Contents

1 A Brief Economic History of the United States 1

Introduction 1
The American Economy in the 19th Century 2
Agricultural Development 2
The National Railroad Network 4
The Age of the Industrial Capitalist 5
The American Economy in the 20th Century 6
The Roaring Twenties 7
The 1930s: The Great Depression 7
The 1940s: World War II and Peacetime Prosperity 10
The 1950s: The Eisenhower Years 13
The Soaring Sixties: The Years of Kennedy and Johnson 14
The Sagging Seventies: The Stagflation Decade 14
The 1980s: The Age of Reagan 15
The State of American Agriculture 16
The “New Economy” of the Nineties 16
The American Economy in the New Millennium 17
9/11 and After 17
Last Word 18

2 Resource Utilization 23

Economics Defined 23
The Central Fact of Economics: Scarcity 24
Scarcity and the Need to Economize 24
The Economic Problem 24
The Four Economic Resources 24
Opportunity Cost 25
Full Employment and Full Production 26
The Production Possibilities Frontier 30
Productive Efficiency 35
Economic Growth 35

3 Supply and Demand 45

Demand 45
Supply 46
Equilibrium 48
Surpluses and Shortages 48
Shifts in Demand and Supply 49
Price Ceilings and Price Floors 53
Applications of Supply and Demand 58
Interest Rate Determination 58
College Parking 59
The Rationing Function of the Price System 59
Last Word 60

4 The Mixed Economy 67

The Three Questions of Economics 67
What Shall We Produce? 67
How Shall These Goods Be Produced? 68
For Whom Shall the Goods Be Produced? 68
The Invisible Hand, the Price Mechanism, and Perfect Competition 68
The Invisible Hand 69
The Price Mechanism 70
Competition 70
Trust 71
Equity and Efficiency 71
The Circular Flow Model 72
The Economic Role of Government 73
Market Failure 74
Externalities 74
Curbing Environmental Pollution 77
Lack of Public Goods and Services 80
Capital 81
The “Isms”: Capitalism, Communism, Fascism, and Socialism 83
The Decline and Fall of the Communist System 86
Transformation in China 86
Last Word: The Mixed Economy 88

5 The Household-ConsumptionSector 91

GDP and Big Numbers 91
Consumption 92
Saving 93
Average Propensity to Consume (APC) 94
Average Propensity to Save (APS) 94
Marginal Propensity to Consume (MPC) 96
Marginal Propensity to Save (MPS) 97
Graphing the Consumption Function 97
The Saving Function 101
What the Consumer Buys 104
Determinants of the Level of Consumption 105
The Level of Disposable Income 105
Credit Availability 106
Stock of Liquid Assets in the Hands of Consumers 106
Stock of Durable Goods in the Hands of Consumers 106
Keeping Up with the Joneses 107
Consumer Expectations 107
The Permanent Income Hypothesis 107
Determinants of the Level of Saving 108
Why Do We Spend So Much and Save So Little? 109
Is the Consumer Really King? 110
Total Saving: Individual Saving 1 Business Saving 1 Government Saving 111
Last Word 111

6  The Business-Investment Sector 117

Proprietorships, Partnerships, and Corporations 117
The Proprietorship 117
The Partnership 118
The Corporation 118
Stocks and Bonds 120
Capitalization and Control 122
The Business Population 123
Investment 123
How Does Savings Get Invested? 126
Gross Investment versus Net Investment 127
Building Capital 128
The Determinants of the Level of Investment 128

(1) The Sales Outlook 128
(2) Capacity Utilization Rate 129
(3) The Interest Rate 129
(4) The Expected Rate of Profit 130

Why Do Firms Invest? 131
Graphing the C 1 I Line 132
The Summing Up of Investment 133

7  The Government Sector 141

Introduction: The Growing Economic Role of Government 141
Government Spending 142
Federal Government Spending 142
State and Local Government Spending 144
Government Purchases versus Transfer Payments 145
Graphing the C 1 I 1 G Line 146
Taxes 146
The Average Tax Rate and the Marginal Tax Rate 147
Types of Taxes 149
Sources of Federal Revenue 151
Recent Tax Legislation 154
Conclusion 156
Sources of State and Local Revenue 156
The State and Local Fiscal Dilemma 157
Comparison of Taxes in the United States and Other Countries 158
The Economic Role of Government 160

