Economics Stiglitz

ECONOMICSF O U R T H E D I T I O N

Joseph E. StiglitzC O L U M B I A U N I V E R S I T Y

Carl E.WalshU N I V E R S I T Y O F C A L I F O R N I A , S A N TA C R U Z

ECONOMICSF O U R T H E D I T I O NB

W. W. NORTON & COMPANYNEW YORK LONDON

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Library of Congress Cataloging-in Publication Data

Stiglitz, Joseph E.

Economics / Joseph E. Stiglitz, Carl E. Walsh.4th ed.

p. cm.

Includes index.

ISBN 0-393-92622-2

1. Economics. I. Walsh, Carl E. II. Title

HB171.5.S884 2005

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ABOUT THE AUTHORS

Joseph E. Stiglitz is professor of economics, business, and international andpublic affairs at Columbia University. Before joining the Columbia faculty, he heldappointments at Yale, Oxford, Princeton, and Stanford. Internationally recognizedas one of the leading economists of his generation, Professor Stiglitz has made impor-tant contributions to virtually all of the major subfields of economics, in particularthe economics of information, one of the key topics highlighted in this text. He wasa co-recipient of the Nobel Prize in Economic Science in 2001, and earlier in hiscareer received the American Economic Associations John Bates Clark Medal,which is given every two years to the most outstanding economist under the age offorty. Professor Stiglitz is the author and editor of hundreds of scholarly articlesand books, including the best-selling undergraduate textbook Economics of the PublicSector (Norton) and, with Anthony Atkinson, the classic graduate textbook Lecturesin Public Economics. He is the author of two influential popular books as well:Globalization and Its Discontents and The Roaring Nineties. In addition, he was thefounding editor of the Journal of Economic Perspectives. Professor Stiglitz has alsoplayed a prominent role at the highest levels of economic policy making. He was amember and chairman of President Clintons Council of Economic Advisers andlater served as Senior Vice President and Chief Economist of the World Bank.

Carl E.Walsh is professor of economics at the University of California, SantaCruz, where he teaches principles of economics. He previously held faculty appoint-ments at Princeton and the University of Auckland, New Zealand, and has been a vis-iting professor at Stanford. He is widely known for his research in monetary economicsand is the author of a leading graduate text, Monetary Theory and Policy (MIT Press).Before joining the Santa Cruz faculty, Professor Walsh was senior economist at theFederal Reserve Bank of San Francisco, where he continues to serve as a visitingscholar. He has also been a visiting scholar at the Federal Reserve Banks of KansasCity, Philadelphia, and at the Board of Governors. He has taught courses in mone-tary economics to the research department and staff economists at the central banksof Hong Kong, Norway, Portugal, Spain, and the United Kingdom, and at theInternational Monetary Fund. He is a past member of the board of editors of theAmerican Economic Review and is currently an associate editor of the Journal ofMoney, Credit, and Banking and the Journal of Economics and Business. He is also onthe editorial board of the Journal of Macroeconomics.

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CONTENTS IN BRIEF

vii

PART 1 INTRODUCTION 1Chapter 1 Modern Economics 3Chapter 2 Thinking Like an Economist 25

PART 2 PERFECT MARKETS 51Chapter 3 Demand, Supply, and Price 53Chapter 4 Using Demand and Supply 77Chapter 5 The Consumption Decision 101Chapter 6 The Firms Costs 131Chapter 7 The Competitive Firm 155Chapter 8 Labor Markets 175Chapter 9 Capital Markets 191Chapter 10 The Efficiency of Competitive Markets 215

PART 3 IMPERFECT MARKETS 237Chapter 11 Introduction to Imperfect Markets 239Chapter 12 Monopoly, Monopolistic Competition, and Oligopoly 261Chapter 13 Government Policies Toward Competition 289Chapter 14 Strategic Behavior 311Chapter 15 Imperfect Information in the Product Market 333Chapter 16 Imperfections in the Labor Market 355

PART 4 ISSUES IN PUBLIC POLICY 373Chapter 17 The Public Sector 375Chapter 18 Environmental Economics 405Chapter 19 International Trade and Trade Policy 423Chapter 20 Technological Change 453

PART 5 INTRODUCTION TO MACROECONOMICS 471Chapter 21 Macroeconomics and the Economic Perspective 473Chapter 22 Measuring Output and Unemployment 485Chapter 23 The Cost of Living and Inflation 509

PART 6 FULL-EMPLOYMENT MACROECONOMICS 523Chapter 24 The Full-Employment Model 525Chapter 25 Government Finance at Full Employment 547Chapter 26 The Open Economy at Full Employment 567Chapter 27 Growth and Productivity 585Chapter 28 Money, the Price Level, and the Federal Reserve 605

PART 7 MACROECONOMIC FLUCTUATIONS 635Chapter 29 Introduction to Macroeconomic Fluctuations 637Chapter 30 Aggregate Expenditures and Income 661Chapter 31 Aggregate Demand and Inflation 689Chapter 32 The Federal Reserve and Interest Rates 715Chapter 33 The Role of Macroeconomic Policy 727

PART 8 THE GLOBAL ECONOMY 755Chapter 34 The International Financial System 757Chapter 35 Policy in the Open Economy 779Chapter 36 Development and Transition 793

PART 9 FURTHER TOPICS IN MACROECONOMICS 817Chapter 37 Inflation and Unemployment 819Chapter 38 Controversies in Macroeconomic Policy 837Chapter 39 A Students Guide to Investing 865

viii

CONTENTS ix

CONTENTS

PREFACE XXXV

PART 1 INTRODUCTION 1

CHAPTER 1 MODERN ECONOMICS 3INTERNET CONNECTION: Tracking the Digital

Economy 6

What Is Economics? 6

Trade-offs 7

Incentives 8

THINKING LIKE AN ECONOMIST: Incentives and

the Price of AOL 9

Exchange 10

INTERNET CONNECTION: Auction Sites 11

Information 13

Distribution 14

The Three Major Markets 15

Keeping Track of Tricky Terms 16

Microeconomics and Macroeconomics: The Two

Branches of Economics 17

The Science of Economics 18

Discovering and Interpreting Relationships 18

Causation and Correlation 19

Why Economists Disagree 19

REVIEW AND PRACTICE 21

CHAPTER 2 THINKING LIKE AN ECONOMIST 25The Basic Competitive Model 25

Rational Consumers and Profit-Maximizing Firms 26

Competitive Markets 27

e-INSIGHT: Markets, Exchange, and e-Commerce 27

Efficiency and Distribution in the Basic Competitive

Model 28

The Basic Competitive Model as a Benchmark 28

Incentives and Information: Prices, Property Rights, and

Profits 29

Incentives Versus Equality 31

When Property Rights Fail 31

Alternatives to the Price System 32

Opportunity Sets and Trade-Offs 34

Budget and Time Constraints 34

The Production Possibilities Curve 35

Costs 37

Opportunity Costs 38

THINKING LIKE AN ECONOMIST: Trade-Offs 39

INTERNET CONNECTION: Internet Resources for

Economists 40

CASE IN POINT: The Opportunity Cost of Attending

College 40

Sunk Costs 42

Marginal Costs 43

INTERNET CONNECTION: The Economists Voice

43


APPENDIX: Reading Graphs 47

Slope 48

Interpreting Curves 49

PART 2 PERFECT MARKETS 51

CHAPTER 3 DEMAND, SUPPLY, AND PRICE 53The Role of Prices 53

Demand 54

The Individual Demand Curve 54

The Market Demand Curve 55

Shifts in Demand Curves 57

x CONTENTS

Sources of Shifts in Demand Curves 57

CASE IN POINT: Gasoline Prices and the Demand for

SUVs 59

Shifts in a Demand Curve Versus Movements along a

Demand Curve 60

FUNDAMENTALS OF DEMAND, SUPPLY, AND

PRICE 1: Demand Declines as Price Rises 61

Supply 61

e-INSIGHT: The Demand for Computers and

Information Technology 62

Market Supply 64

Shifts in Supply Curves 65

Sources of Shifts in Supply Curves 65

Shifts in a Supply Curve Versus Movements along a

Supply Curve 67


PRICE 2: Supply Increases as Price Rises 67

Law of Supply and Demand 67

Using Demand and Supply Curves 69

Consensus on the Determination of Prices 70


PRICE 3: The Market Clears at the Equilibrium

Price 71

Price, Value, and Cost 70

INTERNET CONNECTION: The Demand and Supply

in the Oil Market 71


CHAPTER 4 USING DEMAND AND SUPPLY 77The Price Elasticity of Demand 77

Price Elasticity and Revenues 79

The Determinants of the Elasticity of Demand 80

The Price Elasticity of Supply 82

INTERNATIONAL PERSPECTIVE: Comparing

Reactions to the Oil Price Shock of 2000 83

Using Demand and Supply Elasticities 85

Shortages and Surpluses 88

Interfering with the Law of Supply and Demand 90


the Window Tax 90

Price Ceilings 91

CASE IN POINT: Rent Control in New York City 93

CONTENTS xi

Price Floors 93

INTERNET CONNECTION: Flawed Deregulation 94

Alternative Solutions 94


APPENDIX: Elasticity and Slope 98

CHAPTER 5 THE CONSUMPTION DECISION 101The Basic Problem of Consumer Choice 101

The Budget Constraint 102

Choosing a Point on the Budget Constraint: Individual

Preferences 104

What Happens to Consumption When Income Changes?

105

CASE IN POINT: The Fate of the BTU Tax 107

INTERNET CONNECTION: What We Consume 109

A Closer Look at the Demand Curve 109

Deriving Demand Curves 110

The Importance of Distinguishing Between Income and

Substitution Effects 111

THINKING LIKE AN ECONOMIST: Incentives,

Income Effects, and Substitution Effects 112

Utility and the Description of Preferences 113

Consumer Surplus 117

Looking Beyond the Basic Model 118

How Well Do the Underlying Assumptions Match Reality?

