Essentials of Economics Sixth Edition R. Glenn Hubbard Columbia University Anthony Patrick O’Brien Lehigh University New York, NY A01_HUBB7731_06_SE_FM.indd 1 19/01/18 2:45 pm Vice President, Business, Economics, and UK Courseware: Donna Battista Manager, Learning Tools: Brian Surette Director of Portfolio Management: Adrienne D’Ambrosio Content Developer, Learning Tools: Sarah Peterson Specialist Portfolio Manager: David Alexander Managing Producer, Digital Studio and GLP, Media Production Development Editor: Lena Buonanno and Development: Ashley Santora Editorial Assistant: Nicole Nedwidek Managing Producer, Digital Studio: Diane Lombardo Vice President, Product Marketing: Roxanne McCarley Digital Studio Producer: Melissa Honig Senior Product Marketer: Tricia Murphy Digital Studio Producer: Alana Coles Product Marketing Assistant: Marianela Silvestri Digital Content Team Lead: Noel Lotz Manager of Field Marketing, Business Publishing: Adam Goldstein Digital Content Project Lead: Courtney Kamauf Senior Field Marketing Manager: Carlie Marvel Project Manager: Heidi Allgair, Cenveo® Publisher Services Vice President, Production and Digital Studio, Arts and Business: Interior Design: Cenveo® Publisher Services Etain O’Dea Cover Design: Studio Montage Director of Production, Business: Jeff Holcomb Cover Photos: Phant/Shutterstock; Mariyana M/Shutterstock Managing Producer, Business: Alison Kalil Printer/Binder: LSC Communications, Inc./Kendallville Content Producer: Christine Donovan Cover Printer: Phoenix Color/Hagerstown Operations Specialist: Carol Melville Design Lead: Kathryn Foot Microsoft and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published as part of the services for any purpose. 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Library of Congress Cataloging-in-Publication Data. Names: Hubbard, R. Glenn, author. | O’Brien, Anthony Patrick, author. Title: Essentials of economics / R. Glenn Hubbard, Columbia University, Anthony Patrick O’Brien, Lehigh University. Description: Sixth edition. | New York : Pearson, [2019] | Includes bibliographical references and index. Identifiers: LCCN 2017060843| ISBN 9780134797731 | ISBN 0134797736 Subjects: LCSH: Economics. Classification: LCC HB171 .H83 2019 | DDC 330—dc23 LC record available at https://lccn.loc.gov/2017060843 1 17 ISBN 10: 0-13-479773-6 ISBN 13: 978-0-13-479773-1 A01_HUBB7731_06_SE_FM.indd 2 19/01/18 2:45 pm For Constance, Raph, and Will —R. Glenn Hubbard For Cindy, Matthew, Andrew, and Daniel —Anthony Patrick O’Brien A01_HUBB7731_06_SE_FM.indd 3 19/01/18 2:45 pm This page intentionally left blank ABOUT THE AUTHORS Glenn Hubbard, policymaker, professor, and researcher. R. Glenn Hubbard is the dean and Russell L. Carson Professor of Finance and Economics in the Graduate School of Business at Columbia University and professor of economics in Columbia’s Faculty of Arts and Sciences. He is also a research associate of the National Bureau of Economic Research and a director of Automatic Data Processing, Black Rock Closed- End Funds, and MetLife. He received a PhD in economics from Harvard University in 1983. From 2001 to 2003, he served as chair of the White House Council of Economic Advisers and chair of the OECD Economic Policy Committee, and from 1991 to 1993, he was deputy assistant secretary of the U.S. Treasury Department. He currently serves as co-chair of the nonpartisan Committee on Capital Markets Regulation. Hubbard’s fields of specialization are public economics, financial markets and institutions, corporate finance, macroeconomics, industrial organization, and public policy. He is the author of more than 100 articles in leading journals, including American Economic Review, Brookings Papers on Economic Activity, Journal of Finance, Journal of Financial Economics, Journal of Money, Credit, and Banking, Journal of Political Economy, Journal of Public Economics, Quarterly Journal of Economics, RAND Journal of Economics, and Review of Economics and Statistics. His research has been supported by grants from the National Science Foundation, the National Bureau of Economic Research, and numerous private foundations. Tony O’Brien, award-winning professor and researcher. Anthony Patrick O’Brien is a professor of economics at Lehigh University. He received a PhD from the University of California, Berkeley, in 1987. He has taught principles of economics for more than 20 years, in both large