Campbell R. McConnellUniversity of Nebraska

Stanley L BruePacific Lutheran University

Sean M. FlynnScripps College

A.C

JMcGraw-HillIrwim

?£• List of Key Graphs

Preface

Reviewers

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PART ONE

To the Student

to Economics amd

Chapter 1

Limits, ADternatives, and Choices 3

The Economic Perspective 4Scarcity and Choice / Purposeful Behavior / MarginalAnalysis: Comparing Benefits and CostsConsider This: Free for All? 4Consider This: Fast-Food Lines 5

Theories, Principles, and Models 5

Microeconomics and Macroeconomics 6Microeconomics / Macroeconomics / Positive andNormative Economics

Individual's Economizing Problem 7Limited Income / Unlimited Wants / A Budget LineConsider This: Did Gates,Winfrey, and Rodriguez Make BadChokes? 9

Society's Economizing Problem 10Scarce Resources / Resource Categories

Production Possibilities Model //Production Possibilities Table / Production PossibilitiesCurve / Law of Increasing OpportunityCosts / Optimal AllocationConsider This: The Economics of War 14

Unemployment, Growth, and the Future 14A Growing Economy / Present Choices and FuturePossibilities / A Qualification: International Trade

Last Word: Pitfalls to Sound Economic Reasoning 16

Chapter 1 Appendix: Graphs and Their Meaning 22

Chapter 2

The Market System and the Circular Flow 29

Economic Systems 30The Command System / The Market System

Characteristics of the Market System 30Private Property / Freedom of Enterprise and Choice /Self-Interest / Competition / Markets and Prices /Technology and Capital Goods / Specialization /Use of Money / Active, but Limited, Government

Five Fundamental Questions 34What Wil l Be Produced? / How Will the Goods and ServicesBe Produced? / Who Will Get the Output? / How Will theSystem Accommodate Change? / How Will the SystemPromote Progress?Consider This: McHits and McMisses 35

The "Invisible Hand" 38

Contents

The Demise o f the Command SystemsThe Coordination Problem / The Incentive ProblemConsider This: TheTwo Koreas 39

The Circular Flow ModelHouseholds / Businesses / Product Market /Resource MarketLast Word: Shuffling the Deck 41

PART TWOPrice, Quantity, amd Efficiency

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Chapter 5

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Chapter 3

Demand, Supply, and Market Equilibrium 47

Markets 48

Demand 48Law of Demand / The Demand Curve / MarketDemand / Changes in Demand / Changes in QuantityDemanded

Supply 53Law of Supply / The Supply Curve / Market Supply /Determinants of Supply / Changes in Supply /

Changes in Quantity Supplied

Market Equilibrium 56

Equilibrium Price and Quantity / Rationing Function ofPrices / Efficient Allocation / Changes in Supply, Demand,and EquilibriumConsider This: Ticket Scalping: A Burn Rap! 58

Consider This: Salsa and Coffee Beans 61

A p p l i c a t i o n : G o v e r n m e n t - S e t Pr ices 61Price Ceilings on Gasoline / Rent Controls /Price Floors on Wheat

Last Word: A Legal Market for Human Organs? 62

Chapter 3 Appendix: Addit ional Examples of

Supply and Demand 69

Chapter 4

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76

Elasticity

Price Elasticity o f DemandThe Price-Elasticity Coefficient and Formula /Interpretations of Ed I The Total-Revenue Test / PriceElasticity and the Total-Revenue Curve / Determinants ofPrice Elasticity of Demand / Applications of Price Elasticity ofDemandConsider This: A Bit of a Stretch 78

Price Elasticity o f SupplyPrice Elasticity of Supply: The Market Period / PriceElasticity of Supply: The Short Run / Price Elasticity ofSupply: The Long Run / Applications of Price Elasticity ofSupply

Cross Elasticity and Income Elasticity of DemandCross Elasticity of Demand / Income Elasticity of DemandLast Word: Elasticity and Pricing Power: Why DifferentConsumers Pay Different Prices 86

87

Market Failures: Public Goods and Externalities 92

Market Failures in Competit ive Markets 93Demand-Side Market Failures / Supply-SideMarket Failures

Efficiently Functioning Markets 93Consumer Surplus / Producer Surplus / EfficiencyRevisited / Efficiency Losses (or Deadweight Losses)

Publ ic Goods 99Private Goods Characteristics / Public GoodsCharacteristics / Optimal Quantity of a Public Good /Demand for Public Goods / Comparing MB and MC /Cost-Benefit Analysis / Quasi-Public Goods /The Reallocation ProcessConsider This: Street Entertainers 100Consider This: Art for Art's Sake 101

Externalities 104Negative Externalities / Positive Externalities /Government Intervention / Society's Optimal Amount ofExternality ReductionConsider This: The Fable of the Bees 106

