Cover

Table of Contents

Introduction

About This Book

Conventions Used in This Book

What You’re Not to Read

Foolish Assumptions

How This Book Is Organized

Part I: Economics: The Science of How People Deal with Scarcity

Part II: Microeconomics: The Theories of Consumer and Firm Behavior

Part III: Applying the Theories of Microeconomics

Part IV: Macroeconomics: The Science of Economic Growth and Stability

Part V: The Part of Tens

Icons Used in This Book

Where to Go from Here

Part I: Economics: The Science of How People Deal with Scarcity

Chapter 1: Discovering What Economics Is and Why You Should Care

Considering a Little Economic History

Pondering just how nasty, brutish, and short life used to be

Identifying the institutions that raise living standards

Looking toward the future

Framing Economics as the Science of Scarcity

Sending Microeconomics and Macroeconomics to Separate Corners

Getting up close and personal: Microeconomics

Zooming out: Macroeconomics and the big picture

Understanding How Economists Use Models and Graphs

Introducing your first model: The demand curve

Drawing your own demand curve

Chapter 2: Cookies or Ice Cream? Exploring Consumer Choices

Describing Human Behavior with a Choice Model

Pursuing Personal Happiness

Using utility to measure happiness

Taking “selfless” actions into account

Noting how self-interest can promote the common good

You Can’t Have Everything: Examining Limitations

Resource constraints

Technology constraints

Time constraints

Opportunity cost: The unavoidable cost

Making Your Choice: Deciding What and How Much You Want

Exploring Violations and Limitations of the Economist’s Choice Model

Understanding uninformed decision-making

Making sense of irrationality

Chapter 3: Producing the Right Stuff the Right Way to Maximize Human Happiness

Figuring Out What’s Possible to Produce

Classifying resources

Diminishing returns: Getting less of a good thing

A little here, a little there: Allocating resources

Graphing your production possibilities

Reaching new frontiers with better technology

Deciding What to Produce

Comparing market results and government interventions

Opting for a mixed economy

Promoting Technology and Innovation

Part II: Microeconomics: The Theories of Consumer and Firm Behavior

Chapter 4: Supply and Demand Made Easy

Deconstructing Demand

Prices and other stuff: Looking at what affects quantity demanded

Graphing the demand curve

Opportunity costs: Setting the slope of the demand curve

Elasticity: Looking at extreme demand cases

Sorting Out Supply

Graphing the supply curve

Using elasticity to understand extreme supply cases

Bringing Supply and Demand Together

Market equilibrium: Seeking a balance

Demonstrating the stability of the market equilibrium

Adjusting to new market equilibriums when supply or demand changes

Price Controls: Keeping Prices Away from Market Equilibrium

Setting upper limits with price ceilings

Propping up prices with price floors

Chapter 5: Getting to Know Homo Economicus, the Utility-Maximizing Consumer

Constrained Optimization: Getting the Most Happiness for Your Money

Choosing by Ranking

Getting Less from More: Diminishing Marginal Utility

Choosing Among Many Options When Facing a Limited Budget

Trying to buy as much (marginal) utility as you can

Purchasing the best combination of two goods to maximize total utility

Aiming for equal marginal utility per dollar

Deriving Demand Curves from Diminishing Marginal Utility

Seeing how price changes affect quantities demanded

Graphing the price and quantity changes to form a demand curve

Chapter 6: The Core of Capitalism: The Profit-Maximizing Firm

A Firm’s Goal: Maximizing Profits

Facing Competition

Listing the requirements for perfect competition

Taking prices but setting quantities

Distinguishing between accounting profits and economic profits

Analyzing a Firm’s Cost Structure

Focusing on costs per unit of output

Examining average variable costs

Watching average fixed costs fall

Tracking the movement of average total costs

Focusing on marginal costs

Noticing where marginal cost equals average cost

Comparing Marginal Revenues with Marginal Costs

Finding where marginal revenue equals marginal cost

Visualizing profits

Visualizing losses

Pulling the Plug: When Producing Nothing Is Your Best Bet

Distinguishing between the short run and the long run in microeconomics

The short-run shutdown condition: Variable costs exceed total revenues

The long-run shutdown condition: Total costs exceed total revenues

