ECONOMICS

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ECONOMICS

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ECONOMICS SEVENTH EDITION

DOUGLAS McTAGGART CHRISTOPHER FINDLAY MICHAEL PARKIN

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Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2013 Pearson Australia Unit 4, Level 3 14 Aquatic Drive Frenchs Forest NSW 2086 www.pearson.com.au The Copyright Act 1968 of Australia allows a maximum of one chapter or 10% of this book, whichever is the greater, to be copied by any educational institution for its educational purposes provided that that educational institution (or the body that administers it) has given a remuneration notice to Copyright Agency Limited (CAL) under the Act. For details of the CAL licence for educational institutions contact: Copyright Agency Limited, telephone: (02) 9394 7600, email: [email protected] All rights reserved. Except under the conditions described in the Copyright Act 1968 of Australia and subsequent amendments, no part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner. Editor in Chief: Frances Eden Senior Acquisitions Editor: Simone Bella Senior Project Editor: Rebecca Pomponio Manager – Product Development: Michael Stone Editorial Coordinator: Germaine Silva Production Controller: Barbara Honor Copy Editor: Felicity McKenzie Proofreader: Nicole Le Grand Copyright and Pictures Editor: Lisa Woodland Indexer: Olive Grove Indexing Technical Illustrator: Richard Parkin Cover design by Natalie Bowra Cover photograph from Ivan Cholakov / Dreamstime.com Typeset by Midland Typesetters, Australia Printed in China 1 2 3 4 5 17 16 15 14 13 National Library of Australia Cataloguing-in-Publication Data Author: McTaggart, Douglas, 1953Title: Economics / Douglas McTaggart, Christopher Findlay, Michael Parkin. Edition: 7th ed. ISBN: 9781442550773 (pbk.) Notes: Includes index. Subjects: Economics – Textbooks. Other Authors/Contributors: Findlay, Christopher C. (Christopher Charles); Parkin, Michael, 1939-. Dewey Number: 330 Every effort has been made to trace and acknowledge copyright. However, should any infringement have occurred, the publishers tender their apologies and invite copyright owners to contact them.

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ABOUT THE AUTHORS Doug McTaggart is recently retired as Chief Executive Officer of the Queensland Investment Corporation (a fund manager with over $65 billion in assets under management). He was a student at the Australian National University, earned his PhD at the University of Chicago, and has held academic appointments at the Virginia Polytechnic Institute, the University of Adelaide and Bond University. He is a former Under Treasurer and Under Secretary of the Queensland Treasury, a past President of the Economic Society of Australia, a former member of the Australian Accounting Standards Board, and a former Chairman of the Investment and Financial Services Association (now Financial Services Council). Currently he is a Councillor on the National Competition Council and the Coag Reform Council. He is also a director on a number of listed and unlisted companies. Dr McTaggart’s research and publications spanned a wide area and cover macroeconomics, monetary theory, game theory and applied microeconomics.

Christopher Findlay was educated at the University of Adelaide and the Australian National University (ANU). He was Professor of Economics in the Asia Pacific School of Economics and Government at the ANU before moving in late 2005 to the University of Adelaide to become Professor of Economics and Head of the School of Economics. He is now Executive Dean of the University of Adelaide Faculty of the Professions. His chief interests are Australia’s economic links with Asia and international trade and investment in services, air transport in particular.

Michael Parkin received his training as an economist at the Universities of Leicester and Essex in England. He is Professor Emeritus in the Department of Economics at the University of Western Ontario, Canada. Professor Parkin has held faculty appointments at Brown University, the University of Manchester, the University of Essex and Bond University. He is a past president and fellow of the Canadian Economics Association and has served on the editorial boards of the American Economic Review and the Journal of Monetary Economics and as managing editor of the Canadian Journal of Economics. Professor Parkin’s research on macroeconomics, monetary economics and international economics has resulted in over 160 publications in journals and edited volumes, including the American Economic Review, the Journal of Political Economy, the Review of Economic Studies, the Journal of Monetary Economics, and the Journal of Money, Credit and Banking. He became most visible to the public with his work on inflation that discredited the use of wage and price controls. Michael Parkin also spearheaded the movement towards European monetary union.

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Dedications Douglas McTaggart dedicates this book to Pam, Cameron, Lachlan and especially Andrew. Christopher Findlay dedicates this book to Tania, Marek and Kasia. Michael Parkin dedicates this book to all his students.