Government's Role in the Economy 109Last Word: Carbon Dioxide Emissions, Cap and Trade, andCarbon Taxes 110

PART THREE

Microeconomics of Product Markets 115

Chapter 6

Consumer Behavior 776

Law o f Diminishing Marginal Ut i l i ty 117Terminology / Total Utility and Marginal Utility /Marginal Utility and DemandConsider This: Vending Machines and Marginal Utility 11 7

Theory o f Consumer Behavior 118Consumer Choice and the Budget Constraint /Utility-Maximizing Rule / Numerical Example /Algebraic Generalization

Ut i l i ty Maximizat ion and the Demand Curve 122Deriving the Demand Schedule and Curve / Income andSubstitution Effects

Applications and Extensions 123iPods / The Diamond-Water Paradox / Opportunity Costand the Value of Time / Medical Care Purchases /Cash and Noncash Gifts

Prospect Theory 125Losses and Shrinking Packages / Framing Effects andAdvertising / Anchoring and Credit Card Bills /Mental Accounting and Overpriced Warranties /The Endowment Effect and Market TransactionsConsider This: Rising Consumption and the HedonicTreadmill 126Last Word: Nudging PeopleToward Better Decisions 128

Chapter 6 Appendix: Indifference Curve Analysis 133

Contents I)

Chapter 7

Businesses and the Costs of Production 140

Economic Costs 141Explicit and Implicit Costs / Accounting Profit and NormalProfit / Economic Profit / Short Run and Long Run

Short-Run Production Relationships 144Law of Diminishing ReturnsConsider This: Diminishing Returns from Study 144

Short-Run Production Costs 147Fixed, Variable, and Total Costs / Per-Unit, or Average,Costs / Marginal Cost / Shifts of the Cost Curves

Long-Run Production Costs 152Firm Size and Costs / The Long-Run Cost Curve /Economies and Diseconomies of Scale / Minimum EfficientScale and Industry Structure

Applications and Illustrations 157Rising Gasoline Prices / Successful Start-Up Firms /TheVerson Stamping Machine / The Daily Newspaper /Aircraft and Concrete PlantsLast Word: Don't Cry over Sunk Costs 158

Chapter 8

Pure Competition in the Short Run 763

Four Market Models 164

Pure Competition: Characteristics and

Occurrence 164

Demand as Seen by a Purely Competitive Seller 165Perfectly Elastic Demand / Average,Total, and MarginalRevenue

Profit Maximization in the Short Run: Total-Revenue-

Total-Cost Approach 166

Profit Maximization in the Short Run:

Marginal-Revenue-Marginal-Cost Approach 167

Profit-Maximizing Case / Loss-Minimizing Case /Shutdown CaseConsider This: The StillThere Motel 173

Marginal Cost and Short-Run Supply 173Generalized Depiction / Diminishing Returns, ProductionCosts, and Product Supply / Changes in Supply / Firm andIndustry: Equilibrium PriceLast Word: fixed Costs: Digging Yourself Out of a Hole 177

Chapter 9

Pure Competition in the Long Run 181

The Long Run in Pure Competition 182Profit Maximization in the Long Run / Goal of OurAnalysis / Long-Run Equilibrium / Long-Run Supply for aConstant-Cost Industry / Long-Run Supply for an Increasing-Cost Industry / Long-Run Supply for a Decreasing-CostIndustry

Pure Competition and Efficiency 186Productive Efficiency:? = Minimum ATC / AllocativeEfficiency:? = MC / Maximum Consumer and ProducerSurplus / Dynamic Adjustments / "Invisible Hand" Revisited

Technological Advance and Competition 189Creative DestructionConsider This: Running a Company Is Hard Business / 90Last Word: Efficiency Gains from Entry: The Case of GenericDrugs 191

Chapter 10

Pure Monopoly 194

An Introduction to Pure Monopoly 195Examples of Monopoly / Dual Objectives of theStudy of Monopoly

Barriers to Entry 195Economies of Scale / Legal Barriers to Entry: Patents andLicenses / Ownership or Control of Essential Resources /Pricing and Other Strategic Barriers to Entry

Monopoly Demand 197Marginal Revenue Is Less Than Price / The Monopolist Is aPrice Maker / The Monopolist Sets Prices in the ElasticRegion of Demand

Output and Price Determination 200Cost Data / MR = MC Rule / No Monopoly SupplyCurve / Misconceptions Concerning Monopoly Pricing /Possibility of Losses by Monopolist

Economic Effects of Monopoly 203Price, Output, and Efficiency / Income Transfer / CostComplications / Assessment and Policy Options

Price Discrimination 207Conditions / Examples of Price Discrimination /Graphical AnalysisConsider This: Price Discrimination at the Ballpark 208

