Professional Documents
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PRINCIPLES OF MACRO
ECONOMICS
FRANK • BERNANKE • ANTONOVICS • HEFFETZ
EIGHTH EDITION
PRINCIPLES OF
MACRO
ECONOMICS
Eighth Edition
ROBERT H. FRANK
Cornell University
BEN S. BERNANKE
Brookings Institution [affiliated]
Former Chair, Board of Governors of the Federal Reserve System
KATE ANTONOVICS
University of California, San Diego
ORI HEFFETZ
Cornell University and the Hebrew University of Jerusalem
PRINCIPLES OF MACROECONOMICS
Published by McGraw Hill LLC, 1325 Avenue of the Americas, New York, NY 10121. Copyright ©2022
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1 2 3 4 5 6 7 8 9 LWI 24 23 22 21 20
ISBN 978-1-264-36475-6
MHID 1-264-36475-X
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mheducation.com/highered
D E D I C AT I O N
For Ellen
R. H. F.
For Anna
B. S. B.
iv
ABOUT THE AUTHORS v
FOCUSED ON SEVEN CORE rinciples do most of the heavy lifting in economics, and that
p
if we focus narrowly and repeatedly on those principles, stu-
PRINCIPLES TO PRODUCE dents can actually master them in just a single semester. The
ECONOMIC NATURALISTS enthusiastic reactions of users of previous editions of our
THROUGH ACTIVE LEARNING textbook affirm the validity of this premise. Avoiding exces-
sive reliance on formal mathematical derivations, we present
Our eighth edition arrives in the midst of some of the most concepts intuitively through examples drawn from familiar
dramatic upheavals ever witnessed, both in the economy contexts. We rely throughout on a well-articulated list of seven
generally and in higher education in particular. The Core Principles, which we reinforce repeatedly by illustrating
COVID-19 pandemic has produced levels of unemployment and applying each principle in numerous contexts. We ask
not seen since the Great Depression and has created dra- students periodically to apply these principles themselves to
matic changes in the ways we teach across educational insti- answer related questions, exercises, and problems.
tutions at every level. Another distinguishing feature of this text is its explicit
These developments have reinforced our confidence in recognition of the pedagogical challenge posed by the broad
the instructional philosophy that motivated us to produce variance in students’ quantitative backgrounds and in instruc-
our first edition—the need to strip away clutter and focus tor preferences about the optimal level of mathematical
more intensively on central concepts. This approach, we detail for the course. We confront this challenge by relegating
believe, is especially well suited for the new environment. more detailed mathematical treatment of selected topics to
In earlier editions, we noted that although many mil- chapter appendices. For example, Chapter 13, Spending and
lions of dollars are spent each year on introductory econom- Output in the Short Run, uses diagrams and numerical exam-
ics instruction in American colleges and universities, the ples to convey the main ideas behind the basic Keynesian
return on this investment has been disturbingly low. Studies model (the “Keynesian cross”), saving a more general alge-
have shown, for example, that several months after having braic analysis to Appendix A and a derivation of the multi-
taken a principles of economics course, former students are plier formula to Appendix B—again providing flexibility to
no better able to answer simple economics questions than instructors. Many adopters have cited this additional flexibil-
others who never even took the course. Most students, it ity as a reason for having chosen our book.
seems, leave our introductory courses without having learned Throughout the body of the text, however, our principal
even the most important basic economic principles. Such focus is not on quantitative detail, but rather on students to
dismal performance, never defensible, has become even become “economic naturalists,” people who employ basic
more difficult to justify in the face of looming resource economic principles to understand and explain what they
shortages in higher education. observe in the world around them. An economic naturalist
The problem, in our view, has almost always been that understands, for example, that infant safety seats are required
courses try to teach students far too much. In the process, in cars but not in airplanes because the marginal cost of space
really important ideas get little more coverage than minor to accommodate these seats is typically zero in cars but often
ones, and everything ends up going by in a blur. The human hundreds of dollars in airplanes. Scores of such examples are
brain tends to ignore new information unless it comes up sprinkled throughout the book. Each one, we believe, poses
repeatedly. That’s hardly surprising, since only a tiny fraction a question that should make any curious person eager to learn
of the terabytes of information that bombard us each day is the answer. These examples stimulate interest while teaching
likely to be relevant for anything we care about. Only when students to see each feature of their economic landscape as
something comes up a third or fourth time does the brain the reflection of one or more of the Core Principles. Students
start laying down new circuits for dealing with it. Yet when talk about these examples with their friends and families.
planning their lectures, many instructors ask themselves, Learning economics is like learning a language. In each case,
“How much can I cover today?” And because modern elec- there is no substitution for actually speaking. By inducing
tronic media enable them to click through upwards of 100 students to speak economics, The Economic Naturalist exam-
PowerPoint slides in an hour, they feel they better serve their ples serve this purpose.
students when they put more information before them. But For those who would like to learn more about the role
that’s not the way learning works. Professors should instead of examples in learning economics, Bob Frank’s lecture on
be asking, “How much can my students absorb?” this topic is posted on YouTube’s “Authors@Google” series
Our approach to this text was inspired by our conviction (www.youtube.com/watch?v=QalNVxeIKEE), or search
that students will learn far more if we attempt to cover much “Authors@Google Robert Frank”.
less. Our basic premise is that a small number of basic
vii
viii CONTENTS
PREFACE
KEY THEMES AND FEATURES Economic Naturalist Video Series: We are very excited to offer
an expanded video series based on Economic Naturalist exam-
Emphasis on Seven Core Principles ples. A series of videos covering some of our favorite micro-
Because a few Core Principles do most of the work in eco- and macro-focused examples can be used as part of classroom
nomics, focusing almost exclusively on these principles presentations or assigned for homework along with accompa-
ensures that students leave the course with a deep mastery nying questions within McGraw Hill Connect®. These fasci
of them. In contrast, traditional encyclopedic texts so over- nating, fun, and thought-provoking applications of economics
whelm students with detail that they often leave the course in everyday life encourage students to think like an economist.
with little useful working knowledge at all. Refer to the distinguishing features pages of the preface for
1. The Scarcity Principle: Although we have boundless additional information. You can view one of these dynamic
needs and wants, the resources available to us are lim- videos here: http://econeveryday.com/why-do-cooked-rotisserie-
ited. So having more of one good thing usually means chickens-cost-less-than-fresh-uncooked-chickens/.
having less of another.
2. The Cost-Benefit Principle: An individual (or a firm or Active Learning Stressed
a society) should take an action if, and only if, the extra The only way to learn to hit an overhead smash in tennis is
benefits from taking the action are at least as great as through repeated practice. The same is true for learning
the extra costs. economics. Accordingly, we consistently introduce new
3. The Incentive Principle: A person (or a firm or a society) ideas in the context of simple examples and then follow
is more likely to take an action if its benefit rises, and less them with applications showing how they work in familiar
likely to take it if its cost rises. In short, incentives matter. settings. At frequent intervals, we pose self-tests that both
test and reinforce the understanding of these ideas. The end-
4. The Principle of Comparative Advantage: Everyone does of-chapter questions and problems are carefully crafted to
best when each concentrates on the activity for which help students internalize and extend basic concepts and are
his or her opportunity cost is lowest. available within Connect as assignable content so that
5. The Principle of Increasing Opportunity Cost: In expand- instructors can require students to engage with this material.
ing the production of any good, first employ those Experience with earlier editions confirms that this approach
resources with the lowest opportunity cost, and only after- really does prepare students to apply basic economic prin-
ward turn to resources with higher opportunity costs. ciples to solve economic puzzles drawn from the real world.