sections and small honors classes. He received the Lehigh University Award for Distinguished Teaching. He was formerly the director of the Diamond Center for Economic Education and was named a Dana Foundation Faculty Fellow and Lehigh Class of 1961 Professor of Economics. He has been a visiting professor at the University of California, Santa Barbara, and the Graduate School of Industrial Administration at Carnegie Mellon University. O’Brien’s research has dealt with issues such as the evolution of the U.S. automobile industry, the sources of U.S. economic competitiveness, the development of U.S. trade policy, the causes of the Great Depression, and the causes of black–white income differences. His research has been published in leading journals, including American Economic Review, Quarterly Journal of Economics, Journal of Money, Credit, and Banking, Industrial Relations, Journal of Economic History, and Explorations in Economic History. His research has been supported by grants from government agencies and private foundations. v A01_HUBB7731_06_SE_FM.indd 5 19/01/18 2:45 pm BRIEF CONTENTS Preface P-1 PART 5 Macroeconomic Foundations A Word of Thanks P-23 Chapter 12: GDP: Measuring Total Production PART 1 Introduction and Income 400 Chapter 1: Economics: Foundations and Models 2 Chapter 13: Unemployment and Inflation 426 Appendix: Using Graphs and Formulas 28 PART 6 Long-Run Economic Growth Chapter 2: Trade-offs, Comparative Advantage, and Short-Run Economic Fluctuations and the Market System 40 Chapter 3: Where Prices Come From: The Interaction of Chapter 14: Economic Growth, the Financial System, Demand and Supply 72 and Business Cycles 466 Chapter 15: Aggregate Demand and Aggregate Supply PART 2 Markets in Action: Policy and Analysis 500 Applications Appendix: Macroeconomic Schools of Thought 538 Chapter 4: Market Efficiency and Market Failure 108 Chapter 5: The Economics of Health Care 150 PART 7 Monetary and Fiscal Policy Chapter 16: Money, Banks, and the Federal Reserve PART 3 Microeconomic Foundations: System 542 Consumers and Firms Chapter 17: Monetary Policy 580 Chapter 6: Firms, the Stock Market, and Corporate Chapter 18: Fiscal Policy 624 Governance 184 Chapter 7: Consumer Choice and Elasticity 210 Chapter 19: Comparative Advantage, International Trade, and Exchange Rates 670 Chapter 8: Technology, Production, and Costs 262 Glossary G-1 PART 4 Market Structure and Firm Company Index I-1 Strategy Subject Index I-2 Credits C-1 Chapter 9: Firms in Perfectly Competitive Markets 292 Chapter 10: Monopoly and Antitrust Policy 328 Chapter 11: Monopolistic Competition and Oligopoly 360 vi A01_HUBB7731_06_SE_FM.indd 6 25/01/18 10:10 am CONTENTS Preface P-1 Graphs of Two Variables 30 A Word of Thanks P-23 Slopes of Lines 31 Taking into Account More Than Two Variables on a Graph 32 PART 1 Introduction Positive and Negative Relationships 32 Determining Cause and Effect 34 CHAPTER 1: Economics: Foundations Are Graphs of Economic Relationships and Models 2 Always Straight Lines? 35 Slopes of Nonlinear Curves 35 Why Does Ford Assemble Cars in Both the Formulas 36 United States and Mexico? 2 Formula for a Percentage Change 37 1.1 Three Key Economic Ideas 4 Formulas for the Areas of a Rectangle and People Are Rational 5 a Triangle 37 People Respond to Economic Incentives 5 Summary of Using Formulas 38 Apply the Concept: Does Health Insurance Problems and Applications 38 Give People an Incentive to Become Obese? 5 Optimal Decisions Are Made at the Margin 7 CHAPTER 2: Trade-offs, Comparative Solved Problem 1.1: The Marginal Benefit and Advantage, and the Market System 40 Marginal Cost of Speed Limits 7 1.2 The Economic Problem That Every Society Managers at Tesla Motors Face Trade-offs 40 Must Solve 8 2.1 Production Possibilities Frontiers and What Goods and Services Will Be Produced? 9 Opportunity Costs 42 How Will the Goods and Services Be Produced? 9 Graphing the Production Possibilities Frontier 42 Who Will Receive the Goods and Services Produced? 