THE

COLD
WAR
2020–2021

ECONOMICS RESOURCE GUIDE SKT - China, CH

An Introduction to Economics and the

Economics of the Cold War
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 Table of Contents
INTRODUCTION . . . . . . . . . . . . . . . . . .5 Number of Sellers . . . . . . . . . . . . . . . . . . .15
Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . 15
SECTION I: FUNDAMENTAL The Characteristics of Competitive Market
Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . 20
ECONOMIC CONCEPTS . . . . . . . . . . . 6
Basic Assumptions of Economics . . . . . . . .6 Applications of the Competitive Market
Scarcity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Trade-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Changes in Market Equilibrium . . . . . . . . . . 23
Opportunity Cost . . . . . . . . . . . . . . . . . . . . . . .7 Elasticity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Rationality . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Using Elasticity . . . . . . . . . . . . . . . . . . . . . . .29
Gains from Trade . . . . . . . . . . . . . . . . . . . . . . .7
Evaluating Government Policy: The Impact
Models and Economic Theory . . . . . . . . . . 7 of Price Controls and Taxes . . . . . . . . . . . .29
Price Controls . . . . . . . . . . . . . . . . . . . . . . . . 29
Positive and Normative Economics . . . . . . . 8 Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

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Efficiency as a Goal . . . . . . . . . . . . . . . . . . . 8 International Trade . . . . . . . . . . . . . . . . . . 36
An Isolated Economy . . . . . . . . . . . . . . . . . . .36
Microeconomics and Macroeconomics . . . .9
Adding the Opportunity to Trade . . . . . . . . . .36
Section I Summary . . . . . . . . . . . . . . . . . . . 9 Comparative Advantage and the Gains from
Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
The Political Economy of Trade . . . . . . . . . . 39
SECTION II:
MICROECONOMICS . . . . . . . . . . . . . 10 The Profit Motive and the Behavior
Perfectly Competitive Markets . . . . . . . . . 10 of Firms . . . . . . . . . . . . . . . . . . . . . . . . . . .41
Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Economic Profits and Accounting Profits . . . . 41
Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 Finding the Firm’s Supply Curve . . . . . . . . . .41
Shifts in the Demand Curve . . . . . . . . . . . . . .13 Entry, Exit, and the Market Supply
Income . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .43
The Prices of Related Goods . . . . . . . . . . 13
Tastes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Imperfect Competition . . . . . . . . . . . . . . . 43
Expectations . . . . . . . . . . . . . . . . . . . . . . .14 Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
Number of Buyers . . . . . . . . . . . . . . . . . . .14 Monopoly Supply . . . . . . . . . . . . . . . . . . . . . .45
Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Welfare Consequences of Monopoly . . . . . . . 45
Shifts in the Supply Curve . . . . . . . . . . . . . . .15 Dealing with Monopolies . . . . . . . . . . . . . . . . 47
Input Prices . . . . . . . . . . . . . . . . . . . . . . . 15 Price Discrimination . . . . . . . . . . . . . . . . . . .48
Technology . . . . . . . . . . . . . . . . . . . . . . . . 15 Oligopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Expectations . . . . . . . . . . . . . . . . . . . . . . .15 Monopolistic Competition . . . . . . . . . . . . . . .49

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Creative Destruction: The Profit Motive Yet Another Way to Measure GDP: Income
and the Sources of Economic Change . . . .49 Equals Production Equals Expenditures . . . . 74
Real GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Market Failures . . . . . . . . . . . . . . . . . . . . .50 Measuring Inflation . . . . . . . . . . . . . . . . . . . . 75
Externalities . . . . . . . . . . . . . . . . . . . . . . . . . .50 Unemployment . . . . . . . . . . . . . . . . . . . . . . . . 77
The Effect of Externalities on Resource Frictional Unemployment . . . . . . . . . . . . .77
Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . .51 Structural Unemployment . . . . . . . . . . . . .78
Private Responses to Externalities . . . . . . . . 51 Cyclical Unemployment . . . . . . . . . . . . . . 78
Government Regulation of Externalities . . . . 53
Property Rights . . . . . . . . . . . . . . . . . . . . . . . 55 Economic Growth, Productivity, and Living
The Effects of Private Ownership . . . . . . . . . 56 Standards . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Public and Private Goods . . . . . . . . . . . . . . .56 The Circular Flow Model of the
Private Goods . . . . . . . . . . . . . . . . . . . . . .57 Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Common Resources . . . . . . . . . . . . . . . . . 57 What Determines How Much an Economy
Collective Goods . . . . . . . . . . . . . . . . . . . 57 Produces? . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
Public Goods . . . . . . . . . . . . . . . . . . . . . . 58
Savings, Investment, and the Financial
Institutions, Organizations, and System . . . . . . . . . . . . . . . . . . . . . . . . . . . .83
Government . . . . . . . . . . . . . . . . . . . . . . . .58 Financial Markets . . . . . . . . . . . . . . . . . . . . .84
Pork Barrel Politics . . . . . . . . . . . . . . . . . . . . 59 The Bond Market . . . . . . . . . . . . . . . . . . . 84
Rent Seeking . . . . . . . . . . . . . . . . . . . . . . . . . 59 The Stock Market . . . . . . . . . . . . . . . . . . . 84
What Is the Proper Role for Financial Intermediaries . . . . . . . . . . . . . . . . 84
Government? . . . . . . . . . . . . . . . . . . . . . . . . .60 Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

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Mutual Funds . . . . . . . . . . . . . . . . . . . . . .85
Section II Summary . . . . . . . . . . . . . . . . . 60 Saving and Investment in Aggregate . . . . . . .85
International Capital Flows in an Open
SECTION III: Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
MACROECONOMICS . . . . . . . . . . . . .62 How Financial Markets Coordinate Saving
and Investment Decisions . . . . . . . . . . . . . . . 87
Macroeconomic Issues . . . . . . . . . . . . . . . 62
Money and Prices in the Long Run . . . . . . 89
Economic Growth and Living Standards . . . . 62
What Is Money? . . . . . . . . . . . . . . . . . . . . . . .89
Recessions and Expansions . . . . . . . . . . . . . .66
Measuring Money . . . . . . . . . . . . . . . . . . . . . 91
Unemployment . . . . . . . . . . . . . . . . . . . . . . . . 66
The Federal Reserve System, Banks, and the
Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .68
Supply of Money . . . . . . . . . . . . . . . . . . . . . . 91
International Trade . . . . . . . . . . . . . . . . . . . . 71
Bank Runs . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
Macroeconomic Measurement . . . . . . . . . 71 Money and Inflation in the Long Run . . . . . . 94
Measuring Total Output: Gross Domestic Why Worry about Inflation? . . . . . . . . . . . . . 97
Product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Short-Run Economic Fluctuations . . . . . . 99
Market Value . . . . . . . . . . . . . . . . . . . . . . 71
Characteristics of Short-Run Fluctuations . . . 99
Final Goods and Services . . . . . . . . . . . . 71
Potential Output, the Output Gap, and the
Within a Country . . . . . . . . . . . . . . . . . . . 72
Natural Rate of Unemployment . . . . . . . . . .100
During a Specified Period . . . . . . . . . . . . 72
Explaining Short-Run Fluctuations in
Understanding What GDP Measures . . . . . . 72
Output . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
Other Ways to Measure GDP: Expenditures
The Aggregate Demand Curve . . . . . . . . . . 105
Equal Production . . . . . . . . . . . . . . . . . . . . . .73
Wealth Effects . . . . . . . . . . . . . . . . . . . . .105

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 Interest Rate Effects . . . . . . . . . . . . . . . . 106 Arms Limitation Agreements . . . . . . . . . 123
Foreign Exchange Effects . . . . . . . . . . . .106
The Aggregate Supply Curve . . . . . . . . . . . .106 A Comparative Economic Analysis: U.S.
The Keynesian Model of Short-Run versus U.S.S.R. . . . . . . . . . . . . . . . . . . . . 124
Fluctuations . . . . . . . . . . . . . . . . . . . . . . . . .107
Inflation in the Keynesian Model . . . . . . . . . 110 Proxy Wars, 1950 to 1990 . . . . . . . . . . . .127
Using Fiscal and Monetary Policy to Stabilize The Korean War (1950–53) . . . . . . . . . . . . . 127
the Economy . . . . . . . . . . . . . . . . . . . . . . . . 110 The Vietnam Conflict (1955–75) . . . . . . . . . .127
Afghanistan (1979–89) . . . . . . . . . . . . . . . . .128
Section III Summary . . . . . . . . . . . . . . . . 112
Reagan’s Defense Buildup and the End
SECTION IV: THE ECONOMICS OF of the Cold War . . . . . . . . . . . . . . . . . . . .128
THE COLD WAR . . . . . . . . . . . . . . . . 115 Gorbachev’s Reforms . . . . . . . . . . . . . . . . . .130
The Collapse of the U.S.S.R. . . . . . . . . . . . . 131
The Aftermath of World War Two and the
Origins of the Cold War . . . . . . . . . . . . . 115 Section IV Summary . . . . . . . . . . . . . . . 131
The Marshall Plan (1948–51): A Foundation Section IV Timeline . . . . . . . . . . . . . . . . 132
for Postwar Recovery . . . . . . . . . . . . . . . 116
GLOSSARY . . . . . . . . . . . . . . . . . . . . . 133
New Divisions Emerge . . . . . . . . . . . . . . 118
NATO and the Warsaw Pact . . . . . . . . . . . . 118
Germany Divided: East vs. West . . . . . . . . . 119 NOTES . . . . . . . . . . . . . . . . . . . . . . . . . 138

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The Economics of the Soviet-American BIBLIOGRAPHY . . . . . . . . . . . . . . . .140
Arms Race . . . . . . . . . . . . . . . . . . . . . . . 121

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 Introduction

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

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

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 Section I
Fundamental Economic Concepts
It is not from the benevolence of the butcher, as they almost always are? No one ordered the farmer
the brewer or the baker, that we expect our to grow wheat, or the baker to bake bread; they didn’t
dinner, but from their regard to their own take these actions so that you could stop to pick up a
interest. We address ourselves, not to their loaf of bread on the way home; they did what they did
humanity but to their self-love, and never because it was in their own best interest. Yet somehow,
talk to them of our own necessities but of almost magically, all of these individual choices were
their advantages. coordinated so that when you arrive at the store there
—Adam Smith, An Inquiry into the Nature and is an entire aisle of different types of bread available
Causes of the Wealth of Nations for you to choose from.
Economics is about everyday life, about the choices Now step back and consider the fact that the store
each of us makes, and how these choices affect our you are in is only one of thousands of supermarkets
neighbors, our community, our nation, and our world. across the country, and that the supermarket is only
Looking at these choices from the perspective of one of the many millions of businesses that make up

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

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

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game. You may not have to pay for the ticket, but the resources. As a result, we all are better at and get
opportunity cost of attending the game is the value of more pleasure from some activities than others. By
what you would have been doing during that time if specializing in the things we like and do the best, and
you had not gone to the game. For example, if you had then trading with other people who have different
been planning to work mowing lawns, the opportunity abilities, both we and they can then be better off. As
cost of this choice is the income from mowing that you long as the exchange is voluntary, then the benefits must
would forego by attending the game. outweigh the costs for both of the people involved.

Opportunity cost is a seemingly simple concept but MODELS AND ECONOMIC

applying it can sometimes be rather tricky. Consider
the cost of attending college. It might seem obvious THEORY
that the cost of attending college is the sum of the price Economic analysis relies on careful observation,
of tuition, books, room and board. But this answer description, and measurement of economic activity. But
excludes an important cost of attending college. For it also relies on theory. To understand how the economic
most people, the biggest cost of attending college is phenomena we observe fit together, it is necessary
the value of their time. By choosing to attend class to build theoretical models that capture the essential
and do homework, you are giving up time that could features of these interactions while stripping away the
otherwise be spent working for pay. At the same time, unnecessary details. Models come in a wide variety of
the explicit monetary costs of attending college may forms and can be expressed in many different ways.
overstate the true expense. Even if you did not attend In economics, models most often consist of diagrams
college, you would still need to eat and have someplace or mathematical formulas. At first glance, many of
to live. Thus, the costs of room and board are not really these models may appear hopelessly simplistic. But
part of the cost of college. the test of a model is in how well it captures the

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aspects of reality that we are seeking to understand. workers increase. As this list suggests, an increase
The simplicity and lack of realism of many of these in the minimum wage will benefit some people and
models is what allows us to identify so clearly what hurt others. To decide whether the benefits outweigh
assumptions and characteristics are important. the costs requires a value judgment about the relative
ranking of these effects on the different groups affected
POSITIVE AND NORMATIVE by the legislation.
ECONOMICS
The insights that economics offers about individual EFFICIENCY AS A GOAL
and social decisions can be used in two ways. Positive An important criterion that economists often apply
economics uses the tools of economic analysis to in evaluating a society’s use of scarce resources is
describe and explain economic phenomena and to make the efficiency of the resulting allocation. Given any
predictions about what will happen under particular particular outcome, economists would say that it was
circumstances. It focuses on identifying cause-and- efficient if there is no way to improve at least one
effect relationships and measuring their size. For person’s well-being without reducing the well-being of
example, positive economics tells us how much we someone else. This criterion is called Pareto efficiency,
might expect the consumption of gasoline to decrease after the Italian economist Vilfredo Pareto (1848–1923),
when the price of gasoline increases. In this sense, who was the first to make use of this concept.
positive economics is essentially value free. It does not Notice that Pareto efficiency can characterize a wide
require that the economic analyst express any opinion range of different economic outcomes. Consider, for
about the relative merits of different choices. example, an economy with ten people that produces
Normative economics is the term used to describe the $100 worth of goods and services. If each citizen
use of economic analysis to guide decisions about what receives $9 of benefits and $10 of production is wasted,
should be as opposed to what is the case. Normative then this outcome is not Pareto efficient. Redistributing

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economic statements combine economic analysis with the $10 would make at least some of the citizens better
value judgments about the relative merits of different off without making any of them worse off. On the other
possible economic outcomes. The tools of economic hand, a situation in which each citizen receives $10 is
analysis, such as cost-benefit comparisons, can help to Pareto efficient; there is no way to increase the well-
structure a discussion of different possible outcomes. being of any citizen without reducing the benefits of
But, choices between these outcomes usually require another.
us to refer to criteria beyond the scope of economic However, an outcome in which one citizen receives $91
theory to justify our particular choices. of income and each of the other nine citizens receives $1
To better illustrate this, let’s consider the debate about is also efficient by the Pareto criterion. The only way to
whether to increase the minimum wage. Positive make anyone better off is through redistribution. Pareto
economics can help identify the way in which such an efficiency does not provide a basis for choosing between
increase would affect different groups as well as provide these alternative efficient distributions of benefits.
estimates of their size. In addition to recognizing that a Which distribution is best is, from the perspective of
hike in the minimum wage would increase the incomes economic analysis, a normative judgment that rests on
of those workers who hold minimum-wage jobs, it is criteria outside the realm of positive economics. While
important to also note that higher wages may result economic theory does not provide a basis for such
in some minimum-wage workers losing their jobs. choices, economists often offer such value judgments
Moreover, others who are seeking employment in jobs along with their positive analysis.
covered by the law may be unable to find employment. Despite this limitation, efficiency is an important
Finally, employers who have to pay higher wages may first step in maximizing overall well-being. When we
see their profits diminish, and they may pass some of make decisions about how to allocate resources, it is
the costs on to consumers, who will see the prices of important that we do so in a way that does not waste
goods and services that depend on minimum-wage any of them.

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MICROECONOMICS AND  carcity is inescapable because resources are
S
limited and human desires are insatiable.
MACROECONOMICS
The tools of economic analysis can be used to  very choice we make involves trade-offs. The
E
study a wide array of phenomena, ranging from opportunity cost of what we choose is what we
how individuals and businesses make decisions, to must give up by making that choice.
how they interact in markets, on up to the factors  conomics assumes that people make choices
E
that determine the overall level of production, rationally by comparing the benefits and
employment, and the price level of national economies. opportunity costs of each action and selecting
The field of economics is traditionally divided the action that yields the greatest net benefit.
into two broad subfields: microeconomics and Trade makes everyone involved better off.
macroeconomics. Microeconomics concentrates on
individual behavior and the operation of particular  conomic models help us to understand
E
markets. Macroeconomics concentrates on the overall economic phenomena by capturing essential
performance of the national economy. details and eliminating unnecessary details.
 ositive economics uses the tools of economic
P
Clearly microeconomics and macroeconomics are analysis to describe economic phenomena and
closely linked. They share common assumptions about make predictions about what will happen under
the basic features of human behavior. But, because particular circumstances.
they focus on economic activity on different scales,
different aspects of this behavior are important. And,  ormative economics uses the tools of
N
their modes of analysis are sufficiently different, so it is economic analysis to evaluate the relative
useful to consider them separately. merits of different situations.
 areto efficiency is an important criterion in
P
economics. It describes a situation in which the

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SECTION I SUMMARY only way that anyone can be made better off
 conomics is the study of how individuals
E is by reducing the well-being of one or more
make choices about how to allocate and other people.
distribute scarce resources and how they  he two main branches of economics are
T
interact with one another. microeconomics and macroeconomics.

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

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

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 FIGURE 1

STEVE'S DEMAND SCHEDULE

PRICE QUANTITY OF GASOLINE DEMANDED

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

STEVE'S DEMAND CURVE

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

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

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 FIGURE 2

PRICE STEVE NORA MARKET

0.5 52.5 + 18.5 = 71

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

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

world markets are characterized by a high degree of competitive markets can be applied to less than
competition and can usefully be described in terms of perfectly competitive markets. Our analysis of perfect
the perfect competition assumption. The market for competition will also provide a useful benchmark
gasoline is a good example of a nearly competitive against which to compare the outcomes of other types
market. Unless you live in a very small town, you of markets.
have probably noticed that the price of gasoline is
not precisely the same at different stations. But, the Demand
differences in prices are never very large. As a result, The quantity demanded of any good is the amount of
many of the lessons we learn from analyzing perfectly that good buyers are willing and able to purchase. This

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quantity depends on a wide range of factors. One of the Steve is, of course, just one buyer. To find the market
most important is the good’s price. If the price of the demand schedule, we must add up the quantity that
good is higher, buyers will demand less of the good; if every consumer will purchase at each possible price.
the price is lower, then they will demand more. This Figure 2 illustrates how this process works with
negative relationship between a good’s price and the two individuals. In addition to Steve, the market now
quantity demanded is called the law of demand. includes Nora. The table in Figure 2 shows that the
market quantity demanded is the sum of the quantities
The law of demand is a result of the cost-benefit that Steve and Nora wish to consume at that price.
analysis that rational decision-makers use when The graph shows that we add the two demand curves
deciding how to allocate their resources. As the price horizontally to obtain the market demand.
of a good increases, the opportunity cost of consuming
that good also increases since consumers must cut Shifts in the Demand Curve
back on their consumption of other goods to afford The market demand curve depicts the relationship
the higher price. If, for example, the price of gasoline between the quantity demanded and its price,
rises, people will likely find ways to reduce the amount assuming that all other factors that might influence the
that they drive. They might do this by planning their quantity demanded remain unchanged. But many other
trips more carefully or choosing to take the bus or ride things can influence the quantity demanded. If one
a bicycle rather than drive. of these factors changes, it causes the entire demand
The table in Figure 1 illustrates how Steve’s purchases curve to shift.
of gasoline each month depend on the price per gallon. For example, if your community creates a new system
At $1 per gallon, Steve buys 50 gallons; when the price of bicycle lanes that make it easier to bike from place
rises to $2 a gallon, he cuts back to 45 gallons. If the to place, the quantity of gasoline demanded will
price rises further, to $3 a gallon, he cuts back to 40 decline at every price. As Figure 3 shows, such a
gallons. This table is called a demand schedule.

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change causes the market demand curve to shift to the
The graph in Figure 1 shows another way of left, indicating that at each price a lower quantity is
representing Steve’s demand schedule. The downward- demanded. Let’s consider some of the most important
sloping line in this graph is called Steve’s demand factors affecting the quantity demanded.
curve. Notice that we plot the points of Steve’s
Income
demand schedule with the quantity demanded on the
Suppose Steve’s employer reduces his weekly hours
horizontal axis and the price on the vertical axis. To
of work, and thus his income. Because Steve has less
read this graph, find a price on the vertical axis (say
money to spend on all the things he wishes to buy, he
$3 per gallon) and then draw a line horizontally until it
will likely reduce his consumption of gasoline. For
intersects the demand curve. Now draw a line vertically
most goods, demand is positively related to income:
downward from that point until it intersects the
when income rises, the quantity demanded rises, but
horizontal axis. The point at which this line intersects
when income falls, the quantity demanded falls. Goods
the horizontal axis (40 gallons) is the quantity Steve
for which this is true are called normal goods.
demands when the price is $3 per gallon.
Not all goods are normal goods, however. Goods for
When the market price changes, we find Steve’s
which the quantity demanded falls as income rises are
quantity demanded by moving up or down along the
called inferior goods. Bus rides might be an example
demand curve until we reach the height corresponding
of an inferior good. As their income increases,
to the new market price. For example if the price
consumers will be more likely to buy a car and drive
were to rise from $3 to $5 a gallon, Steve’s quantity
instead of taking the bus.
demanded would decline from 40 gallons a month to
30 gallons a month. This movement is illustrated in The Prices of Related Goods
Figure 1 by the arrow pointing up and to the left along Suppose that the price of airline tickets falls. The law
the demand curve. of demand says that consumers will purchase more

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 FIGURE 3

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

airline travel. Because airline travel is to some extent perceived benefits of consumption change, then so
a substitute for travel by car, people will likely reduce will the quantity demanded. For example, suppose that
the number of miles they drive and hence the quantity concerns about the environmental impacts of driving
of gasoline they demand at any price. When a decline cause people to be more concerned about pollution.
in the price of one good causes a reduction in the The likely impact will be a reduction in the demand for
quantity demanded of another, we say that these goods gasoline.
are substitutes.
Expectations
Suppose, on the other hand, that the price of Changes that you expect to occur in the future may
automobile insurance falls. Lower insurance costs also affect the quantity demanded. For example, if
make it easier for more people to afford to own Steve is afraid that he may lose his job next month,
automobiles; car ownership will increase and so will then he might cut back on his driving now in
the number of miles driven. When a lower price for anticipation of this future change in his income.
one good causes demand for another good to increase,
we call those two goods complements. Number of Buyers
Market demand is derived by adding up the demands
Tastes of individual consumers. If there are more consumers,
Remember that the quantity demanded reflects a then demand will increase. If your community is
comparison of the benefits of consumption with the growing because people and businesses are moving
opportunity costs of purchasing the good. If the there, then the market demand for gasoline will be

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increasing with this growing population. Input Prices
Inputs are any of the things that suppliers have to
Supply purchase to supply a product. For example, the price
The quantity supplied of any good is the amount that that gasoline stations must pay their suppliers for
sellers of that good are willing and able to produce. gasoline is a major cost of doing business. If this price
Many factors influence the quantity supplied, but the falls, the quantity of gasoline supplied will increase,
most important is the price that suppliers receive. The causing the supply curve to shift to the right. But,
higher the price is, the greater the quantity that suppliers there are other inputs that are important as well. These
will want to produce. This positive relation between include labor costs, the real estate costs for the land
price and quantity supplied is called the law of supply. on which the gasoline station is located, and utilities
such as electricity. If any of these input costs increases,
The positive relationship between price and quantity
it will decrease the quantity supplied at every price,
supplied reflects the cost-benefit analysis of rational
causing the entire supply curve to shift to the left.
suppliers. Gasoline station owners compare the
benefits of each gallon sold to the opportunity cost of Technology
their time, effort, and expense to supply that gallon Changes in technology can affect how businesses
of gasoline. As the price rises, it will be rational to operate and hence the quantity supplied. In the case
devote more resources to supplying gasoline. So long of gasoline, the shift from full-service to self-service
as the price they receive exceeds their opportunity reduces labor costs and increases the quantity supplied.
cost, they will be willing to supply gasoline. At higher Similarly, pumps with credit card readers further
prices, they will be willing to work longer hours, hire reduce labor costs and increase the quantity supplied.
additional help, and expand the size of their stations to
boost sales. At lower prices, they will cut back on the Expectations
time they spend supplying gasoline, reduce the number If suppliers expect prices to rise in the future, then

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of their employees, or shift their efforts toward selling they may reduce the quantity they will supply today
other products. and store current inventory in expectation of the higher
future prices.
Figure 4 illustrates the relationship between price and
quantity supplied for Shelly. Again, we plot the price of Number of Sellers
gasoline on the vertical axis and the quantity supplied As more sellers enter the market, the quantity supplied
on the horizontal axis. Shelly’s supply curve is upward will increase. On the other hand, if a seller decides to
sloping, reflecting the positive relationship between leave the market, then the quantity supplied will be
price and quantity supplied. reduced.
The market supply curve is obtained by adding the
Equilibrium
quantities supplied at each price by all of the suppliers
What will the price of gasoline be? How many gallons
in the market. This is illustrated in Figure 5 for the
will be sold? To answer these questions we need to put
case where there are two suppliers. Again, we obtain
the information about the market demand and market
the market supply curve by adding the individual
supply together. There is, as we will see, only one
supply curves horizontally.
combination of price and quantity at which the market
is at equilibrium, and it is at this point that the market
Shifts in the Supply Curve will settle.
The market supply curve shows the quantity supplied
at each price, assuming that all other things remain Equilibrium is a widely used concept in both the
unchanged. There are, however, many other factors physical and social sciences. It is defined as a point at
that will influence the quantity supplied. A change which all the forces at work in a system are balanced
in any of these factors will cause the supply curve to by other forces, resulting in a stable and unchanging
shift. Let’s consider some of the most important factors situation. In economics, a market is in equilibrium
that might cause the supply curve to shift. when no participant in the market has any reason to

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FIGURE 4

PRICE OF A GALLON OF GASOLINE QUANTITY OF GASOLINE SUPPLIED

$1.50 65
$2.00 70
$2.50 75
$3.00 80
$3.50 85
$4.00 90
$4.50 95
$5.00 100
$5.50 105
$6.00 110
$6.50 115
$7.00 120
$7.50 125
$8.00 130
$8.50 135
$9.00 140
$9.50 145

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$10.00 150

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

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FIGURE 5

PRICE OF A SHELLY’S LUTHER’S MARKET

GALLON OF GASOLINE QUANTITY SUPPLIED QUANTITY SUPPLIED QUANTITY SUPPLIED

$0.50 55 + 82 = 137
$1.00 60 89 149
$1.50 65 96 161
$2.00 70 103 173
$2.50 75 110 185
$3.00 80 117 197
$3.50 85 124 209
$4.00 90 131 221
$4.50 95 138 233
$5.00 100 145 245
$5.50 105 152 257
$6.00 110 159 269
$6.50 115 166 281
$7.00 120 173 293
$7.50 125 180 305
$8.00 130 187 317
$8.50 135 194 329

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$9.00 140 201 341
$9.50 145 208 353
$10.00 150 215 365

Derivation of ofthe
Derivation Market
the Market Supply Curve
Supply Curve

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 FIGURE 6

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Market
Market Equilibrium
Equilibrium

alter his or her behavior. price is too low and would like it to be higher.
The market equilibrium occurs at the combination An important feature of market equilibrium is that
of price and quantity where the market supply and the market has an automatic tendency to gravitate
demand curves intersect. Because the supply curve is toward this combination of price and quantity. Figure
upward sloping and the demand curve is downward 7 illustrates this point. We start (Figure 7a) by
sloping, there is only one possible point of intersection. supposing that the price is higher than $2.50. At a price
Figure 6 illustrates the market equilibrium for of $4 a gallon, for example, suppliers would like to sell
gasoline. In this hypothetical example, the equilibrium 10,600 gallons, but buyers only wish to purchase 8,500
price is $2.50, and the equilibrium quantity is 10,000 gallons a month. In other words, there is an excess
gallons of gasoline per month. supply. No one can force people to buy more gasoline
than they want. Suppliers will find that they have too
At this point, we can say that the buyers and sellers in much gasoline on hand, their storage tanks are filling
this market are all satisfied, in the sense that buyers are up, and they cannot unload their inventory.
able to purchase as much gasoline as they would like
at a price of $2.50 a gallon, and suppliers can sell as Under these circumstances, suppliers have an incentive
much gasoline as they would like at this price. There to lower their price a little bit. If one station posts a
are, no doubt, buyers who complain that the price of price of $3.90 a gallon, it will attract buyers from other
gasoline is too high and would like the price to be stations, and its surplus will be reduced. But once
lower, and similarly suppliers who complain that the the other stations see that they are losing customers,

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FIGURE 7

(a) EXCESS SUPPLY

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(b) EXCESS DEMAND

Markets out of Equilibrium

Markets out of Equilibrium

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they will be forced to lower their prices as well. The marginal buyer is the buyer who, at that price, is just
pressure to cut prices and attract business will not go indifferent between buying the good in question or not
away until the price has reached the equilibrium level buying it.
of $2.50 a gallon.
To illustrate this, let’s consider the highly simplified
Now suppose that the price is below the equilibrium example presented in Figure 8. The table lists the
price. Figure 7b illustrates this situation. At a price amount each of four fans would be willing to pay to
of $1.50 there is an excess demand for gasoline. purchase a ticket to a Bruce Springsteen concert. The
Buyers wish to purchase 11,000 gallons of gasoline, table shows that Barb values attending the concert at
but suppliers are willing to sell only 9,600 gallons. $100, and at any price less than that she will purchase
Now there are shortages: some drivers cannot find a ticket. The other potential buyers place a lower value
any gasoline, and others have to wait in long lines to on attending the concert.
purchase gasoline.
If the concert promoter sets the price of tickets at $60,
Buyers might be tempted to offer to pay a little bit extra then Steve will not purchase a ticket, since the most he
to be sure to get what they need, and sellers will see they is willing to pay is $50. The other three consumers will
can raise prices without sacrificing sales. The pressure all purchase tickets, but the benefit they receive from
to raise prices will continue until the price has reached being able to purchase the ticket for $60 varies. Barb
the equilibrium level. Only at this point will buyers and would have paid $100, so attending the concert produces
sellers have no desire to change their behavior. a benefit valued at $40 for her. Since Bob was willing
to pay $80, his benefit is $20, and Sharon’s benefit is
The Characteristics of Competitive just $10. Adding these amounts together, we see that the
Market Equilibrium three purchasers receive a combined benefit of $70. We
Competitive markets tend to gravitate toward call this amount the consumer surplus since it is the
surplus value that consumers receive.

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the equilibrium quantity and price. This is a very
important feature of markets and has several desirable The demand curve in Figure 8 slopes downward,
consequences. First, competitive markets are an indicating that as the price falls, more of the fans will
extremely effective method of allocating resources. be willing to purchase tickets. At any point along
When the market for a good is in equilibrium, the price this demand curve, its height shows the marginal
conveys important information for potential suppliers purchaser’s willingness to pay. Because the height of
about the value consumers place on that good. At the the demand curve measures buyers’ willingness to
same time, the price informs potential demanders about pay, the difference between the height of the demand
the opportunity cost of supplying the good. This two- curve and a horizontal line drawn at the market price
way communication is how markets insure that scarce measures the consumer surplus for the marginal buyer
goods and services are produced at the lowest cost and at each quantity demanded. More generally, we can use
allocated to the buyers who value them the most highly. the total area below the demand curve and above the
The competitive market equilibrium insures that the market price as a measure of total consumer surplus.
available supply goes to those buyers who value the This area, then, provides a monetary measure of how
good most highly, and that it is provided by those much benefit all of the buyers in a particular market
suppliers who have the lowest costs of supplying the receive from participating in that market.
good. This fact leads to the second characteristic of In the same way the height of the demand curve
the competitive market equilibrium: it maximizes the represents buyers’ willingness to pay, the height of
benefits buyers and sellers receive from exchange. the supply curve at each quantity supplied measures
Let’s begin by considering the benefits buyers receive the willingness to supply of the marginal seller—that
from participating in the market. The important insight is, the seller who would leave the market if the price
is the height of the market demand curve at each point were any lower. Put somewhat differently, the height
reveals the marginal buyer’s willingness to pay. The of the supply curve measures the opportunity cost to
the marginal seller. If the market price exceeds this

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FIGURE 8

BUYER WILLINGNESS TO PAY

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

DEMAND SCHEDULE
PRICE BUYERS QUANTITY DEMANDED

more than $100 None 0

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

DEMAND CURVE

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The DemandTheCurve Represents Buyers’ Willingness to Pay

Demand Curve Represents Buyers’ Willingness to Pay

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 FIGURE 9

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Producer Surplus
Producer Surplus

opportunity cost, the difference is a monetary measure meets the efficiency criterion and maximizes total
of what is called the producer surplus. And we can surplus, let’s consider Figure 10. Suppose first that
measure the combined surplus of all suppliers using a quantity Q1, which is less than the equilibrium
the area above the supply curve and below the market quantity, was exchanged in the market. At this point,
price as is illustrated in Figure 9. the value of the good to buyers exceeds the cost to
sellers of supplying the good. A slight increase in the
Combining consumer surplus and producer surplus quantity in such a market would yield an increased
provides a measure of the total benefits that market benefit to both parties. So Q1, or any other point to
participants receive from their transactions. We call the left of the market equilibrium, cannot be efficient.
this benefit the total surplus. One goal of a benevolent Now, suppose that the quantity traded in the market is
social planner should be to maximize this combined Q2, an amount greater than the equilibrium quantity.
surplus, since this is the outcome that produces the At Q2 the supply curve is above the demand curve,
greatest overall good. An outcome that maximizes indicating that the cost to producers exceeds the
total surplus satisfies the economist’s criterion of value to consumers. Such an exchange cannot be
Pareto efficiency, since at this point there is no way to accomplished voluntarily, but if it did take place, then
make anyone better off without reducing the welfare of buyers or sellers would suffer a loss in welfare. Moving
someone else. to the left would raise overall well-being.
To see that the competitive market equilibrium indeed

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 FIGURE 10

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

To achieve an efficient outcome, a market planner in the economy will affect the market. Let’s consider
would need to know the value each consumer places some examples illustrating how the competitive market
on the good in question, and the cost of producing each model can be used to analyze important issues.
unit, and would have to determine how much should
be produced, by whom, and to whom it should be One of the defining characteristics of our modern
given. While such a task would be extremely difficult, economy is technological progress. New inventions
a competitive market achieves the same result simply are continually being developed that allow suppliers
through the self-interested actions of its participants, to produce more at lower costs. One example is the
responding only to the signals provided by the market development of synthetic Bovine Growth Hormone
price. (BGH), which allows dairy farmers to increase milk
production by between 10 and 15 percent at little
APPLICATIONS OF THE additional cost. The direct effects of this innovation
are illustrated in Figure 11. As is often the case,
COMPETITIVE MARKET the introduction of a new technology has other,
MODEL more subtle effects, called externalities, that are not
immediately obvious from an analysis of the market
Changes in Market Equilibrium that is immediately affected.3 We will discuss how to
Now that we have seen how to use the concepts of
incorporate externalities into our analysis later in this
supply and demand to find the equilibrium price and
section of the resource guide.
quantity in a competitive market, we can use our
market model to make predictions about how shifts The first panel shows the market equilibrium before

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FIGURE 11

(a) MARKET EQUILIBRIUM BEFORE BGH

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(b) MARKET EQUILIBRIUM AFTER BGH

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

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the introduction of BGH. The shaded regions indicate the impact of these changes, it is important to be
the consumer and producer surplus at this equilibrium. able to measure the size of the changes in prices and
The introduction of BGH is illustrated in the second quantities as well as their direction. To do this, we
panel of Figure 11. This innovation allows dairy need to introduce the concept of price elasticity.
farmers to increase the quantity of milk they supply
at any price, so the supply curve for milk shifts to The price elasticity of demand measures how much
the right. As a result, the point at which supply and the quantity demanded responds to a change in price.
demand intersect moves down along the demand curve We calculate the price elasticity of demand using the
from point A to point B. In the new equilibrium, the following formula:
price is lower, and the quantity is higher. Price elasticity of demand =
It is clear that the total surplus has increased as well, (Percentage change in quantity demanded) /
since the shaded area between the supply and demand (Percentage change in price)
curves is now larger. Consumers are unambiguously Recall that because of the law of demand, the quantity
better off as a result of the innovation. Since the market demanded of a good is negatively related to its price,
price is now lower, everyone who previously purchased so this ratio will always be negative. It is conventional
milk receives a larger surplus. In addition, at the to ignore this sign when discussing the elasticity
lower price consumers purchase additional quantities of demand. In other words, in practice, we use the
of milk. The effect on producers is more ambiguous. absolute value of the price elasticity of demand.
The increase in sales causes an increase in producer
surplus, but the lower price reduces the producer The price elasticity of demand reflects how responsive
surplus on the quantity that was previously being sold. consumers are to changes in the price of a good. The
Whether producers benefit depends on the balance of greater the elasticity, the greater the proportionate
these two effects. change in the quantity consumers demand due to any

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

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 of demand because it is easy for consumers illustrating the range of possible elasticities. In the
to switch from one product to another. For extreme case (a) demand is perfectly inelastic; the
example, the price elasticity of demand for quantity demanded does not depend on price at all.
a particular cola drink is likely quite high The remaining panels show progressively more elastic
because consumers can easily switch to a cases: (b) inelastic, (c) unit elastic, (d) elastic, and the
different brand if the price rises. Conversely, other extreme case (e) perfectly elastic, where the
when there are no close substitutes, the price demand curve is completely flat.
elasticity of demand will tend to be lower.
The price elasticity of supply is defined analogously to
Necessities. Items that are regarded as the price elasticity of demand. It is calculated as:
necessities will generally have lower price
elasticities of demand than luxuries. Many Price elasticity of supply =
people must drive to and from work and use (Percentage change in quantity supplied) /
their cars to run important errands. As a (Percentage change in price)
result, the demand for gasoline has a low price
elasticity of demand. The elasticity of supply reflects the ease with which
suppliers can alter the quantity of production. We
Market Definition. The price elasticity of can establish some general guidelines that allow
demand will depend on how we define the us to identify factors that are likely to affect this
market. The broader the market definition, responsiveness.
the fewer close substitutes there will be and
the lower the elasticity of demand. The price Ease of entry and exit. If it is easy for new
elasticity of demand for soft drinks will be businesses to begin supplying a product or for
lower than the price elasticity of demand for those in the market to leave, then supply will
any particular brand of cola drink. tend to be more elastic. The supply of airline
flights on a particular route is quite elastic

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Time Horizon. Fully adjusting to changes
in prices may take time. Take the example because airlines can easily shift planes from one
of gasoline prices considered earlier. At first route to another to respond to changes in prices.
there is not much people can do to reduce their Scarce resources. If an input required to
consumption when the price of gasoline rises. produce a good is scarce, then the supply will be
But, over time people will buy more fuel- inelastic. For example, the supply of beachfront
efficient cars, move closer to their work, and vacation homes is highly inelastic because the
make other changes that will allow them to amount of beachfront property is limited.
more significantly reduce their demand. Time horizon. The longer the time horizon is,
Elasticity is related to the slope of the demand curve. the greater the elasticity of supply will be. Over
If two demand curves pass through the same point, short time horizons, firms may not be able to
the curve that is flatter will have a higher elasticity. hire and train additional workers or add the
It is important to note that as we move down along necessary equipment to increase production.
a linear demand curve, the elasticity will be falling Over a longer horizon, they can do this more
continuously. To see this, note that a linear demand easily.
curve must have a constant slope ∆P/∆Q = e, (where As was the case with the price elasticity of demand,
we use the Greek letter ∆ to denote the change in price if two supply curves pass through the same point, the
and quantity along the demand curve). The ratio ∆Q/∆P flatter curve will be the more elastic one. Figure 14
= 1/e, is also a constant.4 Consequently the elasticity of illustrates the variety of possible supply curves. Again
demand is equal to (1/e)·(P/Q). As we move down and there are five cases. In the extreme case (a) the supply is
to the right along the demand curve, P is falling and Q perfectly inelastic, indicating that the quantity supplied
is rising, so the ratio P/Q must be decreasing. Since 1/e will not change at all as the price changes. The supply
is constant, the elasticity must also be falling. of Van Gogh sunflower paintings is perfectly inelastic
Figure 13 shows five different possible demand curves since there is no way to produce more of these. The

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FIGURE 12

(a) MARKET EQUILIBRIUM BEFORE CAMPAIGN

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(b) MARKET EQUILIBRIUM AFTER CAMPAIGN

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

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 FIGURE 13

(a) PERFECTLY
(b) INELASTIC DEMAND: INELASTIC
ELASTICITY IS LESS THAN 1 (b) INELASTIC DEMAND: ELASTICITY IS LESS THAN 1

A 22%inincrease
A 22% increase in price
price leads andreduction
to a 7% no changeininquantity.
quantity. A 22% increase in price leads to a 7% reduction in quantity.

