ECONOMICS

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RESOURCE GUIDE
A N I N T R O D U C T I O N T O E C O N O M I C S A N D T H E E C O N O M I C S O F W AT E R

2021–2022

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 Table of Contents

INTRODUCTION . . . . . . . . . . . . . . . . . .5 Number of Sellers . . . . . . . . . . . . . . . . . . . . . . 15

Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . 15
SECTION I: FUNDAMENTAL The Characteristics of Competitive Market
ECONOMIC CONCEPTS . . . . . . . . . . . 6 Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Basic Assumptions of Economics . . . . . . . .6
Applications of the Competitive Market
Scarcity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Trade-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Opportunity Cost . . . . . . . . . . . . . . . . . . . . . . .7 Changes in Market Equilibrium . . . . . . . . . . 22
Rationality . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Elasticity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Gains from Trade . . . . . . . . . . . . . . . . . . . . . . .7 Using Elasticity . . . . . . . . . . . . . . . . . . . . . . .26

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Models and Economic Theory . . . . . . . . . . 7 Evaluating Government Policy: The Impact
of Price Controls and Taxes . . . . . . . . . . . .29
Positive and Normative Economics . . . . . . . 8 Price Controls . . . . . . . . . . . . . . . . . . . . . . . . 29
Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Efficiency as a Goal . . . . . . . . . . . . . . . . . . . 8
International Trade . . . . . . . . . . . . . . . . . . 34
Microeconomics and Macroeconomics . . . .8 An Isolated Economy . . . . . . . . . . . . . . . . . . .35
Adding the Opportunity to Trade . . . . . . . . . .36
Section I Summary . . . . . . . . . . . . . . . . . . . 9 Comparative Advantage and the Gains from
Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
SECTION II: The Political Economy of Trade . . . . . . . . . . 40
MICROECONOMICS . . . . . . . . . . . . . 10
The Profit Motive and the Behavior
Perfectly Competitive Markets . . . . . . . . . 10
Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 of Firms . . . . . . . . . . . . . . . . . . . . . . . . . . .40
Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 Economic Profits and Accounting Profits . . . . 40
Shifts in the Demand Curve . . . . . . . . . . . . . .13 Finding the Firm’s Supply Curve . . . . . . . . . .42
Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Entry, Exit, and the Market Supply Curve . . . 43
The Prices of Related Goods . . . . . . . . . . . . . 13
Tastes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Imperfect Competition . . . . . . . . . . . . . . . 43
Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
Number of Buyers . . . . . . . . . . . . . . . . . . . . . . 14 Monopoly Supply . . . . . . . . . . . . . . . . . . . . . 44
Welfare Consequences of Monopoly . . . . . . . 45
Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Dealing with Monopolies . . . . . . . . . . . . . . . . 45
Shifts in the Supply Curve . . . . . . . . . . . . . . .15 Price Discrimination . . . . . . . . . . . . . . . . . . .45
Input Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Oligopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Monopolistic Competition . . . . . . . . . . . . . . .48
Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . 15

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Creative Destruction: The Profit Motive Measuring Inflation . . . . . . . . . . . . . . . . . . . . 72
and the Sources of Economic Change . . . .49 Unemployment . . . . . . . . . . . . . . . . . . . . . . . . 74
Frictional Unemployment . . . . . . . . . . . . . . . . 76
Market Failures . . . . . . . . . . . . . . . . . . . . .49 Structural Unemployment . . . . . . . . . . . . . . . . 76
Externalities . . . . . . . . . . . . . . . . . . . . . . . . . .50 Cyclical Unemployment . . . . . . . . . . . . . . . . . 77
The Effect of Externalities on Resource Economic Growth, Productivity, and Living
Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . .50
Private Responses to Externalities . . . . . . . . 51
Standards . . . . . . . . . . . . . . . . . . . . . . . . . . 77
The Circular Flow Model of the Economy . . . 77
Government Regulation of Externalities . . . . 53
What Determines How Much an Economy
Property Rights . . . . . . . . . . . . . . . . . . . . . . . 53
Produces? . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
The Effects of Private Ownership . . . . . . . . . 55
Public and Private Goods . . . . . . . . . . . . . . .56 Savings, Investment, and the Financial
Private Goods . . . . . . . . . . . . . . . . . . . . . . . . . 56
Common Resources . . . . . . . . . . . . . . . . . . . . 56
System . . . . . . . . . . . . . . . . . . . . . . . . . . . .81
Collective Goods . . . . . . . . . . . . . . . . . . . . . . . 56
Financial Markets . . . . . . . . . . . . . . . . . . . . .81
The Bond Market . . . . . . . . . . . . . . . . . . . . . . 81
Public Goods . . . . . . . . . . . . . . . . . . . . . . . . . . 56
The Stock Market . . . . . . . . . . . . . . . . . . . . . . 81
Institutions, Organizations, and
Financial Intermediaries . . . . . . . . . . . . . . . . 82
Government . . . . . . . . . . . . . . . . . . . . . . . .57 Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
Pork Barrel Politics . . . . . . . . . . . . . . . . . . . . 58 Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . 82
Rent Seeking . . . . . . . . . . . . . . . . . . . . . . . . . 59

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What Is the Proper Role for Government? . . . 59 Saving and Investment in Aggregate . . . . . . .82
International Capital Flows in an Open
Section II Summary . . . . . . . . . . . . . . . . . 59 Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
How Financial Markets Coordinate Saving
SECTION III: and Investment Decisions . . . . . . . . . . . . . . . 84
MACROECONOMICS . . . . . . . . . . . . .61 Money and Prices in the Long Run . . . . . . 87
Macroeconomic Issues . . . . . . . . . . . . . . . 61 What Is Money? . . . . . . . . . . . . . . . . . . . . . . .87
Economic Growth and Living Standards . . . . 61 Measuring Money . . . . . . . . . . . . . . . . . . . . . 88
Recessions and Expansions . . . . . . . . . . . . . 64 The Federal Reserve System, Banks, and the
Unemployment . . . . . . . . . . . . . . . . . . . . . . . . 64 Supply of Money . . . . . . . . . . . . . . . . . . . . . . 89
Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .65 Bank Runs . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
International Trade . . . . . . . . . . . . . . . . . . . . 66 Money and Inflation in the Long Run . . . . . . 92
Why Worry about Inflation? . . . . . . . . . . . . . 95
Macroeconomic Measurement . . . . . . . . . 66
Measuring Total Output: Gross Domestic Short-Run Economic Fluctuations . . . . . . 96
Product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 Characteristics of Short-Run Fluctuations . . . 96
Market Value . . . . . . . . . . . . . . . . . . . . . . . . . . 67 Potential Output, the Output Gap, and the
Final Goods and Services . . . . . . . . . . . . . . . . 68 Natural Rate of Unemployment . . . . . . . . . . .98
Within a Country . . . . . . . . . . . . . . . . . . . . . . 70 Explaining Short-Run Fluctuations in
During a Specified Period . . . . . . . . . . . . . . . . 70
Output . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Understanding What GDP Measures . . . . . . 70 The Aggregate Demand Curve . . . . . . . . . . 102
Other Ways to Measure GDP: Expenditures Wealth Effects . . . . . . . . . . . . . . . . . . . . . . . . 102
Equal Production . . . . . . . . . . . . . . . . . . . . . .70 Interest Rate Effects . . . . . . . . . . . . . . . . . . . 102
Foreign Exchange Effects . . . . . . . . . . . . . . . 102
Yet Another Way to Measure GDP: Income
Equals Production Equals Expenditures . . . . 72 The Aggregate Supply Curve . . . . . . . . . . . .102
Real GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72

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 The Keynesian Model of Short-Run Riparian Doctrine . . . . . . . . . . . . . . . . . . . . 119
Fluctuations . . . . . . . . . . . . . . . . . . . . . . . . .104 Prior Appropriation . . . . . . . . . . . . . . . . . . 120
Inflation in the Keynesian Model . . . . . . . . .107 Case Study: Saline Lake Depletion . . . . 120
Using Fiscal and Monetary Policy to Stabilize Groundwater Rights . . . . . . . . . . . . . . . . . . 121
the Economy . . . . . . . . . . . . . . . . . . . . . . . . 108
Water Quantity Markets . . . . . . . . . . . . . 122
Section III Summary . . . . . . . . . . . . . . . .109 The Basics . . . . . . . . . . . . . . . . . . . . . . . . . . 122
Water Transfers . . . . . . . . . . . . . . . . . . . . . . 122
SECTION IV: THE ECONOMICS Environmental Transfers . . . . . . . . . . . . . . . 123
Case Study: Extreme Water Scarcity
OF WATER . . . . . . . . . . . . . . . . . . . . . .111
in Chile . . . . . . . . . . . . . . . . . . . . . . . . . . . .123
Introduction . . . . . . . . . . . . . . . . . . . . . . . 111
The Basics . . . . . . . . . . . . . . . . . . . . . . . . 112 Water Pollution . . . . . . . . . . . . . . . . . . . . 123
Users . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 Externalities and Water Quality . . . . . . . . . 123
Water Sources . . . . . . . . . . . . . . . . . . . . . . . 112 Case Study: Cleaning Up Coal Ash . . . . .124
Water Quantity . . . . . . . . . . . . . . . . . . . . . . 113 Water Quality Regulation . . . . . . . . . . . . . . 124
Water Quality . . . . . . . . . . . . . . . . . . . . . . . 113 The Clean Water Act . . . . . . . . . . . . . . . . . . 125
Case Study: China’s South-North Water Case Study: Invasive Species in the
Transfer Project . . . . . . . . . . . . . . . . . . . . 113 Great Lakes . . . . . . . . . . . . . . . . . . . . . . . . 125

Supply and Demand . . . . . . . . . . . . . . . . 114 Drinking Water . . . . . . . . . . . . . . . . . . . .126

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Water Supply . . . . . . . . . . . . . . . . . . . . . . . . 114 Access to Drinking Water . . . . . . . . . . . . . . 126
Water Pricing . . . . . . . . . . . . . . . . . . . . . . . . 115 Case Study: The Flint Water Crisis . . . . 126
Consumer Water Demand . . . . . . . . . . . . . . 115
Case Study: Pumping and Subsidies Water Quality Markets . . . . . . . . . . . . . . 127
in India . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 Market Instruments . . . . . . . . . . . . . . . . . . . 127
Water Quality Trading in Practice . . . . . . . 127
Water and Agriculture . . . . . . . . . . . . . . . 117 Case Study: North Carolina . . . . . . . . . . 128
The History of Irrigation . . . . . . . . . . . . . . . 117
Irrigation Organizations . . . . . . . . . . . . . . . 118 Section IV Summary . . . . . . . . . . . . . . . 128
Case Study: The Value of Irrigation
in the United States . . . . . . . . . . . . . . . . . 118
GLOSSARY . . . . . . . . . . . . . . . . . . . . . 130
Water Conservation . . . . . . . . . . . . . . . . . . . 119
NOTES . . . . . . . . . . . . . . . . . . . . . . . . . 136
Water Property Rights . . . . . . . . . . . . . . . 119
Water Law . . . . . . . . . . . . . . . . . . . . . . . . . . 119
BIBLIOGRAPHY . . . . . . . . . . . . . . . .138

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 Introduction

For well over two hundred years, the field of In the second and third sections of the resource guide,
economics has studied how human societies organize we describe some of the most important themes in
themselves to transform their available resources into economics. The second section provides a description
the goods and services that their members wish to of microeconomics. This section starts with the
consume. The outlines of modern economic analysis model of perfectly competitive markets. Although
were already apparent in Adam’s Smith’s An Inquiry the assumptions of this model apply precisely to only
into the Nature and Causes of the Wealth of Nations, a small subset of economic activity, it is a crucial
published in 1776, but discussion of topics relevant to starting point. In the remainder of the section, we
economics can be found even earlier in the writings of show how relaxing the assumptions of the perfectly
Aristotle. competitive model allows us to analyze a much broader
range of phenomena, and how this analysis in turn
At its core, economics is concerned with how leads to important insights about public policy and

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individuals make choices and how these individual individual actions.
decisions and actions interact with one another to
determine what happens at the level of the entire The third section of the resource guide turns
economy. Modern economics approaches this problem to the subject of macroeconomics. It begins by
from several directions. Whereas microeconomics describing important characteristics of aggregate
begins with the analysis of individual decisions economic performance and how these characteristics
and then explores how these individual decisions are measured. It then lays out a framework for
are coordinated through market transactions, understanding differences over time and across
macroeconomics begins by considering aspects of the countries in the quantity of output produced
behavior of entire economies and develops models by economies and for understanding short-run
that help make sense of these observed phenomena. fluctuations in economic activity.
Although these two branches of economic analysis
start from different points, they are unified by a set of In the fourth and final section of this resource guide,
fundamental assumptions about human behavior. we employ some of the conceptual tools developed in
the first three sections to examine the economics of
This resource guide begins by describing the basic water.
assumptions on which all economic analysis rests. The
list of these assumptions is relatively short, and, as you
will see, they are not terribly controversial. Yet, these NOTE TO STUDENTS: You will notice as you read through
assumptions provide the basis for the development of the resource guide that some key terms and phrases are
an extremely rich and flexible set of theories that can boldfaced. While many of these terms are defined and/
account for a wide range of observed phenomena. or explained in the text of the guide, you can also find
explanations of these terms in the glossary at the end of the
resource guide.

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 Section I
Fundamental Economic Concepts
It is not from the benevolence of the butcher, to grow wheat, or the baker to bake bread; they didn’t
the brewer or the baker, that we expect our take these actions so that you could stop to pick up a
dinner, but from their regard to their own loaf of bread on the way home; they did what they did
interest. We address ourselves, not to their because it was in their own best interest. Yet somehow,
humanity but to their self-love, and never almost magically, all of these individual choices were
talk to them of our own necessities but of coordinated so that when you arrive at the store there
their advantages. is an entire aisle of different types of bread available
—Adam Smith, An Inquiry into the Nature and for you to choose from.
Causes of the Wealth of Nations
Now step back and consider the fact that the store
Economics is about everyday life, about the choices you are in is only one of thousands of supermarkets
each of us makes, and how these choices affect our across the country, and that the supermarket is only

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neighbors, our community, our nation, and our world. one of the many millions of businesses that make up
Looking at these choices from the perspective of our economy. Many people take all of this for granted,
economics helps to illuminate hidden wonders in but as the example of less developed countries around
the everyday world around us. For example, the next the world makes clear, there is nothing automatic or
time you stop at the supermarket to pick up a loaf of inevitable about how well our economy functions.
bread on your way home, pause for a minute to reflect Economics can help us to understand both why our
on your surroundings. If your supermarket is like economy functions smoothly most of the time, and
most, there will be rows of fresh produce, aisles of why it occasionally breaks down.
baked goods, shelves full of laundry detergent, cases
of frozen foods and dairy products, and many other BASIC ASSUMPTIONS OF
items. In fact, the average supermarket carries more
than 33,000 different items.1
ECONOMICS
Economics is the study of how individuals make choices
That each of these items is on the shelf is the result about how to allocate scarce resources in order to
of a complicated chain of decisions by an almost satisfy virtually unlimited human wants and about how
uncountable number of different people. For example, individuals interact with one another. While economists
for a loaf of bread to reach the store, a farmer had to study a vast range of different behaviors, their work is
decide to grow the wheat, a milling company had to unified by their reliance on a few seemingly simple, yet
purchase the wheat and grind it into flour, a bakery remarkably powerful assumptions.
had to purchase the flour along with other ingredients
and then combine them to produce the loaf, and finally Scarcity
this perishable product had to be delivered in a timely Scarcity is an inescapable fact of human existence.
fashion to the store. Each product has a similar story. There are only twenty-four hours in the day to
devote to work, study, play, sleep, and other essential
When you go to the store, you expect to be able to find activities. No matter how wealthy a society is, the
the bread and all the other products your supermarket amount of work, energy, knowledge, and capital
carries; but what insures that all of them will be there, available to produce the goods and services people
as they almost always are? No one ordered the farmer wish to consume is limited. On the other hand, our

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desires are insatiable. Just as families must choose opportunity costs of that action and then select the
how much income to spend on food, clothing, vacation action that produces the greatest benefit. It is important
travel, and savings for retirement, societies face to note that the benefits can be interpreted broadly.
choices about how much of their resources to devote to Many people care a great deal about social issues—such
healthcare, national defense, and education. as reducing pollution or helping those less fortunate than
themselves. Such concerns are entirely consistent with
Trade-offs rational decision-making or rationality.
Scarcity implies that every choice we make requires
us to give up something to get something else. If you Most of the time, people perform this cost-benefit
decide to spend an hour watching television, then that calculation intuitively and approximately. In the same
is one less hour you have available to study. Similarly, way that a basketball player does not stop to calculate
if you choose to spend $10 to go to a movie, then you the physics behind a perfect three-point shot, rational
have $10 less to spend on video games or to save for people acquire a feel for what the costs and benefits
college expenses. of their actions will be. Just as some of us are better
at hitting three-point shots than others, we are not
Opportunity Cost born with the ability to infallibly calculate costs and
The cost of what you choose is what you have to give benefits. One of the rewards of studying economics is
up to get it. Economists call what you give up the that it helps us to become better decision-makers.
“opportunity cost” of your choice. It is important to
note that the opportunity cost is not necessarily the Gains from Trade
same as the monetary price you pay. For example, Individuals differ in their abilities, interests, and
suppose a friend offers you a free ticket to a baseball resources. As a result, we all are better at and get

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game. You may not have to pay for the ticket, but the more pleasure from some activities than others. By
opportunity cost of attending the game is the value of specializing in the things we like and do the best, and
what you would have been doing during that time if then trading with other people who have different
you had not gone to the game. For example, if you had abilities, both we and they can then be better off. As
been planning to work mowing lawns, the opportunity long as the exchange is voluntary, then the benefits must
cost of this choice is the income from mowing that you outweigh the costs for both of the people involved.
would forego by attending the game.
MODELS AND ECONOMIC
Opportunity cost is a seemingly simple concept but
applying it can sometimes be rather tricky. Consider
THEORY
Economic analysis relies on careful observation,
the cost of attending college. It might seem obvious
description, and measurement of economic activity.
that the cost of attending college is the sum of the price
But it also relies on theory. To understand how the
of tuition, books, room and board. But this answer
economic phenomena we observe fit together, it is
excludes an important cost of attending college. For
necessary to build theoretical models that capture the
most people, the biggest cost of attending college is
essential features of these interactions while stripping
the value of their time. By choosing to attend class
away the unnecessary details. Models come in a
and do homework, you are giving up time that could
wide variety of forms and can be expressed in many
otherwise be spent working for pay. At the same time,
different ways.
the explicit monetary costs of attending college may
overstate the true expense. Even if you did not attend In economics, models most often consist of diagrams
college, you would still need to eat and have someplace or mathematical formulas. At first glance, many of
to live. Thus, the costs of room and board are not really these models may appear hopelessly simplistic. But
part of the cost of college. the test of a model is in how well it captures the
aspects of reality that we are seeking to understand.
Rationality The simplicity and lack of realism of many of these
Economics assumes that people make choices by models is what allows us to identify so clearly what
comparing the benefits of each action with the assumptions and characteristics are important.

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POSITIVE AND NORMATIVE EFFICIENCY AS A GOAL
ECONOMICS An important criterion that economists often apply
The insights that economics offers about individual in evaluating a society’s use of scarce resources is
and social decisions can be used in two ways. Positive the efficiency of the resulting allocation. Given any
economics uses the tools of economic analysis to particular outcome, economists would say that it was
describe and explain economic phenomena and to efficient if there is no way to improve at least one
make predictions about what will happen under person’s well-being without reducing the well-being of
particular circumstances. It focuses on identifying someone else. This criterion is called Pareto efficiency,
cause-and-effect relationships and measuring their after the Italian economist Vilfredo Pareto (1848–1923),
size. For example, positive economics tells us how who was the first to make use of this concept.
much we might expect the consumption of gasoline to Notice that Pareto efficiency can characterize a wide
decrease when the price of gasoline increases. In this range of different economic outcomes. Consider, for
sense, positive economics is essentially value free. It example, an economy with ten people that produces
does not require that the economic analyst express any $100 worth of goods and services. If each citizen
opinion about the relative merits of different choices. receives $9 of benefits and $10 of production is wasted,
Normative economics is the term used to describe the then this outcome is not Pareto efficient. Redistributing
use of economic analysis to guide decisions about what the $10 would make at least some of the citizens better
should be as opposed to what is the case. Normative off without making any of them worse off. On the other
economic statements combine economic analysis with hand, a situation in which each citizen receives $10 is
value judgments about the relative merits of different Pareto efficient; there is no way to increase the well-
being of any citizen without reducing the benefits of

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possible economic outcomes. The tools of economic
analysis, such as cost-benefit comparisons, can help to another.
structure a discussion of different possible outcomes. However, an outcome in which one citizen receives $91
But, choices between these outcomes usually require of income and each of the other nine citizens receives $1
us to refer to criteria beyond the scope of economic is also efficient by the Pareto criterion. The only way to
theory to justify our particular choices. make anyone better off is through redistribution. Pareto
To better illustrate this, let’s consider the debate about efficiency does not provide a basis for choosing between
whether to increase the minimum wage. Positive these alternative efficient distributions of benefits.
economics can help identify the way in which such an Which distribution is best is, from the perspective of
increase would affect different groups as well as provide economic analysis, a normative judgment that rests on
estimates of their size. In addition to recognizing that a criteria outside the realm of positive economics. While
hike in the minimum wage would increase the incomes economic theory does not provide a basis for such
of those workers who hold minimum-wage jobs, it is choices, economists often offer such value judgments
important to also note that higher wages may result along with their positive analysis.
in some minimum-wage workers losing their jobs. Despite this limitation, efficiency is an important first
Moreover, others who are seeking employment in jobs step in maximizing overall well-being. When we make
covered by the law may be unable to find employment. decisions about how to allocate resources, it is important
Finally, employers who have to pay higher wages may that we do so in a way that does not waste any of them.
see their profits diminish, and they may pass some of
the costs on to consumers, who will see the prices of MICROECONOMICS AND
goods and services that depend on minimum-wage
workers increase. As this list suggests, an increase MACROECONOMICS
in the minimum wage will benefit some people and The tools of economic analysis can be used to
hurt others. To decide whether the benefits outweigh study a wide array of phenomena, ranging from
the costs requires a value judgment about the relative how individuals and businesses make decisions, to
ranking of these effects on the different groups affected how they interact in markets, on up to the factors
by the legislation. that determine the overall level of production,
employment, and the price level of national economies.

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8
The field of economics is traditionally divided 6  conomics assumes that people make choices
E
into two broad subfields: microeconomics and rationally by comparing the benefits and
macroeconomics. Microeconomics concentrates on opportunity costs of each action and selecting
individual behavior and the operation of particular the action that yields the greatest net benefit.
markets. Macroeconomics concentrates on the overall Trade makes everyone involved better off.
6
performance of the national economy.
6  conomic models help us to understand
E
Clearly microeconomics and macroeconomics are economic phenomena by capturing essential
closely linked. They share common assumptions about details and eliminating unnecessary details.
the basic features of human behavior. But, because  ositive economics uses the tools of economic
P
6
they focus on economic activity on different scales, analysis to describe economic phenomena and
different aspects of this behavior are important. And, make predictions about what will happen under
their modes of analysis are sufficiently different, so it is particular circumstances.
useful to consider them separately.
6  ormative economics uses the tools of
N
economic analysis to evaluate the relative
SECTION I SUMMARY merits of different situations.
6  conomics is the study of how individuals
E 6  areto efficiency is an important criterion in
P
make choices about how to allocate and economics. It describes a situation in which the
distribute scarce resources and how they only way that anyone can be made better off
interact with one another. is by reducing the well-being of one or more
 carcity is inescapable because resources are
S other people.
6

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limited and human desires are insatiable. 6  he two main branches of economics are
T
 very choice we make involves trade-offs. The
E microeconomics and macroeconomics.
6
opportunity cost of what we choose is what we
must give up by making that choice.

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 Section II
Microeconomics
As the example of the supermarket discussed earlier PERFECTLY COMPETITIVE
illustrates, our modern economy achieves a high
degree of coordination. The mechanism that produces MARKETS
this coordination is the interaction of supply and Markets
demand within markets. Within markets, the actions A market is comprised of all of the buyers and sellers
of buyers and sellers determine the price at which each of a particular good or service. Some markets, such
product or service sells and the quantity that changes as the New York Stock Exchange or the Chicago
hands. Individual buyers and sellers respond to market Mercantile Exchange, are highly organized. Buyers
prices in predictable ways. and sellers in such markets come together at a single
location, and an auctioneer helps to set a price at which
The interaction of supply and demand in markets is exchanges take place.2
the central topic of microeconomics. Our starting

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point is to develop an understanding of the behavior More often, markets are less formal. Nevertheless, we
of perfectly competitive markets. We will begin by can think of the interaction between buyers and sellers
defining what we mean by a market, and then we will as constituting a market. For example, consider the
describe in more detail how supply and demand are market for gasoline in your community. The sellers
determined by the self-interested choices of individual in this market are all the local gas stations in town,
market participants. Although the assumptions of while the buyers consist of all the vehicle owners in the
perfect competition may seem unrealistic at first, community or passing through it. Each of the sellers in
the resulting model is an essential building block for this market posts the prices at which he or she will sell
economic analysis. It is approximately true in many a gallon of gasoline, and buyers will select where to fill
situations and provides an important benchmark their tanks based on price and convenience. The buyers
against which to compare many other more of gasoline are likely to be well informed about prices
complicated models. because gas prices are continually posted at all of the
different stations.
After developing the model of perfect competition,
we will illustrate its usefulness in analyzing a range The market for gasoline is highly competitive. There
of important topics, including the effects of taxation are many buyers and sellers even in a relatively small
and other types of government policies, as well as community, and none of these market participants
the costs and benefits of trade. Having explored these trades more than a small fraction of the gasoline that
applications, we will then begin to introduce additional changes hands. As a result, no one buyer or seller
features necessary to capture a wider range of influences the price of gasoline, or the quantity sold.
economic phenomena. In this segment of the resource Rather, the price and quantity sold are determined by
guide, we will examine a number of different ways in the combined actions of all the buyers and sellers in
which markets may “fail” to be economically efficient. the market. The owner of each gas station knows that
there are other stations selling a very similar product,
We will conclude our discussion of microeconomics so if the owner raises his or her price above the going
with a closer look at the role of government and other price, then customers will go elsewhere. On the other
forms of collective choice. hand, the owner has no reason to lower the price
significantly below the going price because this will

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 FIGURE 1

STEVE'S DEMAND SCHEDULE

PRICE QUANTITY OF GASOLINE DEMANDED

$0.50 52.5
$1.00 50
$2.00 45
$3.00 40
$4.00 35
$5.00 30
$6.00 25
$7.00 20
$8.00 15
$9.00 10

STEVE'S DEMAND CURVE

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Steve’s Demand Schedule
Steve’s and
Demand Schedule Demand
and Demand Curve forCurve
Gasoline for Gasoline

simply reduce his or her income. In much the same way, the market price. In such a market, buyers and sellers
because each buyer purchases only a small amount of know that they can buy or sell as much as they wish
gasoline compared to the total market, no one buyer can without influencing the market price.
influence the price.
While only a few markets precisely conform to
We say that a market is perfectly competitive if the the assumptions of perfect competition, many real
good or service being bought and sold is highly world markets are characterized by a high degree of
standardized, the number of buyers and sellers is large, competition and can usefully be described in terms of
and all of the participants are well informed about the perfect competition assumption. The market for

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 FIGURE 2

PRICE STEVE NORA MARKET

0.5 52.5 + 18.5 = 71

1 50 17 67
2 45 14 59
3 40 11 51
4 35 8 43
5 30 5 35
6 25 2 27
7 20 0 20
8 15 0 15
9 10 0 10

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Derivation of Market
Derivation Demand
of Market Demand for Gasoline
for Gasoline

gasoline is a good example of a nearly competitive Demand

market. Unless you live in a very small town, you The quantity demanded of any good is the amount of
have probably noticed that the price of gasoline is that good buyers are willing and able to purchase. This
not precisely the same at different stations. But, the quantity depends on a wide range of factors. One of the
differences in prices are never very large. As a result, most important is the good’s price. If the price of the
many of the lessons we learn from analyzing perfectly good is higher, buyers will demand less of the good; if
competitive markets can be applied to less than perfectly the price is lower, then they will demand more. This
competitive markets. Our analysis of perfect competition negative relationship between a good’s price and the
will also provide a useful benchmark against which to quantity demanded is called the law of demand.
compare the outcomes of other types of markets.

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The law of demand is a result of the cost-benefit analysis The graph shows that we add the two demand curves
that rational decision-makers use when deciding how horizontally to obtain the market demand.
to allocate their resources. As the price of a good
increases, the opportunity cost of consuming that good Shifts in the Demand Curve
also increases since consumers must cut back on their The market demand curve depicts the relationship
consumption of other goods to afford the higher price. between the quantity demanded and its price, assuming
If, for example, the price of gasoline rises, people that all other factors that might influence the quantity
will likely find ways to reduce the amount that they demanded remain unchanged. But many other things
drive. They might do this by planning their trips more can influence the quantity demanded. If one of these
carefully or choosing to take the bus or ride a bicycle factors changes, it causes the entire demand curve to
rather than drive. shift.

The table in Figure 1 illustrates how Steve’s purchases For example, if your community creates a new system
of gasoline each month depend on the price per gallon. of bicycle lanes that make it easier to bike from place
At $1 per gallon, Steve buys 50 gallons; when the price to place, the quantity of gasoline demanded will
rises to $2 a gallon, he cuts back to 45 gallons. If the decline at every price. As Figure 3 shows, such a
price rises further, to $3 a gallon, he cuts back to 40 change causes the market demand curve to shift to the
gallons. This table is called a demand schedule. left, indicating that at each price a lower quantity is
demanded. Let’s consider some of the most important
The graph in Figure 1 shows another way of factors affecting the quantity demanded.
representing Steve’s demand schedule. The downward-
sloping line in this graph is called Steve’s demand Income

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curve. Notice that we plot the points of Steve’s Suppose Steve’s employer reduces his weekly hours
demand schedule with the quantity demanded on the of work, and thus his income. Because Steve has less
horizontal axis and the price on the vertical axis. To money to spend on all the things he wishes to buy, he
read this graph, find a price on the vertical axis (say will likely reduce his consumption of gasoline. For
$3 per gallon) and then draw a line horizontally until it most goods, demand is positively related to income:
intersects the demand curve. Now draw a line vertically when income rises, the quantity demanded rises, but
downward from that point until it intersects the when income falls, the quantity demanded falls. Goods
horizontal axis. The point at which this line intersects for which this is true are called normal goods.
the horizontal axis (40 gallons) is the quantity Steve
demands when the price is $3 per gallon. Not all goods are normal goods, however. Goods for
which the quantity demanded falls as income rises are
When the market price changes, we find Steve’s quantity called inferior goods. Bus rides might be an example of
demanded by moving up or down along the demand an inferior good. As their income increases, consumers
curve until we reach the height corresponding to the will be more likely to buy a car and drive instead of
new market price. For example if the price were to taking the bus.
rise from $3 to $5 a gallon, Steve’s quantity demanded
would decline from 40 gallons a month to 30 gallons The Prices of Related Goods
a month. This movement is illustrated in Figure 1 by Suppose that the price of airline tickets falls. The law
the arrow pointing up and to the left along the demand of demand says that consumers will purchase more
curve. airline travel. Because airline travel is to some extent
a substitute for travel by car, people will likely reduce
Steve is, of course, just one buyer. To find the market the number of miles they drive and hence the quantity
demand schedule, we must add up the quantity that of gasoline they demand at any price. When a decline
every consumer will purchase at each possible price. in the price of one good causes a reduction in the
Figure 2 illustrates how this process works with two quantity demanded of another, we say that these goods
individuals. In addition to Steve, the market now are substitutes.
includes Nora. The table in Figure 2 shows that the
market quantity demanded is the sum of the quantities Suppose, on the other hand, that the price of
that Steve and Nora wish to consume at that price. automobile insurance falls. Lower insurance costs

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 FIGURE 3

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Effects ofEffects
a Bike Lane
of a Bike Lane onon Demand
Demand for Gasoline for Gasoline

make it easier for more people to afford to own then he might cut back on his driving now in
automobiles; car ownership will increase and so will anticipation of this future change in his income.
the number of miles driven. When a lower price for
one good causes demand for another good to increase, Number of Buyers
we call those two goods complements. Market demand is derived by adding up the demands
of individual consumers. If there are more consumers,
Tastes then demand will increase. If your community is
Remember that the quantity demanded reflects a growing because people and businesses are moving
comparison of the benefits of consumption with the there, then the market demand for gasoline will be
opportunity costs of purchasing the good. If the increasing with this growing population.
perceived benefits of consumption change, then so
will the quantity demanded. For example, suppose that Supply
concerns about the environmental impacts of driving The quantity supplied of any good is the amount that
cause people to be more concerned about pollution. sellers of that good are willing and able to produce.
The likely impact will be a reduction in the demand for Many factors influence the quantity supplied, but the
gasoline. most important is the price that suppliers receive. The
higher the price is, the greater the quantity that suppliers
Expectations will want to produce. This positive relation between
Changes that you expect to occur in the future may price and quantity supplied is called the law of supply.
also affect the quantity demanded. For example, if
Steve is afraid that he may lose his job next month, The positive relationship between price and quantity

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14
supplied reflects the cost-benefit analysis of rational causing the entire supply curve to shift to the left.
suppliers. Gasoline station owners compare the
benefits of each gallon sold to the opportunity cost of Technology
their time, effort, and expense to supply that gallon Changes in technology can affect how businesses
of gasoline. As the price rises, it will be rational to operate and hence the quantity supplied. In the case
devote more resources to supplying gasoline. So long of gasoline, the shift from full-service to self-service
as the price they receive exceeds their opportunity reduces labor costs and increases the quantity supplied.
cost, they will be willing to supply gasoline. At higher Similarly, pumps with credit card readers further
prices, they will be willing to work longer hours, hire reduce labor costs and increase the quantity supplied.
additional help, and expand the size of their stations to
boost sales. At lower prices, they will cut back on the
Expectations
If suppliers expect prices to rise in the future, then
time they spend supplying gasoline, reduce the number
they may reduce the quantity they will supply today
of their employees, or shift their efforts toward selling
and store current inventory in expectation of the higher
other products.
future prices.
Figure 4 illustrates the relationship between price and
quantity supplied for Shelly. Again, we plot the price of Number of Sellers
gasoline on the vertical axis and the quantity supplied As more sellers enter the market, the quantity supplied
on the horizontal axis. Shelly’s supply curve is upward will increase. On the other hand, if a seller decides to
sloping, reflecting the positive relationship between leave the market, then the quantity supplied will be
price and quantity supplied. reduced.

