FIFTH EDITION B BARRON'S. Walter J.Wessels. BUSINESS REVIEW BOOKS Economics

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1 BUSINESS REVIEW BOOKS Economics FIFTH EDITION Walter J.Wessels Professor of Economics Department of Economics and Business North Carolina State University B BARRON'S

2 CONTENTS Preface xiii 1 WHAT IS ECONOMICS ALL ABOUT? 7 What Is Economics About? 2 The Basis for Economics 2 Scarcity " 3 Opportunity Cost 3 Marginal Analysis " - 10 KNOW THE CONCEPTS 13 PRACTICAL APPLICATION ANSWERS ; 2 HOW TO USE GRAPHS IN ECONOMICS 20 Reading Graphs 20 How Two Variables Are Related 21 Plotting Graphs 22 Measuring the Slope 23 KNOW THE CONCEPTS 25 PRACTICAL APPLICATION 25 ANSWERS 27 3 SUPPLY AND DEMAND: PART ONE 32 How to Study Supply and Demand 32 Price 33 Demand and the Law of Demand 34 The Demand Curve 35 Supply and the Law of Supply 37 The Supply Curve 38 Market Equilibrium. 39 Studying Demand and Supply Curves 41 Price Floors : 43 Price Ceilings * 44 Effects of Price Ceilings and Floors 45 On the Nature of the Price System 46 KNOW THE CONCEPTS 47 PRACTICAL APPLICATION 48 ANSWERS 49 4 SUPPLY AND DEMAND: PART TWO 52 The Difference Between Economic Shifts and Movements 52 Factors Shifting Demand 53 16

3 iv CONTENTS Factors Shifting Supply 57 How to Avoid Mistakes in Analyzing Supply and Demand 60 KNOW THE CONCEPTS 61 PRACTICAL APPLICATION 62 ANSWERS 65 MEASURING NATIONAL OUTPUT 68 Introduction 68 Basic Premises 69 The Circular Flow of Income 70 Measuring GDP.. 71 GDP and National Welfare " * 75 National Income Accounting Formulas 75 Applying the National Income Premises 76 KNOW THE CONCEPTS 79 PRACTICAL APPLICATION 79 ANSWERS 81 INFLATION AND UNEMPLOYMENT 84 Measuring Inflation 84 The Three Main Price Indexes 86 Problems with Price Indexes 86 The Meaning of Inflation 87 Key Procedure for Calculating Annual Inflation Rate for TV Years 87 How Inflation Affects Real Income 88 The Economic Costs of Inflation 89 Measuring Unemployment 92 The Effect of Recession 93 The Types and Costs of Unemployment 93 KNOW THE CONCEPTS 95 PRACTICAL APPLICATION 95 ANSWERS 97 INTRODUCTION TO MACROECONOMICS: OUTPUT, GROWTH, AND CAPITAL 100 What Is Macroeconomics? 101 Recessions 101 Why Recessions Occur 102 Full-Employment Output 103 The Level of Current Output 104 Growth Accounting 106 Creation of Capital 108 Capital Markets 109 Financial Intermediaries 113 Will Savings Be Invested? 115

4 CONTENTS v Long-Run Growth 116 KNOW THE CONCEPTS 118 PRACTICAL APPLICATION 119 ANSWERS AGGREGATE DEMAND AND SUPPLY: THE KEY TO MACROECONOMICS 724 Aggregate Demand and Supply 125 Aggregate Demand. 126 Aggregate Supply (Short Run) 128 The Effects of Shifts in Aggregate Demand and Supply 131 Aggregate Supply (Long Run) 134 How to Apply Aggregate Demand and Supply 135 KNOW THE CONCEPTS ; 136 PRACTICAL APPLICATION 137 ANSWERS AGGREGATE DEMAND IN THE PRIVATE SECTOR: THE KEYNESIAN MODEL 747 The Basic Keynesian Model 142 Consumption Function 142 Investment Function 145 Equilibrium in Aggregate Demand 146 Applying the Keynesian Model 149 Shifts in Investment 149 Determinants of Consumption 152 Determinants of Investment 153 Factors Shifting the Total Spending Curve 154 Plotting Aggregate Demand 154 The Keynesian Model 155 KNOW THE CONCEPTS 156 PRACTICAL APPLICATION 157 ANSWERS AGGREGATE SUPPLY AND GETTING TO FULL EMPLOYMENT 162 Constructing the Aggregate Supply Curve to Get to Full Employment 163 Long-Run Equilibrium 163 From Recession to Full Employment 165 From Too Little Unemployment to Full Employment 168 The Effects of Employment on the Spending Multiplier 169 The Natural Rate of Unemployment 170 KNOW THE CONCEPTS 173 PRACTICAL APPLICATION 174 ANSWERS 177