1 (c) UNIT
(d) ELASTIC ELASTICELASTICITY
DEMAND: DEMAND: ELASTICITY
IS GREATEREQUALS
THAN 1 1 (d) ELASTIC DEMAND: ELASTICITY IS GREATER THAN 1

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ntity. A increase
A 22% 22% increase in price
in price leadsleads to a decrease
to a 44% 22% reduction in quantity.
in quantity. A 22% increase in price leads to a 44% decrease in quantity.

DEMAND: ELASTICITY EQUALS INFINITY (e) PERFECTLY ELASTIC DEMAND: ELASTICITY EQUALS INFINITY

ntity; if the price is above $4, they will buy At $4 consumers will buy any quantity; if the price is above $4, they will buy none,
none,
w $4, they will buy an infinite quantity. and if the price is below $4, they will buy an infinite quantity.

e Elasticity of Demand The Price Elasticity

The Price of Demand
Elasticity of Demand

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remaining cases illustrate (b) inelastic supply, (c) unit his or her choice about whether to use BGH has no
elastic supply, (d) elastic supply, and the other extreme effect on the market price. Given the existing market
case (e) perfectly elastic supply. price, each farmer can increase his or her sales by
using BGH. As a result, competition causes them to all
Using Elasticity adopt the technology, increasing the market supply and
To see how measurements of elasticity can be used, driving down prices.5
let’s return to the example of the introduction of
Bovine Growth Hormone that we considered earlier. As farm revenue falls, it is likely that some farmers
As a starting point, we need to consider how the will choose to cease producing, allowing the remaining
elasticity of demand affects total revenues available to farmers to maintain or increase their standard of living
producers in this market. by producing a greater quantity. This is, in fact, more
or less what has happened in the farm sector over
Total revenue is the equilibrium price multiplied by the the past two hundred years. Successive technological
equilibrium quantity: innovations have increased the ability of farmers
to produce greater quantities of crops, though this
Total Revenue = P × Q advance has been accompanied by a steady decline in
The total revenue can be depicted graphically as in the number of farmers.
Figure 15. As the price falls, we move down along
the demand curve: the height of the box is reduced EVALUATING GOVERNMENT
as its width increases. If the demand is elastic, total POLICY: THE IMPACT OF
revenue will increase since the proportionate change in
quantity will be greater than the proportionate increase
PRICE CONTROLS AND TAXES
So far our discussion has been confined to describing
in the price. But, if demand is inelastic, then total
how competitive markets work. The tools we have
revenue will decrease when prices fall.

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

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FIGURE 14

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

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

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

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

(e) PERFECTLY ELASTIC SUPPLY: ELASTICITY INFINITE

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

Elasticity ofSupply
Elasticity of Supply

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FIGURE 15

(a) INITIAL REVENUE

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

Calculation ofTotal
Calculation of Total Revenue
Revenue

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 FIGURE 16

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Effects ofof aa Rent
Effects Rent Ceiling
Ceiling

such efforts create significant, though not always find an apartment benefit from the lower rental rates,
obvious, social costs. To see these, consider a few while landlords find themselves with lower incomes.
examples. Figure 16 illustrates the impact of imposing Meanwhile, other renters lose their apartments. One
a price ceiling on the housing market. In this example, effect of rent control, then, is to increase the consumer
the competitive market equilibrium occurs at a rent surplus of some renters while reducing the producer
of $400 per month. At this price, consumers rent two surplus of landlords and thus negatively affecting other
thousand apartments each month. renters. A second consequence is that total surplus
is reduced since rent control prevents some mutually
Now suppose that landlords are told they may charge beneficial transactions from taking place. There are
no more than $300. At this price consumers wish to landlords who would like to rent their apartments for
rent 2,100 apartments, but landlords only supply 1,900 more than $300 per month, and there are consumers
apartments. Those tenants lucky enough to be able to who would be willing to pay a higher price.

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Less immediately apparent is the disruptive effect income and will likely be forced to go out of business.
of rent controls on the allocation of apartments. In
the competitive market equilibrium, apartments Taxes
are rationed by price. Everyone who values an All levels of government use taxes of one sort or
apartment as much or more than the market price another to raise revenue that is used to pay for public
is able to rent one, and landlords who are willing to expenditures. An important issue that often comes up
supply apartments at or below the market price are in public discussion of taxes is who bears the burden
able to rent them. Now, however, landlords are in a of paying the tax. It would seem that government could
position to select tenants. They may require people control the distribution of burdens through legislation,
to pay a finders fee, they may choose to rent to their but the results suggest that matters are not that simple.
friends, or they may discriminate based on personal
characteristics they value or dislike. As a result, To make matters more concrete, let’s consider a tax on
apartments may no longer go to the individuals mobile phone usage. Figure 18a illustrates the demand
who value them most highly, producing a further and supply in this market before any tax is imposed.
inefficiency in the market. In the competitive market equilibrium, cell phone calls
cost $0.20 per minute, and consumers make 1 million
Historical experience points to further negative effects minutes of calls each day. Suppose the government
of rent controls. In the short run, both the supply of decides that mobile phones are a luxury and chooses to
housing in a city and the demand for housing may be impose a tax of $0.10 per minute on consumers. From
highly inelastic. As a result, rent controls mainly lower the perspective of mobile phone users, the cost of a
the price without creating a large excess demand. But, minute of talk is now higher than before—it costs them
over time, both supply and demand become more $0.30 (= $0.20 + $0.10).
elastic. Landlords will cut back on maintenance costs,
allowing apartments to deteriorate, and eventually We can represent the effect of this change in Figure
18b as a downward shift in the market demand curve.

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removing them from the available housing stock.
Meanwhile, low prices will attract more residents to Notice that if the market price were $0.10, then
the city. With these changes, the problem of excess consumers would face a cost of $0.20 per minute and
demand and non-market rationing will become would demand the same quantity as they had in the
increasingly significant. competitive market equilibrium (1 million minutes).
So, the demand curve shifts down by $0.10, the
To illustrate the effect of establishing a price floor, amount of the tax. The new market equilibrium occurs
let’s consider Figure 17, which shows the market for at a lower quantity than before, and as a result, the
wheat. The competitive market equilibrium price in this price received by suppliers falls. In this hypothetical
market is $5 a bushel, and the equilibrium quantity is example, the new equilibrium price is $0.16 per
100 million bushels. Suppose that in an effort to protect minute; so suppliers receive $0.16 per minute, and
family farms, Congress establishes a minimum price of consumers pay $0.26 per minute. Even though the tax
$8 a bushel. Because this price is higher than the current is added to the consumers’ bill, the actual burden of
market equilibrium, it is binding. At this higher price, the tax is divided between suppliers and buyers. At the
demand for wheat falls to 80 million bushels, and supply same time, the tax reduces the equilibrium quantity,
rises to 115 million bushels. Farmers cannot sell all the lowering total surplus by preventing otherwise
wheat they are producing on the free market. mutually beneficial exchange from taking place.

Once again this intervention reduces consumer and Suppose that instead of taxing consumers, the
producer surplus. There are farmers who would be government imposed the tax on suppliers, charging
happy to supply wheat at lower prices and consumers them $0.10 for every minute of talk they supplied. As
who would be willing to buy from them, but they are a result, the revenue that suppliers receive is reduced
prohibited from doing so. Those farmers who find by $0.10. The effect of the tax on their behavior can
buyers at the higher minimum price benefit from the be illustrated by shifting the supply curve upward
legislation, but others find they are unable to earn any by $0.10. Because of the tax, suppliers will require a

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 FIGURE 17

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Effect ofof aaPrice
Effect PriceFloor Floor
for Wheat for Wheat

market price of $0.30 per minute to supply the quantity between the demand and supply curves is equal to
they previously supplied at a price of $0.20 per minute. the amount of the tax. The heights of the supply and
demand curves, respectively, at this point identify
This situation is illustrated in Figure 18c. The new the prices that suppliers receive and consumers pay.
market equilibrium occurs at a market price of $0.26 Extending a vertical line downward from this point to
per minute. At this price, suppliers receive $0.16 per the horizontal axis identifies the equilibrium quantity
minute. Notice that this is precisely the same outcome once the tax has been imposed.
as we found when the tax was imposed on consumers.
With regard to consumer and producer surplus, the
This example illustrates an important point that is tax has several effects. By introducing a difference
true more generally. A tax creates a price wedge between the price buyers pay and that received by
between the amount consumers pay and the amount suppliers, the tax prevents some otherwise mutually
suppliers receive. This price wedge reduces the market beneficial transactions from taking place. This is
quantity, and regardless of who legally pays the tax, indicated by the small triangle to the right of the new
both consumers and suppliers share the cost of the equilibrium quantity and between the supply and
tax. Recognizing this fact, we can depict the impact demand curves. This is a reduction in social welfare
of the tax in a third way, as is illustrated in Figure and is called the deadweight loss of the tax.
18d. Rather than shifting the supply or demand curve,
we search for the point where the vertical distance The other effect of the tax is to transfer revenue to

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 FIGURE 18

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

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

AND SELLERS’ PRICES

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

the government. The government collects $0.10 on the tax has caused people to demand fewer minutes
every minute purchased at the new equilibrium. of calling than before. As this diagram makes clear,
The amount of this revenue is illustrated in Figure the revenue that the government receives reduces the
18d by the shaded rectangle. Initially people talked combined consumer and producer surplus from these
1 million minutes, but notice that a tax of ten cents transactions by an amount equal to the income that the
per minute generates less than $100,000 ($0.10 × $1 tax produces for the government.
million) in revenue to the government. This is because
In our hypothetical example, suppliers paid 40 percent

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of the cost of the tax through reduced revenues, while all of his time catching fish, then he can catch eight
buyers paid 60 percent of the cost of the tax through fish—this is the distance from the origin to the point
an increase in their cost per minute. In general, the where the PPF intersects the horizontal axis.
distribution of the burden of a tax depends on the
relative price elasticities of supply and demand. For Robinson can select any point along the PPF, which we
any given supply curve, the less elastic the demand is, have drawn here as a straight line. The slope of this
the greater the share of the tax paid by buyers. This line reflects the opportunity cost of coconuts in terms
is illustrated for two demand curves in Figure 19a. of fish. Since the PPF has a slope of –3, it indicates
Figure 19b depicts a similar comparison, showing that Robinson must give up three coconuts to get one
how the elasticity of supply affects the division of the additional fish. All of the points on the PPF are efficient
tax. One final point that emerges from an examination from the perspective of production since along this line
of Figure 19 is that the less elastic the supply and there is no way that Robinson can increase the quantity
demand curves are, the smaller the effect of the tax on of one good produced without reducing the quantity of
the equilibrium quantity, and therefore the lower the the other.
deadweight loss of the tax. The point that Robinson chooses along the PPF depends
on his relative preferences for fish and coconut. He
INTERNATIONAL TRADE will select the combination of fish and coconuts that
One of the fundamental insights of economics is maximizes his satisfaction. Suppose that he selects a
that exchange makes people better off. It does so by point like A, where he is consuming fifteen coconuts
encouraging specialization. When individuals or and three fish. From our discussion of the demand
countries specialize in the activity they do the best, the curve, we know that at this point if Robinson is a
overall economic pie increases. These gains from trade rational consumer, he will get just as much pleasure
are the reason that our modern economy is characterized from one more fish as from three coconuts. If this
by such a high degree of interdependence. were not so, then he could improve his well-being

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To appreciate the gains achieved from trade, we need to by moving along the PPF. For example, if one fish
begin by considering an isolated economy. Then, we can gave him as much pleasure as two coconuts, he could
consider how the opportunity to trade alters well-being. reduce his consumption of fish by one and increase his
consumption of coconuts by three. Since it only takes
An Isolated Economy two coconuts to compensate for the fish he has given up,
As a starting point, let’s consider a highly simplified he would be better off.
economy. Robinson is stranded on a tropical island.
Each day he works for eight hours to produce food, Adding the Opportunity to Trade
which he consumes. He can devote his time either to Crusoe lives on a nearby island, where she too gathers
harvesting coconuts or catching fish. Each hour that coconuts and catches fish. In Figure 20b we show
Robinson spends gathering coconuts is an hour that he her PPF. Looking at her production, we can see that
does not spend catching fish. The opportunity cost of Crusoe is better at catching fish than Robinson, and
the additional coconuts that he gathers is the quantity she is better at gathering coconuts. In an eight-hour
of fish that he does not catch during that hour. day, she can catch thirty-six fish or gather thirty-six
coconuts. Because Crusoe’s PPF is above and to the
We can represent the trade-off that Robinson faces right of Robinson’s at every point, we say that she has
in terms of a production possibility frontier or PPF an absolute advantage.
like that drawn in Figure 20a. In this diagram, we
measure the quantity of coconuts Robinson gathers on The slope of her PPF is –1, indicating that the
the vertical axis and the number of fish he catches on opportunity cost of one fish is one coconut. Crusoe can
the horizontal axis. The graph shows that if Robinson select any point along her PPF. But by the same logic
spends all eight hours gathering coconuts, he can we used before, we know that at that point she will
collect twenty-four coconuts—this is the height of the value one fish the same as one coconut. Let’s suppose
curve where it intersects the vertical axis. If he spends that Crusoe is initially consuming eighteen fish and

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FIGURE 19

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

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

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

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FIGURE 20

(a) ROBINSON’S PRODUCTION POSSIBILITIES

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(b) CRUSOE’S PRODUCTION POSSIBILITIES

Production Possibility
Production Frontiers
Possibility Frontiers

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eighteen coconuts at point B. specialization and the larger the gains from trade.
One day, Robinson finds a boat and sails to Crusoe’s The Political Economy of Trade
island. They begin to talk about their respective If trade increases a nation’s well-being, then why
consumption patterns, and Robinson proposes that if is there so much public opposition to international
they agree to trade, they can both be better off. Crusoe agreements designed to promote freer trade? While
is skeptical at first since she produces more fish and free trade expands the overall size of the economy, it
more coconuts than Robinson, and so she cannot also implies shifts in the size of different industries.
see how they could find an opportunity to trade. But In the previous example, Robinson and Crusoe simply
Robinson persists. He points out to her that at the reallocated their time. But when countries become
moment they are producing a total of thirty-three increasingly specialized, the costs and benefits of trade
coconuts (Robinson’s 15 plus Crusoe’s 18) and twenty- fall on different groups of people. As a result, even
one fish (3 + 18). But, if Robinson were to devote eight though the gains from free trade exceed the losses,
hours to gathering coconuts, he could produce twenty- those citizens who will experience losses are likely to
four. Meanwhile, if Crusoe were to spend two more oppose freer trade.
hours fishing, then she could produce nine coconuts
and twenty-seven fish. Together their combined To see this, let’s consider the impact of free trade in
production would be thirty-three coconuts (the same as more detail. We will begin by considering a small
before) and twenty-seven fish (six more than before). economy that is isolated from international markets
If they split this extra production, they could each because trade is prohibited. As a result, the domestic
increase their consumption by three fish. equilibrium is determined by the intersection of the
country’s supply and demand curves as depicted
Comparative Advantage and the Gains in Figure 21a. Suppose that the world price is PW,
from Trade illustrated by the horizontal line above the domestic

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How can it be that Crusoe, who is better at everything, equilibrium price. Consumer surplus is equal to the
can be made better off by trading with Robinson? sum of the areas marked A and B; producer surplus is
The answer to this question lies in the insight that equal to the area C.
what matters is not the absolute productivity of If the law prohibiting trade is removed, this country will
either Robinson or Crusoe, but rather their respective become an exporter, since its cost of supply is below the
comparative advantage. Even though Robinson world price. To simplify the analysis, we assume that
produces fewer coconuts per hour than Crusoe, he has the country is so small relative to the world market that
a comparative advantage in producing coconuts. its additional supply will not alter the world price. The
By changing their allocation of time between fishing equilibrium quantity will occur where the world price
and gathering coconuts, Robinson and Crusoe in effect intersects the country’s market supply curve.
“transform” fish into coconuts. Robinson faces a cost At PW, domestic consumers reduce their consumption.
of just 1/3 fish per coconut, while it takes Crusoe one The difference between domestic consumption and the
fish to produce a coconut. When Robinson specializes quantity supplied is exported. Consumer surplus falls
in producing coconuts and Crusoe specializes in because the price rises, and consumers purchase less
producing fish, their collective economy can increase of the good. The value of their surplus is represented
its total production. by the area labeled A. Producer surplus increases,
The principle of comparative advantage offers a however. It is equal to the sum of the areas marked
profound insight about the opportunities for gains from B, C, and D. So, producers benefit and consumers
trade that applies equally to individuals and to nations. suffer when a country becomes an exporter. In total,
So long as trading partners differ in their comparative however, social welfare increases from the area
advantage, they can improve their overall well-being A+B+C to the area A+B+C+D, yielding a net increase
by specializing. The more extensive the markets in equal to the area denoted by D.
which they trade are, the greater the opportunities for For a country that becomes an importer, social

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FIGURE 21

(a) MARKET EQUILIBRIUM WITHOUT TRADE

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(b) MARKET EQUILIBRIUM WITH TRADE

Welfare Effects ofofIsolation

Welfare Effects and
Isolation and Free TradeFree Trade

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welfare again increases, but now it is consumers who ingredients, for which he pays $600 a day; hiring labor
benefit, while producers suffer losses. This situation to produce the bread costs $300 per day; and renting
is illustrated in Figure 22, where the domestic the shop in which he operates costs Bob $50 per day.
equilibrium price is above the world price. When trade These explicit costs total $950, leaving an accounting
is allowed, the domestic price falls to the world price, profit of $250 a day.
and the quantity consumed rises. Domestic producers,
however, respond to the lower price by reducing their But, we have not yet included all of the firm’s
supply. The difference between the quantity produced opportunity costs. Bob is a skilled retailer and, if he
domestically and the quantity consumed domestically were not managing his bread company, he could earn
is made up by imports. Producer surplus declines from $200 a day managing another store in town. Because
the areas B+C to B, while consumer surplus increases Bob gives up this income to manage his own business,
from A to A+C+D. we must include this forgone income as part of his
economic costs. As a result, the true economic profit
THE PROFIT MOTIVE AND that Bob’s Bread Company earns is $50 per day.

THE BEHAVIOR OF FIRMS Finding the Firm’s Supply Curve

Economists use the term “firm” to describe the In the example above, Bob is producing 300 loaves
economic actors who are responsible for supplying of bread each day. How does he choose this level of
goods and services in the economy. Firms combine production? Recall that Bob’s objective is to maximize
labor, capital equipment, raw materials, and other his profits. Some of his costs, such as the opportunity
inputs to produce the products that we want to cost of his time and the rent on the building and
consume. Up to now, we have used the supply curve equipment do not depend on the quantity of bread
to summarize their actions. According to the law of he produces and cannot be changed in the short run.
supply, as the price of a good rises, firms are willing to These are what we call his fixed costs. However, the

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supply a greater quantity. In many cases, this is all we cost of Bob’s labor and materials can be varied in the
need to know about the behavior of firms. But, in other short run. These are called his variable costs.
instances, we need to look more closely at how firms
decide what to produce and how to produce it. The table in Figure 23 summarizes information about
Bob’s costs of production. In the second column, we
Economic Profits and Accounting Profits list his fixed costs. Because these do not depend on the
We assume a firm’s goal is to maximize profits. quantity of bread Bob chooses to supply, they do not
Profits are defined as the difference between the change. In the third column, we show Bob’s variable
firm’s total revenue and its total costs. The meaning costs of production. Notice that each time we move
of total revenue is fairly clear: it is the total quantity down a row, output increases by 50 loaves a day, but
of output the firm produces for sale multiplied by the the additional cost of producing those additional loaves
price it receives. Measuring total costs is a bit more of bread increases from row to row.
complicated. Economic costs include the opportunity
The increase in costs that occurs when producing an
costs of all resources required for production. In
additional unit of output is referred to as marginal
contrast, accounting costs will likely include only
cost. The marginal cost is calculated by dividing the
actual monetary expenditures.
increase in total costs by the increase in the quantity
This distinction can be seen more clearly by of bread produced. This additional cost is referred to
considering an example. Consider Bob’s Bread as the marginal cost of production. For example, when
Company. Bob’s is a small bakery that sells a variety Bob increases his production from 50 to 100 loaves,
of freshly baked breads. All of the baking is done in his total costs increase from $358 to $483, and thus his
the back of the store, and Bob operates a retail shop at marginal cost of producing these additional loaves is
the front. Suppose that Bob sells 300 loaves of bread a ($483 –$358) / (100 – 50) = $2.50. As you go down the
day for $4 each. Total revenues are $1,200 a day. rows in the top section of the table, the change in total
cost is increasing, implying that marginal costs are
Bob’s explicit costs include purchasing flour and other increasing as well.

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FIGURE 22

(a) MARKET EQUILIBRIUM WITHOUT TRADE

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(b) MARKET EQUILIBRIUM WITH TRADE

WelfareWelfare
EffectsEffectsof Isolation
of Isolation and Free and
Trade Free Trade

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The bottom panel of the table provides the information be an upward-sloping line.
necessary to determine Bob’s profit-maximizing
production level. Because Bob can vary his production Entry, Exit, and the Market Supply Curve
by amounts smaller than 50 loaves, we have calculated Bob is, of course, only one possible supplier of bread.
his marginal costs of production for the quantity Other potential producers are likely to notice that Bob
shown in each row for small changes in the quantity is making an economic profit of $100 a day. Recall that
produced at that point. As a result, these values will we have already accounted for the opportunity cost
differ somewhat from the marginal costs you would of Bob’s time. The opportunity to earn extra profits
calculate using the data in the top part of the table.6 will induce some of these producers to rent shops and
equipment and begin producing bread as well.
Increasing marginal costs of the type illustrated
in Figure 23 are common in economics. Such a The addition of more producers has the effect of shifting
relationship usually arises because some of the factors the market supply curve outward. And, this in turn
of production are fixed and cannot be increased in will cause the equilibrium price to fall. The entry of
the short run. In this case, Bob cannot increase the additional producers will continue as long as there are
number of ovens available. As a result, once the ovens positive economic profits to be earned in the market.
begin to fill up, the addition of more workers produces Only when economic profits have reached zero will
less and less additional output. This is an example of entry cease. In the same way, if economic profits were
diminishing returns to scale. to fall below zero at some point—say because of a shift
in preferences that reduced the demand for bread—
Bob’s marginal cost of production is the opportunity producers would begin to leave the market, shifting to
cost of supplying an additional loaf of bread since it other activities that offered greater opportunities.
measures the amount that Bob must spend to produce
that loaf. The benefit that Bob gets from supplying Two points are worth emphasizing about this
another loaf of bread is the additional revenue that conclusion. First, in a competitive market business

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it will produce. This additional revenue is called the owners earn zero economic profits. They will, however,
marginal revenue. be content, because they are earning their opportunity
wage. In other words, this remains their best alternative.
By assumption, the market for bread is perfectly
competitive, meaning that the price Bob receives is not Second, in addition to their role in rationing scarce
affected by the quantity he chooses to supply. From goods, prices serve a second important function:
his perspective, the demand curve is horizontal at the they allocate productive resources between different
market equilibrium price of $4 a loaf. This means that activities. If prices exceed production costs in some
Bob’s marginal revenue is equal to $4 regardless of the activity, then the existence of positive economic profits
quantity he chooses to supply. acts as a signal that additional resources should be
deployed to that activity to increase production.
Combining the information about Bob’s costs with
the information about his marginal revenue, we can IMPERFECT COMPETITION
now find his profit maximizing output. The necessary Now that we understand how firms behave in perfectly
information is summarized in the bottom panel competitive markets, we can begin to develop an
of Figure 23. So long as Bob’s marginal cost of understanding of how markets that are not perfectly
supplying an additional loaf of bread is less than $4, competitive work. Although perfect competition is
he can increase his profits by producing and selling a reasonable approximation for many parts of the
that loaf. Reading down the marginal cost column, economy, the markets for many important products
we see that Bob’s marginal cost equals $4 when he is are dominated by a small number of very large firms.
producing 300 loaves of bread. Examples include the markets for computer operating
So long as diminishing returns to scale apply, marginal systems, commercial airplanes, automobiles, air travel,
costs will be rising as the firm’s output increases. As a and mobile phones. In other cases, such as electricity,
result, the profit-maximizing firm’s supply curve will water, and cable television, there is only a single supplier

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 FIGURE 23

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

50 $250 $108 $358

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

MARGINAL MARGINAL TOTAL TOTAL

QUANTITY REVENUE COST REVENUE – COST = PROFITS

50 $4.00 $2.33 $200 $358 –$158

100 $4.00 $2.67 $400 $483 –$83
150 $4.00 $3.00 $600 $625 –$25
200 $4.00 $3.33 $800 $783 $17

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

Bob’s Bread Company

Bob’s Bread Costs
Company Costs and Revenues
and Revenues

in any community. Economists call markets with one or market prices. Of course, they are not entirely free
only a few suppliers imperfectly competitive. to choose any price since they are constrained by the
combinations of price and quantity determined by the
Firms in imperfectly competitive markets have the market demand.
same objective as firms in perfectly competitive
markets: to maximize their economic profits. But Monopoly
unlike firms in a perfectly competitive market, a firm There are a wide range of different types of
in an imperfectly competitive market can no longer imperfectly competitive markets. The simplest case to
assume that its decision about how much to supply consider is the extreme situation of a single supplier, a
does not affect the price at which its products can be situation called a monopoly. Monopolies arise because
sold. Rather, the demand curve it faces is downward there are barriers to entry that prevent competitors
sloping, meaning that if it chooses to increase its from entering the market. The most important sources
supply, the price it receives will be lower. of barriers to entry are:
Firms facing a downward sloping demand curve are The ownership of a key resource. The market
said to possess market power, meaning that instead of for residential electricity supply is a monopoly
taking prices as given, they have the ability to choose in most communities because a single company

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 owns the retail electricity distribution system. What happens to the company’s revenues as it selects
It would not be possible for a competitor to different points along the demand curve? For example,
establish another distribution system. Another consider moving from point A in the graph in Figure
example is the market for diamonds. Until 24, where price equals $16 and the quantity is 400,
recently the DeBeers company owned mines to point B where the price is $15. The additional
from which 80 percent of the world’s diamonds subscribers generate more revenue, but to achieve this,
are produced. Because diamonds can be the company must lower its price to existing subscribers.
mined in only a few places, ownership of these At point A total revenue is $6,400, and at point B it rises
places allows for the establishment of what is to $7,500. Lowering the price and increasing supply
effectively a monopoly. increases total revenue, but the marginal revenue—the
Government-created monopolies. Many incremental increase in revenues produced by each
monopolies are created when the government additional subscriber—is less than the price of service.
gives the rights to supply a product to a single Here the additional 100 subscribers generate just $1,100
company. Patent and copyright laws are one in additional revenue, an increase of $11 per subscriber,
mechanism through which such exclusive even though the price of a monthly subscription is $15.
rights are granted. If the government grants a The difference is attributable to the fact that Local
patent to an inventor who has developed a new Media must lower the price it charges its existing
technology, he or she is awarded the exclusive subscribers to attract additional customers.
right to utilize the technology for twenty years What price should Local Media choose and how much
in exchange for revealing the details of his/ should it supply at this price? The profit-maximizing
her innovation. Under copyright law, an author strategy that we identified for a firm in a competitive
becomes a monopolist over the book he or she market—increase supply until marginal cost equals
has written. marginal revenue—still applies for a monopolist. As

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Natural monopolies. An industry is a natural long as marginal revenue is greater than marginal cost,
monopoly when a single firm can supply the increasing supply causes economic profits to increase,
market at a lower cost than could two or more but increasing supply beyond this point causes profits
firms. This happens when there are large fixed to begin to decline.
costs that cause the firm’s average costs to be
falling at a scale of production that can serve Figure 25 illustrates the application of this strategy.
the entire market. Railroads, pipelines, and Local Media’s marginal cost curve is drawn as upward
cable television are all examples of markets sloping, reflecting the fact that adding additional
that are prone to natural monopoly. subscribers requires the extension of the network,
which requires increasingly costly equipment. Local
Monopoly Supply Media’s marginal cost curve intersects the marginal
To illustrate the supply decision of a monopolist, let’s revenue curve at a quantity of 700 subscribers. At this
consider the example of the market for cable television quantity, the marginal cost and marginal revenue are
services in Smallville, which is served by a single both $7, and the height of the demand curve indicates
provider Local Media. The table in Figure 24 shows that demand equals 700 when the price is $13 per
the demand for cable television service is negatively month. Local Media’s profit-maximizing choice is to
related to the price of a monthly subscription. At a set the price at $13 and provide 700 subscriptions.
price of $20, no one will purchase the service, but
when the price falls to $19 a month, 100 households Welfare Consequences of Monopoly
will subscribe. As the price falls further, demand If cable TV service in Smallville had been provided by
increases. Local Media can choose to supply at any a competitive market with marginal costs equivalent
combination of price and quantity along the demand to Local Media’s, then the market equilibrium would
curve. Its total revenue at that point is equal to the occur at a lower price and higher quantity, as can be
price times the quantity. seen from the location of the intersection of the market
demand curve with the marginal cost curve. Compared

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FIGURE 24

PRICE OF QUANTITY DEMANDED TOTAL REVENUE MARGINAL

SERVICE (100 S OF HOUSEHOLDS) =P Q REVENUE

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

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

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 FIGURE 25

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Monopolist’s Quantity
Monopolist’s Supplied
Quantity Supplied and Price and Price
to this hypothetical competitive outcome, the Dealing with Monopolies
monopoly supplies a lower quantity at a higher price. Because of the negative effects that monopolies create,
It may also earn an economic profit. But, because of government policymakers have adopted a variety of
barriers to entry, there is no competition to drive these responses intended to reduce the impact of monopoly.
profits toward zero. Beginning with the passage of the Sherman Anti-
Trust Act in 1890, the federal government has sought
From the point of view of social welfare, the fact
to use legislation to increase market competition.
that Local Media is a monopoly has two effects.
As a result, large mergers and acquisitions must be
First, there is a transfer of consumer surplus to Local
reviewed by government regulators to insure that
Media because those subscribers willing to purchase
they do not reduce competition in key markets. Anti-
service at the monopoly price would have been
trust regulators can also break up companies, as
able to purchase this service at a lower price in the
happened when AT&T was split up in 1984, or take
competitive case. Second, there is a reduction in social
other steps to restrict anti-competitive practices, such
well-being because Local Media restricts supply to
as the requirements that Microsoft unbundle Internet
be less than the competitive quantity. The additional
Explorer from the Windows operating system.
output would cost less to produce than its value
to consumers. But, Local Media will not supply it Another widely used approach is regulation. Many
because to do so would reduce the revenue it gets from natural monopolies are allowed to exist but are closely
subscribers who place a higher value on the service. regulated. Public utilities such as electric power
companies and cable television providers cannot freely

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set prices, but must have rates approved by public Oligopoly
oversight agencies. A third approach to the problem Relatively few industries are true monopolies. In many
of monopoly is public ownership. Local water, sewer, more cases, a small number of producers supplies
and sanitation services are often operated by municipal the bulk of the market. In the United States, the
governments, for example. manufacture of tennis balls, breakfast cereals, aircraft,
electric light bulbs, washing machines, and cigarettes
Price Discrimination are all industries in which production is highly
In the monopoly example we considered before, we concentrated.7 Economists call a market with only a
assumed Local Media charged the same price to all few sellers an oligopoly.
of its customers. But, what would happen if it could
charge different prices to different customers? If Local In comparison to monopoly markets, oligopoly markets
Media could charge each customer a price equivalent are much harder to analyze. The reason for this is that
to the value that customer placed on its service, then in such markets, producers must consider not only the
it could avoid the negative effect of expanding sales characteristics of the downward-sloping demand curve
on the revenue earned from existing customers. By that they face, but also the choices that other suppliers
charging different prices, Local Media’s marginal will make. In other words, there is an opportunity for
revenue curve would be identical to the market demand strategic interaction between the different suppliers.
curve, and it would choose to supply a quantity
If the suppliers could agree, for example, to cooperate
equivalent to the competitive market outcome.
and behave like a monopolist, total industry profits
Such a strategy is called perfect price discrimination. could be maximized. Such an agreement is called
While companies can rarely discriminate perfectly a cartel, and it is illegal under U.S. anti-trust law.
between customers, it is easy to identify examples of There are also significant economic forces at work
ways that firms seek to separate customers into groups to undermine efforts by the members of potential

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who value their product differently. One way that cable cartels to collude. If a cartel is successful in restricting
companies can price discriminate, for example, is by output, then marginal revenue will be greater than
offering different packages of channels. Those who the marginal cost of production for each firm in the
value the service most highly are likely to buy a large industry, creating a temptation to increase production.
package at a higher price. Of course, such an increase in supply lowers the
market price, but much of this negative effect is felt by
There are many other examples of price the other members of the cartel.
discrimination. Many movie theaters offer lower priced
tickets for children and senior citizens, consumers The Organization of Petroleum Exporting Countries
who are likely to have a lower willingness to pay. (OPEC) provides a good illustration of the problem that
Airlines typically charge lower prices for travelers cartels face. Because it is an international agreement
who stay over a Saturday night. While leisure travelers between sovereign nations, OPEC does not face legal
will accept this condition in exchange for lower fares, obstacles to its efforts to coordinate production and
business travelers, whose willingness to pay is higher, raise prices. In the 1970s, OPEC played an important
will not. College need-based financial aid is another role in raising oil prices from $11 a barrel in 1972 to
price discrimination strategy. $35 a barrel in 1981. Tempted by the high price of oil,
many of its members began to increase production, and
Price discrimination further increases monopoly by 1986 oil prices had collapsed back to $13 a barrel.
profits by allowing the monopoly to capture a greater
fraction of the benefits produced by each transaction. As these considerations suggest, oligopoly outcomes
But, price discrimination also has the positive effect of depend critically on the circumstances of each market.
increasing social welfare by moving the market closer We can nonetheless conclude that the outcome will lie
to the socially efficient quantity. somewhere between the polar cases of monopoly and
perfect competition. As a rule then, oligopoly results in

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some reduction in social welfare, but we cannot easily product at more than the cost of increasing production.
say how large this reduction will be. The failure to complete these transactions is a failure
to fully exploit mutually beneficial exchanges. This
Monopolistic Competition failure occurs because of the firm’s monopoly incentive
Perhaps the most common form of imperfect to restrain production. Second, the diversification of
competition is monopolistic competition. As its products that results from the efforts of firms to create
name suggests, monopolistically competitive markets a distinctive identity for their product creates benefits
combine aspects of the perfectly competitive and for consumers by increasing the range of choices
monopoly models. Specifically, these are markets available to them.
in which firms produce similar but differentiated
products. An example of such a market is book CREATIVE DESTRUCTION:
publishing. Each particular title is unique and
distinctive, but there are thousands of titles for you to
THE PROFIT MOTIVE AND
choose from when you are looking for a book. Other THE SOURCES OF ECONOMIC
examples include restaurants, clothing, breakfast CHANGE
cereals, and many local service industries. When we considered the entry and exit of producers
Because the product of each firm is differentiated— in a competitive market in the previous section, we
meaning that you can tell the difference between its came to the somewhat surprising conclusion that even
product and those of other firms—the firm faces a though producers in a perfectly competitive market
downward-sloping demand curve. As a result, each would earn zero profits, they would be satisfied
firm chooses its output in the same way a monopoly with this result. In part this is a consequence of our
firm does, by finding the point at which its marginal definition of economic profits, which factors in the
revenue equals its marginal cost. Because the firm’s opportunity cost of all of the resources employed,
including the business owner’s time.