6. The Efficiency Principle: Efficiency is an important Learning Glass Lecture Videos: A collection of brief instruc-
social goal because when the economic pie grows larger, tional videos featuring the authors Kate Antonovics and
everyone can have a larger slice. Ori Heffetz utilize learning glass technology to provide
students with an overview of important economic concepts.
7. The Equilibrium Principle: A market in equilibrium leaves Perfect for an introduction to basic concepts before coming
no unexploited opportunities for individuals but may not to class, or as a quick review, these videos, with accompa-
exploit all gains achievable through collective action. nying questions, can be assigned within Connect or used as
part of classroom discussion.
Economic Naturalism Both The Economic Naturalist and Learning Glass videos
Our ultimate goal is to produce economic naturalists—people and accompanying multiple-choice questions that test stu-
who see each human action as the result of an implicit or dents’ understanding of the principles illustrated in the videos
explicit cost-benefit calculation. The economic naturalist have become valued tools for instructors who incorporate
sees mundane details of ordinary existence in a new light elements of the flipped-classroom approach in their teach-
and becomes actively engaged in the attempt to understand ing, or those who are relying more heavily on other forms
them. Some representative examples: of remote learning.
formation. Our treatment of these issues is organized as • Updated appendix on working with equations, graphs,
follows: and tables based on electric scooter rentals
• A five-chapter treatment of long-run issues, followed by Chapter 2
a modern treatment of short-term fluctuations and stabi- • Updated student-centered examples, such as interior
lization policy, emphasizes the important distinction designer Kelly Wearstler
between short- and long-run behavior of the economy. • Updated section on comparative advantage and out-
• Designed to allow for flexible treatment of topics, these sourcing, including updates related to the United States-
chapters are written so that short-run material Mexico-Canada Agreement
(Chapters 12–15) can be used before long-run material • New end-of-chapter problem related to outsourcing
(Chapters 7–11) with no loss of continuity.
Chapter 3
• The analysis of aggregate demand and aggregate supply • Updated student-centered examples, such as digital
relates output to inflation, rather than to the price level, versus print ads and Marvel Studio films
sidestepping the necessity of a separate derivation of
• New Economic Naturalist, “Why was there a shortage
the link between the output gap and inflation. The dis- of toilet paper during the COVID-19 pandemic?”
cussion of monetary policy has two parts. It starts with
a standard supply and demand analysis of the market • Three new end-of-chapter questions that reinforce the
for money that is centered on the short-run interest chapter’s learning objectives, including a question
rate. It then introduces the new tools of monetary pol- related to the drop in crude oil prices during the coro-
icy, such as quantitative easing and forward guidance, navirus pandemic
that have been so important since 2008, and that again Chapter 4
took center stage in the 2020 response to the pandemic. • Updated discussion of growth that reflects higher Internet
• This book places a heavy emphasis on globalization, and cell phone penetration
starting with an analysis of its effects on real wage • Updated discussion of recessions and expansions that
inequality and progressing to such issues as the costs mentions the COVID-19 economic disruptions
and benefits of—and the likely winners and losers from—
trade, the causes and effects of protectionism, the role Chapter 5
of capital flows in domestic capital formation, the link • Updated discussion of the correlation between per cap-
between exchange rates and monetary policy, and the ita GDP and health outcomes such as life expectancy
sources of speculative attacks on currencies. that now mentions that within high-income countries,
the relationship can even reverse, with examples of data
from the U.S., Canada, and Japan
CHANGES IN THE EIGHTH EDITION Chapter 6
Changes Common to All Chapters • Updated discussion of the development of real wages
In all chapters, the narrative has been tightened. Many of for production workers and for highly paid baseball
the examples have been updated, with a focus on student- players over time that is now linked together, in the
centered examples that connect to current topics such as context of a new discussion about increasing wage
the COVID-19 pandemic and the rise of the gig economy. inequalities between the highest- and lowest-paid U.S.
The examples, self-tests, and end-of-chapter material from workers
the previous edition have been redesigned to provide
more clarity and ease of use. Data have been updated Chapter 7
throughout. • Updated examples, data, and figures
Chapter 8
Chapter-by-Chapter Changes • Clarification throughout the chapter of the difference
Chapter 1 between trends in average incomes and trends in income
• Updated student-centered examples, such as Netflix, inequality
wireless keyboards, dogwalking, and Jeff Bezos
• Updated discussion of globalization that now includes
• New and updated end-of-chapter problems that rein- recent developments, including the political opposition
force the chapter’s learning objectives to the Trans-Pacific Partnership trade agreement and
x CONTENTS
PREFACE
Anthony A. Noce, State University of New York Markland Tuttle, Sam Houston State University
(SUNY)–Plattsburgh David Vera, California State University–Fresno
Diego Nocetti, Clarkson University Nancy Virts, California State University–Northridge
Stephanie Owings, Fort Lewis College Gilbert J. Werema, Texas Woman’s University
Dishant Pandya, Spalding University Elizabeth Wheaton, Southern Methodist University
Martin Pereyra, University of Missouri Amanda Wilsker, Georgia Gwinnett College
Tony Pizelo, Northwest University William C. Wood, James Madison University
Ratha Ramoo, Diablo Valley College
D IST I N G UI S H I NG F EATUR ES
466 CHAPTER 17 EXCHANGE RATES AND THE OPEN ECONOMY
ECONOMIC
NATURALIST The Economic Naturalist 17.1
⊲ Visit your instructor’s Connect Likewise, policymakers sometimes view a depreciating (“weak”) currency as a sign
ist example starts with a course and access your eBook to
view this video.
of economic failure. Does a strong currency necessarily imply a strong economy?
question to spark curios- Contrary to popular impression, there is no simple connection between the
strength of a country’s currency and the strength of its economy. For example,
ity and interest in learn- Figure 17.1 shows that the value of the U.S. dollar relative to other major currencies
ing an answer. These was greater in the year 1973 than in the 1990s, though U.S. economic performance
was considerably better in the 1990s than in 1973, a period of deep recession
examples fuel interest and rising inflation. Indeed, the one period shown in Figure 17.1 during which the
while teaching students dollar rose the most in value, 1980–1985, was a time of recession and high unem-
ployment in the United States.
to see economics in the One reason a strong currency does not necessarily imply a strong economy
is that an appreciating currency (an increase in e) tends to raise the real exchange
world around them. Videos of rate (equal to eP/P f), which may hurt a country’s net exports. For example, if the
select and new Economic Naturalist dollar strengthens against the yen (that is, if a dollar buys more yen than before),
Japanese goods will become cheaper in terms of dollars. The result may be that
examples are denoted in the margin Americans prefer to buy Japanese goods rather than goods produced at home.
Likewise, a stronger dollar implies that each yen buys fewer dollars, so exported
of the material to which they per- U.S. goods become more expensive to Japanese consumers. As U.S. goods
tain and they are housed within become more expensive in terms of yen, the willingness of Japanese consumers
to buy U.S. exports declines. A strong dollar may therefore imply lower sales and
Connect. A full list of Economic profits for U.S. industries that export, as well as for U.S. industries (like automobile
manufacturers) that compete with foreign firms for the domestic U.S. market.
Naturalist examples and videos can
be found in the following pages.
RECAP
EXCHANGE RATES
4 CHAPTER 1 THINKING LIKE AN ECONOMIST
• The nominal exchange rate between two currencies is the rate at which
NUMBERED EXAMPLES the currencies can be traded for each other. More precisely, the nominal
exchange
EXA MPL rateE e1.1
for any given country Costs
Comparing is the number
and Benefits of units of foreign
currency that can be bought for one unit of the domestic currency.