Equilibrium

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The market supply curve is obtained by adding the
quantities supplied at each price by all of the suppliers What will the price of gasoline be? How many gallons
in the market. This is illustrated in Figure 5 for the will be sold? To answer these questions we need to put
case where there are two suppliers. Again, we obtain the information about the market demand and market
the market supply curve by adding the individual supply together. There is, as we will see, only one
supply curves horizontally. combination of price and quantity at which the market
is at equilibrium, and it is at this point that the market
Shifts in the Supply Curve will settle.
The market supply curve shows the quantity supplied
at each price, assuming that all other things remain Equilibrium is a widely used concept in both the
unchanged. There are, however, many other factors physical and social sciences. It is defined as a point at
that will influence the quantity supplied. A change which all the forces at work in a system are balanced
in any of these factors will cause the supply curve to by other forces, resulting in a stable and unchanging
shift. Let’s consider some of the most important factors situation. In economics, a market is in equilibrium
that might cause the supply curve to shift. when no participant in the market has any reason to
alter his or her behavior.
Input Prices
The market equilibrium occurs at the combination
Inputs are any of the things that suppliers have to
of price and quantity where the market supply and
purchase to supply a product. For example, the price
demand curves intersect. Because the supply curve is
that gasoline stations must pay their suppliers for
upward sloping and the demand curve is downward
gasoline is a major cost of doing business. If this price
sloping, there is only one possible point of intersection.
falls, the quantity of gasoline supplied will increase,
Figure 6 illustrates the market equilibrium for
causing the supply curve to shift to the right. But,
gasoline. In this hypothetical example, the equilibrium
there are other inputs that are important as well. These
price is $2.50, and the equilibrium quantity is 10,000
include labor costs, the real estate costs for the land
gallons of gasoline per month.
on which the gasoline station is located, and utilities
such as electricity. If any of these input costs increases, At this point, we can say that the buyers and sellers in
it will decrease the quantity supplied at every price, this market are all satisfied, in the sense that buyers are

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FIGURE 4

PRICE OF A GALLON OF GASOLINE QUANTITY OF GASOLINE SUPPLIED

$1.50 65
$2.00 70
$2.50 75
$3.00 80
$3.50 85
$4.00 90
$4.50 95
$5.00 100
$5.50 105
$6.00 110
$6.50 115
$7.00 120
$7.50 125
$8.00 130
$8.50 135

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$9.00 140
$9.50 145
$10.00 150

Shelly’s Shelly’s
Supply Schedule and Supply Curve
Supply Schedule and Supply Curve

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FIGURE 5

PRICE OF A SHELLY’S LUTHER’S MARKET

GALLON OF GASOLINE QUANTITY SUPPLIED QUANTITY SUPPLIED QUANTITY SUPPLIED

$0.50 55 + 82 = 137
$1.00 60 89 149
$1.50 65 96 161
$2.00 70 103 173
$2.50 75 110 185
$3.00 80 117 197
$3.50 85 124 209
$4.00 90 131 221
$4.50 95 138 233
$5.00 100 145 245
$5.50 105 152 257
$6.00 110 159 269
$6.50 115 166 281
$7.00 120 173 293
$7.50 125 180 305

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$8.00 130 187 317
$8.50 135 194 329
$9.00 140 201 341
$9.50 145 208 353
$10.00 150 215 365

Derivation of ofthe
Derivation Market
the Market Supply Curve
Supply Curve

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 FIGURE 6

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Market
Market Equilibrium
Equilibrium

able to purchase as much gasoline as they would like Under these circumstances, suppliers have an incentive
at a price of $2.50 a gallon, and suppliers can sell as to lower their price a little bit. If one station posts a
much gasoline as they would like at this price. There price of $3.90 a gallon, it will attract buyers from other
are, no doubt, buyers who complain that the price of stations, and its surplus will be reduced. But once
gasoline is too high and would like the price to be the other stations see that they are losing customers,
lower, and similarly suppliers who complain that the they will be forced to lower their prices as well. The
price is too low and would like it to be higher. pressure to cut prices and attract business will not go
away until the price has reached the equilibrium level
An important feature of market equilibrium is that of $2.50 a gallon.
the market has an automatic tendency to gravitate
toward this combination of price and quantity. Figure 7 Now suppose that the price is below the equilibrium
illustrates this point. We start (Figure 7a) by supposing price. Figure 7b illustrates this situation. At a price
that the price is higher than $2.50. At a price of $4 a of $1.50 there is an excess demand for gasoline.
gallon, for example, suppliers would like to sell 10,600 Buyers wish to purchase 11,000 gallons of gasoline,
gallons, but buyers only wish to purchase 8,500 gallons but suppliers are willing to sell only 9,600 gallons.
a month. In other words, there is an excess supply. Now there are shortages: some drivers cannot find
No one can force people to buy more gasoline than any gasoline, and others have to wait in long lines to
they want. Suppliers will find that they have too much purchase gasoline.
gasoline on hand, their storage tanks are filling up, and
they cannot unload their inventory. Buyers might be tempted to offer to pay a little bit extra
to be sure to get what they need, and sellers will see they

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FIGURE 7

(a) EXCESS SUPPLY

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(b) EXCESS DEMAND

Markets out of Equilibrium

Markets out of Equilibrium

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19
can raise prices without sacrificing sales. The pressure would have paid $100, so attending the concert produces
to raise prices will continue until the price has reached a benefit valued at $40 for her. Since Bob was willing
the equilibrium level. Only at this point will buyers and to pay $80, his benefit is $20, and Sharon’s benefit is
sellers have no desire to change their behavior. just $10. Adding these amounts together, we see that the
three purchasers receive a combined benefit of $70. We
The Characteristics of Competitive call this amount the consumer surplus since it is the
Market Equilibrium surplus value that consumers receive.
Competitive markets tend to gravitate toward The demand curve in Figure 8 slopes downward,
the equilibrium quantity and price. This is a very indicating that as the price falls, more of the fans will
important feature of markets and has several desirable be willing to purchase tickets. At any point along
consequences. First, competitive markets are an this demand curve, its height shows the marginal
extremely effective method of allocating resources. purchaser’s willingness to pay. Because the height of
When the market for a good is in equilibrium, the price the demand curve measures buyers’ willingness to
conveys important information for potential suppliers pay, the difference between the height of the demand
about the value consumers place on that good. At the curve and a horizontal line drawn at the market price
same time, the price informs potential demanders about measures the consumer surplus for the marginal buyer
the opportunity cost of supplying the good. This two- at each quantity demanded. More generally, we can use
way communication is how markets insure that scarce the total area below the demand curve and above the
goods and services are produced at the lowest cost and market price as a measure of total consumer surplus.
allocated to the buyers who value them the most highly. This area, then, provides a monetary measure of how
The competitive market equilibrium insures that the much benefit all of the buyers in a particular market

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available supply goes to those buyers who value the receive from participating in that market.
good most highly, and that it is provided by those In the same way the height of the demand curve
suppliers who have the lowest costs of supplying the represents buyers’ willingness to pay, the height of
good. This fact leads to the second characteristic of the supply curve at each quantity supplied measures
the competitive market equilibrium: it maximizes the the willingness to supply of the marginal seller—that
benefits buyers and sellers receive from exchange. is, the seller who would leave the market if the price
Let’s begin by considering the benefits buyers receive were any lower. Put somewhat differently, the height
from participating in the market. The important insight of the supply curve measures the opportunity cost to
is the height of the market demand curve at each point the marginal seller. If the market price exceeds this
reveals the marginal buyer’s willingness to pay. The opportunity cost, the difference is a monetary measure
marginal buyer is the buyer who, at that price, is just of what is called the producer surplus. And we can
indifferent between buying the good in question or not measure the combined surplus of all suppliers using
buying it. the area above the supply curve and below the market
price as is illustrated in Figure 9.
To illustrate this, let’s consider the highly simplified
example presented in Figure 8. The table lists the Combining consumer surplus and producer surplus
amount each of four fans would be willing to pay to provides a measure of the total benefits that market
purchase a ticket to a Bruce Springsteen concert. The participants receive from their transactions. We call
table shows that Barb values attending the concert at this benefit the total surplus. One goal of a benevolent
$100, and at any price less than that she will purchase social planner should be to maximize this combined
a ticket. The other potential buyers place a lower value surplus, since this is the outcome that produces the
on attending the concert. greatest overall good. An outcome that maximizes
total surplus satisfies the economist’s criterion of
If the concert promoter sets the price of tickets at $60, Pareto efficiency, since at this point there is no way to
then Steve will not purchase a ticket, since the most he make anyone better off without reducing the welfare of
is willing to pay is $50. The other three consumers will someone else.
all purchase tickets, but the benefit they receive from
being able to purchase the ticket for $60 varies. Barb To see that the competitive market equilibrium indeed

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FIGURE 8

BUYER WILLINGNESS TO PAY

Barb $100
Bob $80
Shar on $70
Steve $50

DEMAND SCHEDULE
PRICE BUYERS QUANTITY DEMANDED

more than $100 None 0

$80 to $100 Barb 1
$70 to $80 Barb, Bob 2
$50 to $70 Barb, Bob, Sharon 3
$50 or less Barb, Bob, Sharon, and Steve 4

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DEMAND CURVE

The DemandTheCurve Represents Buyers’ Willingness to Pay

Demand Curve Represents Buyers’ Willingness to Pay

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 FIGURE 9

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Producer Surplus
Producer Surplus

meets the efficiency criterion and maximizes total on the good in question, and the cost of producing each
surplus, let’s consider Figure 10. Suppose first that unit, and would have to determine how much should
a quantity Q1, which is less than the equilibrium be produced, by whom, and to whom it should be
quantity, was exchanged in the market. At this point, given. While such a task would be extremely difficult,
the value of the good to buyers exceeds the cost to a competitive market achieves the same result simply
sellers of supplying the good. A slight increase in the through the self-interested actions of its participants,
quantity in such a market would yield an increased responding only to the signals provided by the market
benefit to both parties. So Q1, or any other point to price.
the left of the market equilibrium, cannot be efficient.
Now, suppose that the quantity traded in the market is APPLICATIONS OF THE
Q2, an amount greater than the equilibrium quantity.
At Q2 the supply curve is above the demand curve,
COMPETITIVE MARKET
indicating that the cost to producers exceeds the MODEL
value to consumers. Such an exchange cannot be Changes in Market Equilibrium
accomplished voluntarily, but if it did take place, then Now that we have seen how to use the concepts of
buyers or sellers would suffer a loss in welfare. Moving supply and demand to find the equilibrium price and
to the left would raise overall well-being. quantity in a competitive market, we can use our
market model to make predictions about how shifts
To achieve an efficient outcome, a market planner
in the economy will affect the market. Let’s consider
would need to know the value each consumer places

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 FIGURE 10

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Competitive Market Equilibrium
Competitive Market Maximizes
Equilibrium Maximizes Social Welfare
Social Welfare

some examples illustrating how the competitive market the consumer and producer surplus at this equilibrium.
model can be used to analyze important issues. The introduction of BGH is illustrated in the second
panel of Figure 11. This innovation allows dairy
One of the defining characteristics of our modern farmers to increase the quantity of milk they supply
economy is technological progress. New inventions at any price, so the supply curve for milk shifts to
are continually being developed that allow suppliers the right. As a result, the point at which supply and
to produce more at lower costs. One example is the demand intersect moves down along the demand curve
development of synthetic Bovine Growth Hormone from point A to point B. In the new equilibrium, the
(BGH), which allows dairy farmers to increase milk price is lower, and the quantity is higher.
production by between 10 and 15 percent at little
additional cost. The direct effects of this innovation It is clear that the total surplus has increased as well,
are illustrated in Figure 11. As is often the case, since the shaded area between the supply and demand
the introduction of a new technology has other, curves is now larger. Consumers are unambiguously
more subtle effects, called externalities, that are not better off as a result of the innovation. Since the market
immediately obvious from an analysis of the market price is now lower, everyone who previously purchased
that is immediately affected.3 We will discuss how to milk receives a larger surplus. In addition, at the
incorporate externalities into our analysis later in this lower price consumers purchase additional quantities
section of the resource guide. of milk. The effect on producers is more ambiguous.
The increase in sales causes an increase in producer
The first panel shows the market equilibrium before surplus, but the lower price reduces the producer
the introduction of BGH. The shaded regions indicate surplus on the quantity that was previously being sold.

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FIGURE 11

(a) MARKET EQUILIBRIUM BEFORE BGH

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(b) MARKET EQUILIBRIUM AFTER BGH

Effects Effects
of BGH on the Market for Milk
of BGH on the Market for Milk

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Whether producers benefit depends on the balance of given change in the price. Demand is said to be elastic
these two effects. if a one percent change in price results in a greater
than one percent change in the quantity demanded.
Let’s consider another example of how shifts in supply Demand is said to be inelastic if a one percent change
and demand affect market equilibrium. Public health in price results in a less than one percent change in
officials have long recognized that cigarette smoking the quantity demanded. And demand is said to be unit
is harmful. As a result, policymakers would like to elastic if a one percent change in price results in a one
reduce smoking. One approach is to reduce the demand percent change in the quantity demanded.
for cigarettes through public education campaigns
and the inclusion of warning labels on packages of Economists use elasticity because it provides a measure
cigarettes. Assuming that these efforts do in fact cause of the responsiveness of demand to price changes that is
buyers to demand fewer cigarettes, what is the effect independent of the units of measurement. For example,
on the market for cigarettes? if we express the quantity of gasoline demanded in
liters, then we will find that the demand curve has a
The answer can be found by examining Figure 12. To different slope from the one that would result if we
illustrate the effect of public efforts to reduce smoking, measured demand in gallons. However, the elasticity
Figure 12 shows the demand curve for cigarettes will be the same in both cases.
shifting to the left. As a result, the intersection of the
supply and demand curves shifts down and to the left Measuring the actual elasticity of demand for particular
along the market supply curve for cigarettes. After this products is an important activity of applied economics.
shift, the equilibrium price and quantity both decrease. Nonetheless, we can state some general guidelines about
the factors that influence the price elasticity of demand.
Elasticity

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The competitive market model we have developed 6 Substitutes. Goods with close substitutes will
allows us to predict the direction in which equilibrium tend to have relatively high price elasticities
price and quantity will change in response to changes of demand because it is easy for consumers
in market supply or demand. But to fully understand to switch from one product to another. For
the impact of these changes, it is important to be example, the price elasticity of demand for
able to measure the size of the changes in prices and a particular cola drink is likely quite high
quantities as well as their direction. To do this, we because consumers can easily switch to a
need to introduce the concept of price elasticity. different brand if the price rises. Conversely,
when there are no close substitutes, the price
The price elasticity of demand measures how much elasticity of demand will tend to be lower.
the quantity demanded responds to a change in price. Necessities. Items that are regarded as
6
We calculate the price elasticity of demand using the necessities will generally have lower price
following formula: elasticities of demand than luxuries. Many
Price elasticity of demand = people must drive to and from work and use
(Percentage change in quantity demanded) / their cars to run important errands. As a
(Percentage change in price) result, the demand for gasoline has a low price
elasticity of demand.
Recall that because of the law of demand, the quantity Market Definition. The price elasticity of
6
demanded of a good is negatively related to its price, demand will depend on how we define the
so this ratio will always be negative. It is conventional market. The broader the market definition,
to ignore this sign when discussing the elasticity the fewer close substitutes there will be and
of demand. In other words, in practice, we use the the lower the elasticity of demand. The price
absolute value of the price elasticity of demand. elasticity of demand for soft drinks will be
The price elasticity of demand reflects how responsive lower than the price elasticity of demand for
consumers are to changes in the price of a good. The any particular brand of cola drink.
greater the elasticity, the greater the proportionate 6 Time Horizon. Fully adjusting to changes
change in the quantity consumers demand due to any in prices may take time. Take the example

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25
 of gasoline prices considered earlier. At first 6 Scarce resources. If an input required to
there is not much people can do to reduce their produce a good is scarce, then the supply will be
consumption when the price of gasoline rises. inelastic. For example, the supply of beachfront
But, over time people will buy more fuel- vacation homes is highly inelastic because the
efficient cars, move closer to their work, and amount of beachfront property is limited.
make other changes that will allow them to Time horizon. The longer the time horizon is,
6
more significantly reduce their demand. the greater the elasticity of supply will be. Over
Elasticity is related to the slope of the demand curve. short time horizons, firms may not be able to
If two demand curves pass through the same point, hire and train additional workers or add the
the curve that is flatter will have a higher elasticity. necessary equipment to increase production.
It is important to note that as we move down along Over a longer horizon, they can do this more
a linear demand curve, the elasticity will be falling easily.
continuously. To see this, note that a linear demand As was the case with the price elasticity of demand,
curve must have a constant slope ∆P/∆Q = e, (where if two supply curves pass through the same point, the
we use the Greek letter ∆ to denote the change in price flatter curve will be the more elastic one. Figure 14
and quantity along the demand curve). The ratio ∆Q/∆P illustrates the variety of possible supply curves. Again
= 1/e, is also a constant.4 Consequently the elasticity of there are five cases. In the extreme case (a) the supply is
demand is equal to (1/e)·(P/Q). As we move down and perfectly inelastic, indicating that the quantity supplied
to the right along the demand curve, P is falling and Q will not change at all as the price changes. The supply
is rising, so the ratio P/Q must be decreasing. Since 1/e of Van Gogh sunflower paintings is perfectly inelastic
is constant, the elasticity must also be falling. since there is no way to produce more of these. The

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Figure 13 shows five different possible demand curves remaining cases illustrate (b) inelastic supply, (c) unit
illustrating the range of possible elasticities. In the elastic supply, (d) elastic supply, and the other extreme
extreme case (a) demand is perfectly inelastic; the case (e) perfectly elastic supply.
quantity demanded does not depend on price at all.
The remaining panels show progressively more elastic Using Elasticity
cases: (b) inelastic, (c) unit elastic, (d) elastic, and the To see how measurements of elasticity can be used,
other extreme case (e) perfectly elastic, where the let’s return to the example of the introduction of
demand curve is completely flat. Bovine Growth Hormone that we considered earlier.
As a starting point, we need to consider how the
The price elasticity of supply is defined analogously to elasticity of demand affects total revenues available to
the price elasticity of demand. It is calculated as: producers in this market.

Price elasticity of supply = Total revenue is the equilibrium price multiplied by the
(Percentage change in quantity supplied) / equilibrium quantity:
(Percentage change in price)
Total Revenue = P × Q
The elasticity of supply reflects the ease with which
suppliers can alter the quantity of production. We The total revenue can be depicted graphically as in
can establish some general guidelines that allow Figure 15. As the price falls, we move down along
us to identify factors that are likely to affect this the demand curve: the height of the box is reduced
responsiveness. as its width increases. If the demand is elastic, total
revenue will increase since the proportionate change in
6 Ease of entry and exit. If it is easy for new quantity will be greater than the proportionate increase
businesses to begin supplying a product or for in the price. But, if demand is inelastic, then total
those in the market to leave, then supply will revenue will decrease when prices fall.
tend to be more elastic. The supply of airline
flights on a particular route is quite elastic Empirical estimates suggest that the demand for milk
because airlines can easily shift planes from one is relatively inelastic. Milk is a necessity, and it does
route to another to respond to changes in prices. not have many close substitutes. As a result, declining

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FIGURE 12

(a) MARKET EQUILIBRIUM BEFORE CAMPAIGN

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(b) MARKET EQUILIBRIUM AFTER CAMPAIGN

Effects of Effects
a Reduction in Market Demand
of a Reduction in Market Demand

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27
 FIGURE 13

(a)PERFECTLY
(a)
(b) INELASTIC DEMAND:PERFECTLY INELASTIC
INELASTIC
ELASTICITY IS LESS THAN 1 (b)INELASTIC
(b) INELASTICDEMAND:
DEMAND:ELASTICITY
ELASTICITYIS
ISLESS
LESSTHAN
THAN11

AA22%
22%
A 22% increase increase
inincrease inprice
in
price leads price andreduction
and
to a 7% nochange
no change in
inin quantity.
quantity.
quantity. AA22%
22%increase
increasein
inprice
priceleads
leadsto
toaa7%
7%reduction
reductionin
inquantity.
quantity.

1 (c)UNIT
(c) UNIT
(d) ELASTIC ELASTICELASTICITY
ELASTIC
DEMAND: DEMAND:ELASTICITY
DEMAND: ELASTICITY EQUALS
THAN 111
IS GREATEREQUALS (d)ELASTIC
(d) ELASTICDEMAND:
DEMAND:ELASTICITY
ELASTICITYIS
ISGREATER
GREATERTHAN
THAN11

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tity. AAincrease
A 22% 22%increase
22% increase inprice
in
in price priceleads
leads leads toaadecrease
to
to a 44% 22%reduction
22% reduction inquantity.
in quantity.
in quantity. AA22%
22%increase
increasein
inprice
priceleads
leadsto
toaa44%
44%decrease
decreasein
inquantity.
quantity.

DEMAND: ELASTICITY EQUALS INFINITY (e)PERFECTLY

(e) PERFECTLYELASTIC
ELASTICDEMAND:
DEMAND:ELASTICITY
ELASTICITYEQUALS
EQUALSINFINITY
INFINITY

At$4
ntity; if the price is above $4, they will buy At $4consumers
none, consumerswill
willbuy
buyany
anyquantity;
quantity;ififthe
theprice
priceisisabove
above$4,
$4,they
theywill
willbuy
buynone,
none,
w $4, they will buy an infinite quantity. andififthe
and theprice
priceisisbelow
below$4,
$4,they
theywill
willbuy
buyan aninfinite
infinitequantity.
quantity.

e Elasticity of Demand The Price

The Price Elasticity
Elasticity
The Price of Demand
of Demand
Elasticity of Demand

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28
prices do not induce a large increase in the quantity Price Controls
demanded. On the other hand, the supply of milk is Efforts to legislate minimum or maximum prices are a
relatively elastic over a time horizon of a year or more. fairly common kind of policy intervention in markets.
There are a great many dairy farms, and it is easy for For many years, U.S. farm policy established minimum
these farms to expand or contract their production. prices of major food crops, such as corn and wheat. The
federal government and most states have established
In Figure 15, the demand curve is drawn as inelastic
a minimum wage, and some communities have gone
at the initial price and quantity pair. As the price of
further, seeking to legislate that employers pay a “living
milk falls from an initial level of $2 a gallon to $1.50,
wage.” Similarly, New York and some other cities
the quantity demanded per day rises only from 2,000
have sought to control residential housing costs by
gallons to 2,250. In this case, the price has fallen by 25
establishing rent controls that limit increases in the rates
percent, and the quantity demanded has increased by
that landlords can charge. In 1979, when Middle Eastern
just 12.5 percent, which implies an elasticity of –0.5 (=
oil supplies were interrupted and heating oil prices shot
12.5 / –25). As a result, total farm revenue falls from
up, the federal government imposed a ceiling on prices
$4,000 to $3,375. In aggregate, dairy farmers are now
in an effort to protect low-income families.
earning significantly less revenue than before.
When the market price appears to unfairly hurt either
If using BGH reduces farm income, why do dairy
consumers or suppliers, it is tempting to suggest that
farmers adopt this technology? The answer is that in a
government intervention could set a better price. But,
competitive market they have no choice. Each farmer
such efforts create significant, though not always
supplies only a small amount of the total output, and
obvious, social costs. To see these, consider a few
his or her choice about whether to use BGH has no
examples. Figure 16 illustrates the impact of imposing

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effect on the market price. Given the existing market
a price ceiling on the housing market. In this example,
price, each farmer can increase his or her sales by
the competitive market equilibrium occurs at a rent
using BGH. As a result, competition causes them to all
of $400 per month. At this price, consumers rent two
adopt the technology, increasing the market supply and
thousand apartments each month.
driving down prices.5
Now suppose that landlords are told they may charge
As farm revenue falls, it is likely that some farmers
no more than $300. At this price consumers wish to
will choose to cease producing, allowing the remaining
rent 2,100 apartments, but landlords only supply 1,900
farmers to maintain or increase their standard of living
apartments. Those tenants lucky enough to be able to
by producing a greater quantity. This is, in fact, more
find an apartment benefit from the lower rental rates,
or less what has happened in the farm sector over
while landlords find themselves with lower incomes.
the past two hundred years. Successive technological
Meanwhile, other renters lose their apartments. One
innovations have increased the ability of farmers
effect of rent control, then, is to increase the consumer
to produce greater quantities of crops, though this
surplus of some renters while reducing the producer
advance has been accompanied by a steady decline in
surplus of landlords and thus negatively affecting other
the number of farmers.
renters. A second consequence is that total surplus
is reduced since rent control prevents some mutually
EVALUATING GOVERNMENT beneficial transactions from taking place. There are
POLICY: THE IMPACT OF landlords who would like to rent their apartments for
PRICE CONTROLS AND TAXES more than $300 per month, and there are consumers
So far our discussion has been confined to describing who would be willing to pay a higher price.
how competitive markets work. The tools we have Less immediately apparent is the disruptive effect of
developed to describe the operation of competitive rent controls on the allocation of apartments. In the
markets can also be used to analyze several commonly competitive market equilibrium, apartments are rationed
used policy interventions. As we will see, the effects by price. Everyone who values an apartment as much
of these policies often diverge from the goals of those or more than the market price is able to rent one, and
who designed them. landlords who are willing to supply apartments at or

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FIGURE 14

(a) PERFECTLY INELASTIC SUPPLY: ELASTICITY EQUALS 0 (b) INELASTIC SUPPLY: ELASTICITY IS LESS THAN 1

A 22% increase in price leads to no change in quantity. A 22% increase in price leads to an 11% increase in quantity.

(c) UNIT ELASTIC SUPPLY: ELASTICITY EQUALS 1 (d) ELASTIC SUPPLY: ELASTICITY IS GREATER THAN 1

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A 22% increase in price leads to a 22% increase in quantity. A 22% increase in price leads to a 44% increase in quantity.

(e) PERFECTLY ELASTIC SUPPLY: ELASTICITY INFINITE

Producers will supply any quantity demanded at $4; if the price is above $4,
they will supply an infinite amount; if it is below $4, they will supply zero.

Elasticity ofSupply
Elasticity of Supply

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FIGURE 15

(a) INITIAL REVENUE

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(b) AFTER A FALL IN PRICE,
REVENUE DECLINES.

Calculation ofTotal
Calculation of Total Revenue
Revenue

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 FIGURE 16

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Effects ofof aa Rent
Effects Rent Ceiling
Ceiling

below the market price are able to rent them. Now, highly inelastic. As a result, rent controls mainly lower
however, landlords are in a position to select tenants. the price without creating a large excess demand. But,
They may require people to pay a finders fee, they may over time, both supply and demand become more elastic.
choose to rent to their friends, or they may discriminate Landlords will cut back on maintenance costs, allowing
based on personal characteristics they value or dislike. apartments to deteriorate, and eventually removing
As a result, apartments may no longer go to the them from the available housing stock. Meanwhile, low
individuals who value them most highly, producing a prices will attract more residents to the city. With these
further inefficiency in the market. changes, the problem of excess demand and non-market
rationing will become increasingly significant.
Historical experience points to further negative effects
of rent controls. In the short run, both the supply of To illustrate the effect of establishing a price floor,
housing in a city and the demand for housing may be let’s consider Figure 17, which shows the market for

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32
wheat. The competitive market equilibrium price in this minute; so suppliers receive $0.16 per minute, and
market is $5 a bushel, and the equilibrium quantity is consumers pay $0.26 per minute. Even though the tax
100 million bushels. Suppose that in an effort to protect is added to the consumers’ bill, the actual burden of
family farms, Congress establishes a minimum price of the tax is divided between suppliers and buyers. At the
$8 a bushel. Because this price is higher than the current same time, the tax reduces the equilibrium quantity,
market equilibrium, it is binding. At this higher price, lowering total surplus by preventing otherwise
demand for wheat falls to 80 million bushels, and supply mutually beneficial exchange from taking place.
rises to 115 million bushels. Farmers cannot sell all the
wheat they are producing on the free market. Suppose that instead of taxing consumers, the
government imposed the tax on suppliers, charging
Once again this intervention reduces consumer and them $0.10 for every minute of talk they supplied. As
producer surplus. There are farmers who would be a result, the revenue that suppliers receive is reduced
happy to supply wheat at lower prices and consumers by $0.10. The effect of the tax on their behavior can
who would be willing to buy from them, but they are be illustrated by shifting the supply curve upward
prohibited from doing so. Those farmers who find by $0.10. Because of the tax, suppliers will require a
buyers at the higher minimum price benefit from the market price of $0.30 per minute to supply the quantity
legislation, but others find they are unable to earn any they previously supplied at a price of $0.20 per minute.
income and will likely be forced to go out of business.
This situation is illustrated in Figure 18c. The new
Taxes market equilibrium occurs at a market price of $0.26
All levels of government use taxes of one sort or per minute. At this price, suppliers receive $0.16 per
another to raise revenue that is used to pay for public minute. Notice that this is precisely the same outcome

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expenditures. An important issue that often comes up as we found when the tax was imposed on consumers.
in public discussion of taxes is who bears the burden This example illustrates an important point that is
of paying the tax. It would seem that government could true more generally. A tax creates a price wedge
control the distribution of burdens through legislation, between the amount consumers pay and the amount
but the results suggest that matters are not that simple. suppliers receive. This price wedge reduces the market
To make matters more concrete, let’s consider a tax on quantity, and regardless of who legally pays the tax,
mobile phone usage. Figure 18a illustrates the demand both consumers and suppliers share the cost of the
and supply in this market before any tax is imposed. tax. Recognizing this fact, we can depict the impact
In the competitive market equilibrium, cell phone calls of the tax in a third way, as is illustrated in Figure
cost $0.20 per minute, and consumers make 1 million 18d. Rather than shifting the supply or demand curve,
minutes of calls each day. Suppose the government we search for the point where the vertical distance
decides that mobile phones are a luxury and chooses to between the demand and supply curves is equal to
impose a tax of $0.10 per minute on consumers. From the amount of the tax. The heights of the supply and
the perspective of mobile phone users, the cost of a demand curves, respectively, at this point identify
minute of talk is now higher than before—it costs them the prices that suppliers receive and consumers pay.
$0.30 (= $0.20 + $0.10). Extending a vertical line downward from this point to
the horizontal axis identifies the equilibrium quantity
We can represent the effect of this change in Figure once the tax has been imposed.
18b as a downward shift in the market demand curve.
Notice that if the market price were $0.10, then With regard to consumer and producer surplus, the
consumers would face a cost of $0.20 per minute and tax has several effects. By introducing a difference
would demand the same quantity as they had in the between the price buyers pay and that received by
competitive market equilibrium (1 million minutes). suppliers, the tax prevents some otherwise mutually
So, the demand curve shifts down by $0.10, the beneficial transactions from taking place. This is
amount of the tax. The new market equilibrium occurs indicated by the small triangle to the right of the new
at a lower quantity than before, and as a result, the equilibrium quantity and between the supply and
price received by suppliers falls. In this hypothetical demand curves. This is a reduction in social welfare
example, the new equilibrium price is $0.16 per and is called the deadweight loss of the tax.

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 FIGURE 17

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Effect ofof aaPrice
Effect PriceFloor Floor
for Wheat for Wheat

The other effect of the tax is to transfer revenue to relative price elasticities of supply and demand. For
the government. The government collects $0.10 on any given supply curve, the less elastic the demand is,
every minute purchased at the new equilibrium. the greater the share of the tax paid by buyers. This is
The amount of this revenue is illustrated in Figure illustrated for two demand curves in Figure 19a. Figure
18d by the shaded rectangle. Initially people talked 19b depicts a similar comparison, showing how the
1 million minutes, but notice that a tax of ten cents elasticity of supply affects the division of the tax. One
per minute generates less than $100,000 ($0.10 × $1 final point that emerges from an examination of Figure
million) in revenue to the government. This is because 19 is that the less elastic the supply and demand curves
the tax has caused people to demand fewer minutes are, the smaller the effect of the tax on the equilibrium
of calling than before. As this diagram makes clear, quantity, and therefore the lower the deadweight loss of
the revenue that the government receives reduces the the tax.
combined consumer and producer surplus from these
transactions by an amount equal to the income that the INTERNATIONAL TRADE
tax produces for the government. One of the fundamental insights of economics is
that exchange makes people better off. It does so by
In our hypothetical example, suppliers paid 40 percent encouraging specialization. When individuals or
of the cost of the tax through reduced revenues, while countries specialize in the activity they do the best, the
buyers paid 60 percent of the cost of the tax through overall economic pie increases. These gains from trade
an increase in their cost per minute. In general, the are the reason that our modern economy is characterized
distribution of the burden of a tax depends on the

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 FIGURE 18

(a) MARKET EQUILIBRIUM FOR CELL PHONE MINUTES (b) EFFECTS OF A $0.10 TA X ON BUYERS

(c) EFFECTS OF A $0.10 TA X ON SUPPLIERS (d) A TAX AS A WEDGE BETWEEN BUYERS’

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AND SELLERS’ PRICES

Representing the
Representing the Effects
Effects of a Tax of a Tax

by such a high degree of interdependence. Each day he works for eight hours to produce food,
which he consumes. He can devote his time either to
To appreciate the gains achieved from trade, we need to harvesting coconuts or catching fish. Each hour that
begin by considering an isolated economy. Then, we can Robinson spends gathering coconuts is an hour that he
consider how the opportunity to trade alters well-being. does not spend catching fish. The opportunity cost of
the additional coconuts that he gathers is the quantity
An Isolated Economy of fish that he does not catch during that hour.
As a starting point, let’s consider a highly simplified
economy. Robinson is stranded on a tropical island. We can represent the trade-off that Robinson faces

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35
in terms of a production possibility frontier or PPF The slope of her PPF is –1, indicating that the
like that drawn in Figure 20a. In this diagram, we opportunity cost of one fish is one coconut. Crusoe can
measure the quantity of coconuts Robinson gathers on select any point along her PPF. But by the same logic
the vertical axis and the number of fish he catches on we used before, we know that at that point she will
the horizontal axis. The graph shows that if Robinson value one fish the same as one coconut. Let’s suppose
spends all eight hours gathering coconuts, he can that Crusoe is initially consuming eighteen fish and
collect twenty-four coconuts—this is the height of the eighteen coconuts at point B.
curve where it intersects the vertical axis. If he spends
all of his time catching fish, then he can catch eight One day, Robinson finds a boat and sails to Crusoe’s
fish—this is the distance from the origin to the point island. They begin to talk about their respective
where the PPF intersects the horizontal axis. consumption patterns, and Robinson proposes that if
they agree to trade, they can both be better off. Crusoe is
Robinson can select any point along the PPF, which we skeptical at first since she produces more fish and more
have drawn here as a straight line. The slope of this coconuts than Robinson, and so she cannot see how
line reflects the opportunity cost of coconuts in terms they could find an opportunity to trade. But Robinson
of fish. Since the PPF has a slope of –3, it indicates persists. He points out to her that at the moment they are
that Robinson must give up three coconuts to get producing a total of thirty-three coconuts (Robinson’s
one additional fish. All of the points on the PPF are 15 plus Crusoe’s 18) and twenty-one fish (3 + 18). But,
efficient from the perspective of production since along if Robinson were to devote eight hours to gathering
this line there is no way that Robinson can increase the coconuts, he could produce twenty-four. Meanwhile,
quantity of one good produced without reducing the if Crusoe were to spend two more hours fishing, then
quantity of the other. she could produce nine coconuts and twenty-seven

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fish. Together their combined production would be
The point that Robinson chooses along the PPF depends thirty-three coconuts (the same as before) and twenty-
on his relative preferences for fish and coconut. He seven fish (six more than before). If they split this extra
will select the combination of fish and coconuts that production, they could each increase their consumption
maximizes his satisfaction. Suppose that he selects a by three fish.
point like A, where he is consuming fifteen coconuts
and three fish. From our discussion of the demand Comparative Advantage and the Gains
curve, we know that at this point if Robinson is a
rational consumer, he will get just as much pleasure from Trade
from one more fish as from three coconuts. If this How can it be that Crusoe, who is better at everything,
were not so, then he could improve his well-being can be made better off by trading with Robinson?
by moving along the PPF. For example, if one fish The answer to this question lies in the insight that
gave him as much pleasure as two coconuts, he could what matters is not the absolute productivity of
reduce his consumption of fish by one and increase his either Robinson or Crusoe, but rather their respective
consumption of coconuts by three. Since it only takes comparative advantage. Even though Robinson
two coconuts to compensate for the fish he has given up, produces fewer coconuts per hour than Crusoe, he has
he would be better off. a comparative advantage in producing coconuts.
By changing their allocation of time between fishing
Adding the Opportunity to Trade and gathering coconuts, Robinson and Crusoe in effect
Crusoe lives on a nearby island, where she too gathers “transform” fish into coconuts. Robinson faces a cost
coconuts and catches fish. In Figure 20b we show of just 1/3 fish per coconut, while it takes Crusoe one
her PPF. Looking at her production, we can see that fish to produce a coconut. When Robinson specializes
Crusoe is better at catching fish than Robinson, and in producing coconuts and Crusoe specializes in
she is better at gathering coconuts. In an eight-hour producing fish, their collective economy can increase
day, she can catch thirty-six fish or gather thirty-six its total production.
coconuts. Because Crusoe’s PPF is above and to the
right of Robinson’s at every point, we say that she has The principle of comparative advantage offers a
an absolute advantage. profound insight about the opportunities for gains from

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FIGURE 19

(a) E FFECTS OF
ELASTICITY OF
DEMAND ON
IMPACT OF A TAX

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(b) E FFECTS OF
ELASTICITY
OF SUPPLY ON
IMPACT OF A TAX

Effects of Elasticity
Effects on
of Elasticity on the Impact
the Impact of a Tax of a Tax

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FIGURE 20

(a) ROBINSON’S PRODUCTION POSSIBILITIES

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(b) CRUSOE’S PRODUCTION POSSIBILITIES

Production Possibility
Production Frontiers
Possibility Frontiers

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FIGURE 21

(a) MARKET EQUILIBRIUM WITHOUT TRADE

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(b) MARKET EQUILIBRIUM WITH TRADE

Welfare Effects ofofIsolation

Welfare Effects and
Isolation and Free TradeFree Trade

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39
trade that applies equally to individuals and to nations. A+B+C to the area A+B+C+D, yielding a net increase
So long as trading partners differ in their comparative equal to the area denoted by D.
advantage, they can improve their overall well-being
by specializing. The more extensive the markets in For a country that becomes an importer, social
which they trade are, the greater the opportunities for welfare again increases, but now it is consumers who
specialization and the larger the gains from trade. benefit, while producers suffer losses. This situation
is illustrated in Figure 22, where the domestic
The Political Economy of Trade equilibrium price is above the world price. When trade
If trade increases a nation’s well-being, then why is allowed, the domestic price falls to the world price,
is there so much public opposition to international and the quantity consumed rises. Domestic producers,
agreements designed to promote freer trade? While however, respond to the lower price by reducing their
free trade expands the overall size of the economy, it supply. The difference between the quantity produced
also implies shifts in the size of different industries. domestically and the quantity consumed domestically
In the previous example, Robinson and Crusoe simply is made up by imports. Producer surplus declines from
reallocated their time. But when countries become the areas B+C to B, while consumer surplus increases
increasingly specialized, the costs and benefits of trade from A to A+C+D.
fall on different groups of people. As a result, even
though the gains from free trade exceed the losses, THE PROFIT MOTIVE AND
those citizens who will experience losses are likely to THE BEHAVIOR OF FIRMS
oppose freer trade. Economists use the term “firm” to describe the
economic actors who are responsible for supplying
To see this, let’s consider the impact of free trade in
goods and services in the economy. Firms combine

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more detail. We will begin by considering a small
labor, capital equipment, raw materials, and other
economy that is isolated from international markets
inputs to produce the products that we want to
because trade is prohibited. As a result, the domestic
consume. Up to now, we have used the supply curve
equilibrium is determined by the intersection of the
to summarize their actions. According to the law of
country’s supply and demand curves as depicted
supply, as the price of a good rises, firms are willing to
in Figure 21a. Suppose that the world price is PW,
supply a greater quantity. In many cases, this is all we
illustrated by the horizontal line above the domestic
need to know about the behavior of firms. But, in other
equilibrium price. Consumer surplus is equal to the
instances, we need to look more closely at how firms
sum of the areas marked A and B; producer surplus is
decide what to produce and how to produce it.
equal to the area C.
If the law prohibiting trade is removed, this country will Economic Profits and Accounting Profits
become an exporter, since its cost of supply is below the We assume a firm’s goal is to maximize profits.
world price. To simplify the analysis, we assume that Profits are defined as the difference between the
the country is so small relative to the world market that firm’s total revenue and its total costs. The meaning
its additional supply will not alter the world price. The of total revenue is fairly clear: it is the total quantity
equilibrium quantity will occur where the world price of output the firm produces for sale multiplied by the
intersects the country’s market supply curve. price it receives. Measuring total costs is a bit more
complicated. Economic costs include the opportunity
At PW, domestic consumers reduce their consumption. costs of all resources required for production. In
The difference between domestic consumption and the contrast, accounting costs will likely include only
quantity supplied is exported. Consumer surplus falls actual monetary expenditures.
because the price rises, and consumers purchase less
of the good. The value of their surplus is represented This distinction can be seen more clearly by considering
by the area labeled A. Producer surplus increases, an example. Consider Bob’s Bread Company. Bob’s is a
however. It is equal to the sum of the areas marked small bakery that sells a variety of freshly baked breads.
B, C, and D. So, producers benefit and consumers All of the baking is done in the back of the store, and
suffer when a country becomes an exporter. In total, Bob operates a retail shop at the front. Suppose that
however, social welfare increases from the area Bob sells 300 loaves of bread a day for $4 each. Total

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FIGURE 22

(a) MARKET EQUILIBRIUM WITHOUT TRADE

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(b) MARKET EQUILIBRIUM WITH TRADE

WelfareWelfare
EffectsEffectsof Isolation
of Isolation and Free and
Trade Free Trade

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revenues are $1,200 a day. cost is increasing, implying that marginal costs are
increasing as well.
Bob’s explicit costs include purchasing flour and other
ingredients, for which he pays $600 a day; hiring labor The bottom panel of the table provides the information
to produce the bread costs $300 per day; and renting necessary to determine Bob’s profit-maximizing
the shop in which he operates costs Bob $50 per day. production level. Because Bob can vary his production
These explicit costs total $950, leaving an accounting by amounts smaller than 50 loaves, we have calculated
profit of $250 a day. his marginal costs of production for the quantity shown
in each row for small changes in the quantity produced
But, we have not yet included all of the firm’s at that point. As a result, these values will differ
opportunity costs. Bob is a skilled retailer and, if he somewhat from the marginal costs you would calculate
were not managing his bread company, he could earn using the data in the top part of the table.6
$200 a day managing another store in town. Because
Bob gives up this income to manage his own business, Increasing marginal costs of the type illustrated
we must include this forgone income as part of his in Figure 23 are common in economics. Such a
economic costs. As a result, the true economic profit relationship usually arises because some of the factors
that Bob’s Bread Company earns is $50 per day. of production are fixed and cannot be increased in
the short run. In this case, Bob cannot increase the
Finding the Firm’s Supply Curve number of ovens available. As a result, once the ovens
In the example above, Bob is producing 300 loaves begin to fill up, the addition of more workers produces
of bread each day. How does he choose this level of less and less additional output. This is an example of
production? Recall that Bob’s objective is to maximize diminishing returns to scale.