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demand curve slopes downward, marginal revenue
is less than price, so at this point the market price is Economic profits, then, are an additional payment
greater than the marginal cost of production. above and beyond the compensation that can be earned
We have seen that at the profit-maximizing quantity, in the next best alternative activity. We should not be
a monopolist will earn positive economic profits. In a surprised, then, that self-interested economic agents
monopolistically competitive market, however, if firms should seek to identify or create opportunities to earn
are earning positive profits this will lead to the entry economic profits. One important way that they can
of new firms supplying similar goods or services. As do this is by escaping the constraints of competitive
the range of choices available to consumers expands, markets. When producers can create barriers to entry,
existing firms will see their demand curves shift to the they can create situations of imperfect competition in
left, causing profits to fall. which they are able to earn economic profits.

Because there are no barriers to entry in a As we saw earlier, in comparison to a hypothetical

monopolistically competitive market, entry will competitive market outcome, imperfectly competitive
continue until profits have been reduced to zero. If at markets create inefficiencies because producers restrict
some point profits fall below zero, there will be exit supply as part of their effort to maximize profits. But,
from the industry, which will continue until the zero this comparison of different market structures fails to
economic profit equilibrium is restored. capture an important aspect of the actual way in which
economies evolve over time. One of the important routes
A full analysis of the welfare properties of that firms take to establish market power is innovation.
monopolistically competitive markets requires more
sophisticated mathematical analysis. But there are Entrepreneurs are individuals who take on the risk of
several points to note about such markets. First, attempting to create new products or services, establish
because price exceeds marginal cost, there is some new markets, or develop new methods of production.
social inefficiency: there are consumers who value the The rewards of entrepreneurship are the economic

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profits that can be earned by being the first to market opportunities for private profit tend to break down
with a new product. In the case of scientific innovation, efforts by cartels to restrict output. Where these forces
entrepreneurs can obtain a legal monopoly through are not sufficient, economic theory can help us to
patents; but in other cases market power arises because evaluate possible policy solutions.
of their ability to differentiate the goods or services
they produce from other products in the market. There are some circumstances, however, in which
Entrepreneurs can differentiate their product by competitive markets will fail to produce socially
defining the desirable characteristics of their product desirable outcomes. These circumstances are called
or by the possession of trade secrets. market failures. Most instances of market failure can
be grouped into two broad categories.
At the same time that innovation helps to create
barriers to entry that reward the innovator with The first type of market failure arises because of
economic profits, it also serves to break down existing externalities. An externality arises when the actions
market imperfections because the existence of profits of one person affect the well-being of someone else,
encourages efforts to invent around existing barriers but neither party pays nor is paid for these effects.
to entry. Examples of this include the development of When the effect of these actions is beneficial, it is
satellite television in competition with the monopoly called a positive externality; when the effect of these
of cable television and the efforts of mobile phone actions causes harm, it is called a negative externality.
manufacturers to imitate the Apple iPhone. The second type of market failure occurs when the
institution of private property breaks down. When it
The continued development of new and improved is impossible to establish private property rights in
products is one of the key sources of long-run important economic goods or services, we refer to the
improvements in well-being, a fact that economist goods or services in question as public goods.
Joseph Schumpeter sought to capture when he
described the impact of entrepreneurs as a type of Addressing the problems of externalities and public

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“creative destruction.” The essential catalyst of creative goods is one of the most compelling roles for
destruction is the opportunity to earn economic government in our economy. Economics allows us to
profits. But, the inefficiency in resource allocation that understand more precisely how the characteristics of
creates these economic profits is—in the view of many externalities and public goods affect market outcomes
economists—small in comparison to the benefits of the and can provide important guidance when considering
innovation to which it gives rise. the options for policies to correct these market failures.

MARKET FAILURES Externalities

A widely cited example of an externality involves
Our study of competitive markets has revealed the
beekeepers and apple growers. In the course of
remarkable way in which they coordinate the self-
producing honey, the bees pollinate the apple trees,
interested actions of market participants to produce
increasing the size and value of the farmer’s crop.
socially desirable outcomes. Market prices ration
Since the value of the apple crop does not figure
scarce goods and services so that they go to those
in the beekeeper’s costs or benefits, it constitutes
consumers who value them most highly. At the same
an externality. Since the farmer benefits from the
time, the search for economic profits encourages the
beekeeper’s actions, it is a positive externality.
allocation of scarce resources toward the production of
those goods and services that are valued most highly. One can easily find many other examples of similar
types of interactions. For example, when movie
Of course, not all markets fit the ideal of perfect
studios release movies on blu-ray discs, they increase
competition. But, in these cases, the opportunities
consumer demand for blu-ray disc players, which
to profit by facilitating mutually beneficial exchange
increases the revenue of their manufacturers. In this
encourages private actors to move closer to the socially
instance, the externality operates in the other direction
efficient outcome. Monopolists, for example, have an
as well because increases in the sale of blu-ray players
incentive to find ways to price discriminate, while the
increases consumer demand for the studios’ movies.

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When a new highway interchange is built on a busy cost of production, then, by drawing a new supply curve
freeway, it increases traffic on nearby roads, raising that is shifted up by $15 at every point. This is illustrated
their value as business locations. This is a positive in Figure 26b. Notice that the curve representing total
externality for the landowners. social costs intersects the demand curve above and to
the left of the private market equilibrium. The socially
Externalities can have negative consequences as well. optimal level of production is lower than the amount
If one of your neighbors fails to maintain his house, it supplied by a profit-maximizing firm because the firm
can have a depressing effect on the value of your home. fails to take account of the external costs.
Pollution is another example of a negative externality.
Runoff from farm fields containing traces of fertilizers An important implication of the analysis illustrated
and pesticides commonly finds its way into nearby in Figure 26 is that the optimal level of a negative
rivers. As a result, downstream communities that take externality is not zero. Rather, there is likely to be
their drinking water from these rivers have to spend some positive level of the externality that will be
more money treating this water before distributing it. consistent with maximizing consumer and producer
Concerns about climate change have focused attention surplus. This is true because the activity that generates
on the negative consequences of carbon-dioxide the externality has a positive value, and the cost of
(CO²) emissions. Again, because the businesses and reducing this activity too greatly will outweigh the
individuals do not take into account the negative additional benefits of reducing the externality.
impact of their activities on the global climate, this is
an externality. We can use a similar approach to analyze a case of
positive externalities. Figure 27 illustrates the market
The Effect of Externalities on Resource for honey that a beekeeper faces. Here the demand
curve reflects only the value that consumers place on
Allocation the honey the beekeeper supplies. But, since each unit
In general, there will be too little of an activity that of honey also results in an increase in the value of the

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generates positive externalities and too much of an crop of nearby orchards, the true social value of the
activity that generates negative externalities. To see activity is shifted up by the amount of this increase. As
this, let’s consider the example of a paper plant. As a this analysis suggests, the resulting equilibrium occurs
by-product of producing paper, the plant also produces above and to the right of the equilibrium when the
polluted waste that it dumps untreated into a nearby externality is not accounted for.
river. Figure 26a shows the market for the plant’s
primary product: paper. The firm’s supply curve is Private Responses to Externalities
upward sloping, reflecting the fact that its marginal The existence of externalities creates incentives for
costs are increasing as production rises. The demand market participants to attempt to solve the problems
curve is drawn as downward sloping. they create. In the case of the beekeeper and the apple
As we have seen, the competitive market equilibrium grower, total revenues would increase if the beekeeper
occurs at the point where the demand and supply expanded his production. This additional revenue
curves intersect. This is the quantity the profit- could be divided between the two parties so that both
maximizing firm will choose to supply. But this increased their profits. Similarly, in the case of the
decision does not take account of the social costs negative externality caused by the paper company, the
that the firm’s actions impose on the downstream downstream community could pay the paper company
community. For simplicity’s sake, let’s assume that the to produce less or to take other steps to prevent the
cost of removing the pollutant produced by the paper pollutant from entering the river in the first place. Again,
company is a constant amount of $15 per unit of paper such an arrangement would leave both parties better off.
that it produces. Another approach to solving the problem of externalities
The true social cost of the firm’s production is equal is to internalize them by combining the activities that
to the firm’s marginal cost plus the cost of treating the produce the externality within a single company. For
pollution it produces. We can represent the true social example, a maker of blu-ray players could purchase a

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FIGURE 26

(a) MARKET EQUILIBRIUM

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(b) THE SOCIALLY OPTIMAL LEVEL OF PRODUCTION

The Impact ofThea Impact

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

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movie studio so as to internalize the externalities that affected parties are prohibitively high. As an example,
the two businesses generate for each other. consider the emission of sulfur dioxide by power plants
in the Midwest. The sulfur dioxide combines with water
As long as the parties involved can negotiate with each vapor in the atmosphere to create acid rain that falls on
other, the private market should be able to resolve the the Northeast, damaging lakes and forests. The impact
inefficiencies created by externalities. This insight of this pollution is extremely diffuse, affecting millions
was first reached by Ronald Coase and is often called of people.
the Coase Theorem. To illustrate this point, consider
the case of two neighbors, Tad and Sue. Tad lets his Because there are a great many people who each suffer
grass grow long and does not take good care of his a small harm from acid rain, the total effect is quite
yard. Sue must look at the yard from her front porch, large. However, none of those affected have much
which reduces her enjoyment, and it also lowers the incentive to attempt to negotiate with the sources of the
value of her house. She can offer to pay Tad to take sulfur dioxide. In this instance, the costs of negotiating
better care of his yard. So long as the value she places are prohibitively high, and private parties cannot arrive
on the appearance of Tad’s yard exceeds the cost to at a solution.
him of caring for it, they will be able to negotiate an
appropriate payment that makes both of them better Government Regulation of Externalities
off. Of course, if the benefit to Sue is less than the cost When private bargaining fails, governments can
to Tad, then they will not reach an agreement, but in sometimes step in to resolve the matter. Since the
this case, that is the efficient solution. problem of externalities arises because the actions of
private parties do not fully reflect the social costs or
Notice that we have assumed that Tad is under no benefits of their actions, one solution is to use taxes or
obligation to maintain his yard. Suppose, however, that subsidies to correct this problem. An example of the
a local ordinance requires that he do so, and Sue can use of taxes to address externalities is the introduction
compel him to do so by reporting him to city officials.

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of a congestion charge in London in 2003. Under this
In this circumstance, Tad could negotiate with Sue, law, drivers entering a well-defined area of central
offering to pay her to put up with his poorly maintained London must pay a fee of about $16.
yard. If the value Sue places on having a well-kept yard
to look at is less than the cost to Tad of cleaning it up, At the time the congestion charge scheme was
they will be able to arrive at a bargain where he pays introduced, London had the worst traffic congestion
her to put up with his yard. If his cost of cleaning up of any city in Europe. It was estimated that drivers
the yard is less than the value Sue places on having spent nearly fifty percent of their time idling and that
his yard well maintained, then they will not reach a the economic value of time lost due to congestion
bargain, and he will be obliged to take care of his yard. was between $3 and $6 million each week.8 Although
But in this case, this is the efficient solution. congestion remains a significant problem in London, the
introduction of the fee has reduced vehicle traffic in the
As this example illustrates, Tad and Sue will arrive at original congestion charging zone by over 20 percent.
the efficient solution regardless of whether Tad is free
to ignore the upkeep of his yard or is required to keep Using taxes to remedy the effect of externalities is most
it neat. One of the important insights of the Coase effective when it is possible to estimate the value of
Theorem is that the initial distribution of rights does not the externality. In many cases, this information is not
affect the ability of the parties to come to an efficient readily available. So it may be more effective to reduce
agreement. So long as the property rights are clearly a negative externality by establishing a quota limiting
defined, the parties will arrive at the efficient solution. the activity that produces the externality. If such an
approach were to be used to reduce traffic congestion,
Of course, if matters were this simple, then externalities then a target number of vehicles would be set and
would be only a minor footnote rather than an important only that many permits would be issued. Of course, a
topic in economics. The reason they are often a problem problem with this approach is that the drivers who get
is that in many cases property rights are poorly defined, permits may not be those who value them most highly.
or nonexistent, and the costs of negotiating between the

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FIGURE 27

(a) SUPPLY AND DEMAND IN THE MARKET FOR HONEY

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

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

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 FIGURE 28

(a) VILLAGE INCOME

NUMBER AVERAGE VALUE NET INCOME INTEREST TOTAL VILLAGE

OF FISHERMEN OF FISH CAUGHT FROM FISHING + INCOME = INCOME

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

(b) MARGINAL REVENUE

NUMBER MARGINAL REVENUE

OF FISHERMEN FROM FISHING

1 30
2 10
3 5

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4 –5
5 –15
6 –20

When Some
WhenResources
Some Resources AreAre NotProperty
Not Private Private Property
But, this can be resolved by creating a market in which we consider what happens when valuable economic
drivers can buy and sell permits. resources have no owner.
The United States Environmental Protection Agency To illustrate the importance of private property, let’s
(EPA) has used this approach to deal with sulfur consider what happens to property that no one owns
dioxide emissions. After establishing a maximum in this simple example. A village located next to a lake
level of emissions, the EPA auctioned off the rights to has six residents, each of whom has $100 in savings
emit sulfur dioxide to the highest bidders. The owners they can use to either purchase a government bond
of these permits are allowed to trade them if they that pays 15 percent interest, or to purchase a fishing
discover that they can reduce pollution at a cost that is boat necessary to catch fish in the lake. The number of
lower than other potential polluters value the right to fish each resident can catch depends on the number of
emit pollutants. residents who catch fish. This relationship is shown in
the table in Figure 28. If only one villager purchases
Property Rights a boat, then he/she can catch $130 worth of fish, and
Having grown up in a market economy, the existence his/her net income is $30 ($130 in income minus the
of private property seems quite natural to most of $100 cost of the boat). If two villagers buy boats, then
us. However, the institution of property rights is not they catch $120 worth of fish each, and each earns a
a natural occurrence; it is a social innovation. The net income of $20. The average value of fish caught
importance of this innovation becomes clear when declines as additional villagers buy boats because

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they are all fishing in the same lake, and as each one the commons. When a resource is owned jointly, no
depletes the fish population, it becomes increasingly one takes account of the negative externalities caused
difficult for others to find fish. by overuse. We have seen in the previous section that
taxes or other regulations can ameliorate the effects
Imagine, first, that the villagers decide one at a of externalities. But a simpler solution is to create
time whether to purchase a boat or to invest in the property rights in the resource.
government bond, and that the decisions are public.
How many villagers will purchase boats? If a villager Suppose that in the previous example we allow for one
purchases the government bond, he/she will earn $15 of the villagers to purchase the lake. The owner can
interest income at the end of the year. He/she should then decide how many boats to allow on the lake. We
only purchase a boat if his/her income from fishing have seen that the most profitable choice is to allow a
is $15 or more. From the table, we can see that three single boat on the lake, which generates an income of
villagers will purchase boats. After three boats are $30. So, if the lake is privately owned, resources will
purchased, the fourth villager will see that his/her be allocated in the most efficient manner.
income from fishing will only be $10 and will choose
to purchase a government bond. Total income in the How much would one of the villagers be willing to
village will be $90 per year. Three villagers will earn pay to purchase the lake? Since the opportunity cost
$15 each from fishing (3·$15 = $45), and three villagers of investing in the boat is the $15 forgone interest, the
will earn $15 each from bonds (3·$15 = $45). owner of the lake would earn $15 profit if he or she
could use the lake for free. The most one of the villagers
Is this the socially optimal allocation of resources? would be willing to pay to purchase the lake is $100.
Suppose that the villagers got together and decided At this price, the purchase of the lake yields the same
collectively how to allocate their resources? To return as buying a government bond. If the villagers
maximize village revenue, the villagers should invest invest the $100 paid by the purchaser in a government
in fishing boats only if the marginal contribution to bond, then they can divide the additional income that it

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village revenue exceeds the marginal cost. In this case, generates, thus raising all of their incomes.
the cost of purchasing a boat is the opportunity cost of
not purchasing the government bond, or $15. The table Public and Private Goods
in Figure 28(b) calculates the marginal income from In the example we just considered, private ownership
fishing for each additional fisherman. The marginal of the lake solves the allocation problem created by
revenue generated by the first boat is $30. But the a common resource. But private ownership may not
purchase of a second boat raises income from fishing always be a feasible solution. Some resources like the
only to $40, so the marginal contribution to village oceans or the atmosphere are not easily privatized.
revenue is $10. The villagers should purchase just one Recent developments in economic theory have helped
boat. Total income will be $30 from fishing, plus $75 = to clarify the characteristics of goods that can easily be
5·$15 from interest income, or $105. privatized versus those that cannot. To understand this
distinction, we need to differentiate goods along two
When the villagers make their choices independently, dimensions.
they fail to account for the external effects of their
fishing on the income of other boat owners. Because The first of these dimensions is the extent of rivalry in
the fish in the lake are a common resource, one consumption. Most goods have the characteristic that
villager’s decision to purchase a boat and catch fish one person’s consumption of them reduces the amount
reduces the income that others can earn from fishing. that is available for others. For example, if you consume
The villagers do better when they decide collectively a slice of pizza, then there is one less slice available for
because they internalize the externality. your friend. We say that pizza is a rival good. On the
other hand, when you listen to a radio broadcast, your
The Effects of Private Ownership enjoyment of it does not diminish the ability of other
The example we have just considered is a version of listeners to enjoy it as well. The radio broadcast is a
a problem that is often referred to as the tragedy of non-rival good. Note that rivalry is not always a black

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 FIGURE 29

EXTENT OF RIVALRY IN CONSUMPTION

EXTENT OF
EXCLUDABILITY HIGH LOW

Private Goods Collective Goods

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

Common Resources Public Goods

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

Four Types
Four Typesof Goods
of Goods

or white condition. On a lightly traveled highway, the consumption, but a low degree of excludability. These

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presence of one driver may not interfere with the value are common resources that suffer from the problem
of the road to other drivers. But as congestion increases, of the tragedy of the commons: because no one owns
and traffic approaches the road’s capacity, then them, they will tend to be over-utilized. Fish in the
additional drivers will begin to have a negative effect. ocean provide an illustration. Every fish that is caught
by one person is not available to be caught by someone
The second dimension is the degree of excludability. else. But, because it is difficult to limit access, it is
This describes the ability to control who consumes the difficult to make the fish a private good.
good. National defense is a non-excludable good. If the
military protects the country from invasion, all of its Goods that are rival in consumption but not owned are
citizens benefit from this protection. Similarly, if your the source of externalities. As we discussed earlier,
city puts on a fireworks display on the Fourth of July, it there are strong incentives for private actors to find
is difficult to prevent people from seeing it. In contrast, ways to internalize these externalities. When these
it is easy to exclude someone from consuming a slice incentives are insufficient, however, public policy
of pizza by simply not giving it to them. Figure 29 can seek to establish property rights or use taxes
summarizes this two-way categorization. and other types of regulatory controls to address the
inefficiencies created by a common resource.
Private Goods
Conventional private goods are characterized by a high Collective Goods
degree of rivalry in consumption and a high degree of Goods that have a low degree of rivalry but a high
excludability. This corresponds to the entry in the upper degree of excludability (upper right corner) are termed
left corner of Figure 29. Examples of such goods are all collective goods. Such goods can easily be privatized,
around us—they include pizza, gasoline, and haircuts. but they are often natural monopolies because non-
rivalry in consumption means that the marginal cost
Common Resources of producing them is zero or close to zero. Examples
In the lower left-hand corner of the table in Figure include satellite radio and pay-per-view television.
29 are goods that have a high degree of rivalry in

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A monopoly can profitably supply these goods, but it important. Differences in standards of living around
has an incentive to set the price too high and supply the world are vast today, and economists believe that
too little, thus leading to an inefficient outcome. This in large part these differences are due to variations in
characteristic may lead to regulation or to government the success with which different societies have dealt
provision of collective goods. with the challenge of organizing collective decision-
making.
Public Goods
The final category of goods combines non-rivalry Collective decision-making begins with institutions.
in consumption with non-excludability. These are Institutions are both formal and informal rules that
true public goods. Because it is difficult to exclude structure human interaction. Most markets are, in
consumers, it is difficult for private actors to charge this sense, institutions; so too are marriage and
for these goods. And, because they are non-rival in child-rearing practices and norms such as how much
consumption, the marginal cost of their provision is to tip a waiter in a restaurant. Like institutions,
close to zero. organizations help to organize human interaction,
Many public goods are provided by the government. but do so through formal rules and structures.
But, in some instances public goods, such as television Commodity and stock exchanges are organizations
and radio broadcasts, are supported in other ways— as are corporations and organized religions.
such as through advertising or private donations. It is
likely, however, that when public goods are supplied An important limitation constraining institutions and
this way that the quantity supplied will be too low. organizations is the need for voluntary cooperation.
One illustration of this is the vastly greater number of For this reason, self-interested individuals will
channels available via cable and satellite TV than via conform to social institutions or participate in
over the air broadcast. Because subscribers to cable voluntary organizations only so long as that
cooperation makes them better off. Cooperation in

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or satellite providers pay directly for programming, a
much greater variety of content is available than can be some contexts can indeed improve social welfare, but,
supported by advertising alone. as we have seen in the case of cartels, there can be
powerful incentives to cheat on voluntary agreements.
INSTITUTIONS,
In comparison to private institutions and
ORGANIZATIONS, AND organizations, government possesses two distinctive
GOVERNMENT powers. The first of these is the ability to tax its
One of the central insights of economics is how citizens. Private businesses can earn revenue only by
markets help to convert the actions of self-interested selling their products. Consumers will only buy their
individuals into socially desirable outcomes. As we products if they value them more than their prices.
have seen, however, this conclusion may not hold In contrast, government can compel the payment of
when producers have a degree of market power, or taxes. Of course this power is not absolute. In the
when market failures occur because of externalities United States, citizens are free to move between
or circumstances that make it difficult to define cities, counties, and states, and they can vote with
private property rights. In these cases, collective their feet if they dislike the level of taxation in one
decision-making mechanisms may be necessary area by moving someplace else. Similarly, citizens of
to overcome the effects of these departures from any of the member countries of the European Union
perfect competition. are free to move from one country to another. Other
types of international mobility are more limited. The
Understanding how collective decision-making United States imposes significant restrictions, for
processes have emerged in modern economies is example, on legal immigration into the country, as
a complex topic, and we can only begin to touch do most other countries.
on the most important insights of this branch of
economics here. But the topic is, nevertheless, vitally The second distinctive power of government is the

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legal monopoly on the legitimate use of force. This sundae for $4. You value the sundae at no more than
power is used to restrain criminals, compel military $3, so if you were dining alone you would skip dessert.
service, and to protect national security. Clearly the But you do the math and realize that if you order the
government’s ability to use force underlies its ability sundae your share of the bill will only increase by $0.80
to collect taxes. The government’s ability to compel ( = $4/5). As result, you order it. Not surprisingly, your
citizens to act in ways that are not in their individual friends make a similar calculation for themselves, and
self-interest is also essential to supporting a system you wind up paying an additional $4 each.
of private property on which the whole system of A similar logic is at work in the legislative process.
voluntary exchange rests. A member of the House of Representatives might,
Government also helps to support a broader range for example, be able to introduce an amendment
to a bill that will bring $100 million in benefits
of voluntary cooperation than would otherwise be
to his/her district. The cost of the program to the
possible through activities such as the enforcement
federal government is $150 million (so clearly the
of contractual obligations. Contracts represent
costs outweigh the benefits). But the cost to the
agreements entered into voluntarily because both community is just a small fraction of this, since it
parties anticipate that they will gain from the will be supported by all taxpayers, not just those
agreement. But, subsequent changes may cause one in the affected community. For the representative’s
party to regret having entered into the agreement. constituency this is a terrific deal. They get $100
Without the courts to enforce such agreements, million in benefits for a small fraction of this amount
individuals would be far more reluctant to enter into in increased taxes.
them in the first place.
Of course the legislation has to get the support of a
The powers that governments possess are truly majority of the House members to be passed into law.
awesome. As we have suggested, they can be used Why would a legislator representing another district

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to fix problems that prevent private economic actors support legislation that will increase the cost to his
from achieving efficient outcomes. But government constituents without producing any benefits? The
can also be a source of inefficiency and corruption. answer is that by supporting his/her colleague’s pet
We must remember that both elected officials and project, the legislator can win support for his/her own
government employees are themselves self-interested pet project. This vote trading activity is commonly
economic agents, whose interests may diverge from called logrolling, and much like the restaurant
those of the larger community. Economics can help example above, it accounts for a certain amount of
us to identify and understand these conflicting forces wasteful government spending.
more clearly.
Rent Seeking
Pork Barrel Politics A related source of inefficiency arises because
Pork barrel politics refers to the proclivity of elected the gains from many government programs are
officials to introduce projects that steer money to their concentrated, while the costs are spread widely. An
communities. Such projects are often popular with the example of this problem is the current U.S. policy of
voters who matter for the particular legislator, but the price supports for domestic sugar producers. These
combined effect of these projects is to increase the cost supports combined with restrictions on the importation
of government. of cheaper sugar from outside the country keep U.S.
sugar prices at nearly twice world levels. The cost to
To understand this problem, it may help to think about U.S. consumers is over $1 billion a year. Spread across
an experience you may have had before. You have gone a population of over 300 million, the cost per person is
out with four of your friends to a restaurant and agreed relatively small. But the benefits to the small number of
that to simplify matters you will split the bill evenly. sugar producers are much larger. Sugar growers have a
When the waiter asks if you want dessert, you look at strong and compelling motivation to hire lobbyists and
the menu and see that you can purchase a hot fudge spend money to influence key legislators to continue

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price supports. Most voters, however, are unaware of participants are well informed about the market
this policy, and even those who are aware of it would price, and the good or service being exchanged
be unlikely to find it worth the effort to oppose it. is highly standardized.
Even when the overall benefits of projects exceed The demand curve graphs the quantity of a
their costs, they may generate wasteful resource good or service that buyers are willing and
allocation. Competition to influence the location of able to purchase at each price. According to
expensive federally supported activities can lead to the law of demand, the quantity demanded is
the expenditure of large amounts of money seeking to negatively related to the price.
influence decision-makers. The position of the demand curve depends
on income, the prices of related goods, tastes,
In general, socially unproductive activities that seek expectations, and the number of buyers.
simply to direct economic benefits to one set of actors
rather than another are called rent seeking. The supply curve graphs the quantity of a good
or service that producers are willing and able
What Is the Proper Role for Government? to supply at each price. According to the law
Determining what functions the government should of supply, the quantity supplied is a positive
play, how big it should be, and how much it should function of the price.
regulate are normative judgments that must be made The position of the supply curve depends on
on grounds that extend beyond purely economic the prices of inputs used in the production
considerations. Nonetheless, economics helps to of the good or service being exchanged, the
illuminate the issues and frame these choices more technology used to produce it, expectations,
clearly. and the number of sellers.
Government is not essential to the establishment of In a perfectly competitive market, equilibrium

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a market economy, but the enforcement of the rule occurs when no market participant has any
of law helps to support a much broader range of reason to alter his or her behavior. The only
transactions than would be possible without it. Most point that satisfies this requirement is the point
of us are willing to accept the small loss of individual where the supply and demand curves intersect.
autonomy for the protection of property and the The competitive market equilibrium
individual security that this entails. But, unconstrained maximizes the combined benefits or total
government can become an intrusive force that can surplus of market participants.
substantially reduce individual freedoms. One important use of the competitive market
Similarly, government can, as we noted earlier, correct model is to analyze how changes in economic
market failures arising because of externalities and conditions affect the equilibrium price and
public goods; however, the ability to rectify these quantity as well as the surplus of market
problems also gives rise to inefficiencies. People may participants.
genuinely differ in their evaluation of the relative costs Elasticity provides a measure of the
and benefits of these trade-offs. responsiveness of supply and demand to price
changes that is independent of the units used to
SECTION II SUMMARY measure price and quantity.
The interaction of supply and demand in Governments intervene in markets for a variety
markets is the central topic of microeconomics. of reasons. They may set price ceilings or price
A market consists of all the buyers and sellers floors. Governments may also impose taxes on
of a particular good or service. certain types of transactions to raise revenues
The model of a perfectly competitive market to pay for essential services.
applies to situations in which the numbers Trade makes people better off. International
of buyers and sellers is large, all the market trade increases total surplus.

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Not everyone in an economy benefits from production.
trade, however, which explains why there is Market failures occur when externalities or
often opposition to free trade. breakdowns in the system of private property
Firms are the economic actors who supply cause market outcomes to deviate from the
goods and services by combining labor, capital, socially efficient outcome.
raw materials, and other inputs to produce the Externalities occur when there are important
products consumers want to purchase. Firms economic interactions that do not take place
seek to maximize their economic profits. through markets. One solution is to create a
In a competitive market, the entry and exit of market for these interactions; another solution
firms insures that the firms in the market earn is government regulation.
zero economic profits. All goods and services can be classified along
The model of perfect competition cannot be two dimensions: (1) the extent of rivalry in
applied to all parts of the economy. There consumption and (2) the ease of excludability.
are many different types of imperfectly This two-way classification allows us to
competitive markets. The most important cases identify four categories of goods and services:
are monopoly (a single supplier), oligopoly (a private goods, common resources, collective
small number of suppliers), and monopolistic goods, and public goods.
competition (many suppliers of similar but Institutions, organizations, and governments
differentiated products). help to organize human interactions through
Imperfect competition arises because of formal and informal rules. Governments are
barriers to entry into the market. distinguished from private organizations
Relative to perfectly competitive markets, through their ability to compel citizens to pay
taxes and their monopoly on the legitimate use

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imperfect competition results in a lower
equilibrium quantity and a higher equilibrium of force.
price. This outcome causes total surplus to be Government is an important factor in
lower than it would be in a competitive market. enhancing well-being through its support of
The economic profits that arise in imperfectly private property and market transactions,
competitive markets are the incentive that but pork barrel politics and rent seeking are
motivates entrepreneurs to develop new goods inefficient outcomes that arise because of how
and services, new markets, or new methods of governments operate.

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

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

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 FIGURE 30

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SOURCE: Louis D. Johnston and Samuel H. Williamson, “What Was the U.S. GDP Then?” MeasuringWorth, 2008.
URL: http://www.measuringworth.org/usgdp/.
All values expressed in 2005 prices.

Real Output of the

Real Output of theU.S. Economy,
U.S. Economy, 1900–20081900–2008

to 1945 (World War II). Viewed on this time scale, more output. But output has grown much faster
however, the impact of these events is dwarfed by the than population. Since 1900, the U.S. population
expansion of the size of the overall economy. has increased by a factor of four. Combining this
information with the data in Figure 30 implies the
At the level of the overall economy, what we can average output per person has increased by a factor
consume is limited by what we produce. One reason of nearly eight. Figure 31 illustrates the growth of
for the rising level of production historically has been output per person. Economists refer to this quantity
the growth in population. More people can produce as output (GDP) per capita. The term “per capita” is

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 FIGURE 31

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SOURCES:
Louis D. Johnston and Samuel H. Williamson, “What Was the U.S. GDP Then?” MeasuringWorth, 2008.
URL: http://www.measuringworth.org/usgdp/.
Carter, Susan B., “Labor force, employment, and unemployment: 1890-1990.” Table Ba470-477 in Historical Statistics of the United States,
Earliest Times to the Present: Millennial Edition, edited by Susan B. Carter, Scott Sigmund Gartner, Michael R. Haines, Alan L. Olmstead,
Richard
Sutch, and Gavin Wright. New York: Cambridge University Press, 2006. http://dx.doi.org/10.1017/ISBN-9780511132971.Ba340-651.
U.S. Department of Labor, Bureau of Labor Statistics, “Current Population Survey,” ftp://ftp.bls.gov/pub/special.requests/lf/aat1.txt.
Output valued in prices of 2005.

