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College of Administrative and Financial Sciences

Assignment 2

Macroeconomics (ECON 201)

Chapter 13, 14 & 15: Critical Thinking: Financial System: Saving and Investment &

Unemployment and Its Natural Rate: (10 Points)

In the second assignment for the Macroeconomics course, the students are required to choose a specific area from the subject and answer the questions given, upon successful completion of the assignment; the student should be able to achieve the following learning outcomes:

Learning Outcomes:

1. Describe how to evaluate macroeconomic conditions such as unemployment, inflation, and growth. [CLO 1.2]
2. Recognize the fundamental determinant’s of a nation’s long-run economic growth. [CLO 1.3]

Reference Source:

Textbook: – Mankiw, N. Gregory. Principles of Macroeconomics, 6th ed. Mason, OH: South-Western Cengage Learning, 2011. ISBN: 9780538453066 (hard copy); ISBN: 9781115468523 (eBook)

Q.1. Critical Thinking: Financial System: Saving and Investment: Chapter 13: (4 Points)

Suppose the government borrows $20 billion more next year than this year.
a. Use a supply-and-demand diagram to analyze this policy. Does the interest rate rise or fall?
b. What happens to investment, private saving, public saving, and national saving? Compare the size of the changes to the $20 billion of extra government borrowing.
c. How does the elasticity of supply of loanable funds affect the size of these changes?
d. How does the elasticity of demand for loanable funds affect the size of these changes?
e. Suppose households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future. What does this belief do to private saving and the supply of loanable funds today? Does it increase or decrease the affects you discussed in parts (a) and (b)?

Important Note: – Support your submission with course material concepts, principles, and theories from the textbook and at least two scholarly, peer-reviewed journal articles.

Q.2. Critical Thinking: Financial System: The Basic Tools of Finance: Chapter 14: (3 Points)

When company executives buy and sell stock based on private information they obtain as part of their jobs, they are engaged in insider trading.
a. Give an example of inside information that might be useful for buying or selling stock.
b. Those who trade stocks based on inside information usually earn very high rates of return. Does this fact violate the efficient markets hypothesis?
c. Insider trading is illegal. Why do you suppose that is?

Important Note: – Support your submission with course material concepts, principles, and theories from the textbook and at least two scholarly, peer-reviewed journal articles.

Q.3. Problems and Applications: Unemployment: Chapter 15: (3 Points)

The Bureau of Labor Statistics announced that in April 2010, of all adult Americans, 139,455,000 were employed, 15,260,000 were unemployed, and 82,614,000 were not in the labor force. Use this information to calculate:
a. The Adult Population
b. The Labor Force
c. The Labor-Force Participation Rate
d. The Unemployment Rate

Important Note: – Support your submission with course material concepts, principles, and theories from the textbook and at least two scholarly, peer-reviewed journal articles.

Answer:

52609_00_fm_pi-pxxvi.indd ii52609_00_fm_pi-pxxvi.indd ii 2/1/10 11:37:43 PM2/1/10 11:37:43 PM

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Principles of

Economics
Sixth Edition

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N. Gregory Mankiw

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N . G r e g o r y M a n k i w
H A R V A R D U N I V E R S I T Y

Principles of

Economics
Sixth Edition

Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).

Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

To Catherine, Nicholas, and Peter,
my other contributions to the next generation

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

author

vi

about the

N. Gregory Mankiw is professor of economics at
Harvard University. As a student, he studied eco-
nomics at Princeton University and MIT. As a teach-
er, he has taught macroeconomics, microeconomics,
statistics, and principles of economics. He even
spent one summer long ago as a sailing instructor
on Long Beach Island.
Professor Mankiw is a prolific writer and a regu-
lar participant in academic and policy debates. His
work has been published in scholarly journals, such
as the American Economic Review, Journal of Political
Economy, and Quarterly Journal of Economics, and in
more popular forums, such as The New York Times
and The Wall Street Journal. He is also author of

the best-selling intermediate-level textbook Macroeconomics (Worth Publishers).
In addition to his teaching, research, and writing, Professor Mankiw has been a
research associate of the National Bureau of Economic Research, an adviser to the
Congressional Budget Office and the Federal Reserve Banks of Boston and New
York, and a member of the ETS test development committee for the Advanced
Placement exam in economics. From 2003 to 2005, he served as chairman of the
President’s Council of Economic Advisers.
Professor Mankiw lives in Wellesley, Massachusetts, with his wife, Deborah,
three children, Catherine, Nicholas, and Peter, and their border terrier, Tobin.

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

vii

contents
brief

Part I Introduction 1
1 Ten Principles of Economics 3
2 Thinking Like an Economist 21
3 Interdependence and the Gains from Trade 49

Part II How Markets Work 63
4 The Market Forces of Supply and Demand 65
5 Elasticity and Its Application 89
6 Supply, Demand, and Government Policies 111

Part III Markets and Welfare 133
7 Consumers, Producers, and the Efficiency of Markets 135
8 Application: The Costs of Taxation 155
9 Application: International Trade 171

Part IV The Economics of the Public Sector 193
10 Externalities 195
11 Public Goods and Common Resources 217
12 The Design of the Tax System 233

Part V Firm Behavior and the Organization of
Industry 257

13 The Costs of Production 259
14 Firms in Competitive Markets 279
15 Monopoly 299
16 Monopolistic Competition 329
17 Oligopoly 349

Part VI The Economics of Labor Market 373
18 The Markets for the Factors of Production 375
19 Earnings and Discrimination 397
20 Income Inequality and Poverty 415

Part VII Topics for Further Study 437
21 The Theory of Consumer Choice 439
22 Frontiers of Microeconomics 467

Part VIII The Data of Macroeconomics 489
23 Measuring a Nation’s Income 491
24 Measuring the Cost of Living 513

Part IX The Real Economy in the Long Run 529
25 Production and Growth 531
26 Saving, Investment, and the Financial System 555
27 The Basic Tools of Finance 577
28 Unemployment 593

Part X Money and Prices in the Long Run 617
29 The Monetary System 619
30 Money Growth and Inflation 643

Part XI The Macroeconomics of Open Economies 669
31 Open-Economy Macroeconomics: Basic Concepts 671
32 A Macroeconomic Theory of the Open Economy 695

Part XII Short-Run Economic Fluctuations 717
33 Aggregate Demand and Aggregate Supply 719
34 The Influence of Monetary and Fiscal Policy on

Aggregate Demand 757
35 The Short-Run Trade-off between Inflation

and Unemployment 785

Part XIII Final Thoughts 809
36 Six Debates over Macroeconomic Policy 811

vii

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ix

to the student
preface

Economics is a study of mankind in the ordinary business of life.” So wrote Alfred Marshall, the great 19th-century economist, in his textbook, Principles of Economics. Although we have learned much about the economy since Marshall’s time, this definition of economics is as true today as it
was in 1890, when the first edition of his text was published.
Why should you, as a student at the beginning of the 21st century, embark on
the study of economics? There are three reasons.
The first reason to study economics is that it will help you understand the
world in which you live. There are many questions about the economy that might
spark your curiosity. Why are apartments so hard to find in New York City? Why
do airlines charge less for a round-trip ticket if the traveler stays over a Saturday
night? Why is Johnny Depp paid so much to star in movies? Why are living stan-
dards so meager in many African countries? Why do some countries have high
rates of inflation while others have stable prices? Why are jobs easy to find in
some years and hard to find in others? These are just a few of the questions that a
course in economics will help you answer.
The second reason to study economics is that it will make you a more astute
participant in the economy. As you go about your life, you make many economic
decisions. While you are a student, you decide how many years to stay in school.
Once you take a job, you decide how much of your income to spend, how much
to save, and how to invest your savings. Someday you may find yourself running
a small business or a large corporation, and you will decide what prices to charge
for your products. The insights developed in the coming chapters will give you
a new perspective on how best to make these decisions. Studying economics will
not by itself make you rich, but it will give you some tools that may help in that
endeavor.
The third reason to study economics is that it will give you a better understand-
ing of both the potential and the limits of economic policy. Economic questions
are always on the minds of policymakers in mayors’ offices, governors’ mansions,
and the White House. What are the burdens associated with alternative forms of
taxation? What are the effects of free trade with other countries? What is the best
way to protect the environment? How does a government budget deficit affect
the economy? As a voter, you help choose the policies that guide the allocation of
society’s resources. An understanding of economics will help you carry out that
responsibility. And who knows: Perhaps someday you will end up as one of those
policymakers yourself.
Thus, the principles of economics can be applied in many of life’s situations.
Whether the future finds you reading the newspaper, running a business, or sit-
ting in the Oval Office, you will be glad that you studied economics.

N. Gregory Mankiw
December 2010

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

i CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

N. Gregory Mankiw
HARVARD UNIVERSITY

Principles of

Economics
Sixth Edition

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The Spark of Discovery

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xi

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iCHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

N . G r e g o r y M a n k i w
H A R V A R D U N I V E R S I T Y

Principles of

Economics
Sixth Edition

Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

http://www.cengagebrain.com

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xiii

acknowledgments

In writing this book, I benefited from the input of many talented people. Indeed, the list of people who have contributed to this project is so long, and their contributions so valuable, that it seems an injustice that only a single name appears on the cover.
Let me begin with my colleagues in the economics profession. The six editions
of this text and its supplemental materials have benefited enormously from their
input. In reviews and surveys, they have offered suggestions, identified challeng-
es, and shared ideas from their own classroom experience. I am indebted to them
for the perspectives they have brought to the text. Unfortunately, the list has be-
come too long to thank those who contributed to previous editions, even though
students reading the current edition are still benefiting from their insights.
Most important in this process have been Ron Cronovich (Carthage College)
and David Hakes (University of Northern Iowa). Ron and David, both dedicated
teachers, have served as reliable sounding boards for ideas and hardworking part-
ners with me in putting together the superb package of supplements.
For this new edition, the following diary reviewers recorded their day-to-day
experience over the course of a semester, offering detailed suggestions about how
to improve the text.

Mark Abajian, San Diego Mesa College
Jennifer Bailly, Long Beach City College
J. Ulyses Balderas, Sam Houston State

University
Antonio Bos, Tusculum College
Greg Brock, Georgia Southern

University
Donna Bueckman, University of

Tennessee Knoxville

Rita Callahan, Keiser University
Tina Collins, San Joaquin Valley College
Bob Holland, Purdue University
Tom Holmes, University of Minnesota
Simran Kahai, John Carroll University
Miles Kimball, University of Michigan
Jason C. Rudbeck, University of Georgia
Kent Zirlott, University of Alabama

Tuscaloosa

Mark Abajian, San Diego Mesa College
Hamid Bastin, Shippensburg University
Laura Jean Bhadra, Northern Virginia

Community College
Benjamin Blair, Mississippi State

University
Lane Boyte, Troy University
Greg Brock, Georgia Southern University
Andrew Cassey, Washington State

University
Joni Charles, Texas State University –

San Marcos

Daren Conrad, Bowie State University
Diane de Freitas, Fresno City College
Veronika Dolar, Cleveland State

University
Justin Dubas, Texas Lutheran

University
Robert L Holland, Purdue University
Andres Jauregui, Columbus State

University
Miles Kimball, University of Michigan
Andrew Kohen,  James Madison

University

The following reviewers of the fifth edition provided suggestions for refining
the content, organization, and approach in the sixth.

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

xiv acknowledgmentS

I received detailed feedback on specific elements in the text, including all end-of-
chapter problems and applications, from the following instructors.

Mark Abajian, San Diego Mesa College
Afolabi Adebayo, University of New

Hampshire
Mehdi Afiat, College of Southern

Nevada
Douglas Agbetsiafa, Indiana University

South Bend
Richard Agnello, University of

Delaware
Henry Akian, Gibbs College
Constantine Alexandrakis, Hofstra

University
Michelle Amaral, University of the

Pacific
Shahina Amin, University of Northern

Iowa
Larry Angel, South Seattle Community

College
Kathleen Arano, Fort Hays State

University
J. J. Arias, Georgia College & State

University
Nestor Azcona, Babson College
Steve Balassi, St. Mary’s College/Napa

Valley College
Juventino Ulyses Balderas, Sam

Houston State University
Tannista Banerjee, Purdue University
Jason Barr, Rutgers University, Newark
Alan Barreca, Tulane University
Hamid Bastin, Shippensburg University
Tammy Batson, Northern Illinois

University / Rock Valley College
Carl Bauer, Oakton Community College
Klaus Becker, Texas Tech University
Robert Beekman, University of Tampa

Christian Beer, Cape Fear Community
College

Gary Bennett, State University of New
York Fredonia

Bettina Berch, Borough of Manhattan
Community College

Thomas M. Beveridge, Durham
Technical Community College

Abhijeet Bhattacharya, Illinois Valley
Community College

Prasad Bidarkota, Florida International
University

Jekab Bikis, Dallas Baptist University
Michael Bognanno, Temple University
Cecil Bohanon, Ball State University
Natalia Boliari, Manhattan College
Melanie Boyte, Troy University
Charles Braymen, Kansas State
William Brennan, Minnesota State

University at Mankato
Greg Brock, Georgia Southern

University
Ken Brown, University of Northern

Iowa
Laura Bucila, Texas Christian

University
Stan Buck, Huntington University
Donna Bueckman, University of

Tennessee Knoxville
Joe Bunting, St. Andrews Presbyterian

College
Rita Callahan, Keiser University
Michael G. Carew, Baruch College
John Carter, Modesto Junior College
Kalyan Chakraborty, Emporia State

University

Daniel Lee, Shippensburg University
David Lindauer, Wellesley College
Joshua Long, Ivy Tech Community

College
James Makokha, Collin College
Jim McAndrew, Luzerne County

Community College
William Mertens, University of Colorado
Cindy Munson, Western Technical

College
David Mushinski, Colorado State University
Fola Odebunmi, Cypress College

Jeff Rubin, Rutgers University, New
Brunswick

Lynda Rush, California State
Polytechnic University Pomona

Naveen Sarna, Northern Virginia
Community College

Jesse Schwartz, Kennesaw State
University

Mark Showalter, Brigham Young
University

Michael Tasto, Southern New
Hampshire University

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

xvacknowledgmentS

Henry Check, Penn State University
Xudong Chen, Baldwin-Wallace College
Clifton M. Chow, Mass Bay

Community College
Tina Collins, San Joaquin Valley College
Valerie Collins, Sheridan College
Sarah Cosgrove, University of

Massachusetts Dartmouth
Dana Costea, Indiana University South

Bend
Maria DaCosta, University of Wisconsin

Eau Claire
Mian Dai, Drexel University
Joel Dalafave, Bucks County

Community College
Maylene Damoense, Monash

University South Africa
Lorie Darche, Southwest Florida College
Diane de Freitas, Fresno City College
Ejigou Demissie, University of

Maryland Eastern Shore
Richard DePolt, Guilford Technical

Community College
Aaron Dighton, University of

Minnesota
Veronika Dolar, Cleveland State

University
Fisher Donna, Georgia Southern

University
Harold Elder, University of Alabama
Jamie Emerson, Salisbury University
Elena Ermolenko, Oakton Community

College
Pat Euzent, University of Central Florida
Yan Feng, Hunter College, Queens

College, CUNY
Donna K. Fisher, Georgia Southern

University
Paul Fisher, Henry Ford Community

College
Fred Foldvary, Santa Clara University
Nikki Follis, Chadron State College
Kent Ford, State University of New York /

Onondaga Community College
Ryan Ford, Pasadena City College
Timothy Ford, California State

University Sacramento
Johanna Francis, Fordham University
Robert Francis, Shoreline Community

College
Mark Frascatore, Clarkson University
David Furst, University of South Florida

Monica Galizzi, University of
Massachusetts Lowell

Jean-Philippe Gervais, North Carolina
State University

Dipak Ghosh, Emporia State University
Bill Goffe, State University of New York

Oswego
Ryan Gorka, University of Nebraska

Lincoln
Marshall Gramm, Rhodes College
Elias C. Grivoyannis, Yeshiva University
Eleanor Gubins, Rosemont College
Darrin Gulla, University of Kentucky
Karen Gulliver, Argosy University
Ranganai Gwati, University of

Washington Seattle
Mike Haupert, University of Wisconsin

La Crosse
L Jay Helms, University of California

Davis
Dr. David Hennessy, University of

Dubuque
Curry Hilton, Guilford Technical

Community College
George Hoffer, Virginia Commonwealth

University
Mark Holmes, University of Waikato
Carl Hooker, Community College of

Vermont
Daniel Horton, Cleveland State University
Scott Houser, Colorado School of the

Mines
Fanchang Huang, Washington

University in St Louis
Gregory Hunter, California State

Polytechnic University Pomona
Christopher Hyer, University of New

Mexico
Leke Ijiyode, St. Mary’s University of

Minnesota
Chris Inama, Golden Gate University
Sarbaum Jeff, University of North

Carolina Greensboro
Chad Jennings, Tennessee Temple

University
Philipp Jonas, Kalamazoo Valley

Community College
Robert Jones, Rensselaer Polytechnic

Institute
Prathibha Joshi, Gordon College
James Jozefowicz, Indiana University of

Pennsylvania

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xvi

Mahbubul Kabir, Lyon College
Simran Kahai, John Carroll University
David Kalist, Shippensburg University
Camilla Kazimi, St. Mary’s College
Chris Kelton, Naval Postgraduate School
Brian Kench, University of Tampa
Hyeongwoo Kim, Auburn University
Miles Kimball, University of Michigan
Alfreda L. King, Lawson State

Community College
Elizabeth Knowles, –Univeristy of

Wisconsin La Crosse
Fred Kolb, University of Wisconsin Eau

Claire
Risa Kumazawa, Duquesne University
Sumner La Croix, University of Hawaii
Christopher Laincz, Drexel University
Ghislaine Lang, San Jose State

University
Carolyn Langston, South Arkansas

Community College
Richard Le, Cosumnes River College
Daniel Lee, Shippensburg University
Tom Lehman, Indiana Wesleyan

University
Megan Leonard, Hendrix College
Larry Lichtenstein, Canisius College
Tad Lincoln, Middlesex Community

College
David Linthicum, Cecil College North

East
Sam Liu, West Valley College
Melody Lo, University of Texas at San

Antonio
Volodymyr Logovskyy, Georgia

Institute of Technology
Min Lu, Robert Morris University
Gennady Lyakir, Champlain College
Bruce Madariaga, Montgomery

Community College
Brinda Mahalingam, University of

California Riverside
Rubana Mahjabeen, Truman State

University
Bahman Maneshni, Paradise Valley

Community College
Denton Marks, University of Wisconsin-

Whitewater
Timothy Mathews, Kennesaw State

University
Frances Mc Donald, Northern Virginia

Community College

Edward McGrath, Holyoke Community
College

Shirley Ann Merchant, George
Washington University

William Mertens, University of
Colorado

Mitch Mitchell, Bladen Community
College

Mitch Mitchell, North Carolina
Wesleyan

Mike Mogavero, University of Notre
Dame

Prof Ramesh Mohan, Bryant University
Daniel Monchuk, University of

Southern Mississippi
Vasudeva Murthy, Creighton

University
David Mushinsk, Colorado State

University
Paula Nas, University of Michigan Flint
Russ Neal, Collin County Community

College
Megumi Nishimura, University of

Colorado
Peter Olson, Indiana University
Esen Onur, California State University

Sacramento
Stephen Onyeiwu, Allegheny College
Margaret Oppenheimer, DePaul

University
Glenda Orosco, Oklahoma State

University Institute of Technology
David Ortmeyer, Bentley University
Thomas Owen, College of the Redwoods
Jan Palmer, Ohio University
Amar Parai, State University of New

York at Fredonia
Nitin Paranjpe, Wayne State and

Oakland University
Carl Parker, Fort Hays State University
Michael Petrack, Oakland Community

College
Gyan Pradhan, Eastern Kentucky

University
Michael Pries, University of Notre

Dame
Joe Quinn, Boston College
Mahesh Ramachandran, Clark

University
Ratha Ramoo, Diablo Valley College
Surekha Rao, Indiana University

Northwest

acknowledgmentS

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xvii

Ryan Ratcliff, University of San Diego
Scott Redenius, Brandeis University
Susan Reilly, Florida State College at

Jacksonville
Imke Reimers, University of Minnesota
Christopher Richardson, Merrillville

High School
Art Riegal, State University of New

York Sullivan
Richard Risinit, Middlesex Community

College
Michael Rogers, Albany State

University
Paul Roscelli, Canada College
Larry Ross, University of Alaska Anchorage
Jeff Rubin, Rutgers University
Allen Sanderson, University of Chicago
Jeff Sarbaum, University of North

Carolina Greensboro
Dennis Shannon, Southwestern Illinois

College
Xuguang Sheng, State University of

New York at Fredonia
Mark Showalter, Brigham Young

University
Johnny Shull, Central Carolina

Community College
Suann Shumaker, Las Positas

Community College
Jonathan Silberman, Oakland University
Steven Skinner, Western Connecticut

State University
Catherine Skura, Sandhills Community

College
Gary Smith, D’Youville College
Warren Smith, Keiser University
William Snyder, Peru State College
Ken Somppi, Southern Union State

Community College
Dale Steinreich, Drury University
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Carolyn Fabian Stumph, Indiana

University Purdue University Fort
Wayne

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Birmingham

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University

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University

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New York at Nassau

Ngoc Bich Tran, San Jacinto College
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Pennsylvania
Julie Trivitt, Arkansas Tech University
Arja Turunen-Red, University of New

Orleans
Diane Tyndall, Craven Community

College
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Wisconsin Oshkosh
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Priti Verma, Texas A&M University,

Kingsville
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Jing Wang, Northeastern University
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College, Virginia Beach, Virgina
Campus

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Elizabeth Wheaton, Southern Methodist

University
Luther White, Central Carolina

Community College
Oxana Wieland, University of

Minnesota Crookston
John Winters, Auburn University at

Montgomery
Suzanne Wisniewski, University of

St. Thomas
Patricia Wiswell, Columbia-Greene

Community College
Mark Witte, College of Charleston
Louis A. Woods, University of North

Florida
Guy Yamashiro, California State

University Long Beach
Benhua Yang, Stetson University
Leslie Young, Kilian Community College
Karen Zempel, Bryant and Stratton

College

The team of editors who worked on this book improved it tremendously. Jane
Tufts, developmental editor, provided truly spectacular editing—as she always
does. Mike Worls, economics executive editor, did a splendid job of overseeing the

acknowledgmentS

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xviii

many people involved in such a large project. Jennifer Thomas (supervising devel-
opmental editor) and Katie Yanos (supervising developmental editor) were crucial
in assembling an extensive and thoughtful group of reviewers to give me feed-
back on the previous edition, while putting together an excellent team to revise the
supplements. Colleen Farmer, senior content project manager, and Malvine Litten,
project manager, had the patience and dedication necessary to turn my manu-
script into this book. Michelle Kunkler, senior art director, gave this book its clean,
friendly look. Larry Moore, the illustrator, helped make the book more visually
appealing and the economics in it less abstract. Sheryl Nelson, copyeditor, refined
my prose, and Cindy Kerr, indexer, prepared a careful and thorough index. John
Carey, senior marketing manager, worked long hours getting the word out to po-
tential users of this book. The rest of the Cengage team was also consistently pro-
fessional, enthusiastic, and dedicated: Allyn Bissmeyer, Darrell Frye, Sarah Greber,
Betty Jung, Deepak Kumar, Kim Kusnerak, Sharon Morgan, Suellen Ruttkay, and
Joe Sabatino.
I am grateful also to Stacy Carlson and Daniel Norris, two star Harvard under-
graduates, who helped me refine the manuscript and check the page proofs for
this edition. Josh Bookin, a former Advanced Placement economics teacher and
recently an extraordinary section leader for Harvard’s Ec 10, gave invaluable
advice on some of the new material in this edition.
As always, I must thank my “in-house” editor Deborah Mankiw. As the first
reader of most things I write, she continued to offer just the right mix of criticism
and encouragement.
Finally, I would like to mention my three children Catherine, Nicholas, and
Peter. Their contribution to this book was putting up with a father spending too
many hours in his study. The four of us have much in common—not least of
which is our love of ice cream (which becomes apparent in Chapter 4). Maybe
sometime soon one of them will pick up my passion for economics as well.

N. Gregory Mankiw
December 2010

acknowledgmentS

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table of
contents

PartI Introduction 1
Chapter 1

ten Principles of Economics 3
How People make decisions 4

Principle 1: People Face Trade-offs 4
Principle 2: The Cost of Something Is What You Give

Up to Get It 5
Principle 3: Rational People Think at the Margin 6
Principle 4: People Respond to Incentives 7
Case Study: The Incentive Effects of Gasoline Prices 8
In The News: Incentive Pay 9

How People Interact 10
Principle 5: Trade Can Make Everyone Better Off 10
Principle 6: Markets Are Usually a Good Way to Organize

Economic Activity 10
Principle 7: Governments Can Sometimes Improve Market

Outcomes 11

Preface: to the Student ix

acknowledgments xiii

FYI: Adam Smith and the Invisible Hand 12

How the economy as a whole works 13
Principle 8: A Country’s Standard of Living Depends on Its

Ability to Produce Goods and Services 13
In The News: Why You Should Study Economics 14
Principle 9: Prices Rise When the Government Prints Too

Much Money 15
Principle 10: Society Faces a Short-Run Trade-off between

Inflation and Unemployment 16
FYI: How to Read This Book 17

conclusion 17

Chapter 2

thinking Like an Economist 21
the economist as Scientist 22

The Scientific Method: Observation, Theory, and More
Observation 22

The Role of Assumptions 23
Economic Models 24
Our First Model: The Circular-Flow Diagram 24
Our Second Model: The Production Possibilities

Frontier 26
Microeconomics and Macroeconomics 29

the economist as Policy adviser 29
FYI: Who Studies Economics? 30
Positive versus Normative Analysis 30
Economists in Washington 31
In The News: The Economics of President

Obama 32
Why Economists’ Advice Is Not Always Followed 32

why economists disagree 34
Differences in Scientific Judgments 34
Differences in Values 34
Perception versus Reality 35

let’s get going 35
In The News: Environmental Economics 37

aPPendIX graphing: a Brief Review 40
Graphs of a Single Variable 40
Graphs of Two Variables: The Coordinate System 41
Curves in the Coordinate System 42
Slope 44
Cause and Effect 46

xix

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xx

Chapter 3

Interdependence and the Gains
from trade 49
a Parable for the modern economy 50

Production Possibilities 50
Specialization and Trade 52

comparative advantage: the driving Force
of Specialization 54
Absolute Advantage 54
Opportunity Cost and Comparative

Advantage 54
Comparative Advantage and Trade 55
The Price of the Trade 56
FYI: The Legacy of Adam Smith and David

Ricardo 57

applications of comparative advantage 57
Should Tom Brady Mow His Own Lawn? 57
Should the United States Trade with Other

Countries? 58
In The News: The Changing Face of International

Trade 59

conclusion 59

Chapter 4

the Market Forces of Supply
and Demand 65
markets and competition 66

What Is a Market? 66
What Is Competition? 66

demand 67
The Demand Curve: The Relationship between Price and

Quantity Demanded 67
Market Demand versus Individual Demand 68
Shifts in the Demand Curve 69
Case Study: Two Ways to Reduce the Quantity of

Smoking Demanded 71

Supply 73
The Supply Curve: The Relationship between Price and

Quantity Supplied 73
Market Supply versus Individual Supply 73
Shifts in the Supply Curve 74

Supply and demand together 77
Equilibrium 77
Three Steps to Analyzing Changes in Equilibrium 79
In The News: Price Increases after Disasters 82

conclusion: How Prices allocate Resources 84

Chapter 5

Elasticity and Its application 89
the elasticity of demand 90

The Price Elasticity of Demand and Its Determinants 90
Computing the Price Elasticity of Demand 91
The Midpoint Method: A Better Way to Calculate

Percentage Changes and Elasticities 91
The Variety of Demand Curves 92
FYI: A Few Elasticities from the Real World 94
Total Revenue and the Price Elasticity of Demand 94
Elasticity and Total Revenue along a Linear Demand Curve 96
Other Demand Elasticities 97

the elasticity of Supply 98
The Price Elasticity of Supply and Its Determinants 98
Computing the Price Elasticity of Supply 98
The Variety of Supply Curves 99

three applications of Supply, demand, and elasticity 101
Can Good News for Farming Be Bad News for Farmers? 101
Why Did OPEC Fail to Keep the Price of Oil High? 103
Does Drug Interdiction Increase or Decrease Drug-Related

Crime? 105

conclusion 106

contentS

PartII How Markets
Work 63

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xxicontentS

Chapter 6

Supply, Demand, and Government
Policies 111
controls on Prices 112

How Price Ceilings Affect Market Outcomes 112
Case Study: Lines at the Gas Pump 114
Case Study: Rent Control in the Short Run and

the Long Run 115
How Price Floors Affect Market Outcomes 116
Case Study: The Minimum Wage 117
Evaluating Price Controls 119
In The News: Should Unpaid Internships Be Allowed? 120

taxes 121
How Taxes on Sellers Affect Market Outcomes 121
How Taxes on Buyers Affect Market Outcomes 123
Case Study: Can Congress Distribute the Burden of a Payroll

Tax? 124
Elasticity and Tax Incidence 125
Case Study: Who Pays the Luxury Tax? 127

conclusion 128

How a Lower Price Raises Consumer Surplus 138
What Does Consumer Surplus Measure? 140

Producer Surplus 141
Cost and the Willingness to Sell 141
Using the Supply Curve to Measure Producer Surplus 142
How a Higher Price Raises Producer Surplus 144

market efficiency 145
The Benevolent Social Planner 145
Evaluating the Market Equilibrium 146
In The News: Ticket Scalping 148
Case Study: Should There Be a Market in Organs? 149

conclusion: market efficiency and market Failure 150

Chapter 8

application: the Costs of taxation 155
the deadweight loss of taxation 156

How a Tax Affects Market Participants 157
Deadweight Losses and the Gains from Trade 159

the determinants of the deadweight loss 160
Case Study: The Deadweight Loss Debate 162

deadweight loss and tax Revenue as taxes Vary 163
Case Study: The Laffer Curve and Supply-Side Economics 165
In The News: New Research on Taxation 166

conclusion 166

Chapter 9

application: International trade 171
the determinants of trade 172

The Equilibrium without Trade 172
The World Price and Comparative Advantage 173

the winners and losers from trade 174
The Gains and Losses of an Exporting Country 174
The Gains and Losses of an Importing Country 175
The Effects of a Tariff 177
FYI: Import Quotas: Another Way to Restrict Trade 179
The Lessons for Trade Policy 179
Other Benefits of International Trade 180
In The News: Trade Skirmishes 181

the arguments for Restricting trade 182
The Jobs Argument 182
In The News: Should the Winners from Free Trade

Compensate the Losers? 183
The National-Security Argument 184
In The News: Second Thoughts about Free Trade 184
The Infant-Industry Argument 185
The Unfair-Competition Argument 186
The Protection-as-a-Bargaining-Chip Argument 186
Case Study: Trade Agreements and the World Trade

Organization 186

conclusion 187

PartIII Markets and
Welfare 133

Chapter 7

Consumers, Producers, and the
Efficiency of Markets 135
consumer Surplus 136

Willingness to Pay 136
Using the Demand Curve to Measure Consumer Surplus 137

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xxii contentS

Chapter 11

Public Goods and Common
resources 217
the different kinds of goods 218

Public goods 220
The Free-Rider Problem 220
Some Important Public Goods 220
Case Study: Are Lighthouses Public

Goods? 222
The Difficult Job of Cost–Benefit Analysis 223
Case Study: How Much Is a Life Worth? 223

common Resources 224
The Tragedy of the Commons 224
Some Important Common Resources 225
In The News: The Case for Toll Roads 226
Case Study: Why the Cow Is Not Extinct 228

conclusion: the Importance of Property
Rights 229

Chapter 12

the Design of the tax System 233
a Financial overview of the U.S. government 234

The Federal Government 235
Case Study: The Fiscal Challenge

Ahead 238
State and Local Government 240

taxes and efficiency 242
Deadweight Losses 242
Case Study: Should Income or Consumption

Be Taxed? 243
In The News: The Temporarily Disappearing

Estate Tax 244
Administrative Burden 244
Marginal Tax Rates versus Average

Tax Rates 245
Lump-Sum Taxes 245

taxes and equity 246
The Benefits Principle 246
The Ability-to-Pay Principle 247
Case Study: How the Tax Burden Is

Distributed 248
Tax Incidence and Tax Equity 249
Case Study: Who Pays the Corporate

Income Tax? 250
In The News: The Value-Added Tax 250

conclusion: the trade-off between equity and
efficiency 252

PartIV the Economics
of the Public
Sector 193

Chapter 10

Externalities 195
externalities and market Inefficiency 197

Welfare Economics: A Recap 197
Negative Externalities 198
Positive Externalities 199
In The News: The Externalities of Country

Living 200
Case Study: Technology Spillovers, Industrial Policy, and

Patent Protection 201

Public Policies toward externalities 202
Command-and-Control Policies: Regulation 203
Market-Based Policy 1: Corrective Taxes and

Subsidies 203
Case Study: Why Is Gasoline Taxed So Heavily? 204
Market-Based Policy 2: Tradable Pollution

Permits 205
Objections to the Economic Analysis of Pollution 207
In The News: Cap and Trade 208

Private Solutions to externalities 209
The Types of Private Solutions 210
The Coase Theorem 210
Why Private Solutions Do Not Always Work 211

conclusion 212

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xxiiicontentS

Chapter 14

Firms in Competitive Markets 279
what Is a competitive market? 280

The Meaning of Competition 280
The Revenue of a Competitive Firm 280

Profit maximization and the competitive Firm’s
Supply curve 282
A Simple Example of Profit Maximization 282
The Marginal-Cost Curve and the Firm’s Supply

Decision 283
The Firm’s Short-Run Decision to Shut Down 285
Spilt Milk and Other Sunk Costs 286
Case Study: Near-Empty Restaurants and Off-Season

Miniature Golf 287
The Firm’s Long-Run Decision to Exit or Enter a

Market 288
Measuring Profit in Our Graph for the Competitive

Firm 288

the Supply curve in a competitive market 289
The Short Run: Market Supply with a Fixed

Number of Firms 290
The Long Run: Market Supply with Entry and Exit 290
Why Do Competitive Firms Stay in Business If They Make

Zero Profit? 292
A Shift in Demand in the Short Run and Long Run 293
Why the Long-Run Supply Curve Might Slope

Upward 293

conclusion: Behind the Supply curve 295

Chapter 15

Monopoly 299
why monopolies arise 300

Monopoly Resources 301
Government-Created Monopolies 301
Natural Monopolies 302

How monopolies make Production and
Pricing decisions 303
Monopoly versus Competition 303
A Monopoly’s Revenue 304
Profit Maximization 306
A Monopoly’s Profit 308
FYI: Why a Monopoly Does Not Have a Supply

Curve 308
Case Study: Monopoly Drugs versus Generic

Drugs 309

the welfare cost of monopolies 310
The Deadweight Loss 311
The Monopoly’s Profit: A Social Cost? 313

PartV Firm Behavior and
the Organization
of Industry 257

Chapter 13

the Costs of Production 259
what are costs? 260

Total Revenue, Total Cost, and Profit 260
Costs as Opportunity Costs 260
The Cost of Capital as an Opportunity Cost 261
Economic Profit versus Accounting Profit 262

Production and costs 263
The Production Function 263
From the Production Function to the Total-Cost

Curve 265

the Various measures of cost 265
Fixed and Variable Costs 266
Average and Marginal Cost 267
Cost Curves and Their Shapes 268
Typical Cost Curves 270

costs in the Short Run and in the
long Run 271
The Relationship between Short-Run and Long-Run Average

Total Cost 271
Economies and Diseconomies of Scale 272
FYI: Lessons from a Pin Factory 273

conclusion 274

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xxiv contentS

Price discrimination 314
A Parable about Pricing 314
The Moral of the Story 315
The Analytics of Price Discrimination 315
Examples of Price Discrimination 317

Public Policy toward monopolies 318
In The News: TKTS and Other Schemes 318
Increasing Competition with Antitrust Laws 319
In The News: President Obama’s Antitrust

Policy 320
Regulation 321
Public Ownership 323
Doing Nothing 323

conclusion: the Prevalence of monopolies 323

Chapter 16

Monopolistic Competition 329
Between monopoly and Perfect competition 330

competition with differentiated Products 332
The Monopolistically Competitive Firm in the

Short Run 332
The Long-Run Equilibrium 332
Monopolistic versus Perfect Competition 335
Monopolistic Competition and the Welfare of

Society 336
In The News: Insufficient Variety as a Market

Failure 338

advertising 338
The Debate over Advertising 340
Case Study: Advertising and the Price of

Eyeglasses 340
Advertising as a Signal of Quality 341
FYI: Galbraith versus Hayek 342
Brand Names 343

conclusion 344

Chapter 17

Oligopoly 349
markets with only a Few Sellers 350

A Duopoly Example 350
Competition, Monopolies, and Cartels 351
In The News: Public Price Fixing 352
The Equilibrium for an Oligopoly 353
How the Size of an Oligopoly Affects the

Market Outcome 354

the economics of cooperation 355
The Prisoners’ Dilemma 355
Oligopolies as a Prisoners’ Dilemma 357

Case Study: OPEC and the World Oil Market 358
Other Examples of the Prisoners’ Dilemma 358
The Prisoners’ Dilemma and the Welfare of Society 360
Why People Sometimes Cooperate 360
Case Study: The Prisoners’ Dilemma

Tournament 361

Public Policy toward oligopolies 362
Restraint of Trade and the Antitrust Laws 362
Case Study: An Illegal Phone Call 363
Controversies over Antitrust Policy 363
Case Study: The Microsoft Case 365

conclusion 366
In The News: The Next Big Antitrust Target? 367

PartVI the Economics
of Labor Markets 373

Chapter 18

the Markets for the Factors of
Production 375
the demand for labor 376

The Competitive Profit-Maximizing Firm 377
The Production Function and the Marginal Product of

Labor 377
The Value of the Marginal Product and the Demand

for Labor 379
What Causes the Labor-Demand Curve to Shift? 380

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xxvcontentS

the measurement of Inequality 416
U.S. Income Inequality 416
Inequality around the World 417
The Poverty Rate 419
Problems in Measuring Inequality 420
Case Study: Alternative Measures of Inequality 421
In The News: What’s Wrong with the

Poverty Rate? 422
Economic Mobility 423

the Political Philosophy of Redistributing
Income 424
Utilitarianism 424
Liberalism 425
Libertarianism 427

Policies to Reduce Poverty 427
Minimum-Wage Laws 428
Welfare 428
Negative Income Tax 429
In-Kind Transfers 430
In The News: The Root Cause of a Financial

Crisis 430
Antipoverty Programs and Work Incentives 431

conclusion 432

FYI: Input Demand and Output Supply: Two Sides of the
Same Coin 381

FYI: The Luddite Revolt 382

the Supply of labor 383
The Trade-off between Work and Leisure 383
What Causes the Labor-Supply Curve to Shift? 383

equilibrium in the labor market 384
Shifts in Labor Supply 385
In The News: The Economics of Immigration 386
Shifts in Labor Demand 386
Case Study: Productivity and Wages 387
FYI: Monopsony 389

the other Factors of Production: land and capital 389
Equilibrium in the Markets for Land and Capital 390
FYI: What Is Capital Income? 391
Linkages among the Factors of Production 391
Case Study: The Economics of the Black Death 392

conclusion 393

Chapter 19

Earnings and Discrimination 397
Some determinants of equilibrium wages 398

Compensating Differentials 398
Human Capital 398
Case Study: The Increasing Value of Skills 399
Ability, Effort, and Chance 400
Case Study: The Benefits of Beauty 401
An Alternative View of Education: Signaling 402
The Superstar Phenomenon 402
In The News: The Human Capital of Terrorists 403
Above-Equilibrium Wages: Minimum-Wage Laws, Unions,

and Efficiency Wages 404

the economics of discrimination 405
Measuring Labor-Market Discrimination 405
Case Study: Is Emily More Employable than

Lakisha? 407
Discrimination by Employers 407
Case Study: Segregated Streetcars and the Profit

Motive 408
Discrimination by Customers and Governments 408
Case Study: Discrimination in Sports 409
In The News: Gender Differences 410

conclusion 411

Chapter 20

Income Inequality and Poverty 415
PartVII topics for Further

Study 437

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xxvi contentS

Chapter 21

the theory of Consumer Choice 439
the Budget constraint: what the consumer

can afford 440

Preferences: what the consumer wants 441
Representing Preferences with Indifference Curves 442
Four Properties of Indifference Curves 443
Two Extreme Examples of Indifference Curves 444

optimization: what the consumer chooses 446
The Consumer’s Optimal Choices 446
FYI: Utility: An Alternative Way to Describe Preferences and

Optimization 447
How Changes in Income Affect the Consumer’s

Choices 448
How Changes in Prices Affect the Consumer’s

Choices 449
Income and Substitution Effects 450
Deriving the Demand Curve 452

three applications 453
Do All Demand Curves Slope Downward? 453
Case Study: The Search for Giffen Goods 454
How Do Wages Affect Labor Supply? 454
Case Study: Income Effects on Labor Supply: Historical

Trends, Lottery Winners, and the Carnegie
Conjecture 457

In The News: Backward-sloping Labor Supply
in Kiribati 458

How Do Interest Rates Affect Household Saving? 459

conclusion: do People Really think this way? 461

Chapter 22

Frontiers of Microeconomics 467
asymmetric Information 468

Hidden Actions: Principals, Agents, and Moral Hazard 468
FYI: Corporate Management 469
Hidden Characteristics: Adverse Selection and the

Lemons Problem 470
Signaling to Convey Private Information 471
Case Study: Gifts as Signals 471
Screening to Uncover Private Information 472
Asymmetric Information and Public Policy 473

Political economy 473
The Condorcet Voting Paradox 474
Arrow’s Impossibility Theorem 475
In The News: Arrow’s Problem in Practice 476
The Median Voter Is King 478
Politicians Are People Too 479

Behavioral economics 480

People Aren’t Always Rational 480
People Care about Fairness 481
In The News: Sin Taxes 482
People Are Inconsistent over Time 484

conclusion 485

PartVIII the Data of
Macro-
economics 489

Chapter 23

Measuring a Nation’s Income 491
the economy’s Income and expenditure 492

the measurement of gross domestic Product 494
“GDP Is the Market Value…” 494
“… of All …” 494
“… Final …” 495
“… Goods and Services …” 495
“… Produced …” 495
“… Within a Country …” 495
“… In a Given Period of Time.” 495

the components of gdP 496
FYI: Other Measures of Income 497
Consumption 497
Investment 497
Government Purchases 498

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xxviicontentS

Net Exports 498
Case Study: The Components of U.S. GDP 499

Real versus nominal gdP 499
A Numerical Example 500
The GDP Deflator 501
Case Study: Real GDP over Recent History 502

Is gdP a good measure of economic well-Being? 503
In The News: The Underground Economy 504
In The News: Beyond Gross Domestic Product 506
Case Study: International Differences in GDP and the

Quality of Life 507

conclusion 508

Chapter 24

Measuring the Cost of Living 513
the consumer Price Index 514

How the Consumer Price Index Is Calculated 514
FYI: What Is in the CPI’s Basket? 516
Problems in Measuring the Cost of Living 517
In The News: Shopping for the CPI 518
The GDP Deflator versus the Consumer Price

Index 520

correcting economic Variables for the effects of
Inflation 521
Dollar Figures from Different Times 522
Indexation 522
FYI: Mr. Index Goes to Hollywood 523
Real and Nominal Interest Rates 523
Case Study: Interest Rates in the

U.S. Economy 525

conclusion 526

Part IX the real Economy
in the Long
run 529

Chapter 25

Production and Growth 531
economic growth around the world 532

FYI: A Picture Is Worth a Thousand Statistics 534
FYI: Are You Richer Than the Richest American? 536

Productivity: Its Role and determinants 536
Why Productivity Is So Important 536
How Productivity Is Determined 537
FYI: The Production Function 539
Case Study: Are Natural Resources a Limit to

Growth? 539

economic growth and Public Policy 540
Saving and Investment 540
Diminishing Returns and the Catch-Up Effect 541
Investment from Abroad 542
Education 543
Health and Nutrition 544
In The News: Promoting Human Capital 545
Property Rights and Political Stability 546
Free Trade 547
Research and Development 548
Population Growth 548
In The News: One Economist’s Answer 550

conclusion: the Importance of long-Run growth 552

Chapter 26

Saving, Investment, and the
Financial System 555
Financial Institutions in the U.S. economy 556

Financial Markets 556
Financial Intermediaries 558
FYI: Key Numbers for Stock Watchers 559
Summing Up 560
FYI: Financial Crises 561

Saving and Investment in the national
Income accounts 561
Some Important Identities 562
The Meaning of Saving and Investment 563

the market for loanable Funds 564
Supply and Demand for Loanable Funds 564
Policy 1: Saving Incentives 566

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xxviii contentS

Policy 2: Investment Incentives 568
Policy 3: Government Budget Deficits and

Surpluses 568
Case Study: The History of U.S. Government

Debt 570

conclusion 572

Chapter 27

the Basic tools of Finance 577
Present Value: measuring the time Value of money 578

FYI: The Magic of Compounding and the Rule of 70 580

managing Risk 580
Risk Aversion 580
The Markets for Insurance 581
Diversification of Firm-Specific Risk 582
The Trade-off between Risk and Return 583

asset Valuation 584
Fundamental Analysis 585
The Efficient Markets Hypothesis 585
In The News: A Cartoonist’s Guide to Stock

Picking 586
Case Study: Random Walks and Index Funds 587
In The News: Is the Efficient Markets Hypothesis

Kaput? 588
Market Irrationality 590

conclusion 590

Chapter 28

Unemployment 593
Identifying Unemployment 594

How Is Unemployment Measured? 594
Case Study: Labor-Force Participation of Men and

Women in the U.S. Economy 597
Does the Unemployment Rate Measure What We

Want It To? 598
How Long Are the Unemployed without Work? 600
Why Are There Always Some People

Unemployed? 600
In The News: The Rise of Long-Term

Unemployment 601
FYI: The Jobs Number 602

Job Search 602
Why Some Frictional Unemployment Is

Inevitable 603
Public Policy and Job Search 603
Unemployment Insurance 604
In The News: How Much Do the Unemployed

Respond to Incentives? 604

minimum-wage laws 606
FYI: Who Earns the Minimum Wage? 608

Unions and collective Bargaining 608
The Economics of Unions 609
Are Unions Good or Bad for the Economy? 610

the theory of efficiency wages 610
Worker Health 611
Worker Turnover 611
Worker Quality 611
Worker Effort 612
Case Study: Henry Ford and the Very Generous

$5-a-Day Wage 612

conclusion 613

Part X Money and Prices
in the Long
run 617

Chapter 29

the Monetary System 619
the meaning of money 620

The Functions of Money 621
The Kinds of Money 621
In The News: Mackereleconomics 622
Money in the U.S. Economy 623
FYI: Why Credit Cards Aren’t Money 624
Case Study: Where Is All the Currency? 624

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xxixcontentS

the Federal Reserve System 625
The Fed’s Organization 626
The Federal Open Market Committee 626

Banks and the money Supply 627
The Simple Case of 100-Percent-Reserve

Banking 627
Money Creation with Fractional-Reserve

Banking 628
The Money Multiplier 629
Bank Capital, Leverage, and the Financial Crisis

of 2008–2009 631

the Fed’s tools of monetary control 632
How the Fed Influences the Quantity of Reserves 633
How the Fed Influences the Reserve Ratio 634
Problems in Controlling the Money Supply 635
Case Study: Bank Runs and the Money Supply 636
The Federal Funds Rate 636
In The News: Bernanke on the Fed’s Toolbox 638

conclusion 640

Chapter 30

Money Growth and Inflation 643
the classical theory of Inflation 644

The Level of Prices and the Value of Money 645
Money Supply, Money Demand, and

Monetary Equilibrium 645
The Effects of a Monetary Injection 647
A Brief Look at the Adjustment Process 648
The Classical Dichotomy and Monetary

Neutrality 649
Velocity and the Quantity Equation 650
Case Study: Money and Prices during

Four Hyperinflations 652
The Inflation Tax 652
FYI: Hyperinflation in Zimbabwe 654
The Fisher Effect 655

the costs of Inflation 656
A Fall in Purchasing Power? The Inflation Fallacy 656
Shoeleather Costs 657
Menu Costs 658
Relative-Price Variability and the Misallocation

of Resources 658
Inflation-Induced Tax Distortions 659
Confusion and Inconvenience 660
A Special Cost of Unexpected Inflation: Arbitrary

Redistributions of Wealth 661
Inflation Is Bad, But Deflation May Be Worse 662
Case Study: The Wizard of Oz and the

Free-Silver Debate 662
In The News: Inflationary Threats 664

conclusion 664

Part XI the Macro-
economics
of Open
Economies 669

Chapter 31

Open-Economy Macroeconomics:
Basic Concepts 671
the International Flows of goods and capital 672

The Flow of Goods: Exports, Imports, and Net
Exports 672

Case Study: The Increasing Openness of the U.S.
Economy 673

In The News: Breaking Up the Chain of
Production 674

The Flow of Financial Resources: Net Capital
Outflow 676

The Equality of Net Exports and Net Capital
Outflow 677

Saving, Investment, and Their Relationship to the
International Flows 678

Summing Up 679
Case Study: Is the U.S. Trade Deficit a National

Problem? 680

the Prices for International transactions: Real and nominal
exchange Rates 682
Nominal Exchange Rates 682
FYI: The Euro 683
Real Exchange Rates 684

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xxx contentS

a First theory of exchange-Rate determination:
Purchasing-Power Parity 685
The Basic Logic of Purchasing-Power Parity 686
Implications of Purchasing-Power Parity 686
Case Study: The Nominal Exchange Rate during a

Hyperinflation 688
Limitations of Purchasing-Power Parity 689
Case Study: The Hamburger Standard 689

conclusion 690

Chapter 32

a Macroeconomic theory of the Open
Economy 695
Supply and demand for loanable Funds and for

Foreign-currency exchange 696
The Market for Loanable Funds 696
The Market for Foreign-Currency Exchange 698
FYI: Purchasing-Power Parity as a Special Case 700

equilibrium in the open economy 701
Net Capital Outflow: The Link between the Two

Markets 701
Simultaneous Equilibrium in Two Markets 702
FYI: Disentangling Supply and Demand 704

How Policies and events affect an open
economy 704
Government Budget Deficits 704
Trade Policy 706
Political Instability and Capital Flight 709
Case Study: Capital Flows from China 711
In The News: Alternative Exchange-Rate

Regimes 712

conclusion 712

Part XII Short-run
Economic
Fluctuations 717

Chapter 33

aggregate Demand and
aggregate Supply 719
three key Facts about economic Fluctuations 720

Fact 1: Economic Fluctuations Are Irregular and
Unpredictable 720

Fact 2: Most Macroeconomic Quantities Fluctuate
Together 722

Fact 3: As Output Falls, Unemployment Rises 722

explaining Short-Run economic Fluctuations 722
The Assumptions of Classical Economics 722
The Reality of Short-Run Fluctuations 723
In The News: The Social Influences of Economic

Downturns 724
The Model of Aggregate Demand and Aggregate

Supply 724

the aggregate-demand curve 726
Why the Aggregate-Demand Curve Slopes

Downward 726
Why the Aggregate-Demand Curve Might Shift 729

the aggregate-Supply curve 731
Why the Aggregate-Supply Curve Is Vertical in the

Long Run 731
Why the Long-Run Aggregate-Supply Curve Might

Shift 732
Using Aggregate Demand and Aggregate Supply to Depict

Long-Run Growth and Inflation 734
Why the Aggregate-Supply Curve Slopes Upward in

the Short Run 734
Why the Short-Run Aggregate-Supply Curve Might

Shift 738

two causes of economic Fluctuations 740
The Effects of a Shift in Aggregate Demand 740
FYI: Monetary Neutrality Revisited 743
Case Study: Two Big Shifts in Aggregate Demand: The Great

Depression and World War II 744
Case Study: The Recession of 2008–2009 745
In The News: Modern Parallels to the Great

Depression 746
The Effects of a Shift in Aggregate Supply 748
Case Study: Oil and the Economy 750
FYI: The Origins of the Model of Aggregate Demand and

Aggregate Supply 751

conclusion 752

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xxxicontentS

Chapter 34

the Influence of Monetary and Fiscal
Policy on aggregate Demand 757
How monetary Policy Influences aggregate demand 758

The Theory of Liquidity Preference 759
The Downward Slope of the Aggregate-Demand Curve 761
FYI: Interest Rates in the Long Run and the Short Run 762
Changes in the Money Supply 764
The Role of Interest-Rate Targets in Fed Policy 765
FYI: The Zero Lower Bound 766
Case Study: Why the Fed Watches the Stock Market

(and Vice Versa) 766

How Fiscal Policy Influences aggregate demand 767
Changes in Government Purchases 768
The Multiplier Effect 768
A Formula for the Spending Multiplier 769
Other Applications of the Multiplier Effect 770
The Crowding-Out Effect 771
Changes in Taxes 772
FYI: How Fiscal Policy Might Affect Aggregate Supply 773

Using Policy to Stabilize the economy 773
The Case for Active Stabilization Policy 773
Case Study: Keynesians in the White House 775
The Case against Active Stabilization Policy 775
In The News: How Large Is the Fiscal Policy

Multiplier? 776
Automatic Stabilizers 777
In The News: Offbeat Indicators 779

conclusion 780

Chapter 35

the Short-run trade-off between
Inflation and Unemployment 785
the Phillips curve 786

Origins of the Phillips Curve 786
Aggregate Demand, Aggregate Supply, and the Phillips

Curve 787

Shifts in the Phillips curve: the Role of expectations 789
The Long-Run Phillips Curve 789
The Meaning of “Natural” 791
Reconciling Theory and Evidence 792
The Short-Run Phillips Curve 793
The Natural Experiment for the Natural-Rate

Hypothesis 794

Shifts in the Phillips curve: the Role of Supply Shocks 796

the cost of Reducing Inflation 798
The Sacrifice Ratio 799

Rational Expectations and the Possibility of Costless
Disinflation 800

The Volcker Disinflation 801
The Greenspan Era 802
The Phillips Curve during the Financial Crisis 804
In The News: Do We Need More Inflation? 805

conclusion 806

PartXIII Final
thoughts 809

Chapter 36

Six Debates over Macroeconomic
Policy 811
Should monetary and Fiscal Policymakers try to

Stabilize the economy? 812
Pro: Policymakers Should Try to Stabilize the

Economy 812
Con: Policymakers Should Not Try to Stabilize the

Economy 812

Should the government Fight Recessions with Spending
Hikes Rather than tax cuts? 814
Pro: The Government Should Fight Recessions with Spending

Hikes 814
Con: The Government Should Fight Recessions with

Tax Cuts 815

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xxxii contentS

Should monetary Policy Be made by Rule Rather than by
discretion? 816
Pro: Monetary Policy Should Be Made by Rule 817
Con: Monetary Policy Should Not Be Made by Rule 818
FYI: Inflation Targeting 819

Should the central Bank aim for Zero Inflation? 819
Pro: The Central Bank Should Aim for Zero

Inflation 820
Con: The Central Bank Should Not Aim for

Zero Inflation 821
In The News: What Is the Optimal Inflation Rate? 822

Should the government Balance Its Budget? 823
Pro: The Government Should Balance Its Budget 823
Con: The Government Should Not Balance Its

Budget 824

In The News: Dealing with Debt and Deficits 826

Should the tax laws Be Reformed to encourage
Saving? 826
Pro: The Tax Laws Should Be Reformed to Encourage

Saving 826
Con: The Tax Laws Should Not Be Reformed to Encourage

Saving 828

conclusion 829

glossary 833
Index 839

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IntroductionIPart
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3

1ten Principles of Economics
the word economy comes from the Greek word oikonomos, which means “one who manages a household.” At first, this origin might seem pecu-liar. But in fact, households and economies have much in common. A household faces many decisions. It must decide which members of
the household do which tasks and what each member gets in return: Who cooks
dinner? Who does the laundry? Who gets the extra dessert at dinner? Who gets to
choose what TV show to watch? In short, the household must allocate its scarce
resources among its various members, taking into account each member’s abili-
ties, efforts, and desires.

Like a household, a society faces many decisions. A society must find some
way to decide what jobs will be done and who will do them. It needs some people
to grow food, other people to make clothing, and still others to design computer
software. Once society has allocated people (as well as land, buildings, and
machines) to various jobs, it must also allocate the output of goods and services

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4 PART I IntroductIon

they produce. It must decide who will eat caviar and who will eat potatoes. It
must decide who will drive a Ferrari and who will take the bus.

The management of society’s resources is important because resources are
scarce. Scarcity means that society has limited resources and therefore cannot
produce all the goods and services people wish to have. Just as each member of
a household cannot get everything he or she wants, each individual in a society
cannot attain the highest standard of living to which he or she might aspire.

Economics is the study of how society manages its scarce resources. In most
societies, resources are allocated not by an all-powerful dictator but through the
combined actions of millions of households and firms. Economists therefore study
how people make decisions: how much they work, what they buy, how much they
save, and how they invest their savings. Economists also study how people inter-
act with one another. For instance, they examine how the multitude of buyers and
sellers of a good together determine the price at which the good is sold and the
quantity that is sold. Finally, economists analyze forces and trends that affect the
economy as a whole, including the growth in average income, the fraction of
the population that cannot find work, and the rate at which prices are rising.

The study of economics has many facets, but it is unified by several central
ideas. In this chapter, we look at Ten Principles of Economics. Don’t worry if you
don’t understand them all at first or if you aren’t completely convinced. We will
explore these ideas more fully in later chapters. The ten principles are introduced
here to give you an overview of what economics is all about. Consider this chapter
a “preview of coming attractions.”

How People Make Decisions
There is no mystery to what an economy is. Whether we are talking about the
economy of Los Angeles, the United States, or the whole world, an economy
is just a group of people dealing with one another as they go about their lives.
Because the behavior of an economy reflects the behavior of the individuals who
make up the economy, we begin our study of economics with four principles of
individual decision making.

Principle 1: People Face Trade-offs
You may have heard the old saying, “There ain’t no such thing as a free lunch.”
Grammar aside, there is much truth to this adage. To get one thing that we like,
we usually have to give up another thing that we like. Making decisions requires
trading off one goal against another.

Consider a student who must decide how to allocate her most valuable
resource—her time. She can spend all her time studying economics, spend all of
it studying psychology, or divide it between the two fields. For every hour she
studies one subject, she gives up an hour she could have used studying the other.
And for every hour she spends studying, she gives up an hour that she could have
spent napping, bike riding, watching TV, or working at her part-time job for some
extra spending money.

Or consider parents deciding how to spend their family income. They can buy
food, clothing, or a family vacation. Or they can save some of the family income
for retirement or the children’s college education. When they choose to spend an
extra dollar on one of these goods, they have one less dollar to spend on some
other good.

scarcity
the limited nature of
society’s resources

economics
the study of how society
manages its scarce
resources

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5CHAPTER 1 ten PrIncIPles of economIcs

When people are grouped into societies, they face different kinds of trade-offs.
One classic trade-off is between “guns and butter.” The more a society spends
on national defense (guns) to protect its shores from foreign aggressors, the less
it can spend on consumer goods (butter) to raise the standard of living at home.
Also important in modern society is the trade-off between a clean environment
and a high level of income. Laws that require firms to reduce pollution raise the
cost of producing goods and services. Because of the higher costs, these firms end
up earning smaller profits, paying lower wages, charging higher prices, or some
combination of these three. Thus, while pollution regulations yield the benefit of
a cleaner environment and the improved health that comes with it, the regulations
come at the cost of reducing the incomes of the regulated firms’ owners, workers,
and customers.

Another trade-off society faces is between efficiency and equality. Efficiency
means that society is getting the maximum benefits from its scarce resources.
Equality means that those benefits are distributed uniformly among society’s
members. In other words, efficiency refers to the size of the economic pie, and
equality refers to how the pie is divided into individual slices.

When government policies are designed, these two goals often conflict. Con-
sider, for instance, policies aimed at equalizing the distribution of economic
well-being. Some of these policies, such as the welfare system or unemployment
insurance, try to help the members of society who are most in need. Others, such
as the individual income tax, ask the financially successful to contribute more than
others to support the government. While achieving greater equality, these policies
reduce efficiency. When the government redistributes income from the rich to the
poor, it reduces the reward for working hard; as a result, people work less and
produce fewer goods and services. In other words, when the government tries to
cut the economic pie into more equal slices, the pie gets smaller.

Recognizing that people face trade-offs does not by itself tell us what decisions
they will or should make. A student should not abandon the study of psychol-
ogy just because doing so would increase the time available for the study of
economics. Society should not stop protecting the environment just because envi-
ronmental regulations reduce our material standard of living. The poor should
not be ignored just because helping them distorts work incentives. Nonetheless,
people are likely to make good decisions only if they understand the options they
have available. Our study of economics, therefore, starts by acknowledging life’s
trade-offs.

Principle 2: The Cost of Something Is
What You Give Up to Get It
Because people face trade-offs, making decisions requires comparing the costs
and benefits of alternative courses of action. In many cases, however, the cost of
an action is not as obvious as it might first appear.

Consider the decision to go to college. The main benefits are intellectual enrich-
ment and a lifetime of better job opportunities. But what are the costs? To answer
this question, you might be tempted to add up the money you spend on tuition,
books, room, and board. Yet this total does not truly represent what you give up
to spend a year in college.

There are two problems with this calculation. First, it includes some things
that are not really costs of going to college. Even if you quit school, you need a
place to sleep and food to eat. Room and board are costs of going to college only
to the extent that they are more expensive at college than elsewhere. Second, this

efficiency
the property of society
getting the most it can
from its scarce resources

equality
the property of distrib­
uting economic prosperity
uniformly among the
members of society

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6 PART I IntroductIon

calculation ignores the largest cost of going to college—your time. When you
spend a year listening to lectures, reading textbooks, and writing papers, you can-
not spend that time working at a job. For most students, the earnings given up to
attend school are the largest single cost of their education.

The opportunity cost of an item is what you give up to get that item. When
making any decision, decision makers should be aware of the opportunity costs
that accompany each possible action. In fact, they usually are. College athletes
who can earn millions if they drop out of school and play professional sports are
well aware that their opportunity cost of college is very high. It is not surprising
that they often decide that the benefit of a college education is not worth the cost.

Principle 3: Rational People Think at the Margin
Economists normally assume that people are rational. Rational people systemati-
cally and purposefully do the best they can to achieve their objectives, given the
available opportunities. As you study economics, you will encounter firms that
decide how many workers to hire and how much of their product to manufacture
and sell to maximize profits. You will also encounter individuals who decide how
much time to spend working and what goods and services to buy with the result-
ing income to achieve the highest possible level of satisfaction.

Rational people know that decisions in life are rarely black and white but usu-
ally involve shades of gray. At dinnertime, the decision you face is not between
fasting or eating like a pig but whether to take that extra spoonful of mashed pota-
toes. When exams roll around, your decision is not between blowing them off or
studying 24 hours a day but whether to spend an extra hour reviewing your notes
instead of watching TV. Economists use the term marginal change to describe
a small incremental adjustment to an existing plan of action. Keep in mind that
margin means “edge,” so marginal changes are adjustments around the edges of
what you are doing. Rational people often make decisions by comparing marginal
benefits and marginal costs.

For example, consider an airline deciding how much to charge passengers who
fly standby. Suppose that flying a 200-seat plane across the United States costs the
airline $100,000. In this case, the average cost of each seat is $100,000/200, which is
$500. One might be tempted to conclude that the airline should never sell a ticket
for less than $500. Actually, a rational airline can often find ways to raise its profits
by thinking at the margin. Imagine that a plane is about to take off with ten empty
seats, and a standby passenger waiting at the gate will pay $300 for a seat. Should
the airline sell the ticket? Of course it should. If the plane has empty seats, the cost
of adding one more passenger is tiny. Although the average cost of flying a pas-
senger is $500, the marginal cost is merely the cost of the bag of peanuts and can
of soda that the extra passenger will consume. As long as the standby passenger
pays more than the marginal cost, selling the ticket is profitable.

Marginal decision making can help explain some otherwise puzzling eco-
nomic phenomena. Here is a classic question: Why is water so cheap, while
diamonds are so expensive? Humans need water to survive, while diamonds
are unnecessary; but for some reason, people are willing to pay much more for
a diamond than for a cup of water. The reason is that a person’s willingness to
pay for a good is based on the marginal benefit that an extra unit of the good
would yield. The marginal benefit, in turn, depends on how many units a person
already has. Water is essential, but the marginal benefit of an extra cup is small
because water is plentiful. By contrast, no one needs diamonds to survive, but
because diamonds are so rare, people consider the marginal benefit of an extra
diamond to be large.

opportunity cost
whatever must be given
up to obtain some item

rational people
people who systematically
and purposefully do the
best they can to achieve
their objectives

marginal change
a small incremental
adjustment to a plan of
action

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7CHAPTER 1 ten PrIncIPles of economIcs

A rational decision maker takes an action if and only if the marginal benefit of the
action exceeds the marginal cost. This principle can explain why airlines are will-
ing to sell a ticket below average cost and why people are willing to pay more for
diamonds than for water. It can take some time to get used to the logic of marginal
thinking, but the study of economics will give you ample opportunity to practice.

Principle 4: People Respond to Incentives
An incentive is something that induces a person to act, such as the prospect of a
punishment or a reward. Because rational people make decisions by comparing
costs and benefits, they respond to incentives. You will see that incentives play
a central role in the study of economics. One economist went so far as to suggest
that the entire field could be summarized simply: “People respond to incentives.
The rest is commentary.”

Incentives are crucial to analyzing how markets work. For example, when the
price of an apple rises, people decide to eat fewer apples. At the same time, apple
orchards decide to hire more workers and harvest more apples. In other words,
a higher price in a market provides an incentive for buyers to consume less and
an incentive for sellers to produce more. As we will see, the influence of prices on
the behavior of consumers and producers is crucial for how a market economy
allocates scarce resources.

Public policymakers should never forget about incentives: Many policies change
the costs or benefits that people face and, therefore, alter their behavior. A tax on
gasoline, for instance, encourages people to drive smaller, more fuel-efficient cars.
That is one reason people drive smaller cars in Europe, where gasoline taxes are
high, than in the United States, where gasoline taxes are low. A gasoline tax also
encourages people to carpool, take public transportation, and live closer to where
they work. If the tax were larger, more people would be driving hybrid cars, and
if it were large enough, they would switch to electric cars.

When policymakers fail to consider how their policies affect incentives, they
often end up with unintended consequences. For example, consider public policy
regarding auto safety. Today, all cars have seat belts, but this was not true 50 years
ago. In the 1960s, Ralph Nader’s book Unsafe at Any Speed generated much public
concern over auto safety. Congress responded with laws requiring seat belts as
standard equipment on new cars.

How does a seat belt law affect auto safety? The direct effect is obvious: When
a person wears a seat belt, the probability of surviving an auto accident rises. But
that’s not the end of the story because the law also affects behavior by altering
incentives. The relevant behavior here is the speed and care with which drivers
operate their cars. Driving slowly and carefully is costly because it uses the
driver’s time and energy. When deciding how safely to drive, rational people com-
pare, perhaps unconsciously, the marginal benefit from safer driving to the mar-
ginal cost. As a result, they drive more slowly and carefully when the benefit of
increased safety is high. For example, when road conditions are icy, people drive
more attentively and at lower speeds than they do when road conditions are clear.

Consider how a seat belt law alters a driver’s cost–benefit calculation. Seat belts
make accidents less costly because they reduce the likelihood of injury or death.
In other words, seat belts reduce the benefits of slow and careful driving. People
respond to seat belts as they would to an improvement in road conditions—by
driving faster and less carefully. The result of a seat belt law, therefore, is a larger
number of accidents. The decline in safe driving has a clear, adverse impact on
pedestrians, who are more likely to find themselves in an accident but (unlike the
drivers) don’t have the benefit of added protection.

incentive
something that induces a
person to act

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8 PART I IntroductIon

At first, this discussion of incentives and seat belts might seem like idle specula-
tion. Yet in a classic 1975 study, economist Sam Peltzman argued that auto- safety
laws have had many of these effects. According to Peltzman’s evidence, these
laws produce both fewer deaths per accident and more accidents. He concluded
that the net result is little change in the number of driver deaths and an increase
in the number of pedestrian deaths.

Peltzman’s analysis of auto safety is an offbeat and controversial example of
the general principle that people respond to incentives. When analyzing any pol-
icy, we must consider not only the direct effects but also the less obvious indirect
effects that work through incentives. If the policy changes incentives, it will cause
people to alter their behavior.

The Incentive Effects of
Gasoline Prices

From 2005 to 2008 the price of oil in world oil markets skyrocketed, the result of
limited supplies together with surging demand from robust world growth, espe-
cially in China. The price of gasoline in the United States rose from about $2 to
about $4 a gallon. At the time, the news was filled with stories about how people
responded to the increased incentive to conserve, sometimes in obvious ways,
sometimes in less obvious ways.
Here is a sampling of various stories:

• “As Gas Prices Soar, Buyers Are Flocking to Small Cars”
• “As Gas Prices Climb, So Do Scooter Sales”
• “Gas Prices Knock Bicycles Sales, Repairs into Higher Gear”
• “Gas Prices Send Surge of Riders to Mass Transit”
• “Camel Demand Up as Oil Price Soars“: Farmers in the Indian state of

Rajasthan are rediscovering the humble camel. As the cost of running gas-
guzzling tractors soars, even-toed ungulates are making a comeback.

• “The Airlines Are Suffering, But the Order Books of Boeing and Airbus
Are Bulging“: Demand for new, more fuel-efficient aircraft has never been
greater. The latest versions of the Airbus A320 and Boeing 737, the single-
aisle workhorses for which demand is strongest, are up to 40% cheaper to
run than the vintage planes some American airlines still use.

• “Home Buying Practices Adjust to High Gas Prices“: In his hunt for a new
home, Demetrius Stroud crunched the numbers to find out that, with gas
prices climbing, moving near an Amtrak station is the best thing for his wallet.