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BRIEF CONTENTS PART ONE INTRODUCTION CHAPTER CHAPTER CHAPTER CHAPTER

1 2 3 4

1

What Is Economics? 1 The Economic Problem 29 Demand and Supply 51 Elasticity 79

PART TWO HOW MARKETS WORK CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER

101

Efficiency and Equity 101 Government Actions in Markets 123 Global Markets in Action 147 Public Choices and Public Goods 171 Economics of the Environment 193 10 Monopoly 215 11 Economic Inequality 239 5 6 7 8 9

PART THREE DECISIONS AND STRATEGIES IN MARKETS 261 CHAPTER

CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER

12 Consumer Choices and Constraints 261 13 Producer Choices and Constraints 281 14 Perfect Competition 305 15 Monopolistic Competition 331 16 Oligopoly Games and Strategies 349 17 Decisions in Factor Markets 373

PART FOUR MONITORING MACROECONOMIC PERFORMANCE 397 CHAPTER

CHAPTER

18 Measuring GDP and Economic Growth 397 19 Monitoring Jobs and Inflation 421

PART FIVE UNDERSTANDING THE MACROECONOMY 443 CHAPTER CHAPTER CHAPTER

CHAPTER

CHAPTER

CHAPTER

CHAPTER

20 Economic Growth 443 21 Finance, Saving and Investment 469 22 Money, the Price Level and Inflation 493 23 The Exchange Rate and the Balance of Payments 519 24 Aggregate Supply and Aggregate Demand 545 25 Expenditure Multipliers: The Keynesian Model 569 26 Australian Macroeconomic Fluctuations 599

PART SIX MACROECONOMIC POLICY CHAPTER CHAPTER

621

27 Fiscal Policy 621 28 Monetary Policy 645

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PREFACE The future is always uncertain. But at some times, and now is one such time, the range of possible futures is enormous. As a small economy tightly integrated into the global economy, it is uncertainty about external forces that dominates Australia’s outlook.

There is uncertainty about monetary policy with the European Central bank and the U.S. Federal Reserve Bank holding interest rates at historical lows and injecting billions of dollars of money in an attempt to stimulate a flagging recovery from a global financial crisis. And there is extraordinary uncertainty about fiscal policy as budget deficits in the United States and Europe seem ever harder to control. Whether or when economic growth in China and India will slow and dampen the growth of the rest of the world is a big unknown. Since the global financial crisis of August 2007 moved economics from the business page of the newspaper to the front page, fear has gripped producers, consumers, financial institutions and governments. Even the idea that the market is an efficient mechanism for allocating scarce resources came into question as some political leaders trumpeted the end of capitalism and the dawn of a new economic order in which tighter regulation reined in unfettered greed. Rarely do teachers of economics have such a rich feast on which to draw. And rarely are the principles of economics more surely needed to provide the solid foundation on which to think about economic events and navigate the turbulence of economic life. Although thinking like an economist can bring a clearer perspective to and a deeper understanding of today’s events, students don’t find the economic way of thinking easy or natural. Economics seeks to put clarity and understanding in the grasp of the student through its careful and vivid exploration of the tension between self-interest and the social interest, the role and power of incentives – of opportunity cost and marginal benefit – and the possibility that markets supplemented by other mechanisms might allocate resources efficiently. McTaggart, Findlay and Parkin students begin to think about issues the way real economists do and learn how to explore difficult policy problems and make more informed decisions in their own lives.

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◆ The Seventh Edition Revision Simpler where possible, stripped of some technical detail, more copiously illustrated with well-chosen photographs, reinforced with improved chapter summaries and problem sets, and even more tightly integrated with MyEconLab: These are the hallmarks of this seventh edition of Economics. This comprehensive revision also incorporates and responds to the detailed suggestions for improvements made by reviewers and users, both in the broad architecture of the text and in each chapter. The revision builds on the improvements achieved in previous editions and retains its thorough and detailed presentation of the principles of economics, its emphasis on real-world examples and applications, its development of critical thinking skills, its diagrams renowned for pedagogy and precision and its pathbreaking technology. Most chapters have been fine-tuned to achieve even greater clarity and to present the material in a more straightforward, visual and intuitive way. Some chapters have been thoroughly reworked to cover new issues, particularly those that involve current policy problems. These changes are aimed at better enabling students to learn how to use the economic toolkit to analyse their own decisions and understand the events and issues they are confronted with in the media and at the ballot box. Current issues organise each chapter. News stories about today’s major economic events tie a chapter together, from new, briefer chapter-opening questions to end-of-chapter problems and online practice. Each chapter includes a discussion of a critical issue of our time to demonstrate how economic theory can be applied to explore a particular debate or question. Among the many issues covered are ■ The rising cost of food in Chapter 2 ■ The fluctuating price of bananas and coffee in Chapter 3 ■ Expanding the universities in Chapter 8 ■ Climate change and the carbon tax in Chapter 9 ■ Monopoly and competition policy in Chapter 10 ■ The top 1 per cent, rising inequality in Australia and falling inequality across nations in Chapter 11

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Recession and unemployment in Chapters 18, 24 and 26 Currency fluctuations and the managed Chinese yuan in Chapter 23 Fiscal stimulus and the debate about the fiscal stimulus multipliers in Chapter 27 Monetary stimulus in Chapter 28.