Real Output
Realper Capita
Output per Capita and
and per per
Worker,Worker,
1900–2008 1900–2008

a Latin phrase literally meaning “per head,” which is While average output per capita provides an indication
commonly used to denote averages calculated for an of what the typical person can consume, economists
entire population. are also interested in changes in what the average
person can produce. The economy’s total output

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 FIGURE 32

GDP GDP PER CAPITA

BILLIONS OF $ INDEX (USA=100) $ INDEX (USA=100)

United States $13,751.4 100.0 $45,592 100.0

Germany $3,317.4 24.1 $40,324 88.4
France $2,589.8 18.8 $45,452 99.7
United Kingdom $2,722.0 19.8 $36,509 80.1
Japan $4,384.3 31.9 $34,313 75.3
South Korea $969.8 7.1 $20,014 43.9
Russia $129.1 0.9 $9,079 19.9
Brazil $1,313.4 9.6 $6,855 15.0
Mexico $1,022.8 7.4 $9,715 21.3
China $3,205.5 23.3 $2,432 5.3
India $1,176.9 8.6 $1,046 2.3
Pakistan $142.9 1.0 $879 1.9
Egypt $130.5 0.9 $1,729 3.8
Ghana $15.1 0.1 $646 1.4
Nigeria $165.5 1.2 $1,118 2.5

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Output and Output
Output andper
OutputCapita
per Capita inin 2007
2007 in Different
in Different Countries Countries
divided by the total number of workers employed is percent of output per person in the United States. This
called average labor productivity. This is a measure is less than $2 per day.10
of how much the typical worker can produce. The
second (higher) line in Figure 31 shows the history of Even in the United States and other advanced
average labor productivity since 1900. economies, such as those of Japan and Western
Europe, there are still many people living in poverty.
The average output per person in the U.S. economy But even the poorest citizens of these countries enjoy
in 2008 was over $43,000. To put this figure in access to a bounty of material goods that far exceeds
perspective, Figure 32 compares total output and the consumption possibilities of the typical resident of
output per person in the United States to a selection countries at the bottom of the list in Figure 32.
of other countries around the world. The range of
variation in production per person is remarkably large. Human happiness, of course, depends on more than
Despite having a population nearly five times as large just the material level of consumption that we are able
as the United States, China’s total production is still to achieve. Living a long and healthy life, access to
only a fraction of that of the United States, and total education, and a clean environment are also important.
output is only about one-fifth the size of the United But, the reality is that the material resources created
States’, and its per capita production is only about five by higher levels of production make possible longer
percent as large as the United States’. The countries life, broader access to education, better healthcare,
with the lowest levels of production per person in and a cleaner environment. These relationships are
this list are in Africa. In Ghana, for example, output illustrated in Figure 33, which shows the relationship
per person averages $458, or slightly more than one between output per person and several other indicators
of quality of life.

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 FIGURE 33

GDP LIFE EXPECTANCY ADULT INTERNET USERS

PER CAPITA, AT BIRTH LITERACY PER 1000
DOLLARS IN YEARS PERCENTAGE POPULATION

United States $45,592 77.9 99 630

Germany $40,324 80.3 99 455
France $45,452 80.2 99 430
United Kingdom $36,509 79 99 473
Japan $34,313 82.3 99 668
South Korea $20,014 77.9 99 684
Russia $9,079 65 99 152
Brazil $6,855 71.7 88.6 195
Mexico $9,715 75.6 91.6 181
China $2,432 72.5 90.9 85
India $1,046 63.7 61 55
Pakistan $879 64.6 49.9 67
Egypt $1,729 70.7 71.4 34
Ghana $646 59.1 57.9 18
Nigeria $1,118 46.5 69.1 38

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Output Per Capita and
Output per CapitaOther
and Other Development Indicators, 2007
Development Indicators, 2007

Recessions and Expansions The alternation of periods of expansion and recession

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

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 FIGURE 34

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Annual Percentage Change
Annual Percentage inGDP,
Change in Real Real GDP, 1900–2008
1900–2008

recessions and falls during expansions. You can see different industries, regions, and businesses within
that the unemployment rate was especially high during the economy. Even in expansions, some companies
the Great Depression. Figure 35 illustrates two other are closing, while others are growing. Even during the
important points about the unemployment rate. Great Depression, when many employers were laying
off workers, others were expanding their workforce.
First, the unemployment rate is never zero. There Second, despite the huge changes that have taken place
are always some people searching for work. This in the economy since 1900, there is no indication that
reflects the continual entry of new job-seekers into the unemployment rate is increasing in the long term.
the labor market as well as the shifting fortunes of

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 FIGURE 35

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SOURCES:
Carter, Susan B., “Labor force, Employment, and Unemployment: 1890-1990.” Table Ba470–477 in Historical Statistics of the United States,
Earliest Times to the Present: Millennial Edition, edited by Susan B. Carter, Scott Sigmund Gartner, Michael R. Haines, Alan L. Olmstead,
Richard Sutch, and Gavin Wright. New York: Cambridge University Press, 2006. http://dx.doi.org/10.1017/ISBN-9780511132971.Ba340–651.
United States, Bureau of Labor Statistics, http://www.bls.gov.

Unemployment as a Percentage
Unemployment ofCivilian
as a Percentage of the the Civilian
Labor Force Labor Force

Inflation choices within markets. When the price of a particular

We have seen that the prices of individual goods and good—say a gallon of gasoline—rises, this increase
services play a central role in coordinating individual signals consumers to reduce their consumption and

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 FIGURE 36

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NOTE: calculated as year-to-year change in the GDP Deflator
SOURCE: Louis D. Johnston and Samuel H. Williamson, “What Was the U.S. GDP Then?” MeasuringWorth, 2008.
URL: http://www.measuringworth.org/usgdp/.

Annual
AnnualRate of Inflation
Rate of Inflation

creates incentives for suppliers to increase production. worse off. We will see that inflation imposes other
When all prices rise together, economists call this economic costs as well. So, keeping inflation low is
inflation. Because inflation means that all the things another important goal of macroeconomic policy.
people consume are becoming more expensive,
inflation reduces purchasing power and makes people Figure 36 shows the U.S. inflation rate since 1900. As

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FIGURE 37

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SOURCE: Irwin, Douglas A., “Exports and Imports of Goods and Services: 1929-2002.” Table Ee376-384 in Historical Statistics of the United
States, Earliest Times to the Present: Millennial Edition, edited by Susan B. Carter, Scott Sigmund Gartner, Michael R. Haines, Alan L. Olmstead,
Richard Sutch, and Gavin Wright. New York: Cambridge University Press, 2006. http://dx.doi.org/10.1017/ISBN-9780511132971.Ee362-611.

Exports Exports
and Imports as a Percentage of GDP
and Imports as a Percentage of GDP

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this figure makes clear, the rate of inflation has varied detail how the most important macroeconomic
considerably over time. It was quite high during the variables are defined, and we will discuss the
First and Second World Wars and again in the 1970s. significance of these definitions.
Since the early 1980s, inflation has been quite low.
Since World War II, prices have risen consistently, but Measuring Total Output: Gross
before 1940, there were several periods in which prices Domestic Product
actually declined. Earlier we presented data showing the growth of the
total output of the U.S. economy. But, how can we
International Trade measure the total output of an economy? How do we add
National economies are linked to one another through up haircuts, personal computers, fast food hamburgers,
international trade. Because of its size, the United financial advice, automobiles, and the myriad other
States is relatively less dependent on trade than many goods and services produced by an economy?
other, smaller countries. Nonetheless, the level of
transactions between the United States and other The answer that economists have developed to this
countries has been increasing in recent years. question is called Gross Domestic Product (or GDP).
Formally, GDP is defined as: “the market value of all
Figure 37 plots the volume of exports from the United final goods and services produced within a country
States to other countries and the volume of imports to during a specified period of time.” This definition is
the United States since 1929 as a percentage of total short, but there are several important points to note
output. When exports exceed imports, economists about it.
say that a country is running a trade surplus. When
exports are less than imports, they say that a country is Market Value
running a trade deficit. To combine all the different types of things that a
country produces, we use their dollar value to add them
In the long run, the levels of imports and exports

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up. Suppose, for example, that an economy produced
appear to move in similar ways. But there have been
only two goods: t-shirts and shorts, and that t-shirts sell
shifts in their relative levels. Up until the late 1950s,
for $5 each, while shorts sell for $10. If the economy
the United States generally exported more than it
produced 100 t-shirts and 25 pairs of shorts, then its
imported. Since the 1970s, the relationship has shifted,
GDP would be 100 × $5 + 25 × $10 = $750. Because of
and imports are greater than exports.
the use of market prices, higher-priced goods contribute
more to total GDP. Recall from our discussion of
MACROECONOMIC microeconomics that market prices reflect the value that
MEASUREMENT the marginal consumer places on the good. So, goods
In our description of the behavior of the U.S. economy that have higher prices have a higher value to consumers
in the previous section, we made use of concepts like and therefore should contribute more to total output.
the total national output, inflation, and unemployment.
Constructing measures that capture the overall Final Goods and Services
behavior of the national economy involves aggregation. Most of the products we consume are the result of a
Aggregation is the combination of many different things complex chain of production activities. For example,
into a single economic variable. Well-constructed automakers purchase steel from refiners, who in turn
economic aggregates help us to see the big picture, but purchase iron ore from a mining company. Because
at the cost of obscuring important details. the automobile is the end product of this chain of
purchases, we count only its value in GDP and exclude
Developing appropriate economic aggregates is the purchase of inputs that are used up to produce the
an important branch of macroeconomics, and car. Goods that are used up in the production of a final
understanding the choices that go into the construction good are called intermediate goods.
of these aggregates is important if we are to fully
understand what their behavior tells us about the Excluding intermediate goods from GDP insures that
economy. In this section, we will describe in more our measure of GDP is not affected by the extent of

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vertical integration in the economy. This is important manufacturer or by a foreign-owned one.
to avoid the possibility of double counting the value
of some goods. To see this, consider the following During a Specified Period
alternative scenarios. First, suppose a steel producer Production takes a certain amount of time, but we only
sells $200,000 worth of steel to an auto manufacturer, include items that are produced between the beginning
and the auto manufacturer converts the steel into and end of the period in question. Conventionally
$1 million worth of automobiles. The steel is an economists consider either annual or quarterly (three-
intermediate good because it is used to produce the month periods) GDP. An important implication is that
automobiles. Now, suppose the automaker produces its the sale of goods produced in earlier periods is not
own steel and sells $1 million worth of automobiles. included in GDP. For example if a twenty-year-old
Notice that in both cases the value of the steel is house is sold this year for $150,000, then this amount is
included in the value of the automobiles. By excluding not included in GDP. The house was not produced this
the transaction involving the intermediate good, we year. It was included in GDP when it was produced, so
arrive at the same contribution to GDP regardless of we don’t count it again when it changes hands. On the
the pattern of industry ownership. other hand, if the real estate agent who arranged the
sale received a 6 percent commission, this $9,000 fee is
Some goods can be either final goods or intermediate included in GDP since the real estate services the agent
goods. In this case, we only count that portion of provided were produced in the current year.
production that is sold to final users. As an example,
suppose Sylvia raises tomatoes. In one year, she Understanding What GDP Measures
produces $200 worth of tomatoes. She sells $100 The conceptual basis for the measurement of GDP
worth at a local farmers market and uses the other was developed in the 1930s. Interest in measuring
$100 worth to make tomato sauce, which she sells economic output is longstanding, however. One of the
for $200. Sylvia’s contribution to GDP is $300—the earliest known efforts to measure national output was

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result of adding the $100 worth of tomatoes she sells to undertaken by Sir William Petty in the mid-1600s as
consumers and the $200 worth of tomato sauce. We do part of the British government’s effort to assess the
not count directly the $100 worth of tomatoes used to ability of the Irish people to pay taxes to the crown.
produce the sauce, but it is reflected in the value of the
final product that it is used to produce. Because the lack of comprehensive data on national
economic activity was hampering efforts to respond to
Capital goods do not fit easily into either of the the Great Depression, in 1932 the U.S. Department of
categories we have discussed so far. Capital goods are Commerce commissioned the economist Simon Kuznets
long-lived goods that are themselves produced and are to develop a system to measure national output. Kuznets
used to produce other goods and services but are not presented his system in a report to the U.S. Senate
used up in production. Machinery and factory buildings in 1934. The U.S. entry into the Second World War
are examples of capital goods. For the purpose of provided an additional impetus for perfecting techniques
consistency, economists have adopted the convention of measuring output and establishing the necessary data
that capital goods are included in GDP in the year they collection tools to produce ongoing estimates of GDP.
are produced. If we did not count them, then a country In 1971, Kuznets received the Nobel Prize in Economic
that invested in its future by building capital equipment Science in part for his contributions to the measurement
would appear to have a lower GDP than one that used all of national production.12
its resources to produce consumer goods.
The continued use of the concepts developed by
Within a Country Kuznets, and their subsequent refinement by other
The word “domestic” in Gross Domestic Product scholars, reflects the practical value of these concepts.
indicates that we count only goods produced within the But, it is important to recognize that despite the
borders of the country that we are discussing. So, U.S. usefulness of these ideas, they have a number of
GDP includes the value of all automobiles produced in important limitations. Three of these are described
the United States, whether made by an American auto below.13

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First, as we have already noted, it is not always easy to expenditures on new houses are included in investment
determine what constitutes final goods and services. rather than in consumer durables. Consumer
One illustration of this point is the treatment of nondurables are goods that are used up more quickly
expenditures on national defense. Conventionally these than durable goods, such as food or clothing. Services
are included in GDP, but Kuznets pointed out that they are intangible goods such as education, legal services,
might equally well be viewed as an intermediate good insurance, and financial services.
that enables the citizens of a country to enjoy other
final goods and services. Spending by firms on final goods and services, along
with household purchases of new houses, comprise
A second limitation of GDP arises from its exclusion investment. Investment is subdivided into three
of goods that are not bought and sold in markets. One categories. Business purchases of factories, offices,
very important example is unpaid household work. machinery, and equipment is called business fixed
Housekeeping and childcare performed by family investment. The purchase of new homes and apartment
members are not counted in GDP, but if these services buildings is called residential fixed investment. The
are purchased in the market, then they are. Over the final category of investment spending is inventories,
past sixty years, as women have increasingly entered which consists of additions of unsold goods to
the paid labor force, the amount of commercially company inventories.
provided childcare and housecleaning has increased,
causing GDP to rise. But, because some of this increase Notice that economists’ use of the word “investment”
is simply a shift from non-market to market activity, it is somewhat different from the word’s use in ordinary
does not in fact reflect an increase in total production. conversation. In ordinary conversation, we often
describe the purchase of financial assets, such as
A third limitation of conventional GDP measurement shares of stock or bonds, as making an investment.
is that it ignores activities that deplete a country’s Such purchases transfer ownership of an existing
stock of natural resources or pollute the environment. financial or physical asset, but do not create new assets.

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Although economic theory provides some guidance In economics, the term “investment” is reserved for
about how natural resources and environmental quality the purchase of new capital goods, such as buildings or
should be valued, actually measuring their value has equipment.
proved more difficult.
Government purchases include all of the goods
Other Ways to Measure GDP: and services purchased by federal, state, and local
governments. These include wages paid to firefighters
Expenditures Equal Production and teachers and purchases of fighter planes for the
GDP is a measure of the quantity of goods and services military. In addition to purchasing goods and services,
produced in a country. But, since goods that are governments make transfer payments, such as paying
produced are also purchased, we can also think of GDP Social Security benefits. These transfer payments are
as a measure of the total value of expenditures within not counted in government purchases of goods and
a country. Economists divide purchasers into four services and neither is interest paid on government debt.
categories: households, firms, government, and the
foreign sector (that is foreign purchasers of domestic Net exports is the difference between the value
products). Each of these categories corresponds to a of domestically produced goods sold to foreigners
category of spending. (exports) and the value of foreign-produced goods
purchased by domestic buyers.
Household purchases are called consumption
expenditures, or consumption for short. These The relationship between GDP and the various
purchases are subdivided between consumer durables, categories of spending can be summarized by
nondurables, and services. Consumer durables are the equation GDP = C + I + G + NX, where C
long-lived consumer goods such as automobiles, is consumption, I is investment, G is government
washing machines, and furniture. Note that spending, and NX is net exports.

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 FIGURE 38

T-SHIRTS SHORTS GDP

QUANTITY PRICE QUANTITY PRICE NOMINAL REAL

2000 100 $5.00 25 $10.00 $750 $750

2005 200 $7.50 50 $15.00 $2,250 $1,500
2005 relative to 2000 2 1.5 2 1.5 3 2

T-SHIRTS SHORTS GDP

QUANTITY PRICE QUANTITY PRICE NOMINAL REAL

2000 100 5 25 10 $750 $750

2005 200 7.5 75 15 $2,625 $1,750
2005 relative to 2000 2 1.5 3 1.5 3.5 2.33

Calculation of Real GDP

Calculation of Real GDP

Yet Another Way to Measure GDP: the quantity of goods and services produced.
Income Equals Production Equals The problem posed by changing prices is illustrated
Expenditures in the example shown in the top panel of Figure 38.

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We have seen that GDP can be measured either in This table reports prices and quantities for an economy
terms of production or spending. In addition, GDP can producing just two goods in two years. Between 2000
be thought of as income. Whenever a good or service and 2005, GDP tripled, rising from $750 to $2250. But,
is sold, the revenue is distributed between the workers if you look more closely at the quantity data, you can
and the owners of the capital used to produce it. Except see that output of both t-shirts and shorts has doubled.
for some minor technical adjustments, the combined Because prices increased by 50 percent, however, GDP
income of labor and capital equals expenditures, tripled while the physical volume of production doubled.
which equals production. As a result, we can state the
In this case, it is simple to isolate the effects of
following important identity: GDP = Production =
changes in the physical quantity of production from
Expenditures = Income.
the effects of changes in prices, but in most situations
For this reason, economists use these three different the quantities produced of some goods are increasing,
designations interchangeably when discussing the while others are decreasing. Prices, too, will not
nation’s GDP. change in a consistent way. To isolate the effects
of changes in production from changes in prices,
Real GDP economists construct real GDP by using prices from
Recall that GDP is calculated by adding up the market a single year to value production in each year. This
value of all the goods and services produced (purchased) year is called the base year. For the example shown
in a country during a specified period. As a result, the in Figure 38, if we use the prices in 2000 as the base
size of the resulting sum depends on both the quantity of year, then real GDP in 2005 would be calculated by
goods and services produced and their respective prices. taking the 2005 levels of production and multiplying
Because economists are often interested in comparing by the 2000 prices of each good. That is, real GDP
the level of economic activity over time or between in 2005 = 200 × $5 + 50 × $10 = $1,500, twice the
different locations, it is important to have a way to real GDP in 2000 and consistent with the doubling of
separate the effects of changes in prices from changes in production of each good.

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The bottom panel of Figure 38 illustrates the year, we set the cost of the bundle in this year equal
calculation of real GDP in a more complicated to 100, and calculate the CPI in the other years using
situation where production does not grow at the same the following formula: CPI in year t = 100 × (cost of
rate for the different goods. In this case, the quantity bundle in year t)/(cost of bundle in base year).
of t-shirts doubles, while the quantity of shorts
produced triples. Using 2000 prices as the base year, Notice that the quantities of each item in the bundle
GDP in 2005 is now $1,750 = 200 × $5 + 75 × $10. determine the impact of that item’s price changes on
To clearly distinguish the current year GDP from the overall index. Because consumers purchase three
real GDP, economists commonly call GDP calculated t-shirts and only one pair of shoes, a change in the price
with current year prices nominal GDP. As Figure of t-shirts will cause a larger change in the CPI than will
38 shows, nominal GDP in 2005 is $2,625. The an equivalent dollar increase in the price of shoes.
increase in real GDP is $1,750 / $750 = 2.33, which is The CPI is of considerable practical importance in our
somewhere between the quantitative increase of the economy. Each year, Social Security benefit payments
two products of the economy. are adjusted to reflect changes in the cost of living as
reflected in the CPI. Similarly many union employment
Measuring Inflation contracts include cost-of-living adjustment provisions
To measure inflation, the U.S. Bureau of Labor Statistics that tie wage increases to the CPI. More informally,
calculates the Consumer Price Index or CPI each employers and employees take into account changes in
month. The CPI measures the cost of purchasing a the CPI when considering adjustments in wage rates.
market basket of goods and services intended to be
representative of the consumption of a typical consumer. The goal of the CPI is to measure how changes in prices
To identify the components of the market basket, the affect the ability of households to maintain the level of
Bureau of Labor Statistics (BLS) conducts periodic well-being they enjoyed in the base year. What the CPI
surveys of consumer expenditures in which a sample actually measures, however, is how changes in prices

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of households collects careful records of all of their affect the cost of a fixed bundle of goods and services.
expenditures. These responses are then aggregated This difference means that the CPI will typically
to create a picture of the types and amount of goods overstate the true increase in the cost of living. This
and services purchased each month by representative upward bias in the CPI arises for three reasons.
households. Different market baskets are calculated for
consumers at different income levels and for those living The first factor causing the CPI to overstate the effect
in different parts of the country to reflect differences in of rising prices on the cost of living is substitution
consumption patterns. bias. As relative prices change, households will shift
their consumption away from more expensive goods
Each month BLS employees visit stores, check and services and toward less expensive ones. When
websites, and otherwise collect actual price information the price of beef increases, for example, families will
(including any temporary discounts offered by retailers) consume more chicken; when airline ticket prices
for all of the items in the market basket of goods decline, consumers will choose to fly more and drive
determined by the Consumer Expenditure Survey. The less. By adjusting their consumption toward less
BLS then combines these price data with the quantities expensive goods, households can achieve the same
in the market basket to calculate the cost of purchasing level of well-being at a cost that is lower than the cost
this bundle of goods and services. Finally, this cost is of buying a fixed basket of goods and services.
expressed as an index number relative to the cost of the
bundle in the base year. The second source of upward bias in the CPI is
unmeasured quality change. Many goods and services
Figure 39 illustrates this calculation for an economy in get better over time due to technological change.
which the consumption bundle consists of three items: In the past several decades, for example, personal
pants, t-shirts, and shoes. We see that the quantity computers have steadily become more powerful
consumed each month is two pairs of pants, three because of increased processor speeds, greater storage,
t-shirts, and one pair of shoes. Using 2000 as the base and better software. Similarly, the addition of anti-

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 FIGURE 39

Household Consumption Bundle

QUANTITY

Pants 2 pairs
T-shirts 3
Shoes 1 pair

CPI Calculation
PANTS T-SHIRTS SHOES CONSUMPTION BUNDLE
PRICE COST PRICE COST PRICE COST COST INDEX (2000 = 100)

2000 10 20 5 15 25 25 60 100.0
2001 10 20 7 21 30 30 71 118.3
2002 11 22 7 21 35 35 78 130.0
2003 12 24 8 24 50 50 98 163.3
2004 14 28 10 30 50 50 108 180.0
2005 13 26 10 30 40 40 96 160.0
2006 14 28 11 33 45 45 106 176.7

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CalculationCalculation
of theofConsumer
the Consumer PricePrice
Index Index

lock brakes, airbags, satellite radio, and GPS systems effects were reflected in measures of inflation. Only
has substantially improved the quality of the typical after cell phones had achieved a relatively large market
automobile. Such quality improvements would be penetration were they added to the CPI basket.
expected to raise the price of these goods, so a simple
comparison of prices between one year and the next In 1996 the Boskin Commission, headed by economist
will overstate the price increase or understate any Michael Boskin, carefully reviewed the methods used
decline in prices. Although BLS statisticians try to calculate the CPI and concluded that the combined
to account for these quality changes, they are very effects of substitution bias, quality improvement, and the
difficult to remove completely from the CPI. introduction of new goods meant that the CPI overstated
the rate of price inflation by 1.3 percent per year.14
The third reason the CPI overstates the true rate of
inflation is because of the introduction of new goods The CPI is just one way that economists measure
and services. A striking example of this is the cell changes in the cost of living. The relationship between
phone. The first cell phones were introduced in the real and nominal GDP provides a slightly different
mid-1970s. Prior to this, mobile communication was perspective on inflation. This measure is called the GDP
simply unavailable at any price for most consumers. deflator, and it is defined by the following equation:
Because cell phones did not exist, they were not Nominal GDP = (GDP Deflator/100) × (Real GDP).
included in the market basket used by the BLS to That is, we define the GDP deflator to be an index
calculate the CPI. During the early years of their number, such that when we multiply real GDP by that
development, prices for cell phones fell rapidly, and index number we get the nominal GDP. Dividing both
the quality of service vastly improved. But, because sides of the equation by Real GDP and multiplying
cell phones were not included in the CPI, none of these both sides by 100, we can state this relationship as:

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GDP Deflator = 100 × (Nominal GDP)/(Real GDP). in the household into one of three categories:
Figure 40 compares the rate of inflation as measured Employed. If that person worked for pay either
by the CPI and the GDP deflator since the early full- or part-time during the previous week or
1960s. As this comparison illustrates, they tell similar is on vacation or sick leave from a regular job.
stories about the cost of living, but the GDP deflator Unemployed. If that person did not work during
is somewhat less volatile, rising less at peaks and the previous week but made some effort to find
decelerating less at low points. Over the entire period, paid employment during the past four weeks.
the GDP deflator has risen somewhat less than the CPI.
Out of the labor force. If that person did not
There are several reasons for these differences. The work during the past week and did not actively
first difference is that the GDP deflator reflects only the seek work during the previous four weeks.
prices of domestically produced goods. To the extent Together these three categories comprise the
that foreign produced goods have a larger role in the working-age population. The sum of the employed
CPI market basket, differences in their behavior will and unemployed constitutes the labor force, and the
show up in differences in the two indexes. One reason unemployment rate is the quantity of people unemployed
the CPI rose so much more than the GDP deflator at the expressed as a percentage of the labor force.
beginning and end of the 1970s is that rising oil prices
had a large effect on the CPI, but because this was Figure 41 shows data on the U.S. labor force collected
mainly produced overseas, it did not affect the GDP by the BLS in August 2009. The table shows that there
deflator. are approximately 236 million working-age persons
in the United States. Of these, 154.6 million are in
The second reason the GDP deflator and the CPI diverge the labor force. The ratio of those in the labor force to
has to do with the way in which they weight the prices the working-age population is called the labor force
of different goods and services. Whereas the CPI uses participation rate. The participation rate is about

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a fixed market basket to weight the prices of different 66 percent. Of those in the labor force, roughly 140
goods, the GDP deflator weights prices by their current million had jobs, and 15 million were unemployed,
levels of production. As a result, the basket of goods resulting in an overall unemployment rate of 9.7
used to weight prices in the GDP deflator adjusts to percent. The unemployment rate was highest among
changing consumption patterns over time. the teenage population—close to one out of every
four teenagers was unemployed. There were also
Unemployment significant differences in the unemployment rate by
Macroeconomists use a variety of indicators to gauge race, ethnicity, and gender.
the state of the economy. The unemployment rate
is an especially sensitive indicator of how well the There are many reasons why some people are
economy is performing at any moment. When the unemployed. Economists divide these reasons into
unemployment rate is low, workers feel secure in their three broad categories.
jobs, and competition between employers helps to
drive up wages. When unemployment is high, however, Frictional Unemployment
workers worry about losing their jobs. The U.S. economy is remarkably dynamic. Every
month several million workers leave their jobs
The unemployment rate is defined as the percentage either voluntarily (i.e., they quit) or involuntarily
of the labor force that is unable to find a job. The labor (i.e., they get laid-off), and several million more
force, in turn, consists of all working-age adults who are hired. Because job-searching takes time, many
are either employed or are actively seeking work. In of these workers show up as unemployed for brief
the United States, the Bureau of Labor Statistics (BLS) periods of time. An additional source of frictional
is responsible for measuring the unemployment rate. unemployment comes from new workers entering the
To do this each month, the BLS surveys approximately labor force for the first time. Frictional unemployment
60,000 households. Based on a series of questions, refers to the portion of the unemployed who are
interviewers classify every person age sixteen or older currently not working because of the normal process of

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 FIGURE 40

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Comparison ofComparison
CPI and GDP
of CPI Deflator,
and GDP 1960–2008
Deflator, 1960–2008 (1960=100) (1960=100)

matching employees and employers. In the 1980s, for example, the U.S. steel industry
was contracting while the computer industry was
Structural Unemployment expanding. Not only were laid-off steel workers located
Sometimes the jobs that are available require different in the industrial northeast far from expanding Sunbelt
skills or characteristics from those possessed by the industries, but many of them also lacked the skills to
workers who are seeking employment. The locations pursue such jobs.
of job-seekers and vacancies may also be different,
preventing those seeking employment from filling the Cyclical Unemployment
available positions. That portion of total unemployment During recessions, unemployment rises as lay-
attributable to the mismatch between job openings offs increase, and new hires decline. In these
and job-seekers is called structural unemployment. circumstances, job-seekers find it harder to find

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 FIGURE 41

Civilian Population and Labor Force (in 1000s)

Adult Non-institutional Population 236,086
Labor For ce 154,577
Employment 139,649
Unemployment 14,928
Not in Labor Force 81,509
Unemployment Rates (percentage)
All Workers 9.7
Adult Men 10.1
Adult Women 7.6
Teenagers 25.5
White 8.9
Black or African American 15.1
Hispanic or Latino Ethnicity 13
SOURCE: United States, Department of Labor, Bureau of Labor Statistics, “Employment Situation Summary,” Sept. 4, 2009.
http://www.bls.gov/news.release/empsit.toc.htm.

Employment and Unemployment

Employment and Unemployment in thein the
U.S., U.S.,
August 2009 August 2009

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employment, and many of them spend longer searching without computers, the internet, modern medicine, and
for work. The additional unemployment that occurs for all the conveniences we take for granted today that
this reason is called cyclical unemployment. were not available a hundred years ago? Many people
would conclude that no level of financial incentives
ECONOMIC GROWTH, would induce them to give up all of these modern
conveniences.
PRODUCTIVITY, AND LIVING
STANDARDS The improvement in living standards that has
Would you prefer to have an average income in the taken place in the United States in the last century
United States today or to have been the richest person is a manifestation of a broader phenomenon that
living in 1900? Earlier we saw (Figure 31) that output economists call economic growth. The phenomenon
per capita, or more precisely real GDP per capita, of sustained economic growth began a little more
grew almost eight-fold between 1900 and 2008. In than two hundred years ago in the United States and
other words, the value of goods and services available Western Europe. During the nineteenth and twentieth
to the average person today is eight times as large as centuries, it spread to Japan and parts of Latin
what the average citizen could consume in 1900. But America, and since the 1950s to a growing number of
this comparison hardly captures the change that has countries around the world. Yet, when we look around
taken place in our economy and consumption patterns the world (Figure 33) there is still a strikingly large
over the past century. variation in material well-being and living standards.

In 1900, even the wealthiest American citizen could In this section of the resource guide, we will look at
not go to the movies, could not travel from the United what economists know about the factors that account
States to Europe in a single day, watch television, use a for differences in the standard of living over time and
computer, or get antibiotics to treat an infection. How between countries. That is, we will develop a theory that
much income would it take to compensate you to live explains the size of a nation’s economy in the long run.

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 FIGURE 42

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,

The Circular Flow

The Circular FlowModel ofEconomy
Model of the the Economy
The Circular Flow Model of the flows of real things—goods and services, inputs to
production—are drawn as arrows.
Economy
A useful starting point for our discussion is a To understand the model, begin on the left-hand
conceptual model of the economy called the circular side with households. Households receive income by
flow model, which is depicted in Figure 42. By tracing providing factors of production (labor, capital, land) to
the flow of dollars through the economy, this diagram firms. This transaction is reflected in the arrow leading
illustrates schematically the complex set of interactions from the households’ box to the factor market, and the
between the major sets of economic actors in our parallel arrow labeled income in the other direction.
economy: households, firms, and the government.
In this diagram, the major actors are depicted by Even though firms purchase many of the capital
rectangles, while the markets through which they goods in our economy, these capital goods are owned
interact are depicted as ovals. Flows of money and indirectly by households through their ownership of

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the firms, and it is appropriate to depict households The left-hand side of this equation is just real GDP per
as providing this capital to the firms in exchange capita. By cancelling out N in the two fractions on the
for rental payments. Households use their income to right-hand side, you can see that the right-hand side
purchase goods and services, to pay taxes, and to save reduces to GDP per capita as well, so this relationship
through financial markets. These three uses of their is always true. What this expression tells us is that
income are illustrated by the three arrows leading out the average quantity of goods and services available
of the box labeled households. for each person to consume depends on the average
amount that each worker can produce, or average labor
Firms receive revenue from the sale of goods and productivity, and the proportion of the population that
services (the arrow leading from the markets for goods is engaged in production.
and services) and use this income to pay for the factors
of production that they must hire to produce the goods Most of the variation in GDP per capita occurs because
and services that they sell. of differences in average labor productivity. In the
United States, labor force participation rates have
The government receives income from households in increased modestly in the last century as more women
the form of taxes, and the government borrows from have entered the labor force and as lower birth rates
financial markets. It uses these sources of income to have reduced the share of children in the population
purchase goods and services. and consequently increased the relative size of the
The final flow of funds illustrated in this diagram is working-age population. These trends have, however,
from financial markets to the market for goods and been offset by earlier retirement and longer education.
services. This flow represents borrowing by both As a result, virtually all of the increase in output
households and firms, which is used to purchase per person in the economy is explained by increased
consumer durable goods and capital equipment. average labor productivity. Figure 43 shows that there
is also a strong positive association between labor

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What Determines How Much an productivity and real GDP per capita across countries.
Economy Produces? Average labor productivity depends on a number of
As the circular flow model emphasizes, an economy’s different factors. The most prominent of these are the
output depends on the total quantity of goods and following:
services that firms are able to produce. This in
turn depends on the quantity of factor inputs that Physical capital. Workers equipped with more
households are able to supply to the firms and the and better tools, machinery, and up-to-date
ability of the firms to transform these inputs into the factories will be more productive. Modern
outputs that households and the government choose to manufacturing methods rely on the use of large
purchase. Larger economies will produce more (other quantities of capital per worker to achieve
things being equal) than smaller economies. But, this high levels of production. Recall that capital
source of variation cannot account for differences in equipment is a produced factor of production;
GDP per capita. so it is an input that in the past was an output
of the production process. As such, increasing
To explain differences in GDP per capita, it is helpful the capital stock in the future requires giving
to note that real GDP per capita is equal to real GDP up consumption in the present.
per worker multiplied by the fraction of the population Human capital. Human capital is the term
employed. Let POP stand for the country’s population, that economists use to refer to the skills and
and N stand for the labor force. Then, we can express experience that are acquired through education,
this relationship in the following equation: training, and on-the-job experience. Unlike
physical capital, human capital is not tangible,
GDP = GDP ⨯ N but like physical capital, creating it usually
POP N POP requires sacrificing current consumption.
Students and trainees must reduce the amount

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FIGURE 43

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Relationship Between GDP per
Relationship Between GDPCapita
per Capitaand Average
and Average LaborLabor Productivity,
Productivity, 2005 2005

of time they engage in productive activities income by importing raw materials produced
while they are learning. elsewhere.
Natural resources. Some countries or regions Technological knowledge. Economists refer
have natural resources like iron ore, petroleum, to the knowledge about techniques by which
or natural gas reserves that contribute to the inputs are transformed into the goods and
wealth of their citizens. The high standard services households desire as technological
of living of countries like Saudi Arabia and knowledge or simply technology. Advances in
Kuwait are in large part due to the fact that this know-how are the single most important
they are located on top of large pools of oil. On factor in raising average labor productivity
the other hand, in an increasingly global world, historically. These advances include the
natural resources are not essential to a high invention of entirely new products, like
standard of living. Countries like Japan have semiconductors, integrated circuits, lasers,
been able to achieve high levels of per capita and genetic engineering, as well as the

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 development of better methods of organization, development (R&D) is desirable. Because new
such as Henry Ford’s introduction of the knowledge is a true public good—since the utility of a
moving assembly line. discovery is not diminished by other people knowing
The political and legal environment. Some it—private incentives to create new knowledge may
kinds of technological knowledge are protected lead to underinvestment. As a result, there is an
by patents, and others may be kept as trade important role for government to play in encouraging
secrets. But, most of the know-how behind R&D either through tax credits, subsidies, direct
the high levels of productivity in advanced expenditures, or legal protections such as the patent
countries like the United States is available to system that give inventors a temporary monopoly on
be learned and copied. The very rapid growth the exploitation of their inventions in exchange for the
of living standards in Japan, South Korea, and disclosure of their discovery.
China illustrates that countries can catch up
quickly if they successfully borrow and adapt SAVINGS, INVESTMENT, AND
these techniques. Yet, the persistent poverty of THE FINANCIAL SYSTEM
other countries implies that there are obstacles As the preceding discussion makes clear, the quantity
to successful borrowing. The most persuasive of resources that an economy directs toward the
explanation for this is that dysfunctional formation of capital—both physical and human—and
political and legal systems prevent many toward the creation of new technological knowledge
countries from fully exploiting the potential plays a central role in determining the rate of
of modern manufacturing techniques. A growth of productivity, and hence the standard of
stark illustration of this point is the divergent living. In essence, we face—both as individuals
fortunes of North and South Korea. After and collectively—trade-offs between how much we
World War II both countries had similar consume today and how much will be available to
resources, populations, and standards of living.

