Principles of Economics Dirk Mateer University of Kentucky


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Principles of Economics Dirk Mateer University of Kentucky Lee Coppock University of Virgínia
W-W'NORTON NEW YORK • LONDON

r BRIEF CONTENTS

PARTI Introduction 1 The Five Foundations of Economics 4 2 Model Building and Gains from Trade 24

PART II The Role of Markets
3 The Market at Work: Supply and Demand 68
4 Elasticity 108
5 Price Controls 146
6 The Efficiency of Markets and the Costs of Taxation 176
7 Market Inefficiencies: Externalities and Public Goods 210

PART III The Theory of the Firm 8 Business Costs and Production 9 Firms in a Competitive Market 10 Understanding Monopoly 302 11 Price Discrimination 332 12 Monopolistic Competition and Advertising 354 13 Oligopoly and Strategic Behavior

240 270
382

PART IV Labor Markets and Earnings 14 The Demand and Supply of Resources 420 15 Income, Inequality, and Poverty 456

PARTV Special Topics in Microeconomics 16 Consumer Choice 492 17 Behavioral Economics and Risk Taking 526 18 Health Insurance and Health Care 548

PART VI Macroeconomic Basics 19 Introduction to Macroeconomics and Gross
Domestic Product 582 20 Unemployment 616 21 The Price Level and Inflation 648 22 Savings, Interest Rates, and the Market for
Loanable Funds 678 23 Financial Markets and Securities 708
PART VII The Long and Short of Macroeconomics 24 Economic Growth and the Wealth of
Nations 734 25 Growth Theory 768 26 The Aggregate Demand-Aggregate Supply
Model 802 27 The Great Recession, The Great Depression, and
Great Macroeconomic Debates 836
PART VIII Fiscal Policy 28 Federal Budgets: The Tools of Fiscal
Policy 860 29 Fiscal Policy 892
PART IX Monetary Policy 30 Money and the Federal Reserve 924 31 Monetary Policy 956
PART X International Economics 32 International Trade 992 33 International Finance 1018

vii

CONTENTS
Preface xxxiii Acknowledgments xlvii About the Authors li
PARTI Introduction
1 The Five Foundations of Economics 4
Big Questions 6 What Is Economics? 6
Microeconomics and Macroeconomics 7 What Are the Five Foundations of Economics? 7
Incentives 7 Economics in the Real World: How Incentives Create Unintended Consequences 10 Economics in the Media: Incentives: Ferris Bueller's Day Off 12

r
i
Trade-offs 12 Opportunity Cost 13 Practice What You Know: The Opportunity Cost of Attending College 14 Economics in the Real World: Breaking the Curse of the Bambino: How Opportunity Cost Causes a Drop in Hospital Visits While the Red Sox Play 15 Marginal Thinking 15 Economics in the Real World: Why Buying and Selling Your Textbooks Benefits You at the Margin 16 Trade 17 Conclusion 18 SNAPSHOT: The Foundations of Economics 19 ECONOMICS FOR LIFE: Midcareer Earnings by Selected Majors 20 Answering the Big Questions 21 Concepts You Should Know 22 Questions for Review 22 Study Problems 22 Solved Problems 23

ix

x / Contents

2 Model Building and Gains
from Trade 24
Big Buestions 26
How Do Economists Study the Economy? 26 The Scientific Method in Economics 26 Positive and Normative Analysis 27 Economic Models 28
Practice What You Know: Positive versus Normative Statements 30
What Is a Production Possibilities Frontier? 31 The Production Possibilities Frontier and Opportunity Cost 32 The Production Possibilities Frontier and Economic Growth 34
Practice What You Know: The Production Possibilities Frontier: Bicycles and Cars 36
What Are the Benefits of Specialization and Trade? 37
Gains from Trade 37 Comparative Advantage 40 Finding the Right Price to Facilitate Trade 41
Economics in the Real World: Why Shaquille O'Neal Has Someone Else Help Him Move 42
SNAPSHOT: Shaq and Comparative Demand 43
Practice What You Know: Opportunity Cost 44
Economics in the Media: Opportunity Cost: Saving Private Ryan 45