• “Gas Prices Drive Students to Online Courses“: For Christy LaBadie, a sopho-
more at Northampton Community College, the 30-minute drive from her
home to the Bethlehem, Pa., campus has become a financial hardship now
that gasoline prices have soared to more than $4 a gallon. So this semester she
decided to take an online course to save herself the trip —and the money.

• “Diddy Halts Private Jet Flights Over Fuel Prices“: Fuel prices have
grounded an unexpected frequent-flyer: Sean “Diddy” Combs. . . . The
hip-hop mogul said he is now flying on commercial airlines instead of in
private jets, which Combs said had previously cost him $200,000 and up for
a roundtrip between New York and Los Angeles. ”I’m actually flying com-
mercial,“ Diddy said before walking onto an airplane, sitting in a first-class
seat and flashing his boarding pass to the camera. ”That’s how high gas
prices are.”

Hip-hop mogul Sean
“Diddy” Combs responds
to incentives.

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9CHAPTER 1 ten PrIncIPles of economIcs

Many of these developments proved transitory. The economic downturn that
began in 2008 and continued into 2009 reduced the world demand for oil, and the
price of gasoline declined substantially. No word yet on whether Mr. Combs has
returned to his private jet. ■

Quick Quiz Describe an important trade-off you recently faced. • Give an example of
some action that has both a monetary and nonmonetary opportunity cost. • Describe an
incentive your parents offered to you in an effort to influence your behavior.

Incentive Pay
As this article illustrates, how people are paid affects their incentives and
the decisions they make. (The article’s author, by the way, subsequently
became one of the chief economic advisers to President Barack Obama.)

in the news

Where the Buses
run on time
By AustAn GoolsBee

On a summer afternoon, the drive home from the University of Chicago to the
north side of the city must be one of the
most beautiful commutes in the world. On
the left on Lake Shore Drive you pass Grant
Park, some of the world’s first skyscrapers,
and the Sears Tower. On the right is the
intense blue of Lake Michigan. But for all the
beauty, the traffic can be hell. So, if you drive
the route every day, you learn the shortcuts.
You know that if it backs up from the Buck-
ingham Fountain all the way to McCormick
Place, you’re better off taking the surface
streets and getting back onto Lake Shore
Drive a few miles north.
A lot of buses, however, wait in the traf-
fic jams. I have always wondered about that:
Why don’t the bus drivers use the shortcuts?
Surely they know about them—they drive
the same route every day, and they probably
avoid the traffic when they drive their own

cars. Buses don’t stop on Lake Shore Drive,
so they wouldn’t strand anyone by detour-
ing around the congestion. And when buses
get delayed in heavy traffic, it wreaks havoc
on the scheduled service. Instead of arriving
once every 10 minutes, three buses come in
at the same time after half an hour. That sort
of bunching is the least efficient way to run
a public transportation system. So, why not
take the surface streets if that would keep
the schedule properly spaced and on time?
You might think at first that the problem
is that the drivers aren’t paid enough to
strategize. But Chicago bus drivers are the
seventh-highest paid in the nation; full-timers
earned more than $23 an hour, according to
a November 2004 survey. The problem may
have to do not with how much they are paid,
but how they are paid. At least, that’s the
implication of a new study of Chilean bus driv-
ers by Ryan Johnson and David Reiley of the
University of Arizona and Juan Carlos Muñoz
of Pontificia Universidad Católica de Chile.
Companies in Chile pay bus drivers one
of two ways: either by the hour or by the
passenger. Paying by the passenger leads
to significantly shorter delays. Give them

incentives, and drivers start acting like regu-
lar people do. They take shortcuts when the
traffic is bad. They take shorter meal breaks
and bathroom breaks. They want to get on
the road and pick up more passengers as
quickly as they can. In short, their productiv-
ity increases….
Not everything about incentive pay is
perfect, of course. When bus drivers start
moving from place to place more quickly,
they get in more accidents (just like the rest
of us). Some passengers also complain that
the rides make them nauseated because the
drivers stomp on the gas as soon as the last
passenger gets on the bus. Yet when given
the choice, people overwhelmingly choose
the bus companies that get them where
they’re going on time. More than 95 percent
of the routes in Santiago use incentive pay.
Perhaps we should have known that
incentive pay could increase bus driver pro-
ductivity. After all, the taxis in Chicago take
the shortcuts on Lake Shore Drive to avoid
the traffic that buses just sit in. Since taxi
drivers earn money for every trip they make,
they want to get you home as quickly as
possible so they can pick up somebody else.

Source: Slate.com, March 16, 2006.

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10 PART I IntroductIon

How People Interact
The first four principles discussed how individuals make decisions. As we go
about our lives, many of our decisions affect not only ourselves but other people
as well. The next three principles concern how people interact with one another.

Principle 5: Trade Can Make Everyone Better Off
You may have heard on the news that the Japanese are our competitors in the
world economy. In some ways, this is true because American and Japanese firms
produce many of the same goods. Ford and Toyota compete for the same customers
in the market for automobiles. Apple and Sony compete for the same customers in
the market for digital music players.

Yet it is easy to be misled when thinking about competition among countries.
Trade between the United States and Japan is not like a sports contest in which
one side wins and the other side loses. In fact, the opposite is true: Trade between
two countries can make each country better off.

To see why, consider how trade affects your family. When a member of your
family looks for a job, he or she competes against members of other families who
are looking for jobs. Families also compete against one another when they go
shopping because each family wants to buy the best goods at the lowest prices. In
a sense, each family in the economy is competing with all other families.

Despite this competition, your family would not be better off isolating itself
from all other families. If it did, your family would need to grow its own food,
make its own clothes, and build its own home. Clearly, your family gains much
from its ability to trade with others. Trade allows each person to specialize in the
activities he or she does best, whether it is farming, sewing, or home building.
By trading with others, people can buy a greater variety of goods and services at
lower cost.

Countries as well as families benefit from the ability to trade with one another.
Trade allows countries to specialize in what they do best and to enjoy a greater
variety of goods and services. The Japanese, as well as the French and the
Egyptians and the Brazilians, are as much our partners in the world economy as
they are our competitors.

Principle 6: Markets Are Usually a Good Way to
Organize Economic Activity
The collapse of communism in the Soviet Union and Eastern Europe in the 1980s
may be the most important change in the world during the past half century.
Communist countries worked on the premise that government officials were in
the best position to allocate the economy’s scarce resources. These central plan-
ners decided what goods and services were produced, how much was produced,
and who produced and consumed these goods and services. The theory behind
central planning was that only the government could organize economic activity
in a way that promoted economic well-being for the country as a whole.

Most countries that once had centrally planned economies have abandoned
the system and are instead developing market economies. In a market economy,
the decisions of a central planner are replaced by the decisions of millions of
firms and households. Firms decide whom to hire and what to make. Households
decide which firms to work for and what to buy with their incomes. These firms

market economy
an economy that allocates
resources through the
decentralized decisions
of many firms and
households as they
interact in markets for
goods and services

“For $5 a week you can
watch baseball without
being nagged to cut the
grass!”

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Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

11CHAPTER 1 ten PrIncIPles of economIcs

and households interact in the marketplace, where prices and self-interest guide
their decisions.

At first glance, the success of market economies is puzzling. In a market
economy, no one is looking out for the economic well-being of society as a whole.
Free markets contain many buyers and sellers of numerous goods and services,
and all of them are interested primarily in their own well-being. Yet despite
decentralized decision making and self-interested decision makers, market econo-
mies have proven remarkably successful in organizing economic activity to pro-
mote overall economic well-being.

In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations,
economist Adam Smith made the most famous observation in all of econom-
ics: Households and firms interacting in markets act as if they are guided by an
“invisible hand” that leads them to desirable market outcomes. One of our goals
in this book is to understand how this invisible hand works its magic.

As you study economics, you will learn that prices are the instrument with
which the invisible hand directs economic activity. In any market, buyers look at
the price when determining how much to demand, and sellers look at the price
when deciding how much to supply. As a result of the decisions that buyers and
sellers make, market prices reflect both the value of a good to society and the
cost to society of making the good. Smith’s great insight was that prices adjust to
guide these individual buyers and sellers to reach outcomes that, in many cases,
maximize the well-being of society as a whole.

Smith’s insight has an important corollary: When the government prevents
prices from adjusting naturally to supply and demand, it impedes the invisible
hand’s ability to coordinate the decisions of the households and firms that make
up the economy. This corollary explains why taxes adversely affect the alloca-
tion of resources, for they distort prices and thus the decisions of households
and firms. It also explains the great harm caused by policies that directly control
prices, such as rent control. And it explains the failure of communism. In com-
munist countries, prices were not determined in the marketplace but were dic-
tated by central planners. These planners lacked the necessary information about
consumers’ tastes and producers’ costs, which in a market economy is reflected
in prices. Central planners failed because they tried to run the economy with one
hand tied behind their backs—the invisible hand of the marketplace.

Principle 7: Governments Can Sometimes
Improve Market Outcomes
If the invisible hand of the market is so great, why do we need government? One
purpose of studying economics is to refine your view about the proper role and
scope of government policy.

One reason we need government is that the invisible hand can work its magic
only if the government enforces the rules and maintains the institutions that are
key to a market economy. Most important, market economies need institutions
to enforce property rights so individuals can own and control scarce resources.
A farmer won’t grow food if he expects his crop to be stolen; a restaurant won’t
serve meals unless it is assured that customers will pay before they leave; and an
entertainment company won’t produce DVDs if too many potential customers
avoid paying by making illegal copies. We all rely on government-provided
police and courts to enforce our rights over the things we produce—and the invis-
ible hand counts on our ability to enforce our rights.

property rights
the ability of an individual
to own and exercise
control over scarce
resources

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12 PART I IntroductIon

Yet there is another reason we need government: The invisible hand is powerful,
but it is not omnipotent. There are two broad reasons for a government to intervene
in the economy and change the allocation of resources that people would choose
on their own: to promote efficiency or to promote equality. That is, most policies
aim either to enlarge the economic pie or to change how the pie is divided.

Consider first the goal of efficiency. Although the invisible hand usually leads
markets to allocate resources to maximize the size of the economic pie, this is not
always the case. Economists use the term market failure to refer to a situation in
which the market on its own fails to produce an efficient allocation of resources.
As we will see, one possible cause of market failure is an externality, which is
the impact of one person’s actions on the well-being of a bystander. The classic

market failure
a situation in which a
market left on its own
fails to allocate resources
efficiently

externality
the impact of one
person’s actions on the
well­being of a bystander

FYI
Adam Smith and the Invisible Hand

It may be only a coincidence that Adam Smith’s great book The Wealth of Nations was published in 1776, the exact year Ameri-
can revolutionaries signed the Declaration of Independence. But
the two documents share a point of view that was prevalent at the
time: Individuals are usually best left to their own devices, without
the heavy hand of government guiding their actions. This political
philosophy provides the intellectual basis for the market economy
and for free society more generally.
Why do decentralized market economies work so well? Is it
because people can be counted on to treat one another with love
and kindness? Not at all. Here is Adam Smith’s description of how
people interact in a market economy:

Man has almost constant occasion for the
help of his brethren, and it is in vain for him to
expect it from their benevolence only. He will
be more likely to prevail if he can interest their
self-love in his favour, and show them that it
is for their own advantage to do for him what
he requires of them. . . . Give me that which I
want, and you shall have this which you want,
is the meaning of every such offer; and it is in
this manner that we obtain from one another
the far greater part of those good offices
which we stand in need of.

It is not from the benevolence of the butcher, the brewer,
or the baker that we expect our dinner, but from their regard
to their own interest. We address ourselves, not to their
humanity but to their self-love, and never talk to them of
our own necessities but of their advantages. Nobody but a
beggar chooses to depend chiefly upon the benevolence of
his fellow-citizens. . . .

Every individual . . . neither intends to promote the public
interest, nor knows how much he is promoting it. . . . He
intends only his own gain, and he is in this, as in many other
cases, led by an invisible hand to promote an end which was
no part of his intention. Nor is it always the worse for the
society that it was no part of it. By pursuing his own interest he

frequently promotes that of the society more effec-
tually than when he really intends to promote it.

Smith is saying that participants in the economy
are motivated by self-interest and that the “invisible
hand” of the marketplace guides this self-interest
into promoting general economic well-being.
Many of Smith’s insights remain at the center of
modern economics. Our analysis in the coming chap-
ters will allow us to express Smith’s conclusions more
precisely and to analyze more fully the strengths and
weaknesses of the market’s invisible hand.Adam Smith

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13CHAPTER 1 ten PrIncIPles of economIcs

example of an externality is pollution. Another possible cause of market failure
is market power, which refers to the ability of a single person (or small group)
to unduly influence market prices. For example, if everyone in town needs water
but there is only one well, the owner of the well is not subject to the rigorous
competition with which the invisible hand normally keeps self-interest in check.
In the presence of externalities or market power, well-designed public policy can
enhance economic efficiency.

Now consider the goal of equality. Even when the invisible hand is yielding
efficient outcomes, it can nonetheless leave sizable disparities in economic well-
being. A market economy rewards people according to their ability to produce
things that other people are willing to pay for. The world’s best basketball
player earns more than the world’s best chess player simply because people are
willing to pay more to watch basketball than chess. The invisible hand does not
ensure that everyone has sufficient food, decent clothing, and adequate health-
care. This inequality may, depending on one’s political philosophy, call for gov-
ernment intervention. In practice, many public policies, such as the income tax
and the welfare system, aim to achieve a more equal distribution of economic
well-being.

To say that the government can improve on market outcomes at times does
not mean that it always will. Public policy is made not by angels but by a political
process that is far from perfect. Sometimes policies are designed simply to reward
the politically powerful. Sometimes they are made by well-intentioned leaders
who are not fully informed. As you study economics, you will become a better
judge of when a government policy is justifiable because it promotes efficiency or
equality and when it is not.

Quick Quiz Why is a country better off not isolating itself from all other coun-
tries? • Why do we have markets, and, according to economists, what roles should
government play in them?

How the Economy as a Whole Works
We started by discussing how individuals make decisions and then looked at how
people interact with one another. All these decisions and interactions together
make up “the economy.” The last three principles concern the workings of the
economy as a whole.

Principle 8: A Country’s Standard of Living Depends
on Its Ability to Produce Goods and Services
The differences in living standards around the world are staggering. In 2008, the
average American had an income of about $47,000. In the same year, the average
Mexican earned about $10,000, and the average Nigerian earned only $1,400. Not
surprisingly, this large variation in average income is reflected in various mea-
sures of the quality of life. Citizens of high-income countries have more TV sets,
more cars, better nutrition, better healthcare, and a longer life expectancy than
citizens of low-income countries.
Changes in living standards over time are also large. In the United States,
incomes have historically grown about 2 percent per year (after adjusting for

market power
the ability of a single
economic actor (or small
group of actors) to have
a substantial influence on
market prices

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

14 PART I IntroductIon

changes in the cost of living). At this rate, average income doubles every 35 years.
Over the past century, average U.S. income has risen about eightfold.

What explains these large differences in living standards among countries and
over time? The answer is surprisingly simple. Almost all variation in living stan-
dards is attributable to differences in countries’ productivity—that is, the amount
of goods and services produced from each unit of labor input. In nations where
workers can produce a large quantity of goods and services per unit of time, most
people enjoy a high standard of living; in nations where workers are less produc-
tive, most people endure a more meager existence. Similarly, the growth rate of a
nation’s productivity determines the growth rate of its average income.

The fundamental relationship between productivity and living standards is
simple, but its implications are far-reaching. If productivity is the primary deter-
minant of living standards, other explanations must be of secondary importance.
For example, it might be tempting to credit labor unions or minimum-wage laws
for the rise in living standards of American workers over the past century. Yet the
real hero of American workers is their rising productivity. As another example,
some commentators have claimed that increased competition from Japan and
other countries explained the slow growth in U.S. incomes during the 1970s and
1980s. Yet the real villain was not competition from abroad but flagging produc-
tivity growth in the United States.

The relationship between productivity and living standards also has profound
implications for public policy. When thinking about how any policy will affect liv-
ing standards, the key question is how it will affect our ability to produce goods
and services. To boost living standards, policymakers need to raise productivity
by ensuring that workers are well educated, have the tools needed to produce
goods and services, and have access to the best available technology.

productivity
the quantity of goods and
services produced from
each unit of labor input

the Dismal Science?
Hardly!
By RoBeRt D. McteeR, JR.

My take on training in economics is that it becomes increasingly valuable as
you move up the career ladder. I can’t imag-
ine a better major for corporate CEOs, con-
gressmen, or American presidents. You’ve

learned a systematic, disciplined way of
thinking that will serve you well. By contrast,
the economically challenged must be per-
plexed about how it is that economies work
better the fewer people they have in charge.
Who does the planning? Who makes deci-
sions? Who decides what to produce?
For my money, Adam Smith’s invisible
hand is the most important thing you’ve
learned by studying economics. You under-
stand how we can each work for our own

self-interest and still produce a desirable
social outcome. You know how uncoordi-
nated activity gets coordinated by the market
to enhance the wealth of nations. You under-
stand the magic of markets and the dangers
of tampering with them too much. You know
better what you first learned in kindergarten:
that you shouldn’t kill or cripple the goose
that lays the golden eggs. . . .
Economics training will help you under-
stand fallacies and unintended consequences.

Why You Should Study Economics
In this excerpt from a commencement address, the former president
of the Federal Reserve Bank of Dallas makes the case for studying
economics

in the news

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15CHAPTER 1 ten PrIncIPles of economIcs

“Well it may have
been 68 cents when
you got in line, but
it’s 74 cents now!”

Source: The Wall Street Journal, June 4, 2003.

In fact, I am inclined to define economics as
the study of how to anticipate unintended
consequences. . . .
Little in the literature seems more rele-
vant to contemporary economic debates
than what usually is called the broken
window fallacy. Whenever a government
program is justified not on its merits but by
the jobs it will create, remember the broken
window: Some teenagers, being the little
beasts that they are, toss a brick through
a bakery window. A crowd gathers and
laments, “What a shame.” But before you
know it, someone suggests a silver lining to
the situation: Now the baker will have to
spend money to have the window repaired.
This will add to the income of the repair-
man, who will spend his additional income,
which will add to another seller’s income,
and so on. You know the drill. The chain of

spending will multiply and generate higher
income and employment. If the broken
window is large enough, it might produce
an economic boom! . . .
Most voters fall for the broken window
fallacy, but not economics majors. They will
say, “Hey, wait a minute!” If the baker
hadn’t spent his money on window repair,
he would have spent it on the new suit he
was saving to buy. Then the tailor would
have the new income to spend, and so on.
The broken window didn’t create net new
spending; it just diverted spending from
somewhere else. The broken window does
not create new activity, just different activ-
ity. People see the activity that takes place.
They don’t see the activity that would have
taken place.
The broken window fallacy is perpetu-
ated in many forms. Whenever job creation

or retention is the primary objective I call
it the job-counting fallacy. Economics
majors understand the non-intuitive real-
ity that real progress comes from job
destruction. It once took 90 percent of
our population to grow our food. Now it
takes 3 percent. Pardon me, Willie, but are
we worse off because of the job losses in
agriculture? The would-have-been farmers
are now college professors and computer
gurus. . . .
So instead of counting jobs, we
should make every job count. We will
occasionally hit a soft spot when we
have a mismatch of supply and demand
in the labor market. But that is tempo-
rary. Don’t become a Luddite and destroy
the machinery, or become a protectionist
and try to grow bananas in New York
City.

Principle 9: Prices Rise When the Government
Prints Too Much Money
In January 1921, a daily newspaper in Germany cost 0.30 marks. Less than two
years later, in November 1922, the same newspaper cost 70,000,000 marks. All
other prices in the economy rose by similar amounts. This episode is one of his-
tory’s most spectacular examples of inflation, an increase in the overall level of
prices in the economy.

Although the United States has never experienced inflation even close to
that of Germany in the 1920s, inflation has at times been an economic prob-
lem. During the 1970s, for instance, when the overall level of prices more
than doubled, President Gerald Ford called inflation “public enemy number
one.” By contrast, inflation in the first decade of the 21st century has run
about 2½ percent per year; at this rate, it would take almost 30 years for
prices to double. Because high inflation imposes various costs on society,
keeping inflation at a low level is a goal of economic policymakers around
the world.

What causes inflation? In almost all cases of large or persistent inflation, the
culprit is growth in the quantity of money. When a government creates large
quantities of the nation’s money, the value of the money falls. In Germany in
the early 1920s, when prices were on average tripling every month, the quantity
of money was also tripling every month. Although less dramatic, the economic
history of the United States points to a similar conclusion: The high inflation of
the 1970s was associated with rapid growth in the quantity of money, and the
low inflation of more recent experience was associated with slow growth in the
quantity of money.

inflation
an increase in the overall
level of prices in the
economy

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Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

16 PART I IntroductIon

Principle 10: Society Faces a Short-Run Trade-off
between Inflation and Unemployment
Although a higher level of prices is, in the long run, the primary effect of
increasing the quantity of money, the short-run story is more complex and con-
troversial. Most economists describe the short-run effects of monetary injections
as follows:

• Increasing the amount of money in the economy stimulates the overall level
of spending and thus the demand for goods and services.

• Higher demand may over time cause firms to raise their prices, but in the
meantime, it also encourages them to hire more workers and produce a
larger quantity of goods and services.

• More hiring means lower unemployment.

This line of reasoning leads to one final economy-wide trade-off: a short-run
trade-off between inflation and unemployment.

Although some economists still question these ideas, most accept that society
faces a short-run trade-off between inflation and unemployment. This simply
means that, over a period of a year or two, many economic policies push infla-
tion and unemployment in opposite directions. Policymakers face this trade-off
regardless of whether inflation and unemployment both start out at high levels (as
they did in the early 1980s), at low levels (as they did in the late 1990s), or some-
place in between. This short-run trade-off plays a key role in the analysis of the
business cycle—the irregular and largely unpredictable fluctuations in economic
activity, as measured by the production of goods and services or the number of
people employed.

Policymakers can exploit the short-run trade-off between inflation and
unemployment using various policy instruments. By changing the amount
that the government spends, the amount it taxes, and the amount of money
it prints, policymakers can influence the overall demand for goods and ser-
vices. Changes in demand in turn influence the combination of inflation and
unemployment that the economy experiences in the short run. Because these
instruments of economic policy are potentially so powerful, how policymakers
should use these instruments to control the economy, if at all, is a subject of
continuing debate.

This debate heated up in the early years of Barack Obama’s presidency. In 2008
and 2009, the U.S. economy, as well as many other economies around the world,
experienced a deep economic downturn. Problems in the financial system, caused
by bad bets on the housing market, spilled over into the rest of the economy,
causing incomes to fall and unemployment to soar. Policymakers responded in
various ways to increase the overall demand for goods and services. President
Obama’s first major initiative was a stimulus package of reduced taxes and
increased government spending. At the same time, the nation’s central bank, the
Federal Reserve, increased the supply of money. The goal of these policies was to
reduce unemployment. Some feared, however, that these policies might over time
lead to an excessive level of inflation.

Quick Quiz List and briefly explain the three principles that describe how the
economy as a whole works.

business cycle
fluctuations in
economic activity, such
as employment and
production

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

17CHAPTER 1 ten PrIncIPles of economIcs

Conclusion
You now have a taste of what economics is all about. In the coming chapters, we
develop many specific insights about people, markets, and economies. Mastering
these insights will take some effort, but it is not an overwhelming task. The field of
economics is based on a few big ideas that can be applied in many different situations.

Throughout this book, we will refer back to the Ten Principles of Economics high-
lighted in this chapter and summarized in Table 1. Keep these building blocks
in mind: Even the most sophisticated economic analysis is founded on the ten
principles introduced here.

FYI
How to Read This Book

Economics is fun, but it can also be hard to learn. My aim in writ-ing this text is to make it as enjoyable and easy as possible. But
you, the student, also have a role to play. Experience shows that if
you are actively involved as you study this book, you will enjoy a
better outcome both on your exams and in the years that follow.
Here are a few tips about how best to read this book.
1. Read before class. Students do better when they read the

relevant textbook chapter before attending a lecture. You will
understand the lecture better, and your questions will be better
focused on where you need extra help.

2. Summarize, don’t highlight. Running a yellow marker over
the text is too passive an activity to keep your mind engaged.
Instead, when you come to the end of a section, take a minute
and summarize what you just learned in your own words, writing
your summary in the wide margins we’ve provided. When you’ve
finished the chapter, compare your summaries with the one at
the end of the chapter. Did you pick up the main points?

3. Test yourself. Throughout the book, Quick Quizzes offer instant
feedback to find out if you’ve learned what you are supposed to.
Take the opportunity to write down your answer, and then check
it against the answers provided at this book’s website. The quiz-
zes are meant to test your basic comprehension. If your answer
is incorrect, you probably need to review the section.

4. Practice, practice, practice. At the end of each chapter, Ques-
tions for Review test your understanding, and Problems and
Applications ask you to apply and extend the material. Perhaps
your instructor will assign some of these exercises as homework.

If so, do them. If not, do them anyway. The more you use your
new knowledge, the more solid it becomes.

5. Go online. The publisher of this book maintains an extensive
website to help you in your study of economics. It includes
additional examples, applications, and problems, as well as quiz-
zes so you can test yourself. Check it out. The website is www
.cengage.com/economics/mankiw.

6. Study in groups. After you’ve read the book and worked prob-
lems on your own, get together with classmates to discuss the
material. You will learn from each other—an example of the
gains from trade.

7. Teach someone. As all teachers know, there is no better way
to learn something than to teach it to someone else. Take the
opportunity to teach new economic concepts to a study partner,
a friend, a parent, or even a pet.

8. Don’t skip the real-world examples. In the midst of all the num-
bers, graphs, and strange new words, it is easy to lose sight of
what economics is all about. The Case Studies and In the News
boxes sprinkled throughout this book should help remind you.
They show how the theory is tied to events happening in all our
lives.

9. Apply economic thinking to your daily life. Once you’ve read
about how others apply economics to the real world, try it
yourself! You can use economic analysis to better understand
your own decisions, the economy around you, and the events
you read about in the newspaper. The world may never look the
same again.

Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

18 PART I IntroductIon

S u m m a r y

scarcity, p. 4
economics, p. 4
efficiency, p. 5
equality, p. 5
opportunity cost, p. 6
rational people, p. 6

marginal change, p. 6
incentive, p. 7
market economy, p. 10
property rights, p. 11
market failure, p. 12
externality, p. 12

market power, p. 13
productivity, p. 14
inflation, p. 15
business cycle, p. 16

• The fundamental lessons about individual deci-
sion making are that people face trade-offs
among alternative goals, that the cost of any
action is measured in terms of forgone oppor-
tunities, that rational people make decisions by
comparing marginal costs and marginal bene-
fits, and that people change their behavior in
response to the incentives they face.

• The fundamental lessons about interactions
among people are that trade and interdepen-
dence can be mutually beneficial, that markets

are usually a good way of coordinating economic
activity among people, and that the government
can potentially improve market outcomes by
remedying a market failure or by promoting
greater economic equality.

• The fundamental lessons about the economy
as a whole are that productivity is the ultimate
source of living standards, that growth in the
quantity of money is the ultimate source of infla-
tion, and that society faces a short-run trade-off
between inflation and unemployment.

K e y C o n C e p t s

Q u e s t i o n s f o r r e v i e w
1. Give three examples of important trade-offs that

you face in your life.
2. What is the opportunity cost of seeing a movie?

3. Water is necessary for life. Is the marginal bene-
fit of a glass of water large or small?

4. Why should policymakers think about incentives?

Ten Principles of Economics

Table 1
How People Make Decisions
1: People Face Trade-offs
2: The Cost of Something Is What You Give Up to Get It
3: Rational People Think at the Margin
4: People Respond to Incentives

How People Interact
5: Trade Can Make Everyone Better Off
6: Markets Are Usually a Good Way to Organize Economic Activity
7: Governments Can Sometimes Improve Market Outcomes

How the Economy as a Whole Works
8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and

Services
9: Prices Rise When the Government Prints Too Much Money
10: Society Faces a Short-Run Trade-off between Inflation and Unemployment

Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

19CHAPTER 1 ten PrIncIPles of economIcs

5. Why isn’t trade among countries like a game
with some winners and some losers?

6. What does the “invisible hand” of the market-
place do?

7. Explain the two main causes of market failure
and give an example of each.

8. Why is productivity important?
9. What is inflation and what causes it?
10. How are inflation and unemployment related in

the short run?

P r o b l e m s a n d a P P l i c a t i o n s

1. Describe some of the trade-offs faced by each of
the following:
a. a family deciding whether to buy a new car
b. a member of Congress deciding how much

to spend on national parks
c. a company president deciding whether to

open a new factory
d. a professor deciding how much to prepare

for class
e. a recent college graduate deciding whether

to go to graduate school
2. You are trying to decide whether to take a

vacation. Most of the costs of the vacation (air-
fare, hotel, and forgone wages) are measured in
dollars, but the benefits of the vacation are psy-
chological. How can you compare the benefits
to the costs?

3. You were planning to spend Saturday working
at your part-time job, but a friend asks you to
go skiing. What is the true cost of going skiing?
Now suppose you had been planning to spend
the day studying at the library. What is the cost
of going skiing in this case? Explain.

4. You win $100 in a basketball pool. You have
a choice between spending the money now or
putting it away for a year in a bank account
that pays 5 percent interest. What is the oppor-
tunity cost of spending the $100 now?

5. The company that you manage has invested
$5 million in developing a new product, but the
development is not quite finished. At a recent
meeting, your salespeople report that the intro-
duction of competing products has reduced
the expected sales of your new product to
$3 million. If it would cost $1 million to finish
development and make the product, should
you go ahead and do so? What is the most that
you should pay to complete development?

6. The Social Security system provides income for
people over age 65. If a recipient of Social

Security decides to work and earn some
income, the amount he or she receives in Social
Security benefits is typically reduced.
a. How does the provision of Social Security

affect people’s incentive to save while
working?

b. How does the reduction in benefits associ-
ated with higher earnings affect people’s
incentive to work past age 65?

7. A 1996 bill reforming the federal government’s
antipoverty programs limited many welfare
recipients to only two years of benefits.
a. How does this change affect the incentives

for working?
b. How might this change represent a trade-off

between equality and efficiency?
8. Your roommate is a better cook than you are,

but you can clean more quickly than your
roommate can. If your roommate did all the
cooking and you did all the cleaning, would
your chores take you more or less time than if
you divided each task evenly? Give a similar
example of how specialization and trade can
make two countries both better off.

9. Explain whether each of the following govern-
ment activities is motivated by a concern about
equality or a concern about efficiency. In the
case of efficiency, discuss the type of market
failure involved.
a. regulating cable TV prices
b. providing some poor people with vouchers

that can be used to buy food
c. prohibiting smoking in public places
d. breaking up Standard Oil (which once

owned 90 percent of all oil refineries) into
several smaller companies

e. imposing higher personal income tax rates
on people with higher incomes

f. instituting laws against driving while
intoxicated

Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

20 PART I IntroductIon

10. Discuss each of the following statements from
the standpoints of equality and efficiency.
a. “Everyone in society should be guaranteed

the best healthcare possible.”
b. “When workers are laid off, they should be

able to collect unemployment benefits until
they find a new job.”

11. In what ways is your standard of living differ-
ent from that of your parents or grandparents
when they were your age? Why have these
changes occurred?

12. Suppose Americans decide to save more of
their incomes. If banks lend this extra saving to
businesses, which use the funds to build new
factories, how might this lead to faster growth
in productivity? Who do you suppose benefits
from the higher productivity? Is society getting
a free lunch?

13. In 2010, President Barack Obama and Congress
enacted a healthcare reform bill in the United
States. Two goals of the bill were to provide
more Americans with health insurance (via sub-
sidies for lower-income households financed
by taxes on higher-income households) and
to reduce the cost of healthcare (via various
reforms in how healthcare is provided).
a. How do these goals relate to equality and

efficiency?

b. How might healthcare reform increase pro-
ductivity in the United States?

c. How might healthcare reform decrease pro-
ductivity in the United States?

14. During the Revolutionary War, the American
colonies could not raise enough tax revenue
to fully fund the war effort; to make up this
difference, the colonies decided to print more
money. Printing money to cover expenditures
is sometimes referred to as an “inflation tax.”
Who do you think is being “taxed” when more
money is printed? Why?

15. Imagine that you are a policymaker trying to
decide whether to reduce the rate of inflation.
To make an intelligent decision, what would
you need to know about inflation, unemploy-
ment, and the trade-off between them?

16. A policymaker is deciding how to finance the
construction of a new airport. He can either
pay for it by increasing citizens’ taxes or by
printing more money. What are some of the
short-run and long-run consequences of each
option?

For further information on topics in this chapter,
additional problems, applications, examples, online
quizzes, and more, please visit our website at
www.cengage.com/economics/mankiw.

Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

http://www.cengage.com/economics/mankiw

21

2Thinking Like an Economist
Every field of study has its own language and its own way of thinking. Mathematicians talk about axioms, integrals, and vector spaces. Psycholo-gists talk about ego, id, and cognitive dissonance. Lawyers talk about venue, torts, and promissory estoppel.

Economics is no different. Supply, demand, elasticity, comparative advantage,
consumer surplus, deadweight loss—these terms are part of the economist’s lan-
guage. In the coming chapters, you will encounter many new terms and some
familiar words that economists use in specialized ways. At first, this new lan-
guage may seem needlessly arcane. But as you will see, its value lies in its ability
to provide you with a new and useful way of thinking about the world in which
you live.

The purpose of this book is to help you learn the economist’s way of thinking.
Just as you cannot become a mathematician, psychologist, or lawyer overnight,
learning to think like an economist will take some time. Yet with a combination of

Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

22 PART I IntroductIon

theory, case studies, and examples of economics in the news, this book will give
you ample opportunity to develop and practice this skill.

Before delving into the substance and details of economics, it is helpful to have
an overview of how economists approach the world. This chapter discusses the
field’s methodology. What is distinctive about how economists confront a ques-
tion? What does it mean to think like an economist?

The Economist as Scientist
Economists try to address their subject with a scientist’s objectivity. They
approach the study of the economy in much the same way a physicist
approaches the study of matter and a biologist approaches the study of life:
They devise theories, collect data, and then analyze these data in an attempt to
verify or refute their theories.

To beginners, it can seem odd to claim that economics is a science. After all,
economists do not work with test tubes or telescopes. The essence of science,
however, is the scientific method—the dispassionate development and testing of
theories about how the world works. This method of inquiry is as applicable to
studying a nation’s economy as it is to studying the earth’s gravity or a species’
evolution. As Albert Einstein once put it, “The whole of science is nothing more
than the refinement of everyday thinking.”

Although Einstein’s comment is as true for social sciences such as economics
as it is for natural sciences such as physics, most people are not accustomed to
looking at society through the eyes of a scientist. Let’s discuss some of the ways in
which economists apply the logic of science to examine how an economy works.

The Scientific Method: Observation,
Theory, and More Observation
Isaac Newton, the famous 17th-century scientist and mathematician, allegedly
became intrigued one day when he saw an apple fall from a tree. This observation
motivated Newton to develop a theory of gravity that applies not only to an apple
falling to the earth but to any two objects in the universe. Subsequent testing of
Newton’s theory has shown that it works well in many circumstances (although,
as Einstein would later emphasize, not in all circumstances). Because Newton’s
theory has been so successful at explaining observation, it is still taught in under-
graduate physics courses around the world.

This interplay between theory and observation also occurs in the field
of economics. An economist might live in a country experiencing rapidly
increasing prices and be moved by this observation to develop a theory of
inflation. The theory might assert that high inflation arises when the govern-
ment prints too much money. To test this theory, the economist could collect
and analyze data on prices and money from many different countries. If
growth in the quantity of money were not at all related to the rate at which
prices are rising, the economist would start to doubt the validity of this
theory of inflation. If money growth and inflation were strongly correlated
in international data, as in fact they are, the economist would become more
confident in the theory.

Although economists use theory and observation like other scientists, they face
an obstacle that makes their task especially challenging: In economics, conducting

“I’m a social scientist,
Michael. That means I
can’t explain electricity
or anything like that,
but if you ever want to
know about people, I’m
your man.”

©
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Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

http://www.cartoonbank.com

http://www.cartoonbank.com

http://www.cartoonbank.com

23CHAPTER 2 tHInkIng lIke an economIst

experiments is often difficult and sometimes impossible. Physicists studying
gravity can drop many objects in their laboratories to generate data to test their
theories. By contrast, economists studying inflation are not allowed to manipu-
late a nation’s monetary policy simply to generate useful data. Economists, like
astronomers and evolutionary biologists, usually have to make do with whatever
data the world happens to give them.

To find a substitute for laboratory experiments, economists pay close atten-
tion to the natural experiments offered by history. When a war in the Middle
East interrupts the flow of crude oil, for instance, oil prices skyrocket around the
world. For consumers of oil and oil products, such an event depresses living stan-
dards. For economic policymakers, it poses a difficult choice about how best to
respond. But for economic scientists, the event provides an opportunity to study
the effects of a key natural resource on the world’s economies. Throughout this
book, therefore, we consider many historical episodes. These episodes are valu-
able to study because they give us insight into the economy of the past and, more
important, because they allow us to illustrate and evaluate economic theories of
the present.

The Role of Assumptions
If you ask a physicist how long it would take a marble to fall from the top of a ten-
story building, she will likely answer the question by assuming that the marble
falls in a vacuum. Of course, this assumption is false. In fact, the building is sur-
rounded by air, which exerts friction on the falling marble and slows it down.
Yet the physicist will point out that the friction on the marble is so small that its
effect is negligible. Assuming the marble falls in a vacuum simplifies the problem
without substantially affecting the answer.

Economists make assumptions for the same reason: Assumptions can simplify
the complex world and make it easier to understand. To study the effects of
international trade, for example, we might assume that the world consists of only
two countries and that each country produces only two goods. In reality, there
are numerous countries, each of which produces thousands of different types of
goods. But by assuming two countries and two goods, we can focus our thinking
on the essence of the problem. Once we understand international trade in this sim-
plified imaginary world, we are in a better position to understand international
trade in the more complex world in which we live.

The art in scientific thinking—whether in physics, biology, or economics—is
deciding which assumptions to make. Suppose, for instance, that instead of drop-
ping a marble from the top of the building, we were dropping a beachball of the
same weight. Our physicist would realize that the assumption of no friction is
less accurate in this case: Friction exerts a greater force on a beachball than on a
marble because a beachball is much larger. The assumption that gravity works
in a vacuum is reasonable for studying a falling marble but not for studying a
falling beachball.

Similarly, economists use different assumptions to answer different ques-
tions. Suppose that we want to study what happens to the economy when the
government changes the number of dollars in circulation. An important piece
of this analysis, it turns out, is how prices respond. Many prices in the economy
change infrequently; the newsstand prices of magazines, for instance, change only
every few years. Knowing this fact may lead us to make different assumptions
when studying the effects of the policy change over different time horizons. For

Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

24 PART I IntroductIon

studying the short-run effects of the policy, we may assume that prices do not
change much. We may even make the extreme and artificial assumption that all
prices are completely fixed. For studying the long-run effects of the policy, how-
ever, we may assume that all prices are completely flexible. Just as a physicist
uses different assumptions when studying falling marbles and falling beachballs,
economists use different assumptions when studying the short-run and long-run
effects of a change in the quantity of money.

Economic Models
High school biology teachers teach basic anatomy with plastic replicas of the
human body. These models have all the major organs: the heart, the liver, the
kidneys, and so on. The models allow teachers to show their students very
simply how the important parts of the body fit together. Because these plas-
tic models are stylized and omit many details, no one would mistake one of
them for a real person. Despite this lack of realism—indeed, because of this
lack of realism—studying these models is useful for learning how the human
body works.

Economists also use models to learn about the world, but instead of being
made of plastic, they are most often composed of diagrams and equations. Like a
biology teacher’s plastic model, economic models omit many details to allow us to
see what is truly important. Just as the biology teacher’s model does not include
all the body’s muscles and capillaries, an economist’s model does not include
every feature of the economy.

As we use models to examine various economic issues throughout this book,
you will see that all the models are built with assumptions. Just as a physicist
begins the analysis of a falling marble by assuming away the existence of friction,
economists assume away many of the details of the economy that are irre le vant for
studying the question at hand. All models—in physics, biology, and economics—
simplify reality to improve our understanding of it.

Our First Model: The Circular-Flow Diagram
The economy consists of millions of people engaged in many activities—buying,
selling, working, hiring, manufacturing, and so on. To understand how the economy
works, we must find some way to simplify our thinking about all these activities. In
other words, we need a model that explains, in general terms, how the economy is
organized and how participants in the economy interact with one another.

Figure 1 presents a visual model of the economy called a circular-flow diagram.
In this model, the economy is simplified to include only two types of decision
makers—firms and households. Firms produce goods and services using inputs,
such as labor, land, and capital (buildings and machines). These inputs are called
the factors of production. Households own the factors of production and consume
all the goods and services that the firms produce.

Households and firms interact in two types of markets. In the markets for goods
and services, households are buyers, and firms are sellers. In particular, households
buy the output of goods and services that firms produce. In the markets for the fac-
tors of production, households are sellers, and firms are buyers. In these markets,
households provide the inputs that firms use to produce goods and services. The
circular-flow diagram offers a simple way of organizing the economic transac-
tions that occur between households and firms in the economy.

The two loops of the circular-flow diagram are distinct but related. The inner
loop represents the flows of inputs and outputs. The households sell the use of

circular-flow
diagram
a visual model of the
economy that shows
how dollars flow
through markets among
households and firms

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25CHAPTER 2 tHInkIng lIke an economIst

their labor, land, and capital to the firms in the markets for the factors of pro-
duction. The firms then use these factors to produce goods and services, which
in turn are sold to households in the markets for goods and services. The outer
loop of the diagram represents the corresponding flow of dollars. The households
spend money to buy goods and services from the firms. The firms use some of the
revenue from these sales to pay for the factors of production, such as the wages
of their workers. What’s left is the profit of the firm owners, who themselves are
members of households.

Let’s take a tour of the circular flow by following a dollar bill as it makes its
way from person to person through the economy. Imagine that the dollar begins
at a household, say, in your wallet. If you want to buy a cup of coffee, you take
the dollar to one of the economy’s markets for goods and services, such as your
local Starbucks coffee shop. There, you spend it on your favorite drink. When the
dollar moves into the Starbucks cash register, it becomes revenue for the firm.
The dollar doesn’t stay at Starbucks for long, however, because the firm uses it to
buy inputs in the markets for the factors of production. Starbucks might use the
dollar to pay rent to its landlord for the space it occupies or to pay the wages of
its workers. In either case, the dollar enters the income of some household and,
once again, is back in someone’s wallet. At that point, the story of the economy’s
circular flow starts once again.

The circular-flow diagram in Figure 1 is a very simple model of the econ-
omy. It dispenses with details that, for some purposes, are significant. A more

The Circular Flow
This diagram is a schematic
representation of the organization
of the economy. Decisions are
made by households and firms.
Households and firms interact in
the markets for goods and services
(where households are buyers and
firms are sellers) and in the markets
for the factors of production (where
firms are buyers and households
are sellers). The outer set of arrows
shows the flow of dollars, and
the inner set of arrows shows the
corresponding flow of inputs and
outputs.

Figure 1
Spending

Goods and
services
bought

Revenue

Goods
and services
sold

Labor, land,
and capital

Income

� Flow of inputs
and outputs

� Flow of dollars

Factors of
production

Wages, rent,
and profit

FIRMS
• Produce and sell
goods and services
• Hire and use factors
of production

• Buy and consume
goods and services
• Own and sell factors
of production

HOUSEHOLDS

• Households sell
• Firms buy

MARKETS
FOR

FACTORS OF PRODUCTION

• Firms sell
• Households buy

MARKETS
FOR

GOODS AND SERVICES

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26 PART I IntroductIon

complex and realistic circular-flow model would include, for instance, the roles
of government and international trade. (A portion of that dollar you gave to
Starbucks might be used to pay taxes or to buy coffee beans from a farmer in
Brazil.) Yet these details are not crucial for a basic understanding of how the
economy is organized. Because of its simplicity, this circular-flow diagram is
useful to keep in mind when thinking about how the pieces of the economy fit
together.

Our Second Model: The Production
Possibilities Frontier
Most economic models, unlike the circular-flow diagram, are built using the tools
of mathematics. Here we use one of the simplest such models, called the produc-
tion possibilities frontier, to illustrate some basic economic ideas.

Although real economies produce thousands of goods and services, let’s
assume an economy that produces only two goods—cars and computers.
Together, the car industry and the computer industry use all of the economy’s
factors of production. The production possibilities frontier is a graph that shows
the various combinations of output—in this case, cars and computers—that the
economy can possibly produce given the available factors of production and the
available production technology that firms use to turn these factors into output.

Figure 2 shows this economy’s production possibilities frontier. If the economy
uses all its resources in the car industry, it produces 1,000 cars and no computers.
If it uses all its resources in the computer industry, it produces 3,000 computers
and no cars. The two endpoints of the production possibilities frontier represent
these extreme possibilities.

More likely, the economy divides its resources between the two industries,
producing some cars and some computers. For example, it can produce 600 cars

production
possibilities frontier
a graph that shows the
combinations of output
that the economy can
possibly produce given
the available factors
of production and the
available production
technology

Figure 2

1,000

2,200

Production
possibilities
frontier

B

D

A

Quantity of
Cars Produced

7006003000

2,000

3,000

1,000

Quantity of
Computers

Produced

CF

E

The Production Possibilities Frontier
The production possibilities frontier
shows the combinations of output—in
this case, cars and computers—that the
economy can possibly produce. The
economy can produce any combination
on or inside the frontier. Points outside
the frontier are not feasible given the
economy’s resources.

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27CHAPTER 2 tHInkIng lIke an economIst

and 2,200 computers, shown in the figure by point A. Or, by moving some of the
factors of production to the car industry from the computer industry, the economy
can produce 700 cars and 2,000 computers, represented by point B.

Because resources are scarce, not every conceivable outcome is feasible. For
example, no matter how resources are allocated between the two industries,
the economy cannot produce the amount of cars and computers represented by
point C. Given the technology available for manufacturing cars and computers,
the economy does not have enough of the factors of production to support that
level of output. With the resources it has, the economy can produce at any point
on or inside the production possibilities frontier, but it cannot produce at points
outside the frontier.

An outcome is said to be efficient if the economy is getting all it can from
the scarce resources it has available. Points on (rather than inside) the produc-
tion possibilities frontier represent efficient levels of production. When the
economy is producing at such a point, say point A, there is no way to produce
more of one good without producing less of the other. Point D represents an
inefficient outcome. For some reason, perhaps widespread unemployment, the
economy is producing less than it could from the resources it has available:
It is producing only 300 cars and 1,000 computers. If the source of the inef-
ficiency is eliminated, the economy can increase its production of both goods.
For example, if the economy moves from point D to point A, its production of
cars increases from 300 to 600, and its production of computers increases from
1,000 to 2,200.

One of the Ten Principles of Economics discussed in Chapter 1 is that people face
trade-offs. The production possibilities frontier shows one trade-off that society
faces. Once we have reached the efficient points on the frontier, the only way of
producing more of one good is to produce less of the other. When the economy
moves from point A to point B, for instance, society produces 100 more cars but
at the expense of producing 200 fewer computers.

This trade-off helps us understand another of the Ten Principles of Economics:
The cost of something is what you give up to get it. This is called the opportunity
cost. The production possibilities frontier shows the opportunity cost of one
good as measured in terms of the other good. When society moves from point
A to point B, it gives up 200 computers to get 100 additional cars. That is, at
point A, the opportunity cost of 100 cars is 200 computers. Put another way, the
opportunity cost of each car is two computers. Notice that the opportunity cost
of a car equals the slope of the production possibilities frontier. (If you don’t
recall what slope is, you can refresh your memory with the graphing appendix
to this chapter.)

The opportunity cost of a car in terms of the number of computers is not con-
stant in this economy but depends on how many cars and computers the economy
is producing. This is reflected in the shape of the production possibilities frontier.
Because the production possibilities frontier in Figure 2 is bowed outward, the
opportunity cost of a car is highest when the economy is producing many cars and
few computers, such as at point E, where the frontier is steep. When the economy
is producing few cars and many computers, such as at point F, the frontier is
flatter, and the opportunity cost of a car is lower.

Economists believe that production possibilities frontiers often have this
bowed shape. When the economy is using most of its resources to make comput-
ers, such as at point F, the resources best suited to car production, such as skilled

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28 PART I IntroductIon

autoworkers, are being used in the computer industry. Because these workers
probably aren’t very good at making computers, the economy won’t have to lose
much computer production to increase car production by one unit. The opportu-
nity cost of a car in terms of computers is small, and the frontier is relatively flat.
By contrast, when the economy is using most of its resources to make cars, such as
at point E, the resources best suited to making cars are already in the car industry.
Producing an additional car means moving some of the best computer techni-
cians out of the computer industry and making them autoworkers. As a result,
producing an additional car will mean a substantial loss of computer output. The
opportunity cost of a car is high, and the frontier is steep.

The production possibilities frontier shows the trade-off between the out-
puts of different goods at a given time, but the trade-off can change over time.
For example, suppose a technological advance in the computer industry raises
the number of computers that a worker can produce per week. This advance
expands society’s set of opportunities. For any given number of cars, the
economy can make more computers. If the economy does not produce any
computers, it can still produce 1,000 cars, so one endpoint of the frontier stays
the same. But the rest of the production possibilities frontier shifts outward,
as in Figure 3.

This figure illustrates economic growth. Society can move production from a
point on the old frontier to a point on the new frontier. Which point it chooses
depends on its preferences for the two goods. In this example, society moves from
point A to point G, enjoying more computers (2,300 instead of 2,200) and more
cars (650 instead of 600).

The production possibilities frontier simplifies a complex economy to highlight
some basic but powerful ideas: scarcity, efficiency, trade-offs, opportunity cost,

Figure 3

2,300
2,200

A

G

Quantity of
Cars Produced

600 6500

4,000

3,000

1,000

Quantity of
Computers

Produced
A Shift in the Production
Possibilities Frontier
A technological advance in the
computer industry enables the
economy to produce more computers
for any given number of cars. As a
result, the production possibilities
frontier shifts outward. If the economy
moves from point A to point G, then
the production of both cars and
computers increases.

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29CHAPTER 2 tHInkIng lIke an economIst

and economic growth. As you study economics, these ideas will recur in various
forms. The production possibilities frontier offers one simple way of thinking
about them.

Microeconomics and Macroeconomics
Many subjects are studied on various levels. Consider biology, for example.
Molecular biologists study the chemical compounds that make up living things.
Cellular biologists study cells, which are made up of many chemical compounds
and, at the same time, are themselves the building blocks of living organisms.
Evolutionary biologists study the many varieties of animals and plants and how
species change gradually over the centuries.

Economics is also studied on various levels. We can study the decisions of indi-
vidual households and firms. Or we can study the interaction of households and
firms in markets for specific goods and services. Or we can study the operation
of the economy as a whole, which is the sum of the activities of all these decision
makers in all these markets.

The field of economics is traditionally divided into two broad subfields. Micro-
economics is the study of how households and firms make decisions and how
they interact in specific markets. Macroeconomics is the study of economywide
phenomena. A microeconomist might study the effects of rent control on housing
in New York City, the impact of foreign competition on the U.S. auto industry,
or the effects of compulsory school attendance on workers’ earnings. A macro-
economist might study the effects of borrowing by the federal government, the
changes over time in the economy’s rate of unemployment, or alternative policies
to promote growth in national living standards.

Microeconomics and macroeconomics are closely intertwined. Because
changes in the overall economy arise from the decisions of millions of indi-
viduals, it is impossible to understand macroeconomic developments without
considering the associated microeconomic decisions. For example, a macroecon-
omist might study the effect of a federal income tax cut on the overall production
of goods and services. But to analyze this issue, he or she must consider how the
tax cut affects the decisions of households about how much to spend on goods
and services.

Despite the inherent link between microeconomics and macroeconomics, the
two fields are distinct. Because they address different questions, each field has its
own set of models, which are often taught in separate courses.

Quick Quiz In what sense is economics like a science? • Draw a production possi-
bilities frontier for a society that produces food and clothing. Show an efficient point,
an inefficient point, and an infeasible point. Show the effects of a drought. • Define
microeconomics and macroeconomics.

The Economist as Policy Adviser
Often, economists are asked to explain the causes of economic events. Why, for
example, is unemployment higher for teenagers than for older workers? Some-
times, economists are asked to recommend policies to improve economic out-
comes. What, for instance, should the government do to improve the economic

microeconomics
the study of how
households and firms
make decisions and how
they interact in markets

macroeconomics
the study of economywide
phenomena, including
inflation, unemployment,
and economic growth

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30 PART I IntroductIon

well-being of teenagers? When economists are trying to explain the world, they
are scientists. When they are trying to help improve it, they are policy advisers.

Positive versus Normative Analysis
To help clarify the two roles that economists play, let’s examine the use of lan-
guage. Because scientists and policy advisers have different goals, they use lan-
guage in different ways.

For example, suppose that two people are discussing minimum-wage laws.
Here are two statements you might hear:

Polly: Minimum-wage laws cause unemployment.
Norm: The government should raise the minimum wage.

Ignoring for now whether you agree with these statements, notice that Polly
and Norm differ in what they are trying to do. Polly is speaking like a scientist:
She is making a claim about how the world works. Norm is speaking like a pol-
icy adviser: He is making a claim about how he would like to change the world.

FYI
Who Studies Economics?

As a college student, you might be asking yourself: How many economics classes should I take? How useful will this stuff be to
me later in life? Economics can seem abstract at first, but the field is
fundamentally very practical, and the study of economics is useful in
many different career paths. Here is a small sampling of some well-
known people who majored in economics when they were in college.

George H. W. Bush Former President of the United States
Donald Trump Business and

TV Mogul
Meg Whitman Former Chief

Executive
Officer of eBay

Danny Glover Actor
Barbara Boxer U.S. Senator
John Elway Former NFL

Quarterback
Kofi Annan Former

Secretary General,
United Nations

Ted Turner Founder of CNN
Lionel Richie Singer

Diane von Furstenberg Fashion Designer
Michael Kinsley Journalist
Ben Stein Political Speechwriter, Journalist,

and Actor
Cate Blanchett Actor
Anthony Zinni General (ret.), U.S. Marine Corps
Steve Ballmer Chief Executive Officer, Microsoft
Arnold Schwarzenegger Governor of California

Sandra Day-O’Connor Former
Supreme
Court Justice

Scott Adams Cartoonist for
Dilbert

Mick Jagger Singer for the
Rolling Stones

Having studied at the London School of
Economics may not help Mick Jagger hit
the high notes, but it has probably given
him some insight about how to invest the
substantial sums he has earned during his
rock ’n’ roll career.

When asked in 2005 why The Rolling
Stones were going on tour again, former

economics major Mick Jagger replied,
“Supply and demand.” Keith Richards

added, “If the demand’s there, we’ll supply.”

©
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

31CHAPTER 2 tHInkIng lIke an economIst

In general, statements about the world come in two types. One type, such as
Polly’s, is positive. Positive statements are descriptive. They make a claim about
how the world is. A second type of statement, such as Norm’s, is normative. Norma-
tive statements are prescriptive. They make a claim about how the world ought to be.

A key difference between positive and normative statements is how we judge
their validity. We can, in principle, confirm or refute positive statements by exam-
ining evidence. An economist might evaluate Polly’s statement by analyzing data
on changes in minimum wages and changes in unemployment over time. By
contrast, evaluating normative statements involves values as well as facts. Norm’s
statement cannot be judged using data alone. Deciding what is good or bad policy
is not just a matter of science. It also involves our views on ethics, religion, and
political philosophy.

Positive and normative statements are fundamentally different, but they are
often intertwined in a person’s set of beliefs. In particular, positive views about
how the world works affect normative views about what policies are desirable.
Polly’s claim that the minimum wage causes unemployment, if true, might lead
her to reject Norm’s conclusion that the government should raise the minimum
wage. Yet normative conclusions cannot come from positive analysis alone; they
involve value judgments as well.

As you study economics, keep in mind the distinction between positive and
normative statements because it will help you stay focused on the task at hand.
Much of economics is positive: It just tries to explain how the economy works. Yet
those who use economics often have normative goals: They want to learn how to
improve the economy. When you hear economists making normative statements,
you know they are speaking not as scientists but as policy advisers.

Economists in Washington
President Harry Truman once said that he wanted to find a one-armed economist.
When he asked his economists for advice, they always answered, “On the one
hand, . . . On the other hand, . . . “

Truman was right in realizing that economists’ advice is not always straight-
forward. This tendency is rooted in one of the Ten Principles of Economics: People
face trade-offs. Economists are aware that trade-offs are involved in most policy
decisions. A policy might increase efficiency at the cost of equality. It might help
future generations but hurt current generations. An economist who says that all
policy decisions are easy is an economist not to be trusted.

Truman was not the only president who relied on the advice of economists.
Since 1946, the president of the United States has received guidance from the
Council of Economic Advisers, which consists of three members and a staff of a
few dozen economists. The council, whose offices are just a few steps from the
White House, has no duty other than to advise the president and to write the
annual Economic Report of the President, which discusses recent developments in
the economy and presents the council’s analysis of current policy issues.

The president also receives input from economists in many administrative
departments. Economists at the Office of Management and Budget help formulate
spending plans and regulatory policies. Economists at the Department of the Trea-
sury help design tax policy. Economists at the Department of Labor analyze data
on workers and those looking for work to help formulate labor-market policies.
Economists at the Department of Justice help enforce the nation’s antitrust laws.

Economists are also found outside the administrative branch of government.
To obtain independent evaluations of policy proposals, Congress relies on the
advice of the Congressional Budget Office, which is staffed by economists. The

normative
statements
claims that attempt to
prescribe how the world
should be

positive statements
claims that attempt to
describe the world as it is

“Let’s switch. I’ll make
the policy, you implement
it, and he’ll explain it.”© J

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

http://www.cartoonbank.com

http://www.cartoonbank.com

http://www.cartoonbank.com

32 PART I IntroductIon

A Vision for
Innovation, Growth,
and Quality Jobs
By Lawrence H. SummerS

President Obama laid out his vision for innovation, growth, and quality jobs earlier
today at Hudson Valley Community College.
Ths President’s plan is grounded not only in the
American tradition of entrepreneurship, but also
in the traditions of robust economic thought.

During the past two years, the ideas
propounded by John Maynard Keynes have
assumed greater importance than most
people would have thought in the previous
generation.  As Keynes famously observed,
during those rare times of deep financial
and economic crisis, when the “invisible
hand” Adam Smith talked about has tem-
porarily ceased to function, there is a more
urgent need for government to play an
active role in restoring markets to their
healthy function. 

The wisdom of Keynesian policies has
been confirmed by the performance of the econ-
omy over the past year.  After the collapse of
Lehman Brothers last September, government
policy moved in a strongly activist direction. 
As a result of those policies, our outlook
today has shifted from rescue to recovery,
from worrying about the very real prospect
of depression to thinking about what kind of
an expansion we want to have. 
An important aspect of any economic
expansion is the role innovation plays as

The Economics of President Obama
Here is how Larry Summers, a chief economic adviser to Barack
Obama, describes the president’s policies.

in the news

Federal Reserve, the institution that sets the nation’s monetary policy, employs
hundreds of economists to analyze economic developments in the United States
and throughout the world.

The influence of economists on policy goes beyond their role as advisers: Their
research and writings often affect policy indirectly. Economist John Maynard
Keynes offered this observation:

The ideas of economists and political philosophers, both when they are right
and when they are wrong, are more powerful than is commonly under-
stood. Indeed, the world is ruled by little else. Practical men, who believe
themselves to be quite exempt from intellectual influences, are usually the
slaves of some defunct economist. Madmen in authority, who hear voices
in the air, are distilling their frenzy from some academic scribbler of a few
years back.

Although these words were written in 1935, they remain true. Indeed, the “aca-
demic scribbler” now influencing public policy is often Keynes himself.

Why Economists’ Advice Is Not Always Followed
Any economist who advises presidents or other elected leaders knows that his
or her recommendations are not always heeded. Frustrating as this can be, it
is easy to understand. The process by which economic policy is actually made
differs in many ways from the idealized policy process assumed in economics
textbooks.

Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

33CHAPTER 2 tHInkIng lIke an economIst

Source: The White House Blog, September 21, 2009. http://www.whitehouse.gov/blog/A-Vision-for-Innovation-Growth-and-Quality-Jobs/

an engine of economic growth.  In this
regard, the most important economist of
the twenty-first century might actually turn
out to be not Smith or Keynes, but Joseph
Schumpeter. 
One of Schumpeter’s most important
contributions was the emphasis he placed
on the tremendous power of innovation and
entrepreneurial initiative to drive growth
through a process he famously characterized
as “creative destruction.”  His work cap-
tured not only an economic truth, but also
the particular source of America’s strength
and dynamism.
One of the ways to view the trajectory
of economic history is through the key tech-
nologies that have reverberated across the
economy.  In the nineteenth century, these
included the transcontinental railroad, the
telegraph, and the steam engine, among
others.  In the twentieth, the most powerful
innovations included the automobile, the jet

plane, and, over the last generation, infor-
mation technology.
While we can’t know exactly where the
next great area of American innovation will
be, we already see a number of prominent
sectors where American entrepreneurs are
unleashing explosive, innovative energy:

• In information technology, where tremen-
dous potential remains for a range of
applications to increase for years to come;

• In life-science technologies, where devel-
opments made at the National Institutes
of Health and in research facilities around
the country will have profound implica-
tions not just for human health, but also
for the environment, agriculture, and a
range of other areas that require techno-
logical creativity; and,

• In energy, where the combination of environ-
mental and geopolitical imperatives have
created the context for an enormously

productive period in developing energy
technologies as well.

Looking across the breadth of the U.S.
economy, the prospects for transformational
innovation to occur are enormous.  But to ensure
that the entrepreneurial spirit that Schumpeter
recognized in the early twentieth century will
continue to drive the American economy in the
twenty-first century requires a role for govern-
ment as well: to create an environment that is
conducive to generating those developments.  

Throughout this text, whenever we discuss economic policy, we often focus on
one question: What is the best policy for the government to pursue? We act as if
policy were set by a benevolent king. Once the king figures out the right policy,
he has no trouble putting his ideas into action.

In the real world, figuring out the right policy is only part of a leader’s job,
sometimes the easiest part. After a president hears from his economic advisers
about what policy is best from their perspective, he turns to other advisers for
related input. His communications advisers will tell him how best to explain
the proposed policy to the public, and they will try to anticipate any misunder-
standings that might make the challenge more difficult. His press advisers will
tell him how the news media will report on his proposal and what opinions
will likely be expressed on the nation’s editorial pages. His legislative affairs
advisers will tell him how Congress will view the proposal, what amendments
members of Congress will suggest, and the likelihood that Congress will pass
some version of the president’s proposal into law. His political advisers will tell
him which groups will organize to support or oppose the proposed policy, how
this proposal will affect his standing among different groups in the electorate,
and whether it will affect support for any of the president’s other policy initia-
tives. After hearing and weighing all this advice, the president then decides
how to proceed.

Making economic policy in a representative democracy is a messy affair—and
there are often good reasons presidents (and other politicians) do not advance the

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34 PART I IntroductIon

policies that economists advocate. Economists offer crucial input into the policy
process, but their advice is only one ingredient of a complex recipe.

Quick Quiz Give an example of a positive statement and an example of a norma-
tive statement that somehow relates to your daily life. • Name three parts of govern-
ment that regularly rely on advice from economists.

Why Economists Disagree
“If all economists were laid end to end, they would not reach a conclusion.” This
quip from George Bernard Shaw is revealing. Economists as a group are often
criticized for giving conflicting advice to policymakers. President Ronald Reagan
once joked that if the game Trivial Pursuit were designed for economists, it would
have 100 questions and 3,000 answers.

Why do economists so often appear to give conflicting advice to policymakers?
There are two basic reasons:

• Economists may disagree about the validity of alternative positive theories
about how the world works.

• Economists may have different values and therefore different normative
views about what policy should try to accomplish.

Let’s discuss each of these reasons.

Differences in Scientific Judgments
Several centuries ago, astronomers debated whether the earth or the sun was at the
center of the solar system. More recently, meteorologists have debated whether
the earth is experiencing global warming and, if so, why. Science is a search for
understanding about the world around us. It is not surprising that as the search
continues, scientists can disagree about the direction in which truth lies.

Economists often disagree for the same reason. Economics is a young science,
and there is still much to be learned. Economists sometimes disagree because they
have different hunches about the validity of alternative theories or about the size
of important parameters that measure how economic variables are related.

For example, economists disagree about whether the government should tax
a household’s income or its consumption (spending). Advocates of a switch
from the current income tax to a consumption tax believe that the change would
encourage households to save more because income that is saved would not be
taxed. Higher saving, in turn, would free resources for capital accumulation,
leading to more rapid growth in productivity and living standards. Advocates of
the current income tax system believe that household saving would not respond
much to a change in the tax laws. These two groups of economists hold different
normative views about the tax system because they have different positive views
about the responsiveness of saving to tax incentives.

Differences in Values
Suppose that Peter and Paula both take the same amount of water from the town
well. To pay for maintaining the well, the town taxes its residents. Peter has
income of $100,000 and is taxed $10,000, or 10 percent of his income. Paula has
income of $20,000 and is taxed $4,000, or 20 percent of her income.

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35CHAPTER 2 tHInkIng lIke an economIst

Is this policy fair? If not, who pays too much and who pays too little? Does it
matter whether Paula’s low income is due to a medical disability or to her deci-
sion to pursue an acting career? Does it matter whether Peter’s high income is
due to a large inheritance or to his willingness to work long hours at a dreary job?

These are difficult questions on which people are likely to disagree. If the town
hired two experts to study how the town should tax its residents to pay for the
well, we would not be surprised if they offered conflicting advice.

This simple example shows why economists sometimes disagree about public
policy. As we learned earlier in our discussion of normative and positive analysis,
policies cannot be judged on scientific grounds alone. Economists give conflicting
advice sometimes because they have different values. Perfecting the science of
economics will not tell us whether Peter or Paula pays too much.

Perception versus Reality
Because of differences in scientific judgments and differences in values, some
disagreement among economists is inevitable. Yet one should not overstate the
amount of disagreement. Economists agree with one another far more than is
sometimes understood.

Table 1 contains 20 propositions about economic policy. In surveys of profes-
sional economists, these propositions were endorsed by an overwhelming major-
ity of respondents. Most of these propositions would fail to command a similar
consensus among the public.

The first proposition in the table is about rent control, a policy that sets a legal
maximum on the amount landlords can charge for their apartments. Almost all
economists believe that rent control adversely affects the availability and quality
of housing and is a costly way of helping the neediest members of society. None-
theless, many city governments ignore the advice of economists and place ceilings
on the rents that landlords may charge their tenants.

The second proposition in the table concerns tariffs and import quotas, two poli-
cies that restrict trade among nations. For reasons we discuss more fully later in this
text, almost all economists oppose such barriers to free trade. Nonetheless, over the
years, presidents and Congress have chosen to restrict the import of certain goods.

Why do policies such as rent control and trade barriers persist if the experts are
united in their opposition? It may be that the realities of the political process stand
as immovable obstacles. But it also may be that economists have not yet convinced
enough of the public that these policies are undesirable. One purpose of this book
is to help you understand the economist’s view of these and other subjects and,
perhaps, to persuade you that it is the right one.

Quick Quiz Why might economic advisers to the president disagree about a ques-

tion of policy?

Let’s Get Going
The first two chapters of this book have introduced you to the ideas and meth-
ods of economics. We are now ready to get to work. In the next chapter, we start
learning in more detail the principles of economic behavior and economic policy.

As you proceed through this book, you will be asked to draw on many of your
intellectual skills. You might find it helpful to keep in mind some advice from the
great economist John Maynard Keynes:

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36 PART I IntroductIon

The study of economics does not seem to require any specialized gifts of an
unusually high order. Is it not . . . a very easy subject compared with the higher
branches of philosophy or pure science? An easy subject, at which very few
excel! The paradox finds its explanation, perhaps, in that the master-economist
must possess a rare combination of gifts. He must be mathematician, historian,
statesman, philosopher—in some degree. He must understand symbols and
speak in words. He must contemplate the particular in terms of the general,
and touch abstract and concrete in the same flight of thought. He must study
the present in the light of the past for the purposes of the future. No part
of man’s nature or his institutions must lie entirely outside his regard. He
must be purposeful and disinterested in a simultaneous mood; as aloof and
incorruptible as an artist, yet sometimes as near the earth as a politician.

It is a tall order. But with practice, you will become more and more accustomed
to thinking like an economist.

Propositions about
Which Most Economists
Agree

Table 1 Proposition (and percentage of economists who agree)
1. A ceiling on rents reduces the quantity and quality of housing available. (93%)
2. Tariffs and import quotas usually reduce general economic welfare. (93%)
3. Flexible and floating exchange rates offer an effective international monetary arrangement. (90%)
4. Fiscal policy (e.g., tax cut and/or government expenditure increase) has a significant stimulative

impact on a less than fully employed economy. (90%)
5. The United States should not restrict employers from outsourcing work to foreign countries. (90%)
6. Economic growth in developed countries like the United States leads to greater levels of well-

being. (88%)
7. The United States should eliminate agricultural subsidies. (85%)
8. An appropriately designed fiscal policy can increase the long-run rate of capital formation. (85%)
9. Local and state governments should eliminate subsidies to professional sports franchises. (85%)
10. If the federal budget is to be balanced, it should be done over the business cycle rather than

yearly. (85%)
11. The gap between Social Security funds and expenditures will become unsustainably large within

the next 50 years if current policies remain unchanged. (85%)
12. Cash payments increase the welfare of recipients to a greater degree than do transfers-in-kind

of equal cash value. (84%)
13. A large federal budget deficit has an adverse effect on the economy. (83%)
14. The redistribution of income in the United State is a legitimate role for the government. (83%)
15. Inflation is caused primarily by too much growth in the money supply. (83%)
16. The United States should not ban genetically modified crops. (82%)
17. A minimum wage increases unemployment among young and unskilled workers. (79%)
18. The government should restructure the welfare system along the lines of a “negative income

tax.” (79%)
19. Effluent taxes and marketable pollution permits represent a better approach to pollution control

than imposition of pollution ceilings. (78%)
20. Government subsidies on ethanol in the United States should be reduced or eliminated. (78%)

Source: Richard M. Alston, J. R. Kearl, and Michael B. Vaughn, “Is There Consensus among Economists in the 1990s?”
American Economic Review (May 1992): 203–209; Dan Fuller and Doris Geide-Stevenson, “Consensus among Economists
Revisited,” Journal of Economics Education (Fall 2003): 369–387; Robert Whaples, “Do Economists Agree on Anything? Yes!”
Economists’ Voice (November 2006): 1–6; Robert Whaples, “The Policy Views of American Economic Association Members: The
Results of a New Survey, Econ Journal Watch (September 2009): 337–348.