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his profits. Some of his costs, such as the opportunity
cost of his time and the rent on the building and Bob’s marginal cost of production is the opportunity
equipment do not depend on the quantity of bread cost of supplying an additional loaf of bread since it
he produces and cannot be changed in the short run. measures the amount that Bob must spend to produce
These are what we call his fixed costs. However, the that loaf. The benefit that Bob gets from supplying
cost of Bob’s labor and materials can be varied in the another loaf of bread is the additional revenue that
short run. These are called his variable costs. it will produce. This additional revenue is called the
marginal revenue.
The table in Figure 23 summarizes information about
Bob’s costs of production. In the second column, we By assumption, the market for bread is perfectly
list his fixed costs. Because these do not depend on the competitive, meaning that the price Bob receives is not
quantity of bread Bob chooses to supply, they do not affected by the quantity he chooses to supply. From
change. In the third column, we show Bob’s variable his perspective, the demand curve is horizontal at the
costs of production. Notice that each time we move market equilibrium price of $4 a loaf. This means that
down a row, output increases by 50 loaves a day, but Bob’s marginal revenue is equal to $4 regardless of the
the additional cost of producing those additional loaves quantity he chooses to supply.
of bread increases from row to row. Combining the information about Bob’s costs with
The increase in costs that occurs when producing an the information about his marginal revenue, we can
additional unit of output is referred to as marginal now find his profit maximizing output. The necessary
cost. The marginal cost is calculated by dividing the information is summarized in the bottom panel of
increase in total costs by the increase in the quantity Figure 23. So long as Bob’s marginal cost of supplying
of bread produced. This additional cost is referred to an additional loaf of bread is less than $4, he can
as the marginal cost of production. For example, when increase his profits by producing and selling that loaf.
Bob increases his production from 50 to 100 loaves, Reading down the marginal cost column, we see that
his total costs increase from $358 to $483, and thus his Bob’s marginal cost equals $4 when he is producing
marginal cost of producing these additional loaves is 300 loaves of bread.
($483 –$358) / (100 – 50) = $2.50. As you go down the So long as diminishing returns to scale apply, marginal
rows in the top section of the table, the change in total costs will be rising as the firm’s output increases. As a

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result, the profit-maximizing firm’s supply curve will competitive.
be an upward-sloping line.
Firms in imperfectly competitive markets have the
Entry, Exit, and the Market Supply Curve same objective as firms in perfectly competitive
Bob is, of course, only one possible supplier of bread. markets: to maximize their economic profits. But
Other potential producers are likely to notice that Bob unlike firms in a perfectly competitive market, a firm
is making an economic profit of $50 a day. Recall that in an imperfectly competitive market can no longer
we have already accounted for the opportunity cost assume that its decision about how much to supply
of Bob’s time. The opportunity to earn extra profits does not affect the price at which its products can be
will induce some of these producers to rent shops and sold. Rather, the demand curve it faces is downward
equipment and begin producing bread as well. sloping, meaning that if it chooses to increase its
supply, the price it receives will be lower.
The addition of more producers has the effect of shifting
the market supply curve outward. And, this in turn Firms facing a downward sloping demand curve are
will cause the equilibrium price to fall. The entry of said to possess market power, meaning that instead of
additional producers will continue as long as there are taking prices as given, they have the ability to choose
positive economic profits to be earned in the market. market prices. Of course, they are not entirely free
Only when economic profits have reached zero will to choose any price since they are constrained by the
entry cease. In the same way, if economic profits were combinations of price and quantity determined by the
to fall below zero at some point—say because of a shift market demand.
in preferences that reduced the demand for bread—
producers would begin to leave the market, shifting to Monopoly

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other activities that offered greater opportunities. There are a wide range of different types of
imperfectly competitive markets. The simplest case to
Two points are worth emphasizing about this consider is the extreme situation of a single supplier, a
conclusion. First, in a competitive market business situation called a monopoly. Monopolies arise because
owners earn zero economic profits. They will, however, there are barriers to entry that prevent competitors
be content, because they are earning their opportunity from entering the market. The most important sources
wage. In other words, this remains their best alternative. of barriers to entry are:
Second, in addition to their role in rationing scarce 6 The ownership of a key resource. The market
goods, prices serve a second important function: for residential electricity supply is a monopoly
they allocate productive resources between different in most communities because a single company
activities. If prices exceed production costs in some owns the retail electricity distribution system.
activity, then the existence of positive economic profits It would not be possible for a competitor to
acts as a signal that additional resources should be establish another distribution system. Another
deployed to that activity to increase production. example is the market for diamonds. Until
recently the DeBeers company owned mines
IMPERFECT COMPETITION from which 80 percent of the world’s diamonds
Now that we understand how firms behave in perfectly are produced. Because diamonds can be
competitive markets, we can begin to develop an mined in only a few places, ownership of these
understanding of how markets that are not perfectly places allows for the establishment of what is
competitive work. Although perfect competition is effectively a monopoly.
a reasonable approximation for many parts of the Government-created monopolies. Many
6
economy, the markets for many important products monopolies are created when the government
are dominated by a small number of very large firms. gives the rights to supply a product to a single
Examples include the markets for commercial airplanes, company. Patent and copyright laws are one
automobiles, and ride sharing services. In other cases, mechanism through which such exclusive
such as electricity, water, and cable television, there is rights are granted. If the government grants a
only a single supplier in any community. Economists patent to an inventor who has developed a new
call markets with one or only a few suppliers imperfectly technology, he or she is awarded the exclusive

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 FIGURE 23

QUANTITY FIXED COST + VARIABLE COST = TOTAL COST CHANGE IN TOTAL COST

50 $250 $108 $358

100 $250 $233 $483 $125
150 $250 $375 $625 $142
200 $250 $533 $783 $158
250 $250 $708 $958 $175
300 $250 $900 $1,150 $192
350 $250 $1,108 $1,358 $208
400 $250 $1,333 $1,583 $225
450 $250 $1,575 $1,825 $242

MARGINAL MARGINAL TOTAL TOTAL

QUANTITY REVENUE COST REVENUE – COST = PROFITS

50 $4.00 $2.33 $200 $358 –$158

100 $4.00 $2.67 $400 $483 –$83

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150 $4.00 $3.00 $600 $625 –$25
200 $4.00 $3.33 $800 $783 $17
250 $4.00 $3.67 $1,000 $958 $42
300 $4.00 $4.00 $1,200 $1,150 $50
350 $4.00 $4.33 $1,400 $1,358 $42
400 $4.00 $4.67 $1,600 $1,583 $17
450 $4.00 $5.00 $1,800 $1,825 –$25

Bob’s Bread Company

Bob’s Bread Costs
Company Costs and Revenues
and Revenues

right to utilize the technology for twenty years services in Smallville, which is served by a single
in exchange for revealing the details of his/ provider Local Media. The table in Figure 24 shows
her innovation. Under copyright law, an author the demand for cable television service is negatively
becomes a monopolist over the book he or she related to the price of a monthly subscription. At a
has written. price of $20, no one will purchase the service, but
Natural monopolies. An industry is a natural when the price falls to $19 a month, 100 households
6
monopoly when a single firm can supply the will subscribe. As the price falls further, demand
market at a lower cost than could two or more increases. Local Media can choose to supply at any
firms. This happens when there are large fixed combination of price and quantity along the demand
costs that cause the firm’s average costs to be curve. Its total revenue at that point is equal to the
falling at a scale of production that can serve price times the quantity.
the entire market. Railroads, pipelines, and What happens to the company’s revenues as it selects
cable television are all examples of markets different points along the demand curve? For example,
that are prone to natural monopoly. consider moving from point A in the graph in Figure
Monopoly Supply 24, where price equals $16 and the quantity is 400,
To illustrate the supply decision of a monopolist, let’s to point B where the price is $15. The additional
consider the example of the market for cable television subscribers generate more revenue, but to achieve this,

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the company must lower its price to existing subscribers. First, there is a transfer of consumer surplus to Local
At point A total revenue is $6,400, and at point B it rises Media because those subscribers willing to purchase
to $7,500. Lowering the price and increasing supply service at the monopoly price would have been
increases total revenue, but the marginal revenue— able to purchase this service at a lower price in the
the incremental increase in revenues produced by competitive case. Second, there is a reduction in social
each additional subscriber—is less than the price of well-being because Local Media restricts supply to
service. Here the additional 100 subscribers generate be less than the competitive quantity. The additional
just $1,100 in additional revenue, an increase of $11 output would cost less to produce than its value
per subscriber, even though the price of a monthly to consumers. But, Local Media will not supply it
subscription is $15. The difference is attributable to the because to do so would reduce the revenue it gets from
fact that Local Media must lower the price it charges subscribers who place a higher value on the service.
its existing subscribers to attract additional customers.
Dealing with Monopolies
What price should Local Media choose and how much Because of the negative effects that monopolies create,
should it supply at this price? The profit-maximizing government policymakers have adopted a variety of
strategy that we identified for a firm in a competitive responses intended to reduce the impact of monopoly.
market—increase supply until marginal cost equals Beginning with the passage of the Sherman Anti-
marginal revenue—still applies for a monopolist. As Trust Act in 1890, the federal government has sought
long as marginal revenue is greater than marginal cost, to use legislation to increase market competition.
increasing supply causes economic profits to increase, As a result, large mergers and acquisitions must be
but increasing supply beyond this point causes profits reviewed by government regulators to insure that they
to begin to decline. do not reduce competition in key markets. Anti-trust

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Figure 25 illustrates the application of this strategy. regulators can also break up companies, as happened
Local Media’s marginal cost curve is drawn as upward when AT&T was split up in 1984, or take other steps
sloping, reflecting the fact that adding additional to restrict anti-competitive practices, such as the
subscribers requires the extension of the network, requirement that Microsoft unbundle its Internet
which requires increasingly costly equipment. Local browser from the Windows operating system.
Media’s marginal cost curve intersects the marginal Another widely used approach is regulation. Many
revenue curve at a quantity of 700 subscribers. At this natural monopolies are allowed to exist but are closely
quantity, the marginal cost and marginal revenue are regulated. Public utilities such as electric power
both $7, and the height of the demand curve indicates companies and cable television providers cannot freely
that demand equals 700 when the price is $13 per set prices, but must have rates approved by public
month. Local Media’s profit-maximizing choice is to oversight agencies. A third approach to the problem
set the price at $13 and provide 700 subscriptions. of monopoly is public ownership. Local water, sewer,
and sanitation services are often operated by municipal
Welfare Consequences of Monopoly governments, for example.
If cable TV service in Smallville had been provided by
a competitive market with marginal costs equivalent Price Discrimination
to Local Media’s, then the market equilibrium would In the monopoly example we considered before, we
occur at a lower price and higher quantity, as can be assumed Local Media charged the same price to all
seen from the location of the intersection of the market of its customers. But, what would happen if it could
demand curve with the marginal cost curve. Compared charge different prices to different customers? If Local
to this hypothetical competitive outcome, the Media could charge each customer a price equivalent
monopoly supplies a lower quantity at a higher price. to the value that customer placed on its service, then
It may also earn an economic profit. But, because of it could avoid the negative effect of expanding sales
barriers to entry, there is no competition to drive these on the revenue earned from existing customers. By
profits toward zero. charging different prices, Local Media’s marginal
From the point of view of social welfare, the fact revenue curve would be identical to the market demand
that Local Media is a monopoly has two effects. curve, and it would choose to supply a quantity

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FIGURE 24

PRICE OF QUANTITY DEMANDED TOTAL REVENUE MARGINAL

SERVICE (100 S OF HOUSEHOLDS) =P Q REVENUE

20 0 $0
19 1 $1,900 19
18 2 $3,600 17
17 3 $5,100 15
16 4 $6,400 13
15 5 $7,500 11
14 6 $8,400 9
13 7 $9,100 7
12 8 $9,600 5
11 9 $9,900 3
10 10 $10,000 1
9 11 $9,900 –1
8 12 $9,600 –3
7 13 $9,100 –5

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6 14 $8,400 –7
5 15 $7,500 –9

DemandDemand
andand
Marginal Revenue
Marginal Revenue of a Monopoly
of a Monopoly

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 FIGURE 25

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Monopolist’s Quantity
Monopolist’s Supplied
Quantity Supplied and Price and Price

equivalent to the competitive market outcome. price discrimination strategy.

Such a strategy is called perfect price discrimination. Price discrimination further increases monopoly
While companies can rarely discriminate perfectly profits by allowing the monopoly to capture a greater
between customers, it is easy to identify examples of fraction of the benefits produced by each transaction.
ways that firms seek to separate customers into groups But, price discrimination also has the positive effect of
who value their product differently. One way that cable increasing social welfare by moving the market closer
companies can price discriminate, for example, is by to the socially efficient quantity.
offering different packages of channels. Those who
value the service most highly are likely to buy a large Oligopoly
package at a higher price. Relatively few industries are true monopolies. In many
more cases, a small number of producers supplies
There are many other examples of price the bulk of the market. In the United States, the
discrimination. Many movie theaters offer lower priced manufacture of tennis balls, breakfast cereals, aircraft,
tickets for children and senior citizens, consumers electric light bulbs, washing machines, and cigarettes
who are likely to have a lower willingness to pay. are all industries in which production is highly
Airlines typically charge lower prices for travelers concentrated.7 Economists call a market with only a
who stay over a Saturday night. While leisure travelers few sellers an oligopoly.
will accept this condition in exchange for lower fares,
business travelers, whose willingness to pay is higher, In comparison to monopoly markets, oligopoly markets
will not. College need-based financial aid is another are much harder to analyze. The reason for this is that

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in such markets, producers must consider not only the produce similar but differentiated products. An example
characteristics of the downward-sloping demand curve of such a market is book publishing. Each particular
that they face, but also the choices that other suppliers title is unique and distinctive, but there are thousands of
will make. In other words, there is an opportunity for titles for you to choose from when you are looking for
strategic interaction between the different suppliers. a book. Other examples include restaurants, clothing,
breakfast cereals, and many local service industries.
If the suppliers could agree, for example, to cooperate
and behave like a monopolist, total industry profits Because the product of each firm is differentiated—
could be maximized. Such an agreement is called meaning that you can tell the difference between its
a cartel, and it is illegal under U.S. anti-trust law. product and those of other firms—the firm faces a
There are also significant economic forces at work downward-sloping demand curve. As a result, each
to undermine efforts by the members of potential firm chooses its output in the same way a monopoly
cartels to collude. If a cartel is successful in restricting firm does, by finding the point at which its marginal
output, then marginal revenue will be greater than revenue equals its marginal cost. Because the firm’s
the marginal cost of production for each firm in the demand curve slopes downward, marginal revenue
industry, creating a temptation to increase production. is less than price, so at this point the market price is
Of course, such an increase in supply lowers the greater than the marginal cost of production.
market price, but much of this negative effect is felt by
the other members of the cartel. We have seen that at the profit-maximizing quantity,
a monopolist will earn positive economic profits. In a
The Organization of Petroleum Exporting Countries monopolistically competitive market, however, if firms
(OPEC) provides a good illustration of the problem that are earning positive profits this will lead to the entry

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cartels face. Because it is an international agreement of new firms supplying similar goods or services. As
between sovereign nations, OPEC does not face legal the range of choices available to consumers expands,
obstacles to its efforts to coordinate production and existing firms will see their demand curves shift to the
raise prices. In the 1970s, OPEC played an important left, causing profits to fall.
role in raising oil prices from $11 a barrel in 1972 to
$35 a barrel in 1981. Tempted by the high price of oil, Because there are no barriers to entry in a
many of its members began to increase production, monopolistically competitive market, entry will
and by 1986 oil prices had collapsed back to $13 a continue until profits have been reduced to zero. If at
barrel. In April 2020, in response to share reductions some point profits fall below zero, there will be exit
in demand for oil due to the COVID-19 crisis, OPEC from the industry, which will continue until the zero
initiated a record reduction in oil output. In part due economic profit equilibrium is restored.
to this significant reduction in the supply of oil, prices A full analysis of the welfare properties of
increased sharply over the subsequent months. monopolistically competitive markets requires more
As these considerations suggest, oligopoly outcomes sophisticated mathematical analysis. But there are
depend critically on the circumstances of each market. several points to note about such markets. First,
We can nonetheless conclude that the outcome will lie because price exceeds marginal cost, there is some
somewhere between the polar cases of monopoly and social inefficiency: there are consumers who value the
perfect competition. As a rule then, oligopoly results in product at more than the cost of increasing production.
some reduction in social welfare, but we cannot easily The failure to complete these transactions is a failure
say how large this reduction will be. to fully exploit mutually beneficial exchanges. This
failure occurs because of the firm’s monopoly incentive
Monopolistic Competition to restrain production. Second, the diversification of
Perhaps the most common form of imperfect products that results from the efforts of firms to create
competition is monopolistic competition. As its name a distinctive identity for their product creates benefits
suggests, monopolistically competitive markets combine for consumers by increasing the range of choices
aspects of the perfectly competitive and monopoly available to them.
models. Specifically, these are markets in which firms

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CREATIVE DESTRUCTION: economic profits, it also serves to break down existing
market imperfections because the existence of profits
THE PROFIT MOTIVE AND encourages efforts to invent around existing barriers
THE SOURCES OF ECONOMIC to entry. Examples of this include the development of
CHANGE satellite television in competition with the monopoly
When we considered the entry and exit of producers of cable television and the efforts of mobile phone
in a competitive market in the previous section, we manufacturers to imitate the Apple iPhone.
came to the somewhat surprising conclusion that even The continued development of new and improved
though producers in a perfectly competitive market products is one of the key sources of long-run
would earn zero profits, they would be satisfied improvements in well-being, a fact that economist
with this result. In part this is a consequence of our Joseph Schumpeter sought to capture when he
definition of economic profits, which factors in the described the impact of entrepreneurs as a type of
opportunity cost of all of the resources employed, “creative destruction.” The essential catalyst of creative
including the business owner’s time. destruction is the opportunity to earn economic
Economic profits, then, are an additional payment profits. But, the inefficiency in resource allocation that
above and beyond the compensation that can be earned creates these economic profits is—in the view of many
in the next best alternative activity. We should not be economists—small in comparison to the benefits of the
surprised, then, that self-interested economic agents innovation to which it gives rise.
should seek to identify or create opportunities to earn
economic profits. One important way that they can MARKET FAILURES
do this is by escaping the constraints of competitive Our study of competitive markets has revealed the

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markets. When producers can create barriers to entry, remarkable way in which they coordinate the self-
they can create situations of imperfect competition in interested actions of market participants to produce
which they are able to earn economic profits. socially desirable outcomes. Market prices ration
scarce goods and services so that they go to those
As we saw earlier, in comparison to a hypothetical consumers who value them most highly. At the same
competitive market outcome, imperfectly competitive time, the search for economic profits encourages the
markets create inefficiencies because producers restrict allocation of scarce resources toward the production of
supply as part of their effort to maximize profits. But, those goods and services that are valued most highly.
this comparison of different market structures fails to
capture an important aspect of the actual way in which Of course, not all markets fit the ideal of perfect
economies evolve over time. One of the important routes competition. But, in these cases, the opportunities
that firms take to establish market power is innovation. to profit by facilitating mutually beneficial exchange
encourages private actors to move closer to the socially
Entrepreneurs are individuals who take on the risk of efficient outcome. Monopolists, for example, have an
attempting to create new products or services, establish incentive to find ways to price discriminate, while the
new markets, or develop new methods of production. opportunities for private profit tend to break down
The rewards of entrepreneurship are the economic efforts by cartels to restrict output. Where these forces
profits that can be earned by being the first to market are not sufficient, economic theory can help us to
with a new product. In the case of scientific innovation, evaluate possible policy solutions.
entrepreneurs can obtain a legal monopoly through
patents; but in other cases market power arises because There are some circumstances, however, in which
of their ability to differentiate the goods or services competitive markets will fail to produce socially
they produce from other products in the market. desirable outcomes. These circumstances are called
Entrepreneurs can differentiate their product by market failures. Most instances of market failure can
defining the desirable characteristics of their product be grouped into two broad categories.
or by the possession of trade secrets. The first type of market failure arises because of
At the same time that innovation helps to create externalities. An externality arises when the actions
barriers to entry that reward the innovator with of one person affect the well-being of someone else,

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but neither party pays nor is paid for these effects. on the negative consequences of carbon-dioxide
When the effect of these actions is beneficial, it is (CO²) emissions. Again, because the businesses and
called a positive externality; when the effect of these individuals do not take into account the negative
actions causes harm, it is called a negative externality. impact of their activities on the global climate, this is
The second type of market failure occurs when the an externality.
institution of private property breaks down. When it
is impossible to establish private property rights in The Effect of Externalities on Resource
important economic goods or services, we refer to the Allocation
goods or services in question as public goods. In general, there will be too little of an activity that
Addressing the problems of externalities and public generates positive externalities and too much of an
goods is one of the most compelling roles for activity that generates negative externalities. To see
government in our economy. Economics allows us to this, let’s consider the example of a paper plant. As a
understand more precisely how the characteristics of by-product of producing paper, the plant also produces
externalities and public goods affect market outcomes polluted waste that it dumps untreated into a nearby
and can provide important guidance when considering river. Figure 26a shows the market for the plant’s
the options for policies to correct these market failures. primary product: paper. The firm’s supply curve is
upward sloping, reflecting the fact that its marginal
Externalities costs are increasing as production rises. The demand
A widely cited example of an externality involves curve is drawn as downward sloping.
beekeepers and apple growers. In the course of As we have seen, the competitive market equilibrium
producing honey, the bees pollinate the apple trees, occurs at the point where the demand and supply curves

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increasing the size and value of the farmer’s crop. intersect. This is the quantity the profit-maximizing
Since the value of the apple crop does not figure firm will choose to supply. But this decision does not
in the beekeeper’s costs or benefits, it constitutes take account of the social costs that the firm’s actions
an externality. Since the farmer benefits from the impose on the downstream community. For simplicity’s
beekeeper’s actions, it is a positive externality. sake, let’s assume that the cost of removing the pollutant
One can easily find many other examples of similar produced by the paper company is a constant amount of
types of interactions. For example, when movie $15 per unit of paper that it produces.
studios release movies on blu-ray discs, they increase The true social cost of the firm’s production is equal
consumer demand for blu-ray disc players, which to the firm’s marginal cost plus the cost of treating the
increases the revenue of their manufacturers. In this pollution it produces. We can represent the true social
instance, the externality operates in the other direction cost of production, then, by drawing a new supply curve
as well because increases in the sale of blu-ray players that is shifted up by $15 at every point. This is illustrated
increases consumer demand for the studios’ movies. in Figure 26b. Notice that the curve representing total
When a new highway interchange is built on a busy social costs intersects the demand curve above and to
freeway, it increases traffic on nearby roads, raising the left of the private market equilibrium. The socially
their value as business locations. This is a positive optimal level of production is lower than the amount
externality for the landowners. supplied by a profit-maximizing firm because the firm
Externalities can have negative consequences as well. fails to take account of the external costs.
If one of your neighbors fails to maintain his house, it An important implication of the analysis illustrated
can have a depressing effect on the value of your home. in Figure 26 is that the optimal level of a negative
Pollution is another example of a negative externality. externality is not zero. Rather, there is likely to be
Runoff from farm fields containing traces of fertilizers some positive level of the externality that will be
and pesticides commonly finds its way into nearby consistent with maximizing consumer and producer
rivers. As a result, downstream communities that take surplus. This is true because the activity that generates
their drinking water from these rivers have to spend the externality has a positive value, and the cost of
more money treating this water before distributing it. reducing this activity too greatly will outweigh the
Concerns about climate change have focused attention

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additional benefits of reducing the externality. him of caring for it, they will be able to negotiate an
appropriate payment that makes both of them better
We can use a similar approach to analyze a case of off. Of course, if the benefit to Sue is less than the cost
positive externalities. Figure 27 illustrates the market to Tad, then they will not reach an agreement, but in
for honey that a beekeeper faces. Here the demand this case, that is the efficient solution.
curve reflects only the value that consumers place on
the honey the beekeeper supplies. But, since each unit Notice that we have assumed that Tad is under no
of honey also results in an increase in the value of the obligation to maintain his yard. Suppose, however,
crop of nearby orchards, the true social value of the that a local ordinance requires that he do so, and Sue
activity is shifted up by the amount of this increase. As can compel him to do so by reporting him to city
this analysis suggests, the resulting equilibrium occurs officials. In this circumstance, Tad could negotiate
above and to the right of the equilibrium when the with Sue, offering to pay her to put up with his poorly
externality is not accounted for. maintained yard. If the value Sue places on having a
well-kept yard to look at is less than the cost to Tad of
Private Responses to Externalities cleaning it up, they will be able to arrive at a bargain
The existence of externalities creates incentives for where he pays her to put up with his yard. If his cost of
market participants to attempt to solve the problems cleaning up the yard is less than the value Sue places
they create. In the case of the beekeeper and the apple on having his yard well maintained, then they will not
grower, total revenues would increase if the beekeeper reach a bargain, and he will be obliged to take care of
expanded his production. This additional revenue his yard. But in this case, this is the efficient solution.
could be divided between the two parties so that both
increased their profits. Similarly, in the case of the As this example illustrates, Tad and Sue will arrive at

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negative externality caused by the paper company, the the efficient solution regardless of whether Tad is free
downstream community could pay the paper company to ignore the upkeep of his yard or is required to keep
to produce less or to take other steps to prevent the it neat. One of the important insights of the Coase
pollutant from entering the river in the first place. Theorem is that the initial distribution of rights does not
Again, such an arrangement would leave both parties affect the ability of the parties to come to an efficient
better off. agreement. So long as the property rights are clearly
defined, the parties will arrive at the efficient solution.
Another approach to solving the problem of
externalities is to internalize them by combining Of course, if matters were this simple, then
the activities that produce the externality within a externalities would be only a minor footnote rather
single company. For example, Netflix started out than an important topic in economics. The reason they
by streaming movies and TV shows that had been are often a problem is that in many cases property
produced by other companies. In recent years, rights are poorly defined, or nonexistent, and the
however, Netflix has started producing its own content; costs of negotiating between the affected parties are
in doing so, Netflix is combining activities that could prohibitively high. As an example, consider an oil
produce externalities within a single company. refinery that pollutes the water of a nearby river used
for recreation or fishing. The pollution can cause
As long as the parties involved can negotiate with each significant damage even miles downriver from the
other, the private market should be able to resolve the refinery, so the effects can be extremely diffuse.
inefficiencies created by externalities. This insight
was first reached by Ronald Coase and is often called Given that the pollution can negatively impact so
the Coase Theorem. To illustrate this point, consider many people, the total effects are large. However, the
the case of two neighbors, Tad and Sue. Tad lets his individuals affected have little incentive to negotiate
grass grow long and does not take good care of his with the oil refinery to reduce its pollution—and
yard. Sue must look at the yard from her front porch, Coase pointed out that the damages are reciprocal in
which reduces her enjoyment, and it also lowers the nature. Prohibiting the pollution would help those who
value of her house. She can offer to pay Tad to take fish in the river while harming the refinery whereas
better care of his yard. So long as the value she places allowing the pollution would help the refinery while
on the appearance of Tad’s yard exceeds the cost to harming those who use the river. In any case, the costs

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FIGURE 26

(a) MARKET EQUILIBRIUM

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(b) THE SOCIALLY OPTIMAL LEVEL OF PRODUCTION

The Impact ofThea Impact

Negative Externality
of a Negative ononthe
Externality Socially
the Socially Optimal
Optimal Level of Level of Production
Production

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of negotiating between the many people who use the a natural occurrence; it is a social innovation. The
river and the oil refinery are prohibitively high, so a importance of this innovation becomes clear when
negotiated solution is highly unlikely to emerge. we consider what happens when valuable economic
resources have no owner.
Government Regulation of Externalities
When private bargaining fails, governments can To illustrate the importance of private property, let’s
sometimes step in to resolve the matter. Since the consider what happens to property that no one owns
problem of externalities arises because the actions of in this simple example. A village located next to a lake
private parties do not fully reflect the social costs or has six residents, each of whom has $100 in savings
benefits of their actions, one solution is to use taxes or they can use to either purchase a government bond
subsidies to correct this problem. An example of the use that pays 15 percent interest, or to purchase a fishing
of taxes to address negative externalities can be seen boat necessary to catch fish in the lake. The number of
in cases where some cities have implemented or are fish each resident can catch depends on the number of
considering implementing congestion pricing. Under residents who catch fish. This relationship is shown in
such a system, drivers in certain parts of cities must pay the table in Figure 28. If only one villager purchases
fees to drive. New York City became the first U.S. city a boat, then he/she can catch $130 worth of fish, and
to approve congestion pricing in April 2019. Under the his/her net income is $30 ($130 in income minus the
New York plan, for-hire drivers are required to pay a fee $100 cost of the boat). If two villagers buy boats, then
for every trip into certain parts of Manhattan, but that they catch $120 worth of fish each, and each earns a
policy will be extended to all drivers in 2020.8 net income of $20. The average value of fish caught
declines as additional villagers buy boats because
Using taxes to remedy the effect of externalities is most they are all fishing in the same lake, and as each one

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effective when it is possible to estimate the value of depletes the fish population, it becomes increasingly
the externality. In many cases, this information is not difficult for others to find fish.
readily available. So it may be more effective to reduce
a negative externality by establishing a quota limiting Imagine, first, that the villagers decide one at a
the activity that produces the externality. If such an time whether to purchase a boat or to invest in the
approach were to be used to reduce traffic congestion, government bond, and that the decisions are public.
then a target number of vehicles would be set and How many villagers will purchase boats? If a villager
only that many permits would be issued. Of course, a purchases the government bond, he/she will earn $15
problem with this approach is that the drivers who get interest income at the end of the year. He/she should
permits may not be those who value them most highly. only purchase a boat if his/her income from fishing
But, this can be resolved by creating a market in which is $15 or more. From the table, we can see that three
drivers can buy and sell permits. villagers will purchase boats. After three boats are
purchased, the fourth villager will see that his/her
The United States Environmental Protection Agency income from fishing will only be $10 and will choose
(EPA) has used this approach to deal with sulfur to purchase a government bond. Total income in the
dioxide emissions. After establishing a maximum level village will be $90 per year. Three villagers will
of emissions, the EPA auctioned off the rights to emit earn $15 each from fishing (3 × $15 = $45), and three
sulfur dioxide to the highest bidders. A similar approach villagers will earn $15 each from bonds (3 × $15 =
is used in California, which created an emissions $45).
trading system in 2013. The California system sets a
cap on greenhouse gas emissions each year but allows Is this the socially optimal allocation of resources?
companies to buy and sell pollution credits in auction Suppose that the villagers got together and decided
markets, which allows them some flexibility in how they collectively how to allocate their resources? To
achieve the emissions reductions. maximize village revenue, the villagers should invest
in fishing boats only if the marginal contribution to
Property Rights village revenue exceeds the marginal cost. In this case,
Having grown up in a market economy, the existence the cost of purchasing a boat is the opportunity cost of
of private property seems quite natural to most of not purchasing the government bond, or $15. The table
us. However, the institution of property rights is not in Figure 28(b) calculates the marginal income from

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FIGURE 27

(a) SUPPLY AND DEMAND IN THE MARKET FOR HONEY

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(b) THE MARKET FOR HONEY WITH EXTERNAL BENEFITS OF HONEY BEES

The EffectThe
ofEffect
External Benefits
of External Benefits in the
in the Market Market for Honey
for Honey

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 FIGURE 28

(a) VILLAGE INCOME

NUMBER AVERAGE VALUE NET INCOME INTEREST TOTAL VILLAGE

OF FISHERMEN OF FISH CAUGHT FROM FISHING + INCOME = INCOME

1 130 30 75 105
2 120 40 60 100
3 115 45 45 90
4 110 40 30 70
5 105 25 15 40
6 100 0 0 0

(b) MARGINAL REVENUE

NUMBER MARGINAL REVENUE

OF FISHERMEN FROM FISHING

1 30

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2 10
3 5
4 –5
5 –15
6 –20

When Some
WhenResources
Some Resources AreAre NotProperty
Not Private Private Property

fishing for each additional fisherman. The marginal the commons. When a resource is owned jointly, no
revenue generated by the first boat is $30. But the one takes account of the negative externalities caused
purchase of a second boat raises income from fishing by overuse. We have seen in the previous section that
only to $40, so the marginal contribution to village taxes or other regulations can ameliorate the effects
revenue is $10. The villagers should purchase just one of externalities. But a simpler solution is to create
boat. Total income will be $30 from fishing, plus $75 = property rights in the resource.
5·$15 from interest income, or $105.
Suppose that in the previous example we allow for one
When the villagers make their choices independently, of the villagers to purchase the lake. The owner can
they fail to account for the external effects of their then decide how many boats to allow on the lake. We
fishing on the income of other boat owners. Because have seen that the most profitable choice is to allow a
the fish in the lake are a common resource, one single boat on the lake, which generates an income of
villager’s decision to purchase a boat and catch fish $30. So, if the lake is privately owned, resources will
reduces the income that others can earn from fishing. be allocated in the most efficient manner.
The villagers do better when they decide collectively
because they internalize the externality. How much would one of the villagers be willing to
pay to purchase the lake? Since the opportunity cost
The Effects of Private Ownership of investing in the boat is the $15 forgone interest, the
The example we have just considered is a version of owner of the lake would earn $15 profit if he or she
a problem that is often referred to as the tragedy of could use the lake for free. The most one of the villagers

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would be willing to pay to purchase the lake is $100. left corner of Figure 29. Examples of such goods are all
At this price, the purchase of the lake yields the same around us—they include pizza, gasoline, and haircuts.
return as buying a government bond. If the villagers
invest the $100 paid by the purchaser in a government Common Resources
bond, then they can divide the additional income that it In the lower left-hand corner of the table in Figure
generates, thus raising all of their incomes. 29 are goods that have a high degree of rivalry in
consumption, but a low degree of excludability. These
Public and Private Goods are common resources that suffer from the problem
In the example we just considered, private ownership of the tragedy of the commons: because no one owns
of the lake solves the allocation problem created by them, they will tend to be over-utilized. Fish in the
a common resource. But private ownership may not ocean provide an illustration. Every fish that is caught
always be a feasible solution. Some resources like the by one person is not available to be caught by someone
oceans or the atmosphere are not easily privatized. else. But, because it is difficult to limit access, it is
Recent developments in economic theory have helped difficult to make the fish a private good.
to clarify the characteristics of goods that can easily be
Goods that are rival in consumption but not owned are
privatized versus those that cannot. To understand this
the source of externalities. As we discussed earlier,
distinction, we need to differentiate goods along two
there are strong incentives for private actors to find
dimensions.
ways to internalize these externalities. When these
The first of these dimensions is the extent of rivalry in incentives are insufficient, however, public policy
consumption. Most goods have the characteristic that can seek to establish property rights or use taxes
one person’s consumption of them reduces the amount and other types of regulatory controls to address the

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that is available for others. For example, if you consume inefficiencies created by a common resource.
a slice of pizza, then there is one less slice available for
your friend. We say that pizza is a rival good. On the Collective Goods
other hand, when you listen to a radio broadcast, your Goods that have a low degree of rivalry but a high
enjoyment of it does not diminish the ability of other degree of excludability (upper right corner) are termed
listeners to enjoy it as well. The radio broadcast is a collective goods. Such goods can easily be privatized,
non-rival good. Note that rivalry is not always a black but they are often natural monopolies because non-
or white condition. On a lightly traveled highway, the rivalry in consumption means that the marginal cost
presence of one driver may not interfere with the value of producing them is zero or close to zero. Examples
of the road to other drivers. But as congestion increases, include satellite radio and pay-per-view television.
and traffic approaches the road’s capacity, then A monopoly can profitably supply these goods, but it
additional drivers will begin to have a negative effect. has an incentive to set the price too high and supply
The second dimension is the degree of excludability. too little, thus leading to an inefficient outcome. This
This describes the ability to control who consumes the characteristic may lead to regulation or to government
good. National defense is a non-excludable good. If the provision of collective goods.
military protects the country from invasion, all of its Public Goods
citizens benefit from this protection. Similarly, if your The final category of goods combines non-rivalry
city puts on a fireworks display on the Fourth of July, it in consumption with non-excludability. These are
is difficult to prevent people from seeing it. In contrast, true public goods. Because it is difficult to exclude
it is easy to exclude someone from consuming a slice consumers, it is difficult for private actors to charge
of pizza by simply not giving it to them. Figure 29 for these goods. And, because they are non-rival in
summarizes this two-way categorization. consumption, the marginal cost of their provision is
Private Goods close to zero.
Conventional private goods are characterized by a high Many public goods are provided by the government.
degree of rivalry in consumption and a high degree of But, in some instances public goods, such as television
excludability. This corresponds to the entry in the upper and radio broadcasts, are supported in other ways—

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 FIGURE 29

EXTENT OF RIVALRY IN CONSUMPTION

EXTENT OF
EXCLUDABILITY HIGH LOW

Private Goods Collective Goods

• Pizza • Satellite radio
HIGH
• Haircuts • Websites
• Gasoline • Pay-per-view movies

Common Resources Public Goods

• Fish in the ocean • Radio broadcast
LOW
• The environment • Tornado siren
• City streets • National defense

Four Types
Four Typesof Goods
of Goods

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such as through advertising or private donations. It is complex topic, and we can only begin to touch on the
likely, however, that when public goods are supplied most important insights of this branch of economics
this way that the quantity supplied will be too low. here. But the topic is, nevertheless, vitally important.
One illustration of this is the vastly greater number of Differences in standards of living around the world are
channels available via cable and satellite TV than via vast today, and economists believe that in large part
over the air broadcast. Because subscribers to cable these differences are due to variations in the success
or satellite providers pay directly for programming, a with which different societies have dealt with the
much greater variety of content is available than can be challenge of organizing collective decision-making.
supported by advertising alone.
Collective decision-making begins with institutions.
INSTITUTIONS, Institutions are both formal and informal rules that
structure human interaction. Most markets are, in
ORGANIZATIONS, AND this sense, institutions; so too are marriage and child-
GOVERNMENT rearing practices and norms such as how much to tip a
One of the central insights of economics is how waiter in a restaurant. Like institutions, organizations
markets help to convert the actions of self-interested help to organize human interaction, but do so through
individuals into socially desirable outcomes. As we formal rules and structures. Commodity and stock
have seen, however, this conclusion may not hold exchanges are organizations as are corporations and
when producers have a degree of market power, or organized religions.
when market failures occur because of externalities or
An important limitation constraining institutions and
circumstances that make it difficult to define private
organizations is the need for voluntary cooperation.
property rights. In these cases, collective decision-
For this reason, self-interested individuals will
making mechanisms may be necessary to overcome the
conform to social institutions or participate in
effects of these departures from perfect competition.
voluntary organizations only so long as that
Understanding how collective decision-making cooperation makes them better off. Cooperation in
processes have emerged in modern economies is a some contexts can indeed improve social welfare, but,

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as we have seen in the case of cartels, there can be economic agents, whose interests may diverge from
powerful incentives to cheat on voluntary agreements. those of the larger community. Economics can help
us to identify and understand these conflicting forces
In comparison to private institutions and organizations, more clearly.
government possesses two distinctive powers. The
first of these is the ability to tax its citizens. Private Pork Barrel Politics
businesses can earn revenue only by selling their Pork barrel politics refers to the proclivity of elected
products. Consumers will only buy their products if officials to introduce projects that steer money to their
they value them more than their prices. In contrast, communities. Such projects are often popular with the
government can compel the payment of taxes. Of course voters who matter for the particular legislator, but the
this power is not absolute. In the United States, citizens combined effect of these projects is to increase the cost
are free to move between cities, counties, and states, of government.
and they can vote with their feet if they dislike the
level of taxation in one area by moving someplace else. To understand this problem, it may help to think about
Similarly, citizens of any of the member countries of an experience you may have had before. You have gone
the European Union are free to move from one country out with four of your friends to a restaurant and agreed
to another. Other types of international mobility are that to simplify matters you will split the bill evenly.
more limited. The United States imposes significant When the waiter asks if you want dessert, you look at
restrictions, for example, on legal immigration into the the menu and see that you can purchase a hot fudge
country, as do most other countries. sundae for $4. You value the sundae at no more than
$3, so if you were dining alone you would skip dessert.
The second distinctive power of government is the But you do the math and realize that if you order the

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legal monopoly on the legitimate use of force. This sundae your share of the bill will only increase by $0.80
power is used to restrain criminals, compel military ( = $4/5). As result, you order it. Not surprisingly, your
service, and to protect national security. Clearly the friends make a similar calculation for themselves, and
government’s ability to use force underlies its ability you wind up paying an additional $4 each.
to collect taxes. The government’s ability to compel
citizens to act in ways that are not in their individual A similar logic is at work in the legislative process. A
self-interest is also essential to supporting a system member of the House of Representatives might, for
of private property on which the whole system of example, be able to introduce an amendment to a bill
voluntary exchange rests. that will bring $100 million in benefits to his/her district.
The cost of the program to the federal government is
Government also helps to support a broader range $150 million (so clearly the costs outweigh the benefits).
of voluntary cooperation than would otherwise be But the cost to the community is just a small fraction of
possible through activities such as the enforcement this, since it will be supported by all taxpayers, not just
of contractual obligations. Contracts represent those in the affected community. For the representative’s
agreements entered into voluntarily because both constituency this is a terrific deal. They get $100
parties anticipate that they will gain from the million in benefits for a small fraction of this amount in
agreement. But, subsequent changes may cause one increased taxes.
party to regret having entered into the agreement.
Of course the legislation has to get the support of a
Without the courts to enforce such agreements,
majority of the House members to be passed into law.
individuals would be far more reluctant to enter into
Why would a legislator representing another district
them in the first place.
support legislation that will increase the cost to his
The powers that governments possess are truly constituents without producing any benefits? The
awesome. As we have suggested, they can be used answer is that by supporting his/her colleague’s pet
to fix problems that prevent private economic actors project, the legislator can win support for his/her own
from achieving efficient outcomes. But government pet project. This vote trading activity is commonly
can also be a source of inefficiency and corruption. called logrolling, and much like the restaurant
We must remember that both elected officials and example above, it accounts for a certain amount of
government employees are themselves self-interested wasteful government spending.

