You'll be hooked from page 1 ... T he pri oners were dying of scurvy, typhoid fever, and small pox, but nothing was killing them more than bad incentives. In 1787, the Uritish government had hired sea captains to ship convicted felons to Australia. Conditions on board the ships were monstrous; some even said the conditions were worse than on slave ships. On one voyage, more than a third of the males died and the rest arrived beaten, starved, and sick. A first mate remarked cruelly of the convicts, "Let them die and be damned the owners have [already! been paid for their passage."1 The British public had no love for the convicts, but it wa n't prepared to give them a death sentence either. Newspapers edito rialized in favor of better conditions, clergy appealed to the cap tains' sense of humanity, and legislators passed regulations requiring better food and water, light and air, and proper medical care. Yet the death rate remained shockingly high. othing appeared to be working until an economi t suggested something new. Can you guess what the economist sugge. tl·d? Instead of paying the captains for each prisoner placed on board ship in Great Uritain, the economist suggesting paying for each prisoner that walked off the ship in Australia. In ·t793, the new system was implemented and im mediately the survival rate shot up to 99%. One astute observer explained what had happened: "Economy beat sentiment and benevolence."2 The tory of the convict ships illustrates the first big les on that runs through out this book and throughout economics, ittmlfives //latter. By incentive , we mean rewards and enalties that motivate behavior. Let's Incentives arc rewards and C haos, conflict, and war may dominate the news, but it\ heartening to know that there is also an astounding amount of world cooperation. The next rime you are in your local supermarket, stop and comider how many people co operated to bring the !Tuits of the world to your table: kiwis !Tom cw Zealand, dried apricots from Turkey, dates from Eb'YPt. mangoes from ~ Mexico, bananas from Guatemala. How is it that farmer~ in ew Zealand 0 wake up at 5 AM to work hard tending their fidds '0 that you. on the other side of the world, may enjoy a kiwi with your fn1it salad' u This chapter is about a central ft•ature of our world, trJde. It', about how you eat reasonably well every day yt't have little knowledge of farming, it's about how you cooperate with people whom you will never meet, and it's Q about how civilization i' made po' ibk. z Wf: will locus on three oftht' benefits of trade: 1. Trade makes people better off when preferences differ. c( 2. Trade increa~cs productivity through specialization and the division of knowledge. :J: w > z w ... by the most compelling writing in the :J: .... w principles of economics market. w U\ COWEN • TABARROK ~_. ...M, .."7 ¥J0IIf 'f~D::!" E.. "' "R'f~.. . ~N~ VP: R~ I*N'C, ~I P. . ~L ~E ~S ~0 :RF~ .._MrP I:, -C: ... ~R~; t0; 7!E~ ..~ C-. :0f SN\. ~0~ a~M I C S, S~r;·q·o',N D .£ D I iTi When you write this well, you don't -1 need boxes to maintain interest ... J: m z < I n the fall of2000, Harvard phornore Jay Willian flev to the Sudan where a terrible civil war had resulted in many thousands of deaths. Women and children captured in raids by warring m tribes were being enslaved and held for ran om. Working with J: hristian olidariry International, Williams" a able to pay for the release of 4,000 people. But did Williams do the right thing? It's > a serious question and one that i urprisingly complex, both mor- z ally and economically. By paying for the release of laves, could William have A encouraged more people to be enslaved? If so, by how much? lavery i an 0 rmageddon almo t happened on epternber 29, 2004. abomination. Because of the terrible effects of lavery, careful thought about We aren't talking about the final battle described in the the best way to deal with the problem is essential. Perhaps urprisingly, the n Bible, but what happened in Arma,Reddon the movie. In economic concept of elasticity can help people think clearly abouc the mo t Annageddon, an asteroid is di covered to be on a collision cotwe effective pobcies to adopt to end slavery. \ ith Earth and A A recruit a group of roughneck oil drillers to rocket into pace, deflect the asteroid, and save civilization. Anuageddon the movie i a bit ab urd, but it got a few things right. Even an asteroid the ize of an apartment building would hit Earth with the force of a 4-megaton nuclear bomb. On September 29, 2004, an asteroid called Toutati , 2.9 miles long by 1.5 miles wide, narrowly mi ed Earth. If Toutati had hit, it would have meant the A Price Is a Signal Wrapped Up in an Incentive end of civilization. The probability of death by asteroid is remarkably high, by some How is order produced from freedom of choice? That is a cientific my tery, calculation about the ame as death b pa enger aircraft crash. How and prices are the biggest clue to the solution. Prices do much more than tell can thi be? Although the probability of an asteroid hitting Earth is people how much they must shell out for a burger and fries. Prices are incen very mall, a lot of people would be killed if one did hit, so the prob tives, prices are signal, price are prediction . To understand the market, you abiliry of death by asteroid i much larger than most people irna!,rine. need to better understand price . It doe n't happen very often but watch out when it does.