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37CHAPTER 2 tHInkIng lIke an economIst

Environmental Economics
Some economists are helping to save the planet.

in the news

Green Groups See
Potent Tool in
Economics
By JeSSica e. VaSceLLaro

Many economists dream of getting high-paying jobs on Wall Street, at
prestigious think tanks and universities or
at powerful government agencies like the
Federal Reserve.
But a growing number are choosing
to use their skills not to track inflation or
interest rates but to rescue rivers and trees.
These are the “green economists,” more
formally known as environmental econo-
mists, who use economic arguments and
systems to persuade companies to clean
up pollution and to help conserve natural
areas.
Working at dozens of advocacy groups
and a myriad of state and federal envi-
ronmental agencies, they are helping to
formulate the intellectual framework behind
approaches to protecting endangered spe-
cies, reducing pollution and preventing cli-
mate change. They also are becoming a link
between left-leaning advocacy groups and
the public and private sectors.
“In the past, many advocacy groups
interpreted economics as how to make a
profit or maximize income,” says Lawrence
Goulder, a professor of environmental and
resource economics at Stanford University
in Stanford, Calif. “More economists are

realizing that it offers a framework for
resource allocation where resources are not
only labor and capital but natural resources
as well.”
Environmental economists are on
the payroll of government agencies (the
Environmental Protection Agency had
about 164 on staff in 2004, up 36%
from 1995) and groups like the Wilderness
Society, a Washington-based conservation
group, which has four of them to work
on projects such as assessing the eco-
nomic impact of building off-road driving
trails. Environmental Defense, also based in
Washington, was one of the first environ-
mental-advocacy groups to hire economists
and now has about eight, who do such
things as develop market incentives to
address environmental problems like climate
change and water shortages. . . .
“There used to be this idea that we
shouldn’t have to monetize the environment
because it is invaluable,” says Caroline
Alkire, who in 1991 joined the Wilderness
Society, an advocacy group in Washington,
D.C., as one of the group’s first economists.
“But if we are going to engage in debate on
the Hill about drilling in the Arctic we need
to be able to combat the financial argu-
ments. We have to play that card or we are
going to lose.”
The field of environmental economics
began to take form in the 1960s when
academics started to apply the tools of
economics to the nascent green movement.
The discipline grew more popular through-

out the 1980s when the Environmental
Protection Agency adopted a system of trad-
able permits for phasing out leaded gaso-
line. It wasn’t until the 1990 amendment
to the Clean Air Act, however, that most
environmentalists started to take economics
seriously.
The amendment implemented a system
of tradable allowances for acid rain, a
program pushed by Environmental Defense.
Under the law, plants that can reduce their
emissions more cost-effectively may sell
their allowances to more heavy polluters.
Today, the program has exceeded its goal
of reducing the amount of acid rain to half
its 1980 level and is celebrated as evidence
that markets can help achieve environmen-
tal goals.
Its success has convinced its former
critics, who at the time contended that
environmental regulation was a matter of
ethics, not economics, and favored installing
expensive acid rain removal technology in
all power plants instead.
Greenpeace, the international environ-
mental giant, was one of the leading oppo-
nents of the 1990 amendment. But Kert
Davies, research director for Greenpeace
USA, said its success and the lack of any
significant action on climate policy through-
out [the] early 1990s brought the organi-
zation around to the concept. “We now
believe that [tradable permits] are the most
straightforward system of reducing emis-
sions and creating the incentives necessary
for massive reductions.”

Source: The Wall Street Journal, August 23, 2005.

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• Economists try to address their subject with a
scientist’s objectivity. Like all scientists, they
make appropriate assumptions and build sim-
plified models to understand the world around
them. Two simple economic models are the
circular-flow diagram and the production pos-
sibilities frontier.

• The field of economics is divided into two
subfields: microeconomics and macroeconom-
ics. Microeconomists study decision making
by households and firms and the interaction
among households and firms in the marketplace.
Macroeconomists study the forces and trends
that affect the economy as a whole.

• A positive statement is an assertion about
how the world is. A normative statement is
an assertion about how the world ought to be.
When economists make normative statements,
they are acting more as policy advisers than
scientists.

• Economists who advise policymakers offer con-
flicting advice either because of differences in
scientific judgments or because of differences
in values. At other times, economists are united
in the advice they offer, but policymakers may
choose to ignore it.

S u m m a r y

K e y C o n C e p t s

circular-flow diagram, p. 24
production possibilities

frontier, p. 26

microeconomics, p. 29
macroeconomics, p. 29

positive statements, p. 31
normative statements, p. 31

Q u e s t i o n s f o r r e v i e w

1. How is economics a science?
2. Why do economists make assumptions?
3. Should an economic model describe reality

exactly?
4. Name a way that your family interacts in the

factor market and a way that it interacts in the
product market.

5. Name one economic interaction that isn’t cov-
ered by the simplified circular-flow diagram.

6. Draw and explain a production possibilities
frontier for an economy that produces milk and

cookies. What happens to this frontier if disease
kills half of the economy’s cows?

7. Use a production possibilities frontier to
describe the idea of “efficiency.”

8. What are the two subfields into which eco-
nomics is divided? Explain what each subfield
studies.

9. What is the difference between a positive and a
normative statement? Give an example of each.

10. Why do economists sometimes offer conflicting
advice to policymakers?

P r o b l e m s a n d a P P l i c a t i o n s

1. Draw a circular-flow diagram. Identify the
parts of the model that correspond to the flow
of goods and services and the flow of dollars
for each of the following activities.
a. Selena pays a storekeeper $1 for a quart of

milk.

b. Stuart earns $4.50 per hour working at a fast-
food restaurant.

c. Shanna spends $30 to get a haircut.
d. Sally earns $10,000 from her 10 percent

owner ship of Acme Industrial.

38 PART I IntroductIon

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2. Imagine a society that produces military goods
and consumer goods, which we’ll call “guns”
and “butter.”
a. Draw a production possibilities frontier for

guns and butter. Using the concept of oppor-
tunity cost, explain why it most likely has a
bowed-out shape.

b. Show a point that is impossible for the econ-
omy to achieve. Show a point that is feasible
but inefficient.

c. Imagine that the society has two politi-
cal parties, called the Hawks (who want a
strong military) and the Doves (who want a
smaller military). Show a point on your pro-
duction possibilities frontier that the Hawks
might choose and a point the Doves might
choose.

d. Imagine that an aggressive neighboring
country reduces the size of its military. As a
result, both the Hawks and the Doves reduce
their desired production of guns by the same
amount. Which party would get the bigger
“peace dividend,” measured by the increase
in butter production? Explain.

3. The first principle of economics discussed in
Chapter 1 is that people face trade-offs. Use
a production possibilities frontier to illustrate
society’s trade-off between two “goods”—a
clean environment and the quantity of indus-
trial output. What do you suppose determines
the shape and position of the frontier? Show
what happens to the frontier if engineers
develop a new way of producing electricity
that emits fewer pollutants.

4. An economy consists of three workers: Larry,
Moe, and Curly. Each works ten hours a day
and can produce two services: mowing lawns
and washing cars. In an hour, Larry can either
mow one lawn or wash one car; Moe can either
mow one lawn or wash two cars; and Curly
can either mow two lawns or wash one car.
a. Calculate how much of each service is pro-

duced under the following circumstances,
which we label A, B, C, and D:
• All three spend all their time mowing

lawns. (A)
• All three spend all their time washing

cars. (B)

• All three spend half their time on each
activity. (C)

• Larry spends half his time on each activity,
while Moe only washes cars and Curly
only mows lawns. (D)

b. Graph the production possibilities frontier
for this economy. Using your answers to
part (a), identify points A, B, C, and D on
your graph.

c. Explain why the production possibilities
frontier has the shape it does.

d. Are any of the allocations calculated in part
(a) inefficient? Explain.

5. Classify the following topics as relating to
microeconomics or macroeconomics.
a. a family’s decision about how much income

to save
b. the effect of government regulations on auto

emissions
c. the impact of higher national saving on eco-

nomic growth
d. a firm’s decision about how many workers

to hire
e. the relationship between the inflation rate

and changes in the quantity of money
6. Classify each of the following statements as

positive or normative. Explain.
a. Society faces a short-run trade-off between

inflation and unemployment.
b. A reduction in the rate of money growth will

reduce the rate of inflation.
c. The Federal Reserve should reduce the rate

of money growth.
d. Society ought to require welfare recipients to

look for jobs.
e. Lower tax rates encourage more work and

more saving.
7. If you were president, would you be more

interested in your economic advisers’ positive
views or their normative views? Why?

For further information on topics in this chapter,
additional problems, applications, examples, online
quizzes, and more, please visit our website at
www.cengage.com/economics/mankiw.

39CHAPTER 2 tHInkIng lIke an economIst

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40 PART I IntroductIon

Appendix

Graphing: A Brief Review
Many of the concepts that economists study can be expressed with numbers—the
price of bananas, the quantity of bananas sold, the cost of growing bananas, and
so on. Often, these economic variables are related to one another: When the price
of bananas rises, people buy fewer bananas. One way of expressing the relation-
ships among variables is with graphs.

Graphs serve two purposes. First, when developing economic theories, graphs
offer a way to visually express ideas that might be less clear if described with
equations or words. Second, when analyzing economic data, graphs provide a
powerful way of finding and interpreting patterns. Whether we are working with
theory or with data, graphs provide a lens through which a recognizable forest
emerges from a multitude of trees.

Numerical information can be expressed graphically in many ways, just as
there are many ways to express a thought in words. A good writer chooses words
that will make an argument clear, a description pleasing, or a scene dramatic. An
effective economist chooses the type of graph that best suits the purpose at hand.

In this appendix, we discuss how economists use graphs to study the mathe-
matical relationships among variables. We also discuss some of the pitfalls that
can arise in the use of graphical methods.

Graphs of a Single Variable
Three common graphs are shown in Figure A-1. The pie chart in panel (a) shows
how total income in the United States is divided among the sources of income,
including compensation of employees, corporate profits, and so on. A slice of the

The pie chart in panel (a) shows how U.S. national income in 2008 was derived from
various sources. The bar graph in panel (b) compares the 2008 average income in four
countries. The time-series graph in panel (c) shows the productivity of labor in U.S.
businesses from 1950 to 2000.

Types of Graphs
Figure A-1

Rental
income (2%)

Corporate
profits (11%)

(a) Pie Chart (c) Time-Series Graph

Income per
Person in 2008

United
States

($46,720)

United
Kingdom
($43,090)

(b) Bar Graph

Mexico
($10,210)

India
($1,070)

Compensation
of employees

(72%)

Proprietors’
income (9%)

Interest
income (6%)

Productivity
Index

115
95
75
55
35

1950 1960 1970 1980 1990 2000

40,000

$50,000

30,000

20,000

10,000

0

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41CHAPTER 2 tHInkIng lIke an economIst

pie represents each source’s share of the total. The bar graph in panel (b) compares
income for four countries. The height of each bar represents the average income
in each country. The time-series graph in panel (c) traces the rising productivity in
the U.S. business sector over time. The height of the line shows output per hour in
each year. You have probably seen similar graphs in newspapers and magazines.

Graphs of Two Variables: The Coordinate System
The three graphs in Figure A-1 are useful in showing how a variable changes
over time or across individuals, but they are limited in how much they can tell us.
These graphs display information only on a single variable. Economists are often
concerned with the relationships between variables. Thus, they need to display
two variables on a single graph. The coordinate system makes this possible.

Suppose you want to examine the relationship between study time and grade
point average. For each student in your class, you could record a pair of numbers:
hours per week spent studying and grade point average. These numbers could
then be placed in parentheses as an ordered pair and appear as a single point on the
graph. Albert E., for instance, is represented by the ordered pair (25 hours/week,
3.5 GPA), while his “what-me-worry?” classmate Alfred E. is represented by the
ordered pair (5 hours/week, 2.0 GPA).

We can graph these ordered pairs on a two-dimensional grid. The first number
in each ordered pair, called the x-coordinate, tells us the horizontal location of the
point. The second number, called the y-coordinate, tells us the vertical location
of the point. The point with both an x-coordinate and a y-coordinate of zero is
known as the origin. The two coordinates in the ordered pair tell us where the
point is located in relation to the origin: x units to the right of the origin and y
units above it.

Figure A-2 graphs grade point average against study time for Albert E., Alfred E.,
and their classmates. This type of graph is called a scatterplot because it plots
scattered points. Looking at this graph, we immediately notice that points farther

Figure A-2Grade
Point

Average

2.5

2.0

1.5

1.0

0.5

40 Study
Time

(hours per week)

3.0

3.5

4.0

0 5 10 15 20 25 30 35

Alfred E.
(5, 2.0)

Albert E.
(25, 3.5)

Using the Coordinate
System
Grade point average is
measured on the vertical
axis and study time on the
horizontal axis. Albert E.,
Alfred E., and their classmates
are represented by various
points. We can see from the
graph that students who
study more tend to get higher
grades.

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42 PART I IntroductIon

to the right (indicating more study time) also tend to be higher (indicating a better
grade point average). Because study time and grade point average typically move
in the same direction, we say that these two variables have a positive correlation.
By contrast, if we were to graph party time and grades, we would likely find that
higher party time is associated with lower grades; because these variables typi-
cally move in opposite directions, we call this a negative correlation. In either case,
the coordinate system makes the correlation between the two variables easy to see.

Curves in the Coordinate System
Students who study more do tend to get higher grades, but other factors also influ-
ence a student’s grade. Previous preparation is an important factor, for instance,
as are talent, attention from teachers, even eating a good breakfast. A scatterplot
like Figure A-2 does not attempt to isolate the effect that studying has on grades
from the effects of other variables. Often, however, economists prefer looking at
how one variable affects another, holding everything else constant.

To see how this is done, let’s consider one of the most important graphs in eco-
nomics: the demand curve. The demand curve traces out the effect of a good’s price
on the quantity of the good consumers want to buy. Before showing a demand
curve, however, consider Table A-1, which shows how the number of novels that
Emma buys depends on her income and on the price of novels. When novels are
cheap, Emma buys them in large quantities. As they become more expensive, she
instead borrows books from the library or chooses to go to the movies rather than
read. Similarly, at any given price, Emma buys more novels when she has a higher
income. That is, when her income increases, she spends part of the additional
income on novels and part on other goods.

We now have three variables—the price of novels, income, and the number
of novels purchased—which are more than we can represent in two dimensions.
To put the information from Table A-1 in graphical form, we need to hold one of
the three variables constant and trace out the relationship between the other two.
Because the demand curve represents the relationship between price and quantity
demanded, we hold Emma’s income constant and show how the number of nov-
els she buys varies with the price of novels.

Suppose that Emma’s income is $30,000 per year. If we place the number of
novels Emma purchases on the x-axis and the price of novels on the y-axis, we

Novels Purchased by Emma
This table shows the number
of novels Emma buys at various
incomes and prices. For any given
level of income, the data on
price and quantity demanded can
be graphed to produce Emma’s
demand curve for novels, as shown
in Figures A-3 and A-4.

Table A-1
Price

For
$20,000
Income:

For
$30,000
Income:

For
$40,000
Income:

$10 2 novels 5 novels 8 novels
9 6 9 12
8 10 13 16
7 14 17 20
6 18 21 24
5 22 25 28

Demand curve, D
3

Demand curve, D
1

Demand curve, D
2

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43CHAPTER 2 tHInkIng lIke an economIst

can graphically represent the middle column of Table A-1. When the points that
represent these entries from the table—(5 novels, $10), (9 novels, $9), and so on—are
connected, they form a line. This line, pictured in Figure A-3, is known as Emma’s
demand curve for novels; it tells us how many novels Emma purchases at any
given price. The demand curve is downward sloping, indicating that a higher price
reduces the quantity of novels demanded. Because the quantity of novels demanded
and the price move in opposite directions, we say that the two variables are nega-
tively related. (Conversely, when two variables move in the same direction, the curve
relating them is upward sloping, and we say the variables are positively related.)

Now suppose that Emma’s income rises to $40,000 per year. At any given price,
Emma will purchase more novels than she did at her previous level of income.
Just as earlier we drew Emma’s demand curve for novels using the entries from
the middle column of Table A-1, we now draw a new demand curve using the
entries from the right column of the table. This new demand curve (curve D

2
) is

pictured alongside the old one (curve D
1
) in Figure A-4; the new curve is a similar

line drawn farther to the right. We therefore say that Emma’s demand curve for
novels shifts to the right when her income increases. Likewise, if Emma’s income
were to fall to $20,000 per year, she would buy fewer novels at any given price
and her demand curve would shift to the left (to curve D

3
).

In economics, it is important to distinguish between movements along a curve
and shifts of a curve. As we can see from Figure A-3, if Emma earns $30,000 per
year and novels cost $8 apiece, she will purchase 13 novels per year. If the price of
novels falls to $7, Emma will increase her purchases of novels to 17 per year. The
demand curve, however, stays fixed in the same place. Emma still buys the same

Figure A-3Price of
Novels

5

4

3

2

1

30 Quantity
of Novels

Purchased

6

7

8

9

10

$11

0 5 10 15 20 25

Demand, D1

(5, $10)

(9, $9)

(13, $8)

(17, $7)

(21, $6)

(25, $5)

Demand Curve
The line D

1
shows how

Emma’s purchases of novels
depend on the price of novels
when her income is held
constant. Because the price
and the quantity demanded
are negatively related,
the demand curve slopes
downward.

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44 PART I IntroductIon

number of novels at each price, but as the price falls, she moves along her demand
curve from left to right. By contrast, if the price of novels remains fixed at $8 but
her income rises to $40,000, Emma increases her purchases of novels from 13 to 16
per year. Because Emma buys more novels at each price, her demand curve shifts
out, as shown in Figure A-4.

There is a simple way to tell when it is necessary to shift a curve: When a vari-
able that is not named on either axis changes, the curve shifts. Income is on neither
the x-axis nor the y-axis of the graph, so when Emma’s income changes, her
demand curve must shift. The same is true for any change that affects Emma’s
purchasing habits besides a change in the price of novels. If, for instance, the
public library closes and Emma must buy all the books she wants to read, she
will demand more novels at each price, and her demand curve will shift to the
right. Or if the price of movies falls and Emma spends more time at the mov-
ies and less time reading, she will demand fewer novels at each price, and her
demand curve will shift to the left. By contrast, when a variable on an axis of
the graph changes, the curve does not shift. We read the change as a movement
along the curve.

Slope
One question we might want to ask about Emma is how much her purchasing
habits respond to price. Look at the demand curve pictured in Figure A-5. If this
curve is very steep, Emma purchases nearly the same number of novels regardless

Figure A-4
Price of
Novels

5

4

3

2

1

30 Quantity
of Novels

Purchased

6

7

8

9

10

$11

0 5 13 1610 15 20 25

(13, $8)

(16, $8)

D3
(income =
$20,000)

D1
(income =
$30,000)

D2 (income =
$40,000)

(10, $8)
When income increases, the
demand curve shifts to
the right.

When income
decreases, the
demand curve
shifts to the left.

Shifting Demand Curves
The location of Emma’s
demand curve for novels
depends on how much
income she earns. The more
she earns, the more novels
she will purchase at any given
price, and the farther to
the right her demand curve
will lie. Curve D

1
represents

Emma’s original demand
curve when her income
is $30,000 per year. If her
income rises to $40,000 per
year, her demand curve shifts
to D

2
. If her income falls to

$20,000 per year, her demand
curve shifts to D

3
.

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45CHAPTER 2 tHInkIng lIke an economIst

of whether they are cheap or expensive. If this curve is much flatter, the number
of novels Emma purchases is more sensitive to changes in the price. To answer
questions about how much one variable responds to changes in another variable,
we can use the concept of slope.

The slope of a line is the ratio of the vertical distance covered to the horizontal
distance covered as we move along the line. This definition is usually written out
in mathematical symbols as follows:

slope =
Δy

Δx
,

where the Greek letter Δ (delta) stands for the change in a variable. In other words,
the slope of a line is equal to the “rise” (change in y) divided by the “run” (change
in x). The slope will be a small positive number for a fairly flat upward-sloping
line, a large positive number for a steep upward-sloping line, and a negative num-
ber for a downward-sloping line. A horizontal line has a slope of zero because in
this case the y-variable never changes; a vertical line is said to have an infinite
slope because the y-variable can take any value without the x-variable changing
at all.

What is the slope of Emma’s demand curve for novels? First of all, because the
curve slopes down, we know the slope will be negative. To calculate a numerical
value for the slope, we must choose two points on the line. With Emma’s income

Figure A-5Price of
Novels

5

4

3

2

1

30 Quantity
of Novels

Purchased

6

7

8

9

10

$11

0 5 211310 15 20 25

Demand, D1

(13, $8)

(21, $6)
6 � 8 � �2

21 � 13 � 8

Calculating the Slope
of a Line
To calculate the slope of the
demand curve, we can look
at the changes in the x- and
y-coordinates as we move
from the point (21 novels,
$6) to the point (13 novels,
$8). The slope of the line is
the ratio of the change in
the y-coordinate (∙2) to the
change in the x-coordinate
(∙8), which equals ∙1⁄4

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46 PART I IntroductIon

at $30,000, she will purchase 21 novels at a price of $6 or 13 novels at a price of
$8. When we apply the slope formula, we are concerned with the change between
these two points; in other words, we are concerned with the difference between
them, which lets us know that we will have to subtract one set of values from the
other, as follows:

slope =
Δy


first y-coordinate – second y-coordinate


6  8


2


1

Δx first x-coordinate – second x-coordinate 21  13 8 4

Figure A-5 shows graphically how this calculation works. Try computing the
slope of Emma’s demand curve using two different points. You should get exactly
the same result, 1⁄4. One of the properties of a straight line is that it has the same
slope everywhere. This is not true of other types of curves, which are steeper in
some places than in others.

The slope of Emma’s demand curve tells us something about how responsive
her purchases are to changes in the price. A small slope (a number close to zero)
means that Emma’s demand curve is relatively flat; in this case, she adjusts the
number of novels she buys substantially in response to a price change. A larger
slope (a number farther from zero) means that Emma’s demand curve is relatively
steep; in this case, she adjusts the number of novels she buys only slightly in
response to a price change.

Cause and Effect
Economists often use graphs to advance an argument about how the economy
works. In other words, they use graphs to argue about how one set of events
causes another set of events. With a graph like the demand curve, there is no
doubt about cause and effect. Because we are varying price and holding all other
variables constant, we know that changes in the price of novels cause changes in
the quantity Emma demands. Remember, however, that our demand curve came
from a hypothetical example. When graphing data from the real world, it is often
more difficult to establish how one variable affects another.

The first problem is that it is difficult to hold everything else constant when
studying the relationship between two variables. If we are not able to hold other
variables constant, we might decide that one variable on our graph is causing
changes in the other variable when actually those changes are caused by a third
omitted variable not pictured on the graph. Even if we have identified the correct

c
o

u
r
te

sY
o

f
r
a

n
d

a
ll

m
u

n
r
o

e/
x

k
c

d
.c

o
m

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

47CHAPTER 2 tHInkIng lIke an economIst

two variables to look at, we might run into a second problem—reverse causality.
In other words, we might decide that A causes B when in fact B causes A. The
omitted-variable and reverse-causality traps require us to proceed with caution
when using graphs to draw conclusions about causes and effects.

Omitted Variables To see how omitting a variable can lead to a deceptive
graph, let’s consider an example. Imagine that the government, spurred by
public concern about the large number of deaths from cancer, commissions
an exhaustive study from Big Brother Statistical Services, Inc. Big Brother
examines many of the items found in people’s homes to see which of them
are associated with the risk of cancer. Big Brother reports a strong relation-
ship between two variables: the number of cigarette lighters that a household
owns and the probability that someone in the household will develop cancer.
Figure A-6 shows this relationship.

What should we make of this result? Big Brother advises a quick policy
response. It recommends that the government discourage the ownership of
cigarette lighters by taxing their sale. It also recommends that the government
require warning labels: “Big Brother has determined that this lighter is danger-
ous to your health.”

In judging the validity of Big Brother’s analysis, one question is paramount:
Has Big Brother held constant every relevant variable except the one under
consideration? If the answer is no, the results are suspect. An easy explanation
for Figure A-6 is that people who own more cigarette lighters are more likely to
smoke cigarettes and that cigarettes, not lighters, cause cancer. If Figure A-6 does
not hold constant the amount of smoking, it does not tell us the true effect of own-
ing a cigarette lighter.

This story illustrates an important principle: When you see a graph used to
support an argument about cause and effect, it is important to ask whether the
movements of an omitted variable could explain the results you see.

Reverse Causality Economists can also make mistakes about causality by
misreading its direction. To see how this is possible, suppose the Association of
American Anarchists commissions a study of crime in America and arrives at

Figure A-6
Risk of
Cancer

Number of Lighters in House
0

Graph with an Omitted Variable
The upward-sloping curve shows
that members of households
with more cigarette lighters are
more likely to develop cancer.
Yet we should not conclude that
ownership of lighters causes
cancer because the graph does not
take into account the number of
cigarettes smoked.

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48 PART I IntroductIon

Figure A-7, which plots the number of violent crimes per thousand people in
major cities against the number of police officers per thousand people. The anar-
chists note the curve’s upward slope and argue that because police increase rather
than decrease the amount of urban violence, law enforcement should be abolished.

If we could run a controlled experiment, we would avoid the danger of reverse
causality. To run an experiment, we would set the number of police officers in dif-
ferent cities randomly and then examine the correlation between police and crime.
Figure A-7, however, is not based on such an experiment. We simply observe that
more dangerous cities have more police officers. The explanation for this may be
that more dangerous cities hire more police. In other words, rather than police
causing crime, crime may cause police. Nothing in the graph itself allows us to
establish the direction of causality.

It might seem that an easy way to determine the direction of causality is to
examine which variable moves first. If we see crime increase and then the police
force expand, we reach one conclusion. If we see the police force expand and then
crime increase, we reach the other. Yet there is also a flaw with this approach:
Often, people change their behavior not in response to a change in their present
conditions but in response to a change in their expectations of future conditions. A
city that expects a major crime wave in the future, for instance, might hire more
police now. This problem is even easier to see in the case of babies and minivans.
Couples often buy a minivan in anticipation of the birth of a child. The minivan
comes before the baby, but we wouldn’t want to conclude that the sale of mini-
vans causes the population to grow!

There is no complete set of rules that says when it is appropriate to draw causal
conclusions from graphs. Yet just keeping in mind that cigarette lighters don’t
cause cancer (omitted variable) and minivans don’t cause larger families (reverse
causality) will keep you from falling for many faulty economic arguments.

Figure A-7 Violent
Crimes

(per 1,000
people)

Police Officers
(per 1,000 people)

0

Graph Suggesting Reverse
Causality
The upward-sloping curve
shows that cities with a higher
concentration of police are more
dangerous. Yet the graph does
not tell us whether police cause
crime or crime-plagued cities hire
more police.

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49

3Interdependence and the Gains from Trade
Consider your typical day. You wake up in the morning and pour your-self juice from oranges grown in Florida and coffee from beans grown in Brazil. Over breakfast, you watch a news program broadcast from New York on your television made in China. You get dressed in clothes made
of cotton grown in Georgia and sewn in factories in Thailand. You drive to class
in a car made of parts manufactured in more than a dozen countries around the
world. Then you open up your economics textbook written by an author living
in Massachusetts, published by a company located in Ohio, and printed on paper
made from trees grown in Oregon.

Every day, you rely on many people, most of whom you have never met, to
provide you with the goods and services that you enjoy. Such interdependence
is possible because people trade with one another. Those people providing you
goods and services are not acting out of generosity. Nor is some government
agency directing them to satisfy your desires. Instead, people provide you and

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50 PART I IntroductIon

other consumers with the goods and services they produce because they get
something in return.

In subsequent chapters, we examine how our economy coordinates the activi-
ties of millions of people with varying tastes and abilities. As a starting point for
this analysis, here we consider the reasons for economic interdependence. One
of the Ten Principles of Economics highlighted in Chapter 1 is that trade can make
everyone better off. In this chapter, we examine this principle more closely. What
exactly do people gain when they trade with one another? Why do people choose
to become interdependent?

The answers to these questions are key to understanding the modern global
economy. In most countries today, many goods and services consumed are
imported from abroad, and many goods and services produced are exported to
foreign customers. The analysis in this chapter explains interdependence not only
among individuals but also among nations. As we will see, the gains from trade
are much the same whether you are buying a haircut from your local barber or a
T-shirt made by a worker on the other side of the globe.

A Parable for the Modern Economy
To understand why people choose to depend on others for goods and services and
how this choice improves their lives, let’s look at a simple economy. Imagine that
there are two goods in the world: meat and potatoes. And there are two people
in the world—a cattle rancher and a potato farmer—each of whom would like to
eat both meat and potatoes.

The gains from trade are most obvious if the rancher can produce only meat
and the farmer can produce only potatoes. In one scenario, the rancher and the
farmer could choose to have nothing to do with each other. But after several
months of eating beef roasted, boiled, broiled, and grilled, the rancher might
decide that self-sufficiency is not all it’s cracked up to be. The farmer, who has
been eating potatoes mashed, fried, baked, and scalloped, would likely agree. It is
easy to see that trade would allow them to enjoy greater variety: Each could then
have a steak with a baked potato or a burger with fries.

Although this scene illustrates most simply how everyone can benefit from
trade, the gains would be similar if the rancher and the farmer were each capable
of producing the other good, but only at great cost. Suppose, for example, that the
potato farmer is able to raise cattle and produce meat, but that he is not very good
at it. Similarly, suppose that the cattle rancher is able to grow potatoes but that her
land is not very well suited for it. In this case, the farmer and the rancher can each
benefit by specializing in what he or she does best and then trading with the other.

The gains from trade are less obvious, however, when one person is better at
producing every good. For example, suppose that the rancher is better at raising
cattle and better at growing potatoes than the farmer. In this case, should the
rancher choose to remain self-sufficient? Or is there still reason for her to trade
with the farmer? To answer this question, we need to look more closely at the fac-
tors that affect such a decision.

Production Possibilities
Suppose that the farmer and the rancher each work 8  hours per day and can
devote this time to growing potatoes, raising cattle, or a combination of the two.

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51CHAPTER 3 Interdependence and the GaIns from trade

The table in Figure 1 shows the amount of time each person requires to produce
1 ounce of each good. The farmer can produce an ounce of potatoes in 15 minutes
and an ounce of meat in 60 minutes. The rancher, who is more productive in both
activities, can produce an ounce of potatoes in 10 minutes and an ounce of meat
in 20 minutes. The last two columns in the table show the amounts of meat or
potatoes the farmer and rancher can produce if they work an 8-hour day produc-
ing only that good.

Panel (b) of Figure 1 illustrates the amounts of meat and potatoes that the
farmer can produce. If the farmer devotes all 8 hours of his time to potatoes, he
produces 32 ounces of potatoes (measured on the horizontal axis) and no meat. If
he devotes all his time to meat, he produces 8 ounces of meat (measured on the
vertical axis) and no potatoes. If the farmer divides his time equally between the
two activities, spending 4 hours on each, he produces 16 ounces of potatoes and
4 ounces of meat. The figure shows these three possible outcomes and all others
in between.

The Production
Possibilities Frontier

Figure 1Panel (a) shows the production opportunities available to the farmer and the rancher.
Panel (b) shows the combinations of meat and potatoes that the farmer can produce.
Panel (c) shows the combinations of meat and potatoes that the rancher can produce.
Both production possibilities frontiers are derived assuming that the farmer and rancher
each work 8 hours per day. If there is no trade, each person’s production possibilities
frontier is also his or her consumption possibilities frontier.

4

8

Potatoes (ounces)
16 32

A

0

Meat (ounces)

(b) The Farmer’s Production Possibilities Frontier

If there is no
trade, the farmer
chooses this
production and
consumption.

12

Potatoes (ounces)
24

B

0

Meat (ounces)

(c) The Rancher’s Production Possibilities Frontier

48

24
If there is no
trade, the rancher
chooses this
production and
consumption.

(a) Production Opportunities

Minutes Needed to
Make 1 Ounce of:

Amount
Produced in 8 Hours

Meat Potatoes Meat Potatoes

Farmer 60 min/oz 15 min/oz 8 oz 32 oz

Rancher 20 min/oz 10 min/oz 24 oz 48 oz

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52 PART I IntroductIon

This graph is the farmer’s production possibilities frontier. As we discussed in
Chapter 2, a production possibilities frontier shows the various mixes of output
that an economy can produce. It illustrates one of the Ten Principles of Economics
in Chapter 1: People face trade-offs. Here the farmer faces a trade-off between
producing meat and producing potatoes.

You may recall that the production possibilities frontier in Chapter 2 was
drawn bowed out. In that case, the rate at which society could trade one good for
the other depended on the amounts that were being produced. Here, however, the
farmer’s technology for producing meat and potatoes (as summarized in Figure 1)
allows him to switch between the two goods at a constant rate. Whenever the
farmer spends 1 hour less producing meat and 1 hour more producing potatoes,
he reduces his output of meat by 1 ounce and raises his output of potatoes by
4 ounces—and this is true regardless of how much he is already producing. As a
result, the production possibilities frontier is a straight line.

Panel (c) of Figure 1 shows the production possibilities frontier for the rancher.
If the rancher devotes all 8 hours of her time to potatoes, she produces 48 ounces of
potatoes and no meat. If she devotes all her time to meat, she produces 24 ounces
of meat and no potatoes. If the rancher divides her time equally, spending 4 hours
on each activity, she produces 24 ounces of potatoes and 12 ounces of meat. Once
again, the production possibilities frontier shows all the possible outcomes.

If the farmer and rancher choose to be self-sufficient rather than trade with
each other, then each consumes exactly what he or she produces. In this case, the
production possibilities frontier is also the consumption possibilities frontier. That
is, without trade, Figure 1 shows the possible combinations of meat and potatoes
that the farmer and rancher can each produce and then consume.

These production possibilities frontiers are useful in showing the trade-offs
that the farmer and rancher face, but they do not tell us what the farmer and
rancher will actually choose to do. To determine their choices, we need to know
the tastes of the farmer and the rancher. Let’s suppose they choose the combina-
tions identified by points A and B in Figure 1: The farmer produces and consumes
16 ounces of potatoes and 4 ounces of meat, while the rancher produces and con-
sumes 24 ounces of potatoes and 12 ounces of meat.

Specialization and Trade
After several years of eating combination B, the rancher gets an idea and goes to
talk to the farmer:

Rancher: Farmer, my friend, have I got a deal for you! I know how to improve
life for both of us. I think you should stop producing meat alto-
gether and devote all your time to growing potatoes. According to
my calculations, if you work 8 hours a day growing potatoes, you’ll
produce 32 ounces of potatoes. If you give me 15 of those 32 ounces,
I’ll give you 5 ounces of meat in return. In the end, you’ll get to eat
17 ounces of potatoes and 5 ounces of meat every day, instead of the
16 ounces of potatoes and 4 ounces of meat you now get. If you go
along with my plan, you’ll have more of both foods. [To illustrate her
point, the rancher shows the farmer panel (a) of Figure 2.]

Farmer: (sounding skeptical) That seems like a good deal for me. But I don’t
understand why you are offering it. If the deal is so good for me, it
can’t be good for you too.

Rancher: Oh, but it is! Suppose I spend 6 hours a day raising cattle and
2 hours growing potatoes. Then I can produce 18 ounces of meat

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53CHAPTER 3 Interdependence and the GaIns from trade

and 12 ounces of potatoes. After I give you 5 ounces of my meat in
exchange for 15 ounces of your potatoes, I’ll end up with 13 ounces of
meat and 27 ounces of potatoes, instead of the 12 ounces of meat and
24 ounces of potatoes that I now get. So I will also consume more of
both foods than I do now. [She points out panel (b) of Figure 2.]

Farmer: I don’t know. . . . This sounds too good to be true.
Rancher: It’s really not as complicated as it first seems. Here—I’ve summa-

rized my proposal for you in a simple table. [The rancher shows the
farmer a copy of the table at the bottom of Figure 2.]

Farmer: (after pausing to study the table) These calculations seem correct, but
I am puzzled. How can this deal make us both better off?

How Trade Expands
the Set of Consumption
Opportunities

Figure 2The proposed trade between the farmer and the rancher offers each of them a
combination of meat and potatoes that would be impossible in the absence of trade.
In panel (a), the farmer gets to consume at point A* rather than point A. In panel (b),
the rancher gets to consume at point B* rather than point B. Trade allows each to
consume more meat and more potatoes.

4
5

8

Potatoes (ounces)
16 17

32

A

A*

0

Meat (ounces)

(a) The Farmer’s Production and Consumption

Farmer’s
production and
consumption
without trade

Farmer’s
consumption
with trade

Farmer’s
production
with trade

12

13

Potatoes (ounces)
2412 27

B

0

Meat (ounces)

48

24

18

B*

(b) The Rancher’s Production and Consumption

Rancher’s
consumption
with trade

Rancher’s
production
with trade

Rancher’s
production and
consumption
without trade

(c) The Gains from Trade: A Summary

Farmer Rancher

Meat Potatoes Meat Potatoes

Without Trade:
Production and Consumption 4 oz 16 oz 12 oz 24 oz

With Trade:
Production 0 oz 32 oz 18 oz 12 oz
Trade Gets 5 oz Gives 15 oz Gives 5 oz Gets 15 oz
Consumption 5 oz 17 oz 13 oz 27 oz

GAINS FROM TRADE:
Increase in Consumption +1 oz +1 oz +1 oz +3 oz

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54 PART I IntroductIon

Rancher: We can both benefit because trade allows each of us to specialize in
doing what we do best. You will spend more time growing potatoes
and less time raising cattle. I will spend more time raising cattle and
less time growing potatoes. As a result of specialization and trade,
each of us can consume more meat and more potatoes without work-
ing any more hours.

Quick Quiz Draw an example of a production possibilities frontier for Robinson
Crusoe, a shipwrecked sailor who spends his time gathering coconuts and catching
fish. Does this frontier limit Crusoe’s consumption of coconuts and fish if he lives by
himself? Does he face the same limits if he can trade with natives on the island?

Comparative Advantage: The Driving Force of Specialization
The rancher’s explanation of the gains from trade, though correct, poses a puzzle:
If the rancher is better at both raising cattle and growing potatoes, how can the
farmer ever specialize in doing what he does best? The farmer doesn’t seem to do
anything best. To solve this puzzle, we need to look at the principle of comparative
advantage.

As a first step in developing this principle, consider the following question:
In our example, who can produce potatoes at a lower cost—the farmer or the
rancher? There are two possible answers, and in these two answers lie the solution
to our puzzle and the key to understanding the gains from trade.

Absolute Advantage
One way to answer the question about the cost of producing potatoes is to com-
pare the inputs required by the two producers. Economists use the term absolute
advantage when comparing the productivity of one person, firm, or nation to that
of another. The producer that requires a smaller quantity of inputs to produce a
good is said to have an absolute advantage in producing that good.

In our example, time is the only input, so we can determine absolute advan-
tage by looking at how much time each type of production takes. The rancher
has an absolute advantage both in producing meat and in producing potatoes
because she requires less time than the farmer to produce a unit of either good.
The rancher needs to input only 20 minutes to produce an ounce of meat, whereas
the farmer needs 60 minutes. Similarly, the rancher needs only 10 minutes to pro-
duce an ounce of potatoes, whereas the farmer needs 15 minutes. Based on this
information, we can conclude that the rancher has the lower cost of producing
potatoes, if we measure cost by the quantity of inputs.

Opportunity Cost and Comparative Advantage
There is another way to look at the cost of producing potatoes. Rather than
comparing inputs required, we can compare the opportunity costs. Recall from
Chapter 1 that the opportunity cost of some item is what we give up to get that
item. In our example, we assumed that the farmer and the rancher each spend
8  hours a day working. Time spent producing potatoes, therefore, takes away
from time available for producing meat. When reallocating time between the two
goods, the rancher and farmer give up units of one good to produce units of the
other, thereby moving along the production possibilities frontier. The opportunity
cost measures the trade-off between the two goods that each producer faces.

absolute advantage
the ability to produce a
good using fewer inputs
than another producer

opportunity cost
whatever must be given
up to obtain some item

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55CHAPTER 3 Interdependence and the GaIns from trade

Let’s first consider the rancher’s opportunity cost. According to the table in
panel (a) of Figure 1, producing 1 ounce of potatoes takes 10 minutes of work.
When the rancher spends those 10 minutes producing potatoes, she spends
10 minutes less producing meat. Because the rancher needs 20 minutes to produce
1 ounce of meat, 10 minutes of work would yield ½ ounce of meat. Hence, the
rancher’s opportunity cost of producing 1 ounce of potatoes is ½ ounce of meat.

Now consider the farmer’s opportunity cost. Producing 1 ounce of potatoes
takes him 15 minutes. Because he needs 60 minutes to produce 1 ounce of meat,
15 minutes of work would yield ¼ ounce of meat. Hence, the farmer’s opportunity
cost of 1 ounce of potatoes is ¼ ounce of meat.

Table 1 shows the opportunity costs of meat and potatoes for the two producers.
Notice that the opportunity cost of meat is the inverse of the opportunity cost of pota-
toes. Because 1 ounce of potatoes costs the rancher ½ ounce of meat, 1 ounce of meat
costs the rancher 2 ounces of potatoes. Similarly, because 1 ounce of potatoes costs
the farmer ¼ ounce of meat, 1 ounce of meat costs the farmer 4 ounces of potatoes.

Economists use the term comparative advantage when describing the oppor-
tunity cost of two producers. The producer who gives up less of other goods to
produce Good X has the smaller opportunity cost of producing Good X and is
said to have a comparative advantage in producing it. In our example, the farmer
has a lower opportunity cost of producing potatoes than the rancher: An ounce of
potatoes costs the farmer only ¼ ounce of meat, but it costs the rancher ½ ounce of
meat. Conversely, the rancher has a lower opportunity cost of producing meat than
the farmer: An ounce of meat costs the rancher 2  ounces of potatoes, but it costs
the farmer 4 ounces of potatoes. Thus, the farmer has a comparative advantage in
growing potatoes, and the rancher has a comparative advantage in producing meat.

Although it is possible for one person to have an absolute advantage in both
goods (as the rancher does in our example), it is impossible for one person to
have a comparative advantage in both goods. Because the opportunity cost of one
good is the inverse of the opportunity cost of the other, if a person’s opportunity
cost of one good is relatively high, the opportunity cost of the other good must
be relatively low. Comparative advantage reflects the relative opportunity cost.
Unless two people have exactly the same opportunity cost, one person will have a
comparative advantage in one good, and the other person will have a comparative
advantage in the other good.

Comparative Advantage and Trade
The gains from specialization and trade are based not on absolute advantage but on
comparative advantage. When each person specializes in producing the good for
which he or she has a comparative advantage, total production in the economy rises.
This increase in the size of the economic pie can be used to make everyone better off.

comparative
advantage
the ability to produce
a good at a lower
opportunity cost than
another producer

The Opportunity Cost
of Meat and Potatoes

Table 1
Opportunity Cost of:

1 oz of Meat 1 oz of Potatoes

Farmer 4 oz potatoes 1/4 oz meat
Rancher 2 oz potatoes 1/2 oz meat

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56 PART I IntroductIon

In our example, the farmer spends more time growing potatoes, and the rancher
spends more time producing meat. As a result, the total production of potatoes
rises from 40 to 44  ounces, and the total production of meat rises from 16 to
18 ounces. The farmer and rancher share the benefits of this increased production.

We can also look at the gains from trade in terms of the price that each party
pays the other. Because the farmer and rancher have different opportunity costs,
they can both get a bargain. That is, each benefits from trade by obtaining a good
at a price that is lower than his or her opportunity cost of that good.

Consider the proposed deal from the viewpoint of the farmer. The farmer gets
5 ounces of meat in exchange for 15 ounces of potatoes. In other words, the farmer
buys each ounce of meat for a price of 3 ounces of potatoes. This price of meat is
lower than his opportunity cost for an ounce of meat, which is 4 ounces of potatoes.
Thus, the farmer benefits from the deal because he gets to buy meat at a good price.

Now consider the deal from the rancher’s viewpoint. The rancher buys
15 ounces of potatoes for a price of 5 ounces of meat. That is, the price of potatoes
is ¹∕³ ounce of meat. This price of potatoes is lower than her opportunity cost of
an ounce of potatoes, which is ½ ounce of meat. The rancher benefits because she
gets to buy potatoes at a good price.

The moral of the story of the farmer and the rancher should now be clear: Trade
can benefit everyone in society because it allows people to specialize in activities in which
they have a comparative advantage.

The Price of the Trade
The principle of comparative advantage establishes that there are gains from spe-
cialization and trade, but it leaves open a couple of related questions: What deter-
mines the price at which trade takes place? How are the gains from trade shared
between the trading parties? The precise answer to these questions is beyond the
scope of this chapter, but we can state one general rule: For both parties to gain from
trade, the price at which they trade must lie between the two opportunity costs.

In our example, the farmer and rancher agreed to trade at a rate of 3 ounces of
potatoes for each ounce of meat. This price is between the rancher’s opportunity
cost (2  ounces of potatoes per ounce of meat) and the farmer’s opportunity cost
(4  ounces of potatoes per ounce of meat). The price need not be exactly in the
middle for both parties to gain, but it must be somewhere between 2 and 4.

To see why the price has to be in this range, consider what would happen if it
were not. If the price of meat were below 2  ounces of potatoes, both the farmer
and the rancher would want to buy meat, because the price would be below their
opportunity costs. Similarly, if the price of meat were above 4 ounces of potatoes,
both would want to sell meat, because the price would be above their opportunity
costs. But there are only two members of this economy. They cannot both be buyers
of meat, nor can they both be sellers. Someone has to take the other side of the deal.

A mutually advantageous trade can be struck at a price between 2 and 4. In this
price range, the rancher wants to sell meat to buy potatoes, and the farmer wants
to sell potatoes to buy meat. Each party can buy a good at a price that is lower
than his or her opportunity cost. In the end, both of them specialize in the good
for which he or she has a comparative advantage and are, as a result, better off.

Quick Quiz Robinson Crusoe can gather 10 coconuts or catch 1 fish per hour. His
friend Friday can gather 30 coconuts or catch 2 fish per hour. What is Crusoe’s oppor-
tunity cost of catching one fish? What is Friday’s? Who has an absolute advantage in
catching fish? Who has a comparative advantage in catching fish?

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57CHAPTER 3 Interdependence and the GaIns from trade

Applications of Comparative Advantage
The principle of comparative advantage explains interdependence and the gains
from trade. Because interdependence is so prevalent in the modern world, the
principle of comparative advantage has many applications. Here are two exam-
ples, one fanciful and one of great practical importance.

Should Tom Brady Mow His Own Lawn?
Tom Brady spends a lot of time running around on grass. One of the most talented
football players of all time, he can throw a pass with a speed and accuracy that
most casual athletes can only dream of. Most likely, he is talented at other physical
activities as well. For example, let’s imagine that Brady can mow his lawn faster than
anyone else. But just because he can mow his lawn fast, does this mean he should?

To answer this question, we can use the concepts of opportunity cost and com-
parative advantage. Let’s say that Brady can mow his lawn in 2  hours. In that

FYI
The Legacy of Adam Smith
and David Ricardo

Economists have long understood the gains from trade. Here is how the great economist Adam Smith put the argument:
It is a maxim of every prudent master of a family, never
to attempt to make at home what it will cost him more
to make than to buy. The tailor does not attempt to make
his own shoes, but buys them of the shoemaker. The
shoe maker does not attempt to make his own clothes but
employs a tailor. The farmer attempts to make neither the
one nor the other, but employs those different artificers.
All of them find it for their interest to employ their whole
industry in a way in which they have some
advantage over their neighbors, and to purchase
with a part of its produce, or what is the same
thing, with the price of part of it, whatever else
they have occasion for.

This quotation is from Smith’s 1776 book An Inquiry
into the Nature and Causes of the Wealth of Nations,
which was a landmark in the analysis of trade and
economic interdependence.
Smith’s book inspired David Ricardo, a millionaire
stockbroker, to become an economist. In his 1817

book Principles of Political Economy and Taxation, Ricardo devel-
oped the principle of comparative advantage as we know it today.
He considered an example with two goods (wine and cloth) and two
countries (England and Portugal). He showed that both countries
can gain by opening up trade and specializing based on comparative
advantage.
Ricardo’s theory is the starting point of modern international
economics, but his defense of free trade was not a mere academic
exercise. Ricardo put his beliefs to work as a member of the British
Parliament, where he opposed the Corn Laws, which restricted the
import of grain.

The conclusions of Adam Smith and David
Ricardo on the gains from trade have held up well
over time. Although economists often disagree on
questions of policy, they are united in their support
of free trade. Moreover, the central argument for
free trade has not changed much in the past two
centuries. Even though the field of economics has
broadened its scope and refined its theories since the
time of Smith and Ricardo, economists’ opposition to
trade restrictions is still based largely on the principle
of comparative advantage.David Ricardo

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58 PART I IntroductIon

same 2 hours, he could film a television commercial and earn $20,000. By contrast,
Forrest Gump, the boy next door, can mow Brady’s lawn in 4 hours. In that same
4 hours, Gump could work at McDonald’s and earn $40.

In this example, Brady has an absolute advantage in mowing lawns because he
can do the work with a lower input of time. Yet because Brady’s opportunity cost
of mowing the lawn is $20,000 and Gump’s opportunity cost is only $40, Gump
has a comparative advantage in mowing lawns.

The gains from trade in this example are tremendous. Rather than mowing his
own lawn, Brady should make the commercial and hire Gump to mow the lawn.
As long as Brady pays Gump more than $40 and less than $20,000, both of them
are better off.

Should the United States Trade
with Other Countries?
Just as individuals can benefit from specialization and trade with one another, as
the farmer and rancher did, so can populations of people in different countries.
Many of the goods that Americans enjoy are produced abroad, and many of the
goods produced in the United States are sold abroad. Goods produced abroad
and sold domestically are called imports. Goods produced domestically and sold
abroad are called exports.

To see how countries can benefit from trade, suppose there are two countries,
the United States and Japan, and two goods, food and cars. Imagine that the two
countries produce cars equally well: An American worker and a Japanese worker
can each produce one car per month. By contrast, because the United States has
more and better land, it is better at producing food: A U.S. worker can produce
2 tons of food per month, whereas a Japanese worker can produce only 1 ton of
food per month.

The principle of comparative advantage states that each good should be
produced by the country that has the smaller opportunity cost of producing
that good. Because the opportunity cost of a car is 2 tons of food in the United
States but only 1 ton of food in Japan, Japan has a comparative advantage in
producing cars. Japan should produce more cars than it wants for its own use
and export some of them to the United States. Similarly, because the opportu-
nity cost of a ton of food is 1 car in Japan but only ½ car in the United States,
the United States has a comparative advantage in producing food. The United
States should produce more food than it wants to consume and export some
to Japan. Through specialization and trade, both countries can have more food
and more cars.

In reality, of course, the issues involved in trade among nations are more com-
plex than this example suggests. Most important among these issues is that each
country has many citizens with different interests. International trade can make
some individuals worse off, even as it makes the country as a whole better off.
When the United States exports food and imports cars, the impact on an American
farmer is not the same as the impact on an American autoworker. Yet, contrary to
the opinions sometimes voiced by politicians and pundits, international trade is
not like war, in which some countries win and others lose. Trade allows all coun-
tries to achieve greater prosperity.

Quick Quiz Suppose that a skilled brain surgeon also happens to be the world’s
fastest typist. Should she do her own typing or hire a secretary? Explain.

imports
goods produced abroad
and sold domestically

exports
goods produced domesti-
cally and sold abroad

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“They did a nice job
mowing this grass.”

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59CHAPTER 3 Interdependence and the GaIns from trade

Conclusion
You should now understand more fully the benefits of living in an interdependent
economy. When Americans buy tube socks from China, when residents of Maine
drink orange juice from Florida, and when a homeowner hires the kid next door

The Changing Face of International Trade
A decade ago, no one would have asked which nation has a comparative
advantage in slaying ogres. But technology is rapidly changing the goods
and services that are traded across national borders.

in the news

Ogre to Slay?
Outsource It to
Chinese
By DaviD BarBoza

Fuzhou, China—One of China’s newest factories operates here in the basement
of an old warehouse. Posters of World
of Warcraft and Magic Land hang above
a corps of young people glued to their
computer screens, pounding away at their
keyboards in the latest hustle for money.
The people working at this clandestine
locale are “gold farmers.” Every day, in
12-hour shifts, they “play” computer games
by killing onscreen monsters and winning
battles, harvesting artificial gold coins and
other virtual goods as rewards that, as it
turns out, can be transformed into real cash.
That is because, from Seoul to San
Francisco, affluent online gamers who lack
the time and patience to work their way up
to the higher levels of gamedom are willing
to pay the young Chinese here to play the
early rounds for them.

“For 12 hours a day, 7 days a week, my
colleagues and I are killing monsters,” said
a 23-year-old gamer who works here in this
makeshift factory and goes by the online
code name Wandering. “I make about $250
a month, which is pretty good compared
with the other jobs I’ve had. And I can play
games all day.”
He and his comrades have created
yet another new business out of cheap
Chinese labor. They are tapping into the
fast-growing world of “massively multi-
player online games,” which involve role
playing and often revolve around fantasy
or warfare in medieval kingdoms or distant
galaxies. . . .

For the Chinese in game-playing facto-
ries like these, though, it is not all fun and
games. These workers have strict quotas
and are supervised by bosses who equip
them with computers, software and Internet
connections to thrash online trolls, gnomes
and ogres.
As they grind through the games, they
accumulate virtual currency that is valu-
able to game players around the world.
The games allow players to trade cur-
rency to other players, who can then use
it to buy better armor, amulets, magic
spells and other accoutrements to climb
to higher levels or create more powerful
characters.
The Internet is now filled with classified
advertisements from small companies—
many of them here in China—auctioning
for real money their powerful figures, called
avatars. . . .
“It’s unimaginable how big this is,”
says Chen Yu, 27, who employs 20 full-time
gamers here in Fuzhou. “They say that in
some of these popular games, 40 or 50
percent of the players are actually Chinese
farmers.”

Source: New York Times, December 9, 2005.

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60 PART I IntroductIon

to mow the lawn, the same economic forces are at work. The principle of compara-
tive advantage shows that trade can make everyone better off.

Having seen why interdependence is desirable, you might naturally ask how it
is possible. How do free societies coordinate the diverse activities of all the people
involved in their economies? What ensures that goods and services will get from
those who should be producing them to those who should be consuming them? In
a world with only two people, such as the rancher and the farmer, the answer is
simple: These two people can bargain and allocate resources between themselves.
In the real world with billions of people, the answer is less obvious. We take up
this issue in the next chapter, where we see that free societies allocate resources
through the market forces of supply and demand.

absolute advantage, p. 54
opportunity cost, p. 54

comparative advantage, p. 55
imports, p. 58

exports, p. 58

• Each person consumes goods and services pro-
duced by many other people both in the United
States and around the world. Interdependence
and trade are desirable because they allow
everyone to enjoy a greater quantity and variety
of goods and services.

• There are two ways to compare the ability of two
people in producing a good. The person who
can produce the good with the smaller quantity
of inputs is said to have an absolute advantage in
producing the good. The person who has the

smaller opportunity cost of producing the good
is said to have a comparative advantage. The gains
from trade are based on comparative advantage,
not absolute advantage.

• Trade makes everyone better off because it
allows people to specialize in those activities in
which they have a comparative advantage.

• The principle of comparative advantage applies
to countries as well as to people. Economists
use the principle of comparative advantage to
advocate free trade among countries.

S u m m a r y

K e y C o n C e p t s

1. Under what conditions is the production possi-
bilities frontier linear rather than bowed out?

2. Explain how absolute advantage and compara-
tive advantage differ.

3. Give an example in which one person has an
absolute advantage in doing something but
another person has a comparative advantage.

4. Is absolute advantage or comparative advan-
tage more important for trade? Explain your

reasoning using the example in your answer to
Question 3.

5. If two parties trade based on comparative
advantage and both gain, in what range must
the price of the trade lie?

6. Will a nation tend to export or import goods for
which it has a comparative advantage? Explain.

7. Why do economists oppose policies that restrict
trade among nations?

Q u e s t i o n s f o r r e v i e w

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61CHAPTER 3 Interdependence and the GaIns from trade

1. Maria can read 20 pages of economics in an
hour. She can also read 50 pages of sociology in
an hour. She spends 5 hours per day studying.
a. Draw Maria’s production possibilities fron-

tier for reading economics and sociology.
b. What is Maria’s opportunity cost of reading

100 pages of sociology?
2. American and Japanese workers can each pro-

duce 4 cars a year. An American worker can
produce 10 tons of grain a year, whereas a
Japanese worker can produce 5 tons of grain a
year. To keep things simple, assume that each
country has 100 million workers.
a. For this situation, construct a table analogous

to the table in Figure 1.
b. Graph the production possibilities frontier of

the American and Japanese economies.
c. For the United States, what is the opportunity

cost of a car? Of grain? For Japan, what is the
opportunity cost of a car? Of grain? Put this
information in a table analogous to Table 1.

d. Which country has an absolute advantage in
producing cars? In producing grain?

e. Which country has a comparative advantage
in producing cars? In producing grain?

f. Without trade, half of each country’s workers
produce cars and half produce grain. What
quantities of cars and grain does each coun-
try produce?

g. Starting from a position without trade, give
an example in which trade makes each coun-
try better off.

3. Pat and Kris are roommates. They spend most
of their time studying (of course), but they leave
some time for their favorite activities: making
pizza and brewing root beer. Pat takes 4 hours
to brew a gallon of root beer and 2 hours to
make a pizza. Kris takes 6 hours to brew a gal-
lon of root beer and 4 hours to make a pizza.
a. What is each roommate’s opportunity cost

of making a pizza? Who has the absolute
advantage in making pizza? Who has the
comparative advantage in making pizza?

b. If Pat and Kris trade foods with each other,
who will trade away pizza in exchange for
root beer?

c. The price of pizza can be expressed in terms
of gallons of root beer. What is the high-
est price at which pizza can be traded that

would make both roommates better off?
What is the lowest price? Explain.

4. Suppose that there are 10 million workers in
Canada and that each of these workers can pro-
duce either 2 cars or 30 bushels of wheat in a year.
a. What is the opportunity cost of producing a

car in Canada? What is the opportunity cost
of producing a bushel of wheat in Canada?
Explain the relationship between the oppor-
tunity costs of the two goods.

b. Draw Canada’s production possibilities fron-
tier. If Canada chooses to consume 10 million
cars, how much wheat can it consume with-
out trade? Label this point on the production
possibilities frontier.

c. Now suppose that the United States offers to
buy 10 million cars from Canada in exchange
for 20 bushels of wheat per car. If Canada
continues to consume 10 million cars, how
much wheat does this deal allow Canada to
consume? Label this point on your diagram.
Should Canada accept the deal?

5. England and Scotland both produce scones and
sweaters. Suppose that an English worker can
produce 50 scones per hour or 1 sweater per
hour. Suppose that a Scottish worker can pro-
duce 40 scones per hour or 2 sweaters per hour.
a. Which country has the absolute advantage in

the production of each good? Which country
has the comparative advantage?

b. If England and Scotland decide to trade,
which commodity will Scotland trade to
England? Explain.

c. If a Scottish worker could produce only 1
sweater per hour, would Scotland still gain
from trade? Would England still gain from
trade? Explain.

6. The following table describes the production pos-
sibilities of two cities in the country of Baseballia:

Pairs of Red Socks Pairs of White Socks
per Worker per Hour per Worker per Hour

Boston 3 3
Chicago 2 1

a. Without trade, what is the price of white
socks (in terms of red socks) in Boston? What
is the price in Chicago?

b. Which city has an absolute advantage in the
production of each color sock? Which city has

P r o b l e m s a n d a P P l i c a t i o n s

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62 PART I IntroductIon

a comparative advantage in the production of
each color sock?

c. If the cities trade with each other, which color
sock will each export?

d. What is the range of prices at which trade can
occur?

7. Suppose that in a year an American worker
can produce 100 shirts or 20 computers, while
a Chinese worker can produce 100 shirts or
10 computers.
a. Graph the production possibilities curve for

the two countries. Suppose that without trade
the workers in each country spend half their
time producing each good. Identify this point
in your graph.

b. If these countries were open to trade, which
country would export shirts? Give a specific
numerical example and show it on your
graph. Which country would benefit from
trade? Explain.

c. Explain at what price of computers (in terms
of shirts) the two countries might trade.

d. Suppose that China catches up with
American productivity so that a Chinese
worker can produce 100 shirts or 20 com-
puters. What pattern of trade would you
predict now? How does this advance
in Chinese productivity affect the eco-
nomic well-being of the citizens of the two
countries?

8. An average worker in Brazil can produce an
ounce of soybeans in 20 minutes and an ounce
of coffee in 60 minutes, while an average worker
in Peru can produce an ounce of soybeans in
50 minutes and an ounce of coffee in 75 minutes.
a. Who has the absolute advantage in coffee?

Explain.
b. Who has the comparative advantage in cof-

fee? Explain.
c. If the two countries specialize and trade

with each other, who will import coffee?
Explain.

d. Assume that the two countries trade and that
the country importing coffee trades 2 ounces
of soybeans for 1 ounce of coffee. Explain why
both countries will benefit from this trade.

9. Are the following statements true or false?
Explain in each case.
a. “Two countries can achieve gains from trade

even if one of the countries has an absolute
advantage in the production of all goods.”

b. “Certain very talented people have a compara-
tive advantage in everything they do.”

c. “If a certain trade is good for one person, it
can’t be good for the other one.”

d. “If a certain trade is good for one person, it is
always good for the other one.”

e. “If trade is good for a country, it must be
good for everyone in the country.”

10. The United States exports corn and aircraft to the
rest of the world, and it imports oil and clothing
from the rest of the world. Do you think this pat-
tern of trade is consistent with the principle of
comparative advantage? Why or why not?

11. Bill and Hillary produce food and clothing. In
an hour, Bill can produce 1 unit of food or 1 unit
of clothing, while Hillary can produce 2 units
of food or 3 units of clothing. They each work
10 hours a day.
a. Who has an absolute advantage in producing

food? Who has an absolute advantage in pro-
ducing clothing? Explain.

b. Who has a comparative advantage in produc-
ing food? Who has a comparative advantage
in producing clothing? Explain.

c. Draw the production possibilities frontier
for the household (that is, Bill and Hillary
together) assuming that each spends the
same number of hours each day as the other
producing food and clothing.

d. Hillary suggests, instead, that she specialize
in making clothing. That is, she will do all the
clothing production for the family; however, if
all her time is devoted to clothing and they still
want more, then Bill can help with clothing
production. What does the household produc-
tion possibilities frontier look like now?

e. Bill suggests that Hillary specialize in produc-
ing food. That is, Hillary will do all the food
production for the family; however, if all her
time is devoted to food and they still want
more, then Bill can help with food production.
What does the household production possi-
bilities frontier look like under Bill’s proposal?

f. Comparing your answers to parts c, d, and e,
which allocation of time makes the most
sense? Relate your answer to the theory of
comparative advantage.

For further information on topics in this chapter,
additional problems, applications, examples, online
quizzes, and more, please visit our website at www
.cengage.com/economics/mankiw.

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How Markets
WorkI IPart

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65

4The Market Forces of Supply and Demand
When a cold snap hits Florida, the price of orange juice rises in supermar-kets throughout the country. When the weather turns warm in New England every summer, the price of hotel rooms in the Caribbean plum-mets. When a war breaks out in the Middle East, the price of gasoline
in the United States rises, and the price of a used Cadillac falls. What do these events
have in common? They all show the workings of supply and demand.

Supply and demand are the two words economists use most often—and for good
reason. Supply and demand are the forces that make market economies work.
They determine the quantity of each good produced and the price at which it is
sold. If you want to know how any event or policy will affect the economy, you
must think first about how it will affect supply and demand.

This chapter introduces the theory of supply and demand. It considers how
buyers and sellers behave and how they interact with one another. It shows how
supply and demand determine prices in a market economy and how prices, in
turn, allocate the economy’s scarce resources.

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66 PART II How Markets work

Markets and Competition
The terms supply and demand refer to the behavior of people as they interact with
one another in competitive markets. Before discussing how buyers and sellers
behave, let’s first consider more fully what we mean by the terms market and
competition.

What Is a Market?
A market is a group of buyers and sellers of a particular good or service. The buy-
ers as a group determine the demand for the product, and the sellers as a group
determine the supply of the product.

Markets take many forms. Some markets are highly organized, such as the
markets for many agricultural commodities. In these markets, buyers and sellers
meet at a specific time and place, where an auctioneer helps set prices and arrange
sales.

More often, markets are less organized. For example, consider the market for
ice cream in a particular town. Buyers of ice cream do not meet together at any
one time. The sellers of ice cream are in different locations and offer somewhat
different products. There is no auctioneer calling out the price of ice cream. Each
seller posts a price for an ice-cream cone, and each buyer decides how much ice
cream to buy at each store. Nonetheless, these consumers and producers of ice
cream are closely connected. The ice-cream buyers are choosing from the various
ice-cream sellers to satisfy their cravings, and the ice-cream sellers are all trying
to appeal to the same ice-cream buyers to make their businesses successful. Even
though it is not as organized, the group of ice-cream buyers and ice-cream sellers
forms a market.

What Is Competition?
The market for ice cream, like most markets in the economy, is highly competitive.
Each buyer knows that there are several sellers from which to choose, and each
seller is aware that his or her product is similar to that offered by other sellers. As a
result, the price of ice cream and the quantity of ice cream sold are not determined
by any single buyer or seller. Rather, price and quantity are determined by all buy-
ers and sellers as they interact in the marketplace.

Economists use the term competitive market to describe a market in which
there are so many buyers and so many sellers that each has a negligible impact
on the market price. Each seller of ice cream has limited control over the price
because other sellers are offering similar products. A seller has little reason
to charge less than the going price, and if he or she charges more, buyers will
make their purchases elsewhere. Similarly, no single buyer of ice cream can
influence the price of ice cream because each buyer purchases only a small
amount.

In this chapter, we assume that markets are perfectly competitive. To reach this
highest form of competition, a market must have two characteristics: (1) the goods
offered for sale are all exactly the same, and (2) the buyers and sellers are so
numerous that no single buyer or seller has any influence over the market price.
Because buyers and sellers in perfectly competitive markets must accept the price
the market determines, they are said to be price takers. At the market price, buyers
can buy all they want, and sellers can sell all they want.

market
a group of buyers and
sellers of a particular
good or service

competitive market
a market in which there
are many buyers and
many sellers so that each
has a negligible impact on
the market price

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67CHAPTER 4 tHe Market Forces oF supply and deMand

There are some markets in which the assumption of perfect competition applies
perfectly. In the wheat market, for example, there are thousands of farmers
who sell wheat and millions of consumers who use wheat and wheat products.
Because no single buyer or seller can influence the price of wheat, each takes the
price as given.

Not all goods and services, however, are sold in perfectly competitive markets.
Some markets have only one seller, and this seller sets the price. Such a seller is
called a monopoly. Your local cable television company, for instance, may be a
monopoly. Residents of your town probably have only one cable company from
which to buy this service. Still other markets fall between the extremes of perfect
competition and monopoly.

Despite the diversity of market types we find in the world, assuming perfect
competition is a useful simplification and, therefore, a natural place to start.
Perfectly competitive markets are the easiest to analyze because everyone par-
ticipating in the market takes the price as given by market conditions. Moreover,
because some degree of competition is present in most markets, many of the les-
sons that we learn by studying supply and demand under perfect competition
apply in more complicated markets as well.

Quick Quiz What is a market? • What are the characteristics of a perfectly competi-
tive market?

Demand
We begin our study of markets by examining the behavior of buyers. To focus our
thinking, let’s keep in mind a particular good—ice cream.

The Demand Curve: The Relationship between
Price and Quantity Demanded
The quantity demanded of any good is the amount of the good that buyers
are willing and able to purchase. As we will see, many things determine the
quantity demanded of any good, but in our analysis of how markets work, one
determinant plays a central role—the price of the good. If the price of ice cream
rose to $20 per scoop, you would buy less ice cream. You might buy frozen
yogurt instead. If the price of ice cream fell to $0.20 per scoop, you would buy
more. This relationship between price and quantity demanded is true for most
goods in the economy and, in fact, is so pervasive that economists call it the
law of demand: Other things equal, when the price of a good rises, the quantity
demanded of the good falls, and when the price falls, the quantity demanded
rises.

The table in Figure 1 shows how many ice-cream cones Catherine buys each
month at different prices of ice cream. If ice cream is free, Catherine eats 12 cones
per month. At $0.50 per cone, Catherine buys 10 cones each month. As the price
rises further, she buys fewer and fewer cones. When the price reaches $3.00,
Catherine doesn’t buy any ice cream at all. This table is a demand schedule, a
table that shows the relationship between the price of a good and the quantity
demanded, holding constant everything else that influences how much of the
good consumers want to buy.

quantity demanded
the amount of a good
that buyers are willing
and able to purchase

law of demand
the claim that, other things
equal, the quantity
demand ed of a good falls
when the price of the
good rises

demand schedule
a table that shows the
relationship between the
price of a good and the
quantity demanded

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

68 PART II How Markets work

The graph in Figure 1 uses the numbers from the table to illustrate the law
of demand. By convention, the price of ice cream is on the vertical axis, and the
quantity of ice cream demanded is on the horizontal axis. The downward-sloping
line relating price and quantity demanded is called the demand curve.

Market Demand versus Individual Demand
The demand curve in Figure 1 shows an individual’s demand for a product. To
analyze how markets work, we need to determine the market demand, the sum of
all the individual demands for a particular good or service.

