Economics For Dummies®, 2nd Edition Visit www.dummies.com/cheatsheet/economics to view this book's cheat sheet. Table of Contents Introduction About This Book Conventions Used in This Book What You’re Not to Read Foolish Assumptions How This Book Is Organized Part I: Economics: The Science of How People Deal with Scarcity Part II: Microeconomics: The Theories of Consumer and Firm Behavior Part III: Applying the Theories of Microeconomics Part IV: Macroeconomics: The Science of Economic Growth and Stability Part V: The Part of Tens Icons Used in This Book Where to Go from Here Part I: Economics: The Science of How People Deal with Scarcity Chapter 1: Discovering What Economics Is and Why You Should Care Considering a Little Economic History Pondering just how nasty, brutish, and short life used to be
Identifying the institutions that raise living standards Looking toward the future Framing Economics as the Science of Scarcity Sending Microeconomics and Macroeconomics to Separate Corners Getting up close and personal: Microeconomics Zooming out: Macroeconomics and the big picture
Understanding How Economists Use Models and Graphs Introducing your first model: The demand curve Drawing your own demand curve Chapter 2: Cookies or Ice Cream? Exploring Consumer Choices Describing Human Behavior with a Choice Model Pursuing Personal Happiness Using utility to measure happiness Taking “selfless” actions into account Noting how self-interest can promote the common good You Can’t Have Everything: Examining Limitations Resource constraints Technology constraints Time constraints Opportunity cost: The unavoidable cost Making Your Choice: Deciding What and How Much You Want Exploring Violations and Limitations of the Economist’s Choice Model Understanding uninformed decision-making Making sense of irrationality Chapter 3: Producing the Right Stuff the Right Way to Maximize Human Happiness Figuring Out What’s Possible to Produce Classifying resources Diminishing returns: Getting less of a good thing A little here, a little there: Allocating resources Graphing your production possibilities Reaching new frontiers with better technology Deciding What to Produce Comparing market results and government interventions
Opting for a mixed economy Promoting Technology and Innovation
Part II: Microeconomics: The Theories of Consumer and Firm Behavior Chapter 4: Supply and Demand Made Easy Deconstructing Demand Prices and other stuff: Looking at what affects quantity demanded Graphing the demand curve Opportunity costs: Setting the slope of the demand curve Elasticity: Looking at extreme demand cases Sorting Out Supply Graphing the supply curve Using elasticity to understand extreme supply cases Bringing Supply and Demand Together Market equilibrium: Seeking a balance Demonstrating the stability of the market equilibrium Adjusting to new market equilibriums when supply or demand changes Price Controls: Keeping Prices Away from Market Equilibrium Setting upper limits with price ceilings Propping up prices with price floors Chapter 5: Getting to Know Homo Economicus, the Utility-Maximizing Consumer Constrained Optimization: Getting the Most Happiness for Your Money Choosing by Ranking Getting Less from More: Diminishing Marginal Utility Choosing Among Many Options When Facing a Limited Budget Trying to buy as much (marginal) utility as you can Purchasing the best combination of two goods to maximize total utility Aiming for equal marginal utility per dollar
Deriving Demand Curves from Diminishing Marginal Utility Seeing how price changes affect quantities demanded Graphing the price and quantity changes to form a demand curve Chapter 6: The Core of Capitalism: The Profit-Maximizing Firm A Firm’s Goal: Maximizing Profits Facing Competition Listing the requirements for perfect competition Taking prices but setting quantities Distinguishing between accounting profits and economic profits Analyzing a Firm’s Cost Structure Focusing on costs per unit of output Examining average variable costs Watching average fixed costs fall Tracking the movement of average total costs Focusing on marginal costs Noticing where marginal cost equals average cost Comparing Marginal Revenues with Marginal Costs Finding where marginal revenue equals marginal cost Visualizing profits Visualizing losses Pulling the Plug: When Producing Nothing Is Your Best Bet Distinguishing between the short run and the long run in microeconomics The short-run shutdown condition: Variable costs exceed total revenues The long-run shutdown condition: Total costs exceed total revenues Chapter 7: Why Economists Love Free Markets and Competition Ensuring That Benefits Exceed Costs: Competitive Free Markets Examining the traits of a properly functioning market