(1) Provision of Public Goods and Services 160
(2) Redistribution of Income 160
(3) Stabilization 161
(4) Economic Regulation 161

Conclusion 161

8 The Export-Import Sector 167

The Basis for International Trade 167
Specialization and Exchange 168
U.S. Exports and Imports 169
A Summing Up: C 1 I 1 G 1 X_n 172
World Trade Agreements and Free Trade Zones 174
Free Trade Zones 174
World Trade Agreements 175

9  Gross Domestic Product 183

What Is Gross Domestic Product? 183
How GDP Is Measured 184
The Expenditures Approach 185
The Flow-of-Income Approach 186
Two Things to Avoid When Compiling GDP 189
Multiple Counting 189
Treatment of Transfer Payments 191
GDP versus Real GDP 191
International GDP Comparisons 196
Per Capita Real GDP 197
Shortcomings of GDP as a Measure of National Economic Well-Being 200
Production That Is Excluded 200
Treatment of Leisure Time 202
Human Costs and Benefits 202
What Goes into GDP? 203
The Last Word on GDP 204

10 Economic Fluctuations, Unemployment, and Inflation 209

Economic Fluctuations 209
Is There a Business Cycle? 209
Cycle Turning Points: Peaks and Troughs 210
The Conventional Three-Phase Business Cycle 211
Business Cycle Theories 212
Endogenous Theories 212
Exogenous Theories 213
Business Cycle Forecasting 213
Unemployment 214
The Problem 214
How the Unemployment Rate Is Computed 215
Types of Unemployment 219
Natural Unemployment Rate 222
Inflation 222
Defining Inflation 222
Deflation and Disinflation 224
The Post–World War II History of Inflation 226
The Construction of the Consumer Price Index 227
Anticipated and Unanticipated Inflation: Who Is Hurt by Inflation and Who Is Helped? 229
Theories of the Causes of Inflation 231
Inflation as a Psychological Process 234
Creeping Inflation and Hyperinflation 234
The Misery Index 235

11 Classical and Keynesian Economics 243

Part I: The Classical Economic System 243

Say’s Law 243
Supply and Demand Revisited 245
The Classical Equilibrium: Aggregate Demand Equals Aggregate Supply 247
The Aggregate Demand Curve 247
The Long-Run Aggregate Supply Curve 249
The Short-Run Aggregate Supply Curve 250

Part II: The Keynesian Critique of the Classical System 252

Part III: The Keynesian System 255

The Keynesian Aggregate Expenditure Model 256
Disequilibrium and Equilibrium 258

(1) Aggregate Demand Exceeds Aggregate Supply 258
(2) Aggregate Supply Exceeds Aggregate Demand 259
(3) Summary: How Equilibrium Is Attained 259

Keynesian Policy Prescriptions 259

12 Fiscal Policy and the National Debt 267

Putting Fiscal Policy into Perspective 267

Part I: The Deflationary Gap and the Inflationary Gap 268

The Deflationary Gap 268
The Inflationary Gap 269

Part II: The Multiplier and Its Applications 271

The Multiplier 271
Applications of the Multiplier 272

Part III: The Automatic Stabilizers 274

Personal Income and Payroll Taxes 275
Personal Savings 276
Credit Availability 276
Unemployment Compensation 276
The Corporate Profits Tax 276
Other Transfer Payments 277

Part IV: Discretionary Fiscal Policy 277

Making the Automatic Stabilizers More Effective 278
Public Works 278
Changes in Tax Rates 278
Changes in Government Spending 279
Who Makes Fiscal Policy? 279

Part V: The Deficit Dilemma 280

Deficits, Surpluses, and the Balanced Budget 280
Deficits and Surpluses: The Record 280
Why Are Large Deficits So Bad? 282
Must We Balance the Budget Every Year? 283

