8 PART ONE INTRODUCTION in road conditions-by faster and less careful driving. The end result of a seat belt law, therefore, is a larger number of accidents How does the law affect the number of deaths from driving? Drivers who wear their seat belts are more likely to survive any given accident, but they are als more likely to find themselves in an accident. The net effect is ambiguous. More- over, the reduction in safe driving has an adverse impact on pedestrians(and on drivers who do not wear their seat belts). They are put in jeopardy by the law be- cause they are more likely to find themselves in an accident but are not protected by a seat belt. Thus, a seat belt law tends to increase the number of pedestrian At first, this discussion of incentives and seat belts might seem like idle spec ulation. Yet, in a 1975 study, economist Sam Peltzman showed that the auto-safety aws have, in fact, had many of these effects. According to Peltzman's evidence these laws produce both fewer deaths per accident and more accidents. The net re of pedestrian deaths Peltzman's analysis of auto safety is an example of the general principle that people respond to incentives. Many incentives that economists study are more straightforward than those of the auto-safety laws. No one is surprised that people drive smaller cars in Europe, where gasoline taxes are high, than in the United States, where gasoline taxes are low. Yet, as the seat belt example shows, policies can have effects that are not obvious in advance. When analyzing any policy, we must consider not only the direct effects but also the indirect effects that work through incentives. If the policy changes incentives, it will cause people to alter their behavior QUICK QUIZ: List and briefly explain the four principles of individual HOW PEOPLE INTERACT The first four principles discussed how individuals make decisions. As we go about our lives, many of our decisions affect not only ourselves but other people as well. The next three principles concern how people interact with one another PRINCIPLE #5: TRADE CAN MAKE EVERYONE BETTER OFF You have probably heard on the news that the Japanese are our competitors in the world economy. In some ways, this is true, for American and Japanese firms do produce many of the same goods. Ford and Toyota compete for the same cus- tomers in the market for automobiles. Compaq and Toshiba compete for the same customers in the market for personal computers Yet it is easy to be misled when thinking about competition among countries Trade between the United States and Japan is not like a sports contest, where one
8 PART ONE INTRODUCTION in road conditions—by faster and less careful driving. The end result of a seat belt law, therefore, is a larger number of accidents. How does the law affect the number of deaths from driving? Drivers who wear their seat belts are more likely to survive any given accident, but they are also more likely to find themselves in an accident. The net effect is ambiguous. Moreover, the reduction in safe driving has an adverse impact on pedestrians (and on drivers who do not wear their seat belts). They are put in jeopardy by the law because they are more likely to find themselves in an accident but are not protected by a seat belt. Thus, a seat belt law tends to increase the number of pedestrian deaths. At first, this discussion of incentives and seat belts might seem like idle speculation. Yet, in a 1975 study, economist Sam Peltzman showed that the auto-safety laws have, in fact, had many of these effects. According to Peltzman’s evidence, these laws produce both fewer deaths per accident and more accidents. The net result is little change in the number of driver deaths and an increase in the number of pedestrian deaths. Peltzman’s analysis of auto safety is an example of the general principle that people respond to incentives. Many incentives that economists study are more straightforward than those of the auto-safety laws. No one is surprised that people drive smaller cars in Europe, where gasoline taxes are high, than in the United States, where gasoline taxes are low. Yet, as the seat belt example shows, policies can have effects that are not obvious in advance. When analyzing any policy, we must consider not only the direct effects but also the indirect effects that work through incentives. If the policy changes incentives, it will cause people to alter their behavior. QUICK QUIZ: List and briefly explain the four principles of individual decisionmaking. HOW PEOPLE INTERACT The first four principles discussed how individuals make decisions. As we go about our lives, many of our decisions affect not only ourselves but other people as well. The next three principles concern how people interact with one another. PRINCIPLE #5: TRADE CAN MAKE EVERYONE BETTER OFF You have probably heard on the news that the Japanese are our competitors in the world economy. In some ways, this is true, for American and Japanese firms do produce many of the same goods. Ford and Toyota compete for the same customers in the market for automobiles. Compaq and Toshiba compete for the same customers in the market for personal computers. Yet it is easy to be misled when thinking about competition among countries. Trade between the United States and Japan is not like a sports contest, where one