Chapter 7: Why Economists Love Free Markets and Competition

Ensuring That Benefits Exceed Costs: Competitive Free Markets

Examining the traits of a properly functioning market

Analyzing the efficiency of free markets

Measuring everyone’s gains with total surplus

When Free Markets Lose Their Freedom: Dealing with Deadweight Losses

Coming up short: The deadweight loss from a price ceiling

Death and taxes: Finding the deadweight loss of a tax

Hallmarks of Perfect Competition: Zero Profits and Lowest Possible Costs

Understanding the causes and consequences of perfect competition

Peering into the process of perfect competition

Graphing how profits guide firm entry and exit

Chapter 8: Monopolies: How Badly Would You Behave If You Had No Competition?

Examining Profit-Maximizing Monopolies

Zeroing in on the problems monopolies cause

Identifying the source of the problem: Decreasing marginal revenues

Choosing an output level to maximize profits

Comparing Monopolies with Competitive Firms

Looking at output and price levels

Deadweight losses: Quantifying the harm caused by monopolies

Losing efficiency

Considering Examples of Good Monopolies

Encouraging innovation and investment with patents

Reducing annoyingly redundant competitors

Keeping costs low with natural monopolies

Regulating Monopolies

Subsidizing a monopoly to increase output

Imposing minimum output requirements

Regulating monopoly pricing

Breaking up a monopoly into several competing firms

Chapter 9: Oligopoly and Monopolistic Competition: Middle Grounds

Oligopolies: Looking at the Allure of Joining Forces

Sharing power over prices

Cartel behavior: Trying to imitate monopolists

Noting the criteria for coordinating a cartel

Understanding Incentives to Cheat the Cartel

Fleshing out the Prisoner’s Dilemma

Enforcing the agreement: Resolving the dilemma with credible threats

Seeing that OPEC is trapped in a Prisoner’s Dilemma

Using an enforcer to help OPEC members stick to quotas

Regulating Oligopolies

Breaking up dominant firms

Attempting to apply antitrust laws

Studying a Hybrid: Monopolistic Competition

Benefiting from product differentiation

Facing profit limits

Part III: Applying the Theories of Microeconomics

Chapter 10: Property Rights and Wrongs

Allowing Markets to Reach Socially Optimal Outcomes

Examining Externalities: The Costs and Benefits Others Feel from Your Actions

Noting the effects of negative externalities

Accepting positive amounts of negative externalities

Dealing with negative externalities

Calculating the consequences of positive externalities

Subsidizing things that provide positive externalities

Tragedy of the Commons: Overexploiting Commonly Owned Resources

Having a cow: Overgrazing on a commonly owned field

Sleeping with the fishes: Extinctions caused by poor property rights

Avoiding the tragedy

Chapter 11: Market Failure: Asymmetric Information and Public Goods

Facing Up to Asymmetric Information

Realizing that asymmetric information limits trade

Souring on the lemons problem: The used car market

Issuing insurance when you can’t tell individuals apart

Providing Public Goods

Taxing to provide public goods

Enlisting philanthropy to provide public goods

Providing a public good by selling a related private good

Ranking new technology as a public good

Chapter 12: Taking the Pulse of Health Economics and Finance

Defining Health Economics and Health Finance

Noting the Limits of Health Insurance

Adverse selection: Looking at who buys insurance

Combating adverse selection

Comparing Healthcare Internationally

Inflated Demand: Suffering from “Free” and Reduced-Cost Healthcare

Diverting funds to lower-value uses

Rationing healthcare

Facing shortages and higher prices

Trying to combat inefficiency with bureaucracy

Investigating Singapore’s Secrets

Exploring cost-saving features

Weighing costs and benefits of medical procedures

Supporting cost-cutting innovations

Trying to copy Singapore’s success

Part IV: Macroeconomics: The Science of Economic Growth and Stability

Chapter 13: Measuring the Macroeconomy: How Economists Keep Track of Everything

Getting a Grip on the GDP (and All Its Parts)

Leaving some things out of GDP

Tallying up what counts in GDP

Accounting for the tides of incomes and assets

Following the funds, around and around

Counting stuff when it’s made, not when it’s sold

Watching GDP rise with the good, the bad, and the ugly

Diving In to the GDP Equation

“C” is for consumption (that’s good enough for me!)