118

Behavioral Economics 119


APPENDIX: Indifference Curves and the Consumption

Decision 124

Using Indifference Curves to Illustrate Consumer Choices

124

Indifference Curves and Marginal Rates of Substitution

126

Using Indifference Curves to Illustrate Choices 127

Using Indifference Curves to Derive Demand Curves 128

Substitution and Income Effects 128

CHAPTER 6 THE FIRMS COSTS 131Profits, Costs, and Factors of Production 132

Production with One Variable Input 132

Types of Costs and Cost Curves 135

xii CONTENTS

Short-Run and Long-Run Cost Curves 141

Short-Run Cost Curves 142

Long-Run Cost Curves 142

INTERNET CONNECTION: Economic Definitions

146

Production with Many Factors 146

Cost Minimization 147

The Principle of Substitution 147

CASE IN POINT: The Principle of Substitution and

Global Warming 148

Economies of Scope 150


CHAPTER 7 THE COMPETITIVE FIRM 155Revenue 155

Costs 156

INTERNET CONNECTION: Firms Profit-and-Loss

Statements 157

Basic Conditions of Competitive Supply 158

Entry, Exit, and Market Supply 160

Sunk Costs and Exit 161

The Firms Supply Curve 162

The Market Supply Curve 163

Long-Run Versus Short-Run Supply 164

e-INSIGHT: The 2001 Recession: Cutbacks Versus

Shutdowns 165

Accounting Profits and Economic Profits 166


Economic Rent 168

CASE IN POINT: Entering the Painting Business and


The Theory of the Competitive Firm 171


CHAPTER 8 LABOR MARKETS 175The Labor Supply Decision 175

INTERNET CONNECTION: Labor Force Data 176

The Choice Between Leisure and Consumption 176

Labor Force Participation 179

THINKING LIKE AN ECONOMIST: Trade-Offs 179

Firms and the Demand for Labor 181

Factor Demand 182

CONTENTS xiii

From the Firms Factor Demand to the Markets Factor

Demand 184

Labor Supply, Demand, and the Equilibrium Wage 184


APPENDIX: Indifference Curves and the Labor Supply

Decision 188

Deciding Whether to Work 188

CHAPTER 9 CAPITAL MARKETS 191Supply in the Capital Market 191

The Household Decision to Save 192

THINKING LIKE AN ECONOMIST: Wealth

Distribution and Interest Rates 197

INTERNET CONNECTION: Household Saving 198

CASE IN POINT: Why is the U.S. Saving Rate So Low?

198

Demand in the Capital Market 200

A Behavioral Perspective on Saving 202

Education and Human Capital 203

e-INSIGHT: Financing the New Economy 205

Education and Economic Trade-Offs 206

The Basic Competitive Model 206


APPENDIX A: Indifference Curves and the Saving

Decision 209

Deciding How Much to Save 209

Changing the Interest Rate 210

APPENDIX B: Calculating Present Discounted Value 211

CHAPTER 10 THE EFFICIENCY OF COMPETITIVEMARKETS 215Competitive Markets and Economic Efficiency 216

Consumer and Producer Surplus 217

FUNDAMENTALS OF COMPETITIVE MARKETS 1:

Households and Firms are Price Takers 218


The Equilibrium Price Maximizes Consumer Plus

Producer Surplus 219

INTERNET CONNECTION: Digital Economist 219

Taxes and Efficiency 220

Efficiency 221

Pareto Efficiency 222

xiv CONTENTS

Conditions for the Pareto Efficiency of the Market

Economy 222

THINKING LIKE AN ECONOMIST: Exchange and

Distribution 224

Competitive Markets and Pareto Efficiency 225


The Competitive Market Economy is Pareto

Efficient 225

Competitive Markets and Income Distribution 225

General Equilibrium Analysis 227

The Basic Competitive Equilibrium Model 227

THINKING LIKE AN ECONOMIST: Indirect Trade-

Offs and Air Safety for Children 228

CASE IN POINT: The Labor Market and the Widening

Wage Gap 230

CASE IN POINT: The Minimum Wage and General

Equilibrium 231

General Equilibrium Over Time 232

When Partial Equilibrium Analysis Will Do 234

Looking Beyond the Basic Model 234


PART 3 IMPERFECT MARKETS 237

CHAPTER 11 INTRODUCTION TO IMPERFECTMARKETS 239Extending the Basic Competitive Model 240

FUNDAMENTALS OF IMPERFECT MARKETS 1:

Imperfect Markets Lead to Market Failures 242

Imperfect Competition and Market Structure 242

Price and Quantity with Imperfect Competition 244

Government Policies 245

INTERNET CONNECTION: The Federal Trade

Commission 245

INTERNATIONAL PERSPECTIVE: Trade and

Competition 246


Imperfect Competition 246

Imperfect Information 247

The Information Problem 247

How Big a Problem? 247

CONTENTS xv

How Prices Convey Information 248

Markets for Information 249

e-INSIGHT: Information, Competition, and the Internet

249

Government Policies 250


Imperfect Information 251

Externalities 252

Government Policies Toward Externalities 252


the Environment 253


Externalities 254

Public Goods 254


Public Goods 255

Looking Ahead 256


CHAPTER 12 MONOPOLY, MONOPOLISTICCOMPETITION, AND OLIGOPOLY261Monopoly Output 261

An Example: The ABC-ment Company 264

Monopoly Profits 265

Price Discrimination 266

Economies of Scale and Natural Monopolies 267

INTERNATIONAL PERSPECTIVE: South Africa,

AIDS, and Price Discrimination 268

Assessing the Degree of Competition 270

Number of Firms in the Industry 270

Product Differentiation 271

e-INSIGHT: Network Externalities, the New Economy,

and Monopoly Power 272

Equilibrium with Monopolistic Competition 273

Oligopolies 274

Collusion 275

Restrictive Practices 279

Entry Deterrence 281

INTERNET CONNECTION: Keeping Track of

Oligopolies 281

xvi CONTENTS

THINKING LIKE AN ECONOMIST: Trade-Offs,

American Airlines, and Predation 283

The Importance of Imperfections in Competition 284


CHAPTER 13 GOVERNMENT POLICIES TOWARDCOMPETITION 289The Drawbacks of Monopolies and Limited Competition

289

Restricted Output 289

Managerial Slack 291

Reduced Research and Development 291

Rent Seeking 292

Further Drawbacks of Limited Competition 292

e-INSIGHT: Using the Internet to Enhance Price

Discrimination 293

Policies Toward Natural Monopolies 293

Public Ownership 294

Regulation 295

Encouraging Competition 296

INTERNATIONAL PERSPECTIVE: The Darker Side of

Privatization 296

CASE IN POINT: California Electricity Deregulation

298

Antitrust Policies 299

Limiting Market Domination 300

Defining Markets 301

INTERNET CONNECTION: U.S. Department of

Justice and Antitrust Laws 301


the Remedy to the Microsoft Monopoly Problem

302

Curbing Restrictive Practices 304

Enforcing the Antitrust Laws 305

CASE IN POINT: Coke and Pepsi Play Merger 306


CHAPTER 14 STRATEGIC BEHAVIOR 311Review of the Prisoners Dilemma 312

Dominant Strategies 313

CONTENTS xvii

Nash Equilibrium 313

Strategic Behavior in More General Games 316

Games With Only One Dominant Strategy 316

INTERNATIONAL PERSPECTIVE: Beggar-Thy-

Neighbor Tariff Policies 317

Games Without Dominant Strategies 318

INTERNET CONNECTION: The Zero-Sum Game

Solver 319

Repeated Games 320

Reputations 321

Tit for Tat 321

INTERNET CONNECTION: The Prisoners Dilemma

321

Institutions 322

CASE IN POINT: Banking Panics 322

Sequential Moves 324

THINKING LIKE AN ECONOMIST: Information and

Thinking Strategically 326

Time Inconsistency 326

Commitment 327


CHAPTER 15 IMPERFECT INFORMATION IN THEPRODUCT MARKET 333The Market for Lemons and Adverse Selection 333

Signaling 335

Judging Quality by Price 336

The Incentive Problem 337

Market Solutions 337

Contract Solutions 338

Reputation Solutions 339

The Market for Health Insurance 340

CASE IN POINT: Buying Health Insurance 341

The Search Problem 342

THINKING LIKE AN ECONOMIST: Incentive and

Information Problems in the Housing Market

343

e-INSIGHT: Information Technology and Middlemen

344

INTERNET CONNECTION: Job Search 345

Search and Imperfect Competition 345

Search and the Labor Market 346

xviii CONTENTS

Search and Information Intermediaries 346

Advertising 347

Advertising and Competition 348

Advertising and Profits 348

The Importance of Imperfect Information 350


CHAPTER 16 IMPERFECTIONS IN THE LABOR MARKET 355Labor Unions 355

A Brief History 356

INTERNET CONNECTION: Unions on the Internet

358

Economic Effects 359

Limits on Union Power 360

Wage Differentials 362

Discrimination 363

Motivating Workers 364

Piece Rates and Incentives 365

Efficiency Wages 366

CASE IN POINT: Minimum Wages 367

Other Incentives 368

Compensating Workers 368

e-INSIGHT: Labor Markets and the Internet 369


PART 4 ISSUES IN PUBLIC POLICY373

CHAPTER 17 THE PUBLIC SECTOR 375Why Does the Government Intervene in the Economy?