Analyzing the efficiency of free markets Measuring everyone’s gains with total surplus When Free Markets Lose Their Freedom: Dealing with Deadweight Losses Coming up short: The deadweight loss from a price ceiling Death and taxes: Finding the deadweight loss of a tax Hallmarks of Perfect Competition: Zero Profits and Lowest Possible Costs Understanding the causes and consequences of perfect competition Peering into the process of perfect competition Graphing how profits guide firm entry and exit Chapter 8: Monopolies: How Badly Would You Behave If You Had No Competition? Examining Profit-Maximizing Monopolies Zeroing in on the problems monopolies cause Identifying the source of the problem: Decreasing marginal revenues Choosing an output level to maximize profits Comparing Monopolies with Competitive Firms Looking at output and price levels Deadweight losses: Quantifying the harm caused by monopolies Losing efficiency Considering Examples of Good Monopolies Encouraging innovation and investment with patents Reducing annoyingly redundant competitors Keeping costs low with natural monopolies Regulating Monopolies Subsidizing a monopoly to increase output Imposing minimum output requirements Regulating monopoly pricing Breaking up a monopoly into several competing firms
Chapter 9: Oligopoly and Monopolistic Competition: Middle Grounds Oligopolies: Looking at the Allure of Joining Forces Sharing power over prices Cartel behavior: Trying to imitate monopolists Noting the criteria for coordinating a cartel Understanding Incentives to Cheat the Cartel Fleshing out the Prisoner’s Dilemma Enforcing the agreement: Resolving the dilemma with credible threats Seeing that OPEC is trapped in a Prisoner’s Dilemma Using an enforcer to help OPEC members stick to quotas Regulating Oligopolies Breaking up dominant firms Attempting to apply antitrust laws Studying a Hybrid: Monopolistic Competition Benefiting from product differentiation Facing profit limits Part III: Applying the Theories of Microeconomics Chapter 10: Property Rights and Wrongs Allowing Markets to Reach Socially Optimal Outcomes Examining Externalities: The Costs and Benefits Others Feel from Your Actions Noting the effects of negative externalities Accepting positive amounts of negative externalities Dealing with negative externalities Calculating the consequences of positive externalities Subsidizing things that provide positive externalities Tragedy of the Commons: Overexploiting Commonly Owned Resources
Having a cow: Overgrazing on a commonly owned field Sleeping with the fishes: Extinctions caused by poor property rights Avoiding the tragedy Chapter 11: Market Failure: Asymmetric Information and Public Goods Facing Up to Asymmetric Information Realizing that asymmetric information limits trade Souring on the lemons problem: The used car market Issuing insurance when you can’t tell individuals apart Providing Public Goods Taxing to provide public goods Enlisting philanthropy to provide public goods Providing a public good by selling a related private good Ranking new technology as a public good Chapter 12: Taking the Pulse of Health Economics and Finance Defining Health Economics and Health Finance Noting the Limits of Health Insurance Adverse selection: Looking at who buys insurance Combating adverse selection Comparing Healthcare Internationally Inflated Demand: Suffering from “Free” and Reduced-Cost Healthcare Diverting funds to lower-value uses Rationing healthcare Facing shortages and higher prices Trying to combat inefficiency with bureaucracy Investigating Singapore’s Secrets Exploring cost-saving features Weighing costs and benefits of medical procedures Supporting cost-cutting innovations
Trying to copy Singapore’s success Part IV: Macroeconomics: The Science of Economic Growth and Stability Chapter 13: Measuring the Macroeconomy: How Economists Keep Track of Everything Getting a Grip on the GDP (and All Its Parts) Leaving some things out of GDP Tallying up what counts in GDP Accounting for the tides of incomes and assets Following the funds, around and around Counting stuff when it’s made, not when it’s sold Watching GDP rise with the good, the bad, and the ugly Diving In to the GDP Equation “C” is for consumption (that’s good enough for me!) “I” is for investment in capital stock The big “G” (government, that is) Measuring foreign trade with “NX” Making Sense of International Trade and Its Effect on the Economy “Trade deficit” ain’t fightin’ words Considering assets — not just cash Wielding a comparative advantage Chapter 14: Inflation Frustration: Why More Money Isn’t Always a Good Thing Buying an Inflation: When Too Much Money Is a Bad Thing Balancing money supply and demand Giving in to the inflation temptation Tallying up the effects of inflation Measuring Inflation Creating your very own market basket Calculating the inflation rate