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Rent Seeking Similarly, government can, as we noted earlier, correct
A related source of inefficiency arises because market failures arising because of externalities and
the gains from many government programs are public goods; however, the ability to rectify these
concentrated, while the costs are spread widely. An problems also gives rise to inefficiencies. People may
example of this problem is the current U.S. policy of genuinely differ in their evaluation of the relative costs
price supports for domestic sugar producers. These and benefits of these trade-offs.
supports combined with restrictions on the importation
of cheaper sugar from outside the country keep U.S. SECTION II SUMMARY
sugar prices at nearly twice world levels. A report in 6 The interaction of supply and demand in
2017 found that resulting losses to households are from markets is the central topic of microeconomics.
$2.4–$4 billion in total. Spread across a population 6 A market consists of all the buyers and sellers
of over 300 million, the cost per person is relatively of a particular good or service.
small. But the benefits to the small number of sugar
6 The model of a perfectly competitive market
producers are much larger. Sugar growers have a
applies to situations in which the numbers
strong and compelling motivation to hire lobbyists and
of buyers and sellers is large, all the market
spend money to influence key legislators to continue
participants are well informed about the market
price supports. Most voters, however, are unaware of
price, and the good or service being exchanged
this policy, and even those who are aware of it would
is highly standardized.
be unlikely to find it worth the effort to oppose it.
6 The demand curve graphs the quantity of a
Even when the overall benefits of projects exceed good or service that buyers are willing and
their costs, they may generate wasteful resource able to purchase at each price. According to

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allocation. Competition to influence the location of the law of demand, the quantity demanded is
expensive federally supported activities can lead to negatively related to the price.
the expenditure of large amounts of money seeking to
6 The position of the demand curve depends
influence decision-makers.
on income, the prices of related goods, tastes,
In general, socially unproductive activities that seek expectations, and the number of buyers.
simply to direct economic benefits to one set of actors 6 The supply curve graphs the quantity of a good
rather than another are called rent seeking. or service that producers are willing and able
to supply at each price. According to the law
What Is the Proper Role for of supply, the quantity supplied is a positive
Government? function of the price.
Determining what functions the government should The position of the supply curve depends on
6
play, how big it should be, and how much it should the prices of inputs used in the production
regulate are normative judgments that must be made of the good or service being exchanged, the
on grounds that extend beyond purely economic technology used to produce it, expectations,
considerations. Nonetheless, economics helps to and the number of sellers.
illuminate the issues and frame these choices more
clearly. 6 In a perfectly competitive market, equilibrium
occurs when no market participant has any
Government is not essential to the establishment of reason to alter his or her behavior. The only
a market economy, but the enforcement of the rule point that satisfies this requirement is the point
of law helps to support a much broader range of where the supply and demand curves intersect.
transactions than would be possible without it. Most The competitive market equilibrium
6
of us are willing to accept the small loss of individual maximizes the combined benefits or total
autonomy for the protection of property and the surplus of market participants.
individual security that this entails. But, unconstrained
government can become an intrusive force that can 6 One important use of the competitive market
substantially reduce individual freedoms. model is to analyze how changes in economic
conditions affect the equilibrium price and

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 quantity as well as the surplus of market equilibrium quantity and a higher equilibrium
participants. price. This outcome causes total surplus to be
Elasticity provides a measure of the lower than it would be in a competitive market.
6
responsiveness of supply and demand to price 6 The economic profits that arise in imperfectly
changes that is independent of the units used to competitive markets are the incentive that
measure price and quantity. motivates entrepreneurs to develop new goods
Governments intervene in markets for a variety and services, new markets, or new methods of
6
of reasons. They may set price ceilings or price production.
floors. Governments may also impose taxes on 6 Market failures occur when externalities or
certain types of transactions to raise revenues breakdowns in the system of private property
to pay for essential services. cause market outcomes to deviate from the
Trade makes people better off. International socially efficient outcome.
6
trade increases total surplus. 6 Externalities occur when there are important
Not everyone in an economy benefits from economic interactions that do not take place
6
trade, however, which explains why there is through markets. One solution is to create a
often opposition to free trade. market for these interactions; another solution
is government regulation.
6 Firms are the economic actors who supply
goods and services by combining labor, capital, 6 All goods and services can be classified along
raw materials, and other inputs to produce the two dimensions: (1) the extent of rivalry in
products consumers want to purchase. Firms consumption and (2) the ease of excludability.

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seek to maximize their economic profits. This two-way classification allows us to
identify four categories of goods and services:
6 In a competitive market, the entry and exit of private goods, common resources, collective
firms insures that the firms in the market earn goods, and public goods.
zero economic profits.
6 Institutions, organizations, and governments
6 The model of perfect competition cannot be help to organize human interactions through
applied to all parts of the economy. There formal and informal rules. Governments are
are many different types of imperfectly distinguished from private organizations
competitive markets. The most important cases through their ability to compel citizens to pay
are monopoly (a single supplier), oligopoly (a taxes and their monopoly on the legitimate use
small number of suppliers), and monopolistic of force.
competition (many suppliers of similar but
differentiated products). 6 Government is an important factor in
enhancing well-being through its support of
6 Imperfect competition arises because of private property and market transactions,
barriers to entry into the market. but pork barrel politics and rent seeking are
6 Relative to perfectly competitive markets, inefficient outcomes that arise because of how
imperfect competition results in a lower governments operate.

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 Section III
Macroeconomics
As is true in the physical sciences, the methods and economic policy. Knowing how these concepts are
approaches that are most effective in understanding defined and interpreted is important for everyone and is
economic phenomena depend on the type of questions essential to understanding the behavior of the economy.
we are asking. For example, biologists studying the
operation of particular molecules use models and types The remainder of this part of the resource guide
of data that are different from those used by scientists will develop a theoretical framework for analyzing
who wish to understand larger ecosystems, even aggregate economic performance. We begin by
though the same fundamental principles apply. describing factors that determine the size of an
economy in the long run. We then will consider the
In the same way, when economists wish to understand role of the financial system and the uses of money.
the performance of an entire economy—how much Finally, we will turn to the causes of short-run
it produces or what causes national unemployment fluctuations in economic activity.

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rates to fluctuate—the models and data they use are
different from those that they use when they want to MACROECONOMIC ISSUES
understand what happens in specific markets, such as We have said that macroeconomics is concerned with
the market for petroleum. The branch of economics the performance of national economies. To get a more
that studies the performance of national economies is concrete sense of why this is important and what it
called macroeconomics. means, it will be helpful for us to look at a number of
aspects of the U.S. economy.
This section of the resource guide provides an
introduction to the major questions addressed in Economic Growth and Living Standards
macroeconomics and describes the most important One of the most remarkable facts about the U.S.
approaches to these questions. Broadly speaking, economy is its long-run history of growth. Figure
macroeconomics is concerned with two questions. 30 illustrates the growth of total output of the U.S.
The first concerns the factors that determine the long- economy from 1900 to the present. The measure
run growth in the size of economies, the standard of of output used in Figure 30 is real Gross Domestic
living that they provide for their participants, and the Product (GDP). This is a measure of the total quantity
price level. The second issue concerns the causes and of goods and services produced in the economy,
consequences of short-run fluctuations in the level of adjusted to remove the effects of inflation. We will
economic activity, unemployment, and inflation. discuss in more detail how output is measured shortly,
We will begin this part of the resource guide by but for now, let’s focus on what Figure 30 shows.
presenting some evidence about these issues that helps According to these data, since 1900, the total real
to motivate our subsequent analysis and by discussing output of the U.S. economy has increased by a factor
the types of aggregate economic indicators that are of nearly forty.9 There are some small ups and downs
used to describe the performance of the aggregate apparent in this chart—most notably the decline in
economy. These include measures such as Gross output between 1929 and 1933 (the Great Depression)
Domestic Product (GDP), the cost of living, and the and the expansion of output from 1941 to 1945 (World
unemployment rate. These measures figure prominently War II). Viewed on this time scale, however, the
in public discussion of the state of the economy and impact of these events is dwarfed by the expansion of

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 FIGURE 30

$20,000,000

$18,000,000

$16,000,000

$14,000,000

$12,000,000

$10,000,000

$8,000,000

$6,000,000

$4,000,000

Taylor High School - Katy, TX

$2,000,000

$0
1900
1904
1908
1912
1916
1920
1924
1928
1932
1936
1940
1944
1948
1952
1956
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
2008
2012
2016
SOURCE: Louis Johnston and Samuel H. Williamson, “What Was the U.S. GDP Then?” MeasuringWorth, 2020 
URL: http://www.measuringworth.org/usgdp/. All values expressed in 2012 prices.

Real Output of the U.S. Economy, 1900–2019

the size of the overall economy. While average output per capita provides an indication
of what the typical person can consume, economists
At the level of the overall economy, what we can are also interested in changes in what the average
consume is limited by what we produce. One reason person can produce. The economy’s total output
for the rising level of production historically has been divided by the total number of workers employed is
the growth in population. More people can produce called average labor productivity. This is a measure
more output. But output has grown much faster than of how much the typical worker can produce. The
population. Since 1900, the U.S. population has second (higher) line in Figure 31 shows the history of
increased by a factor of more than four. Combining average labor productivity since 1900.
this information with the data in Figure 30 implies the
average output per person has increased by a factor The average output per person in the U.S. economy
of nearly eight. Figure 31 illustrates the growth of in 2019 was over $65,000. To put this figure in
output per person. Economists refer to this quantity perspective, Figure 32 compares total output and
as output (GDP) per capita. The term “per capita” is output per person in the United States to a selection
a Latin phrase literally meaning “per head,” which is of other countries around the world. The range of
commonly used to denote averages calculated for an variation in production per person is remarkably large.
entire population. Despite having a population nearly five times as large
as the United States, China’s total production is only

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62
 FIGURE 31

----
----
$120,000
----
---- $100,000
----
---- $80,000
----
$60,000
----
---- $40,000
----
---- $20,000
----
----
$0
1900
1906
1912
1918
1924
1930
1936
1942
1948
1954
1960
1966
1972
1978
1984
1990
1996
2002
2008
2014

Taylor High School - Katy, TX

----
----
---- Output per capita Output per worker
----
SOURCES: Louis D. Johnston and Samuel H. Williamson, “What Was the U.S. GDP Then?” MeasuringWorth, 2020.
---- URL: http://www.measuringworth.org/usgdp/.
Carter, Susan B., “Labor force, employment, and unemployment: 1890-1990.” Table Ba470-477 in Historical Statistics of the United States,
---- Earliest Times to the Present: Millennial Edition, edited by Susan B. Carter, Scott Sigmund Gartner, Michael R. Haines, Alan L. Olmstead,
Richard Sutch, and Gavin Wright. New York: Cambridge University Press, 2006. http://dx.doi.org/10.1017/ISBN-9780511132971.Ba340-651.
---- U.S. Department of Labor, Bureau of Labor Statistics, “Current Population Survey,” ftp://ftp.bls.gov/pub/special.requests/lf/aat1.txt.
Output valued in prices of 2012.
----
Real Output per Capita and per Worker, 1900–2019
----
----
about two-thirds that of the United States while its per countries at the bottom of the list in Figure 32.
capita output is only about 15 percent as large as in the
United States. The countries with the lowest levels of Human happiness, of course, depends on more than
production per person in this list are in South Asia and just the material level of consumption that we are able
Africa. While India, for example, is starting to catch to achieve. Living a long and healthy life, access to
up to wealthier countries, its output per capita is only education, and a clean environment are also important.
3.2 percent that of the United States.10 But, the reality is that the material resources created
by higher levels of production make possible longer
Even in the United States and other advanced life, broader access to education, better healthcare,
economies, such as those of Japan and Western and a cleaner environment. These relationships are
Europe, there are still many people living in poverty. illustrated in Figure 33, which shows the relationship
But even the poorest citizens of these countries enjoy between output per person and several other indicators
access to a bounty of material goods that far exceeds of quality of life.
the consumption possibilities of the typical resident of

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 FIGURE 32

GDP GDP per capita
Billions of $ Index (USA=100) $ Index (USA=100)
United States 21,427.7 100.0 65,280.7 100.0
Germany 3,845.6 17.9 46,258.9 70.9
United Kingdom 2,827.1 13.2 42,300.3 64.8
France 2,715.5 12.7 40,493.9 62.0
Japan 5,081.8 23.7 40,246.9 61.7
South Korea 1,642.4 7.7 31,762.0 48.7
Russia 1,699.9 7.9 11,585.0 17.7
China 14,342.9 66.9 10,261.7 15.7
Mexico 1,258.3 5.9 9,863.1 15.1
Brazil 1,839.8 8.6 8,717.2 13.4
Egypt 303.2 1.4 3,020.0 4.6
Nigeria 448.1 2.1 2,229.9 3.4
Ghana 67.0 0.3 2,202.1 3.4

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India 2,875.1 13.4 2,104.1 3.2
Pakistan 278.2 1.3 1,284.7 2.0
Source: https://data.worldbank.org.

Output and Output per Capita in 2019 in Different Countries.

Recessions and Expansions The alternation of periods of expansion and recession

If you look closely at the line showing total output in is referred to as the business cycle. These fluctuations
Figure 30, you will see that the rate at which the U.S. are one of the fundamental features of the economy
economy’s output has grown is not steady. There are that macroeconomics seeks to explain. Because
periods of rapid growth and periods of slower growth, periods of recession are associated with declining
or even decline. The decline in real output during the employment opportunities and slower wage growth, a
Great Depression is particularly striking as is the sharp central focus of macroeconomic policy is to find ways
increase during the Second World War (1941–45).11 We to reduce the severity and duration of such periods.
can also see in these data the recession that coincided
with the 2008 financial crisis. Unemployment
The unemployment rate is the percentage of the
The variability of the growth of output is more labor force that would like to work but cannot find
obvious in Figure 34, which plots the percentage employment. The labor force is made up of all
change in output between successive years. A period individuals who are employed or unemployed. When
between a trough and a peak in economic activity is the unemployment rate is high, it is hard to find work,
called an expansion; a period between a peak and and people who do have jobs generally find it harder to
a trough in economic activity is called a recession. earn promotions or increase their pay. Figure 35 shows
When a recession is particularly severe, it is called a the unemployment rate since 1900.
depression. The period from 1929 to 1933 is the most
severe episode of economic decline observed to date In general, the unemployment rate goes up during
and is called the Great Depression. recessions and falls during expansions. You can see
that the unemployment rate was especially high during

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 FIGURE 33

GDP PER CAPITA LIFE EXPECTANCY ADULT LITERACY

INTERNET USAGE
IN U.S. DOLLLARS AT BIRTH, IN RATE
(% IN 2018)
(2019) YEARS (2018) (% IN 2018)
Brazil 8,717.2 76 93 70
China 10,261.7 77 97 54
Egypt 3,020.0 72 71 47
France 40,493.9 83 * 82
Germany 46,258.9 81 * 90
Ghana 2,202.1 64 79 39
India 2,104.1 69 74 34
Japan 40,246.9 84 * 91
Mexico 9,863.1 75 95 66
Nigeria 2,229.9 54 62 42
Pakistan 1,284.7 67 59 16
Russia 11,585.0 73 100 81

Taylor High School - Katy, TX

South Korea 31,762.0 83 * 96
United Kingdom 42,300.3 81 * 95
United States 65,280.7 79 * 87
SOURCE: https://data.worldbank.org.
*Data not reported.

Output per Capita and Other Development Indicators.

the Great Depression. Figure 35 illustrates two other choices within markets. When the price of a particular
important points about the unemployment rate. good—say a gallon of gasoline—rises, this increase
signals consumers to reduce their consumption and
First, the unemployment rate is never zero. There creates incentives for suppliers to increase production.
are always some people searching for work. This When all prices rise together, economists call this
reflects the continual entry of new job-seekers into inflation. Because inflation means that all the things
the labor market as well as the shifting fortunes of people consume are becoming more expensive,
different industries, regions, and businesses within inflation reduces purchasing power and makes people
the economy. Even in expansions, some companies worse off. We will see that inflation imposes other
are closing, while others are growing. Even during the economic costs as well. So, keeping inflation low is
Great Depression, when many employers were laying another important goal of macroeconomic policy.
off workers, others were expanding their workforce.
Second, despite the huge changes that have taken place Figure 36 shows the U.S. inflation rate since 1900. As
in the economy since 1900, there is no indication that this figure makes clear, the rate of inflation has varied
the unemployment rate is increasing in the long term. considerably over time. Prices generally increase over
time, but there have been some periods during which
Inflation the price level fell. Most notably, this occurred during
We have seen that the prices of individual goods and the Great Depression, but we also saw the price level
services play a central role in coordinating individual fall during the 2008 financial crisis.

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65
hen?' MeasuringWorth, 2020.

FIGURE 34

25.0%

20.0%

15.0%

10.0%

5.0%

0.0%
1900
1903
1906
1909
1912
1915
1918
1921
1924
1927
1930
1933
1936
1939
1942
1945
1948
1951
1954
1957
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
2011
2014
2017
‐5.0%

Taylor High School - Katy, TX

‐10.0%

‐15.0%

Annual Percentage Change in Real GDP, 1900–2019

International Trade imported. Since the 1970s, the relationship has shifted,
National economies are linked to one another through and imports are greater than exports.
international trade. Because of its size, the United
States is relatively less dependent on trade than many MACROECONOMIC
other, smaller countries. While international trade MEASUREMENT
has generally increased since the 1950s, the level of In our description of the behavior of the U.S. economy
exports and imports as a share of GDP has fallen over in the previous section, we made use of concepts like
the past few years in the United States. the total national output, inflation, and unemployment.
Figure 37 plots the volume of exports from the United Constructing measures that capture the overall
States to other countries and the volume of imports to behavior of the national economy involves aggregation.
the United States since 1929 as a percentage of total Aggregation is the combination of many different things
output. When exports exceed imports, economists into a single economic variable. Well-constructed
say that a country is running a trade surplus. When economic aggregates help us to see the big picture, but
exports are less than imports, they say that a country is at the cost of obscuring important details.
running a trade deficit. Developing appropriate economic aggregates is
In the long run, the levels of imports and exports an important branch of macroeconomics, and
appear to move in similar ways. But there have been understanding the choices that go into the construction
shifts in their relative levels. Up until the late 1950s, of these aggregates is important if we are to fully
the United States generally exported more than it understand what their behavior tells us about the

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66
over
https://data.bls.gov/timeseries/LNU04023554&series_id=LNU04000000&series_id=LNU03023554&
Table Ba470-477 - Carter, Susan B. , “Labor force, employment, and unemploym
FIGURE 35

25.0

20.0

15.0

10.0

5.0

Taylor High School - Katy, TX

0.0
1900
1904
1908
1912
1916
1920
1924
1928
1932
1936
1940
1944
1948
1952
1956
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
2008
2012
2016
SOURCES: Carter, Susan B., “Labor force, Employment, and Unemployment: 1900–2019.” Table Ba470–477 in Historical Statistics of the
United States, Earliest Times to the Present: Millennial Edition, edited by Susan B. Carter, Scott Sigmund Gartner, Michael R. Haines, Alan L.
Olmstead, Richard Sutch, and Gavin Wright. New York: Cambridge University Press, 2006.
http://dx.doi.org/10.1017/ISBN-9780511132971.Ba340–651.
United States, Bureau of Labor Statistics, http://www.bls.gov.

Unemployment as a Percentage of the Civilian Labor Force

economy. In this section, we will describe in more The answer that economists have developed to this
detail how the most important macroeconomic question is called Gross Domestic Product (or GDP).
variables are defined, and we will discuss the Formally, GDP is defined as: “the market value of all
significance of these definitions. final goods and services produced within a country
during a specified period of time.” This definition is
Measuring Total Output: Gross short, but there are several important points to note
Domestic Product about it.
Earlier we presented data showing the growth of the total
Market Value
output of the U.S. economy. But, how can we measure the
To combine all the different types of things that a
total output of an economy? How do we add up haircuts,
country produces, we use their dollar value to add
personal computers, fast food hamburgers, financial
them up. Suppose, for example, that an economy
advice, automobiles, and the myriad other goods and
produced only two goods: t-shirts and shorts, and
services produced by an economy?
that t-shirts sell for $5 each, while shorts sell for $10.

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67
e Annual Consumer Price Index for the United States, 1774‐Present,' MeasuringWorth, 2020. 
FIGURE 36

25.0%

20.0%

15.0%

10.0%

5.0%

0.0%
1900
1904
1908
1912
1916
1920
1924
1928
1932
1936
1940
1944
1948
1952
1956
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
2008
2012
2016

Taylor High School - Katy, TX

‐5.0%

‐10.0%

‐15.0%

NOTE: calculated as year-to-year change in the GDP Deflator

SOURCE: Louis D. Johnston and Samuel H. Williamson, “What Was the U.S. GDP Then?” MeasuringWorth, 2020.
URL: http://www.measuringworth.org/usgdp/.

Annual Rate of Inflation

If the economy produced 100 t-shirts and 25 pairs of purchase iron ore from a mining company. Because
shorts, then its GDP would be 100 × $5 + 25 × $10 the automobile is the end product of this chain of
= $750. Because of the use of market prices, higher- purchases, we count only its value in GDP and exclude
priced goods contribute more to total GDP. Recall the purchase of inputs that are used up to produce the
from our discussion of microeconomics that market car. Goods that are used up in the production of a final
prices reflect the value that the marginal consumer good are called intermediate goods.
places on the good. So, goods that have higher prices
have a higher value to consumers and therefore should Excluding intermediate goods from GDP insures that
contribute more to total output. our measure of GDP is not affected by the extent of
vertical integration in the economy. This is important
Final Goods and Services to avoid the possibility of double counting the value
Most of the products we consume are the result of a of some goods. To see this, consider the following
complex chain of production activities. For example, alternative scenarios. First, suppose a steel producer
automakers purchase steel from refiners, who in turn sells $200,000 worth of steel to an auto manufacturer,

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68
DP

FIGURE 37

20.0%

18.0%

16.0%

14.0%

12.0%

10.0%

8.0%

6.0%

4.0%

Taylor High School - Katy, TX

2.0%

0.0%
1929
1932
1935
1938
1941
1944
1947
1950
1953
1956
1959
1962
1965
1968
1971
1974
1977
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010
2013
2016
2019
Exports Imports

SOURCE: Irwin, Douglas A., “Exports and Imports of Goods and Services: 1929–2019.” Table Ee376-384 in Historical Statistics of the United
States, Earliest Times to the Present: Millennial Edition, edited by Susan B. Carter, Scott Sigmund Gartner, Michael R. Haines, Alan L. Olmstead,
Richard Sutch, and Gavin Wright. New York: Cambridge University Press, 2006. http://dx.doi.org/10.1017/ISBN-9780511132971.Ee362-611.

Exports and Imports as a Percentage of GDP

and the auto manufacturer converts the steel into suppose Sylvia raises tomatoes. In one year, she
$1 million worth of automobiles. The steel is an produces $200 worth of tomatoes. She sells $100
intermediate good because it is used to produce the worth at a local farmers market and uses the other
automobiles. Now, suppose the automaker produces its $100 worth to make tomato sauce, which she sells
own steel and sells $1 million worth of automobiles. for $200. Sylvia’s contribution to GDP is $300—the
Notice that in both cases the value of the steel is result of adding the $100 worth of tomatoes she sells to
included in the value of the automobiles. By excluding consumers and the $200 worth of tomato sauce. We do
the transaction involving the intermediate good, we not count directly the $100 worth of tomatoes used to
arrive at the same contribution to GDP regardless of produce the sauce, but it is reflected in the value of the
the pattern of industry ownership. final product that it is used to produce.
Some goods can be either final goods or intermediate Capital goods do not fit easily into either of the
goods. In this case, we only count that portion of categories we have discussed so far. Capital goods are
production that is sold to final users. As an example, long-lived goods that are themselves produced and are

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69
used to produce other goods and services but are not provided an additional impetus for perfecting techniques
used up in production. Machinery and factory buildings of measuring output and establishing the necessary data
are examples of capital goods. For the purpose of collection tools to produce ongoing estimates of GDP.
consistency, economists have adopted the convention In 1971, Kuznets received the Nobel Prize in Economic
that capital goods are included in GDP in the year they Science in part for his contributions to the measurement
are produced. If we did not count them, then a country of national production.12
that invested in its future by building capital equipment
would appear to have a lower GDP than one that used all The continued use of the concepts developed by
its resources to produce consumer goods. Kuznets, and their subsequent refinement by other
scholars, reflects the practical value of these concepts.
Within a Country But, it is important to recognize that despite the
The word “domestic” in Gross Domestic Product usefulness of these ideas, they have a number of
indicates that we count only goods produced within the important limitations. Three of these are described
borders of the country that we are discussing. So, U.S. below.13
GDP includes the value of all automobiles produced in
First, as we have already noted, it is not always easy to
the United States, whether made by an American auto
determine what constitutes final goods and services.
manufacturer or by a foreign-owned one.
One illustration of this point is the treatment of
During a Specified Period expenditures on national defense. Conventionally these
Production takes a certain amount of time, but we only are included in GDP, but Kuznets pointed out that they
include items that are produced between the beginning might equally well be viewed as an intermediate good
and end of the period in question. Conventionally that enables the citizens of a country to enjoy other

Taylor High School - Katy, TX

economists consider either annual or quarterly (three- final goods and services.
month periods) GDP. An important implication is that A second limitation of GDP arises from its exclusion
the sale of goods produced in earlier periods is not of goods that are not bought and sold in markets. One
included in GDP. For example if a twenty-year-old very important example is unpaid household work.
house is sold this year for $150,000, then this amount is Housekeeping and childcare performed by family
not included in GDP. The house was not produced this members are not counted in GDP, but if these services
year. It was included in GDP when it was produced, so are purchased in the market, then they are. Over the
we don’t count it again when it changes hands. On the past sixty years, as women have increasingly entered
other hand, if the real estate agent who arranged the the paid labor force, the amount of commercially
sale received a 6 percent commission, this $9,000 fee is provided childcare and housecleaning has increased,
included in GDP since the real estate services the agent causing GDP to rise. But, because some of this increase
provided were produced in the current year. is simply a shift from non-market to market activity, it
does not in fact reflect an increase in total production.
Understanding What GDP Measures
The conceptual basis for the measurement of GDP A third limitation of conventional GDP measurement
was developed in the 1930s. Interest in measuring is that it ignores activities that deplete a country’s
economic output is longstanding, however. One of the stock of natural resources or pollute the environment.
earliest known efforts to measure national output was Although economic theory provides some guidance
undertaken by Sir William Petty in the mid-1600s as about how natural resources and environmental quality
part of the British government’s effort to assess the should be valued, actually measuring their value has
ability of the Irish people to pay taxes to the crown. proved more difficult.
Because the lack of comprehensive data on national Other Ways to Measure GDP:
economic activity was hampering efforts to respond to
the Great Depression, in 1932 the U.S. Department of Expenditures Equal Production
Commerce commissioned the economist Simon Kuznets GDP is a measure of the quantity of goods and services
to develop a system to measure national output. Kuznets produced in a country. But, since goods that are
presented his system in a report to the U.S. Senate produced are also purchased, we can also think of GDP
in 1934. The U.S. entry into the Second World War as a measure of the total value of expenditures within

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 FIGURE 38

T-SHIRTS SHORTS GDP

QUANTITY PRICE QUANTITY PRICE NOMINAL REAL
2015 100 $5.00 25 $10.00 $750.00 $750.00
2020 200 $7.50 50 $15.00 $2,250.00 $1,500.00
2020 relative to 2015 2 1.5 2 1.5 3 2

T-SHIRTS SHORTS GDP

QUANTITY PRICE QUANTITY PRICE NOMINAL REAL
2015 100 $5.00 25 $10.00 $750.00 $750.00
2020 200 $7.50 75 $15.00 $2,625.00 $1,750.00
2020 relative to 2015 2 1.5 3 1.5 3.5 2.3
Calculation of Real GDP

a country. Economists divide purchasers into four Notice that economists’ use of the word “investment”

Taylor High School - Katy, TX

categories: households, firms, government, and the is somewhat different from the word’s use in ordinary
foreign sector (that is foreign purchasers of domestic conversation. In ordinary conversation, we often
products). Each of these categories corresponds to a describe the purchase of financial assets, such as
category of spending. shares of stock or bonds, as making an investment.
Such purchases transfer ownership of an existing
Household purchases are called consumption financial or physical asset, but do not create new assets.
expenditures, or consumption for short. These In economics, the term “investment” is reserved for
purchases are subdivided between consumer durables, the purchase of new capital goods, such as buildings or
nondurables, and services. Consumer durables are long- equipment.
lived consumer goods such as automobiles, washing
machines, and furniture. Note that expenditures on Government purchases include all of the goods
new houses are included in investment rather than in and services purchased by federal, state, and local
consumer durables. Consumer nondurables are goods governments. These include wages paid to firefighters
that are used up more quickly than durable goods, such and teachers and purchases of fighter planes for the
as food or clothing. Services are intangible goods such military. In addition to purchasing goods and services,
as education, legal services, insurance, and financial governments make transfer payments, such as paying
services. Social Security benefits. These transfer payments are
not counted in government purchases of goods and
Spending by firms on final goods and services, along services and neither is interest paid on government debt.
with household purchases of new houses, comprise
investment. Investment is subdivided into three Net exports is the difference between the value
categories. Business purchases of factories, offices, of domestically produced goods sold to foreigners
machinery, and equipment is called business fixed (exports) and the value of foreign-produced goods
investment. The purchase of new homes and apartment purchased by domestic buyers.
buildings is called residential fixed investment. The
final category of investment spending is inventories, The relationship between GDP and the various
which consists of additions of unsold goods to categories of spending can be summarized by
company inventories. the equation GDP = C + I + G + NX, where C
is consumption, I is investment, G is government

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71
spending, and NX is net exports. by using prices from a single year to value production
in each year. This year is called the base year. For the
Yet Another Way to Measure GDP: example shown in Figure 38, if we use the pries in
Income Equals Production Equals 2015 as the base year, then real GDP in 2020 would
be calculated by taking the 2020 levels of production
Expenditures and multiplying by the 2015 prices for each good. For
We have seen that GDP can be measured either in
example, real GDP in 2020 = (200 x $5) + (50 x $10) =
terms of production or spending. In addition, GDP can
$1,500, twice the real GDP in 2015 and consistent with
be thought of as income. Whenever a good or service
the doubling of production of each good.
is sold, the revenue is distributed between the workers
and the owners of the capital used to produce it. Except The bottom panel of Figure 38 illustrates the
for some minor technical adjustments, the combined calculation of real GDP in a more complicated
income of labor and capital equals expenditures, situation where production does not grow at the same
which equals production. As a result, we can state the rate for the different goods. In this case, the quantity
following important identity: GDP = Production = of t-shirts doubles, while the quantity of shorts
Expenditures = Income. produced triples. Using 2015 prices as the base year,
GDP in 2020 is now $1,750 = 200 × $5 + 75 × $10.
For this reason, economists use these three different
To clearly distinguish the current year GDP from real
designations interchangeably when discussing the
GDP, economists commonly call GDP calculated with
nation’s GDP.
current year prices nominal GDP. As Figure 38 shows,
nominal GDP in 2020 is $2,625. The increase in real
Real GDP GDP is $1,750 / $750 = 2.33, which is somewhere

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Recall that GDP is calculated by adding up the
between the quantitative increase of the two products
market value of all the goods and services produced
of the economy.
(purchased) in a country during a specified period.
As a result, the size of the resulting sum depends on
Measuring Inflation
both the quantity of goods and services produced and
To measure inflation, the U.S. Bureau of Labor
their respective prices. Because economists are often
Statistics calculates the Consumer Price Index
interested in comparing the level of economic activity
or CPI each month. The CPI measures the cost of
over time or between different locations, it is important
purchasing a market basket of goods and services
to have a way to separate the effects of changes in
intended to be representative of the consumption of a
prices from changes in the quantity of goods and
typical consumer. To identify the components of the
services produced.
market basket, the Bureau of Labor Statistics (BLS)
The problem posed by changing prices is illustrated conducts periodic surveys of consumer expenditures
in the example shown in the top panel of Figure 38. in which a sample of households collects careful
This table reports prices and quantities for an economy records of all of their expenditures. These responses
producing just two goods in two years. Between 2015 are then aggregated to create a picture of the types and
and 2020, GDP tripled, rising from $750 to $2,250. But, amount of goods and services purchased each month
if you look more closely at the quantity data, you can by representative households. Different market baskets
see that output of both t-shirts and shorts has doubled. are calculated for consumers at different income levels
Because prices increased by 50 percent, however, GDP and for those living in different parts of the country to
tripled while the physical volume of production doubled. reflect differences in consumption patterns.

In this case, it is simple to isolate the effects of changes Each month BLS employees visit stores, check
in the physical quantity of production from the effects of websites, and otherwise collect actual price information
changes in prices, but in most situations the quantities (including any temporary discounts offered by retailers)
produced of some goods are increasing, while others are for all of the items in the market basket of goods
decreasing. Prices, too, will not change in a consistent determined by the Consumer Expenditure Survey. The
way. To isolate the effects of changes in production BLS then combines these price data with the quantities
from changes in prices, economists construct real GDP in the market basket to calculate the cost of purchasing
this bundle of goods and services. Finally, this cost is

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 FIGURE 39

Household Consumption Bundle

QUANTITY
Pants 2 pairs
T-Shirts 3
Shoes 1 pair

CPI Calculation
PANTS T-SHIRTS SHOES CONSUMPTION BUNDLE
PRICE COST PRICE COST PRICE COST COST INDEX (2014=100)
2014 10 20 5 15 25 25 60 100.0
2015 10 20 7 21 30 30 71 118.3
2016 11 22 7 21 35 35 78 130.0
2017 12 24 8 24 50 50 98 163.3

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2018 14 28 10 30 50 50 108 180.0
2019 13 26 10 30 40 40 96 160.0
2020 14 28 11 33 45 45 106 176.7
Calculation of the Consumer Price Index

expressed as an index number relative to the cost of the are adjusted to reflect changes in the cost of living as
bundle in the base year. reflected in the CPI. Similarly many union employment
contracts include cost-of-living adjustment provisions
Figure 39 illustrates this calculation for an economy in that tie wage increases to the CPI. More informally,
which the consumption bundle consists of three items: employers and employees take into account changes in
pants, t-shirts, and shoes. We see that the quantity the CPI when considering adjustments in wage rates.
consumed each month is two pairs of pants, three
t-shirts, and one pair of shoes. Using 2015 as the base The goal of the CPI is to measure how changes in prices
year, we set the cost of the bundle in this year equal affect the ability of households to maintain the level of
to 100, and calculate the CPI in the other years using well-being they enjoyed in the base year. What the CPI
the following formula: CPI in year t = 100 × (cost of actually measures, however, is how changes in prices
bundle in year t)/(cost of bundle in base year). affect the cost of a fixed bundle of goods and services.
This difference means that the CPI will typically
Notice that the quantities of each item in the bundle overstate the true increase in the cost of living. This
determine the impact of that item’s price changes on upward bias in the CPI arises for three reasons.
the overall index. Because consumers purchase three
t-shirts and only one pair of shoes, a change in the price The first factor causing the CPI to overstate the effect
of t-shirts will cause a larger change in the CPI than will of rising prices on the cost of living is substitution
an equivalent dollar increase in the price of shoes. bias. As relative prices change, households will shift
their consumption away from more expensive goods
The CPI is of considerable practical importance in our and services and toward less expensive ones. When
economy. Each year, Social Security benefit payments

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73
the price of beef increases, for example, families will perspective on inflation. This measure is called the GDP
consume more chicken; when airline ticket prices deflator, and it is defined by the following equation:
decline, consumers will choose to fly more and drive Nominal GDP = (GDP Deflator/100) × (Real GDP).
less. By adjusting their consumption toward less
expensive goods, households can achieve the same That is, we define the GDP deflator to be an index
level of well-being at a cost that is lower than the cost number, such that when we multiply real GDP by that
of buying a fixed basket of goods and services. index number we get the nominal GDP. Dividing both
sides of the equation by Real GDP and multiplying
The second source of upward bias in the CPI is both sides by 100, we can state this relationship as:
unmeasured quality change. Many goods and services GDP Deflator = 100 × (Nominal GDP)/(Real GDP).
get better over time due to technological change.
In the past several decades, for example, personal Figure 40 compares the rate of inflation as measured
computers have steadily become more powerful by the CPI and the GDP deflator since the early
because of increased processor speeds, greater storage, 1960s. As this comparison illustrates, they tell similar
and better software. Similarly, the addition of anti- stories about the cost of living, but the GDP deflator
lock brakes, airbags, satellite radio, and GPS systems is somewhat less volatile, rising less at peaks and
has substantially improved the quality of the typical decelerating less at low points. Over the entire period,
automobile. Such quality improvements would be the GDP deflator has risen somewhat less than the CPI.
expected to raise the price of these goods, so a simple There are several reasons for these differences. The
comparison of prices between one year and the next first difference is that the GDP deflator reflects only the
will overstate the price increase or understate any prices of domestically produced goods. To the extent
decline in prices. Although BLS statisticians try that foreign produced goods have a larger role in the

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to account for these quality changes, they are very CPI market basket, differences in their behavior will
difficult to remove completely from the CPI. show up in differences in the two indexes. One reason
The third reason the CPI overstates the true rate of the CPI rose so much more than the GDP deflator at
inflation is because of the introduction of new goods the beginning and end of the 1970s is that rising oil
and services. A striking example of this is the cell prices had a large effect on the CPI, but because this
phone. The first cell phones were introduced in the mid- was mainly produced overseas, it did not affect the
1970s. Prior to this, mobile communication was simply GDP deflator.
unavailable at any price for most consumers. Because The second reason the GDP deflator and the CPI diverge
cell phones did not exist, they were not included in the has to do with the way in which they weight the prices
market basket used by the BLS to calculate the CPI. of different goods and services. Whereas the CPI uses
During the early years of their development, prices for a fixed market basket to weight the prices of different
cell phones fell rapidly, and the quality of service vastly goods, the GDP deflator weights prices by their current
improved. But, because cell phones were not included in levels of production. As a result, the basket of goods
the CPI, none of these effects were reflected in measures used to weight prices in the GDP deflator adjusts to
of inflation. Only after cell phones had achieved a changing consumption patterns over time.
relatively large market penetration were they added to
the CPI basket. Unemployment
In 1996 the Boskin Commission, headed by economist Macroeconomists use a variety of indicators to gauge
Michael Boskin, carefully reviewed the methods used the state of the economy. The unemployment rate
to calculate the CPI and concluded that the combined is an especially sensitive indicator of how well the
effects of substitution bias, quality improvement, and the economy is performing at any moment. When the
introduction of new goods meant that the CPI overstated unemployment rate is low, workers feel secure in
the rate of price inflation by 1.3 percent per year.14 their jobs, and competition between employers helps
to drive up wages. When unemployment is high,
The CPI is just one way that economists measure however, workers worry about losing their jobs.
changes in the cost of living. The relationship between
real and nominal GDP provides a slightly different The unemployment rate is defined as the percentage
of the labor force that is unable to find a job. The labor

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 CPI 
960=100) FIGURE 40
100
101 900
102
104
800
105
107
700
110
113
118 600
124
131 500
137
141 400
150
167
300
182
192
200
205

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221
245 100

278
307 0
326
337
GDP Deflator (1960=100) CPI (1960=100)
351
364 SOURCE: Federal Reserve Economic Data, Economic Research Division Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org.
371
Comparison of CPI and GDP Deflator, 1960–2019 (1960=100).
384
400
419
442 force, in turn, consists of all working-age adults who work during the past week and did not actively
460 are either employed or are actively seeking work. In seek work during the previous four weeks.
474 the United States, the Bureau of Labor Statistics (BLS) Together these three categories comprise the
488 is responsible for measuring the unemployment rate. working-age population. The sum of the employed
501 To do this each month, the BLS surveys approximately and unemployed constitutes the labor force, and
515
60,000 households. Based on a series of questions, the unemployment rate is the quantity of people
interviewers classify every person age sixteen or older unemployed expressed as a percentage of the labor
530
in the household into one of three categories: force.
543
6 Employed. If that person worked for pay either Figure 41 shows data on the U.S. labor force collected
full- or part-time during the previous week or by the BLS in July 2020. The table shows that there
is on vacation or sick leave from a regular job. are approximately 260 million working-age persons in
6 Unemployed. If that person did not work during the United States. Of these, almost 160 million are in
the previous week but made some effort to find the labor force. The ratio of those in the labor force to
paid employment during the past four weeks. the working-age population is called the labor force
Out of the labor force. If that person did not participation rate, which is about 61.4 percent. Of
6

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 FIGURE 41

Employment Situation Summary Table A. Household data, seasonally adjusted, July 2020

Civilian Population and Labor Force (in 1000s)

Civilian noninstitutional population 260,373
Civilian labor force 159,870
Employed 143,532
Unemployed 16,338
Not in Labor Force 100,503

Unemployment Rates (percentage)

Total, 16 years and over 10.2
Adult men (20 years and over) 9.4
Adult women (20 years and over) 10.5
Teenagers (16 to 19 years) 19.3
White 9.2

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Black or African American 14.6
Asian 12.0
Hispanic or Latino Ethnicity 12.9
SOURCE: United States, Department of Labor, Bureau of Labor Statistics, “Employment Situation Summary,” July 2020.
http://www.bls.gov/news.release/empsit.toc.htm.