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consume tomorrow. Devoting more resources to capital
Today, the South enjoys a standard of living formation or to research and development means
comparable with the most developed countries that there are fewer goods and services available to
while poverty and starvation are widespread in consume today. But, there will be more in the future.
the North. This variance is almost entirely due
to differences in governmental institutions. Recall that economists use the terms “saving” and
“investment” somewhat differently from how they are
The importance of the political and legal environment
used in common conversation. To economists, saving
illustrates that creating the appropriate incentives is an
is what happens when someone has more income than
essential prerequisite for achieving a high standard of
they wish to spend. Someone in this situation might put
living. But, what actions should policymakers seek to
the money they don’t want to spend now in a bank, or
encourage?
they might use it to buy shares of stock in a company.
Investment in both physical and human capital should They might think of this as investing their money, but
be encouraged, but only up to a point. Recall that to an economist, the term “investment” is reserved to
capital is created as part of the production process, so describe the purchase of new capital equipment. So, it
creating more capital to use in the future requires giving is only when the bank lends the money to a business
up current consumption. In the extreme, if all of our to construct a new factory, or the when the company
current output were directed to investment, there would uses the funds it receives from the sale of stock, that
be no goods and services available to consume, and we investment takes place.
would all starve. Long before this, however, diminishing
A variety of different financial institutions help to
returns would make it undesirable to keep investing.
coordinate the saving and investment decisions within
Similarly, investment in the creation of new our economy. It will be helpful to begin our discussion
technological knowledge through research and by examining several of these institutions in more detail.

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Financial Markets the business. The sale of shares of stock is called equity
Financial markets are institutions through which finance, whereas the sale of bonds is called debt finance.
individuals who have money they wish to save can
Most companies use both equity and debt finance
supply these funds directly to persons or companies
because these two methods of borrowing funds have
that wish to borrow money for investment.
very different characteristics. The purchaser of a share
The Bond Market of Wal-Mart becomes a part owner of the company. If
When a large corporation like Wal-Mart wants to Wal-Mart is profitable, then the shareholders enjoy the
borrow money to finance the construction of a new benefits of these profits either through the payment of
store, it can borrow directly from the public. It does this dividends or through an increase in the value of their
by selling bonds. A bond is a certificate of indebtedness shares. The bondholders only receive their interest
that specifies the obligations of the borrower to the payments. If, however, Wal-Mart runs into financial
holder of the bond. In other words, it is a sort of IOU. difficulties, the bondholders are paid before stockholders
The typical bond specifies when the loan will be receive any dividend payments. Purchasers of stock face
repaid—called the date of maturity—and the rate of greater risks than purchasers of bonds, but they also
interest to be paid periodically until the loan is repaid. have a greater potential for high returns.

The purchaser of the bond gives the company his or her Someone who buys shares of stock in a corporation can
money in exchange for the promise of repayment of the sell those shares on an organized stock exchange, such
original amount, called the principal, and the periodic as the New York Stock Exchange (NYSE) or NASDAQ
interest payments. The purchaser can hold the bond (National Association of Securities Dealers Automated
until maturity, or he or she can sell the bond to someone Quotation System). The price at which they can sell
else. As market interest rates change, the price at which shares depends on the supply of and demand for shares
the bond can be sold will change to equate the promised in the company. These, in turn, respond to the current
profits and future prospects of the company.

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payments of the bond with the new interest rate. This
potential variation in the value of a bond is a risk that It is important to recognize that when shares of stock
the buyer assumes. The longer the maturity of the bond are traded on a stock exchange, the company does
is, the greater the risk of such changes in price, and not receive any revenue from these transactions.
the higher the interest rate that borrowers must pay to Consequently, these transactions do not contribute
induce people to lend them money. to investment. Only new issues of stock contribute
The buyer of a bond also assumes the risk that the to a nation’s investment. The ability of shareholders
borrower may fail to pay some or all of the principal to easily buy and sell shares of stock on organized
or interest on the bond. The probability that the exchanges does, however, contribute to their
borrower will default on their obligation by declaring willingness to hold these assets by making it easier for
bankruptcy depends on the financial conditions of the them to access the wealth that they represent.
borrower. The greater this risk is, the higher the rate of
interest a borrower must pay to compensate lenders for Financial Intermediaries
this risk. Because the U.S. government is considered a An intermediary is a third party who acts as a link
safe credit risk, it can generally borrow at lower rates between two others. In developed economies, there
than private companies. By contrast, financially shaky are a great variety of intermediaries who help to link
corporations must pay high interest rates. savers and borrowers. Two of the most important
intermediaries are banks and mutual funds.
The Stock Market
Wal-Mart and other companies can also raise funds by Banks
issuing shares of stock and selling them to savers. Each Many small businesses, such as local construction
share of stock represents ownership of a portion of a companies or retail stores, are too small to issue bonds.
firm. If a company issues 10,000,000 shares of stock, When these businesses need to borrow money to finance
then each share represents ownership of 1/10,000,000 of investments that they are undertaking, they are likely
to turn to a bank. Banks get the funds that they lend by

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accepting deposits from people who have money they The second advantage of saving through a mutual
wish to save. Banks pay their depositors interest and fund is that it provides access to the knowledge and
charge borrowers more than they pay to depositors. insight of professional money managers. The skill and
knowledge of these professionals mean that individuals
The difference between the interest rate banks charge do not have to closely follow market developments.
and what they pay depositors covers the costs of
accepting deposits and making loans, as well as the Saving and Investment in
risk that some borrowers may be unable to repay their
loans and provides profits for the bank owners. Aggregate
Saving occurs when individuals earn more than they
Because most bank deposits are fully insured and can be wish to spend. Investment occurs when businesses or
withdrawn at any time, depositors correctly view them households purchase capital equipment or pay for the
as having little or no risk. The value of the deposits does construction of new buildings. Before considering how
not fluctuate with the fortunes of the bank’s borrowers, financial markets coordinate independent saving and
and all of the risks are borne by the bank owners. investment decisions, we need to consider how saving
and investment are measured at the aggregate level.
In addition to their role as financial intermediaries,
banks serve another important function in the Recall that for an economy, production (GDP) is equal
economy—they facilitate purchases of goods and to income and to expenditures. We can express the
services by providing checking accounts. We will equality of income and expenditures mathematically
discuss this aspect of bank activities in greater detail in in the following expression: Y = C + I + G + NX. In
a later section of the guide when we turn our attention this equation, Y stands for income, C is consumption
to monetary institutions. expenditures, I is investment, G is government
purchases, and NX is net exports. By virtue of the
Mutual Funds definitions of these quantities, this equality is an

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Mutual funds provide a way for savers with small identity—it is always true.
amounts of money to purchase bonds and stocks that
would otherwise be difficult for them to purchase. To simplify, we will begin by assuming that the
Mutual funds purchase a portfolio of stocks and bonds economy is closed; that is, it does not engage in any
and sell shares to savers. The value of the mutual fund’s international trade. As a result, net exports are zero,
shares fluctuates with the value of the portfolio of assets and the identity between income and expenditures can
that it owns. Mutual fund shareholders assume all of the be written as: Y = C + I + G.
risks of variation in the value of the shares.
Subtracting C + G from both sides of this expression,
Mutual funds are attractive to savers with small we obtain Y – C – G = I. The left-hand side of this
amounts of money for two reasons. First, mutual expression (Y – C – G) is national savings, S, since it
funds make it possible to achieve a higher degree of is the difference between income Y and expenditures
diversification than would be feasible through the by households, C, and government, G. In other words,
direct purchases of stocks and bonds. Holding the the identity between income and expenditures implies
stock or bonds of a single company is risky because the a second important identity: savings equals investment.
value of that financial asset depends on the fortunes of Written in symbols, this would be: S = I. Because this
that one company. Diversification reduces the potential is an identity, by definition it is always true.
ups and downs because some companies will do well
Further insight about this identity can be gleaned by
when others are suffering. For instance, discount
some further rearrangement. In the expression above,
retailers like Wal-Mart find that their sales may
we can add and subtract net taxes, T, from the left-hand
actually rise during recessions while department stores
side of the expression to obtain: S = Y – C – G = (Y –
that cater to more upscale tastes see their sales fall. By
C – T) + (T – G). The second and third expressions are
diversifying, savers can avoid tying the value of their
equal because the two T terms in the last expression
assets to the ups and downs of a single business.
cancel each other out.

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We can interpret this expression as saying that saving expression, and increases the net capital outflow.
is equal to the sum of private saving (Y – C – T)
and government saving (T – G). Private saving is the There are two types of international capital flows:
amount of money households have left over after they foreign direct investment and portfolio investment.
pay for their taxes and pay for their consumption. Foreign direct investment is used to describe situations
While taxes are an expense from the perspective of in which a company or individual acquires assets in
households, they are income for the government, a foreign country that they will manage actively. An
and the difference between government income, T, example of foreign direct investment in the United
and government purchases, G, is called government States is the purchase of Rockefeller Center in New
saving. If T – G is a positive number, then we say the York by the Japanese corporation Mitsubishi in 1989.
government runs a budget surplus. If T – G is negative, Portfolio investment occurs when an individual or
then we say that it runs a budget deficit. business purchases shares of stock or bonds issued by
a foreign corporation. When the Chinese government
One important implication that emerges from breaking purchases U.S. government bonds, it is making a
down saving into its components is that when the portfolio investment.
government runs a deficit, it reduces investment in
the economy, which reduces the growth rate of living In an open economy, net capital outflows (NCO) are
standards. precisely equal to net exports (NX). This equality
always holds because, like the equality of saving and
International Capital Flows in an Open investment, it is an identity. To see why, it is helpful
to consider an example. Suppose that Electronics
Economy Importers purchases a container full of video games
In an open economy, domestic savings no longer have from a Japanese manufacturer and pays them
to equal domestic investment because of the possibility $100,000. This purchase is an import, so it reduces net
of international borrowing or lending. Nonetheless, exports by $100,000.

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there is an important parallel to the relationships we
have just described and one that closely relates the The Japanese video game producer could put the
level of international trade with domestic investment. money in a safe. In this case, the owners of the
company are using some of their income to invest in
In an open economy, residents interact with citizens the U.S. economy by purchasing a domestic asset (U.S.
of other countries either in the world market for goods currency). As a result, net capital outflows decrease by
and services or in the world financial markets. In the $100,000, thus balancing the change in net exports.
same way that net exports measures the difference
between the sale of domestically produced goods to More realistically, the video game manufacturer might
foreigners and the purchase by domestic residents use the $100,000 to purchase U.S. government bonds.
of foreign-produced goods, we can define a second Or, they might take the money to a bank and exchange
concept—net capital outflow. The net capital outflow it for Yen. The company no longer has any dollars, but
equals the purchase of foreign capital or financial the situation has not really changed since now the bank
assets by domestic residents minus the purchase of faces the same choices as the company about what to
domestic assets by foreigners. do with the funds.
When Inbev, a Brazilian- and Belgian-owned brewing Another possible outcome is that the company uses the
company, purchased the U.S. company Anheuser- money to purchase U.S.-produced goods and services.
Busch, it resulted in the purchase of domestic assets For example, they might pay a U.S. advertising
by foreign residents. This purchase added to the company to develop new advertisements. If they spend
purchase of domestic (U.S.) assets by foreigners. the entire amount of their revenue, then this causes
Since we subtract such purchases, the net capital U.S. exports of services to increase by $100,000,
outflow decreased. When Intel builds a new factory in balancing the earlier imports. In this case, neither net
Taiwan, this results in the purchase of foreign assets by exports nor net capital outflows change.
domestic residents, so it increases the first term in this

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For the economy as a whole, the amount of net capital horizontal axis and the interest rate on the vertical axis.
outflows must exactly equal net exports. Returning to
the equality of income and expenditures for an open In the financial market, the interest rate functions as
economy, we have: Y = C + I + G + NX. the price of a loan. It is the amount that borrowers
must pay for the loan, and it is the amount that savers
Rearranging the terms of this equation we obtain receive for making the loan. For a lender, the decision to
Y – C – G = S = I + NX. save a dollar today is, in effect, a decision to postpone
consumption until some time in the future. Suppose the
But, we have just shown that net exports equals net interest rate is 10 percent per year. A saver who lends
capital outflows, so we can replace NX with NCO to $100 will receive $110 = $100 × (1 + 0.1) the following
get S = I + NCO. This states that domestic saving year. The possibility of consuming more in the future is
equals domestic investment plus net capital outflows. one of the principal motivations for saving.
In an open economy, savings can differ from investment, Of course, if prices are rising, the same bundle of
but only to the extent that the difference is offset by goods becomes more expensive next year, so what
net capital outflows. If foreigners are willing to lend to matters is the real interest rate, which is the nominal
domestic citizens (so NCO is negative), then investment rate minus the rate of inflation. If prices increase 10
can be larger than savings. Of course, foreigners percent per year, then it will take $110 next year to
make such loans with the expectation that they will be purchase a bundle of goods that costs $100 today. In
repaid at some point in the future. So, eventually the this case, the real interest rate will be zero, indicating
situation will likely be reversed, with saving exceeding that the saver receives no increase in purchasing power
investment to produce positive capital outflows. from postponing his or her consumption.
How Financial Markets Coordinate The higher the real interest rate is, the greater the
Saving and Investment Decisions rewards for being patient, and the greater the amount

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We have seen that by definition saving must equal that people will choose to save. As a result, the supply
investment in a closed economy. And, even in an open of savings is drawn as an upward-sloping line in
economy saving and investment are closely linked with Figure 44.
each other and with the net capital flows into or out of Businesses invest because they anticipate that the
the economy. But, what determines the level of savings additional capital equipment they are acquiring will
and investment that occurs in an economy? raise their revenues in the future. The price of making
For simplicity’s sake, we will again focus on a closed these investments is the real interest rate. So long as
economy, but the situation would be quite similar in an businesses expect that the additional revenues they will
open economy. In reality, there are a large number of receive will exceed the cost of borrowing the funds,
financial markets, but they are all closely linked to one businesses will be willing to borrow. The lower the
another because individuals with excess savings can real interest rate is, the larger the number of investment
easily move funds between markets to obtain the best projects that businesses will find profitable to pursue.
return for their money, while borrowers can similarly As a result, the demand curve for savings is drawn as
choose between many different markets. As a result, downward sloping.
it is convenient to collapse these many markets into a In the same way that competitive forces move prices
single financial market. in other markets toward the market equilibrium level,
In the financial market, the supply of savings and there are strong pressures on the real interest rate
the demand for savings (that is, the demand by firms that cause it to adjust to equilibrate the market. At an
for funds to purchase or construct new capital, or interest rate below the equilibrium level, borrowers
investment) are equalized through adjustments of would not be able to find enough savers willing to lend
the interest rate. This is illustrated in Figure 44. As them funds, and competition to obtain the available
before, we have graphed the quantity (in dollars) of funds would drive up the real interest rate. At an
supply (savings) and demand (investment) on the interest rate above the equilibrium, there would be

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 FIGURE 44

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Equilibrium in the
Equilibrium Financial
in the Financial Market Market

an excess supply of funds, and competition between government deficit; or, equivalently, a reduction in
lenders to find borrowers willing to take their funds government saving. With the government saving
would cause the real interest rate to fall. less or borrowing more, the supply of saving in the
economy is reduced at every interest rate, which is
Now that we have seen how the financial market shown as a leftward shift in the supply of savings
determines the real interest rate and the quantity of curve. Now the equilibrium shifts up and to the left.
saving and investment, we are in a position to consider As a result, interest rates are higher, and the total
how various events affect this equilibrium. Figure quantity of saving and investment in the economy is
45 illustrates three possible changes in the market lower. This tendency of government deficits to reduce
equilibrium. Panel (a) depicts the effects of a new private investment is called crowding out.
technology that raises the productivity of capital. As a
result, the demand for funds schedule shifts out to the The third example we will consider is the effect of a
right since businesses will want to borrow more money government tax credit to encourage savings. More
at every interest rate. Rising interest rates cause savings concretely, suppose that the government reduces the
to rise, and the new equilibrium occurs at a higher tax rate on interest income earned on savings accounts.
interest rate and higher level of savings and investment. In this case, as is illustrated in panel (c), the supply of
savings curve shifts out to the right. As a result, interest
In panel (b) we show the effect of an increase in the

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rates fall while saving and investment both increase.15 interest payments we give up.
Unit of Account. A unit of account is a
MONEY AND PRICES IN THE yardstick used to establish the value of
LONG RUN different goods and services. Expressing the
Having grown up in an advanced market economy, prices of goods and services in a common
it does not surprise us at all that we can walk into a unit of account greatly facilitates comparisons
store and hand over some small green pieces of paper of economic value. The use of money as a
and walk out with valuable merchandise. Nor does it medium of exchange is closely linked to its use
surprise us that the store owner will allow us to simply as a unit of account. Because money is used to
swipe a credit card through a magnetic strip reader or buy and sell things, it makes sense to express
write a check in payment for the merchandise. Money prices in money terms.
is a remarkable innovation that greatly facilitates Store of Value. A store of value is an item that
exchange in our economy. Without it, we would be people can use to transfer purchasing power
forced to barter, finding people who have the items from the present into the future. When a seller
we wish to acquire and who are willing to accept accepts dollar bills today in exchange for a
something that we are willing to give up in return. good or service, that seller can hold onto those
bills for weeks or months before becoming
Because money represents purchasing power, the
a buyer. Paper currency is only one of many
quantity of money in circulation in an economy can
stores of value, but—unlike stocks or bonds—
have a powerful influence on the level of economic
it pays no interest and offers no opportunities
activity. Too much money can lead to inflation, and too
for appreciation in value.
little money can lead to deflation. This section begins
by defining more precisely what we mean by money. Economists use the term “wealth” to describe all
Then, we will describe the forces that determine the of the different stores of value in an economy. An

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quantity of money in the economy. Finally, we will important characteristic that distinguishes different
consider how money affects prices and output. assets that make up wealth is their liquidity. Liquidity
is a measure of the ease with which an asset can be
What Is Money? converted into the economy’s medium of exchange.
While we all have an intuitive sense of what money is, Currency is clearly the most liquid asset, but deposits
it is important in economic analysis to have a clearer held in checking accounts, most stocks and bonds,
and more precise definition. To economists, money is and shares of mutual funds can be easily used to
any asset that has three functions. It is a medium of complete transactions and are thus also highly liquid.
exchange, a unit of account, and a store of value. These In contrast, real estate and collectable antiques require
functions distinguish money from other assets, such as more effort to sell and are consequently less liquid.
stocks and bonds, paintings, real estate, or barrels of
oil. Let’s consider each function of money. Throughout history many things have functioned as
money. These can be divided into two categories:
Medium of Exchange. A medium of exchange commodity money and fiat money. When an item
is an item that buyers can use to purchase with some intrinsic value is used as money it is called
goods and services. For money to function commodity money. The use of precious metals such
as a medium of exchange, sellers have to as gold or silver is an example of commodity money.
be confident that they can use the money Similarly, during World War II prisoners of war used
they receive to pay for the things they wish cigarettes as money to trade goods and services with
to purchase. The usefulness of money as a one another. When an item with no intrinsic value is
medium of exchange explains why people are used as money it is called fiat money. A fiat is simply
willing to hold onto it even though it earns an order or decree. The value of dollar bills as legal
no interest. The ability to quickly and easily tender is established by government decree.
complete a transaction compensates us for the

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FIGURE 45

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

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

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

The Effects ofThe

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

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Measuring Money is an institution created to oversee the banking system
To be able to analyze the effects of money on the and regulate the supply of money.
economy, a first step is simply to be able to measure
The Federal Reserve System was created in 1913
the amount of it. In the United States, the stock of
and consists of twelve regional banks owned by the
money is made up of several components. The most
commercial banks in their region, and the Federal
obvious of these is currency, which includes the
Reserve Board in Washington, D.C. The Fed is run by
paper bills and coins in the hands of the public. But
a board of governors that consists of seven members
currency is not the only asset that functions as money.
who are appointed by the President and confirmed by
The wealth represented by your checking account
the Senate. Governors’ terms are fourteen years, which
is nearly as good as (if not better than) currency. By
helps to insure that the actions of the Federal Reserve
writing a check or swiping your debit card, you can
system are insulated from political pressures.16
use this wealth to make purchases in the same way
you can use currency. Many other types of accounts, The twelve regional banks are largely responsible
such as savings accounts or mutual fund accounts, are for overseeing commercial banks in their respective
essentially equivalent to checking accounts. regions and for facilitating transactions by clearing
checks. They also act as a sort of bankers’ bank,
It is not easy to draw a line between assets that are
making loans to banks when they wish to borrow
“money” and those that are not. Dollar bills in your
funds. When a member bank is unable to obtain funds
wallet are money, whereas your house is not; but
from other sources, the Federal Reserve banks act as
there are many assets somewhere between these two
a lender of last resort to maintain the stability of the
extremes. For this reason, monetary economists have
overall banking system.
developed several different measures of the stock of
money in the economy. The most widely used are The task of controlling the quantity of money in the
called M1 and M2. The table in Figure 46 lists the economy, called the money supply, is the responsibility

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

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 FIGURE 46

M1 $1,366.6
Currency $758.7
Nonbank Travelers Checks $6.3
Demand (Checking) Deposits $294.8
Other Checkable Deposits $306.8

M2 $6,579.1
M1 $1,366.6
Savings Deposits $3,033.7
Small Denomination Time Deposits $1,218.9
Retail Money Funds $959.9

Components ofComponents
the Money Stock,
of the Money December
Stock, December 2007 (in Billions)
2007 (in Billions)

Let’s begin by considering how banks affect the money major purchase. The bank needs to keep some reserves
supply. To begin, let’s suppose that there are no banks to be able to pay its depositors, but this is likely only a
and that the money supply consists of $100 of currency. small fraction of total deposits.
Now suppose that someone establishes a bank offering
depositors a safe place to store their currency. The Suppose that the bank owners determine that they need

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bank accepts currency and stores it in its vault; when to hold reserves equal to just twenty percent of their
a depositor wants to make a purchase, the depositor liabilities. Then, they can lend out $80 to borrowers
goes to the bank, withdraws the necessary funds, and and receive interest income on this. Figure 48(a)
uses them to make a purchase. After the transaction is illustrates the bank’s situation now. On the right-hand
completed, the seller takes the funds and deposits them side the bank still has $100 in liabilities, but now its
in his or her account with the bank. assets consist of $20 in reserves and $80 in loans. Once
again, assets and liabilities exactly balance.
We can summarize the bank’s financial position
as shown in Figure 47. In this table, there are two Notice, however, what has happened to the money
columns: on the left we list the bank’s assets, while on supply. The bank’s depositors have $100 in deposits,
the right we list the bank’s liabilities. The bank’s assets and its borrowers have $80 in currency. The money
consist of the $100 in cash that it holds in its vault; and, supply has grown to $180. By holding only a fraction
its liabilities are the $100 in deposits that its depositors of deposits as reserves, the bank is able, in effect, to
can withdraw at any time. The bank’s assets and create money. This may seem to be too good to be true.
liabilities are in balance. Whether people hold currency But, it is important to understand that while the bank
or place it in bank accounts, the money supply in this has created more money, it has not created any more
economy is $100. wealth. Its borrowers have an additional $80 in assets
(the money they have borrowed), but they also have an
The situation depicted in Figure 47 is simple, but additional $80 in liabilities (the debt that they have to
it doesn’t offer the bank’s owners much opportunity repay). Because of fractional reserves, the bank makes
to earn a profit, and they will have noticed that most the economy more liquid, but it doesn’t increase the
of the money on deposit remains unused. Instead of total amount of wealth in the economy.
holding all $100 in deposits, they could lend some
of this out to people who wish to borrow funds to The process of money creation does not stop with the
purchase a house, pay for college, or make some other initial loans made by the bank. Its borrowers may

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 FIGURE 47

ASSETS LIABILITIES

Reserves $100 Deposits $100

Bank Balance Sheet

Bank Balance Sheetwith
with 100100 Percent
Percent Reserves Reserves
deposit the loan in another account until they make a have seen, the Federal Reserve can adjust the amount of
purchase with the funds. Or, once they have made a currency in circulation through open market operations.
purchase, the seller will deposit the funds that he or
she receives in his or her bank account. Figure 48(b) Suppose that the Fed has provided M dollars of
shows that now the bank’s liabilities have increased to currency. If the public chooses to hold C dollars as
$180 and its assets have grown to $180 as well—$100 currency, then the banking sector must be holding
in reserves and $80 in loans. M–C in reserves. The amount of currency plus
reserves is often referred to as the monetary base or
With $180 in liabilities, the twenty percent reserve high-powered money. If banks hold a fraction, R, of
ratio suggests that the bank should hold reserves equal each dollar of deposits as reserves, then there will be
to $36, which means it can lend an additional $64. (1/R) × (M–C) dollars of deposits, and C dollars of
Figure 48(c) shows the situation once it has made currency, so the money supply (which is deposits plus
these loans. Its liabilities remain the same, but now it currency) will equal.

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has $144 in loans and $36 in reserves. At this point,
the money supply has increased by $64, reflecting the C + M - C = R ⨯ C + M - C = M + (R - 1) ⨯ C
additional loans the bank has made. R R R
In due course the additional funds that the bank
has loaned will find their way back to the bank as If you experiment with this equation, you will find that
additional deposits. And, the cycle of loans and the smaller that C is, or the smaller that R is, the larger
money creation will continue until the total deposits the money supply will become.
equal $500, and the bank has $100 in reserves and In addition to open market operations, the Federal
$400 in loans. At this point, the bank cannot make Reserve has several other tools it can use to influence
any additional loans without falling below its twenty the supply of money in the economy. The Fed has the
percent reserve ratio. power to set reserve requirements for commercial
The amount of money the banking sector creates from banks. Banks can, of course, choose to hold reserves
each dollar of reserves is called the money multiplier. beyond this requirement, but manipulation of required
The money multiplier is the reciprocal of the reserve reserves is nonetheless a powerful lever. Because it is
ratio. If R is the reserve ratio, then each dollar of disruptive to the business of banking, however, the Fed
reserves will support $1/R of money supply. When only rarely makes changes in reserve requirements.
banks change the reserve ratio they hold, they can alter The third tool available to the Fed is the discount
the stock of money in the economy. rate, which is the interest rate that the Federal Reserve
To keep matters simple, we have thus far assumed that charges on loans that it makes to banks. Although
the public holds all of its money as deposits. In reality, banks rarely borrow directly from the Federal
the public’s behavior also affects the money supply Reserve because such borrowing suggests they may
through decisions about how much money to hold as be in financial difficulty, the discount rate is closely
bank deposits and how much to hold as currency. As we linked to the federal funds rate, which is the rate

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 FIGURE 48

Panel (a)
ASSETS LIABILITIES

Reserves $20 Deposits $100

Loans $80

Panel (b)
ASSETS LIABILITIES

Reserves $100 Deposits $180

Loans $80

Panel (c)
ASSETS LIABILITIES

Reserves $36 Deposits $180

Loans $144

Bank Balance Sheet

Bank Balance with
Sheet with Fractional
Fractional Reserves Reserves

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charged by banks when they lend reserves to other of last resort to prevent disruptions to the banking
banks. A higher discount rate discourages banks from system.
borrowing reserves. Thus, raising the discount rate
helps to reduce the quantity of borrowed reserves and Today bank runs are very infrequent, but in the past
therefore reduces the supply of money. they were a significant source of financial disruption.

Bank Runs Money and Inflation in the Long Run

One problem that can arise in a system based on Earlier we discussed how economists measure
fractional reserves occurs when the public suddenly inflation. Figure 40 showed how the cost of living has
decides that it wants to hold substantially more changed since 1960. The increase in the CPI shown
currency than it has been holding. Since banks have in Figure 40 implies that over the last half-century
reserves equal to only a fraction of their liabilities, the cost of a fixed basket of consumption goods has
they will not be able to pay all their depositors. If increased by a factor of a bit more than seven. (The
depositors begin to fear that they may not be able to ratio of the CPI in 2008—215.3—to the CPI in 1960—
withdraw their deposits, they will hurry to the bank to 29.6—equals 7.3.) Although prices have risen in
get their deposits ahead of other depositors. every year between 1960 and the present, a picture of
longer-term trends in prices would show that in some
Such a rush of withdrawals is called a bank run. Even years prices have actually fallen. The most significant
if a bank is solvent, meaning that its assets exceed its declines in the CPI occurred between 1929 and 1933,
liabilities, it will not have enough cash on hand to meet when the price level fell almost 25 percent, and
all of the demand, and it will be forced to shut its doors between 1920 and 1922, when the price level dropped
until loans are repaid or it can borrow additional funds a bit more than 16 percent.
or sell assets. When a solvent bank experiences a spike
in demand, it is the Fed’s responsibility to act as lender What causes the price level to rise or fall over time?

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

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In the long run, the value of money is determined in the
same way as the value of any other item in an economy: In Figure 49(b) we illustrate the effect of a doubling
by the interaction of supply and demand. We have just of the money supply. As the Fed adds to the money
seen how the supply of money depends on the Federal supply by purchasing government bonds, people find
Reserve and the banking system. When the Federal that they have more money than they want to have.
Reserve uses open market operations to sell bonds, the They may attempt to reduce their cash holdings by
supply of money contracts; when the Federal Reserve purchasing additional goods and services, or they
uses open market operations to buy bonds, the supply may lend the additional money to someone else by
of money expands. Because of fractional reserves, the depositing it in a bank or using it to buy stocks or
effects of these actions are magnified. But, the key point bonds. The extra supply of savings will cause interest
is that through its policy actions the Federal Reserve can rates to fall and will encourage businesses and
choose the supply of money. consumers to increase their spending.

The demand for money depends on how much of their The injection of more money into the economy thus
wealth people wish to hold as money, instead of in the causes an increase in the demand for goods and
form of other less liquid assets. The chief reason that services. But, the economy’s supply of goods and
people choose to hold money rather than other assets services has not changed. We have seen that the ability
is because of the usefulness of money as a medium of of an economy to produce goods and services depends
exchange. The greater use of credit cards will reduce on the available technology and on the quantities of
the need to use money; similarly, if automated teller labor, capital, and natural resources available. None of
machines (ATMs) are widely available, then people these has been changed by the additional money, so the
will likely carry less currency. But, the most important supply of goods and services should not change.
determinants of how much money people demand The combination of higher demand with a fixed
are the volume of transactions they engage in and the supply will cause the price of goods and services

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FIGURE 49
(a) INITIAL EQUILIBRIUM

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(b) EFFECTS OF A DOUBLING OF THE MONEY SUPPLY

Equilibrium in inthe
Equilibrium Market
the Market for Money for Money

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 The injection of more money into the economy thus produces 500 t-shirts and each sells for $5, then nominal
causes an increase in the demand for goods and services. GDP is $2,500. Suppose the supply of money is $250,
But, the economy’s supply of goods and services has not then velocity in this economy is $2,500/250 = 10. For
changed. We this
to rise. And, haveincrease
seen thatinthe ability
prices willofcontinue
an economy $2,500 in spending
the velocity to occur
of money, V, weusing
divideonly P ×$250
Y byinthecash,
number
to produce goods and services depends on the avail- each dollar must change hands an average of ten times
until prices have risen enough to cause the demand of dollars in circulation, M. That is: V = (P × Y)/M.
able technology and on the quantities of labor, capital, during the year.
for money
and natural to once again
resources equal None
available. the supply.
of theseOnce
has the
been igure 50 graphs nominal GDP, M2, and the velocity
FTo
economybyhas see why this makes sense, let’s consider a very
changed theadjusted,
additionalthe new equilibrium
money, so the supplyoccurs
of goods of money that they imply. As you can see in this figure,
at the
and point should
services labelednot
“B.” At this point, the value of
change. simple
over the past economy that produces
sixty years, nominal only GDPt-shirts.
and theIfstock
this
money has fallen by half (ordemand
The combination of higher with a the
equivalently fixedprice
supply of economy
money have produces
followed500 veryt-shirts
similarandgrowtheachpaths,
sells forwith$5,
will cause the price of goods and services to
level has doubled). In the long run, assuming nothingrise. And, thethen nominal
velocity of moneyGDPremaining
is $2,500.approximately
Suppose the constant.
supply
this
else changes, the increase in prices will be exactlyris-
increase in prices will continue until prices have of money
Using is $250,
this stability thenvelocity
of the velocity of in this economy
money, we can rear- is
en enough to cause the demand for money to once again range the quantity equation to obtain the
$2,500/250 = 10. For $2,500 in spending to occur using following ex-
proportional
equal to the
the supply. change
Once the in the supply
economy has of money.the
adjusted, pression: V×M = P × Y.
only $250 in cash, each dollar must change hands an
new equilibrium occurs at the point
This result—that in the long run an increase in the labeled “B.” At this This
average of ten timesthat
equation states the velocity
during the year.of money times
point, the value of money has fallen by half (or equiva- the quantity of money will be equal to nominal GDP.
supplythe
lently of price
money leads
level hastodoubled).
a proportional
In the increase
long run,inas-the So,Figure any increase in thenominal
supply ofGDP,
money will bethe
reflected
price level—reflects the long-run neutrality of money. 50 graphs M2, and velocity
suming nothing else changes, the increase in prices will in one of three ways: 1) as a fall in the velocity of money,
Theexactly
be neutrality of money
proportional tomeans that changes
the change in the supplyin the of 2) of money that they imply. As you can see in this figure,
an increase in real GDP, or 3) an increase in the price
quantity of money have no effect on real quantities in level. the past sixty years, nominal GDP and the stock
money. over
This
the result—that
economy. in the long
Monetary run an
changes onlyincrease
affectinnominal
the sup- Why of money have followed very similar growth paths,
ply of money leads to a proportional increase
quantities. Real quantities are things that are measured Inflationin the price with WOrry
the velocityAbOUT of moneyINFlATION?
remaining approximately
level—reflects the long-run neutrality of money. The is unpopular.
constant. Using this stability ofDuring thethe 1970s whenofinfla-
velocity money,
in physical units; for example, a bushel of wheat and a
neutrality of money means that changes in the quantity tion we rates
can reached
rearrange double
the digits,
quantity many consumers
equation to viewed
obtain the
tonmoney
of of steel haveareno real quantities.
effect on real Nominal
quantitiesquantities
in the econ- are inflation as the number one economic problem of the
things that are measured in monetary units;quantities.
examples country. following But,expression:
the neutralityV×M of =money
P × Y.suggests that
omy. Monetary changes only affect nominal
would
Real include are
quantities the things
price ofthat a bushel of steel in
are measured GDP in changes
orphysical in the aggregate price level should not matter
This equation states thatreal
the velocity of Despite
money times
units; for example,
current prices. a bushel of wheat and a ton of steel because they do not affect quantities. the
the quantity of money will be equal to nominal
are real quantities. Nominal quantities are things that neutrality of money, inflation does impose real costs on
Notice
are that the
measured relative prices
in monetary units;of different
examples goods
would and
include theGDP. So, any increase in the supply of money will
economy.
the price of
services area real
bushel of steel orFor
quantities. GDP in current
example, bushel of First,
if a prices. be reflected
although in inflation
one of three
doesways: 1) asrelative
not alter a fall in the
prices,

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Notice that the relative prices of different goods and it does
velocityreduce of the value2)ofan
money, money.
increaseIn effect,
in realinflation
GDP, or is3)a an
wheat costs $6, and a ton of steel costs $600, then the tax on people who hold money. As prices rise, the value
services are real quantities.
cost of steel relative to wheat is For example, if a bushel of increase in the price level.
wheat costs $6, and a ton of steel costs $600, then the of the currency people have in their wallets declines rela-
tive to the goods and services they want to purchase. As
cost of steel relative to wheat is Whypeople
a result, Worry willabout
reduce Inflation?
the amount of money they
$600 Inflation
hold. This meansis unpopular.
they haveDuring
to go to thethe 1970s
bankwhenor ATMinflation
bushels rates reached double digits, many
more frequently, which imposes an inconvenience. Infla-consumers viewed
ton inflation
tion also imposesas the anumber
cost ononefirmseconomic
because problem
firms haveoftothe
adjust the prices
country. But, theof their products
neutrality more frequently,
of money suggests that and
Since dollars appear in both the top and bottom terms thischanges can be aincostly process.
the aggregate price level should not matter
of this ratio, they cancel out of the equation, and we are Second,
becauseinflation
they do not introduces distortions
affect real quantities. intoDespite
pricing.the
Since
left withdollars
a ratio appear in bothquantities.
of physical the top and bottom ifterms
Similarly, the Because
neutrality
firms will not all adjust their prices at the same
wage
of thisrate is $10/hour
ratio, they cancel andouttheof price
the of an iPodand
equation, is $200,
we time, relative of money,
prices will inflation
not alwaysdoes imposereflect
accurately real costs
the on
the economy.
then taking
are left withthe ratio of
a ratio of the price of
physical the hourly relative costs of production. Recall that these prices play
an iPod toSimilarly,
quantities.
wage, an important role in coordinating economic decisions in
if the we
wage canrate
express the priceand
is $10/hour of an
theiPodpriceasof20anhours
iPadofis marketFirst,economies.
although inflation
Becausedoes not alter
of these relativethe
distortions, prices,
in-
work.
$500, then taking the ratio of the price of an iPad to the it does reduce the
The neutrality of money gives rise to a very useful tool formation conveyed by market prices becomes less valu- value of money. In effect, inflation
hourlythe
called wage, we can
quantity expressAs
equation. thea price
startingof an iPadletasus50 able.
point, is a tax on people who hold money. As prices rise,
hours of
define thework.
velocity of money as the average number Third,
the value inflation
of the introduces
currency peopleconfusion
have about
in theirthe true
wallets
of times a typical dollar bill is used during a year. If Y value of goods
declines and services
relative in the and
to the goods future. Remember
services that
they want
The neutrality
stands for real GDP of moneyand gives riseprice
P is the to a very
level,useful
then tool
the when someone with savings lends it, they
to purchase. As a result, people will reduce the amount are compen-
called the
nominal GDP quantity
= P ×equation.
Y measures As thea starting
value ofpoint,
goodsletand us sated by an interest payment for postponing their use of
of money they hold. This means they have to go to
define the velocity of money as the average number the bank or ATM more frequently, which imposes an
of times a typical dollar bill is used during a year. If Y inconvenience. Inflation also imposes a cost on firms
stands for real GDP andUSAD P is theEconomics
price level, Resource
then the Guide • 2016–2017
because firms have to adjust the prices of their products
85
nominal GDP = P × Y measures the value of goods and more frequently, and this can be a costly process.
services (and hence dollars) that change hands. To find

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 FIGURE 50

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SOURCES:
M2 — Federal Reserve Board, http://www.federalreserve.gov/releases/h6/hist/h6hist1.txt.
GDP — Louis D. Johnston and Samuel H. Williamson, “What Was the U.S. GDP Then?” MeasuringWorth, 2008.
URL: http://www.measuringworth.org/usgdp/.