Setting up a price index Determining the real standard of living with the price index Identifying price index problems Pricing the Future: Nominal and Real Interest Rates Using the Fisher equation Realizing that predictions aren’t perfect Chapter 15: Understanding Why Recessions Happen Introducing the Business Cycle Striving for Full-Employment Output Returning to Y*: The Natural Result of Price Adjustments Responding to Economic Shocks: Short-Run and Long-Run Effects Defining some critical terms The tao of P: Looking at price adjustments in the long run A shock to the system: Adjusting to a shift in aggregate demand Dealing with fixed prices in the short run Putting together the long and short of it Heading toward Recession: Getting Stuck with Sticky Prices Cutting wages or cutting workers Adding up the costs of wages and profits Returning to Y* with and without government intervention Achieving Equilibrium with Sticky Prices: The Keynesian Model Adjusting inventories instead of prices Boosting GDP in the Keynesian model Chapter 16: Fighting Recessions with Monetary and Fiscal Policy Stimulating Demand to End Recessions Aiming for full-employment output Back to work: Shifting the AD curve to the right Generating Inflation: The Risk of Too Much Stimulation
An exercise in futility: Trying to increase output beyond Y* A temporary high: Tracing the movement of real wages Failing to stimulate: What happens when a stimulus is expected Figuring Out Fiscal Policy Increasing government spending to help end recessions Dealing with deficits Dissecting Monetary Policy Identifying the benefits of fiat money over the gold standard Realizing that you can have too much money! Getting the basics about bonds Seeing the link between bond prices and interest rates Changing the money supply to change interest rates Lowering interest rates to stimulate the economy Understanding how rational expectations can limit monetary policy Chapter 17: Grasping the Origins and Aftermath of Financial Crises Understanding How Debt-Driven Bubbles Develop Embracing borrowing in a booming economy Offering larger loans as collateral values rise Relaxing lending standards Borrowing more in hopes of profit Watching the process gain momentum Seeing the Bubble Burst Deleveraging: Trying to ditch debt as prices fall Comprehending bank collapses caused by bursting bubbles Leading into a recession After the Crisis: Looking toward Recovery Enduring a broken banking system Struggling with structural mismatches Noting the limits of government policy
Part V: The Part of Tens Chapter 18: Ten Seductive Economic Fallacies The Lump of Labor The World Is Facing Overpopulation Order Indicates Causes Protectionism Is the Best Solution to Foreign Competition The Fallacy of Composition If It’s Worth Doing, Do It 100 Percent Free Markets Are Volatile Low Foreign Wages Mean That Rich Countries Can’t Compete Tax Rates Don’t Affect Work Effort Forgetting That Policies Have Unintended Consequences Chapter 19: Ten Economic Ideas to Hold Dear Self-Interest Can Improve Society Free Markets Require Regulation Economic Growth Relies on Innovation Freedom and Democracy Make Us Richer Education Raises Living Standards Intellectual Property Rights Boost Innovation Weak Property Rights Cause All Environmental Problems International Trade Is a Good Thing Government Can Provide Public Goods Preventing Inflation Is Easy Chapter 20: Ten Great Ways to Become Informed about Economic Issues Sort Through the Popular Press Peruse Economics Blogs Absorb Think-Tank Policy Papers Review the Latest Research Investigate Entrepreneurship Talk to All Stakeholders Dissect the Tax System Peruse Your City’s Budget Uncover Government Policy Papers
Get to Know Government Data Appendix: Glossary Cheat Sheet
Economics For Dummies®, 2nd Edition by Sean Flynn, PhD
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About the Author Sean Flynn is an assistant professor of economics at Scripps College in Claremont, California. A recurring commentator on radio and television, Sean holds a BA in economics from the University of Southern California and a PhD in economics from UC Berkeley, where he completed his dissertation under the supervision of Nobel Laureate George Akerlof. As one of America’s leading economic educators, Sean is a coauthor (along with Campbell
McConnell and Stanley Brue) of the world’s best-selling college economics textbook, Economics: Principles, Problems, and Policies (McGraw-Hill). The book’s popularity is such that it’s also the world’s best-selling college textbook of any subject. Sean’s academic research focuses on the often puzzling and seemingly irrational behavior of stock market investors, but he’s also investigated topics as wide-ranging as the factors that affect tipping behavior in restaurants and why you see a lot of unionized workers only in certain industries. He’s also a leading expert on closed-end mutual funds. Sean’s (rather serious) hobby is the Japanese martial art of aikido, which he has taught for over 15 years to hundreds of students in the United States and abroad. A former national forms champion himself, Sean has coached five of his students to U.S. national aikido titles in either forms or fullcontact sparring.