“I” is for investment in capital stock

The big “G” (government, that is)

Measuring foreign trade with “NX”

Making Sense of International Trade and Its Effect on the Economy

“Trade deficit” ain’t fightin’ words

Considering assets — not just cash

Wielding a comparative advantage

Chapter 14: Inflation Frustration: Why More Money Isn’t Always a Good Thing

Buying an Inflation: When Too Much Money Is a Bad Thing

Balancing money supply and demand

Giving in to the inflation temptation

Tallying up the effects of inflation

Measuring Inflation

Creating your very own market basket

Calculating the inflation rate

Setting up a price index

Determining the real standard of living with the price index

Identifying price index problems

Pricing the Future: Nominal and Real Interest Rates

Using the Fisher equation

Realizing that predictions aren’t perfect

Chapter 15: Understanding Why Recessions Happen

Introducing the Business Cycle

Striving for Full-Employment Output

Returning to Y*: The Natural Result of Price Adjustments

Responding to Economic Shocks: Short-Run and Long-Run Effects

Defining some critical terms

The tao of P: Looking at price adjustments in the long run

A shock to the system: Adjusting to a shift in aggregate demand

Dealing with fixed prices in the short run

Putting together the long and short of it

Heading toward Recession: Getting Stuck with Sticky Prices

Cutting wages or cutting workers

Adding up the costs of wages and profits

Returning to Y* with and without government intervention

Achieving Equilibrium with Sticky Prices: The Keynesian Model

Adjusting inventories instead of prices

Boosting GDP in the Keynesian model

Chapter 16: Fighting Recessions with Monetary and Fiscal Policy

Stimulating Demand to End Recessions

Aiming for full-employment output

Back to work: Shifting the AD curve to the right

Generating Inflation: The Risk of Too Much Stimulation

An exercise in futility: Trying to increase output beyond Y*

A temporary high: Tracing the movement of real wages

Failing to stimulate: What happens when a stimulus is expected

Figuring Out Fiscal Policy

Increasing government spending to help end recessions

Dealing with deficits

Dissecting Monetary Policy

Identifying the benefits of fiat money over the gold standard

Realizing that you can have too much money!

Getting the basics about bonds

Seeing the link between bond prices and interest rates

Changing the money supply to change interest rates

Lowering interest rates to stimulate the economy

Understanding how rational expectations can limit monetary policy

Chapter 17: Grasping the Origins and Aftermath of Financial Crises

Understanding How Debt-Driven Bubbles Develop

Embracing borrowing in a booming economy

Offering larger loans as collateral values rise

Relaxing lending standards

Borrowing more in hopes of profit

Watching the process gain momentum

Seeing the Bubble Burst

Deleveraging: Trying to ditch debt as prices fall

Comprehending bank collapses caused by bursting bubbles

Leading into a recession

After the Crisis: Looking toward Recovery

Enduring a broken banking system

Struggling with structural mismatches

Noting the limits of government policy

Part V: The Part of Tens

Chapter 18: Ten Seductive Economic Fallacies

The Lump of Labor

The World Is Facing Overpopulation

Order Indicates Causes

Protectionism Is the Best Solution to Foreign Competition

The Fallacy of Composition

If It’s Worth Doing, Do It 100 Percent

Free Markets Are Volatile

Low Foreign Wages Mean That Rich Countries Can’t Compete

Tax Rates Don’t Affect Work Effort

Forgetting That Policies Have Unintended Consequences

Chapter 19: Ten Economic Ideas to Hold Dear

Self-Interest Can Improve Society

Free Markets Require Regulation

Economic Growth Relies on Innovation

Freedom and Democracy Make Us Richer

Education Raises Living Standards

Intellectual Property Rights Boost Innovation

Weak Property Rights Cause All Environmental Problems

International Trade Is a Good Thing

Government Can Provide Public Goods

Preventing Inflation Is Easy

Chapter 20: Ten Great Ways to Become Informed about Economic Issues

Sort Through the Popular Press

Peruse Economics Blogs

Absorb Think-Tank Policy Papers

Review the Latest Research

Investigate Entrepreneurship

Talk to All Stakeholders

Dissect the Tax System

Peruse Your City’s Budget

Uncover Government Policy Papers

Get to Know Government Data

Appendix: Glossary

Cheat Sheet

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Sean Flynn is an assistant professor of economics at Scripps College in Claremont, California.