Throughout the text, numbered and titled • An appreciation is an increase Shouldin the
youvalue of a currency
walk downtown relative
to save $10 on toaother
$25 wireless keyboard?
examples are referenced and called out to fur- currencies (a rise in e); a depreciation
Imagine you areisabouta decline
to buy a $25 in awireless
currency’s
keyboard value
at the nearby campus store
when a friend tells you that the same keyboard is on sale at a downtown store for
(a fall in e).
ther illustrate concepts. Our engaging questions only $15. If the downtown store is a 30-minute walk away, where should you buy
• An exchange rate can be flexible—meaning
the keyboard?
that it varies freely accord-
ing to supply and demand for the currency in the foreign exchange
and examples from everyday life highlight how market—or fixed—meaning that
Cost-Benefit
Theits
Cost-Benefit
value isPrinciple tells us that
established byyou should buy
official gov- it downtown if the benefit
of doing so exceeds the cost. The benefit of taking any action is the dollar value
each human
32
action is the result of an implicit
CHAPTER 2 COMPARATIVE ADVANTAGE ernment policy. (While not ofour focus you
everything in gain
thisbychapter, an exchange
taking it. Here, the benefit ofratebuying downtown is exactly
can also combine the two $10, approaches.)
because that’s the amount you’ll save on the price of the keyboard. The cost
or explicit cost-benefit calculation. • The real exchange rate is ofthe taking any action
price of the is the dollar value
average of everything
domestic goodyou give
or up by taking it. Here,
The alternative to a system in which everyone is a the cost of buying downtown is the dollar value you assign to the time and trouble
service relative to the price itoftakes
thetoaverage
make the foreign
trip. But howgood or service,
do we estimate thatwhenvalue?
jack-of-all-trades is one in which people specialize in par-
ticular goods and services and then satisfy their needs by prices are expressed in termsOne of way
a common
is to perform currency.
the following Ahypothetical
useful formula
auction. Imagine that a stranger
trading among themselves. Economic systems based on for the real exchange rate(perhaps
has eP/Pf, towhere
is offered pay youe toisdothe an errand
nominal that exchange
involves the same walk downtown
to drop offf a package for her at the post office). If she offered you a pay-
specialization and the exchange of goods and services are rate, P is the domestic price level, and P is the foreign price level.
ment of, say, $1,000, would you accept? If so, we know that your cost of walking
generally far more productive than those with little spe- • An increase in the real exchange downtownrate implies
and back must be that
lessdomestic goods
than $1,000. Now areher offer being reduced
imagine
Courtesy of Robert H. Frank
cialization. Our task in this chapter is to investigate why becoming more expensivein relative to foreign
small increments until you goods,
finally refusewhich
the lasttends toexample, if you’d agree
offer. For
this is so. to walk downtown and back for $9 but not for $8.99, then your cost of making
reduce exports and stimulate imports. Conversely, a decline in the real
the trip is $9. In this case, you should buy the keyboard downtown because the
As this chapter will show, the reason that specializa- exchange rate tends to increase net exports.
$10 you’ll save (your benefit) is greater than your $9 cost of making the trip.
tion is so productive is comparative advantage. Roughly, But suppose your cost of making the trip had been greater than $10. In that
a person has a comparative advantage at producing a case, your best bet would have been to buy the keyboard from the nearby cam-
particular good or service (say, haircuts) if that person pus store. Confronted with this choice, different people may choose differently,
is relatively more efficient at producing haircuts than at Did this man perform most of his depending on how costly they think it is to make the trip downtown. But although
there is no uniquely correct choice, most people who are asked what they would
producing other goods or services. We will see that we own services because he was
poor, or was he poor because do in this situation say they would buy the keyboard downtown.
can all have more of every good and service if each of us he performed most of his own
specializes in the activities at which we have a compara- services?
tive fra6475x_ch17_459-492.indd
advantage. 466 21/10/20 1:37 PM
ECONOMIC SURPLUS
This chapter also will introduce the production possibilities curve, which is a graphical
method of describing the combinations of goods and services that an economy can pro- Suppose that in Example 1.1 your “cost” of making the trip downtown was $9. Compared
duce. This tool will allow us to see more clearly how specialization enhances the produc-to the alternative of buying the keyboard at the campus store, buying it downtown
economic surplus the resulted in an economic surplus of $1, the difference between the benefit of making the
tive capacity of even the simplest economy.
CORE PRINCIPLES
trip and its cost. In general, your goal as an economic decision maker is to choose those
benefit of taking an action
minus its cost actions that generate the largest possible economic surplus. This means taking all actions
that yield a positive total economic surplus, which is just another way of restating the Cost-
Cost-Benefit
EXCHANGE AND OPPORTUNITY COST Benefit Principle.
Although Kelly devotes most of her time and talent to interior design, she
is well equipped to do a broad range of other design work. Suppose Kelly
could design her own web page in 300 hours, half the time it would take any
xiii
other web designer. Does that mean that Kelly should design her own web
page?
Suppose that on the strength of her talents as an interior designer, Kelly earns
more than $1 million a year, implying that the opportunity cost of any time she
reservation price must be only $2.
SUPPLY AND DEMAND We defined the demand curve for any good as a schedule telling how much of it
consumers wish to purchase at various prices. This is called the horizontal interpretation
of the demand curve. Using the horizontal interpretation, we start with price on the
xiv CONTENTS
DISTINGUISHING FEATURES vertical axis and read the corresponding quantity demanded on the horizontal axis. Thus,
Supply
at a price of $4 per slice, the demand curve in Figure 3.1 tells us that the quantity of
pizza demanded will be 8,000 slices per day.
4
The demand curve also can be interpreted in a second way, which is to start with
Price ($/slice)
3
quantity on the horizontal axis and then read the marginal buyer’s reservation price on
Excess demand = 8,000
slices/day the vertical axis. Thus, when the quantity of pizza sold is 8,000 slices per day, the demand
Price ceiling = 2 curve in Figure 3.1 tells us that the marginal buyer’s reservation price is $4 per slice. This
second way of reading the demand curve is called the vertical interpretation.
Demand
SELF-TESTS
SELF-TEST 3.1
These self-test questions 0 in the 8body 12 of16the chapter
In Figure 3.1, what is the marginal buyer’s reservation price when the quantity
Quantity (1,000s of slices/day)
enable students to determine whether the preced- of pizza sold is 10,000 slices per day? For the same demand curve, what will
ing material has been understood and reinforce be the quantity of pizza demanded at a price of $2.50 per slice?
The very idea of not being able to buy a pizza seems absurd, yet precisely such things
understanding before reading further. Detailed
happen routinely in markets in which prices are held below the equilibrium levels. For
answers to the
example, prior self-test
to the questions
collapse of communist are found itatwasthe
governments, consideredTHE SUPPLY
normal in CURVE
end
thoseof each for
countries chapter.
people to stand in line for hours to buy bread and other basic goods,
supply curve a graph or In the market for pizza, the supply curve is a simple schedule or graph that tells us,
while the politically connected had first choice of those goods that were available.
schedule showing the for each possible price, the total number of slices that all pizza vendors would be
quantity of a good that sellers
RECAP
willing to sell at that price. What does the supply curve of pizza look like? The answer
wish to sell at each price R to
E Cthis
A Pquestion is based on the logical assumption that suppliers should be willing to
MARKET EQUILIBRIUM sell additional slices as long as the price they receive is sufficient to cover their oppor-
Sprinkled
tunity cost of supplying throughout
them. Thus, each could
if what someone chapter
earn are Recap
by selling boxes
a slice of
Market equilibrium, the situation in which all buyers and sellers are satisfied
pizza is insufficientthat underscore
to compensate and
her for summarize
what the
she could have importance
earned if she had of the
spent
with their respective quantities at the market price, occurs at the intersection
of the supply and demand curves. The corresponding price and quantity are
her time and invested her moneymaterial
preceding in some other
and way,
keyshe will not takeaways.
concept sell that slice. Oth-
called the equilibrium price and the equilibrium quantity. erwise, she will.