Part VI: The Crowding-Out and Crowding-In Effects 283

Part VII: The Public Debt 285

Conclusion 287

13 Money and Banking 293

Money 293
The Four Jobs of Money 293
Medium of Exchange 294
Standard of Value 294
Store of Value 294
Standard of Deferred Payment 294
Money versus Barter 295
M1, M2, and M3 295
Our Growing Money Supply 299
The Demand for Money 299
The Demand Schedule for Money 302
The Liquidity Trap 302
Determination of the Interest Rate 303
Banking 305
A Short History of Banking 305
Modern Banking 307
The Creation and Destruction of Money 311
The Creation of Money 311
The Destruction of Money 312
Limits to Deposit Creation 312
Bank Regulation 312
Branch Banking and Bank Chartering 312
The Federal Deposit Insurance Corporation 314
The Savings and Loan Debacle 314

14 The Federal Reserve and Monetary Policy 321

The Federal Reserve System 321
The Federal Reserve District Banks 322
The Board of Governors 323
Independence of the Board of Governors 324
Legal Reserve Requirements 325
Primary and Secondary Reserves 327
Deposit Expansion 327
How Deposit Expansion Works 327
The Deposit Expansion Multiplier 327
Cash, Checks, and Electronic Money 329
The Tools of Monetary Policy 331
How Open-Market Operations Work 331
The Federal Open-Market Committee 332
Discount Rate and Federal Funds Rate Changes 334
Changing Reserve Requirements 335
Summary: The Tools of Monetary Policy 336
The Fed’s Effectiveness in Fighting Inflation and Recession 338
The American Economy According to Chairman Greenspan 339
The Depository Institutions Deregulation and Monetary Control Act of 1980 341
The Banking Act of 1999 342
Fiscal and Monetary Policies Should Mesh 342
Last Word 343

15 Twentieth-Century Economic Theory 349

The Equation of Exchange 349
The Quantity Theory of Money 351
Classical Economics 352
Keynesian Economics 354
The Monetarist School 355
The Importance of the Rate of Monetary Growth 355
The Basic Propositions of Monetarism 356
The Monetary Rule 358
The Decline of Monetarism 358
Supply-Side Economics 359
The Work Effect 359
The Saving and Investment Effect 359
The Elimination of Productive Market Exchanges 360
The Laffer Curve 360
Rational Expectations Theory 362
The Three Assumptions of Rational Expectations Theory 362
Are Wages Downwardly Flexible? 365
21st Century Economic Theory 366
Supply-Side Revival? 366
The Economic Behaviorists 366
Conclusion 367
Appendix: A Guide to Macropolicy 373
Fighting Recessions 373
Conventional Fiscal Policy 373
Conventional Monetary Policy 374
Two Policy Dilemmas 374
Fight Inflation 374
Conventional Fiscal Policy 374
Conventional Monetary Policy 374
Fighting Inflationary Recessions: Two More Policy Dilemmas 374
Fiscal and Monetary Policy Lags 375
The Lags 375
Fiscal Policy Lags 375
Monetary Policy Lags 376
The Limits of Macropolicy 377
Conclusion 378

16 Economic Growth and Productivity 381

The Industrial Revolution and American Economic Development 381
The Record of Economic and Productivity Growth 382
How Saving and Investment Affect Productivity Growth 384
How Labor Force Changes Affect Productivity Growth 387

(1) The Average Workweek 387
(2) Our Declining Educational System 387
(3) The Permanent Underclass: Poverty, Drugs, and Crime 388
(4) Restrictions on Immigration 389

The Role of Technological Change 390
Additional Factors Affecting Our Rate of Growth 391
Summary 393
Productivity Growth and the “Jobless Recovery” 395
Economic Growth in Less Developed Countries 396

17 Demand, Supply, and Equilibrium 403

Demand Defined 403
Individual Demand and Market Demand 404
What Causes Changes in Demand 405
Increases in Demand 405
Decreases in Demand 406
Problems 406
What Causes Changes in Demand? 409
Supply Defined 411
Individual Supply and Market Supply 412
Changes in Supply 413
What Causes Changes in Supply? 414
Changes in the Cost of Production 414
Technological Advance 415
Prices of Other Goods 416
Change in the Number of Suppliers 416
Changes in Taxes 416
Expectation of Future Price Changes 416
Graphing the Demand and Supply Curves 416
Graphing the Demand Curve 416
Graphing the Supply Curve 419
Equilibrium 419
Finding the Equilibrium Price and Quantity 421
Last Word 424