377

INTERNATIONAL PERSPECTIVE:The Size of

Government in Different Countries 377

Equity-Efficiency Trade-Offs 380

e-INSIGHT: The New Economy and Inequality 381

The U.S. Tax System in Practice 381

CONTENTS xix

Characteristics of a Good Tax System 382

The Scope of the U.S. Tax System 383

Grading the U.S. Tax System 383

Transfers 386

Welfare 387

Housing 388

Social Insurance 389

Designing Government Programs 390

Government Failures 391

Incentives and Constraints 392

Budgeting and Spending Procedures 393

Imperfections of Information 393

Collective Decision Making 394

Current and Recent Controversies in the Economics of

the Public Sector 395

Dealing With the Deficit 395

Social Security 396

Health Care 398

INTERNET CONNECTION: Policy Analysis 400


CHAPTER 18 ENVIRONMENTAL ECONOMICS 405Negative Externalities and Oversupply 405

Policy Responses to Problems in the Environment 407

Property Rights Responses 407

INTERNATIONAL PERSPECTIVE: Global Warming

408

THINKING LIKE AN ECONOMIST: Environmental

and Economic Trade-Offs 410

Regulation 410

Taxes and Subsidies 412

The Marketable Permit Response 413

CASE IN POINT: Reducing Acid Rain 414

Weighing the Alternative Approaches 415

Natural Resources 416

INTERNET CONNECTION: The National Center for

Environmental Economics 416

e-INSIGHT: Information and the Environment 418

Merit Goods and the Environment 418


xx CONTENTS

CHAPTER 19 INTERNATIONAL TRADE AND TRADEPOLICY 423Trade Between Countries 423

Interdependence in the Product Market 424

Interdependence in the Labor Market 424

Interdependence in the Capital Market 425

Multilateral Trade 425

Comparative Advantage 426

INTERNET CONNECTION: David Ricardo 427

Production Possibilities Curves and Comparative

Advantage 427

Comparative Advantage and Specialization 428

e-INSIGHT: The United States Comparative Advantage

in the Internet Age 429

What Determines Comparative Advantage? 430

The Perceived Costs of International Interdependence

432

THINKING LIKE AN ECONOMIST: Exchange and

the Globalization Controversy 432

Trade Policies 434

Commercial Policy 434

Tariffs 435

Quotas 436

Voluntary Export Restraints 436

Other Nontariff Barriers 437

Fair Trade Laws 437

INTERNATIONAL PERSPECTIVE: Surrogate

Countries and Canadian Golf Carts 438

Political and Economic Rationale for Protection 439

Displaced Firms and Workers 440

Beggar-Thy-Neighbor Policies 441

Wages in Affected Sectors 442

Increased Competition 442

THINKING LIKE AN ECONOMIST: Distribution and

Trade Liberalization 443

The Infant Industry Argument 443

e-INSIGHT: Trade Liberalization in Information

Technology and Financial Services 444

Strategic Trade Theory 445

International Cooperation 445

GATT and the WTO 445

CONTENTS xxi

The Growing Protest Against the WTO 446

CASE IN POINT: The Banana War 447

Regional Trading Blocs 448

INTERNET CONNECTION: The World Trade

Organization 449


CHAPTER 20 TECHNOLOGICAL CHANGE 453Links Between Technological Change and Imperfect

Competition 454

e-INSIGHT: The New Economy and Innovation 455

Patents and the Production of Ideas 455

THINKING LIKE AN ECONOMIST: Intellectual

Property Rights and Distribution 456

The Trade-Off Between Short-term Efficiency and

Innovation 457

CASE IN POINT: Eli Whitney and the Cotton Gin 460

R & D as a Fixed Cost 460

Learning by Doing 461

Access to Capital Markets 462

Schumpeterian Competition 463

Basic Research as a Public Good 464

Government Promotion of Technological Progress 465

Subsidies 465

Protection 466

Relaxing Antitrust Policies 466

INTERNET CONNECTION: Competitiveness 468

Technological Change and Economic Growth 468


PART 5 INTRODUCTION TOMACROECONOMICS 471

CHAPTER 21 MACROECONOMICS AND THEECONOMIC PERSPECTIVE 473The Commitment to Full Employment and Growth 474

Getting the Country Moving Again 477

Stagflation 477

The Conquest of Inflation 478

xxii CONTENTS

Government Deficits and Trade Deficits 479

Getting the Economy Moving (Again) 479

New Challenges 480

The Three Key Goals of Macroeconomic Performance 481

A Look Ahead 482


CHAPTER 22 MEASURING OUTPUT ANDUNEMPLOYMENT 485Measuring Output and Growth 485

Gross Domestic Product 486

Measuring GDP: The Value of Output 489

INTERNET CONNECTION: The Bureau of Economic

Analysis 489

CASE IN POINT: Is Software a Final Good or an

Intermediate Good? 491

Potential GDP 494

INTERNATIONAL PERSPECTIVE: What Gets

Measured in the GDP? 495

Problems in Measuring Output 496

Measuring the Standard of Living 497

A Green GDP 497

Unemployment 498

Unemployment Statistics 499

Forms of Unemployment 500

Output Gaps and the Natural Rate of Unemployment 503

Flows and Stocks 505


CHAPTER 23 THE COST OF LIVING AND INFLATION 509The Costs of Inflation 509

Who Suffers from Inflation 510

The Economy 511

The Costs of Deflation 512

CASE IN POINT: Hyperinflation in Germany in the

1920s 512

Measuring Inflation 514

INTERNET CONNECTION: Improving Our Measure

of the CPI 516

CASE IN POINT: The Price Index Makes a Difference

516

CONTENTS xxiii

Alternative Measures of Inflation 517

INTERNET CONNECTION: The Inflation Calculator

517

e-INSIGHT: Measuring the Price and Quantity of

Software 518

The American Experience with Inflation 519


PART 6 FULL-EMPLOYMENTMACROECONOMICS 523

CHAPTER 24 THE FULL-EMPLOYMENT MODEL 525Macroeconomic Equilibrium 526

The Labor Market 527

Shifts in the Demand and Supply of Labor 529

CASE IN POINT: Mass Migration in the Nineteenth

Century 531

e-INSIGHT: Labor Markets and the Internet 532

The Product Market 532

Potential GDP 533

Demand and Equilibrium Output 534

The Capital Market 536

Household Saving 536

Investment 537

Equilibrium in the Capital Market 538

The General Equilibrium Model 540

Using the General Equilibrium Model 541


CHAPTER 25 GOVERNMENT FINANCE AT FULLEMPLOYMENT 547The Composition of Spending and Taxes 548

Extending the Basic Full-Employment Model 548

Adding the Government 549

The Government and the Capital Market 549

Leakages and Injections 554

INTERNATIONAL PERSPECTIVE: Deficits in Other

Countries 555

THINKING LIKE AN ECONOMIST: Distribution,

Deficits and Intergenerational Transfers 556

xxiv CONTENTS

Evaluating Government Deficits and Surpluses 557

Government Deficits and Surpluses: Our Recent

Experiences 558

Factors Affecting the Federal Budget 561

Risk Factors for the Federal Budget 562


CHAPTER 26 THE OPEN ECONOMY AT FULLEMPLOYMENT 567The Open Economy 568

The Capital Market in the Open Economy 568

The Basic Trade Identity 572

INTERNET CONNECTION: U.S. Trade Data 573

CASE IN POINT: The Trade Deficit 574

e-INSIGHT: High-Tech Exports and Imports 576

Exchange Rates 577

THINKING LIKE AN ECONOMIST: Net Exports and

the Exchange Rate 579

Is the Trade Deficit a Problem? 580


CHAPTER 27 GROWTH AND PRODUCTIVITY 585Rising Standards of Living 586

Explaining Productivity 589

INTERNET CONNECTION: How Fast Is Modern

Economic Growth? 590

The Capital Stock and the Role of Saving and Investment

590

The Quality of the Labor Force 592

The Reallocation of Resources from Low- to High-

Productivity Sectors 592

Technological Change and the Role of Ideas 593

Total Factor Productivity: Measuring the Sources of

Growth 596

CASE IN POINT: Calculating Total Factor Productivity

in the 1990s 597

e-INSIGHT: Computers and Increased Productivity

Growth 598

FUNDAMENTALS OF GROWTH: Growth in the

Economys Labor Force, Growth in the Economys

Capital Stock, Technological Change 599

CONTENTS xxv

Are There Limits to Economic Growth? 600

THINKING LIKE AN ECONOMIST: Trade-Offs and

the Costs of Economic Growth 601


CHAPTER 28 MONEY, THE PRICE LEVEL, AND THEFEDERAL RESERVE 605Prices and Inflation 606