Nominal GDP, Money

Nominal GDP, Stock,
Money Stock, and1959–2008
and Velocity, Velocity, 1959–2008

Second, inflation introduces distortions into pricing. compensated by an interest payment for postponing
Because firms will not all adjust their prices at the their use of that money until a future date. But, if they
same time, relative prices will not always accurately cannot accurately forecast the rate of inflation, they
reflect the relative costs of production. Recall that these cannot calculate how much purchasing power they
prices play an important role in coordinating economic will have in the future. Uncertainty about the rate of
decisions in market economies. Because of these inflation adds to the risks that both borrowers and
distortions, the information conveyed by market prices lenders face in credit markets, and this increased risk
becomes less valuable. reduces both the supply of savings and the demand for
investment. Because investment is crucial to economic
Third, inflation introduces confusion about the true growth, inflation reduces economic growth.
value of goods and services in the future. Remember
that when someone with savings lends it, they are

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SHORT–RUN ECONOMIC a non-profit organization of economists that has been
a major source of research on short-term fluctuations
FLUCTUATIONS in the economy. The NBER considers a broad array of
We noted earlier that macroeconomics is concerned different economic indicators in fixing the dates listed
with two issues: the long-term growth of the in Figure 51.
aggregate economy and short-term fluctuations. In the
preceding sections, we have developed a framework Looking at the data in Figure 51, the longest and
for understanding the forces that determine the long- deepest period of recession is the 43-month decline
run performance of national economies. This theory that began in August 1929, which has come to be
provides a useful description of how the economy known as the Great Depression. During this episode,
evolves over long periods of time of several decades the nation’s real GDP fell by more than one-quarter.
or more. But, it does not provide much guidance for Since the Second World War, periods of recession have
understanding the shorter-run deviations of economic tended to be relatively short, with only three stretching
growth from these long-run trends. longer than twelve months, and relatively mild in terms
of the decline in real GDP. Expansions have tended to
In Figure 30, we graphed the growth of real GDP in be much longer than the recessions, with most lasting
the United States between 1900 and 2008. If you look more than two years—a fact that is reflected in the
closely at that figure, you can see that superimposed on sustained upward trend of real GDP.
the upward trend in total output are some significant
fluctuations. In particular, the drop in output during We will begin our examination of short-run
the Great Depression (1929–33) stands out, as does fluctuations by describing their characteristics in
the rapid growth of production during World War greater detail. We will then develop a model that can
II (1941–45). According to the National Bureau of account for recessions and expansions and will use this
Economic Research (NBER), a recession is a period model to consider the role that government economic
between a peak and a trough in economic activity, policy can play in mitigating the negative effects of

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and an expansion is a period between a trough and business cycle fluctuations.
a peak in economic activity. During a recession,
a significant decline in economic activity spreads Characteristics of Short-Run
across the economy and can last from a few months Fluctuations
to more than a year. Similarly, during an expansion, Expansions and recessions have effects that are visible
economic activity rises substantially, spreads across throughout the economy and are characterized by
the economy, and usually lasts for several years. systematic patterns of change in a wide array of
In both recessions and expansions, brief reversals different macroeconomic variables. Two of the most
in economic activity may occur—a recession may important correlates of fluctuations in the economy’s
include a short period of expansion followed by further aggregate growth are unemployment and inflation.
decline; an expansion may include a short period of
contraction followed by further growth. A depression Figure 52 shows the unemployment rate from 1960
is a particularly severe or protracted recession. through 2008. The shaded portions indicate periods of
recession. It is apparent that recessions are generally
The recurrent alternation of expansions and characterized by rising unemployment. Typically
recessions is commonly referred to as the business businesses are slow to increase hiring in the early
cycle. Business cycles have been a characteristic of phases of an expansion, so declines in unemployment
industrial societies since at least the late eighteenth typically lag somewhat behind the onset of the next
century. The table in Figure 51 shows the dates and phase of economic growth.
duration of U.S. business cycles. A commonly used
rule of thumb is that periods when real GDP declines Like unemployment, the rate of inflation is also tied
for two consecutive quarters are recessions. The to the business cycle. Periods of expansion are often
determination of the dates on which recessions and characterized by accelerating inflation, and recessions
expansions begin and end is performed by the NBER, typically are linked to a slowing in the rate of inflation.

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 Figure 51
FIGURE 51

CONTrACTION ExpANSION FUll CyClE

(pEAk TO (TrOUGh TO (TrOUGh pEAk TO
TrOUGh) pEAk) TO TrOUGh) pEAk
TrOUGh pEAk mONThS mONThS mONThS mONThS
Jun 1897 Jun 1899 n/a 24 36 42
Dec 1900 Sep 1902 18 21 42 39
Oct 1904 May 1907 23 33 44 56
Jun 1908 Jan 1910 13 19 46 32
Jan 1912 Jan 1913 24 12 43 36
Dec 1914 Aug 1918 23 44 35 67
Mar 1919 Jan 1920 7 10 51 17
Jul 1921 May 1923 18 22 28 40
Jul 1924 Oct 1926 14 27 36 41
Nov 1927 Aug 1929 13 21 40 34
Mar 1933 May 1937 43 50 64 93
Jun 1938 Feb 1945 13 80 63 93
Oct 1945 Nov 1948 8 37 88 45
Oct 1949 Jul 1953 11 45 48 56

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May 1954 Aug 1957 10 39 55 49
Apr 1958 Apr 1960 8 24 47 32
Feb 1961 Dec 1969 10 106 34 116
Nov 1970 Nov 1973 11 36 117 47
Mar 1975 Jan 1980 16 58 52 74
Jul 1980 Jul 1981 6 12 64 18
Nov 1982 Jul 1990 16 92 28 108
Mar 1991 Mar 2001 8 120 100 128
Nov 2001 Dec 2007 8 73 128 81
SOURCE: Sutch, Richard, “Business cycle turning dates and duration - monthly: 1854-2001.” Table Cb5-8 in Historical Statistics of the
United States, Earliest Times to the Present: Millennial Edition, edited by Susan B. Carter, Scott Sigmund Gartner, Michael R. Haines,
Alan L. Olmstead, Richard Sutch, and Gavin Wright. New York: Cambridge University Press, 2006, Cb1-8; and NBER
Business Cycle Peaks, Turning Points, 1897–2008
http://wwwdev.nber.org/cycles/cyclesmain.html.

BusinessBusiness
Cycle Peaks,
Cycle Turning
Peaks, Turning Points, 1897–2008
Points, 1897–2008

and the level of cyclical unemployment. Specifically, he rate of potential output or could occur because actual
observed
Figurethat
rateBetween
twotrend
percent
every one
53 graphs
differed 1960
fromand
deviation
Business Cycle Peaks, Turning Points, 1897–2008
the percent
the1979,
natural
in the
that thesince
rate of inflation
rate
output
was
gap.
associated
In other
output falls above
unemployment
1960.Potential
with a
there was a generally upward
the
words,
in the rate of inflation, which makes the business
Natural
population,
Output,
theRate
or below
the potential.
rate atofwhich
Unemployment
The rateand
Output Gap,
of potential output depends on the growth rate of the
of growth

the capital stock increas-

if cyclical unemployment increased from 1 percentIn thinking about the short-run performance
es, and changes in the pace of technological of the
advances.
cycle effect somewhat difficult to see. But, if you to 2
percent, then the output gap would rise from economy, it is useful to think of the actual level
Over long periods, shifts in these underlying forces do
2 percent
look closely, you can see that the rate of inflation was
to 4declining
percent.during
This recessions.
relationship is called Okun’s Law. of GDP atimportant
produce any time as consisting of
modulations intwo
the parts:
pace oftheeconomic
potential
growth. But, most of the short-run variation ingap.
output of the economy and an output the level
ExplAINING ShOrT-rUN Potential output
of economic is the appears
activity quantityto
ofbe
goods
due and services
to the divergence
FlUCTUATIONS IN OUTpUT between actual and potential output.
What explains the recurrent alternation between peri- In a world in which prices would adjust immediately
ods of expansion and recession in the aggregate economy? to balance supply and demand in all markets, the econo-
Logically, variations in the rate of growth of output
2020–2021 over my’s
Economics resourcesGuide
Resource would always be fully employed, and ac-
time could be caused either by changes in the growth100tual output would not deviate from potential output. Ac-
 FIGURE 52

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SOURCES:
Carter, Susan B., “Labor force, Employment, and Unemployment: 1890-1990.” Table Ba470-477 in Historical Statistics of the United States,
Earliest Times to the Present: Millennial Edition, edited by Susan B. Carter, Scott Sigmund Gartner, Michael R. Haines, Alan L. Olmstead,
Richard Sutch, and Gavin Wright. New York: Cambridge University Press, 2006. http://dx.doi.org/10.1017/ISBN-9780511132971.Ba340-651.
United States, Bureau of Labor Statistics, http://www.bls.gov.

U.S. Unemployment
U.S. Unemployment Rate,Rate,
1960–20081960–2008

that the economy can produce when using its resources of the difference between actual output, which we’ll
(such as capital and labor) at normal rates. The level of denote by Y, and potential output. In other words, the
potential output is not fixed, of course, but increases output gap = Y – Y*. Figure 54 plots the growth of
over time as technology improves, and the economy actual output in the postwar period along with the
accumulates additional resources. trend growth of output between successive business
cycle peaks, which approximates the growth of
In the subsequent discussion, we will use the variable potential output. Relative to the trend growth of
Y* to denote potential output. The output gap consists output, deviations appear small in this figure, but they

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 FIGURE 53

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SOURCE: See Figures 40 and 51.

U.S. Price
U.S.Inflation, 1960–2008
Price Inflation, 1960–2008

nonetheless result in significant economic hardships. The natural rate of unemployment varies over time
due to changes in the labor market. During the 1970s
When output is below potential output, the economy’s and 1980s, the entry of many more women into
productive resources are not being completely utilized. the paid labor force helped to raise the natural rate
In particular, unemployment rises when the economy of unemployment, as did the decline of traditional
is below its potential output. Recall that unemployment manufacturing industries and the growth of the service
is conventionally divided into frictional, structural, sector. More recently, the natural rate of unemployment
and cyclical components. The cyclical component is has fallen.
the part that rises when the economy is in a recession.
Economists call the level of unemployment due to In the early 1960s, Arthur Okun, who was one of
frictional and structural causes the natural rate of President Kennedy’s chief economic advisors at the
unemployment. It is the level of unemployment that time, noted that there was a relationship between the
would exist when the actual output is equal to potential output gap and the level of cyclical unemployment.
output. Specifically, he observed that every one percent that

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 FIGURE 54

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SOURCE: Louis D. Johnston and Samuel H. Williamson, “What Was the U.S. GDP Then?” MeasuringWorth, 2008.
URL: http://www.measuringworth.org/usgdp/.

Actual and Trend

ActualReal Output
and Trend Real Outputfor
for thethe U.S. Economy,
U.S. Economy, 1946–2008 1946–2008
the unemployment rate differed from the natural rate Explaining Short-Run Fluctuations in
was associated with a two percent deviation in the
output gap. In other words, if cyclical unemployment
Output
What explains the recurrent alternation between
increased from 1 percent to 2 percent, then the output
periods of expansion and recession in the aggregate
gap would rise from 2 percent to 4 percent. This
economy? Logically, variations in the rate of growth
relationship is called Okun’s Law.
of output over time could be caused either by changes

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in the growth rate of potential output or could occur governments—federal, state, and local—on
because actual output falls above or below potential. goods and services. Transfer payments, such
The rate of growth of potential output depends on as Social Security benefits and unemployment
the growth rate of the population, the rate at which insurance, as well as interest payments on
the capital stock increases, and changes in the pace government debt are not included in this
of technological advances. Over long periods, shifts category.
in these underlying forces do produce important Net Exports (NX) is the difference between
modulations in the pace of economic growth. But, the value of goods and services produced
most of the short-run variation in the level of economic domestically and sold to foreigners and the
activity appears to be due to the divergence between value of goods and services produced abroad
actual and potential output. and purchased by domestic residents.
In a world in which prices would adjust immediately Although firms initially respond to variations in
to balance supply and demand in all markets, the demand by adjusting quantities, in the longer run
economy’s resources would always be fully employed, firms will adjust their prices to move back toward their
and actual output would not deviate from potential normal level of production. When demand is above
output. Accounting for deviations of actual output their desired level, firms will raise prices, causing
from potential output requires that we modify the basic inflation to accelerate; when demand is below their
microeconomic model of markets to account for the fact normal level of production, firms will lower prices,
that in many markets prices do not adjust immediately. causing inflation to slow.
The most common approach to modifying our model Over the long run, price changes eliminate the gap
of the economy rests on the observation that in many between actual and potential output and ensure that the
parts of the economy, firms do not constantly adjust economy’s resources are once again fully employed.
prices in response to fluctuations in market demand. Because these adjustments can take a significant

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Instead, firms tend to set prices and sell as much or as amount of time, however, there may be the potential
little as is demanded. It is only after a sustained period for government policies to help eliminate output gaps
of imbalance between demand and desired supply that more quickly.
firms adjust prices.
This explanation for short-run fluctuations in the level
Because in the short run firms respond to variations of economic activity was developed by the British
in demand by adjusting production rather than prices, economist John Maynard Keynes (1883–1946) in
output in the economy is determined by the level of his 1936 book The General Theory of Employment,
aggregate demand rather than by potential output. Interest, and Money. The theory that Keynes developed
Aggregate demand is the total desired spending on in this book was a response to what he perceived as
final goods and services by everyone in the economy. the inadequacy of prevailing microeconomic models
Recall that when we discussed the equality of GDP and to account for the events of the Great Depression. In
expenditures, we saw that total expenditures had four recognition of Keynes’s contribution, the resulting
components: model of the economy is often called the Keynesian
model.
Consumption (C) is spending by households on
final goods and services. According to Keynesian theory, the causes of short-
Investment (I) is spending by firms on run fluctuations in the level of economic activity can
new capital goods, such as machinery be summarized in terms of the interaction between
and structures, as well as spending on the an aggregate demand (AD) curve and a short-run
construction of new houses and apartment aggregate supply (ASSR) curve, as is illustrated in
buildings. In addition, increases in inventories Figure 55. In addition to the short-run aggregate
are also included in investment. supply curve, the diagram also includes a long-run
aggregate supply curve, which is drawn as a vertical
Government purchases (G) is spending by line at the point Y=Y*; that is where output equals

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 FIGURE 55

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

potential output. better bargain relative to muffins, and people will buy
fewer muffins and more bagels. At the level of the
In this diagram, the horizontal axis measures real GDP, aggregate economy, however, such an explanation no
and the vertical axis measures the aggregate price longer makes sense since a decline in the aggregate
level. This diagram looks quite similar to the demand price level means that the prices of all goods and
and supply diagrams we have used before to analyze services have declined.
individual markets, but it is important to understand
that the reasons for the shapes of the AD and ASSR If shifts in relative prices don’t account for the
curves are entirely different from the demand and downward-sloping aggregate demand curve, then
supply curves we have considered up to now. what does? There are three reasons for the negative
relationship between aggregate demand and the
The Aggregate Demand Curve aggregate price level.
We will begin by considering the derivation of
the aggregate demand curve. Recall that in the Wealth Effects
conventional analysis of a single market, the quantity With a fixed supply of money, when the aggregate
demanded increased as the price fell primarily because price level declines, the money that people have in their
a lower price meant that the good in question had wallets and bank accounts will allow them to purchase
become less expensive relative to other goods. For a greater quantity of goods and services. Lower prices
example, as the price of bagels falls, they become a in effect increase their wealth and encourage a higher

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level of spending. Notice that this conclusion follows consumption spending and will shift the AD curve.
directly from the quantity equation that we introduced For example, a drop in stock prices, such as occurred
earlier (M × V = P × Y). If the velocity of money (V) in the wake of the 9-11 attacks, reduces wealth and
doesn’t change and the quantity of money (M) in the causes consumers to reduce their level of spending at
economy is constant, then a lower price level (P) must every price level. Such a change would be reflected as
lead to a higher level of real GDP (Y). a leftward shift of the AD curve.

Interest Rate Effects The AD curve can also be shifted by changes in

At a lower price level, people will find that they are government spending or taxes. An increase in
holding more money than they want to have. As we spending by the federal government will, other things
saw when we analyzed the demand for and supply of being equal, increase spending at every price level,
money, when people are holding more money than a change that can be illustrated as a rightward shift
they view as optimal, they will attempt to reduce their in the AD curve. When state governments reduce
monetary assets by using their money to acquire less spending by furloughing employees as some did during
liquid assets, including bank certificates of deposit, the recession of 2007–2009, this reduces spending and
stocks, and bonds. All of these actions increase the shifts the AD curve to the left. When the government
supply of savings. Increased saving causes interest reduces taxes, it increases households’ disposable
rates to fall and encourages households and firms to income, which should increase consumption spending,
borrow more funds and increase their spending. which will shift the AD curve to the right.

Foreign Exchange Effects The Aggregate Supply Curve

The third channel through which a lower aggregate In Figure 55 the aggregate supply curve is drawn as
price level affects aggregate demand is exports. At upward sloping, indicating that the quantity of goods
a lower domestic price level, domestically produced and services supplied is an increasing function of the

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goods and services are less expensive relative to aggregate price level. Once again, while the shape of
foreign-produced goods. As a result, domestic the aggregate supply curve is similar to the supply
consumers will buy fewer imported goods and curves we encountered earlier in our microeconomic
services, and foreign consumers will purchase more analysis of markets for particular goods, it is upward
domestically produced goods and services, causing net sloping for different reasons. In the microeconomic
exports to increase. analysis of markets, the supply curve was upward
sloping because higher prices are necessary to
Now that we have explained the downward slope of the attract resources from producing other products. For
aggregate demand curve in Figure 55, we can consider example, in the market for bagels, as the price of bagels
the factors that influence its position. Anything that increases, bakers who were previously producing
influences the consumption decisions of households or muffins will be induced to shift over to bagel
foreign residents, or leads firms to increase investment, production. At the aggregate level, however, resources
will cause the aggregate demand curve to shift. The cannot be shifted from other less profitable activities.
introduction of a promising new technology, such as
the commercialization of the internet, will cause firms As we noted at the beginning of our discussion of
to increase investment spending. During the dot.com short-run economic fluctuations, many firms do not
boom of the 1990s, communications companies made immediately adjust prices in response to variations in
substantial investments in new fiber-optic transmission demand. Instead, they fix prices for some period of
lines in anticipation of growing volumes of data traffic, time and sell as much or as little as consumers choose
and many novel online businesses sprang up. Such an to purchase. Over time firms adjust their prices in
increase in investment increases aggregate demand at response to the gap between actual and anticipated
any price level and causes the AD curve to shift to the sales. The aggregate supply curve slopes upward to
right. reflect the relationship between this price adjustment
process and the size of unanticipated sales.
Similarly, changes in consumer sentiment will affect

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The position of the aggregate supply curve depends Figure 55 is drawn so that this intersection occurs at
on the economy’s long-run potential output and on the point where actual output is equal to its potential,
what people expect the aggregate price level to be. The so the output gap is zero. At this point, there is no
short-run aggregate supply curve will pass through the cyclical unemployment, and resources are being fully
vertical line at Y* at a price level equal to the prevailing employed. But, if the aggregate supply or aggregate
expectation about aggregate prices. Resources will be demand curve were to shift for some reason, the
fully employed, and aggregate supply will equal its long- intersection of the two curves would be either above or
run potential output, Y* in our earlier discussion, when below potential output.
the aggregate price level is equal to the level that firms
and consumers anticipated. We will begin by illustrating the effect of a negative
aggregate demand shock. In March of 2001, the United
Thus, there are two reasons for the short-run aggregate States economy went into recession. The beginning
supply curve to shift. The first and most common of the recession appears to have been the result of a
cause of shifts in the position of the aggregate supply reduction in investment spending. Businesses became
curve is changes in the expected price level. Since less optimistic about the profitability of internet
ASSR is equal to Y* at the expected aggregate price business models, and this, combined with rising
level, an increase in the expected price level will cause interest rates, caused businesses to reduce spending.
the aggregate supply curve to shift upward. A decrease This initial reduction in spending was substantially
in the expected price level will cause the aggregate exacerbated by the effects of the 9-11 terrorist attacks
supply curve to shift downward. and by revelations of accounting fraud at Enron, which
emerged later in the fall of 2001.
The second cause of shifts in the aggregate supply curve
is aggregate supply shocks. For example, weather and In panel (a) of Figure 56, we show the combined effect
climate conditions that affect agricultural production of these events as a leftward shift in the AD curve. As a
may shift the aggregate supply curve. An especially result, the economy’s short-run equilibrium now occurs

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good harvest means that more agricultural commodities at Y1, which is less than Y*. The economy is now in a
are available at every price, an event that would cause recession because of the shift in consumer sentiment.
the aggregate supply curve to shift rightward. An
important example of a shock to aggregate supply in As the equilibrium point in Figure 56 shifts down
recent history is the OPEC-initiated oil embargo that and to the left along the ASSR curve, some businesses
began in 1973. Because of the importance of fossil lower their prices, and the aggregate price level begins
fuels as a source of power throughout the economy, the to decline, a response that moderates the impact of the
shortage of imported oil had a widespread effect on the shift in consumer sentiment.
U.S. economy, causing a reduction in quantities supplied Panel (b) of Figure 56 illustrates the adjustment of the
at every price, and a leftward/upward shift of the short- economy as it begins to recover from the recession.
run aggregate supply curve. The position of the aggregate supply curve in Figure
In addition to these movements of the short-run 56(a) indicates that businesses and households were
aggregate supply curve, technological progress will expecting that prices would be at P0, since this is
cause the economy’s potential output to shift out to the where the curve passes through the point where Y=Y*.
right over time. It is this increase in potential output that However, the actual price level, P1, is now below P0.
accounts for the long-run growth of real GDP we noted As time passes and firms find that they are selling
at the beginning of this section of the resource guide. less, they will begin to adjust their expectations about
the aggregate price level downward. As a result of the
The Keynesian Model of Short-Run decline in prices, output has increased to Y2, but it is
still below potential output. Prices will continue to fall
Fluctuations until the AD and ASSR curves once again intersect at
At any point, the Keynesian model implies that the the point where output equals potential (Y*).
economy’s aggregate production and price level are
determined by the intersection of AD and ASSR. In Figure 57 we illustrate a recession caused by an

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 FIGURE 56

(a) NEGATIVE AD SHOCK CAUSES A RECESSION

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

Aggregate Demand and

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

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FIGURE 57

(a) A NEGATIVE AGGREGATE SUPPLY SHOCK CAUSES OUTPUT TO

FALL AND THE PRICE LEVEL TO RISE

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(b) ADJUSTMENT TO A NEGATIVE AGGREGATE SUPPLY SHOCK

Effects of an Aggregate Supply Shock

Effects of an Aggregate Supply Shock

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aggregate supply shock such as the OPEC oil embargo To begin with, we need to ask why an economy would
of 1973. The shortage of petroleum and higher prices experience persistent inflation. The quantity equation
of gasoline and other products is shown in Figure 57 implies that in the long run, the aggregate price level
(a) as a leftward shift of the ASSR curve. Beginning can rise only if the money supply is growing faster than
at the point Y=Y* and price level P0, output falls to the economy’s potential output. Suppose, for example,
Y1, and the aggregate price level rises to P1. With that because of technological change, potential output
the economy in recession, firms find that actual sales increases 2 percent per year, and the stock of money
are falling short of expectations. Eventually they increases at 5 percent per year. The quantity equation
will begin to cut prices, causing the ASSR curve to can be rearranged to show the price level must equal (M
shift out to the right. This movement is illustrated in × V)/Y*. So long as velocity is constant, prices will rise
Figure 57(b). Prices will fall until output once again at 3 percent (= 5% – 2%) each year.
equals potential. At this point, the price level will have
returned to its original level at P0. In the aggregate demand–aggregate supply model,
an increase in the money supply causes the AD
Figures 56 and 57 illustrate the basic explanation of curve to shift to the right. But, if people have become
recessions and expansions in the Keynesian model. accustomed to an increasing money supply and rising
Recessions and expansions occur because of the prices, then they will expect the price level to rise
sequence of unpredictable shocks to aggregate demand each year, and the ASSR curve will shift upward so that
or aggregate supply that strike the economy and cause AD and ASSR continue to intersect at the economy’s
the equilibrium level of production to move away from potential output. This is illustrated in Figure 58.
its potential. The reason these shocks are translated
into recessions or expansions is because of the short- Thus, full employment equilibrium is consistent with
run inflexibility of prices. If prices everywhere in the any anticipated level of inflation. In this context,
economy adjusted instantly to the effects of shocks, unexpected shocks that move the economy away from
full employment cause actual inflation to deviate

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then output would never differ from potential. It is
the short-run inflexibility of prices that is the basic from the anticipated level. For example, suppose that
explanation for recessions and expansions. the federal government decides to begin a military
buildup, but chooses to finance it through borrowing
You will notice that up until now, we have been because it is afraid that increased taxes will be
somewhat vague about the period of time that is unpopular. This is roughly what happened in the 1960s
represented by the “short run.” That is because the under President Lyndon Johnson.
definition of the short run is effectively the period
of time in which the performance of the economy The increased government spending causes output to
deviates from the predictions of the long-run model. increase precisely because it is not anticipated. In the
Judging from the length of typical economic cycles, long run, however, there is no policy that will maintain
this is usually from one to three years. output at a level different from the economy’s potential
output. Thus, when we use the aggregate demand–
Inflation in the Keynesian Model aggregate supply model, we need to remember that
The model of recessions and expansions we have the changes in aggregate prices that it indicates are
sketched so far has assumed that the level of inflation unanticipated deviations from the prevailing (and
in the economy is zero. That is, we have drawn the expected) rate of inflation.
AD and ASSR curves on the assumption that everyone
believes the aggregate price level is stable. We have Using Fiscal and Monetary Policy to
seen, however, that since the Second World War the Stabilize the Economy
aggregate price level has followed a generally upward The adjustment of the aggregate price level when output
trend. Moreover, as the previous section demonstrated, differs from potential suggests that the economy has
the process of adjustment by which the economy a natural tendency to return to a situation in which
returns to full employment after a shock involves resources are fully employed. Such an adjustment can,
changes in the price level. however, take a year or more to significantly affect the

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 FIGURE 58

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Effects ofEffects
a Fully
of a FullyAnticipated
Anticipated AD ShockAD Shock

economy, a fact that leads many economists to argue are described by the equation Y = C + I + G + NX.
that fiscal or monetary policy measures should be used The term G stands for government purchases of goods
to help speed up the adjustment process. Nonetheless, and services. If shifts in household and business
the use of activist policies remains controversial, and spending and net exports reduce expenditures,
a significant number of economists believe that such increased government spending can be used to make
interventions are generally counterproductive. We will up the shortfall in aggregate demand. Increased
begin here by describing how government policy affects government spending, or expansionary fiscal policy, is
the short-run equilibrium in the economy, and then we one form of intervention that should offset a recession
will discuss arguments for and against intervention. and restore full employment.
As we have seen, total expenditures in the economy Fiscal policy can also be used to indirectly increase

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spending through a tax cut. Lower taxes (with a but almost all economic information has some lags,
constant level of government spending) mean that meaning that policymakers must act on partial and
consumers have a higher level of disposable income. incomplete evidence about the state of the economy.
Higher income should encourage increased consumer
spending and cause the AD curve to shift to the right, Moreover, the effects of their actions take time to be
thus mitigating the effects of a recession. felt. When interest rates are reduced, for example, it
can take many months for businesses to undertake
In addition to fiscal policy, the Federal Reserve can new investment projects since they often require
use monetary policy instruments to offset short- considerable planning. Efforts to increase government
run economic fluctuations. By varying the amount spending operate with even longer lags. It can easily
of money it supplies to the economy, the Federal take six months or a year from the time Congress
Reserve can control the interest rate. And, as we have authorizes additional spending until projects are
seen, changes in the interest rate can affect the level actually undertaken. So, even if Congress acts quickly,
of both investment and consumption spending. If which is not usually the case, the additional spending
the economy is producing above potential output, a may not begin to take effect until the economy has
situation that would cause inflationary pressures, the already begun to recover.
Federal Reserve can help to reduce consumption and
investment spending by decreasing the money supply If the effects of increased government spending
and causing interest rates to rise. Conversely, if the begin to be felt only after the economy has begun
economy is in recession, increasing the money supply to recover on its own, they may cause the economy
will lower interest rates and stimulate additional to overshoot full employment and contribute to
consumption and investment spending. inflationary pressures rather than mitigating the effects
of the recession. For this reason, many economists
The main argument in favor of using monetary or believe that activist policies are as likely to be
fiscal policy to stabilize the economy is that deviations counterproductive as to be helpful.

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of actual output from potential output are costly.
In recessions, when some resources are not fully SECTION III SUMMARY
employed, the economy forever loses the output that Macroeconomics is concerned with two
these resources could have produced. Moreover, questions: (1) What determines the long-run
unemployment imposes significant hardships on those growth in the size of economies? (2) What
who lose their jobs or see their incomes reduced. When are the causes and consequences of short-run
output is above potential, inflation will accelerate. We fluctuations in the level of economic activity,
have seen that inflation is costly for a variety of reasons. employment, and inflation?
Controversy about the desirability of fiscal and Economists measure the total output of the
monetary policy interventions arises for two reasons. economy using Gross Domestic Product
The first is the difficulty of identifying precisely what (GDP). GDP is the market value of all final
the economy’s potential output is and thus the difficulty goods and services produced within a country
in determining when interventions are needed. The during a specified period of time.
second and more significant concern centers on the In the United States, output has grown much
practicality of carrying out such fiscal and monetary faster than population. Since 1900, the U.S.
policy effectively. population has increased by a factor of
four, while GDP has grown by a factor of
One of the biggest challenges that economic approximately thirty-two.
policymakers face is that information about the
aggregate economy takes time to collect. It takes about The rate of growth of output is quite variable.
three months to calculate the first estimates of GDP, A period between a trough and a peak in
and these estimates are subject to substantial revision economic activity is called an expansion;
over the next few months as additional data becomes a period between a peak and a trough in
available. Other data are available more quickly, economic activity is called a recession.

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The alternation of periods of expansion and `` In the financial markets, the interest rate
recession is referred to as the business cycle. adjusts to equate the supply of saving to
The labor force is the total of all individuals who the demand for saving (investment).
are either working or are available for work but `` Money is any asset that serves the
are not currently working. The unemployment functions of: (1) a medium of exchange,
rate is the percentage of the labor force who (2) a unit of account, and (3) a store of
would like to work but cannot find jobs. value. Because it is not easy to draw an
Economists often break down unemployment absolute distinction between assets that
into frictional unemployment, structural are and are not money, economists use
unemployment, and cyclical unemployment. several different measures of money.
The most common are M1 and M2.
Inflation occurs when prices in the economy
are all increasing. The Consumer Price Index `` The Federal Reserve System is the
and the Gross Domestic Product Deflator central bank of the United States. It
provide two different measures of inflation. was established in 1913 and consists
of twelve district banks located in
Gross Domestic Product is defined as a major cities across the country and
measure of production; but at the level of the the Federal Reserve Board, which is
economy, production equals expenditures located in Washington, D.C.
equals income.
`` The Federal Reserve controls the
Economists divide expenditures into four supply of money in the economy and
categories: Consumption, Investment, acts as lender of last resort for the
Government Purchases of Goods and Services, banking system.
and Net Exports.
In the long run, increases in the supply of

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The quantity of GDP per capita that an money do not affect the real economy, but affect
economy produces is closely related to the only prices. But, in the short run, changes in
level of average labor productivity. Labor the supply of money alter credit conditions and
productivity depends on many things, the influence the level of economic activity.
most important of which are the quantities of
physical and human capital an economy has To analyze short-run variations in the level of
accumulated, its natural resource supplies, economic activity, economists divide actual
the level of technological knowledge, and the output into two parts: potential output and the
political and legal environment. output gap. Potential output is the quantity of
goods and services that would be produced if
Economists use the term “savings” to all resources were fully employed. The output
describe income that is not spent on the gap is the difference between actual output and
consumption of goods and services in the potential output.
current period. “Investment” is the term used to
describe the purchase of new capital equipment. In the long run, an economy’s output is
determined by its potential output. But, in the
Financial markets are the institutions through short run, many firms set prices and sell as
which individuals who have money they wish much or as little as is demanded. As a result,
to save can supply these funds to persons or output is determined by the level of aggregate
companies who wish to borrow money to invest. demand, which may be more or less than
Because of the way they are defined, savings potential output.
must equal investment in a closed economy. In Deviations of actual output from potential
an open economy, savings equals investment output eventually cause the aggregate price
plus net capital outflows. level to change so that the economy returns to

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potential output. process. In practice, however, changes in
When actual output deviates from potential government spending or the money supply
output, monetary and fiscal policy tools can affect the economy with long and variable lags.
be used to help speed up the adjustment Consequently, attempts to stabilize the economy
may actually magnify economic fluctuations.