Dedication To my father, Thomas Ray Flynn, who always impressed upon me the importance of good economic policy both for improving our quality of life and as our last, best hope for lifting billions out of poverty and disease.
Author’s Acknowledgments I’d like to thank the many great economists who managed to get things into my head despite my very thick skull. Among my teachers, I can’t help but thank Caroline Betts, Tim Cason, Richard Ciccetti, Michael DePrano, Richard Easterlin, Robert Kalaba, Timur Kuran, Jeffrey Nugent, and Morton Shapiro for the excellent education I received as an undergraduate at the University of Southern California. I was equally blessed at UC Berkeley, where I got to complete a doctorate under the tutelage of some true intellectual giants, including George Akerlof, David Card, J. Bradford DeLong, Jan deVries, Barry Eichengreen, Richard Gilbert, Daniel McFadden, Maurey Obstfeld, Matthew Rabin, David Romer, Christina Romer, and Janet Yellen. It was especially fun when Professors McFadden and Akerlof won their Nobel Prizes during my last two years at Cal. However, my fellow economics students often did more than my professors to explain things to me when I wasn’t getting them, and they continue to educate me even now. So a very heartfelt thank you to Corinne Alexander, Lorenzo Blanco, Mark Carlson, Carlos Dobkin, Tim Doede, Mike Enriquez, Fabio Ghironi, Petra Geraats, Aaron Green, Galina Hale, Alan Marco, Carolina Marquez, Marcelo Moreira, Petra Moser, Marc Muendler, Stefan Palmqvist, Doug Park, Raj Patel, Steve Puller, Desiree Schaan, Doug Schwalm, Mark Stehr, Sam Thompson, Carla Tully,
Jeff Weinstein, and Marta Wosinska. I’ve also got to thank my current and former students at Scripps College, Vassar College, and UC Berkeley. Having to answer your many insightful questions made me a much better economist. A big thank you to my literary agent Linda Roghaar and my old friend Mike Jones for getting me this book deal. They heard Dummies and immediately thought of me. Tracy Boggier, Joan Friedman, Alissa Schwipps, Chad Sievers, and the entire production team at Wiley also deserve huge praise. All their edits, suggestions, and formatting have turned out a book that’s far better than anything I could have come up with on my own. I also have to deeply thank Dr. Robert Harris, the technical editor of this book. His comments and suggestions have made it far better than it would have been otherwise. Finally, many thanks to my parents for always making me do my homework.