Regulated Monopoly 209Socially Optimal Price: P = MC / Fair-Return Price: P =ATC / Dilemma of RegulationLast W o r d : De Beers Diamonds: Are Monopolies Forever? 212

Chapter 11

Monopolistic Competition and Oligopoly 276

Monopolistic Competition 216Relatively Large Number of Sellers / DifferentiatedProducts / Easy Entry and Exit / Advertising /Monopolistically Competitive Industries

Price and Output in Monopolistic Competition 219The Firm's Demand Curve / The Short Run:Profit or Loss / The Long Run: Only a Normal Profit

Monopolistic Competition and Efficiency 221Neither Productive nor Allocative Efficiency / ExcessCapacity

Product Variety 222Benefits of Product Variety / Further Complexity

Oligopoly 223A Few Large Producers / Homogeneous or DifferentiatedProducts / Control over Price, but Mutual Interdependence /Entry Barriers / Mergers / Oligopolistic IndustriesConsider This: Creative Strategic Behavior 224

xxx Contents

Oligopoly Behavior: A Game Theory Overview 226Mutual Interdependence Revisited / Collusion /Incentive to CheatConsider This: The Prisoner's Dilemma 227

Three Oligopoly Models 228Kinked-Demand Theory: Noncollusive Oligopoly / Cartelsand Other Collusion / Price Leadership Model

Oligopoly and Advertising 234Positive Effects of Advertising / Potential NegativeEffects of Advertising

$ Oligopoly and Efficiency 235Productive and Allocative Efficiency / QualificationsLast Word: Oligopoly in the Beer Industry 236

Chapter 11 Appendix: AdditionalGame Theory Applications 241

WEB Chapter 11 www.mcconnelH 9e.com

Technology, R&D, and Efficiency 246

Invention, Innovation, and Diffusion 1IW-2Invention / Innovation / Diffusion / R&DExpenditures / Modern View of Technological Advance

Role of Entrepreneurs and Other Innovators IIW-4Forming Start-Ups / Innovating within Existing Firms /Anticipating the Future / Exploiting University andGovernment Scientific Research

A Firm's Optimal Amount of R&-D IIW-5Interest-Rate Cost of Funds / Expected Rateof Return / Optimal R&D Expenditures

Increased Profit via Innovation IIW-8Increased Revenue via Product Innovation / Reduced Costvia Process Innovation

Imitation and R&-D Incentives IIW-10Benefits of Being FirstConsider This: Trade Secrets / IW-12

Role of Market Structure IIW-13Market Structure and Technological Advance / Inverted-UTheory of R&D / Market Structure and TechnologicalAdvance: The Evidence

Technological Advance and Efficiency IIW-15Productive Efficiency / Allocative Efficiency / CreativeDestruction

Last Word: On the Path to the PersonalComputer and Internet IIW-16

PART FOUR

Microeconomics of Resource Markets 247

Chapter 12

The Demand for Resources

Significance of Resource PricingMarginal Productivity Theory of Resource Demand

Resource Demand as a Derived Demand / Marginal RevenueProduct / Rule for Employing Resources: MRP =MRC / MRP as Resource Demand Schedule /

249249

Resource Demand under Imperfect Product MarketCompetition / Market Demand for a ResourceConsider This: Superstars 253

Determinants of Resource Demand 253Changes in Product Demand / Changes in Productivity /Changes in the Prices of Other Resources / OccupationalEmployment Trends

Elasticity of Resource Demand 256

Optimal Combination of Resources 258The Least-Cost Rule / The Profit-Maximizing Rule /Numerical Illustration

Marginal Productivity Theory of IncomeDistribution 260

Last Word: Input Substitution: The Case of ATMs 261

Chapter 13

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Wage Determination

Labor, Wages, and Earnings

General Level of WagesRole of Productivity / Real Wages and Productivity /Long-Run Trend of Real Wages

A Purely Competitive Labor MarketMarket Demand for Labor / Market Supply of Labor /Labor Market Equilibrium

Monopsony ModelUpsloping Labor Supply to Firm / MRC Higher Than theWage Rate / Equilibrium Wage and Employment /Examples of Monopsony Power

Three Union ModelsDemand-Enhancement Model / Exclusive or Craft UnionModel / Inclusive or Industrial Union Model / WageIncreases and Job Loss

Bilateral Monopoly ModelIndeterminate Outcome of Bilateral Monopoly /Desirability of Bilateral Monopoly

The Minimum-Wage ControversyCase against the Minimum Wage / Case for the MinimumWage / Evidence and Conclusions

Wage DifferentialsMarginal Revenue Productivity / Noncompeting Groups /Compensating Differences / Market ImperfectionsConsider This: My Entire Life 280

