CONTENTS PART 1 : INTRODUCTION TO ECONOMICS 1. The Art and Science of Economic Analysis ... 1 The Economic Problem: Scarce Resources But Unlimited Wants ... 2 Resources ... 2 Goods and Services ... 3 Economic Actors ... 4 Microeconomics and Macroeconomics ... 4 The Art of Economic Analysis ... 5 Rational Self-Interest ... 5 Economic Analysis Is Marginal Analysis ... 5 Case Study: Marginal Analysis in the Computer Industry ... 6 Choice Requires Time and Information ... 7 The Science of Economic Analysis ... 7 The Role of Theory ... 8 The Scientific Method ... 8 Economists Tell Stories ... 9 Case Study: A Yen for Vending Machines ... 9 Predicting Average Behavior ... 10 Normative Versus Positive Analysis ... 10 Some Pitfalls of Faulty Economic Analysis ... 11 If Economists Are So Smart, Why Arent They Rich? ... 12 Appendix: Understanding Graphs ... 16 Drawing Graphs ... 17 The Slopes of Straight Lines ... 19 The Slope Depends on How Units Are Measured ... 19 The Slopes of Curved Lines ... 19 Curve Shifts ... 21 The 45-Degree Ray from the Origin ... 22 2. Some Tools of Economic Analysis ... 25 Choice and Opportunity Cost ... 26 Opportunity Cost ... 26 Case Study: The Opportunity Cost of College ... 26 Opportunity Cost Is Subjective ... 27 Sunk Cost and Choice ... 28 Specialization, Comparative Advantage, and Exchange ... 28 The Law of Comparative Advantage ... 29 Absolute and Comparative Advantage ... 29 Specialization and Exchange ... 30 Divisio of Labor and Gains from Specialization ... 30 Case Study: Evidence of Specialization ... 31 The Economys Production Possibilites ... 32 Efficiency and the Production Possibilities Frontier ... 32 Inefficient and Unattainable Production ... 34 Shape of the Production Possibilities Frontier ... 34 What Shifts the Production Possibilites Frontier? ... 35 What We Can Learn from the PPF ... 37 Three Questions Each Economic System Must Answer ... 37 Economic Systems ... 38 Pure Capitalism ... 38 Command Economy ... 39 Mixed and Transitional Economies ... 39 Economies Based on Custom or Religion ... 40 3. The Market System ... 43 Demand ... 44 The Law of Demand ... 44 The Demand Schedule and Demand Curve ... 45 Changes in Demand ... 47 Changes in Consumer Income ... 47 Changes in the Prices of Related Goods ... 48 Changes in Consumer Expectations ... 49 Changes in the Number or Composition of Consumers ... 49 Change in Consumer Tastes ... 49 supply ... 50 The Supply Schedule and Supply Curve ... 50 Changes in Supply ... 51 Changes in Technology ... 52 Changes in the Prices of Relevant Resources ... 53 Changes in the Prices of Alternative Goods ... 53 Changes in Producer Expectations ... 53 Changes in the Number of Producers ... 53 Demand and Supply Create a Market ... 54 Markets ... 54 Specialized Markets ... 54 Market Equilibrium ... 55 Markets Allocate Resources ... 55 Changes in Equilibrium Price and Quantity ... 57 Impact of Changes in Demand ... 57 Impact of Changes in Supply ... 58 Simultaneous Changes in Demand and Supply ... 59 Case Study: The Market for Professional Basketball ... 60 Disequilibrium Prices ... 61 Price Floors ... 62 Price Ceilings ... 62 Case Study: Toys Are serious Business ... 63 4. The Economic Actors: Households, Firms, Governments, and the Rest of the World ... 67 The Household ... 68 The Evolution of the Household ... 68 Households Maximize Utility ... 68 Households as Resource Suppliers ... 68 Households as Demanders of Goods and Services ... 70 The Firm ... 70 Transaction Costs and Evolution of the Firm ... 70 Why Do Firms Specialize? ... 71 Why Does Household Production Still Exist? ... 72 Case Study: The Electronic Cottage ... 73 Kinds of Firms ... 73 Nonprofit Institutions ... 75 The Government ... 76 The Role of Government ... 76 Governments Structure and Objectives ... 