Employment and Unemployment in the U.S., July 2020

those in the labor force, about 143.5 million had jobs job-searching takes time, many of these workers
while 16.3 million were unemployed, resulting in an show up as unemployed for brief periods of time. An
unemployment rate of 10.2 percent. Just one year earlier, additional source of frictional unemployment comes
the unemployment rate was only 3.4 percent, so this from new workers entering the labor force for the first
significant increase in the fraction of the labor force time. Frictional unemployment refers to the portion of
that is unemployed reflects the significant economic the unemployed who are currently not working because
damage caused by the COVID-19 pandemic. Note that of the normal process of matching employees and
the unemployment rate is highest among the teenage employers.
population, and it varies by race, ethnicity, and gender.
Structural Unemployment
There are many reasons why some people are Sometimes the jobs that are available require different
unemployed. Economists divide these reasons into skills or characteristics from those possessed by the
three broad categories. workers who are seeking employment. The locations
of job-seekers and vacancies may also be different,
Frictional Unemployment preventing those seeking employment from filling the
The U.S. economy is remarkably dynamic. Every available positions. That portion of total unemployment
month several million workers leave their jobs either attributable to the mismatch between job openings
voluntarily (i.e., they quit) or involuntarily (i.e., they get and job-seekers is called structural unemployment.
laid-off), and several million more are hired. Because In the 1980s, for example, the U.S. steel industry

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76
was contracting while the computer industry was than two hundred years ago in the United States and
expanding. Not only were laid-off steel workers located Western Europe. During the nineteenth and twentieth
in the industrial northeast far from expanding Sunbelt centuries, it spread to Japan and parts of Latin
industries, but many of them also lacked the skills America, and since the 1950s to a growing number of
to pursue such jobs. If self-driving vehicles begin to countries around the world. Yet, when we look around
replace Uber drivers in the coming years, then those the world (Figure 33) there is still a strikingly large
drivers would be structurally unemployed as a result of variation in material well-being and living standards.
long-term changes in the structure of the economy (in
this case due to automation). In this section of the resource guide, we will look at
what economists know about the factors that account
Cyclical Unemployment for differences in the standard of living over time and
During recessions, unemployment rises as lay-offs between countries. That is, we will develop a theory that
increase, and new hires decline. In these circumstances, explains the size of a nation’s economy in the long run.
job-seekers find it harder to find employment, and many
of them spend longer searching for work. The additional The Circular Flow Model of the Economy
unemployment that occurs for this reason is called A useful starting point for our discussion is a conceptual
cyclical unemployment. model of the economy called the circular flow model,
which is depicted in Figure 42. By tracing the flow of
ECONOMIC GROWTH, dollars through the economy, this diagram illustrates
schematically the complex set of interactions between
PRODUCTIVITY, AND LIVING the major sets of economic actors in our economy:
STANDARDS households, firms, and the government. In this diagram,

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Would you prefer to have an average income in the the major actors are depicted by rectangles, while the
United States today or to have been the richest person markets through which they interact are depicted as
living in 1900? Earlier we saw (Figure 31) that real ovals. Flows of money and flows of real things—goods
GDP per capita grew by a factor of 9 between 1900 and services, inputs to production—are drawn as
and 2019. In other words, the value of goods and arrows.
services available to the average person today is
nine times as large as what the average citizen could To understand the model, begin on the left-hand
consume in 1900. But this comparison hardly captures side with households. Households receive income by
the change that has taken place in our economy and providing factors of production (labor, capital, land) to
consumption patterns over the past century. firms. This transaction is reflected in the arrow leading
from the households’ box to the factor market, and the
In 1900, even the wealthiest American citizen could parallel arrow labeled income in the other direction.
not go to the movies, could not travel from the United
States to Europe in a single day, watch television, use a Even though firms purchase many of the capital
computer, or get antibiotics to treat an infection. How goods in our economy, these capital goods are owned
much income would it take to compensate you to live indirectly by households through their ownership of
without computers, the internet, modern medicine, and the firms, and it is appropriate to depict households
all the conveniences we take for granted today that as providing this capital to the firms in exchange
were not available a hundred years ago? Many people for rental payments. Households use their income to
would conclude that no level of financial incentives purchase goods and services, to pay taxes, and to save
would induce them to give up all of these modern through financial markets. These three uses of their
conveniences. income are illustrated by the three arrows leading out
of the box labeled households.
The improvement in living standards that has
taken place in the United States in the last century Firms receive revenue from the sale of goods and
is a manifestation of a broader phenomenon that services (the arrow leading from the markets for goods
economists call economic growth. The phenomenon and services) and use this income to pay for the factors
of sustained economic growth began a little more of production that they must hire to produce the goods

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 FIGURE 42

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,

The Circular Flow

The Circular FlowModel ofEconomy
Model of the the Economy

and services that they sell. What Determines How Much an

The government receives income from households in Economy Produces?
the form of taxes, and the government borrows from As the circular flow model emphasizes, an economy’s
financial markets. It uses these sources of income to output depends on the total quantity of goods and
purchase goods and services. services that firms are able to produce. This in
turn depends on the quantity of factor inputs that
The final flow of funds illustrated in this diagram is households are able to supply to the firms and the
from financial markets to the market for goods and ability of the firms to transform these inputs into the
services. This flow represents borrowing by both outputs that households and the government choose to
households and firms, which is used to purchase purchase. Larger economies will produce more (other
consumer durable goods and capital equipment. things being equal) than smaller economies. But, this
source of variation cannot account for differences in

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 FIGURE 43

 140,000

 120,000

 100,000
GDP Per Capita

 80,000

 60,000

 40,000

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 20,000

 ‐
0 20 40 60 80 100 120
Average Labor Productivity (GDP per hour worked)

Relationship Between GDP per Capita and Average Labor Productivity, 2019

GDP per capita. amount that each worker can produce, or average labor
productivity, and the proportion of the population that
To explain differences in GDP per capita, it is helpful is engaged in production.
to note that real GDP per capita is equal to real GDP
per worker multiplied by the fraction of the population Most of the variation in GDP per capita occurs because
employed. Let POP stand for the country’s population, of differences in average labor productivity. In the
and N stand for the labor force. Then, we can express United States, labor force participation rates have
this relationship in the following equation: increased modestly in the last century as more women
have entered the labor force and as lower birth rates
GDP GDP N
POP = N × POP have reduced the share of children in the population
and consequently increased the relative size of the
The left-hand side of this equation is just real GDP per working-age population. These trends have, however,
capita. By cancelling out N in the two fractions on the been offset by earlier retirement and longer education.
right-hand side, you can see that the right-hand side As a result, virtually all of the increase in output
reduces to GDP per capita as well, so this relationship per person in the economy is explained by increased
is always true. What this expression tells us is that average labor productivity. Figure 43 shows that there
the average quantity of goods and services available is also a strong positive association between labor
for each person to consume depends on the average productivity and real GDP per capita across countries.

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Average labor productivity depends on a number of of the moving assembly line.
different factors. The most prominent of these are the The political and legal environment. Some
6
following: kinds of technological knowledge are protected
Physical capital. Workers equipped with more by patents, and others may be kept as trade
6
and better tools, machinery, and up-to-date secrets. But, most of the know-how behind
factories will be more productive. Modern the high levels of productivity in advanced
manufacturing methods rely on the use of large countries like the United States is available to
quantities of capital per worker to achieve be learned and copied. The very rapid growth
high levels of production. Recall that capital of living standards in Japan, South Korea, and
equipment is a produced factor of production; China illustrates that countries can catch up
so it is an input that in the past was an output quickly if they successfully borrow and adapt
of the production process. As such, increasing these techniques. Yet, the persistent poverty of
the capital stock in the future requires giving other countries implies that there are obstacles
up consumption in the present. to successful borrowing. The most persuasive
explanation for this is that dysfunctional
6 Human capital. Human capital is the term political and legal systems prevent many
that economists use to refer to the skills countries from fully exploiting the potential
and experience that are acquired through of modern manufacturing techniques. A
education, training, and on-the-job experience. stark illustration of this point is the divergent
Unlike physical capital, human capital is not fortunes of North and South Korea. After
tangible, but like physical capital, creating World War II, both countries had similar
it usually requires sacrificing current

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resources, populations, and standards of living.
consumption. Students and trainees must Today, the South enjoys a standard of living
reduce the amount of time they engage in comparable with the most developed countries
productive activities while they are learning. while poverty is widespread in the North. This
6 Natural resources. Some countries or regions variance is almost entirely due to differences in
have natural resources like iron ore, petroleum, governmental institutions.
or natural gas reserves that contribute to the The importance of the political and legal environment
wealth of their citizens. The high standard of illustrates that creating the appropriate incentives is an
living of countries like Saudi Arabia and Kuwait essential prerequisite for achieving a high standard of
are in large part due to the fact that they are living. But, what actions should policymakers seek to
located on top of large pools of oil. On the other encourage?
hand, in an increasingly global world, natural
resources are not essential to a high standard Investment in both physical and human capital should
of living. Countries like Japan have been able be encouraged, but only up to a point. Recall that
to achieve high levels of per capita income by capital is created as part of the production process, so
importing raw materials produced elsewhere. creating more capital to use in the future requires giving
Technological knowledge. Economists refer to up current consumption. In the extreme, if all of our
6
the knowledge about techniques by which inputs current output were directed to investment, there would
are transformed into the goods and services be no goods and services available to consume, and we
households desire as technological knowledge would all starve. Long before this, however, diminishing
or simply technology. Advances in this know- returns would make it undesirable to keep investing.
how are the single most important factor in Similarly, investment in the creation of new
raising average labor productivity historically. technological knowledge through research and
These advances include the invention of entirely development (R&D) is desirable. Because new
new products, like semiconductors, integrated knowledge is a true public good—since the utility of a
circuits, lasers, and genetic engineering, as discovery is not diminished by other people knowing
well as the development of better methods of it—private incentives to create new knowledge may
organization, such as Henry Ford’s introduction lead to underinvestment. As a result, there is an

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important role for government to play in encouraging The Bond Market
R&D either through tax credits, subsidies, direct When a large corporation like Wal-Mart wants to
expenditures, or legal protections such as the patent borrow money to finance the construction of a new
system that give inventors a temporary monopoly on store, it can borrow directly from the public. It does this
the exploitation of their inventions in exchange for the by selling bonds. A bond is a certificate of indebtedness
disclosure of their discovery. that specifies the obligations of the borrower to the
holder of the bond. In other words, it is a sort of IOU.
SAVINGS, INVESTMENT, AND The typical bond specifies when the loan will be
THE FINANCIAL SYSTEM repaid—called the date of maturity—and the rate of
As the preceding discussion makes clear, the quantity interest to be paid periodically until the loan is repaid.
of resources that an economy directs toward the The purchaser of the bond gives the company his or her
formation of capital—both physical and human—and money in exchange for the promise of repayment of the
toward the creation of new technological knowledge original amount, called the principal, and the periodic
plays a central role in determining the rate of interest payments. The purchaser can hold the bond until
growth of productivity, and hence the standard of maturity, or he or she can sell the bond to someone else.
living. In essence, we face—both as individuals As market interest rates change, the price at which the
and collectively—trade-offs between how much we bond can be sold will change to equate the promised
consume today and how much will be available to payments of the bond with the new interest rate. This
consume tomorrow. Devoting more resources to capital potential variation in the value of a bond is a risk that
formation or to research and development means the buyer assumes. The longer the maturity of the bond
that there are fewer goods and services available to is, the greater the risk of such changes in price, and

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consume today. But, there will be more in the future. the higher the interest rate that borrowers must pay to
Recall that economists use the terms “saving” and induce people to lend them money.
“investment” somewhat differently from how they are The buyer of a bond also assumes the risk that the
used in common conversation. To economists, saving borrower may fail to pay some or all of the principal
is what happens when someone has more income or interest on the bond. The probability that the
than they wish to spend. Someone in this situation borrower will default on their obligation by declaring
might put the money they don’t want to spend now in bankruptcy depends on the financial conditions of the
a bank, or they might use it to buy shares of stock in a borrower. The greater this risk is, the higher the rate of
company. They might think of this as investing their interest a borrower must pay to compensate lenders for
money, but to an economist, the term “investment” this risk. Because the U.S. government is considered a
is reserved to describe the purchase of new capital safe credit risk, it can generally borrow at lower rates
equipment. So, it is only when the bank lends the than private companies. By contrast, financially shaky
money to a business to construct a new factory, or the corporations must pay high interest rates.
when the company uses the funds it receives from the
sale of stock, that investment takes place. The Stock Market
Wal-Mart and other companies can also raise funds by
A variety of different financial institutions help to issuing shares of stock and selling them to savers. Each
coordinate the saving and investment decisions within share of stock represents ownership of a portion of a
our economy. It will be helpful to begin our discussion firm. If a company issues 10,000,000 shares of stock,
by examining several of these institutions in more detail. then each share represents ownership of 1/10,000,000 of
the business. The sale of shares of stock is called equity
Financial Markets finance, whereas the sale of bonds is called debt finance.
Financial markets are institutions through which
individuals who have money they wish to save can Most companies use both equity and debt finance
supply these funds directly to persons or companies because these two methods of borrowing funds have
that wish to borrow money for investment. very different characteristics. The purchaser of a share
of Wal-Mart becomes a part owner of the company. If

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Wal-Mart is profitable, then the shareholders enjoy the loans and provides profits for the bank owners.
benefits of these profits either through the payment of
dividends or through an increase in the value of their Because most bank deposits are fully insured and can be
shares. The bondholders only receive their interest withdrawn at any time, depositors correctly view them
payments. If, however, Wal-Mart runs into financial as having little or no risk. The value of the deposits does
difficulties, the bondholders are paid before stockholders not fluctuate with the fortunes of the bank’s borrowers,
receive any dividend payments. Purchasers of stock face and all of the risks are borne by the bank owners.
greater risks than purchasers of bonds, but they also In addition to their role as financial intermediaries,
have a greater potential for high returns. banks serve another important function in the
Someone who buys shares of stock in a corporation can economy—they facilitate purchases of goods and
sell those shares on an organized stock exchange, such services by providing checking accounts. We will
as the New York Stock Exchange (NYSE) or NASDAQ discuss this aspect of bank activities in greater detail in
(National Association of Securities Dealers Automated a later section of the guide when we turn our attention
Quotation System). The price at which they can sell to monetary institutions.
shares depends on the supply of and demand for shares
Mutual Funds
in the company. These, in turn, respond to the current
Mutual funds provide a way for savers with small
profits and future prospects of the company.
amounts of money to purchase bonds and stocks that
It is important to recognize that when shares of stock would otherwise be difficult for them to purchase.
are traded on a stock exchange, the company does Mutual funds purchase a portfolio of stocks and bonds
not receive any revenue from these transactions. and sell shares to savers. The value of the mutual fund’s
shares fluctuates with the value of the portfolio of assets

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Consequently, these transactions do not contribute
to investment. Only new issues of stock contribute that it owns. Mutual fund shareholders assume all of the
to a nation’s investment. The ability of shareholders risks of variation in the value of the shares.
to easily buy and sell shares of stock on organized
Mutual funds are attractive to savers with small
exchanges does, however, contribute to their
amounts of money for two reasons. First, mutual
willingness to hold these assets by making it easier for
funds make it possible to achieve a higher degree of
them to access the wealth that they represent.
diversification than would be feasible through the
direct purchases of stocks and bonds. Holding the
Financial Intermediaries stock or bonds of a single company is risky because the
An intermediary is a third party who acts as a link
value of that financial asset depends on the fortunes of
between two others. In developed economies, there
that one company. Diversification reduces the potential
are a great variety of intermediaries who help to link
ups and downs because some companies will do well
savers and borrowers. Two of the most important
when others are suffering. For instance, discount
intermediaries are banks and mutual funds.
retailers like Wal-Mart find that their sales may
Banks actually rise during recessions while department stores
Many small businesses, such as local construction that cater to more upscale tastes see their sales fall. By
companies or retail stores, are too small to issue bonds. diversifying, savers can avoid tying the value of their
When these businesses need to borrow money to finance assets to the ups and downs of a single business.
investments that they are undertaking, they are likely The second advantage of saving through a mutual
to turn to a bank. Banks get the funds that they lend by fund is that it provides access to the knowledge and
accepting deposits from people who have money they insight of professional money managers. The skill and
wish to save. Banks pay their depositors interest and knowledge of these professionals mean that individuals
charge borrowers more than they pay to depositors. do not have to closely follow market developments.
The difference between the interest rate banks charge
and what they pay depositors covers the costs of Saving and Investment in Aggregate
accepting deposits and making loans, as well as the Saving occurs when individuals earn more than they
risk that some borrowers may be unable to repay their wish to spend. Investment occurs when businesses or

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households purchase capital equipment or pay for the then we say that it runs a budget deficit.
construction of new buildings. Before considering how
financial markets coordinate independent saving and One important implication that emerges from breaking
investment decisions, we need to consider how saving down saving into its components is that when the
and investment are measured at the aggregate level. government runs a deficit, it reduces investment in
the economy, which reduces the growth rate of living
Recall that for an economy, production (GDP) is equal standards.
to income and to expenditures. We can express the
equality of income and expenditures mathematically International Capital Flows in an Open
in the following expression: Y = C + I + G + NX. In Economy
this equation, Y stands for income, C is consumption In an open economy, domestic savings no longer have
expenditures, I is investment, G is government to equal domestic investment because of the possibility
purchases, and NX is net exports. By virtue of the of international borrowing or lending. Nonetheless,
definitions of these quantities, this equality is an there is an important parallel to the relationships we
identity—it is always true. have just described and one that closely relates the
To simplify, we will begin by assuming that the level of international trade with domestic investment.
economy is closed; that is, it does not engage in any In an open economy, residents interact with citizens
international trade. As a result, net exports are zero, of other countries either in the world market for goods
and the identity between income and expenditures can and services or in the world financial markets. In the
be written as: Y = C + I + G. same way that net exports measures the difference
Subtracting C + G from both sides of this expression, between the sale of domestically produced goods to

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we obtain Y – C – G = I. The left-hand side of this foreigners and the purchase by domestic residents
expression (Y – C – G) is national savings, S, since it of foreign-produced goods, we can define a second
is the difference between income Y and expenditures concept—net capital outflow. The net capital outflow
by households, C, and government, G. In other words, equals the purchase of foreign capital or financial
the identity between income and expenditures implies assets by domestic residents minus the purchase of
a second important identity: savings equals investment. domestic assets by foreigners.
Written in symbols, this would be: S = I. Because this When Inbev, a Brazilian- and Belgian-owned brewing
is an identity, by definition it is always true. company, purchased the U.S. company Anheuser-
Further insight about this identity can be gleaned Busch, it resulted in the purchase of domestic assets
by some further rearrangement. In the expression by foreign residents. This purchase added to the
above, we can add and subtract net taxes, T, from the purchase of domestic (U.S.) assets by foreigners.
left-hand side of the expression to obtain: S = Y – C Since we subtract such purchases, the net capital
– G = (Y – C – T) + (T – G). The second and third outflow decreased. When Intel builds a new factory in
expressions are equal because the two T terms in the Taiwan, this results in the purchase of foreign assets by
last expression cancel each other out. domestic residents, so it increases the first term in this
expression, and increases the net capital outflow.
We can interpret this expression as saying that saving
is equal to the sum of private saving (Y – C – T) There are two types of international capital flows:
and government saving (T – G). Private saving is the foreign direct investment and portfolio investment.
amount of money households have left over after they Foreign direct investment is used to describe situations
pay for their taxes and pay for their consumption. in which a company or individual acquires assets in
While taxes are an expense from the perspective of a foreign country that they will manage actively. An
households, they are income for the government, example of foreign direct investment in the United
and the difference between government income, T, States is the purchase of Rockefeller Center in New
and government purchases, G, is called government York by the Japanese corporation Mitsubishi in 1989.
saving. If T – G is a positive number, then we say the Portfolio investment occurs when an individual or
government runs a budget surplus. If T – G is negative, business purchases shares of stock or bonds issued by
a foreign corporation. When the Chinese government

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purchases U.S. government bonds, it is making a net capital outflows. If foreigners are willing to lend to
portfolio investment. domestic citizens (so NCO is negative), then investment
can be larger than savings. Of course, foreigners
In an open economy, net capital outflows (NCO) are make such loans with the expectation that they will be
precisely equal to net exports (NX). This equality repaid at some point in the future. So, eventually the
always holds because, like the equality of saving and situation will likely be reversed, with saving exceeding
investment, it is an identity. To see why, it is helpful investment to produce positive capital outflows.
to consider an example. Suppose that Electronics
Importers purchases a container full of video games How Financial Markets Coordinate
from a Japanese manufacturer and pays them $100,000.
This purchase is an import, so it reduces net exports by Saving and Investment Decisions
$100,000. We have seen that by definition saving must equal
investment in a closed economy. And, even in an open
The Japanese video game producer could put the economy saving and investment are closely linked with
money in a safe. In this case, the owners of the each other and with the net capital flows into or out of
company are using some of their income to invest in the economy. But, what determines the level of savings
the U.S. economy by purchasing a domestic asset (U.S. and investment that occurs in an economy?
currency). As a result, net capital outflows decrease by
$100,000, thus balancing the change in net exports. For simplicity’s sake, we will again focus on a closed
economy, but the situation would be quite similar in an
More realistically, the video game manufacturer might open economy. In reality, there are a large number of
use the $100,000 to purchase U.S. government bonds. financial markets, but they are all closely linked to one
Or, they might take the money to a bank and exchange another because individuals with excess savings can

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it for Yen. The company no longer has any dollars, but easily move funds between markets to obtain the best
the situation has not really changed since now the bank return for their money, while borrowers can similarly
faces the same choices as the company about what to choose between many different markets. As a result,
do with the funds. it is convenient to collapse these many markets into a
single financial market.
Another possible outcome is that the company uses the
money to purchase U.S.-produced goods and services. In the financial market, the supply of savings and
For example, they might pay a U.S. advertising the demand for savings (that is, the demand by firms
company to develop new advertisements. If they spend for funds to purchase or construct new capital, or
the entire amount of their revenue, then this causes investment) are equalized through adjustments of the
U.S. exports of services to increase by $100,000, interest rate. This is illustrated in Figure 44. As before,
balancing the earlier imports. In this case, neither net we have graphed the quantity (in dollars) of supply
exports nor net capital outflows change. (savings) and demand (investment) on the horizontal
axis and the interest rate on the vertical axis.
For the economy as a whole, the amount of net capital
outflows must exactly equal net exports. Returning to In the financial market, the interest rate functions as
the equality of income and expenditures for an open the price of a loan. It is the amount that borrowers
economy, we have: Y = C + I + G + NX. must pay for the loan, and it is the amount that savers
receive for making the loan. For a lender, the decision to
Rearranging the terms of this equation we obtain save a dollar today is, in effect, a decision to postpone
Y – C – G = S = I + NX. consumption until some time in the future. Suppose the
But, we have just shown that net exports equal net interest rate is 10 percent per year. A saver who lends
capital outflows, so we can replace NX with NCO to $100 will receive $110 = $100 × (1 + 0.1) the following
get S = I + NCO. This states that domestic saving year. The possibility of consuming more in the future is
equals domestic investment plus net capital outflows. one of the principal motivations for saving.

In an open economy, savings can differ from investment, Of course, if prices are rising, the same bundle of
but only to the extent that the difference is offset by goods becomes more expensive next year, so what
matters is the real interest rate, which is the nominal

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 FIGURE 44

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Equilibrium in the
Equilibrium Financial
in the Financial Market Market

rate minus the rate of inflation. If prices increase 10 businesses will be willing to borrow. The lower the
percent per year, then it will take $110 next year to real interest rate is, the larger the number of investment
purchase a bundle of goods that costs $100 today. In projects that businesses will find profitable to pursue.
this case, the real interest rate will be zero, indicating As a result, the demand curve for savings is drawn as
that the saver receives no increase in purchasing power downward sloping.
from postponing his or her consumption.
In the same way that competitive forces move prices
The higher the real interest rate is, the greater the in other markets toward the market equilibrium level,
rewards for being patient, and the greater the amount there are strong pressures on the real interest rate
that people will choose to save. As a result, the supply that cause it to adjust to equilibrate the market. At an
of savings is drawn as an upward-sloping line in interest rate below the equilibrium level, borrowers
Figure 44. would not be able to find enough savers willing to lend
them funds, and competition to obtain the available
Businesses invest because they anticipate that the funds would drive up the real interest rate. At an
additional capital equipment they are acquiring will interest rate above the equilibrium, there would be
raise their revenues in the future. The price of making an excess supply of funds, and competition between
these investments is the real interest rate. So long as lenders to find borrowers willing to take their funds
businesses expect that the additional revenues they will would cause the real interest rate to fall.
receive will exceed the cost of borrowing the funds,

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FIGURE 45

(a) TECHNOLOGICAL INNOVATION SHIFTS INVESTMENT (DEMAND FOR SAVINGS)

(b) REDUCTION IN GOVERNMENT SAVINGS SHIFTS THE SUPPLY OF SAVINGS

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(c) TAX CREDIT FOR SAVING SHIFTS THE SUPPLY OF SAVING

The Effects ofThe

Supply
Effects ofand
SupplyDemand
and Demand Shifts on Financial
Shifts on Financial Market Equilibrium
Market Equilibrium

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Now that we have seen how the financial market have a powerful influence on the level of economic
determines the real interest rate and the quantity of activity. Too much money can lead to inflation, and too
saving and investment, we are in a position to consider little money can lead to deflation. This section begins
how various events affect this equilibrium. Figure by defining more precisely what we mean by money.
45 illustrates three possible changes in the market Then, we will describe the forces that determine the
equilibrium. Panel (a) depicts the effects of a new quantity of money in the economy. Finally, we will
technology that raises the productivity of capital. As a consider how money affects prices and output.
result, the demand for funds schedule shifts out to the
right since businesses will want to borrow more money What Is Money?
at every interest rate. Rising interest rates cause savings While we all have an intuitive sense of what money is,
to rise, and the new equilibrium occurs at a higher it is important in economic analysis to have a clearer
interest rate and higher level of savings and investment. and more precise definition. To economists, money is
any asset that has three functions. It is a medium of
In panel (b) we show the effect of an increase in the exchange, a unit of account, and a store of value. These
government deficit; or, equivalently, a reduction in functions distinguish money from other assets, such as
government saving. With the government saving stocks and bonds, paintings, real estate, or barrels of
less or borrowing more, the supply of saving in the oil. Let’s consider each function of money.
economy is reduced at every interest rate, which is
shown as a leftward shift in the supply of savings 6 Medium of Exchange. A medium of exchange
curve. Now the equilibrium shifts up and to the left. is an item that buyers can use to purchase
As a result, interest rates are higher, and the total goods and services. For money to function
quantity of saving and investment in the economy is as a medium of exchange, sellers have to

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lower. This tendency of government deficits to reduce be confident that they can use the money
private investment is called crowding out. they receive to pay for the things they wish
to purchase. The usefulness of money as a
The third example we will consider is the effect of a medium of exchange explains why people are
government tax credit to encourage savings. More willing to hold onto it even though it earns
concretely, suppose that the government reduces the no interest. The ability to quickly and easily
tax rate on interest income earned on savings accounts. complete a transaction compensates us for the
In this case, as is illustrated in panel (c), the supply of interest payments we give up.
savings curve shifts out to the right. As a result, interest
rates fall while saving and investment both increase.15 6 Unit of Account. A unit of account is a
yardstick used to establish the value of
MONEY AND PRICES IN THE different goods and services. Expressing the
prices of goods and services in a common
LONG RUN unit of account greatly facilitates comparisons
Having grown up in an advanced market economy, of economic value. The use of money as a
it does not surprise us at all that we can walk into a medium of exchange is closely linked to its use
store and hand over some small green pieces of paper as a unit of account. Because money is used to
and walk out with valuable merchandise. Nor does it buy and sell things, it makes sense to express
surprise us that the store owner will allow us to simply prices in money terms.
swipe a credit card through a magnetic strip reader or
6 Store of Value. A store of value is an item that
write a check in payment for the merchandise. Money
people can use to transfer purchasing power
is a remarkable innovation that greatly facilitates
from the present into the future. When a seller
exchange in our economy. Without it, we would be
accepts dollar bills today in exchange for a
forced to barter, finding people who have the items
good or service, that seller can hold onto those
we wish to acquire and who are willing to accept
bills for weeks or months before becoming
something that we are willing to give up in return.
a buyer. Paper currency is only one of many
Because money represents purchasing power, the stores of value, but—unlike stocks or bonds—
quantity of money in circulation in an economy can it pays no interest and offers no opportunities

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 FIGURE 46

M1 $5,209.90
Currency $1,855.90
Demand (Checking) Deposits $2,211.70
Other Checkable Deposits $1,142.30

M2 $18,166.80
M1 $5,209.90
Savings Deposits $11,391.80
Small Denomination Time Deposits $428.40
Retail Money Funds $1,136.70
Note: Outstanding amount of U.S. dollar-denominated traveler’s checks of nonbank issuers. Publication of new data for this item was discontinued
in January 2019. Traveler’s checks issued by depository institutions are included in demand deposits.
SOURCE: https://www.federalreserve.gov/releases/h6/current/default.htm.

Components of the Money Stock, June 2020 (in Billions).

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for appreciation in value. Measuring Money
Economists use the term “wealth” to describe all To be able to analyze the effects of money on the
of the different stores of value in an economy. An economy, a first step is simply to be able to measure
important characteristic that distinguishes different the amount of it. In the United States, the stock of
assets that make up wealth is their liquidity. Liquidity money is made up of several components. The most
is a measure of the ease with which an asset can be obvious of these is currency, which includes the
converted into the economy’s medium of exchange. paper bills and coins in the hands of the public. But
Currency is clearly the most liquid asset, but deposits currency is not the only asset that functions as money.
held in checking accounts, most stocks and bonds, The wealth represented by your checking account
and shares of mutual funds can be easily used to is nearly as good as (if not better than) currency. By
complete transactions and are thus also highly liquid. writing a check or swiping your debit card, you can
In contrast, real estate and collectable antiques require use this wealth to make purchases in the same way
more effort to sell and are consequently less liquid. you can use currency. Many other types of accounts,
such as savings accounts or mutual fund accounts, are
Throughout history many things have functioned as essentially equivalent to checking accounts.
money. These can be divided into two categories:
commodity money and fiat money. When an item It is not easy to draw a line between assets that are
with some intrinsic value is used as money it is called “money” and those that are not. Dollar bills in your
commodity money. The use of precious metals such wallet are money, whereas your house is not; but
as gold or silver is an example of commodity money. there are many assets somewhere between these two
Similarly, during World War II prisoners of war used extremes. For this reason, monetary economists have
cigarettes as money to trade goods and services with developed several different measures of the stock of
one another. When an item with no intrinsic value is money in the economy. The most widely used are
used as money it is called fiat money. A fiat is simply called M1 and M2. The table in Figure 46 lists the
an order or decree. The value of dollar bills as legal components of each. M2 includes all of the items in
tender is established by government decree. M1 plus a broad array of other assets.

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Notice that neither M1 nor M2 includes credit cards as member, but the other four places on the FOMC rotate
part of the stock of money, even though credit cards among the remaining banks. The FOMC meets about
are often used to make purchases. The reason is that a every six weeks in Washington, D.C., to assess the
credit card is not so much a way of making a payment state of the economy and determine if any changes in
as it is a way of putting off a payment. When you pay monetary policy are necessary.
for your groceries with a credit card, the bank that
issued the card pays the supermarket, and then at a When the FOMC decides that the money supply should
later date you pay the bank. Although credit cards are be adjusted, the Fed achieves this goal primarily
not part of the money stock, people who use them are through open market operations. If the Fed wishes
able to pay many of their bills at one time, and they to increase the money supply, then it purchases U.S.
are therefore likely to hold less currency than they government bonds from banks or the public. As a
otherwise would. To this extent, credit cards help to result, the amount of currency and deposits in the
reduce the economy’s need for money. hands of the public increases. If the Fed wishes to
reduce the money supply, then the Fed reverses the
The Federal Reserve System, Banks, and process, selling bonds to the public and removing
money from circulation.
the Supply of Money
The amount of money in the U.S. economy is Open market operations are a powerful tool, but by
determined by the interaction between the public, themselves they do not determine the stock of money
commercial banks, and the Federal Reserve System. in the economy. The money supply also depends on the
The Federal Reserve System, often called “the Fed,” is behavior of banks and of the public.
the central bank of the United States. A central bank
Let’s begin by considering how banks affect the money

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is an institution created to oversee the banking system
and regulate the supply of money. supply. To begin, let’s suppose that there are no banks
and that the money supply consists of $100 of currency.
The Federal Reserve System was created in 1913 Now suppose that someone establishes a bank offering
and consists of twelve regional banks owned by the depositors a safe place to store their currency. The
commercial banks in their region, and the Federal bank accepts currency and stores it in its vault; when
Reserve Board in Washington, D.C. The Fed is run by a depositor wants to make a purchase, the depositor
a board of governors that consists of seven members goes to the bank, withdraws the necessary funds, and
who are appointed by the President and confirmed by uses them to make a purchase. After the transaction is
the Senate. Governors’ terms are fourteen years, which completed, the seller takes the funds and deposits them
helps to insure that the actions of the Federal Reserve in his or her account with the bank.
system are insulated from political pressures.16
We can summarize the bank’s financial position
The twelve regional banks are largely responsible as shown in Figure 47. In this table, there are two
for overseeing commercial banks in their respective columns: on the left we list the bank’s assets, while on
regions and for facilitating transactions by clearing the right we list the bank’s liabilities. The bank’s assets
checks. They also act as a sort of bankers’ bank, consist of the $100 in cash that it holds in its vault; and,
making loans to banks when they wish to borrow its liabilities are the $100 in deposits that its depositors
funds. When a member bank is unable to obtain funds can withdraw at any time. The bank’s assets and
from other sources, the Federal Reserve banks act as liabilities are in balance. Whether people hold currency
a lender of last resort to maintain the stability of the or place it in bank accounts, the money supply in this
overall banking system. economy is $100.
The task of controlling the quantity of money The situation depicted in Figure 47 is simple, but it
in the economy, called the money supply, is the doesn’t offer the bank’s owners much opportunity
responsibility of the Federal Open Market Committee to earn a profit, and they will have noticed that most
(FOMC). The FOMC is composed of the seven of the money on deposit remains unused. Instead of
governors of the Fed plus five regional bank presidents. holding all $100 in deposits, they could lend some
The president of the New York Fed is always a of this out to people who wish to borrow funds to

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 FIGURE 47

ASSETS LIABILITIES

Reserves $100 Deposits $100

Bank Balance Sheet

Bank Balance Sheetwith
with 100100 Percent
Percent Reserves Reserves

purchase a house, pay for college, or make some With $180 in liabilities, the twenty percent reserve
other major purchase. The bank needs to keep some ratio suggests that the bank should hold reserves equal
reserves to be able to pay its depositors, but this is to $36, which means it can lend an additional $64.
likely only a small fraction of total deposits. Figure 48(c) shows the situation once it has made
these loans. Its liabilities remain the same, but now it
Suppose that the bank owners determine that they has $144 in loans and $36 in reserves. At this point,
need to hold reserves equal to just twenty percent the money supply has increased by $64, reflecting the
of their liabilities. Then, they can lend out $80 to additional loans the bank has made.
borrowers and receive interest income on this. Figure
48(a) illustrates the bank’s situation now. On the right- In due course the additional funds that the bank has

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hand side the bank still has $100 in liabilities, but now loaned will find their way back to the bank as additional
its assets consist of $20 in reserves and $80 in loans. deposits. And, the cycle of loans and money creation
Once again, assets and liabilities exactly balance. will continue until the total deposits equal $500, and
the bank has $100 in reserves and $400 in loans. At
Notice, however, what has happened to the money this point, the bank cannot make any additional loans
supply. The bank’s depositors have $100 in deposits, without falling below its twenty percent reserve ratio.
and its borrowers have $80 in currency. The money
supply has grown to $180. By holding only a fraction The amount of money the banking sector creates from
of deposits as reserves, the bank is able, in effect, to each dollar of reserves is called the money multiplier.
create money. This may seem to be too good to be The money multiplier is the reciprocal of the reserve
true. But, it is important to understand that while the ratio. If R is the reserve ratio, then each dollar of
bank has created more money, it has not created any reserves will support $1/R of money supply. When
more wealth. Its borrowers have an additional $80 in banks change the reserve ratio they hold, they can alter
assets (the money they have borrowed), but they also the stock of money in the economy.
have an additional $80 in liabilities (the debt that they
have to repay). Because of fractional reserves, the bank To keep matters simple, we have thus far assumed that
makes the economy more liquid, but it doesn’t increase the public holds all of its money as deposits. In reality,
the total amount of wealth in the economy. the public’s behavior also affects the money supply
through decisions about how much money to hold as
The process of money creation does not stop with the bank deposits and how much to hold as currency. As we
initial loans made by the bank. Its borrowers may have seen, the Federal Reserve can adjust the amount of
deposit the loan in another account until they make a currency in circulation through open market operations.
purchase with the funds. Or, once they have made a
purchase, the seller will deposit the funds that he or Suppose that the Fed has provided M dollars of
she receives in his or her bank account. Figure 48(b) currency. If the public chooses to hold C dollars as
shows that now the bank’s liabilities have increased to currency, then the banking sector must be holding
$180 and its assets have grown to $180 as well—$100 M–C in reserves. The amount of currency plus
in reserves and $80 in loans. reserves is often referred to as the monetary base or
high-powered money. If banks hold a fraction, R, of

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 FIGURE 48

Panel (a)
ASSETS LIABILITIES

Reserves $20 Deposits $100

Loans $80

Panel (b)
ASSETS LIABILITIES

Reserves $100 Deposits $180

Loans $80

Panel (c)
ASSETS LIABILITIES

Reserves $36 Deposits $180

Loans $144

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Bank Balance Sheet
Bank Balance with
Sheet with Fractional
Fractional Reserves Reserves

each dollar of deposits as reserves, then there will be Reserve because such borrowing suggests they may
(1/R) × (M–C) dollars of deposits, and C dollars of be in financial difficulty, the discount rate is closely
currency, so the money supply (which is deposits plus linked to the federal funds rate, which is the rate
currency) will equal. charged by banks when they lend reserves to other
banks. A higher discount rate discourages banks from
C+ M–C =
R × C + M – C = M + (R – 1) × C borrowing reserves. Thus, raising the discount rate
R R R
helps to reduce the quantity of borrowed reserves and
If you experiment with this equation, you will find that therefore reduces the supply of money.
the smaller that C is, or the smaller that R is, the larger
the money supply will become. Bank Runs
In addition to open market operations, the Federal One problem that can arise in a system based on
Reserve has several other tools it can use to influence fractional reserves occurs when the public suddenly
the supply of money in the economy. The Fed has the decides that it wants to hold substantially more
power to set reserve requirements for commercial currency than it has been holding. Since banks have
banks. Banks can, of course, choose to hold reserves reserves equal to only a fraction of their liabilities,
beyond this requirement, but manipulation of required they will not be able to pay all their depositors. If
reserves is nonetheless a powerful lever. Because it is depositors begin to fear that they may not be able to
disruptive to the business of banking, however, the Fed withdraw their deposits, they will hurry to the bank to
only rarely makes changes in reserve requirements. get their deposits ahead of other depositors.