Pay for PerformanceThe Principal-Agent Problem Revisited / Addenda: NegativeSide Effects of Pay for PerformanceLast Word: Are Chief Executive Officers (CEOs) Overpaid? 283

Chapter 13 Appendix: Labor Unions and TheirImpacts

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248 Chapter 14

Rent, Interest, and Profit

Economic RentPerfectly Inelastic Supply / Equilibrium Rent and Changes inDemand / Productivity Differences and RentDifferences / Land Rent:A Surplus Payment / Land

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Contents xxxi

Ownership: Fairness versus Allocative Efficiency /Application: A Single Tax on Land

Interest 297Money Is Not a Resource / Interest Rates and InterestIncome / Range of Interest Rates / Pure Rate of Interest /Loanable Funds Theory of Interest Rates / Extending theModel / Time-Value of Money / Role of InterestRates / Application: Usury LawsConsider This: That Is Interest 301

Economic Profit 304Entrepreneurship and Profit / Insurable and UninsurableRisks / Sources of Uninsurable Risks / Profit asCompensation for Bearing Uninsurable Risks / Sources ofEconomic Profit / Profit Rations Entrepreneurship /Entrepreneurs, Profits, and Corporate StockholdersConsider This: Apple CEO Steve Jobs 305Last Word: Determining the Price of Credit 306

Income Shares 308

Chapter 15

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313

Natural Resource and Energy Economics

Resource Supplies: Doom or Boom?Population Growth / Resource Consumption per PersonConsider This: Can Governments Raise Birthrates? 314

Energy EconomicsEfficient Energy Use / Running Out of Energy!Consider This: Developing/Uternative Fuel Sources Is Both Riskyand Costly 320

Natural Resource EconomicsUsing Present Values to Evaluate Future PossibilitiesNonrenewable Resources

Present Use versus Future Use / Incomplete Property RightsLead to Excessive Present Use / Application: ConflictDiamonds

Renewable ResourcesElephant Preservation / Forest Management / OptimalForest Harvesting / Optimal Fisheries Management / Policiesto Limit Catch SizesLast Word: Is Economic Growth Bad for the Environment? 330

PART FIVE

Microeconomics of Government

Chapter 16

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325

Public Finance: Expendituresand Taxes

Government and the Circular FlowGovernment Finance

Government Purchases and Transfers /Government Revenues

Federal FinanceFederal Expenditures / Federal Tax Revenues

State and Local FinanceState Finances / Local FinancesConsider This: State Lotteries: A Good Bet? 342

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Local, State, and Federal Employment 342Apportioning the Tax Burden 344

Benefits Received versus Ability to Pay /Progressive, Proportional, and Regressive TaxesConsider This: The VAT: A Very Alluring Tax? 346

Tax Incidence and Efficiency Loss 347Elasticity and Tax Incidence /Efficiency Loss of a Tax

Probable Incidence of U.S. Taxes 350Personal IncomeTax / PayrollTaxes /

Corporate IncomeTax / Sales and Excise Taxes /Property TaxesLast Word: Taxation and Spending: Redistribution versusRecycling 350

The U.S. Tax Structure 353

Chapter 17Asymmetric Information, Voting, andPublic Choice

Information FailuresInadequate Buyer Information about Sellers /Inadequate Seller Information about Buyers /QualificationConsider This: "Lemons" 360

Public Choice TheoryRevealing Preferences throughMajority Voting

Inefficient Voting Outcomes / Paradox ofVoting /Median-Voter Model

Government FailureRepresentative Democracy and the Principal-AgentProblem / Clear Benefits, Hidden Costs /Limited and Bundled Choice / Bureaucracy andInefficiency / Corruption / Imperfect InstitutionsConsiderThis: Mohair and the Collective Action Problem 366Last Word: "Government Failure" in the News 370

PART SIX

MocroecoDDomic Issues amd Policies

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335 Chapter 18Antitrust Policy and RegulationThe Antitrust Laws

Historical Background / Sherman Act of 1890 /Clayton Act of 1914 / Federal Trade CommissionAct of 1914 / Celler-KefauverActof 1950

Antitrust Policy: Issues and ImpactsIssues of Interpretation / Issues of Enforcement /Effectiveness of Antitrust LawsConsiderThis: Of Catfish and Art (and OtherThings inCommon) 381

Industrial RegulationNatural Monopoly / Problems with IndustrialRegulation / Legal Cartel Theory

Deregulation

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Contents

Social Regulation 384Distinguishing Features / The Optimal Level of SocialRegulation / Two RemindersLast Word: United States v. Microsoft 386

Chapter 19 _ _ _Agriculture: Economics and Policy 391

Economics of Agriculture 392The Short Run: Price and Income Instability / The Long Run:

f. A Declining Industry / Farm-Household IncomeConsiderThis: Risky Business 396

Economics of Farm Policy 398Rationale for Farm Subsidies / Background:The ParityConcept / Economics of Price Supports / Reduction ofSurplusesConsiderThis: Putting Corn inYour GasTank 401