The table in Figure 2 shows the demand schedules for ice cream of the two
individuals in this market—Catherine and Nicholas. At any price, Catherine’s
demand schedule tells us how much ice cream she buys, and Nicholas’s demand
schedule tells us how much ice cream he buys. The market demand at each price
is the sum of the two individual demands.

The graph in Figure 2 shows the demand curves that correspond to these
demand schedules. Notice that we sum the individual demand curves horizon-
tally to obtain the market demand curve. That is, to find the total quantity
demanded at any price, we add the individual quantities, which are found on
the horizontal axis of the individual demand curves. Because we are interested in
analyzing how markets function, we work most often with the market demand
curve. The market demand curve shows how the total quantity demanded of a

demand curve
a graph of the
relationship between the
price of a good and the
quantity demanded

The demand schedule is a table that shows the quantity demanded at each price.
The demand curve, which graphs the demand schedule, illustrates how the quantity
demanded of the good changes as its price varies. Because a lower price increases the
quantity demanded, the demand curve slopes downward.

Figure 1

Price of
Ice-Cream Cone

Quantity of
Cones Demanded

$0.00 12 cones
0.50 10
1.00 8
1.50 6
2.00 4
2.50 2
3.00 0

Price of
Ice-Cream Cone

0

2.50

2.00

1.50

1.00

0.50

1 2 3 4 5 6 7 8 9 10 11 Quantity of
Ice-Cream Cones

$3.00

12

1. A decrease in
price . . .

2. . . . increases quantity of
cones demanded.

Demand curve

Catherine’s Demand
Schedule and Demand
Curve

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

69CHAPTER 4 tHe Market Forces oF supply and deMand

good varies as the price of the good varies, while all the other factors that affect
how much consumers want to buy are held constant.

Shifts in the Demand Curve
Because the market demand curve holds other things constant, it need not be
stable over time. If something happens to alter the quantity demanded at any
given price, the demand curve shifts. For example, suppose the American Medi-
cal Association discovered that people who regularly eat ice cream live longer,
healthier lives. The discovery would raise the demand for ice cream. At any given
price, buyers would now want to purchase a larger quantity of ice cream, and the
demand curve for ice cream would shift.

Figure 3 illustrates shifts in demand. Any change that increases the quantity
demanded at every price, such as our imaginary discovery by the American Medi-
cal Association, shifts the demand curve to the right and is called an increase in
demand. Any change that reduces the quantity demanded at every price shifts the
demand curve to the left and is called a decrease in demand.

There are many variables that can shift the demand curve. Here are the most
important.

Market Demand as the
Sum of Individual Demands

Figure 2The quantity demanded in a market is the sum of the quantities demanded by all the
buyers at each price. Thus, the market demand curve is found by adding horizontally
the individual demand curves. At a price of $2.00, Catherine demands 4 ice-cream
cones, and Nicholas demands 3 ice-cream cones. The quantity demanded in the
market at this price is 7 cones.

Price of
Ice-Cream

Cone

Price of
Ice-Cream

Cone

Price of
Ice-Cream

Cone
$3.00

2.50

2.00

1.50

1.00

0.50

0 1 2 3 4 5 6
Quantity of Ice-Cream Cones

DCatherine

7 8 9 10 11 12

Catherine’s Demand Nicholas’s Demand Market Demand+ =

$3.00

2.50

2.00

1.50

1.00

0.50

0 1 2 3 4 5 6
Quantity of Ice-Cream Cones

7 8 9 10 11 12

$3.00

2.50

2.00

1.50

1.00

0.50

0 2 4 6
Quantity of Ice-Cream Cones

8 10 12 14 16 18

DNicholas
DMarket

Price of Ice-Cream Cone Catherine Nicholas Market

$0.00 12 + 7 = 19 cones
0.50 10 6 16
1.00 8 5 13
1.50 6 4 10
2.00 4 3 7
2.50 2 2 4
3.00 0 1 1

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70 PART II How Markets work

Income What would happen to your demand for ice cream if you lost your
job one summer? Most likely, it would fall. A lower income means that you have
less to spend in total, so you would have to spend less on some—and probably
most—goods. If the demand for a good falls when income falls, the good is called
a normal good.

Not all goods are normal goods. If the demand for a good rises when income
falls, the good is called an inferior good. An example of an inferior good might be
bus rides. As your income falls, you are less likely to buy a car or take a cab and
more likely to ride a bus.

Prices of Related Goods Suppose that the price of frozen yogurt falls. The
law of demand says that you will buy more frozen yogurt. At the same time,
you will probably buy less ice cream. Because ice cream and frozen yogurt are
both cold, sweet, creamy desserts, they satisfy similar desires. When a fall in the
price of one good reduces the demand for another good, the two goods are called
substitutes. Substitutes are often pairs of goods that are used in place of each
other, such as hot dogs and hamburgers, sweaters and sweatshirts, and movie
tickets and DVD rentals.

Now suppose that the price of hot fudge falls. According to the law of demand,
you will buy more hot fudge. Yet in this case, you will buy more ice cream as
well because ice cream and hot fudge are often used together. When a fall in the
price of one good raises the demand for another good, the two goods are called
complements. Complements are often pairs of goods that are used together, such
as gasoline and automobiles, computers and software, and peanut butter and jelly.

Tastes The most obvious determinant of your demand is your tastes. If you like
ice cream, you buy more of it. Economists normally do not try to explain people’s
tastes because tastes are based on historical and psychological forces that are
beyond the realm of economics. Economists do, however, examine what happens
when tastes change.

normal good
a good for which, other
things equal, an increase
in income leads to an
increase in demand

inferior good
a good for which, other
things equal, an increase
in income leads to a
decrease in demand

substitutes
two goods for which an
increase in the price of
one leads to an increase in
the demand for the other

complements
two goods for which an
increase in the price of
one leads to a decrease in
the demand for the other

Figure 3 Price ofIce-Cream
Cone

Quantity of
Ice-Cream Cones

Increase
in demand

Decrease
in demand

Demand curve, D3

Demand
curve, D1

Demand
curve, D2

0

Shifts in the Demand
Curve
Any change that raises the
quantity that buyers wish to
purchase at any given price
shifts the demand curve to
the right. Any change that
lowers the quantity that
buyers wish to purchase at
any given price shifts the
demand curve to the left.

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71CHAPTER 4 tHe Market Forces oF supply and deMand

Expectations Your expectations about the future may affect your demand for
a good or service today. If you expect to earn a higher income next month, you
may choose to save less now and spend more of your current income buying ice
cream. If you expect the price of ice cream to fall tomorrow, you may be less will-
ing to buy an ice-cream cone at today’s price.

Number of Buyers In addition to the preceding factors, which influence the
behavior of individual buyers, market demand depends on the number of these
buyers. If Peter were to join Catherine and Nicholas as another consumer of ice
cream, the quantity demanded in the market would be higher at every price, and
market demand would increase.

Summary The demand curve shows what happens to the quantity demanded of
a good when its price varies, holding constant all the other variables that influence
buyers. When one of these other variables changes, the demand curve shifts. Table
1 lists the variables that influence how much consumers choose to buy of a good.

If you have trouble remembering whether you need to shift or move along the
demand curve, it helps to recall a lesson from the appendix to Chapter 2. A curve
shifts when there is a change in a relevant variable that is not measured on either
axis. Because the price is on the vertical axis, a change in price represents a move-
ment along the demand curve. By contrast, income, the prices of related goods,
tastes, expectations, and the number of buyers are not measured on either axis, so
a change in one of these variables shifts the demand curve.

Two Ways to Reduce the Quantity
of Smoking Demanded

Public policymakers often want to reduce the amount that people smoke because
of smoking’s adverse health effects. There are two ways that policy can attempt
to achieve this goal.
One way to reduce smoking is to shift the demand curve for cigarettes and other
tobacco products. Public service announcements, mandatory health warnings on
cigarette packages, and the prohibition of cigarette advertising on tele vision are
all policies aimed at reducing the quantity of cigarettes demanded at any given
price. If successful, these policies shift the demand curve for cigarettes to the left,
as in panel (a) of Figure 4.

Variables That Influence Buyers
This table lists the variables that
affect how much consumers choose
to buy of any good. Notice the
special role that the price of the
good plays: A change in the good’s
price represents a movement
along the demand curve, whereas
a change in one of the other
variables shifts the demand curve.

Table 1
Variable A Change in This Variable . . .

Price of the good itself Represents a movement along the demand curve
Income Shifts the demand curve
Prices of related goods Shifts the demand curve
Tastes Shifts the demand curve
Expectations Shifts the demand curve
Number of buyers Shifts the demand curve

What is the best way
to stop this?

©
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es

to
c

k
/a

c
e

st
o

c
k

l
iM

it
ed

/a
la

M
y

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72 PART II How Markets work

Alternatively, policymakers can try to raise the price of cigarettes. If the gov-
ernment taxes the manufacture of cigarettes, for example, cigarette companies
pass much of this tax on to consumers in the form of higher prices. A higher price
encourages smokers to reduce the numbers of cigarettes they smoke. In this case,
the reduced amount of smoking does not represent a shift in the demand curve.
Instead, it represents a movement along the same demand curve to a point with a
higher price and lower quantity, as in panel (b) of Figure 4.
How much does the amount of smoking respond to changes in the price of
cigarettes? Economists have attempted to answer this question by studying what
happens when the tax on cigarettes changes. They have found that a 10 percent
increase in the price causes a 4 percent reduction in the quantity demanded.
Teenagers are found to be especially sensitive to the price of cigarettes: A 10 per-
cent increase in the price causes a 12 percent drop in teenage smoking.
A related question is how the price of cigarettes affects the demand for illicit
drugs, such as marijuana. Opponents of cigarette taxes often argue that tobacco
and marijuana are substitutes so that high cigarette prices encourage marijuana
use. By contrast, many experts on substance abuse view tobacco as a “gateway
drug” leading the young to experiment with other harmful substances. Most stud-
ies of the data are consistent with this latter view: They find that lower cigarette
prices are associated with greater use of marijuana. In other words, tobacco and
marijuana appear to be complements rather than substitutes. ■

Figure 4 If warnings on cigarette packages convince smokers to smoke less, the demand curve
for cigarettes shifts to the left. In panel (a), the demand curve shifts from D

1
to D

2
. At

a price of $2.00 per pack, the quantity demanded falls from 20 to 10 cigarettes per
day, as reflected by the shift from point A to point B. By contrast, if a tax raises the
price of cigarettes, the demand curve does not shift. Instead, we observe a movement
to a different point on the demand curve. In panel (b), when the price rises from $2.00
to $4.00, the quantity demanded falls from 20 to 12 cigarettes per day, as reflected by
the movement from point A to point C.

D2

D1

0 10 20

$2.00
B A

(a) A Shift in the Demand Curve

A policy to discourage
smoking shifts the
demand curve to the left.

Number of Cigarettes Smoked per Day

Price of
Cigarettes,

per Pack

D1

0 12 20

2.00

$4.00 C

A

(b) A Movement along the Demand Curve

Number of Cigarettes Smoked per Day

Price of
Cigarettes,

per Pack

A tax that raises the price
of cigarettes results in a
movement along the
demand curve.

Shifts in the Demand
Curve versus Movements
along the Demand Curve

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73CHAPTER 4 tHe Market Forces oF supply and deMand

Quick Quiz Make up an example of a monthly demand schedule for pizza and
graph the implied demand curve. • Give an example of something that would shift
this demand curve, and briefly explain your reasoning. • Would a change in the price
of pizza shift this demand curve?

Supply
We now turn to the other side of the market and examine the behavior of sellers.
Once again, to focus our thinking, let’s consider the market for ice cream.

The Supply Curve: The Relationship between Price
and Quantity Supplied
The quantity supplied of any good or service is the amount that sellers are
willing and able to sell. There are many determinants of quantity supplied,
but once again, price plays a special role in our analysis. When the price of
ice cream is high, selling ice cream is profitable, and so the quantity supplied
is large. Sellers of ice cream work long hours, buy many ice-cream machines,
and hire many workers. By contrast, when the price of ice cream is low, the
business is less profitable, so sellers produce less ice cream. At a low price,
some sellers may even choose to shut down, and their quantity supplied falls
to zero. This relationship between price and quantity supplied is called the
law of supply: Other things equal, when the price of a good rises, the quantity
supplied of the good also rises, and when the price falls, the quantity supplied
falls as well.

The table in Figure 5 shows the quantity of ice-cream cones supplied each
month by Ben, an ice-cream seller, at various prices of ice cream. At a price below
$1.00, Ben does not supply any ice cream at all. As the price rises, he supplies
a greater and greater quantity. This is the supply schedule, a table that shows
the relationship between the price of a good and the quantity supplied, holding
constant everything else that influences how much producers of the good want
to sell.

The graph in Figure 5 uses the numbers from the table to illustrate the law
of supply. The curve relating price and quantity supplied is called the supply
curve. The supply curve slopes upward because, other things equal, a higher price
means a greater quantity supplied.

Market Supply versus Individual Supply
Just as market demand is the sum of the demands of all buyers, market supply is
the sum of the supplies of all sellers. The table in Figure 6 shows the supply sched-
ules for the two ice-cream producers in the market—Ben and Jerry. At any price,
Ben’s supply schedule tells us the quantity of ice cream Ben supplies, and Jerry’s
supply schedule tells us the quantity of ice cream Jerry supplies. The market sup-
ply is the sum of the two individual supplies.

The graph in Figure 6 shows the supply curves that correspond to the supply
schedules. As with demand curves, we sum the individual supply curves horizon-
tally to obtain the market supply curve. That is, to find the total quantity supplied
at any price, we add the individual quantities, which are found on the horizontal
axis of the individual supply curves. The market supply curve shows how the

quantity supplied
the amount of a good
that sellers are willing and
able to sell

law of supply
the claim that, other things
equal, the quantity supplied
of a good rises when the
price of the good rises

supply schedule
a table that shows the
relationship between the
price of a good and the
quantity supplied

supply curve
a graph of the
relationship between the
price of a good and the
quantity supplied

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74 PART II How Markets work

total quantity supplied varies as the price of the good varies, holding constant
all the other factors beyond price that influence producers’ decisions about how
much to sell.

Shifts in the Supply Curve
Because the market supply curve holds other things constant, the curve shifts
when one of the factors changes. For example, suppose the price of sugar falls.
Sugar is an input into producing ice cream, so the fall in the price of sugar makes
selling ice cream more profitable. This raises the supply of ice cream: At any given
price, sellers are now willing to produce a larger quantity. The supply curve for
ice cream shifts to the right.

Figure 7 illustrates shifts in supply. Any change that raises quantity supplied at
every price, such as a fall in the price of sugar, shifts the supply curve to the right
and is called an increase in supply. Similarly, any change that reduces the quantity
supplied at every price shifts the supply curve to the left and is called a decrease
in supply.

There are many variables that can shift the supply curve. Here are some of the
most important.

Input Prices To produce their output of ice cream, sellers use various inputs:
cream, sugar, flavoring, ice-cream machines, the buildings in which the ice
cream is made, and the labor of workers to mix the ingredients and operate
the machines. When the price of one or more of these inputs rises, producing

Figure 5 The supply schedule is a table that shows the quantity supplied at each price. This
supply curve, which graphs the supply schedule, illustrates how the quantity supplied
of the good changes as its price varies. Because a higher price increases the quantity
supplied, the supply curve slopes upward.

Price of
Ice-Cream

Cone

0

2.50

2.00

1.50

1.00

1 2 3 4 5 6 7 8 9 10 11 Quantity of
Ice-Cream Cones

$3.00

12

0.50

1. An
increase
in price . . .

2. . . . increases quantity of cones supplied.

Supply curve

Ben’s Supply Schedule and
Supply Curve

Price of
Ice-Cream Cone

Quantity of
Cones Supplied

$0.00 0 cones
0.50 0
1.00 1
1.50 2
2.00 3
2.50 4
3.00 5

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75CHAPTER 4 tHe Market Forces oF supply and deMand

Market Supply as the Sum
of Individual Supplies

Figure 6The quantity supplied in a market is the sum of the quantities supplied by all the
sellers at each price. Thus, the market supply curve is found by adding horizontally the
individual supply curves. At a price of $2.00, Ben supplies 3 ice-cream cones, and Jerry
supplies 4 ice-cream cones. The quantity supplied in the market at this price is 7 cones.

$3.00

2.50

2.00

1.50

1.00

0.50

0 1 2 3 4 5 6
Quantity of Ice-Cream Cones

7 8 9 10 11 12

Ben’s Supply Jerry’s Supply Market Supply+ =
Price of

Ice-Cream
Cone

Price of
Ice-Cream

Cone

Price of
Ice-Cream

Cone
$3.00

2.50

2.00

1.50

1.00

0.50

0 1 2 3 4 5 6
Quantity of Ice-Cream Cones

7 8 9 10 11 12

$3.00

2.50

2.00

1.50

1.00

0.50

0 1 2 3 4 5 6
Quantity of Ice-Cream Cones

7 8 9 10 11 12

S Ben S Jerry

S Market

Price of Ice-Cream Cone Ben Jerry Market

$0.00 0 + 0 = 0 cones
0.50 0 0 0
1.00 1 0 1
1.50 2 2 4
2.00 3 4 7
2.50 4 6 10
3.00 5 8 13

Shifts in the Supply Curve
Any change that raises the
quantity that sellers wish to
produce at any given price
shifts the supply curve to
the right. Any change that
lowers the quantity that
sellers wish to produce at
any given price shifts the
supply curve to the left.

Figure 7Price ofIce-Cream
Cone

Quantity of
Ice-Cream Cones

0

Increase
in supply

Decrease
in supply

Supply curve, S3
Supply

curve, S1
Supply

curve, S2

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76 PART II How Markets work

ice cream is less profitable, and firms supply less ice cream. If input prices rise
substantially, a firm might shut down and supply no ice cream at all. Thus, the
supply of a good is negatively related to the price of the inputs used to make
the good.

Technology The technology for turning inputs into ice cream is another
determinant of supply. The invention of the mechanized ice-cream machine, for
example, reduced the amount of labor necessary to make ice cream. By reducing
firms’ costs, the advance in technology raised the supply of ice cream.

Expectations The amount of ice cream a firm supplies today may depend on
its expectations about the future. For example, if a firm expects the price of ice
cream to rise in the future, it will put some of its current production into storage
and supply less to the market today.

Number of Sellers In addition to the preceding factors, which influence the
behavior of individual sellers, market supply depends on the number of these
sellers. If Ben or Jerry were to retire from the ice-cream business, the supply in
the market would fall.

Summary The supply curve shows what happens to the quantity supplied
of a good when its price varies, holding constant all the other variables that
influence sellers. When one of these other variables changes, the supply curve
shifts. Table 2 lists the variables that influence how much producers choose to
sell of a good.

Once again, to remember whether you need to shift or move along the supply
curve, keep in mind that a curve shifts only when there is a change in a relevant
variable that is not named on either axis. The price is on the vertical axis, so a
change in price represents a movement along the supply curve. By contrast,
because input prices, technology, expectations, and the number of sellers are
not measured on either axis, a change in one of these variables shifts the supply
curve.

Quick Quiz Make up an example of a monthly supply schedule for pizza and graph
the implied supply curve. • Give an example of something that would shift this supply
curve, and briefly explain your reasoning. • Would a change in the price of pizza shift
this supply curve?

Variables That Influence Sellers
This table lists the variables that affect how
much producers choose to sell of any good.
Notice the special role that the price of the
good plays: A change in the good’s price
represents a movement along the supply
curve, whereas a change in one of the other
variables shifts the supply curve.

Table 2
Variable A Change in This Variable . . .

Price of the good itself Represents a movement along the supply curve
Input prices Shifts the supply curve
Technology Shifts the supply curve
Expectations Shifts the supply curve
Number of sellers Shifts the supply curve

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77CHAPTER 4 tHe Market Forces oF supply and deMand

Supply and Demand Together
Having analyzed supply and demand separately, we now combine them to see
how they determine the price and quantity of a good sold in a market.

Equilibrium
Figure 8 shows the market supply curve and market demand curve together.
Notice that there is one point at which the supply and demand curves intersect.
This point is called the market’s equilibrium. The price at this intersection is
called the equilibrium price, and the quantity is called the equilibrium quantity.
Here the equilibrium price is $2.00 per cone, and the equilibrium quantity is 7 ice-
cream cones.

The dictionary defines the word equilibrium as a situation in which various
forces are in balance—and this also describes a market’s equilibrium. At the equi-
librium price, the quantity of the good that buyers are willing and able to buy exactly
balances the quantity that sellers are willing and able to sell. The equilibrium price is
sometimes called the market-clearing price because, at this price, everyone in the
market has been satisfied: Buyers have bought all they want to buy, and sellers
have sold all they want to sell.

The actions of buyers and sellers naturally move markets toward the equilib-
rium of supply and demand. To see why, consider what happens when the mar-
ket price is not equal to the equilibrium price.

Suppose first that the market price is above the equilibrium price, as in panel (a)
of Figure 9. At a price of $2.50 per cone, the quantity of the good supplied (10 cones)
exceeds the quantity demanded (4 cones). There is a surplus of the good: Suppliers
are unable to sell all they want at the going price. A surplus is sometimes called a
situation of excess supply. When there is a surplus in the ice-cream market, sellers
of ice cream find their freezers increasingly full of ice cream they would like to sell

equilibrium
a situation in which
the market price has
reached the level at which
quantity supplied equals
quantity demanded

equilibrium price
the price that balances
quantity supplied and
quantity demanded

equilibrium
quantity
the quantity supplied and
the quantity demanded
at the equilibrium price

surplus
a situation in which
quantity supplied is
greater than quantity
demanded

The Equilibrium of Supply
and Demand
The equilibrium is found
where the supply and
demand curves intersect. At
the equilibrium price, the
quantity supplied equals
the quantity demanded.
Here the equilibrium price
is $2.00: At this price, 7 ice-
cream cones are supplied,
and 7 ice-cream cones are
demanded.

Figure 8Price ofIce-Cream
Cone

$2.00

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones

13

Equilibrium
quantity

Equilibrium
price

Equilibrium

Supply

Demand

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78 PART II How Markets work

but cannot. They respond to the surplus by cutting their prices. Falling prices, in
turn, increase the quantity demanded and decrease the quantity supplied. These
changes represent movements along the supply and demand curves, not shifts in
the curves. Prices continue to fall until the market reaches the equilibrium.

Suppose now that the market price is below the equilibrium price, as in panel
(b) of Figure 9. In this case, the price is $1.50 per cone, and the quantity of the
good demanded exceeds the quantity supplied. There is a shortage of the good:
Demanders are unable to buy all they want at the going price. A shortage is some-
times called a situation of excess demand. When a shortage occurs in the ice-cream
market, buyers have to wait in long lines for a chance to buy one of the few cones
available. With too many buyers chasing too few goods, sellers can respond to the
shortage by raising their prices without losing sales. These price increases cause
the quantity demanded to fall and the quantity supplied to rise. Once again, these
changes represent movements along the supply and demand curves, and they
move the market toward the equilibrium.

Thus, regardless of whether the price starts off too high or too low, the activi-
ties of the many buyers and sellers automatically push the market price toward
the equilibrium price. Once the market reaches its equilibrium, all buyers and
sellers are satisfied, and there is no upward or downward pressure on the price.
How quickly equilibrium is reached varies from market to market depending
on how quickly prices adjust. In most free markets, surpluses and shortages are
only temporary because prices eventually move toward their equilibrium levels.

shortage
a situation in which
quantity demanded is
greater than quantity
supplied

Figure 9 In panel (a), there is a surplus. Because the market price of $2.50 is above the
equilibrium price, the quantity supplied (10 cones) exceeds the quantity demanded
(4 cones). Suppliers try to increase sales by cutting the price of a cone, and this moves
the price toward its equilibrium level. In panel (b), there is a shortage. Because the
market price of $1.50 is below the equilibrium price, the quantity demanded (10
cones) exceeds the quantity supplied (4 cones). With too many buyers chasing too few
goods, suppliers can take advantage of the shortage by raising the price. Hence, in
both cases, the price adjustment moves the market toward the equilibrium of supply
and demand.

Price of
Ice-Cream

Cone

Price of
Ice-Cream

Cone

2.00

$2.50

0 4 7 10

Supply

Demand

(a) Excess Supply

Quantity
demanded

Quantity
supplied

Surplus

$2.00

1.50

0 4 7 10Quantity of
Ice-Cream

Cones

Quantity of
Ice-Cream

Cones

Supply

Demand

(b) Excess Demand

Quantity
supplied

Quantity
demanded

Shortage

Markets Not in Equilibrium

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79CHAPTER 4 tHe Market Forces oF supply and deMand

Indeed, this phenomenon is so pervasive that it is called the law of supply and
demand: The price of any good adjusts to bring the quantity supplied and quan-
tity demanded for that good into balance.

Three Steps to Analyzing Changes in Equilibrium
So far, we have seen how supply and demand together determine a market’s equi-
librium, which in turn determines the price and quantity of the good that buyers
purchase and sellers produce. The equilibrium price and quantity depend on the
position of the supply and demand curves. When some event shifts one of these
curves, the equilibrium in the market changes, resulting in a new price and a new
quantity exchanged between buyers and sellers.

When analyzing how some event affects the equilibrium in a market, we proceed
in three steps. First, we decide whether the event shifts the supply curve, the demand
curve, or, in some cases, both curves. Second, we decide whether the curve shifts to
the right or to the left. Third, we use the supply-and-demand diagram to compare
the initial and the new equilibrium, which shows how the shift affects the equilib-
rium price and quantity. Table 3 summarizes these three steps. To see how this recipe
is used, let’s consider various events that might affect the market for ice cream.

Example: A Change in Market Equilibrium Due to a Shift in Demand
Suppose that one summer the weather is very hot. How does this event affect the
market for ice cream? To answer this question, let’s follow our three steps.

1. The hot weather affects the demand curve by changing people’s taste for
ice cream. That is, the weather changes the amount of ice cream that people
want to buy at any given price. The supply curve is unchanged because the
weather does not directly affect the firms that sell ice cream.

2. Because hot weather makes people want to eat more ice cream, the demand
curve shifts to the right. Figure 10 shows this increase in demand as the shift
in the demand curve from D

1
to D

2
. This shift indicates that the quantity of

ice cream demanded is higher at every price.
3. At the old price of $2, there is now an excess demand for ice cream, and this

shortage induces firms to raise the price. As Figure 10 shows, the increase in
demand raises the equilibrium price from $2.00 to $2.50 and the equilibrium
quantity from 7 to 10 cones. In other words, the hot weather increases the
price of ice cream and the quantity of ice cream sold.

Shifts in Curves versus Movements along Curves Notice that when hot
weather increases the demand for ice cream and drives up the price, the quantity
of ice cream that firms supply rises, even though the supply curve remains the

law of supply and
demand
the claim that the price of
any good adjusts to bring
the quantity supplied and
the quantity demanded
for that good into balance

Three Steps for
Analyzing Changes in
Equilibrium

Table 3

1. Decide whether the event
shifts the supply or demand
curve (or perhaps both).

2. Decide in which direction
the curve shifts.

3. Use the supply-and-demand
diagram to see how the
shift changes the equilib-
rium price and quantity.

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Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

80 PART II How Markets work

same. In this case, economists say there has been an increase in “quantity sup-
plied” but no change in “supply.”

Supply refers to the position of the supply curve, whereas the quantity supplied
refers to the amount suppliers wish to sell. In this example, supply does not change
because the weather does not alter firms’ desire to sell at any given price. Instead,
the hot weather alters consumers’ desire to buy at any given price and thereby
shifts the demand curve to the right. The increase in demand causes the equilib-
rium price to rise. When the price rises, the quantity supplied rises. This increase in
quantity supplied is represented by the movement along the supply curve.

To summarize, a shift in the supply curve is called a “change in supply,” and
a shift in the demand curve is called a “change in demand.” A movement along a
fixed supply curve is called a “change in the quantity supplied,” and a movement
along a fixed demand curve is called a “change in the quantity demanded.”

Example: A Change in Market Equilibrium Due to a Shift in Supply
Suppose that during another summer, a hurricane destroys part of the sugarcane
crop and drives up the price of sugar. How does this event affect the market for
ice cream? Once again, to answer this question, we follow our three steps.

1. The change in the price of sugar, an input for making ice cream, affects the
supply curve. By raising the costs of production, it reduces the amount of
ice cream that firms produce and sell at any given price. The demand curve
does not change because the higher cost of inputs does not directly affect the
amount of ice cream households wish to buy.

2. The supply curve shifts to the left because, at every price, the total amount
that firms are willing and able to sell is reduced. Figure 11 illustrates this
decrease in supply as a shift in the supply curve from S

1
to S

2
.

Figure 10 Price ofIce-Cream
Cone

2.00

$2.50

0 7 10 Quantity of
Ice-Cream Cones

Supply

New equilibrium

Initial
equilibrium

D1

D2

3. . . . and a higher
quantity sold.

2. . . . resulting
in a higher
price . . .

1. Hot weather increases the
demand for ice cream . . .How an Increase in

Demand Affects the
Equilibrium
An event that raises quantity
demanded at any given price
shifts the demand curve to the
right. The equilibrium price
and the equilibrium quantity
both rise. Here an abnormally
hot summer causes buyers
to demand more ice cream.
The demand curve shifts
from D

1
to D

2
, which causes

the equilibrium price to rise
from $2.00 to $2.50 and the
equilibrium quantity to rise
from 7 to 10 cones.

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81CHAPTER 4 tHe Market Forces oF supply and deMand

3. At the old price of $2, there is now an excess demand for ice cream, and
this shortage causes firms to raise the price. As Figure 11 shows, the shift in
the supply curve raises the equilibrium price from $2.00 to $2.50 and low-
ers the equilibrium quantity from 7 to 4 cones. As a result of the sugar price
increase, the price of ice cream rises, and the quantity of ice cream sold falls.

Example: Shifts in Both Supply and Demand Now suppose that a heat
wave and a hurricane occur during the same summer. To analyze this combina-
tion of events, we again follow our three steps.

1. We determine that both curves must shift. The hot weather affects the
demand curve because it alters the amount of ice cream that households
want to buy at any given price. At the same time, when the hurricane drives
up sugar prices, it alters the supply curve for ice cream because it changes
the amount of ice cream that firms want to sell at any given price.

2. The curves shift in the same directions as they did in our previous analysis:
The demand curve shifts to the right, and the supply curve shifts to the left.
Figure 12 illustrates these shifts.

3. As Figure 12 shows, two possible outcomes might result depending on the
relative size of the demand and supply shifts. In both cases, the equilibrium
price rises. In panel (a), where demand increases substantially while supply
falls just a little, the equilibrium quantity also rises. By contrast, in panel (b),
where supply falls substantially while demand rises just a little, the equilib-
rium quantity falls. Thus, these events certainly raise the price of ice cream,
but their impact on the amount of ice cream sold is ambiguous (that is, it
could go either way).

How a Decrease in Supply
Affects the Equilibrium
An event that reduces quantity
supplied at any given price shifts
the supply curve to the left. The
equilibrium price rises, and the
equilibrium quantity falls. Here an
increase in the price of sugar (an
input) causes sellers to supply less
ice cream. The supply curve shifts
from S

1
to S

2
, which causes the

equilibrium price of ice cream to
rise from $2.00 to $2.50 and the
equilibrium quantity to fall from
7 to 4 cones.

Figure 11Price ofIce-Cream
Cone

2.00

$2.50

0 4 7 Quantity of
Ice-Cream Cones

Demand

New
equilibrium

Initial equilibrium

S1

S2

2. . . . resulting
in a higher
price of ice
cream . . .

1. An increase in the price of
sugar reduces the supply of
ice cream. . .

3. . . . and a lower
quantity sold.

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82 PART II How Markets work

What’s Wrong with
Price Gouging?
By Jeff JacoBy

There wasn’t much [Attorney General] Martha Coakley could do about the massive
pipe break that left dozens of Greater Boston
towns without clean drinking water over the
weekend. So she kept herself busy instead
lecturing vendors not to increase the price of
the bottled water that tens of thousands of
consumers were suddenly in a frenzy to buy.
“We have begun hearing anecdotal
reports of the possible price gouging of

store-bought water,’’ Coakley announced
Sunday. “Businesses and individuals can-
not and should not take advantage of
this public emergency to unfairly charge
consumers  .  .  .  for water.’’ Inspectors were
being dispatched, “spot-checks’’ were being
conducted, and “if we discover that businesses
are engaging in price gouging,’’ she warned,
“we will take appropriate legal action.’’
Governor Deval Patrick got into the
act, too. He ordered the state’s Division of
Standards to “closely monitor bottled water
prices’’ in the area affected by the water
emergency. “There is never an excuse for
taking advantage of consumers,’’ he intoned,
“especially not during times like this.’’

It never fails. No sooner does some
calamity trigger an urgent need for basic
resources than self-righteous voices are
raised to denounce the amazingly efficient
system that stimulates suppliers to speed
those resources to the people who need
them. That system is the free market’s
price mechanism—the fluctuation of prices
because of changes in supply and demand.
When the demand for bottled water goes
through the roof—which is another way of
saying that bottled water has become (rela-
tively) scarce—the price of water quickly rises
in response. That price spike may be annoying,
but it’s not nearly as annoying as being
unable to find water for sale at any price.

Price Increases after Disasters
For several days in 2010, many towns around Boston found themselves
without drinkable tap water. This increased the demand for bottled
water, putting upward pressure on the price. While some policymakers
cried foul, this opinion piece endorses the market’s natural response.

in the news

Figure 12 Here we observe a simultaneous increase in demand and decrease in supply. Two
outcomes are possible. In panel (a), the equilibrium price rises from P

1
to P

2
, and the

equilibrium quantity rises from Q
1
to Q

2
. In panel (b), the equilibrium price again rises

from P
1
to P

2
, but the equilibrium quantity falls from Q

1
to Q

2
.

(b) Price Rises, Quantity Falls

0

New
equilibrium

Initial
equilibrium

(a) Price Rises, Quantity Rises

Quantity of
Ice-Cream Cones

Quantity of
Ice-Cream Cones

0

New
equilibrium

Initial equilibrium

S1

S1

D1
D1

D2
D2

S2

S2

Q1 Q2Q2 Q1

P2

P1

P2

P1

Large
increase in
demand

Small
decrease
in supply

Small
increase in
demand

Large
decrease
in supply

Price of
Ice-Cream

Cone

Price of
Ice-Cream

Cone

A Shift in Both Supply
and Demand

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83CHAPTER 4 tHe Market Forces oF supply and deMand

Summary We have just seen three examples of how to use supply and demand
curves to analyze a change in equilibrium. Whenever an event shifts the supply
curve, the demand curve, or perhaps both curves, you can use these tools to pre-
dict how the event will alter the price and quantity sold in equilibrium. Table  4
shows the predicted outcome for any combination of shifts in the two curves. To
make sure you understand how to use the tools of supply and demand, pick a

What Happens to Price and Quantity When
Supply or Demand Shifts?
As a quick quiz, make sure you can explain at
least a few of the entries in this table using a
supply-and-demand diagram.

Table 4
No Change
in Supply

An Increase
in Supply

A Decrease
in Supply

No Change P same P down P up
in Demand Q same Q up Q down

An Increase P up P ambiguous P up
in Demand Q up Q up Q ambiguous

A Decrease P down P down P ambiguous
in Demand Q down Q ambiguous Q down

Source: The Boston Globe, May 4, 2010.

Rising prices help keep limited quantities
from vanishing today, while increasing the
odds of fresh supplies arriving tomorrow.
It is easy to demonize vendors who
charge what the market will bear follow-
ing a catastrophe. “After storm come the
vultures’’ USA Today memorably head-
lined a story about the price hikes that fol-
lowed Hurricane Charley in Florida in 2004.
Coakley hasn’t called anybody a vulture, at
least not yet, but her office has dedicated
a telephone hotline and is encouraging the
public to drop a dime on “price gougers.’’
Before you drop that dime, though, con-
sider who really serves the public interest—
the merchant who boosts his price during a
crisis, or the merchant who refuses to?
A thought experiment: A massive pipe
ruptures, tap water grows undrinkable, and
consumers rush to buy bottled water from
the only two vendors who sell it. Vendor
A, not wanting to annoy the governor
and attorney general, leaves the price of
his water unchanged at 69 cents a bottle.
Vendor B, who is more interested in doing
business than truckling to politicians, more
than quadruples his price to $2.99.

You don’t need an economics textbook
to know what happens next.
Customers descend on Vendor A in
droves, loading up on his 69-cent water.
Within hours his entire stock has been
cleaned out, and subsequent customers are
turned away empty-handed. At Vendor B’s,
on the other hand, sales of water are slower
and there is a lot of grumbling about the
high price. But even late-arriving customers
are able to buy the water they need—and
almost no one buys more than he truly
needs.

When demand intensifies, prices rise. And
as prices rise, suppliers work harder to meet
demand. The same Globe story that reported
yesterday on Coakley’s “price-gouging’’ state-
ment reported as well on the lengths to which
bottlers and retailers were going to get more
water into customers’ hands.
“Suppliers worked overtime, pumping
up production at regional bottling facili-
ties and coordinating deliveries,’’ reporter
Erin Ailworth noted. Polar Beverages in
Worcester, for example, “had emptied out
its plant in the city last night and trucked
in loads of water from its New York
facility.’’
Letting prices rise freely isn’t the only
possible response to a sudden shortage.
Government rationing is an option, and
so are price controls—assuming you don’t
object to the inevitable corruption, long
lines, and black market. Better by far to let
prices rise and fall freely. That isn’t “goug-
ing,’’ but plain good sense—and the best
method yet devised for allocating goods and
services among free men and women.

©
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A scarce resource.

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

84 PART II How Markets work

few entries in this table and make sure you can explain to yourself why the table
contains the prediction it does.

Quick Quiz On the appropriate diagram, show what happens to the market for
pizza if the price of tomatoes rises. • On a separate diagram, show what happens to
the market for pizza if the price of hamburgers falls.

Conclusion: How Prices Allocate Resources
This chapter has analyzed supply and demand in a single market. Although our
discussion has centered on the market for ice cream, the lessons learned here
apply in most other markets as well. Whenever you go to a store to buy some-
thing, you are contributing to the demand for that item. Whenever you look for
a job, you are contributing to the supply of labor services. Because supply and
demand are such pervasive economic phenomena, the model of supply and
demand is a powerful tool for analysis. We will be using this model repeatedly
in the following chapters.

One of the Ten Principles of Economics discussed in Chapter 1 is that markets are
usually a good way to organize economic activity. Although it is still too early to
judge whether market outcomes are good or bad, in this chapter we have begun
to see how markets work. In any economic system, scarce resources have to be
allocated among competing uses. Market economies harness the forces of supply
and demand to serve that end. Supply and demand together determine the prices
of the economy’s many different goods and services; prices in turn are the signals
that guide the allocation of resources.

For example, consider the allocation of beachfront land. Because the amount of
this land is limited, not everyone can enjoy the luxury of living by the beach. Who
gets this resource? The answer is whoever is willing and able to pay the price. The
price of beachfront land adjusts until the quantity of land demanded exactly bal-
ances the quantity supplied. Thus, in market economies, prices are the mechanism
for rationing scarce resources.

Similarly, prices determine who produces each good and how much is pro-
duced. For instance, consider farming. Because we need food to survive, it is
crucial that some people work on farms. What determines who is a farmer and
who is not? In a free society, there is no government planning agency making
this decision and ensuring an adequate supply of food. Instead, the allocation
of workers to farms is based on the job decisions of millions of workers. This
decentralized system works well because these decisions depend on prices. The
prices of food and the wages of farmworkers (the price of their labor) adjust to
ensure that enough people choose to be farmers.

If a person had never seen a market economy in action, the whole idea might
seem preposterous. Economies are enormous groups of people engaged in a
multitude of interdependent activities. What prevents decentralized decision
making from degenerating into chaos? What coordinates the actions of the mil-
lions of people with their varying abilities and desires? What ensures that what
needs to be done is in fact done? The answer, in a word, is prices. If an invisible
hand guides market economies, as Adam Smith famously suggested, then the
price system is the baton that the invisible hand uses to conduct the economic
orchestra. ©

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“Two dollars”

“—and seventy-five
cents.”

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

http://www.cartoonbank.com

http://www.cartoonbank.com

http://www.cartoonbank.com

85CHAPTER 4 tHe Market Forces oF supply and deMand

• Economists use the model of supply and demand
to analyze competitive markets. In a competitive
market, there are many buyers and sellers, each
of whom has little or no influence on the market
price.

• The demand curve shows how the quantity of a
good demanded depends on the price. According
to the law of demand, as the price of a good falls,
the quantity demanded rises. Therefore, the
demand curve slopes downward.

• In addition to price, other determinants of how
much consumers want to buy include income,
the prices of substitutes and complements,
tastes, expectations, and the number of buy-
ers. If one of these factors changes, the demand
curve shifts.

• The supply curve shows how the quantity of a
good supplied depends on the price. According
to the law of supply, as the price of a good rises,
the quantity supplied rises. Therefore, the supply
curve slopes upward.

• In addition to price, other determinants of how
much producers want to sell include input prices,
technology, expectations, and the number of sell-
ers. If one of these factors changes, the supply
curve shifts.

• The intersection of the supply and demand
curves determines the market equilibrium. At
the equilibrium price, the quantity demanded
equals the quantity supplied.

• The behavior of buyers and sellers naturally
drives markets toward their equilibrium. When
the market price is above the equilibrium price,
there is a surplus of the good, which causes the
market price to fall. When the market price is
below the equilibrium price, there is a shortage,
which causes the market price to rise.

• To analyze how any event influences a mar-
ket, we use the supply-and-demand diagram to
examine how the event affects the equilibrium
price and quantity. To do this, we follow three
steps. First, we decide whether the event shifts
the supply curve or the demand curve (or both).
Second, we decide in which direction the curve
shifts. Third, we compare the new equilibrium
with the initial equilibrium.

• In market economies, prices are the signals that
guide economic decisions and thereby allocate
scarce resources. For every good in the economy,
the price ensures that supply and demand are in
balance. The equilibrium price then determines
how much of the good buyers choose to consume
and how much sellers choose to produce.

S u m m a r y

K e y C o n C e p t s

Q u e s t i o n s f o r r e v i e w

market, p. 66
competitive market, p. 66
quantity demanded, p. 67
law of demand, p. 67
demand schedule, p. 67
demand curve, p. 68
normal good, p. 70

inferior good, p. 70
substitutes, p. 70
complements, p. 70
quantity supplied, p. 73
law of supply, p. 73
supply schedule, p. 73
supply curve, p. 73

equilibrium, p. 77
equilibrium price, p. 77
equilibrium quantity, p. 77
surplus, p. 77
shortage, p. 78
law of supply and
demand, p. 79

1. What is a competitive market? Briefly
describe a type of market that is not perfectly
competitive.

2. What are the demand schedule and the demand
curve, and how are they related? Why does the
demand curve slope downward?

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86 PART II How Markets work

3. Does a change in consumers’ tastes lead to a
movement along the demand curve or a shift in
the demand curve? Does a change in price lead
to a movement along the demand curve or a
shift in the demand curve?

4. Popeye’s income declines, and as a result, he
buys more spinach. Is spinach an inferior or
a normal good? What happens to Popeye’s
demand curve for spinach?

5. What are the supply schedule and the supply
curve, and how are they related? Why does the
supply curve slope upward?

6. Does a change in producers’ technology lead to
a movement along the supply curve or a shift in

the supply curve? Does a change in price lead to
a movement along the supply curve or a shift in
the supply curve?

7. Define the equilibrium of a market. Describe
the forces that move a market toward its
equilibrium.

8. Beer and pizza are complements because they
are often enjoyed together. When the price of
beer rises, what happens to the supply, demand,
quantity supplied, quantity demanded, and the
price in the market for pizza?

9. Describe the role of prices in market economies.

P R o B l E M S A N D A P P l I C A T I o N S

1. Explain each of the following statements using
supply-and-demand diagrams.
a. “When a cold snap hits Florida, the price of

orange juice rises in supermarkets through-
out the country.”

b. “When the weather turns warm in New
England every summer, the price of hotel
rooms in Caribbean resorts plummets.”

c. “When a war breaks out in the Middle East,
the price of gasoline rises, and the price of a
used Cadillac falls.”

2. “An increase in the demand for notebooks
raises the quantity of notebooks demanded but
not the quantity supplied.” Is this statement
true or false? Explain.

3. Consider the market for minivans. For each
of the events listed here, identify which of the
determinants of demand or supply are affected.
Also indicate whether demand or supply
increases or decreases. Then draw a diagram
to show the effect on the price and quantity of
minivans.
a. People decide to have more children.
b. A strike by steelworkers raises steel prices.
c. Engineers develop new automated machin-

ery for the production of minivans.
d. The price of sports utility vehicles rises.
e. A stock-market crash lowers people’s wealth.

4. Consider the markets for DVDs, TV screens,
and tickets at movie theaters.
a. For each pair, identify whether they are

complements or substitutes:

• DVDs and TV screens
• DVDs and movie tickets
• TV screens and movie tickets

b. Suppose a technological advance reduces the
cost of manufacturing TV screens. Draw a
diagram to show what happens in the market
for TV screens.

c. Draw two more diagrams to show how the
change in the market for TV screens affects
the markets for DVDs and movie tickets.

5. Over the past 30 years, technological advances
have reduced the cost of computer chips. How
do you think this has affected the market
for computers? For computer software? For
typewriters?

6. Using supply-and-demand diagrams, show the
effect of the following events on the market for
sweatshirts.
a. A hurricane in South Carolina damages the

cotton crop.
b. The price of leather jackets falls.
c. All colleges require morning exercise in

appropriate attire.
d. New knitting machines are invented.

7. A survey shows an increase in drug use by
young people. In the ensuing debate, two
hypotheses are proposed:
• Reduced police efforts have increased the

availability of drugs on the street.
• Cutbacks in education efforts have

decreased awareness of the dangers of drug
addiction.

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87CHAPTER 4 tHe Market Forces oF supply and deMand

a Use supply-and-demand diagrams to show
how each of these hypotheses could lead to
an increase in quantity of drugs consumed.

b How could information on what has hap-
pened to the price of drugs help us to distin-
guish between these explanations?

8. Suppose that in the year 2015 the number of
births is temporarily high. How does this baby
boom affect the price of babysitting services in
2020 and 2030? (Hint: 5-year-olds need baby-
sitters, whereas 15-year-olds can be babysitters.)

9. Ketchup is a complement (as well as a condi-
ment) for hot dogs. If the price of hot dogs rises,
what happens to the market for ketchup? For
tomatoes? For tomato juice? For orange juice?

10. The market for pizza has the following demand
and supply schedules:

Price Quantity Demanded Quantity Supplied

$4 135 pizzas 26 pizzas
5 104 53
6 81 81
7 68 98
8 53 110
9 39 121

a. Graph the demand and supply curves. What
is the equilibrium price and quantity in this
market?

b. If the actual price in this market were above
the equilibrium price, what would drive the
market toward the equilibrium?

c. If the actual price in this market were below
the equilibrium price, what would drive the
market toward the equilibrium?

11. Consider the following events: Scientists reveal
that consumption of oranges decreases the risk
of diabetes, and at the same time, farmers use
a new fertilizer that makes orange trees more
productive. Illustrate and explain what effect
these changes have on the equilibrium price and
quantity of oranges.

12. Because bagels and cream cheese are often eaten
together, they are complements.
a. We observe that both the equilibrium price of

cream cheese and the equilibrium quantity of
bagels have risen. What could be responsible
for this pattern—a fall in the price of flour
or a fall in the price of milk? Illustrate and
explain your answer.

b. Suppose instead that the equilibrium
price of cream cheese has risen but the

equilibrium quantity of bagels has fallen.
What could be responsible for this pattern—
a rise in the price of flour or a rise in the
price of milk? Illustrate and explain your
answer.

13. Suppose that the price of basketball tickets at
your college is determined by market forces.
Currently, the demand and supply schedules
are as follows:

Price Quantity Demanded Quantity Supplied

$ 4 10,000 tickets 8,000 tickets
8 8,000 8,000

12 6,000 8,000
16 4,000 8,000
20 2,000 8,000

a. Draw the demand and supply curves. What
is unusual about this supply curve? Why
might this be true?

b. What are the equilibrium price and quantity
of tickets?

c. Your college plans to increase total enroll-
ment next year by 5,000 students. The
additional students will have the following
demand schedule:

Price Quantity Demanded

$ 4 4,000 tickets
8 3,000

12 2,000
16 1,000
20 0

Now add the old demand schedule and the
demand schedule for the new students to
calculate the new demand schedule for the
entire college. What will be the new equilib-
rium price and quantity?

14. Market research has revealed the following
information about the market for chocolate bars:
The demand schedule can be represented by
the equation QD = 1,600 – 300P, where QD is the
quantity demanded and P is the price. The sup-
ply schedule can be represented by the equation
QS = 1,400 + 700P, where QS is the quantity sup-
plied. Calculate the equilibrium price and quan-
tity in the market for chocolate bars.

For further information on topics in this chapter,
additional problems, applications, examples, online
quizzes, and more, please visit our website at www
.cengage.com/economics/mankiw.

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

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89

5Elasticity and Its Application
Imagine that some event drives up the price of gasoline in the United States. It could be a war in the Middle East that disrupts the world supply of oil, a booming Chinese economy that boosts the world demand for oil, or a new tax on gasoline passed by Congress. How would U.S. consumers respond to
the higher price?

It is easy to answer this question in broad fashion: Consumers would buy less.
That is simply the law of demand we learned in the previous chapter But you
might want a precise answer. By how much would consumption of gasoline fall?
This question can be answered using a concept called elasticity, which we develop
in this chapter.

Elasticity is a measure of how much buyers and sellers respond to changes in
market conditions. When studying how some event or policy affects a market,
we can discuss not only the direction of the effects but their magnitude as well.
Elasticity is useful in many applications, as we see toward the end of this chapter.

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90 PART II HOW MARKETS WORK

Before proceeding, however, you might be curious about the answer to the
gasoline question. Many studies have examined consumers’ response to gasoline
prices, and they typically find that the quantity demanded responds more in the
long run than it does in the short run. A 10 percent increase in gasoline prices
reduces gasoline consumption by about 2.5 percent after a year and about 6 percent
after five years. About half of the long-run reduction in quantity demanded arises
because people drive less and half arises because they switch to more fuel-efficient
cars. Both responses are reflected in the demand curve and its elasticity.

The Elasticity of Demand
When we introduced demand in Chapter 4, we noted that consumers usually buy
more of a good when its price is lower, when their incomes are higher, when the
prices of substitutes for the good are higher, or when the prices of complements of
the good are lower. Our discussion of demand was qualitative, not quantitative.
That is, we discussed the direction in which quantity demanded moves but not the
size of the change. To measure how much consumers respond to changes in these
variables, economists use the concept of elasticity.

The Price Elasticity of Demand and Its Determinants
The law of demand states that a fall in the price of a good raises the quantity
demanded. The price elasticity of demand measures how much the quantity
demanded responds to a change in price. Demand for a good is said to be elastic if the
quantity demanded responds substantially to changes in the price. Demand is said to
be inelastic if the quantity demanded responds only slightly to changes in the price.

The price elasticity of demand for any good measures how willing consumers
are to buy less of the good as its price rises. Because the demand curve reflects
the many economic, social, and psychological forces that shape consumer prefer-
ences, there is no simple, universal rule for what determines the demand curve’s
elasticity. Based on experience, however, we can state some rules-of-thumb about
what influences the price elasticity of demand.

Availability of Close Substitutes Goods with close substitutes tend to have
more elastic demand because it is easier for consumers to switch from that good to
others. For example, butter and margarine are easily substitutable. A small increase
in the price of butter, assuming the price of margarine is held fixed, causes the quan-
tity of butter sold to fall by a large amount. By contrast, because eggs are a food with-
out a close substitute, the demand for eggs is less elastic than the demand for butter.

Necessities versus Luxuries Necessities tend to have inelastic demands, whereas
luxuries have elastic demands. When the price of a doctor’s visit rises, people will not
dramatically reduce the number of times they go to the doctor, although they might
go somewhat less often. By contrast, when the price of sailboats rises, the quantity
of sailboats demanded falls substantially. The reason is that most people view doc-
tor visits as a necessity and sailboats as a luxury. Whether a good is a necessity or a
luxury depends not on the intrinsic properties of the good but on the preferences of
the buyer. For avid sailors with little concern over their health, sailboats might be a
necessity with inelastic demand and doctor visits a luxury with elastic demand.

Definition of the Market The elasticity of demand in any market depends on
how we draw the boundaries of the market. Narrowly defined markets tend to have
more elastic demand than broadly defined markets because it is easier to find close

elasticity
a measure of the respon-
siveness of quantity
demanded or quantity
supplied to a change in
one of its determinants

price elasticity of
demand
a measure of how much
the quantity demanded
of a good responds to
a change in the price of
that good, computed as
the percentage change
in quantity demanded
divided by the percentage
change in price

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

91CHAPTER 5 ElASTiciTy And iTS ApplicATiOn

substitutes for narrowly defined goods. For example, food, a broad category, has a
fairly inelastic demand because there are no good substitutes for food. Ice cream, a
narrower category, has a more elastic demand because it is easy to substitute other
desserts for ice cream. Vanilla ice cream, a very narrow category, has a very elastic
demand because other flavors of ice cream are almost perfect substitutes for vanilla.

Time Horizon Goods tend to have more elastic demand over longer time hori-
zons. When the price of gasoline rises, the quantity of gasoline demanded falls only
slightly in the first few months. Over time, however, people buy more fuel-efficient
cars, switch to public transportation, and move closer to where they work. Within
several years, the quantity of gasoline demanded falls more substantially.

Computing the Price Elasticity of Demand
Now that we have discussed the price elasticity of demand in general terms, let’s
be more precise about how it is measured. Economists compute the price elas-
ticity of demand as the percentage change in the quantity demanded divided by
the percentage change in the price. That is,

Price elasticity of demand 5
Percentage change in quantity demanded

.
Percentage change in price

For example, suppose that a 10 percent increase in the price of an ice-cream cone
causes the amount of ice cream you buy to fall by 20 percent. We calculate your
elasticity of demand as

Price elasticity of demand 5 20 percent 5 2.
10 percent

In this example, the elasticity is 2, reflecting that the change in the quantity
demanded is proportionately twice as large as the change in the price.

Because the quantity demanded of a good is negatively related to its price, the
percentage change in quantity will always have the opposite sign as the percent-
age change in price. In this example, the percentage change in price is a positive 10
percent (reflecting an increase), and the percentage change in quantity demanded
is a negative 20 percent (reflecting a decrease). For this reason, price elasticities of
demand are sometimes reported as negative numbers. In this book, we follow the
common practice of dropping the minus sign and reporting all price elasticities of
demand as positive numbers. (Mathematicians call this the absolute value.) With
this convention, a larger price elasticity implies a greater responsiveness of quan-
tity demanded to changes in price.

The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities
If you try calculating the price elasticity of demand between two points on a
demand curve, you will quickly notice an annoying problem: The elasticity from
point A to point B seems different from the elasticity from point B to point A. For
example, consider these numbers:

Point A: Price 5 $4 Quantity 5 120
Point B: Price 5 $6 Quantity 5 80

Going from point A to point B, the price rises by 50 percent, and the quantity falls by
33 percent, indicating that the price elasticity of demand is 33/50, or 0.66. By contrast,
going from point B to point A, the price falls by 33 percent, and the quantity rises

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

92 PART II HOW MARKETS WORK

by 50 percent, indicating that the price elasticity of demand is 50/33, or 1.5. This dif-
ference arises because the percentage changes are calculated from a different base.

One way to avoid this problem is to use the midpoint method for calculating
elasticities. The standard procedure for computing a percentage change is to
divide the change by the initial level. By contrast, the midpoint method computes
a percentage change by dividing the change by the midpoint (or average) of the
initial and final levels. For instance, $5 is the midpoint between $4 and $6. There-
fore, according to the midpoint method, a change from $4 to $6 is considered a
40 percent rise because (6 2 4) / 5 3 100 5 40. Similarly, a change from $6 to $4
is considered a 40 percent fall.

Because the midpoint method gives the same answer regardless of the direc-
tion of change, it is often used when calculating the price elasticity of demand
between two points. In our example, the midpoint between point A and point B is:

Midpoint: Price = $5 Quantity = 100

According to the midpoint method, when going from point A to point B, the price
rises by 40 percent, and the quantity falls by 40 percent. Similarly, when going
from point B to point A, the price falls by 40 percent, and the quantity rises by 40
percent. In both directions, the price elasticity of demand equals 1.

The following formula expresses the midpoint method for calculating the price
elasticity of demand between two points, denoted (Q

1
, P

1
) and (Q

2
, P

2
):

Price elasticity of demand 5
(Q

2
2 Q

1
) / [(Q

2
1 Q

1
) / 2]

.
(P

2
2 P

1
) / [(P

2
1 P

1
) / 2]

The numerator is the percentage change in quantity computed using the midpoint
method, and the denominator is the percentage change in price computed using
the midpoint method. If you ever need to calculate elasticities, you should use
this formula.

In this book, however, we rarely perform such calculations. For most of our
purposes, what elasticity represents—the responsiveness of quantity demanded
to a change in price—is more important than how it is calculated.

The Variety of Demand Curves
Economists classify demand curves according to their elasticity. Demand is con-
sidered elastic when the elasticity is greater than 1, which means the quantity
moves proportionately more than the price. Demand is considered inelastic when
the elasticity is less than 1, which means the quantity moves proportionately less
than the price. If the elasticity is exactly 1, the quantity moves the same amount
proportionately as the price, and demand is said to have unit elasticity.

Because the price elasticity of demand measures how much quantity demanded
responds to changes in the price, it is closely related to the slope of the demand
curve. The following rule of thumb is a useful guide: The flatter the demand curve
that passes through a given point, the greater the price elasticity of demand. The
steeper the demand curve that passes through a given point, the smaller the price
elasticity of demand.

Figure 1 shows five cases. In the extreme case of a zero elasticity, shown in
panel (a), demand is perfectly inelastic, and the demand curve is vertical. In this
case, regardless of the price, the quantity demanded stays the same. As the elasticity
rises, the demand curve gets flatter and flatter, as shown in panels (b), (c), and (d).
At the opposite extreme, shown in panel (e), demand is perfectly elastic. This

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93CHAPTER 5 ElASTiciTy And iTS ApplicATiOn

2. . . . leads to a 22% decrease in quantity demanded.

(a) Perfectly Inelastic Demand: Elasticity Equals 0

$5

4

Demand

Quantity1000

(b) Inelastic Demand: Elasticity Is Less Than 1

$5

4

Quantity1000 90

Demand

(c) Unit Elastic Demand: Elasticity Equals 1

$5

4

Demand

Quantity1000

Price

80

1. An
increase
in price . . .

2. . . . leaves the quantity demanded unchanged.

1. A 22%
increase
in price . . .

Price Price

2. . . . leads to an 11% decrease in quantity demanded.

1. A 22%
increase
in price . . .

(d) Elastic Demand: Elasticity Is Greater Than 1

$5

4 Demand

Quantity1000

Price

50

(e) Perfectly Elastic Demand: Elasticity Equals Infinity

$4

Quantity0

Price

Demand

1. A 22%
increase
in price . . .

2. . . . leads to a 67% decrease in quantity demanded.
3. At a price below $4,
quantity demanded is infinite.

2. At exactly $4,
consumers will
buy any quantity.

1. At any price
above $4, quantity
demanded is zero.

Figure 1The Price Elasticity of DemandThe price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.

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94 PART II HOW MARKETS WORK

FYI

We have talked about what elasticity means, what determines it, and how it is calculated. Beyond these general ideas, you
might ask for a specific number. How much, precisely, does the price
of a particular good influence the quantity demanded?
To answer such a question, economists collect data from market
outcomes and apply statistical techniques to estimate the price
elasticity of demand. Here are some price elasticities of demand,
obtained from various studies, for a range of goods:

Eggs 0.1
Healthcare 0.2
Rice 0.5
Housing 0.7
Beef 1.6
Restaurant Meals 2.3
Mountain Dew 4.4

These kinds of numbers are fun to think about, and they can be
useful when comparing markets.
Nonetheless, one should take these estimates with a grain of
salt. One reason is that the statistical techniques used to obtain
them require some assumptions about the world, and these
assumptions might not be true in practice. (The details of these
techniques are beyond the scope of this book, but you will encoun-
ter them if you take a course in econometrics.) Another reason is
that the price elasticity of demand need not be the same at all
points on a demand curve, as we will see shortly in the case of a
linear demand curve. For both reasons, you should not be surprised
if different studies report different price elasticities of demand for
the same good.

occurs as the price elasticity of demand approaches infinity and the demand curve
becomes horizontal, reflecting the fact that very small changes in the price lead to
huge changes in the quantity demanded.

Finally, if you have trouble keeping straight the terms elastic and inelastic, here’s
a memory trick for you: Inelastic curves, such as in panel (a) of Figure 1, look like
the letter I. This is not a deep insight, but it might help on your next exam.

Total Revenue and the Price Elasticity of Demand
When studying changes in supply or demand in a market, one variable we often
want to study is total revenue, the amount paid by buyers and received by sellers
of the good. In any market, total revenue is P 3 Q, the price of the good times the
quantity of the good sold. We can show total revenue graphically, as in Figure 2.
The height of the box under the demand curve is P, and the width is Q. The area
of this box, P 3 Q, equals the total revenue in this market. In Figure 2, where
P = $4 and Q = 100, total revenue is $4 3 100, or $400.

How does total revenue change as one moves along the demand curve? The
answer depends on the price elasticity of demand. If demand is inelastic, as in panel
(a) of Figure 3, then an increase in the price causes an increase in total revenue. Here
an increase in price from $4 to $5 causes the quantity demanded to fall from 100 to
90, so total revenue rises from $400 to $450. An increase in price raises P 3 Q because
the fall in Q is proportionately smaller than the rise in P. In other words, the extra
revenue from selling units at a higher price (represented by area A in the figure) more
than offsets the decline in revenue from selling fewer units (represented by area B).

total revenue
the amount paid by
buyers and received
by sellers of a good,
computed as the price
of the good times the
quantity sold

A Few Elasticities from the Real World

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95CHAPTER 5 ElASTiciTy And iTS ApplicATiOn

$4

Demand

Quantity

Q

P

0

Price

P � Q � $400
(revenue)

100

Total Revenue
The total amount paid by buyers, and
received as revenue by sellers, equals
the area of the box under the demand
curve, P 3 Q. Here, at a price of $4, the
quantity demanded is 100, and total
revenue is $400.

Figure 2

How Total Revenue
Changes When Price
Changes

Figure 3The impact of a price change on total revenue (the product of price and quantity) depends on the elasticity of demand. In panel (a), the demand curve is inelastic. In
this case, an increase in the price leads to a decrease in quantity demanded that is
proportionately smaller, so total revenue increases. Here an increase in the price from
$4 to $5 causes the quantity demanded to fall from 100 to 90. Total revenue rises from
$400 to $450. In panel (b), the demand curve is elastic. In this case, an increase in the
price leads to a decrease in quantity demanded that is proportionately larger, so total
revenue decreases. Here an increase in the price from $4 to $5 causes the quantity
demanded to fall from 100 to 70. Total revenue falls from $400 to $350.

$4

$5

Price

Quantity

A

B

0 10090

Demand

$4

$5

Price

Quantity

A

B

0 10070

Demand

(a) The Case of Inelastic Demand (b) The Case of Elastic Demand

1. When the demand
curve is inelastic. . .

1. When the demand
curve is elastic. . .

3. . . . is greater than the lost revenue
from selling fewer units.

3. . . . is less than the lost revenue
from selling fewer units.

2. . . . the extra revenue from
selling at a higher price. . .

2. . . . the extra revenue from
selling at a higher price. . .

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96 PART II HOW MARKETS WORK

We obtain the opposite result if demand is elastic: An increase in the price
causes a decrease in total revenue. In panel (b) of Figure 3, for instance, when the
price rises from $4 to $5, the quantity demanded falls from 100 to 70, so total rev-
enue falls from $400 to $350. Because demand is elastic, the reduction in the quan-
tity demanded is so great that it more than offsets the increase in the price. That is,
an increase in price reduces P 3 Q because the fall in Q is proportionately greater
than the rise in P. In this case, the extra revenue from selling units at a higher price
(area A) is smaller than the decline in revenue from selling fewer units (area B).

The examples in this figure illustrate some general rules:

• When demand is inelastic (a price elasticity less than 1), price and total
revenue move in the same direction.

• When demand is elastic (a price elasticity greater than 1), price and total
revenue move in opposite directions.

• If demand is unit elastic (a price elasticity exactly equal to 1), total revenue
remains constant when the price changes.

Elasticity and Total Revenue along a Linear
Demand Curve
Let’s examine how elasticity varies along a linear demand curve, as shown in
Figure 4. We know that a straight line has a constant slope. Slope is defined as

Elasticity of a Linear Demand Curve
The slope of a linear demand curve is constant, but its elasticity
is not. The demand schedule in the table was used to calculate
the price elasticity of demand by the midpoint method. At points
with a low price and high quantity, the demand curve is inelastic.
At points with a high price and low quantity, the demand curve
is elastic.

Figure 4

5

6

$7

4

1

2

3

Quantity
122 4 6 8 10 140

Price
Elasticity is
larger
than 1.

Elasticity is
smaller
than 1.

Percentage Percentage
Total Revenue Change Change
Price Quantity (Price × Quantity) in Price in Quantity Elasticity Description

$7 0 $ 0
15 200 13.0 Elastic

6 2 12
18 67 3.7 Elastic

5 4 20
22 40 1.8 Elastic

4 6 24
29 29 1.0 Unit elastic

3 8 24
40 22 0.6 Inelastic

2 10 20
67 18 0.3 Inelastic

1 12 12
200 15 0.1 Inelastic

0 14 0

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97CHAPTER 5 ElASTiciTy And iTS ApplicATiOn

“rise over run,” which here is the ratio of the change in price (“rise”) to the change
in quantity (“run”). This particular demand curve’s slope is constant because each
$1 increase in price causes the same two-unit decrease in the quantity demanded.

Even though the slope of a linear demand curve is constant, the elasticity is not.
This is true because the slope is the ratio of changes in the two variables, whereas
the elasticity is the ratio of percentage changes in the two variables. You can see
this by looking at the table in Figure 4, which shows the demand schedule for the
linear demand curve in the graph. The table uses the midpoint method to calcu-
late the price elasticity of demand. At points with a low price and high quantity,
the demand curve is inelastic. At points with a high price and low quantity, the
demand curve is elastic.

The table also presents total revenue at each point on the demand curve. These
numbers illustrate the relationship between total revenue and elasticity. When the
price is $1, for instance, demand is inelastic, and a price increase to $2 raises total
revenue. When the price is $5, demand is elastic, and a price increase to $6 reduces
total revenue. Between $3 and $4, demand is exactly unit elastic, and total revenue
is the same at these two prices.

The linear demand curve illustrates that the price elasticity of demand need not
be the same at all points on a demand curve. A constant elasticity is possible, but
it is not always the case.

Other Demand Elasticities
In addition to the price elasticity of demand, economists use other elasticities to
describe the behavior of buyers in a market.

The Income Elasticity of Demand The income elasticity of demand mea-
sures how the quantity demanded changes as consumer income changes. It is
calculated as the percentage change in quantity demanded divided by the per-
centage change in income. That is,

Income elasticity of demand =
Percentage change in quantity demanded

.
Percentage change in income

As we discussed in Chapter 4, most goods are normal goods: Higher income raises
the quantity demanded. Because quantity demanded and income move in the
same direction, normal goods have positive income elasticities. A few goods, such
as bus rides, are inferior goods: Higher income lowers the quantity demanded.
Because quantity demanded and income move in opposite directions, inferior
goods have negative income elasticities.

Even among normal goods, income elasticities vary substantially in size.
Necessities, such as food and clothing, tend to have small income elasticities
because consumers choose to buy some of these goods even when their incomes
are low. Luxuries, such as caviar and diamonds, tend to have large income elas-
ticities because consumers feel that they can do without these goods altogether if
their incomes are too low.

The Cross-Price Elasticity of Demand The cross-price elasticity of demand
measures how the quantity demanded of one good responds to a change in the price
of another good. It is calculated as the percentage change in quantity demanded of
good 1 divided by the percentage change in the price of good 2. That is,

Cross-price elasticity of demand =
Percentage change in quantity demanded of good 1

.
Percentage change in the price of good 2

income elasticity
of demand
a measure of how much
the quantity demanded
of a good responds to
a change in consumers’
income, computed as
the percentage change
in quantity demanded
divided by the percentage
change in income

cross-price elasticity
of demand
a measure of how much
the quantity demanded
of one good responds to
a change in the price of
another good, computed as
the percentage change in
quantity demanded of the
first good divided by the
percentage change in the
price of the second good

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98 PART II HOW MARKETS WORK

Whether the cross-price elasticity is a positive or negative number depends on
whether the two goods are substitutes or complements. As we discussed in Chapter
4, substitutes are goods that are typically used in place of one another, such as
hamburgers and hot dogs. An increase in hot dog prices induces people to grill
hamburgers instead. Because the price of hot dogs and the quantity of hamburgers
demanded move in the same direction, the cross-price elasticity is positive. Con-
versely, complements are goods that are typically used together, such as computers
and software. In this case, the cross-price elasticity is negative, indicating that an
increase in the price of computers reduces the quantity of software demanded.

Quick Quiz Define the price elasticity of demand. • Explain the relationship
between total revenue and the price elasticity of demand.

The Elasticity of Supply
When we introduced supply in Chapter 4, we noted that producers of a good offer to
sell more of it when the price of the good rises. To turn from qualitative to quantita-
tive statements about quantity supplied, we once again use the concept of elasticity.

The Price Elasticity of Supply and Its Determinants
The law of supply states that higher prices raise the quantity supplied. The price
elasticity of supply measures how much the quantity supplied responds to
changes in the price. Supply of a good is said to be elastic if the quantity supplied
responds substantially to changes in the price. Supply is said to be inelastic if the
quantity supplied responds only slightly to changes in the price.

The price elasticity of supply depends on the flexibility of sellers to change the
amount of the good they produce. For example, beachfront land has an inelastic
supply because it is almost impossible to produce more of it. By contrast, manu-
factured goods, such as books, cars, and televisions, have elastic supplies because
firms that produce them can run their factories longer in response to a higher price.

