Second Edition ROBERT H. FRANK Cornell University BEN S. BERNANKE Princeton University [affiliated] Chairman, Board of Governors of the Federal Reserve System with special contribution by LOUIS D. JOHNSTON College of Saint Benedict I Saint John's University w t McGraw-Hill J III Irwin
FART 9 1 Thinking Like an Economist 3 2 Comparative Advantage 35 3 Supply and Demand 61 PART 2 Competition and the Invisible Hand 4 Demand and Elasticity 97 5 Perfectly Competitive Supply 127 6 Efficiency, Exchange, and the Invisible Hand in Action 159 FART 3 Market Imperfections 7 Monopoly, Oligopoly, and Monopolistic Competition 191 8 Games and Strategic Behavior 225 9 Externalities and Property Rights 253 FART 4 Economics of Public Policy 10 Using Economics to Make Better Policy Choices 283 FART 5 Macroeconomics; Data and Issues 11 Spending, Income, and GDP 307 12 * Inflation and the Price Level 331 13 Wages and Unemployment 359 PART 6 The Economy in the Long Run 14 Economic Growth 393 15 Saving, Capital Formation, and Financial Markets 423 16 Money, Prices, and the Financial System 453 FART 7 The Economy in the Short Run 17 Short-Term Economic Fluctuations 485 18 Spending, Output, and Fiscal Policy 505 19 Monetary Policy and the Federal Reserve 539 20 Aggregate Demand, Aggregate Supply, and Stabilization Policy 571 PART 8 The International Economy 21 Exchange Rates, International Trade, and Capital Flows 601 Glossary G-l Index 1-1 xxi
CONTENTS PART I Introduction Chapter I Thinking Like an Economist 3 Economics: Studying Choice in a World of Scarcity 4 Applying the Cost-Benefit Principle 5 Economic Surplus 6 Opportunity Cost 6 The Role of Economic Models 7 Three Important Decision Pitfalls 8 Pitfall 1: Measuring Costs and Benefits as Proportions Rather Than Absolute Dollar Amounts 8 Pitfall 2: Ignoring Implicit Costs 9 Pitfall 3: Failure to Think at the Margin 10 Normative Economics versus Positive Economics 15 Economics: Micro and Macro 15 The Approach of This Text 16 Economic Naturalism 16 THE ECONOMIC NATURALIST I.I 17 THE ECONOMIC NATURALIST 1.2 18 THE ECONOMIC NATURALIST 1.3 18 Summary 19 Core Principles 19 Key Terms 20 Review Questions 20 Problems 20 Answers to Concept Checks 22 Appendix: Working with Equations, Graphs, and Tables 23 Chapter 2 Comparative Advantage 35 Exchange and Opportunity Cost 36 The Principle of Comparative Advantage 37 THE ECONOMIC NATURALIST 2.1 39 Sources of Comparative Advantage 40 THE ECONOMIC NATURALIST 2.2 41 Comparative Advantage and Production Possibilities 41 The Production Possibilities Curve 41 How Individual Productivity Affects the Slope and Position of the PPC 44 The Gains from Specialization and Exchange 46 A Production Possibilities Curve for a Many- Person Economy 47 Factors That Shift the Economy's Production Possibilities Curve 49 Why Have Some Countries Been Slow to Specialize? 51 Can We Have Too Much Specialization? 52 Comparative Advantage and International Trade 53 THE ECONOMICNATURALIST 2.3 53 Outsourcing 53 THE ECONOMIC NATURALIST 2.4 54 Summary 56 Core Principles 56 Key Terms 56 Review Questions 57 Problems 57 Answers to Concept Checks 58 Chapter 3 Supply and Demand 61 What, How, and for Whom? Central Planning versus the Market 63 Buyers and Sellers in Markets 64 The Demand Curve 65 The Supply Curve 66 Market Equilibrium 68 Rent Controls Reconsidered 71 Pizza Price Controls? 73 Predicting and Explaining Changes in Prices and Quantities 74 Shifts in Demand 75 THE ECONOMIC NATURALIST 3.1 77 Shifts in the Supply Curve 78 THE ECONOMIC NATURALIST 3.2 81 Four Simple Rules 82 THE ECONOMIC NATURALIST 3.3 84 Efficiency and Equilibrium 85 Cash on the Table 85 Smart for One, Dumb for All 86 Summary 88 Core Principles 89