Criticisms and Politics 402Criticisms of the Parity Concept / Criticisms of thePrice-Support System / The Politics of Farm PolicyLast Word: The Sugar Program: A Sweet Deal 404

Recent Farm Policies 405Freedom to Farm Act of 1996 / The Food, Conservation, andEnergy Act of 2008

Chapter 20Income Inequality, Poverty, 470and DiscriminationFacts about Income Inequality 411

Distribution by Income Category / Distribution by Quintiles(Fifths) / The Lorenz Curve and Gini Ratio / Income Mobility:The Time Dimension / Effect of Government Redistribution

Causes of Income Inequality 414Ability / Education and Training / Discrimination /Preferences and Risks / Unequal Distribution of Wealth /Market Power / Luck, Connections, and Misfortune

Income Inequality over Time 415Rising Income Inequality since 1970 / Causes of GrowingInequalityConsiderThis: Laughing at Shrek 417

Equality versus Efficiency 417The Case for Equality: Maximizing Total Utility /The Case for Inequality: Incentives and Efficiency /The Equality-Efficiency Trade-offC o n s i d e r T h i s : Slicing the Pizza 419

The Economics of Poverty 419Definition of Poverty / Incidence of Poverty /Poverty Trends / Measurement Issues

The U.S. Income-Maintenance System 421Social Insurance Programs / Public Assistance Programs

Discrimination 424Economic Analysis of Discrimination 424

Taste-for-Discrimination Model / StatisticalDiscrimination / Occupational Segregation: The CrowdingModel / Cost to Society as Well as to IndividualsLast Word: U.S. Family Wealth and Its Distribution 428

Chapter 21Health Care 433The Health Care Industry 434The U.S. Emphasis on Private Health Insurance 434

Twin Problems: Costs and Access 434High and Rising: Health Care Costs . 435

Health Care Spending / Quality of Care: Are We Healthier? /Economic Implications of Rising costs / Too Much Spending?

Limited Access 438Why the Rapid Rise in Costs? 439

Peculiarities of the Health Care Market / The IncreasingDemand for Health Care / Role of Health Insurance /Supply Factors in Rising Health Care Prices /Relative ImportanceConsiderThis: Cancer Fight Goes Nuclear 445

Cost Containment: Altering Incentives 445Deductibles and Copayments / Health Savings Accounts /Managed Care / Medicare and DRG / Limits on MalpracticeAwards

The Patient Protection and Affordable Care Act 447Major Provisions / Objections and AlternativesLast Word: Singapore's Efficient and Effective Health CareSystem 448

Chapter 22Immigration 454Number of Immigrants 455

Legal Immigrants / Illegal Immigrants

The Decision to Migrate 456Earnings Opportunities / Moving Costs / Factors AffectingCosts and Benefits

Economic Effects of Immigration 458Personal Gains / Impacts on Wage Rates, Efficiency, andOutput / Income Shares / Complications andModifications / Fiscal Impacts / Research FindingsConsiderThis: Stars and Stripes 459

The Illegal Immigration Debate 463Employment Effects / Wage Effects / Price Effects / FiscalImpacts on Local and State Governments / Other ConcernsLast Word: Immigration Reform: The Beaten Path to the CurrentStalemate 466

Optimal Immigration 467

PART SEVENGDP, Growth, and Instability 471

Chapter 23An Introduction to Macroeconomics 472

Performance and Policy 473The Miracle of Modern Economic Growth 474

Saving, Investment, and Choosing between Present and FutureConsumption / Banks and Other Financial InstitutionsConsiderThis: Economic versus Financial Investment 476

Contents xxxiii

Uncertainty, Expectations, and Shocks 476Demand Shocks and Flexible Prices / Demand Shocks andSticky PricesConsiderThis: The Great Recession 479

How Sticky Are Prices? 480Last Word: Inventory Management and the Business Cycle 480

Categorizing Macroeconomic Models UsingPrice Stickiness 482

Chapter 24Measuring Domestic Output andNational Income 485

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486

Assessing the Economy's PerformanceGross Domestic Product

A Monetary Measure / Avoiding Multiple Counting /GDP Excludes Nonproduction Transactions / Two Ways ofLooking at GDP: Spending and Income

The Expenditures Approach 488Personal Consumption Expenditures (C) / Gross PrivateDomestic Investment (lg) I Government Purchases (G) /Net Exports (Xn) / Putting It All Together: GDP = C +/e + G + Xn

ConsiderThis: Stocks versus Flows 491

The Income Approach 492Compensation of Employees / Rents / Interest /Proprietors' Income / Corporate Profits / Taxes onProduction and Imports / From National Income to GDP