Publisher’s Acknowledgments We’re proud of this book; please send us your comments through our online registration form located at http://dummies.custhelp.com. For other comments, please contact our Customer Care Department within the U.S. at 877-762-2974, outside the U.S. at 317-572-3993, or fax 317-5724002. Some of the people who helped bring this book to market include the following: Acquisitions, Editorial, and Media Development Senior Project Editor: Chad R. Sievers (Previous Edition: Joan Friedman, Alissa Schwipps) Acquisitions Editor: Tracy Boggier Copy Editors: Danielle Voirol, Sarah Westfall Assistant Editor: David Lutton Technical Editor: Eric Dodge, PhD Editorial Manager: Michelle Hacker Editorial Assistant: Rachelle S. Amick Art Coordinator: Alicia B. South
Introduction Economics is all about humanity’s struggle to achieve happiness in a world full of constraints. There’s never enough time or money to do everything people want, and things like curing cancer are still impossible because the necessary technologies haven’t been developed yet. But people are clever. They tinker and invent, ponder and innovate. They look at what they have and what they can do with it and take steps to make sure that if they can’t have everything, they’ll at least have as much as possible. Having to choose is a fundamental part of everyday life. The science that studies how people choose — economics — is indispensable if you really want to understand human beings both as individuals and as members of larger organizations. Sadly, though, economics has typically been explained so badly that people either dismiss it as impenetrable gobbledygook or stand falsely in awe of it — after all, if it’s hard to understand, it must be important, right? I wrote this book so you can quickly and easily understand economics for what it is — a serious science that studies a serious subject and has developed some seriously good ways of explaining human behavior out in the (very serious) real world. Economics touches on nearly everything, so the returns on reading this book are huge. You’ll understand much more about people, the government, international relations, business, and even environmental issues.
About This Book The English poet Thomas Carlyle called economics the “dismal science,” but I’m going to do my best to make sure that you don’t come to agree with him. I’ve organized this book to try to get as much economics into you as quickly and effortlessly as possible. I’ve also done my best to keep it lively and fun. In this book, you find the most important economic theories, hypotheses, and discoveries without a zillion obscure details, outdated examples, or complicated mathematical “proofs.” Among the topics covered are How the government fights recessions and unemployment How and why international trade is good for both individuals and nations Why poorly designed property rights are responsible for environmental problems such as global warming, pollution, and species extinctions How profits guide businesses to produce the goods and services you take for granted How economic incentives affect healthcare costs, prices, and efficiency
Why competitive firms are almost always better for society than monopolies How the Federal Reserve controls the money supply, interest rates, and inflation all at the same time Why government policies such as price controls and subsidies often cause much more harm than good How the simple supply and demand model can explain the prices of everything from comic books to open-heart surgeries You can read the chapters in any order, and you can immediately jump to what you need to know without having to read a bunch of stuff that you couldn’t care less about. Economists like competition, so you shouldn’t be surprised that there are a lot of competing views. Indeed, it’s only through vigorous debate and careful review of the evidence that the profession improves its understanding of how the world works. This book contains core ideas and concepts that economists agree are true and important — I try to steer clear of fads or ideas that foster a lot of disagreement. (If you want to be subjected to my opinions and pet theories, you’ll have to buy me a drink.)
Conventions Used in This Book Economics is full of two things you may not find very appealing: jargon and algebra. To minimize confusion, whenever I introduce a new term, I put it in italics and follow it closely with an easyto-understand definition. Also, whenever I bring algebra into the discussion, I use those handy italics again to let you know that I’m referring to a variable. For instance, I indicates investment, so you may see a sentence like this one: I think that I is too big. I try to keep equations to a minimum, but sometimes they help make things clearer. In such instances, I sometimes have to use several equations one after another. To avoid confusion about which equation I’m referring to at any given time, I give each equation a number, which I put in parentheses. For example, (1) MTV = ESPN + CNN 2 Finally, the following conventions are used throughout the text of all For Dummies books to make things consistent and easy to understand: All Web addresses appear in this font. Bold is used to highlight the action parts of numbered steps.
What You’re Not to Read The whole point of a For Dummies book is to give you quick access to the essentials so you don’t have to wade through a bunch of stories, factoids, and anecdotes. On the other hand, sometimes stories, factoids, and anecdotes can be both fun and enlightening. Consequently, I’ve clearly identified all the “skippable” material. This information is the stuff that, although interesting and related to the topic at hand, isn’t essential for you to know: Text in sidebars: The sidebars are shaded boxes that share interesting stories and observations but aren’t necessary reading. Anything with a Technical Stuff icon attached: This information is interesting but not critical to your understanding of what’s being explained. The stuff on the acknowledgements page: Unless you’re one of my friends who needs an ego stroke, there’s nothing here for you. Naturally, I’d like to believe that you’ll choose to read everything I’ve written, but don’t worry. I’ll never know.