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 Section IV
The Economics of the Cold War
THE AFTERMATH OF WORLD
WAR TWO AND THE ORIGINS
OF THE COLD WAR
According to the U.S. Department of Defense, the Cold
War started with the official end of World War Two
on September 2, 1945,17 and ended on December 26,
1991, when the Soviet Union was formally dissolved.
The Cold War was ultimately a geopolitical struggle
between the U.S.S.R. and the U.S., but it also had
important economic aspects. An examination of these
economic facets of the Cold War will help us better
understand this defining feature of the twentieth-
century world. Russian soldiers carry a banner reading “Communism” in

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Moscow during the Russian Revolution in October 1917.
The Soviet and American economic systems were
drastically and fundamentally different. Whereas Bolshevik party forcibly removed Tsar Nicholas from
the American model relied, more or less, on markets power, eventually executing him and his family. Lenin
to organize production, the Soviet model relied on became the head of the Soviet government late in 1917
centralized control that emphasized heavy industry. and served in that role until his death in 1924. Joseph
Over the long-run, the market-based system of the Stalin was elevated to power after Lenin’s death, and
United States fared better than the command economy Stalin played a key role in constructing the authoritarian
of the Soviet Union. In the Soviet economy, the economic system in the U.S.S.R. and would lead the
fundamental lack of price information and the profit- Soviet effort against Germany in World War Two.
motive—which coordinates the desires of consumers
with the plans of producers—created a fundamentally On the American side, the United States was still
unsustainable economic model. A study of the Cold struggling to recover from the Great Depression
War gives us an opportunity to better understand these (which began in late 1929) when World War Two
differences in economic organization, which ultimately began. In the 1930s, President Franklin Roosevelt
determined the productive capacity of each system and created a more active role for the federal government
undoubtedly played an important role in the outcome of through a variety of federal programs, public works,
the state of hostility between the U.S. and the U.S.S.R. and regulatory reforms that were collectively known
as the New Deal. It was against this backdrop that both
While the Cold War between the Soviet Union and the U.S.S.R. and the U.S. were eventually pulled into
the United States—and their allies—emerged when World War Two.
World War Two ended, it is nonetheless important to
understand its pre-war context. The Union of Soviet The Second World War was an epic catastrophe
Socialist Republics (U.S.S.R.) was born with the fought in Europe, with the United Kingdom, the
Russian Revolution of 1917. Led by Vladimir Lenin, the Soviet Union, and the United States leading the Allies

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against Germany and Italy, and in the Pacific, where
the Americans led the fight against Japan. In Europe,
the war began with Germany’s invasion of Poland in
September 1939 and officially ended at the Potsdam
Conference in the summer of 1945. In the end, World
War Two was the deadliest international conflict in
history, claiming the lives of an estimated 60 to 80
million people, most of them civilians. While the
estimates vary, nearly 417,000 American soldiers and at
least 8.8 million Soviet soldiers died during the war.18
During the war, the United States and the Soviet
Union collaborated in the fight against Nazi Germany;
indeed, it is hard to imagine how Germany could have President Harry Truman introduced the Truman Doctrine,
been defeated without Soviet armed forces on the which held that the main purpose of American foreign policy
Eastern Front. Nevertheless, that alliance had begun to was to stop Soviet expansion.
Photo Courtesy Reuters
fray even before the war ended in 1945. In large part,
this was due to the American and British refusal to
contributed to the American desire to financially assist
open a Western Front against Germany earlier in the
Western European nations as they recovered from
war. Despite the tensions, the military alliance held,
World War Two, primarily through the Marshall Plan
and the Germans unconditionally surrendered on May
(named after Secretary of State George Marshall).19
8, 1945. While the immense destructiveness of the
war in Europe had finally come to an end, the process In total, the Marshall Plan provided $13 billion in
of rebuilding was just beginning. It was with this financial aid to Western European countries. (In

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American-led effort to rebuild Europe that the U.S.- today’s dollars, that amounts to at least $111 billion.)
Soviet divisions would become clear. The new balance Most of these funds were provided as grants on
of power in the immediate postwar world changed the an annual basis between July 1948 and June 1951.
American-Soviet relationship in fundamental ways Logistically, the plan was fairly straightforward:
that would endure throughout the twentieth century European countries in need of assistance would
and, in many ways, to the present day. make requests to the Economic Cooperation Agency
(ECA), a U.S. board that operated in Europe. After
THE MARSHALL PLAN (1948– evaluating the requests, the ECA determined how
51): A FOUNDATION FOR much assistance to provide. The Soviets had their own
version of the Marshall Plan, known as the Council for
POSTWAR RECOVERY Mutual Economic Assistance (CMEA), which was
In the immediate aftermath of the war, Germany was established in 1949. Its purpose was to facilitate the
split into four separate zones that were controlled by postwar economic development of Eastern Europe, just
the U.S., Britain, France, and the U.S.S.R.; in effect, as the Marshall Plan did for Western Europe.
however, these were really two separate political blocs
with the western portion of Germany under U.S. What impact did the Marshall Plan actually have on the
influence and the eastern portion under Soviet control. economies of Western Europe? The evidence is mixed.
President Harry Truman, who assumed the presidency While it remains one of the most successful foreign aid
upon Roosevelt’s death in April 1945, introduced what programs in history, more recent analysis has shown that
is known as the Truman Doctrine, which held that the Marshall Plan had a somewhat limited economic
the main purpose of American foreign policy was to impact. In part, this is a reflection of a particularly
stop Soviet expansion, which had already begun in harsh winter in 1947 that depleted coal supplies and led
Eastern Europe. This American concern about Soviet to harvest failures. As a result, the seriousness of the
expansionism would become the dominant factor postwar crisis may have been overstated. Moreover,
in U.S.-Soviet relations during the Cold War, and it the low levels of industrial production in 1947 were

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 economic; while it was in part designed to promote
free market economic systems in Europe, it was also
aimed at spreading democracy.
If we take a longer-term perspective on postwar
European economic growth, the foundations laid by
the Marshall Plan and more generally by the rebuilding
efforts after the war, the picture is quite good. The
1950s through the 1970s saw real GDP grow at rates
nearly double those of any comparable period in
European history. This is not entirely surprising given
the economics of “catch-up” or “convergence,” which
suggests that poorer countries (as in the war-ravaged
nations of Europe) will grow more rapidly than richer
countries. As a result, per capita income levels in the
poorer countries should eventually converge to those
in the richer countries. Barry Eichengreen examined
this postwar growth pattern in Europe and concluded
that, “the proximate cause of Europe’s growth miracle
was high investment. Net investment rates in Europe
were nearly twice as high in the 1950s and 1960s
Postwar construction takes place in West Berlin with the help
of funding from the Marshall Plan. as before or since.”23 In Eichengreen’s view, the
underlying reasons for this are to be found in economic
institutions that were “singularly well suited to
concentrated in Germany rather than across Western

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reconstruction and growth.”24
Europe. In his article “Lessons from the Marshall
Plan,” economist Barry Eichengreen notes that, For example, new international institutions were
“Production in the three Western zones of Germany created to open Western Europe to world markets; as a
(occupied by the U.S., France, and Britain respectively) result, exports grew by over 8 percent each year during
was only 34 percent of 1938 levels.”20 That low level the 1950s and 1960s, which allowed investment to be
of production artificially reduces the overall levels directed to the highest growth sectors. Thus, export
of production; removing Germany from the Western growth helps explain the high rates of investment and
European totals yields industrial production in 1947 that the rapid economic growth of the 1950s and 1960s.
is actually about 5 percent higher than it was in 1938. A new international monetary system, known as the
Finally, Eichengreen points out that while the wartime Bretton Woods system, was established in 1944 to
devastation in Europe was considerable, the European help facilitate international trade in the postwar world
economy was already highly developed and thus economy.
capable of growing and recovering on its own. It would
likely have done so, albeit more slowly, even without While its elements are complex, the basic idea of the
American aid.21 Bretton Woods system was rather straightforward:
this system established the U.S. dollar as the primary
The Marshall Plan was relatively small—only about currency, which was convertible to gold at a fixed
2.5 percent of the GNP of recipient countries in price of $35 per ounce. The currencies of other
Europe—which in part explains why it may have member countries were then tied to the U.S. dollar
had a more limited impact than we might expect.22 (so, they were at least indirectly linked to the price
Nevertheless, it may have still played an important of gold). The reason for all this was to create stable
role in accelerating the recovery of certain industries exchange rates, which reflect the value of one currency
in postwar Europe. And, it is important to remember relative to another. The thinking was that these stable
that the Marshall Plan’s objectives were not purely exchange rates would help facilitate trade across

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international borders and thereby create stability and
interdependence.
The Bretton Woods agreement also established two new
international institutions to help facilitate international
economic cooperation: (1) The International Monetary
Fund (IMF), whose goal is “to foster global monetary
cooperation, secure financial stability, facilitate
international trade, promote high employment and
sustainable economic growth, and reduce poverty
around the world,” 25 and (2) the World Bank, which
aims to end extreme poverty and boost shared
prosperity around the world.26
New trade agreements like the GATT (General
Agreement on Tariffs and Trade), which was signed A meeting of the North Atlantic Treaty Association (NATO).
in late 1947 to help boost economic recovery after the Bundesarchiv, B 145 Bild-P098967 / Unknown / CC BY-SA 3.0 DE

war, also helped contribute to this global prosperity

by eliminating or reducing tariffs and other barriers assistance has been an important element in Warsaw
to free trade. The GATT has gone through a number Pact foreign policy since the U.S.S.R. extended its first
of rounds over the years, and the number of countries credits to its Asian neighbors in 1954. Together with
included in it has grown considerably over time, from military sales, the Kremlin and Eastern Europe have
twenty-three in the initial agreement to 159 in the most used their economic aid programs to contest Western
recent round of negotiations held in 2001.27 influence in LDCs (least developed countries), to
expand trade, to gain access to strategic raw materials,

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These institutional factors helped promote a more open and to increase hard currency earnings.”28
market economy in Western Europe. As we will see
later, this contrast between the market economies of Both NATO and the Warsaw Pact were political
the West and the command economies of the East is alliances whose primary objective was to serve the
the defining economic feature of the Cold War. common interests of the member countries: protecting
them from aggression by the other side. In other words,
NEW DIVISIONS EMERGE the objective was deterring aggression and maintaining
NATO and the Warsaw Pact peace. As Economists Mancur Olson and Richard
The Cold War began with the emergence of two major Zeckhauser put it, “An organization of states allied for
political alliances within a decade of the end of World defense…produce a public good, only in this case the
War Two. The North Atlantic Treaty Organization ‘public’—the members of the organization—are states
(NATO) was formally established in April 1949 as rather than individuals.”29 In this context, a “public
an alliance of twelve founding member countries. good” is non-rival, which means that one member can
(Its membership has grown over time and there are enjoy the benefits of the good without diminishing
currently twenty-nine member countries.) NATO the enjoyment of other members. In other words, “if
was led by the United States, which had by then the good is available to any one person in a group it is
established itself as the world’s leading military power. or can be made available to the other members of the
The Warsaw Pact, officially established in May 1955, group at little or no marginal cost.” A public good is
was similar to NATO in many respects, but it was also non-excludable, which means that “if the common
led by the Soviet Union. It was a collective defense goal is achieved, everyone who shares this goal
treaty based on the principle of mutual assistance for automatically benefits…nonpurchasers cannot feasibly
its Eastern European member states, and it included be kept from consuming the good.”30
specific economic aid components. According to a now This economic view of political alliances suggests, in
declassified CIA report published in 1988, “economic part, that large nations will bear a disproportionate

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share of the burden of common defense spending.
This is because smaller member countries “who get
smaller shares of the total benefits…find that they have
little or no incentive to provide additional amounts
of the collective good once the larger members have
provided the amounts they want for themselves….”31
The evidence is consistent with this hypothesis.
Olson and Zeckhauser show, for example, that the
larger NATO economies, as measured by their Gross
National Product (GNP), spent a larger percentage of
GNP on defense. For instance, American GNP in 1964
was $569 billion, the largest in the world, and it spent
significantly more than any other country on defense
(9 percent of its GNP compared to 7 percent for the
East German construction workers build the Berlin Wall in
country ranked second, the United Kingdom).32
November 1961.

Germany Divided: East vs. West

Perhaps the most iconic symbol of the Cold War East German economic data are notoriously unreliable,
was the Berlin Wall, which separated East and West so these comparisons are more difficult than one
Germany within the city of Berlin. Erected in 1961, the might imagine. In part, this is because the official
wall was officially designed to keep westerners from figures exclude the service sector, focusing instead
entering East Germany and destabilizing the socialist on manufacturing and resource extraction.34 Doing so
government there; in reality, its primary function was generates an implausibly high rate of growth because
to prevent defections of East Germans to the West. it suggests that East German living standards should

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The Berlin Wall’s roots were to be found in the peace have been better than those in the West—and other
conference that ended World War Two. The defeated evidence contradicts that conclusion. Indeed, as
German territory was to be split, according to the Ritschl explained, it is unlikely that the 1989 revolution
peace treaty, into four different zones. The eastern would have ever occurred if economic growth had
part of the country fell under Soviet control while the been that strong in East Germany. While we should
western part was to be under the control of the U.S., therefore be skeptical of the official East German
Great Britain, and France. economic statistics, Ritschl used GDP estimates done
by Merkel and Wahl (1991) to calculate what he refers
While it was primarily a political and military barrier, to as “plausible” growth rates in GDP per capita, labor
the Berlin Wall can also be viewed as symbolic of productivity, and total factor productivity for East
the economic rift that had emerged between the two Germany.35 He also includes a set of “pessimistic”
Germanys. Indeed, the wall—and the underlying growth rates, which uses the West German currency
political and economic divisions it represented—gives (the Deutschmark) to evaluate East German growth—
us a rare example of a natural experiment that we can the idea is that deteriorating product quality and
use to draw some conclusions about the vastly different inflation actually meant that the external value of
economic systems that emerged on either side of it. As East German output was steadily declining. While
economist Albrecht O. Ritschl put it, “Divide a country this procedure has its problems since it is difficult
in such a way as to create a rich mix of industries, of to precisely determine West German prices of East
natural resources and of human capital in either part. German traded goods, the “pessimistic” estimates
Then isolate both halves from one another and expose at least provide us with a “lower bound on the range
them to entirely different sets of economic policies. of plausible growth paths.”36 Overall, this shows just
After forty years of experimenting on various stages, how difficult it is to compare economic data across
just lift the barriers again and let markets decide on two countries that use dramatically different methods
the final outcome. This, in short, is what shapes the to produce their official data. Nevertheless, Table 1
economic history of East Germany.”33 provides a summary of the various estimates for a

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 TABLE 1

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Per capita output and productivity growth rates in East and West Germany, 1950–89
Source: Ritschl (1996, p. 500)

number of different periods between 1950 and 1989. per capita consumption in East Germany was only 69
percent of that in the West just after the end of World
While the growth rates vary considerably in each War Two and had fallen to 59 percent by 1949.38 By
subperiod, and a lot depends on which set of estimates the end of the Cold War, East German GDP was only
one uses, the overall “plausible” East German 69 percent of that of West Germany.39 Other studies
growth rate in GDP per capita from 1950 to 1989 suggest the differences were even greater. For example,
was 3.77 percent rather than the official estimate of Economist Charles Maier wrote that, “even at the time
5.62 percent—and growth rates in the East may well of reunification…East German productivity and per
have been negative by the 1980s, as illustrated in the capita national income were probably about half those
“pessimistic” estimates. West Germany grew relatively of West Germany.”40 To some extent, these differences
slowly in the 1970s and 1980s, largely because of the remain even today—the parts of Germany today that
disappearance of the catch-up effects that had propelled were once East Germany have higher unemployment
the West German economy after World War Two.37 rates, lower after-tax income, and fewer foreign
What about the actual income levels and living residents as a percent of the population.41 This is one
standards in East and West Germany? The differences illustration of how underlying institutional and cultural
between the two countries emerged early in the Cold differences can shape an economy’s trajectory for
War and persisted over time. Ritschl estimated that many decades.

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THE ECONOMICS OF THE
SOVIET-AMERICAN ARMS
RACE
The economics of the arms race in which the Soviet
Union and the United States engaged throughout
the Cold War can be viewed quite simply as a
consideration of the benefits of deterrence compared
to the costs of the armaments (especially the strategic
forces). The strategy of deterrence—with each side
building a sufficiently powerful arsenal to discourage
military aggression by the other—can be understood
through the economics of public goods, just as in
the case of the NATO and Warsaw Pact alliances
described earlier. Given the non-rival and non-
excludable characteristics of public goods like military
Soviet Premier Nikita Khrushchev visited the U.S. as a guest
defense, private actors in the economy do not have
of President Eisenhower in 1959.
sufficient incentive to provide them. After all, if they
are unable to exclude non-payers from consuming
serving a town of 60,000 population. It is
the good, what incentive do they have to provide
two fine, fully equipped hospitals. It is some
it? Therefore, governments are required to provide
fifty miles of concrete pavement. We pay for
deterrence—and to pay for it.
a single fighter with a half-million bushels
However, “nonmarket methods for allocating economic of wheat. We pay for a single destroyer with

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resources to nuclear weapons … increased the costs new homes that could have housed more
of those weapons. As a result, the United States often than 8,000 people.
incorrectly estimated both the requirements for and
These ideas reflect a central focus of economics—the
the full costs of its nuclear forces.”42 And whatever the
existence of tradeoffs. Given that we have limited
benefits of deterrence, there are important opportunity
resources, individuals and countries alike must
costs to consider in weighing those benefits against
make choices between competing alternatives. More
the costs—opportunity costs reflect the value of the
spending on military defense during the Cold War
foregone alternatives. For instance, if a government
necessarily implied fewer resources to devote to the
decides to spend $333 million on one B-1B bomber,
types of things President Eisenhower identified.
it means that it foregoes the opportunity to spend that
money on some other project. These ideas are reflected Of course, the benefits of effective deterrence are
in President Eisenhower’s April 1953 “Chance for immeasurable; how does one estimate the benefits of
Peace” speech in which he said: avoiding nuclear war between the world’s superpowers?
The real question is at the margin: how much more
Every gun that is made, every warship
deterrence effect do we get from one more dollar of
launched, every rocket fired signifies, in
spending on a weapons system? As economist William
the final sense, a theft from those who
Weida pointed out, the allocation of dollars to weapons
hunger and are not fed, those who are cold
systems was done in a Cold War political environment
and are not clothed. This world in arms is
in which a systematic, rational allocation process was
not spending money alone. It is spending
difficult; rather, “the urgency, classification, and politics
the sweat of its laborers, the genius of its
of spending for nuclear deterrence often proceeded with
scientists, the hopes of its children. The
grossly insufficient congressional and public scrutiny
cost of one modern heavy bomber is this:
to allow it to be compared accurately with other uses of
a modern brick school in more than thirty
national resources.”43
cities. It is two electric power plants, each

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 FIGURE 59

U.S. Stockpiled Strategic Nuclear Weapons: 1945–1996 (measured in thousands)

Source: Gartner, Scott Sigmund, “National Defense, Wars, and Armed Forces” in chapter Ed of Historical Statistics of the United States, Earliest Times
to the Present: Millennial Edition, edited by Susan B. Carter, Scott Sigmund Gartner, Michael R. Haines, Alan L. Olmstead, Richard Sutch, and Gavin

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Wright. New York: Cambridge University Press, 2006.

Military spending contributes to the aggregate At the height of the Reagan defense buildup in the
demand for goods and services and thus contributes mid-1980s, the U.S. Department of Energy employed
to employment, although we should not forget 65,000 people to build and design nuclear weapons.
the opportunity costs that such spending implies. The aerospace industry employed a total of about
Nevertheless, some regions in the United States 550,000 production workers, many of whom worked on
benefitted from military spending that was focused in building nuclear-capable delivery systems.
those regions, particularly in the Midwest and West.
Economist Ann Markusen et al, for example, show One important element of the strategic forces built by
that the decline of the Midwestern industrial heartland both the U.S. and the U.S.S.R. was the Intercontinental
and the emergence of high-tech industry in places like Ballistic Missile (ICBM) forces. The Soviets first
California directly resulted from the military industrial successfully tested an atomic bomb in August 1949,
complex that emerged during the Cold War.44 and the American buildup of nuclear forces over the
1950s, as reflected in Figure 59, was a response to this
Weida cites a study by the Department of Defense new global threat.
which found that the job creation impact of defense
spending was significant in the 1980s but became less Despite the considerable number of nuclear weapons
impactful over that decade. According to this analysis, amassed during this period, nuclear forces themselves
“$1 billion in defense spending created about 35,000 only constituted a small fraction of total American
jobs” at the beginning of the Reagan administration’s defense spending during the Cold War, but they were
military buildup. But in only a few years—by 1985— perhaps the primary deterrent on both sides of the
that impact had fallen to 25,000 jobs because of conflict. (See Table 2.) Moreover, these figures do not
changes in the types of spending over that period.45 include the considerable costs of delivery systems—
aircraft and missiles, for example. Nor do they include

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 TABLE 2

Annual Spending on Nuclear Weapons Materials Production in the United States, 1950–95 (millions of current dollars)
Source: Operating expenses, source materials procurement, and spending on construction and capital equipment are taken from Schwartz (1998) Table
A-1, pp. 560–56. National defense outlays are from Historical Statistics of the United States, Earliest Times to the Present: Millennial Edition, edited

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by Susan B. Carter, Scott Sigmund Gartner, Michael R. Haines, Alan L. Olmstead, Richard Sutch, and Gavin Wright. New York: Cambridge University
Press, 2006, Ed147.

the significant environmental costs that were created vary, Soviet defense spending was consistently higher
by the development of nuclear weapons in particular. than U.S. defense spending as a fraction of its GDP
throughout the Cold War. For example, in 1987 the
Economist Michael Edelstein estimates that total Soviet Union is estimated to have spent 16.6 percent
defense spending in the United States was 8 percent of GDP on defense. (By contrast, the U.S. spent only
of Gross Domestic Product (GDP) from 1946–49 and about 6 percent of GDP on defense in that year.) But
then rose to 14 percent during the Korean War years.46 Soviet defense spending fell dramatically after the
It fell only slightly after the Korean War, to about 12 Cold War: by 1997, it spent less than 4 percent of its
percent from 1954–63. Perhaps surprisingly, military GDP on defense.48
spending fell during the 1960s as the Vietnam conflict
began. By 1965, it was only 7.2 percent of GDP.47 Until ARMS LIMITATION
1980, defense spending in the U.S. as a percent of
GDP generally fell, but that pattern changed under the AGREEMENTS
Reagan administration: when Reagan took office in In 1967, President Johnson announced that the U.S.S.R.
1981, defense spending was only about 5.4 percent of had constructed an Anti-Ballistic Missile (ABM)
GDP, but it peaked at 6.5 percent in just the next year. system around Moscow to shoot down any incoming
By the end of Reagan’s term in office, spending relative American missiles. President Johnson responded to this
to GDP had fallen back to close to where it had been at development by proposing Strategic Arms Limitation
the start of his administration. Talks (SALT); the first official SALT talks were held
in late 1969 between President Richard Nixon and
Estimating Soviet defense spending is a challenge for Soviet General Secretary Leonid Brezhnev. The two
many of the same reasons as we saw with East German leaders signed an ABM treaty in 1972, which limited
economic statistics. While the estimates therefore strategic missile defenses to two hundred interceptors

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 SKT - China, CH
U.S. President Jimmy Carter (left) and Soviet leader Leonid Brezhnev (right) sign the SALT II agreement on June 18, 1979.

each.49 But this first SALT agreement had not prevented Afghanistan. While the treaty was therefore never
either country from using what were known as Multiple ratified in the United States, both sides voluntarily
Independent Targeted Re-Entry Vehicles (MIRV). An observed its terms in subsequent years.50
MIRV is a single missile with several warheads, each of
which can hit a different target. A COMPARATIVE ECONOMIC
SALT II was in part designed to deal with the issue of ANALYSIS: U.S. VERSUS U.S.S.R.
MIRVs. President Ford and Soviet General Secretary The Soviet-American standoff during the Cold War
Brezhnev agreed to a basic framework for SALT II in highlights important differences between the economic
November 1974. According to the US State Department, systems of the two countries; after all, it was the
the SALT II agreement “included a 2,400 limit on capacity to spend on military defense that would play
strategic nuclear delivery vehicles [missiles and heavy an important role in who prevailed. The Communist
bombers] for each side; a 1,320 limit on MIRV systems; economy of the U.S.S.R. had its origins in the 1917
a ban on new land-based ICBM (intercontinental Russian Revolution in which left-wing revolutionaries
ballistic missile) launchers; and limits on the deployment overthrew czar Nicholas II. The leftist revolutionaries
of new types of strategic offensive arms.” The final were led by Vladimir Lenin who had founded the
agreement was signed by President Carter and General Bolshevik Party, and shortly after the successful
Secretary Brezhnev in June 1979, but President Carter overthrow of the czar, Lenin was installed as the head
removed the treaty from consideration by the Senate of a new revolutionary government.
soon thereafter as a result of the Soviet invasion of
The Union of Soviet Socialist Republics (U.S.S.R.)

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was the first Marxist government in the world, so
it implemented economic policies that followed the
broad outlines of Marxist economic doctrine. The
main element of this doctrine, at least the way Lenin
deployed it, was that the central government would
own the major resources and means of production in
the economy. As economist Philip Hanson explained,
“Soviet leaders were the directors of a giant firm—
what some American commentators called U.S.S.R.
Inc…Some acted like chairmen of the board, others
like chief executive officers, others again like both.
One or two were, or became, more like part-time non-
executive directors. The leadership team, at any rate,
had formal powers to micro-manage everything, and
ultimate responsibility for the economy, in ways that
went far beyond the authority of any government in a At the American National Exhibition in Moscow in 1959,
developed market economy.”51 in a model American kitchen, Soviet premier Khrushchev
(left) and Vice President Nixon (right) debated the merits of
By nearly every economic metric, the Soviet economy communism versus capitalism.
Photo by Thomas J. O’Halloran
lagged well behind that of the United States during
much of the Cold War. According to a 1985 report by
the Central Intelligence Agency, gross national product for its people.53 This was perhaps most effectively
and its growth rate, per capita consumption, the quality illustrated by the 1959 “Kitchen Debate” between Soviet
of consumer goods and services, agriculture, the premier Khrushchev and Vice President Nixon. In that
televised “debate,” which occurred during the American

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development of new technology, and the productivity
of labor were all higher in the U.S. after the mid- National Exhibition in Moscow (part of a cultural
1970s than in the Soviet Union. The Soviet economy exchange effort between the two countries), Khrushchev
did grow at a faster rate, on average, between the ridiculed the more advanced American technology
mid-1960s and mid-1970s, but the Western European on display, claiming that the Soviets would have the
economies experienced much more rapid overall same technology within a few years. The two political
productivity growth than did the Eastern European leaders continued a heated discussion of capitalism and
command economies. communism, all in front of a captivated news media that
eagerly transmitted the debate to its American audience.
Abram Bergson examined how Western and Eastern
European productivity levels compared to those in The idea—that American consumers had access to a
the United States. He found that Western European variety of household amenities that were unavailable in
economies were considerably closer to American the U.S.S.R.—captures the essence of the differences
productivity levels than those of Eastern Europe: “With between the two economic systems. The market-
employment adjusted also for quality, the corresponding based system of the United States was responsive
minimal [Western European] level is 67.8 percent, while to consumer demands because sellers who failed to
among socialist [Eastern European] countries output provide the things that consumers wanted would have
per worker ranges from 42.0 to 57.6 percent of the U.S. lost customers to more responsive sellers. The lack
level.”52 Given the differing work incentives in each of a market system in the U.S.S.R. failed to provide
economic system, such differences are to be expected— these same incentives. The CIA estimated that Soviet
we will return to this point later in this discussion. per capita consumption levels were only about one-
third the American level, but not only was the level
One of the costs of the arms race, in which the Soviet of consumption lower in the U.S.S.R., the quality
Union outspent the Americans in many years, came of goods available for consumption was also worse.
in the form of surprisingly low levels of consumption These differences led to meaningful negative impacts

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 FIGURE 60

 50,000

Real GDP Per Capita, 2011 US Dollars
 45,000
 40,000
 35,000
 30,000
 25,000
 20,000
 15,000
 10,000
 5,000
 ‐

95
98
86
89
92
50
53
56

65
68
71
59
62

74
77
80
83

19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
USSR USA
 
Real GDP Per Capita in the U.S. and the U.S.S.R., 1950 to 2000. (Note: Data from 1992–2000 is aggregated across
Real GDP Per Capita
multipleincountries
the U.S. and
that the U.S.S.R.,
were formerly1950
parttoof2000. (Note: Data from 1992–2000 is aggregated across
the U.S.S.R.)
multiple countries that were formerly part of the U.S.S.R.)
Source: http://www.ggdc.net/maddison.

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on Soviet citizens; for example, the low quality of first-served system) will play that role. According to
Soviet healthcare and diets contributed to lower life economist Mark Harrison, the Soviet system “built the
expectancies while poor quality housing often meant capacity of an authoritarian state to select and direct
less than ideal living conditions. personnel, to protect its supply chains and to channel
and filter information.”54 Unlike in the American
Figure 60 illustrates the differences in real GDP per economy, Soviet consumers had little influence over
capita between the United States and the Soviet Union what was produced, and there was little competition
during the Cold War. These data, based on estimates among the producers. As a result, inefficiencies piled
compiled by Angus Maddison, show Soviet GDP per up and contributed to economic stagnation. As Philip
capita never really approached that of the United States Hanson put it, the Soviet system repeatedly “ran into
throughout this period. (The data also illustrate the the limits on economic progress set by a system that
devastating economic effects of the collapse of the took shape during industrialization in the 1930s.”55
Soviet Union in the late 1980s and early 1990s.)
But this is not to say that the Soviet economy was
The problems the Soviet economy faced were incapable of impressive feats. In particular, the
fundamentally a result of a lack of markets; in the industrial capacity of the U.S.S.R. was remarkable
United States, prices that emerge as buyers and sellers at its zenith, and the U.S.S.R. did develop important
interact in markets provide valuable signals to guide technology that helped them beat the Americans to
economic decisions, but in the Soviet system markets space and build what was perhaps the most formidable
and prices were suppressed as they were replaced by military power on the planet. The Sputnik program
centralized planning of the economy. This resulted probably best exemplifies Soviet technology at its
in shortages of some goods, which forced Soviet height. Sputnik was the world’s first satellite, launched
consumers to wait in line for those things. When prices in October 1957; while it was only a single event, it
are not allowed to allocate goods to consumers, a non- marked the beginning of the space race between the
price mechanism (here, waiting in line in a first-come-

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U.S. and the Soviet Union. That the U.S.S.R. beat the
Americans into space was a remarkable achievement,
even though the Americans would eventually win the
overall space race.
While Soviet industrial output never quite matched
that of the United States, it came close. By the mid-
1980s, Soviet industrial output reached about 80
percent that of the U.S.56 The theory of economic
development that governed Soviet economic policy
was that heavy industry was the foundation for
economic development. In this respect, economic
organization in the U.S.S.R. was, perhaps ironically,
partly influenced by American-style mass-production
of goods under centralized management as exemplified
by Henry Ford’s mass-production of automobiles. It Soldiers battle in the streets of Seoul during the Korean War.
was also influenced by the German model of a wartime
economy in which an economy mobilizes for warfare
with commodities rationed at fixed prices—hence the Vietnam conflict but still a significant cost at a time
lack of markets referenced earlier. when American GDP was around $370 billion. The
war was enormously costly in terms of human lives.
PROXY WARS, 1950 TO 1990 Over one million North Korean and Chinese soldiers
Fortunately, the Cold War remained cold—it never were killed during the war. An estimated 217,000
became an actual armed conflict, except indirectly in South Korean soldiers died, and nearly 34,000
American soldiers were killed in combat, and many

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a number of “proxy wars” and in the ongoing battle
for influence in the “third world,” often involving more civilians died on both sides of the conflict. The
economic and military aid. In these conflicts, the war ended in a stalemate that persists to this day
Americans and the Soviets supported opposing sides in though an armistice ending hostilities was signed on
regional conflicts, particularly in Asia, but also in other July 27, 1953. The Korean War was an important factor
parts of the world. The first of these conflicts broke in setting the stage for the American-Soviet standoff
out on the Korean peninsula at the very beginning of for the duration of the Cold War.57
the Cold War and perhaps was a harbinger of things to
come. And nearly as soon as the Korean War ended,
The Vietnam Conflict (1955–75)
The Vietnam conflict grew out of the Indochina
the struggle between East and West manifested in
War (1946–54) between France and the Viet Minh,
Southeast Asia in one of the most divisive wars in
a Communist independence coalition pushing for
American history: the Vietnam War. Finally, the
independence from France, their colonial occupier.
Soviets had, in some respects, their own version of the
The end of that war created a dividing line at the
Vietnam conflict after they invaded Afghanistan in
17th Parallel, splitting the country into Communist-
1979.
controlled North Vietnam and Western-leaning South
The Korean War (1950–53) Vietnam. There was ongoing civil strife between
The first of these armed conflicts broke out on the North and South Vietnam even after 1954, and fighting
Korean peninsula in June 1950. The Soviet Union resumed when the South Vietnamese moved to expel
provided significant material support to the North North Vietnamese forces that had been allowed to
Korean military during the conflict, while the remain in the South.58 The Americans got directly
Americans fought on the ground next to their South involved when the first wave of U.S. combat troops
Korean allies. The Korean War cost the U.S. an arrived in the country in 1965.
estimated $30 billion (over $300 billion in today’s Vietnam was enormously costly in terms of lives lost—
dollars), considerably less than the much longer

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Russian advisors inspect the wreckage of a downed B-52 near
Hanoi during the Vietnam War. Soviet soldiers with captured Mujahideen, photographed in
By Photoarchive Sergey A. Varyukhina, CC BY-SA 3.0, 1987 during the Soviet-Afghan War.
https://commons.wikimedia.org/w/index.php?curid=25021160 By Кувакин Е. (1985); scanned and processed by User:Vizu (2009);
E.Kuvakin by personal collection, CC BY-SA 3.0,
https://commons.wikimedia.org/w/index.php?curid=7046938
nearly 60,000 American soldiers were killed while
an estimated 1 million North Vietnamese, and up to directly entered the Afghan war, it did supply critical
250,000 South Vietnamese soliders died—but it was armaments to the Mujahideen, who were fighting the
also costly in economic terms.59 Because of the military Soviet army there. While it did not significantly impact
buildup that was already part of the Cold War, American the Soviet economy, in part because troop commitments
military spending was high even before the ramping increased only slowly over time and because the Soviet
up of U.S. action in Vietnam in 1965. Moreover, one

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government sought to minimize material and human
means by which President Kennedy sought to stimulate losses, it played at least some role in directing valuable
the sluggish economy early in his administration was resources away from potentially more productive areas.
through increased defense spending. This so-called
“military Keynesianism”—named after the economist A now declassified CIA report from 1987 estimates
John M. Keynes who argued that government spending that the Soviets spent about 15 billion rubles (the Soviet
could effectively boost the aggregate demand—was currency)—about 12.5 percent of their defense budget
partly justified by the fact that the United States had in 1986—on the conflict from 1979 to 1986 and noted
fallen behind the Soviet Union in its military readiness. that the costs of the war rose more rapidly than the total
As a result, defense spending increased to 9 percent defense spending. An estimated 13,310 Soviet soldiers
of GDP in the early 1960s. Because it was already at died in the Soviet-Afghan War, according to official
relatively high levels, the surge related to Vietnam is statistics released by the Soviet government in 1988.61
perhaps less noticeable than one might expect. In 1962,
military spending was about 8.6 percent of GDP, and REAGAN’S DEFENSE BUILDUP
by the peak of the conflict, this figure had risen only AND THE END OF THE COLD
slightly to just over 8.7 percent. Military spending as a
share of GDP declined considerably between 1962 and WAR
1965, so the “surge” was from a low of 7 percent in 1965 President Ronald Reagan took office in January 1981,
to 8.7 percent in 1967.60 having promised to build up America’s military
defenses partly by using revenues that he thought would
Afghanistan (1979–89) be generated by lower tax rates. (The idea was to lower
The Soviets first intervened in Afghanistan in late tax rates, which would stimulate economic growth
1979, but the war that its intervention sparked would and actually increase revenues.) While the promised
drag on for a decade and would kill an estimated 2 increases in tax revenues failed to fully materialize,
million Afghan civilians. While the United States never Reagan did manage to increase U.S. defense spending

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 TABLE 3

President Ronald Reagan outlines his planned tax cut in

a televised address from the Oval Office in 1981. Reagan
promised to build up America’s military defenses partly by
using revenues he thought would be generated by lower tax
rates.

percent between 1981 and 1985, before starting to fall

slightly (in real, not nominal) terms beginning in 1987.
In other words, defense spending continued to increase
in the late 1980s, but not enough to keep pace with the
general increase in prices during that period.