18 The Elasticities of Demand and Supply 429

The Elasticity of Demand 429
Measuring Elasticity 429
The Meaning of Elasticity 431
Determinants of the Degree of Elasticity of Demand 435
Advertising 439
Elasticity and Total Revenue 440
Elastic Demand and Total Revenue 440
Inelastic Demand and Total Revenue 441
Elasticity of Supply 442
Elasticity over Time 442
Tax Incidence 445
Last Word 448

19 Theory of Consumer Behavior 453

Utility 454
What Is Utility? 454
Marginal Utility 454
Total Utility 455
Maximizing Utility 455
Some Limitations of Utility Applications 457
The Water–Diamond Paradox 458
Consumer Surplus 458
Last Word 462

20 Cost 467

Costs 467
Fixed Costs 468
Variable Costs 468
Total Cost 468
Marginal Cost 468
The Short Run and the Long Run 470
The Short Run 470
The Long Run 471
Average Cost 471
Average Fixed Cost 471
Average Variable Cost 472
Average Total Cost 472
Graphing the AFC, AVC, ATC, and MC Curves 473
Why Are the AVC and ATC Curves U-Shaped? 477
The Law of Diminishing Returns 477
Economies of Scale 479
Diseconomies of Scale 480
A Summing Up 481
Choosing Plant Size 482
The Decision to Operate of Shut Down 483
The Decision to Go Out of Business or Stay in Business 485

21       Profit, Loss, and Perfect Competition 495

Total Revenue and Marginal Revenue 495
Graphing Demand and Marginal Revenue 496
Economic and Accounting Profit 497
Profit Maximization and Loss Minimization 497
A Summing Up 502
Efficiency 503
Review of Efficiency and Profit Maximization 505
Do You Really Need to Make a Profit? 505
Definition of Perfect Competition 506
The Perfect Competitor’s Demand Curve 509
The Short Run 510
The Long Run 512
The Perfect Competitor: A Price Taker, Not a Price Maker 517
Efficiency, Price, and Profit 517

22       Monopoly 527

Monopoly Defined 527
The Graph of the Monopolist 528
Calculating the Monopolist’s Profit 530
Review of the Monopolist’s Economic Analysis 531
The Monopolist in the Short Run and the Long Run 534
Are All Monopolies Big Companies? 534
Barriers to Entry 535
Limits to Monopoly Power 539
Economies of Scale and Natural Monopoly 539
Is Bigness Good or Bad? 542
When Is Bigness Bad? 542
When Is Bigness Good? 543
The Economic Case against Bigness 545
Two Policy Alternatives 545
Conclusion 547

23       Monopolistic Competition 553

Monopolistic Competition Defined 553
The Monopolistic Competitor in the Short Run 553
The Monopolistic Competitor in the Long Run 555
Product Differentiation 556
The Typical Monopolistic Competitor 558
Price Discrimination 559
Is the Monopolistic Competitor Inefficient? 563

24       Oligopoly 567

Oligopoly Defined 567
Two Measures of the Degree of Oligopolization 568
Concentration Ratios 568
The Herfindahl-Hirschman Index (HHI) 569
The Competitive Spectrum 571
Cartels 571
Open Collusion 572
Covert Collusion 572
Price Leadership 574
Cutthroat Competition 575
Conclusion 577
Appendix: The Four Types of Competition: A Review 583
Perfect Competition 583
Monopoly 583
Monopolistic Competition 584
Oligopoly 584
Perfect Competition versus Imperfect Competition 584
Summary Tables 584

25       Corporate Mergers and Antitrust 589

A Historical Perspective on Corporate Concentration Antitrust 589
Antitrust 590
The Political Background 590
The Sherman Antitrust Act 590
The Clayton Antitrust Act 592
The Federal Trade Commission Act (1914) 593
Modern Antitrust 593
Partial Breakdown of the Rule of Reason 594
The 60 Percent Rule 595
Four Landmark Cases 595
European Antitrust 596
Types of Mergers 597
Horizontal Mergers 597
Vertical Mergers 598
Conglomerate Mergers 598
Deregulation 599
Corporate Misconduct 599
How Effective Is Antitrust? 600
The Trend toward Bigness 603