In most markets, a key determinant of the price elasticity of supply is the time
period being considered. Supply is usually more elastic in the long run than in
the short run. Over short periods of time, firms cannot easily change the size of
their factories to make more or less of a good. Thus, in the short run, the quantity
supplied is not very responsive to the price. By contrast, over longer periods,
firms can build new factories or close old ones. In addition, new firms can enter a
market, and old firms can shut down. Thus, in the long run, the quantity supplied
can respond substantially to price changes.

Computing the Price Elasticity of Supply
Now that we have a general understanding about the price elasticity of supply,
let’s be more precise. Economists compute the price elasticity of supply as the
percentage change in the quantity supplied divided by the percentage change in
the price. That is,

Price elasticity of supply
=

Percentage change in quantity supplied
.

Percentage change in price

For example, suppose that an increase in the price of milk from $2.85 to $3.15 a
gallon raises the amount that dairy farmers produce from 9,000 to 11,000 gallons

price elasticity of
supply
a measure of how much
the quantity supplied of
a good responds to a
change in the price of
that good, computed as
the percentage change in
quantity supplied divided
by the percentage change
in price

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99CHAPTER 5 ElASTiciTy And iTS ApplicATiOn

per month. Using the midpoint method, we calculate the percentage change in
price as

Percentage change in price = (3.15 – 2.85) / 3.00 × 100 = 10 percent.

Similarly, we calculate the percentage change in quantity supplied as

Percentage change in quantity supplied = (11,000 – 9,000) / 10,000 × 100 = 20 percent.

In this case, the price elasticity of supply is

Price elasticity of supply =
20 percent = 2.0.

10 percent

In this example, the elasticity of 2 indicates that the quantity supplied changes
proportionately twice as much as the price.

The Variety of Supply Curves
Because the price elasticity of supply measures the responsiveness of quantity sup-
plied to the price, it is reflected in the appearance of the supply curve. Figure 5 shows
five cases. In the extreme case of a zero elasticity, as shown in panel (a), supply is
perfectly inelastic, and the supply curve is vertical. In this case, the quantity supplied
is the same regardless of the price. As the elasticity rises, the supply curve gets flat-
ter, which shows that the quantity supplied responds more to changes in the price.
At the opposite extreme, shown in panel (e), supply is perfectly elastic. This occurs
as the price elasticity of supply approaches infinity and the supply curve becomes
horizontal, meaning that very small changes in the price lead to very large changes
in the quantity supplied.

In some markets, the elasticity of supply is not constant but varies over the
supply curve. Figure 6 shows a typical case for an industry in which firms have
factories with a limited capacity for production. For low levels of quantity sup-
plied, the elasticity of supply is high, indicating that firms respond substantially
to changes in the price. In this region, firms have capacity for production that is
not being used, such as plants and equipment idle for all or part of the day. Small
increases in price make it profitable for firms to begin using this idle capacity. As
the quantity supplied rises, firms begin to reach capacity. Once capacity is fully
used, increasing production further requires the construction of new plants. To
induce firms to incur this extra expense, the price must rise substantially, so sup-
ply becomes less elastic.

Figure 6 presents a numerical example of this phenomenon. When the price
rises from $3 to $4 (a 29 percent increase, according to the midpoint method), the
quantity supplied rises from 100 to 200 (a 67 percent increase). Because quantity
supplied changes proportionately more than the price, the supply curve has elas-
ticity greater than 1. By contrast, when the price rises from $12 to $15 (a 22 percent
increase), the quantity supplied rises from 500 to 525 (a 5 percent increase). In this
case, quantity supplied moves proportionately less than the price, so the elasticity
is less than 1.

Quick Quiz Define the price elasticity of supply. • Explain why the price elasticity
of supply might be different in the long run than in the short run.

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100 PART II HOW MARKETS WORK

The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.

The Price Elasticity of Supply
Figure 5

100 110

100 125

(a) Perfectly Inelastic Supply: Elasticity Equals 0

$5

4

Supply

Quantity1000

(b) Inelastic Supply: Elasticity Is Less Than 1

$5

4

Quantity0

(c) Unit Elastic Supply: Elasticity Equals 1

$5

4

Quantity0

Price

1. An
increase
in price . . .

2. . . . leaves the quantity supplied unchanged.

2. . . . leads to a 22% increase in quantity supplied.

1. A 22%
increase
in price . . .

Price Price

2. . . . leads to a 10% increase in quantity supplied.

1. A 22%
increase
in price . . .

(d) Elastic Supply: Elasticity Is Greater Than 1

$5

4

Quantity0

Price
(e) Perfectly Elastic Supply: Elasticity Equals Infinity

$4

Quantity0

Price

Supply

1. A 22%
increase
in price . . .

2. . . . leads to a 67% increase in quantity supplied.
3. At a price below $4,
quantity supplied is zero.

Supply

Supply

100 200

Supply

2. At exactly $4,
producers will
supply any quantity.

1. At any price
above $4, quantity
supplied is infinite.

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101CHAPTER 5 ElASTiciTy And iTS ApplicATiOn

How the Price Elasticity of Supply Can Vary
Because firms often have a maximum capacity for
production, the elasticity of supply may be very high
at low levels of quantity supplied and very low at high
levels of quantity supplied. Here an increase in price
from $3 to $4 increases the quantity supplied from 100
to 200. Because the 67 percent increase in quantity
supplied (computed using the midpoint method) is
larger than the 29 percent increase in price, the supply
curve is elastic in this range. By contrast, when the
price rises from $12 to $15, the quantity supplied rises
only from 500 to 525. Because the 5 percent increase in
quantity supplied is smaller than the 22 percent increase
in price, the supply curve is inelastic in this range.

Figure 6
$15

12

3

Quantity100 200 5000

Price

525

Elasticity is small
(less than 1).

Elasticity is large
(greater than 1).

4

Three Applications of Supply, Demand, and Elasticity
Can good news for farming be bad news for farmers? Why did OPEC fail to keep
the price of oil high? Does drug interdiction increase or decrease drug-related
crime? At first, these questions might seem to have little in common. Yet all three
questions are about markets, and all markets are subject to the forces of supply
and demand. Here we apply the versatile tools of supply, demand, and elasticity
to answer these seemingly complex questions.

Can Good News for Farming Be Bad News
for Farmers?
Imagine yourself as a Kansas wheat farmer. Because you earn all your income
from selling wheat, you devote much effort to making your land as productive
as possible. You monitor weather and soil conditions, check your fields for pests
and disease, and study the latest advances in farm technology. You know that the
more wheat you grow, the more you will have to sell after the harvest, and the
higher will be your income and your standard of living.

One day, Kansas State University announces a major discovery. Researchers
in its agronomy department have devised a new hybrid of wheat that raises the
amount farmers can produce from each acre of land by 20 percent. How should
you react to this news? Does this discovery make you better off or worse off than
you were before?

Recall from Chapter 4 that we answer such questions in three steps. First, we
examine whether the supply or demand curve shifts. Second, we consider in
which direction the curve shifts. Third, we use the supply-and-demand diagram
to see how the market equilibrium changes.

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102 PART II HOW MARKETS WORK

In this case, the discovery of the new hybrid affects the supply curve. Because
the hybrid increases the amount of wheat that can be produced on each acre
of land, farmers are now willing to supply more wheat at any given price. In
other words, the supply curve shifts to the right. The demand curve remains the
same because consumers’ desire to buy wheat products at any given price is not
affected by the introduction of a new hybrid. Figure 7 shows an example of such
a change. When the supply curve shifts from S

1
to S

2
, the quantity of wheat sold

increases from 100 to 110, and the price of wheat falls from $3 to $2.
Does this discovery make farmers better off? As a first cut to answering

this question, consider what happens to the total revenue received by farmers.
Farmers’ total revenue is P 3 Q, the price of the wheat times the quantity sold. The
discovery affects farmers in two conflicting ways. The hybrid allows farmers to
produce more wheat (Q rises), but now each bushel of wheat sells for less (P falls).

Whether total revenue rises or falls depends on the elasticity of demand.
In practice, the demand for basic foodstuffs such as wheat is usually inelastic
because these items are relatively inexpensive and have few good substitutes.
When the demand curve is inelastic, as it is in Figure 7, a decrease in price causes
total revenue to fall. You can see this in the figure: The price of wheat falls sub-
stantially, whereas the quantity of wheat sold rises only slightly. Total revenue
falls from $300 to $220. Thus, the discovery of the new hybrid lowers the total
revenue that farmers receive from the sale of their crops.

If farmers are made worse off by the discovery of this new hybrid, one might
wonder why they adopt it. The answer goes to the heart of how competitive mar-
kets work. Because each farmer is only a small part of the market for wheat, he or
she takes the price of wheat as given. For any given price of wheat, it is better to
use the new hybrid to produce and sell more wheat. Yet when all farmers do this,
the supply of wheat increases, the price falls, and farmers are worse off.

Although this example may at first seem hypothetical, it helps to explain a
major change in the U.S. economy over the past century. Two hundred years ago,
most Americans lived on farms. Knowledge about farm methods was sufficiently

An Increase in Supply in the Market for Wheat
When an advance in farm technology increases the
supply of wheat from S

1
to S

2
, the price of wheat

falls. Because the demand for wheat is inelastic,
the increase in the quantity sold from 100 to 110 is
proportionately smaller than the decrease in
the price from $3 to $2. As a result, farmers’
total revenue falls from $300 ($3 3 100) to
$220 ($2 3 110).

Figure 7

$3

2

Quantity of
Wheat

1000

Price of
Wheat

3. . . . and a proportionately smaller increase
in quantity sold. As a result, revenue falls
from $300 to $220.

110

Demand

S1 S2

2. . . . leads
to a large fall
in price . . .

1. When demand is inelastic,
an increase in supply . . .

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103CHAPTER 5 ElASTiciTy And iTS ApplicATiOn

primitive that most Americans had to be farmers to produce enough food to feed
the nation’s population. Yet over time, advances in farm technology increased
the amount of food that each farmer could produce. This increase in food supply,
together with inelastic food demand, caused farm revenues to fall, which in turn
encouraged people to leave farming.

A few numbers show the magnitude of this historic change. As recently as 1950,
10 million people worked on farms in the United States, representing 17 percent
of the labor force. Today, fewer than 3 million people work on farms, or 2 percent
of the labor force. This change coincided with tremendous advances in farm pro-
ductivity: Despite the 70 percent drop in the number of farmers, U.S. farms now
produce more than twice the output of crops and livestock that they did in 1950.

This analysis of the market for farm products also helps to explain a seeming
paradox of public policy: Certain farm programs try to help farmers by induc-
ing them not to plant crops on all of their land. The purpose of these programs
is to reduce the supply of farm products and thereby raise prices. With inelastic
demand for their products, farmers as a group receive greater total revenue if
they supply a smaller crop to the market. No single farmer would choose to leave
his land fallow on his own because each takes the market price as given. But if all
farmers do so together, each of them can be better off.

When analyzing the effects of farm technology or farm policy, it is important to
keep in mind that what is good for farmers is not necessarily good for society as a
whole. Improvement in farm technology can be bad for farmers because it makes
farmers increasingly unnecessary, but it is surely good for consumers who pay
less for food. Similarly, a policy aimed at reducing the supply of farm products
may raise the incomes of farmers, but it does so at the expense of consumers.

Why Did OPEC Fail to Keep the Price of Oil High?
Many of the most disruptive events for the world’s economies over the past sev-
eral decades have originated in the world market for oil. In the 1970s, members
of the Organization of Petroleum Exporting Countries (OPEC) decided to raise
the world price of oil to increase their incomes. These countries accomplished this
goal by jointly reducing the amount of oil they supplied. From 1973 to 1974, the
price of oil (adjusted for overall inflation) rose more than 50 percent. Then, a few
years later, OPEC did the same thing again. From 1979 to 1981, the price of oil
approximately doubled.

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104 PART II HOW MARKETS WORK

Yet OPEC found it difficult to maintain a high price. From 1982 to 1985, the
price of oil steadily declined about 10 percent per year. Dissatisfaction and disar-
ray soon prevailed among the OPEC countries. In 1986, cooperation among OPEC
members completely broke down, and the price of oil plunged 45 percent. In 1990,
the price of oil (adjusted for overall inflation) was back to where it began in 1970,
and it stayed at that low level throughout most of the 1990s. (In the first decade of
the 21st century, the price of oil fluctuated substantially once again, but the main
driving force was changes in world demand rather than OPEC supply restrictions.
Early in the decade, oil demand and prices spiked up, in part because of a large
and rapidly growing Chinese economy. Prices plunged in 2008–2009 as the world
economy fell into a deep recession and then started rising once again as the world
economy started to recover.)

The OPEC episodes of the 1970s and 1980s show how supply and demand
can behave differently in the short run and in the long run. In the short run, both
the supply and demand for oil are relatively inelastic. Supply is inelastic because
the quantity of known oil reserves and the capacity for oil extraction cannot be
changed quickly. Demand is inelastic because buying habits do not respond
immediately to changes in price. Thus, as panel (a) of Figure 8 shows, the short-
run supply and demand curves are steep. When the supply of oil shifts from S

1
to

S
2
, the price increase from P

1
to P

2
is large.

The situation is very different in the long run. Over long periods of time,
producers of oil outside OPEC respond to high prices by increasing oil explora-
tion and by building new extraction capacity. Consumers respond with greater
conservation, such as by replacing old inefficient cars with newer efficient ones.
Thus, as panel (b) of Figure 8 shows, the long-run supply and demand curves are

When the supply of oil falls, the response depends on the time horizon. In the short
run, supply and demand are relatively inelastic, as in panel (a). Thus, when the supply
curve shifts from S

1
to S

2
, the price rises substantially. By contrast, in the long run,

supply and demand are relatively elastic, as in panel (b). In this case, the same size
shift in the supply curve (S

1
to S

2
) causes a smaller increase in the price.

A Reduction in Supply in the World Market for Oil
Figure 8

P2

P1

Quantity of Oil0

Price of Oil

Demand

S2
S1

(a) The Oil Market in the Short Run

P2

P1

Quantity of Oil0

Price of Oil

Demand

S2
S1

(b) The Oil Market in the Long Run

2. . . . leads
to a large
increase
in price.

1. In the long run, when
supply and demand are
elastic, a shift in
supply . . .

2. . . . leads
to a small
increase
in price.

1. In the short run, when supply and
demand are inelastic, a shift in
supply . . .

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105CHAPTER 5 ElASTiciTy And iTS ApplicATiOn

more elastic. In the long run, the shift in the supply curve from S
1
to S

2
causes a

much smaller increase in the price.
This analysis shows why OPEC succeeded in maintaining a high price of oil

only in the short run. When OPEC countries agreed to reduce their production
of oil, they shifted the supply curve to the left. Even though each OPEC member
sold less oil, the price rose by so much in the short run that OPEC incomes rose.
By contrast, in the long run, when supply and demand are more elastic, the same
reduction in supply, measured by the horizontal shift in the supply curve, caused
a smaller increase in the price. Thus, OPEC’s coordinated reduction in supply
proved less profitable in the long run. The cartel learned that raising prices is
easier in the short run than in the long run.

Does Drug Interdiction Increase or Decrease
Drug-Related Crime?
A persistent problem facing our society is the use of illegal drugs, such as heroin,
cocaine, ecstasy, and crack. Drug use has several adverse effects. One is that drug
dependence can ruin the lives of drug users and their families. Another is that drug
addicts often turn to robbery and other violent crimes to obtain the money needed
to support their habit. To discourage the use of illegal drugs, the U.S. government
devotes billions of dollars each year to reduce the flow of drugs into the country.
Let’s use the tools of supply and demand to examine this policy of drug interdiction.

Suppose the government increases the number of federal agents devoted to
the war on drugs. What happens in the market for illegal drugs? As is usual,
we answer this question in three steps. First, we consider whether the supply or
demand curve shifts. Second, we consider the direction of the shift. Third, we see
how the shift affects the equilibrium price and quantity.

Although the purpose of drug interdiction is to reduce drug use, its direct impact
is on the sellers of drugs rather than the buyers. When the government stops some
drugs from entering the country and arrests more smugglers, it raises the cost of
selling drugs and, therefore, reduces the quantity of drugs supplied at any given
price. The demand for drugs—the amount buyers want at any given price—is not
changed. As panel (a) of Figure 9 shows, interdiction shifts the supply curve to the
left from S

1
to S

2
and leaves the demand curve the same. The equilibrium price of

drugs rises from P
1
to P

2
, and the equilibrium quantity falls from Q

1
to Q

2
. The fall

in the equilibrium quantity shows that drug interdiction does reduce drug use.
But what about the amount of drug-related crime? To answer this question,

consider the total amount that drug users pay for the drugs they buy. Because
few drug addicts are likely to break their destructive habits in response to a
higher price, it is likely that the demand for drugs is inelastic, as it is drawn in the
figure. If demand is inelastic, then an increase in price raises total revenue in the
drug market. That is, because drug interdiction raises the price of drugs propor-
tionately more than it reduces drug use, it raises the total amount of money that
drug users pay for drugs. Addicts who already had to steal to support their habits
would have an even greater need for quick cash. Thus, drug interdiction could
increase drug-related crime.

Because of this adverse effect of drug interdiction, some analysts argue for alter-
native approaches to the drug problem. Rather than trying to reduce the supply
of drugs, policymakers might try to reduce the demand by pursuing a policy of
drug education. Successful drug education has the effects shown in panel (b) of
Figure 9. The demand curve shifts to the left from D

1
to D

2
. As a result, the equi-

librium quantity falls from Q
1
to Q

2
, and the equilibrium price falls from P

1
to P

2
.

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106 PART II HOW MARKETS WORK

Drug interdiction reduces the supply of drugs from S
1
to S

2
, as in panel (a). If the

demand for drugs is inelastic, then the total amount paid by drug users rises, even
as the amount of drug use falls. By contrast, drug education reduces the demand for
drugs from D

1
to D

2
, as in panel (b). Because both price and quantity fall, the amount

paid by drug users falls.

Policies to Reduce the Use of Illegal Drugs
Figure 9

P2

P1

Quantity of Drugs0 Q2 Q1

Price of
Drugs

Demand

S2

S1

Q2 Q1

(a) Drug Interdiction

Quantity of Drugs0

Price of
Drugs

Supply

D2
D1

(b) Drug Education

3. . . . and reduces
the quantity sold.

2. . . . which
raises the
price . . .

2. . . . which
reduces the
price . . .

P1

P2

1. Drug interdiction reduces
the supply of drugs . . .

1. Drug education reduces
the demand for drugs . . .

3. . . . and reduces
the quantity sold.

Total revenue, which is price times quantity, also falls. Thus, in contrast to drug
interdiction, drug education can reduce both drug use and drug-related crime.

Advocates of drug interdiction might argue that the long-run effects of this
policy are different from the short-run effects because the elasticity of demand
depends on the time horizon. The demand for drugs is probably inelastic over
short periods because higher prices do not substantially affect drug use by estab-
lished addicts. But demand may be more elastic over longer periods because
higher prices would discourage experimentation with drugs among the young
and, over time, lead to fewer drug addicts. In this case, drug interdiction would
increase drug-related crime in the short run while decreasing it in the long run.

Quick Quiz How might a drought that destroys half of all farm crops be good for
farmers? If such a drought is good for farmers, why don’t farmers destroy their own
crops in the absence of a drought?

Conclusion
According to an old quip, even a parrot can become an economist simply by learn-
ing to say “supply and demand.” These last two chapters should have convinced
you that there is much truth in this statement. The tools of supply and demand
allow you to analyze many of the most important events and policies that shape
the economy. You are now well on your way to becoming an economist (or at least
a well-educated parrot).

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107CHAPTER 5 ElASTiciTy And iTS ApplicATiOn

S u m m a r y

• The price elasticity of demand measures how
much the quantity demanded responds to
changes in the price. Demand tends to be more
elastic if close substitutes are available, if the
good is a luxury rather than a necessity, if the
market is narrowly defined, or if buyers have
substantial time to react to a price change.

• The price elasticity of demand is calculated as
the percentage change in quantity demanded
divided by the percentage change in price. If
quantity demanded moves proportionately less
than the price, then the elasticity is less than 1,
and demand is said to be inelastic. If quantity
demanded moves proportionately more than
the price, then the elasticity is greater than 1,
and demand is said to be elastic.

• Total revenue, the total amount paid for a good,
equals the price of the good times the quantity
sold. For inelastic demand curves, total revenue
moves in the same direction as the price. For
elastic demand curves, total revenue moves in
the opposite direction as the price.

• The income elasticity of demand measures
how much the quantity demanded responds to

changes in consumers’ income. The cross-price
elasticity of demand measures how much the
quantity demanded of one good responds to
changes in the price of another good.

• The price elasticity of supply measures how
much the quantity supplied responds to changes
in the price. This elasticity often depends on the
time horizon under consideration. In most mar-
kets, supply is more elastic in the long run than
in the short run.

• The price elasticity of supply is calculated as the
percentage change in quantity supplied divided
by the percentage change in price. If quantity
supplied moves proportionately less than the
price, then the elasticity is less than 1, and sup-
ply is said to be inelastic. If quantity supplied
moves proportionately more than the price, then
the elasticity is greater than 1, and supply is said
to be elastic.

• The tools of supply and demand can be applied
in many different kinds of markets. This chap-
ter uses them to analyze the market for wheat,
the market for oil, and the market for illegal
drugs.

K e y C o n C e p t s

elasticity, p. 90
price elasticity of demand, p. 90
total revenue, p. 94

income elasticity of demand, p. 97
cro ss-price elasticity of

demand, p. 97

price elasticity of supply, p. 98

Q u e s t i o n s f o r r e v i e w

1. Define the price elasticity of demand and the
income elasticity of demand.

2. List and explain the four determinants of the
price elasticity of demand discussed in the
chapter.

3. What is the main advantage of using the
midpoint method for calculating elasticity?

4. If the elasticity is greater than 1, is demand
elastic or inelastic? If the elasticity equals 0,
is demand perfectly elastic or perfectly
inelastic?

5. On a supply-and-demand diagram, show
equilibrium price, equilibrium quantity, and
the total revenue received by producers.

6. If demand is elastic, how will an increase in
price change total revenue? Explain.

7. What do we call a good whose income
elasticity is less than 0?

8. How is the price elasticity of supply calculated?
Explain what it measures.

9. What is the price elasticity of supply of Picasso
paintings?

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108 PART II HOW MARKETS WORK

10. Is the price elasticity of supply usually larger in
the short run or in the long run? Why?

11. How can elasticity help explain why drug
interdiction could reduce the supply of drugs,
yet possibly increase drug-related crime?

P r o b l e m s a n d a P P l i c a t i o n s

1. For each of the following pairs of goods, which
good would you expect to have more elastic
demand and why?
a. required textbooks or mystery novels
b. Beethoven recordings or classical music

recordings in general
c. subway rides during the next six months or

subway rides during the next five years
d. root beer or water

2. Suppose that business travelers and vacationers
have the following demand for airline tickets
from New York to Boston:

Quantity Demanded Quantity Demanded
Price (business travelers) (vacationers)

$150 2,100 tickets 1,000 tickets
200 2,000 800
250 1,900 600
300 1,800 400

a. As the price of tickets rises from $200 to
$250, what is the price elasticity of demand
for (i) business travelers and (ii) vacation-
ers? (Use the midpoint method in your
calculations.)

b. Why might vacationers have a different
elasticity from business travelers?

3. Suppose the price elasticity of demand for
heating oil is 0.2 in the short run and 0.7 in the
long run.
a. if the price of heating oil rises from $1.80

to $2.20 per gallon, what happens to the
quantity of heating oil demanded in the short
run? In the long run? (Use the midpoint
method in your calculations.)

b. Why might this elasticity depend on the time
horizon?

4. A price change causes the quantity demanded
of a good to decrease by 30 percent, while
the total revenue of that good increases by
15 percent. Is the demand curve elastic or
inelastic? Explain.

5. The equilibrium price of coffee mugs rose sharply
last month, but the equilibrium quantity was
the same as ever. Three people tried to explain
the situation. Which explanations could be
right? Explain your logic.

Billy: Demand increased, but supply was
totally inelastic.

Marian: Supply increased, but so did
demand.

Valerie: Supply decreased, but demand was
totally inelastic.

6. Suppose that your demand schedule for DVDs
is as follows:

Quantity Demanded Quantity Demanded
Price (income = $10,000) (income = $12,000)

$ 8 40 DVDs 50 DVDs
10 32 45
12 24 30
14 16 20
16 8 12

a. Use the midpoint method to calculate your
price elasticity of demand as the price of
DVDs increases from $8 to $10 if (i) your
income is $10,000 and (ii) your income is
$12,000.

b. Calculate your income elasticity of demand
as your income increases from $10,000 to
$12,000 if (i) the price is $12 and (ii) the price
is $16.

7. You have the following information about good
X and good Y:
• Income elasticity of demand for good X: –3
• Cross-price elasticity of demand for good X

with respect to the price of good Y: 2
Would an increase in income and a decrease in
the price of good Y unambiguously decrease
the demand for good X? Why or why not?

8. Maria has decided always to spend one-third of
her income on clothing.

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109CHAPTER 5 ElASTiciTy And iTS ApplicATiOn

a. What is her income elasticity of clothing
demand?

b. What is her price elasticity of clothing
demand?

c. If Maria’s tastes change and she decides
to spend only one-fourth of her income
on clothing, how does her demand curve
change? What is her income elasticity and
price elasticity now?

9. The New York Times reported (Feb. 17, 1996) that
subway ridership declined after a fare increase:
“There were nearly four million fewer riders
in December 1995, the first full month after the
price of a token increased 25 cents to $1.50, than
in the previous December, a 4.3 percent decline.”
a. Use these data to estimate the price elasticity

of demand for subway rides.
b. According to your estimate, what happens

to the Transit Authority’s revenue when the
fare rises?

c. Why might your estimate of the elasticity be
unreliable?

10. Two drivers—Tom and Jerry—each drive up to
a gas station. Before looking at the price, each
places an order. Tom says, “I’d like 10 gallons
of gas.” Jerry says, “I’d like $10 worth of gas.”
What is each driver’s price elasticity of demand?

11. Consider public policy aimed at smoking.
a. Studies indicate that the price elasticity of

demand for cigarettes is about 0.4. If a pack
of cigarettes currently costs $2 and the
government wants to reduce smoking by
20 percent, by how much should it increase
the price?

b. If the government permanently increases
the price of cigarettes, will the policy have a
larger effect on smoking one year from now
or five years from now?

c. Studies also find that teenagers have a
higher price elasticity than do adults. Why
might this be true?

12. You are the curator of a museum. The
museum is running short of funds, so you
decide to increase revenue. Should you
increase or decrease the price of admission?
Explain.

13. Pharmaceutical drugs have an inelastic
demand, and computers have an elastic
demand. Suppose that technological advance
doubles the supply of both products (that is,
the quantity supplied at each price is twice
what it was).
a. What happens to the equilibrium price and

quantity in each market?
b. Which product experiences a larger change

in price?
c. Which product experiences a larger change

in quantity?
d. What happens to total consumer spending

on each product?
14. Several years ago, flooding along the Missouri

and the Mississippi rivers destroyed thousands
of acres of wheat.
a. Farmers whose crops were destroyed by the

floods were much worse off, but farmers
whose crops were not destroyed benefited
from the floods. Why?

b. What information would you need about the
market for wheat to assess whether farmers
as a group were hurt or helped by the
floods?

15. Explain why the following might be true:
A drought around the world raises the total
revenue that farmers receive from the sale of
grain, but a drought only in Kansas reduces the
total revenue that Kansas farmers receive.

For further information on topics in this chapter,
additional problems, applications, examples, online
quizzes, and more, please visit our website at www
.cengage.com/economics/mankiw.

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111

6Supply, Demand, and
Government Policies

Economists have two roles. As scientists, they develop and test theories to explain the world around them. As policy advisers, they use their theo-ries to help change the world for the better. The focus of the preceding two chapters has been scientific. We have seen how supply and demand
determine the price of a good and the quantity of the good sold. We have also seen
how various events shift supply and demand and thereby change the equilibrium
price and quantity.

This chapter offers our first look at policy. Here we analyze various types of
government policy using only the tools of supply and demand. As you will see,
the analysis yields some surprising insights. Policies often have effects that their
architects did not intend or anticipate.

We begin by considering policies that directly control prices. For example,
rent-control laws dictate a maximum rent that landlords may charge tenants.
Minimum-wage laws dictate the lowest wage that firms may pay workers. Price

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112 PART II HOW MARKETS WORK

controls are usually enacted when policymakers believe that the market price of a
good or service is unfair to buyers or sellers. Yet, as we will see, these policies can
generate inequities of their own.

After discussing price controls, we consider the impact of taxes. Policymakers
use taxes to raise revenue for public purposes and to influence market outcomes.
Although the prevalence of taxes in our economy is obvious, their effects are not.
For example, when the government levies a tax on the amount that firms pay their
workers, do the firms or the workers bear the burden of the tax? The answer is not
at all clear—until we apply the powerful tools of supply and demand.

Controls on Prices
To see how price controls affect market outcomes, let’s look once again at the
market for ice cream. As we saw in Chapter 4, if ice cream is sold in a competitive
market free of government regulation, the price of ice cream adjusts to balance
supply and demand: At the equilibrium price, the quantity of ice cream that buy-
ers want to buy exactly equals the quantity that sellers want to sell. To be concrete,
suppose the equilibrium price is $3 per cone.

Not everyone may be happy with the outcome of this free-market process. Let’s
say the American Association of Ice-Cream Eaters complains that the $3 price is
too high for everyone to enjoy a cone a day (their recommended daily allowance).
Meanwhile, the National Organization of Ice-Cream Makers complains that the
$3 price—the result of “cutthroat competition”—is too low and is depressing the
incomes of its members. Each of these groups lobbies the government to pass laws
that alter the market outcome by directly controlling the price of an ice-cream
cone.

Because buyers of any good always want a lower price while sellers want a
higher price, the interests of the two groups conflict. If the Ice-Cream Eaters are
successful in their lobbying, the government imposes a legal maximum on the
price at which ice-cream cones can be sold. Because the price is not allowed to rise
above this level, the legislated maximum is called a price ceiling. By contrast, if
the Ice-Cream Makers are successful, the government imposes a legal minimum
on the price. Because the price cannot fall below this level, the legislated mini-
mum is called a price floor. Let us consider the effects of these policies in turn.

How Price Ceilings Affect Market Outcomes
When the government, moved by the complaints and campaign contributions of
the Ice-Cream Eaters, imposes a price ceiling on the market for ice cream, two
outcomes are possible. In panel (a) of Figure 1, the government imposes a price
ceiling of $4 per cone. In this case, because the price that balances supply and
demand ($3) is below the ceiling, the price ceiling is not binding. Market forces
naturally move the economy to the equilibrium, and the price ceiling has no effect
on the price or the quantity sold.

Panel (b) of Figure 1 shows the other, more interesting, possibility. In this case,
the government imposes a price ceiling of $2 per cone. Because the equilibrium
price of $3 is above the price ceiling, the ceiling is a binding constraint on the mar-
ket. The forces of supply and demand tend to move the price toward the equi-
librium price, but when the market price hits the ceiling, it can, by law, rise no
further. Thus, the market price equals the price ceiling. At this price, the quantity
of ice cream demanded (125 cones in the figure) exceeds the quantity supplied

price ceiling
a legal maximum on the
price at which a good can
be sold

price floor
a legal minimum on the
price at which a good can
be sold

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113CHAPTER 6 Supply, DEMAnD, AnD GOvERnMEnT pOliciES

A Market with a Price
Ceiling

Figure 1In panel (a), the government imposes a price ceiling of $4. Because the price ceiling is
above the equilibrium price of $3, the price ceiling has no effect, and the market can
reach the equilibrium of supply and demand. In this equilibrium, quantity supplied
and quantity demanded both equal 100 cones. In panel (b), the government imposes
a price ceiling of $2. Because the price ceiling is below the equilibrium price of $3,
the market price equals $2. At this price, 125 cones are demanded and only 75 are
supplied, so there is a shortage of 50 cones.

(a) A Price Ceiling That Is Not Binding

$4

3

Quantity of
Ice-Cream

Cones

0

Price of
Ice-Cream

Cone

100

Equilibrium
quantity

(b) A Price Ceiling That Is Binding

$3

Quantity of
Ice-Cream

Cones

0

Price of
Ice-Cream

Cone

2

Price
ceiling

Demand

Supply

Price
ceilingShortage

75

Quantity
supplied

125

Quantity
demanded

Equilibrium
price

Equilibrium
price

Demand

Supply

(75 cones). There is a shortage: 50 people who want to buy ice cream at the going
price are unable to do so.

In response to this shortage, some mechanism for rationing ice cream will
naturally develop. The mechanism could be long lines: Buyers who are willing
to arrive early and wait in line get a cone, but those unwilling to wait do not.
Alternatively, sellers could ration ice-cream cones according to their own personal
biases, selling them only to friends, relatives, or members of their own racial or
ethnic group. Notice that even though the price ceiling was motivated by a desire
to help buyers of ice cream, not all buyers benefit from the policy. Some buyers
do get to pay a lower price, although they may have to wait in line to do so, but
other buyers cannot get any ice cream at all.

This example in the market for ice cream shows a general result: When the gov-
ernment imposes a binding price ceiling on a competitive market, a shortage of the good
arises, and sellers must ration the scarce goods among the large number of potential buy-
ers. The rationing mechanisms that develop under price ceilings are rarely desir-
able. Long lines are inefficient because they waste buyers’ time. Discrimination
according to seller bias is both inefficient (because the good does not necessarily
go to the buyer who values it most highly) and potentially unfair. By contrast, the
rationing mechanism in a free, competitive market is both efficient and imper-
sonal. When the market for ice cream reaches its equilibrium, anyone who wants
to pay the market price can get a cone. Free markets ration goods with prices.

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114 PART II HOW MARKETS WORK

Lines at the Gas Pump

As we discussed in the preceding chapter, in 1973 the Organization of Petroleum
Exporting Countries (OPEC) raised the price of crude oil in world oil markets.
Because crude oil is the major input used to make gasoline, the higher oil prices
reduced the supply of gasoline. Long lines at gas stations became commonplace,
and motorists often had to wait for hours to buy only a few gallons of gas.

What was responsible for the long gas lines? Most people blame OPEC. Surely,
if OPEC had not raised the price of crude oil, the shortage of gasoline would not
have occurred. Yet economists blame U.S. government regulations that limited
the price oil companies could charge for gasoline.

Figure 2 shows what happened. As shown in panel (a), before OPEC raised the
price of crude oil, the equilibrium price of gasoline, P

1
, was below the price ceil-

ing. The price regulation, therefore, had no effect. When the price of crude oil rose,
however, the situation changed. The increase in the price of crude oil raised the
cost of producing gasoline, and this reduced the supply of gasoline. As panel (b)
shows, the supply curve shifted to the left from S

1
to S

2
. In an unregulated market,

this shift in supply would have raised the equilibrium price of gasoline from P
1

to P
2
, and no shortage would have resulted. Instead, the price ceiling prevented

the price from rising to the equilibrium level. At the price ceiling, producers were

Panel (a) shows the gasoline market when the price ceiling is not binding because
the equilibrium price, P

1
, is below the ceiling. Panel (b) shows the gasoline market

after an increase in the price of crude oil (an input into making gasoline) shifts the
supply curve to the left from S

1
to S

2
. In an unregulated market, the price would have

risen from P
1
to P

2
. The price ceiling, however, prevents this from happening. At the

binding price ceiling, consumers are willing to buy Q
D
, but producers of gasoline

are willing to sell only Q
S
. The difference between quantity demanded and quantity

supplied, Q
D

– Q
S
, measures the gasoline shortage.

The Market for Gasoline
with a Price Ceiling

Figure 2

(a) The Price Ceiling on Gasoline Is Not Binding

Quantity of
Gasoline

0

Price of
Gasoline

(b) The Price Ceiling on Gasoline Is Binding

P2

P1

Quantity of
Gasoline

0

Price of
Gasoline

Q1QD

Demand

S1

S2

Price ceiling

QS

4. . . .
resulting
in a
shortage.

3. . . . the price
ceiling becomes
binding . . .

2. . . . but when
supply falls . . .

1. Initially,
the price
ceiling
is not
binding . . . Price ceiling

P1

Q1

Demand

Supply, S1

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115CHAPTER 6 Supply, DEMAnD, AnD GOvERnMEnT pOliciES

willing to sell Q
S
, and consumers were willing to buy Q

D
. Thus, the shift in supply

caused a severe shortage at the regulated price.
Eventually, the laws regulating the price of gasoline were repealed. Lawmakers

came to understand that they were partly responsible for the many hours Ameri-
cans lost waiting in line to buy gasoline. Today, when the price of crude oil changes,
the price of gasoline can adjust to bring supply and demand into equilibrium. ■

Rent Control in the Short Run
and the Long Run

One common example of a price ceiling is rent control. In many cities, the local
government places a ceiling on rents that landlords may charge their tenants. The
goal of this policy is to help the poor by making housing more affordable. Econo-
mists often criticize rent control, arguing that it is a highly inefficient way to help
the poor raise their standard of living. One economist called rent control “the best
way to destroy a city, other than bombing.”

The adverse effects of rent control are less apparent to the general population
because these effects occur over many years. In the short run, landlords have a
fixed number of apartments to rent, and they cannot adjust this number quickly as
market conditions change. Moreover, the number of people searching for housing
in a city may not be highly responsive to rents in the short run because people take
time to adjust their housing arrangements. Therefore, the short-run supply and
demand for housing are relatively inelastic.

Panel (a) of Figure 3 shows the short-run effects of rent control on the housing
market. As with any binding price ceiling, rent control causes a shortage. Yet because

Rent Control in the
Short Run and in the
Long Run

Figure 3Panel (a) shows the short-run effects of rent control: Because the supply and demand
curves for apartments are relatively inelastic, the price ceiling imposed by a rent-
control law causes only a small shortage of housing. Panel (b) shows the long-run
effects of rent control: Because the supply and demand curves for apartments are
more elastic, rent control causes a large shortage.

(a) Rent Control in the Short Run
(supply and demand are inelastic)

(b) Rent Control in the Long Run
(supply and demand are elastic)

Quantity of
Apartments

0

Supply

Controlled rent

Shortage

Rental
Price of

Apartment

0

Rental
Price of

Apartment

Quantity of
Apartments

Demand

Supply

Controlled rent

Shortage

Demand

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116 PART II HOW MARKETS WORK

supply and demand are inelastic in the short run, the initial shortage caused by rent
control is small. The primary effect in the short run is to reduce rents.

The long-run story is very different because the buyers and sellers of rental
housing respond more to market conditions as time passes. On the supply side,
landlords respond to low rents by not building new apartments and by failing to
maintain existing ones. On the demand side, low rents encourage people to find
their own apartments (rather than living with their parents or sharing apartments
with roommates) and induce more people to move into a city. Therefore, both
supply and demand are more elastic in the long run.

Panel (b) of Figure 3 illustrates the housing market in the long run. When rent
control depresses rents below the equilibrium level, the quantity of apartments
supplied falls substantially, and the quantity of apartments demanded rises sub-
stantially. The result is a large shortage of housing.

In cities with rent control, landlords use various mechanisms to ration hous-
ing. Some landlords keep long waiting lists. Others give a preference to tenants
without children. Still others discriminate on the basis of race. Sometimes apart-
ments are allocated to those willing to offer under-the-table payments to building
superintendents. In essence, these bribes bring the total price of an apartment
(including the bribe) closer to the equilibrium price.

To understand fully the effects of rent control, we have to remember one of the
Ten Principles of Economics from Chapter 1: People respond to incentives. In free
markets, landlords try to keep their buildings clean and safe because desirable
apartments command higher prices. By contrast, when rent control creates short-
ages and waiting lists, landlords lose their incentive to respond to tenants’ con-
cerns. Why should a landlord spend money to maintain and improve the property
when people are waiting to get in as it is? In the end, tenants get lower rents, but
they also get lower-quality housing.

Policymakers often react to the effects of rent control by imposing additional
regulations. For example, various laws make racial discrimination in housing ille-
gal and require landlords to provide minimally adequate living conditions. These
laws, however, are difficult and costly to enforce. By contrast, when rent control
is eliminated and a market for housing is regulated by the forces of competition,
such laws are less necessary. In a free market, the price of housing adjusts to elimi-
nate the shortages that give rise to undesirable landlord behavior. ■

How Price Floors Affect Market Outcomes
To examine the effects of another kind of government price control, let’s return
to the market for ice cream. Imagine now that the government is persuaded by
the pleas of the National Organization of Ice-Cream Makers whose members feel
the $3 equilibrium price is too low. In this case, the government might institute a
price floor. Price floors, like price ceilings, are an attempt by the government to
maintain prices at other than equilibrium levels. Whereas a price ceiling places a
legal maximum on prices, a price floor places a legal minimum.

When the government imposes a price floor on the ice-cream market, two out-
comes are possible. If the government imposes a price floor of $2 per cone when
the equilibrium price is $3, we obtain the outcome in panel (a) of Figure 4. In this
case, because the equilibrium price is above the floor, the price floor is not bind-
ing. Market forces naturally move the economy to the equilibrium, and the price
floor has no effect.

Panel (b) of Figure 4 shows what happens when the government imposes a
price floor of $4 per cone. In this case, because the equilibrium price of $3 is below

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117CHAPTER 6 Supply, DEMAnD, AnD GOvERnMEnT pOliciES

A Market with a Price
Floor

Figure 4In panel (a), the government imposes a price floor of $2. Because this is below the
equilibrium price of $3, the price floor has no effect. The market price adjusts to
balance supply and demand. At the equilibrium, quantity supplied and quantity
demanded both equal 100 cones. In panel (b), the government imposes a price floor
of $4, which is above the equilibrium price of $3. Therefore, the market price equals
$4. Because 120 cones are supplied at this price and only 80 are demanded, there is a
surplus of 40 cones.

(a) A Price Floor That Is Not Binding

$3

2

Quantity of
Ice-Cream

Cones

0

Price of
Ice-Cream

Cone

100

Equilibrium
quantity

(b) A Price Floor That Is Binding

$4

Quantity of
Ice-Cream

Cones

0

Price of
Ice-Cream

Cone

3
Price
floor

Demand

Supply

Price
floor

80

Quantity
demanded

120

Quantity
supplied

Equilibrium
price

Equilibrium
price

Demand

Supply

Surplus

the floor, the price floor is a binding constraint on the market. The forces of sup-
ply and demand tend to move the price toward the equilibrium price, but when
the market price hits the floor, it can fall no further. The market price equals the
price floor. At this floor, the quantity of ice cream supplied (120 cones) exceeds
the quantity demanded (80 cones). Some people who want to sell ice cream at the
going price are unable to. Thus, a binding price floor causes a surplus.

Just as the shortages resulting from price ceilings can lead to undesirable
rationing mechanisms, so can the surpluses resulting from price floors. In the
case of a price floor, some sellers are unable to sell all they want at the market
price. The sellers who appeal to the personal biases of the buyers, perhaps due to
racial or familial ties, are better able to sell their goods than those who do not. By
contrast, in a free market, the price serves as the rationing mechanism, and sellers
can sell all they want at the equilibrium price.

The Minimum Wage

An important example of a price floor is the minimum wage. Minimum-wage
laws dictate the lowest price for labor that any employer may pay. The U.S.
Congress first instituted a minimum wage with the Fair Labor Standards Act
of 1938 to ensure workers a minimally adequate standard of living. In 2009,
the minimum wage according to federal law was $7.25 per hour. (Some states

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118 PART II HOW MARKETS WORK

mandate minimum wages above the federal level.) Most European nations have
minimum-wage laws as well; some, such as France and the United Kingdom,
have significantly higher minimums than the United States.

To examine the effects of a minimum wage, we must consider the market for
labor. Panel (a) of Figure 5 shows the labor market, which, like all markets, is sub-
ject to the forces of supply and demand. Workers determine the supply of labor,
and firms determine the demand. If the government doesn’t intervene, the wage
normally adjusts to balance labor supply and labor demand.

Panel (b) of Figure 5 shows the labor market with a minimum wage. If the
minimum wage is above the equilibrium level, as it is here, the quantity of labor
supplied exceeds the quantity demanded. The result is unemployment. Thus, the
minimum wage raises the incomes of those workers who have jobs, but it lowers
the incomes of workers who cannot find jobs.

To fully understand the minimum wage, keep in mind that the economy
contains not a single labor market but many labor markets for different types of
workers. The impact of the minimum wage depends on the skill and experience of
the worker. Highly skilled and experienced workers are not affected because their
equilibrium wages are well above the minimum. For these workers, the minimum
wage is not binding.

The minimum wage has its greatest impact on the market for teenage labor.
The equilibrium wages of teenagers are low because teenagers are among the least
skilled and least experienced members of the labor force. In addition, teenagers
are often willing to accept a lower wage in exchange for on-the-job training. (Some
teenagers are willing to work as “interns” for no pay at all. Because internships
pay nothing, however, the minimum wage does not apply to them. If it did, these

Panel (a) shows a labor market in which the wage adjusts to balance labor supply
and labor demand. Panel (b) shows the impact of a binding minimum wage. Because
the minimum wage is a price floor, it causes a surplus: The quantity of labor supplied
exceeds the quantity demanded. The result is unemployment.

How the Minimum Wage
Affects the Labor Market

Figure 5

(a) A Free Labor Market

Quantity of
Labor

0

Wage

Equilibrium
employment

(b) A Labor Market with a Binding Minimum Wage

Quantity of
Labor

0

Wage

Quantity
demanded

Quantity
supplied

Labor
supply

Labor
demand

Minimum
wage

Labor surplus
(unemployment)

Equilibrium
wage

Labor
demand

Labor
supply

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119CHAPTER 6 Supply, DEMAnD, AnD GOvERnMEnT pOliciES

jobs might not exist.) As a result, the minimum wage is more often binding for
teenagers than for other members of the labor force.

Many economists have studied how minimum-wage laws affect the teenage
labor market. These researchers compare the changes in the minimum wage over
time with the changes in teenage employment. Although there is some debate
about how much the minimum wage affects employment, the typical study finds
that a 10 percent increase in the minimum wage depresses teenage employment
between 1 and 3 percent. In interpreting this estimate, note that a 10 percent
increase in the minimum wage does not raise the average wage of teenagers
by 10 percent. A change in the law does not directly affect those teenagers who
are already paid well above the minimum, and enforcement of minimum-wage
laws is not perfect. Thus, the estimated drop in employment of 1 to 3 percent is
significant.

In addition to altering the quantity of labor demanded, the minimum wage
alters the quantity supplied. Because the minimum wage raises the wage that
teenagers can earn, it increases the number of teenagers who choose to look for
jobs. Studies have found that a higher minimum wage influences which teenagers
are employed. When the minimum wage rises, some teenagers who are still
attending high school choose to drop out and take jobs. These new dropouts
displace other teenagers who had already dropped out of school and who now
become unemployed.

The minimum wage is a frequent topic of debate. Economists are about evenly
divided on the issue. In a 2006 survey of Ph.D. economists, 47 percent favored
eliminating the minimum wage, while 14 percent would maintain it at its current
level and 38 percent would increase it.

Advocates of the minimum wage view the policy as one way to raise the
income of the working poor. They correctly point out that workers who earn the
minimum wage can afford only a meager standard of living. In 2009, for instance,
when the minimum wage was $7.25 per hour, two adults working 40 hours a
week for every week of the year at minimum-wage jobs had a total annual income
of only $30,160, which was less than two-thirds of the median family income in
the United States. Many advocates of the minimum wage admit that it has some
adverse effects, including unemployment, but they believe that these effects are
small and that, all things considered, a higher minimum wage makes the poor
better off.

Opponents of the minimum wage contend that it is not the best way to combat
poverty. They note that a high minimum wage causes unemployment, encour-
ages teenagers to drop out of school, and prevents some unskilled workers from
getting the on-the-job training they need. Moreover, opponents of the minimum
wage point out that it is a poorly targeted policy. Not all minimum-wage workers
are heads of households trying to help their families escape poverty. In fact, fewer
than a third of minimum-wage earners are in families with incomes below the
poverty line. Many are teenagers from middle-class homes working at part-time
jobs for extra spending money. ■

Evaluating Price Controls
One of the Ten Principles of Economics discussed in Chapter 1 is that markets are
usually a good way to organize economic activity. This principle explains why
economists usually oppose price ceilings and price floors. To economists, prices
are not the outcome of some haphazard process. Prices, they contend, are the

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120 PART II HOW MARKETS WORK

Should Unpaid Internships Be Allowed?
Some students take internships without pay to gain skills and experi-
ence. Regulators are starting to ask whether this should be legal.

in the news

The Unpaid Intern,
Legal or Not
By Steven GreenhouSe

With job openings scarce for young people, the number of unpaid intern-
ships has climbed in recent years, leading
federal and state regulators to worry that
more employers are illegally using such
internships for free labor.
Convinced that many unpaid intern-
ships violate minimum wage laws, officials
in Oregon, California and other states have

begun investigations and fined employers.
Last year, M. Patricia Smith, then New York’s
labor commissioner, ordered investigations
into several firms’ internships. Now, as the fed-
eral Labor Department’s top law enforcement
official, she and the wage and hour division
are stepping up enforcement nationwide….
The Labor Department says it is crack-
ing down on firms that fail to pay interns
properly and expanding efforts to educate
companies, colleges and students on the
law regarding internships.
“If you’re a for-profit employer or
you want to pursue an internship with a

for-profit employer, there aren’t going to be
many circumstances where you can have
an internship and not be paid and still be
in compliance with the law,” said Nancy J.
Leppink, the acting director of the depart-
ment’s wage and hour division.

Note from the author: The rules dis-
cussed in this article are being applied to
for-profit firms but not to government.
Many government internships, including
those at congressional offices, are unpaid.
The Labor Department is not trying to pro-
hibit this arrangement.

Source: New York Times, April 2, 2010.

result of the millions of business and consumer decisions that lie behind the
supply and demand curves. Prices have the crucial job of balancing supply and
demand and, thereby, coordinating economic activity. When policymakers set
prices by legal decree, they obscure the signals that normally guide the allocation
of society’s resources.

Another one of the Ten Principles of Economics is that governments can some-
times improve market outcomes. Indeed, policymakers are led to control prices
because they view the market’s outcome as unfair. Price controls are often aimed
at helping the poor. For instance, rent-control laws try to make housing affordable
for everyone, and minimum-wage laws try to help people escape poverty.

Yet price controls often hurt those they are trying to help. Rent control may
keep rents low, but it also discourages landlords from maintaining their buildings
and makes housing hard to find. Minimum-wage laws may raise the incomes of
some workers, but they also cause other workers to be unemployed.

Helping those in need can be accomplished in ways other than controlling
prices. For instance, the government can make housing more affordable by
paying a fraction of the rent for poor families. Unlike rent control, such rent
subsidies do not reduce the quantity of housing supplied and, therefore, do not
lead to housing shortages. Similarly, wage subsidies raise the living standards
of the working poor without discouraging firms from hiring them. An example

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121CHAPTER 6 Supply, DEMAnD, AnD GOvERnMEnT pOliciES

of a wage subsidy is the earned income tax credit, a government program that
supplements the incomes of low-wage workers.

Although these alternative policies are often better than price controls, they are
not perfect. Rent and wage subsidies cost the government money and, therefore,
require higher taxes. As we see in the next section, taxation has costs of its own.

Quick Quiz Define price ceiling and price floor and give an example of each. Which
leads to a shortage? Which leads to a surplus? Why?

Taxes
All governments—from the federal government in Washington, D.C., to the local
governments in small towns—use taxes to raise revenue for public projects, such
as roads, schools, and national defense. Because taxes are such an important
policy instrument, and because they affect our lives in many ways, we return to
the study of taxes several times throughout this book. In this section, we begin our
study of how taxes affect the economy.

To set the stage for our analysis, imagine that a local government decides to
hold an annual ice-cream celebration—with a parade, fireworks, and speeches by
town officials. To raise revenue to pay for the event, the town decides to place a
$0.50 tax on the sale of ice-cream cones. When the plan is announced, our two lob-
bying groups swing into action. The American Association of Ice-Cream Eaters
claims that consumers of ice cream are having trouble making ends meet, and it
argues that sellers of ice cream should pay the tax. The National Organization of
Ice-Cream Makers claims that its members are struggling to survive in a competi-
tive market, and it argues that buyers of ice cream should pay the tax. The town
mayor, hoping to reach a compromise, suggests that half the tax be paid by the
buyers and half be paid by the sellers.

To analyze these proposals, we need to address a simple but subtle question:
When the government levies a tax on a good, who actually bears the burden of the
tax? The people buying the good? The people selling the good? Or if buyers and
sellers share the tax burden, what determines how the burden is divided? Can the
government simply legislate the division of the burden, as the mayor is suggest-
ing, or is the division determined by more fundamental market forces? The term
tax incidence refers to how the burden of a tax is distributed among the various
people who make up the economy. As we will see, some surprising lessons about
tax incidence can be learned by applying the tools of supply and demand.

How Taxes on Sellers Affect Market Outcomes
We begin by considering a tax levied on sellers of a good. Suppose the local gov-
ernment passes a law requiring sellers of ice-cream cones to send $0.50 to the gov-
ernment for each cone they sell. How does this law affect the buyers and sellers of
ice cream? To answer this question, we can follow the three steps in Chapter 4 for
analyzing supply and demand: (1) We decide whether the law affects the supply
curve or demand curve. (2) We decide which way the curve shifts. (3) We examine
how the shift affects the equilibrium price and quantity.

Step One The immediate impact of the tax is on the sellers of ice cream.
Because the tax is not levied on buyers, the quantity of ice cream demanded at
any given price is the same; thus, the demand curve does not change. By contrast,

tax incidence
the manner in which the
burden of a tax is shared
among participants in a
market

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122 PART II HOW MARKETS WORK

the tax on sellers makes the ice-cream business less profitable at any given price,
so it shifts the supply curve.

Step Two Because the tax on sellers raises the cost of producing and selling ice
cream, it reduces the quantity supplied at every price. The supply curve shifts to
the left (or, equivalently, upward).

In addition to determining the direction in which the supply curve moves, we
can also be precise about the size of the shift. For any market price of ice cream,
the effective price to sellers—the amount they get to keep after paying the tax—is
$0.50 lower. For example, if the market price of a cone happened to be $2.00, the
effective price received by sellers would be $1.50. Whatever the market price, sell-
ers will supply a quantity of ice cream as if the price were $0.50 lower than it is.
Put differently, to induce sellers to supply any given quantity, the market price
must now be $0.50 higher to compensate for the effect of the tax. Thus, as shown
in Figure 6, the supply curve shifts upward from S

1
to S

2
by the exact size of the

tax ($0.50).

Step Three Having determined how the supply curve shifts, we can now com-
pare the initial and the new equilibriums. The figure shows that the equilibrium
price of ice cream rises from $3.00 to $3.30, and the equilibrium quantity falls from
100 to 90 cones. Because sellers sell less and buyers buy less in the new equilib-
rium, the tax reduces the size of the ice-cream market.

Implications We can now return to the question of tax incidence: Who pays
the tax? Although sellers send the entire tax to the government, buyers and sell-
ers share the burden. Because the market price rises from $3.00 to $3.30 when the
tax is introduced, buyers pay $0.30 more for each ice-cream cone than they did
without the tax. Thus, the tax makes buyers worse off. Sellers get a higher price
($3.30) from buyers than they did previously, but the effective price after paying
the tax falls from $3.00 before the tax to $2.80 with the tax ($3.30 – $0.50 = $2.80).
Thus, the tax also makes sellers worse off.

Figure 6
A Tax on Sellers
When a tax of $0.50 is levied on
sellers, the supply curve shifts up by
$0.50 from S

1
to S

2
. The equilibrium

quantity falls from 100 to 90 cones.
The price that buyers pay rises from
$3.00 to $3.30. The price that sellers
receive (after paying the tax) falls
from $3.00 to $2.80. Even though the
tax is levied on sellers, buyers and
sellers share the burden of the tax.

$3.30
3.00
2.80

Quantity of
Ice-Cream Cones

0

Price of
Ice-Cream

Cone

Price
without

tax

Price
sellers
receive

10090

Equilibrium
with tax

Equilibrium without tax

Tax ($0.50)

Price
buyers

pay
S1

S2

Demand, D1

A tax on sellers shifts
the supply curve
upward by the size of
the tax ($0.50).

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123CHAPTER 6 Supply, DEMAnD, AnD GOvERnMEnT pOliciES

To sum up, this analysis yields two lessons:

• Taxes discourage market activity. When a good is taxed, the quantity of the
good sold is smaller in the new equilibrium.

• Buyers and sellers share the burden of taxes. In the new equilibrium, buyers
pay more for the good, and sellers receive less.

How Taxes on Buyers Affect Market Outcomes
Now consider a tax levied on buyers of a good. Suppose that our local govern-
ment passes a law requiring buyers of ice-cream cones to send $0.50 to the govern-
ment for each ice-cream cone they buy. What are the effects of this law? Again,
we apply our three steps.

Step One The initial impact of the tax is on the demand for ice cream. The sup-
ply curve is not affected because, for any given price of ice cream, sellers have the
same incentive to provide ice cream to the market. By contrast, buyers now have
to pay a tax to the government (as well as the price to the sellers) whenever they
buy ice cream. Thus, the tax shifts the demand curve for ice cream.

Step Two We next determine the direction of the shift. Because the tax on
buyers makes buying ice cream less attractive, buyers demand a smaller quantity
of ice cream at every price. As a result, the demand curve shifts to the left (or,
equivalently, downward), as shown in Figure 7.

Once again, we can be precise about the size of the shift. Because of the $0.50
tax levied on buyers, the effective price to buyers is now $0.50 higher than the
market price (whatever the market price happens to be). For example, if the
market price of a cone happened to be $2.00, the effective price to buyers would
be $2.50. Because buyers look at their total cost including the tax, they demand a
quantity of ice cream as if the market price were $0.50 higher than it actually is.
In other words, to induce buyers to demand any given quantity, the market price

Figure 7
A Tax on Buyers
When a tax of $0.50 is levied
on buyers, the demand curve
shifts down by $0.50 from
D

1
to D

2
. The equilibrium

quantity falls from 100 to
90 cones. The price that
sellers receive falls from
$3.00 to $2.80. The price that
buyers pay (including the
tax) rises from $3.00 to $3.30.
Even though the tax is levied
on buyers, buyers and sellers
share the burden of the tax.

$3.30
3.00
2.80

Quantity of
Ice-Cream Cones

0

Price of
Ice-Cream

Cone

Price
without

tax

Price
sellers
receive

10090

Equilibrium
with tax

Equilibrium without tax
Tax ($0.50)

Price
buyers

pay

D1
D2

Supply, S1

A tax on buyers shifts
the demand curve
downward by the size
of the tax ($0.50).

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124 PART II HOW MARKETS WORK

must now be $0.50 lower to make up for the effect of the tax. Thus, the tax shifts
the demand curve downward from D

1
to D

2
by the exact size of the tax ($0.50).

Step Three Having determined how the demand curve shifts, we can now
see the effect of the tax by comparing the initial equilibrium and the new equi-
librium. You can see in the figure that the equilibrium price of ice cream falls
from $3.00 to $2.80, and the equilibrium quantity falls from 100 to 90 cones. Once
again, the tax on ice cream reduces the size of the ice-cream market. And once
again, buyers and sellers share the burden of the tax. Sellers get a lower price
for their product; buyers pay a lower market price to sellers than they did previ-
ously, but the effective price (including the tax buyers have to pay) rises from
$3.00 to $3.30.

Implications If you compare Figures 6 and 7, you will notice a surprising
conclusion: Taxes levied on sellers and taxes levied on buyers are equivalent. In both
cases, the tax places a wedge between the price that buyers pay and the price that
sellers receive. The wedge between the buyers’ price and the sellers’ price is the
same, regardless of whether the tax is levied on buyers or sellers. In either case,
the wedge shifts the relative position of the supply and demand curves. In the
new equilibrium, buyers and sellers share the burden of the tax. The only differ-
ence between taxes on sellers and taxes on buyers is who sends the money to the
government.

The equivalence of these two taxes is easy to understand if we imagine that the
government collects the $0.50 ice-cream tax in a bowl on the counter of each ice-
cream store. When the government levies the tax on sellers, the seller is required
to place $0.50 in the bowl after the sale of each cone. When the government levies
the tax on buyers, the buyer is required to place $0.50 in the bowl every time a
cone is bought. Whether the $0.50 goes directly from the buyer’s pocket into the
bowl, or indirectly from the buyer’s pocket into the seller’s hand and then into the
bowl, does not matter. Once the market reaches its new equilibrium, buyers and
sellers share the burden, regardless of how the tax is levied.

Can Congress Distribute the Burden of a
Payroll Tax?

If you have ever received a paycheck, you probably noticed that taxes were
deducted from the amount you earned. One of these taxes is called FICA, an
acronym for the Federal Insurance Contributions Act. The federal government
uses the revenue from the FICA tax to pay for Social Security and Medicare, the
income support and healthcare programs for the elderly. FICA is an example of a
payroll tax, which is a tax on the wages that firms pay their workers. In 2010, the
total FICA tax for the typical worker was 15.3 percent of earnings.

Who do you think bears the burden of this payroll tax—firms or workers?
When Congress passed this legislation, it tried to mandate a division of the tax
burden. According to the law, half of the tax is paid by firms, and half is paid by
workers. That is, half of the tax is paid out of firms’ revenues, and half is deducted
from workers’ paychecks. The amount that shows up as a deduction on your pay
stub is the worker contribution.

Our analysis of tax incidence, however, shows that lawmakers cannot so
easily dictate the distribution of a tax burden. To illustrate, we can analyze a
payroll tax as merely a tax on a good, where the good is labor and the price is

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125CHAPTER 6 Supply, DEMAnD, AnD GOvERnMEnT pOliciES

the wage. The key feature of the payroll tax is that it places a wedge between
the wage that firms pay and the wage that workers receive. Figure 8 shows the
outcome. When a payroll tax is enacted, the wage received by workers falls, and
the wage paid by firms rises. In the end, workers and firms share the burden
of the tax, much as the legislation requires. Yet this division of the tax burden
between workers and firms has nothing to do with the legislated division: The
division of the burden in Figure 8 is not necessarily fifty-fifty, and the same
outcome would prevail if the law levied the entire tax on workers or if it levied
the entire tax on firms.

This example shows that the most basic lesson of tax incidence is often over-
looked in public debate. Lawmakers can decide whether a tax comes from the
buyer’s pocket or from the seller’s, but they cannot legislate the true burden of a
tax. Rather, tax incidence depends on the forces of supply and demand. ■

Elasticity and Tax Incidence
When a good is taxed, buyers and sellers of the good share the burden of the tax.
But how exactly is the tax burden divided? Only rarely will it be shared equally.
To see how the burden is divided, consider the impact of taxation in the two
markets in Figure 9. In both cases, the figure shows the initial demand curve, the
initial supply curve, and a tax that drives a wedge between the amount paid by
buyers and the amount received by sellers. (Not drawn in either panel of the fig-
ure is the new supply or demand curve. Which curve shifts depends on whether
the tax is levied on buyers or sellers. As we have seen, this is irrelevant for the
incidence of the tax.) The difference in the two panels is the relative elasticity of
supply and demand.

Panel (a) of Figure 9 shows a tax in a market with very elastic supply and rela-
tively inelastic demand. That is, sellers are very responsive to changes in the price
of the good (so the supply curve is relatively flat), whereas buyers are not very
responsive (so the demand curve is relatively steep). When a tax is imposed on a

Figure 8
A Payroll Tax
A payroll tax places a wedge between
the wage that workers receive and the
wage that firms pay. Comparing wages
with and without the tax, you can see
that workers and firms share the tax
burden. This division of the tax burden
between workers and firms does not
depend on whether the government
levies the tax on workers, levies the
tax on firms, or divides the tax equally
between the two groups.

Wage without tax

Quantity
of Labor

0

Wage

Labor demand

Labor supply

Tax wedge

Wage workers
receive

Wage firms pay

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126 PART II HOW MARKETS WORK

Figure 9
How the Burden of a Tax Is Divided
In panel (a), the supply curve is elastic,
and the demand curve is inelastic. In
this case, the price received by sellers
falls only slightly, while the price paid
by buyers rises substantially. Thus,
buyers bear most of the burden of
the tax. In panel (b), the supply curve
is inelastic, and the demand curve is
elastic. In this case, the price received
by sellers falls substantially, while the
price paid by buyers rises only slightly.
Thus, sellers bear most of the burden
of the tax.

Price without tax

Quantity0

Price

Demand

Supply

Tax

Price sellers
receive

Price buyers pay

(a) Elastic Supply, Inelastic Demand

Price without tax

Quantity0

Price

Demand

Supply

Tax

Price sellers
receive

Price buyers pay

(b) Inelastic Supply, Elastic Demand

2. . . . the
incidence of the
tax falls more
heavily on
consumers . . .

1. When supply is more elastic than
demand . . .

3. . . . than
on producers.

2. . . . the
incidence of
the tax falls
more heavily
on producers . . .

3. . . . than on
consumers.

1. When demand is more elastic than
supply . . .

market with these elasticities, the price received by sellers does not fall much, so
sellers bear only a small burden. By contrast, the price paid by buyers rises sub-
stantially, indicating that buyers bear most of the burden of the tax.

Panel (b) of Figure 9 shows a tax in a market with relatively inelastic supply
and very elastic demand. In this case, sellers are not very responsive to changes
in the price (so the supply curve is steeper), whereas buyers are very responsive
(so the demand curve is flatter). The figure shows that when a tax is imposed, the
price paid by buyers does not rise much, but the price received by sellers falls
substantially. Thus, sellers bear most of the burden of the tax.

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127CHAPTER 6 Supply, DEMAnD, AnD GOvERnMEnT pOliciES

The two panels of Figure 9 show a general lesson about how the burden of
a tax is divided: A tax burden falls more heavily on the side of the market that is
less elastic. Why is this true? In essence, the elasticity measures the willingness
of buyers or sellers to leave the market when conditions become unfavorable.
A small elasticity of demand means that buyers do not have good alternatives
to consuming this particular good. A small elasticity of supply means that
sellers do not have good alternatives to producing this particular good. When
the good is taxed, the side of the market with fewer good alternatives is less
willing to leave the market and must, therefore, bear more of the burden of
the tax.

We can apply this logic to the payroll tax discussed in the previous case study.
Most labor economists believe that the supply of labor is much less elastic than
the demand. This means that workers, rather than firms, bear most of the burden
of the payroll tax. In other words, the distribution of the tax burden is not at all
close to the fifty-fifty split that lawmakers intended.

Who Pays the Luxury Tax?

In 1990, Congress adopted a new luxury tax on items such as yachts, private
airplanes, furs, jewelry, and expensive cars. The goal of the tax was to raise
revenue from those who could most easily afford to pay. Because only the rich
could afford to buy such extravagances, taxing luxuries seemed a logical way
of taxing the rich.

Yet, when the forces of supply and demand took over, the outcome was quite
different from the one Congress intended. Consider, for example, the market for
yachts. The demand for yachts is quite elastic. A millionaire can easily not buy a
yacht; she can use the money to buy a bigger house, take a European vacation, or
leave a larger bequest to her heirs. By contrast, the supply of yachts is relatively
inelastic, at least in the short run. Yacht factories are not easily converted to
alternative uses, and workers who build yachts are not eager to change careers in
response to changing market conditions.

Our analysis makes a clear prediction in this case. With elastic demand and
inelastic supply, the burden of a tax falls largely on the suppliers. That is, a tax on
yachts places a burden largely on the firms and workers who build yachts because
they end up getting a significantly lower price for their product. The workers,
however, are not wealthy. Thus, the burden of a luxury tax falls more on the
middle class than on the rich.

The mistaken assumptions about the incidence of the luxury tax quickly
became apparent after the tax went into effect. Suppliers of luxuries made their
congressional representatives well aware of the economic hardship they experi-
enced, and Congress repealed most of the luxury tax in 1993. ■

Quick Quiz In a supply-and-demand diagram, show how a tax on car buyers of
$1,000 per car affects the quantity of cars sold and the price of cars. In another dia-
gram, show how a tax on car sellers of $1,000 per car affects the quantity of cars sold
and the price of cars. In both of your diagrams, show the change in the price paid by
car buyers and the change in the price received by car sellers.

“If this boat were any
more expensive, we’d be
playing golf.”

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TO

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128 PART II HOW MARKETS WORK

Conclusion
The economy is governed by two kinds of laws: the laws of supply and demand
and the laws enacted by governments. In this chapter, we have begun to see how
these laws interact. Price controls and taxes are common in various markets in
the economy, and their effects are frequently debated in the press and among
policymakers. Even a little bit of economic knowledge can go a long way toward
understanding and evaluating these policies.

In subsequent chapters, we analyze many government policies in greater
detail. We examine the effects of taxation more fully and consider a broader range
of policies than we considered here. Yet the basic lessons of this chapter will not
change: When analyzing government policies, supply and demand are the first
and most useful tools of analysis.

price ceiling, p. 112 price floor, p. 112 tax incidence, p. 121

• A price ceiling is a legal maximum on the price
of a good or service. An example is rent control.
If the price ceiling is below the equilibrium price,
then the price ceiling is binding, and the quantity
demanded exceeds the quantity supplied. Because
of the resulting shortage, sellers must in some way
ration the good or service among buyers.

• A price floor is a legal minimum on the price of
a good or service. An example is the minimum
wage. If the price floor is above the equilibrium
price, then the price floor is binding, and the quan-
tity supplied exceeds the quantity demanded.
Because of the resulting surplus, buyers’ demands
for the good or service must in some way be
rationed among sellers.

• When the government levies a tax on a good,
the equilibrium quantity of the good falls. That

is, a tax on a market shrinks the size of the
market.

• A tax on a good places a wedge between the
price paid by buyers and the price received
by sellers. When the market moves to the new
equilibrium, buyers pay more for the good and
sellers receive less for it. In this sense, buyers
and sellers share the tax burden. The incidence
of a tax (that is, the division of the tax burden)
does not depend on whether the tax is levied on
buyers or sellers.