77 Size and Growth of U.S. Government ... 78 Sources of Government Revenue ... 80 Tax Principles and Tax Incidence ... 81 The Rest of the World ... 82 International Trade ... 82 Exchange Rates ... 83 Trade Restrictions ... 83 Case Study: The World of Automobiles ... 84 PART 2 : FUNDAMENTALS OF MACROECONOMICS 5. Introduction to Macroeconomics ... 89 The National Economy ... 90 Whats Special about the National Economy? ... 90 Similarities Between the Human Body and the Economy ... 90 Testing New Theories ... 91 Knowledge and Performance ... 92 Economic Fluctuations and Growth ... 93 Economic Fluctuation Analysis ... 93 Case Study: The Global Economy ... 96 Leading Economic Indicators ... 98 Aggregate Demand and Aggregate Supply ... 98 Aggregate Output and the Price Level ... 98 Aggregate Supply Curve ... 100 Equilibrium ... 100 A Short History of the U.S. Economy ... 101 The Great Depression and Before ... 101 The Age of Keynes: Between the Great Depression and the Early 1970s ... 103 The Great Stagflation ... 104 Experience Since 1980 ... 104 The Twin Deficits ... 106 Case Study: Half Century of Price Levels and Real GDP ... 106 6. Productivity and Growth ... 110 U.S. Productivity ... 111 What Is Productivity? ... 111 Labor Productivity ... 111 The Per-Worker Production Function ... 112 Long-Term Productivity Growth ... 113 The Recent Slowdown in Productivity Growth ... 114 Why the Slowdown in Labor Productivity Growth? ... 115 Rate of Capital Formation ... 115 Change in the Labor Force ... 115 Changing Composition of Output ... 116 Increased Role of Government ... 116 Huge Budget Deficits ... 117 Research and Development ... 118 Basic and Applied Research ... 118 Expenditures for Research and Dvelopment ... 118 Patents and Productivity ... 120 Case Study: Computers and Productivity ... 120 Other Issues of Technology and Growth ... 122 Industrial Policy ... 122 Case Study: Picking Technological Winners ... 122 Dose Technological Change Lead to Unemployment? ... 123 Output Per Capita ... 124 Do Economies Converage? ... 125 7. Unemployment and Inflation ... 130 Unemployment ... 131 Measuring Unemployment ... 131 Changes over Time in Unemployment Statistics ... 133 Unemployment in Various Groups ... 134 Duration of Unemployment ... 135 Unemployment Differences across the Country ... 135 Case Study: Poor King Coal ... 136 Types of Unemployment ... 136 The Meaning of Full Employment ... 138 Unemployment Insurance ... 138 International Comparisons of Unemployment ... 139 Problems with Official Unemployment Figures ... 139 Inflation ... 140 Case Study: Hyperinflation in Brazil ... 140 Two Sources of Inflation ... 142 A Historical Look at Inflation and the Price Level ... 143 Anticipated versus Unticipated Inflation ... 143 The Transaction Costs of Variable Inflation ... 144 Adapting to Relative Price Changes ... 144 International Comparisons of Inflation ... 145 Inflation and Interest Rates ... 147 Why Is Inflation So Unpopular? ... 148 8. Measuring Economic Aggregates ... 152 The Product of a Nation ... 153 National Income Accounts ... 153 GDP Based on the Expenditure Approach ... 154 Composition of Aggregate Expenditure ... 155 GDP Based on the Income Approach ... 155 Limitations of National Income Accounting ... 157 Some Production Is Not Included in GDP ... 157 Leisure, Quality, and Variety ... 158 Case Study: Tracking a ＄ Trillion Economy ... 159 Gross Domestic Product Ignores Depreciation ... 160 GDP Does Not Reflect All Costs ... 160 GDP Values All Output Equally ... 161 Accounting for Price Changes ... 161 Price Indexes ... 162 Consumer Price Index ... 162 Problems with the CPI ... 163 GDP Price Index ... 164 Moving from Fixed Weights to Chain Weights ... 165 Case Study: Computer Prices ad GDP Estimation ... 165 Real GDP Estimates ... 160 Appendix A: A Closer Look at National Income Accounts ... 