Money Demand 607

Money Supply 609

The Price Level 609

INTERNET CONNECTION: How Much Cash Do We

Hold? 610

The Financial System in Modern Economies 612

CASE IN POINT: When Atlanta Printed Money 614

Creating Money in Modern Economies 615

Money Is What Money Does 615

Measuring the Money Supply 617

Money and Credit 618

CASE IN POINT: Boggs Bills and the Meaning of

Money 619

The Money Supply and the Banks Balance Sheet 620

THINKING LIKE AN ECONOMIST: Exchange,

Money, and the Internet 620

How Banks Create Money 622

e-INSIGHT: Electronic Cash 623

The Federal Reserve 626

How the Fed Affects the Money Supply 628

INTERNET CONNECTION: The Federal Reserve

Banks and International Central Banks 629

The Stability of the U.S. Banking System 630

Reducing the Threat of Bank Runs 631


xxvi CONTENTS

PART 7 MACROECONOMICFLUCTUATIONS 635

CHAPTER 29 INTRODUCTION TOMACROECONOMIC FLUCTUATIONS637Economic Fluctuations 638

INTERNET CONNECTION: Dating Business Cycle

Peaks and Troughs 642

CASE IN POINT: Estimating the Output Costs of a

Recession 642

THINKING LIKE AN ECONOMIST: Employment

Fluctuations and Trade-Offs 643

Why Economies Experience Fluctuations 643

Nominal Versus Real Wages 645

The Slow Adjustment of Nominal Wages 645

The Slow Adjustment of Prices 645

THINKING LIKE AN ECONOMIST: Information and

Measuring the Business Cycle 647

Understanding Macroeconomic Fluctuations: Key

Concepts 648

Sticky Wages 649

FUNDAMENTALS OF FLUCTUATIONS 1: Sticky

Wages 649

Sticky Prices 649

e-INSIGHT: Cyclical and Structural Productivity 650

FUNDAMENTALS OF FLUCTUATIONS 2: Sticky

Prices 651

Inflation and Adjustment 652

FUNDAMENTALS OF FLUCTUATIONS 3: Short-Run

Inflation-Unemployment Trade-Off 653

Inflation, Monetary Policy, and Spending 653

FUNDAMENTALS OF FLUCTUATIONS 4: Inflation,

Monetary Policy, and Spending 655

CASE IN POINT: Inflation Targeting 655

Linking the Four Key Concepts 656


CONTENTS xxvii

CHAPTER 30 AGGREGATE EXPENDITURES ANDINCOME 661Income-Expenditure Analysis 661

The National Income-Output Identity 663

Equilibrium Output 663

Shifts in the Aggregate Expenditures Schedule 664

Mathematical Formulation 665

A Look Forward 666

Consumption 667

Disposable Income 667

Expectations of Future Income 671

Wealth 671

Investment 672

Investment and the Real Interest Rate 673

Inventory Investment 674

Macroeconomic Implications of Investment 675

Government Purchases 676

Net Exports 676

Exports 678

Imports 678

Macroeconomic Implications 679

Putting International Trade into the Equation 680

Calculating Equilibrium Output 681

Aggregate Expenditures and the Real Interest Rate

683


the Real After-Tax Rate of Interest 684


CHAPTER 31 AGGREGATE DEMAND ANDINFLATION 689The Real Interest Rate and the Capital Market 690

The Aggregate DemandInflation Curve 691

The Feds Policy Rule 692

What Can Shift the ADI Curve? 694

INTERNATIONAL PERSPECTIVE: How Do Other

Central Banks React to Inflation? 696

Other Factors That Can Shift the ADI Curve 696

Using the ADI Curve 697

Output Effects of a Shift in the ADI Curve 698

CASE IN POINT: The Volcker Disinflation 700

xxviii CONTENTS

An Expansionary Shift in the ADI Curve 701

CASE IN POINT: The Kennedy Tax Cut 701

THINKING LIKE AN ECONOMIST: Tough Trade-

Offs 703

Macroeconomic Policy and Shifts in the ADI Curve 703

Shifts in the Inflation Adjustment Curve 704

Changes in Energy Prices 704

CASE IN POINT: Oil Price Shocks of the 1970s 705

A Shift in Potential GDP 705

CASE IN POINT: The 1990s 707

e-INSIGHT: Productivity Growth and the Punch Bowl

708

INTERNET CONNECTION: The FOMC 710


CHAPTER 32 THE FEDERAL RESERVE AND INTERESTRATES 715The Federal Funds Market 715

A Day at the Trading Desk 716

The Demand for Reserves 718

The Supply of Reserves 719

Open Market Operations 719

Equilibrium in the Federal Funds Market 720

Monetary Policy Operating Procedures 721

Inflation, Money Supply, and the Nominal Rate of Interest

722


CHAPTER 33 THE ROLE OF MACROECONOMICPOLICY 727Inflation-Unemployment Trade-Offs 728

The Old Inflation-Unemployment Trade-Off 728

The New Trade-Off: Output StabilityInflation Stability

429

Fiscal Policy 729

Automatic Stabilizers 729

Discretionary Policy Actions 731

INTERNET CONNECTION: The Economic Report of

the President 732

The Full-Employment Deficit 733

CONTENTS xxix

INTERNATIONAL PERSPECTIVE: Fiscal Transfers

734

Monetary Policy 736

Behind the ADI CurveThe Role of Monetary Policy

736

INTERNET CONNECTION: The Beige Book 738

CASE IN POINT: Announcing the Feds Decisions 738

Real Interest Rates and Nominal Interest Rates 739

The Central Bank Policy Rule 740

THINKING LIKE AN ECONOMIST: Real Values

Matter for Incentives 742

CASE IN POINT: The Interest Rate Cut of January 3,

2001 743

CASE IN POINT: September 11, 2001 743

e-INSIGHT: The Dot-Com Bubble and Macroeconomic

Stability 744

The Position of the Policy Rule 745

The Slope of the Policy Rule 748

Interactions Between Monetary and Fiscal Policies 749


PART 8 THE GLOBAL ECONOMY755

CHAPTER 34 THE INTERNATIONAL FINANCIALSYSTEM 757Determining the Exchange Rate 758

Supply and Demand in the Foreign Exchange Market

759


the Real Exchange Rate 764

Exchange Rate Management 766

INTERNATIONAL PERSPECTIVE: Global Financial

Crises 770

Flexible Exchange Rate Systems 771

CASE IN POINT: Currency Boards and Dollarization

772


xxx CONTENTS

CHAPTER 35 POLICY IN THE OPEN ECONOMY779The ADI Curve and the Open Economy 780

Inflation, the Interest Rate, and the Exchange Rate 780

The Exchange Rate and Aggregate Expenditures 781

The Exchange Rate and Inflation 783

Imported Inputs 783

THINKING LIKE AN ECONOMIST: Interest Parity

and Incentives 784

Consumer Price Inflation and the Exchange Rate 784

INTERNET CONNECTION: Foreign Exchange Rates

785

Comparing Monetary and Fiscal Policies in the Open

Economy 785

Monetary Policy with Flexible Exchange Rates 785

e-INSIGHT: New Technology and the Integration of

World Financial Markets 786

Fiscal Policy with Flexible Exchange Rates 787

INTERNATIONAL PERSPECTIVE: Is a Strong Dollar

Good for the United States? 788

Policy Coordination 789


CHAPTER 36 DEVELOPMENT AND TRANSITION793Development 794

INTERNET CONNECTION: The World Banks

Development Goals 796

Life in a Less-Developed Country 797

The Success of East Asia 799

Alternative Development Strategies 802

Globalization and Development 803

CASE IN POINT: A Historical Perspective on

Globalization 804

e-INSIGHT: Indian Engineers in Silicon Valley and

Silicon Valleys Capital in India 806

The Prognosis for Development 807

Economies in Transition 808

The Communist Economic System 808

The Move Toward a Market Economy 810


CONTENTS xxxi

PART 9 FURTHER TOPICS INMACROECONOMICS 817

CHAPTER 37 INFLATION AND UNEMPLOYMENT819Short-Run Inflation Adjustment 820

The Role of Expectations: Shifts in the Short-Run Inflation

Adjustment Curve 824

THINKING LIKE AN ECONOMIST: Distributional

Effects of Inflation and Unemployment 826

CASE IN POINT: Nobel Views on Inflation and

Unemployment 827

INTERNET CONNECTION: Winners of the Nobel

Prize in Economics 829

Shifts in the Natural Rate 829

CASE IN POINT: The Baby Boomers and the Natural

Rate 829

Shifts in Potential GDP 830

Inflation Shocks 830

FUNDAMENTALS OF INFLATION: Cyclical

Unemployment, Expectations, Inflation Shocks 831

Combining the Aggregate DemandInflation and Inflation

Adjustment Curves 832


CHAPTER 38 CONTROVERSIES INMACROECONOMIC POLICY 837Do Deficits Matter? 838

Deficits and the Traditional View 839

Economic Consequences of Deficits and Surpluses 840

How Future Generations Are Affected by Government

Debt 840

Alternative Views 841

The Goals of Macroeconomic Policy 842

The Noninterventionist Perspective 844

THINKING LIKE AN ECONOMIST: Trade-Offs and

Choices 845

The Interventionist Perspective 847

Should the Federal Reserve Target Inflation? 848

Inflation Targeting and Policy Trade-Offs 849

xxxii CONTENTS

CASE IN POINT: Fed Policy StatementsBalancing

Policy Goals 851

INTERNET CONNECTION: Banks and Inflation

Targeting 852

Consequences of Inflation Targeting 853

INTERNATIONAL PERSPECTIVE: Central Bank

Mandates 855

Demand Versus Supply Disturbances and Policy Trade-

Offs 857

e-INSIGHT: e-Time and Macroeconomic Policy 858


APPENDIX: Price Level Targeting 862

CHAPTER 39 A STUDENTS GUIDE TO INVESTING865Investment Alternatives 866

Bank Deposits 866

Housing 866

INTERNET CONNECTION: Calculating Interest Rates

867

Bonds 867

Shares of Stock 868

Mutual Funds 869

Desirable Attributes of Investments 870

Expected Returns 870

INTERNET CONNECTION: Index Funds 870

e-INSIGHT: Investing in the New Economy 872

CASE IN POINT: PG&E Employees Learn Why

Diversification Is Important 872

Risk 874

Tax Considerations 876

Liquidity 877

Expectations and the Market for Assets 878

THINKING LIKE AN ECONOMIST: The Distribution

of Wealth and Ownership of Assets 879

Forming Expectations 880

Efficient Market Theory 881

Efficiency and the Stock Market 882

Efficient Markets or Random Noise? 884

Strategies for Intelligent Investing 885


CONTENTS xxxiii

GLOSSARY A-1

CREDITS A-13

INDEX A-15

PREFACE

T he study of economics has always been fascinating, yet it is difficult toremember a more exciting or important time in the discipline. Think of todays major economic issuesthe huge American trade and budgetdeficits, global warming, the debate between proponents of conservation and energyexploration, ensuring adequate health care, ending global poverty, reforming SocialSecurity, outsourcing, rethinking the nature of competition and regulation in theInternet age, and copyright protection in a digital, downloadable world. The listgoes on and on. To understand these issues, the core insights of economics areinvaluable.