* When the price of oil ri e , all u ers of oil are encouraged to econornize perhap by simply using les but also by thinking about sub titute : everything from electric cars to moving flO\: er cultivation overseas. An increase in the price of oil is al o a signal to suppliers to in e t more in exploration, to look for alternatives like ethanol, and to increa e recycling. Do you know the mo t recycled product in America? Ic' asphalt.9 Politicians and consumers ometime fail to understand the ignaling role of price . After a hurricane, the prices of ice, generators, and chain aws often skyrocket. Consumers complain of price gouging, and politician call for price controls. That's understandable, because it can seem doubly harsh to be hit by a hurricane a11d high price . But the price . ystem is just doing its job. A skyrocketing price i like a flare being hot into the night ky that hours-bring ice here! A price con trol eliminates the ignal to bring ice into the devastated area as quickly as po.sible. The high price of ice in a hurricane-devastated area ig nals a profit opportunity for ice uppliers. Buy ice where the price is low and ship it to where the price is high. A the supply of ice in the hurricane-devastated area increase , the price will fall. More generally, price signals and the ac companying profits and losses tell entrepreneur what area of the economy consumers want expanded and what areas they want contracted. If consumer want more computer , prices and profits in the computer industry will increase and the industry will expand. Losses may be an even more important signal than prof its. Entrepreneur who fail to compete with lower co t and better produces take lo e and their busine e contract or even go bankrupt. Bankruptc i bad for a bu ines but can be good for capitali m. E er heard of mith Corona, Polaroid, Pan Am, or Hechinger ? At one point, each of the e companie led it indu try, but today all are either bankrupt or much smaller than at their peak. In a free mar- Beautiful, uncluttered design with pictures that drive the story ... President Nixon said no to commercial holiday lights during the Christmas of 1973. The Clean Air Conservancy has permanently retired 30 pounds of Sulfur Dioxide emissions allowances on behalr of Alex Tabarrok and V0::l: Tyler Cowen 0 I 1- ::J RETIRED NOVEMBER 2007 <! w I I LL 0 &:; w 1- 0::: ::J 0 u Externalities Price Controls Thomas Edison spent years experimenting with thousands of materials before he discov ered that carbonized bamboo filament would make a long-lasting lightbulb. If anyone could ~ have capitalized on his idea, Edison would 0 not have been able to profit from his labori u ous research and development and perhaps he would not have done the necessary research in the first place. Monopoly w How to smuggle sugar The high price of U.S. sugar has encouraged smuggling and attempts to circumvent the tariff. In the 1980s when the U.S. price was four > times the world price, Canadian entrepreneurs z created super-high-sugar iced tea. The "tea" was shipped into the United States and then sifted for the sugar, which was resold. w To combat this entrepreneurship, the U.S. l: government created even more tariffs for .... w Investments International Trade w ln COWEN • TABARROK MODERN PRINCIPLES: MICROECONOMICS Second Edition Tyler Cowen George Mason University Alex Tabarrok George Mason University Worth Publishers of Economics is the study how to get the most out of life. Tyler and Alex Senior Publisher: Catherine Woods Executive Editor: Charles Linsmeier Senior Acquisitions Editor: Sarah Dorger Executive Marketing Manager: Scott Guile Consulting Editor: Paul Shensa Senior Developmental Editor: Bruce Kaplan Supplements and Media Editor: Tom Acox Director of Market Research and Development: Steven Rigolosi Associate Managing Editor: Lisa Kinne Editorial Assistant: Mary Walsh Art Director: Babs Reingold Cover and Text Designer: Kevin Kall Project Editor: Anthony Calcara Photo Editor: Christine Buese Production Manager: Barbara Anne Seixas Supplements Production Manager: Stacey Alexander Supplements Project Editor: Edgar Bonilla Composition: TSI Graphics Printing and Binding: RR Donnelley Cover Image: Image Werks/Corbis and Jim Roof/myLoupe.com Library of Congress Control Number: 2011936404 ISBN-13: 978-1-4292-3999-8 ISBN-1 0: 1-4292-3999-9 © 2013, 2010 by Worth Publishers All rights reserved. Printed in the United States of America Third printing Worth Publishers 41 Madison A venue New York, NY 10010 www.worthpublishers.com ABOUT THE AUTHORS Tyler Cowen (left) is Holbert C. Harris Professor of Economics at George Mason University. His latest book is The Great Stagnation. With Alex Tabarrok, he writes an economics blog at www.m.arginalrevolution.com. He has published in the American Economic Review, Journal of Political Economy, and many other economics journals. He also writes regularly for the popular press, including the New York Times, the Washington