Real-world examples and applications appear in the body of each chapter and in the end-of-chapter problems and applications, which are available in MyEconLab for assignment as homework, quizzes or tests. A selection of the questions that appear weekly in MyEconLab in Economics in the News is also available for assignment as homework, quizzes or tests.

Highpoints of the Micro Revision In addition to being thoroughly updated and revised to include the topics and features just described, the micro chapters feature the following five notable changes: 1. What Is Economics? (Chapter 1): We have reworked the explanation of the economic way of thinking around six key ideas, all illustrated with student-relevant choices. The graphing appendix to this chapter has an increased focus on scatter diagrams and their interpretation and on understanding shifts of curves. 2. Economics of the Environment (Chapter 9): This chapter has been revised to deal more thoroughly with the economics of pollution and carbon emission and the role of the carbon tax. The section on the tragedy of the commons has also been extensively revised to explain the problem of overfishing using an analysis that matches that of negative externalities. 3. Economic Inequality (Chapter 11): This chapter now includes a section on inequality in the world economy and compares Australian inequality with that in nations at the two extremes of equality and inequality. It also looks at the reasons why the super rich are getting richer. 4. Consumer Choices and Constraints (Chapter 12): Students find the analysis of the price effect in terms of an income effect and a substitution effect difficult,

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so we have reworked this material to make the explanation clearer. We have omitted the work–leisure choice coverage of earlier editions and given the chapter a student-friendly application on choices about movies and DVDs. 5. Oligopoly Games and Strategies (Chapter 16): We have omitted the kinked demand curve and dominant firm coverage of earlier editions and given the chapter a stronger game theory focus. A Gillette–Schick battle for the razor market illustrates game theory in action.

Highpoints of the Macro Revision All the macro chapters have been updated to incorporate data to the second quarter of 2011 and the news and policy situation to the second quarter of 2012. Beyond these general updates, the macro chapters feature the following eight notable revisions: 1. Measuring GDP and Economic Growth (Chapter 18): We have revised the section on crosscountry comparisons and the limitations of GDP to make the material clearer and we have added photo illustrations of purchasing power parity and of items omitted from GDP. A new appendix to this chapter explains the graphing of time-series data and the use of a ratio scale to reveal trends. The Mathematical Note on chain volume measure of GDP has been simplified. 2. Monitoring Jobs and Inflation (Chapter 19): This chapter now includes a discussion and illustration of the duration of unemployment spells. We have rewritten the section on full employment and the influences on the natural unemployment rate. The coverage of the price level has been expanded to define and explain the costs of deflation as well as inflation. 3. Economic Growth (Chapter 20): We have simplified this chapter by omitting the technical details on growth accounting and replacing them with an intuitive discussion of the crucial role of human capital and intellectual property rights. We illustrate the role played by these key factors during Britain’s Industrial Revolution. We have made the chapter more relevant and empirical by including a summary of the correlations between the growth rate and the positive and negative influences on it.

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◆ Features to Enhance Teaching and Learning Reading Between the Lines This McTaggart, Findlay and Parkin hallmark helps students think like economists by connecting chapter tools and concepts to the world around them. In Reading Between the Lines at the end of each chapter students apply the tools they have just learned by analysing an article from a newspaper or news website. Each article sheds additional light on the questions first raised in the chapter opener. Questions about the article also appear with the end-of-chapter problems and applications. R EA D ING BETWEEN THE LINES

Demand and Supply: The Price of Coffee Coffee Surges on Poor Colombian Harvests FT.com 30 July 2010 Coffee prices hit a 12-year high on Friday on the back of low supplies of premium Arabica coffee from Colombia after a string of poor crops in the Latin American country. The strong fundamental picture has also encouraged hedge funds to reverse their previous bearish views on coffee prices. In New York, … Arabica coffee jumped 3.2 per cent to 178.75 cents per pound, the highest since February 1998. It traded later at 177.25 cents, up 6.8 per cent on the week. The London-based International Coffee Organization on Friday warned that the ‘current tight demand and supply situation’ was ‘likely to persist in the near to medium term’. Coffee industry executives believe prices could rise towards 200 cents per pound in New York before the arrival of the new Brazilian crop later this year. ‘Until October it is going to be tight on high quality coffee,’ said a senior executive at one of Europe’s largest coffee roasters. He said: ‘The industry has been surprised by the scarcity of high quality beans’. Colombian coffee production, key for supplies of premium beans, last year plunged to a 33-year low of 7.8 m bags, each of 60 kg, down nearly a third from 11.1 m bags in 2008, tightening supplies worldwide … Excerpted from ‘Coffee Surges on Poor Colombian Harvests’ by Javier Blas, Financial Times. © The Financial Times Limited (2010). All rights reserved.