Exciting new theoretical advances are allowing economists to better understandhow individuals, families, and businesses make decisions about what to buy, whatto sell, how much to save, and how to invest their savings. These advances affectthe way governments design policies to protect the environment, promote educationalopportunities, and deal with the changes in our economy brought about by innova-tions in information technologies and the increasingly global economic marketplacein which we all participate.

There has never been a time in which the need to be informed about economicissues has been more acute. Nor is it any less critical for students to acquire thetools that will enable them to think critically about the economic decisions they facein their personal lives and the issues they must decide on as engaged citizens. Evensomething as basic to the study of economics as the concept of trade-offs helps pro-vide students with a tool that can inform the way they think about issues at the per-sonal, local, state, national, and even global level. Whereas the Principles of Economicscourse has always been popular among business students, now most students real-ize that everyone needs to be conversant with the fundamentals of economics. Wehave written our book, and revised it for the Fourth Edition, keeping this very impor-tant concept of the politically engaged student in mind.

Preparing the Fourth Edition of this textbook has provided us with the oppor-tunity to make several fundamental improvements over the previous edition. Westill emphasize the five core concepts of modern economics, which are the importanceof trade-offs, incentives, exchange, information, and distribution. Yet, economicresearch is continuously yielding new, interesting, and important insights, and webelieve that these exciting new developments should be conveyed to students inintroductory courses. While the textbook has always offered the most integratedcoverage of information economics, in this new edition we introduce students tosome of the results from new research in behavioral economics. We have also madeseveral changes to the organization of the book that will give instructors increasedflexibility in structuring their courses.

PREFACE xxxv

Mission Statement for the FourthEditionOur text has always strived for two goals: One, to be transparently accessible and inter-esting, dare we say a good read, for the student reader; and two, to not shy awayfrom teaching students the latest exciting insights of the discipline, to teach them thesubstance of economics as a field of study. Many books seem to take the stance thatstudents cannot handle the new topicswe believe that it is just a matter of explain-ing the ideas simply and clearly.

To achieve these goals, the four main objectives of previous editions continuedto guide us. These objectives are to provide students with a clear presentation ofthe basic competitive model, to present macroeconomics in its modern form con-sistent with the way active researchers and economists in policy-making institu-tions analyze the economy, to structure the textbook in ways that are conducive togood teaching and to student learning, and to ensure that the textbook reflects thecontemporary scene, stressing the core insights economics provides for understand-ing the ever-changing economy.

Changes to the Fourth EditionMicroeconomicsThe hallmark of this textbook, its emphasis on information, imperfect markets, innova-tion, and technology, remain in the new edition. New material on behavioral economicshas been incorporated into the chapters on consumer choice and capital markets.

KEY CHANGES FOR THE FOURTH EDITION:For the Fourth Edition, we worked hard to streamline the text. Chapters in earliereditions that many students found too long or too dense have been significantlyrestructured. In some cases, material has been divided into separate chapters,making chapters shorter on average and more focused.

Important changes made to the microeconomic sections include:

Shortening the introductory section, Part 1, to provide a greater focus onthe core concepts of economics.

Splitting the material on the labor and capital markets under perfectcompetition into two separate chapters. This helps make the presentationmore student-friendly as well as giving instructors increased flexibility indeciding what material to include in their courses.

Reorganizing Part 3 to provide a more cohesive discussion of imperfectmarkets and public policy issues. Because strategic behavior is at the heart

xxxvi PREFACE

of the economists approach to imperfect competition, the chapter onstrategic behavior has been moved into Part 3 (Chapter 14).

Part 4, now titled Issues in Public Policy, is more closely organized aroundthe theme of public policy, rather than simply including a set of topics.Part 4 includes chapters on the public sector (Chapter 17), environmentalpolicy (Chapter 18), and international trade and trade policy (Chapter 19).

Changes to the Fourth EditionMacroeconomicsThe new edition maintains the modern approach to macroeconomics, one that rec-ognizes that the Federal Reserve and other central banks implement monetary policythrough interest rates rather than through the explicit control of the money supply.By providing a more realistic treatment of monetary policy, the modern approachalso allows students to understand and discuss the types of policy actions they readabout in newspapers. While the general approach developed in the Third Edition ismaintained, our treatment of macroeconomics in the new edition aims to streamlinethe presentation, moving more advanced material into the Topics chapters.

KEY CHANGES FOR THE FOURTH EDITION:Important changes made to the macroeconomic sections include:

The opening chapter of the macroeconomics material has been updated toreflect new developments since the Third Edition.

The discussion of price indices and the measurement of inflation are nowtreated in a separate chapter (Chapter 23).

Part 6, on Full-Employment Macroeconomics, has been reorganized.Separate chapters are now devoted to government finance (Chapter 25)and the open economy (Chapter 26). This allows these two important topicsto be treated individually, allowing instructors greater choice in decidinghow to organize their course, as well as reducing the number of newconcepts introduced in each chapter.

The important material on government deficits and surpluses has beencombined in Chapter 25 rather than split between Part 6 and Part 8 as inthe previous edition.

The material on money, prices, and the Federal Reserve has been moved tothe end of Part 6 (Chapter 28). This improves the flow of the full-employmentsection, with Chapter 24 providing the basic framework for the determinationof real output, real wages, and the real interest rate, Chapter 25 adding the

PREFACE xxxvii

government, Chapter 26 extending the results to the case of the openeconomy, and Chapter 27 providing a discussion of economic growth. Thematerial on money and prices then follows in Chapter 28.

Part 7 on Macroeconomic Fluctuations has been extensively rewritten toimprove the exposition. Many users of the Third Edition felt that too muchmaterial was introduced in the chapters on the aggregate demandinflationrelationship and the short-run inflation adjustment relationship. To addressthis concern, we have moved the extended discussion of inflation andunemployment into Part 9 (Further Topics in Macroeconomics). Part 7begins with an overview (Chapter 29), covers the basics of aggregateexpenditures (Chapter 30), and then develops the aggregatedemandinflation relationship in Chapter 31.

The material on the international economy has been consolidated into anew Part 8, with chapters dealing with the international financial system(Chapter 34), policy in the open economy (Chapter 35), and economicdevelopment and transition (Chapter 36).

In making these changes, we have continued to be motivated by the desire to writea modern, student-friendly textbook that reflects the way economists approach theirsubject today.

The Organization of the TextThe text is organized to work for both students and instructors. For students, we uti-lize the five core concepts of trade-offs, incentives, exchange, information, and distri-bution throughout the text, in both the chapters on microeconomics and those onmacroeconomics. These concepts anchor the wide range of topics we cover, linkingall the topics to a core set of basic principles to which students can always refer. We alsoprovide a firm grounding in basic concepts first, but we do not stop there. We alsoensure that students are able to understand the tremendous insights offered by thebasic economic model of competitive markets and its limitations. This prepares thestudent for understanding the lessons offered by modern economics for study of imper-fect competition, information, growth, and economic fluctuations. We show how theseinsights help one understand economic phenomena that classical economics cannot.By exposing students to modern economicsfrom the economics of information andinnovation to behavioral economicsthe text helps them obtain a sense of the rich-ness of the discipline and its value for understanding the world around them.

The text is designed to offer solid coverage of traditional topics, combined with aflexible structure that allows it to be tailored to fit with the individual needs of theinstructor. In covering both microeconomics and macroeconomics, the basic mate-rial of competitive markets and the full-employment economy are presented first.Then, the sections dealing with imperfect markets and fluctuations each begin withan overview chapter that allows students to gain insight into the basic institutionsand key issues that are addressed in more detail in subsequent chapters. This struc-

xxxviii PREFACE

ture also allows an instructor who does not wish to devote too much time to a topicsuch as imperfect information to still give students a sense of the its importance andthe lessons economists have learned about this important topic. Finally, both themicroeconomics and macroeconomics sections end with topics chapters that offeradditional flexibility for the instructor in fine-tuning the readings from the text tothe context of his or her course structure, while a new and expanded treatment ofthe international economy is contained in the macroeconomics section.

Learning ToolsWe have developed a clutch of Learning Tools that will help our student readersrelate to the principles being described and also better retain the information.

RIVETING BOXES THAT HIGHLIGHT THENEW ECONOMY BEING CREATED BY THEINTERNET AND INFORMATIONREVOLUTION

From Google, to eBay, Expedia, StubHub, Napster, and online poker, the manifes-tations of the New Economy are changing the way we live, work, shop, travel, andspend our leisure time. Though the fundamentals of economics will not change, howthose fundamentals are utilized is changing, at an ever-quickening pace. Stiglitz/WalshFourth Edition recognizes this fact.

e-INSIGHT BOXES apply economic principles to new developments in informationtechnology and the Internet.

INTERNET CONNECTION BOXES provide useful links to Web resources andhome pages.

ADDITIONAL TOOLS TO HEIGHTENSTUDENT UNDERSTANDING

THINKING LIKE AN ECONOMIST boxes reinforce the core ideas emphasizedthroughout the book: Trade-offs, Incentives, Exchange, Information, and Distribution.

CASE IN POINT vignettes highlight real-world applications in each chapter.

INTERNATIONAL PERSPECTIVE boxes present applications to internationalissues.

2

1

PREFACE xxxix

FUNDAMENTALS OF . . . sections distill the essence of particularly importantand tricky topics.

WRAP-UPS provide a short summary of the key points presented in a section.

ECONOMICS, FOURTH EDITION e-BOOK

Same Great Content, Half the Price The e-book version of Economics,Fourth Edition, offers the full content of the print version, at half the price.

In addition, a variety of features make the Norton e-book a powerful tool forstudy and review.

Zoomable images allow students to get a closer look at the figures andphotographs.

Clear text, designed specifically for screen use, makes reading easy.

A search function facilitates study and review.