xxiv CONTENTS Key Terms 89 Review Questions 89 Problems 89 Answers to Concept Checks 91 Appendix: The Algebra of Supply and Demand 93 Chapter 4 Demand and Elasticity 97 The Law of Demand 98 The Origins of Demand 98 Needs versus Wants 99 THE ECONOMIC NATURALIST 4.1 99 Applying the Law of Demand 100 Substitution at Work 100 THE ECONOMIC NATURALIST 4.2 100 THE ECONOMIC NATURALIST 4.3 101 THE ECONOMIC NATURALIST 4.4 102 The Importance of Income Differences 102 THE ECONOMIC NATURALIST 4.5 102 Individual and Market Demand Curves 103 Horizontal Addition 103 Demand and Consumer Surplus 104 Calculating Consumer Surplus 105 Elasticity 108 Price Elasticity of Demand 108 Price Elasticity Defined 109 Determinants of Price Elasticity of Demand 110 Some Representative Elasticity Estimates 111 Using Price Elasticity of Demand 112 THE ECONOMIC NATURALIST 4.6 112 THE ECONOMIC NATURALIST 4.7 112 A Graphical Interpretation of Price Elasticity 113 Price Elasticity Changes along a Straight-Line Demand Curve 115 Two Special Cases 116 Elasticity and Total Expenditure 117 Income Elasticity and Cross-Price Elasticity of Demand 122 Summary 122 Key Terms 123 Review Questions 123 Problems 123 Answers to Concept Checks 126 Chapter 5 Perfectly Competitive Supply 127 Thinking about Supply: The Importance of Opportunity Cost 128 Individual and Market Supply Curves 130 Profit-Maximizing Firms in Perfectly Competitive Markets 131 Profit Maximization 131 The Demand Curve Facing a Perfectly Competitive Firm 132 Production in the Short Run 133 Choosing Output to Maximize Profit 134 Price Equals Marginal Cost: The Seller's Supply Rule 137 Graphing Marginal Cost 137 The "Law" of Supply 140 Determinants of Supply Revisited 140 Technology 141 Input Prices 141 The Number of Suppliers 141 Expectations 141 Changes in Prices of Other Products 141 The Price Elasticity of Supply 142 Determinants of Supply Elasticity 144 THE ECONOMIC NATURALIST 5.1 146 Unique and Essential Inputs: The Ultimate Supply Bottleneck 148 Applying the Theory of Supply 149 THE ECONOMIC NATURALIST 5.2 149 Supply and Producer Surplus 151 Calculating Producer Surplus 151 Summary 153 Key Terms 154 Review Questions 154 Problems 154 Answers to Concept Checks 157 Chapter 6 Efficiency, Exchange, and the Invisible Hand in Action 159 The Central Role of Economic Profit 160 Three Types of Profit 160 The Invisible Hand Theory 164 Two Functions of Price 164 Responses to Profits and Losses 164 The Effect of Market Forces on Economic Profit 166 The Importance of Free Entry and Exit 166 Economic Rent versus Economic Profit 168 The Invisible Hand in Action 169 The Invisible Hand at the Supermarket and on the Freeway 170 THE ECONOMIC NATURALIST 6.1 170 The Invisible Hand and Cost-Saving Innovations 170
CONTENTS The Distinction between an Equilibrium and a Social Optimum 171 Smart for One, Dumb for All 172 THE ECONOMIC NATURALIST 6.2 172 Market Equilibrium and Efficiency 173 Efficiency Is Not the Only Goal 176 Why Efficiency Should Be the First Goal 177 The Cost of Preventing Price Adjustments 177 Price Ceilings 177 Price Subsidies 181 Summary 183 Key Terms 184 Review Questions 184 Problems 185 Answers to Concept Checks 187 PART 3 Market Imperfections Chapter 7 Monopoly, Oligopoly, and Monopolistic Competition 191 Imperfect Competition 192 Different Forms of Imperfect Competition 192 The Essential Difference between Perfectly and Imperfectly Competitive Firms 194 Five Sources of Market Power 195 Exclusive Control over Important Inputs 195 Patents and Copyrights 195 Government Licenses or Franchises 195 Economies of Scale and Natural Monopolies 196 \ Network Economies 196 Economies of Scale and the Importance of Start-Up Costs 197 THE ECONOMIC NATURALIST 7.1 199 Profit Maximization for the Monopolist 200 Marginal Revenue for the Monopolist 201 The Monopolist's Profit-Maximizing Decision Rule 203 Being a Monopolist Doesn't Guarantee an Economic Profit 204 Why the Invisible Hand Breaks Down under Monopoly 205 Using Discounts to Expand the Market 207 Price Discrimination Defined 207 THE ECONOMIC NATURALIST 7.2 208 How Price Discrimination Affects Output 208 The Hurdle Method of Price Discrimination 211 Is Price Discrimination a Bad Thing? 