171 National Income ... 171 Personal Income ... 171 Disposable Income ... 172 Summary of National Income Accounts ... 172 Summary Income Statment of the Economy ... 172 Appendix B: The Chain-Weighted Index ... 174 Real GDP Index ... 174 GDP Price Index ... 175 9. Consumption and Aggregate Expenditure ... 177 Early Views of the Macroeconomy ... 178 The Classical View ... 178 Keynes and the Great Depression ... 178 The Circular Flow of Income and Expenditure ... 179 The Income Half of the Circular Flow ... 179 The Expenditure Half of the Circular Flow ... 181 Leakages Equal Injections ... 182 Planned Investment versus Actual Investment ... 182 Consumption ... 183 An Initial Look at Income and Consumption ... 183 The consumption Function ... 184 Marginal Propensities to Consume and to Save ... 185 MPC, MPS, and the Slope of the Consumption and Savings Functions ... 186 Nonincome Determinants of Consumption ... 188 Case Study: The Life-Cycle Hypothesis ... 190 Investment ... 191 The Demand for Investment ... 192 From Micro to Macro ... 193 Planned Investments of Investment ... 194 Case Study: Variability of Consumption and Investment ... 195 Government ... 196 Government Purchase Function ... 196 Net Taxes ... 196 Net Exports ... 197 Net Exports and Income ... 198 Nonincome Determinants of Net Exports ... 198 Appendix: Variable Net Exports ... 202 Net Exports and Income ... 202 Shifts in Net Exports ... 203 10. Aggregate Expenditure and Demand-Side Equilibrium ... 205 Aggregate Expenditure and Income ... 206 The Components of Aggregate Expenditure ... 206 Quantity of Real GDP Demanded ... 207 When Output and Planned Spending Differ ... 209 Leakages Equal Planned Injections ... 209 The Simple Spending Multiplier ... 210 Effects of an Increase in Aggregate Expenditure ... 210 The Spending Multiplier and the Circular Flow ... 212 Numerical Value of the Spending Multiplier ... 213 Case Study: Hard Times in Connecticut ... 214 Changes in the Price Level ... 215 A Higher Price Level ... 215 A Lower Price Level ... 217 The Multiplier and Shifts in Aggregate Demand ... 217 Case Study: Not Enough Saving ... 219 Appendix A: Variable Net Exports ... 224 Net Exports and the Spending Multiplier ... 225 A Change in Autonomous Spending ... 226 Appendix B: Algebra of Income and Expenditure ... 227 The Aggregate Expenditure Function ... 227 A More General Form of Income and Expenditure ... 227 Introducing Variable Net Exports ... 228 11. Aggregate Supply ... 230 Aggregate Supply in the Short Run ... 231 Labor Supply and Aggregate Supply ... 231 Potential Output and the Natural Rate of Unemployment ... 232 Actual Price Level Higher than Expected ... 233 Why Costs Rise When Output Exceeds Potential ... 233 The Price Level, Real Wages, and Labor Supply ... 234 Actual Price Level Lower than Expected ... 234 The Short-Run Aggregate Supply Curve ... 235 Equilibrium in the Short Run and Long Run ... 236 Actual Price Level Higher than Expected ... 237 Actual Price Level Lower than Expected ... 239 Tracing Potential Output ... 241 Evidence on Aggregate Supply ... 241 Case Study: Output Gaps and Wage Flexibility ... 242 Changes in Aggregate Supply ... 244 Increases in Aggregate Supply ... 244 Decreases in Aggregate Supply ... 246 Case Study: Why Is Unemployment So High in Europe? ... 247 Appendix: The Market for Resources ... 251 The Market for Labor ... 251 Changes in the Expected Price Level ... 252 Potential GDP ... 253 Transitional Economies ... 462 Type of Economic Systems ... 462 Enterprises and Soft Budget Constraints ... 462 Case Study: Ownership and Resources Use ... 463 Markets and Institutions ... 464 Institutions and Economic Development ... 465 The "Big Bang" versus Gradualism ... 465 Privatization ... 466 Glossary ... 473 Index ... 481 Photo Credits ... 493