26       Demand in the Factor Market 609

Derived Demand 609
Productivity 610
Prices of Substitute Resources 610
Marginal Revenue Product (MRP) 611
The MRP of the Imperfect Competitor 615
Changes in Resource Demand 617
Changes in Resource Demand versus Changes in Quantity of Resource Demanded 617
The Four Reasons for Changes in Resource Demand 617
Optimum Resource Mix for the Firm 619

27       Labor Unions 625

A Short History of the American Labor Movement 625
The Early Years 625
Key Labor Legislation 626
Craft Unions vs. Industrial Unions 627
Union Organizing since the 1950s 629
Jobs: Exportable and Nonexportable 631
The Economic Power of Labor Unions 631
The Economic Power of Large Employers 632
Collective Bargaining 634
Strikes, Lockouts, and Givebacks 634
The Collective Bargaining Agreement 636
The Strike 637
Averting Strikes: Mediation and Arbitration 639

28       Labor Markets and Wage Rates 645

Income Disparity 645
The Supply of Labor 646
Noncompeting Groups 646
The Theory of the Dual Labor Market 646
The Backward-Bending Labor Supply Curve 647
The Demand for Labor 649
The Marginal Revenue Product Schedule 649
Nonhomogeneous Jobs 650
Graph of the Demand for Labor 651
The Wage Rate: Supply and Demand 651
High Wage Rates and Economic Rent 652
Real Wages versus Nominal Wages 654
The Minimum Wage and the Living Wage 658
The Minimum Wage Rate: 1938 to the Present 658
Should There Be a Minimum Wage Rate 659
The Living Wage 660
Last Word 660

29 Rent, Interest, and Profit 665

Rent 665
What Is Land? 665
How Is Rent Determined? 667
Economic Rent 668
Are Prices High because Rents Are High, or Are Rents High because Prices Are High? 669
Interest 670
What Is Capital? 670
How Is the Interest Rate Determined? 670
Interest Rates and Consumer Loans 671
The Present Value of Future Income 673
Profits 676
How Are Profits Determined? 676
How Large Are Profits? 676
Theories of Profit 676
Conclusion 679

30 Income Distribution and Poverty 685

Income Distribution in the United States 685
The Poor, the Middle Class, and the Rich 685
Distribution of Wealth in the United States 689
Distribution of Income: Equity and Efficiency 691
What Determines Income Distribution? 692
Poverty in America 694
Poverty Defined 694
Who Are the Poor? 696
Child Poverty 697
The Main Government Transfer Programs 699
Theories of the Causes of Poverty 700
The Conservative View versus the Liberal View 702
Solutions 704
Last Word 707

31 International Trade 713

Part I: A Brief History of U.S. Trade 714

U.S. Trade before 1975 714
U.S. Trade since 1975 714
U.S. Government Trade Policy 715

Part II: The Theory of International Trade 716

Specialization and Trade 716
Domestic Exchange Equations 718
The Terms of Trade 718
Absolute Advantage and Comparative Advantage 720
The Arguments for Protection 725
Tariffs or Quotas 729
Conclusion 730

Part III: The Practice of International Trade 731

What Are the Causes of Our Trade Imbalance? 731

Part IV: Our Trade Deficit with Japan and China 734

Japanese Trading Practices 735
Our Trade Deficit with China 737
Trading with China and Japan: More Differences than Similarities 737
Final Word 737

32 International Finance 745

The Mechanics of International Finance 745
Financing International Trade 746
The Balance of Payments 746
Exchange Rate Systems 749
The Gold Standard 749
The Gold Exchange Standard, 1934–73 750
The Freely Floating Exchange Rate System, 1973 to the Present 751
How Well Do Freely Floating (Flexible) Exchange Rates Work? 754
The Euro 754
The Yen and the Yuan 754
Running Up a Tab in the Global Economy 756
From Largest Creditor to Largest Debtor 756
Living beyond Our Means 759
Why We Need to Worry about the Current Account Deficit 760

Glossary 767

Index 777