9 Solved Problem 2.1: Drawing a Production Centrally Planned Economies versus Market Possibilities Frontier for Tesla Motors 44 Economies 10 Increasing Marginal Opportunity Costs 46 The Modern “Mixed” Economy 10 Economic Growth 47 Efficiency and Equity 11 2.2 Comparative Advantage and Trade 48 1.3 Economic Models 12 Specialization and Gains from Trade 48 The Role of Assumptions in Economic Models 12 Absolute Advantage versus Comparative Forming and Testing Hypotheses in Advantage 50 Economic Models 13 Comparative Advantage and the Gains from Trade 51 Positive and Normative Analysis 14 Don’t Let This Happen to You: Don’t Confuse Don’t Let This Happen to You: Don’t Confuse Absolute Advantage and Comparative Positive Analysis with Normative Analysis 14 Advantage 51 Economics as a Social Science 15 Solved Problem 2.2: Comparative Advantage and Apply the Concept: What Can Economics the Gains from Trade 52 Contribute to the Debate over Tariffs? 15 Apply the Concept: Comparative Advantage, 1.4 Microeconomics and Macroeconomics 16 Opportunity Cost, and Housework 53 1.5 Economic Skills and Economics as a Career 16 2.3 The Market System 54 1.6 A Preview of Important Economic Terms 17 The Circular Flow of Income 55 Conclusion 19 The Gains from Free Markets 56 An Inside Look: Is Manufacturing Returning to The Market Mechanism 56 the United States? 20 Apply the Concept: A Story of the Market System *Chapter Summary and Problems 22 in Action: How Do You Make an iPad? 57 The Role of the Entrepreneur in the Market System 59 Key Terms, Summary, Review Questions, Problems and Applications, and Critical Thinking Exercises The Legal Basis of a Successful Market System 59 Apply the Concept: Managers at Feeding Appendix: Using Graphs and Formulas 28 America Use the Market Mechanism to Graphs of One Variable 29 Reduce Hunger 62 * These end-of-chapter resource materials repeat in all chapters. Select chapters also include Real-Time Data Exercises. Students can complete all questions, problems, and exercises in MyLab Economics. vii A01_HUBB7731_06_SE_FM.indd 7 19/01/18 2:45 pm viii CONTENTS Conclusion 63 PART 2 Markets in Action: Policy and An Inside Look: Tesla Bets Big on Nevada Battery Plant 64 Applications Chapter Summary and Problems 66 CHAPTER 4: Market Efficiency and CHAPTER 3: Where Prices Come From: Market Failure 108 The Interaction of Demand and Supply 72 What Do Food Riots in Venezuela and the How Smart Is Your Water? 72 Rise of Uber in the United States Have 3.1 The Demand Side of the Market 74 in Common? 108 Demand Schedules and Demand Curves 74 4.1 Consumer Surplus and Producer Surplus 110 The Law of Demand 75 Consumer Surplus 110 What Explains the Law of Demand? 75 Apply the Concept: The Consumer Surplus Holding Everything Else Constant: The Ceteris Paribus from Uber 113 Condition 76 Producer Surplus 114 Variables That Shift Market Demand 76 What Consumer Surplus and Producer Surplus Apply the Concept: Virtual Reality Headsets: Measure 115 Will a Substitute Fail for a Lack of 4.2 The Efficiency of Competitive Markets 115 Complements? 77 Marginal Benefit Equals Marginal Cost in Apply the Concept: Millennials Shake Up the Competitive Equilibrium 115 Markets for Soda, Groceries, Big Macs, and Economic Surplus 116 Running Shoes 78 Deadweight Loss 117 A Change in Demand versus a Change in Economic Surplus and Economic Efficiency 117 Quantity Demanded 81 4.3 Government Intervention in the Market: Apply the Concept: Forecasting the Demand for Price Floors and Price Ceilings 118 Premium Bottled Water 81 Price Floors: Government Policy in Agricultural 3.2 The Supply Side of the Market 82 Markets 118 Supply Schedules and Supply Curves 83 Apply the Concept: Price Floors in Labor Markets: The Law of Supply 83 The Debate over Minimum Wage Policy 119 Variables That Shift Market Supply 83 Price Ceilings: Government Rent Control Policy in A Change in Supply versus a Change in Housing Markets 121 Quantity Supplied 86 Don’t Let This Happen to You: Don’t Confuse 3.3 Market Equilibrium: Putting Demand and “Scarcity” with “Shortage” 122 Supply Together 86 Black Markets and Peer-to-Peer Sites 122 How Markets Eliminate Surpluses Solved Problem 4.3: What’s the Economic and Shortages 87 Effect of a Black Market in Renting Demand and Supply Both Count 88 Apartments? 123 Solved Problem 3.3: Demand and Supply Both The Results of Government Price Controls: Count: A Tale of Two Letters 88 Winners, Losers, and Inefficiency 124 3.4 The Effect of Demand and Supply Shifts on Apply the Concept: Price Controls Lead to Equilibrium 90 Economic Decline in Venezuela 124 The Effect of Shifts in Demand on Equilibrium 90 Positive and Normative Analysis of Price Ceilings The Effect of Shifts in Supply on Equilibrium 90 and Price Floors 126 The Effect of Shifts in Demand and Supply 4.4 Externalities and Economic Efficiency 126 over Time 90 The Effect of Externalities 126 Apply the Concept: Lower Demand for Orange Externalities and Market Failure 128 Juice—But Higher Prices? 