The third tool available to the Fed is the discount Such a rush of withdrawals is called a bank run. Even
rate, which is the interest rate that the Federal Reserve if a bank is solvent, meaning that its assets exceed its
charges on loans that it makes to banks. Although liabilities, it will not have enough cash on hand to meet
banks rarely borrow directly from the Federal all of the demand, and it will be forced to shut its doors
until loans are repaid or it can borrow additional funds

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or sell assets. When a solvent bank experiences a spike In the long run, the value of money is determined in the
in demand, it is the Fed’s responsibility to act as lender same way as the value of any other item in an economy:
of last resort to prevent disruptions to the banking by the interaction of supply and demand. We have just
system. seen how the supply of money depends on the Federal
Reserve and the banking system. When the Federal
Today bank runs are very infrequent, but in the past Reserve uses open market operations to sell bonds, the
they were a significant source of financial disruption. supply of money contracts; when the Federal Reserve
uses open market operations to buy bonds, the supply
Money and Inflation in the Long Run of money expands. Because of fractional reserves, the
Earlier we discussed how economists measure effects of these actions are magnified. But, the key point
inflation. Figure 40 showed how the cost of living has is that through its policy actions the Federal Reserve can
changed since 1960. The increase in the CPI shown choose the supply of money.
in Figure 40 implies that over the last half-century
the cost of a fixed basket of consumption goods has The demand for money depends on how much of their
increased by a factor of about 8.6—the CPI in 2019 wealth people wish to hold as money, instead of in the
was about 8.6 times larger than it was in 1960. While form of other less liquid assets. The chief reason that
this is a significant increase in the overall price level people choose to hold money rather than other assets
over the long-term, there have sometimes been periods is because of the usefulness of money as a medium
of large declines in the price level. The most significant of exchange. The greater use of digital payments (for
such decline occurred during the Great Depression example, using Apple Pay on an iPhone) will reduce the
when the price level fell by about 25 percent from need to use money. A desire for contactless payment
1929 to 1933. We also saw a small decline in the in an effort to avoid the transmission of COVID-19

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CPI between 2008 and 2009 as a result of the 2008 may speed up this transition in the coming years. But,
financial crisis. the most important determinants of how much money
people demand are the volume of transactions they
What causes the price level to rise or fall over time? engage in and the prices at which these transactions take
To begin with, suppose that the price of a can of soda place. Holding constant the real level of activity in the
increases from $1 to $2 over some period of time. economy, we would expect that a doubling of all prices
What does it mean when people are willing to give up would cause the demand for money to double.
twice as much money in exchange for a can of soda? It
could be that they have come to enjoy soda more. But How does the economy balance people’s demand for
this is probably not the case. It is more likely that their money with the level of money that the Fed chooses to
enjoyment of a can of soda has remained the same, but, supply? The answer depends on the time horizon that
over time, the money they use to buy soda has become we are considering. For the moment, we will focus on
less valuable. In other words, inflation is more about the long run, by which we mean a time period over
changes in the value of money than about the value of which the price level adjusts to equate the demand for
goods. money with the available supply.
When the economy’s overall price level rises, it takes Figure 49(a) illustrates this equilibrium. In this figure,
more money to purchase a fixed basket of goods. Or, the horizontal axis measures the quantity of money. On
looking at the matter differently, we can say that the the vertical axis we have plotted the value of money
value of money relative to goods and services has (= 1/P). In Figure 49, the money supply is drawn as a
declined. It may be helpful to state this observation vertical line, indicating that the Federal Reserve has
more formally. Suppose P is the price level—measured fixed the supply. The demand for money is drawn as a
by the CPI or GDP deflator—then P measures the cost downward-sloping line, reflecting the fact that as the
in dollars of a basket of goods. The quantity of goods value of money rises (the price level falls), people need
and services that can be bought with $1 is 1/P. If P is less money to purchase a given quantity of goods and
the price of goods and services measured in money, services. The equilibrium occurs at the point labeled
then 1/P is the value of money measured in terms of “A” in the diagram, where the demand curve crosses
goods and services. the supply.

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92
FIGURE 49
(a) INITIAL EQUILIBRIUM

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(b) EFFECTS OF A DOUBLING OF THE MONEY SUPPLY

Equilibrium in inthe
Equilibrium Market
the Market for Money for Money

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93
 Notice that the relative prices of different goods and it does reduc
services are real quantities. For example, if a bushel of tax on peopl
wheat costs $6, and a ton of steel costs $600, then the of the curren
In Figure 49(b) we illustrate the effect of a doubling cost of steel relative to wheat is tive to the go
of the money supply. As the Fed adds to the money a result, peo
$600 hold. This m
supply by purchasing government bonds, people find bushels more frequen
that they have more money than they want to have. ton tion also im
They may attempt to reduce their cash holdings by adjust the pr
purchasing additional goods and services, or they Since dollars appear in both the top and bottom terms this can be a
may lend the additional money to someone else by of this ratio, they cancel out of the equation, and we are Second, in
depositing it in a bank or using it to buy stocks or Since
left dollars
with a appear
ratio of in both
physical the top
quantities. and bottom
Similarly, terms
if the Because firm
wage rate is $10/hour and the price of an iPod
of this ratio, they cancel out of the equation, and we is $200, time, relative
bonds. The extra supply of savings will cause interest
rates to fall and will encourage businesses and then taking
are left withthe ratio of
a ratio of the price of
physical the hourly relative costs
an iPod toSimilarly,
quantities.
wage, an importan
consumers to increase their spending. if the wage rate is $10/hour and the price of anhours
we can express the price of an iPod as 20 iPadofis market econ
work.
$500, then taking
The neutrality the ratio
of money of the
gives riseprice of anuseful
to a very iPad tool
to the formation co
The injection of more money into the economy thus
called the quantity equation. As a starting point, let us50 able.
hourly wage, we can express the price of an iPad as
causes an increase in the demand for goods and hours of
define thework.
velocity of money as the average number Third, infl
services. But, the economy’s supply of goods and of times a typical dollar bill is used during a year. If Y value of good
The neutrality
services has not changed. We have seen that the ability stands for real GDPof money
and gives riseprice
P is the to a very
level,useful
then toolthe when someo
called the
of an economy to produce goods and services depends nominal GDPquantity
= P ×equation.
Y measuresAs the
a starting
value ofpoint,
goodsletand us sated by an i
on the available technology and on the quantities of define the velocity of money as the average number
labor, capital, and natural resources available. None of of times a typical dollar bill is used during a year. If Y
these has been changed by the additional money, so the stands for real GDP andUSAD P is theEconomics
price level, Resource
then the Guide • 2016
supply of goods and services should not change. nominal GDP = P × Y measures the value of goods and
services (and hence dollars) that change hands. To find

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The combination of higher demand with a fixed supply the velocity of money, V, we divide P × Y by the number
will cause the price of goods and services to rise. And, of dollars in circulation, M. That is: V = (P × Y)/M.
this increase in prices will continue until prices have
risen enough to cause the demand for money to once To see why this makes sense, let’s consider a very
again equal the supply. Once the economy has adjusted, simple economy that produces only t-shirts. If this
the new equilibrium occurs at the point labeled “B.” economy produces 500 t-shirts and each sells for $5,
At this point, the value of money has fallen by half (or then nominal GDP is $2,500. Suppose the supply
equivalently the price level has doubled). In the long of money is $250, then velocity in this economy is
run, assuming nothing else changes, the increase in $2,500/250 = 10. For $2,500 in spending to occur using
prices will be exactly proportional to the change in the only $250 in cash, each dollar must change hands an
supply of money. average of ten times during the year.

This result—that in the long run, an increase in the Figure 50 graphs nominal GDP, M2, and the velocity
supply of money leads to a proportional increase in the of money that they imply. As you can see in this figure,
price level—reflects the long-run neutrality of money. between 1960 and 2019, the growth trajectories of
The neutrality of money means that changes in the nominal GDP and the stock of money have followed
quantity of money have no effect on real quantities in very similar paths, with the velocity of money
the economy. Monetary changes only affect nominal remaining relatively stable. Using this stability of
quantities. Real quantities are things that are measured the velocity of money, we can rearrange the quantity
in physical units; for example, a bushel of wheat and a equation to obtain the following expression: V × M =
ton of steel are real quantities. Nominal quantities are P × Y.
things that are measured in monetary units; examples
This equation states that the velocity of money times
would include the price of a bushel of steel or GDP in
the quantity of money will be equal to nominal
current prices.
GDP. So, any increase in the supply of money will
Notice that the relative prices of different goods and be reflected in one of three ways: 1) as a fall in the
services are real quantities. For example, if a bushel of velocity of money, 2) an increase in real GDP, or 3) an
wheat costs $6, and a ton of steel costs $600, then the increase in the price level.
cost of steel relative to wheat is

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94
 ty of 
2  FIGURE 50
=100)
100.0
  97.1  5,000.0
  96.8
  94.2  4,500.0

  93.8
  94.1  4,000.0

  96.8
 3,500.0
  95.8
  96.8
 3,000.0
  98.6
100.1
 2,500.0
  96.9
  94.7
 2,000.0
  96.1
  98.4  1,500.0
  98.1
  96.7  1,000.0
  95.6

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  99.7  500.0
103.4
104.1  ‐
107.2
102.5
  99.2 Nominal GDP (1960=100) M2 Money Stock (1960=100) Velocity of M2 (1960=100)

102.1
SOURCES: GDP: Louis Johnston and Samuel H. Williamson, “What Was the U.S. GDP Then?” MeasuringWorth, 2020,
100.7 URL: http://www.measuringworth.org/usgdp/.
  98.4 M2 1960–99: Anderson, Richard G., “Federal Reserve Board monetary aggregates and major components: 1959–1999.” Table Cj84-99 in
Historical Statistics of the United States, Earliest Times to the Present: Millennial Edition, edited by Susan B. Carter, Scott Sigmund Gartner,
  97.9 Michael R. Haines, Alan L. Olmstead, Richard Sutch, and Gavin Wright. New York: Cambridge University Press, 2006.
100.2 M2 2000–2019: Federal Reserve Economic Data / Link: https://fred.stlouisfed.org.
103.6 Velocity: Federal Reserve Bank of St. Louis, Velocity of M2 Money Stock [M2V], retrieved from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/M2V, August 12, 2020.
103.8
103.4 Nominal GDP, Money Stock, and Velocity, 1960–2019
107.4
111.8
117.4 Why Worry about Inflation? is a tax on people who hold money. As prices rise,
120.5 Inflation is unpopular. During the 1970s when inflation the value of the currency people have in their wallets
121.5 rates reached double digits, many consumers viewed declines relative to the goods and services they want
122.9 inflation as the number one economic problem of the to purchase. As a result, people will reduce the amount
121.2 country. But, the neutrality of money suggests that of money they hold. This means they have to go to
119.9 changes in the aggregate price level should not matter the bank or ATM more frequently, which imposes an
120.3 because they do not affect real quantities. Despite the inconvenience. Inflation also imposes a cost on firms
114.4 neutrality of money, inflation does impose real costs on because firms have to adjust the prices of their products
110.0 the economy. more frequently, and this can be a costly process.
107.7
109.6 First, although inflation does not alter relative prices, Second, inflation introduces distortions into pricing.
112.1 it does reduce the value of money. In effect, inflation Because firms will not all adjust their prices at the
112.9
111.3
106.2 2021–2022 Economics Resource Guide
  96.4 95
  97.6
same time, relative prices will not always accurately than a year. Similarly, during an expansion, economic
reflect the relative costs of production. Recall that these activity rises substantially, spreads across the economy,
prices play an important role in coordinating economic and usually lasts for several years. In both recessions
decisions in market economies. Because of these and expansions, brief reversals in economic activity
distortions, the information conveyed by market prices may occur—a recession may include a short period of
becomes less valuable. expansion followed by further decline; an expansion
may include a short period of contraction followed by
Third, inflation introduces confusion about the true further growth. A depression is a particularly severe or
value of goods and services in the future. Remember protracted recession.
that when someone with savings lends it, they are
compensated by an interest payment for postponing The recurrent alternation of expansions and recessions
their use of that money until a future date. But, if they is commonly referred to as the business cycle. Business
cannot accurately forecast the rate of inflation, they cycles have been a characteristic of industrial societies
cannot calculate how much purchasing power they since at least the late eighteenth century. The table in
will have in the future. Uncertainty about the rate of Figure 51 shows the dates and duration of U.S. business
inflation adds to the risks that both borrowers and cycles. A commonly used rule of thumb is that periods
lenders face in credit markets, and this increased risk when real GDP declines for two consecutive quarters
reduces both the supply of savings and the demand for are recessions. The determination of the dates on which
investment. Because investment is crucial to economic recessions and expansions begin and end is performed
growth, inflation reduces economic growth. by the NBER, a non-profit organization of economists
that has been a major source of research on short-term
SHORT–RUN ECONOMIC fluctuations in the economy. The NBER considers a

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broad array of different economic indicators in fixing
FLUCTUATIONS the dates listed in Figure 51.
We noted earlier that macroeconomics is concerned
with two issues: the long-term growth of the Looking at the data in Figure 51, the longest and
aggregate economy and short-term fluctuations. In the deepest period of recession is the 43-month decline
preceding sections, we have developed a framework that began in August 1929, which has come to be
for understanding the forces that determine the long- known as the Great Depression. During this episode,
run performance of national economies. This theory the nation’s real GDP fell by more than one-quarter.
provides a useful description of how the economy Since the Second World War, periods of recession have
evolves over long periods of time of several decades tended to be relatively short, with only three stretching
or more. But, it does not provide much guidance for longer than twelve months, and relatively mild in terms
understanding the shorter-run deviations of economic of the decline in real GDP. Expansions have tended to
growth from these long-run trends. be much longer than the recessions, with most lasting
more than two years—a fact that is reflected in the
In Figure 30, we graphed the growth of real GDP in
sustained upward trend of real GDP.
the United States between 1900 and 2019. If you look
closely at that figure, you can see that superimposed on We will begin our examination of short-run fluctuations
the upward trend in total output are some significant by describing their characteristics in greater detail.
fluctuations. In particular, the drop in output during We will then develop a model that can account for
the Great Depression stands out, as does the rapid recessions and expansions and will use this model to
growth of production during World War II. The consider the role that government economic policy can
downturn during the 2008 financial crisis is also play in mitigating the negative effects of business cycle
clearly evident. According to the National Bureau of fluctuations.
Economic Research (NBER), a recession is a period
between a peak and a trough in economic activity, Characteristics of Short-Run
and an expansion is a period between a trough and
a peak in economic activity. During a recession, a
Fluctuations
Expansions and recessions have effects that are visible
significant decline in economic activity spreads across
throughout the economy and are characterized by
the economy and can last from a few months to more
systematic patterns of change in a wide array of

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96
 FIGURE 51

Peak Trough Contraction Expansion Cycle

Previous Trough from Peak from
Quarterly dates are in parentheses Peak to trough trough to this previous peak previous peak
(months) peak (months) (months) (months)
June 1857(II) December 1858 (IV) 18 30 48 --
October 1860(III) June 1861 (III) 8 22 30 40
April 1865(I) December 1867 (I) 32 46 78 54
June 1869(II) December 1870 (IV) 18 18 36 50
October 1873(III) March 1879 (I) 65 34 99 52
March 1882(I) May 1885 (II) 38 36 74 101
March 1887(II) April 1888 (I) 13 22 35 60
July 1890(III) May 1891 (II) 10 27 37 40
January 1893(I) June 1894 (II) 17 20 37 30
December 1895(IV) June 1897 (II) 18 18 36 35
June 1899(III) December 1900 (IV) 18 24 42 42

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September 1902(IV) August 1904 (III) 23 21 44 39
May 1907(II) June 1908 (II) 13 33 46 56
January 1910(I) January 1912 (IV) 24 19 43 32
January 1913(I) December 1914 (IV) 23 12 35 36
August 1918(III) March 1919 (I) 7 44 51 67
January 1920(I) July 1921 (III) 18 10 28 17
May 1923(II) July 1924 (III) 14 22 36 40
October 1926(III) November 1927 (IV) 13 27 40 41
August 1929(III) March 1933 (I) 43 21 64 34
May 1937(II) June 1938 (II) 13 50 63 93
February 1945(I) October 1945 (IV) 8 80 88 93
November 1948(IV) October 1949 (IV) 11 37 48 45
July 1953(II) May 1954 (II) 10 45 55 56
August 1957(III) April 1958 (II) 8 39 47 49
April 1960(II) February 1961 (I) 10 24 34 32
December 1969(IV) November 1970 (IV) 11 106 117 116
November 1973(IV) March 1975 (I) 16 36 52 47
January 1980(I) July 1980 (III) 6 58 64 74
July 1981(III) November 1982 (IV) 16 12 28 18
July 1990(III) March 1991(I) 8 92 100 108
March 2001(I) November 2001 (IV) 8 120 128 128
December 2007 (IV) June 2009 (II) 18 73 91 81
February 2020 (2019 IV) 128 146
SOURCE: https://www.nber.org/cycles.html.

Business Cycle Peaks, Turning Points, 1857–2020.

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97
 FIGURE 52

12.0

10.0

8.0

6.0

4.0

2.0

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0.0

SOURCE: U.S. Bureau of Labor Statistics, Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/UNRATE, August 13, 2020.

U.S. Unemployment Rate, 1960–2019

different macroeconomic variables. Two of the most look closely, you can see that the rate of inflation was
important correlates of fluctuations in the economy’s declining during recessions.
aggregate growth are unemployment and inflation.
Potential Output, the Output Gap, and
Figure 52 shows the unemployment rate from 1960
through 2019. Recessions are generally characterized the Natural Rate of Unemployment
by rising unemployment. Typically businesses are slow In thinking about the short-run performance of the
to increase hiring in the early phases of an expansion, economy, it is useful to think of the actual level
so declines in unemployment typically lag somewhat of GDP at any time as consisting of two parts: the
behind the onset of the next phase of economic growth. potential output of the economy and an output gap.
Potential output is the quantity of goods and services
Like unemployment, the rate of inflation is also tied that the economy can produce when using its resources
to the business cycle. Periods of expansion are often (such as capital and labor) at normal rates. The level of
characterized by accelerating inflation, and recessions potential output is not fixed, of course, but increases
typically are linked to a slowing in the rate of inflation. over time as technology improves, and the economy
Figure 53 graphs the rate of inflation since 1960. accumulates additional resources.
Between 1960 and 1979, there was a generally upward
trend in the rate of inflation, which makes the business In the subsequent discussion, we will use the variable
cycle effect somewhat difficult to see. But, if you Y* to denote potential output. The output gap consists

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98
 FIGURE 53

15.0%

13.0%

11.0%

9.0%

7.0%

5.0%

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3.0%

1.0%
60
62
64
66
68
70
72
74
76
78
80
82
84
86
88
90
92
94
96
98
00
02
04
06
08
10
12
14
16
18
-1.0%
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20
20
20
20
20
20
20
20
SOURCE: Lawrence H. Officer and Samuel H. Williamson, ‘The Annual Consumer Price Index for the United States, 1774–Present,’
MeasuringWorth, 2020.

U.S. Price Inflation, 1960–2019. Average 1982–84 = 100.

of the difference between actual output, which we’ll Economists call the level of unemployment due to
denote by Y, and potential output. In other words, frictional and structural causes the natural rate of
the output gap = Y – Y*. Figure 54 plots the growth unemployment. It is the level of unemployment that
of actual output in the postwar period along with the would exist when the actual output is equal to potential
trend growth of output between successive business output.
cycle peaks, which approximates the growth of
potential output. Relative to the trend growth of The natural rate of unemployment varies over time
output, deviations appear small in this figure, but they due to changes in the labor market. During the 1970s
nonetheless result in significant economic hardships. and 1980s, the entry of many more women into
the paid labor force helped to raise the natural rate
When output is below potential output, the economy’s of unemployment, as did the decline of traditional
productive resources are not being completely utilized. manufacturing industries and the growth of the
In particular, unemployment rises when the economy service sector. More recently, the natural rate of
is below its potential output. Recall that unemployment unemployment has fallen.
is conventionally divided into frictional, structural,
and cyclical components. The cyclical component is In the early 1960s, Arthur Okun, who was one of
the part that rises when the economy is in a recession. President Kennedy’s chief economic advisors at the

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99
suringWorth, 2020.

d  FIGURE 54

4  $20,000,000
4
4  $18,000,000
4
6
9  $16,000,000
3
1
 $14,000,000
1
7
3  $12,000,000
7
5
 $10,000,000
0
6
5  $8,000,000
8
4
 $6,000,000

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7
5
5  $4,000,000
2
5
 $2,000,000
4
1
0  $‐
1945
1947
1949
1951
1953
1955
1957
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
2019
1
7
Real GDP (millions of 2012 dollars) Trend
5
4
SOURCE: Louis D. Johnston and Samuel H. Williamson, “What Was the U.S. GDP Then?” MeasuringWorth, 2020.
2 URL: http://www.measuringworth.org/usgdp/.
4
9 Actual and Trend Real Output for the U.S. Economy, 1945–2019
5
3
6
9
time, noted that there was a relationship between the Explaining Short-Run Fluctuations in
output gap and the level of cyclical unemployment.
8
Specifically, he observed that every one percent that
Output
What explains the recurrent alternation between
the unemployment rate differed from the natural rate
periods of expansion and recession in the aggregate
was associated with a two percent deviation in the
economy? Logically, variations in the rate of growth
output gap. In other words, if cyclical unemployment
of output over time could be caused either by changes
increased from 1 percent to 2 percent, then the output
in the growth rate of potential output or could occur
gap would rise from 2 percent to 4 percent. This
because actual output falls above or below potential.
relationship is called Okun’s Law.
The rate of growth of potential output depends on
the growth rate of the population, the rate at which
the capital stock increases, and changes in the pace

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100
of technological advances. Over long periods, shifts 6 Net Exports (NX) is the difference between
in these underlying forces do produce important the value of goods and services produced
modulations in the pace of economic growth. But, domestically and sold to foreigners and the
most of the short-run variation in the level of economic value of goods and services produced abroad
activity appears to be due to the divergence between and purchased by domestic residents.
actual and potential output. Although firms initially respond to variations in
In a world in which prices would adjust immediately demand by adjusting quantities, in the longer run
to balance supply and demand in all markets, the firms will adjust their prices to move back toward their
economy’s resources would always be fully employed, normal level of production. When demand is above
and actual output would not deviate from potential their desired level, firms will raise prices, causing
output. Accounting for deviations of actual output inflation to accelerate; when demand is below their
from potential output requires that we modify the basic normal level of production, firms will lower prices,
microeconomic model of markets to account for the fact causing inflation to slow.
that in many markets prices do not adjust immediately. Over the long run, price changes eliminate the gap
The most common approach to modifying our model between actual and potential output and ensure that the
of the economy rests on the observation that in many economy’s resources are once again fully employed.
parts of the economy, firms do not constantly adjust Because these adjustments can take a significant
prices in response to fluctuations in market demand. amount of time, however, there may be the potential
Instead, firms tend to set prices and sell as much or as for government policies to help eliminate output gaps
little as is demanded. It is only after a sustained period more quickly.

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of imbalance between demand and desired supply that This explanation for short-run fluctuations in the level
firms adjust prices. of economic activity was developed by the British
Because in the short run firms respond to variations economist John Maynard Keynes (1883–1946) in
in demand by adjusting production rather than prices, his 1936 book The General Theory of Employment,
output in the economy is determined by the level of Interest, and Money. The theory that Keynes developed
aggregate demand rather than by potential output. in this book was a response to what he perceived as
Aggregate demand is the total desired spending on the inadequacy of prevailing microeconomic models
final goods and services by everyone in the economy. to account for the events of the Great Depression. In
Recall that when we discussed the equality of GDP and recognition of Keynes’s contribution, the resulting
expenditures, we saw that total expenditures had four model of the economy is often called the Keynesian
components: model.

Consumption (C) is spending by households on According to Keynesian theory, the causes of short-
6
final goods and services. run fluctuations in the level of economic activity can
be summarized in terms of the interaction between an
6 Investment (I) is spending by firms on new aggregate demand (AD) curve and a short-run aggregate
capital goods, such as machinery and structures, supply (ASSR) curve, as is illustrated in Figure 55. In
as well as spending on the construction of new addition to the short-run aggregate supply curve, the
houses and apartment buildings. In addition, diagram also includes a long-run aggregate supply
increases in inventories are also included in curve, which is drawn as a vertical line at the point
investment. Y=Y*; that is where output equals potential output.
6 Government purchases (G) is spending by
governments—federal, state, and local—on In this diagram, the horizontal axis measures real
goods and services. Transfer payments, such GDP, and the vertical axis measures the aggregate
as Social Security benefits and unemployment price level. This diagram looks quite similar to the
insurance, as well as interest payments on demand and supply diagrams we have used before
government debt are not included in this to analyze individual markets, but it is important to
category. understand that the reasons for the shapes of the AD
and ASSR curves are entirely different from the demand

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101
and supply curves we have considered up to now. price level affects aggregate demand is exports. At
a lower domestic price level, domestically produced
The Aggregate Demand Curve goods and services are less expensive relative to foreign-
We will begin by considering the derivation of produced goods. As a result, domestic consumers will
the aggregate demand curve. Recall that in the buy fewer imported goods and services, and foreign
conventional analysis of a single market, the quantity consumers will purchase more domestically produced
demanded increased as the price fell primarily because goods and services, causing net exports to increase.
a lower price meant that the good in question had
become less expensive relative to other goods. For Now that we have explained the downward slope of the
example, as the price of bagels falls, they become a aggregate demand curve in Figure 55, we can consider
better bargain relative to muffins, and people will buy the factors that influence its position. Anything that
fewer muffins and more bagels. At the level of the influences the consumption decisions of households or
aggregate economy, however, such an explanation no foreign residents, or leads firms to increase investment,
longer makes sense since a decline in the aggregate will cause the aggregate demand curve to shift. The
price level means that the prices of all goods and introduction of a promising new technology, such as
services have declined. high-speed satellite internet, will cause some firms
to increase investment spending. For instance, Elon
If shifts in relative prices don’t account for the Musk’s SpaceX company is manufacturing over a
downward-sloping aggregate demand curve, then hundred internet satellites per month on its way to
what does? There are three reasons for the negative building a network with 12,000 satellites that will
relationship between aggregate demand and the be able to provide internet from orbit to anywhere in
aggregate price level. the world. Such an increase in investment spending

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increases aggregate demand at every price level and
Wealth Effects causes the AD curve to shift to the right.
With a fixed supply of money, when the aggregate
price level declines, the money that people have in their Similarly, changes in consumer sentiment will affect
wallets and bank accounts will allow them to purchase a consumption spending and will shift the AD curve.
greater quantity of goods and services. Lower prices in For example, a drop in stock prices, such as occurred
effect increase their wealth and encourage a higher level in the wake of the 2008 financial crisis, reduces wealth
of spending. Notice that this conclusion follows directly and causes consumers to reduce their level of spending
from the quantity equation that we introduced earlier at every price level. Such a change would be reflected
(M × V = P × Y). If the velocity of money (V) doesn’t as a leftward shift of the AD curve.
change and the quantity of money (M) in the economy
The AD curve can also be shifted by changes in
is constant, then a lower price level (P) must lead to a
government spending or taxes. An increase in spending
higher level of real GDP (Y).
by the federal government will, other things being
Interest Rate Effects equal, increase spending at every price level, a change
At a lower price level, people will find that they are that can be illustrated as a rightward shift in the AD
holding more money than they want to have. As we curve. When state governments reduce spending by
saw when we analyzed the demand for and supply of furloughing employees as some did during the recession
money, when people are holding more money than of 2007–2009, this reduces spending and shifts the AD
they view as optimal, they will attempt to reduce their curve to the left. When the government reduces taxes, it
monetary assets by using their money to acquire less increases households’ disposable income, which should
liquid assets, including bank certificates of deposit, increase consumption spending, which will shift the AD
stocks, and bonds. All of these actions increase the curve to the right.
supply of savings. Increased saving causes interest
rates to fall and encourages households and firms to The Aggregate Supply Curve
borrow more funds and increase their spending. In Figure 55 the aggregate supply curve is drawn as
upward sloping, indicating that the quantity of goods
Foreign Exchange Effects and services supplied is an increasing function of the
The third channel through which a lower aggregate aggregate price level. Once again, while the shape of the

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 FIGURE 55

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Aggregate Demand and Aggregate Supply in the Keynesian Model
Aggregate Demand and Aggregate Supply in the Keynesian Model

aggregate supply curve is similar to the supply curves sales. The aggregate supply curve slopes upward to
we encountered earlier in our microeconomic analysis reflect the relationship between this price adjustment
of markets for particular goods, it is upward sloping process and the size of unanticipated sales.
for different reasons. In the microeconomic analysis of
markets, the supply curve was upward sloping because The position of the aggregate supply curve depends
higher prices are necessary to attract resources from on the economy’s long-run potential output and on
producing other products. For example, in the market what people expect the aggregate price level to be. The
for bagels, as the price of bagels increases, bakers who short-run aggregate supply curve will pass through the
were previously producing muffins will be induced to vertical line at Y* at a price level equal to the prevailing
shift over to bagel production. At the aggregate level, expectation about aggregate prices. Resources will be
however, resources cannot be shifted from other less fully employed, and aggregate supply will equal its
profitable activities. long-run potential output, Y* in our earlier discussion,
when the aggregate price level is equal to the level that
As we noted at the beginning of our discussion of firms and consumers anticipated.
short-run economic fluctuations, many firms do not
immediately adjust prices in response to variations in Thus, there are two reasons for the short-run aggregate
demand. Instead, they fix prices for some period of supply curve to shift. The first and most common
time and sell as much or as little as consumers choose cause of shifts in the position of the aggregate supply
to purchase. Over time firms adjust their prices in curve is changes in the expected price level. Since
response to the gap between actual and anticipated ASSR is equal to Y* at the expected aggregate price
level, an increase in the expected price level will cause

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the aggregate supply curve to shift upward. A decrease In panel (a) of Figure 56, we show the combined effect
in the expected price level will cause the aggregate of these events as a leftward shift in the AD curve. As a
supply curve to shift downward. result, the economy’s short-run equilibrium now occurs
at Y1, which is less than Y*. The economy is now in a
The second cause of shifts in the aggregate supply curve recession because of the shift in consumer sentiment.
is aggregate supply shocks. For example, weather and
climate conditions that affect agricultural production As the equilibrium point in Figure 56 shifts down and
may shift the aggregate supply curve. An especially to the left along the ASSR curve, some businesses lower
good harvest means that more agricultural commodities their prices, and the aggregate price level begins to
are available at every price, an event that would cause decline, a response that moderates the impact of the
the aggregate supply curve to shift rightward. An shift in consumer sentiment.
important example of a shock to aggregate supply in
recent history is the OPEC-initiated oil embargo that Panel (b) of Figure 56 illustrates the adjustment of the
began in 1973. Because of the importance of fossil economy as it begins to recover from the recession.
fuels as a source of power throughout the economy, the The position of the aggregate supply curve in Figure
shortage of imported oil had a widespread effect on the 56(a) indicates that businesses and households were
U.S. economy, causing a reduction in quantities supplied expecting that prices would be at P0, since this is
at every price, and a leftward/upward shift of the short- where the curve passes through the point where Y=Y*.
run aggregate supply curve. However, the actual price level, P1, is now below P0.
As time passes and firms find that they are selling
In addition to these movements of the short-run less, they will begin to adjust their expectations about
aggregate supply curve, technological progress will the aggregate price level downward. As a result of the

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cause the economy’s potential output to shift out to the decline in prices, output has increased to Y2, but it is
right over time. It is this increase in potential output that still below potential output. Prices will continue to fall
accounts for the long-run growth of real GDP we noted until the AD and ASSR curves once again intersect at
at the beginning of this section of the resource guide. the point where output equals potential (Y*).

The Keynesian Model of Short-Run In Figure 57 we illustrate a recession caused by an

aggregate supply shock such as the OPEC oil embargo
Fluctuations of 1973. The shortage of petroleum and higher prices
At any point, the Keynesian model implies that the of gasoline and other products is shown in Figure 57
economy’s aggregate production and price level are (a) as a leftward shift of the ASSR curve. Beginning
determined by the intersection of AD and ASSR. at the point Y=Y* and price level P0, output falls to
Figure 55 is drawn so that this intersection occurs at Y1, and the aggregate price level rises to P1. With
the point where actual output is equal to its potential, the economy in recession, firms find that actual sales
so the output gap is zero. At this point, there is no are falling short of expectations. Eventually they
cyclical unemployment, and resources are being fully will begin to cut prices, causing the ASSR curve to
employed. But, if the aggregate supply or aggregate shift out to the right. This movement is illustrated in
demand curve were to shift for some reason, the Figure 57(b). Prices will fall until output once again
intersection of the two curves would be either above or equals potential. At this point, the price level will have
below potential output. returned to its original level at P0.
We will begin by illustrating the effects of a negative Figures 56 and 57 illustrate the basic explanation of
aggregate demand shock. In February 2020, the United recessions and expansions in the Keynesian model.
States economy went into recession as a result of the Recessions and expansions occur because of the
nationwide shutdowns that followed the spread of sequence of unpredictable shocks to aggregate demand
COVID-19 in the country. As consumers stayed at or aggregate supply that strike the economy and cause
home, and many business closed in an effort to slow the equilibrium level of production to move away from
the spread of the virus, consumption and business its potential. The reason these shocks are translated
investment spending both fell sharply. Government into recessions or expansions is because of the short-
spending increased to try to fill the gap, but the end run inflexibility of prices. If prices everywhere in the
result was a recession.