Other National Accounts 494Net Domestic Product / National Income / PersonalIncome / Disposable Income / The Circular Flow Revisited

Nominal GDP versus Real GDP 497Adjustment Process in a One-Product Economy / AnAlternative Method / Real-World Considerations and Data

Shortcomings of GDP 499Nonmarket Activities / Leisure / Improved ProductQuality / The Underground Economy / GDP and theEnvironment / Composition and Distribution of Output /Noneconomic Sources of Well-BeingLast Word: Magical Mystery Tour 501

Chapter 25

Economic Growth 505

Economic Growth 506Growth as a Goal / Arithmetic of Growth / Growth in theUnited States

Modern Economic Growth 508The Uneven Distribution of Growth / Catching Up Is PossibleConsiderThis: Economic Growth Rates Matter! 510

Institutional Structures That Promote Growth 511C o n s i d e r T h i s : Patents and Innovation 512

Determinants of Growth 512Supply Factors / Demand Factor / Efficiency Factor

Production Possibilities Analysis 513Growth and Production Possibilities /Labor and Productivity

Accounting for Growth 514Labor Inputs versus Labor Productivity / TechnologicalAdvance / Quantity of Capital / Education andTraining / Economies of Scale and Resource AllocationConsiderThis: Women, the Labor Force, and Economic Growth 5 / 6

The Rise in the Average Rate of Productivity Growth 518Reasons for the Rise in the Average Rate of ProductivityGrowth / Implications for Economic Growth /Skepticism about Longevity / What Can We Conclude?

Is Growth Desirable and Sustainable? 521The Antigrowth View / In Defense of Economic GrowthLast Word: Economic Growth in China 522

Chapter 26Business Cycles, Unemployment, and Inflation 526The Business Cycle 527

Phases of the Business Cycle / Causation: A First Glance /Cyclical Impact: Durables and Nondurables

Unemployment 529Measurement of Unemployment / Types of Unemployment /Definition of Full Employment / Economic Cost ofUnemployment / NoneconomicCosts / International Comparisons

Inflation 535Meaning of Inflation / Measurement of Inflation / Facts ofInflation / Types of Inflation / Complexities / Core InflationConsiderThis: Clipping Coins 537

Redistribution Effects of Inflation 538Who Is Hurt by Inflation? / Who Is Unaffected or Helped byInflation? / Anticipated Inflation / Other Redistribution Issues

Does Inflation Affect Output? 541Cost-Push Inflation and Real Output / Demand-Pull Inflationand Real Output / HyperinflationLast Word: The Stock Market and the Economy 542

PART EIGHT

Macroeconomic Models andFiscal Policy 546

Chapter 27Basic Macroeconomic Relationships 547

The Income-Consumption andIncome-Saving Relationships 548

The Consumption Schedule / The Saving Schedule /Average and Marginal Propensities / NonincomeDeterminants of Consumption and Saving /Other Important ConsiderationsConsiderThis: The Great Recession and the Paradox of Thrift 554

The Interest-Rate-InvestmentRelationship 555

Expected Rate of Return / The Real Interest Rate /Investment Demand Curve / Shifts of the InvestmentDemand Curve / Instability of InvestmentConsiderThis: The Great Recession and the Investment Riddle 560

xxxiv Contents

The Multiplier Effect 560Rationale / The Multiplier and the Marginal Propensities /How Large Is the Actual Multiplier Effect?Last Word: Squaring the Economic Circle 563

Chapter 28The Aggregate ExpendituresModel 567

Assumptions and Simplifications 568

^Consumption and Investment Schedules 568Equilibrium GDP: C + lg = GDP 569

Tabular Analysis / Graphical Analysis

Other Features of Equilibrium GDP 572Saving Equals Planned Investment / No Unplanned Changesin Inventories

Changes in Equilibrium GDP and the Multiplier 573Adding International Trade 574

Net Exports and Aggregate Expenditures / The Net ExportSchedule / Net Exports and Equilibrium GDP / InternationalEconomic Linkages

Adding the Public Sector 578Government Purchases and Equilibrium GDP / Taxation andEquilibrium GDP

Equilibrium versus Full-Employment GDP 581Recessionary Expenditure Gap / Inflationary ExpenditureGap / Application: The Recession of 2007-2009Last Word: Say's Law, the Great Depression, and Keynes 584

Chapter 29Aggregate Demand andAggregate Supply 589

Aggregate Demand 590Aggregate Demand Curve

Changes in Aggregate Demand 591Consumer Spending / Investment Spending / GovernmentSpending / Net Export Spending

Aggregate Supply 594Aggregate Supply in the Immediate Short Run / AggregateSupply in the Short Run / Aggregate Supply in the LongRun / Focusing on the Short Run