Foolish Assumptions I wrote this book assuming some things about you: You’re sharp, thoughtful, and interested in how the world works. You’re a high school or college student trying to flesh out what you’re learning in class, or you’re a citizen of the world who realizes that a good grounding in economics will help you understand everything from business and politics to social issues like poverty and environmental degradation. You want to know some economics, but you’re also busy leading a very full life. Consequently, although you want the crucial facts, you don’t want to have to read through a bunch of minutia to find them. You’re not totally intimidated by numbers, facts, and figures. Indeed, you welcome them because you like to have things proven to you instead of taking them on faith because some pinhead with a PhD says so. You like learning why as well as what. That is, you want to know why things happen and how they work instead of just memorizing factoids.
How This Book Is Organized This book is divided into five parts to make the material easier to understand and access. In this section, I explain what you have to look forward to in each of these parts.
Part I: Economics: The Science of How People Deal with Scarcity Economics is all about how people deal with scarcity, which is a situation that occurs when the quantities of goods and services that are available for consumption are less than the amounts that people desire to consume. There’s never enough time, and there’s a limited supply of natural resources such as oil and iron. Consequently, people have to be clever about getting the most out of life — choosing wisely about what to do with the limited resources they’re given. Part I explains how people go about dealing with scarcity and the tradeoffs that it forces them to make. The rest of economics is just seeing how scarcity forces people to make tradeoffs in more specific situations.
Part II: Microeconomics: The Theories of Consumer and Firm Behavior Microeconomic theory attempts to understand and predict the behavior of individual people and individual firms. It studies what motivates them and how they act to achieve their goals given the constraints they face. In this part, you discover what motivates firms to produce output, how buyers and sellers interact in markets to allocate that output, and how markets can break down and do perverse things if not properly managed. You also explore how consumer decisions about what goods and services to purchase and in which quantities to purchase them are driven by a desire on the part of consumers to maximize the total amount of utility, or satisfaction, that they can get from their limited budgets. I also delve in to the details of supply and demand, competition, monopolies, and Adam Smith’s “invisible hand.”
Part III: Applying the Theories of Microeconomics In this part, I present three chapters that show how well microeconomic theory can illuminate many real-world behaviors. Among other things, you explore why health insurance costs so much, why it’s so difficult to find a quality used car, and how a few simple changes in the way property rights are defined and enforced can mean the difference between extinction and survival for many species of wild animals as well as entire rainforests and other ecosystems.
Part IV: Macroeconomics: The Science of Economic Growth and Stability Macroeconomics views the economy from on high, at the national or international level. It deals with the choices countries face about economic growth and development as well as choices about how to best manage their economies to avoid recessions. It also deals with the misery caused by unemployment and inflation. In this part, you find out about monetary and fiscal policy, the Federal Reserve, the effects of taxation on the economy, and international trade and trade policy.
Part V: The Part of Tens Every For Dummies book ends with top-ten lists that are both helpful and fun. In this part, I give you ten economic ideas to hold dear, ten false economic assertions that are repeated all the time in the media and by politicians, and ten ways to become a better economist.
Icons Used in This Book To make this book easier to read and simpler to use, I include a few icons that can help you find and fathom key ideas and information.
This icon alerts you that I’m explaining a fundamental economic concept or fact. It saves you the time and effort of marking the book with a highlighter.
Economics is chock full of theories, and sometimes it’s helpful to kick those theories out into the real world and see how they actually work. This icon alerts you to the presence of a helpful, real-world example.
This icon tells you that the ideas and information that it accompanies are a bit more technical or mathematical than other sections of the book. This information can be interesting and informative, but I’ve designed the book so that you don’t need to understand it to get the big picture about what’s going on. Feel free to skip this stuff.
This icon points out time and energy savers. I place this icon next to suggestions for ways to do or think about things that can save you some effort.
This icon discusses any troublesome areas in economics you need to know. Keep an eye open for them for to alert you of potential pitfalls.
Where to Go from Here This book is set up so that you can understand what’s going on even if you skip around. The book is also divided into independent parts so that you can, for instance, read all about microeconomics without having to read anything about macroeconomics. The table of contents and index can help you find specific topics easily. But, hey, if you don’t know where to begin, just do the oldfashioned thing and start at the beginning.
Economics: The Science of How People Deal with Scarcity