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 FIGURE 56

(a) NEGATIVE AD SHOCK CAUSES A RECESSION

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(b) FALLING PRICE EXPECTATIONS SHIFT AS SR DOWNWARD
AND CAUSE ECONOMY TO RECOVER

Aggregate Demand and

Aggregate Aggregate
Demand Supply
and Aggregate Supply in the
in the Keynesian Keynesian Model
Model

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FIGURE 57

(a) A NEGATIVE AGGREGATE SUPPLY SHOCK CAUSES OUTPUT TO

FALL AND THE PRICE LEVEL TO RISE

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(b) ADJUSTMENT TO A NEGATIVE AGGREGATE SUPPLY SHOCK

Effects of an Aggregate Supply Shock

Effects of an Aggregate Supply Shock

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 FIGURE 58

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Effects ofEffects
a Fully
of a FullyAnticipated
Anticipated AD ShockAD Shock

economy adjusted instantly to the effects of shocks, this is usually from one to three years.
then output would never differ from potential. It is
the short-run inflexibility of prices that is the basic Inflation in the Keynesian Model
explanation for recessions and expansions. The model of recessions and expansions we have
sketched so far has assumed that the level of inflation
You will notice that up until now, we have been in the economy is zero. That is, we have drawn the
somewhat vague about the period of time that is AD and ASSR curves on the assumption that everyone
represented by the “short run.” That is because the believes the aggregate price level is stable. We have
definition of the short run is effectively the period seen, however, that since the Second World War the
of time in which the performance of the economy aggregate price level has followed a generally upward
deviates from the predictions of the long-run model. trend. Moreover, as the previous section demonstrated,
Judging from the length of typical economic cycles, the process of adjustment by which the economy

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returns to full employment after a shock involves however, take a year or more to significantly affect the
changes in the price level. economy, a fact that leads many economists to argue
that fiscal or monetary policy measures should be used
To begin with, we need to ask why an economy would to help speed up the adjustment process. Nonetheless,
experience persistent inflation. The quantity equation the use of activist policies remains controversial, and
implies that in the long run, the aggregate price level a significant number of economists believe that such
can rise only if the money supply is growing faster than interventions are generally counterproductive. We will
the economy’s potential output. Suppose, for example, begin here by describing how government policy affects
that because of technological change, potential output the short-run equilibrium in the economy, and then we
increases 2 percent per year, and the stock of money will discuss arguments for and against intervention.
increases at 5 percent per year. The quantity equation
can be rearranged to show the price level must equal (M As we have seen, total expenditures in the economy
× V)/Y*. So long as velocity is constant, prices will rise are described by the equation Y = C + I + G + NX.
at 3 percent (= 5% – 2%) each year. The term G stands for government purchases of goods
and services. If shifts in household and business
In the aggregate demand–aggregate supply model, spending and net exports reduce expenditures,
an increase in the money supply causes the AD increased government spending can be used to make
curve to shift to the right. But, if people have become up the shortfall in aggregate demand. Increased
accustomed to an increasing money supply and rising government spending, or expansionary fiscal policy, is
prices, then they will expect the price level to rise one form of intervention that should offset a recession
each year, and the ASSR curve will shift upward so that and restore full employment.
AD and ASSR continue to intersect at the economy’s

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potential output. This is illustrated in Figure 58. Fiscal policy can also be used to indirectly increase
spending through a tax cut. Lower taxes (with a
Thus, full employment equilibrium is consistent with constant level of government spending) mean that
any anticipated level of inflation. In this context, consumers have a higher level of disposable income.
unexpected shocks that move the economy away from Higher income should encourage increased consumer
full employment cause actual inflation to deviate spending and cause the AD curve to shift to the right,
from the anticipated level. For example, suppose that thus mitigating the effects of a recession.
the federal government decides to begin a military
buildup, but chooses to finance it through borrowing In addition to fiscal policy, the Federal Reserve can
because it is afraid that increased taxes will be use monetary policy instruments to offset short-
unpopular. This is roughly what happened in the 1960s run economic fluctuations. By varying the amount
under President Lyndon Johnson. of money it supplies to the economy, the Federal
Reserve can control the interest rate. And, as we have
The increased government spending causes output to seen, changes in the interest rate can affect the level
increase precisely because it is not anticipated. In the of both investment and consumption spending. If
long run, however, there is no policy that will maintain the economy is producing above potential output, a
output at a level different from the economy’s potential situation that would cause inflationary pressures, the
output. Thus, when we use the aggregate demand– Federal Reserve can help to reduce consumption and
aggregate supply model, we need to remember that investment spending by decreasing the money supply
the changes in aggregate prices that it indicates are and causing interest rates to rise. Conversely, if the
unanticipated deviations from the prevailing (and economy is in recession, increasing the money supply
expected) rate of inflation. will lower interest rates and stimulate additional
consumption and investment spending.
Using Fiscal and Monetary Policy to
Stabilize the Economy The main argument in favor of using monetary or
The adjustment of the aggregate price level when output fiscal policy to stabilize the economy is that deviations
differs from potential suggests that the economy has of actual output from potential output are costly.
a natural tendency to return to a situation in which In recessions, when some resources are not fully
resources are fully employed. Such an adjustment can, employed, the economy forever loses the output that

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these resources could have produced. Moreover, growth in the size of economies? (2) What
unemployment imposes significant hardships on those are the causes and consequences of short-run
who lose their jobs or see their incomes reduced. When fluctuations in the level of economic activity,
output is above potential, inflation will accelerate. We employment, and inflation?
have seen that inflation is costly for a variety of reasons. Economists measure the total output of the
6
Controversy about the desirability of fiscal and economy using Gross Domestic Product
monetary policy interventions arises for two reasons. (GDP). GDP is the market value of all final
The first is the difficulty of identifying precisely what goods and services produced within a country
the economy’s potential output is and thus the difficulty during a specified period of time.
in determining when interventions are needed. The 6 In the United States, output has grown much
second and more significant concern centers on the faster than population. Since 1900, the U.S.
practicality of carrying out such fiscal and monetary population has increased by a factor of about
policy effectively. four, while GDP has grown by a factor of
almost forty.
One of the biggest challenges that economic
policymakers face is that information about the 6 The rate of growth of output is quite variable.
aggregate economy takes time to collect. It takes about A period between a trough and a peak in
three months to calculate the first estimates of GDP, economic activity is called an expansion;
and these estimates are subject to substantial revision a period between a peak and a trough in
over the next few months as additional data becomes economic activity is called a recession.
available. Other data are available more quickly, 6 The alternation of periods of expansion and

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but almost all economic information has some lags, recession is referred to as the business cycle.
meaning that policymakers must act on partial and The labor force is the total of all individuals who
6
incomplete evidence about the state of the economy. are either working or are available for work but
Moreover, the effects of their actions take time to be are not currently working. The unemployment
felt. When interest rates are reduced, for example, it rate is the percentage of the labor force who
can take many months for businesses to undertake would like to work but cannot find jobs.
new investment projects since they often require 6 Economists often break down unemployment
considerable planning. Efforts to increase government into frictional unemployment, structural
spending operate with even longer lags. It can easily unemployment, and cyclical unemployment.
take six months or a year from the time Congress Inflation occurs when prices in the economy
6
authorizes additional spending until projects are are all increasing. The Consumer Price Index
actually undertaken. So, even if Congress acts quickly, and the Gross Domestic Product Deflator
which is not usually the case, the additional spending provide two different measures of inflation.
may not begin to take effect until the economy has
already begun to recover. 6 Gross Domestic Product is defined as a measure
of production; but at the level of the economy,
If the effects of increased government spending production equals expenditures equals income.
begin to be felt only after the economy has begun Economists divide expenditures into four
6
to recover on its own, they may cause the economy categories: Consumption, Investment,
to overshoot full employment and contribute to Government Purchases of Goods and Services,
inflationary pressures rather than mitigating the effects and Net Exports.
of the recession. For this reason, many economists
believe that activist policies are as likely to be 6 The quantity of GDP per capita that an
counterproductive as to be helpful. economy produces is closely related to the
level of average labor productivity. Labor
SECTION III SUMMARY productivity depends on many things, the
Macroeconomics is concerned with two most important of which are the quantities of
6
questions: (1) What determines the long-run physical and human capital an economy has

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 accumulated, its natural resource supplies, supply of money in the economy and
the level of technological knowledge, and the acts as lender of last resort for the
political and legal environment. banking system.
6 Economists use the term “savings” to 6 In the long run, increases in the supply of
describe income that is not spent on the money do not affect the real economy, but affect
consumption of goods and services in the only prices. But, in the short run, changes in
current period. “Investment” is the term used to the supply of money alter credit conditions and
describe the purchase of new capital equipment. influence the level of economic activity.
6 Financial markets are the institutions through 6 To analyze short-run variations in the level of
which individuals who have money they wish economic activity, economists divide actual
to save can supply these funds to persons or output into two parts: potential output and the
companies who wish to borrow money to invest. output gap. Potential output is the quantity of
Because of the way they are defined, savings goods and services that would be produced if
6
must equal investment in a closed economy. In all resources were fully employed. The output
an open economy, savings equals investment gap is the difference between actual output and
plus net capital outflows. potential output.
6 In the long run, an economy’s output is
7 In the financial markets, the interest rate determined by its potential output. But, in the
adjusts to equate the supply of saving to
the demand for saving (investment). short run, many firms set prices and sell as
much or as little as is demanded. As a result,
7 Money is any asset that serves the output is determined by the level of aggregate

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functions of: (1) a medium of exchange, demand, which may be more or less than
(2) a unit of account, and (3) a store of potential output.
value. Because it is not easy to draw an
absolute distinction between assets that 6 Deviations of actual output from potential
are and are not money, economists use output eventually cause the aggregate price
several different measures of money. level to change so that the economy returns to
The most common are M1 and M2. potential output.
6 When actual output deviates from potential
7 The Federal Reserve System is the output, monetary and fiscal policy tools can
central bank of the United States. It
was established in 1913 and consists be used to help speed up the adjustment
of twelve district banks located in process. In practice, however, changes in
major cities across the country and government spending or the money supply
the Federal Reserve Board, which is affect the economy with long and variable lags.
located in Washington, D.C. Consequently, attempts to stabilize the economy
may actually magnify economic fluctuations.
7 The Federal Reserve controls the

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 Section IV
The Economics of Water
INTRODUCTION
Water is essential to human life for drinking and
sanitation, but it is also a productive input for many
other goods and services. In many areas, there is a
lot of water, and the economic value of water can be
low. In The Wealth of Nations, Adam Smith noted this
apparent incongruity:
Nothing is more useful than water: but it will
purchase scarce any thing; scarce any thing
can be had in exchange for it. A diamond, The Akosombo Dam on the Volta River in southeastern Ghana.
on the contrary, has scarce any value in use;

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but a very great quantity of other goods may When water provides a habitat, cleans pollutants, or
frequently be had in exchange for it. provides a service that would otherwise require capital
investment, we say it is providing an ecosystem service.
—Adam Smith, The Wealth of Nations, 1776 These services may define the opportunity cost, or best
alternative, of human water use. Because these services
Smith is describing scarcity value. Diamonds are are unpriced, they can result in market failure. Market
valuable because they are scarce, not because they failure occurs when a good or service is not allocated
are useful. Water can be extremely cheap when it is efficiently in a market, and these types of problems are
abundant, but this does not make it any less critical for more common with water because of the important role
life. Because humans use a lot of water and it is heavy, it plays in human and ecosystem health.
and therefore costly to transport, local conditions
determine its scarcity. While in wet regions water The potential for market failure is not limited to
can be abundant, in drier regions, the value of limited ecosystem services. Externalities associated with water
water exceeds the cost of supplying it, and this cost pollution are common throughout the world. Water
difference is referred to as scarcity value. pollution is damaging to human and ecosystem health,
and the free market will provide too much pollution
But scarcity value is just one of many attributes that because polluters do not bear the full cost of their
make water interesting as a topic of economic study. actions.
Water is a renewable resource. You may have heard
the adage that the water you drink may have rolled Because of market failures and externalities, water
down a dinosaur’s back. This attribute means water extraction and use may be regulated and monitored.
can provide sequential benefits when it is consecutively Where water is scarce, the right to use it is valuable;
used, for instance by cities, farms, power plants, and where it is abundant, the right to pollute it is contested.
ecosystems. After you water your lawn, some of the The study of economic institutions is crucial to
water percolates into an aquifer underground where understand water economics. Economic institutions are
it is later pumped by a well owner, whose irrigation the “rules of the game” under which economic activity
water flows into a river where it provides a habitat for is conducted. They include legal systems and courts,
fish, and so on. property rights and markets, and government regulation.
This section of the resource guide on water economics

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 Crop sprinklers near Rio Vista, California. Worldwide, Groundwater pumping typically occurs near the point of
more than 70 percent of the consumptive use of water is for use and therefore requires relatively low infrastructure
irrigated agriculture. investment.

will provide an application for the economic content of use is fundamental to water economics. Water use can
the earlier sections as well as build a new framework be consumptive, where the water is not returned to
for the study of institutions to provide a thorough the system, or non-consumptive, where some portion
background on the economics of water. of the amount diverted is available to be used again.
One key sticking point for students beginning to Worldwide, more than 70 percent of the consumptive

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study water economics is the treatment of water as a use of water is for irrigated agriculture. In the western
good with monetary value. While water is essential to part of the United States, many states see agricultural
human life, and the United Nations even defines water water use in excess of 90 percent of total diversions.
as a human right, the rules of economics still apply to
its allocation and use. Water has a value, and where
Water Sources
Water is typically classified by its source: ground
it is scarce, that value is high. Economics is the study
or surface. Surface water is stored in reservoirs
of how markets and other mechanisms allocate scarce
and diverted through canals and pipes, requiring
resources, whether they are luxuries or necessities.
infrastructure investment. Where it is used for human
Studying water as a market-allocated good does not
supply, surface water may require treatment to
change its essential nature, our moral obligation to
eliminate contaminants and pathogens. Groundwater
allocate it fairly, or the need to preserve water for
is pumped through wells from subsurface aquifers,
the natural environment. The study of the economics
where water collects in the pore space between
of water provides key insights into water resource
rocks. Groundwater pumping typically occurs near
challenges and the tradeoffs of water use in a variety of
the point of use and therefore requires relatively low
situations around the world.
infrastructure investment. Pumping groundwater
requires energy, with costs increasing the deeper the
THE BASICS water is located below the ground. As groundwater
Users enters an aquifer, it is filtered through soil and
There are three main categories of economic water rock, which act as natural filters, reducing needed
user groups: agricultural, urban, and commercial/ investment in treatment for human consumption.
industrial. A fourth category, water for the environment,
also deserves attention, as ecosystems are recognized In the United States about 68 percent of freshwater
as providing substantial economic value. Historically, withdrawals are from surface water systems.
environmental water has been the amount left over Hydrologically, ground and surface water are often
after diversions were made for the other three uses, connected, complicating its allocation. Surface water
but this is changing. The study of the allocation of withdrawals reduce flows in streams and availability
scarce water resources across these four categories of to downstream users but can also reduce recharge of

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groundwater systems. Groundwater pumping lowers the
elevation of underground water, raising the expense of
pumping and leading to collateral effects like seawater
intrusion into coastal freshwater aquifers and drying up
of wells. Pumping can also reduce streamflow.

Water Quantity
Water quantity describes the amount of water available
at a given time and place. Water quantity is determined
by precipitation, surface water flows, existing
groundwater resources, and constructed infrastructure
like reservoirs and canals. When economists discuss
water quantity, they are discussing the allocation of
water, and water quantity markets refer to the transfer
A water sample pulled from Lake Erie after a toxic algal
of water between uses and sectors. Water is often a
bloom in 2014.
common-pool resource (CPR)—its use decreases the
Photo Credit: Haraz N. Ghanbari/AP Photo
amount available to others, but it is difficult to exclude
anyone from using it. When institutions to manage use when the condition of a water source is not suitable
do not exist, such resources are susceptible to overuse, for its intended use. Examples include heavy metal
with each user taking too much water because if they contamination making drinking water unhealthy,
don’t, someone else will. This is known as the tragedy nitrogen loading leading to excessive algal growth in
of the commons. To address these issues, water is

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rivers, and bacterial contamination making beaches
typically allocated via institutions, including legal unsafe for swimming. Water pollution can reduce the
systems and courts, property rights and markets, and function of natural ecosystems. For instance, excess
government regulation. Institutions determine who nitrogen or phosphorous from stormwater runoff,
gets to use water, what it can be used for, and to what agriculture, lawn fertilizers, and industrial discharges
extent it can be polluted. When water is scarce, these can lead to large-scale fish die-offs. There is a tradeoff
allocations can become more contentious because between economic activity that creates polluted water
water becomes valuable. and investment in reducing the pollution. The economic
activity that leads to pollution generates income for a
Water Quality different person than the fisherman, swimmer, or other
Water quality describes the condition of water for a
party that is affected by the pollution. For this reason,
specific purpose in terms of chemical, physical, and
water pollution is an example of market failure, where
biological characteristics. Water quality problems arise
too much pollution is created.

CASE STUDY

China’s South-North Water Transfer Project

A large water transfer in China illustrates aspects of all four basics (users, water sources, water quantity,
and water quality) of water economics. Governmental water projects often move large quantities of water
across large distances to create more water supply in arid areas. The majority of China’s freshwater
resources are located in the southern part of the country, whereas the key population and agricultural
production centers are in the north and east.74
The Yellow River in the north has suffered completely dry periods in twenty-two of the past twenty-eight
years,75 and the Yangtze River in the south has seen rising water levels that have threatened the lives and
property of millions of people, including a flood in 1998 that killed approximately 4,000 people.76 To address

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 The starting point of the South–North Water Transfer Project central route, looking toward the Danjiangkou Reservoir, from
which the water is coming.
Photo Credit: By Nsbdgc - Own work, CC BY-SA 4.0, https://commons.wikimedia.org/w/index.php?curid=42831666

these issues, the Chinese government has developed the South-North Water Transfer Project, which uses
a series of inter-basin transfers to move up to forty-eight billion cubic meters of water per year from the
Yangtze to the Yellow River.77 Water quality is a significant concern. Much of the system suffers from acute

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agricultural and industrial pollution. Socio-economic impacts are also problematic. The resettlement of more
than 300,000 people was required to complete the project.

SUPPLY AND DEMAND

Water Supply
The supply of water differs from many goods we
use every day in several important respects that can
allow for market failure and in some cases justify
government intervention to remedy. Water resources
are big and can benefit from economies of scale,
which occur when the marginal cost of production is
decreasing as production increases. For instance, one
large dam project is more cost effective than everyone
building their own dams to divert water. This means
the most cost-effective way of providing water may
be through a monopoly. Similarly, you only have
one set of pipes running to your house; it would be
The Mission District in San Francisco burns in the aftermath
unnecessarily expensive to build multiple sets of pipes
of the San Francisco Earthquake of 1906.
for different companies to supply you with water. So,
while you have the option of shopping at a variety of
Where water resources are scarce, the value of water
grocery stores, and they compete for your business,
is higher than the cost of extracting it. In a competitive
you only have one water utility to buy from. In the
market, goods are sold at their marginal cost. If water
absence of regulation, this market power would allow
were to be sold at its marginal cost of extraction, there
monopolies to limit the supply of water, making the
would be a shortage. In a well-functioning market,
price artificially high. This is one reason why water
shortages are only temporary because prices rise.
supply is often regulated.

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 consumers, it returns a large surplus to the city’s
general fund.

Water Pricing
Every market has buyers and sellers. In the San
Francisco example, when the city sells water, the water
is purchased by the end users of water: consumers.
Consumers are the water utility’s customers. The
water utility sets a price schedule, and then consumers
choose how much to buy. There are four types of rate
schedules used by water utilities to charge per unit
(often 1,000 gallons of water):

6 Flat fee – A hookup or other charge is applied,

but the charge does not change with changes in
The O’Shaughnessy Dam in Yosemite National Park. water use.
Photo Credit: By Inklein at English Wikipedia, CC BY-SA 3.0,
https://commons.wikimedia.org/w/index.php?curid=8256821 6 Constant marginal price – Each unit of water
has the same charge.
Higher prices cause buyers to reduce their purchases
and cause more suppliers to enter the market. However, 6 Decreasing block rate – As the volume
water can be expensive or challenging to trade, so purchased increases, the price per unit
often one area or sector sees a shortage while another decreases (also referred to as bulk discounts).

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may use water in a more profligate manner. 6 Increasing block rate – As more water is used,
the charge per unit increases (also referred to
The history of San Francisco’s water supply nicely
as conservation pricing).
illustrates all these dimensions of water supply. In the
early 1900s, San Francisco was supplied by a single Economic theory predicts that the type of rate changes
private entity, Spring Valley Water Works. Behaving the incentives consumers face. Under a flat fee,
as a monopoly, the company limited the water flowing consumers do not face any price difference in using a
into San Francisco. The company purposefully limited little or a lot of water. Flat fees can encourage wasteful
the supply of water to the city, keeping prices, and its water use, just like an all-you can-eat buffet might
profits, high. In 1906 a massive series of fires started encourage excessive eating. Similarly, decreasing
after a large earthquake struck just to the north of block rates create incentives for consumers to use
the city. Ultimately, more than three thousand people more water. Like a buy one, get one half-off discount,
were killed, and over 80 percent of the city burned. quantity discounts provide additional water at lower
Many blamed the water company for limiting the city’s prices. Alternatively, constant marginal prices can
water supply, although the impact that additional water provide some incentive for consumers to conserve
supply would have made on firefighting is not clear. water by applying the same charge for each additional
unit. Increasing block rates double down on these
Ultimately, the fires resulted in a municipal takeover incentives, increasing the charge for subsequent units
of the water company, making it a publicly regulated of water. This type of pricing scheme is referred to as
monopoly, and led to a search for additional water conservation pricing because it reduces demand, via
supplies. The city settled on the Tuolumne River in the higher prices, as more water is consumed.
Hetch Hetchy Valley of the newly created Yosemite
National Park as a water supply. To this day, San Consumer Water Demand
Francisco still receives the bulk of its water from the Real-world water bills, and the response of consumers,
park, paying just $30,000 per year to lease the valley pose a challenge for economic theory. Rational
that is now flooded by the dam. Although the marginal consumers should respond to marginal price because
cost of diverting the water to San Francisco is low, the they make decisions on the margin. However, water
city sells the water for over $440 million. Although bills often do not show consumers the marginal price
the city does bear costs transporting the water to of water. For instance, if the bill only shows a total cost

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and amount, a consumer can only compute the average
price per unit. Figure 59 shows an increasing block rate
bill—marginal price—and the computed average price
of water. If a consumer only sees the average price,
they are likely to respond less, because the price they
see is lower.

FIGURE 59

An irrigation canal in Gujarat. Irrigation has virtually

eliminated famine in India.
Photo Credit: By Nvvchar - Own work, CC BY-SA 3.0,
https://commons.wikimedia.org/w/index.php?curid=4655844

the elasticity of demand to determine how a percentage

change in price will affect the percentage change in
demand. A meta-analysis showed that the mean
elasticity of urban water demand was –0.41.78 This
Sample Water Rate Schedule and Average Price means a one percent increase in price will decrease
Curve from Utah demand by 0.41 percent. Water delivered to urban

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customers and agricultural irrigators is typically
viewed as an inelastic good because estimated
Even after knowing that a water consumer is
elasticities are generally estimated to be between –1
responding to marginal price, a calculation must be
and 0. This means consumers are relatively
made to understand the relationship between price and
unresponsive to the price of water.
quantity consumed. To do so requires an estimate of

CASE STUDY

Pumping and Subsidies in India

Groundwater is critical to irrigation in India, where high agricultural intensity combined with poorly planned
energy subsidies create incentives for unsustainable water use. According to the World Bank, groundwater
irrigation contributes up to 10 percent of India’s GDP.79 In the 1970s, Energy subsidies were introduced
by the Indian government to allow poor farmers to access water for irrigating high-yield crops.80 After the
implementation of the subsidy, the amount of land with accessible groundwater increased by over 300 percent
due to nonexistent costs of pumping.81 As agriculture grew, it became increasingly difficult to install, monitor,
or maintain meters for pumps. Overextraction and unsustainable use of the resource ensued. Flat fee pricing
was implemented, which does not effectively incentivize water conservation, and it is not well understood
whether these fees are actually enforced.
Today, the lack of regulations on groundwater withdrawal in India threatens the viability of the
electrical power sector and groundwater sustainability. Yet it is the impact of these subsidies on low-
income and rural households that is the roadblock to removing them. Irrigation has virtually eliminated
famine in India, and groundwater is the backbone of Indian agriculture, supporting 70 to 80 percent of
irrigated output. Not surprisingly, there is little political support from farmers for the implementation of
conservation pricing via increasing block rates.

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 FIGURE 60

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Worldwide intensity of irrigated land.10

WATER AND AGRICULTURE

The amount of water needed to successfully grow
crops varies depending on the crop, but staple cereals
typically require somewhere between 450mm and
700mm per year. From 1961 to 2003, the world’s
harvested land increased by about 24 percent, out of
which 28 percent was irrigated. Approximately 70
percent of the world’s irrigated land is in Asia, where
it accounts for almost 35 percent of cultivated land.82
Figure 60 shows the intensity of irrigation by the
percentage of a one-kilometer grid that is irrigated.

The History of Irrigation

Irrigation has been linked to the growth and expansion The water in the Alhambra palace and fortress in Granada,
Spain is natural spring water that is channeled and conducted
of various empires through history.84 In prehistoric
by a still-working irrigation system originally organized by the
America, the Hohokam people of the American Alhambra’s Arab occupants.
Southwest built an estimated 850 miles of waterways Photo Credit: Jebulon
in the fifteenth century.85 At the time, this irrigation
infrastructure supported the largest population in
what is now the United States, and the remains of this managed and financed by water use associations. The
system can still be found near Phoenix, Arizona.86 majority of irrigated land in Spain today is still based
on traditional systems and irrigator organizations.87
In Europe, Spain has a long history of irrigation. With
a shortage of sites available for the construction of Where it has occurred, the modernization of irrigation
dams, Spanish irrigation works focused on canals took place at different times in different areas. In

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the American West, the late nineteenth century saw
advanced irrigation development in California and
Colorado, by Mormon settlers in present-day Utah,
and Hispanic farmers in formerly Spanish areas of
southern Colorado and New Mexico. In Asia, the
adoption of widespread irrigation coincided with the
Green Revolution in the 1960s, which also included
the introduction of fertilizers, pesticides, and high-
yield seed varieties. Combined with irrigation,
these new practices led to a massive increase in
food production. However, the associated ecological
impacts, especially related to the ongoing decline and
pollution of groundwater, remain a key challenge.
Lithograph of the Erie Canal at Lockport, New York c.1855.
Irrigation Organizations
Irrigation involves solving both technical and of the canal infrastructure with the farmers themselves.
organizational challenges to move large amounts Eventually the irrigation district, with governmental
of water long distances. When several irrigators taxing authority, emerged as the dominant institutional
utilize the same infrastructure, for instance a mutual structure. These districts solved the problems with
canal, the organizational form matters as much as large-scale coordination by electing boards and raising
the technology. In the United States, irrigation was revenue sufficient to contract for water deliveries to
originally undertaken by individuals and private

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irrigate hundreds of thousands of acres.88
enterprise. However, for-profit canal companies and
dams soon faced difficulties because the canal works Another irrigation institution found in the western
were linked directly to a fixed group of farmers. part of the United States, particularly in New Mexico,
Farmers could withhold payment, and canal owners is the acequia. This water allocation system, in place
could withhold water, leaving both vulnerable. since the southwest United States was under Spanish
Economists refer to this type of situation as a bilateral and Mexican control, consists of a decentralized but
monopoly, where players on both sides of an exchange complex set of rules from both Spanish and Anglo-
can exercise bargaining power. American water law to allocate scarce water resources
to irrigators.89 In the early twentieth century, these
Private canal enterprises were soon replaced by mutual systems were generally replaced by irrigation districts
ditch companies, where irrigator-owners invested time in order to centralize the organization of additional
and money in the construction of a ditch for a share irrigated acres. However, where irrigation did not
of water. These enterprises solved the market power expand, acequias have worked as effectively as
problem by combining the construction and operation irrigation districts in coordinating irrigation.90

CASE STUDY

The Value of Irrigation in the United States

In the United States, the 98th meridian approximates the divide between the humid East and the semi-
arid West. A lack of adequate water for agricultural production is one of the defining characteristics of
the West. Beginning with the completion of the Hoover Dam in 1936, federal reclamation projects began
to deliver water across the West and increased irrigation rates in many areas. Starting in the 1940s,
technological innovation allowed for the widespread adoption of groundwater irrigation on the Great
Plains and across the West. As a result, irrigated acreage doubled from around 20 million acres in 1940
to 40 million acres by 1978. Areas using large streams or groundwater as irrigation sources increased

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 crop production by $19 billion after 1940, around 90 percent of the subsequent total increase in crop value
in the western United States.91 Areas where irrigation is present may be better able to deal with weather
variability, maintain harvest levels, and decrease failed acreage during periods of severe drought.

WATER PROPERTY RIGHTS

Water Law
Water law defines the allocation of water and water
pollution for a society. Legal rules are intertwined
with economics because they assign the benefits and
the costs of a resource to people. Legislation regarding
water allocations and regulatory policies for water
pollution are predicated on existing water rights and
other applicable legal frameworks. Spanish water law
consists of a set of customs for allocating scarce water
based on prior usage, need, existing legal rights or
precedents, and intent of use; equity and the common
good of the community are prioritized. Alternatively,
Workers on a jumbo rig used for drilling tunnels in the English common law relies on legal precedent. One set
construction of the Hoover Dam. of precedents recognized in England and the eastern

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United States for managing water is the riparian
Water Conservation doctrine.
Improved irrigation technology has the potential to Statutes can also define more formal property rights
conserve large volumes of water and to do so with to water, which outline expectations for resource use,
little or no loss in crop yields. For instance, replacing investment, and exchange by owners.94 Property rights
gravity or flood irrigation, where water is allowed to solve the tragedy of the commons by allocating the
flow out across a field, with sprinklers can save 10–35 right to use the commons to a finite group of owners;
percent of the applied water.92 However, realized ownership can be held by a private person, group, or
savings depend on the attributes of the system, the the state. Property rights to surface water have often
physical characteristics of the field, and the rules and taken the form of the appropriative rights doctrine,
institutions governing water use. Generally, water which allocates water based on a seniority system.
costs are low, and irrigation efficiency improvements If property rights are fully defined and enforced,
may not appear especially responsive to water prices. owners have incentives to maximize resource values
Even where adopted, the use of efficient irrigation in use, investment, and trade. Formal property rights
technology is not enough to ensure more water to groundwater are seldom defined, and common law
availability. Termed the irrigation efficiency paradox, remedies may not apply, leaving users to work together
increased water use efficiency can lead to only small to find solutions.
gains in usable water. This is both an accounting
and a behavioral problem. Because non-consumptive Riparian Doctrine
water use at a particular farm may be recovered Under riparian right systems, water is allocated
and reused at the basin level, measuring water use equally to users along a water body’s path or location.
at too fine a scale can overestimate the savings of The rights to water are actually rights to the flow of
efficiency improvements. Technologies that make crop water; the quantity of water allocated is not precisely
production more efficient may induce farmers to switch specified, and all users face an obligation to use water
to water-intensive crops or even apply more water to responsibly. Each riparian right is linked to water-
the same crop.93 adjacent land, and landowners have the same rights
and obligations regardless of how much land they own.

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 minerals, prior-appropriation rights to water are
assigned through first possession, or “first-in-time,
first-in-right.” Appropriative water rights grant
possessory rights to a fixed quantity or flow of water
for diversion from a stream based on the date of
the original claim. Those with the earliest claims or
senior rights have the highest priority, and subsequent
claimants have lower-priority or junior rights.
Diversions are accommodated by rank so long as there
is sufficient stream flow. During drought, water is
progressively rationed by priority of right, and junior
diversions may be halted.
Cargo is unloaded from a ship at the Port of New Orleans on Diversion is a low-cost method of allocating water
the Mississippi River. and was efficient when overall consumption was less
By Gnovick at English Wikipedia, CC BY 3.0, than stream flow. Appropriative rights are not tied to
https://commons.wikimedia.org/w/index.php?curid=80825474
the land and can be sold or leased for use elsewhere,
Whenever land is sold or otherwise transacted, the creating a basis for water markets and security
associated riparian water rights go with it. for investment in water-delivery infrastructure,
agriculture, and other endeavors. Appropriative rights
Two types of riparian rights systems exist: natural flow require that water is put into beneficial use and that
and reasonable use. Natural flow systems permit the use these uses inflict no injury to third parties.

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of water for domestic purposes only, and each user is
entitled to the maintenance of their adjacent watercourse Under prior appropriation there is a critical
at its normal level. Reasonable use systems permit each interdependence among diverters from the same water
user to divert water for any lawful purpose to the extent source with different priority rights. As little as 50
that their use does not infringe upon the rights of other percent of senior diversions are consumed by plants
riparian users. Across both types, riparian rights do not or evaporation, and thus much water flows back to the
grant rights to water storage and failure to use water stream or percolates to be available for subsequent
does not result in any loss of rights. users. During times of drought when natural stream
volumes are diminished and senior appropriators have
Prior Appropriation priority of use, junior appropriators are especially
Following the same property right allocation practices dependent upon these return flows.
used for western agricultural land and hard rock

CASE STUDY

Saline Lake Depletion

Water property right systems have often failed to protect ecosystems because property rights to the
environment are difficult to define. Increasing water diversions, especially for agricultural irrigation, have
significantly affected the health of the world’s terminal saline lakes. Terminal saline lakes exist where
watersheds ultimately drain into enclosed basins rather than the ocean. These ecosystems are especially
vulnerable to human water diversions because these lakes are shallow and exist in delicate balance
between evaporation and inflows.
Diversions in the Aral Sea watershed (located between Kazakhstan and Uzbekistan) reduced lake area
by 74 percent and volume by 90 percent, with significant environmental and economic impact. Salinity
increases in the Aral Sea have led to the collapse of the commercial fishery that once harvested 40,000

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 metric tons annually and provided around 60,000 jobs. Water development and river diversions by
Mormon settlers and later residents of the state of Utah produced persistent reduction of flow into Great
Salt Lake. Today, the lake’s surface area is about 50 percent of what it was when settlers first arrived,
and a 29 percent increase in inflows is required to restore fully-functioning ecosystems in the lake.95 In
California, the City of Los Angeles diverted all inflow away from Owens Lake in eastern California,
drying the lake and increasing air pollution.
Absent preservation, a dry lake has significant economic consequences. For instance, Los Angeles has
spent billions of dollars to mitigate the effects of its drying of Owens Lake. Two approaches have been
used to preserve saline lakes. First, as in the case of the Aral Sea, is the construction of a smaller lake
to match the decreased flow into the lake. Though this solution allows more water to be diverted, which
provides economic benefits, it incurs costs in constructing the lake and preventing dust pollution from the
former lakebed. Second is the litigation of minimum water delivery needed to preserve the lake, as in the
case of Mono Lake in California. In that case, the City of Los Angeles was required by a court order to
reduce its diversions to protect the lake.96

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An abandoned ship near Aral, Kazakhstan.

Groundwater Rights
Groundwater—water in an underground aquifer—has
proven difficult to manage using the surface water
right concepts discussed in this section. To illustrate
the issues, consider an aquifer accessed by a group
of neighbors running out of water for their wells.
Individually, any neighbor could cut back on water,
but if they do, they fear other neighbors will not join
them in cutting back. If this happens, the considerate
neighbor would lose out on water without improving
the overall water situation. The local government could Economist Elinor Ostrom won the Nobel Prize in economics
come in and limit pumping via rules on who can pump, for her work describing how small groups, like water users,
how much, or when. This approach, if fully enforced, can come together to manage common-pool resources.
would lead to a reduction in pumping, but may be Photo Credit: By © Holger Motzkau 2010, Wikipedia/Wikimedia Commons
(cc-by-sa-3.0), CC BY-SA 3.0, https://commons.wikimedia.org/w/index.
excessively costly or lead to resentment and neighbors php?curid=10997825
not following the rules.

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Property rights could be implemented by setting up a QLE. Additional water is exported to the new market,
permit system where each neighbor receives a pumping leading to higher overall water extraction, QTE. The
allotment, and then these allotments could be bought marginal benefits of water use are equalized across the
and sold. Finally, the community could work together local users and users in the export market, and so the
to find a collective solution, for instance collectively allocation creates the highest total net benefits; this is
building one pump and allocating water, or by creating known as the equimarginal principle.
an unwritten neighborhood rule regarding the types of
uses into which pumped water can be placed. Elinor Water Transfers
Ostrom won the Nobel Prize in economics for her work Countries like the United States, Chile, and Australia
describing how small groups, like water users, can have utilized markets to allocate scarce water among
come together to manage common-pool resources.97 users and create economic gains by allowing users
In the United States and around the world, these types to voluntarily transfer water. Property rights to water
of group management institutions are a key solution to are separated from property rights to land and are
managing groundwater. traded in a market as a separate good. In opening the
option for water right holders—mostly irrigators—
WATER QUANTITY MARKETS to sell conserved water, markets create incentives
The Basics for investment in conservation without subsidies.
A water market uses price and voluntary sales to However, allowing irrigators to sell water still requires
allocate water across different users and types of uses. careful planning to avoid reduced water in the natural
Consider the supply and demand relationship shown in system, interference with the extractions of other
Figure 61. Sellers extract water from a river for local users, and degradation in water quality.

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sale, and their marginal cost of extraction is represented In the United States, applications for transferring rights
by the supply curve. Extractions are made until the are filed with the relevant state regulatory agency
sale price is such that the marginal cost of extraction is for approval. The applicant specifies the location and
equal to the marginal benefit to water users (demand). amount of water, the duration of the contract, the timing
In Figure 61, this occurs at point PL. If another market of the exchange, the type of water right involved, the
is made available to sellers to export their water where consumptive use, and possibly hydraulic and other
buyers are willing to pay price PE, the market price legal information. Different states have different rules
immediately increases, and water is reallocated. At the and processes for determining who has the standing to
new higher price, local water users now only consume go to court to prevent transfers, e.g., other users, local
communities, or environmental advocates. These groups
who are affected by a transaction but are not a part of
FIGURE 61 the transaction are referred to as third parties. They
can argue that the transfer impairs their ability to use
P water, and often the burden of proof lies with the party
proposing the transfer.
Supply
exports (local) Until the latter part of the twentieth century, third-
PE Export Price party impairment generally was not an issue because
most traded water stayed within the local agricultural
PL community where demand was concentrated. In the
face of contemporary pressures to re-allocate water to
other uses, however, protests of harm can be significant
Demand barriers to trade. Restrictions on the transferability
(local) of water rights are an important limit on the rights
Q holder. The potential to realize the capital gains of
QLE QL QTE moving assets to parties who can maximize their
Water Supply and Demand in the Presence of an value provides incentive for prudent management and
Export Market conservation investment.

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 have to spend significantly more on procuring
water from desalination, an economically and
environmentally costly solution.98 As populations
grow in arid regions, markets offer a solution for
the transfer of water from irrigated agriculture
to industrial and urban users. Markets allow
industrial and urban water users to reach mutually
beneficial agreements with farmers that can result
in large gains from trade.99

A raft approaches the remains of Savage Rapids Dam on

Oregon’s Rogue River. Water transfers associated with the
dam removal helped restore water flows.
Photo Credit: Jeff Barnard, Associated Press

Environmental Transfers
In many settings, surface water has value as instream
flow, whether for ecosystem support, pollution
abatement, or the provision of recreation. While

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instream users could purchase appropriative water
rights to supplement supplies, when the water remains
A copper mine in Chile’s Atacama Desert. The Antofagasta
in the stream, it may be available for other extractors to region of Chile receives less than 5 mm of precipitation per
extract. Defining property rights to include the social year, but it also sees high water demand since it is the world’s
benefits of increased downstream water use requires largest copper producer.
additional costs for measurement and enforcement. Photo Credit: BHP Billiton
Expanding the definition of a water market, however,
allows water prices to equalize along the river. In
the United States, most western states have enacted WATER POLLUTION
instream flow rights legislation, and instream trading Externalities and Water Quality
is active in states such as Oregon. Externalities, which are direct, uncompensated costs
or benefits incurred as a result of other people’s
transactions, can lead to market failure. Externalities
CASE STUDY create a wedge between a firm’s private cost of
production and the social cost of production, where
the latter accounts for both the firm’s costs and the
Extreme Water Scarcity in Chile external cost of pollution. These costs are shown in
The Antofagasta Region of Chile receives less Figure 62, where some good is produced but creates
than 5 mm of precipitation per year, but it also an external cost, like water pollution. If firms do not
sees high water demand since it is the world’s internalize externalities when making their production
largest copper producer. Agriculture currently decisions, then their resulting choice of output (and
accounts for around 33 percent of the freshwater level of pollution) will not be socially efficient (QMarket).
consumption in the region while mining uses
about 56 percent. Over time, mining firms The point where marginal social costs equal demand is
have spent millions of dollars purchasing the efficient level of production, QEfficient. At this point,
water rights from agricultural water users. there is still economic production, and some water
Absent this mechanism, mining firms would pollution continues. However, there is less pollution
than when just private costs are considered. The

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remainder of this section discusses examples of water
pollution and options for institutional remedies to
allow the market price to reflect social cost.