Changes in Aggregate Supply 597Input Prices / Productivity / Legal-InstitutionalEnvironment

Equilibrium and Changes in Equilibrium 600Increases in AD: Demand-Pull Inflation / Decreases in AD:Recession and Cyclical Unemployment / Decreases in AS:Cost-Push Inflation / Increases in AS: Full Employment withPrice-Level StabilityConsiderThis: Ratchet Effect 603Last Word: Has the Impact of Oil Prices Diminished? 605

Chapter 29 Appendix: The Relationship of theAggregate Demand Curve to the AggregateExpenditures Model 610

Chapter 30Fiscal Policy, Deficits, and Debt 673Fiscal Policy and the AD-AS Model 614

Expansionary Fiscal Policy / ContractionaryFiscal Policy / Policy Options: G or T?

Built-in Stability 617Automatic or Built-in Stabilizers

Evaluating Fiscal Policy 619Cyclically Adjusted Budget / Recent U.S. Fiscal Policy /Budget Deficits and Projections

Problems, Criticisms, and Complications 623Problems of Timing / Political Considerations /Future Policy Reversals / Offsetting State and LocalFinance / Crowding-Out Effect / Current Thinkingon Fiscal Policy

The U.S. Public Debt 625Ownership / Debt and GDP / InternationalComparisons / Interest Charges

False Concerns 627Bankruptcy / Burdening Future Generations

Substantive Issues 628Income Distribution / Incentives / Foreign-Owned PublicDebt / Crowding-Out Effect RevisitedLast Word: The Social Security and MedicareShortfalls 630

PART NINE

Money, Banking, and MonetaryPolicy 635

Chapter 31Money, Banking, and FinancialInstitutions

The Functions of MoneyThe Components of the Money Supply

Money Definition MI / Money Definition M2ConsiderThis: Are Credit Cards Money? 640

What "Backs" the Money Supply?Money as Debt / Value of Money / Money andPrices / Stabilizing Money's Purchasing Power

The Federal Reserve and the Banking SystemHistorical Background / Board of Governors /The 12 Federal Reserve Banks / FOMC / Commercial Banksand Thrifts / Fed Functions and the Money Supply /Federal Reserve Independence

The Financial Crisis of 2007 and 2008The Mortgage Default Crisis / Securitization /Failures and Near-Failures of Financial Firms /The Treasury Bailout: TARP / The Fed's Lender-of-Last-Resort Activities

The Postcrisis U.S. Financial ServicesIndustry

Last Word: Electronic Banking 651

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Contents xxxv

Chapter 32

Money Creation 655

The Fractional Reserve System 656Illustrating the Idea: The Goldsmiths / SignificantCharacteristics of Fractional Reserve Banking

A Single Commercial Bank 657Transaction I: Creating a Bank / Transaction 2:AcquiringProperty and Equipment / Transaction 3:Accepting Deposits /Transaction 4: Depositing Reserves in a Federal ReserveBank / Transaction 5: Clearing a Check Drawn against the Bank

Money-Creating Transactions of a Commercial Bank 660Transaction 6: Granting a Loan / Transaction 7: BuyingGovernment Securities / Profits, Liquidity, and the FederalFunds Market

The Banking System: Multiple-Deposit Expansion 663The Banking System's Lending Potential / The MonetaryMultiplier / Reversibility: The Multiple Destruction of MoneyLast Word: The Bank Panics of 1930-1933 666

Chapter 33

Interest Rates and Monetary Policy 670

Interest Rates 671The Demand for Money / The Equilibrium Interest Rate /Interest Rates and Bond Prices

The Consolidated Balance Sheet of theFederal Reserve Banks

Assets / Liabilities

Tools of Monetary PolicyOpen-Market Operations / The Reserve Ratio /The Discount Rate / Term Auction Facility /Relative Importance

Targeting the Federal Funds RateExpansionary Monetary Policy / Restrictive MonetaryPolicy / The Taylor RuleConsiderThis: The Fed as a Sponge 683

Monetary Policy, Real GDP and the Price LevelCause-Effect Chain / Effects of an Expansionary MonetaryPolicy / Effects of a Restrictive Monetary Policy

Monetary Policy: Evaluation and IssuesRecent U.S. Monetary Policy / Problems and ComplicationsConsiderThis: Up, Up, and Away 689

The "Big Picture"Last Word: The "Big Picture" 690

Chapter 34

Financial Economics 697

Financial Investment 698Present Value 698

Compound Interest / The PresentValue Model /Applications

Some Popular Investments 701Stocks / Bonds / Mutual Funds / Calculating InvestmentReturns / Asset Prices and Rates of Return

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Arbitrage 703Risk 704

Diversification / Comparing Risky Investments /Relationship of Risk and Average Expected Rates of Return /The Risk-Free Rate of Return