A recurring commentator on radio and television, Sean holds a BA in economics from the University of Southern California and a PhD in economics from UC Berkeley, where he completed his dissertation under the supervision of Nobel Laureate George Akerlof.

As one of America’s leading economic educators, Sean is a coauthor (along with Campbell McConnell and Stanley Brue) of the world’s best-selling college economics textbook, Economics: Principles, Problems, and Policies (McGraw-Hill). The book’s popularity is such that it’s also the world’s best-selling college textbook of any subject.

Sean’s academic research focuses on the often puzzling and seemingly irrational behavior of stock market investors, but he’s also investigated topics as wide-ranging as the factors that affect tipping behavior in restaurants and why you see a lot of unionized workers only in certain industries. He’s also a leading expert on closed-end mutual funds.

Sean’s (rather serious) hobby is the Japanese martial art of aikido, which he has taught for over 15 years to hundreds of students in the United States and abroad. A former national forms champion himself, Sean has coached five of his students to U.S. national aikido titles in either forms or full-contact sparring.

To my father, Thomas Ray Flynn, who always impressed upon me the importance of good economic policy both for improving our quality of life and as our last, best hope for lifting billions out of poverty and disease.

I’d like to thank the many great economists who managed to get things into my head despite my very thick skull.

Among my teachers, I can’t help but thank Caroline Betts, Tim Cason, Richard Ciccetti, Michael DePrano, Richard Easterlin, Robert Kalaba, Timur Kuran, Jeffrey Nugent, and Morton Shapiro for the excellent education I received as an undergraduate at the University of Southern California.

I was equally blessed at UC Berkeley, where I got to complete a doctorate under the tutelage of some true intellectual giants, including George Akerlof, David Card, J. Bradford DeLong, Jan deVries, Barry Eichengreen, Richard Gilbert, Daniel McFadden, Maurey Obstfeld, Matthew Rabin, David Romer, Christina Romer, and Janet Yellen. It was especially fun when Professors McFadden and Akerlof won their Nobel Prizes during my last two years at Cal.

However, my fellow economics students often did more than my professors to explain things to me when I wasn’t getting them, and they continue to educate me even now. So a very heartfelt thank you to Corinne Alexander, Lorenzo Blanco, Mark Carlson, Carlos Dobkin, Tim Doede, Mike Enriquez, Fabio Ghironi, Petra Geraats, Aaron Green, Galina Hale, Alan Marco, Carolina Marquez, Marcelo Moreira, Petra Moser, Marc Muendler, Stefan Palmqvist, Doug Park, Raj Patel, Steve Puller, Desiree Schaan, Doug Schwalm, Mark Stehr, Sam Thompson, Carla Tully, Jeff Weinstein, and Marta Wosinska.

I’ve also got to thank my current and former students at Scripps College, Vassar College, and UC Berkeley. Having to answer your many insightful questions made me a much better economist.

A big thank you to my literary agent Linda Roghaar and my old friend Mike Jones for getting me this book deal. They heard Dummies and immediately thought of me.

Tracy Boggier, Joan Friedman, Alissa Schwipps, Chad Sievers, and the entire production team at Wiley also deserve huge praise. All their edits, suggestions, and formatting have turned out a book that’s far better than anything I could have come up with on my own.

I also have to deeply thank Dr. Robert Harris, the technical editor of this book. His comments and suggestions have made it far better than it would have been otherwise.

We’re proud of this book; please send us your comments through our online registration form located at http://dummies.custhelp.com. For other comments, please contact our Customer Care Department within the U.S. at 877-762-2974, outside the U.S. at 317-572-3993, or fax 317-572-4002.

Senior Project Editor: Chad R. Sievers (Previous Edition: Joan Friedman, Alissa Schwipps)

Introduction

Economics is all about humanity’s struggle to achieve happiness in a world full of constraints. There’s never enough time or money to do everything people want, and things like curing cancer are still impossible because the necessary technologies haven’t been developed yet. But people are clever. They tinker and invent, ponder and innovate. They look at what they have and what they can do with it and take steps to make sure that if they can’t have everything, they’ll at least have as much as possible.