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS side wins and the other side loses. In fact, the opposite is true: Trade between two THE WALL STREE了 JOU RNAL countries can make each country better off To see why, consider how trade affects your family. When a member of your family looks for a job, he or she competes against members of other families who are looking for jobs. Families also compete against one another when they go shopping, because each family wants to buy the best goods at the lowest prices. So, in a sense, each family in the economy is competing with all other families make its own clothes, and build its own home. Clearly, your family gains ucs Despite this competition, your family would not be better off isolating itself from all other families. If it did, your family would need to grow its own food, from its ability to trade with others. Trade allows each person to specialize in the activities he or she does best, whether it is farming, sewing, or home building. By trading with others, people can buy a greater variety of goods and services at lower cost Countries as well as families benefit from the ability to trade with one another Trade allows countries to specialize in what they do best and to enjoy a greater va- riety of goods and services. The Japanese, as well as the French and the Egyptians and the Brazilians, are as much our partners in the world economy as they are our "For $5 a week you can watch competitors baseball without being nagged te cut the gra PRINCIPLE #6: MARKETS ARE USUALLY A GOOD WAY TO ORGANIZE ECONOMIC ACTIVITY The collapse of communism in the Soviet Union and Eastern Europe may be the most important change in the world during the past half century. Communist countries worked on the premise that central planners in the government were in the best position to guide economic activity. These planners decided what goods and services were produced, how much was produced, and who produced and consumed these goods and services. The theory behind central planning was that only the government could organize economic activity in a way that promoted economic well-being for the country as a whole Today, most countries that once had centrally planned economies have aban- doned this system and are trying to develop market economies. In a market econ- market economy omy, the decisions of a central planner are replaced by the decisions of millions of an economy that allocates resources firms and households. Firms decide whom to hire and what to make Households through the decentralized decide which firms to work for and what to buy with their incomes. These firms of many firms and households as and households interact in the marketplace, where prices and self-interest guide they interact in markets for good their decisions At first glance, the success of market economies is puzzling. After ket economy, no one is looking out for the economic well-being of society as a whole. Free markets contain many buyers and sellers of numerous goods and services,and all of them are interested primarily in their own well-being. Yet, despite decentralized decisionmaking and self-interested decisionmakers, market economies have proven remarkably successful in organizing economic activity in a way that promotes overall economic well-being In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, economist adam smith made the most famous observation in all of economics Households and firms interacting in markets act as if they are guided by an"in- visible hand" that leads them to desirable market outcomes. One of our goals in
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 9 side wins and the other side loses. In fact, the opposite is true: Trade between two countries can make each country better off. To see why, consider how trade affects your family. When a member of your family looks for a job, he or she competes against members of other families who are looking for jobs. Families also compete against one another when they go shopping, because each family wants to buy the best goods at the lowest prices. So, in a sense, each family in the economy is competing with all other families. Despite this competition, your family would not be better off isolating itself from all other families. If it did, your family would need to grow its own food, make its own clothes, and build its own home. Clearly, your family gains much from its ability to trade with others. Trade allows each person to specialize in the activities he or she does best, whether it is farming, sewing, or home building. By trading with others, people can buy a greater variety of goods and services at lower cost. Countries as well as families benefit from the ability to trade with one another. Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services. The Japanese, as well as the French and the Egyptians and the Brazilians, are as much our partners in the world economy as they are our competitors. PRINCIPLE #6: MARKETS ARE USUALLY A GOOD WAY TO ORGANIZE ECONOMIC ACTIVITY The collapse of communism in the Soviet Union and Eastern Europe may be the most important change in the world during the past half century. Communist countries worked on the premise that central planners in the government were in the best position to guide economic activity. These planners decided what goods and services were produced, how much was produced, and who produced and consumed these goods and services. The theory behind central planning was that only the government could organize economic activity in a way that promoted economic well-being for the country as a whole. Today, most countries that once had centrally planned economies have abandoned this system and are trying to develop market economies. In a market economy, the decisions of a central planner are replaced by the decisions of millions of firms and households. Firms decide whom to hire and what to make. Households decide which firms to work for and what to buy with their incomes. These firms and households interact in the marketplace, where prices and self-interest guide their decisions. At first glance, the success of market economies is puzzling. After all, in a market economy, no one is looking out for the economic well-being of society as a whole. Free markets contain many buyers and sellers of numerous goods and services, and all of them are interested primarily in their own well-being. Yet, despite decentralized decisionmaking and self-interested decisionmakers, market economies have proven remarkably successful in organizing economic activity in a way that promotes overall economic well-being. In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, economist Adam Smith made the most famous observation in all of economics: Households and firms interacting in markets act as if they are guided by an “invisible hand” that leads them to desirable market outcomes. One of our goals in “For $5 a week you can watch baseball without being nagged to cut the grass!” market economy an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services
PART ONE INTRODUCTION EY Adam Smith It may be only a coincidence the butcher. the brewer, or that Adam Smith's great book, he baker that we expect our and the An Inquiry into the Nature and dinner, but from their regard Invisible hand Causes of the wealth of Na to their interes tions, was published in 1776 Every individual the exact year American revolu neither intends to promote tion of Independence. But the how much he is promoting two documents do share it.. He intends only his point of view that was preva- wn gain, and he is in this, as ent at the time-that individu- in many other cases, led by als are usually best left to their an invisible hand to promote own devices, without the heay an end which was no part of ADAM SMITH hand of government guiding their actions. This political phi- his intention. Nor is it always osophy provides the intellectual basis for the market econ- the worse for the society that omy, and for free society more generally it was no part of it. By pursuing his own interest he Why do decentralized market economies work so frequently promotes that of the society more effectually well? Is it because people can be counted on to treat one han when he really intends to promote it. another with love and kindness? Not at all. here is adam Smiths description of how people interact in a market Smith is saying that participants in the economy are moth- economy. vated by self-interest and that the "invisible hand" of the marketplace guides this self-interest into promoting general Man has almost constant oc for the help of his economic well-being. brethren and it is vain for him to expect it from their Many of Smith's insights remain at the center of mod- benevolence only. He will be more likely to prevail if he ern economics. Our analysis in the coming chapters will al an interest their self-love in his favor, and show them low us to express smith,'s conclusions more precisely and that it is for their own advantage to do for him what he to analyze fully the strengths and weaknesses of the mar- requires of them .. It is not from the benevolence of ket's invisible hand this book is to understand how this invisible hand works its magic. As you study economics, you will learn that prices are the instrument with which the invisible hand directs economic activity. Prices reflect both the value of a good to society and the cost to society of making the good. Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social benefits and costs of their actions. As a result, prices guide these indi- vidual decisionmakers to reach outcomes that, in many cases, maximize the wel- sa There is an important corollary to the skill of the invisible hand in guiding eco- nomic activity: When the government prevents prices from adjusting naturally to supply and demand, it impedes the invisible hand's ability to coordinate the mil lions of households and firms that make up the economy. This corollary explains why taxes adversely affect the allocation of resources: Taxes distort prices and thus the decisions of households and firms. It also explains the even greater harm caused by policies that directly control prices, such as rent control. And it explains the failure of communism. In communist countries, prices were not determined in the marketplace but were dictated by central planners. These planners lacked the information that gets reflected in prices when prices are free to respond to market