213 Examples of Price Discrimination 214 THE ECONOMIC NATURALIST 7.3 215 Summary 216 Key Terms 217 Review Questions 217 Problems 217 Answers to Concept Checks 220 Appendix: The Algebra of Monopoly Profit Maximization 223 Chapter 8 Games and Strategic Behavior 225 Using Game Theory to Analyze Strategic Decisions 226 The Three Elements of a Game 226 Nash Equilibrium 228 The Prisoner's Dilemma 230 The Original Prisoner's Dilemma 230 The Economics of Cartels 231 THE ECONOMIC NATURALIST 8.1 231 Tit-for-Tat and the Repeated Prisoner's Dilemma 234 THE ECONOMIC NATURALIST 8.2 235 THE ECONOMIC NATURALIST 8.3 236 Games in Which Timing Matters 237 Credible Threats and Promises 239 Monopolistic Competition When Location Matters 240 THE ECONOMIC NATURALIST 8.4 241 Commitment Problems 242 The Strategic Role of Preferences 244 Are People Fundamentally Selfish? 245 Preferences as Solutions to Commitment Problems 245 Summary 247 Key Terms 247 Review Questions 247 Problems 248 Answers to Concept Checks 251 Chapter 9 Externalities and Property Rights 253 External Costs and Benefits 253 How Externalities Affect Resource Allocation 254 How Do Externalities Affect Supplyand Demand? 255 The Coase Theorem 257 Legal Remedies for Externalities 261 THE ECONOMIC NATURALIST 9.1 262 THE ECONOMIC NATURALIST 9.2 263 The Optimal Amount of Negative Externalities Is Not Zero 263 Compensatory Taxes and Subsidies 264
xxvi CONTENTS Property Rights and the Tragedy of the Commons 265 The Problem of Unpriced Resources 266 The Effect of Private Ownership 268 When Private Ownership Is Impractical 269 THE ECONOMIC NATURALIST 9.3 269 THE ECONOMIC NATURALIST 9.4 270 Positional Externalities 271 Payoffs That Depend on Relative Performance.271 THE ECONOMIC NATURALIST 9.5 271 Positional Arms Races and Positional Arms Control Agreements 272 Social Norms as Positional Arms Control Agreements 273 Summary x 276 Key Terms 277 Review Questions 277 Problems 277 Answers to Concept Checks 280 PART 4 Economics of Public Policy Chapter 10 Using Economics to Make Better Policy Choices 283 The Economics of Health Care 284 The Case for Mandatory Immunization Laws 284 Explaining Rising Health Care Costs 285 Designing a Solution 287 The HMO Revolution 288 THE ECONOMIC NATURALIST 10.1 288 Paying for Health Insurance 289 THE ECONOMIC NATURALIST 10.2 289 Using Price Incentives in Environmental Regulation 291 Taxing Pollution 291 Auctioning Pollution Permits 292 Overcoming Opposition to International Trade 294 Methods of Income Redistribution 296 Welfare Payments and In-Kind Transfers 296 Means-Tested Benefit Programs 297 The Negative Income Tax 297 Minimum Wages 298 The Earned-Income Tax Credit 298 Public Employment for the Poor 299 A Combination of Methods 299 Summary 300 Key Terms 301 Review Questions 301 Problems 301 Answers to Concept Checks 303 Chapter 11 Spending, Income, and GDP 307 Gross Domestic Product: Measuring the Nation's Output 308 Market Value 308 Final Goods and Services 309 Produced within a Country during a Given Period 312 The Expenditure Method for Measuring GDP 313 GDP and the Incomes of Capital and Labor 317 Nominal GDP versus Real GDP 318 THE ECONOMIC NATURALIST 11.1 320 Real GDP Is Not the Same as Economic Weil-Being 321 Leisure Time 321 THE ECONOMIC NATURALIST 11.2 322 Nonmarket Economic Activities 322 Environmental Quality and Resource Depletion.323 Quality of Life 323 Poverty and Economic Inequality 323 But GDP Is Related to Economic Well-Being 324 Availability of Goods and Services 324 Health and Education 324 THE ECONOMIC NATURALIST 11.3 326 Summary 327 Key Terms 327 Review Questions 327 Problems 328 Answers to Concept Checks 330 Chapter 12 Inflation and the Price Level 331 The Consumer Price Index: Measuring the Price Level 332 Inflation 334 THE ECONOMIC NATURALIST 12.1 336 Adjusting for Inflation 336 Deflating a Nominal Quantity 337 Indexing to Maintain Buying Power 339 Does the CPI Measure "True" Inflation? 340 The Costs of Inflation: Not What You Think 343 The True Costs of Inflation 344 "Noise" in the Price System 344 Distortions of the Tax System 345 "Shoe-Leather" Costs 346 Unexpected Redistributions of Wealth 347 Interference with Long-Term Planning 347