Unless prevented by regulation, prices and quantities are driven toward Just as buyers differ with respect to the amounts they are willing to pay for pizza,
their equilibrium values by the actions of buyers and sellers. If thesellers price also
is differ with respect to their opportunity cost of supplying pizza. For those with
initially too high, so that there is excess supply, frustrated sellers willlimited
cut theireducation and work experience, the opportunity cost of selling pizza is relatively
price in order to sell more. If the price is initially too low, so thatlow there is
(because such individuals typically do not have a lot of high-paying alternatives). For
excess demand, competition among buyers drives the price upward. others,This
the opportunity cost of selling pizza is of moderate value, and for still others—like
process continues until equilibrium is reached. rock stars and professional athletes—it is prohibitively high. In part because of these dif-
ferences in opportunity cost among people, the daily supply curve of pizza will be
upward-sloping with respect to price. As an illustration, see Figure 3.2, which shows a
hypothetical supply curve for pizza in the Chicago market on a given day.
PREDICTING AND EXPLAINING CHANGES IN
WORKED PROBLEM
PRICES AND VIDEOS
QUANTITIES
If we know how the factors that govern supply and demand curves are changing, we can
Brief videos predictions
make informed work through
about how end-of-chapter problems
prices and the corresponding quantities will change.
toButaid in describing
when studentchanging
understanding
circumstances ofincore economic
the marketplace, we must take care to
recognize some important terminological distinctions.60For example, we must distinguish
concepts and offer assistance with more
fra32893_ch03_055-088.indd
challeng-
between the meanings of the seemingly similar expressions change in the quantity demanded
8/4/20 10:07 AM
ing
and material. The When
change in demand. videos are ofavailable
we speak a “change inas thehints
quantity demanded,” this
means the
within change in the quantity that people wish to buy that occurs in response to a
Connect.
change in price. For instance, Figure 3.10(a) depicts an increase in the quantity demanded
that occurs in response to a reduction in the price of tuna. When the price falls from $2
to $1 per can, the quantity demanded rises from 8,000 to 10,000 cans per day. By contrast,
a shift of
when we speak of a “change in demand,” this means a shift in the entire demand curve.
For example, Figure 3.10(b) depicts an increase in demand, meaning that at every price
the quantity demanded is higher than before. In summary, a “change in the quantity
demanded” refers to a movement along the demand curve and a “change in demand”
means a shift of the entire curve.
Commercial Banking: Why can it be more expensive to Inflation: Can inflation be too low?
transfer funds between banks electronically than it is to Menu Costs: Will new technologies eliminate menu costs?
send a check through the mail? Money and Its Uses: Is there such a thing as private, or
Comparative Advantage: iPhones: Designed in California, but communicably traded, money?
assembled in China Saving: Why do American households save so little while
Cost Benefit 1: Why does the light come on when you open Chinese households save so much?
the refrigerator door but not when you open the freezer? Sources of Increasing Inequality: Why have the salaries of
Cost Benefit 2: Why are child safety seats required in auto- top earners been growing so much faster than everyone
mobiles but not in airplanes? else’s?
Economy Strength and Currency Value: Does a strong Supply and Demand: Why are rotisserie chickens less
currency imply a strong economy? expensive than fresh chickens?
Human Capital: Why do almost all countries provide free Tariffs: Why do consumers in the United States often pay
education? more than double the world price for sugar?
Inflation: Do official inflation figures overstate actual increases The Demand for Money: Why does the average Argentine
in our living costs? citizen hold more U.S. dollars than the average U.S. citizen?
xv
EC ON O M I C N ATUR A LI ST EXA MPL E S
1.1 Why do many hardware manufacturers include more than 5.1 Can nominal and real GDP ever move in different
$1,000 worth of “free” software with a computer selling directions?
for only slightly more than that? 5.2 Why do people work fewer hours today than their great-
1.2 Why don’t auto manufacturers make cars without grandparents did?
heaters? 5.3 Why do far fewer children complete high school in poor
1.3 Why do the keypad buttons on drive-up automated teller countries than in rich countries?
machines have Braille dots? 6.1 Every few years, there is a well-publicized battle in
2.1 Where have all the .400 hitters gone? Congress over whether the minimum wage should be
2.2 What happened to the U.S. lead in the television market? raised. Why do these heated legislative debates recur so
2.3 If trade among nations is so beneficial, why are free- regularly?
trade agreements so controversial? 7.1 Why did West Germany and Japan recover so
2.4 Is PBS economics reporter Paul Solman’s job a likely successfully from the devastation of World War II?
candidate for outsourcing? 7.2 Why did U.S. labor productivity grow so rapidly in the
3.1 When the federal government implements a large pay late 1990s?
increase for its employees, why do rents for apartments 7.3 Why did medieval China stagnate economically?
located near Washington Metro stations go up relative to 7.4 Why do almost all countries provide free public education?
rents for apartments located far away from Metro 8.1 Can new technology hurt workers?
stations? 8.2 How did the COVID-19 pandemic affect the demand for
3.2 Why do major term papers go through so many more U.S. jobs?
revisions today than in the 1970s? 9.1 How did many American households increase their
3.3 Why do the prices of some goods, like airline tickets to wealth in the 1990s and 2000s while saving very little?
Europe, go up during the months of heaviest 9.2 Why do Chinese households save so much?
consumption, while others, like sweet corn, go down? 9.3 Why do U.S. households save so little?
3.4 Why was there a shortage of toilet paper during the 9.4 Why have real interest rates declined globally in recent
COVID-19 pandemic? decades?
xvi
ECONOMIC NATURALIST EXAMPLES xvii
10.1 From Ithaca Hours to Bitcoin: what is private money, 14.4 Why does news of inflation hurt the stock market?
communally created money, and open-source money? 14.5 Should the Federal Reserve respond to changes in asset
10.2 Why did the banking panics of 1930–1933 reduce the prices?
national money supply? 14.6 What is the Taylor rule?
11.1 What happens to national economies during banking 15.1 How did inflation get started in the United States in the
crises? 1960s?
11.2 Why did the U.S. stock market rise sharply and fall 15.2 Why did oil price increases cause U.S. inflation to
sharply in the 1990s and again in the 2000s? escalate in the 1970s but not in the 2000s and
11.3 Why is the U.S. trade deficit so large? 2010s?
12.1 Do economic fluctuations affect presidential elections? 15.3 Why was the United States able to experience rapid
12.2 How was the 2007 recession called? growth and low inflation in the latter part of the 1990s?
12.3 Why has the natural rate of unemployment in the United 15.4 How was inflation conquered in the 1980s?
States declined? 15.5 Can inflation be too low?
12.4 Why did the Federal Reserve act to slow down the 16.1 What is the China trade shock?
economy in 1999 and 2000? 16.2 Why did the U.S. start a trade war with China?
13.1 Will new technologies eliminate menu costs? 16.3 What is fast track authority?
13.2 How did the decline in U.S. stock market values from 17.1 Does a strong currency imply a strong economy?
2000–2002 affect consumption spending? 17.2 What is a safe haven currency?
13.3 What caused the 2007–2009 recession in the United 17.3 Why did the dollar appreciate nearly 50 percent in the
States? first half of the 1980s and nearly 40 percent in the
13.4 Does military spending stimulate the economy? second half of the 1990s?
13.5 Why did the federal government temporarily cut taxes in 17.4 What were the causes and consequences of the East
2001, 2009, and 2020? Asian crisis of 1997–1998?