ESSENCE OF THE STORY ■

The price of premium Arabica coffee increased by 3.2 per cent to almost 180 cents per pound in July 2010, the highest price since February 1998.

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A sequence of poor crops in Colombia cut the production of premium Arabica coffee to a 33-year low of 7.8 million 60 kilogram bags, down from 11.1 million bags in 2008.

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The International Coffee Organization said that the ‘current tight demand and supply situation’ was ‘likely to persist in the near to medium term’.

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Coffee industry executives say prices might approach 200 cents per pound before the arrival of the new Brazilian crop later this year.

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Hedge funds previously expected the price of coffee to fall but now expect it to rise further.

ECONOMIC ANALYSIS ■

This news article reports two sources of changes in supply and demand that changed the price of coffee.

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The first source of change is the sequence of poor harvests in Colombia. These events decreased the world supply of Arabica coffee. (Arabica is the type that Starbucks uses.)

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Before the reported events, the world production of Arabica was 120 million bags per year and its price was 174 cents per pound.

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The decrease in the Colombian harvest decreased world production to about 116 million bags, which is about 3 per cent of world production.

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Figure 1 shows the situation before the poor Colombian harvests and the effects of those poor harvests. The demand curve is D and initially the supply curve was S0. The market equilibrium is at 120 million bags per year and a price of 174 cents per pound.

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The poor Colombian harvests decreased supply and the supply curve shifted leftward to S1. The price increased to 180 cents per pound and the quantity decreased to 116 million bags.

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The second source of change influenced both supply and demand. It is a change in the expected future price of coffee.

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The hedge funds referred to in the news article are speculators that try to profit from buying at a low price and selling at a high price.

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With the supply of coffee expected to remain low, the price was expected to rise further – a rise in the expected future price of coffee.

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When the expected future price of coffee rises, some people want to buy more coffee (so they can sell it later) – an increase in the demand today. And some people offer less coffee for sale (so they can sell it later for a higher price) – a decrease in the supply today.

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Figure 2 shows the effects of these changes in the demand and supply today.

Price (cents per pound)

4. Money, the Price Level and Inflation (Chapter 22): This chapter compares the Reserve Bank’s response to the global financial crisis with the U.S. Federal Reserve’s extraordinary injection of monetary base following the financial panic of 2008.We have redrawn the line between this chapter, the ‘money and banking’ chapter, and the later ‘monetary policy’ chapter by including in this chapter a complete explanation of how an open market operation works. We have also provided clearer and more thorough explanations of the money multiplier and money market equilibrium in the short and the long run and in the transition to the long run. 5. The Exchange Rate and the Balance of Payments (Chapter 23): We have revised this chapter to better explain the distinction between the fundamentals and the role of expectations. We have also included an explanation of how arbitrage works in the foreign exchange market and the temporary and risky nature of seeking to profit from the so-called ‘carry trade’. 6. Aggregate Supply and Aggregate Demand (Chapter 24): We have revised the section of this chapter that explains the use of the AS-AD model to understand growth and inflation trends and business cycle fluctuations. We have closely tied these explanations to the Australian data on economic growth, inflation and the business cycle with an emphasis on the most recent business cycle. 7. Fiscal Policy (Chapter 27): The topic of this chapter is front-page news almost every day and is likely to remain so. The revision describes the budget deficit and debt and explains the consequences of the uncertainty they engender. A thoroughly revised section examines the fiscal stimulus measures taken over the past year, channels through which the stimulus works, the unwanted side effects of the stimulus, its potentially limited power and its shortcomings. The chapter also examines the controversy about and range of views on the size of the fiscal stimulus multiplier. 8. Monetary Policy (Chapter 28): This chapter describes and explains the monetary policy responses to the 2008–2009 recession and the persistent headwinds of 2010 and 2011. It also contains an improved description of the Reserve Bank’s decision-making process. Technical details about alternative monetary policy strategies have been replaced with a shorter and more focused discussion of this topic and the need to bring clarity and predictability to monetary policy to anchor inflation expectations.

Decrease in Colombian crop ...

200

S1 S0

190 ... raises price ... 180 174 170

160

0

... and decreases quantity 100

D

130 140 110 116 120 Quantity (millions of bags)

Figure 1 The Effects of the Colombian Crop

Price (cents per pound)

x

Rise in expected future price increases demand and decreases supply ...