CONTENTS Hyperinflation 348 Inflation Interest Rates 349 Inflation and the Real Interest Rate 349 The Fisher Effect 352 Summary 353 Key Terms 353 Review Questions 354 Problems 354 Answers to Concept Checks 356 Chapter 13 Wages and Unemployment 359 Four Important Labor Market Trends 360 Supply and Demand in the Labor Market s 361 Wages and the Demand for Labor 361 Shifts in the Demand for Labor 363 The Supply of Labor 367 Shifts in the Supply of Labor 368 Explaining the Trends in Real Wages and Employment 369 Why Have Real Wages Increased By So Much in thetridustrialized Countries? 369 Since the 1970s, Real Wage Growth in the United States Has Slowed, Even Though Employment Growth Was Rapid during the 1990s 370 Increasing Wage Inequality: The Effects of Globalization 371 Increasing Wage Inequality: Technological Change 373 \ Unemployment and the Unemployment Rate 376 Measuring Unemployment 376 The Costs of Unemployment 378 The Duration of Unemployment 378 The Unemployment Rate versus "True" Unemployment 379 Types of Unemployment and Their Costs 380 Frictional Unemployment 380 Structural Unemployment 380 Cyclical Unemployment 381 Impediments to Full Employment 382 Minimum Wage Laws 382 Labor Unions 383 Unemployment Insurance 384 Other Government Regulations 384 Summary 385 Key Terms 386 Review Questions 386 Problems 386 Answers to Concept Checks 388 PART 6 The Economy in the Chapter 14 Economic Growth 393 The Remarkable Rise in Living Standards: The Record 394 Why "Small" Differences in Growth Rates Matter 396 Why Nations Become Rich: The Crucial Role of Average Labor Productivity 398 The Determinants of Average Labor Productivity 400 Human Capital 401 Physical Capital 403 Land and Other Natural Resources 405 Technology 406 Entrepreneurship and Management 407 THE ECONOMIC NATURALIST 14.1 408 The Political and Legal Environment 409 Promoting Economic Growth 411 Policies to Increase Human Capital 411 THE ECONOMIC NATURALIST 14.2 412 Policies That Promote Saving and Investment 412 Policies That Support Research and Development 413 The Legal and Political Framework 413 The Poorest Countries: A Special Case? 413 The Costs of Economic Growth 414 Are There Limits to Growth? 415 Summary 418 Key Terms 418 Review Questions 418 Problems 419 Answers to Concept Checks 421 Chapter 15 Saving, Capital Formation, and Financial Markets 423 Saving and Wealth 424 Stocks and Flows 425 Capital Gains and Losses 426 National Saving and Its Components 429 The Measurement of National Saving 429 Private and Public Components of National Saving 430 Public Saving and the Government Budget 431 Is Low Household Saving a Problem? 433 Why Do People Save? 434 Saving and the Real Interest Rate 436 Saving, Self-Control, and Demonstration Effects 438 Investment and Capital Formation 440
xxviil CONTENTS THE ECONOMIC NATURALIST 15.1 443 Saving, Investment, and Financial Markets 444 Summary 448 Key Terms 449 Review Questions 449 Problems 449 Answers to Concept Checks 452 Chapter 16 Money, Prices, and the Financial System 453 The Financial System and the Allocation of Saving to Productive Uses 454 The Banking System 454 Bonds and Stocks 456 Bond Markets, Stock Markets, and the Allocation of Saving 461 THE ECONOMIC NATURALIST 16.1 463 Money and Its Uses 464 Measuring Money 465 Commercial Banks and the Creation of Money 467 The Money Supply with Both Currency and Deposits 470 Central Banks, the Money Supply, and Prices 472 Controlling the Money Supply with Open-Market Operations 473 Money and Prices 474 Velocity 475 Money and Inflation in the Long Run 476 Summary All Key Terms 418 Review Questions 478 Problems 479 Answers to Concept Checks 481 PART 7 The Economy in the Short Run Chapter 17 Short-Term Economic Fluctuations 485 Recessions and Expansions 486 Some Facts about Short-Term Economic Fluctuations 489 Output Gaps and Cyclical Unemployment 491 Potential Output and the Output Gap 491 The Natural Rate of Unemployment and Cyclical Unemployment 494 Okun's Law 496 Why Do Short-Term Fluctuations Occur? A Preview and a Parable 498 