Post, Forbes, the Wilson Quarterly, Money Magazine, and m.any other outlets. Alex Tabarrok (right) is Bartley J. Madden Chair in Econom.ics at the Mercatus Center at George Mason University and director of research for The Independent Institute. His latest book is Launching the Innovation Renaissance. His recent research looks at bounty hunters, judicial incen tives and elections, crime control, patent reform, methods to increase the supply of human organs for tran plant, and the regulation of pharmaceuticals. He is the editor of the books Entrepreneurial Economics: Bright Ideas from the Dismal Science and The Voluntary City: Choice, Community, and Civil Society among others. His papers have appeared in the Journal of Law and Econom ics, Public Choice, Economic Inquiry, the Journal of Health Economics, the Journal of Theoretical Politics, the American Law and Economics Review, and many other journals. Popular articles have appeared in the New York Times, the Wall treet Journal, Forbes, and many other magazines and newspapers. v BRIEF CONTENTS Preface ............................................................................................................. xvi Part 1: Supply and Demand CHAPTER 1 The Big Ideas ............................................................................... 1 CHAPTER 2 The Power of Trade and Comparative Advantage .................... 13 CHAPTER 3 Supply and Demand .................................................................. 27 CHAPTER 4 Equilibrium: How Supply and Demand Determine Prices ......... 47 CHAPTER 5 Elasticity and Its Applications .................................................... 65 CHAPTER 6 Taxes and Subsidies .................................................................. 93 Part 2: The Price System CHAPTER 7 The Price System: Signals, Speculation, and Prediction .......... 113 CHAPTER 8 Price Ceilings and Floors ......................................................... 131 CHAPTER 9 International Trade .................................................................. 159 CHAPTER 10 Externalities: When Prices Send the Wrong Signals .............. 175 Part 3: Firms and Factor Markets CHAPTER 11 Costs and Profit Maximization Under Competition ............... 193 CHAPTER 12 Competition and the Invisible Hand ...................................... 223 CHAPTER 13 Monopoly .............................................................................. 233 CHAPTER 14 Price Discrimination ............................................................... 257 CHAPTER 15 Cartels, Oligopolies, and Monopolistic Competition ............ 279 CHAPTER 16 Competing for Monopoly: The Economics of Network Goods .......................................................................................... 303 CHAPTER 17 Labor Markets ........................................................................ 319 Part 4: Government CHAPTER 18 Public Goods and the Tragedy of the Commons .................. 343 CHAPTER 19 Political Economy and Public Choice .................................... 361 CHAPTER 20 Economics, Ethics, and Public Policy ..................................... 385 VI Brief Contents • vii Part 5: Decision Making for Businesses, Investors, and Consumers CHAPTER 21 Managing Incentives ............................................................. 401 CHAPTER 22 Stock Markets and Personal Finance ..................................... 419 CHAPTER 23 Consumer Choice .................................................................. 435 APPENDIX A Reading Graphs and Making Graphs .................................... A-1 APPENDIX 8 Solutions to Check Yourself Questions .................................. B-1 Glossary G-1 References R-1 Index 1-1 CONTENTS Preface xvi Part 1: Supply and Demand CHAPTER 1 The Big Ideas ............................................................................... 1 Big Idea One: Incentives Matter 2 Big Idea Two: Good Institutions Align Self-Interest with the Social Interest 2 Big Idea Three: Trade-offs Are Everywhere 3 Opportunity Cost 4 Big Idea Four: Thinking on the Margin 5 Big Idea Five: The Power of Trade 6 Big Idea Six: The Importance of Wealth and Economic Growth 7 Big Idea Seven: Institutions Matter 7 Big Idea Eight: Economic Booms and Busts Cannot Be Avoided but Can Be Moderated 8 Big Idea Nine: Prices Rise When the Government Prints Too Much Money 9 Big Idea Ten: Central Banking Is a Hard Job 9 The Biggest Idea of All: Economics Is Fun 1 0 Chapter Review 11 CHAPTER 2 The Power of Trade and Comparative Advantage .................... 13 Trade and Preferences 13 Specialization, Productivity, and the Division of Knowledge 14 Comparative Advantage 16 The Production Possibility Frontier 16 Opportunity Costs and Comparative Advantage 17 Comparative Advantage and Wages 19 Adam Smith on Trade 21 Trade and Globalization 21 Takeaway 21 Chapter Review 22 CHAPTER 3 Supply and Demand .................................................................. 27 The Demand Curve for Oil 27 Consumer Surplus 30 What Shifts the Demand Curve? 31 Important Demand Shifters 31 The Supply Curve for Oil 34 Producer Surplus 37 What Shifts the Supply Curve? 37 Important Supply Shifters 37 viii