92 What Causes Externalities? 129 Solved Problem 3.4: Can We Predict Changes in 4.5 Government Policies to Deal with the Price and Quantity of Organic Corn? 94 Externalities 129 Shifts in a Curve versus Movements along a Curve 95 Imposing a Tax When There Is a Negative Don’t Let This Happen to You: Remember: Externality 129 A Change in a Good’s Price Does Not Cause Providing a Subsidy When There Is a Positive the Demand or Supply Curve to Shift 96 Externality 130 Conclusion 97 Apply the Concept: Should the Government An Inside Look: McDonald’s Looks for Tax Cigarettes and Soda? 131 New Ways to Attract Customers 98 Solved Problem 4.5: Dealing with the Chapter Summary and Problems 100 Externalities of Car Driving 132 A01_HUBB7731_06_SE_FM.indd 8 19/01/18 2:45 pm CONTENTS ix Command-and-Control versus Market-Based PART 3 Microeconomic Foundations: Approaches 134 The End of the Sulfur Dioxide Cap-and-Trade Consumers and Firms System 135 Are Tradable Emission Allowances Licenses to CHAPTER 6: Firms, the Stock Market, and Pollute? 135 Corporate Governance 184 Apply the Concept: Should the United States Enact a Carbon Tax to Fight Global Is Snapchat the Next Facebook . . . or the Warming? 135 Next Twitter? 184 Conclusion 137 6.1 Types of Firms 186 An Inside Look: Will Uber Be Required to Pay Who Is Liable? Limited and Unlimited British VAT? 138 Liability 186 Chapter Summary and Problems 140 Corporations Earn the Majority of Revenue and Profits 187 CHAPTER 5: The Economics of Health Care 150 Apply the Concept: Why Are Fewer Young People Starting Businesses? 188 Where Will You Find Health Insurance? 150 The Structure of Corporations and the 5.1 The Improving Health of People in the Principal–Agent Problem 189 United States 152 6.2 How Firms Raise Funds 190 Changes over Time in U.S. Health 153 Sources of External Funds 190 Reasons for Long-Run Improvements in U.S. Apply the Concept: The Rating Game: Are the Health 153 Federal Government or State Governments 5.2 Health Care around the World 154 Likely to Default on Their Bonds? 191 The U.S. Health Care System 154 Stock and Bond Markets Provide Capital—and Apply the Concept: The Increasing Importance Information 193 of Health Care in the U.S. Economy 156 The Fluctuating Stock Market 194 The Health Care Systems of Canada, Japan, and the Don’t Let This Happen to You: When Snap United Kingdom 157 Shares Are Sold, Snap Doesn’t Get Comparing Health Care Outcomes around the Money 194 the World 158 Apply the Concept: Why Are Many People Poor How Useful Are Cross-Country Comparisons of Stock Market Investors? 196 Health Outcomes? 159 Solved Problem 6.2: Why Does Warren Buffett 5.3 Information Problems and Externalities in the Like Mutual Funds? 197 Market for Health Care 160 6.3 Using Financial Statements to Evaluate a Adverse Selection and the Market for “Lemons” 160 Corporation 198 Asymmetric Information in the Market for Health The Income Statement 198 Insurance 161 The Balance Sheet 199 Don’t Let This Happen to You: Don’t Confuse 6.4 Recent Issues in Corporate Governance Policy 200 Adverse Selection with Moral Hazard 162 The Accounting Scandals of the Early 2000s 200 Externalities in the Market for Health Care 163 Corporate Governance and the Financial Crisis of Should the Government Run the Health 2007–2009 200 Care System? 165 Government Regulation in Response to the 5.4 The Debate over Health Care Policy in the Financial Crisis 201 United States 166 Did Principal–Agent Problems Help Cause the The Rising Cost of Health Care 166 2007–2009 Financial Crisis? 201 Apply the Concept: Are U.S. Firms Handicapped Apply the Concept: Should Investors Worry by Paying for Their Employees’ about Corporate Governance at Snapchat? 202 Health Insurance? 168 Conclusion 204 Explaining Increases in Health Care Spending 169 Chapter Summary and Problems 205 The Continuing Debate over Health Care Policy 172 CHAPTER 7: Consumer Choice and Elasticity 210 Solved Problem 5.4: Recent Trends in U.S. Health Care 173 J.C. Penney Customers Didn’t Buy into Apply the Concept: How Much Is That “Everyday Low Prices” 210 MRI Scan? 175 7.1 Utility and Consumer Decision Making 212 Conclusion 177 An Overview of the Economic Model of Chapter Summary and Problems 178 Consumer Behavior 212 A01_HUBB7731_06_SE_FM.indd 9 19/01/18 2:45 pm