230

S2

220 S1

210 200 190 180 170

... and raises price further

160

0

D1 D0

100

130 140 110 116 120 Quantity (millions of bags)

Figure 2 The Effects of the Expected Future Price

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Chapter Openers

Through the past six editions, this book has set new standards of clarity in its graphs; the seventh edition continues to uphold this tradition. Our goal has always been to show ‘where the economic action is’. Our graphs continue to generate an enormously positive response, which confirms our view that graphical analysis is the most powerful tool available for teaching and learning economics. Because many students find graphs hard to work with, we have developed the entire art program with the study and review needs of the student in mind. The graphs feature ■ Original curves consistently shown in blue ■ Shifted curves, equilibrium points and other important features highlighted in red ■ Colour-blended arrows to suggest movement ■ Graphs paired with data tables ■ Graphs labelled with boxed notes ■ Extended captions that make each graph and its caption a self-contained object for study and review.

Each chapter opens with a carefully chosen photograph, question and student-friendly vignette designed to give students a quick sense of what the chapter is about and how it connects with their own economic world and experience. The chapter opening story is woven into the body of the chapter and explored further in the Reading Between the Lines feature that ends the chapter.

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Graphs That Show the Action

Economics in Action Boxes This new feature addresses current events and economic occurrences that highlight and amplify the topics covered in the chapter. Instead of simply reporting the current events, the material applies the event to an economics lesson, enabling students to see how economics plays a part in the world around them as they read through the chapter. Some of the many issues covered in this feature include the global market for crude oil, the best affordable choice of movies and DVDs, the cost of selling a pair of shoes, how Apple doesn’t make the iPhone, the trends and cycles in real GDP and the price level, and the size of the fiscal stimulus multipliers. 6

S0

S1 Economics in Action

Increase in quantity supplied

The Global Market for Crude Oil

Decrease in

Increase in

supply

supply

Decrease in quantity supplied

0

Quantity

Chapter Objectives Each chapter begins with a list of learning objectives, which enables students to see exactly where the chapter is going and to set their goals before they embark on their detailed study.

The demand and supply model provides insights into all competitive markets. Here, we’ll apply what you’ve learned about the effects of an increase in demand to the global market for crude oil. Crude oil is like the life-blood of the global economy. It is used to fuel our cars, aeroplanes, trains and buses, to generate electricity and to produce a wide range of plastics. When the price of crude oil rises, the costs of transportation, power and materials all increase. In 2001, the price of a barrel of oil was $20 (using the value of money in 2010). In 2008, before the global financial crisis ended a long period of economic expansion, the price peaked at $127 a barrel. While the price of oil was rising, the quantity of oil produced and consumed also increased. In 2001, the world produced 65 million barrels of oil a day. By 2008, that quantity was 72 million barrels. Who or what has been raising the price of oil? Is it the action of greedy oil producers? Oil producers might be greedy and some of them might be big enough to withhold supply and raise the price, but it wouldn’t be in their self-interest to do so. The higher price would bring forth a greater quantity supplied from other producers and the profit of the producer limiting supply would fall. Oil producers could try to cooperate and jointly withhold supply. The Organisation of Petroleum Exporting Countries, OPEC, is such a group of producers. But OPEC doesn’t control the world supply and its members’ self-interest is to produce the quantities that give them the maximum attainable profit. So even though the global oil market has some big players, they don’t fix the price. Instead, the actions of thousands of buyers and sellers and the forces of demand and supply determine the price of oil. So how have demand and supply changed? Because both the price and the quantity have increased, the demand for oil must have increased. Supply might have changed too, but here we’ll suppose that supply has remained the same. The global demand for oil has increased for one major reason: World income has increased. The increase has been particularly large in the emerging economies of China, India and Brazil. Increased world income has increased the demand for oil-using goods such as electricity, petrol and plastics, which in turn has increased the demand for oil.

The figure illustrates the effects of the increase in demand on the global oil market. The supply of oil remained constant along supply curve S. The demand for oil in 2001 was D2001, so in 2001 the price was $20 a barrel and the quantity was 65 million barrels per day. The demand for oil increased and by 2008 it had reached D2008. The price of oil increased to $127 a barrel and the quantity increased to 72 million barrels a day. The increase in the quantity is an increase in the quantity supplied, not an increase in supply. Price (2010 dollars per barrel)

S2

200 180

Rise in global incomes increases the demand for oil S

160 140 127 Price of oil rises ...

