Introduction to

WILLIAM D. ROHLF, JR.Drury University

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Contents viPreface xviii

S K ] Introduction: Scarcity and the Economic System 1CHAPTER 1 The Study of Economics 3

CHAPTER 2 Economic Systems 35

Microeconomics: Markets, Prices, and the Roleof Competition 65

CHAPTER 3 Demand and Supply: Price Determination in CompetitiveMarkets 67

CHAPTER 4 Applications Using Demand and Supply 100

CHAPTER 5 Costs and Decision Making 131

CHAPTER 6 Price Taking: The Purely Competitive Firm 165

CHAPTER 7 Price Searching: The Firm with Market Power 192

CHAPTER 8 Industry Structure and Public Policy 227

CHAPTER 9 Market Failure 261

291P A R f f H R E I j Macroeconomics: The Economy as a WholeCHAPTER io Measuring Aggregate Performance 293

CHAPTER n Aggregate Demand and Supply: The Model of theSelf-Correcting Economy 324

CHAPTER 12 Fiscal Policy 354

CHAPTER 13 Money, Banking, and Monetary Policy 380

CHAPTER 14 The Activist-Nonactivist Debate 415

CHAPTER 15 Economic Growth: The Importance of the Long Run 439

P A R T F O U R | International Economics: Trade, Exchange Rates,and the Role of Trade Agreements 469

CHAPTER 16 International Economics 471

Glossary 506Index 514

Preface xviii

PART ONE

Introduction: Scarcity and the Economic System 1CHAPTER 1 The Study of Economics 3 '

The Economic Problem 4Cost-Benefit Analysis and Opportunity Cost 5

D o a a n ^ r r 1 0 ^ 5 0 " ^ B^B..Bnce Benefit*. CostThe Production Possibilities Curve 8

Opportunity Costs along the Curve 10The Law of Increasing Costs 11Economic Growth and the Benefits of Trade 12

The Three Fundamental Questions 14What to Produce 14How to Produce 14For Whom to Produce 15

Five Economic Goals 15Conflicts and Trade-Offs 17

Full Employment versus Stable Prices 18Economic Growth versus Environmental Protection 18Equality versus Efficiency 18Choosing between Objectives 19

Economic Theory and Policy 19Theory in Everyday Life 19Lessons from the Production Possibilities Model 20A Theory of Cigarette Consumption 21

Policies and Predictions 24Economists and Conclusions 24The Organization of the Text 25

VI

Contents vii

CHAPTER 2 Economic Systems 35The Model of Pure Capitalism 36

Elements of Capitalism 36The Circular-Flow Model 38How Capitalism Answers the Three Fundamental Questions 41Capitalism: Strengths and Weaknesses 43

The Model of Pure Command Socialism 44Elements of Command Socialism 44The Pyramid Model 45How Command Socialism Answers the Three Fundamental Questions 46Command Socialism: Strengths and Weaknesses 47

Mixed Economies: The Real-World Solution 48The U.S. Economic System 48The Rest of the World 52

• USE YOUR ECONOMIC REASONING: In Hard Times, Russia Movesin to Reclaim Private Industries 54

SUMMARY 58 n KEY TERMS 59 • STUDY QUESTIONS 59 a ANSWER KEY 63

PART TWO |

Microeconomics: Markets, Prices, and the Role of Competition 65

CHAPTER 3 Demand and Supply: Price Determination in Competitive Markets 67Demand 68

Demand Curves 69The Law of Demand 70Determinants of Demand 70

Income 71Tastes and Preferences 71Expectations about Prices 72Price of Related Goods 72The Number of Consumers in the Market 72

Change in Quantity Demanded versus Change in Demand 73Supply 74

The Supply Curve 75a USE YOUR ECONOMIC REASONING: Today's Special 76

The Law of Supply 76Determinants of Supply 78

Technology 78Resource Prices 78The Number of Producers in the Market 79

Change in Supply versus Change in Quantity Supplied 80

VIII Contents

The Process of Price Determination 81• USE YOUR ECONOMIC REASONING: Like a Lead Balloon 82

Equilibrium Price and Quantity 84The Rationing and Motivating Functions of Prices 86

Changes in the Equilibrium Price 87The Impact of a Change in Demand 87The Impact of a Change in Supply 89The Impact of Simultaneous Changes in Demand and Supply 90

D USE YOUR ECONOMIC REASONING: Don't Get Used to Cheap Oil, Analysts Say 92Economic Efficiency and the^Role of Prices 93

SUMMARY 94 • KEY TERMS 96 • STUDY QUESTIONS 96 - ANSWER KEY 99

CHAPTER 4 Applications Using Demand and Supply 100Government Intervention in Pricing 101