Having to choose is a fundamental part of everyday life. The science that studies how people choose — economics — is indispensable if you really want to understand human beings both as individuals and as members of larger organizations. Sadly, though, economics has typically been explained so badly that people either dismiss it as impenetrable gobbledygook or stand falsely in awe of it — after all, if it’s hard to understand, it must be important, right?

I wrote this book so you can quickly and easily understand economics for what it is — a serious science that studies a serious subject and has developed some seriously good ways of explaining human behavior out in the (very serious) real world. Economics touches on nearly everything, so the returns on reading this book are huge. You’ll understand much more about people, the government, international relations, business, and even environmental issues.

About This Book

The English poet Thomas Carlyle called economics the “dismal science,” but I’m going to do my best to make sure that you don’t come to agree with him. I’ve organized this book to try to get as much economics into you as quickly and effortlessly as possible. I’ve also done my best to keep it lively and fun.

In this book, you find the most important economic theories, hypotheses, and discoveries without a zillion obscure details, outdated examples, or complicated mathematical “proofs.” Among the topics covered are

How the government fights recessions and unemployment

How and why international trade is good for both individuals and nations

Why poorly designed property rights are responsible for environmental problems such as global warming, pollution, and species extinctions

How profits guide businesses to produce the goods and services you take for granted

How economic incentives affect healthcare costs, prices, and efficiency

Why competitive firms are almost always better for society than monopolies

How the Federal Reserve controls the money supply, interest rates, and inflation all at the same time

Why government policies such as price controls and subsidies often cause much more harm than good

How the simple supply and demand model can explain the prices of everything from comic books to open-heart surgeries

You can read the chapters in any order, and you can immediately jump to what you need to know without having to read a bunch of stuff that you couldn’t care less about.

Economists like competition, so you shouldn’t be surprised that there are a lot of competing views. Indeed, it’s only through vigorous debate and careful review of the evidence that the profession improves its understanding of how the world works. This book contains core ideas and concepts that economists agree are true and important — I try to steer clear of fads or ideas that foster a lot of disagreement. (If you want to be subjected to my opinions and pet theories, you’ll have to buy me a drink.)

Conventions Used in This Book

Economics is full of two things you may not find very appealing: jargon and algebra. To minimize confusion, whenever I introduce a new term, I put it in italics and follow it closely with an easy-to-understand definition. Also, whenever I bring algebra into the discussion, I use those handy italics again to let you know that I’m referring to a variable. For instance, I indicates investment, so you may see a sentence like this one: I think that I is too big.

I try to keep equations to a minimum, but sometimes they help make things clearer. In such instances, I sometimes have to use several equations one after another. To avoid confusion about which equation I’m referring to at any given time, I give each equation a number, which I put in parentheses. For example,

(1) MTV = ESPN + CNN 2

Finally, the following conventions are used throughout the text of all For Dummies books to make things consistent and easy to understand:

All Web addresses appear in this font.

Bold is used to highlight the action parts of numbered steps.

What You’re Not to Read

The whole point of a For Dummies book is to give you quick access to the essentials so you don’t have to wade through a bunch of stories, factoids, and anecdotes. On the other hand, sometimes stories, factoids, and anecdotes can be both fun and enlightening. Consequently, I’ve clearly identified all the “skippable” material. This information is the stuff that, although interesting and related to the topic at hand, isn’t essential for you to know:

Text in sidebars: The sidebars are shaded boxes that share interesting stories and observations but aren’t necessary reading.

Anything with a Technical Stuff icon attached: This information is interesting but not critical to your understanding of what’s being explained.

The stuff on the acknowledgements page: Unless you’re one of my friends who needs an ego stroke, there’s nothing here for you.

Naturally, I’d like to believe that you’ll choose to read everything I’ve written, but don’t worry. I’ll never know.

Foolish Assumptions

I wrote this book assuming some things about you:

You’re sharp, thoughtful, and interested in how the world works.