A print function permits individual pages to be printed as needed.

Sticky notes allow students to add their own notes to the text.

Online and cross-platform software works on both Macs and PCs and allows stu-dents to access their e-book from home, school, or anywhere with an Internet con-nection. Visit NortonEbooks.com for more information.

Ancillary Package A variety of valuable supplements are available to students and teachers who use thetextbook.

SmartWork Homework Management System Developed in coordina-tion with Science Technologies, SmartWork is an innovative online homework man-agement system. SmartWork requires active learning from students and providessmart, interactive feedback. Instructors can choose from three types of ready-madeassignments:

Interactive Graphing Exercises allow students to manipulate points, lines, andcurves, see the implications instantly, and then answer questions about them.

Audio Graphs guide students step-by-step through a slide show presentingcore concepts. On screen, students see economic equations worked out andgraphs manipulated while hearing an audio presentation of the lesson.

Conceptual Quizzes pair questions with thought-provoking feedback.Students are asked to reconsider their answers after they respond to eachquestion.

xl PREFACE

With SmartWorks intuitive interface, instructors can also customize Nortons ready-made assignments or write their own exercises with remarkable ease. Access toSmartWork is free to all students who purchase a new textbook or e-book.

Student Web Site This free companion Web site offers students powerfulreview materials. Practice quizzes feature diagnostic feedback indicating which sec-tions in the chapter the student should review. The student Web site also provideschapter reviews, a glossary, and a daily economics newsfeed.

NORTON MEDIA LIBRARYThis instructors CD-ROM includes PowerPoint lecture slides (corresponding to thelecture modules in the Instructors Manual) as well as all the graphs and tables fromthe book. New lecture-launcher audio/visual slide shows provide brief segmentson each chapters material as it relates to imperfect markets or the new economy.

NORTON RESOURCE LIBARYThe Norton Resource Library provides comprehensive instructor resources in onecentralized online location. In the library, instructors can download ready-to-use,one-stop solutions for online courses, such as WebCT e-packs and BlackBoard coursecartridges, or can tailor these pre-made course packs to suit their own needs. Thelibrarys exceptional resources include PowerPoint lecture slides, graphs and tablesfrom the book, and a computerized test-item file.

TRANSPARENCIESA set of color transparencies is available to qualified adopters.

STUDY GUIDEBY LAWRENCE W. MARTIN, MICHIGAN STATE UNIVERSITYPRINCIPLES OF MICROECONOMICS 0-393-92826-8 PAPERPRINCIPLES OF MACROECONOMICS 0-393-92827-6 PAPER

This innovative study guide reinforces the key concepts of each chapter throughreviews, practice exams, and problem sets designed to help students apply whattheyve learned. Doing Economics sections are structured around a series of ToolKits in which students learn a problem-solving technique through its step-by-stepapplication. Each Tool Kit is followed by worked examples and practice problemsthat apply the relevant technique.

PREFACE xli

INSTRUCTORS MANUALBY GERALD McINTYRE, OCCIDENTAL COLLEGEPRINCIPLES OF MICROECONOMICS 0-393-92805-5 PAPERPRINCIPLES OF MACROECONOMICS 0-393-92821-7 PAPER

For each chapter of the textbook the Instructors Manual contains lecture advice,lecture modules, lecture applications, problem sets, and solutions. The extensivelecture modules can be used with a set of PowerPoint slides that Gerald McIntyrehas prepared. These lecture notes are far more extensive than what other publish-ers offer, and will be extremely valuable to the first time instructor.

TEST-ITEM FILE BY DAVID GILLETTE, TRUMAN STATE UNIVERSITYPRINCIPLES OF MICROECONOMICS 0-393-92840-3 PAPERPRINCIPLES OF MACROECONOMICS 0-393-10727-2 PAPER

The Fourth Edition Test-Item File includes over 4,000 questions, a 15 percent increaseover the previous edition. In addition, each chapter includes a subset of questionscovering the boxed inserts (such as e-Insights), which professors can use in theirexams, thereby encouraging students to read these discussions.

xlii PREFACE

AcknowledgmentsThe books first three editions were improved immeasurable by the input of numer-ous reviewers. In particular, we thank Robert T. Averitt, Smith College; MohsenBahmani-Oskoose, University of Wisconsin, Milwaukee; Richard Barret, Universityof Montana; H. Scott Bierman, Carleton College; John Payne Bigelow, University ofMissouri; Howard Bodenhorn, Lafayette College; Bruce R. Bolnick, NortheasternUniversity; Adhip Chaudhuri, Georgetown University; Michael D. Curley, KennesawState College; John Devereus, University of Miami; Stephen Erfle, Dickinson College;Rudy Fichtenbaum, Wright State University; Kevin Forbes, Catholic University; K.K. Fung, Memphis State; Christopher Georges, Hamilton College; Ronald D. Gilbert,Texas Tech University; Robert E. Graf, Jr., United States Military Academy; GlennW. Harrison, University of South Carolina; Marc Hayford, Loyola University; YutakaHoriba, Tulane University; Charles How, University of Colorado; Sheng Cheng Hu,Purdue University; Glenn Hubbard, Columbia University; Nancy Jianakopolos,Colorado State University; Allen C, Kelley, Duke University; Lori Kletzer, Universityof California, Santa Cruz; Michael M. Knetter, Dartmouth College; Kevin Lang,Boston University; William Lastrapes, University of Georgia; John Leahy, BostonUniversity; Eric Leeper, Indiana University; Colin Linsley, St. John Fisher College;Stefan Lutz, Purdue University; Mark J. Machina, University of California, SanDiego; Burton G. Malkiel, Princeton University; Lawrence Martin, Michigan StateUniversity; Thomas Mayer, University of California, Davis; Craig J. McCann, Universityof South Carolina; Henry N. McCarl, University of Alabama, Birmingham; JohnMcDermott, University of South Carolina; Marshall H. Medoff, University of California,Irving; Peter Mieszkowski, Rice University; Myra Moore, University of Georgia; W.Douglas Morgan, University of California, Santa Barbara; John S. Murphy, CanisiusCollege; Michael Nelson, University of Akron; William Nielson, Texas A & MUniversity; Neil B. Niman, University of New Hampshire; David H. Papell, Universityof Houston; Douglas Pearce, North Carolina State University; Jerrold Peterson,University of Minnesota, Duluth; James E. Price, Syracuse University; Daniel M.Raff, Harvard Business School; Christina D. Romer, University of California, Berkeley;Richard Rosenberg, Pennsylvania State University; Rosemary Rossiter, OhioUniversity; David F. Ruccio, University of Notre Dame; Christopher J. Ruhm, BostonUniversity; Suzanna A. Scotchmer, University of California, Berkeley; Richard Selden,University of Virginia; Andrei Shleifer, Harvard University; Nirvikar Singh, Universityof California, Santa Cruz; John L. Solow, University of Iowa; George Spiva, Universityof Tennessee, Mark Sproul, University of California, Los Angeles; Frank P. Stafford,University of Michigan; Raghu Sundaram, University of Rochester; Hal R. Varian,University of California, Berkeley; Franklin V. Walker, State University of New Yorkat Albany; James M. Walker, Indiana University; Andrew Weiss, Boston University;Mark Wohar, University of Nebraska, Omaha; and Gilbert R. Yochum, Old DominionUniversity.

Many additional reviewers provided suggestions that help guide us in prepar-ing the Fourth Edition. Our thanks to John Nader, Grand Valley State University;Timothy A. Duy, University of Oregon; Richard Fox, Madonna University; DaleCloninger, University of Houston, Clear Lake; Gavin Wright, Stanford University;

PREFACE xliii

Richard Stahnke, Hamilton College; Maristella Botticini, Boston University; ChrisNiggle, University of Redlands; Santanu Roy, Southern Methodist University; RogerWhite, Franklin and Marshall College; Geoffrey Carliner, Boston University; RobertL. Pennington, University of Central Florida; Roger A. McCain, Drexel University;Nancy A. Jianakoplos, Colorado State University; Sudeshna C. Bandyopadhyay,West Virginia University; Jennifer Thacher, University of New Mexico; AlanGummerson, Florida International University; Nejat Anbarci, Florida InternationalUniversity; Samuel Allen, University of California, Davis; Robert G. Bise, OrangeCoast College; Sarah L. Stafford, College of William and Mary; Catherine Krause,University of New Mexico; Ariel Belasen, Binghamton University; Alina Luca, DrexelUniversity; S. Abu Turab Rizvi, University of Vermont; Nivedita Mukherji, OaklandUniversity; Faik A. Koray, Louisiana State University; Mehdi Haririan, BloomsburgUniversity; F. G. Hank Hilton, Loyola College; Michael Margolis, Oberlin College;Joseph K. Cavanaugh, Wright State University; Lisa Gundersen, Iowa State University;Eva Toth Szalvai, Bowling Green State University; Maya Federman, Pitzer College;Annie Fang Yang, University of Minnesota, Twin Cities; Molly Espey, ClemsonUniversity; Nora Underwood, University of California, Davis; Mary Schranz, Universityof Wisconsin, Madison; Scott Cunningham, University of Georgia; Ehsan Ahmed,James Madison University; Lee van Scyoc, University of Wisconsin, Oshkosh; ParkerWheatley, Carleton College; Daniel Rubenson, Southern Oregon University; ElliottParker, University of Nevada, Reno; Peter Murrell, University of Maryland;Abdulhamid Sukar, Cameron University; Philip S. Heap, James Madison University;Erik D. Craft, University of Richmond; Sharmila King, University of the Pacific;Linus Yamane, Pitzer College; Cathleen Leue, University of Oregon; Daniel Monchuk,University of Southern Mississippi; Rik W. Hafer, Southern Illinois University,Edwardsville; and Ben Young, University of Missouri, Kansas City.