What Is the Trade-off between Having More Now and Having More Later? 45
Consumer Goods, Capital Goods, and Investment 46
Economics in the Media: The Trade-off between the Present and the Future: A Knight's Tale 48
Practice What You Know: Trade-offs 49
Conclusion 49
ECONOMICS FOR LIFE: Failing to Account for Exogenous Factors When Making Predictions 50
Answering the Big Questions 51
Concepts You Should Know 52 Questions for Review 52 Study Problems 52 Solved Problems 54
Appendix 2A: Graphs in Economics 55
Graphs That Consist of One Variable 55 Time-Series Graphs 57
Graphs That Consist of Two Variables 57 The Slope of a Curve 59 Formulas for the Area of a Rectangle and a Triangle 62
Cautions in Interpreting Numerical Graphs 63 Concepts You Should Know 65 Study Problems 65 Solved Problems 65

PART II The Role of Markets

Contents / xi

3 The Market at Work: Supply and
Demand es
Big Questions 70
What Are the Fundamentals of Markets? 70 Competitive Markets 71 Imperfect Markets 72
What Determines Demand? 72 SNAPSHOT: The Invisible Hand 73
Practice What You Know: Markets and the Nature of Competition 74 The Demand Curve 75 Market Demand 75 Shifts in the Demand Curve 76
Practice What You Know: Shift or Slide? 81
Economics in the Media: Shifting the Demand Curve: The Hudsucker Proxy 83
What Determines Supply? 84 The Supply Curve 84 Market Supply 86 Shifts in the Supply Curve 87
Economics in the Real World: Why Do the Prices of New Electronics Always Drop? 91
Practice What You Know: The Supply and Demand of Ice Cream 92

How Do Supply and Demand Shifts Affect a Market? 93
Supply, Demand, and Equilibrium 93
ECONOMICS FOR LIFE: Bringing Supply and Demand Together: Advice for Buying Your First Place 97
Conclusion 98
Answering the Big Questions 98
Concepts You Should Know 100 Questions For Review 100 Study Problems 100 Solved Problems 102
Appendix 3A: Changes in Both Demand and Supply 103 Practice What You Know: When Supply and Demand Both Change: Hybrid Cars 106 Questions for Review 107 Study Problem 107

4 Elasticity ios
Big Questions 110
What Is the Price Elasticity of Demand, and What Are Its Determinants? 110
Determinants of the Price Elasticity of Demand 110 Computing the Price Elasticity of Demand 113
Economics in the Media: Price Elasticity of Demand: Jingle All the Way 115

Graphing the Price Elasticity of Demand 117 Price Elasticity of Demand and Total Revenue 123
Economics in the Media: Elasticity and Total Revenue: D'oh! The Simpsons and Total Revenue 126
How Do Changes in Income and the Prices of Other Goods Affect Elasticity? 127
Income Elasticity 127
Practice What You Know: The Price Elasticity of Demand 128

xii / Contents
Cross-Price Elasticity 130 Economics in the Real World: The Wii Rollout and Changes in the Video Game Industry 132
SNAPSHOT: Elasticity and Demand 133 Practice What You Know: Income Elasticity 134
What Is the Price Elasticity of Supply? 134 Determinants of the Price Elasticity of Supply 135 Practice What You Know: The Price Elasticity of Supply 138
How Do the Price Elasticity of Demand and Supply Relate to Each Other? 138
Practice What You Know: Elasticity: Trick or Treat Edition 140

Conclusion 140 ECONOMICS FOR LIFE: Price Elasticity of Supply and Demand: Buying Your First Car 141

A

142

Concepts You Should Know 143 Questions for Review 143 Study Problems 143 Solved Problems 145

5 Price Controls m
Big Questions 148
When Do Price Ceilings Matter? 148 Understanding Price Ceilings 148 The Effect of Price Ceilings 150 Price Ceilings in the Long Run 152
Economics in the Media: Price Ceilings: Moscow on the Hudson 153
Practice What You Know: Price Ceilings: Concert Tickets 154
What Effects Do Price Ceilings Have on Economic Activity? 154
Rent Control 154 Price Gouging 155
Practice What You Know: Price Ceilings: Student Rental Apartments 158
When Do Price Floors Matter? 158 Understanding Price Floors 159 The Effect of Price Floors 159 Price Floors in the Long Run 162
Practice What You Know-. Price Floors: Fair-Trade Coffee 163

What Effects Do Price Floors Have on Economic Activity? 164
The Minimum Wage 164

Economics in the Real World: Wage Laws Squeeze South Africa's Poor 165
The Minimum Wage Is Often Nonbinding 166

Economics in the Real World: A Sweet Deal, If You Can Get It 167

Economics in the Media: The Minimum Wage: 30 Days 168

SNAPSHOT: Minimum Wage.- Always the Same? 169

Practice What You Know: Price Ceilings and Price
Floors: Would a Price Control on Internet Access Be Effective? 170

Conclusion 171

Answ;