100 80

… and quantity of oil supplied increases

60 40 20 D2001 0

60

65

D2008

80 72 85 Quantity (millions of barrels per day)

The Global Market for Crude Oil

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Highlighted terms simplify the student’s task of learning the vocabulary of economics. Each highlighted term appears in an end-of-chapter list with its page number, in an end-of-book glossary with its page number, bold-faced in the index, and in MyEconLab in the interactive glossary and flashcards.

do so. The flexibility charts on pp. xvi and xvii illustrate the book’s flexibility. By following the arrows through the charts you can select the path that best fits your preference for course structure. Whether you want to teach a traditional course that blends theory and policy, or one that takes a fast track through either theory or policy issues, Economics gives you the choice.

End-of-Chapter Summary

Supplemental Resources

Each chapter closes with a concise summary organised by major topics and list of key terms with page references. These learning tools provide students with a summary for review and exam preparation.

All instructor supplements are available via: ■ the Pearson catalogue page (www.pearson.com.au/9781442550773) ■ MyEconLab (www.pearson.com.au/mctaggart)

In-Text Review Quizzes and End-of-Chapter Problems and Applications

Computerised Test Banks The seventh edition test bank (Test Item File) with more than 3,000 multiplechoice questions has been prepared by Mark Dodd of the University of Adelaide and Tikiri Agalewatte of the University of Wollongong. Mark and Tikiri reviewed all existing questions to ensure their clarity and consistency with the seventh edition. New questions follow the style and format of the end-of-chapter text problems and they provide the lecturer with a new set of testing opportunities and/or homework assignments. Test Item File questions are available in MyEconLab for instructors to use in a test, a quiz or as homework. Pearson’s TestGen enables instructors to view and edit test bank questions, generate tests, and print them in a variety of formats. Search and sort functions make it easy to locate questions and arrange them in any order desired. TestGen also enables instructors to administer tests on a local area network, have tests graded electronically, and have the results prepared in electronic or printed reports. Pearson TestGen is compatible with Windows or Macintosh systems.

Key Terms

A Review Quiz at the end of each major section enables students to determine whether a topic needs further study before moving on, and Problems and Applications at the end of each chapter provide an opportunity to practise and apply the topics of the chapter. All the Review Quizzes and end-of-chapter Problems and Applications are in the MyEconLab Study Plan (see p. xiii) where students can work them and receive instant feedback and explanations.

◆ For the Lecturer This book enables you to focus on the economic way of thinking and choose your own course structure.

Focus on the Economic Way of Thinking As a teacher, you know how hard it is to encourage a student to think like an economist. But that is your goal. Consistent with this goal, the text focuses on and repeatedly uses the central ideas: choice; tradeoff; opportunity cost; the margin; incentives; the gains from voluntary exchange; the forces of demand, supply and equilibrium; the pursuit of economic rent; the tension between self-interest and the social interest; and the scope and limitations of government actions.

Solutions Manual For ease of use and instructor refer-

ence, a comprehensive Solutions Manual provides lecturers with detailed solutions to the Review Quizzes and the end-of-chapter Study Plan Problems and Applications and Additional Problems and Applications. John Snelling of the University of Adelaide has prepared the Solutions Manual. For an electronic version of the Solutions Manual go to www.pearson.com.au/9781442550773.

Flexible Structure

PowerPoint Resources Robin Bade has developed the

You have preferences for how you want to teach your course. We have organised this book to enable you to

full-colour Microsoft PowerPoint Lecture Presen tation for each chapter, which includes animated

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versions of the textbook figures, tables from the textbook and speaking notes. A separate set of PowerPoint files containing largescale animated versions of all the textbook’s figures and the tables from the text is available. Use the presentations electronically in the classroom or printed to create hard-copy transparency masters. This item is available for Macintosh and Windows.

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supplements from a secure, instructor-only source at www.pearson.com.au/9781442550773.

A suite of ABC News (U.S.) videos, which address current topics such as education, energy, U.S. Federal Reserve policy and business cycles, is available for classroom use. Video-specific exercises are available for instructor assignment. Michael Parkin and Robin Bade, assisted by Jeannie Gillmore and Laurel Davies, author and oversee all of the MyEconLab content for Economics. Our peerless MyEconLab team has worked hard to ensure that it is tightly integrated with the book’s content and vision. For more information go to www.pearson.com.au/mctaggart.