A particular note of appreciation is due Mary Schranz, University of Wisconsin,Madison, who provided detailed, thoughtful, and extremely helpful comments ondraft chapters of the macroeconomics material. Her insights significantly improvedthe end product.

The major changes in the Fourth Edition and the improvements they representare due in no small measure to the constant encouragement, advice, and enthusi-asm of our editor, Jack Repcheck. Jack provided the perfect blend of critical feed-back and positive reinforcement to encourage us at each stage of the process tostrive towards our goals of accessibility and modernity, and to incorporate the latestinsights from the forefront of economics in a manner that is accessible to studentsgetting their first introduction to economics.

We would also like to thank and acknowledge the entire team at Norton whomade working on the Fourth Edition such a pleasure: Lory Frenkel, Matt Arnold,Mik Awake, Sarah Solomon, Rubina Yeh, Kelly Mitchell, Roy Tedoff, John McAusland,Alice Falk, and Barbara Hults.

A special note of thanks continues to be owed Judy Walsh. Judys knowledge ofeconomics and her willingness to discuss ideas, make suggestions, offer examples andencouragement have all helped contribute greatly to the improvements made to theFourth Edition.

xliv PREFACE

Alternative Course OutlineIn the Fourth Edition, we have further improved the flexibility of the book, allow-ing it to be easily adapted to courses of varying length and objectives. Part 4, Issuesin Public Policy and Part 9, Further Topics in Macroeconomics, contain chap-ters that can be covered at the end of a course, time permitting, or integrated withthe core discussions of microeconomics and macroeconomics. Part 8, The GlobalEconomy, provides instructors with the option of constructing a more internation-ally focused introductory course, covering international trade, finance, and develop-ment. Alternatively, instructors can selectively choose from among these topics andinclude them in a more traditional organized course. The following outlines, whichrepresent only a small subset of those that might be devised, reflect the flexibility theFourth Edition offers.

OUTLINE FOR A ONE-SEMESTER COURSE INMICROECONOMICS AND MACROECONOMICSCHAPTER TITLE

1 Modern Economics 2 Thinking Like an Economist3 Demand, Supply, and Price4 Using Demand and Supply5 The Consumption Decision6 The Firms Costs7 The Competitive Firm8 Labor Markets 9 Capital Markets

10 The Efficiency of Competitive Markets11 Introduction to Imperfect Markets12 Monopoly, Monopolistic Competition, and Oligopoly13 Government Policies Toward Competition21 Macroeconomics and the Economic Perspective22 Measuring Economic Output and Unemployment23 The Cost of Living and Inflation24 The Full-Employment Model25 Government Finance at Full-Employment26 Money, the Price Level, and the Federal Reserve29 Introduction to Economic Fluctuations31 Aggregate Demand and Inflation32 The Federal Reserve and Interest Rates33 The Role of Macroeconomic Policy

PREFACE xlv

OUTLINE FOR A SHORT COURSE INMICROECONOMICS AND MACROECONOMICSCHAPTER TITLE

1 Modern Economics2 Thinking Like an Economist3 Demand, Supply, and Price4 Using Demand and Supply5 The Consumption Decision6 The Firms Costs7 The Competitive Firm

10 The Efficiency of Competitive Markets11 Introduction to Imperfect Markets21 Macroeconomics and the Economic Perspective22 Measuring Economic Output and Unemployment23 The Cost of Living and Inflation24 The Full-Employment Model25 Government Finance at Full Employment28 Money, the Price Level, and the Federal Reserve29 Introduction to Macroeconomic Fluctuations31 Aggregate Demand and Inflation32 The Federal Reserve and Interest Rates

OUTLINE FOR A ONE-SEMESTER COURSE INMICROECONOMICSCHAPTER TITLE

1 Modern Economics2 Thinking Like an Economist3 Demand, Supply, and Price4 Using Demand and Supply5 The Consumption Decision6 The Firms Costs7 The Competitive Firm8 Labor Markets 9 Capital Markets

10 The Efficiency of Competitive Markets11 Introduction to Imperfect Markets12 Monopoly, Monopolistic Competition, and Oligopoly13 Government Policies Toward Competition14 Strategic Behavior15 Imperfect Information in the Product Market16 Imperfections in the Labor Market

xlvi PREFACE

Plus any of the optional chapters comprising Part 4.17 The Public Sector18 Environmental Economics19 International Trade and Trade Policy20 Technological Change39 A Students Guide to Investing

OUTLINE FOR A SHORT COURSE INMICROECONOMICSCHAPTER TITLE

1 Modern Economics2 Thinking Like an Economist3 Demand, Supply, and Price4 Using Demand and Supply5 The Consumption Decision6 The Firms Costs7 The Competitive Firm8 Labor Markets 9 Capital Markets

10 The Efficiency of Competitive Markets11 Introduction to Imperfect Markets12 Monopoly, Monopolistic Competition, and Oligopoly13 Government Policies Toward Competition17 The Public Sector

OUTLINE FOR A ONE-SEMESTER COURSE INMACROECONOMICSCHAPTER TITLE

21 Macroeconomics and the Economic Perspective

Core macroeconomics presentation22 Measuring Economic Output and Unemployment23 The Cost of Living and Inflation24 The Full-Employment Model25 Government Finance at Full Employment26 The Open Economy at Full Employment27 Growth and Productivity28 Money, the Price Level, and the Federal Reserve29 Introduction to Economic Fluctuations30 Aggregate Expenditures and Income

PREFACE xlvii

31 Aggregate Demand and Inflation32 The Federal Reserve and Interest Rates33 The Role of Macroeconomic Policy

Plus any of the optional chapters comprising Parts 8 and 934 The International Financial System35 Policy in the Open Economy36 Economic Development and Transition37 Inflation and Unemployment38 Controversies in Macroeconomics39 A Students Guide to Investing

OUTLINE FOR A SHORT COURSE INMACROECONOMICSCHAPTER TITLE

21 Macroeconomics and the Economic Perspective

Core macroeconomics presentation22 Measuring Economic Output and Unemployment23 The Cost of Living and Inflation24 The Full-Employment Model25 Government Finance at Full Employment27 Growth and Productivity28 Money, the Price Level, and the Federal Reserve29 Introduction to Macroeconomic Fluctuations31 Aggregate Demand and Inflation32 The Federal Reserve and Interest Rates33 The Role of Macroeconomic Policy

xlviii PREFACE

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Part 1

INTRODUCTION

Learning GoalsIn this chapter, you will learn

What economics is, and whatthe key concepts that definecore ideas in economics are

What markets are, and whichare the principal markets thatmake up the economy

Why economics is called ascience, and why it is thateconomists often disagree

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Chapter 1

MODERNECONOMICS

The past decade has seen tremendous changes in the world economy. Manyof these changes are linked to new technological advances that have trans-formed what the global economy produces, the ways in which many goodsand services are produced, where they are produced, and how goods and servicesare transferred from the firms that produce them to the households, governments,and other firms that buy them. New technologies are transforming everything, fromhow airlines sell tickets to how automobiles are produced, from how we buy booksto how we communicate with one another.

Like the industrial revolution of the eighteenth and nineteenth centuries thattransformed first Britain and then other countries from agricultural to manufacturing-based economies, the information revolution of the late twentieth and early twenty-first centuries promises to transform almost all aspects of our daily lives. In 1999, inrecognition of the growing importance of new, high-tech firms, Microsoft and Intelthe producer of the Windows computer operating system and the major producerof the microprocessors at the heart of personal computers, respectivelywere addedto the Dow-Jones Industrial Average, the most widely followed index of prices on U.S. stock markets. Though the booming stock market of the late 1990s that was driven in part by enthusiasm for new technologies came to an end in 2000, innovation continues to be a critical force in the economy.

But the old economy is still alive and kicking. Four of the five largest UnitedStates corporations in Fortune magazines top 500 list for 2003 were traditionalindustrial firmsGeneral Motors, Exxon, Ford, and General Electric. IBM at number8 and Verizon Communications at number 10 were the only information or techfirms in the top 10. Hewlett-Packard was number 14 and Dell Computers was 36,but Microsoft managed to make it no higher than number 47.

So the old economy and the new economy coexist side by side. But it is not justthe emergence of new software and Internet companies that represents the effectsof new technologies. The way all firms do business is being changed, and their

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customers are being affected too. Assembly lines now rely on robots aided and controlled by computers. Car repair shops with grease-stained floors have beenreplaced by clean, quiet garages where computers diagnose a cars problems. Theway we buy things is also changing. Whether an individual purchases a car, book,or CD over the Web; books a hotel or plane reservation; or even applies to a collegethrough the Internet, the relationship between people and firms is evolving. Newtechnologies are changing the way courses are taught, tootextbooks like this onehave Web sites that provide students with help, with interactive exercises, and withlinks to news, policy debates, and the latest economic information. The address ofthe home page for this text is www.wwnorton.com/stiglitzwalsh4.

With such far-reaching changes, what insights and understanding does the studyof economics have to offer? After all, the field usually looks to Adam Smith, an eighteenth-century Scottish professor of moral philosophy, as its founder. Smithpublished his most famous book, The Wealth of Nations, in 1776, a time when todaysindustrial economies were still overwhelmingly agriculture-based. It might seemunlikely that a theory developed to understand the factors that determine the priceof wheat would have much to say about todays modern economy.

But, in fact, study of economics continues to provide a critical understanding oftodays global economy. As Carl Shapiro and Hal Varian of the University of California,Berkeley, put it, Technology changes. Economic laws do not.1 The way we producethings, what we produce, and how goods are exchanged have altered tremendouslysince Smith wrote. Yet the same fundamental laws of economics that explained agri-cultural prices in the eighteenth century can help us understand how economiesfunction in the twenty-first century The foundation laid by Adam Smith and builtupon by generations of economists has yielded insights that will continue to offerguidance to anyone wishing to make sense of the modern economy.