14.1 Why does the average Argentine hold more U.S. dollars 17.5 What is the IMF, and how has its mission evolved over
than the average U.S. citizen? the years?
14.2 How did the Fed respond to recession and the terrorist 17.6 How did policy mistakes contribute to the Great
attacks in 2001? Depression?
14.3 Why did the Fed raise interest rates 17 times in a row 17.7 Why have 19 European countries adopted a common
between 2004 and 2006? currency?
SUP P LE M E N TS
xix
Connect Economics
Asset Alignment with
Bloom’s Taxonomy
Principles of Macroeconomics, 8e
As a learning science company we create content that supports higher order thinking skills. Within
Connect®, we tag assessments accordingly so you can filter your search, assign it, and receive reporting
on it. These content asset types can be associated with one or more levels of Bloom’s Taxonomy.
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Econ
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to focus, asking review questions and pointing them to passages in the text until they
understand. Assignable and assessable.
Videos
Worked examples and real-world application videos help students learn economics.
Learning Glass videos reinforcing challenging topics featuring the authors and innovative
learning glass technology. Economic Naturalist videos bring examples to life showing
interesting applications of economic concepts. Worked Problem videos work through
select end-of-chapter questions for extra help and guidance through challenging material.
Exercises
Exercises with algorithmic variations provide ample opportunities for students to practice
and hone quantitative skills. Graphing Exercises provide opportunities for students to draw,
interact with, manipulate, and analyze graphs.
Interactive Graphs
Interactive Graphs provide visual displays of real data and economic concepts for students
to manipulate. All graphs are accompanied by assignable assessment questions and
feedback to guide students through the experience of learning to read and interpret graphs
and data.
Application-Based Activities
Immersive real-life scenarios engage students and put them in the role of everyday
economists. Students practice their economic thinking and problem-solving skills as they
apply course concepts and see the implications of their decisions as they go. Each activity
is designed as a 15-minute experience, unless students eagerly replay for a better outcome.
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C O MPA R I S O N G U IDE F OR F RANK , BE RNANKE,
A N TO N OV I C S , AND HE F F E T Z PRODUC TS
Principles of Economics provides enhanced coverage, offers more topics, and more mathematical rigor. Principles of Economics: A Streamlined Approach is a stripped
down version of the big book featuring core content with a less is more approach. See which product is right for you!
Comparison Guide
Principles of Economics, 8th edition Principles of Economics: A Streamlined Approach, 4th edition
Econ Micro Macro Streamlined Streamlined Streamlined
Chapter Title 8e 8e 8e Chapter Title 4e Econ 4e Micro 4e Macro
Thinking Like an Economist 1 1 1 Thinking Like An Economist 1 1 1
Comparative Advantage 2 2 2
Supply and Demand 3 3 3 Supply and Demand 2 2 2
Elasticity 4 4
Demand and Elasticity 3 3
Demand 5 5
Perfectly Competitive Supply 6 6 Perfectly Competitive Supply 4 4
Efficiency, Exchange, and 7 7 Efficiency, Exchange, and 5 5
the Invisible Hand in Action the Invisible Hand in Action
Monopoly, Oligopoly, and 8 8 Monopoly, Oligopoly, and 6 6
Monopolistic Competition Monopolistic Competition
Games and Strategic 9 9 Games and Strategic 7 7
Behavior Behavior
An Introduction to 10 10 An Introduction to Behavioral 8 8
Behavioral Economics Economics (NEW)
Externalities, Property 11 11 Externalities and Property 9 9
Rights, and the Environment Rights
The Economics of Information 12 12
Using Economics to Make
Labor Markets, Poverty, and 13 13 10 10
Better Policy Decisions
Income Distribution
Public Goods and Tax Policy 14 14
International Trade and 15 15 16 International Trade and 11 11 12
Trade Policy Trade Policy
Macroeconomics: The Bird’s- 16 4 Macroeconomics: The Bird’s 12 3
Eye View of the Economy Eye View of the Economy
Measuring Economic Activity: 17 5
Measuring Economic Activity:
GDP and Unemployment
GDP, Unemployment, and 13 4
Measuring the Price Level 18 6
Inflation
and Inflation
Economic Growth, Produc- 19 7 Economic Growth, Produc- 14 5
tivity, and Living Standards tivity, and Living Standards
The Labor Market: Workers, 20 8 The Labor Market: Workers, 15 6
Wages, and Unemployment Wages, and Unemployment
Saving and Capital Formation 21 9 Saving and Capital Formation 16 7
Money, Prices, and the 22 10
Money, The Federal
Federal Reserve
Reserve, and Global 17 8
Financial Markets and 23 11
Financial Markets
International Capital Flows
Short-Term Economic Fluc- 24 12
tuations: An Introduction Short-Term Economic Fluc-
18 9
Spending and Output in the 25 13 tuations and Fiscal Policy
Short Run
Stabilizing the Economy: 26 14 Stabilizing the Economy: 19 10
The Role of the Fed The Role of the Fed
Aggregate Demand, Aggre- 27 15 Aggregate Demand, Aggre- 20 11
gate Supply, and Inflation gate Supply, and Inflation
Exchange Rates and the 28 17 Exchange Rates and the 21 13
Open Economy Open Economy
xxiv
BRIE F CON TENTS
PART 3 The Economy in the Long Run PART 5 The International Economy
7 Economic Growth, Productivity, and Living 16 International Trade and Trade Policy 431
Standards 163
17 Exchange Rates and the Open
8 The Labor Market: Workers, Wages, and Economy 459
Unemployment 191
xxv
C ON T E N TS
PART 4 The Economy in the Short Run Fiscal Policy as a Stabilization Tool: Three
Qualifications 340
Chapter 12 Short-Term Economic Fluctuations: Fiscal Policy and the Supply Side 341
An Introduction 295 The Problem of Deficits 341
THE ECONOMIC NATURALIST 12.1 296 The Relative Inflexibility of Fiscal Policy 341
Recessions and Expansions 297 Summary 342 • Key Terms 343 • Review
THE ECONOMIC NATURALIST 12.2 299 Questions 344 • Problems 344 • Answers to
Some Facts about Short-Term Economic Self-Tests 345 • Appendix A: An Algebraic
Fluctuations 300 Solution of the Basic Keynesian Model 347 • Appendix B:
Output Gaps and Cyclical Unemployment 303 The Multiplier in the Basic Keynesian Model 350
Potential Output 303
The Output Gap 304
The Natural Rate of Unemployment and Chapter 14 Stabilizing the Economy: The Role
Cyclical Unemployment 305 of the Fed 353
THE ECONOMIC NATURALIST 12.3 306 The Federal Reserve and Interest Rates:
Okun’s Law 308 The Basic Model 354
THE ECONOMIC NATURALIST 12.4 309 The Demand for Money 355
Why Do Short-Term Fluctuations Occur? A Preview Macroeconomic Factors That Affect the Demand
and a Tale 310 for Money 358
Alice’s Ice Cream Store: A Tale about Short-Run The Money Demand Curve 359
Fluctuations 311 THE ECONOMIC NATURALIST 14.1 360
Summary 312 • Key Terms 313 • Review The Supply of Money and Money Market
Questions 313 • Problems 313 • Answers to Equilibrium 362
Self-Tests 314 How the Fed Controls the Nominal
Interest Rate 363
The Role of the Federal Funds Rate in
Chapter 13 Spending and Output in the Monetary Policy 365
Short Run 315 Can the Fed Control the Real Interest Rate? 366
The Keynesian Model’s Crucial Assumption: Firms Meet The Federal Reserve and Interest Rates:
Demand at Preset Prices 317 A Closer Look 367
THE ECONOMIC NATURALIST 13.1 318 Can the Fed Fully Control the Money
Planned Aggregate Expenditure 319 Supply? 367
Planned Spending versus Actual Affecting Bank Reserves through Open-Market
Spending 319 Operations 368
Consumer Spending and the Economy 321 Affecting Bank Reserves through Discount
THE ECONOMIC NATURALIST 13.2 322 Window Lending 368
Planned Aggregate Expenditure and Output 323 Setting and Changing Reserve Requirements 368
Short-Run Equilibrium Output 326 Excess Reserves: The Norm since 2008 369
Finding Short-Run Equilibrium Output: Numerical Do Interest Rates Always Move Together? 370
Approach 327 The Zero Lower Bound and the Need for
Finding Short-Run Equilibrium Output: Graphical “Unconventional” Monetary Policy 371
Approach 328 Quantitative Easing 371
Planned Spending and the Output Gap 330 Forward Guidance 371
THE ECONOMIC NATURALIST 13.3 332 Interest on Reserves and the New Tools of
The Multiplier 333 Monetary Policy 372
Stabilizing Planned Spending: The Role of Fiscal The Effects of Federal Reserve Actions on the
Policy 334 Economy 374
Government Purchases and Planned Planned Aggregate Expenditure and the Real
Spending 334 Interest Rate 374
THE ECONOMIC NATURALIST 13.4 336 The Fed Fights a Recession 377
Taxes, Transfers, and Aggregate Spending 337 THE ECONOMIC NATURALIST 14.2 378
THE ECONOMIC NATURALIST 13.5 339 The Fed Fights Inflation 379
CONTENTS xxxi
LEARNING OBJECTIVES
After reading this chapter,
you should be able to:
LO1 E
xplain and apply the
Scarcity Principle,
which says that having
more of any good
thing necessarily
requires having less
of something else.