You’re a high school or college student trying to flesh out what you’re learning in class, or you’re a citizen of the world who realizes that a good grounding in economics will help you understand everything from business and politics to social issues like poverty and environmental degradation.

You want to know some economics, but you’re also busy leading a very full life. Consequently, although you want the crucial facts, you don’t want to have to read through a bunch of minutia to find them.

You’re not totally intimidated by numbers, facts, and figures. Indeed, you welcome them because you like to have things proven to you instead of taking them on faith because some pinhead with a PhD says so.

You like learning why as well as what. That is, you want to know why things happen and how they work instead of just memorizing factoids.

How This Book Is Organized

This book is divided into five parts to make the material easier to understand and access. In this section, I explain what you have to look forward to in each of these parts.

Part I: Economics: The Science of How People Deal with Scarcity

Economics is all about how people deal with scarcity, which is a situation that occurs when the quantities of goods and services that are available for consumption are less than the amounts that people desire to consume. There’s never enough time, and there’s a limited supply of natural resources such as oil and iron. Consequently, people have to be clever about getting the most out of life — choosing wisely about what to do with the limited resources they’re given. Part I explains how people go about dealing with scarcity and the tradeoffs that it forces them to make. The rest of economics is just seeing how scarcity forces people to make tradeoffs in more specific situations.

Part II: Microeconomics: The Theories of Consumer and Firm Behavior

Microeconomic theory attempts to understand and predict the behavior of individual people and individual firms. It studies what motivates them and how they act to achieve their goals given the constraints they face. In this part, you discover what motivates firms to produce output, how buyers and sellers interact in markets to allocate that output, and how markets can break down and do perverse things if not properly managed.

You also explore how consumer decisions about what goods and services to purchase and in which quantities to purchase them are driven by a desire on the part of consumers to maximize the total amount of utility, or satisfaction, that they can get from their limited budgets. I also delve in to the details of supply and demand, competition, monopolies, and Adam Smith’s “invisible hand.”

Part III: Applying the Theories of Microeconomics

In this part, I present three chapters that show how well microeconomic theory can illuminate many real-world behaviors. Among other things, you explore why health insurance costs so much, why it’s so difficult to find a quality used car, and how a few simple changes in the way property rights are defined and enforced can mean the difference between extinction and survival for many species of wild animals as well as entire rainforests and other ecosystems.

Part IV: Macroeconomics: The Science of Economic Growth and Stability

Macroeconomics views the economy from on high, at the national or international level. It deals with the choices countries face about economic growth and development as well as choices about how to best manage their economies to avoid recessions. It also deals with the misery caused by unemployment and inflation. In this part, you find out about monetary and fiscal policy, the Federal Reserve, the effects of taxation on the economy, and international trade and trade policy.

Part V: The Part of Tens

Every For Dummies book ends with top-ten lists that are both helpful and fun. In this part, I give you ten economic ideas to hold dear, ten false economic assertions that are repeated all the time in the media and by politicians, and ten ways to become a better economist.

Icons Used in This Book

To make this book easier to read and simpler to use, I include a few icons that can help you find and fathom key ideas and information.

This icon alerts you that I’m explaining a fundamental economic concept or fact. It saves you the time and effort of marking the book with a highlighter.

Economics is chock full of theories, and sometimes it’s helpful to kick those theories out into the real world and see how they actually work. This icon alerts you to the presence of a helpful, real-world example.

This icon tells you that the ideas and information that it accompanies are a bit more technical or mathematical than other sections of the book. This information can be interesting and informative, but I’ve designed the book so that you don’t need to understand it to get the big picture about what’s going on. Feel free to skip this stuff.

This icon points out time and energy savers. I place this icon next to suggestions for ways to do or think about things that can save you some effort.

This icon discusses any troublesome areas in economics you need to know. Keep an eye open for them for to alert you of potential pitfalls.

Where to Go from Here

This book is set up so that you can understand what’s going on even if you skip around. The book is also divided into independent parts so that you can, for instance, read all about microeconomics without having to read anything about macroeconomics. The table of contents and index can help you find specific topics easily. But, hey, if you don’t know where to begin, just do the old-fashioned thing and start at the beginning.

Economics For Dummies®, 2nd Edition

Economics For Dummies^®, 2nd Edition