Over the past two hundred years, economists have refined and expanded ourunderstanding of economic behavior. By incorporating the role of information andtechnological change, they are now able to explain much more than was possiblejust twenty years ago, offering new insights into topics that range from why car deal-ers build fancy showrooms to how the factors important for encouraging the pro-duction of new ideas differ from those that encourage the production of new cars.

But what are these insights? What do economists study? And what can we learnfrom looking at things from the perspective of economics? How can economics helpus understand why we need to worry about the extinction of salmon but not of sheep,why auto manufacturers advertise but wheat farmers dont, why countries that relyon uncoordinated markets have done better than countries that rely on governmentplanners, and why letting a single firm dominate an industry is bad?

The headlines from some recent news stories involving the computer industryand the Internet illustrate some of the key issues that a study of economics can help illuminate.

Bill to Curb Online Piracy Is Challenged as Too Broad, New York Times,June 24, 2004. A bill recently introduced in the U.S. Senate aims to restrict

4 CHAPTER 1 MODERN ECONOMICS

1Carl Shapiro and Hal R. Varian, Information Rules: A Strategic Guide to the Network Economy (Boston: Harvard

Business School Press, 1999), p. 2.

the illegal online sharing of music and other files. This proposed legislationrepresents just the latest development in the running battle between the com-panies that own the rights to the music and consumers who want to freelyshare music files. After all, it doesnt cost the music company any more tohave a file shared by a thousand people than it does to have it shared by two.So why, many ask, should they have to pay for music files? The advent of digi-tal music has made it possible for listeners to exchange copies indistinguish-able from the originals. But if the producers of the music cannot earn a profit,they have less incentive to seek out and record new artists. Property rightsin this case, the legal right of the music company to charge for the use of itspropertyplay an important role in market economics, and disputes overproperty rights arent new. But the new information technologies have madetrading this property much easier and raised new questions. As we will see,economics can tell us a great deal about the issues involved in these disputes.

Internet Drug Trade Proves Bitter Pill for Canada, Financial Times,April 21, 2004. The Internet has changed the nature of the market forgoods such as prescription drugs. Buyers in Florida can as easily havetheir prescriptions filled by a pharmacy based in California, or Canada, asby one in Florida. But why has this led to shortages of some popular pre-scription drugs in Canada? What will be the likely consequences for drugprices in Canada and the United States?

Intel Cancels 2 Chip Projects, San Jose Mercury News, May 8, 2004. After spending as much as $2 billion on a new line of computer chips calledthe Itanium, Intel pulled the plug on the project. As the company decidedwhether to go ahead with the project, was the money already invested a factor? Firms are always concerned about costs, but economics gives criticalinsights that help us understand which costs are important and whethersome costs, such as the $2 billion Intel had already sunk into the Itaniumproject, arent.

Ebay Bids and Buys Baazee, The Economic Times, June 23, 2004.According to a story on economictimes.indiatimes.com, the online auctioncompany eBay purchased Baazee.com, an Indian online shopping company,for $50 million. The purchase extends eBays network throughout Asia,adding to its current ventures in Hong Kong, Singapore, and China. Bylinking online buyers and sellers globally, eBay will enable a consumer inSioux City, Iowa, to trade with someone in Bangalore, India.

Oracles Bid for PeopleSoft to Be Tested in Court, New York Times, June7, 2004. In early 2004, the software giant Oracle announced that it was mak-ing a hostile bid to buy PeopleSoft, another software company. The U.S.Justice Department initially filed a lawsuit to block this takeover, arguingthat it would reduce competition in the market for business software. Oraclewas eventually allowed to take over PeopleSoft, but why does the govern-ment try to ensure that there is competition? What are the advantages ofcompetition? What tools does the government use to promote competition?

FASB Holds Meeting on Expensing Stock Options, San Jose MercuryNews, June 24, 2004. Many tech companies, particularly those located inCalifornias Silicon Valley, have used stock options to reward their employees.

MODERN ECONOMICS 5

Internet Connection

TRACKING THE DIGITAL ECONOMY

Since 1998, the U.S. Department of Commerce has issued anannual report on the digital economy. You can find the latest

report at www.esa.doc.gov/reports.cfm.

This mechanism grants the employee the opportunity to purchase shares inthe company at a set price. If the company does well and its shares go up invalue, the employee can sell the stock for a profita prospect that creates anincentive to work hard and help the company succeed. The FederalAccounting Standards Board (FASB) proposed new accounting rules requir-ing firms that offer stock options to report these as an expense, thereby re-ducing the firms reported profits. The FASB argues that to do so wouldpresent investors with a more accurate picture of the firms profits, enablinginvestors to make better decisions about buying stock in the company.

News headlines frequently focus on economic issues, and these six point to someof the key topics that economists study: the role of incentives and information, glob-alization and exchange, competition and government regulation, costs and businessdecisions. The study of economics will give you new insights into the news stories yousee in the paper, it will give you insights into the world of business, and it will helpyou understand the world of economics you participate in every day.

What Is Economics? Headlines can illustrate many of the important issues with which economics deals,but now a definition of our subject is in order. Economics studies how individuals,firms, government, and other organizations within our society make choices, andhow these choices determine societys use of its resources. Why did consumerschoose to buy small, energy-efficient cars in the 1970s and large sports utility vehi-cles in the 1990s? What determines how many individuals work in health careindustries and how many work in the computer industry? Why did the income gapbetween rich and poor rise in the 1980s? To understand how choices are madeand how these choices affect the use of societys resources, we must examine fiveconcepts that play an important role: trade-offs, incentives, exchange, information,and distribution.

1. Choice involves trade-offsdeciding to spend more on one thing leaves lessto spend on something else; devoting more time to studying economics leavesless time to study physics.

6 CHAPTER 1 MODERN ECONOMICS

2. In making choices, individuals respond to incentives. If the price of Zen MP3players falls relative to the price of iPods, there is a greater incentive to buy aZen. If the salaries for engineers rise relative to the salaries of people with anMBA, there is an increased incentive to choose to study for an engineeringdegree rather than a business degree.

3. When we exchange with others, our range of choices becomes larger. 4. Making intelligent choices requires that we have, and utilize, information.5. Finally, the choices we makeabout how much education to get, what occupa-

tion to enter, and what goods and service to buydetermine the distributionof wealth and income in our society.

These five concepts define the core ideas that are critical to understanding eco-nomics. They also guide the way economists think about issues and problems.Learning to think like an economist means learning how to discover the trade-offsand incentives faced, the implications of exchange, the role of information, and theconsequences for distribution. These key concepts are emphasized throughout thetext in Thinking Like an Economist boxes.

TRADE-OFFS Each of us is constantly making choicesstudents decide to study at thelibrary rather than in the dorm, to have pizza rather than sushi, to go to collegerather than work full-time. Societies, too, make choicesto preserve open spaces rather than provide more housing, to produce computers and import tele-visions rather than produce televisions and import computers, to cut taxes ratherthan increase government expenditures. In some cases, individuals or governments explicitly make these choices. You decided to study economics rather than someother subject. The government decides each year whether to cut taxes or to increasespending. In other cases, however, the choices were the result of the uncoordinatedactions of millions of individuals. Neither the government nor any one individualdecided that the United States would import cars from Japan and export wheat to India. But in each case, choice involves trade-offsto get more of one thinginvolves having less of something else. We are forced to make trade-offs becauseof scarcity.

Scarcity figures prominently in economics; choices matter because resources arescarce. For most of us, our limited income forces us to make choices. We cannot affordeverything we might want. Spending more on rent leaves less available for clothes andentertainment. Getting a sunroof on a new car may mean forgoing leather seats to staywithin a fixed budget. Limited income is not the only reason we are forced to maketrade-offs. Time is also a scarce resource, and even the wealthiest individual mustdecide what expensive toy to play with each day. When we take time into account, werealize scarcity is a fact of life for everyone.

One of the most important points on which economists agree concerns the criticalrole of scarcity. We can summarize this point as follows: There is no free lunch. Having moreof one thing requires giving up something else. Scarcity means that trade-offs are a basic fact of life.

WHAT IS ECONOMICS? 7

INCENTIVES It is one thing to say we all face trade-offs in the choices we make. It is quite anotherto understand how individuals and firms make choices and how those choices mightchange as economic circumstances change. If new technologies are developed, willfirms decide to increase or decrease the amount of labor they employ? If the priceof gasoline rises, will individuals decide to buy different types of automobiles?

When faced with a choice, people evaluate the pros and cons of the differentoptions. In deciding what to eat for dinner tonight, you and your roommates mightweigh the advantages and disadvantages of having a frozen pizza again over goingout for sushi. Similarly, a firm evaluates the pros and cons of its alternatives in termsof the effects different choices will have on its profits. For example, a retail chaindeciding on the location for a new store must weigh the relative advantages of dif-ferent locations. One location might have more foot traffic but also higher rent.Another location might be less desirable but have lower rent.

When decision makers systematically weigh the pros and cons of the alternativesthey face, we can predict how they will respond to changing economic conditions.Higher gas prices raise the cost of driving, but the cost of driving a fuel-efficient carrises less than the cost of driving a sports utility vehicle. Therefore, households weigh-ing a car purchase have a greater incentive to choose the fuel-efficient car. If a firm startsselling more of its goods through the Internet, it will rely less on foot traffic into itsretail store. This shift reduces its incentive to pay a high rent for a good location.

Economists analyze choices by focusing on incentives. In an economic context,incentives are benefits (including reduced costs) that motivate a decision maker infavor of a particular choice. Many things can affect incentives, but among the mostimportant are prices. If the price of gasoline rises, people have a greater incentive todrive less. If the price of MP3 players falls, people have a greater incentive to buy one.When the price of a good rises, firms are induced to produce more of that good, inorder to increase their profits. If a re

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