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Total Defense Outlays in the United States, 1980–1990 The most controversial of Reagan’s defense programs
(billions of dollars)
was the Strategic Defense Initiative (SDI), announced
Sources: Nominal GDP is from Louis Johnston and Samuel H. Williamson, in 1983 and commonly known as the “Star Wars”
“What Was the U.S. GDP Then?” MeasuringWorth, 2019. Total Defense
Outlays is from Historical Statistics of the United States, Earliest Times to
program. This program was designed to neutralize
the Present: Millennial Edition, edited by Susan B. Carter, Scott Sigmund the threat of Soviet intercontinental ballistic missiles
Gartner, Michael R. Haines, Alan L. Olmstead, Richard Sutch, and Gavin (ICBMs) by placing anti-missile satellites in space that
Wright. New York: Cambridge University Press, 2006, Ed147.
could be used to shoot down ICBMs in the event of
war. Some observers have claimed that SDI “seemed
considerably during his two terms in office as shown
to impress the Soviets as a challenge that they might
in Table 3. Military spending rose from $134 billion in
not be able to meet.”62 But on closer examination,
1980 to over $303 billion in 1989 at the end of Reagan's
the claim that Reagan’s defense buildup ended up
term, increasing from less than 5 percent of GDP before
“bankrupting” the Soviet Union is inconsistent with
he took office to a peak of 6 percent in 1986. The federal
the evidence. Estimates by the Central Intelligence
budget deficit rose dramatically, largely because of the
Agency suggest that Soviet defense spending remained
significant increase in defense spending coupled with
relatively constant throughout the 1980s, although it is
the tax cuts of 1981 and 1986.
possible that the Soviets shifted spending within their
Since defense spending will rise over time partly as a defense budget to deal with what they saw as a new
result of general price inflation, Table 3 also includes American threat.
an adjustment for inflation in the calculations for Real
The Soviets spent an unusually high share of their
GDP and Total Defense Outlays in constant 1995
budget on defense, but at its core, the Soviet economic
dollars. The figures for inflation-adjusted defense
system was burdened with deep fundamental flaws
spending show that Reagan’s defense spending rose
that were ultimately more responsible for its collapse.
substantially during his first term. On average, real
Alexander Dallin and Gail Lapidus observed that “the
defense outlays increased at an annual rate of 7.6
[Soviet] system was [already] on the threshold of major

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crisis.”63 Richard Lebow and Janice Stein wrote that the
real problem was that the Soviet economic system “did
not reward individual or collective effort; it absolved
Soviet producers from the discipline of the market;
and it gave power to officials who could not be held
accountable by consumers.”64 As we saw earlier, this led
to relatively low levels of productivity in the Soviet and
Eastern European economies. Soviet president Mikhail
Gorbachev’s economic adviser Grigory Yavlinsky
famously said, “The Soviet system is not working
because the workers are not working.” Given their lack
of incentives, such a conclusion is to be expected.

Gorbachev’s Reforms Reagan and Gorbachev with their wives Nancy and Raisa,
respectively, attend a dinner at the Soviet Embassy in
Mikhail Gorbachev, who became General Secretary Washington in 1987.
in 1985 (he served under different titles as leader of
the Soviet Union until his ouster in 1991), came to
economic order.”67 Since the economy was largely
understand some of these fundamental problems and
managed by thousands of “enterprises” (basically the
sought to reform them in what was broadly referred
equivalent of Western-style corporations), Gorbachev
to as “perestroika.” In his February 1986 report to
understood that increasing the overall efficiency of
the Congress of the Party, Gorbachev committed
the economy would require changing the way those
to radical economic reforms designed to increase
enterprises functioned.
economic efficiency and improve the lives of everyday
consumers.65 Gorbachev’s objective was to reinvigorate In doing so, Gorbachev was actually following the lead

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an economy that was experiencing declining economic of another centrally controlled economy that had begun
growth rates by positioning it to be a part of the new to transition to a more market-oriented one: China.
global economy that was increasingly being driven by Drawing on some lessons from the successful Chinese
high-technology. reforms, in 1986 the “Law on Individual Labor
Activity” permitted people to work outside of state
To do this, he had to make the Soviet economy more
enterprises. Given that the state enterprises had failed
efficient; one way to do this was to make factory
to satisfy consumer demand for goods and services,
managers more responsive to the needs of consumers
freeing up labor to work elsewhere would help remedy
by decentralizing decision-making power. Gorbachev
this problem. This law expanded workers’ rights, in
also authorized some private and cooperative businesses
part by letting those who did not have jobs in the state
and expanded private initiatives for certain general
sector work for themselves. By allowing those who did
agricultural activities. As Marshall Goldman explained,
not have fulltime employment, including “housewives,
farmers could “contract with the farm management
pensioners, invalids and students,” to create their
to raise farm livestock as a sort of sub-contractor…
own jobs, the law led to a significant expansion in the
moreover, the farm as a unit is allowed to sell up to
labor force.68 While there was significant opposition
thirty percent of its output directly to retailers....”66
to this new law from those who feared it would help
The Soviet transition away from Communism was usher in a capitalist system, Gorbachev managed to
anything but a resounding success. According to Chris push it through the Politburo, the U.S.S.R.’s principal
Miller, “Five years after the start of perestroika, the policymaking body.
combination of industrial collapse, food shortages, and
The reforms continued in 1988 with a new “Law on
inflation had polarized Soviet politics. Radicals who
Cooperatives.” This law made sweeping changes
wanted privatization and an immediate transition to a
to the Soviet economy. It allowed for new business
market economy clashed with Stalinists who thought
cooperatives and replaced central planning with
that only renewed authoritarianism could restore
independent planning in some sectors. The cooperatives

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were, for all practical purposes, indistinguishable from SECTION IV SUMMARY
small private businesses and were to be largely free While the Soviet Union and the United States
from the control of government agencies; for instance, fought as allies against Nazi Germany during
they were free to set their own prices rather than have World War Two, political and economic
those prices set by central bureaucracies. According to divisions emerged even before the end of the
Darrell Slider, “cooperatives soon encompassed the full war. Once the war ended, those divisions led
range of economic activities [including] repair shops, to a split between Soviet-dominated Eastern
bakeries and computer programming….”69 Europe (and the Warsaw Pact) and American-
allied Western Europe (and NATO).
The Collapse of the U.S.S.R.
The Americans helped rebuild war-devastated
In the end, the Berlin Wall fell in 1989, and Gorbachev
Europe with the Marshall Plan, which was
was forced out of power in the Soviet Union just
initiated shortly after the end of World War
two years later.70 The Soviet flag was lowered at the
Two. Under the Marshall Plan, the United
Kremlin for the last time on December 25, 1991, and
States provided $13 billion in financial aid to
it was replaced with the Russian tri-color flag on
Western European countries between July 1948
that same day.71 Some of the former Soviet satellite
and June 1951.
countries in Eastern Europe transitioned successfully
and rapidly to market economies. The most successful Nuclear weapons loomed large in the Cold
of these transitions occurred in the Baltic countries War and were the primary deterrent for each
(Estonia, Latvia, and Lithuania) and in Poland, which side; however, the Americans never spent a
experienced significant inflows of foreign direct significant portion of their defense budget on
investment and was able to build an infrastructure these weapons. Spending on nuclear weapons
that supported dynamic small businesses across the never exceeded three percent of the total U.S.
country. Other countries, including Russia, were much defense budget.

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less successful in transitioning out of communism and The Soviet-American standoff during the Cold
ended up with some form of authoritarian rule. War highlights important differences between
the economic systems of the two countries. The
These changes came about after a decades-long struggle
American economy was largely decentralized,
with NATO and the United States. And that struggle,
driven by market prices and the profit motive.
while never becoming the nuclear holocaust that many
The Soviet economy was, by contrast, driven
people feared, was still enormously costly. Robert
from the top-down by centralized planning.
Higgs estimated that real military purchases from 1948
The incentives in each system were drastically
through 1989 cost over $7 trillion in the United States
different, and the American economy was
alone (about $168 billion per year), and Walter LaFeber
ultimately considerably stronger and more
estimated that the Cold War claimed the lives of 100,000
durable.
Americans in the various proxy wars that were a
defining feature of this period in world history.72,73 The underlying economic problems in the
Soviet Union were ultimately more responsible
for its collapse than were Soviet efforts to keep
pace with American military developments in
the 1980s.

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 Section IV Timeline

May 7, 1945 – Germany surrenders, ending World War Two in Europe.

September 2, 1945 – World War Two formally ends with Japan’s surrender.
October 30, 1947 – The General Agreement on Tariffs and Trade (GATT) is signed in Geneva.
April 3, 1948 – President Truman signs the Marshall Plan.
April 4, 1949 – The North Atlantic Treaty Organization (NATO) is formed.
August 29, 1949 – The Soviet Union conducts its first successful atomic bomb test.
June 25, 1950 – The Korean War begins with the North Korean invasion of South Korea.
June 1951 – The Marshall Plan ends.

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July 27, 1953 – The Korean War ends with an armistice.
May 14, 1955 – The Warsaw Pact is formed.
October 4, 1957 – The Soviet Union launches the Sputnik satellite into space.
July 24, 1959 – Nixon and Khrushchev have their “Kitchen Debate” in Moscow.
August 13, 1961 – Construction of the Berlin Wall begins.
Congress passes the Gulf of Tonkin Resolution, authorizing President Johnson to take
August 7, 1964 –
measures he believed necessary to retaliate against North Vietnam.
May 26, 1972 – SALT is signed by the United States and the Soviet Union.
March 29, 1973 – The last American troops leave Vietnam.
June 17, 1979 – SALT II is signed by the United States and the Soviet Union.
December 1979 – The Soviet Union invades Afghanistan.
January 20, 1981 – Ronald Reagan becomes president of the United States.
Mikhail Gorbachev becomes General Secretary of the Communist Party in the Soviet
March 11, 1985 –
Union.
January 20, 1989 – President Reagan’s second term as president of the United States ends.
February 15, 1989 – The Soviet-Afghan war ends as the last Soviet troops leave.
Mikhail Gorbachev steps down as the leader of the Soviet Union and announces its
December 25, 1991 –
dissolution effective the next day.

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 Glossary

Aggregate demand curve – a graphical depiction of the command economy– an economy in which market forces
relationship between the level of desired expenditures are replaced by the control of a central authority, and
in an economy and the price level the means of production are publicly owned; in a
command economy, the government decides what is
Aggregate supply curve– a graphical depiction of the
produced and how much is produced and determines
relationship between the quantity of goods and
the price of goods.
services firms wish to supply and the price level
Comparative advantage– the ability to produce a good
Average labor productivity – total output divided by the
or service at a lower opportunity cost than other
quantity of labor employed in its production
producers
Bank run– a sudden rush of depositors seeking to
Competitive market – a market with many buyers and
withdraw funds from the banking system
sellers trading a homogenous good or service in which
Barriers to entry – conditions that prevent firms from each buyer and seller is a price taker
freely entering or exiting a market
Complements– two goods for which a rise in the price of

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Bretton Woods system – an international monetary one leads to a decline in the demand for the other
system created in 1944 that lasted until 1971; it
Consumer Price Index (CPI)– an index constructed by
established a fixed currency exchange rate, replacing
comparing the cost of purchasing a fixed basket of
the gold standard with a system in which the U.S.
goods at different times
dollar was the primary currency—the currencies of
other countries were tied to the dollar, which was in Consumer surplus– the difference between the amount
turn tied to gold. that a buyer would be willing to pay for a good or
service and the price actually paid
Business cycle– fluctuations in aggregate economic
activity Consumption – spending by households on goods and
services, with the exception of the purchase of new
Capital – one of three factors of production; in classical
housing
economics, capital refers to money or physical assets.
Plows or mature tree crops may be considered forms Crowding out– the decrease in private investment that
of capital in this context. occurs as a result of a reduction in government saving
or an increase in government borrowing
Capital goods– long-lived goods that are themselves
produced and are used to produce other goods and Council for Mutual Economic Assistance (CMEA)
services, but are not used up in the production process – an economic organization established in 1949 to
coordinate the economic development of Eastern bloc
Cartel – a group of firms that collude in a given
countries
market to restrain competition, often making quota
arrangements among themselves Currency – coins and bills in the hands of the public
Coase Theorem– the proposition that if private parties can Cyclical unemployment  – unemployment caused by
bargain without cost over the allocation of resources, deviations of output from its potential level
then they can solve the problem of externalities on
Deadweight loss 
– the reduction in total surplus that
their own

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 results from a market distortion such as a tax aggregate demand and through it the level of overall
economic activity
Demand curve– a graphical representation of the quantity
of a good or service demanded as a function of the Fixed cost– a cost of production that is independent of the
price quantity produced
Demand schedule– a table showing the relationship Foreign direct investment – when a company or
between the price of a good or service and the quantity individual acquires assets in a foreign country that
demanded they will manage directly
Depression– a severe recession Frictional unemployment– unemployment that results
because it takes time for workers to search for the jobs
Diminishing returns to scale– the property whereby
that are best suited to their tastes and skills
each additional increase in inputs results in a smaller
increase in the quantity produced Gains from trade– the benefits that both individuals or
nations realize from mutually beneficial exchange
Discount rate– the interest rate that the Federal Reserve
charges banks when they must borrow reserves from GATT (General Agreement on Tariffs and Trade)
it – Signed in 1947, this agreement aimed to increase
trade among nations by reducing tariffs, quotas, and
Economic profit – the difference between the revenue
subsidies. It has gone through a number of “rounds”
realized by a producer and the opportunity cost of
over time in which the trade agreements have been
production
renegotiated.
Elasticity – the percentage change in quantity demanded
Government purchases – spending on goods and services
or supplied as a result of a one percent change in price
by federal, state, and local governments
Entrepreneur – an individual who takes on the risk of
Gross Domestic Product (GDP)– the market value of
attempting to create new products or services, establish

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final goods and services produced in an economy
new markets, or develop new methods of production
during a specified period of time
Equilibrium – a situation in which the forces in a system
Gross Domestic Product (GDP) per capita– estimate
are in balance so that the situation is stable and
of national output (gross domestic product), divided
unchanging
by the population; its key advantage as a measure of
Excludability – the ability to prevent buyers from economic performance is in giving an average level of
enjoying the benefits of consuming a good or service income per person, which can be compared between
without paying for it countries.
Expansion – a period between a trough and a peak in Human capital– skills and experience that are acquired
economic activity through education, training, and on-the-job experience
that increase a worker’s productivity; considered
Externality – when the action of one person affects the an important factor in facilitating improvements in
well-being of someone else, but where neither party productivity and economic growth
pays nor is paid for these effects
Imperfect competition– the case of a market with a small
Federal funds rate – the rate that banks charge other number of sellers, so that sellers have market power
banks when they lend reserves
Inferior good– a good for which the quantity demanded
Final goods– goods or services that are purchased by falls as buyers’ income increases
their ultimate user
Inflation– a general increase in prices
Financial markets  – the institutions through which
individuals with savings can supply these funds to Institutions – formal and informal rules that structure
persons or firms that wish to borrow money to purchase human interactions
consumption goods or invest in physical capital
Intermediary – a third party who acts as a link between
Fiscal policy– the use of taxes and spending to influence two others who wish to transact business

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Intermediate good – a good or service that is used in the Marshall Plan – a U.S. aid program, passed in 1948,
process of producing other goods and services that provided $13 billion in financial aid to Western
European countries to assist in their recovery in the
International Monetary Fund (IMF) – an international
aftermath of World War II
organization established at the Bretton Woods
conference to encourage global monetary cooperation Monetary base – the quantity of currency plus bank
and financial stability, facilitate trade, and reduce reserves
poverty
Monetary policy – the use of the supply of money in the
Investment – spending on capital equipment, inventories, economy by the Federal Reserve to influence the level
and structures, including household purchases of new of aggregate demand
housing
Money – an asset that is a medium of exchange, unit of
Keynesian model – a model of short-run aggregate account, and store of value
economic fluctuations inspired by the analysis of
Money multiplier – the ratio of the money supply to the
British economist John Maynard Keynes, which
monetary base
attributes short-run deviations in output from potential
to variations in the level of aggregate demand or Money supply– the quantity of money available to the
aggregate supply economy
Labor force – the sum of those individuals who are Monopolistic competition – a market in which there
employed and those who are seeking paid work but is free entry or exit, but every producer supplies a
have not found it differentiated product and faces a downward-sloping
demand curve
Labor force participation rate – the fraction of the
working-age population who are in the labor force Monopoly – a market in which there is a single producer
Law of demand – holding other things equal, the quantity Natural rate of unemployment – the level of

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demanded is negatively related to the price unemployment that would exist if the economy were
producing at its potential output
Law of supply – holding other things equal, the quantity
supplied is positively related to the price Net capital outflow – the difference between the
purchases of foreign assets by domestic residents and
Liquidity – the ease with which a nonmonetary asset may
the purchases of domestic assets by foreign residents
be converted into money
Net exports – the difference between the value of goods
Logrolling – the practice of elected officials trading votes
and services sold to foreigners and the value of goods
Marginal cost – the additional cost of production and services purchased from foreigners
associated with a small increase in the quantity
Neutrality of money – the proposition that in the long
produced
run, changes in the quantity of money affect the price
Marginal revenue – the additional revenue resulting from level but do not affect any real quantities
a small increase in the quantity produced
Nominal GDP – the production of goods and services
Market failure – any situation in which a market does valued at current prices
not do what market theorists believe it should—
Normal good – a good or service for which demand is
allocate goods and services efficiently; externalities
positively related to the buyer’s income
and monopoly/oligopoly are two commonly discussed
failures Normative economics – economic analysis used to guide
decisions about what should be as opposed to what is
Market power – a situation in which one firm, or a
the case
group of them acting as a cartel, can control prices
in a market, often by restricting output, and thus have Okun’s law – a relationship identified by Arthur Okun
market power; in a theoretical, purely competitive between the output gap and the level of cyclical
market, this is not possible unemployment

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Oligopoly – a market in which there are just a few Real GDP – the production of goods and services valued
producers at constant prices
Open market operations – a tool used by the Federal Recession – a period between a peak and a trough in
Reserve to adjust the money supply by buying or economic activity
selling U.S. government bonds in the financial market
Rent seeking – using political influence to increase one’s
Opportunity cost – the cost of any choice is what must be economic profits at the expense of others
given up by making that choice
Reserve requirement – the amount of reserves that the
Output gap – the difference between actual output and Federal Reserve requires banks to hold
potential output
Reserves – the fraction of deposit liabilities that banks
Pareto efficiency – describes an allocation in which hold to meet depositor withdrawals
the only way to make any individual or group of
Rival goods – goods or services characterized by the fact
individuals better off would require making at least
that one person’s enjoyment of the good or service
one other person worse off
reduces the quantity available for others’ enjoyment
Per capita – literally per head, used to denote an average
Savings – the difference between a person’s disposable
value for a population
income and his or her expenditures
Portfolio investment – the purchase of shares of stock or
Scarcity – an inescapable fact of human existence that
bonds
results from the fact that the available resources are
Positive economics – the use of the tools of economic always less than our limitless desires
analysis to describe and explain economic phenomena
Structural unemployment – unemployment that results
and to make predictions about what will happen under
from the mismatch in skills, locations, or other
particular circumstances
important characteristics between job seekers and the

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Potential output – the quantity of output that would be available jobs
produced by an economy if all of its resources were
Substitutes – two goods for which an increase in the price
being employed at normal rates
of one leads to an increase in the demand for the other
Price discrimination – when a business sells the same
Supply curve – a graphical representation of the quantity
product to different buyers at different prices
of a good or service supplied as a function of the price
Price elasticity of demand – the amount by which
Supply schedule – a table showing the relationship
demand for a given product changes in response to
between the price of a good or service and the quantity
changes in price; specifically, the percentage change
supplied
in demand that corresponds to a one percent change
in the price Technology – knowledge about the techniques by which
inputs are transformed into the goods and services
Producer surplus – the difference between the price
that households desire
that producers receive for supplying a good and their
marginal cost of producing it Total revenue – the total revenue received by a supplier
Production possibility frontier (PPF)  – a graphical Total surplus – the sum of consumer and producer surplus
depiction of the combinations of output that can be
produced by an economy Tragedy of the commons – the depletion of a common
resource due to overuse
Public good – a good or service for which it is not possible
to establish individual property rights Truman Doctrine – refers to a U.S. foreign policy that
focused on countering Soviet expansion, first pursued
Rationality – when individual choices are made by under President Truman; this approach constituted
comparing the benefits and costs of different actions a move away from isolationism and toward U.S.
and then selecting the action that produces the greatest involvement in regional conflicts in other parts of the
benefit globe.

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Unemployment – the state of actively seeking paid work Velocity of money – the ratio of nominal GDP to the money
but being unable to find it supply; in effect, the average number of transactions
supported by each dollar of the money supply
Unemployment rate – the number of unemployed workers
as a fraction of the total labor force Wealth – the total value of assets used as a store of value
Variable cost – a cost of production that depends on the World Bank– an international organization affiliated
quantity produced with the United Nations that aims to help developing
economies reduce poverty

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 notes
1. “Supermarket Facts: Industry Overview higher price for their product.
2008,” Food Marketing Institute, 26 6. Bob’s costs of producing a quantity q are C(q)
June 2009 <http://www.fmi.org/facts_ = 300 + 2q + q2/300, and the marginal costs

Notes
figs/?fuseaction=superfact>. corresponding to this equation are MC(q) = 2 +
2. The auctioneer may be an actual person, or q/150.
the process of matching sellers and buyers 7. N. Gregory Mankiw, Principles of Economics, 4th
may be accomplished by means of a computer ed. (Mason, OH: Thomson Southwestern, 2007)
network. 345–46.
3. Many consumers object to genetically 8. “About the Congestion Charge: Background,”
modified foods such as milk produced using Transport for London, 25 July 2009
BGH. The use of BGH by U.S. dairy farmers has <http://www.tfl.gov.uk/roadusers/
led to an ongoing dispute between the U.S. congestioncharging/6725.aspx>.
1. “ Supermarket Facts: Industry Overview 2008,” Food Marketing Institute, 13. F  or a more extensive discussion of these issues, see Clifford Cobb,
and the European Union in the World Trade
26 June 2009 <http://www.fmi.org/facts_figs/?fuseaction=superfact>. 9. Real GDP inTed 1900 Halstead,
was $423 andbillion.
JonathanBy Rowe,
2008, “If
it the GDP is Up, Why is America
Organization (WTO) concerning hormone-fed
2. T he auctioneer may be an actual person, or the process of matching had grown Down,”
to Atlantic
$13,312 Monthly (October 1995) 59–78. Notes 2010–2011 §
billion.
beef. Economics Resource Guide 127.
sellers and buyers may be accomplished by means of a computer
4. Formally, the elasticity measures the
network. 10. International
14. Mcomparisons
ichael Boskin,of et the sort presented
al., “Toward a More Accurate Measure of the Cost
3. percentage change in quantity demanded
Many consumers object to genetically modified foods such as milk in Figure 32ofare sensitive
Living,” to
Final the prices
Report that
to the Senate Finance Committee from the
produced caused by a one
using BGH. Thepercent
use of BGH change in price
by U.S. dairyatfarmers has led are used to Advisory
compareCommission
productiontoacrossStudythe
the Consumer Price Index, December
a specific
to an ongoing point
dispute on thethe
between demand
U.S. andcurve.
the European 1996, Social
When Union in thedifferent countries. The Security
comparisonsOnline, 20 Aug.
made here2009 <http://www.ssa.gov/
World Trade Organization
we measure changes(WTO)over concerning hormone-fed
finite distances, the beef. use current history/reports/boskinrpt.html>.
exchange rates to convert national
4. Formally, results will depend
the elasticity on the
measures theposition
percentagewechange 15. W
take asin quantity GDP figures  into
e assume here
dollars, that the government
a practice that resultscompensates for the income lost as
demanded ourcaused
starting
by point. To avoid
a one percent this problem,
change in price atthe in an understatement of the standardincreasing
a specific point on a result of the tax credit by of living taxes on some other transactions.
the demand curve. When
convention is thatwewe
measure
calculatechanges over finite distances, the
the percentage If this were not the case, then government savings would be reduced,
in lower-income countries. Using an alternative
results will
changedepend
withonreference
the position towethetake as our starting
midpoint of the point. To avoid and the tax credit would have no net effect on the economy.
approach that better reflects actual purchasing
this problem,
initial the
andconvention is that
final values. weprice
If the calculate the percentage change
changed 16. See <http://www.federalreserve.gov/faqs/about_12591.htm>.
power in the different countries would perhaps
with reference
from P1toto theP2,
midpoint
then we of would
the initial and final
calculate values. If the price
the 17. Dates for the start of the Cold War vary depending on the source. Many
changedpercentage
from P1 to P2, then we would calculate the percentage changedouble or triple income levels in countries like
change as: scholars date the start of the Cold War as 1946 or 1947.
as: Ghana or Nigeria. While this would narrow the
18. h ttps://www.nationalww2museum.org/students-teachers/student-
pct change = 100 × P2 – P1 .
gap in living standards relative to the U.S., the
resources/research-starters/research-starters-worldwide-deaths-world-
(½) · (P2 + P1) gap still remains
war. huge.

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5. 5. In farmers
I n reality, reality, farmers cantochoose
can choose producetoorganic
produce 11. The official
milk, which consumers 19. Iseries
t shouldprobably
be noted greatly overstates
that American economic aid to Western Europe
understand organic
is BGHmilk, which
free. consumers
Because understand
some consumers is milk produced
prefer the economicbegan prior to
growth ofthe Marshall
World War II.Plan,
See,but
forthis plan was aimed at longer-term
without BGH BGH,free.
farmers who choose
Because to produce in
some consumers milk with the example, Robert
compliance
prefer postwar recovery.
Higgs, “Wartime Prosperity?
requirement to labelwithout
produced their product as organic
BGH, farmers whocanchoose
command A Reassessment
to a higher price 20. B  arryof the U.S. Economy
Eichengreen, “Lessonsinfromthe the Marshall Plan,” World
for theirproduce
product. in compliance with the requirement to Development
1940s,” Journal of EconomicReport, 2010,52,
History, p.1.no. 1
6. B
 ob’s costs labeloftheir
producing a quantity
product q arecan
as organic = 300 + 2qa+ q2/300, and(March21.
C(q)command 1992).
Ibid.
the marginal costs corresponding to this equation are MC(q) = 2 + q/150. 22. Barry Eichengreen, “The Marshall Plan: Economic Effects and
7. N. Gregory Mankiw, Principles of Economics, 4th ed. (Mason, OH: Implications for Eastern Europe and the Former USSR.” Economic
122 Southwestern, 2007) 345–46. USAD Economics Resource Guide •Policy
Thomson 7(14): 13–75, 1992.
2016–2017
8. “ About the Congestion Charge: Background,” Transport for London, 25 23. B
 arry Eichengreen, “Institutions and Economic Growth: Europe after
July 2009 <http://www.tfl.gov.uk/roadusers/congestioncharging/6725. World War II,” In Economic Growth in Europe since 1945, edited by
aspx>. Nicholas Crafts and Gianni Toniolo (Cambridge: Cambridge University
9. R
 eal GDP in 1900 was $423 billion. By 2008, it had grown to $13,312 Press, 1996) 38.
billion. 24. Ibid., 41.
10. I nternational comparisons of the sort presented in Figure 32 are 25. https://www.imf.org/en/About.
sensitive to the prices that are used to compare production across the 26. https://www.worldbank.org/en/about.
different countries. The comparisons made here use current exchange 27. https://www.wto.org/english/thewto_e/history_e/history_e.htm.
rates to convert national GDP figures into dollars, a practice that
28. h ttps://www.cia.gov/library/readingroom/collection/cia-analysis-
results in an understatement of the standard of living in lower-income
warsaw-pact-forces?page=4.
countries. Using an alternative approach that better reflects actual
purchasing power in the different countries would perhaps double or 29. Mancur Olson, Jr. and Richard Zeckhauser, “An Economic Theory of
triple income levels in countries like Ghana or Nigeria. While this Alliances.” Review of Economics and Statistics 48(3): 267, 1966.
would narrow the gap in living standards relative to the U.S., the gap 30. Ibid.
still remains huge. 31. Ibid.
11. T he official series probably greatly overstates the economic growth of 32. Ibid.
World War II. See, for example, Robert Higgs, “Wartime Prosperity? A
33. Albrecht O. Ritschl, “An Exercise in Futility: East German Economic
Reassessment of the U.S. Economy in the 1940s,” Journal of Economic
Growth and Decline, 1945–89.” In Economic Growth in Europe since
History, 52, no. 1 (March 1992).
1945, edited by Nicholas Crafts and Gianni Toniolo, 498. Cambridge:
12. See Richard Sutch, “National Income and Product,” Historical Statistics Cambridge University Press, 1996.
of the United States, Earliest Times to the Present: Millennial Edition,
34. Ibid.
Eds. Susan B. Carter, Scott Sigmund Gartner, Michael R. Haines, Alan
L. Olmstead, Richard Sutch, and Gavin Wright. New York: Cambridge 35. T  otal factor productivity is calculated as whatever portion of an increase
University Press, 2006. in output cannot be accounted for by the “factors of production” (land,

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 labor, and capital). If an economy produces more than can be accounted Europe, and the West,” Planning and Performance in Socialist
for, that extra production is attributed to the productivity with which Economies: The USSR and Eastern Europe, Edited by Abram Bergson
those factors of production were used. (Boston: Unwin Hyman, 1989) 9–31.
36. A
 lbrecht O. Ritschl, “An Exercise in Futility: East German Economic 53. I n the mid-1970s, the Soviets spent nearly 40 percent more on defense
Growth and Decline, 1945–89.” In Economic Growth in Europe since than did the United States.
1945, edited by Nicholas Crafts and Gianni Toniolo (Cambridge: 54. Mark Harrison, “The Soiet Economy, 1917–1991: Its Life and Afterlife,”
Cambridge University Press, 1996) 501. VOX CEPR Policy Portal, November 7, 2017, https://voxeu.org/article/
37. Wendy Carlin, “West German Growth and Institutions, 1945–90,” CEPR soviet-economy-1917-1991-its-life-and-afterlife.
Discussion Papers, no. 896, 1994. 55. Philip Hanson, The Rise and Fall of the Soviet Economy: An Economic
38. A
 lbrecht O. Ritschl, “An Exercise in Futility: East German Economic History of the USSR from 1945 (London: Routledge, 2014) 6.
Growth and Decline, 1945–89.” In Economic Growth in Europe since 56. CIA 1985.
1945, edited by Nicholas Crafts and Gianni Toniolo (Cambridge:
57. T he American data are from https://www.va.gov/opa/publications/
Cambridge University Press, 1996).
factsheets/fs_americas_wars.pdf. The estimates for Chinese and Korean
39. Jaap Sleifer, Planning Ahead and Falling Behind: The East German deaths are from https://www.britannica.com/event/Korean-War.
Economy in Comparison with West Germany, 1936–2002 (Berlin:
58. S
 pencer C. Tucker, “Overview of the Vietnam War” In The
Akademie Verlag, 2006) 50.
Encyclopedia of the Vietnam War: A Political, Social, and Military
40. Charles S. Maier, “The World Economy and the Cold War in the Middle History, 2nd ed. (Santa Barbara, CA: ABC-CLIO, 2011).
of the Twentieth Century.” In: Leffler M, Westad OA The Cambridge
59. https://www.britannica.com/event/Vietnam-War.
History of the Cold War, vol.1. (Cambridge: Cambridge University
Press, 2011) 64. 60. h ttp://data.worldbank.org/indicator/MS.MIL.XPND.
GD.ZS?end=2016&locations=US&start=1960&view=chart.
41. https://www.zeit.de/feature/german-unification-a-nation-divided.
61. https://www.nytimes.com/1988/05/26/world/soviet-lists-afghan-war-toll-
42. William J. Weida, “The Economic Implications of Nuclear Weapons
13310-dead-35478-wounded.html.
and Nuclear Deterrence.” In Atomic Audit: The Costs and Consequences
of U.S. Nuclear Weapons Since 1940, Stephen I. Schwartz (ed.) 62. https://www.theatlantic.com/past/docs/politics/foreign/reagrus.htm.
(Washington, D.C.: Brookings Institution Press, 1998) 522. 63. A. Dallin and G. Lapidus, “The Roots of Perestroika,” in A. Dallin and
43. W
 illiam J. Weida, “The Economic Implications of Nuclear Weapons G. Lapidus (eds.), The Soviet System in Crisis: A Reader of Western and
and Nuclear Deterrence.” In Atomic Audit: The Costs and Consequences Soviet Views (Boulder, CO: Westview Press, 1991) 9.
of U.S. Nuclear Weapons Since 1940, Stephen I. Schwartz (ed.) 64. R ichard N. Lebow, and Janice G. Stein, “Reagan and the Russians,” The
(Washington, D.C.: Brookings Institution Press, 1998) 540. Atlantic Online, February 1994.
44. A
 nn Markusen, Peter Hall, Scott Campbell and Sabina Deitrick, The 65. J an Adam, “Gorbachev’s Economic Reform,” In: Economic Reforms in
Rise of the Gunbelt: The Military Remapping of Industrial America the Soviet Union and Eastern Europe since the 1960s (London: Palgrave
(Oxford: Oxford University Press, 1991). Macmillan, 1989).

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45. W
 illiam J. Weida, “The Economic Implications of Nuclear Weapons 66. M
 arshall I. Goldman, “Gorbachev and Economic Reform in the Soviet
and Nuclear Deterrence.” In Atomic Audit: The Costs and Consequences Union,” Eastern Economic Journal 14(4): 331–335. 1988.
of U.S. Nuclear Weapons Since 1940, Stephen I. Schwartz (ed.) 67. Chris Miller, The Struggle to Save the Soviet Economy: Mikhail
(Washington, D.C.: Brookings Institution Press, 1998) 527. Gorbachev and the Collapse of the USSR (Chapel Hill: The University
46. Michael Edelstein, “War and the American Economy in the Twentieth of North Carolina Press, 2016) 55.
Century,” The Cambridge Economic History of the United States, edited 68. Ibid., 90.
by Stanley L. Engerman and Robert E. Gallman, Vol III. (New York: 69. D
 arrell Slider, “Embattled Entrepreneurs: Soviet Cooperatives in an
Cambridge University Press, 2000) 329–405. Unreformed Economy.” Soviet Studies, 1991, 43(5): 797.
47. https://data.worldbank.org/indicator/MS.MIL.XPND. 70. The official reunification of Germany occurred in October 1990.
GD.ZS?locations=US.
71. https://history.state.gov/milestones/1989-1992/collapse-soviet-union.
48. https://fas.org/nuke/guide/russia/agency/mo-budget.htm.
72. R
 obert Higgs, “The Cold War Economy: Opportunity Costs, Ideology,
49. https://history.state.gov/milestones/1969-1976/salt. and the Politics of Crisis.” Independent Institute. 1994. Accessed 11
50. https://www.britannica.com/event/Strategic-Arms-Limitation-Talks. September 2019. http://www.independent.org/publications/article.
51. Philip Hanson, The Rise and Fall of the Soviet Economy: An Economic asp?id=1297.
History of the USSR from 1945 (London: Routledge, 2014) 6. 73. W
 alter LaFeber, America, Russia, and the Cold War: 1945–1975 (New
52. Abram Bergson, “Comparative Productivity: The USSR, Eastern York, Wiley, 1976).

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