LO2 E
xplain and apply the
Cost-Benefit Principle,
which says that an
Nick Dolding/Cultura/Corbis
action should be taken
if, but only if, its benefit
is at least as great as
its cost.
LO3 D
iscuss three important
pitfalls that occur when
People often make bad decisions because they fail to compare the relevant costs applying the Cost-
and benefits. Benefit Principle
inconsistently.
LO4 E
xplain and apply the
ow many students are in your introductory economics class? Some classes have
H
Incentive Principle,
just 20 or so. Others average 35, 100, or 200 students. At some schools, introduc- which says that if you
tory economics classes may have as many as 2,000 students. What size is best? want to predict people’s
If cost were no object, the best size might be a single student. Think about it: the behavior, a good place
whole course, all term long, with just you and your professor! Everything could be custom- to start is by examining
tailored to your own background and ability. You could cover the material at just the right their incentives.
pace. The tutorial format also would promote close communication and personal trust
between you and your professor. And your grade would depend more heavily on what you
actually learned than on your luck when taking multiple-choice exams. Let’s suppose, for
the sake of discussion, that students have been shown to learn best in the tutorial format.
Why, then, do so many introductory classes still have hundreds of students? The
simple reason is that costs do matter. They matter not just to the university administrators
who must build classrooms and pay faculty salaries, but also to you. The direct cost of
providing you with your own personal introductory economics course might easily top
$50,000. Someone has to pay these costs. In private universities, a large share of the cost
would be recovered directly from higher tuition payments. In state universities, the burden
1
2 CHAPTER 1 THINKING LIKE AN ECONOMIST
would be split between higher tuition payments and higher tax payments. But, in either
case, the course would be unaffordable for most students.
With larger classes, of course, the cost per student goes down. For example, an intro-
ductory economics course with 300 students might cost as little as $200 per student. But
a class that large could easily compromise the quality of the learning environment. Com-
pared to the custom tutorial format, however, it would be dramatically more affordable.
In choosing what size introductory economics course to offer, then, university admin-
istrators confront a classic economic trade-off. In making the class larger, they risk low-
ering the quality of instruction—a bad thing. At the same time, they reduce costs and
hence the tuition students must pay—a good thing.
In this chapter, we’ll introduce three simple principles that will help you understand
and explain patterns of behavior you observe in the world around you. These principles
also will help you avoid three pitfalls that plague decision makers in everyday life.
Inherent in the idea of a trade-off is the fact that choice involves compromise between
competing interests. Economists resolve such trade-offs by using cost-benefit analysis,
which is based on the disarmingly simple principle that an action should be taken if, and
only if, its benefits exceed its costs. We call this statement the Cost-Benefit Principle, and
it, too, is one of the core principles of economics:
With the Cost-Benefit Principle in mind, let’s think about our class-size question
again. Imagine that classrooms come in only two sizes—100-seat lecture halls and 20-seat
classrooms—and that your university currently offers introductory economics courses to
classes of 100 students. Question: Should administrators reduce the class size to 20 stu-
dents? Answer: Reduce if, and only if, the value of the improvement in instruction out-
weighs its additional cost.
This rule sounds simple. But to apply it we need some way to measure the rele-
vant costs and benefits, a task that’s often difficult in practice. If we make a few
Applying the Cost-Benefit Principle 3
simplifying assumptions, however, we can see how the analysis might work. On the
cost side, the primary expense of reducing class size from 100 to 20 is that we’ll
now need five professors instead of just one. We’ll also need five smaller classrooms
rather than a single big one, and this too may add slightly to the expense of the
move. Let’s suppose that classes with 20 cost $1,000 per student more than those
with 100. Should administrators switch to the smaller class size? If they apply the
Cost-Benefit Principle, they will realize that doing so makes sense only if the value of
Cost-Benefit
attending the smaller class is at least $1,000 per student greater than the value of
attending the larger class.
Would you (or your family) be willing to pay an extra $1,000 for a smaller class? If
not, and if other students feel the same way, then sticking with the larger class size makes
sense. But if you and others would be willing to pay the extra tuition, then reducing the
class size makes good economic sense.
Notice that the “best” class size, from an economic point of view, will generally not be the
same as the “best” size from the point of view of an educational psychologist. That’s because
the economic definition of “best” takes into account both the benefits and the costs of
different class sizes. The psychologist ignores costs and looks only at the learning benefits
of different class sizes.
In practice, of course, different people feel differently about the value of smaller
classes. People with high incomes, for example, tend to be willing to pay more for
the advantage. That helps explain why average class size is smaller, and tuition
higher, at private schools whose students come predominantly from high-income
families.
The cost-benefit framework for thinking about the class-size problem also suggests a
possible reason for the gradual increase in average class size that has been taking place
in American colleges and universities. During the last 30 years, professors’ salaries have
risen sharply, making smaller classes more costly. During the same period, median family
income—and hence the willingness to pay for smaller classes—has remained roughly con-
stant. When the cost of offering smaller classes goes up but willingness to pay for smaller
classes does not, universities shift to larger class sizes.
Scarcity and the trade-offs that result also apply to resources other than money. Jeff
Chip Somodevilla/Getty Images
Bezos is one of the richest people on Earth. His wealth is estimated at more than $180
billion. That’s more than the combined wealth of the poorest 54 percent of Americans.
Bezos could buy more houses, cars, vacations, and other consumer goods than he could
possibly use. Yet he, like the rest of us, has only 24 hours each day and a limited amount
of energy. So even he confronts trade-offs. Any activity he pursues—whether it be build-
ing his business empire or redecorating his mansion—uses up time and energy that he
could otherwise spend on other things. Indeed, someone once calculated that the value If Jeff Bezos saw a $100 bill
of Bezos’s time is so great that pausing to pick up a $100 bill from the sidewalk simply lying on the sidewalk, would it
wouldn’t be worth his while. be worth his time to pick it up?