Price Supports 101Price Ceilings 103Subsidies 106Excise Taxes 107

Elasticity of Demand 109The Coefficient of Demand Elasticity 110Degrees of Elasticity 111Elasticity along a Straight-Line Demand Curve 112Elasticity and Total Revenue 113The Determinants of Elasticity 115Looking Back: Excise Taxes and the Elasticity of Demand 117

• USE YOUR ECONOMIC REASONING: Gas Price Swings Mess Up Automakers' ProductPlans 118

SUMMARY 120 a KEY TERMS 121 n STUDY QUESTIONS 121 n ANSWER KEY 124

n APPENDIX: The Elasticity of Supply 125

CHAPTER 5 Costs and Decision Making 131Explaining Human Behavior: The Role of Assumptions 132

The Pursuit of Self-Interest 132Comparing Costs and Benefits 133

The Importance of Marginal Analysis 133The Improper Estimation of Costs 135

Ignoring Implicit Costs 135Failing to Ignore Fixed and Sunk Costs 137

Business Decision Making and the Pursuit of Profit 139• USE YOUR ECONOMIC REASONING: Subprime Debacle Traps Even Very Credit-

Worthy; As Housing Boomed, Industry Pushed Loans to a Broader Market 140

Short-Run Costs of Production 142Total Costs: Fixed and Variable 142

Contents ix

Average Costs: Fixed, Variable, and Total 144Marginal Cost 145

The Cost Curves 147Selecting the Profit-Maximizing Level of Output 150

Marginal Revenue Is the Marginal Benefit 150Using the Decision Rule: Comparing Marginal Revenueand Marginal Cost 150Graphing and Profit Maximization 152 ^Wise Decisions Don't Always Lead to Profits 153

Gas Stations, Fast Food, and the All-Night Grocery Store 155Whatever Happened to Gas Stations? 155Why Is Breakfast Everywhere? 156Sale! Buy Below Cost! 156SUMMARY 158 • KEY TERMS 159 • STUDY QUESTIONS 159 • ANSWER KEY 164

CHAPTER 6 Price Taking: The Purely Competitive Firm 165The Nature of Pure Competition 166The Firm Under Pure Competition 167Profit Maximization in the Short Run 169

Determining the Profit-Maximizing Output 169Marginal Cost and Firm Supply 171Evaluating Profit or Loss 171

Profit Maximization in the Long Run 177Setting the Stage: The Short-Run Picture 177The Entrance of Firms: Attraction of Profits 177The Exit of Firms: Looking for Greener Pastures 179

The Benefits of Pure Competition 179• USE YOUR ECONOMIC REASONING: Ethanol Boom Is Running Out of Gas 180

Production Efficiency 180Allocative Efficiency 182SUMMARY 184 a KEY TERMS 186 • STUDY QUESTIONS 186 a ANSWER KEY 191

CHAPTER 7 Price Searching: The Firm with Market Power 192The Acquisition of Market Power 193

Product Differentiation as a Source of Market Power 193Control over Supply as a Source of Market Power 194

n USE YOUR ECONOMIC REASONING: Oil Cartel Keeps Cuts on Track 196

Price Searching 197The Price Searcher's Demand Curve 198

The Profit-Maximization Rule 199Calculating Marginal Revenue 200The Profit-Maximizing Price and Quantity 200A Digression on Price Discrimination 203

Contents

Evaluating the Short-Run Profit or Loss 205Barriers to Entry and Long-Run Profits 206Price Searchers and Resource Allocation 207• USE YOUR ECONOMIC REASONING: For Champions of Haggling, No Price Tag Is

Sacred 208

Price Searchers and Economies of Scale 211SUMMARY 214 • KEY TERMS 216 • STUDY QUESTIONS 216 • ANSWER KEY 220

n APPENDIX: Pricing in Practice 221

CHAPTER 8 Industry Structure and Public Policy 227Industry Structure and Market Power 228Pure Competition 228Monopolistic Competition 229

Monopolistic Competition and Market Power 230Evaluating Monopolistic Competition 231

Oligopoly 233Oligopolists and Market Power 233Mutual Interdependence and Game Theory 234Tactics for Cooperating 237Factors Limiting Cooperation 238

• USE YOUR ECONOMIC REASONING: How a Drug Maker Tries to OutwitGenerics 240

Monopoly 240Monopoly and Market Power 242Monopoly and Profit Maximization 243

The Consequences of Monopoly or Oligopoly 245The Problems of Misallocation of Resources and Redistribution of Income 245The Possible Benefits of Size 245