• The incidence of a tax depends on the price
elasticities of supply and demand. Most of the
burden falls on the side of the market that is
less elastic because that side of the market can
respond less easily to the tax by changing the
quantity bought or sold.

S u m m a r y

K e y C o n C e p t s

1. Give an example of a price ceiling and an exam-
ple of a price floor.

2. Which causes a shortage of a good—a price
ceiling or a price floor? Justify your answer
with a graph.

3. What mechanisms allocate resources when the
price of a good is not allowed to bring supply
and demand into equilibrium?

4. Explain why economists usually oppose con-
trols on prices.

Q u e s t i o n s f o r r e v i e w

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129CHAPTER 6 Supply, DEMAnD, AnD GOvERnMEnT pOliciES

1. Lovers of classical music persuade Congress to
impose a price ceiling of $40 per concert ticket.
As a result of this policy, do more or fewer
people attend classical music concerts?

2. The government has decided that the free-
market price of cheese is too low.
a. Suppose the government imposes a binding

price floor in the cheese market. Draw
a supply-and-demand diagram to show the
effect of this policy on the price of cheese and
the quantity of cheese sold. Is there a short-
age or surplus of cheese?

b. Farmers complain that the price floor has
reduced their total revenue. Is this possible?
Explain.

c. In response to farmers’ complaints, the gov-
ernment agrees to purchase all the surplus
cheese at the price floor. Compared to the
basic price floor, who benefits from this new
policy? Who loses?

3. A recent study found that the demand and
supply schedules for Frisbees are as follows:

Price per Quantity Quantity
Frisbee Demanded Supplied

$11 1 million Frisbees 15 million Frisbees
10 2 12
9 4 9
8 6 6
7 8 3
6 10 1

a. What are the equilibrium price and quantity
of Frisbees?

b. Frisbee manufacturers persuade the gov-
ernment that Frisbee production improves

scientists’ understanding of aerodynamics
and thus is important for national security. A
concerned Congress votes to impose a price
floor $2 above the equilibrium price. What is
the new market price? How many Frisbees
are sold?

c. Irate college students march on Washington
and demand a reduction in the price of
Frisbees. An even more concerned Congress
votes to repeal the price floor and impose a
price ceiling $1 below the former price floor.
What is the new market price? How many
Frisbees are sold?

4. Suppose the federal government requires beer
drinkers to pay a $2 tax on each case of beer
purchased. (In fact, both the federal and state
governments impose beer taxes of some sort.)
a. Draw a supply-and-demand diagram of the

market for beer without the tax. Show the
price paid by consumers, the price received
by producers, and the quantity of beer sold.
What is the difference between the price
paid by consumers and the price received by
producers?

b. Now draw a supply-and-demand diagram
for the beer market with the tax. Show the
price paid by consumers, the price received
by producers, and the quantity of beer sold.
What is the difference between the price
paid by consumers and the price received
by producers? Has the quantity of beer sold
increased or decreased?

5. A senator wants to raise tax revenue and make
workers better off. A staff member proposes
raising the payroll tax paid by firms and using
part of the extra revenue to reduce the payroll

P r o b l e m s a n d a P P l i c a t i o n s

5. Suppose the government removes a tax on
buyers of a good and levies a tax of the same
size on sellers of the good. How does this
change in tax policy affect the price that
buyers pay sellers for this good, the amount
buyers are out of pocket including the tax, the
amount sellers receive net of the tax, and the
quantity of the good sold?

6. How does a tax on a good affect the price paid
by buyers, the price received by sellers, and the
quantity sold?

7. What determines how the burden of a tax is
divided between buyers and sellers? Why?

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130 PART II HOW MARKETS WORK

tax paid by workers. Would this accomplish
the senator’s goal? Explain.

6. If the government places a $500 tax on luxury
cars, will the price paid by consumers rise by
more than $500, less than $500, or exactly $500?
Explain.

7. Congress and the president decide that the
United States should reduce air pollution by
reducing its use of gasoline. They impose a
$0.50 tax for each gallon of gasoline sold.
a. Should they impose this tax on producers

or consumers? Explain carefully using a
supply-and-demand diagram.

b. If the demand for gasoline were more elas-
tic, would this tax be more effective or less
effective in reducing the quantity of gasoline
consumed? Explain with both words and a
diagram.

c. Are consumers of gasoline helped or hurt by
this tax? Why?

d. Are workers in the oil industry helped or
hurt by this tax? Why?

8. A case study in this chapter discusses the fed-
eral minimum-wage law.
a. Suppose the minimum wage is above

the equilibrium wage in the market
for unskilled labor. Using a supply-
and-demand diagram of the market for
unskilled labor, show the market wage,
the number of workers who are employed,
and the number of workers who are unem-
ployed. Also show the total wage pay-
ments to unskilled workers.

b. Now suppose the secretary of labor proposes
an increase in the minimum wage. What
effect would this increase have on employ-
ment? Does the change in employment
depend on the elasticity of demand, the elas-
ticity of supply, both elasticities, or neither?

c. What effect would this increase in the mini-
mum wage have on unemployment? Does
the change in unemployment depend on the
elasticity of demand, the elasticity of supply,
both elasticities, or neither?

d. If the demand for unskilled labor were
inelastic, would the proposed increase in the
minimum wage raise or lower total wage
payments to unskilled workers? Would your

answer change if the demand for unskilled
labor were elastic?

9. The U.S. government administers two pro-
grams that affect the market for cigarettes.
Media campaigns and labeling requirements
are aimed at making the public aware of the
dangers of cigarette smoking. At the same
time, the Department of Agriculture maintains
a price-support program for tobacco farmers,
which raises the price of tobacco above the
equili brium price.
a. How do these two programs affect cigarette

consumption? Use a graph of the cigarette
market in your answer.

b. What is the combined effect of these two
programs on the price of cigarettes?

c. Cigarettes are also heavily taxed. What effect
does this tax have on cigarette consumption?

10. At Fenway Park, home of the Boston Red Sox,
seating is limited to 39,000. Hence, the number
of tickets issued is fixed at that figure. Seeing a
golden opportunity to raise revenue, the City of
Boston levies a per ticket tax of $5 to be paid by
the ticket buyer. Boston sports fans, a famously
civic-minded lot, dutifully send in the $5 per
ticket. Draw a well-labeled graph showing the
impact of the tax. On whom does the tax burden
fall—the team’s owners, the fans, or both? Why?

11. A subsidy is the opposite of a tax. With a $0.50
tax on the buyers of ice-cream cones, the gov-
ernment collects $0.50 for each cone purchased;
with a $0.50 subsidy for the buyers of ice-cream
cones, the government pays buyers $0.50 for
each cone purchased.
a. Show the effect of a $0.50 per cone subsidy

on the demand curve for ice-cream cones,
the effective price paid by consumers, the
effective price received by sellers, and the
quantity of cones sold.

b. Do consumers gain or lose from this policy?
Do producers gain or lose? Does the govern-
ment gain or lose?

12. In the spring of 2008, Senators John McCain
and Hillary Clinton (who were then running
for president) proposed a temporary elimina-
tion of the federal gasoline tax, effective only
during the summer of 2008, in order to help
consumers deal with high gasoline prices.

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131CHAPTER 6 Supply, DEMAnD, AnD GOvERnMEnT pOliciES

a. During the summer, when gasoline demand
is high because of vacation driving, gasoline
refiners are operating near full capacity.
What does this fact suggest about the price
elasticity of supply?

b. In light of your answer to (a), who do you
predict would benefit from the temporary
gas tax holiday?

For further information on topics in this chapter,
additional problems, examples, applications, online
quizzes, and more, please visit our website at www
.cengage.com/economics/mankiw.

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Markets and
WelfareI I IPart

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135

7Consumers, Producers, and the Efficiency
of Markets

When consumers go to grocery stores to buy their turkeys for Thanksgiving dinner, they may be disappointed that the price of turkey is as high as it is. At the same time, when farmers bring to market the turkeys they have raised, they wish the price of turkey
were even higher. These views are not surprising: Buyers always want to pay less,
and sellers always want to be paid more. But is there a “right price” for turkey
from the standpoint of society as a whole?

In previous chapters, we saw how, in market economies, the forces of supply
and demand determine the prices of goods and services and the quantities sold.
So far, however, we have described the way markets allocate scarce resources
without directly addressing the question of whether these market allocations are

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136 PART III Markets and Welfare

desirable. In other words, our analysis has been positive (what is) rather than nor-
mative (what should be). We know that the price of turkey adjusts to ensure that
the quantity of turkey supplied equals the quantity of turkey demanded. But at
this equilibrium, is the quantity of turkey produced and consumed too small, too
large, or just right?

In this chapter, we take up the topic of welfare economics, the study of how
the allocation of resources affects economic well-being. We begin by examining
the benefits that buyers and sellers receive from taking part in a market. We then
examine how society can make these benefits as large as possible. This analysis
leads to a profound conclusion: The equilibrium of supply and demand in a mar-
ket maximizes the total benefits received by buyers and sellers.

As you may recall from Chapter 1, one of the Ten Principles of Economics is
that markets are usually a good way to organize economic activity. The study of
welfare economics explains this principle more fully. It also answers our question
about the right price of turkey: The price that balances the supply and demand for
turkey is, in a particular sense, the best one because it maximizes the total welfare
of turkey consumers and turkey producers. No consumer or producer of turkeys
aims to achieve this goal, but their joint action directed by market prices moves
them toward a welfare-maximizing outcome, as if led by an invisible hand.

Consumer Surplus
We begin our study of welfare economics by looking at the benefits buyers receive
from participating in a market.

Willingness to Pay
Imagine that you own a mint-condition recording of Elvis Presley’s first album.
Because you are not an Elvis Presley fan, you decide to sell it. One way to do so
is to hold an auction.

Four Elvis fans show up for your auction: John, Paul, George, and Ringo. Each
of them would like to own the album, but there is a limit to the amount that each
is willing to pay for it. Table 1 shows the maximum price that each of the four pos-
sible buyers would pay. Each buyer’s maximum is called his willingness to pay,
and it measures how much that buyer values the good. Each buyer would be eager
to buy the album at a price less than his willingness to pay, and he would refuse to
buy the album at a price greater than his willingness to pay. At a price equal to his
willingness to pay, the buyer would be indifferent about buying the good: If the
price is exactly the same as the value he places on the album, he would be equally
happy buying it or keeping his money.

welfare economics
the study of how the
allocation of resources
affects economic
well-being

willingness to pay
the maximum amount
that a buyer will pay for
a good

Four Possible Buyers’
Willingness to Pay

Table 1 Buyer Willingness to Pay
John $100
Paul 80
George 70
Ringo 50

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137CHAPTER 7 ConsuMers, ProduCers, and the effiCienCy of Markets

To sell your album, you begin the bidding at a low price, say, $10. Because all
four buyers are willing to pay much more, the price rises quickly. The bidding
stops when John bids $80 (or slightly more). At this point, Paul, George, and
Ringo have dropped out of the bidding because they are unwilling to bid any
more than $80. John pays you $80 and gets the album. Note that the album has
gone to the buyer who values it most highly.

What benefit does John receive from buying the Elvis Presley album? In a
sense, John has found a real bargain: He is willing to pay $100 for the album but
pays only $80 for it. We say that John receives consumer surplus of $20. Consumer
surplus is the amount a buyer is willing to pay for a good minus the amount the
buyer actually pays for it.

Consumer surplus measures the benefit buyers receive from participating in
a market. In this example, John receives a $20 benefit from participating in the
auction because he pays only $80 for a good he values at $100. Paul, George, and
Ringo get no consumer surplus from participating in the auction because they left
without the album and without paying anything.

Now consider a somewhat different example. Suppose that you had two identi-
cal Elvis Presley albums to sell. Again, you auction them off to the four possible
buyers. To keep things simple, we assume that both albums are to be sold for
the same price and that no buyer is interested in buying more than one album.
Therefore, the price rises until two buyers are left.

In this case, the bidding stops when John and Paul bid $70 (or slightly higher).
At this price, John and Paul are each happy to buy an album, and George and
Ringo are not willing to bid any higher. John and Paul each receive consumer sur-
plus equal to his willingness to pay minus the price. John’s consumer surplus is
$30, and Paul’s is $10. John’s consumer surplus is higher now than in the previous
example because he gets the same album but pays less for it. The total consumer
surplus in the market is $40.

Using the Demand Curve to Measure
Consumer Surplus
Consumer surplus is closely related to the demand curve for a product. To see
how they are related, let’s continue our example and consider the demand curve
for this rare Elvis Presley album.

We begin by using the willingness to pay of the four possible buyers to find the
demand schedule for the album. The table in Figure 1 shows the demand sched-
ule that corresponds to Table 1. If the price is above $100, the quantity demanded
in the market is 0 because no buyer is willing to pay that much. If the price is
between $80 and $100, the quantity demanded is 1 because only John is willing to
pay such a high price. If the price is between $70 and $80, the quantity demanded
is 2 because both John and Paul are willing to pay the price. We can continue this
analysis for other prices as well. In this way, the demand schedule is derived from
the willingness to pay of the four possible buyers.

The graph in Figure 1 shows the demand curve that corresponds to this demand
schedule. Note the relationship between the height of the demand curve and the
buyers’ willingness to pay. At any quantity, the price given by the demand curve
shows the willingness to pay of the marginal buyer, the buyer who would leave the
market first if the price were any higher. At a quantity of 4 albums, for instance, the
demand curve has a height of $50, the price that Ringo (the marginal buyer) is will-
ing to pay for an album. At a quantity of 3 albums, the demand curve has a height
of $70, the price that George (who is now the marginal buyer) is willing to pay.

consumer surplus
the amount a buyer is
willing to pay for a good
minus the amount the
buyer actually pays for it

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138 PART III Markets and Welfare

Because the demand curve reflects buyers’ willingness to pay, we can also
use it to measure consumer surplus. Figure 2 uses the demand curve to compute
consumer surplus in our two examples. In panel (a), the price is $80 (or slightly
above), and the quantity demanded is 1. Note that the area above the price and
below the demand curve equals $20. This amount is exactly the consumer surplus
we computed earlier when only 1 album is sold.

Panel (b) of Figure 2 shows consumer surplus when the price is $70 (or slightly
above). In this case, the area above the price and below the demand curve equals
the total area of the two rectangles: John’s consumer surplus at this price is $30
and Paul’s is $10. This area equals a total of $40. Once again, this amount is the
consumer surplus we computed earlier.

The lesson from this example holds for all demand curves: The area below the
demand curve and above the price measures the consumer surplus in a market. This is
true because the height of the demand curve measures the value buyers place on
the good, as measured by their willingness to pay for it. The difference between
this willingness to pay and the market price is each buyer’s consumer surplus.
Thus, the total area below the demand curve and above the price is the sum of the
consumer surplus of all buyers in the market for a good or service.

How a Lower Price Raises Consumer Surplus
Because buyers always want to pay less for the goods they buy, a lower price
makes buyers of a good better off. But how much does buyers’ well-being rise in

Figure 1
The Demand Schedule
and the Demand Curve

Price of
Album

50

70

80

0

$100

Quantity of
Albums

Demand

1 2 3 4

John’s willingness to pay

Paul’s willingness to pay

George’s willingness to pay

Ringo’s willingness to pay

Price Buyers
Quantity

Demanded
More than $100 None 0

$80 to $100 John 1

$70 to $80 John, Paul 2

$50 to $70 John, Paul, George 3

$50 or less John, Paul, 4

George, Ringo

The table shows the demand schedule for the buyers in Table 1. The graph shows
the corresponding demand curve. Note that the height of the demand curve reflects
buyers’ willingness to pay.

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139CHAPTER 7 ConsuMers, ProduCers, and the effiCienCy of Markets

response to a lower price? We can use the concept of consumer surplus to answer
this question precisely.

Figure 3 shows a typical demand curve. You may notice that this curve gradu-
ally slopes downward instead of taking discrete steps as in the previous two fig-
ures. In a market with many buyers, the resulting steps from each buyer dropping
out are so small that they form, in essence, a smooth curve. Although this curve
has a different shape, the ideas we have just developed still apply: Consumer
surplus is the area above the price and below the demand curve. In panel (a),
consumer surplus at a price of P

1
is the area of triangle ABC.

Now suppose that the price falls from P
1
to P

2
, as shown in panel (b). The con-

sumer surplus now equals area ADF. The increase in consumer surplus attribut-
able to the lower price is the area BCFD.

This increase in consumer surplus is composed of two parts. First, those buy-
ers who were already buying Q

1
of the good at the higher price P

1
are better off

because they now pay less. The increase in consumer surplus of existing buyers
is the reduction in the amount they pay; it equals the area of the rectangle BCED.
Second, some new buyers enter the market because they are willing to buy the
good at the lower price. As a result, the quantity demanded in the market increases
from Q

1
to Q

2
. The consumer surplus these newcomers receive is the area of the

triangle CEF.

Measuring Consumer
Surplus with the
Demand Curve

Figure 2In panel (a), the price of the good is $80, and the consumer surplus is $20. In panel (b), the price of the good is $70, and the consumer surplus is $40.

(b) Price = $70
Price of
Album

50

70

80

0

$100

Demand

1 2 3 4

Total
consumer
surplus ($40)

Quantity of
Albums

John’s consumer surplus ($30)

Paul’s consumer
surplus ($10)

(a) Price = $80

Price of
Album

50

70

80

0

$100

Demand

1 2 3 4 Quantity of
Albums

John’s consumer surplus ($20)

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140 PART III Markets and Welfare

What Does Consumer Surplus Measure?
Our goal in developing the concept of consumer surplus is to make judgments
about the desirability of market outcomes. Now that you have seen what consumer
surplus is, let’s consider whether it is a good measure of economic well-being.

Imagine that you are a policymaker trying to design a good economic system.
Would you care about the amount of consumer surplus? Consumer surplus, the
amount that buyers are willing to pay for a good minus the amount they actu-
ally pay for it, measures the benefit that buyers receive from a good as the buyers
themselves perceive it. Thus, consumer surplus is a good measure of economic well-
being if policymakers want to respect the preferences of buyers.

In some circumstances, policymakers might choose not to care about consumer
surplus because they do not respect the preferences that drive buyer behavior. For
example, drug addicts are willing to pay a high price for heroin. Yet we would not
say that addicts get a large benefit from being able to buy heroin at a low price
(even though addicts might say they do). From the standpoint of society, will-
ingness to pay in this instance is not a good measure of the buyers’ benefit, and
consumer surplus is not a good measure of economic well-being, because addicts
are not looking after their own best interests.

In most markets, however, consumer surplus does reflect economic well-being.
Economists normally assume that buyers are rational when they make decisions.
Rational people do the best they can to achieve their objectives, given their oppor-
tunities. Economists also normally assume that people’s preferences should be

In panel (a), the price is P
1
, the quantity demanded is Q

1
, and consumer surplus equals

the area of the triangle ABC. When the price falls from P
1
to P

2
, as in panel (b), the

quantity demanded rises from Q
1
to Q

2
, and the consumer surplus rises to the area of

the triangle ADF. The increase in consumer surplus (area BCFD) occurs in part because
existing consumers now pay less (area BCED) and in part because new consumers enter
the market at the lower price (area CEF).

How the Price Affects
Consumer Surplus

Figure 3

Quantity

(a) Consumer Surplus at Price P1

Price

0

Demand

P1

A

B C

Consumer
surplus

Q1 Quantity

(b) Consumer Surplus at Price P2

Price

0

Demand

P1

P2

A

B

Initial
consumer
surplus

D

C

E
F

Q1 Q2

Consumer surplus
to new consumers

Additional consumer
surplus to initial
consumers

P P

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141CHAPTER 7 ConsuMers, ProduCers, and the effiCienCy of Markets

respected. In this case, consumers are the best judges of how much benefit they
receive from the goods they buy.

Quick Quiz Draw a demand curve for turkey. In your diagram, show a price of
turkey and the consumer surplus at that price. Explain in words what this consumer
surplus measures.

Producer Surplus
We now turn to the other side of the market and consider the benefits sellers
receive from participating in a market. As you will see, our analysis of sellers’
welfare is similar to our analysis of buyers’ welfare.

Cost and the Willingness to Sell
Imagine now that you are a homeowner and you want to get your house painted.
You turn to four sellers of painting services: Mary, Frida, Georgia, and Grandma.
Each painter is willing to do the work for you if the price is right. You decide to
take bids from the four painters and auction off the job to the painter who will do
the work for the lowest price.

Each painter is willing to take the job if the price she would receive exceeds
her cost of doing the work. Here the term cost should be interpreted as the paint-
ers’ opportunity cost: It includes the painters’ out-of-pocket expenses (for paint,
brushes, and so on) as well as the value that the painters place on their own time.
Table 2 shows each painter’s cost. Because a painter’s cost is the lowest price she
would accept for her work, cost is a measure of her willingness to sell her services.
Each painter would be eager to sell her services at a price greater than her cost, and
she would refuse to sell her services at a price less than her cost. At a price exactly
equal to her cost, she would be indifferent about selling her services: She would be
equally happy getting the job or using her time and energy for another purpose.

When you take bids from the painters, the price might start high, but it quickly
falls as the painters compete for the job. Once Grandma has bid $600 (or slightly
less), she is the sole remaining bidder. Grandma is happy to do the job for this
price because her cost is only $500. Mary, Frida, and Georgia are unwilling to do
the job for less than $600. Note that the job goes to the painter who can do the
work at the lowest cost.

What benefit does Grandma receive from getting the job? Because she is willing
to do the work for $500 but gets $600 for doing it, we say that she receives producer
surplus of $100. Producer surplus is the amount a seller is paid minus the cost of
production. Producer surplus measures the benefit sellers receive from participat-
ing in a market.

cost
the value of everything
a seller must give up to
produce a good

producer surplus
the amount a seller is
paid for a good minus the
seller’s cost of providing it

The Costs of Four
Possible Sellers

Table 2Seller Cost
Mary $900
Frida 800
Georgia 600
Grandma 500

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142 PART III Markets and Welfare

Now consider a somewhat different example. Suppose that you have two
houses that need painting. Again, you auction off the jobs to the four painters. To
keep things simple, let’s assume that no painter is able to paint both houses and
that you will pay the same amount to paint each house. Therefore, the price falls
until two painters are left.

In this case, the bidding stops when Georgia and Grandma each offer to do the
job for a price of $800 (or slightly less). Georgia and Grandma are willing to do
the work at this price, while Mary and Frida are not willing to bid a lower price. At
a price of $800, Grandma receives producer surplus of $300, and Georgia receives
producer surplus of $200. The total producer surplus in the market is $500.

Using the Supply Curve to Measure
Producer Surplus
Just as consumer surplus is closely related to the demand curve, producer surplus
is closely related to the supply curve. To see how, let’s continue our example.

We begin by using the costs of the four painters to find the supply schedule
for painting services. The table in Figure 4 shows the supply schedule that corre-
sponds to the costs in Table 2. If the price is below $500, none of the four painters
is willing to do the job, so the quantity supplied is zero. If the price is between
$500 and $600, only Grandma is willing to do the job, so the quantity supplied is 1.
If the price is between $600 and $800, Grandma and Georgia are willing to do the
job, so the quantity supplied is 2, and so on. Thus, the supply schedule is derived
from the costs of the four painters.

The graph in Figure 4 shows the supply curve that corresponds to this supply
schedule. Note that the height of the supply curve is related to the sellers’ costs.

Figure 4
The Supply Schedule
and the Supply Curve

The table shows the supply schedule for the sellers in Table 2. The graph shows
the corresponding supply curve. Note that the height of the supply curve reflects
sellers’ costs.

Price Sellers
Quantity
Supplied

$900 or more Mary, Frida, Georgia,
Grandma

4

$800 to $900 Frida, Georgia, Grandma 3

$600 to $800 Georgia, Grandma 2

$500 to $600 Grandma 1

Less than $500 None 0

Price of
House

Painting

500

800

$900

0 Quantity of
Houses Painted

600

1 2 3 4

Supply

Mary’s cost

Frida’s cost

Georgia’s cost

Grandma’s cost

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143CHAPTER 7 ConsuMers, ProduCers, and the effiCienCy of Markets

At any quantity, the price given by the supply curve shows the cost of the marginal
seller, the seller who would leave the market first if the price were any lower. At a
quantity of 4 houses, for instance, the supply curve has a height of $900, the cost
that Mary (the marginal seller) incurs to provide her painting services. At a quan-
tity of 3 houses, the supply curve has a height of $800, the cost that Frida (who is
now the marginal seller) incurs.

Because the supply curve reflects sellers’ costs, we can use it to measure pro-
ducer surplus. Figure 5 uses the supply curve to compute producer surplus in
our two examples. In panel (a), we assume that the price is $600. In this case, the
quantity supplied is 1. Note that the area below the price and above the supply
curve equals $100. This amount is exactly the producer surplus we computed
earlier for Grandma.

Panel (b) of Figure 5 shows producer surplus at a price of $800. In this case, the
area below the price and above the supply curve equals the total area of the two
rectangles. This area equals $500, the producer surplus we computed earlier for
Georgia and Grandma when two houses needed painting.

The lesson from this example applies to all supply curves: The area below the
price and above the supply curve measures the producer surplus in a market. The logic
is straightforward: The height of the supply curve measures sellers’ costs, and the
difference between the price and the cost of production is each seller’s producer
surplus. Thus, the total area is the sum of the producer surplus of all sellers.

Measuring Producer
Surplus with the
Supply Curve

Figure 5In panel (a), the price of the good is $600, and the producer surplus is $100. In panel (b), the price of the good is $800, and the producer surplus is $500.

Quantity of
Houses Painted

Quantity of
Houses Painted

Price of
House

Painting

500

800

$900

0

Supply

600

1 2 3 4

(b) Price = $800

Price of
House

Painting

500

800

$900

0

600

1 2 3 4

(a) Price = $600

Supply

Grandma’s producer
surplus ($100)

Georgia’s producer
surplus ($200)

Total
producer
surplus ($500)

Grandma’s producer
surplus ($300)

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144 PART III Markets and Welfare

How a Higher Price Raises Producer Surplus
You will not be surprised to hear that sellers always want to receive a higher price for
the goods they sell. But how much does sellers’ well-being rise in response to a higher
price? The concept of producer surplus offers a precise answer to this question.

Figure 6 shows a typical upward-sloping supply curve that would arise in a
market with many sellers. Although this supply curve differs in shape from the
previous figure, we measure producer surplus in the same way: Producer surplus
is the area below the price and above the supply curve. In panel (a), the price is P

1
,

and producer surplus is the area of triangle ABC.
Panel (b) shows what happens when the price rises from P

1
to P

2
. Producer sur-

plus now equals area ADF. This increase in producer surplus has two parts. First,
those sellers who were already selling Q

1
of the good at the lower price P

1
are

better off because they now get more for what they sell. The increase in producer
surplus for existing sellers equals the area of the rectangle BCED. Second, some
new sellers enter the market because they are willing to produce the good at the
higher price, resulting in an increase in the quantity supplied from Q

1
to Q

2
. The

producer surplus of these newcomers is the area of the triangle CEF.
As this analysis shows, we use producer surplus to measure the well-being of

sellers in much the same way as we use consumer surplus to measure the well-
being of buyers. Because these two measures of economic welfare are so similar,
it is natural to use them together. And indeed, that is exactly what we do in the
next section.

Figure 6
How the Price Affects
Producer Surplus

In panel (a), the price is P
1
, the quantity demanded is Q

1
, and producer surplus equals

the area of the triangle ABC. When the price rises from P
1
to P

2
, as in panel (b), the

quantity supplied rises from Q
1
to Q

2
, and the producer surplus rises to the area of

the triangle ADF. The increase in producer surplus (area BCFD) occurs in part because
existing producers now receive more (area BCED) and in part because new producers
enter the market at the higher price (area CEF).

Quantity

(b) Producer Surplus at Price P2

Quantity

(a) Producer Surplus at Price P1

Price

0

Supply

B

A

C
Producer
surplus

Q1

Price

0

P2

P1
B

C
P1

Supply

A

D

Initial
producer
surplus

E
F

Q1 Q2

Producer surplus
to new producers

Additional producer
surplus to initial
producers

P P

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145CHAPTER 7 ConsuMers, ProduCers, and the effiCienCy of Markets

Quick Quiz Draw a supply curve for turkey. In your diagram, show a price of turkey
and the producer surplus at that price. Explain in words what this producer surplus
measures.

Market Efficiency
Consumer surplus and producer surplus are the basic tools that economists use
to study the welfare of buyers and sellers in a market. These tools can help us
address a fundamental economic question: Is the allocation of resources deter-
mined by free markets desirable?

The Benevolent Social Planner
To evaluate market outcomes, we introduce into our analysis a new, hypotheti-
cal character called the benevolent social planner. The benevolent social planner
is an all-knowing, all-powerful, well-intentioned dictator. The planner wants to
maximize the economic well-being of everyone in society. What should this plan-
ner do? Should he just leave buyers and sellers at the equilibrium that they reach
naturally on their own? Or can he increase economic well-being by altering the
market outcome in some way?

To answer this question, the planner must first decide how to measure the
economic well-being of a society. One possible measure is the sum of consumer
and producer surplus, which we call total surplus. Consumer surplus is the benefit
that buyers receive from participating in a market, and producer surplus is the
benefit that sellers receive. It is therefore natural to use total surplus as a measure
of society’s economic well-being.

To better understand this measure of economic well-being, recall how we mea-
sure consumer and producer surplus. We define consumer surplus as

Consumer surplus 5 Value to buyers 2 Amount paid by buyers.

Similarly, we define producer surplus as

Producer surplus 5 Amount received by sellers 2 Cost to sellers.

When we add consumer and producer surplus together, we obtain

Total surplus 5 (Value to buyers 2 Amount paid by buyers)

1 (Amount received by sellers 2 Cost to sellers).

The amount paid by buyers equals the amount received by sellers, so the middle
two terms in this expression cancel each other. As a result, we can write total
surplus as

Total surplus 5 Value to buyers 2 Cost to sellers.

Total surplus in a market is the total value to buyers of the goods, as measured by
their willingness to pay, minus the total cost to sellers of providing those goods.

If an allocation of resources maximizes total surplus, we say that the alloca-
tion exhibits efficiency. If an allocation is not efficient, then some of the potential
gains from trade among buyers and sellers are not being realized. For example,

efficiency
the property of a resource
allocation of maximizing
the total surplus received
by all members of society

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146 PART III Markets and Welfare

an allocation is inefficient if a good is not being produced by the sellers with low-
est cost. In this case, moving production from a high-cost producer to a low-cost
producer will lower the total cost to sellers and raise total surplus. Similarly, an
allocation is inefficient if a good is not being consumed by the buyers who value
it most highly. In this case, moving consumption of the good from a buyer with a
low valuation to a buyer with a high valuation will raise total surplus.

In addition to efficiency, the social planner might also care about equality—
that is, whether the various buyers and sellers in the market have a similar level
of economic well-being. In essence, the gains from trade in a market are like a pie
to be shared among the market participants. The question of efficiency concerns
whether the pie is as big as possible. The question of equality concerns how the
pie is sliced and how the portions are distributed among members of society. In
this chapter, we concentrate on efficiency as the social planner’s goal. Keep in
mind, however, that real policymakers often care about equality as well.

Evaluating the Market Equilibrium
Figure 7 shows consumer and producer surplus when a market reaches the
equilibrium of supply and demand. Recall that consumer surplus equals the area
above the price and under the demand curve and producer surplus equals the
area below the price and above the supply curve. Thus, the total area between
the supply and demand curves up to the point of equilibrium represents the total
surplus in this market.

Is this equilibrium allocation of resources efficient? That is, does it maximize
total surplus? To answer this question, recall that when a market is in equilibrium,
the price determines which buyers and sellers participate in the market. Those
buyers who value the good more than the price (represented by the segment

equality
the property of distrib-
uting economic prosperity
uniformly among the
members of society

Figure 7
Consumer and Producer
Surplus in the Market
Equilibrium
Total surplus—the sum of
consumer and producer
surplus—is the area between the
supply and demand curves up to
the equilibrium quantity.

Price

Equilibrium
price

0 QuantityEquilibrium
quantity

A

Supply

C

B
Demand

D

Producer
surplus

Consumer
surplus

E

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147CHAPTER 7 ConsuMers, ProduCers, and the effiCienCy of Markets

AE on the demand curve) choose to buy the good; buyers who value it less than
the price (represented by the segment EB) do not. Similarly, those sellers whose
costs are less than the price (represented by the segment CE on the supply curve)
choose to produce and sell the good; sellers whose costs are greater than the price
(represented by the segment ED) do not.

These observations lead to two insights about market outcomes:

1. Free markets allocate the supply of goods to the buyers who value them
most highly, as measured by their willingness to pay.

2. Free markets allocate the demand for goods to the sellers who can produce
them at the lowest cost.

Thus, given the quantity produced and sold in a market equilibrium, the social
planner cannot increase economic well-being by changing the allocation of con-
sumption among buyers or the allocation of production among sellers.

But can the social planner raise total economic well-being by increasing or
decreasing the quantity of the good? The answer is no, as stated in this third
insight about market outcomes:

3. Free markets produce the quantity of goods that maximizes the sum of
consumer and producer surplus.

Figure 8 illustrates why this is true. To interpret this figure, keep in mind that the
demand curve reflects the value to buyers and the supply curve reflects the cost
to sellers. At any quantity below the equilibrium level, such as Q

1
, the value to the

marginal buyer exceeds the cost to the marginal seller. As a result, increasing the

The Efficiency of the Equilibrium Quantity
At quantities less than the equilibrium quantity, such
as Q

1
, the value to buyers exceeds the cost to sellers.

At quantities greater than the equilibrium quantity,
such as Q

2
, the cost to sellers exceeds the value to

buyers. Therefore, the market equilibrium maximizes
the sum of producer and consumer surplus.

Figure 8

Quantity

Price

0 Equilibrium
quantity

Supply

Demand

Cost
to

sellers

Cost
to

sellers

Value
to

buyers

Value
to

buyers

Value to buyers is greater than
cost to sellers.

Value to buyers is less than
cost to sellers.

Q1 Q2

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148 PART III Markets and Welfare

quantity produced and consumed raises total surplus. This continues to be true
until the quantity reaches the equilibrium level. Similarly, at any quantity beyond
the equilibrium level, such as Q

2
, the value to the marginal buyer is less than the

cost to the marginal seller. In this case, decreasing the quantity raises total sur-
plus, and this continues to be true until quantity falls to the equilibrium level. To
maximize total surplus, the social planner would choose the quantity where the
supply and demand curves intersect.

Together, these three insights tell us that the market outcome makes the sum of
consumer and producer surplus as large as it can be. In other words, the equilib-
rium outcome is an efficient allocation of resources. The benevolent social planner
can, therefore, leave the market outcome just as he finds it. This policy of leaving
well enough alone goes by the French expression laissez faire, which literally trans-
lates to “allow them to do.”

Society is lucky that the planner doesn’t need to intervene. Although it has been
a useful exercise imagining what an all-knowing, all-powerful, well-intentioned
dictator would do, let’s face it: Such characters are hard to come by. Dictators
are rarely benevolent, and even if we found someone so virtuous, he would lack
crucial information.

Suppose our social planner tried to choose an efficient allocation of resources
on his own, instead of relying on market forces. To do so, he would need to know

Like It or Not,
Scalping Is a Force in
the Free Market
By Charles stein

Chip Case devotes a class each year to the reselling of sports tickets. He has
a section in his economics textbook on the
same subject.
But for Case, an economics professor
at Wellesley College, the sale and scalping
of sports tickets is more than an interesting
theoretical pursuit. Like Margaret Mead, he

has done plenty of firsthand research in the
jungle, and he has the stories to prove it.
In 1984, Case waited in line for two
nights on Causeway Street to get $11
tickets to one of the classic Celtics-Lakers
championship series. The night before the
climactic seventh game, he was in the
shower when his daughter called out to
him: “Dad, there’s a guy on the phone who
wants to buy your Celtics tickets.” Case said
he wasn’t selling. “But Dad,” his daughter
added, “he’s willing to pay at least $1,000
apiece for them.”
Case was selling. An hour later, a limo
arrived at the house to pick up two tickets—

one that belonged to Case and one to a friend
of his. The driver left behind $3,000.
To Case and other economists, tickets
are a textbook case of the free market in
action. When supply is limited and demand
is not, prices rise and the people willing to
pay more will eventually get their hands on
the tickets. “As long as people can com-
municate, there will be trades,” said Case.
In the age of the Internet, buyers and
sellers can link up online, through eBay or
the sites devoted solely to ticket sales. But
even in the pre-Internet era, the process
worked, albeit more slowly. In 1984, the
man who bought Case’s tickets was a rich

Ticket Scalping
To allocate resources efficiently, an economy must get goods—including
tickets to the Red Sox—to the consumers who value them most highly.

in the news

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149CHAPTER 7 ConsuMers, ProduCers, and the effiCienCy of Markets

the value of a particular good to every potential consumer in the market and the
cost of every potential producer. And he would need this information not only for
this market but for every one of the many thousands of markets in the economy.
The task is practically impossible, which explains why centrally planned econo-
mies never work very well.

The planner’s job becomes easy, however, once he takes on a partner: Adam
Smith’s invisible hand of the marketplace. The invisible hand takes all the infor-
mation about buyers and sellers into account and guides everyone in the market
to the best outcome as judged by the standard of economic efficiency. It is, truly,
a remarkable feat. That is why economists so often advocate free markets as the
best way to organize economic activity.

Should There Be a Market in Organs?

Some years ago, the front page of the Boston Globe ran the headline “How a
Mother’s Love Helped Save Two Lives.” The newspaper told the story of Susan
Stephens, a woman whose son needed a kidney transplant. When the doctor

New Yorker whose son attended a Boston
private school. The man called a friend at
the school, who called someone else, who
eventually called Case. Where there is a will,
there is a way.
Trading happens no matter how hard
teams try to suppress it. The National
Football League gives some of its Super
Bowl tickets to its teams, and prohibits them
from reselling. Yet many of those same tick-
ets wind up back on the secondary market.
Last season the league caught Minnesota
Vikings head coach Mike Tice selling his
tickets to a California ticket agency. “I regret
it,” Tice told Sports Illustrated afterward. Or
at least he regretted getting caught.
Like any good market, the one for
tickets is remarkably sensitive to informa-
tion. Case has a story about that, too. He
was in Kenmore Square just before game
four of last year’s playoff series between
the Yankees and Red Sox. The Red Sox
had dropped the first three games and
there was no joy in Mudville. Scalpers were

unloading tickets for the fourth game for
only slightly more than face value. Tickets
for a possible fifth game were going for
even less.
But the Red Sox rallied to win game
four in extra innings. By 2 that morning,
said Case, top tickets for game five were
already selling for more than $1,000 online.
A bear market had become a bull market
instantaneously.
As defenders of the free market, econo-
mists generally see nothing wrong with

scalping. “Consenting adults should be able
to make economic trades when they think
it is to their mutual advantage,” said Greg
Mankiw, a Harvard economics professor
who recently stepped down as chairman
of President Bush’s Council of Economic
Advisers. Mankiw has a section about scalp-
ing in his own textbook.
Teams could eliminate scalping alto-
gether by holding their own online auctions
for desirable tickets. Case doesn’t expect
that to happen. “People would burn down
Fenway Park if the Red Sox charged $2,000
for a ticket,” he said. The team would be
accused of price gouging. Yet if you went
online last week, you could find front-row
Green Monster seats for the July 15 game
against the Yankees selling for more than
$2,000. Go figure.
Case will be at Fenway Park this Friday.
He is taking his father-in-law to the game.
He paid a small fortune for the tickets
online. But he isn’t complaining. It’s the free
market at work.

Source: Boston Globe, May 1, 2005.

©
r

o
b
in

n
el

so
n

/
P

h
o

to
ed

it

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150 PART III Markets and Welfare

learned that the mother’s kidney was not compatible, he proposed a novel solu-
tion: If Stephens donated one of her kidneys to a stranger, her son would move
to the top of the kidney waiting list. The mother accepted the deal, and soon two
patients had the transplant they were waiting for.
The ingenuity of the doctor’s proposal and the nobility of the mother’s act can-
not be doubted. But the story raises some intriguing questions. If the mother could
trade a kidney for a kidney, would the hospital allow her to trade a kidney for
an expensive, experimental cancer treatment that she could not otherwise afford?
Should she be allowed to exchange her kidney for free tuition for her son at the
hospital’s medical school? Should she be able to sell her kidney so she can use the
cash to trade in her old Chevy for a new Lexus?
As a matter of public policy, our society makes it illegal for people to sell their
organs. In essence, in the market for organs, the government has imposed a price
ceiling of zero. The result, as with any binding price ceiling, is a shortage of the
good. The deal in the Stephens case did not fall under this prohibition because no
cash changed hands.
Many economists believe that there would be large benefits to allowing a free
market in organs. People are born with two kidneys, but they usually need only
one. Meanwhile, a few people suffer from illnesses that leave them without any
working kidney. Despite the obvious gains from trade, the current situation is
dire: The typical patient has to wait several years for a kidney transplant, and
every year thousands of people die because a compatible kidney cannot be found.
If those needing a kidney were allowed to buy one from those who have two, the
price would rise to balance supply and demand. Sellers would be better off with
the extra cash in their pockets. Buyers would be better off with the organ they
need to save their lives. The shortage of kidneys would disappear.
Such a market would lead to an efficient allocation of resources, but critics of
this plan worry about fairness. A market for organs, they argue, would benefit the
rich at the expense of the poor because organs would then be allocated to those
most willing and able to pay. But you can also question the fairness of the current
system. Now, most of us walk around with an extra organ that we don’t really
need, while some of our fellow citizens are dying to get one. Is that fair? ■

Quick Quiz Draw the supply and demand for turkey. In the equilibrium, show pro-
ducer and consumer surplus. Explain why producing more turkeys would lower total
surplus.

Conclusion: Market Efficiency and Market Failure
This chapter introduced the basic tools of welfare economics—consumer and
producer surplus—and used them to evaluate the efficiency of free markets. We
showed that the forces of supply and demand allocate resources efficiently. That
is, even though each buyer and seller in a market is concerned only about his or
her own welfare, they are together led by an invisible hand to an equilibrium that
maximizes the total benefits to buyers and sellers.

A word of warning is in order. To conclude that markets are efficient, we made
several assumptions about how markets work. When these assumptions do not
hold, our conclusion that the market equilibrium is efficient may no longer be
true. As we close this chapter, let’s consider briefly two of the most important of
these assumptions.

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151CHAPTER 7 ConsuMers, ProduCers, and the effiCienCy of Markets

S u m m a r y

First, our analysis assumed that markets are perfectly competitive. In the
world, however, competition is sometimes far from perfect. In some markets, a
single buyer or seller (or a small group of them) may be able to control market
prices. This ability to influence prices is called market power. Market power can
cause markets to be inefficient because it keeps the price and quantity away from
the equilibrium of supply and demand.

Second, our analysis assumed that the outcome in a market matters only to
the buyers and sellers in that market. Yet, in the world, the decisions of buyers
and sellers sometimes affect people who are not participants in the market at all.
Pollution is the classic example. The use of agricultural pesticides, for instance,
affects not only the manufacturers who make them and the farmers who use
them, but many others who breathe air or drink water that has been polluted with
these pesticides. Such side effects, called externalities, cause welfare in a market
to depend on more than just the value to the buyers and the cost to the sellers.
Because buyers and sellers do not consider these side effects when deciding how
much to consume and produce, the equilibrium in a market can be inefficient
from the standpoint of society as a whole.

Market power and externalities are examples of a general phenomenon
called market failure—the inability of some unregulated markets to allocate
resources efficiently. When markets fail, public policy can potentially remedy
the problem and increase economic efficiency. Microeconomists devote much
effort to studying when market failure is likely and what sorts of policies are
best at correcting market failures. As you continue your study of economics,
you will see that the tools of welfare economics developed here are readily
adapted to that endeavor.

Despite the possibility of market failure, the invisible hand of the mar-
ketplace is extraordinarily important. In many markets, the assumptions
we made in this chapter work well, and the conclusion of market efficiency
applies directly. Moreover, we can use our analysis of welfare economics and
market efficiency to shed light on the effects of various government policies. In
the next two chapters, we apply the tools we have just developed to study two
important policy issues—the welfare effects of taxation and of international
trade.

• Consumer surplus equals buyers’ willingness to
pay for a good minus the amount they actually
pay, and it measures the benefit buyers get from
participating in a market. Consumer surplus
can be computed by finding the area below the
demand curve and above the price.

• Producer surplus equals the amount sellers
receive for their goods minus their costs of pro-
duction, and it measures the benefit sellers get
from participating in a market. Producer surplus
can be computed by finding the area below the
price and above the supply curve.

• An allocation of resources that maximizes the
sum of consumer and producer surplus is said
to be efficient. Policymakers are often concerned
with the efficiency, as well as the equality, of
economic outcomes.

• The equilibrium of supply and demand maxi-
mizes the sum of consumer and producer surplus.
That is, the invisible hand of the marketplace leads
buyers and sellers to allocate resources efficiently.

• Markets do not allocate resources efficiently in
the presence of market failures such as market
power or externalities.

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152 PART III Markets and Welfare

K e y C o n C e p t s

Q u e s t i o n s f o r r e v i e w

welfare economics, p. 136
willingness to pay, p. 136
consumer surplus, p. 137

cost, p. 141
producer surplus, p. 141

efficiency, p. 145
equality, p. 146

1. Explain how buyers’ willingness to pay, consumer
surplus, and the demand curve are related.

2. Explain how sellers’ costs, producer surplus,
and the supply curve are related.

3. In a supply-and-demand diagram, show producer
and consumer surplus in the market equilibrium.

4. What is efficiency? Is it the only goal of
economic policymakers?

5. What does the invisible hand do?
6. Name two types of market failure. Explain

why each may cause market outcomes to be
inefficient.

1. Melissa buys an iPod for $120 and gets consumer
surplus of $80.
a. What is her willingness to pay?
b. If she had bought the iPod on sale for $90,

what would her consumer surplus have
been?

c. If the price of an iPod were $250, what would
her consumer surplus have been?

2. An early freeze in California sours the lemon
crop. Explain what happens to consumer
surplus in the market for lemons. Explain
what happens to consumer surplus in the
market for lemonade. Illustrate your answers
with diagrams.

3. Suppose the demand for French bread rises.
Explain what happens to producer surplus
in the market for French bread. Explain what
happens to producer surplus in the market for
flour. Illustrate your answers with diagrams.

4. It is a hot day, and Bert is thirsty. Here is the
value he places on a bottle of water:

Value of first bottle $7
Value of second bottle 5
Value of third bottle 3
Value of fourth bottle 1

a. From this information, derive Bert’s demand
schedule. Graph his demand curve for
bottled water.

b. If the price of a bottle of water is $4, how
many bottles does Bert buy? How much
consumer surplus does Bert get from his
purchases? Show Bert’s consumer surplus in
your graph.

c. If the price falls to $2, how does quantity
demanded change? How does Bert’s
consumer surplus change? Show these
changes in your graph.

5. Ernie owns a water pump. Because pumping
large amounts of water is harder than pumping
small amounts, the cost of producing a bottle of
water rises as he pumps more. Here is the cost
he incurs to produce each bottle of water:

Cost of first bottle $1
Cost of second bottle 3
Cost of third bottle 5
Cost of fourth bottle 7

a. From this information, derive Ernie’s supply
schedule. Graph his supply curve for bottled
water.

b. If the price of a bottle of water is $4, how
many bottles does Ernie produce and sell?
How much producer surplus does Ernie get
from these sales? Show Ernie’s producer
surplus in your graph.

c. If the price rises to $6, how does quantity
supplied change? How does Ernie’s producer

P R O B L E M S A N D A P P L I C A T I O N S

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153CHAPTER 7 ConsuMers, ProduCers, and the effiCienCy of Markets

surplus change? Show these changes in your
graph.

6. Consider a market in which Bert from Problem 4
is the buyer and Ernie from Problem 5 is the
seller.
a. Use Ernie’s supply schedule and Bert’s

demand schedule to find the quantity
supplied and quantity demanded at prices of
$2, $4, and $6. Which of these prices brings
supply and demand into equilibrium?

b. What are consumer surplus, producer
surplus, and total surplus in this equilibrium?

c. If Ernie produced and Bert consumed one
fewer bottle of water, what would happen to
total surplus?

d. If Ernie produced and Bert consumed one
additional bottle of water, what would
happen to total surplus?

7. The cost of producing flat-screen TVs has fallen
over the past decade. Let’s consider some
implications of this fact.
a. Draw a supply-and-demand diagram to

show the effect of falling production costs on
the price and quantity of flat-screen TVs sold.

b. In your diagram, show what happens to
consumer surplus and producer surplus.

c. Suppose the supply of flat-screen TVs is
very elastic. Who benefits most from falling
production costs—consumers or producers of
these TVs?

8. There are four consumers willing to pay the
following amounts for haircuts:

Jerry: $7 Oprah: $2 Ellen: $8 Phil: $5

There are four haircutting businesses with the
following costs:

Firm A: $3 Firm B: $6 Firm C: $4 Firm D: $2

Each firm has the capacity to produce only
one haircut. For efficiency, how many haircuts
should be given? Which businesses should cut
hair and which consumers should have their hair
cut? How large is the maximum possible total
surplus?

9. Suppose a technological advance reduces the
cost of making computers.
a. Draw a supply-and-demand diagram to

show what happens to price, quantity,
consumer surplus, and producer surplus in
the market for computers.

b. Computers and typewriters are substitutes.
Use a supply-and-demand diagram to show
what happens to price, quantity, consumer
surplus, and producer surplus in the market
for typewriters. Should typewriter producers
be happy or sad about the technological
advance in computers?

c. Computers and software are complements.
Draw a supply-and-demand diagram to
show what happens to price, quantity,
consumer surplus, and producer surplus in
the market for software. Should software
producers be happy or sad about the
technological advance in computers?

d. Does this analysis help explain why software
producer Bill Gates is one of the world’s
richest men?

10. A friend of yours is considering two cell phone
service providers. Provider A charges $120 per
month for the service regardless of the number
of phone calls made. Provider B does not have
a fixed service fee but instead charges $1 per
minute for calls. Your friend’s monthly demand
for minutes of calling is given by the equation
QD 5 150 2 50P, where P is the price of a
minute.
a. With each provider, what is the cost to your

friend of an extra minute on the phone?
b. In light of your answer to (a), how many

minutes would your friend talk on the phone
with each provider?

c. How much would he end up paying each
provider every month?

d. How much consumer surplus would he
obtain with each provider? (Hint: Graph the
demand curve and recall the formula for the
area of a triangle.)

e. Which provider would you recommend that
your friend choose? Why?

11. Consider how health insurance affects the
quantity of healthcare services performed.
Suppose that the typical medical procedure
has a cost of $100, yet a person with health
insurance pays only $20 out of pocket. Her
insurance company pays the remaining $80.
(The insurance company recoups the $80
through premiums, but the premium a person
pays does not depend on how many procedures
that person chooses to undertake.)
a. Draw the demand curve in the market

for medical care. (In your diagram, the

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154 PART III Markets and Welfare

horizontal axis should represent the number
of medical procedures.) Show the quantity of
procedures demanded if each procedure has
a price of $100.

b. On your diagram, show the quantity of
procedures demanded if consumers pay
only $20 per procedure. If the cost of each
procedure to society is truly $100, and if
individuals have health insurance as just
described, will the number of procedures
performed maximize total surplus? Explain.

c. Economists often blame the health insurance
system for excessive use of medical care.
Given your analysis, why might the use of
care be viewed as “excessive”?

d. What sort of policies might prevent this
excessive use?

For further information on topics in this chapter,
additional problems, applications, examples, online
quizzes, and more, please visit our website at www
.cengage.com/economics/mankiw.

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155

8Application: T he Costs of Taxation
Taxes are often a source of heated political debate. In 1776, the anger of the American colonists over British taxes sparked the American Revolution. More than two centuries later, the American political parties continue to debate the proper size and shape of the tax system. Yet no one would
deny that some level of taxation is necessary. As Oliver Wendell Holmes Jr. once
said, “Taxes are what we pay for civilized society.”

Because taxation has such a major impact on the modern economy, we return
to the topic several times throughout this book as we expand the set of tools we
have at our disposal. We began our study of taxes in Chapter 6. There we saw
how a tax on a good affects its price and the quantity sold and how the forces
of supply and demand divide the burden of a tax between buyers and sellers.
In this chapter, we extend this analysis and look at how taxes affect welfare, the
economic well-being of participants in a market. In other words, we see how high
the price of civilized society can be.

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156 PART III Markets and Welfare

The effects of taxes on welfare might at first seem obvious. The government
enacts taxes to raise revenue and that revenue must come out of someone’s pocket.
As we saw in Chapter 6, both buyers and sellers are worse off when a good is
taxed: A tax raises the price buyers pay and lowers the price sellers receive. Yet to
understand more fully how taxes affect economic well-being, we must compare
the reduced welfare of buyers and sellers to the amount of revenue the govern-
ment raises. The tools of consumer and producer surplus allow us to make this
comparison. The analysis will show that the cost of taxes to buyers and sellers
exceeds the revenue raised by the government.

The Deadweight Loss of Taxation
We begin by recalling one of the surprising lessons from Chapter 6: The outcome
is the same whether a tax on a good is levied on buyers or sellers of the good.
When a tax is levied on buyers, the demand curve shifts downward by the size
of the tax; when it is levied on sellers, the supply curve shifts upward by that
amount. In either case, when the tax is enacted, the price paid by buyers rises, and
the price received by sellers falls. In the end, the elasticities of supply and demand
determine how the tax burden is distributed between producers and consumers.
This distribution is the same regardless of how it is levied.

Figure 1 shows these effects. To simplify our discussion, this figure does not
show a shift in either the supply or demand curve, although one curve must shift.
Which curve shifts depends on whether the tax is levied on sellers (the supply
curve shifts) or buyers (the demand curve shifts). In this chapter, we can keep the
analysis general and simplify the graphs by not bothering to show the shift. The
key result for our purposes here is that the tax places a wedge between the price
buyers pay and the price sellers receive. Because of this tax wedge, the quantity
sold falls below the level that would be sold without a tax. In other words, a tax on

Figure 1
The Effects of a Tax
A tax on a good places a wedge
between the price that buyers pay
and the price that sellers receive.
The quantity of the good sold falls. Price buyers

pay
Size of tax

Price
without tax

QuantityQuantity
with tax

0

Price

Price sellers
receive

Quantity
without tax

Demand

Supply

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157CHAPTER 8 application: the costs of taxation

a good causes the size of the market for the good to shrink. These results should
be familiar from Chapter 6.

How a Tax Affects Market Participants
Let’s use the tools of welfare economics to measure the gains and losses from a
tax on a good. To do this, we must take into account how the tax affects buyers,
sellers, and the government. The benefit received by buyers in a market is mea-
sured by consumer surplus—the amount buyers are willing to pay for the good
minus the amount they actually pay for it. The benefit received by sellers in a
market is measured by producer surplus—the amount sellers receive for the good
minus their costs. These are precisely the measures of economic welfare we used
in Chapter 7.

What about the third interested party, the government? If T is the size of the tax
and Q is the quantity of the good sold, then the government gets total tax revenue
of T 3 Q. It can use this tax revenue to provide services, such as roads, police,
and public education, or to help the needy. Therefore, to analyze how taxes affect
economic well-being, we use the government’s tax revenue to measure the public
benefit from the tax. Keep in mind, however, that this benefit actually accrues not
to the government but to those on whom the revenue is spent.

Figure 2 shows that the government’s tax revenue is represented by the rect-
angle between the supply and demand curves. The height of this rectangle is the
size of the tax, T, and the width of the rectangle is the quantity of the good sold,
Q. Because a rectangle’s area is its height times its width, this rectangle’s area is
T 3 Q, which equals the tax revenue.

Welfare without a Tax To see how a tax affects welfare, we begin by consider-
ing welfare before the government imposes a tax. Figure 3 shows the supply-and-
demand diagram and marks the key areas with the letters A through F.

Tax Revenue
The tax revenue that the government
collects equals T 3 Q, the size of the
tax T times the quantity sold Q. Thus,
tax revenue equals the area of the
rectangle between the supply and
demand curves.

Figure 2

Price buyers
pay

Size of tax (T )

Quantity
sold (Q)

Tax
revenue
(T � Q )

QuantityQuantity
with tax

0

Price

Price sellers
receive

Quantity
without tax

Demand

Supply

“You know, the idea
of taxation with
representation doesn’t
appeal to me very
much, either.”

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158 PART III Markets and Welfare

Without a tax, the equilibrium price and quantity are found at the intersection
of the supply and demand curves. The price is P

1
, and the quantity sold is Q

1
.

Because the demand curve reflects buyers’ willingness to pay, consumer surplus
is the area between the demand curve and the price, A 1 B 1 C. Similarly, because
the supply curve reflects sellers’ costs, producer surplus is the area between the
supply curve and the price, D 1 E 1 F. In this case, because there is no tax, tax
revenue equals zero.

Total surplus, the sum of consumer and producer surplus, equals the area
A 1 B 1 C 1 D 1 E 1 F. In other words, as we saw in Chapter 7, total surplus is
the area between the supply and demand curves up to the equilibrium quantity.
The first column of the table in Figure 3 summarizes these conclusions.

Welfare with a Tax Now consider welfare after the tax is enacted. The price
paid by buyers rises from P

1
to P

B
, so consumer surplus now equals only area A

(the area below the demand curve and above the buyer’s price). The price received
by sellers falls from P

1
to P

S
, so producer surplus now equals only area F (the area

above the supply curve and below the seller’s price). The quantity sold falls from
Q

1
to Q

2
, and the government collects tax revenue equal to the area B 1 D.

Figure 3 A tax on a good reduces consumer surplus (by the area B 1 C) and producer surplus
(by the area D 1 E). Because the fall in producer and consumer surplus exceeds tax
revenue (area B 1 D), the tax is said to impose a deadweight loss (area C 1 E).

� PB

A

F

B

D

C

E
� P1

QuantityQ20

Price

� PS

Q1

Demand

Supply
Price

buyers
pay

Price
without tax

Price
sellers
receive

Without Tax With Tax Change
Consumer Surplus A 1 B 1 C A 2(B 1 C)

Producer Surplus D 1 E 1 F F 2(D 1 E)

Tax Revenue None B 1 D 1(B 1 D)

Total Surplus A 1 B 1 C 1 D 1 E 1 F A 1 B 1 D 1 F 2(C 1 E)

The area C 1 E shows the fall in total surplus and is the deadweight loss of the tax.

How a Tax Affects Welfare

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159CHAPTER 8 application: the costs of taxation

To compute total surplus with the tax, we add consumer surplus, producer
surplus, and tax revenue. Thus, we find that total surplus is area A 1 B 1 D 1 F.
The second column of the table summarizes these results.

Changes in Welfare We can now see the effects of the tax by comparing wel-
fare before and after the tax is enacted. The third column of the table in Figure 3
shows the changes. The tax causes consumer surplus to fall by the area B 1 C and
producer surplus to fall by the area D 1 E. Tax revenue rises by the area B 1 D.
Not surprisingly, the tax makes buyers and sellers worse off and the government
better off.

The change in total welfare includes the change in consumer surplus (which is
negative), the change in producer surplus (which is also negative), and the change
in tax revenue (which is positive). When we add these three pieces together, we find
that total surplus in the market falls by the area C 1 E. Thus, the losses to buyers and
sellers from a tax exceed the revenue raised by the government. The fall in total surplus
that results when a tax (or some other policy) distorts a market outcome is called the
deadweight loss. The area C 1 E measures the size of the deadweight loss.

To understand why taxes impose deadweight losses, recall one of the Ten
Principles of Economics in Chapter 1: People respond to incentives. In Chapter 7,
we saw that free markets normally allocate scarce resources efficiently. That is,
the equilibrium of supply and demand maximizes the total surplus of buyers
and sellers in a market. When a tax raises the price to buyers and lowers the price
to sellers, however, it gives buyers an incentive to consume less and sellers an
incentive to produce less than they would in the absence of the tax. As buyers
and sellers respond to these incentives, the size of the market shrinks below its
optimum (as shown in the figure by the movement from Q

1
to Q

2
). Thus, because

taxes distort incentives, they cause markets to allocate resources inefficiently.

Deadweight Losses and the Gains from Trade
To get some further insight into why taxes result in deadweight losses, consider
an example. Imagine that Joe cleans Jane’s house each week for $100. The oppor-
tunity cost of Joe’s time is $80, and the value of a clean house to Jane is $120. Thus,
Joe and Jane each receive a $20 benefit from their deal. The total surplus of $40
measures the gains from trade in this particular transaction.

Now suppose that the government levies a $50 tax on the providers of cleaning
services. There is now no price that Jane can pay Joe that will leave both of them
better off after paying the tax. The most Jane would be willing to pay is $120, but
then Joe would be left with only $70 after paying the tax, which is less than his
$80 opportunity cost. Conversely, for Joe to receive his opportunity cost of $80,
Jane would need to pay $130, which is above the $120 value she places on a clean
house. As a result, Jane and Joe cancel their arrangement. Joe goes without the
income, and Jane lives in a dirtier house.

The tax has made Joe and Jane worse off by a total of $40 because they have
each lost $20 of surplus. But note that the government collects no revenue from
Joe and Jane because they decide to cancel their arrangement. The $40 is pure
deadweight loss: It is a loss to buyers and sellers in a market that is not offset by
an increase in government revenue. From this example, we can see the ultimate
source of deadweight losses: Taxes cause deadweight losses because they prevent buyers
and sellers from realizing some of the gains from trade.

The area of the triangle between the supply and demand curves (area C 1 E in
Figure 3) measures these losses. This conclusion can be seen more easily in Figure 4

deadweight loss
the fall in total surplus
that results from a market
distortion, such as a tax

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160 PART III Markets and Welfare

by recalling that the demand curve reflects the value of the good to consumers
and that the supply curve reflects the costs of producers. When the tax raises the
price to buyers to P

B
and lowers the price to sellers to P

S
, the marginal buyers and

sellers leave the market, so the quantity sold falls from Q
1
to Q

2
. Yet as the figure

shows, the value of the good to these buyers still exceeds the cost to these sellers.
At every quantity between Q

1
and Q

2
, the situation is the same as in our example

with Joe and Jane. The gains from trade—the difference between buyers’ value
and sellers’ cost—are less than the tax. As a result, these trades are not made
once the tax is imposed. The deadweight loss is the surplus lost because the tax
discourages these mutually advantageous trades.

Quick Quiz Draw the supply and demand curves for cookies. If the government
imposes a tax on cookies, show what happens to the price paid by buyers, the price
received by sellers, and the quantity sold. In your diagram, show the deadweight loss
from the tax. Explain the meaning of the deadweight loss.

The Determinants of the Deadweight Loss
What determines whether the deadweight loss from a tax is large or small? The
answer is the price elasticities of supply and demand, which measure how much
the quantity supplied and quantity demanded respond to changes in the price.

Let’s consider first how the elasticity of supply affects the size of the dead-
weight loss. In the top two panels of Figure 5, the demand curve and the size of
the tax are the same. The only difference in these figures is the elasticity of the
supply curve. In panel (a), the supply curve is relatively inelastic: Quantity supplied

Figure 4
The Deadweight Loss
When the government imposes
a tax on a good, the quantity
sold falls from Q

1
to Q

2
. At every

quantity between Q
1
and Q

2
, the

potential gains from trade among
buyers and sellers are not realized.
These lost gains from trade create
the deadweight loss.

PB

Cost to
sellersValue to

buyers

Size of tax
Price

without tax

QuantityQ20

Price

PS

Q1

Demand

SupplyLost gains
from trade

Reduction in quantity due to the tax

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161CHAPTER 8 application: the costs of taxation

responds only slightly to changes in the price. In panel (b), the supply curve is
relatively elastic: Quantity supplied responds substantially to changes in the
price. Notice that the deadweight loss, the area of the triangle between the supply
and demand curves, is larger when the supply curve is more elastic.

Similarly, the bottom two panels of Figure 5 show how the elasticity of demand
affects the size of the deadweight loss. Here the supply curve and the size of the
tax are held constant. In panel (c), the demand curve is relatively inelastic, and the

Tax Distortions and
Elasticities

Figure 5In panels (a) and (b), the demand curve and the size of the tax are the same, but the
price elasticity of supply is different. Notice that the more elastic the supply curve, the
larger the deadweight loss of the tax. In panels (c) and (d), the supply curve and
the size of the tax are the same, but the price elasticity of demand is different.
Notice that the more elastic the demand curve, the larger the deadweight loss of
the tax.

(a) Inelastic Supply (b) Elastic Supply

Price

0 Quantity

Price

0 Quantity

Demand

Supply

(c) Inelastic Demand (d) Elastic Demand

Price

0 Quantity

Price

0 Quantity

Size
of
tax

Size of tax

Demand

Supply

Demand Demand

Supply

SupplySize
of
tax

Size of tax

When supply is
relatively inelastic,
the deadweight loss
of a tax is small.

When supply is relatively
elastic, the deadweight
loss of a tax is large.

When demand is relatively
elastic, the deadweight
loss of a tax is large.

When demand is
relatively inelastic,
the deadweight loss
of a tax is small.

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162 PART III Markets and Welfare

deadweight loss is small. In panel (d), the demand curve is more elastic, and the
deadweight loss from the tax is larger.

The lesson from this figure is apparent. A tax has a deadweight loss because
it induces buyers and sellers to change their behavior. The tax raises the price
paid by buyers, so they consume less. At the same time, the tax lowers the price
received by sellers, so they produce less. Because of these changes in behavior,
the size of the market shrinks below the optimum. The elasticities of supply and
demand measure how much sellers and buyers respond to the changes in the
price and, therefore, determine how much the tax distorts the market outcome.
Hence, the greater the elasticities of supply and demand, the greater the deadweight loss
of a tax.

The Deadweight Loss Debate

Supply, demand, elasticity, deadweight loss—all this economic theory is enough
to make your head spin. But believe it or not, these ideas go to the heart of a pro-
found political question: How big should the government be? The debate hinges
on these concepts because the larger the deadweight loss of taxation, the larger
the cost of any government program. If taxation entails large deadweight losses,
then these losses are a strong argument for a leaner government that does less
and taxes less. But if taxes impose small deadweight losses, then government
programs are less costly than they otherwise might be.
So how big are the deadweight losses of taxation? Economists disagree on the
answer to this question. To see the nature of this disagreement, consider the most
important tax in the U.S. economy: the tax on labor. The Social Security tax, the
Medicare tax, and to a large extent, the federal income tax are labor taxes. Many
state governments also tax labor earnings. A labor tax places a wedge between the
wage that firms pay and the wage that workers receive. For a typical worker, if all
forms of labor taxes are added together, the marginal tax rate on labor income—the
tax on the last dollar of earnings—is about 40 percent.
Although the size of the labor tax is easy to determine, the deadweight loss of
this tax is less straightforward. Economists disagree about whether this 40 percent
labor tax has a small or a large deadweight loss. This disagreement arises because
economists hold different views about the elasticity of labor supply.
Economists who argue that labor taxes do not greatly distort market outcomes
believe that labor supply is fairly inelastic. Most people, they claim, would work
full time regardless of the wage. If so, the labor supply curve is almost vertical,
and a tax on labor has a small deadweight loss.
Economists who argue that labor taxes are highly distorting believe that labor
supply is more elastic. While admitting that some groups of workers may supply
their labor inelastically, these economists claim that many other groups respond
more to incentives. Here are some examples:

• Many workers can adjust the number of hours they work—for instance,
by working overtime. The higher the wage, the more hours they choose to
work.

• Some families have second earners—often married women with children—
with some discretion over whether to do unpaid work at home or paid
work in the marketplace. When deciding whether to take a job, these second

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163CHAPTER 8 application: the costs of taxation

earners compare the benefits of being at home (including savings on the cost
of child care) with the wages they could earn.

• Many of the elderly can choose when to retire, and their decisions are partly
based on the wage. Once they are retired, the wage determines their incen-
tive to work part time.

• Some people consider engaging in illegal economic activity, such as the
drug trade, or working at jobs that pay “under the table” to evade taxes.
Economists call this the underground economy. In deciding whether to work
in the underground economy or at a legitimate job, these potential criminals
compare what they can earn by breaking the law with the wage they can
earn legally.

In each of these cases, the quantity of labor supplied responds to the wage (the
price of labor). Thus, these workers’ decisions are distorted when their labor
earnings are taxed. Labor taxes encourage workers to work fewer hours, second
earners to stay at home, the elderly to retire early, and the unscrupulous to enter
the underground economy.
These two views of labor taxation persist to this day. Indeed, whenever you see
two political candidates debating whether the government should provide more
services or reduce the tax burden, keep in mind that part of the disagreement may
rest on different views about the elasticity of labor supply and the deadweight
loss of taxation. ■

Quick Quiz The demand for beer is more elastic than the demand for milk. Would
a tax on beer or a tax on milk have a larger deadweight loss? Why?

Deadweight Loss and Tax Revenue as Taxes Vary
Taxes rarely stay the same for long periods of time. Policymakers in local, state,
and federal governments are always considering raising one tax or lowering
another. Here we consider what happens to the deadweight loss and tax revenue
when the size of a tax changes.

Figure 6 shows the effects of a small, medium, and large tax, holding constant
the market’s supply and demand curves. The deadweight loss—the reduction
in total surplus that results when the tax reduces the size of a market below
the optimum—equals the area of the triangle between the supply and demand
curves. For the small tax in panel (a), the area of the deadweight loss triangle is
quite small. But as the size of a tax rises in panels (b) and (c), the deadweight loss
grows larger and larger.

Indeed, the deadweight loss of a tax rises even more rapidly than the size of
the tax. This occurs because the deadweight loss is an area of a triangle, and the
area of a triangle depends on the square of its size. If we double the size of a tax,
for instance, the base and height of the triangle double, so the deadweight loss
rises by a factor of 4. If we triple the size of a tax, the base and height triple, so the
deadweight loss rises by a factor of 9.

The government’s tax revenue is the size of the tax times the amount of the
good sold. As the first three panels of Figure 6 show, tax revenue equals the area
of the rectangle between the supply and demand curves. For the small tax in panel
(a), tax revenue is small. As the size of a tax increases from panel (a) to panel (b),

“What’s your position
on the elasticity of labor
supply?”