5 vi CONTENTS 11 FISCAL POLICY: GOVERNMENT SPENDING AND TAXATION 181 What Fiscal Policy Is 182 The Effect of Spending 182 The Effect of Taxation 184 The Overall Effects of Spending and Taxation 188 Limits of an Active Fiscal Policy 189 The Effect on Aggregate Supply and Demand 189 Deficits: Do They Matter? 190 KNOW THE CONCEPTS 193 PRACTICAL APPLICATION 193 ANSWERS THE SUPPLY OF MONEY. 797 What Is Money? : 197 How Money Is Measured 198 The Federal Reserve 199 Balance Sheets and Banks: Federal and Commercial 200 How Money Is Created 201 How the Fed Controls the Money Supply 204 The Taylor Rule: What Does the Federal Reserve Do? 208 How the Fed Reacted to the Financial Crisis in KNOW THE CONCEPTS 212 PRACTICAL APPLICATION 212 ANSWERS MONEY AND AGGREGATE DEMAND 217 Money Demand 218 The Quantity Theory of Money 218 The Long-Run Neutrality of Money 220 How to Predict Inflation 223 The German Hyperinflation 224 The Short-Run Effects of Money: The Monetarist Model 224 Keynesian Model of the Short-Run Effects of Money 226 The Long-Run Effects of Money Supply on Interest Rates 229 The Spending Multiplier and Fiscal Policy 230 Bonds: Interest Rates and Prices 230 The Differences Between Keynesian and Monetarist Views 232 KNOW THE CONCEPTS 234 PRACTICAL APPLICATION 235 ANSWERS INFLATION AND UNEMPLOYMENT 247 What Causes the Short-Run Aggregate Supply Curve (AS) to Shift? 242 The Relationship Between the AS Curve and the Phillips Curve 244

6 CONTENTS vii How Shifts Affect the AS Curve and the Phillips Curve 245 Visualizing the Business Cycle 246 Inflation and the Phillips Curve 249 The Business Cycle 252 Can Inflation Be Reduced? 252 Can Inflation (at Full Employment) Be Reduced? 254 Can Economic Recovery Be Made Faster? 255 Should the Government Stimulate the Economy by Spending More? 256 KNOW THE CONCEPTS 257 PRACTICAL APPLICATION. 258 ANSWERS RATIONAL EXPECTATIONS AND OTHER MODELS OF THE BUSINESS CYCLE 264 Rational-Expectations Macroeconomics 265 Assumptions 266 Results 268 Rational-Expectations Model 271 An Example of a Rational-Expectations Model 272 Criticisms of Rational Expectations 274 Rational Expectations, Random Walk, and the Stock Market 275 Real Business Cycle Theory Neo-Keynesian Macroeconomics 277 Another Viewpoint: Austrian Business Cycle Theory 281 Where Does Business Cycle Theory Stand Today? 282 KNOW THE CONCEPTS 283 PRACTICAL APPLICATION 284 ANSWERS 286, 16 OPEN-MARKET MACROECONOMICS 290 Introduction 290 The Key to Understanding World Trade 291 The Exchange Rate 293 The Demand and Supply of the Dollar 294 The Market for Assets 298 Factors Affecting the Exchange Rate 303 Other Equations 306 Fixed Exchange Rates 308 Runs on Currencies and Capital Flight 310 Fiscal and Monetary Policy in an Open' Economy 311 KNOW THE CONCEPTS 312 PRACTICAL APPLICATION 313 ANSWERS 315

7 viii CONTENTS 17 ELASTICITY 379 The Price Elasticity of Demand 319 Measuring the Price Elasticity of Demand 322 Elasticity and Total Revenue 324 Greater Precision with Elasticities 327 Factors Affecting Elasticity 328 Pertaining to Demand 328 Pertaining to Supply 331 Interactions of Demand and Supply. 333 KNOW THE CONCEPTS 334 PRACTICAL APPLICATION 335 ANSWERS THE THEORY OF DEMAND Market and Individual Demand 339 The Law of Diminishing Marginal Utility 340 The Law of Equal Marginal Utility per Dollar 342 Deriving the Law of Demand from the Law of Equal Marginal Utility per Dollar 344 Income Effects and Substitution Effects 345 Consumer Surplus 347 Applications for Business: Principle of Equal Marginal Benefit per Unit 349 KNOW THE CONCEPTS 350 PRACTICAL APPLICATION 351 ANSWERS COST AND OUTPUT 355 Short- and Long-Run Costs 355 Short-Run Costs 355 Long-Run Costs 362 Profits and Costs 365 The Wealth of Nations 366 KNOW THE CONCEPTS 367 PRACTICAL APPLICATION 368 ANSWERS COMPETITIVE SUPPLY 373 Rules of Basic Decision Making 373 Concerning Costs 373 Concerning Output 374 How Competitive Firms Make Decisions Concerning Costs and Output 377 Rules of Supply 379 The Construction of the Industry's Short-Run Supply Curve 382