10 PART ONE INTRODUCTION this book is to understand how this invisible hand works its magic. As you study economics, you will learn that prices are the instrument with which the invisible hand directs economic activity. Prices reflect both the value of a good to society and the cost to society of making the good. Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social benefits and costs of their actions. As a result, prices guide these individual decisionmakers to reach outcomes that, in many cases, maximize the welfare of society as a whole. There is an important corollary to the skill of the invisible hand in guiding economic activity: When the government prevents prices from adjusting naturally to supply and demand, it impedes the invisible hand’s ability to coordinate the millions of households and firms that make up the economy. This corollary explains why taxes adversely affect the allocation of resources: Taxes distort prices and thus the decisions of households and firms. It also explains the even greater harm caused by policies that directly control prices, such as rent control. And it explains the failure of communism. In communist countries, prices were not determined in the marketplace but were dictated by central planners. These planners lacked the information that gets reflected in prices when prices are free to respond to market It may be only a coincidence that Adam Smith’s great book, An Inquiry into the Nature and Causes of the Wealth of Nations, was published in 1776, the exact year American revolutionaries signed the Declaration of Independence. But the two documents do share a point of view that was prevalent at the time—that individuals are usually best left to their own devices, without the heavy hand of government guiding their actions. This political philosophy provides the intellectual basis for the market economy, and for free society more generally. Why do decentralized market economies work so well? Is it because people can be counted on to treat one another with love and kindness? Not at all. Here is Adam Smith’s description of how people interact in a market economy: Man has almost constant occasion for the help of his brethren, and it is vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favor, and show them that it is for their own advantage to do for him what he requires of them. . . . It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. . . . Every individual . . . neither intends to promote the public interest, nor knows how much he is promoting it. . . . He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. Smith is saying that participants in the economy are motivated by self-interest and that the “invisible hand” of the marketplace guides this self-interest into promoting general economic well-being. Many of Smith’s insights remain at the center of modern economics. Our analysis in the coming chapters will allow us to express Smith’s conclusions more precisely and to analyze fully the strengths and weaknesses of the market’s invisible hand. ADAM SMITH FYI Adam Smith and the Invisible Hand
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS forces Central planners failed because they tried to run the economy with one hand tied behind their backs-the invisible hand of the marketplace PRINCIPLE #7: GOVERNMENTS CAN SOMETIMES IMPROVE MARKET OUTCOMES Although markets are usually a good way to organize economic activity, this rule has some important exceptions. There are two broad reasons for a government to intervene in the economy: to promote efficiency and to promote equity. That is, most policies aim either to enlarge the economic pie or to change how the pie is divided The invisible hand usually leads markets to allocate resources efficientl Nonetheless, for various reasons the invisible hand sometimes does not work Economists use the term market failure to refer to a situation in which the market market failure on its own fails to allocate resources efficiently. a situation in which a market left One possible cause of market failure is an externality. An externality is the im- its own fails to allocate resources pact of one persons actions on the well-being of a bystander. The classic example efficiently of an external cost is pollution. If a chemical factory does not bear the entire cost of the smoke it emits, it will likely emit too much. Here, the government can raise externality economic well-being through environmental regulation. The classic example of an the woell-being of a bystander ons on the impact of one person's ac external benefit is the creation of knowledge. When a scientist makes an important discovery, he produces a valuable resource that other people can use. In this case, the government can raise economic well-being by subsidizing basic research, as fact it does Another possible cause of market failure is market power Market power market power refers to the ability of a single person(or small group of people) to unduly influ- the ability of a single economic actor competition with which the invisible hand normally keeps self-interest in check. pr( group of actors)to have a ence market prices. For example, suppose that everyone in town needs water but there is only one well. The owner of the well has market power-in this case a substa tial influence on market is not subject to the You will learn that, in this case, regulating the price that the monopolist charges can potentially enhance economic efficiency The invisible hand is even less able to ensure that economic prosperity is dis- tributed fairly. a market economy rewards people according