Antitrust and Regulation 247Antitrust Enforcement 247Criticisms of Antitrust 250Industry Regulation 251

n USE YOUR ECONOMIC REASONING: Price-Fixing Makes Comeback after SupremeCourt Ruling 252

SUMMARY 255 n KEY TERMS 257 • STUDY QUESTIONS 257 • ANSWER KEY 260

CHAPTER 9 Market Failure 261Externalities as a Source of Market Failure 262

Externalities: The Case of External Costs 262• USE YOUR ECONOMIC REASONING: Greenhouse Gases; What to Do about CO2; Some

Are Touting the Benefits of a Carbon Tax over a Cap-and-Trade System for RegulatingHarmful Emissions 270

Externalities: The Case of External Benefits 272

Contents xi

Market Failure and the Provision of Public Goods 276Private Goods versus Public Goods 276The Free-Rider Problem 277

Government Failure: The Theory of Public Choice 277Voters and Rational Ignorance 278Special-Interest Groups 278The Limits of Majority Voting 279Bureaucrats and Inefficiency 279Final Thoughts on Public-Choice Theory 280SUMMARY 2 8 0 a KEY TERMS 281 a STUDY QUESTIONS 282

a ANSWER KEY 285 V - - '

• APPENDIX: Poverty, Equality, and Trends in the Income Distribution 286

Macroeconomics: The Economy as a Whole 291

CHAPTER 10 Measuring Aggregate Performance 293Measuring Unemployment 294

Counting the Unemployed 294Types of Unemployment 296Full Employment versus Zero Unemployment 298A Closer Look at Unemployment Rates 298Unemployment Rates: A Word of Caution 300

Measuring Inflation 301Unanticipated Inflation and Income Redistribution 301

a USE YOUR ECONOMIC REASONING: Recession Finds Even Those

with Jobs Losing Pay 302

When Inflation Is Anticipated 305Calculating a Price Index 306The Consumer Price Index 307The Producer Price Index and the Implicit Price Deflator 309

Measuring Total Output 310Calculating GDP: A Sneak Preview 310GDP and the Circular Flow 310The Expenditures Approach 311The Income Approach 314Interpreting GDP Statistics 315

• USE YOUR ECONOMIC REASONING: Why Beijing Is Trying to Tally the Hidden Costs ofPollution as China's Economy Booms 316

SUMMARY 319 • KEY TERMS 320 • STUDY QUESTIONS 320

o ANSWER KEY 323

xii Contents

CHAPTER ti Aggregate Demand and Supply: The Modelof the Self-Correcting Economy 324Aggregate Demand 325

The Real Balance Effect 326The Interest Rate Effect 326The International Trade Effect 328

Changes in Aggregate Demand 328Household and Business Expectations 329Aggregate Wealth 329Government Policy 330 .Foreign Incomes and Prices 330

Aggregate Supply 331• USE YOUR ECONOMIC REASONING: Homeowners Feel the Pinch

of Lost Equity 332

The Short-Run AS Curve: A Closer Look .334Changes in Aggregate Supply 336

Wage Rates and Other Resource Prices 336Technology and the Productivity of Labor 337Supplies of Labor and Capital 338

The Equilibrium Output and Price Level 338The Impact of Changes in Aggregate Demand or Supply 339• USE YOUR ECONOMIC REASONING: Americans Follow a Basic Instinct-Fear-When

Reacting to the Economy 342

The Model of the Self-Correcting Economy 342Adjustments to an Increase in Aggregate Demand 344Adjustments to a Decrease in Aggregate Demand 345Shifts in the Long-Run Aggregate Supply Curve 347

SUMMARY 348 • KEY TERMS 349 o STUDY QUESTIONS 349 • ANSWER KEY 353

CHAPTER 12 Fiscal Policy 354The Federal Budget 355

Tax Revenues 356Government Expenditures 356

Classical Economics, the Great Depression, and John Maynard Keynes 358The Existence of Unemployment or Inflation 359Discretionary Fiscal Policy: Combating Unemployment or Inflation 360Automatic Fiscal Policy: The Economy's Automatic Stabilizers 362Fiscal Policy and the Federal Budget 363

Planned and Unplanned Deficits and Surpluses 364Unemployment and the Federal Budget 365

Issues Related to Fiscal Policy 366Crowding Out 366The Expansionary Bias 367Time Lags 367

Contents x i i i

• USE YOUR ECONOMIC REASONING: Currents: The New Old Big Thing in Economics:J. M. Keynes 368 ^

The Public Debt 370Concerns about the Public Debt 370Concluding Comments on the Public Debt 372