8 CONTENTS /x Effects of Costs on Supply 387 Competition Bids Price Down to Cost 389 Short and Long Runs 389 Auction Theory 390 KNOW THE CONCEPTS 391 PRACTICAL APPLICATION 392 ANSWERS ASSYMMETRIC INFORMATION 398 Adverse Selection 400 The Market for Lemons, 403 Market Signaling 404 Moral Hazard 407 Principal-Agent Problems '. 409 KNOW THE CONCEPTS 412 PRACTICAL APPLICATION 413 ANSWERS MONOPOLIES 427 Why Do Monopolies Exist? 421 Basic Elements 422 Marginal Revenue 422 The Output Decision 425 Fallacies and Facts 426 Price Discrimination 428 Taxes and Monopolies 432 KNOW THE CONCEPTS 434 PRACTICAL APPLICATION 435 ANSWERS BETWEEN MONOPOLY AND COMPETITION 439 Perfectly Contestable Markets 440 Monopolistic Competition 441 Oligopoly 444 Special Models of t Oligopolies 446 Game Theory and Oligopoly 450 Forces That Promote Competition 451 KNOW THE CONCEPTS 452 PRACTICAL APPLICATION 453 ANSWERS ' GAME THEORY 458 Cooperation 458 Noncooperation 459 Nash Equilibrium 461

9 x CONTENTS Sequential Games 463 Coordination Games 464 Mixed Strategy Games 465 Games and Pay 468 Keynesian Games 468 Evolutionary Games 470 KNOW THE CONCEPTS 472 PRACTICAL APPLICATION 472 ANSWERS EFFICIENCY AND REGULATION 480 The Competitive Process " 480 The Efficiency of Competitive Markets 481 The Social Loss from Monopoly, 484 Regulating Monopoly 486 Vertical Integration 490 Vertical Integration and Antitrust 490 Is Monopoly Bad? 492 When Won't a Competitive Economy Be Efficient? 493 KNOW THE CONCEPTS 494 PRACTICAL APPLICATION 494 ANSWERS FACTOR DEMAND AND PRODUCTIVITY 499 How to Measure Productivity and Profits 500 Determining Marginal Benefit by Marginal Revenue Product 501 Determining Marginal Cost by Marginal Factor Cost 506 The Four Cases Combined 508 Efficiency 510 Income Allocation 512 KNOW THE CONCEPTS. 512 PRACTICAL APPLICATION 513 ANSWERS WAGES, LABOR MARKETS, AND UNIONS 579 Workers and Jobs 519 Model 1: Workers Alike, Jobs Alike 519 Model 2: Workers Alike, Jobs Different 524 Other Models of Differences in Wages 525 Discrimination 527 Unions 528 Unions in Price-Taking Firms 528 Unions and Efficiency 530 Unions and Monopsonistic Employers 531 The Minimum Wage 533

10 CONTENTS xi' KNOW THE CONCEPTS 534 PRACTICAL APPLICATION 534 ANSWERS RENT, INTEREST, AND PROFITS 539 Economic Rent 540 Interest 542 Making Investment Decisions 546 Value of an Asset 547 Economic Profits 547 KNOW THE CONCEPTS,_ 548 PRACTICAL APPLICATION " ~ 549 ANSWERS PUBLIC CHOICE AND EXTERNALITIES 553 Social Optimality and Free Markets 553 Solutions to Market Failures Caused by Externalities 554 Public Goods 557 An Application: Pollution Control 559 Public Choice 561 Dealing with Special Interests 563 KNOW THE CONCEPTS 565 PRACTICAL APPLICATION 566 ANSWERS GOVERNMENT SPENDING AND TAXATION 572 Cost-Benefit Analysis of Government Spending 573 The Economics of Transfer Payments 574 Taxation 575 Equity in Taxes 576 Taxes and Efficiency 577 Major Distortions in Our Current Tax Codes 580 Some Special Taxes 581 Comparing Taxes 582 Tax Incidence and Tax Shifting 583 KNOW THE CONCEPTS 584 PRACTICAL APPLICATION 584 ANSWERS INTERNATIONAL TRADE 590 When Will a Nation Benefit from Trade? 591 What Goods Should a Nation Trade? 592 The Law of Comparative Advantage 593 Graphical Analysis of Comparative Advantage 595 The Effect of Tariffs and Quotas 598

11 xiv CONTENTS Trade and Unemployment 600 Arguments for Tariffs 600 Factor Price Equalization 602 KNOW THE CONCEPTS 603 PRACTICAL APPLICATION 603 ANSWERS 606 APPENDIX Web Sites for Economics 609 Indifference Curve Analysis 610 Glossary, 619 list of Abbreviations 634 Elements of Accounting 635 The Balance Sheet. 635 The Income Statement 635 How to Overstate Profit 636 Sources of Economic Data 637 Business Cycle Indicators 638 Review and Additional Material 640 The Geometry of Profit-Maximizing 640 The Algebra of Income Determination in the Keynesian Model 642 Summary of Macroeconomic Models 644 INDEX 647