Al's Ice Cream Store: A Parable about Short-Run Fluctuations 499 THE ECONOMIC NATURALIST 17.1 501 Summary 502 Key Terms 502 Review Questions 503 Problems 503 Answer to Concept Check 504 Chapter 18 Spending, Output, and Fiscal Policy 505 The Keynesian Model's Crucial Assumption: Firms Meet Demand at Preset Prices 506 Planned Aggregate Expenditure 508 Planned Spending versus Actual Spending 508 Consumer Spending and the Economy 510 Planned Aggregate Expenditure and Output 513 Short-Run Equilibrium Output 515 Finding Short-Run Equilibrium Output: Numerical Approach 516 Finding Short-Run Equilibrium Output: Graphical Approach 517 Planned Spending and the Output Gap 518 The Multiplier 523 Fiscal Policy and Recessions 524 Government Purchases and Planned Spending 525 Taxes, Transfers, and Aggregate Spending 528 Fiscal Policy and the Recession of 2007-2009 530 Fiscal Policy as a Stabilization Tool: Three Qualifications 531 Fiscal Policy and the Supply Side 532 The Problem of Deficits 532 The Relative Inflexibility of Fiscal Policy 532 Summary 533 Key Terms 534 Review Questions 534 Problems 535 Answers to Concept Checks 537 Chapter 19 Monetary Policy and the Federal Reserve 539 The Federal Reserve 540 The History and Structure of the Federal Reserve System 540 The Fed's Role in Stabilizing Financial Markets: Banking Panics 541
CONTENTS xxix Monetary Policy and Economic Fluctuations 544 Can the Fed Control the Real Interest Rate? 544 The Role of the Federal Funds Rate in Monetary Policy 545 Planned Aggregate Expenditure and the Real Interest Rate 546 The Fed Fights a Recession 549 The Fed Fights Inflation 551 THE ECONOMIC NATURALIST 19.1 553. _.. Should the Federal Reserve Respond to Changes in Asset Prices? 553 The Federal Reserve and Interest Rates 555 The Demand for Money 555 Macroeconomic Factors That Affect the Demand for Money 551 The Money Demand Curve 558 THE ECONOMIC NATURALIST 19.2 559 The Supply of Money and Money Market Equilibrium 561 How the Fed Controls the Nominal Interest Rate 562 A Second Way the Fed Controls the Money Supply: Discount Window Lending 564 A Third Way of Controlling the Money Supply: Reserve Requirements and Interest Paid on Reserves 564 Summary 566 Key Terms 566 Review Questions 561 Problems 561 Answers to Concept Checks 569 Chapter 20 Aggregate Demand, Aggregate Supply, and Stabilization Policy 571 The Aggregate Demand-Aggregate Supply Model: A Brief Overview 572 The Aggregate Demand Curve 573 Why Does the AD Curve Slope Downward? 573 What Factors Shift the AD Curve? 577 The Aggregate Supply Curve 580 Why Does the AS Cure Slope Upward? 581 What Causes the AS Curve to Shift? 582 Understanding Business Cycles 585 Demand Shocks: Shifts in the AD Curve 586 Price Shocks: Shifts in the AS Curve 587 Using the AD-AS Model to Study Business Cycles 588 Stabilization Policy 590 The Self-Correcting Economy 590 What is the Role of Stabilization Policy? 592 Summary 595 Key Terms 596 Review Questions 596 Problems 596 Answers to Concept Checks 591 FART 8 The International Economy Chapter 21 Exchange Rates, International Trade, and Capital Flows 601 Exchange Rates 602 Nominal Exchange Rates 602 Flexible versus Fixed Exchange Rates 604 Exchange Rate Determination in the Short Run 605 A Supply and Demand Analysis 605 Changes in the Supply of Dollars 608 Changes in the "Demand for Dollars 609 Monetary Policy and the Exchange Rate 610 The Exchange Rate as a Tool of Monetary Policy 612 Should Exchange Rates Be Fixed or Flexible? 613 The Euro: A Common Currency for Europe 614 Exchange Rate Determination in the Long Run 615 The Real Exchange Rate 615 A Simple Theory of Exchange Rates: Purchasing Power Parity (PPP) 617 Shortcomings of the PPP Theory 620 The Trade Balance and Net Capital Inflows 621 International Capital Flows 623 The Determinants of International Capital Flows 624 Saving, Investment, and Capital Inflows 626 The Saving Rate and the Trade Deficit 627 Summary 630 Key Terms 631 Review Questions 631 Problems 632 Answers to Concept Checks 633 Glossary G-l Index 1-1