MyEconLab MyEconLab

Experiments in MyEconLab

MyEconLab’s assessment and tutorial system works hand-in-hand with Economics. With comprehensive homework, quiz, test and tutorial options, lecturers can manage all assessment needs in one program. ■ All of the Review Quiz questions and end-ofchapter Problems and Applications are assignable and automatically graded. ■ Students can work the Review Quiz questions and end-of-chapter Study Plan Problems and Applications as part of the MyEconLab Study Plan. ■ Instructors can assign the end-of-chapter Additional Problems and Applications as autograded assignments. These Problems and Applications are not available to students in MyEconLab unless assigned by the instructor. ■ Many of the Problems and Applications are algorithmic, draw-graph and numerical exercises. ■ Test Item File questions are available for assignment as homework. ■ The Custom Exercise Builder gives instructors the flexibility of creating their own problems for assignment. ■ The Gradebook records each student’s performance and the time spent on Tests, Study Plan and Homework and generates reports by student or by chapter. ■ Economics in the News is a turn-key solution to bringing daily news into the classroom. Updated weekly during the academic year, we upload two relevant articles (one micro, one macro) and provide links for further information and questions that may be assigned for homework or for classroom discussion.

Experiments are a fun and engaging way to promote active learning and mastery of important economic concepts. Pearson’s experiments program is flexible and easy for lecturers and students to use. ■ Single-player experiments allow your students to play against virtual players from anywhere at any time with an Internet connection. ■ Multiplayer experiments allow you to assign and manage a real-time experiment with your class.

Instructor’s Resource Centre Lecturers can download

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Pre- and post-questions for each experiment are available for assignment in MyEconLab.

◆ For the Student With this textbook, you get access to some powerful learning tools.

MyEconLab MyEconLab MyEconLab’s tutorial system provides lots of opportunities to practise and review what you are learning. ■

Take a ‘Sample Test’ to create your personalised ‘Study Plan’.

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Work the Review Quiz questions and end-ofchapter Study Plan Problems and Applications in your MyEconLab Study Plan and get instant feedback. Use the ‘Help Me Solve This’ problem tools when you need extra help.

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Use the Pearson e-text version of your textbook to search, make notes, view animated versions of the textbook figures and check a definition in the electronic glossary. Use the ‘Ask the Authors’ tool to send an email to the authors and get help when you need it.

Registering for MyEconLab with an access card If

your textbook came bundled with a MyEconLab access code, refer to the card for registration instructions. Purchasing access If your textbook did not come

bundled with a MyEconLab access code, you can purchase an access code at www.pearson.com.au/ mctaggart.

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◆ Acknowledgements As we said in earlier editions, one of the great pleasures of writing an introductory text is the opportunity it affords to learn from so many generous friends and colleagues. Although the extent of our debt cannot be fully acknowledged here, it is nevertheless a joy to record our gratitude to the many people who have helped, some without realising just how helpful they have been. We thank our many exceptional reviewers whose names are listed on the following pages. Many of them spent much more time than we could have reasonably expected and provided detailed comments on drafts of the manuscript. Their comments and suggestions have been extremely helpful and we have made every attempt to heed their advice. We thank the several thousand students whom we have been privileged to teach. The instant response that comes from the look of puzzlement or enlightenment has taught us how to teach economics. We also thank Doon-Louise Williams and David Tucker, students at Griffith University, for pointing out an error in the sixth edition. We thank Richard Parkin for his work on the electronic art manuscript, the PowerPoint animations and the Flash animations of the figures in the e-text on MyEconLab. We thank Jeannie Gillmore and Laurel Davies for creating and managing our evergrowing and ever more complex MyEconLab database. We also thank John Snelling of the University of Adelaide for helping with news-based end-of-chapter problems and applications. Finally, we are deeply grateful to the editorial team at Pearson Australia. Vision, energy, enthusiasm, professionalism, flair and commitment are just some of the characteristics of the team. Editor in Chief Frances Eden, Manager – Product Development Michael Stone, Senior Acquisitions Editor Simone Bella, Senior Project Editor Rebecca Pomponio and Editorial Coordinator Germaine Silva have again confirmed with this new edition their reputation as Australia’s finest academic publishers. They have built a culture that brings out the best in their editors and authors. They have been supported by Copyright and Pictures Editor Lisa Woodland, copy editor Felicity McKenzie, proofreader Nicole Le Grand and typesetter Leonie Ryan. We are grateful for their commitment to the project and their excellent attention to detail.