SUMMARY 374 n KEY TERMS 375 -T STUDY QUESTIONS 376 L: ANSWER KEY 379

CHAPTER 13 Money, Banking, and Monetary Policy 380What Is Money? 381

Money and Near Money 382Credit Cards and Debit Cards 383Definitions of the Money Supply 383

How Depository Institutions Create Money 384A Bank's Balance Sheet 385The Creation of Checkable Deposits 386The Multiple Expansion of Loans and Deposits 389The Deposit Multiplier 391The Destruction of Checkable Deposits 391

The Federal Reserve System 392The Origin of the Federal Reserve 393The Organization and Functions of the Federal Reserve System 394

Monetary Policy and the Federal Reserve 395Open-Market Operations 396Changing the Reserve Requirement 397Changing the Discount Rate 398

Money, Interest Rates, and the Level of Economic Activity 398Interest Rate Determination 399Monetary Policy and the Level of Economic Activity 401

The Limits to Monetary Policy 402Time Lags 402Uneven Effectiveness 403

a USE YOUR ECONOMIC REASONING: Fed Reduces Benchmark Rate to as Lowas Zero 404

SUMMARY 406 • KEY TERMS 407 • STUDY QUESTIONS 408 • ANSWER KEY 411

• APPENDIX: The Great Recession, Capital Requirements, and Fed Policy 412

CHAPTER 14 The Activist-Nonactivist Debate 415The Activist Position: Keynes Revisited 416The Nonactivist Position: The Monetarists 417

Fiscal Policy and Crowding Out 417Monetary Policy and the Monetary Rule 418Policy Lags and the Self-Correcting Economy 419Monetarism: Concluding Points 420Criticisms of Monetarism 420

xiv Contents

The Nonactivist Position: The New Classical Economists 421Wage/Price Flexibility and Full Employment 421Rational Expectations and Discretionary Policy 423The Need for Policy Rules 425Criticisms of the New Classical Economics 426

A Different Form of Activism: Managing Aggregate Supply 426Supply-Side Economics 427The Reagan Supply-Side Experiment 429

a USE YOUR ECONOMIC REASONING: For Insight on Stimulus Battle,

Look to the '30s; For Left and Right, Issue Rekindles New Deal Debate 430

Summing Up: Final Thoughts^on-Policy Activism 432 ,SUMMARY 433 0 KEY TERMS 435 • STUDY QUESTIONS 435 • ANSWER KEY 438

CHAPTER is Economic Growth: The Importance of the Long Run 439Economic Growth and Why It Matters 439

Economic Growth and the Standard of Living 440Per Capita GDP: The United States' Experience 441The Rule of Seventy-Two: Why the Growth Rate Matters 442

Sources of Economic Growth 444Growth in the Stock of Natural Resources 445Growth in the Labor Supply 446Growth in the Capital Stock 446Technological Advances 447

Policies to Promote Growth 448Promoting Capital Investment 449

n USE YOUR ECONOMIC REASONING: Shift from Spending to Saving May Be Slump'sLasting Impact 452

Promoting Technological Progress 456Debates about Growth Policy 459

The Devil Is in the Details: Debates about How to Stimulate Growth 459Will Economic Growth Harm the Environment? 460

SUMMARY 462 • KEY TERMS 464 • STUDY QUESTIONS 464 D ANSWER KEY 467

PART FOUR j

International Economics: Trade, Exchange Rates, and the Role of TradeAgreements 469

CHAPTER 16 International Economics 471Interdependent Economies and U.S. Trade 472

Import and Export Trends 472

Contents xv

The Rationale for International Trade 473Absolute and Comparative Advantage 474Imagining Life without International Trade 475 jThe Gains from International Trade 476Sources of Comparative Advantage 478Additional Benefits from Trade 479

Barriers to Trade 480Quotas 481Tariffs 482Other Restrictions 483

• USE YOUR ECONOMIC REASONING:- Big Slide in Global Trade Looms over G-20

Meeting 484

Reducing Barriers: The Role of Trade Agreements 484International Trade Agreements: GATT and the WTO 486Regional Trade Agreements 487Building Support: The Case for Trade Adjustment Assistance 488

Exchange Rates 489Determining Exchange Rates 490The Equilibrium Exchange Rate 491Changes in the Equilibrium Exchange Rate 492

n USE YOUR ECONOMIC REASONING: UK Pound Drops to Record Low

against Euro 494

The Impact of Changes in Exchange Rates 496Managing Exchange Rates 497

SUMMARY 499 • KEY TERMS 501 a STUDY QUESTIONS 501 a ANSWER KEY 505

Glossary 506Index 514