The Security Market Line 708Security Market Line: ApplicationsConsiderThis: Ponzi Schemes 7/0Last Word: Index Funds versus Actively Managed Funds 712

PART TEN

Extensions and issyes 776

Chapter 35

Extending the Analysis ofAggregate Supply 717

From Short Run to Long Run 718Short-Run Aggregate Supply / Long-Run AggregateSupply / Long-Run Equilibrium in the AD-AS Model

Applying the Extended AD-AS Model 720Demand-Pull Inflation in the Extended AD-AS Model /Cost-Push Inflation in the Extended AD-AS Model /Recession and the Extended AD-AS Model / EconomicGrowth with Ongoing Inflation

The Inflation-Unemployment Relationship 724The Phillips Curve / Aggregate Supply Shocks andthe Phillips Curve

The Long-Run Phillips Curve 728Short-Run Phillips Curve / Long-Run Vertical PhillipsCurve / Disinflation

Taxation and Aggregate Supply 730Taxes and Incentives to Work / Incentives to Save andInvest / The Laffer Curve / Criticisms of the LafferCurve / Rebuttal and EvaluationConsiderThis: Sherwood Forest 732Last Word: Do Tax Increases Reduce Real GDP? 733

Chapter 36

Current Issues in Macro Theoryand Policy 737

What Causes Macro Instability? 738Mainstream View / Monetarist View / Real-Business-CycleView / Coordination FailuresConsiderThis: Too Much Money? 741

Does the Economy "Self-Correct"? 742New Classical View of Self-Correction / Mainstream View ofSelf-Correction

Rules or Discretion? 745In Support of Policy Rules / In Defense of DiscretionaryStabilization Policy / Policy SuccessesConsiderThis: On the Road Again 746

Summary of Alternative Views 750Last Word: The Taylor Rule: Could a Robot ReplaceBen Bernanke? 749

xxxvi Contents

PART ELEVEN

international Economics

Chapter 37

753

International Trade 754

Some Key Trade Facts 755The Economic Basis for Trade 756

Comparative Advantage 756- Two Isolated Nations / Specializing Based on Comparative

Advantage / Terms of Trade / Gains from Trade /Trade with Increasing Costs / The Case for Free TradeConsiderThis: A CPA and a House Painter 757ConsiderThis: Misunderstanding the Gains fromTrade 762

Supply and Demand Analysis of Exports and Imports 764Supply and Demand in the United States / Supply andDemand in Canada / Equilibrium World Price, Exports, andImports

Trade Barriers and Export Subsidies 767Economic Impact of Tariffs / Economic Impact of Quotas /Net Costs of Tariffs and QuotasConsiderThis: Buy American? 767

The Case for Protection: A Critical Review 770Military Self-Sufficiency Argument / Diversification-for-Stability Argument / Infant Industry Argument /Protection-against-Dumping Argument /Increased Domestic Employment Argument /Cheap Foreign Labor Argument

Multilateral Trade Agreements and Free-Trade Zones 772General Agreement on Tariffs and Trade / World TradeOrganization / The European Union / North American FreeTrade Agreement

Trade Adjustment Assistance 774

Offshoring of Jobs 774Last Word: Petition of the Candlemakers, 1845 775

Chapter 38

The Balance off Payments, ExchangeRates, and Trade Deficits

International Financial TransactionsThe Balance of Payments

Current Account / Capital and Financial Account /Why the Balance? / Official Reserves, Payments Deficits, andPayments Surpluses

780

781

781

Flexible Exchange Rates 785Depreciation and Appreciation / Determinants of ExchangeRates / Flexible Rates and the Balance ofPayments / Disadvantages of Flexible Exchange Rates

Fixed Exchange Rates 790Use of Official Reserves / Trade Policies / ExchangeControls and Rationing / Domestic MacroeconomicAdjustments

The Current Exchange Rate System:The Managed Float 792

Recent U. S. Trade Deficits 794Causes of the Trade Deficits / Implications ofU.S.Trade DeficitsLast Word: Speculation in Currency Markets 796

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The Economics of Developing Countries 39W-1

The Rich and the Poor 39W-2Classifications / Comparisons / Growth, Decline, andIncome Gaps / The Human Realities of Poverty

Obstacles to Economic Development 39W-4Natural Resources / Human Resources / CapitalAccumulation / Technological Advance / Sociocultural andInstitutional Factors

The Vicious Circle 39W-IIThe Role of Government 39W-I2

A Positive Role / Public Sector Problems

The Role of Advanced Nations 39W-I4Expanding Trade / Admitting Temporary Workers /Discouraging Arms Sales / Foreign Aid: Public Loans andGrants / Flows of Private CapitalLast Word: Famine in Africa 39W-I6

Glossary G

Credits C-lIndex IND