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164 PART III Markets and Welfare

tax revenue grows. But as the size of the tax increases further from panel (b) to
panel (c), tax revenue falls because the higher tax drastically reduces the size
of the market. For a very large tax, no revenue would be raised because people
would stop buying and selling the good altogether.

The last two panels of Figure 6 summarize these results. In panel (d), we see that
as the size of a tax increases, its deadweight loss quickly gets larger. By contrast,

Figure 6 The deadweight loss is the reduction in total surplus due to the tax. Tax revenue
is the amount of the tax times the amount of the good sold. In panel (a), a small
tax has a small deadweight loss and raises a small amount of revenue. In panel (b),
a somewhat larger tax has a larger deadweight loss and raises a larger amount of
revenue. In panel (c), a very large tax has a very large deadweight loss, but because
it has reduced the size of the market so much, the tax raises only a small amount of
revenue. Panels (d) and (e) summarize these conclusions. Panel (d) shows that as the
size of a tax grows larger, the deadweight loss grows larger. Panel (e) shows that
tax revenue first rises and then falls. This relationship is sometimes called the Laffer
curve.

How Deadweight Loss
and Tax Revenue Vary
with the Size of a Tax

(d) From panel (a) to panel (c),
deadweight loss continually increases.

(e) From panel (a) to panel (c), tax
revenue first increases, then decreases.

Deadweight
Loss

0 Tax Size

Tax
Revenue

0 Tax Size

Demand

Supply

Tax revenue

PB

QuantityQ20

Price

Q1

(b) Medium Tax

Deadweight
loss

PSDemand

Supply

Tax revenue

PB

QuantityQ20

Price

Q1

(a) Small Tax

Deadweight
loss

PS

Demand

Supply

Ta
x

re
ve

nu
e

PB

QuantityQ20

Price

Q1

(c) Large Tax

Deadweight
loss

PS

Laffer curve

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165CHAPTER 8 application: the costs of taxation

panel (e) shows that tax revenue first rises with the size of the tax, but as the tax
gets larger, the market shrinks so much that tax revenue starts to fall.

The Laffer Curve and Supply-Side Economics

One day in 1974, economist Arthur Laffer sat in a Washington restaurant with
some prominent journalists and politicians. He took out a napkin and drew a figure
on it to show how tax rates affect tax revenue. It looked much like panel (e) of
our Figure 6. Laffer then suggested that the United States was on the downward-
sloping side of this curve. Tax rates were so high, he argued, that reducing them
would actually increase tax revenue.
Most economists were skeptical of Laffer’s suggestion. The idea that a cut in tax
rates could increase tax revenue was correct as a matter of economic theory, but
there was more doubt about whether it would do so in practice. There was little evi-
dence for Laffer’s view that U.S. tax rates had in fact reached such extreme levels.
Nonetheless, the Laffer curve (as it became known) captured the imagination of
Ronald Reagan. David Stockman, budget director in the first Reagan administra-
tion, offers the following story:

[Reagan] had once been on the Laffer curve himself. “I came into the Big Money
making pictures during World War II,” he would always say. At that time the
wartime income surtax hit 90 percent. “You could only make four pictures and
then you were in the top bracket,” he would continue. “So we all quit work-
ing after four pictures and went off to the country.” High tax rates caused less
work. Low tax rates caused more. His experience proved it.

When Reagan ran for president in 1980, he made cutting taxes part of his plat-
form. Reagan argued that taxes were so high that they were discouraging hard
work. He argued that lower taxes would give people the proper incentive to work,
which would raise economic well-being and perhaps even tax revenue. Because
the cut in tax rates was intended to encourage people to increase the quantity of
labor they supplied, the views of Laffer and Reagan became known as supply-side
economics.
Economists continue to debate Laffer’s argument. Many believe that sub-
sequent history refuted Laffer’s conjecture that lower tax rates would raise tax
revenue. Yet because history is open to alternative interpretations, other econo-
mists view the events of the 1980s as more favorable to the supply siders. To
evaluate Laffer’s hypothesis definitively, we would need to rerun history without
the Reagan tax cuts and see if tax revenues were higher or lower. Unfortunately,
that experiment is impossible.
Some economists take an intermediate position on this issue. They believe
that while an overall cut in tax rates normally reduces revenue, some taxpayers
at some times may find themselves on the wrong side of the Laffer curve. Other
things equal, a tax cut is more likely to raise tax revenue if the cut applies to those
taxpayers facing the highest tax rates. In addition, Laffer’s argument may be
more compelling when considering countries with much higher tax rates than the
United States. In Sweden in the early 1980s, for instance, the typical worker faced
a marginal tax rate of about 80 percent. Such a high tax rate provides a substantial
disincentive to work. Studies have suggested that Sweden would indeed have
raised more tax revenue if it had lowered its tax rates.

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166 PART III Markets and Welfare

Economists disagree about these issues in part because there is no consensus
about the size of the relevant elasticities. The more elastic supply and demand are
in any market, the more taxes in the market distort behavior, and the more likely
it is that a tax cut will increase tax revenue. There is no debate, however, about
the general lesson: How much revenue the government gains or loses from a tax
change cannot be computed just by looking at tax rates. It also depends on how
the tax change affects people’s behavior. ■

Quick Quiz If the government doubles the tax on gasoline, can you be sure that
revenue from the gasoline tax will rise? Can you be sure that the deadweight loss from
the gasoline tax will rise? Explain.

Conclusion
In this chapter we have used the tools developed in the previous chapter to further
our understanding of taxes. One of the Ten Principles of Economics discussed in
Chapter 1 is that markets are usually a good way to organize economic activity. In

New Research on Taxation
According to the latest research, most countries are on the left side of
the Laffer curve. But that is not true everywhere for all taxes.

in the news

ECB Paper Looks at
U.S., Europe Spots on
the Laffer Curve
By Brian Blackstone

Economist Arthur Laffer’s theory is that, after a certain point, tax increases become
self-defeating by weakening economic
growth and draining tax revenues. There are
two points—zero and 100%—where the
government receives no revenue. The trick is
finding the peak point between the two.
The Laffer curve served as an intel-
lectual foundation for large-scale tax cuts

in the U.S. in the early 1980s. Now, the
U.S. is on the “left side” of the Laffer curve
even more so than Europe, especially when
it comes to labor taxes, meaning higher tax
rates would still bring in added revenues, a
European Central Bank paper concludes.
“We find that the U.S. can increase tax
revenues by 30% by raising labor taxes but
only 6% by raising capital income taxes,
while the same numbers for EU-14 are
8% and 1% respectively,” ECB economist
Mathias Trabandt and University of Chicago
economist Harald Uhlig wrote. Germany
could raise about another 10% in revenues
by increasing labor taxes, they estimate, but
just 2% via capital taxes.

Only 32% of a cut in U.S. labor taxes
would be self-financed, the economists
note, versus 54% self-financing in Europe.
Just over 50% of a cut in U.S. capital taxes
would pay for itself, the authors estimate,
versus 79% in Europe.
“In terms of a ‘Laffer hill’, both the
U.S. and the EU-14 are on the left side of
the peak with respect to their capital tax
rates,” the authors wrote. But in the case
of Denmark and Sweden, “these countries
are on the ‘slippery side’ of the Laffer curve
and can actually improve their budgetary
situation by cutting capital taxes, according
to our calculations,” they wrote.

Source: Wall Street Journal, Real Time Economics blog, April 21, 2010.

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167CHAPTER 8 application: the costs of taxation

Chapter 7, we used the concepts of producer and consumer surplus to make this
principle more precise. Here we have seen that when the government imposes
taxes on buyers or sellers of a good, society loses some of the benefits of market
efficiency. Taxes are costly to market participants not only because taxes transfer
resources from those participants to the government but also because they alter
incentives and distort market outcomes.

The analysis presented here and in Chapter 6 should give you a good basis for
understanding the economic impact of taxes, but this is not the end of the story.
Microeconomists study how best to design a tax system, including how to strike
the right balance between equality and efficiency. Macroeconomists study how
taxes influence the overall economy and how policymakers can use the tax system
to stabilize economic activity and to achieve more rapid economic growth. So as
you continue your study of economics, don’t be surprised when the subject of
taxation comes up yet again.

• A tax on a good reduces the welfare of buyers
and sellers of the good, and the reduction in
consumer and producer surplus usually exceeds
the revenue raised by the government. The fall
in total surplus—the sum of consumer surplus,
producer surplus, and tax revenue—is called the
deadweight loss of the tax.

• Taxes have deadweight losses because they cause
buyers to consume less and sellers to produce less,
and these changes in behavior shrink the size of
the market below the level that maximizes total

surplus. Because the elasticities of supply and
demand measure how much market participants
respond to market conditions, larger elasticities
imply larger deadweight losses.

• As a tax grows larger, it distorts incentives more,
and its deadweight loss grows larger. Because a
tax reduces the size of the market, however, tax
revenue does not continually increase. It first
rises with the size of a tax, but if a tax gets large
enough, tax revenue starts to fall.

S u m m A R y

K E y C o n C E P T

deadweight loss, p. 159

Q u E S T I o n S f o R R E V I E W

1. What happens to consumer and producer
surplus when the sale of a good is taxed? How
does the change in consumer and producer
surplus compare to the tax revenue? Explain.

2. Draw a supply-and-demand diagram with a tax
on the sale of the good. Show the deadweight
loss. Show the tax revenue.

3. How do the elasticities of supply and demand
affect the deadweight loss of a tax? Why do
they have this effect?

4. Why do experts disagree about whether labor
taxes have small or large deadweight losses?

5. What happens to the deadweight loss and tax
revenue when a tax is increased?

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168 PART III Markets and Welfare

1. The market for pizza is characterized by a
downward-sloping demand curve and an
upward-sloping supply curve.
a. Draw the competitive market equilibrium.

Label the price, quantity, consumer
surplus, and producer surplus. Is there any
deadweight loss? Explain.

b. Suppose that the government forces each
pizzeria to pay a $1 tax on each pizza sold.
Illustrate the effect of this tax on the pizza
market, being sure to label the consumer
surplus, producer surplus, government
revenue, and deadweight loss. How does
each area compare to the pre-tax case?

c. If the tax were removed, pizza eaters and sellers
would be better off, but the government would
lose tax revenue. Suppose that consumers and
producers voluntarily transferred some of their
gains to the government. Could all parties
(including the government) be better off than
they were with a tax? Explain using the labeled
areas in your graph.

2. Evaluate the following two statements. Do you
agree? Why or why not?
a. “A tax that has no deadweight loss cannot

raise any revenue for the government.”
b. “A tax that raises no revenue for the

government cannot have any deadweight
loss.”

3. Consider the market for rubber bands.
a. If this market has very elastic supply and

very inelastic demand, how would the
burden of a tax on rubber bands be shared
between consumers and producers? Use
the tools of consumer surplus and producer
surplus in your answer.

b. If this market has very inelastic supply and
very elastic demand, how would the burden
of a tax on rubber bands be shared between
consumers and producers? Contrast your
answer with your answer to part (a).

4. Suppose that the government imposes a tax on
heating oil.
a. Would the deadweight loss from this tax

likely be greater in the first year after it is
imposed or in the fifth year? Explain.

b. Would the revenue collected from this tax
likely be greater in the first year after it is
imposed or in the fifth year? Explain.

5. After economics class one day, your friend
suggests that taxing food would be a good way
to raise revenue because the demand for food
is quite inelastic. In what sense is taxing food a
“good” way to raise revenue? In what sense is it
not a “good” way to raise revenue?

6. Daniel Patrick Moynihan, the late senator from
New York, once introduced a bill that would
levy a 10,000 percent tax on certain hollow-
tipped bullets.
a. Do you expect that this tax would raise much

revenue? Why or why not?
b. Even if the tax would raise no revenue,

why might Senator Moynihan have
proposed it?

7. The government places a tax on the purchase of
socks.
a. Illustrate the effect of this tax on equilibrium

price and quantity in the sock market.
Identify the following areas both before and
after the imposition of the tax: total spending
by consumers, total revenue for producers,
and government tax revenue.

b. Does the price received by producers rise or
fall? Can you tell whether total receipts for
producers rise or fall? Explain.

c. Does the price paid by consumers rise or
fall? Can you tell whether total spending by
consumers rises or falls? Explain carefully.
(Hint: Think about elasticity.) If total
consumer spending falls, does consumer
surplus rise? Explain.

8. Suppose the government currently raises $100
million through a 1-cent tax on widgets, and
another $100 million through a 10-cent tax on
gadgets. If the government doubled the tax rate
on widgets and eliminated the tax on gadgets,
would it raise more tax revenue than it does
today, less tax revenue, or the same amount?
Explain.

9. This chapter analyzed the welfare effects of
a tax on a good. Consider now the opposite
policy. Suppose that the government subsidizes
a good: For each unit of the good sold, the
government pays $2 to the buyer. How does
the subsidy affect consumer surplus, producer
surplus, tax revenue, and total surplus?
Does a subsidy lead to a deadweight loss?
Explain.

P R o b L E m S A n D A P P L I C A T I o n S

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169CHAPTER 8 application: the costs of taxation

10. Hotel rooms in Smalltown go for $100, and
1,000 rooms are rented on a typical day.
a. To raise revenue, the mayor decides to charge

hotels a tax of $10 per rented room. After
the tax is imposed, the going rate for hotel
rooms rises to $108, and the number of rooms
rented falls to 900. Calculate the amount of
revenue this tax raises for Smalltown and the
deadweight loss of the tax. (Hint: The area of
a triangle is 1⁄2 3 base 3 height.)

b. The mayor now doubles the tax to $20. The
price rises to $116, and the number of rooms
rented falls to 800. Calculate tax revenue
and deadweight loss with this larger tax. Do
they double, more than double, or less than
double? Explain.

11. Suppose that a market is described by the
following supply and demand equations:

QS 5 2P
QD 5 300 – P

a. Solve for the equilibrium price and the
equilibrium quantity.

b. Suppose that a tax of T is placed on buyers,
so the new demand equation is

QD 5 300 – (P 1 T).

Solve for the new equilibrium. What happens
to the price received by sellers, the price paid
by buyers, and the quantity sold?

c. Tax revenue is T 3 Q. Use your answer to
part (b) to solve for tax revenue as a function
of T. Graph this relationship for T between 0
and 300.

d. The deadweight loss of a tax is the area of
the triangle between the supply and demand
curves. Recalling that the area of a triangle
is 1⁄2 3 base 3 height, solve for deadweight
loss as a function of T. Graph this relationship
for T between 0 and 300. (Hint: Looking
sideways, the base of the deadweight loss
triangle is T, and the height is the difference
between the quantity sold with the tax and
the quantity sold without the tax.)

e. The government now levies a tax on this
good of $200 per unit. Is this a good policy?
Why or why not? Can you propose a better
policy?

For further information on topics in this chapter,
additional problems, applications, examples, online
quizzes, and more, please visit our website at www
.cengage.com/economics/mankiw.

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171

9Application: International Trade
If you check the labels on the clothes you are now wearing, you will probably find that some of your clothes were made in another country. A century ago, the textile and clothing industry was a major part of the U.S. economy, but that is no longer the case. Faced with foreign competitors that can produce
quality goods at low cost, many U.S. firms have found it increasingly difficult
to produce and sell textiles and clothing at a profit. As a result, they have laid
off their workers and shut down their factories. Today, much of the textiles and
clothing that Americans consume are imported.

The story of the textile industry raises important questions for economic policy:
How does international trade affect economic well-being? Who gains and who
loses from free trade among countries, and how do the gains compare to the
losses?

Chapter 3 introduced the study of international trade by applying the principle
of comparative advantage. According to this principle, all countries can benefit

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172 PART III Markets and Welfare

from trading with one another because trade allows each country to specialize in
doing what it does best. But the analysis in Chapter 3 was incomplete. It did not
explain how the international marketplace achieves these gains from trade or how
the gains are distributed among various economic participants.

We now return to the study of international trade and take up these questions.
Over the past several chapters, we have developed many tools for analyzing
how markets work: supply, demand, equilibrium, consumer surplus, producer
surplus, and so on. With these tools, we can learn more about how international
trade affects economic well-being.

The Determinants of Trade
Consider the market for textiles. The textile market is well suited to examining
the gains and losses from international trade: Textiles are made in many countries
around the world, and there is much world trade in textiles. Moreover, the textile
market is one in which policymakers often consider (and sometimes implement)
trade restrictions to protect domestic producers from foreign competitors. We
examine here the textile market in the imaginary country of Isoland.

The Equilibrium without Trade
As our story begins, the Isolandian textile market is isolated from the rest of the
world. By government decree, no one in Isoland is allowed to import or export
textiles, and the penalty for violating the decree is so large that no one dares try.

Because there is no international trade, the market for textiles in Isoland con-
sists solely of Isolandian buyers and sellers. As Figure 1 shows, the domestic price
adjusts to balance the quantity supplied by domestic sellers and the quantity
demanded by domestic buyers. The figure shows the consumer and producer sur-
plus in the equilibrium without trade. The sum of consumer and producer surplus
measures the total benefits that buyers and sellers receive from participating in
the textile market.

Figure 1
The Equilibrium without
International Trade
When an economy cannot trade
in world markets, the price
adjusts to balance domestic
supply and demand. This figure
shows consumer and producer
surplus in an equilibrium without
international trade for the textile
market in the imaginary country
of Isoland.

Price of
Textiles

Equilibrium
price

0 Quantity of
Textiles

Equilibrium
quantity

Domestic
supply

Domestic
demand

Producer
surplus

Consumer
surplus

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173CHAPTER 9 application: international trade

Now suppose that, in an election upset, Isoland elects a new president. The
president campaigned on a platform of “change” and promised the voters bold
new ideas. Her first act is to assemble a team of economists to evaluate Isolandian
trade policy. She asks them to report on three questions:

• If the government allows Isolandians to import and export textiles, what
will happen to the price of textiles and the quantity of textiles sold in the
domestic textile market?

• Who will gain from free trade in textiles and who will lose, and will the
gains exceed the losses?

• Should a tariff (a tax on textile imports) be part of the new trade policy?

After reviewing supply and demand in their favorite textbook (this one, of
course), the Isolandian economics team begins its analysis.

The World Price and Comparative Advantage
The first issue our economists take up is whether Isoland is likely to become a
textile importer or a textile exporter. In other words, if free trade is allowed, will
Isolandians end up buying or selling textiles in world markets?

To answer this question, the economists compare the current Isolandian
price of textiles to the price of textiles in other countries. We call the price
prevailing in world markets the world price. If the world price of textiles is
higher than the domestic price, then Isoland will export textiles once trade
is permitted. Isolandian textile producers will be eager to receive the higher
prices available abroad and will start selling their textiles to buyers in other
countries. Conversely, if the world price of textiles is lower than the domestic
price, then Isoland will import textiles. Because foreign sellers offer a better
price, Isolandian textile consumers will quickly start buying textiles from other
countries.

In essence, comparing the world price and the domestic price before trade
indicates whether Isoland has a comparative advantage in producing textiles.
The domestic price reflects the opportunity cost of textiles: It tells us how much
an Isolandian must give up to obtain one unit of textiles. If the domestic price is
low, the cost of producing textiles in Isoland is low, suggesting that Isoland has
a comparative advantage in producing textiles relative to the rest of the world. If
the domestic price is high, then the cost of producing textiles in Isoland is high,
suggesting that foreign countries have a comparative advantage in producing
textiles.

As we saw in Chapter 3, trade among nations is ultimately based on compara-
tive advantage. That is, trade is beneficial because it allows each nation to special-
ize in doing what it does best. By comparing the world price and the domestic
price before trade, we can determine whether Isoland is better or worse at produc-
ing textiles than the rest of the world.

Quick Quiz The country Autarka does not allow international trade. In Autarka,
you can buy a wool suit for 3 ounces of gold. Meanwhile, in neighboring countries,
you can buy the same suit for 2 ounces of gold. If Autarka were to allow free trade,
would it import or export wool suits? Why?

world price
the price of a good that
prevails in the world
market for that good

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174 PART III Markets and Welfare

The Winners and Losers from Trade
To analyze the welfare effects of free trade, the Isolandian economists begin with
the assumption that Isoland is a small economy compared to the rest of the world.
This small-economy assumption means that Isoland’s actions have little effect on
world markets. Specifically, any change in Isoland’s trade policy will not affect
the world price of textiles. The Isolandians are said to be price takers in the world
economy. That is, they take the world price of textiles as given. Isoland can be an
exporting country by selling textiles at this price or an importing country by buy-
ing textiles at this price.

The small-economy assumption is not necessary to analyze the gains and losses
from international trade. But the Isolandian economists know from experience
(and from reading Chapter 2 of this book) that making simplifying assumptions
is a key part of building a useful economic model. The assumption that Isoland
is a small economy simplifies the analysis, and the basic lessons do not change in
the more complicated case of a large economy.

The Gains and Losses of an Exporting Country
Figure 2 shows the Isolandian textile market when the domestic equilibrium
price before trade is below the world price. Once trade is allowed, the domestic
price rises to equal the world price. No seller of textiles would accept less than the
world price, and no buyer would pay more than the world price.

Figure 2
International Trade in an Exporting
Country
Once trade is allowed, the domestic price
rises to equal the world price. The supply
curve shows the quantity of textiles
produced domestically, and the demand
curve shows the quantity consumed
domestically. Exports from Isoland equal
the difference between the domestic
quantity supplied and the domestic
quantity demanded at the world price.
Sellers are better off (producer surplus
rises from C to B 1 C 1 D), and buyers
are worse off (consumer surplus falls from
A 1 B to A). Total surplus rises by an
amount equal to area D, indicating that
trade raises the economic well-being of
the country as a whole.

C

B D

A

Price of
Textiles

Price
before
trade

Price
after
trade

0 Quantity of
Textiles

Domestic
supply

World
price

Domestic
demand

Exports

Exports

Domestic
quantity

demanded

Domestic
quantity
supplied

Before Trade After Trade Change

Consumer Surplus A 1 B A –B
Producer Surplus C B 1 C 1 D 1(B 1 D)
Total Surplus A 1 B 1 C A 1 B 1 C 1 D 1D

The area D shows the increase in total surplus
and represents the gains from trade.

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175CHAPTER 9 application: international trade

After the domestic price has risen to equal the world price, the domestic
quantity supplied differs from the domestic quantity demanded. The supply
curve shows the quantity of textiles supplied by Isolandian sellers. The demand
curve shows the quantity of textiles demanded by Isolandian buyers. Because
the domestic quantity supplied is greater than the domestic quantity demanded,
Isoland sells textiles to other countries. Thus, Isoland becomes a textile exporter.

Although domestic quantity supplied and domestic quantity demanded differ,
the textile market is still in equilibrium because there is now another participant
in the market: the rest of the world. One can view the horizontal line at the world
price as representing the rest of the world’s demand for textiles. This demand
curve is perfectly elastic because Isoland, as a small economy, can sell as many
textiles as it wants at the world price.

Now consider the gains and losses from opening up trade. Clearly, not every-
one benefits. Trade forces the domestic price to rise to the world price. Domestic
producers of textiles are better off because they can now sell textiles at a higher
price, but domestic consumers of textiles are worse off because they have to buy
textiles at a higher price.

To measure these gains and losses, we look at the changes in consumer and
producer surplus. Before trade is allowed, the price of textiles adjusts to balance
domestic supply and domestic demand. Consumer surplus, the area between
the demand curve and the before-trade price, is area A 1 B. Producer surplus,
the area between the supply curve and the before-trade price, is area C. Total sur-
plus before trade, the sum of consumer and producer surplus, is area A1 B 1 C.

After trade is allowed, the domestic price rises to the world price. Consumer sur-
plus is reduced to area A (the area between the demand curve and the world price).
Producer surplus is increased to area B 1 C 1 D (the area between the supply curve
and the world price). Thus, total surplus with trade is area A 1 B 1 C 1 D.

These welfare calculations show who wins and who loses from trade in an
exporting country. Sellers benefit because producer surplus increases by the area
B 1 D. Buyers are worse off because consumer surplus decreases by the area B.
Because the gains of sellers exceed the losses of buyers by the area D, total surplus
in Isoland increases.

This analysis of an exporting country yields two conclusions:

• When a country allows trade and becomes an exporter of a good, domestic
producers of the good are better off, and domestic consumers of the good
are worse off.

• Trade raises the economic well-being of a nation in the sense that the gains
of the winners exceed the losses of the losers.

The Gains and Losses of an Importing Country
Now suppose that the domestic price before trade is above the world price. Once
again, after trade is allowed, the domestic price must equal the world price. As
Figure 3 shows, the domestic quantity supplied is less than the domestic quantity
demanded. The difference between the domestic quantity demanded and the
domestic quantity supplied is bought from other countries, and Isoland becomes
a textile importer.

In this case, the horizontal line at the world price represents the supply of the
rest of the world. This supply curve is perfectly elastic because Isoland is a small
economy and, therefore, can buy as many textiles as it wants at the world price.

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176 PART III Markets and Welfare

Now consider the gains and losses from trade. Once again, not everyone bene-
fits. When trade forces the domestic price to fall, domestic consumers are better off
(they can now buy textiles at a lower price), and domestic producers are worse off
(they now have to sell textiles at a lower price). Changes in consumer and producer
surplus measure the size of the gains and losses. Before trade, consumer surplus is
area A, producer surplus is area B 1 C, and total surplus is area A 1 B 1 C. After
trade is allowed, consumer surplus is area A 1 B 1 D, producer surplus is area C,
and total surplus is area A 1 B 1 C 1 D.

These welfare calculations show who wins and who loses from trade in an
importing country. Buyers benefit because consumer surplus increases by the area
B 1 D. Sellers are worse off because producer surplus falls by the area B. The gains
of buyers exceed the losses of sellers, and total surplus increases by the area D.

This analysis of an importing country yields two conclusions parallel to those
for an exporting country:

• When a country allows trade and becomes an importer of a good, domestic
consumers of the good are better off, and domestic producers of the good
are worse off.

• Trade raises the economic well-being of a nation in the sense that the gains
of the winners exceed the losses of the losers.

Having completed our analysis of trade, we can better understand one of the Ten
Principles of Economics in Chapter 1: Trade can make everyone better off. If Isoland

Figure 3
International Trade in an Importing
Country
Once trade is allowed, the domestic
price falls to equal the world price.
The supply curve shows the amount
produced domestically, and the demand
curve shows the amount consumed
domestically. Imports equal the
difference between the domestic quantity
demanded and the domestic quantity
supplied at the world price. Buyers are
better off (consumer surplus rises from A
to A 1 B 1 D), and sellers are worse off
(producer surplus falls from B 1 C to C).
Total surplus rises by an amount equal to
area D, indicating that trade raises the
economic well-being of the country as a
whole.

Before Trade After Trade Change

Consumer Surplus A A 1 B 1 D 1(B 1 D)
Producer Surplus B 1 C C 2B
Total Surplus A 1 B 1 C A 1 B 1 C 1 D 1D

C

B D

A
Price

before trade

0

Domestic
supply

Domestic
demand

Price
after trade

World
price

Imports

Domestic
quantity
supplied

Domestic
quantity

demanded

Price of
Textiles

Quantity of
Textiles

The area D shows the increase in total surplus
and represents the gains from trade.

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177CHAPTER 9 application: international trade

opens its textile market to international trade, the change will create winners and
losers, regardless of whether Isoland ends up exporting or importing textiles.
In either case, however, the gains of the winners would exceed the losses of the
losers, so the winners could compensate the losers and still be better off. In this
sense, trade can make everyone better off. But will trade make everyone better off?
Probably not. In practice, compensation for the losers from international trade is
rare. Without such compensation, opening an economy to international trade is
a policy that expands the size of the economic pie, while perhaps leaving some
participants in the economy with a smaller slice.

We can now see why the debate over trade policy is often contentious.
Whenever a policy creates winners and losers, the stage is set for a political battle.
Nations sometimes fail to enjoy the gains from trade because the losers from free
trade are better organized than the winners. The losers may turn their cohesive-
ness into political clout, lobbying for trade restrictions such as tariffs or import
quotas.

The Effects of a Tariff
The Isolandian economists next consider the effects of a tariff—a tax on imported
goods. The economists quickly realize that a tariff on textiles will have no effect
if Isoland becomes a textile exporter. If no one in Isoland is interested in import-
ing textiles, a tax on textile imports is irrelevant. The tariff matters only if Isoland
becomes a textile importer. Concentrating their attention on this case, the econo-
mists compare welfare with and without the tariff.

Figure 4 shows the Isolandian market for textiles. Under free trade, the domes-
tic price equals the world price. A tariff raises the price of imported textiles
above the world price by the amount of the tariff. Domestic suppliers of textiles,
who compete with suppliers of imported textiles, can now sell their textiles for
the world price plus the amount of the tariff. Thus, the price of textiles—both
imported and domestic—rises by the amount of the tariff and is, therefore, closer
to the price that would prevail without trade.

The change in price affects the behavior of domestic buyers and sellers. Because
the tariff raises the price of textiles, it reduces the domestic quantity demanded
from Q

1
D to Q

2
D and raises the domestic quantity supplied from Q

1
S to Q

2
S. Thus, the

tariff reduces the quantity of imports and moves the domestic market closer to its equilib-
rium without trade.

Now consider the gains and losses from the tariff. Because the tariff raises the
domestic price, domestic sellers are better off, and domestic buyers are worse off.
In addition, the government raises revenue. To measure these gains and losses,
we look at the changes in consumer surplus, producer surplus, and government
revenue. These changes are summarized in the table in Figure 4.

Before the tariff, the domestic price equals the world price. Consumer surplus, the
area between the demand curve and the world price, is area A 1 B 1 C 1 D 1 E 1 F.
Producer surplus, the area between the supply curve and the world price, is area G.
Government revenue equals zero. Total surplus, the sum of consumer surplus,
producer surplus, and government revenue, is area A 1 B 1 C 1 D 1 E 1 F 1 G.

Once the government imposes a tariff, the domestic price exceeds the world
price by the amount of the tariff. Consumer surplus is now area A 1 B. Producer
surplus is area C 1 G. Government revenue, which is the quantity of after-tariff
imports times the size of the tariff, is the area E. Thus, total surplus with the tariff
is area A 1 B 1 C 1 E 1 G.

tariff
a tax on goods produced
abroad and sold
domestically

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178 PART III Markets and Welfare

To determine the total welfare effects of the tariff, we add the change in con-
sumer surplus (which is negative), the change in producer surplus (positive), and
the change in government revenue (positive). We find that total surplus in the
market decreases by the area D 1 F. This fall in total surplus is called the dead-
weight loss of the tariff.

A tariff causes a deadweight loss because a tariff is a type of tax. Like most
taxes, it distorts incentives and pushes the allocation of scarce resources away
from the optimum. In this case, we can identify two effects. First, when the tariff
raises the domestic price of textiles above the world price, it encourages domestic
producers to increase production from Q

1
S to Q

2
S. Even though the cost of making

these incremental units exceeds the cost of buying them at the world price, the

Figure 4
The Effects of a Tariff

A tariff reduces the quantity of imports and moves a market closer to the equilibrium
that would exist without trade. Total surplus falls by an amount equal to area D 1 F.
These two triangles represent the deadweight loss from the tariff.

Before Tariff After Tariff Change

Consumer Surplus A 1 B 1 C 1 D 1 E 1 F A 1 B –(C 1 D 1 E 1 F)
Producer Surplus G C 1 G 1C
Government Revenue None E 1E
Total Surplus A 1 B 1 C 1 D 1 E 1 F 1 G A 1 B 1 C 1 E 1 G –(D 1 F)

The area D 1 F shows the fall in total surplus and represents the deadweight loss of the tariff.

D E F
C

G

B

A

0

Domestic
supply

Domestic
demand

Price
with tariff Tariff

Imports
without tariff

Equilibrium
without trade

Price
without tariff

World
priceImports

with tariff

2Q
S

1Q
S

2Q
D

1Q
D

Price of
Textiles

Quantity of
Textiles

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179CHAPTER 9 application: international trade

tariff makes it profitable for domestic producers to manufacture them nonethe-
less. Second, when the tariff raises the price that domestic textile consumers have
to pay, it encourages them to reduce consumption of textiles from Q

1
D to Q

2
D. Even

though domestic consumers value these incremental units at more than the world
price, the tariff induces them to cut back their purchases. Area D represents the
deadweight loss from the overproduction of textiles, and area F represents the
deadweight loss from the underconsumption of textiles. The total deadweight loss
of the tariff is the sum of these two triangles.

The Lessons for Trade Policy
The team of Isolandian economists can now write to the new president:

Dear Madame President,

You asked us three questions about opening up trade. After much hard work,
we have the answers.

Question: If the government allows Isolandians to import and export textiles,
what will happen to the price of textiles and the quantity of textiles sold in the
domestic textile market?

Answer: Once trade is allowed, the Isolandian price of textiles will be driven to
equal the price prevailing around the world.

FYI
Import Quotas:
Another Way to Restrict Trade

Beyond tariffs, another way that nations sometimes restrict inter-national trade is by putting limits on how much of a good can be
imported. In this book, we will not analyze such a policy, other than to
point out the conclusion: Import quotas are much like tariffs. Both tariffs
and import quotas reduce the quantity of imports, raise the domestic
price of the good, decrease the welfare of domestic consumers, increase
the welfare of domestic producers, and cause deadweight losses.
There is only one difference between these two types of trade
restriction: A tariff raises revenue for the government, whereas an
import quota creates surplus for those who obtain the licenses to
import. The profit for the holder of an import license is the difference
between the domestic price (at which he sells the imported good)
and the world price (at which he buys it).
Tariffs and import quotas are even more similar if the govern-
ment charges a fee for the import licenses. Suppose the government

sets the license fee equal to the difference between the domestic
price and the world price. In this case, all the profit of license hold-
ers is paid to the government in license fees, and the import quota
works exactly like a tariff. Consumer surplus, producer surplus, and
government revenue are precisely the same under the two policies.
In practice, however, countries that restrict trade with import quotas
rarely do so by selling the import licenses. For example, the U.S. govern-
ment has at times pressured Japan to “voluntarily” limit the sale of
Japanese cars in the United States. In this case, the Japanese govern-
ment allocates the import licenses to Japanese firms, and the surplus
from these licenses accrues to those firms. From the standpoint of U.S.
welfare, this kind of import quota is worse than a U.S. tariff on imported
cars. Both a tariff and an import quota raise prices, restrict trade, and
cause deadweight losses, but at least the tariff produces revenue for the
U.S. government rather than profit for foreign producers.

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180 PART III Markets and Welfare

If the world price is now higher than the Isolandian price, our price will rise.
The higher price will reduce the amount of textiles Isolandians consume and
raise the amount of textiles that Isolandians produce. Isoland will, therefore,
become a textile exporter. This occurs because, in this case, Isoland has a com-
parative advantage in producing textiles.

Conversely, if the world price is now lower than the Isolandian price, our
price will fall. The lower price will raise the amount of textiles that Isolandians
consume and lower the amount of textiles that Isolandians produce. Isoland
will, therefore, become a textile importer. This occurs because, in this case,
other countries have a comparative advantage in producing textiles.

Question: Who will gain from free trade in textiles and who will lose, and will
the gains exceed the losses?

Answer: The answer depends on whether the price rises or falls when trade is
allowed. If the price rises, producers of textiles gain, and consumers of textiles lose.
If the price falls, consumers gain, and producers lose. In both cases, the gains are
larger than the losses. Thus, free trade raises the total welfare of Isolandians.

Question: Should a tariff be part of the new trade policy?

Answer: A tariff has an impact only if Isoland becomes a textile importer. In
this case, a tariff moves the economy closer to the no-trade equilibrium and,
like most taxes, has deadweight losses. Although a tariff improves the welfare
of domestic producers and raises revenue for the government, these gains
are more than offset by the losses suffered by consumers. The best policy,
from the standpoint of economic efficiency, would be to allow trade without
a tariff.

We hope you find these answers helpful as you decide on your new policy.

Your faithful servants,
Isolandian economics team

Other Benefits of International Trade
The conclusions of the Isolandian economics team are based on the standard
analysis of international trade. Their analysis uses the most fundamental tools in
the economist’s toolbox: supply, demand, and producer and consumer surplus.
It shows that there are winners and losers when a nation opens itself up to trade,
but the gains to the winners exceed the losses of the losers.

The case for free trade can be made even stronger, however, because there are
several other economic benefits of trade beyond those emphasized in the standard
analysis. Here, in a nutshell, are some of these other benefits:

• Increased variety of goods. Goods produced in different countries are not
exactly the same. German beer, for instance, is not the same as American
beer. Free trade gives consumers in all countries greater variety from which
to choose.

• Lower costs through economies of scale. Some goods can be produced at
low cost only if they are produced in large quantities—a phenomenon called
economies of scale. A firm in a small country cannot take full advantage of
economies of scale if it can sell only in a small domestic market. Free trade

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181CHAPTER 9 application: international trade

Trade Skirmishes
In recent years, trade between the United States and China has not
been completely free, as the following two articles illustrate.

in the news

U.S. Adds Tariffs on
Chinese Tires
By Edmund L. AndrEws

Washington—In a break with the trade policies of his predecessor, President
Obama announced on Friday night that he
would impose a 35 percent tariff on automo-
bile and light-truck tires imported from China.
The decision is a major victory for
the United Steelworkers, the union that
represents American tire workers. And
Mr. Obama cannot afford to jeopardize his
relationship with major unions as he pushes
Congress to overhaul the nation’s health
care system.

But China is certain to be antagonized
by the decision….
The decision signals the first time that
the United States has invoked a special
safeguard provision that was part of its
agreement to support China’s entry into the
World Trade Organization in 2001.
Under that safeguard provision, American
companies or workers harmed by imports from
China can ask the government for protection
simply by demonstrating that American pro-
ducers have suffered a “market disruption” or
a “surge” in imports from China.
Unlike more traditional anti-dumping
cases, the government does not need to deter-
mine that a country is competing unfairly or
selling its products at less than their true cost.A U.S. import

China Moves to
Retaliate Against U.S.
Tire Tariff
By KEith BrAdshEr

Hong Kong—China unexpectedly in creased pressure Sunday on the United States in a
widening trade dispute, taking the first steps
toward imposing tariffs on American exports
of automotive products and chicken meat in
retaliation for President Obama’s decision late
Friday to levy tariffs on tires from China.
The Chinese government’s strong coun-
termove followed a weekend of nationalistic

vitriol against the United States on Chinese
Web sites in response to the tire tariff. “The
U.S. is shameless!” said one posting, while
another called on the Chinese government to
sell all of its huge holdings of Treasury bonds.
The impact of the dispute extends
well beyond tires, chickens and cars.
Both governments are facing domestic
pressure to take a tougher stand against
the other on economic issues. But the
trade battle increases political tensions
between the two nations even as they
try to work together to revive the global
economy and combat mutual security
threats, like the nuclear ambitions of Iran
and North Korea.

A U.S. export

[Three days later]

Source: New York Times, September 11 and 14, 2009.

©
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

182 PART III Markets and Welfare

gives firms access to larger world markets and allows them to realize
economies of scale more fully.

• Increased competition. A company shielded from foreign competitors is more
likely to have market power, which in turn gives it the ability to raise prices
above competitive levels. This is a type of market failure. Opening up trade fos-
ters competition and gives the invisible hand a better chance to work its magic.

• Enhanced flow of ideas. The transfer of technological advances around the
world is often thought to be linked to the trading of the goods that embody
those advances. The best way for a poor agricultural nation to learn about
the computer revolution, for instance, is to buy some computers from
abroad rather than trying to make them domestically.

Thus, free international trade increases variety for consumers, allows firms
to take advantage of economies of scale, makes markets more competitive,
and facilitates the spread of technology. If the Isolandian economists also took
these effects into account, their advice to their president would be even more
forceful.

Quick Quiz Draw a supply and demand diagram for wool suits in the country of
Autarka. When trade is allowed, the price of a suit falls from 3 to 2 ounces of gold.
In your diagram, show the change in consumer surplus, the change in producer sur-
plus, and the change in total surplus. How would a tariff on suit imports alter these
effects?

The Arguments for Restricting Trade
The letter from the economics team starts to persuade the new president of Isoland
to consider allowing trade in textiles. She notes that the domestic price is now high
compared to the world price. Free trade would, therefore, cause the price of textiles
to fall and hurt domestic textiles producers. Before implementing the new policy,
she asks Isolandian textile companies to comment on the economists’ advice.

Not surprisingly, the textile companies oppose free trade in textiles. They
believe that the government should protect the domestic textile industry from
foreign competition. Let’s consider some of the arguments they might give to sup-
port their position and how the economics team would respond.

The Jobs Argument
Opponents of free trade often argue that trade with other countries destroys domestic
jobs. In our example, free trade in textiles would cause the price of textiles to fall, reduc-
ing the quantity of textiles produced in Isoland and thus reducing employment in the
Isolandian textile industry. Some Isolandian textile workers would lose their jobs.

Yet free trade creates jobs at the same time that it destroys them. When
Isolandians buy textiles from other countries, those countries obtain the resources
to buy other goods from Isoland. Isolandian workers would move from the textile
industry to those industries in which Isoland has a comparative advantage. The
transition may impose hardship on some workers in the short run, but it allows
Isolandians as a whole to enjoy a higher standard of living.

Opponents of trade are often skeptical that trade creates jobs. They might
respond that everything can be produced more cheaply abroad. Under free trade,
they might argue, Isolandians could not be profitably employed in any industry. ©

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.

“You like protection-
ism as a ‘working
man.’ How about
as a consumer?”

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183CHAPTER 9 application: international trade

Should the Winners from Free Trade
Compensate the Losers?

Politicians and pundits often say that the government should help work-
ers made worse off by international trade by, for example, paying for their
retraining. In this opinion piece, an economist makes the opposite case.

in the news

What to Expect When
You’re Free Trading
By stEvEn E. LAndsBurg

All economists know that when American jobs are outsourced, Americans as a
group are net winners. What we lose through
lower wages is more than offset by what we
gain through lower prices. In other words, the
winners can more than afford to compensate
the losers. Does that mean they ought to?
Does it create a moral mandate for taxpayer-
subsidized retraining programs?…
Um, no. Even if you’ve just lost your job,
there’s something fundamentally churlish
about blaming the very phenomenon that’s
elevated you above the subsistence level
since the day you were born. If the world
owes you compensation for enduring the
downside of trade, what do you owe the
world for enjoying the upside?
I doubt there’s a human being on earth
who hasn’t benefited from the opportunity
to trade freely with his neighbors. Imagine
what your life would be like if you had to
grow your own food, make your own clothes
and rely on your grandmother’s home reme-

dies for health care. Access to a trained
physician might reduce the demand for
grandma’s home remedies, but—especially
at her age—she’s still got plenty of reason
to be thankful for having a doctor.
Some people suggest, however, that it
makes sense to isolate the moral effects of a
single new trading opportunity or free trade
agreement. Surely we have fellow citizens
who are hurt by those agreements, at least
in the limited sense that they’d be better off
in a world where trade flourishes, except in
this one instance. What do we owe those
fellow citizens?
One way to think about that is to ask what
your moral instincts tell you in analogous situa-
tions. Suppose, after years of buying shampoo
at your local pharmacy, you discover you
can order the same shampoo for less money
on the Web. Do you have an obligation to
compensate your pharmacist? If you move to
a cheaper apartment, should you compensate
your landlord? When you eat at McDonald’s,
should you compensate the owners of the
diner next door? Public policy should not be
designed to advance moral instincts that we
all reject every day of our lives.
In what morally relevant way, then,
might displaced workers differ from dis-

placed pharmacists or displaced land-
lords? You might argue that pharmacists
and landlords have always faced cutthroat
competition and therefore knew what
they were getting into, while decades of
tariffs and quotas have led manufacturing
workers to expect a modicum of protec-
tion. That expectation led them to develop
certain skills, and now it’s unfair to pull
the rug out from under them.
Once again, that argument does not
mesh with our everyday instincts. For many
decades, schoolyard bullying has been a
profitable occupation. All across America,
bullies have built up skills so they can take
advantage of that opportunity. If we toughen
the rules to make bullying unprofitable,
must we compensate the bullies?
Bullying and protectionism have a lot
in common. They both use force (either
directly or through the power of the law)
to enrich someone else at your involun-
tary expense. If you’re forced to pay $20
an hour to an American for goods you
could have bought from a Mexican for $5
an hour, you’re being extorted. When a
free trade agreement allows you to buy
from the Mexican after all, rejoice in your
liberation.

Source: New York Times, January 16, 2008.

As Chapter 3 explains, however, the gains from trade are based on comparative
advantage, not absolute advantage. Even if one country is better than another
country at producing everything, each country can still gain from trading with the
other. Workers in each country will eventually find jobs in an industry in which
that country has a comparative advantage.

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184 PART III Markets and Welfare

The National-Security Argument
When an industry is threatened with competition from other countries, oppo-
nents of free trade often argue that the industry is vital for national security. For
example, if Isoland were considering free trade in steel, domestic steel companies
might point out that steel is used to make guns and tanks. Free trade would allow
Isoland to become dependent on foreign countries to supply steel. If a war later
broke out and the foreign supply was interrupted, Isoland might be unable to
produce enough steel and weapons to defend itself.

Economists acknowledge that protecting key industries may be appropriate when
there are legitimate concerns over national security. Yet they fear that this argument
may be used too quickly by producers eager to gain at consumers’ expense.

One should be wary of the national-security argument when it is made by rep-
resentatives of industry rather than the defense establishment. Companies have
an incentive to exaggerate their role in national defense to obtain protection from
foreign competition. A nation’s generals may see things very differently. Indeed,
when the military is a consumer of an industry’s output, it would benefit from

Trouble with Trade
By PAuL KrugmAn

While the United States has long import-ed oil and other raw materials from
the third world, we used to import manufac-
tured goods mainly from other rich countries
like Canada, European nations and Japan.
But recently we crossed an important
watershed: we now import more manu-
factured goods from the third world than
from other advanced economies. That is, a
majority of our industrial trade is now with
countries that are much poorer than we
are and that pay their workers much lower
wages.

For the world economy as a whole—
and especially for poorer nations—growing
trade between high-wage and low-wage
countries is a very good thing. Above all, it
offers backward economies their best hope
of moving up the income ladder.
But for American workers the story is
much less positive. In fact, it’s hard to avoid
the conclusion that growing U.S. trade with
third-world countries reduces the real wages
of many and perhaps most workers in this
country. And that reality makes the politics
of trade very difficult.
Let’s talk for a moment about the
economics.
Trade between high-wage countries
tends to be a modest win for all, or almost

all, concerned. When a free-trade pact
made it possible to integrate the U.S. and
Canadian auto industries in the 1960s, each
country’s industry concentrated on produc-
ing a narrower range of products at larger
scale. The result was an all-round, broadly
shared rise in productivity and wages.
By contrast, trade between countries at
very different levels of economic develop-
ment tends to create large classes of losers
as well as winners.
Although the outsourcing of some high-
tech jobs to India has made headlines, on
balance, highly educated workers in the
United States benefit from higher wages
and expanded job opportunities because
of trade. For example, ThinkPad notebook

Second Thoughts about Free Trade
Some economists worry about the impact of trade on the distribution of
income. Even if free trade enhances efficiency, it may reduce equality.

in the news

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185CHAPTER 9 application: international trade

computers are now made by a Chinese
company, Lenovo, but a lot of Lenovo’s
research and development is conducted in
North Carolina.
But workers with less formal education
either see their jobs shipped overseas or find
their wages driven down by the ripple effect
as other workers with similar qualifications
crowd into their industries and look for
employment to replace the jobs they lost
to foreign competition. And lower prices at
Wal-Mart aren’t sufficient compensation.
All this is textbook international eco-
nomics: contrary to what people sometimes
assert, economic theory says that free trade
normally makes a country richer, but it
doesn’t say that it’s normally good for every-
one. Still, when the effects of third-world
exports on U.S. wages first became an issue
in the 1990s, a number of economists—
myself included—looked at the data and
concluded that any negative effects on U.S.
wages were modest.
The trouble now is that these effects
may no longer be as modest as they were,
because imports of manufactured goods from
the third world have grown dramatically—

from just 2.5 percent of G.D.P. in 1990 to
6 percent in 2006.
And the biggest growth in imports has
come from countries with very low wages.
The original “newly industrializing econo-
mies” exporting manufactured goods—
South Korea, Taiwan, Hong Kong and
Singapore—paid wages that were about 25
percent of U.S. levels in 1990. Since then,
however, the sources of our imports have
shifted to Mexico, where wages are only 11
percent of the U.S. level, and China, where
they’re only about 3 percent or 4 percent.
There are some qualifying aspects to this
story. For example, many of those made-in-
China goods contain components made in
Japan and other high-wage economies. Still,
there’s little doubt that the pressure of glo-
balization on American wages has increased.
So am I arguing for protectionism? No.
Those who think that globalization is always
and everywhere a bad thing are wrong. On
the contrary, keeping world markets rela-
tively open is crucial to the hopes of billions
of people.
But I am arguing for an end to the
finger-wagging, the accusation either of not

understanding economics or of kowtowing
to special interests that tends to be the
editorial response to politicians who express
skepticism about the benefits of free-trade
agreements.
It’s often claimed that limits on trade
benefit only a small number of Americans,
while hurting the vast majority. That’s still
true of things like the import quota on sugar.
But when it comes to manufactured goods,
it’s at least arguable that the reverse is true.
The highly educated workers who clearly
benefit from growing trade with third-world
economies are a minority, greatly outnum-
bered by those who probably lose.
As I said, I’m not a protectionist. For the
sake of the world as a whole, I hope that
we respond to the trouble with trade not
by shutting trade down, but by doing things
like strengthening the social safety net. But
those who are worried about trade have a
point, and deserve some respect.

Source: New York Times, December 28, 2007.

imports. Cheaper steel in Isoland, for example, would allow the Isolandian mili-
tary to accumulate a stockpile of weapons at lower cost.

The Infant-Industry Argument
New industries sometimes argue for temporary trade restrictions to help them
get started. After a period of protection, the argument goes, these industries will
mature and be able to compete with foreign firms.

Similarly, older industries sometimes argue that they need temporary protection
to help them adjust to new conditions. For example, in 2002, President Bush imposed
temporary tariffs on imported steel. He said, “I decided that imports were severely
affecting our industry, an important industry.” The tariff, which lasted 20 months,
offered “temporary relief so that the industry could restructure itself.”

Economists are often skeptical about such claims, largely because the infant-
industry argument is difficult to implement in practice. To apply protection suc-
cessfully, the government would need to decide which industries will eventually
be profitable and decide whether the benefits of establishing these industries
exceed the costs of this protection to consumers. Yet “picking winners” is extraor-
dinarily difficult. It is made even more difficult by the political process, which
often awards protection to those industries that are politically powerful. And

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186 PART III Markets and Welfare

once a powerful industry is protected from foreign competition, the “temporary”
policy is sometimes hard to remove.

In addition, many economists are skeptical about the infant-industry argument
in principle. Suppose, for instance, that an industry is young and unable to compete
profitably against foreign rivals, but there is reason to believe that the industry can
be profitable in the long run. In this case, firm owners should be willing to incur tem-
porary losses to obtain the eventual profits. Protection is not necessary for an infant
industry to grow. History shows that start-up firms often incur temporary losses and
succeed in the long run, even without protection from competition.

The Unfair-Competition Argument
A common argument is that free trade is desirable only if all countries play by
the same rules. If firms in different countries are subject to different laws and
regulations, then it is unfair (the argument goes) to expect the firms to compete
in the international marketplace. For instance, suppose that the government of
Neighborland subsidizes its textile industry by giving textile companies large tax
breaks. The Isolandian textile industry might argue that it should be protected
from this foreign competition because Neighborland is not competing fairly.

Would it, in fact, hurt Isoland to buy textiles from another country at a subsi-
dized price? Certainly, Isolandian textile producers would suffer, but Isolandian
textile consumers would benefit from the low price. The case for free trade is no
different: The gains of the consumers from buying at the low price would exceed
the losses of the producers. Neighborland’s subsidy to its textile industry may be
a bad policy, but it is the taxpayers of Neighborland who bear the burden. Isoland
can benefit from the opportunity to buy textiles at a subsidized price.

The Protection-as-a-Bargaining-Chip Argument
Another argument for trade restrictions concerns the strategy of bargaining.
Many policymakers claim to support free trade but, at the same time, argue that
trade restrictions can be useful when we bargain with our trading partners. They
claim that the threat of a trade restriction can help remove a trade restriction
already imposed by a foreign government. For example, Isoland might threaten
to impose a tariff on textiles unless Neighborland removes its tariff on wheat. If
Neighborland responds to this threat by removing its tariff, the result can be freer
trade.

The problem with this bargaining strategy is that the threat may not work. If
it doesn’t work, the country faces a choice between two bad options. It can carry
out its threat and implement the trade restriction, which would reduce its own
economic welfare. Or it can back down from its threat, which would cause it to
lose prestige in international affairs. Faced with this choice, the country would
probably wish that it had never made the threat in the first place.

Trade Agreements and the World Trade
Organization

A country can take one of two approaches to achieving free trade. It can take a uni-
lateral approach and remove its trade restrictions on its own. This is the approach
that Great Britain took in the 19th century and that Chile and South Korea have
taken in recent years. Alternatively, a country can take a multilateral approach and

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187CHAPTER 9 application: international trade

reduce its trade restrictions while other countries do the same. In other words, it
can bargain with its trading partners in an attempt to reduce trade restrictions
around the world.
One important example of the multilateral approach is the North American
Free Trade Agreement (NAFTA), which in 1993 lowered trade barriers among the
United States, Mexico, and Canada. Another is the General Agreement on Tariffs
and Trade (GATT), which is a continuing series of negotiations among many of
the world’s countries with the goal of promoting free trade. The United States
helped to found GATT after World War II in response to the high tariffs imposed
during the Great Depression of the 1930s. Many economists believe that the high
tariffs contributed to the worldwide economic hardship of that period. GATT
has successfully reduced the average tariff among member countries from about
40 percent after World War II to about 5 percent today.
The rules established under GATT are now enforced by an international insti-
tution called the World Trade Organization (WTO). The WTO was established in
1995 and has its headquarters in Geneva, Switzerland. As of 2009, 153 countries
have joined the organization, accounting for more than 97 percent of world trade.
The functions of the WTO are to administer trade agreements, provide a forum
for negotiations, and handle disputes among member countries.
What are the pros and cons of the multilateral approach to free trade? One
advantage is that the multilateral approach has the potential to result in freer
trade than a unilateral approach because it can reduce trade restrictions abroad
as well as at home. If international negotiations fail, however, the result could be
more restricted trade than under a unilateral approach.
In addition, the multilateral approach may have a political advantage. In most
markets, producers are fewer and better organized than consumers—and thus
wield greater political influence. Reducing the Isolandian tariff on textiles, for
example, may be politically difficult if considered by itself. The textile compa-
nies would oppose free trade, and the buyers of textiles who would benefit are
so numerous that organizing their support would be difficult. Yet suppose that
Neighborland promises to reduce its tariff on wheat at the same time that Isoland
reduces its tariff on textiles. In this case, the Isolandian wheat farmers, who
are also politically powerful, would back the agreement. Thus, the multilateral
approach to free trade can sometimes win political support when a unilateral
approach cannot. ■

Quick Quiz The textile industry of Autarka advocates a ban on the import of wool
suits. Describe five arguments its lobbyists might make. Give a response to each of
these arguments.

Conclusion
Economists and the public often disagree about free trade. In 2008, the Los Angeles
Times asked the American public, “Generally speaking, do you believe that free
international trade has helped or hurt the economy, or hasn’t it made a differ-
ence to the economy one way or the other?” Only 26 percent of those polled said
free international trade helped, whereas 50 percent thought it hurt. (The rest
thought it made no difference or were unsure.) By contrast, most economists
support free international trade. They view free trade as a way of allocating
production efficiently and raising living standards both at home and abroad.

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188 PART III Markets and Welfare

S u m m A R y

Economists view the United States as an ongoing experiment that confirms the
virtues of free trade. Throughout its history, the United States has allowed unre-
stricted trade among the states, and the country as a whole has benefited from
the specialization that trade allows. Florida grows oranges, Alaska pumps oil,
California makes wine, and so on. Americans would not enjoy the high standard
of living they do today if people could consume only those goods and services
produced in their own states. The world could similarly benefit from free trade
among countries.

To better understand economists’ view of trade, let’s continue our parable.
Suppose that the president of Isoland, after reading the latest poll results, ignores
the advice of her economics team and decides not to allow free trade in textiles.
The country remains in the equilibrium without international trade.

Then, one day, some Isolandian inventor discovers a new way to make textiles
at very low cost. The process is quite mysterious, however, and the inventor
insists on keeping it a secret. What is odd is that the inventor doesn’t need tradi-
tional inputs such as cotton or wool. The only material input he needs is wheat.
And even more oddly, to manufacture textiles from wheat, he hardly needs any
labor input at all.

The inventor is hailed as a genius. Because everyone buys clothing, the lower
cost of textiles allows all Isolandians to enjoy a higher standard of living. Workers
who had previously produced textiles experience some hardship when their
factories close, but eventually, they find work in other industries. Some become
farmers and grow the wheat that the inventor turns into textiles. Others enter new
industries that emerge as a result of higher Isolandian living standards. Everyone
understands that the displacement of workers in outmoded industries is an inevi-
table part of technological progress and economic growth.

After several years, a newspaper reporter decides to investigate this mysteri-
ous new textiles process. She sneaks into the inventor’s factory and learns that the
inventor is a fraud. The inventor has not been making textiles at all. Instead, he
has been smuggling wheat abroad in exchange for textiles from other countries.
The only thing that the inventor had discovered was the gains from international
trade.

When the truth is revealed, the government shuts down the inventor’s opera-
tion. The price of textiles rises, and workers return to jobs in textile factories.
Living standards in Isoland fall back to their former levels. The inventor is jailed
and held up to public ridicule. After all, he was no inventor. He was just an
economist.

• The effects of free trade can be determined by
comparing the domestic price without trade to
the world price. A low domestic price indicates
that the country has a comparative advantage
in producing the good and that the country will
become an exporter. A high domestic price indi-
cates that the rest of the world has a comparative
advantage in producing the good and that the
country will become an importer.

• When a country allows trade and becomes an
exporter of a good, producers of the good are
better off, and consumers of the good are worse
off. When a country allows trade and becomes an
importer of a good, consumers are better off, and
producers are worse off. In both cases, the gains
from trade exceed the losses.

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189CHAPTER 9 application: international trade

• A tariff—a tax on imports—moves a market
closer to the equilibrium that would exist without
trade and, therefore, reduces the gains from
trade. Although domestic producers are better
off and the government raises revenue, the losses
to consumers exceed these gains.

• There are various arguments for restricting trade:
protecting jobs, defending national security,

helping infant industries, preventing unfair
competition, and responding to foreign trade
restrictions. Although some of these arguments
have some merit in some cases, economists
believe that free trade is usually the better policy.

K E y C o n C E P T S

world price, p. 173 tariff, p. 177

Q u E S T I o n S f o R R E v I E w

1. What does the domestic price that prevails
without international trade tell us about a
nation’s comparative advantage?

2. When does a country become an exporter of a
good? An importer?

3. Draw the supply-and-demand diagram for an
importing country. What is consumer surplus
and producer surplus before trade is allowed?
What is consumer surplus and producer

surplus with free trade? What is the change in
total surplus?

4. Describe what a tariff is and its economic effects.
5. List five arguments often given to support trade

restrictions. How do economists respond to
these arguments?

6. What is the difference between the unilateral
and multilateral approaches to achieving free
trade? Give an example of each.

P R o b l E m S A n d A P P l I C A T I o n S

1. Mexico represents a small part of the world
orange market.
a. Draw a diagram depicting the equilibrium

in the Mexican orange market without
international trade. Identify the equilibrium
price, equilibrium quantity, consumer
surplus, and producer surplus.

b. Suppose that the world orange price is below
the Mexican price before trade and that the
Mexican orange market is now opened to
trade. Identify the new equilibrium price,
quantity consumed, quantity produced
domestically, and quantity imported. Also
show the change in the surplus of domestic
consumers and producers. Has total surplus
increased or decreased?

2. The world price of wine is below the price that
would prevail in Canada in the absence of trade.

a. Assuming that Canadian imports of wine are
a small part of total world wine production,
draw a graph for the Canadian market for
wine under free trade. Identify consumer
surplus, producer surplus, and total surplus
in an appropriate table.

b. Now suppose that an unusual shift of the
Gulf Stream leads to an unseasonably cold
summer in Europe, destroying much of the
grape harvest there. What effect does this
shock have on the world price of wine? Using
your graph and table from part (a), show
the effect on consumer surplus, producer
surplus, and total surplus in Canada. Who
are the winners and losers? Is Canada as a
whole better or worse off?

3. Suppose that Congress imposes a tariff on
imported autos to protect the U.S. auto industry

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190 PART III Markets and Welfare

from foreign competition. Assuming that the
United States is a price taker in the world auto
market, show the following on a diagram: the
change in the quantity of imports, the loss to
U.S. consumers, the gain to U.S. manufacturers,
government revenue, and the deadweight
loss associated with the tariff. The loss to
consumers can be decomposed into three pieces:
a gain to domestic producers, revenue for the
government, and a deadweight loss. Use your
diagram to identify these three pieces.

4. When China’s clothing industry expands, the
increase in world supply lowers the world price
of clothing.
a. Draw an appropriate diagram to analyze

how this change in price affects consumer
surplus, producer surplus, and total surplus
in a nation that imports clothing, such as the
United States.

b. Now draw an appropriate diagram to show
how this change in price affects consumer
surplus, producer surplus, and total surplus
in a nation that exports clothing, such as the
Dominican Republic.

c. Compare your answers to parts (a) and
(b). What are the similarities and what are
the differences? Which country should
be concerned about the expansion of the
Chinese textile industry? Which country
should be applauding it? Explain.

5. Imagine that winemakers in the state of
Washington petitioned the state government to
tax wines imported from California. They argue
that this tax would both raise tax revenue for
the state government and raise employment in
the Washington state wine industry. Do you
agree with these claims? Is it a good policy?

6. Consider the arguments for restricting trade.
a. Assume you are a lobbyist for timber, an

established industry suffering from low-
priced foreign competition. Which two or
three of the five arguments do you think
would be most persuasive to the average
member of Congress as to why he or she
should support trade restrictions? Explain
your reasoning.

b. Now assume you are an astute student
of economics (hopefully not a hard
assumption). Although all the arguments for
restricting trade have their shortcomings,
name the two or three arguments that seem

to make the most economic sense to you.
For each, describe the economic rationale
for and against these arguments for trade
restrictions.

7. Senator Ernest Hollings once wrote that
“consumers do not benefit from lower-priced
imports. Glance through some mail-order
catalogs and you’ll see that consumers pay
exactly the same price for clothing whether it is
U.S.-made or imported.” Comment.

8. The nation of Textilia does not allow imports
of clothing. In its equilibrium without trade, a
T-shirt costs $20, and the equilibrium quantity is
3 million T-shirts. One day, after reading Adam
Smith’s The Wealth of Nations while on vacation,
the president decides to open the Textilian
market to international trade. The market
price of a T-shirt falls to the world price of $16.
The number of T-shirts consumed in Textilia
rises to 4 million, while the number of T-shirts
produced declines to 1 million.
a. Illustrate the situation just described in

a graph. Your graph should show all the
numbers.

b. Calculate the change in consumer surplus,
producer surplus, and total surplus that
results from opening up trade. (Hint: Recall
that the area of a triangle is ½ × base ×
height.)

9. China is a major producer of grains, such as
wheat, corn, and rice. In 2008 the Chinese
government, concerned that grain exports were
driving up food prices for domestic consumers,
imposed a tax on grain exports.
a. Draw the graph that describes the market for

grain in an exporting country. Use this graph
as the starting point to answer the following
questions.

b. How does an export tax affect domestic grain
prices?

c. How does it affect the welfare of domestic
consumers, the welfare of domestic
producers, and government revenue?

d. What happens to total welfare in China, as
measured by the sum of consumer surplus,
producer surplus, and tax revenue?

10. Consider a country that imports a good from
abroad. For each of following statements, say
whether it is true or false. Explain your answer.
a. “The greater the elasticity of demand, the

greater the gains from trade.”

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191CHAPTER 9 application: international trade

b. “If demand is perfectly inelastic, there are no
gains from trade.”

c. “If demand is perfectly inelastic, consumers
do not benefit from trade.”

11. Kawmin is a small country that produces and
consumes jelly beans. The world price of jelly
beans is $1 per bag, and Kawmin’s domestic
demand and supply for jelly beans are governed
by the following equations:

Demand: QD 5 8 – P
Supply: QS 5 P,

where P is in dollars per bag and Q is in bags of
jelly beans.
a. Draw a well-labeled graph of the situation in

Kawmin if the nation does not allow trade.
Calculate the following (recalling that the
area of a triangle is ½ 3 base 3 height): the
equilibrium price and quantity, consumer
surplus, producer surplus, and total surplus.

b. Kawmin then opens the market to trade.
Draw another graph to describe the
new situation in the jelly bean market.
Calculate the equilibrium price, quantities
of consumption and production, imports,
consumer surplus, producer surplus, and
total surplus.

c. After a while, the Czar of Kawmin responds
to the pleas of jelly bean producers by
placing a $1 per bag tariff on jelly bean
imports. On a graph, show the effects of
this tariff. Calculate the equilibrium price,
quantities of consumption and production,
imports, consumer surplus, producer surplus,
government revenue, and total surplus.

d. What are the gains from opening up
trade? What are the deadweight losses
from restricting trade with the tariff? Give
numerical answers.

12. Having rejected a tariff on textiles (a tax on
imports), the president of Isoland is now
considering the same-sized tax on textile
consumption (including both imported and
domestically produced textiles).
a. Using Figure 4, identify the quantity

consumed and the quantity produced in
Isoland under a textile consumption tax.

b. Construct a table similar to that in Figure 4
for the textile consumption tax.

c. Which raises more revenue for the
government—the consumption tax or the

tariff? Which has a smaller deadweight loss?
Explain.

13. Assume the United States is an importer of
televisions and there are no trade restrictions.
U.S. consumers buy 1 million televisions
per year, of which 400,000 are produced
domestically and 600,000 are imported.
a. Suppose that a technological advance among

Japanese television manufacturers causes
the world price of televisions to fall by $100.
Draw a graph to show how this change
affects the welfare of U.S. consumers and U.S.
producers and how it affects total surplus in
the United States.

b. After the fall in price, consumers buy 1.2
million televisions, of which 200,000 are
produced domestically and 1 million are
imported. Calculate the change in consumer
surplus, producer surplus, and total surplus
from the price reduction.

c. If the government responded by putting a
$100 tariff on imported televisions, what
would this do? Calculate the revenue
that would be raised and the deadweight
loss. Would it be a good policy from the
standpoint of U.S. welfare? Who might
support the policy?

d. Suppose that the fall in price is attributable
not to technological advance but to a $100
per television subsidy from the Japanese
government to Japanese industry. How
would this affect your analysis?

14. Consider a small country that exports steel.
Suppose that a “pro-trade” government
decides to subsidize the export of steel by
paying a certain amount for each ton sold
abroad. How does this export subsidy affect
the domestic price of steel, the quantity
of steel produced, the quantity of steel
consumed, and the quantity of steel exported?
How does it affect consumer surplus,
producer surplus, government revenue, and
total surplus? Is it a good policy from the
standpoint of economic efficiency? (Hint: The
analysis of an export subsidy is similar to the
analysis of a tariff.)

For further information on topics in this chapter,
additional problems, applications, examples, online
quizzes, and more, please visit our website at
www.cengage.com/economics/mankiw.

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http://www.cengage.com/economics/mankiw

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The Economics of
the Public SectorIVPart

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195

10Externalities
Firms that make and sell paper also create, as a by-product of the manufac-turing process, a chemical called dioxin. Scientists believe that once dioxin enters the environment, it raises the population’s risk of cancer, birth defects, and other health problems.

Is the production and release of dioxin a problem for society? In Chapters 4
through 9, we examined how markets allocate scarce resources with the forces
of supply and demand, and we saw that the equilibrium of supply and demand
is typically an efficient allocation of resources. To use Adam Smith’s famous
metaphor, the “invisible hand” of the marketplace leads self-interested buyers
and sellers in a market to maximize the total benefit that society derives from
that market. This insight is the basis for one of the Ten Principles of Economics in
Chapter 1: Markets are usually a good way to organize economic activity. Should
we conclude, therefore, that the invisible hand prevents firms in the paper market
from emitting too much dioxin?

Markets do many things well, but they do not do everything well. In this chapter,
we begin our study of another of the Ten Principles of Economics: Government

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196 PART Iv The economics of The Public secTor

action can sometimes improve upon market outcomes. We examine why mar-
kets sometimes fail to allocate resources efficiently, how government policies can
potentially improve the market’s allocation, and what kinds of policies are likely
to work best.

The market failures examined in this chapter fall under a general category
called externalities. An externality arises when a person engages in an activity
that influences the well-being of a bystander but neither pays nor receives any
compensation for that effect. If the impact on the bystander is adverse, it is called
a negative externality. If it is beneficial, it is called a positive externality. In the pres-
ence of externalities, society’s interest in a market outcome extends beyond the
well-being of buyers and sellers who participate in the market to include the
well-being of bystanders who are affected indirectly. Because buyers and sellers
neglect the external effects of their actions when deciding how much to demand
or supply, the market equilibrium is not efficient when there are externalities. That
is, the equilibrium fails to maximize the total benefit to society as a whole. The
release of dioxin into the environment, for instance, is a negative externality. Self-
interested paper firms will not consider the full cost of the pollution they create in
their production process, and consumers of paper will not consider the full cost of
the pollution they contribute from their purchasing decisions. Therefore, the firms
will emit too much pollution unless the government prevents or discourages them
from doing so.

Externalities come in many varieties, as do the policy responses that try to deal
with the market failure. Here are some examples:

• The exhaust from automobiles is a negative externality because it creates
smog that other people have to breathe. As a result of this externality,
drivers tend to pollute too much. The federal government attempts to solve
this problem by setting emission standards for cars. It also taxes gasoline to
reduce the amount that people drive.

• Restored historic buildings convey a positive externality because people
who walk or ride by them can enjoy the beauty and the sense of history
that these buildings provide. Building owners do not get the full benefit of
restoration and, therefore, tend to discard older buildings too quickly. Many
local governments respond to this problem by regulating the destruction of
historic buildings and by providing tax breaks to owners who restore them.