FIGURE 62
Supply
(social cost)

PEfficient External cost

Social
cost Supply
(private costs)
PMarket

Private
Demand
value
(private value) Coal ash is a byproduct of coal combustion that can
QEfficient QMarket Quantity contaminate water with heavy metals like lead and mercury.
Photo Credit: Times-Dispatch
Supply and Demand with an External Cost

Water Quality Regulation

When externalities are present, regulation by a
CASE STUDY governmental agency offers a potential solution to

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market failure. The goal is not to eliminate pollution
entirely because doing so would be prohibitively
Cleaning Up Coal Ash expensive. Instead, optimal regulation sets the
Coal ash is a byproduct of coal combustion that marginal control cost (MCC), which is the marginal
can contaminate water with heavy metals like cost of reducing pollution by an additional unit,
lead and mercury. Thus, the burning of coal to equal to the social marginal damage—the total
produce energy generates a negative externality cost to society of one additional unit of pollution.
on water users. Coal ash was historically stored Once the optimal pollution level is found, regulatory
near large coal generation plants, which are instruments must be selected, and the distribution
located near rivers or lakes due to their need for of pollution abatement responsibilities must be
water for cooling. This left waterways vulnerable determined, i.e., what firms abate and by how much.
to spills and seepage. The existing approaches for
solving the coal ash contamination problem are: Regulations fall under two categories: prescriptive
cap-in-place—covering the coal ash on-site and and economic. Prescriptive regulations entail the
leaving it there; recycling; temporary removal and regulator determining which firms abate, how they
lining of existing storage areas; and transportation abate, and how much they abate. To make effective
to off-site lined storage facilities. In the state of prescriptive regulations, a regulator must know a lot
Virginia, Dominion Energy estimates it will cost about how a firm operates such as the technology
$2.4 to 5.6 billion to recycle and remove all coal it uses and its costs of production; acquiring this
ash, and the process will take up to fifteen years. information can be difficult and costly. However,
A benefit-cost analysis can be applied to different prescriptive regulations create greater certainty
approaches to determine whether the total costs regarding pollution levels, and it is easier to verify
of removal (e.g., transportation and construction firms are complying. Economic regulations provide
costs) or recycling are lower than the benefits of firms with economic incentives to abate. Pigouvian
reductions in contamination and improved health. taxes, which require firms to pay a tax per unit of
pollution emitted—thereby increasing their cost
of production and forcing them to internalize the
pollution externality—are one example of an economic

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 The Cuyahoga River Fire, November 3, 1952. The Cuyahoga
River was one of the most polluted rivers in the U.S., and oil
slicks on the river from industrial waste caught fire numerous
times.
Photo Credit: Courtesy of Cleveland Press Collection at Cleveland
State University Library.

regulation. Such taxes have been effective, but their

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implementation has been hindered by difficulties in
accurately estimating the social cost of pollution and
by political opposition. Pollution markets, which are
discussed later in this guide, are another example of an
economic regulation.
A water current meter in Lake Michigan is encrusted in
The Clean Water Act zebra mussels.
In the United States, the 1972 Clean Water Act
(CWA) granted the Environmental Protection Agency
(EPA) the authority to enact water pollution control CASE STUDY
programs to establish and maintain water quality
standards. For the most part, the CWA regulates point
sources, such as municipal wastewater treatment
Invasive Species in the Great Lakes
The Great Lakes offer a water pollution challenge
plants and manufacturing firms, through pollutant
different from those discussed to this point:
(also referred to in some cases as nutrient) reduction
invasive species. Invasive species often move via
requirements. Nonpoint sources, like farms and
human activity from areas where they are native
stormwater runoff, are less regulated. To date,
to areas where they are not. One example is the
governments and industry members have invested
Zebra Mussel, which is native to the freshwaters
over $1 trillion in water pollution abatement under the
of Europe and Asia but arrived in the Great Lakes
CWA. Overall, water pollution levels have significantly
as early as the 1980s via the ballast water of cargo
decreased, yet more than half of all stream and
ships. The mussels are filter eaters, and their
river miles in the U.S. still do not satisfy pollution
effectiveness at filtering out algae has reduced food
standards.
sources and crowded out a variety of native species.
Unlike other pollutants, once invasive species are
introduced, it is of little use to control the source.

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 Three options have been used to try to control
invasive species in the Great Lakes: (1) Biological,
using predators of the invasive species to control
their levels, such as the use of salmon to control
the invasive alewife population; (2) Mechanical,
using barriers such as the electric barrier between
the Great Lakes and the Mississippi River basin
that is intended to keep Asian carp out of the Great
Lakes; and (3) Chemical, using chemicals to kill
off or control the levels of invasive species, such as
the chemicals used to control the population of sea
lamprey.100 Finding economically efficient pollution
Samples of water taken from a home in Flint, Michigan,
control approaches in these settings still requires in January 2015.
the equalization of marginal damage functions and
Photo Credit: www.flintwaterstudy.org
abatement costs.
set. Setting standards too low can lead to high health
costs, while setting them too stringently can result
DRINKING WATER in excessive costs—dollars that could be spent on
Access to Drinking Water other environmental or health improvements. In the
Worldwide, 1.1 billion people lack access to safe developing world, access to clean water remains
drinking water, which causes millions of deaths a critical concern. Improvements to water quality

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each year, including many very young children.101 result in large health and productivity benefits. In
In industrialized countries, access to safe drinking many developing countries, water is not piped to
water is generally close to 100 percent, but pockets of homes, and significant effort is required of (typically
inequality in safe water access remain—for instance female) household members to travel to safe or safer
in rural areas reliant on potentially contaminated water sources. The opportunity cost of the time spent
well water. In addition, water delivery infrastructure fetching water is high and may limit female education
remains a potential channel for contamination. and employment opportunities in some settings.
Improvements in the safety and delivery of drinking
water via piped systems have high economic benefits In the United States, a key regulation ensuring drinking
relative to the costs.102 water quality is the Safe Drinking Water Act. Under
the law, the EPA sets national standards for drinking
In industrialized nations, the key economic question water quality. These rules ensure certain natural and
is at what level should water quality standards be manmade contaminants do not exceed unhealthy levels.

CASE STUDY

The Flint Water Crisis

In April 2014, Flint, Michigan, switched its drinking water supply from the City of Detroit water system to
the Flint River in order to save an estimated $5 million. Health regulations required water from the Flint
River to receive chemical treatment prior to being placed in the city’s aging water system, which had many
lead pipes. However, as a money-saving measure, the water was not treated and subsequently pulled toxic
lead molecules from the aging pipes. Over the course of eighteen months, the switch exposed residents
to dangerous levels of lead. An emergency was finally declared in October 2015. In addition to the direct
health costs, researchers estimate residents have subsequently spent more than $20 million to avoid using
piped water, the value of Flint houses fell by $345 million to $500 million, and state and federal spending
on the crisis has exceeded $343 million.103

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WATER QUALITY MARKETS
Market Instruments
Marginal control costs (MCCs) differ across firms
and industries, and cost-effective regulation requires
that abatement meet the equimarginal principle such
that at each firm’s level of pollution, the marginal
abatement cost is equal across all firms. Water quality
markets are an economic regulatory instrument
used to facilitate the attainment of the equimarginal
principle given a specified level of pollution reduction.
A market is typically defined for a set of polluting
firms in a given area, and the size and stringency can
vary. In a cap-and-trade market, the regulator sets the
total permissible amount of pollution and allocates
pollution permits to each firm, which can then engage
in water quality trading. In nutrient credit markets,
individuals or firms earn credits for improving
water quality through investments in restoration or
preservation.
Cap-and-trade systems allow the market to determine

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permit prices. Regulators provide the initial allocation
of permits, which can occur via auction or based
on historic polluting behavior, which is called
grandfathering. Markets utilize the heterogeneity in
firm marginal abatement costs (MACs) to arrive at This section of the Potomac River is green due to algal blooms
mutually beneficial transfers, which lower the costs of caused by excessive nutrient loads, which can deplete water
oxygen and lead to eutrophication.
abatement. High MAC firms are better off purchasing
Photo Credit: By Alexandr Trubetskoy - Own work, CC BY-SA 3.0,
permits instead of incurring abatement costs while low https://commons.wikimedia.org/w/index.php?curid=19117918
MAC firms are better off abating more than required
under their initial permits and then selling their excess producers who had generated credits in the past
permits. With the possibility of selling permits in change course to expand production by utilizing their
the future, firms are encouraged to invent cheaper previously excess credits. Pollution trading can also
abatement technologies. lead to pollution hot spots, which arise when one
firm or a few firms in a concentrated area purchase
Water Quality Trading in Practice enough credits to satisfy their abatement responsibility,
In practice, water quality trading faces significant
meeting reduction targets over an aggregate area but
obstacles. Uncertainty regarding future regulatory
creating localized points of heavy pollution. Regulators
conditions, abatement capabilities, or pollution needs
can prevent such hot spots by limiting the amount
can make firms unwilling to trade credits. Potential
of credits one firm can purchase or by requiring a
credit purchasers may not want to purchase credits if
baseline level of abatement, but these measures can
they think that credit producers will stop producing
hinder the effectiveness of the market mechanism.
in the future, which is a realistic possibility if some

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 CASE STUDY

North Carolina
The two most problematic water pollutants in North Carolina are phosphorus and nitrogen. Both can lead
to eutrophication, where excessive nutrient loads cause algal blooms, which kill off animals due to a lack
of dissolved oxygen in the water. The economic impacts of eutrophication are due to degradation of the
water for recreational and consumption activities as well as the environmental health costs. The North
Carolina Department of Environmental Quality (NCDEQ) is the chief regulator tasked with achieving the
water quality standards set by the CWA.
The NCDEQ oversees water quality trading markets between point sources in two smaller basins and two
large watersheds in the state. Point source polluters in these basins can trade their nutrient allocations with
other point sources. The transacting firms must obtain permit modifications from the NCDEQ, and trades
must occur between firms in the same watershed. Like many nutrient markets across the United States,
uptake has been limited, and only seven nutrient allocation trades have occurred since 2004.
A more commonly used program in North Carolina allows firms to satisfy their abatement requirement
via the purchase of offsets from private mitigation banks (PMBs). Mitigation banks are typically private
entities that generate credits for sale by restoring or preserving water bodies. The most common and
successful method of credit generation employed by PMBs is the construction of new riparian buffers and

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the enhancement of existing riparian buffers. Credits are typically sold to urban development projects that
require nutrient offsets for pollution flowing into rivers via new stormwater systems.

SECTION IV SUMMARY 6 Irrigation is far and away the largest human

6 Economic concepts and behavior apply to water use. Irrigation allows farmers to increase
water even though it is critically important to crop yields and survive drought.
human life. 6 Water property rights include Spanish water
6 Urban consumers and irrigators have an customs, common law practices referred to
inelastic response to water price. as the riparian doctrine, and the allocation
of water rights based on priority dates called
6 In developing countries, the provision of clean
appropriative rights.
water for drinking is problematic due to the
cost. 6 The allocation of water rights and the diversion
of water for human activities can lead to
6 Economic institutions, such as property rights
environmental degradation, as exemplified by
and regulations, direct who gets water and
saline lakes throughout the world.
what waters get polluted.
6 Water property rights allow for water
6 The tragedy of the commons can occur in
transfers, which can also be used to incentivize
the use of water resources because they are
water conservation or to provide water for
common pool resources.
ecosystems.
6 Solutions to the tragedy of the commons can
6 Water pollution is a key externality problem
involve local collective action, government
throughout the world.
regulation, and the assignment of property
rights. 6 The regulation of water quality provides rules
for ambient pollution levels and typically

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 requires firms and other point source polluters 6 Economic instruments such as Pigouvian taxes,
to abate pollution to meet them. water pollution markets, and pollution offset
Cost-effective regulation requires that all firms markets abide by the equimarginal principle,
6
satisfy the equimarginal principle. but still face implementation challenges and
low uptake.

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 Glossary

Aggregate demand curve – a graphical depiction Plows or mature tree crops may be considered forms
of the relationship between the level of desired of capital in this context.
expenditures in an economy and the price level
Capital goods– long-lived goods that are themselves
Aggregate supply curve– a graphical depiction of produced and are used to produce other goods and
the relationship between the quantity of goods and services, but are not used up in the production process
services firms wish to supply and the price level
Cartel– a group of firms that collude in a given
Appropriative rights doctrine – the allocation of water market to restrain competition, often making quota
rights based on a priority system, often referred to arrangements among themselves
as “first-in-time, first-in-right”; under this doctrine,
Clean Water Act – a U.S. federal statute passed in
water diversion rights are available to landowners not
1972 with the goal of restoring and maintaining the
adjacent to water sources.

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chemical, physical, and biological integrity of the
Aquifer – a subsurface rock formation containing water nation’s rivers, lakes, and streams
Average labor productivity – total output divided by the Coase Theorem– the proposition that if private parties
quantity of labor employed in its production can bargain without cost over the allocation of
resources, then they can solve the problem of
Bank run– a sudden rush of depositors seeking to
externalities on their own
withdraw funds from the banking system
Collective action – action taken by a group of people to
Barriers to entry – conditions that prevent firms from
improve an outcome or address a common objective
freely entering or exiting a market
Common law – English law derived from the customs
Beneficial use – refers to a restriction on a claim to a
and norms established through judicial precedent,
water right requiring that the amount of water used
i.e., prior rulings determine current law
must be in line with appropriate practices for the
purpose for which the water is intended; also, the Common-pool resource (CPR) – resources that are
characterization of which uses of water are appropriate rivalrous but are not excludable, perhaps due to the
high cost of preventing access; these goods are prone
Benefit-cost analysis– a systematic approach to
to the tragedy of the commons.
estimating the strengths and weaknesses of a
proposed action by placing them in common terms, Comparative advantage– the ability to produce a good
such as dollars, and summing the benefits and then or service at a lower opportunity cost than other
subtracting the costs producers
Bilateral monopoly – a case of imperfect competition Competitive market – a market with many buyers and
where both the buyer and seller could potentially sellers trading a homogenous good or service in
exert market power which each buyer and seller is a price taker
Business cycle– fluctuations in aggregate economic Complements– two goods for which a rise in the price
activity of one leads to a decline in the demand for the other
Capital – one of three factors of production; in classical Consumer Price Index (CPI)– an index constructed by
economics, capital refers to money or physical assets. comparing the cost of purchasing a fixed basket of

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 goods at different times by the functioning of natural relationships between
plant and animal communities and the natural
Consumer surplus– the difference between the amount
environment
that a buyer would be willing to pay for a good or
service and the price actually paid Elasticity– the percentage change in quantity demanded
or supplied as a result of a one percent change in price
Consumption– spending by households on goods and
services, with the exception of the purchase of new Entrepreneur– an individual who takes on the risk
housing of attempting to create new products or services,
establish new markets, or develop new methods of
Consumptive use – the use of water that is not returned
production
to the natural system via return flows or seepage into
groundwater Equilibrium – a situation in which the forces in a system
are in balance so that the situation is stable and
Crowding out– the decrease in private investment
unchanging
that occurs as a result of a reduction in government
saving or an increase in government borrowing Equimarginal principle – in pollution control with
multiple polluting firms, an outcome where each
Currency – coins and bills in the hands of the public
polluter has reduced pollution to the level where the
Cyclical unemployment – unemployment caused by marginal cost of the last unit of pollution reduction is
deviations of output from its potential level equal across all firms
Deadweight loss – the reduction in total surplus that Eutrophication – the excess nutrient loading of a
results from a market distortion such as a tax waterway resulting in excessive plant (algae) growth,
a reduction of dissolved oxygen in the water, and

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Demand curve– a graphical representation of the harm to aquatic animals
quantity of a good or service demanded as a function
of the price Excludability– the ability to prevent buyers from
enjoying the benefits of consuming a good or service
Demand schedule– a table showing the relationship without paying for it
between the price of a good or service and the
quantity demanded Expansion– a period between a trough and a peak in
economic activity
Depression– a severe recession
External cost – the marginal cost associated with third-
Diminishing returns to scale– the property whereby party effects or externalities
each additional increase in inputs results in a smaller
increase in the quantity produced Externality– when the action of one person affects the
well-being of someone else, but where neither party
Discount rate– the interest rate that the Federal Reserve pays nor is paid for these effects
charges banks when they must borrow reserves from it
Federal funds rate – the rate that banks charge other
Economic institutions – social or legal rules and norms banks when they lend reserves
that structure the social order; stable, valued, and
recurring patterns of behavior; “the rules of the game” Final goods– goods or services that are purchased by
their ultimate user
Economic profit – the difference between the revenue
realized by a producer and the opportunity cost of Financial markets – the institutions through which
production individuals with savings can supply these funds
to persons or firms that wish to borrow money to
Economic regulations – regulatory measures that rely purchase consumption goods or invest in physical
on price to achieve a regulatory objective capital
Economies of scale – a production process where an Fiscal policy– the use of taxes and spending to influence
increase in all factors of production increases output aggregate demand and through it the level of overall
by a greater amount economic activity
Ecosystem service – the benefits provided to humans Fixed cost– a cost of production that is independent of

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 the quantity produced Investment – spending on capital equipment,
inventories, and structures, including household
Foreign direct investment – when a company or
purchases of new housing
individual acquires assets in a foreign country that
they will manage directly Irrigation efficiency paradox – a situation in which the
improvement of the effectiveness of irrigation (yield
Frictional unemployment– unemployment that results
per unit water) does not result in additional water
because it takes time for workers to search for the
availability/savings
jobs that are best suited to their tastes and skills
Keynesian model – a model of short-run aggregate
Gains from trade– the benefits that both individuals or
economic fluctuations inspired by the analysis of
nations realize from mutually beneficial exchange
British economist John Maynard Keynes, which
Government purchases – spending on goods and attributes short-run deviations in output from
services by federal, state, and local governments potential to variations in the level of aggregate
demand or aggregate supply
Grandfathering – the granting of rights or privileges
based on historic use; may occur even if historic use Labor force – the sum of those individuals who are
was not legally sanctioned employed and those who are seeking paid work but
have not found it
Green Revolution – the dramatic increase in crop
production in developing countries around the 1960s Labor force participation rate – the fraction of the
that is credited to the increased use of fertilizers, working-age population who are in the labor force
pesticides, and high-yield crop varieties
Law of demand – holding other things equal, the
Gross Domestic Product (GDP)– the market value of quantity demanded is negatively related to the price

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final goods and services produced in an economy
Law of supply – holding other things equal, the quantity
during a specified period of time
supplied is positively related to the price
Gross Domestic Product (GDP) per capita– estimate
Liquidity – the ease with which a nonmonetary asset
of national output (gross domestic product), divided
may be converted into money
by the population; its key advantage as a measure
of economic performance is in giving an average Logrolling – the practice of elected officials trading votes
level of income per person, which can be compared
Marginal control cost (MCC)– the cost of reducing the
between countries.
next unit of pollution
Human capital– skills and experience that are acquired
Marginal cost – the additional cost of production
through education, training, and on-the-job experience
associated with a small increase in the quantity
that increase a worker’s productivity; considered
produced
an important factor in facilitating improvements in
productivity and economic growth Marginal revenue – the additional revenue resulting
from a small increase in the quantity produced
Imperfect competition– the case of a market with a
small number of sellers, so that sellers have market Market failure – any situation in which a market does
power not do what market theorists believe it should—
allocate goods and services efficiently; externalities
Inferior good– a good for which the quantity demanded
and monopoly/oligopoly are two commonly discussed
falls as buyers’ income increases
failures; a situation where the allocation of goods and
Inflation– a general increase in prices services is not efficient, for instance when too much
of a good (e.g., pollution) or too little of a good (e.g.,
Instream flow – water flowing naturally in a river; the
clean air) is provided by the free market
definition of a property right to river flows
Market power – a situation in which one firm, or a
Intermediary – a third party who acts as a link between
group of them acting as a cartel, can control prices in
two others who wish to transact business
a market, often by restricting output, and thus have
Intermediate good – a good or service that is used in the market power; in a theoretical, purely competitive
process of producing other goods and services market, this is not possible

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Monetary base – the quantity of currency plus bank unemployment
reserves
Oligopoly – a market in which there are just a few
Monetary policy – the use of the supply of money in producers
the economy by the Federal Reserve to influence the
Open market operations – a tool used by the Federal
level of aggregate demand
Reserve to adjust the money supply by buying or
Money – an asset that is a medium of exchange, unit of selling U.S. government bonds in the financial market
account, and store of value
Opportunity cost – the cost of any choice is what must
Money multiplier – the ratio of the money supply to the be given up by making that choice
monetary base
Output gap – the difference between actual output and
Money supply– the quantity of money available to the potential output
economy
Pareto efficiency – describes an allocation in which
Monopolistic competition – a market in which there the only way to make any individual or group of
is free entry or exit, but every producer supplies a individuals better off would require making at least
differentiated product and faces a downward-sloping one other person worse off
demand curve
Per capita – literally per head, used to denote an average
Monopoly – a market in which there is a single producer value for a population
Natural rate of unemployment – the level of Pigouvian tax – a tax on a negative externality, such
unemployment that would exist if the economy were as a tax on pollution, set equal to the cost of the
producing at its potential output negative externality; equalizes the marginal cost of

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abatement across firms
Net capital outflow – the difference between the
purchases of foreign assets by domestic residents and Point source – pollution from a defined source, such as a
the purchases of domestic assets by foreign residents factory or municipal water treatment facility
Net exports – the difference between the value of goods Pollution hot spots – areas of more intense pollution due
and services sold to foreigners and the value of goods to co-located polluting facilities
and services purchased from foreigners
Portfolio investment – the purchase of shares of stock or
Neutrality of money – the proposition that in the long bonds
run, changes in the quantity of money affect the price
Positive economics – the use of the tools of economic
level but do not affect any real quantities
analysis to describe and explain economic
Nominal GDP – the production of goods and services phenomena and to make predictions about what will
valued at current prices happen under particular circumstances
Nonpoint source – a pollutant that comes from an Potential output – the quantity of output that would be
area rather than a defined source, like stormwater produced by an economy if all of its resources were
outflows or flows out of fields being employed at normal rates
Normal good – a good or service for which demand is Prescriptive regulations – regulatory measures that use
positively related to the buyer’s income defined rules, like quotas or technology standards,
rather than price to reduce pollution
Normative economics – economic analysis used to guide
decisions about what should be as opposed to what is Price discrimination – when a business sells the same
the case product to different buyers at different prices
Nutrient credit markets – the creation and sale of Price elasticity of demand – the amount by which
credits from the creation or restoration of riparian demand for a given product changes in response to
areas that reduce overall nutrient loads changes in price; specifically, the percentage change
in demand that corresponds to a one percent change
Okun’s law – a relationship identified by Arthur Okun
in the price
between the output gap and the level of cyclical

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Producer surplus – the difference between the price extracting or producing it
that producers receive for supplying a good and their
Shortage – a market situation where the demand for a
marginal cost of producing it
product or service exceeds the amount available at
Production possibility frontier (PPF) – a graphical the current price
depiction of the combinations of output that can be
Social cost – the private cost plus the external cost
produced by an economy
Social marginal damage – the total cost to society of
Property rights – the assignment of ownership of a
one additional unit of pollution
resource to individuals
Structural unemployment – unemployment that results
Public good – a good or service for which it is not
from the mismatch in skills, locations, or other
possible to establish individual property rights
important characteristics between job seekers and the
Rationality – when individual choices are made by available jobs
comparing the benefits and costs of different actions
Subsidies – a payment, or reduction in payment owed,
and then selecting the action that produces the
made by a government to an individual or business to
greatest benefit
keep their purchase or production price artificially low
Real GDP – the production of goods and services valued
Substitutes – two goods for which an increase in the price
at constant prices
of one leads to an increase in the demand for the other
Recession – a period between a peak and a trough in
Supply curve – a graphical representation of the quantity
economic activity
of a good or service supplied as a function of the price
Regulated monopoly – an organization that could

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Supply schedule – a table showing the relationship
potentially utilize its market power to raise prices
between the price of a good or service and the
for the good or service it sells, but is restricted in its
quantity supplied
behavior by public ownership or regulation
Technology – knowledge about the techniques by which
Regulatory instruments – methods available to
inputs are transformed into the goods and services
policymakers to reduce pollutants
that households desire
Rent seeking – using political influence to increase one’s
Third party – an entity (individual, firm, etc.) that is not
economic profits at the expense of others
directly involved in a transaction but is potentially
Reserve requirement – the amount of reserves that the affected by it in some way, for instance through a
Federal Reserve requires banks to hold negative externality
Reserves – the fraction of deposit liabilities that banks Total revenue – the total revenue received by a supplier
hold to meet depositor withdrawals
Total surplus – the sum of consumer and producer surplus
Riparian doctrine – a method of allocating water under
Tragedy of the commons – the depletion of a common
English Common Law where all adjacent landowners
resource due to overuse
share equal rights to water
Unemployment – the state of actively seeking paid work
Rival goods – goods or services characterized by the fact
but being unable to find it
that one person’s enjoyment of the good or service
reduces the quantity available for others’ enjoyment Unemployment rate – the number of unemployed
workers as a fraction of the total labor force
Savings – the difference between a person’s disposable
income and his or her expenditures Variable cost – a cost of production that depends on the
quantity produced
Scarcity – an inescapable fact of human existence that
results from the fact that the available resources are Velocity of money – the ratio of nominal GDP to the
always less than our limitless desires money supply; in effect, the average number of
transactions supported by each dollar of the money
Scarcity value – the additional price or value of a
supply
good due to its relative scarcity, beyond the cost of

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Water quality trading – the transfer of rights to pollute the owner with a set of privileges for the use and
to allow market forces to organize the allocation of modification of water
costs for water quality improvements
Wealth – the total value of assets used as a store of value
Water right – a property right to water that provides

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 notes
1. “Supermarket Facts: Industry Overview higher price for their product.
2008,” Food Marketing Institute, 26 6. Bob’s costs of producing a quantity q are C(q)

Notes
June 2009 <http://www.fmi.org/facts_ = 300 + 2q + q2/300, and the marginal costs
figs/?fuseaction=superfact>. corresponding to this equation are MC(q) = 2 +
2. The auctioneer may be an actual person, or q/150.
the process of matching sellers and buyers 7. N. Gregory Mankiw, Principles of Economics, 4th
may be accomplished by means of a computer ed. (Mason, OH: Thomson Southwestern, 2007)
network. 345–46.
3. Many consumers object to genetically 8. “About the Congestion Charge: Background,”
modified foods such as milk produced using Transport for London, 25 July 2009
BGH. The use of BGH by U.S. dairy farmers has <http://www.tfl.gov.uk/roadusers/
1. led to Facts:
“ Supermarket an ongoing
Industry dispute
Overviewbetween
2008,”theFoodU.S.Marketing Institute, University Press, 2006.
congestioncharging/6725.aspx>.
26 June and 2009the European Union in the World Trade
<http://www.fmi.org/facts_figs/?fuseaction=superfact>. 13. F
 or awas
more extensive
Organization 9. Real GDP in 1900 $423 billion.discussion
By 2008, it of these issues, see Clifford Cobb,
2. T he auctioneer may be(WTO) concerning
an actual person, orhormone-fed
the process of matching Ted Halstead, and Jonathan Rowe, “If the GDP is Up, Why is America
beef. had grown to $13,312 billion.
sellers and buyers may be accomplished by means of a computer Down,” Atlantic Monthly (October 1995) 59–78. Notes 2010–2011 §
network.
4. Formally, the elasticity measures the 10. International Economics
comparisons of the sort
Resource Guidepresented
127.
3. percentage
Many consumers change
object in quantity
to genetically demanded
modified foods such as milk in Figure14. 32 are sensitive
Michael to the
Boskin, et prices that a More Accurate Measure of the Cost
al., “Toward
produced using BGH.
caused by a oneThepercent
use of BGHchangeby U.S. dairyatfarmers has ledare used to compare
in price production
of Living,” Final Report across theSenate Finance Committee from the
to the
to an ongoing dispute
a specific pointbetween
on thethe U.S. and
demand the European
curve. When Union in the Advisory
different countries. TheCommission
comparisons to Study
madethe Consumer Price Index, December
here
World Trade Organization
we measure changes (WTO)
overconcerning hormone-fed
finite distances, the beef. use current exchange 1996, SocialratesSecurity Online,
to convert 20 Aug. 2009 <http://www.ssa.gov/
national
4. Formally, results will depend
the elasticity on the
measures theposition
percentagewe change
take asin quantity GDP figures into history/reports/boskinrpt.html>.
dollars, a practice that results
demanded ourcaused
startingby point.
a one percent
To avoid change in price atthe
this problem, a specific pointin
onan understatement
15. W  e assume of here that the government
the standard of living compensates for the income lost as
the demand curve. When
convention is thatwewemeasure
calculate changes over finite distances, the
the percentage a result of the tax credit
in lower-income countries. Using an alternative by increasing taxes on some other transactions.
results will depend
change withonreference
the position to we
thetake as our of
midpoint starting
the point. To avoid
approach thatIfbetterthis were not the
reflects case,purchasing
actual then government savings would be reduced,
this problem,
initialthe
andconvention
final values.is that
If theweprice
calculate the percentage change
changed and the tax credit would have no net effect on the economy.
power in the different countries would perhaps
with reference
from P1 toto
theP2,
midpoint
then weofwould
the initial and final
calculate thevalues. If the price 16. See <http://www.federalreserve.gov/faqs/about_12591.htm>.
changedpercentage
from P1 to P2, then we double or triple income levels in countries like
as: would calculate the percentage change

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change Ghana or17.Nigeria.
Dates While
for thethis
startwould
of thenarrow
Cold War thevary depending on the source. Many
as:
P2 – P1 gap in living scholars
standards date the start
relative to of
thethe Cold
U.S., theWar as 1946 or 1947.
pct change = 100 × . 18. h
 ttps://www.nationalww2museum.org/students-teachers/student-
gap still remains huge.
(½) · (P2 + P1) resources/research-starters/research-starters-worldwide-deaths-world-
5. In farmers
reality, farmers cantochoose toorganic
produce 11. The official series
war. probably greatly overstates
5. I n reality, can choose produce milk, which consumers
organic milk, which consumers understand is the economic
19. It growth
should beofnoted
Worldthat
War II. See, for
American economic aid to Western Europe
understand is BGH free. Because some consumers prefer milk produced
without BGH
BGH,free. Because
farmers some consumers
who choose to produce prefer milk with theexample, Robert
in compliance beganHiggs,
prior “Wartime Prosperity?
to the Marshall Plan, but this plan was aimed at longer-term
produced
requirement to labelwithout BGH, farmers
their product who
as organic canchoose
command
A Reassessment
to a higher price of the
postwar U.S. Economy in the
recovery.
for theirproduce
product. in compliance with the requirement to 1940s,” Journal of Economic History, 52, no. 1
20. B arry Eichengreen, “Lessons from the Marshall Plan,” World
label their product as organic can command a (March 1992).Development Report, 2010, p.1.
6. B ob’s costs of producing a quantity q are C(q) = 300 + 2q + q /300, and
2

the marginal costs corresponding to this equation are MC(q) = 2 + q/150. 21. Ibid.
7. N. Gregory Mankiw, Principles of Economics, 4th ed. (Mason, OH: 22. Barry Eichengreen, “The Marshall Plan: Economic Effects and
122
Thomson Southwestern, 2007) 345–46.
USAD Economics Resource Guide • 2016–2017
Implications for Eastern Europe and the Former USSR.” Economic
8. “ Congestion Surcharge,” New York State Department of Taxation and Policy 7(14): 13–75, 1992.
Finance, Updated 10 July 2020, Accessed 15 September 2020 <https:// 23. Barry Eichengreen, “Institutions and Economic Growth: Europe after
www.tax.ny.gov/bus/cs/csidx.htm>. World War II,” In Economic Growth in Europe since 1945, edited by
9. “ Real Gross Domestic Product (GDP) of the United States of America Nicholas Crafts and Gianni Toniolo (Cambridge: Cambridge University
from 1990 to 2019 (in billion chained (2012) U.S. dollars),” Statista, Press, 1996) 38.
Accessed 15 September 2020 <https://www.statista.com/statistics/188141/ 24. Ibid., 41.
annual-real-gdp-of-the-united-states-since-1990-in-chained-us-dollars/>. 25. https://www.imf.org/en/About.
10. I nternational comparisons of the sort presented in Figure 32 are 26. https://www.worldbank.org/en/about.
sensitive to the prices that are used to compare production across the
27. https://www.wto.org/english/thewto_e/history_e/history_e.htm.
different countries. The comparisons made here use current exchange
rates to convert national GDP figures into dollars, a practice that 28. h ttps://www.cia.gov/library/readingroom/collection/cia-analysis-
results in an understatement of the standard of living in lower-income warsaw-pact-forces?page=4.
countries. Using an alternative approach that better reflects actual 29. Mancur Olson, Jr. and Richard Zeckhauser, “An Economic Theory of
purchasing power in the different countries would perhaps double or Alliances.” Review of Economics and Statistics 48(3): 267, 1966.
triple income levels in countries like Ghana or Nigeria. While this 30. Ibid.
would narrow the gap in living standards relative to the U.S., the gap
31. Ibid.
still remains huge.
32. Ibid.
11. T he official series probably greatly overstates the economic growth of
World War II. See, for example, Robert Higgs, “Wartime Prosperity? A 33. Albrecht O. Ritschl, “An Exercise in Futility: East German Economic
Reassessment of the U.S. Economy in the 1940s,” Journal of Economic Growth and Decline, 1945–89.” In Economic Growth in Europe since
History, 52, no. 1 (March 1992). 1945, edited by Nicholas Crafts and Gianni Toniolo, 498. Cambridge:
Cambridge University Press, 1996.
12. See Richard Sutch, “National Income and Product,” Historical Statistics
of the United States, Earliest Times to the Present: Millennial Edition, 34. Ibid.
Eds. Susan B. Carter, Scott Sigmund Gartner, Michael R. Haines, Alan 35. T otal factor productivity is calculated as whatever portion of an increase
L. Olmstead, Richard Sutch, and Gavin Wright. New York: Cambridge in output cannot be accounted for by the “factors of production” (land,

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 labor, and capital). If an economy produces more than can be accounted 60. h ttp://data.worldbank.org/indicator/MS.MIL.XPND.GD.ZS?end=2016&l
for, that extra production is attributed to the productivity with which ocations=US&start=1960&view=chart.
those factors of production were used. 61. https://www.nytimes.com/1988/05/26/world/soviet-lists-afghan-war-toll-
36. A
 lbrecht O. Ritschl, “An Exercise in Futility: East German Economic 13310-dead-35478-wounded.html.
Growth and Decline, 1945–89.” In Economic Growth in Europe since 62. https://www.theatlantic.com/past/docs/politics/foreign/reagrus.htm.
1945, edited by Nicholas Crafts and Gianni Toniolo (Cambridge:
63. A. Dallin and G. Lapidus, “The Roots of Perestroika,” in A. Dallin and
Cambridge University Press, 1996) 501.
G. Lapidus (eds.), The Soviet System in Crisis: A Reader of Western and
37. Wendy Carlin, “West German Growth and Institutions, 1945–90,” CEPR Soviet Views (Boulder, CO: Westview Press, 1991) 9.
Discussion Papers, no. 896, 1994.
64. R ichard N. Lebow, and Janice G. Stein, “Reagan and the Russians,” The
38. A
 lbrecht O. Ritschl, “An Exercise in Futility: East German Economic Atlantic Online, February 1994.
Growth and Decline, 1945–89.” In Economic Growth in Europe since
65. J an Adam, “Gorbachev’s Economic Reform,” In: Economic Reforms in
1945, edited by Nicholas Crafts and Gianni Toniolo (Cambridge:
the Soviet Union and Eastern Europe since the 1960s (London: Palgrave
Cambridge University Press, 1996).
Macmillan, 1989).
39. Jaap Sleifer, Planning Ahead and Falling Behind: The East German
66. M arshall I. Goldman, “Gorbachev and Economic Reform in the Soviet
Economy in Comparison with West Germany, 1936–2002 (Berlin:
Union,” Eastern Economic Journal 14(4): 331–335. 1988.
Akademie Verlag, 2006) 50.
67. Chris Miller, The Struggle to Save the Soviet Economy: Mikhail
40. Charles S. Maier, “The World Economy and the Cold War in the Middle
Gorbachev and the Collapse of the USSR (Chapel Hill: The University
of the Twentieth Century.” In: Leffler M, Westad OA The Cambridge
of North Carolina Press, 2016) 55.
History of the Cold War, vol.1. (Cambridge: Cambridge University
Press, 2011) 64. 68. Ibid., 90.
41. https://www.zeit.de/feature/german-unification-a-nation-divided. 69. D arrell Slider, “Embattled Entrepreneurs: Soviet Cooperatives in an
Unreformed Economy.” Soviet Studies, 1991, 43(5): 797.
42. William J. Weida, “The Economic Implications of Nuclear Weapons
and Nuclear Deterrence.” In Atomic Audit: The Costs and Consequences 70. The official reunification of Germany occurred in October 1990.
of U.S. Nuclear Weapons Since 1940, Stephen I. Schwartz (ed.) 71. https://history.state.gov/milestones/1989-1992/collapse-soviet-union.
(Washington, D.C.: Brookings Institution Press, 1998) 522. 72. R obert Higgs, “The Cold War Economy: Opportunity Costs, Ideology,
43. W
 illiam J. Weida, “The Economic Implications of Nuclear Weapons and the Politics of Crisis.” Independent Institute. 1994. Accessed 11
and Nuclear Deterrence.” In Atomic Audit: The Costs and Consequences September 2019. http://www.independent.org/publications/article.
of U.S. Nuclear Weapons Since 1940, Stephen I. Schwartz (ed.) asp?id=1297.
(Washington, D.C.: Brookings Institution Press, 1998) 540. 73. W alter LaFeber, America, Russia, and the Cold War: 1945–1975 (New

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44. A
 nn Markusen, Peter Hall, Scott Campbell and Sabina Deitrick, The York, Wiley, 1976).
Rise of the Gunbelt: The Military Remapping of Industrial America 74. Jiang, 2009; Magee, 2011
(Oxford: Oxford University Press, 1991). 75. Magee, 2011
45. W
 illiam J. Weida, “The Economic Implications of Nuclear Weapons 76. Magee, 2011
and Nuclear Deterrence.” In Atomic Audit: The Costs and Consequences
77. Magee, 2011
of U.S. Nuclear Weapons Since 1940, Stephen I. Schwartz (ed.)
(Washington, D.C.: Brookings Institution Press, 1998) 527. 78. Dalhuisen et al 2003
46. Michael Edelstein, “War and the American Economy in the Twentieth 79. Shah et al, 2004
Century,” The Cambridge Economic History of the United States, edited 80. Shah et al, 2004
by Stanley L. Engerman and Robert E. Gallman, Vol III. (New York: 81. Schoengold and Zilberman, 2007
Cambridge University Press, 2000) 329–405.
82. Molden, 2007
47. https://data.worldbank.org/indicator/MS.MIL.XPND.
83. S ource: Author’s drawing using data from the Food and Agriculture
GD.ZS?locations=US.
Organization of the United Nations and ESRI.
48. https://fas.org/nuke/guide/russia/agency/mo-budget.htm.
84. Reddy, 2017; Bjourland and Bjourland, 2009
49. https://history.state.gov/milestones/1969-1976/salt.
85. Nurzaman, 2017
50. https://www.britannica.com/event/Strategic-Arms-Limitation-Talks.
86. Rose, 2014
51. Philip Hanson, The Rise and Fall of the Soviet Economy: An Economic
87. Plusquellec 2009
History of the USSR from 1945 (London: Routledge, 2014) 6.
88. Bresten and Hill, 2007
52. Abram Bergson, “Comparative Productivity: The USSR, Eastern
Europe, and the West,” Planning and Performance in Socialist 89. Smith 2016
Economies: The USSR and Eastern Europe, Edited by Abram Bergson 90. Smith 2018
(Boston: Unwin Hyman, 1989) 9–31. 91. Edwards and Smith 2018
53. I n the mid-1970s, the Soviets spent nearly 40 percent more on defense 92. Negri and Brooks, 1990
than did the United States. 93. Grafton et al, 2018
54. Mark Harrison, “The Soiet Economy, 1917–1991: Its Life and Afterlife,” 94. Libecap 1989; Barzel 1997
VOX CEPR Policy Portal, November 7, 2017, https://voxeu.org/article/
soviet-economy-1917-1991-its-life-and-afterlife. 95. Edwards and Null 2019
55. Philip Hanson, The Rise and Fall of the Soviet Economy: An Economic 96. Wurtsbaugh et al, 2017
History of the USSR from 1945 (London: Routledge, 2014) 6. 97. Ostrom 1990
56. CIA 1985. 98. Edwards et al, 2018
57. T he American data are from https://www.va.gov/opa/publications/ 99. Edwards and Libecap, 2015
factsheets/fs_americas_wars.pdf. The estimates for Chinese and Korean 100. Egan 2017
deaths are from https://www.britannica.com/event/Korean-War. 101. United Nations 2003
58. S
 pencer C. Tucker, “Overview of the Vietnam War” In The 102. Olmstead 2010
Encyclopedia of the Vietnam War: A Political, Social, and Military
103. Christiansen et al. 2019
History, 2nd ed. (Santa Barbara, CA: ABC-CLIO, 2011).
59. https://www.britannica.com/event/Vietnam-War.

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