172

ECONOMICS FOR LIFE: Price Gouging: Disaster Preparedness 173 Concepts You Should Know 174 Questions for Review 174 Study Problems 174 Solved Problems 175

Contents / xiii

6 The Efficiency of Markets and the
Costs of Taxation m
Big Questions 178
What Are Consumer Surplus and Producer Surplus? 178
Consumer Surplus 178 Using Demand Curves to Illustrate Consumer Surplus 179 Producer Surplus 181 Using Supply Curves to Illustrate Producer Surplus 181
Practice What You Know: Consumer and Producer Surplus: Trendy Fashion 183
When Is a Market Efficient? 184 The Efficiency-Equity Debate 185
Economics in the Media: Efficiency Old School 186
Practice What You Know: Total Surplus: How Would Lower Income Affect Urban Outfitters? 187

Why Do Taxes Create Deadweight Loss? 188 Tax Incidence 188 Deadweight Loss 191
Economics in the Media: Taxing Inelastic Goods: "Taxman" by the Beatles 192
Economics in the Real World: The Short-Lived Luxury Tax 198 Balancing Deadweight Loss and Tax Revenues 199
SNAPSHOT: Bizarre Taxes 201
Practice What You Know: Deadweight Loss of Taxation: The Politics of Tax Rates 202
Conclusion 202
Answering the Big Questions 203
ECONOMICS FOR LIFE: Excise Taxes Are Almost Impossible to Avoid 204 Concepts You Should Know 205 Questions for Review 205 Study Problems 205 Solved Problems 209

7 Market Inefficiencies: Externalities
and Public Goods 210
Big Questions 212
What Are Externalities, and How Do They Affect Markets? 212
The Third-Party Problem 212 Economics in the Real World: Congestion Charges 216
Practice What You Know: Externalities: A New Theater Is Proposed 219
What Are Private Goods and Public Goods? 219 Private Property 220 Private and Public Goods 222 SNAPSHOT: The Case Behind the Coase Theorem 223 Practice What You Know: Public Goods: Are Parks Public Goods? 226
What Are the Challenges of Providing Nonexcludable Goods? 227
Cost-Benefit Analysis 227

Economics in the Real World: Internet Piracy 228 Common Resources and the Tragedy of the Commons 228 Solutions to the Tragedy of the Commons 230
Economics in the Real World: Deforestation in Haiti 231
Practice What You Know: Common Resources: President Obama's Inauguration 232
Economics in the Media: Tragedy of the Commons: South Park and Water Parks 232
ECONOMICS FOR LIFE: Buying Used Is Good for Your Wallet and for the Environment 233
Conclusion 233
Answering the Big Questions 234 Concepts You Should Know 235 Questions for Review 235 Study Problems 235 Solved Problems 237

xiv / Contents PART III The Theory of the Firm

8 Business Costs and
Production 240
Big Questions 242
How Are Profits and Losses Calculated? 242 Calculating Profit and Loss 242 Explicit Costs and Implicit Costs 243 Accounting Profit versus Economic Profit 244
Practice What You Know: Accounting Profit versus Economic Profit: Calculating Summer Job Profits 246
How Much Should a Firm Produce? 247 The Production Function 247 Diminishing Marginal Product 249
What Costs Do Firms Consider in the Short Run and the Long Run? 250
Practice What You Know: Diminishing Returns: Snow Cone Production 251 Costs in the Short Run 252
Economics in the Media: Costs in the Short Run: The Office 257 Costs in the Long Run 257

P |R |Q |F.| ' |T.I
SNAPSHOT: Bigger Is Not Always Better 261 Economics in the Media: Economies of Scale: Modern Times 262 Practice What You Know: Marginal Cost: The True Cost of Admission to Universal Studios 263 Conclusion 263 Answering the Big Questions 264 ECONOMICS FOR LIFE: How Much Does It Cost to Raise a Child? 265 Concepts You Should Know 266 Questions for Review 266 Study Problems 266 Solved Problems 269

9 Firms in a Competitive Market 270
Big Questions 272
How Do Competitive Markets Work? 272 Economics in the Real World: Aalsmeer Flower Auction 274
How Do Firms Maximize Profits? 274 Practice What You Know-. Price Takers-. Mall Food Courts 275 The Profit-Maximizing Rule 275 Economics in the Media: Competitive Markets: The Simpsons 277 Deciding How Much to Produce in a Competitive Market 278