to their ability to pro- duce things that other people are willing to pay for. The worlds best basketball player earns more than the world's best chess player simply because people are willing to pay more to watch basketball than chess. The invisible hand does not en sure that everyone has sufficient food, decent clothing, and adequate health care a goal of many public policies, such as the income tax and the welfare system, to achieve a more equitable distribution of economic well-being To say that the government can improve on markets outcomes at times does not mean that it always will. Public policy is made not by angels but by a political process that is far from perfect. Sometimes policies are designed simply to reward the politically powerful. Sometimes they are made by well-intentioned lead who are not fully informed. One goal of the study of economics is to help you judge when a government policy is justifiable to promote efficiency or equity and when it is not QUICK QUIZ: List and briefly explain the three principles concerning economic interactions
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 11 forces. Central planners failed because they tried to run the economy with one hand tied behind their backs—the invisible hand of the marketplace. PRINCIPLE #7: GOVERNMENTS CAN SOMETIMES IMPROVE MARKET OUTCOMES Although markets are usually a good way to organize economic activity, this rule has some important exceptions. There are two broad reasons for a government to intervene in the economy: to promote efficiency and to promote equity. That is, most policies aim either to enlarge the economic pie or to change how the pie is divided. The invisible hand usually leads markets to allocate resources efficiently. Nonetheless, for various reasons, the invisible hand sometimes does not work. Economists use the term market failure to refer to a situation in which the market on its own fails to allocate resources efficiently. One possible cause of market failure is an externality. An externality is the impact of one person’s actions on the well-being of a bystander. The classic example of an external cost is pollution. If a chemical factory does not bear the entire cost of the smoke it emits, it will likely emit too much. Here, the government can raise economic well-being through environmental regulation. The classic example of an external benefit is the creation of knowledge. When a scientist makes an important discovery, he produces a valuable resource that other people can use. In this case, the government can raise economic well-being by subsidizing basic research, as in fact it does. Another possible cause of market failure is market power. Market power refers to the ability of a single person (or small group of people) to unduly influence market prices. For example, suppose that everyone in town needs water but there is only one well. The owner of the well has market power—in this case a monopoly—over the sale of water. The well owner is not subject to the rigorous competition with which the invisible hand normally keeps self-interest in check. You will learn that, in this case, regulating the price that the monopolist charges can potentially enhance economic efficiency. The invisible hand is even less able to ensure that economic prosperity is distributed fairly. A market economy rewards people according to their ability to produce things that other people are willing to pay for. The world’s best basketball player earns more than the world’s best chess player simply because people are willing to pay more to watch basketball than chess. The invisible hand does not ensure that everyone has sufficient food, decent clothing, and adequate health care. A goal of many public policies, such as the income tax and the welfare system, is to achieve a more equitable distribution of economic well-being. To say that the government can improve on markets outcomes at times does not mean that it always will. Public policy is made not by angels but by a political process that is far from perfect. Sometimes policies are designed simply to reward the politically powerful. Sometimes they are made by well-intentioned leaders who are not fully informed. One goal of the study of economics is to help you judge when a government policy is justifiable to promote efficiency or equity and when it is not. QUICK QUIZ: List and briefly explain the three principles concerning economic interactions. market failure a situation in which a market left on its own fails to allocate resources efficiently externality the impact of one person’s actions on the well-being of a bystander market power the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices
PART ONE INTRODUCTION HOW THE ECONOMY AS A WHOLE WORKS We started by discussing how individuals make decisions and then looked at how people interact with one another. All these decisions and interactions together make up"the economy. The last three principles concern the workings of the economy as a whole PRINCIPLE 8: A COUNTRYS STANDARD OF LIVING DEPENDS ON ITS ABILITY TO PRODUCE GOODS AND SERVICES The differences in living standards around the world are staggering. In 1997 the average American had an income of about $29,000. In the same year, the average Mexican earned $8,000, and the average Nigerian earned $900. Not surprisingly, this large variation in average income is reflected in various measures of the qual ity of life. Citizens of high-income countries have more TV sets, more cars, better nutrition, better health care, and longer life expectancy than citizens of low-income countries Changes in living standards over time are also large. In the United States, Over the past century, average income has risen about eightfold What explains these large differences in living standards among countries and over time? The answer is surprisingly simple. Almost all variation in living stan- productivity dards is attributable to differences in countries' productivity-that is, the amount the amount of goods and services of goods and services produced from each hour of a worker's time In nations produced from each hour of a where workers can produce a large quantity of goods and services per unit of time, woorker's time most people enjoy a high standard of living; in nations where workers are less of a n people must endure a more meager existence. Similarly, the growth rate of a nations productivity determines the growth rate of its average The fundamental relationship between productivity and living standards is simple, but its implications are far-reaching. If productivity is the primary deter minant of living standards, other explanations must be of secondary importance For example, it might be tempting to credit labor unions or minimum-wage laws for the rise in living standards of American workers over the past century. Yet the real hero of American workers is their rising productivity. As another example, some commentators have claimed that increased competition from Japan and other countries explains the slow growth in U.S. incomes over the past 30 years Yet the real villain is not competition from abroad but flagging productivity The relationship between productivity and living standards also has profound implications for public policy. When thinking about how any policy will affect liv- ing standards, the key question is how it will affect our ability to produce goods and services. To boost living standards, policymakers need to raise productivity by ensuring that workers are well educated, have the tools needed to produce goods
12 PART ONE INTRODUCTION HOW THE ECONOMY AS A WHOLE WORKS We started by discussing how individuals make decisions and then looked at how people interact with one another. All these decisions and interactions together make up “the economy.” The last three principles concern the workings of the economy as a whole. PRINCIPLE #8: A COUNTRY’S STANDARD OF LIVING DEPENDS ON ITS ABILITY TO PRODUCE GOODS AND SERVICES The differences in living standards around the world are staggering. In 1997 the average American had an income of about $29,000. In the same year, the average Mexican earned $8,000, and the average Nigerian earned $900. Not surprisingly, this large variation in average income is reflected in various measures of the quality of life. Citizens of high-income countries have more TV sets, more cars, better nutrition, better health care, and longer life expectancy than citizens of low-income countries. Changes in living standards over time are also large. In the United States, incomes have historically grown about 2 percent per year (after adjusting for changes in the cost of living). At this rate, average income doubles every 35 years. Over the past century, average income has risen about eightfold. What explains these large differences in living standards among countries and over time? The answer is surprisingly simple. Almost all variation in living standards is attributable to differences in countries’ productivity—that is, the amount of goods and services produced from each hour of a worker’s time. In nations where workers can produce a large quantity of goods and services per unit of time, most people enjoy a high standard of living; in nations where workers are less productive, most people must endure a more meager existence. Similarly, the growth rate of a nation’s productivity determines the growth rate of its average income. The fundamental relationship between productivity and living standards is simple, but its implications are far-reaching. If productivity is the primary determinant of living standards, other explanations must be of secondary importance. For example, it might be tempting to credit labor unions or minimum-wage laws for the rise in living standards of American workers over the past century. Yet the real hero of American workers is their rising productivity. As another example, some commentators have claimed that increased competition from Japan and other countries explains the slow growth in U.S. incomes over the past 30 years. Yet the real villain is not competition from abroad but flagging productivity growth in the United States. The relationship between productivity and living standards also has profound implications for public policy. When thinking about how any policy will affect living standards, the key question is how it will affect our ability to produce goods and services. To boost living standards, policymakers need to raise productivity by ensuring that workers are well educated, have the tools needed to produce goods and services, and have access to the best available technology. productivity the amount of goods and services produced from each hour of a worker’s time