• Barking dogs create a negative externality because neighbors are disturbed
by the noise. Dog owners do not bear the full cost of the noise and,
therefore, tend to take too few precautions to prevent their dogs from
barking. Local governments address this problem by making it illegal to
“disturb the peace.”

• Research into new technologies provides a positive externality because it
creates knowledge that other people can use. Because inventors cannot
capture the full benefits of their inventions, they tend to devote too few
resources to research. The federal government addresses this problem
partially through the patent system, which gives inventors exclusive use of
their inventions for a limited time.

In each of these cases, some decision maker fails to take account of the external
effects of his or her behavior. The government responds by trying to influence this
behavior to protect the interests of bystanders.

externality
the uncompensated
impact of one person’s
actions on the well-being
of a bystander

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197CHAPTER 10 exTernaliTies

Externalities and Market Inefficiency
In this section, we use the tools of welfare economics developed in Chapter 7 to
examine how externalities affect economic well-being. The analysis shows pre-
cisely why externalities cause markets to allocate resources inefficiently. Later in
the chapter, we examine various ways in which private individuals and public
policymakers may remedy this type of market failure.

Welfare Economics: A Recap
We begin by recalling the key lessons of welfare economics from Chapter 7.
To make our analysis concrete, we consider a specific market—the market
for aluminum. Figure 1 shows the supply and demand curves in the market for
aluminum.

As you should recall from Chapter 7, the supply and demand curves contain
important information about costs and benefits. The demand curve for aluminum
reflects the value of aluminum to consumers, as measured by the prices they are
willing to pay. At any given quantity, the height of the demand curve shows
the willingness to pay of the marginal buyer. In other words, it shows the value
to the consumer of the last unit of aluminum bought. Similarly, the supply curve
reflects the costs of producing aluminum. At any given quantity, the height of
the supply curve shows the cost to the marginal seller. In other words, it shows
the cost to the producer of the last unit of aluminum sold.

In the absence of government intervention, the price adjusts to balance the
supply and demand for aluminum. The quantity produced and consumed in the
market equilibrium, shown as Q

MARKET
in Figure 1, is efficient in the sense that it

maximizes the sum of producer and consumer surplus. That is, the market allo-
cates resources in a way that maximizes the total value to the consumers who
buy and use aluminum minus the total costs to the producers who make and sell
aluminum.

Figure 1
The Market for Aluminum
The demand curve reflects the value
to buyers, and the supply curve reflects
the costs of sellers. The equilibrium
quantity, Q

MARKET
, maximizes the total

value to buyers minus the total
costs of sellers. In the absence of
externalities, therefore, the market
equilibrium is efficient.

Equilibrium

Quantity of
Aluminum

0

Price of
Aluminum

QMARKET

Demand
(private value)

Supply
(private cost)

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198 PART Iv The economics of The Public secTor

Negative Externalities
Now let’s suppose that aluminum factories emit pollution: For each unit of alu-
minum produced, a certain amount of smoke enters the atmosphere. Because this
smoke creates a health risk for those who breathe the air, it is a negative externality.
How does this externality affect the efficiency of the market outcome?

Because of the externality, the cost to society of producing aluminum is larger
than the cost to the aluminum producers. For each unit of aluminum produced,
the social cost includes the private costs of the aluminum producers plus the costs
to those bystanders affected adversely by the pollution. Figure 2 shows the social
cost of producing aluminum. The social-cost curve is above the supply curve
because it takes into account the external costs imposed on society by aluminum
production. The difference between these two curves reflects the cost of the pollu-
tion emitted.

What quantity of aluminum should be produced? To answer this question,
we once again consider what a benevolent social planner would do. The plan-
ner wants to maximize the total surplus derived from the market—the value to
consumers of aluminum minus the cost of producing aluminum. The planner
understands, however, that the cost of producing aluminum includes the external
costs of the pollution.

The planner would choose the level of aluminum production at which the
demand curve crosses the social-cost curve. This intersection determines the opti-
mal amount of aluminum from the standpoint of society as a whole. Below this
level of production, the value of the aluminum to consumers (as measured by the
height of the demand curve) exceeds the social cost of producing it (as measured
by the height of the social-cost curve). The planner does not produce more than
this level because the social cost of producing additional aluminum exceeds the
value to consumers.

Note that the equilibrium quantity of aluminum, Q
MARKET

, is larger than the
socially optimal quantity, Q

OPTIMUM
. This inefficiency occurs because the market

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“All I can say is that if
being a leading manu­
facturer means being a
leading polluter, so be it.”

Figure 2
Pollution and the Social
Optimum
In the presence of a
negative externality, such as
pollution, the social cost of
the good exceeds the private
cost. The optimal quantity,
Q

OPTIMUM
, is therefore smaller

than the equilibrium
quantity, Q

MARKET
.

Equilibrium

Quantity of
Aluminum

0

Price of
Aluminum

QMARKET

Demand
(private value)

Supply
(private cost)

Social cost (private cost
and external cost)

QOPTIMUM

Optimum

External
Cost

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http://www.cartoonbank.com

http://www.cartoonbank.com

http://www.cartoonbank.com

199CHAPTER 10 exTernaliTies

equilibrium reflects only the private costs of production. In the market equilib-
rium, the marginal consumer values aluminum at less than the social cost of
producing it. That is, at Q

MARKET
, the demand curve lies below the social-cost

curve. Thus, reducing aluminum production and consumption below the market
equilibrium level raises total economic well-being.

How can the social planner achieve the optimal outcome? One way would be
to tax aluminum producers for each ton of aluminum sold. The tax would shift
the supply curve for aluminum upward by the size of the tax. If the tax accu-
rately reflected the external cost of pollutants released into the atmosphere, the
new supply curve would coincide with the social-cost curve. In the new market
equilibrium, aluminum producers would produce the socially optimal quantity
of aluminum.

The use of such a tax is called internalizing the externality because it
gives buyers and sellers in the market an incentive to take into account the
external effects of their actions. Aluminum producers would, in essence, take
the costs of pollution into account when deciding how much aluminum to
supply because the tax would make them pay for these external costs. And,
because the market price would reflect the tax on producers, consumers of
aluminum would have an incentive to use a smaller quantity. The policy is
based on one of the Ten Principles of Economics: People respond to incentives.
Later in this chapter, we consider in more detail how policymakers can deal
with externalities.

Positive Externalities
Although some activities impose costs on third parties, others yield benefits. For
example, consider education. To a large extent, the benefit of education is private:
The consumer of education becomes a more productive worker and thus reaps
much of the benefit in the form of higher wages. Beyond these private benefits,
however, education also yields positive externalities. One externality is that a
more educated population leads to more informed voters, which means better
government for everyone. Another externality is that a more educated popula-
tion tends to mean lower crime rates. A third externality is that a more educated
population may encourage the development and dissemination of technological
advances, leading to higher productivity and wages for everyone. Because of
these three positive externalities, a person may prefer to have neighbors who are
well educated.

The analysis of positive externalities is similar to the analysis of negative exter-
nalities. As Figure 3 shows, the demand curve does not reflect the value to society
of the good. Because the social value is greater than the private value, the social-
value curve lies above the demand curve. The optimal quantity is found where
the social-value curve and the supply curve (which represents costs) intersect.
Hence, the socially optimal quantity is greater than the quantity determined by
the private market.

Once again, the government can correct the market failure by inducing market
participants to internalize the externality. The appropriate response in the case
of positive externalities is exactly the opposite to the case of negative exter-
nalities. To move the market equilibrium closer to the social optimum, a positive
externality requires a subsidy. In fact, that is exactly the policy the government
follows: Education is heavily subsidized through public schools and government
scholarships.

internalizing the
externality
altering incentives so that
people take account of
the external effects of
their actions

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200 PART Iv The economics of The Public secTor

the Lorax Was
Wrong: Skyscrapers
are Green
By Edward L. GLaEsEr

In Dr. Seuss’ environmentalist fable, “The Lorax,” the Once-ler, a budding textile mag-
nate, chops down Truffula to knit “Thneeds.”
Over the protests of the environmentally
sensitive Lorax, the Once-ler builds a great
industrial town that despoils the environment,
because he “had to grow bigger.” Even tually,
the Once-ler overdoes it, and he chops down
the last Truffula tree, destroying the source of

his income. Chastened, Dr. Seuss’s industrialist
turns green, urging a young listener to take
the last Truffula seed and plant a new forest.
Some of the lessons told by this story
are correct. From a purely profit-maximizing
point of view, the Once-ler is pretty inept,
because he kills his golden goose. Any good
management consultant would have told
him to manage his growth more wisely.
One aspect of the story’s environmentalist
message, that bad things happen when we
overfish a common pool, is also correct.
But the unfortunate aspect of the story
is that urbanization comes off terribly. The
forests are good; the factories are bad. Not
only does the story disparage the remarkable

benefits that came from the mass pro-
duction of clothing in 19th-century textile
towns, it sends exactly the wrong message
on the environment. Contrary to the story’s
implied message, living in cities is green,
while living surrounded by forests is brown.
By building taller and taller buildings,
the Once-ler was proving himself to be the
real environmentalist.
Matthew Kahn, a U.C.L.A. environ mental
economist, and I looked across America’s
metropolitan areas and calculated the carbon
emissions associated with a new home in
different parts of the country. We estimated
expected energy use from driving and public
transportation, for a family of fixed size and

The Externalities of Country Living
Economist Ed Glaeser says urbanization gets a bum rap.

in the news

Figure 3
Education and the Social
Optimum
In the presence of a positive
externality, the social
value of the good exceeds
the private value. The
optimal quantity, Q

OPTIMUM
,

is therefore larger than the
equilibrium quantity, Q

MARKET
.

Quantity of
Education

0

Price of
Education

QMARKET

Demand
(private value)

Social value (private value
and external benefit)

QOPTIMUM

Supply
(private cost)

External
benefit Optimum

Equilibrium

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201CHAPTER 10 exTernaliTies

Source: New York Times, Economix blog, March 10, 2009.

income. We added in carbon emissions from
home electricity and home heating. . . .
In almost every metropolitan area, we
found the central city residents emitted less
carbon than the suburban counterparts. In
New York and San Francisco, the average
urban family emits more than two tons less
carbon annually because it drives less. In
Nashville, the city-suburb carbon gap due
to driving is more than three tons. After all,
density is the defining characteristic of cities.
All that closeness means that people need to
travel shorter distances, and that shows up
clearly in the data.
While public transportation certainly
uses much less energy, per rider, than
driving, large carbon reductions are pos-
sible without any switch to buses or rails.
Higher-density suburban areas, which are
still entirely car-dependent, still involve a lot
less travel than the really sprawling places.
This fact offers some hope for greens eager
to reduce carbon emissions, since it is a lot
easier to imagine Americans driving shorter
distances than giving up their cars.

But cars represent only one-third of
the gap in carbon emissions between New
Yorkers and their suburbanites. The gap in
electricity usage between New York City
and its suburbs is also about two tons.
The gap in emissions from home heating
is almost three tons. All told, we estimate

a seven-ton difference in carbon emis-
sions between the residents of Manhattan’s
urban aeries and the good burghers of
Westchester County. Living surrounded by
concrete is actually pretty green. Living sur-
rounded by trees is not.
The policy prescription that follows from
this is that environmentalists should be
championing the growth of more and taller
skyscrapers. Every new crane in New York
City means less low-density development.
The environmental ideal should be an apart-
ment in downtown San Francisco, not a
ranch in Marin County.
Of course, many environmentalists will
still prefer to take their cue from Henry David
Thoreau, who advocated living alone in the
woods. They would do well to remember
that Thoreau, in a sloppy chowder-cooking
moment, burned down 300 acres of prime
Concord woodland. Few Boston merchants
did as much environmental harm, which sug-
gests that if you want to take good care of
the environment, stay away from it and live
in cities.

To summarize: Negative externalities lead markets to produce a larger quantity than
is socially desirable. Positive externalities lead markets to produce a smaller quantity than
is socially desirable. To remedy the problem, the government can internalize the exter­
nality by taxing goods that have negative externalities and subsidizing goods that have
positive externalities.

Technology Spillovers, Industrial Policy, and
Patent Protection

A potentially important type of positive externality is called a technology spillover—
the impact of one firm’s research and production efforts on other firms’ access to
technological advance. For example, consider the market for industrial robots.
Robots are at the frontier of a rapidly changing technology. Whenever a firm
builds a robot, there is some chance that the firm will discover a new and better
design. This new design may benefit not only this firm but society as a whole
because the design will enter society’s pool of technological knowledge. That
is, the new design may have positive externalities for other producers in the
economy.

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202 PART Iv The economics of The Public secTor

In this case, the government can internalize the externality by subsidizing the
production of robots. If the government paid firms a subsidy for each robot pro-
duced, the supply curve would shift down by the amount of the subsidy, and this
shift would increase the equilibrium quantity of robots. To ensure that the market
equilibrium equals the social optimum, the subsidy should equal the value of the
technology spillover.

How large are technology spillovers, and what do they imply for public policy?
This is an important question because technological progress is the key to why
living standards rise over time. Yet it is also a difficult question on which econo-
mists often disagree.

Some economists believe that technology spillovers are pervasive and that the
government should encourage those industries that yield the largest spillovers.
For instance, these economists argue that if making computer chips yields greater
spillovers than making potato chips, then the government should encourage the
production of computer chips relative to the production of potato chips. The U.S.
tax code does this in a limited way by offering special tax breaks for expenditures
on research and development. Some other nations go farther by subsidizing spe-
cific industries that supposedly offer large technology spillovers. Government
intervention in the economy that aims to promote technology-enhancing indus-
tries is sometimes called industrial policy.

Other economists are skeptical about industrial policy. Even if technology
spillovers are common, the success of an industrial policy requires that the
govern ment be able to measure the size of the spillovers from different markets.
This measurement problem is difficult at best. Moreover, without precise mea-
surements, the political system may end up subsidizing industries with the most
political clout rather than those that yield the largest positive externalities.

Another way to deal with technology spillovers is patent protection. The patent
laws protect the rights of inventors by giving them exclusive use of their inventions
for a period of time. When a firm makes a technological breakthrough, it can patent
the idea and capture much of the economic benefit for itself. The patent internal-
izes the externality by giving the firm a property right over its invention. If other
firms want to use the new technology, they have to obtain permission from the
inventing firm and pay it a royalty. Thus, the patent system gives firms a greater
incentive to engage in research and other activities that advance technology. ■

Quick Quiz Give an example of a negative externality and a positive externality.
Explain why market outcomes are inefficient in the presence of these externalities.

Public Policies toward Externalities
We have discussed why externalities lead markets to allocate resources ineffi-
ciently but have mentioned only briefly how this inefficiency can be remedied.
In practice, both public policymakers and private individuals respond to exter-
nalities in various ways. All of the remedies share the goal of moving the alloca-
tion of resources closer to the social optimum.

This section considers governmental solutions. As a general matter, the govern-
ment can respond to externalities in one of two ways. Command­and­control policies
regulate behavior directly. Market­based policies provide incentives so that private
decision makers will choose to solve the problem on their own.

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203CHAPTER 10 exTernaliTies

Command-and-Control Policies: Regulation
The government can remedy an externality by making certain behaviors either
required or forbidden. For example, it is a crime to dump poisonous chemicals
into the water supply. In this case, the external costs to society far exceed the
benefits to the polluter. The government therefore institutes a command-and-
control policy that prohibits this act altogether.

In most cases of pollution, however, the situation is not this simple. Despite
the stated goals of some environmentalists, it would be impossible to prohibit
all polluting activity. For example, virtually all forms of transportation—even
the horse—produce some undesirable polluting by-products. But it would
not be sensible for the government to ban all transportation. Thus, instead of
trying to eradicate pollution entirely, society has to weigh the costs and bene-
fits to decide the kinds and quantities of pollution it will allow. In the United
States, the Environmental Protection Agency (EPA) is the government agency
with the task of developing and enforcing regulations aimed at protecting the
environment.

Environmental regulations can take many forms. Sometimes the EPA dictates a
maximum level of pollution that a factory may emit. Other times the EPA requires
that firms adopt a particular technology to reduce emissions. In all cases, to design
good rules, the government regulators need to know the details about specific
industries and about the alternative technologies that those industries could
adopt. This information is often difficult for government regulators to obtain.

Market-Based Policy 1: Corrective Taxes
and Subsidies
Instead of regulating behavior in response to an externality, the government can
use market-based policies to align private incentives with social efficiency. For
instance, as we saw earlier, the government can internalize the externality by
taxing activities that have negative externalities and subsidizing activities that
have positive externalities. Taxes enacted to deal with the effects of negative exter-
nalities are called corrective taxes. They are also called Pigovian taxes after econo-
mist Arthur Pigou (1877–1959), an early advocate of their use. An ideal corrective
tax would equal the external cost from an activity with negative externalities, and
an ideal corrective subsidy would equal the external benefit from an activity with
positive externalities.

Economists usually prefer corrective taxes to regulations as a way to deal with
pollution because they can reduce pollution at a lower cost to society. To see why,
let us consider an example.

Suppose that two factories—a paper mill and a steel mill—are each dumping
500 tons of glop into a river every year. The EPA decides that it wants to reduce
the amount of pollution. It considers two solutions:

• Regulation: The EPA could tell each factory to reduce its pollution to
300 tons of glop per year.

• Corrective tax: The EPA could levy a tax on each factory of $50,000 for
each ton of glop it emits.

The regulation would dictate a level of pollution, whereas the tax would give fac-
tory owners an economic incentive to reduce pollution. Which solution do you
think is better?

corrective tax
a tax designed to induce
private decision makers to
take account of the social
costs that arise from a
negative externality

Arthur Pigou

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204 PART Iv The economics of The Public secTor

Most economists prefer the tax. To explain this preference, they would first
point out that a tax is just as effective as a regulation in reducing the overall level
of pollution. The EPA can achieve whatever level of pollution it wants by setting
the tax at the appropriate level. The higher the tax, the larger the reduction in
pollu tion. If the tax is high enough, the factories will close down altogether, reduc-
ing pollution to zero.

Although regulation and corrective taxes are both capable of reducing pollution,
the tax accomplishes this goal more efficiently. The regulation requires each factory
to reduce pollution by the same amount. An equal reduction, however, is not neces-
sarily the least expensive way to clean up the water. It is possible that the paper mill
can reduce pollution at lower cost than the steel mill. If so, the paper mill would
respond to the tax by reducing pollution substantially to avoid the tax, whereas the
steel mill would respond by reducing pollution less and paying the tax.

In essence, the corrective tax places a price on the right to pollute. Just as
markets allocate goods to those buyers who value them most highly, a corrective
tax allocates pollution to those factories that face the highest cost of reducing it.
Whatever the level of pollution the EPA chooses, it can achieve this goal at the
lowest total cost using a tax.

Economists also argue that corrective taxes are better for the environment.
Under the command-and-control policy of regulation, the factories have no reason
to reduce emission further once they have reached the target of 300 tons of glop.
By contrast, the tax gives the factories an incentive to develop cleaner technologies
because a cleaner technology would reduce the amount of tax the factory has to pay.

Corrective taxes are unlike most other taxes. As we discussed in Chapter 8,
most taxes distort incentives and move the allocation of resources away from the
social optimum. The reduction in economic well-being—that is, in consumer and
producer surplus—exceeds the amount of revenue the government raises, result-
ing in a deadweight loss. By contrast, when externalities are present, society also
cares about the well-being of the bystanders who are affected. Corrective taxes
alter incentives to account for the presence of externalities and thereby move the
allocation of resources closer to the social optimum. Thus, while corrective taxes
raise revenue for the government, they also enhance economic efficiency.

Why Is Gasoline Taxed So Heavily?

In many nations, gasoline is among the most heavily taxed goods. The gas tax
can be viewed as a corrective tax aimed at addressing three negative externalities
associated with driving:

• Congestion: If you have ever been stuck in bumper-to-bumper traffic, you
have probably wished that there were fewer cars on the road. A gasoline tax
keeps congestion down by encouraging people to take public transportation,
carpool more often, and live closer to work.

• Accidents: Whenever people buy large cars or sport-utility vehicles, they
may make themselves safer but they certainly put their neighbors at risk.
According to the National Highway Traffic Safety Administration, a person
driving a typical car is five times as likely to die if hit by a sport-utility
vehicle than if hit by another car. The gas tax is an indirect way of making
people pay when their large, gas-guzzling vehicles impose risk on others.

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205CHAPTER 10 exTernaliTies

It would induce them to take this risk into account when choosing what
vehicle to purchase.

• Pollution: Cars cause smog. Moreover, the burning of fossil fuels such as
gasoline is widely believed to be the primary cause of global warming.
Experts disagree about how dangerous this threat is, but there is no doubt
that the gas tax reduces the threat by reducing the use of gasoline.

So the gas tax, rather than causing deadweight losses like most taxes, actually
makes the economy work better. It means less traffic congestion, safer roads, and
a cleaner environment.

How high should the tax on gasoline be? Most European countries impose
gasoline taxes that are much higher than those in the United States. Many observ-
ers have suggested that the United States also should tax gasoline more heavily. A
2007 study published in the Journal of Economic Literature summarized the research
on the size of the various externalities associated with driving. It concluded that
the optimal corrective tax on gasoline was $2.10 per gallon, compared to the actual
tax in the United States of only 40 cents.

The tax revenue from a gasoline tax could be used to lower taxes that distort
incentives and cause deadweight losses, such as income taxes. In addition, some
of the burdensome government regulations that require automakers to produce
more fuel-efficient cars would prove unnecessary. This idea, however, has never
proven politically popular. ■

Market-Based Policy 2: Tradable Pollution Permits
Returning to our example of the paper mill and the steel mill, let us suppose that,
despite the advice of its economists, the EPA adopts the regulation and requires
each factory to reduce its pollution to 300 tons of glop per year. Then one day,

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Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

206 PART Iv The economics of The Public secTor

after the regulation is in place and both mills have complied, the two firms go to
the EPA with a proposal. The steel mill wants to increase its emission of glop by
100 tons. The paper mill has agreed to reduce its emission by the same amount if
the steel mill pays it $5 million. Should the EPA allow the two factories to make
this deal?

From the standpoint of economic efficiency, allowing the deal is good policy.
The deal must make the owners of the two factories better off because they are
voluntarily agreeing to it. Moreover, the deal does not have any external effects
because the total amount of pollution remains the same. Thus, social welfare is
enhanced by allowing the paper mill to sell its pollution rights to the steel mill.

The same logic applies to any voluntary transfer of the right to pollute from
one firm to another. If the EPA allows firms to make these deals, it will, in essence,
have created a new scarce resource: pollution permits. A market to trade these
permits will eventually develop, and that market will be governed by the forces
of supply and demand. The invisible hand will ensure that this new market allo-
cates the right to pollute efficiently. That is, the permits will end up in the hands
of those firms that value them most highly, as judged by their willingness to pay.
A firm’s willingness to pay for the right to pollute, in turn, will depend on its cost
of reducing pollution: The more costly it is for a firm to cut back on pollution, the
more it will be willing to pay for a permit.

An advantage of allowing a market for pollution permits is that the initial allo-
cation of pollution permits among firms does not matter from the standpoint of
economic efficiency. Those firms that can reduce pollution at a low cost will sell
whatever permits they get, and firms that can reduce pollution only at a high cost
will buy whatever permits they need. As long as there is a free market for the pollu-
tion rights, the final allocation will be efficient regardless of the initial allocation.

Reducing pollution using pollution permits may seem very different from
using corrective taxes, but the two policies have much in common. In both cases,
firms pay for their pollution. With corrective taxes, polluting firms must pay a tax
to the government. With pollution permits, polluting firms must pay to buy the
permit. (Even firms that already own permits must pay to pollute: The opportu-
nity cost of polluting is what they could have received by selling their permits
on the open market.) Both corrective taxes and pollution permits internalize the
externality of pollution by making it costly for firms to pollute.

The similarity of the two policies can be seen by considering the market for
pollution. Both panels in Figure 4 show the demand curve for the right to pollute.
This curve shows that the lower the price of polluting, the more firms will choose
to pollute. In panel (a), the EPA uses a corrective tax to set a price for pollution.
In this case, the supply curve for pollution rights is perfectly elastic (because
firms can pollute as much as they want by paying the tax), and the position of the
demand curve determines the quantity of pollution. In panel (b), the EPA sets a
quantity of pollution by issuing pollution permits. In this case, the supply curve
for pollution rights is perfectly inelastic (because the quantity of pollution is fixed
by the number of permits), and the position of the demand curve determines
the price of pollution. Hence, the EPA can achieve any point on a given demand
curve either by setting a price with a corrective tax or by setting a quantity with
pollution permits.

In some circumstances, however, selling pollution permits may be better than
levying a corrective tax. Suppose the EPA wants no more than 600 tons of glop
dumped into the river. But because the EPA does not know the demand curve

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207CHAPTER 10 exTernaliTies

for pollution, it is not sure what size tax would achieve that goal. In this case, it
can simply auction off 600 pollution permits. The auction price would yield the
appropriate size of the corrective tax.

The idea of the government auctioning off the right to pollute may at first
sound like a creature of some economist’s imagination. And in fact, that is how
the idea began. But increasingly, the EPA has used the system as a way to con-
trol pollution. A notable success story has been the case of sulfur dioxide (SO

2
),

a leading cause of acid rain. In 1990, amendments to the Clean Air Act required
power plants to reduce SO

2
emissions substantially. At the same time, the amend-

ments set up a system that allowed plants to trade their SO
2
allowances. Initially,

both industry representatives and environmentalists were skeptical of the pro-
posal, but over time the system has reduced pollution with minimal disruption.
Pollution permits, like corrective taxes, are now widely viewed as a cost-effective
way to keep the environment clean.

Objections to the Economic Analysis of Pollution
“We cannot give anyone the option of polluting for a fee.” This comment by the
late Senator Edmund Muskie reflects the view of some environmentalists. Clean
air and clean water, they argue, are fundamental human rights that should not
be debased by considering them in economic terms. How can you put a price on

In panel (a), the EPA sets a price on pollution by levying a corrective tax, and the
demand curve determines the quantity of pollution. In panel (b), the EPA limits the
quantity of pollution by limiting the number of pollution permits, and the demand
curve determines the price of pollution. The price and quantity of pollution are the
same in the two cases.

Figure 4

Quantity of
Pollution

0

Price of
Pollution

P

Q

Demand for
pollution rights

Corrective
tax

(a) Corrective Tax

Quantity of
Pollution

0 Q

Demand for
pollution rights

Supply of
pollution permits

(b) Pollution Permits

Price of
Pollution

P

2. . . . which, together
with the demand curve,
determines the quantity
of pollution.

2. . . . which, together
with the demand curve,
determines the price
of pollution.

1. A corrective
tax sets the
price of
pollution . . .

1. Pollution
permits set
the quantity
of pollution . . .

The Equivalence of
Corrective Taxes and
Pollution Permits

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208 PART Iv The economics of The Public secTor

clean air and clean water? The environment is so important, they claim, that we
should protect it as much as possible, regardless of the cost.

Economists have little sympathy for this type of argument. To economists, good
environmental policy begins by acknowledging the first of the Ten Principles of
Economics in Chapter 1: People face trade-offs. Certainly, clean air and clean water
have value. But their value must be compared to their opportunity cost—that
is, to what one must give up to obtain them. Eliminating all pollution is impos-
sible. Trying to eliminate all pollution would reverse many of the technological
advances that allow us to enjoy a high standard of living. Few people would be
willing to accept poor nutrition, inadequate medical care, or shoddy housing to
make the environment as clean as possible.

Economists argue that some environmental activists hurt their own cause by not
thinking in economic terms. A clean environment can be viewed as simply another
good. Like all normal goods, it has a positive income elasticity: Rich countries can
afford a cleaner environment than poor ones and, therefore, usually have more
rigorous environmental protection. In addition, like most other goods, clean air

a Missed Opportunity
on Climate Change
By N. GrEGory MaNkiw

During the presidential campaign of 2008, Barack Obama distinguished himself on
the economics of climate change, speaking
far more sensibly about the issue than most
of his rivals. Unfortunately, now that he is
president, Mr. Obama may sign a climate bill
that falls far short of his aspirations. Indeed,
the legislation making its way to his desk
could well be worse than nothing at all.
Let’s start with the basics. The essential
problem of climate change, scientists tell us,
is that humans are emitting too much carbon
into the atmosphere, which tends to raise

world temperatures. Emitting carbon is what
economists call a “negative externality”—an
adverse side effect of certain market activities
on bystanders.
The textbook solution for dealing with
negative externalities is to use the tax system
to align private incentives with social costs and
benefits. Suppose the government imposed a
tax on carbon-based products and used the
proceeds to cut other taxes. People would
have an incentive to shift their consumption
toward less carbon-intensive products. A car-
bon tax is the remedy for climate change that
wins overwhelming support among econo-
mists and policy wonks.
When he was still a candidate, Mr.
Obama did not exactly endorse a carbon tax.
He wanted to be elected, and embracing any
tax that hits millions of middle-class voters

is not a recipe for electoral success. But he
did come tantalizingly close.
What Mr. Obama proposed was a
cap-and-trade system for carbon, with all
the allowances sold at auction. In short, the
system would put a ceiling on the amount
of carbon released, and companies would
bid on the right to emit carbon into the
atmosphere.
Such a system is tantamount to a carbon
tax. The auction price of an emission right
is effectively a tax on carbon. The revenue
raised by the auction gives the government
the resources to cut other taxes that distort
behavior, like income or payroll taxes.
So far, so good. The problem occurred
as this sensible idea made the trip from
the campaign trail through the legislative
process. Rather than auctioning the carbon

Cap and Trade
President Obama has proposed a policy to deal with the externalities
from carbon emissions.

in the news

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209CHAPTER 10 exTernaliTies

and clean water obey the law of demand: The lower the price of environmental
protection, the more the public will want. The economic approach of using pollu-
tion permits and corrective taxes reduces the cost of environmental protection and
should, therefore, increase the public’s demand for a clean environment.

Quick Quiz A glue factory and a steel mill emit smoke containing a chemical that is
harmful if inhaled in large amounts. Describe three ways the town government might
respond to this externality. What are the pros and cons of each solution?

Private Solutions to Externalities
Although externalities tend to cause markets to be inefficient, government action
is not always needed to solve the problem. In some circumstances, people can
develop private solutions.

allowances, the bill that recently passed the
House would give most of them away to
powerful special interests.
The numbers involved are not trivial.
From Congressional Budget Office esti-
mates, one can calculate that if all the
allowances were auctioned, the government
could raise $989 billion in proceeds over
10 years. But in the bill as written, the auc-
tion proceeds are only $276 billion.
Mr. Obama understood these risks. When
asked about a carbon tax in an interview in
July 2007, he said: “I believe that, depending
on how it is designed, a carbon tax accom-
plishes much of the same thing that a cap-
and-trade program accomplishes. The danger
in a cap-and-trade system is that the permits
to emit greenhouse gases are given away for
free as opposed to priced at auction. One of
the mistakes the Europeans made in setting
up a cap-and-trade system was to give too
many of those permits away.”
Congress is now in the process of
sending President Obama a bill that makes
exactly this mistake.
How much does it matter? For the pur-
pose of efficiently allocating the carbon
rights, it doesn’t. Even if these rights are
handed out on political rather than economic

grounds, the “trade” part of “cap and trade”
will take care of the rest. Those companies
with the most need to emit carbon will
buy carbon allowances on newly formed
exchanges. Those without such pressing
needs will sell whatever allowances they are
given and enjoy the profits that resulted from
Congress’s largess.
The problem arises in how the climate
policy interacts with the overall tax system.
As the president pointed out, a cap-and-
trade system is like a carbon tax. The price
of carbon allowances will eventually be
passed on to consumers in the form of
higher prices for carbon-intensive products.
But if most of those allowances are handed
out rather than auctioned, the government
won’t have the resources to cut other taxes
and offset that price increase. The result is
an increase in the effective tax rates facing
most Americans, leading to lower real take-
home wages, reduced work incentives, and
depressed economic activity.
The hard question is whether, on net,
such a policy is good or bad. Here you can
find policy wonks on both sides. To those
who view climate change as an impending
catastrophe and the distorting effects of
the tax system as a mere annoyance, an

imperfect bill is better than none at all. To
those not fully convinced of the enormity of
global warming but deeply worried about
the adverse effects of high current and
prospective tax rates, the bill is a step in the
wrong direction.
What everyone should agree on is that the
legislation making its way through Congress
is a missed opportunity. President Obama
knows what a good climate bill would look
like. But despite his immense popularity and
personal charisma, he appears unable to
persuade Congress to go along.

Source: New York Times, August 9, 2009.

©
d

a
v

id
G

.
k

le
in

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210 PART Iv The economics of The Public secTor

The Types of Private Solutions
Sometimes the problem of externalities is solved with moral codes and social
sanctions. Consider, for instance, why most people do not litter. Although there
are laws against littering, these laws are not vigorously enforced. Most people
do not litter just because it is the wrong thing to do. The Golden Rule taught to
most children says, “Do unto others as you would have them do unto you.” This
moral injunction tells us to take account of how our actions affect other people. In
economic terms, it tells us to internalize externalities.

Another private solution to externalities is charities, many of which are estab-
lished to deal with externalities. For example, the Sierra Club, whose goal is to
protect the environment, is a nonprofit organization funded with private dona-
tions. As another example, colleges and universities receive gifts from alumni, cor-
porations, and foundations in part because education has positive externalities for
society. The government encourages this private solution to externalities through
the tax system by allowing an income tax deduction for charitable donations.

The private market can often solve the problem of externalities by relying on
the self-interest of the relevant parties. Sometimes the solution takes the form of
integrating different types of businesses. For example, consider an apple grower
and a beekeeper who are located next to each other. Each business confers a
positive externality on the other: By pollinating the flowers on the trees, the bees
help the orchard produce apples. At the same time, the bees use the nectar they
get from the apple trees to produce honey. Nonetheless, when the apple grower
is deciding how many trees to plant and the beekeeper is deciding how many
bees to keep, they neglect the positive externality. As a result, the apple grower
plants too few trees and the beekeeper keeps too few bees. These externalities
could be internalized if the beekeeper bought the apple orchard or if the apple
grower bought the beehives: Both activities would then take place within the
same firm, and this single firm could choose the optimal number of trees and bees.
Internalizing externalities is one reason that some firms are involved in different
types of businesses.

Another way for the private market to deal with external effects is for the inter-
ested parties to enter into a contract. In the foregoing example, a contract between
the apple grower and the beekeeper can solve the problem of too few trees and
too few bees. The contract can specify the number of trees, the number of bees,
and perhaps a payment from one party to the other. By setting the right number
of trees and bees, the contract can solve the inefficiency that normally arises from
these externalities and make both parties better off.

The Coase Theorem
How effective is the private market in dealing with externalities? A famous result,
called the Coase theorem after economist Ronald Coase, suggests that it can be
very effective in some circumstances. According to the Coase theorem, if private
parties can bargain over the allocation of resources at no cost, then the private mar-
ket will always solve the problem of externalities and allocate resources efficiently.

To see how the Coase theorem works, consider an example. Suppose that Dick
owns a dog named Spot. Spot barks and disturbs Jane, Dick’s neighbor. Dick gets
a benefit from owning the dog, but the dog confers a negative externality on Jane.
Should Dick be forced to send Spot to the pound, or should Jane have to suffer
sleepless nights because of Spot’s barking?

Coase theorem
the proposition that if
private parties can bargain
without cost over the
allocation of resources,
they can solve the
problem of externalities
on their own

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211CHAPTER 10 exTernaliTies

Consider first what outcome is socially efficient. A social planner, considering
the two alternatives, would compare the benefit that Dick gets from the dog to
the cost that Jane bears from the barking. If the benefit exceeds the cost, it is effi-
cient for Dick to keep the dog and for Jane to live with the barking. Yet if the cost
exceeds the benefit, then Dick should get rid of the dog.

According to the Coase theorem, the private market will reach the efficient
outcome on its own. How? Jane can simply offer to pay Dick to get rid of the dog.
Dick will accept the deal if the amount of money Jane offers is greater than the
benefit of keeping the dog.

By bargaining over the price, Dick and Jane can always reach the efficient out-
come. For instance, suppose that Dick gets a $500 benefit from the dog and Jane
bears an $800 cost from the barking. In this case, Jane can offer Dick $600 to get rid
of the dog, and Dick will gladly accept. Both parties are better off than they were
before, and the efficient outcome is reached.

It is possible, of course, that Jane would not be willing to offer any price that
Dick would accept. For instance, suppose that Dick gets a $1,000 benefit from the
dog and Jane bears an $800 cost from the barking. In this case, Dick would turn
down any offer below $1,000, while Jane would not offer any amount above $800.
Therefore, Dick ends up keeping the dog. Given these costs and benefits, how-
ever, this outcome is efficient.

So far, we have assumed that Dick has the legal right to keep a barking dog.
In other words, we have assumed that Dick can keep Spot unless Jane pays him
enough to induce him to give up the dog voluntarily. But how different would the
outcome be if Jane had the legal right to peace and quiet?

According to the Coase theorem, the initial distribution of rights does not mat-
ter for the market’s ability to reach the efficient outcome. For instance, suppose
that Jane can legally compel Dick to get rid of the dog. Having this right works to
Jane’s advantage, but it probably will not change the outcome. In this case, Dick
can offer to pay Jane to allow him to keep the dog. If the benefit of the dog to Dick
exceeds the cost of the barking to Jane, then Dick and Jane will strike a bargain in
which Dick keeps the dog.

Although Dick and Jane can reach the efficient outcome regardless of how
rights are initially distributed, the distribution of rights is not irrelevant: It deter-
mines the distribution of economic well-being. Whether Dick has the right to a
barking dog or Jane the right to peace and quiet determines who pays whom in
the final bargain. But in either case, the two parties can bargain with each other
and solve the exter nality problem. Dick will end up keeping the dog only if the
benefit exceeds the cost.

To sum up: The Coase theorem says that private economic actors can potentially solve
the problem of externalities among themselves. Whatever the initial distribution of rights,
the interested parties can reach a bargain in which everyone is better off and the outcome
is efficient.

Why Private Solutions Do Not Always Work
Despite the appealing logic of the Coase theorem, private individuals on their
own often fail to resolve the problems caused by externalities. The Coase theorem
applies only when the interested parties have no trouble reaching and enforcing
an agreement. In the real world, however, bargaining does not always work, even
when a mutually beneficial agreement is possible.

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212 PART Iv The economics of The Public secTor

Sometimes the interested parties fail to solve an externality problem because
of transaction costs, the costs that parties incur in the process of agreeing to and
following through on a bargain. In our example, imagine that Dick and Jane speak
different languages so that, to reach an agreement, they need to hire a translator.
If the benefit of solving the barking problem is less than the cost of the translator,
Dick and Jane might choose to leave the problem unsolved. In more realistic exam-
ples, the transaction costs are the expenses not of translators but of the lawyers
required to draft and enforce contracts.

At other times, bargaining simply breaks down. The recurrence of wars and
labor strikes shows that reaching agreement can be difficult and that failing to
reach agreement can be costly. The problem is often that each party tries to hold
out for a better deal. For example, suppose that Dick gets a $500 benefit from the
dog, and Jane bears an $800 cost from the barking. Although it is efficient for Jane
to pay Dick to get rid of the dog, there are many prices that could lead to this out-
come. Dick might demand $750, and Jane might offer only $550. As they haggle
over the price, the inefficient outcome with the barking dog persists.

Reaching an efficient bargain is especially difficult when the number of inter-
ested parties is large because coordinating everyone is costly. For example, consider
a factory that pollutes the water of a nearby lake. The pollution confers a negative
externality on the local fishermen. According to the Coase theorem, if the pollution
is inefficient, then the factory and the fishermen could reach a bargain in which
the fishermen pay the factory not to pollute. If there are many fishermen, however,
trying to coordinate them all to bargain with the factory may be almost impossible.

When private bargaining does not work, the government can sometimes play
a role. The government is an institution designed for collective action. In this
example, the government can act on behalf of the fishermen, even when it is
impractical for the fishermen to act for themselves.

Quick Quiz Give an example of a private solution to an externality. • What is the
Coase theorem? • Why are private economic participants sometimes unable to solve
the problems caused by an externality?

Conclusion
The invisible hand is powerful but not omnipotent. A market’s equilibrium maxi-
mizes the sum of producer and consumer surplus. When the buyers and sellers in
the market are the only interested parties, this outcome is efficient from the stand-
point of society as a whole. But when there are external effects, such as pollu tion,
evaluating a market outcome requires taking into account the well-being of third
parties as well. In this case, the invisible hand of the marketplace may fail to allo-
cate resources efficiently.

In some cases, people can solve the problem of externalities on their own. The
Coase theorem suggests that the interested parties can bargain among themselves
and agree on an efficient solution. Sometimes, however, an efficient outcome can-
not be reached, perhaps because the large number of interested parties makes
bargaining difficult.

When people cannot solve the problem of externalities privately, the govern-
ment often steps in. Yet even with government intervention, society should not
abandon market forces entirely. Rather, the government can address the problem

transaction costs
the costs that parties
incur in the process of
agreeing to and following
through on a bargain

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213CHAPTER 10 exTernaliTies

externality, p. 196
internalizing the externality, p. 199

corrective tax, p. 203
Coase theorem, p. 210

transaction costs, p. 212

by requiring decision makers to bear the full costs of their actions. Corrective taxes
on emissions and pollution permits, for instance, are designed to internalize the
externality of pollution. More and more, these are the policies of choice for those
interested in protecting the environment. Market forces, properly redirected, are
often the best remedy for market failure.

S u M M A Ry

K E y C O n C E P T S

Q u E S T I O n S f O R R E v I E w

1. Give an example of a negative externality and
an example of a positive externality.

2. Draw a supply-and-demand diagram to explain
the effect of a negative externality that occurs as
a result of a firm’s production process.

3. In what way does the patent system help society
solve an externality problem?

4. What are corrective taxes? Why do economists
prefer them to regulations as a way to protect
the environment from pollution?

5. List some of the ways that the problems
caused by externalities can be solved without
government intervention.

6. Imagine that you are a nonsmoker sharing a
room with a smoker. According to the Coase
theorem, what determines whether your
roommate smokes in the room? Is this outcome
efficient? How do you and your roommate
reach this solution?

• When a transaction between a buyer and seller
directly affects a third party, the effect is called
an externality. If an activity yields negative exter-
nalities, such as pollution, the socially optimal
quantity in a market is less than the equilibrium
quantity. If an activity yields positive externalities,
such as technology spillovers, the socially optimal
quantity is greater than the equilibrium quantity.

• Governments pursue various policies to remedy
the inefficiencies caused by externalities. Some-
times the government prevents socially ineffi-
cient activity by regulating behavior. Other times
it internalizes an externality using corrective
taxes. Another public policy is to issue permits.
For example, the government could protect the
environment by issuing a limited number of

pollution permits. The result of this policy is
largely the same as imposing corrective taxes on
polluters.

• Those affected by externalities can sometimes
solve the problem privately. For instance, when
one business imposes an externality on another
business, the two businesses can internalize the
externality by merging. Alternatively, the inter-
ested parties can solve the problem by negotiat-
ing a contract. According to the Coase theorem,
if people can bargain without cost, then they can
always reach an agreement in which resources
are allocated efficiently. In many cases, however,
reaching a bargain among the many interested
parties is difficult, so the Coase theorem does
not apply.

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214 PART Iv The economics of The Public secTor

1. Consider two ways to protect your car from
theft. The Club (a steering wheel lock) makes it
difficult for a car thief to take your car. Lojack
(a tracking system) makes it easier for the police
to catch the car thief who has stolen it. Which
of these types of protection conveys a negative
externality on other car owners? Which conveys
a positive externality? Do you think there are
any policy implications of your analysis?

2. Do you agree with the following statements?
Why or why not?
a. “The benefits of corrective taxes as a way to

reduce pollution have to be weighed against
the deadweight losses that these taxes cause.”

b. “When deciding whether to levy a corrective
tax on consumers or producers, the
government should be careful to levy the
tax on the side of the market generating the
externality.”

3. Consider the market for fire extinguishers.
a. Why might fire extinguishers exhibit positive

externalities?
b. Draw a graph of the market for fire

extinguishers, labeling the demand curve, the
social-value curve, the supply curve, and the
social-cost curve.

c. Indicate the market equilibrium level of
output and the efficient level of output.
Give an intuitive explanation for why these
quantities differ.

d. If the external benefit is $10 per extinguisher,
describe a government policy that would
yield the efficient outcome.

4. A local drama company proposes a new
neighborhood theater in San Francisco. Before
approving the building permit, the city planner
completes a study of the theater’s impact on the
surrounding community.
a. One finding of the study is that theaters

attract traffic, which adversely affects the
community. The city planner estimates that
the cost to the community from the extra
traffic is $5 per ticket. What kind of an
externality is this? Why?

b. Graph the market for theater tickets, labeling
the demand curve, the social-value curve,
the supply curve, the social-cost curve, the
market equilibrium level of output, and the

efficient level of output. Also show the
per-unit amount of the externality.

c. Upon further review, the city planner
uncovers a second externality. Rehearsals
for the plays tend to run until late at night,
with actors, stagehands, and other theater
members coming and going at various hours.
The planner has found that the increased
foot traffic improves the safety of the
surrounding streets, an estimated benefit to
the community of $2 per ticket. What kind of
externality is this? Why?

d. On a new graph, illustrate the market for
theater tickets in the case of these two
externalities. Again, label the demand curve,
the social-value curve, the supply curve, the
social-cost curve, the market equilibrium
level of output, the efficient level of output,
and the per-unit amount of both externalities.

e. Describe a government policy that would
result in an efficient outcome.

5. Greater consumption of alcohol leads to more
motor vehicle accidents and, thus, imposes costs
on people who do not drink and drive.
a. Illustrate the market for alcohol, labeling

the demand curve, the social-value curve,
the supply curve, the social-cost curve, the
market equilibrium level of output, and the
efficient level of output.

b. On your graph, shade the area corresponding
to the deadweight loss of the market
equilibrium. (Hint: The deadweight loss
occurs because some units of alcohol are
consumed for which the social cost exceeds
the social value.) Explain.

6. Many observers believe that the levels of
pollution in our society are too high.
a. If society wishes to reduce overall pollution

by a certain amount, why is it efficient to
have different amounts of reduction at
different firms?

b. Command-and-control approaches often rely
on uniform reductions among firms. Why
are these approaches generally unable to
target the firms that should undertake bigger
reductions?

c. Economists argue that appropriate corrective
taxes or tradable pollution rights will result

P R O b l E M S A n d A P P l I C AT I O n S

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215CHAPTER 10 exTernaliTies

in efficient pollution reduction. How do
these approaches target the firms that should
undertake bigger reductions?

7. The many identical residents of Whoville love
drinking Zlurp. Each resident has the following
willingness to pay for the tasty refreshment:

First bottle $5
Second bottle 4
Third bottle 3
Fourth bottle 2
Fifth bottle 1
Further bottles 0

a. The cost of producing Zlurp is $1.50, and
the competitive suppliers sell it at this price.
(The supply curve is horizontal.) How many
bottles will each Whovillian consume? What
is each person’s consumer surplus?

b. Producing Zlurp creates pollution. Each
bottle has an external cost of $1. Taking this
additional cost into account, what is total
surplus per person in the allocation you
described in part (a)?

c. Cindy Lou Who, one of the residents of
Whoville, decides on her own to reduce her
consumption of Zlurp by one bottle. What
happens to Cindy’s welfare (her consumer
surplus minus the cost of pollution she
experiences)? How does Cindy’s decision
affect total surplus in Whoville?

d. Mayor Grinch imposes a $1 tax on Zlurp.
What is consumption per person now?
Calculate consumer surplus, the external cost,
government revenue, and total surplus per
person.

e. Based on your calculations, would you
support the mayor’s policy? Why or why not?

8. Ringo loves playing rock ‘n’ roll music at
high volume. Luciano loves opera and hates
rock ‘n’ roll. Unfortunately, they are next-door
neighbors in an apartment building with
paper-thin walls.
a. What is the externality here?
b. What command-and-control policy might the

landlord impose? Could such a policy lead to
an inefficient outcome?

c. Suppose the landlord lets the tenants do
whatever they want. According to the Coase
theorem, how might Ringo and Luciano
reach an efficient outcome on their own?

What might prevent them from reaching an
efficient outcome?

9. Figure 4 shows that for any given demand
curve for the right to pollute, the government
can achieve the same outcome either by setting
a price with a corrective tax or by setting a
quantity with pollution permits. Suppose there
is a sharp improvement in the technology for
controlling pollution.
a. Using graphs similar to those in Figure 4,

illustrate the effect of this development on
the demand for pollution rights.

b. What is the effect on the price and quantity
of pollution under each regulatory system?
Explain.

10. Suppose that the government decides to issue
tradable permits for a certain form of pollution.
a. Does it matter for economic efficiency

whether the government distributes or
auctions the permits? Why or why not?

b. If the government chooses to distribute the
permits, does the allocation of permits among
firms matter for efficiency? Explain.

11. There are three industrial firms in Happy Valley.

Initial Cost of Reducing
Firm Pollution Level Pollution by 1 Unit

A 70 units $20
B 80 units $25
C 50 units $10

The government wants to reduce pollution to
120 units, so it gives each firm 40 tradable
pollution permits.
a. Who sells permits and how many do they

sell? Who buys permits and how many do
they buy? Briefly explain why the sellers
and buyers are each willing to do so. What
is the total cost of pollution reduction in this
situation?

b. How much higher would the costs of
pollution reduction be if the permits could
not be traded?

For further information on topics in this chapter,
additional problems, applications, examples, online
quizzes, and more, please visit our website at www
.cengage.com/economics/mankiw.

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217

11Public Goods and Common Resources
An old song lyric maintains that “the best things in life are free.” A moment’s thought reveals a long list of goods that the songwriter could have had in mind. Nature provides some of them, such as rivers, moun-tains, beaches, lakes, and oceans. The government provides others, such
as playgrounds, parks, and parades. In each case, people do not pay a fee when
they choose to enjoy the benefit of the good.

Goods without prices provide a special challenge for economic analysis. Most
goods in our economy are allocated in markets, in which buyers pay for what they
receive and sellers are paid for what they provide. For these goods, prices are the
signals that guide the decisions of buyers and sellers, and these decisions lead
to an efficient allocation of resources. When goods are available free of charge,
however, the market forces that normally allocate resources in our economy are
absent.

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218 PART Iv The economics of The Public secTor

In this chapter, we examine the problems that arise for the allocation of
resources when there are goods without market prices. Our analysis will shed
light on one of the Ten Principles of Economics in Chapter 1: Governments can
sometimes improve market outcomes. When a good does not have a price
attached to it, private markets cannot ensure that the good is produced and con-
sumed in the proper amounts. In such cases, government policy can potentially
remedy the market failure and raise economic well-being.

The Different Kinds of Goods
How well do markets work in providing the goods that people want? The answer
to this question depends on the good being considered. As we discussed in
Chapter 7, a market can provide the efficient number of ice-cream cones: The price
of ice-cream cones adjusts to balance supply and demand, and this equilibrium
maximizes the sum of producer and consumer surplus. Yet as we discussed in
Chapter 10, the market cannot be counted on to prevent aluminum manufactur-
ers from polluting the air we breathe: Buyers and sellers in a market typically do
not take into account the external effects of their decisions. Thus, markets work
well when the good is ice cream, but they work badly when the good is clean air.

In thinking about the various goods in the economy, it is useful to group them
according to two characteristics:

• Is the good excludable? That is, can people be prevented from using the good?
• Is the good rival in consumption? That is, does one person’s use of the good

reduce another person’s ability to use it?

Using these two characteristics, Figure 1 divides goods into four categories:

1. Private goods are both excludable and rival in consumption. Consider an
ice-cream cone, for example. An ice-cream cone is excludable because it is
possible to prevent someone from eating an ice-cream cone—you just don’t
give it to him. An ice-cream cone is rival in consumption because if one
person eats an ice-cream cone, another person cannot eat the same cone.
Most goods in the economy are private goods like ice-cream cones: You
don’t get one unless you pay for it, and once you have it, you are the only
person who benefits. When we analyzed supply and demand in Chapters 4,
5, and 6 and the efficiency of markets in Chapters 7, 8, and 9, we implicitly
assumed that goods were both excludable and rival in consumption.

2. Public goods are neither excludable nor rival in consumption. That is, people
cannot be prevented from using a public good, and one person’s use of a
public good does not reduce another person’s ability to use it. For example,
a tornado siren in a small town is a public good. Once the siren sounds,
it is impossible to prevent any single person from hearing it (so it is not
excludable). Moreover, when one person gets the benefit of the warning, she
does not reduce the benefit to anyone else (so it is not rival in consumption).

3. Common resources are rival in consumption but not excludable. For
example, fish in the ocean are rival in consumption: When one person
catches fish, there are fewer fish for the next person to catch. Yet these fish
are not an excludable good because, given the vast size of an ocean, it is
difficult to stop fishermen from taking fish out of it.

excludability
the property of a good
whereby a person can be
prevented from using it

rivalry in
consumption
the property of a good
whereby one person’s
use diminishes other
people’s use

private goods
goods that are both
excludable and rival in
consumption

public goods
goods that are neither
excludable nor rival in
consumption

common resources
goods that are rival in
consumption but not
excludable

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219CHAPTER 11 Public Goods and common resources

4. Club goods are excludable but not rival in consumption. For instance,
consider fire protection in a small town. It is easy to exclude someone from
using this good: The fire department can just let his house burn down. Yet
fire protection is not rival in consumption: Once a town has paid for the fire
department, the additional cost of protecting one more house is small. (We
discuss club goods again in Chapter , where we see that they are one type
of a natural monopoly.)

Although Figure 1 offers a clean separation of goods into four categories, the
boundaries between the categories are sometimes fuzzy. Whether goods are
excludable or rival in consumption is often a matter of degree. Fish in an ocean may
not be excludable because monitoring fishing is so difficult, but a large enough
coast guard could make fish at least partly excludable. Similarly, although fish are
generally rival in consumption, this would be less true if the population of fisher-
men were small relative to the population of fish. (Think of North American fish-
ing waters before the arrival of European settlers.) For purposes of our analysis,
however, it will be helpful to group goods into these four categories.

In this chapter, we examine goods that are not excludable: public goods and
common resources. Because people cannot be prevented from using these goods,
they are available to everyone free of charge. The study of public goods and
common resources is closely related to the study of externalities. For both of
these types of goods, externalities arise because something of value has no price
attached to it. If one person were to provide a public good, such as a tornado
siren, other people would be better off. They would receive a benefit without
paying for it—a positive externality. Similarly, when one person uses a common
resource such as the fish in the ocean, other people are worse off because there are
fewer fish to catch. They suffer a loss but are not compensated for it—a negative
externality. Because of these external effects, private decisions about consumption
and production can lead to an inefficient allocation of resources, and government
intervention can potentially raise economic well-being.

Quick Quiz Define public goods and common resources and give an example of
each.

club goods
goods that are excludable
but not rival in
consumption

Four Types of Goods
Goods can be grouped into four
categories according to two
characteristics: (1) A good is
excludable if people can be prevented
from using it. (2) A good is rival in
consumption if one person’s use of
the good diminishes other people’s
use of it. This diagram gives examples
of goods in each category.

Figure 1Rival in consumption?
Yes

Yes

• Ice-cream cones
• Clothing
• Congested toll roads

• Fire protection
• Cable TV
• Uncongested toll roads

No

Private Goods Club Goods

No

Excludable?

• Fish in the ocean
• The environment
• Congested nontoll roads

• Tornado siren
• National defense
• Uncongested nontoll roads

Common Resources Public Goods

15

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220 PART Iv The economics of The Public secTor

Public Goods
To understand how public goods differ from other goods and why they present
problems for society, let’s consider an example: a fireworks display. This good is
not excludable because it is impossible to prevent someone from seeing fireworks,
and it is not rival in consumption because one person’s enjoyment of fireworks
does not reduce anyone else’s enjoyment of them.

The Free-Rider Problem
The citizens of Smalltown, U.S.A., like seeing fireworks on the Fourth of July.
Each of the town’s 500 residents places a $10 value on the experience for a total
benefit of $5,000. The cost of putting on a fireworks display is $1,000. Because the
$5,000 benefit exceeds the $1,000 cost, it is efficient for Smalltown to have a fire-
works display on the Fourth of July.

Would the private market produce the efficient outcome? Probably not.
Imagine that Ellen, a Smalltown entrepreneur, decided to put on a fireworks
display. Ellen would surely have trouble selling tickets to the event because her
potential customers would quickly figure out that they could see the fireworks
even without a ticket. Because fireworks are not excludable, people have an incen-
tive to be free riders. A free rider is a person who receives the benefit of a good
but does not pay for it. Because people would have an incentive to be free riders
rather than ticket buyers, the market would fail to provide the efficient outcome.

One way to view this market failure is that it arises because of an externality.
If Ellen puts on the fireworks display, she confers an external benefit on those
who see the display without paying for it. When deciding whether to put on the
display, however, Ellen does not take the external benefits into account. Even
though the fireworks display is socially desirable, it is not profitable. As a result,
Ellen makes the privately rational but socially inefficient decision not to put on
the display.

Although the private market fails to supply the fireworks display demanded
by Smalltown residents, the solution to Smalltown’s problem is obvious: The
local government can sponsor a Fourth of July celebration. The town council can
raise everyone’s taxes by $2 and use the revenue to hire Ellen to produce the
fireworks. Everyone in Smalltown is better off by $8—the $10 at which residents
value the fireworks minus the $2 tax bill. Ellen can help Smalltown reach the effi-
cient outcome as a public employee even though she could not do so as a private
entrepreneur.

The story of Smalltown is simplified but realistic. In fact, many local govern-
ments in the United States pay for fireworks on the Fourth of July. Moreover,
the story shows a general lesson about public goods: Because public goods are
not excludable, the free-rider problem prevents the private market from sup-
plying them. The government, however, can potentially remedy the problem. If
the government decides that the total benefits of a public good exceed its costs,
it can provide the public good, pay for it with tax revenue, and make everyone
better off.

Some Important Public Goods
There are many examples of public goods. Here we consider three of the most
important.

free rider
a person who receives
the benefit of a good but
avoids paying for it

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221CHAPTER 11 Public Goods and common resources

National Defense The defense of a country from foreign aggressors is a clas-
sic example of a public good. Once the country is defended, it is impossible to
prevent any single person from enjoying the benefit of this defense. Moreover,
when one person enjoys the benefit of national defense, he does not reduce the
benefit to anyone else. Thus, national defense is neither excludable nor rival in
consumption.

National defense is also one of the most expensive public goods. In 2009, the
U.S. federal government spent a total of $661 billion on national defense, more
than $2,150 per person. People disagree about whether this amount is too small or
too large, but almost no one doubts that some government spending for national
defense is necessary. Even economists who advocate small government agree that
the national defense is a public good the government should provide.

Basic Research Knowledge is created through research. In evaluating the
appropriate public policy toward knowledge creation, it is important to distin-
guish general knowledge from specific technological knowledge. Specific tech-
nological knowledge, such as the invention of a longer-lasting battery, a smaller
microchip, or a better digital music player, can be patented. The patent gives the
inventor the exclusive right to the knowledge he or she has created for a period
of time. Anyone else who wants to use the patented information must pay the
inventor for the right to do so. In other words, the patent makes the knowledge
created by the inventor excludable.

By contrast, general knowledge is a public good. For example, a mathematician
cannot patent a theorem. Once a theorem is proven, the knowledge is not exclud-
able: The theorem enters society’s general pool of knowledge that anyone can use
without charge. The theorem is also not rival in consumption: One person’s use of
the theorem does not prevent any other person from using the theorem.

Profit-seeking firms spend a lot on research trying to develop new products
that they can patent and sell, but they do not spend much on basic research. Their
incentive, instead, is to free ride on the general knowledge created by others. As a
result, in the absence of any public policy, society would devote too few resources
to creating new knowledge.

The government tries to provide the public good of general knowledge in vari-
ous ways. Government agencies, such as the National Institutes of Health and the
National Science Foundation, subsidize basic research in medicine, mathematics,
physics, chemistry, biology, and even economics. Some people justify govern-
ment funding of the space program on the grounds that it adds to society’s pool
of knowledge (although many scientists are skeptical of the scientific value of
manned space travel). Determining the appropriate level of government sup-
port for these endeavors is difficult because the benefits are hard to measure.
Moreover, the members of Congress who appropriate funds for research usually
have little expertise in science and, therefore, are not in the best position to judge
what lines of research will produce the largest benefits. So, while basic research is
surely a public good, we should not be surprised if the public sector fails to pay
for the right amount and the right kinds.

Fighting Poverty Many government programs are aimed at helping the
poor. The welfare system (officially called the Temporary Assistance for Needy
Families program) provides a small income for some poor families. Similarly, the
Food Stamp program subsidizes the purchase of food for those with low incomes,

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

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222 PART Iv The economics of The Public secTor

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and various government housing programs make shelter more affordable. These
antipoverty programs are financed by taxes paid by families that are financially
more successful.

Economists disagree among themselves about what role the government
should play in fighting poverty. We discuss this debate more fully in Chapter 20,
but here we note one important argument: Advocates of antipoverty programs
claim that fighting poverty is a public good. Even if everyone prefers living in a
society without poverty, fighting poverty is not a “good” that private actions will
adequately provide.

To see why, suppose someone tried to organize a group of wealthy individuals
to try to eliminate poverty. They would be providing a public good. This good
would not be rival in consumption: One person’s enjoyment of living in a society
without poverty would not reduce anyone else’s enjoyment of it. The good would
not be excludable: Once poverty is eliminated, no one can be prevented from
taking pleasure in this fact. As a result, there would be a tendency for people to
free ride on the generosity of others, enjoying the benefits of poverty elimination
without contributing to the cause.

Because of the free-rider problem, eliminating poverty through private charity
will probably not work. Yet government action can solve this problem. Taxing the
wealthy to raise the living standards of the poor can potentially make everyone
better off. The poor are better off because they now enjoy a higher standard of liv-
ing, and those paying the taxes are better off because they enjoy living in a society
with less poverty.

Are Lighthouses Public Goods?

Some goods can switch between being public goods and being private goods
depending on the circumstances. For example, a fireworks display is a public
good if performed in a town with many residents. Yet if performed at a private
amusement park, such as Walt Disney World, a fireworks display is more like a
private good because visitors to the park pay for admission.
Another example is a lighthouse. Economists have long used lighthouses as an
example of a public good. Lighthouses mark specific locations along the coast so
that passing ships can avoid treacherous waters. The benefit that the lighthouse
provides to the ship captain is neither excludable nor rival in consumption, so
each captain has an incentive to free ride by using the lighthouse to navigate
without paying for the service. Because of this free-rider problem, private markets
usually fail to provide the lighthouses that ship captains need. As a result, most
lighthouses today are operated by the government.
In some cases, however, lighthouses have been closer to private goods. On
the coast of England in the 19th century, for example, some lighthouses were
privately owned and operated. Instead of trying to charge ship captains for the
service, however, the owner of the lighthouse charged the owner of the nearby
port. If the port owner did not pay, the lighthouse owner turned off the light, and
ships avoided that port.
In deciding whether something is a public good, one must determine who the
beneficiaries are and whether these beneficiaries can be excluded from using the
good. A free-rider problem arises when the number of beneficiaries is large and
exclusion of any one of them is impossible. If a lighthouse benefits many ship

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223CHAPTER 11 Public Goods and common resources

captains, it is a public good. Yet if it primarily benefits a single port owner, it is
more like a private good. ■

The Difficult Job of Cost–Benefit Analysis
So far we have seen that the government provides public goods because the pri-
vate market on its own will not produce an efficient quantity. Yet deciding that
the government must play a role is only the first step. The government must then
determine what kinds of public goods to provide and in what quantities.

Suppose that the government is considering a public project, such as building a
new highway. To judge whether to build the highway, it must compare the total
benefits of all those who would use it to the costs of building and maintaining
it. To make this decision, the government might hire a team of economists and
engineers to conduct a study, called a cost–benefit analysis, to estimate the total
costs and benefits of the project to society as a whole.

Cost–benefit analysts have a tough job. Because the highway will be avail-
able to everyone free of charge, there is no price with which to judge the
value of the highway. Simply asking people how much they would value the
highway is not reliable: Quantifying benefits is difficult using the results from
a questionnaire, and respondents have little incentive to tell the truth. Those
who would use the highway have an incentive to exaggerate the benefit they
receive to get the highway built. Those who would be harmed by the highway
have an incentive to exaggerate the costs to them to prevent the highway from
being built.

The efficient provision of public goods is, therefore, intrinsically more difficult
than the efficient provision of private goods. When buyers of a private good enter
a market, they reveal the value they place on it through the prices they are willing
to pay. At the same time, sellers reveal their costs with the prices they are willing
to accept. The equilibrium is an efficient allocation of resources because it reflects
all this information. By contrast, cost–benefit analysts do not have any price sig-
nals to observe when evaluating whether the government should provide a public
good and how much to provide. Their findings on the costs and benefits of public
projects are rough approximations at best.

How Much Is a Life Worth?

Imagine that you have been elected to serve as a member of your local town
council. The town engineer comes to you with a proposal: The town can spend
$10,000 to build and operate a traffic light at a town intersection that now has only
a stop sign. The benefit of the traffic light is increased safety. The engineer esti-
mates, based on data from similar intersections, that the traffic light would reduce
the risk of a fatal traffic accident over the lifetime of the traffic light from 1.6 to
1.1 percent. Should you spend the money for the new light?
To answer this question, you turn to cost–benefit analysis. But you quickly
run into an obstacle: The costs and benefits must be measured in the same units
if you are to compare them meaningfully. The cost is measured in dollars, but
the benefit—the possibility of saving a person’s life—is not directly monetary. To
make your decision, you have to put a dollar value on a human life.

cost–benefit
analysis
a study that compares
the costs and benefits
to society of providing a
public good

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224 PART Iv The economics of The Public secTor

At first, you may be tempted to conclude that a human life is priceless. After all,
there is probably no amount of money that you could be paid to voluntarily give
up your life or that of a loved one. This suggests that a human life has an infinite
dollar value.
For the purposes of cost–benefit analysis, however, this answer leads to non-
sensical results. If we truly placed an infinite value on human life, we should place
traffic lights on every street corner, and we should all drive large cars loaded with
all the latest safety features. Yet traffic lights are not at every corner, and people
sometimes choose to pay less for smaller cars without safety options such as side-
impact air bags or antilock brakes. In both our public and private decisions, we
are at times willing to risk our lives to save some money.
Once we have accepted the idea that a person’s life has an implicit dollar value,
how can we determine what that value is? One approach, sometimes used by
courts to award damages in wrongful-death suits, is to look at the total amount of
money a person would have earned if he or she had lived. Economists are often
critical of this approach because it ignores other opportunity costs of losing one’s
life. It thus has the bizarre implication that the life of a retired or disabled person
has no value.
A better way to value human life is to look at the risks that people are volun-
tarily willing to take and how much they must be paid for taking them. Mortality
risk varies across jobs, for example. Construction workers in high-rise buildings
face greater risk of death on the job than office workers do. By comparing wages
in risky and less risky occupations, controlling for education, experience, and
other determinants of wages, economists can get some sense about what value
people put on their own lives. Studies using this approach conclude that the value
of a human life is about $10 million.
We can now return to our original example and respond to the town engineer.
The traffic light reduces the risk of fatality by 0.5 percentage points. Thus, the
expected benefit from installing the traffic light is 0.005 × $10 million, or $50,000.
This estimate of the benefit well exceeds the cost of $10,000, so you should
approve the project. ■

Quick Quiz What is the free-rider problem? Why does the free-rider problem
induce the government to provide public goods? • How should the government
decide whether to provide a public good?

Common Resources
Common resources, like public goods, are not excludable: They are available free
of charge to anyone who wants to use them. Common resources are, however,
rival in consumption: One person’s use of the common resource reduces other
people’s ability to use it. Thus, common resources give rise to a new problem.
Once the good is provided, policymakers need to be concerned about how much
it is used. This problem is best understood from the classic parable called the
Tragedy of the Commons.

The Tragedy of the Commons
Consider life in a small medieval town. Of the many economic activities that take
place in the town, one of the most important is raising sheep. Many of the town’s

Tragedy of the
Commons
a parable that illustrates
why common resources
are used more than
is desirable from the
standpoint of society as a
whole

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225CHAPTER 11 Public Goods and common resources

families own flocks of sheep and support themselves by selling the sheep’s wool,
which is used to make clothing.

As our story begins, the sheep spend much of their time grazing on the land
surrounding the town, called the Town Common. No family owns the land.
Instead, the town residents own the land collectively, and all the residents are
allowed to graze their sheep on it. Collective ownership works well because land
is plentiful. As long as everyone can get all the good grazing land they want, the
Town Common is not rival in consumption, and allowing residents’ sheep to
graze for free causes no problems. Everyone in the town is happy.

As the years pass, the population of the town grows, and so does the number
of sheep grazing on the Town Common. With a growing number of sheep
and a fixed amount of land, the land starts to lose its ability to replenish itself.
Eventually, the land is grazed so heavily that it becomes barren. With no grass left
on the Town Common, raising sheep is impossible, and the town’s once prosper-
ous wool industry disappears. Many families lose their source of livelihood.

What causes the tragedy? Why do the shepherds allow the sheep population
to grow so large that it destroys the Town Common? The reason is that social and
private incentives differ. Avoiding the destruction of the grazing land depends on
the collective action of the shepherds. If the shepherds acted together, they could
reduce the sheep population to a size that the Town Common can support. Yet
no single family has an incentive to reduce the size of its own flock because each
flock represents only a small part of the problem.

In essence, the Tragedy of the Commons arises because of an externality. When
one family’s flock grazes on the common land, it reduces the quality of the land
available for other families. Because people neglect this negative externality when
deciding how many sheep to own, the result is an excessive number of sheep.

If the tragedy had been foreseen, the town could have solved the problem in
various ways. It could have regulated the number of sheep in each family’s flock,
internalized the externality by taxing sheep, or auctioned off a limited number
of sheep-grazing permits. That is, the medieval town could have dealt with the
problem of overgrazing in the way that modern society deals with the problem
of pollution.

In the case of land, however, there is a simpler solution. The t