The Cost-Benefit Principle tells us that you should buy it downtown if the b enefit
Cost-Benefit
of doing so exceeds the cost. The benefit of taking any action is the dollar value
of everything you gain by taking it. Here, the benefit of buying downtown is exactly
$10, because that’s the amount you’ll save on the price of the keyboard. The cost
of taking any action is the dollar value of everything you give up by taking it. Here,
the cost of buying downtown is the dollar value you assign to the time and trouble
it takes to make the trip. But how do we estimate that value?
One way is to perform the following hypothetical auction. Imagine that a stranger
has offered to pay you to do an errand that involves the same walk downtown
(perhaps to drop off a package for her at the post office). If she offered you a pay-
ment of, say, $1,000, would you accept? If so, we know that your cost of walking
downtown and back must be less than $1,000. Now imagine her offer being reduced
in small increments until you finally refuse the last offer. For example, if you’d agree
to walk downtown and back for $9 but not for $8.99, then your cost of making
the trip is $9. In this case, you should buy the keyboard downtown because the
$10 you’ll save (your benefit) is greater than your $9 cost of making the trip.
But suppose your cost of making the trip had been greater than $10. In that
case, your best bet would have been to buy the keyboard from the nearby cam-
pus store. Confronted with this choice, different people may choose differently,
depending on how costly they think it is to make the trip downtown. But although
there is no uniquely correct choice, most people who are asked what they would
do in this situation say they would buy the keyboard downtown.
ECONOMIC SURPLUS
Suppose that in Example 1.1 your “cost” of making the trip downtown was $9. Compared
to the alternative of buying the keyboard at the campus store, buying it downtown
economic surplus the resulted in an economic surplus of $1, the difference between the benefit of making the
benefit of taking an action trip and its cost. In general, your goal as an economic decision maker is to choose those
minus its cost actions that generate the largest possible economic surplus. This means taking all actions
that yield a positive total economic surplus, which is just another way of restating the Cost-
Cost-Benefit
Benefit Principle.
Note that the fact that your best choice was to buy the keyboard downtown doesn’t imply
that you enjoy making the trip, any more than choosing a large class means that you prefer
large classes to small ones. It simply means that the trip is less unpleasant than the prospect
of paying $10 extra for the keyboard. Once again, you’ve faced a trade-off. In this case, the
choice was between a cheaper keyboard and the free time gained by avoiding the trip.
OPPORTUNITY COST
Of course, your mental auction could have produced a different outcome. Suppose, for
example, that the time required for the trip is the only time you have left to study for a
difficult test the next day. Or suppose you are watching one of your favorite shows on
opportunity cost the value Netflix, or that you are tired and would love a short nap. In such cases, we say that the
of what must be forgone to opportunity cost of making the trip—that is, the value of what you must sacrifice to walk
undertake an activity downtown and back—is high and you are more likely to decide against making the trip.
Applying the Cost-Benefit Principle 5
SELF-TEST 1.1
You would again save $10 by buying the wireless keyboard downtown rather
than at the campus store, but your cost of making the trip is now $12, not $9.
By how much would your economic surplus be smaller if you bought the
keyboard downtown rather than at the campus store?
the time-honored tradition of running alongside the bike and holding onto his son, then
giving him a push and hoping for the best. After several hours and painfully skinned
elbows and knees, his son finally got it. A year later, someone pointed out that the trick
to riding a bike is to turn slightly in whichever direction the bike is leaning. Of course!
The economist passed this information along to his second son, who learned to ride
almost instantly. Just as knowing a little physics can help you learn to ride a bike, know-
ing a little economics can help you make better decisions.
RECAP
COST-BENEFIT ANALYSIS
Scarcity is a basic fact of economic life. Because of it, having more of one
good thing almost always means having less of another (the scarcity princi-
ple). The Cost-Benefit Principle holds that an individual (or a firm or a society)
should take an action if, and only if, the extra benefit from taking the action
is at least as great as the extra cost. The benefit of taking any action minus
the cost of taking the action is called the economic surplus from that action.
Hence, the Cost-Benefit Principle suggests that we take only those actions
that create additional economic surplus.
Assuming that the laptop is light enough to carry without effort, the structure
of this example is exactly the same as that of Example 1.1. The only difference is
that the price of the laptop is dramatically higher than the price of the wireless
keyboard. As before, the benefit of buying downtown is the dollar amount you’ll
save, namely, $10. And because it’s exactly the same trip, its cost also must be
the same as before. So if you are perfectly rational, you should make the same
decision in both cases. Yet when people are asked what they would do in these
situations, the overwhelming majority say they’d walk downtown to buy the key-
board but would buy the laptop at the campus store. When asked to explain, most
of them say something like, “The trip was worth it for the keyboard because you
save 40 percent, but not worth it for the laptop because you save only $10 out
of $2,020.”
This is faulty reasoning. The benefit of the trip downtown is not the propor-
tion you save on the original price. Rather, it is the absolute dollar amount you
save. The benefit of walking downtown to buy the laptop is $10, exactly the
same as for the wireless keyboard. And because the cost of the trip must also
be the same in both cases, the economic surplus from making both trips must
be exactly the same. That means that a rational decision maker would make the
same decision in both cases. Yet, as noted, most people choose differently.
The pattern of faulty reasoning in the decision just discussed is one of several decision
pitfalls to which people are often prone. In the discussion that follows, we will identify
two additional decision pitfalls. In some cases, people ignore costs or benefits that they
ought to take into account. On other occasions they are influenced by costs or benefits
that are irrelevant.
SELF-TEST 1.2
Which is more valuable: saving $100 on a $2,000 plane ticket to Tokyo or
saving $90 on a $200 plane ticket to Chicago?
the trip? Using it for that purpose might make the flight to Cancun seem free,
suggesting you’d reap an economic surplus of $350 by making the trip. But doing
so also would mean you’d have to fork over $400 for your airfare to Boston. So
the implicit cost of using your coupon to go to Cancun is really $400. If you use
it for that purpose, the trip still ends up being a loser because the cost of the
Is your flight to Cancun “free”
vacation, $1,400, exceeds the benefit by $50. In cases like these, you’re much
if you travel on a frequent-flyer more likely to decide sensibly if you ask yourself, “Should I use my frequent-flyer
coupon? coupon for this trip or save it for an upcoming trip?”
We cannot emphasize strongly enough that the key to using the Cost-Benefit
Principle correctly lies in recognizing precisely what taking a given action prevents
us from doing. Self-Test 1.3 illustrates this point by modifying the details of Example 1.3
slightly.
SELF-TEST 1.3
Refer to given information in Example 1.3, but this time your frequent-flyer
coupon expires in a week, so your only chance to use it will be for the C
ancun
trip. Should you use your coupon?
E XA MP LE 1 .4 Sunk Cost
Having eaten their first helping, diners in each group confront the following
question: “Should I go back for another helping?” For rational diners, if the ben-
efit of doing so exceeds the cost, the answer is yes; otherwise it is no. Note that
at the moment of decision, the $10 charge for the lunch is a sunk cost. Those
who paid it have no way to recover it. Thus, for both groups, the (extra) cost of
another helping is exactly zero. And because the people who received the free
lunch were chosen at random, there’s no reason their appetites or incomes should
be any different from those of other diners. The benefit of another helping thus
should be the same, on average, for people in both groups. And because their
respective costs and benefits are the same, the two groups should eat the same
number of helpings, on average.
