economists describe the short-run effects of money growth 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 unemployment in opposite directions. Policymakers face this trade-off regard­ less 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 business cycle between. This short-run trade-off plays a key role in the analysis of the business fluctuations in cycle—the irregular and largely unpredictable fluctuations in economic activity, economic activity, such as measured by the production of goods and services or the number of people as employment and employed. production Policymakers can exploit the short-run trade-off between inflation and unem- ployment using various policy instruments. By changing the amount that the government spends, the amount it taxes, and the amount of money it prints, ­policymakers can 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 so powerful, how policymakers should use them to control the economy, if at all, is a subject of continuing debate. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cenga