The Firm in the Short Run 279 The Firm's Short-Run Supply Curve 282 The Firm's Long-Run Supply Curve 283
Economics in the Real World: Blockbuster and the Dynamic Nature of Change 284
Practice What You Know-. The Profit-Maximizing Rule: Show Me the Money! 285 Sunk Costs 286
What Does the Supply Curve Look Like in Perfectly Competitive Markets? 286
SNAPSHOT: Sunk Costs: If You Build It, They Will Come 287 The Short-Run Market Supply Curve 288 The Long-Run Market Supply Curve 288

How the Market Adjusts in the Long Run: An Example 291 Economics in the Media.- Entry and Exit: I Love Lucy 293
Practice What You Know: Long-Run Profits: How Much Can a Firm Expect to Make? 295
Conclusion 296 Answering the Big Questions 297
ECONOMICS FOR LIFE: Tips for Starting Your Own Business 298

Concepts You Should Know 299 Questions for Review 299
Study Problems 299 Solved Problems 301

Contents / xv

10 Understanding Monopoly 302
Big Questions 304
How Are Monopolies Created? 304 Natural Barriers 304 Government-Created Barriers 305
Economics in the Real World: Merck's Zocor 306
Practice What You Know: Monopoly: Can You Spot the Monopolist? 307
Economics in the Media: Barriers to Entry: Forrest Gump 308
How Much Do Monopolies Charge, and How Much Do They Produce? 309
The Profit-Maximizing Rule for the Monopolist 310
Economics in the Real World: The Broadband Monopoly 314
Practice What You Know: Monopoly Profits: How Much Do Monopolists Make? 315

What Are the Problems with, and Solutions for, Monopoly? 315
The Problems with Monopoly 316
Practice What You Know: Problems with Monopoly: Coffee Consolidation 319
Economics in the Real World: New York City Taxis 320
Economics in the Media: The Problems of Monopoly: OneMan Band 321 Solutions to the Problems of Monopoly 321
SNAPSHOT: The Demise of a Monopoly 323
Conclusion 325
Answering the Big Questions 326
ECONOMICS FOR LIFE: Playing Monopoly Like an Economist 327 Concepts You Should Know 328 Questions for Review 328 Study Problems 328 Solved Problems 331

11 Price Discrimination 332

Big Questions 334
What Is Price Discrimination? 334 Conditions for Price Discrimination One Price versus Price Discrimination

334 335

The Welfare Effects of Price Discrimination 338
Economics in the Media: Perfect Price Discrimination: Legally Blonde 340
Economics in the Real World: Outlet Malls—If You Build It, They Will Come 341

xvi / Contents

Practice What You Know: Price Discrimination: Taking Economics to New Heights 342

How Is Price Discrimination Practiced? Price Discrimination at the Movies Price Discrimination on Campus

344 344 345

SNAPSHOT: Now Playing: Economics! 347

Practice What You Know: Price Discrimination in Practice: Everyday Examples 348

Economics in the Media: Price Discrimination: Extreme Couponing 349

Economics in the Real World: Groupon 349
Conclusion 350 Answering the Big Questions 350
ECONOMICS FOR LIFE: Outsmarting Grocery Store Tactics 351 Concepts You Should Know 352 Questions for Review 352 Study Problems 352 Solved Problems 353

12 Monopolistic Competition
and Advertising 354
Big Questions 356
What Is Monopolistic Competition? 356 Product Differentiation 357
Practice What You Know: Product Differentiation: Would You Recognize a Monopolistic Competitor? 358
What Are the Differences among Monopolistic Competition, Competitive Markets, and Monopoly? 358
Monopolistic Competition in the Short Run and the Long Run 359 Monopolistic Competition and Competitive Markets 361 Monopolistic Competition, Inefficiency, and Social Welfare 363
Practice What You Know: Markup: Punch Pizza versus Pizza Hut 366
Why Is Advertising Prevalent in Monopolistic Competition? 366

Economics in the Media-. Advertising: Super Bowl Commercials 367
Why Firms Advertise 367 Advertising in Different Markets 369

Economics in the Media: Advertising: E.T.-, The ExtraTerrestrial 370

SNAPSHOT: Advertising and the Super Bowl 371 The Negative Effects of Advertising 372

Practice What You Know: Advertising: Brands versus Generics 374

Economics in the Real World: The Federal Trade Commission versus Kevin Trudeau 376

ECONOMICS FOR LIFE: Product Differentiation: Would You Buy a Franchise? 377

Conclusion 377

Answering

s 378

Concepts You Should Know 379 Questions for Review 379 Study Problems 379 Solved Problems 381

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Principles of Economics Dirk Mateer University of Kentucky