Psychologists and economists have experimental evidence, however, that
people in such groups do not eat similar amounts.3 In particular, those who have
to pay for the all-you-can eat buffet tend to eat substantially more than those for
whom the buffet is free. People in the former group seem somehow determined
to “get their money’s worth.” Their implicit goal is apparently to minimize the
average cost per bite of the food they eat. Yet minimizing average cost is not a
particularly sensible objective. The irony is that diners who are determined to get
their money’s worth usually end up eating too much.
The fact that the cost-benefit criterion failed the test of prediction in Example 1.4
does nothing to invalidate its advice about what people should do. If you are letting sunk
costs influence your decisions, you can do better by changing your behavior.
In addition to paying attention to costs and benefits that should be ignored, people
often use incorrect measures of the relevant costs and benefits. This error often occurs
marginal cost the increase
when we must choose the extent to which an activity should be pursued (as opposed to
in total cost that results from
choosing whether to pursue it at all). We can apply the Cost-Benefit Principle in such
carrying out one additional
situations by repeatedly asking the question, “Should I increase the level at which I am
unit of an activity
currently pursuing the activity?”
In attempting to answer this question, the focus should always be on the benefit and marginal benefit the
cost of an additional unit of activity. To emphasize this focus, economists refer to the cost increase in total benefit that
of an additional unit of activity as its marginal cost. Similarly, the benefit of an additional results from carrying out one
unit of the activity is its marginal benefit. additional unit of an activity
3
See, for example, Richard Thaler, “Toward a Positive Theory of Consumer Choice,” Journal of Economic Behavior
and Organization 1, no. 1 (1980).
10 CHAPTER 1 THINKING LIKE AN ECONOMIST
When the problem is to discover the proper level for an activity, the cost-benefit rule
is to keep increasing the level as long as the marginal benefit of the activity exceeds its
marginal cost. As the following example illustrates, however, people often fail to apply
this rule correctly.
TABLE 1.1
How Total Cost Varies with the Number of Launches
Number of Total cost Average cost
launches ($ billions) ($ billion/launch)
0 0 0
1 3 3
2 7 3.5
3 12 4
4 20 5
5 32 6.4
THREE IMPORTANT DECISION PITFALLS 11
The following example illustrates how to apply the Cost-Benefit Principle correctly in
this case.
SpaceX should continue to launch its jumbo rockets as long as the marginal
benefit of the program exceeds its marginal cost. In this example, the marginal
benefit is constant at $6 billion per launch, regardless of the number of rockets
launched. SpaceX should thus keep launching rockets as long as the marginal
cost per launch is less than or equal to $6 billion.
Applying the definition of marginal cost to the total cost entries in the second
column of Table 1.1 yields the marginal cost values in the third column of Table 1.2.
(Because marginal cost is the change in total cost that results when we change
the number of launches by one, we place each marginal cost entry midway
between the rows showing the corresponding total cost entries.) Thus, for exam-
ple, the marginal cost of increasing the number of launches from one to two is
$4 billion, the difference between the $7 billion total cost of two launches and
the $3 billion total cost of one launch.
TABLE 1.2
How Marginal Cost Varies with the Number of Launches
Number of Total cost Marginal cost
launches ($ billions) ($ billion/launch)
0 0
3
1 3
4
2 7
5
3 12
8
4 20
12
5 32
SELF-TEST 1.4
If the marginal benefit of each launch had been not $6 billion but $9 billion,
how many rockets should SpaceX have launched?
The cost-benefit framework emphasizes that the only relevant costs and benefits in
deciding whether to pursue an activity further are marginal costs and benefits—measures
that correspond to the increment of activity under consideration. In many contexts, however,
12 CHAPTER 1 THINKING LIKE AN ECONOMIST
people seem more inclined to compare the average cost and benefit of the activity. As
Example 1.5 made clear, increasing the level of an activity may not be justified, even though
its average benefit at the current level is significantly greater than its average cost.
SELF-TEST 1.5
Should a basketball team’s best player take all the team’s shots?
A professional basketball team has a new assistant coach. The assistant
notices that one player scores on a higher percentage of her shots than other
players. Based on this information, the assistant suggests to the head coach
that the star player should take all the shots. That way, the assistant reasons,
the team will score more points and win more games.
On hearing this suggestion, the head coach fires her assistant for incom-
petence. What was wrong with the assistant’s idea?
RECAP
THREE IMPORTANT DECISION PITFALLS
1. The pitfall of measuring costs or benefits proportionally. Many decision
makers treat a change in cost or benefit as insignificant if it constitutes
only a small proportion of the original amount. Absolute dollar amounts,
not proportions, should be employed to measure costs and benefits.
2. The pitfall of ignoring implicit costs. When performing a cost-benefit
analysis of an action, it is important to account for all relevant costs,
including the implicit value of alternatives that must be forgone in order
to carry out the action. A resource (such as a frequent-flyer coupon) may
have a high implicit cost, even if you originally got it “for free,” if its best
alternative use has high value. The identical resource may have a low
implicit cost, however, if it has no good alternative uses.
3. The pitfall of failing to think at the margin. When deciding whether to
perform an action, the only costs and benefits that are relevant are those
that would result from taking the action. It is important to ignore sunk
costs—those costs that cannot be avoided even if the action isn’t taken.
Even though a ticket to a concert may have cost you $100, if you’ve
already bought it and cannot sell it to anyone else, the $100 is a sunk
cost and shouldn’t influence your decision about whether to go to the
concert. It’s also important not to confuse average costs and benefits
with marginal costs and benefits. Decision makers often have ready
information about the total cost and benefit of an activity, and from these
it’s simple to compute the activity’s average cost and benefit. A common
mistake is to conclude that an activity should be increased if its average
benefit exceeds its average cost. The Cost-Benefit Principle tells us that
the level of an activity should be increased if, and only if, its marginal
benefit exceeds its marginal cost.
Some costs and benefits, especially marginal costs and benefits and implicit costs,
are important for decision making, while others, like sunk costs and average costs and
benefits, are essentially irrelevant. This conclusion is implicit in our original statement
of the Cost-Benefit Principle (an action should be taken if, and only if, the extra ben-
Cost-Benefit
efits of taking it exceed the extra costs). When we encounter additional examples of
decision pitfalls, we will flag them by inserting the icon for the Cost-Benefit Principle
as shown here.
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but the description given of the field in which the tournament was
held, corresponds, in a most minute manner, with the “Tournament
Field,” still so called, at the neighbouring village of Smisby, and has
for ages been identified with that famous “Passage of Arms.” Eight
miles south-east of Repton this very interesting “habitation among
the ash trees” is situated.
The first authentic mention we have of it is about the year 1066,
when William the Conqueror granted the Manor to Hugh de
Grentemaisnel, one of his most valiant captains at the battle of
Hastings. In Domesday Book we read of its having a priest and
church. Soon afterwards it fell into the hands of Robert de Beaumeis,
another Norman, whose successor, Philip, granted “the church of St.
Helen of Ashby, with the church of Blackfordby,” &c., &c., to the
Abbey of Lilleshall, Salop. Philip de Beaumeis, having no son to
succeed him, left his estates to his daughter Adeliza, who married
Alan la Zouche, a descendant of the Earls of Brittany. Alan settled at
Ashby, and added the family name to it, to distinguish it from the
other towns of that name. Alan was succeeded by his son Roger,
who was succeeded by his son Alan, the last of the real Zouches, in
the male line, who held the Manor of Ashby, he granted it to Sir
William Mortimer, a distant relative, who assumed the name, and
passed it on to his son Alan, who fought at the battle of Creçy, 1346,
and died in that year, he was succeeded by his son Hugh, who died
in 1399, leaving no heir, with him the name, finally, became extinct.
Plate 16.
Plate 17.
SWARKESTON.
STANTON-BY-BRIDGE.
HARTSHORN.
1612.