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PREFACE

Classroom experience will test the value of this book. We would appreciate hearing from instructors and students about how we can continue to improve it in future editions. Douglas McTaggart Queensland Investment Corporation email: [email protected] Christopher Findlay University of Adelaide email: [email protected] Michael Parkin University of Western Ontario email: [email protected]

◆ Reviewers of the Seventh Edition Rod Duncan, Charles Sturt University Richard Dutu, Deakin University Catherine Fletcher, Monash University Peter Harkness, Swinburne University Yolanta Kwiecien, Monash University Paul Morris, University of Newcastle Munirul Nabin, Deakin University Peter Schuwalow, Monash University Zulfan Tadjoeddin, University of Western Sydney

◆ Reviewers of the Sixth Edition Jayanath Ananda, La Trobe University Siobhan Austen, Curtin Business School Carol Barry, Swinburne University of Technology John Bevacqua, Charles Sturt University

Jonathan Boymal, Royal Melbourne Institute of Technology Mark Buchanek, Deakin University Bob Catley, University of Newcastle Bronwyn Coate, Royal Melbourne Institute of Technology Maxine Darnell, University of New England Sinclair Davidson, Royal Melbourne Institute of Technology Catherine Fletcher, Monash University Gigi Foster, University of South Australia Chris Gellar, Deakin University Mary Graham, Deakin University Branka Krivokapic-Skoko, Charles Sturt University Yun-Lok Lee, Southern Cross University Elizabeth Manning, Deakin University Ann Marsden, University of Tasmania Stephen Mason, Southern Cross University Pundarik Mukhopadhaya, Macquarie University Muni Perumal, University of Canberra Ella Reeks, University of Tasmania John Rice, University of Adelaide Graham Richards, Trinity College, University of Melbourne Sveta Risman, Royal Melbourne Institute of Technology Ali Saleh, University of Wollongong Pasquale Sgro, Deakin University Baljit Singh, La Trobe University Hazbo Skoko, Charles Sturt University Sam Tang, University of Western Australia Mehmet Ulubasoglu, Deakin University Spiro George Vlachos, University of Adelaide Mark Weder, University of Adelaide

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ALTERNATIVE PATHWAYS THROUGH THE MICRO CHAPTERS Micro Flexibility

Chapter 1

Chapter 5

Chapter 6

Chapter 8

What Is Economics?

Efficiency and Equity

Government Actions in Markets

Public Choices and Public Goods

Chapter 2

Chapter 7

Chapter 9

The Economic Problem

Global Markets in Action

Economics of the Environment

Chapter 3

Chapter 4

Chapter 10

Demand and Supply

Elasticity

Monopoly

Chapter 15 Chapter 11 Economic Inequality

Monopolistic Competition

Chapter 12

Chapter 16

Consumer Choices and Constraints

Oligopoly Games and Strategies

Chapter 13 Producer Choices and Constraints

Start here ...

xvi

… then jump to any of these …

Chapter 14 Perfect Competition

Chapter 17 Decisions in Factor Markets

… and jump to any of these after doing the prerequisites indicated

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ALTERNATIVE PATHWAYS THROUGH THE MACRO CHAPTERS Macro Flexibility

Chapter 20 Economic Growth

Chapter 21 Finance, Saving and Investment

Chapter 24

Chapter 18

Chapter 19

Measuring GDP and Economic Growth

Monitoring Jobs and Inflation

Chapter 27 Fiscal Policy

Chapter 26

Aggregate Supply and Aggregate Demand

Australian Macroeconomic Fluctuations

Chapter 22

Chapter 28

Money, the Price Level and Inflation

Monetary Policy

Chapter 23 The Exchange Rate and the Balance of Payments

Chapter 25 Expenditure Multipliers: The Keynesian Model

Start here ...

… then jump to any of these …

… and jump to any of these after doing the prerequisites indicated

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TABLE OF CONTENTS PART ONE INTRODUCTION 1 CHAPTER 1 ◆ WHAT IS ECONOMICS? 1 Definition of Economics 2 Two Big Economic Questions 3 What, How and for Whom? 3 Can the Pursuit of Self-Interest Promote the Social Interest? 5 The Economic Way of Thinking 8 A Choice Is a Tradeoff 8 Making a Rational Choice 8 Benefit: What You Gain 8 Cost: What You Must Give Up 8 How Much? Choosing at the Margin 9 Choices Respond to Incentives 9 Economics as Social Science and Policy Tool 10 Economist as Social Scientist 10 Economist as Policy Adviser 10 Summary 11 Study Plan Problems and Applications 12 Additional Problems and Applications 12 APPENDIX Graphs in Economics 13

Graphing Data 13 Scatter Diagrams 14 Graphs Used in Economic Models 16 Variables That Move in the Same Direction 16 Variables That Move in Opposite Directions 17 Variables That Have a Maximum or a Minimum 18 Variables That Are Unrelated 19 The Slope of a Relationship 20 The Slope of a Straight Line 20 The Slope of a Curved Line 21 Graphing Relationships Among More Than Two Variables 22 Ceteris Paribus 22 When Other Things Change 23

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MATHEMATICAL NOTE

Equations of Straight Lines 24 A Linear Equation 24 Slope of Line 24 Position of Line 25 Positive Relationships 25 Negative Relationships 25 Example 25 Summary 26 Study Plan Problems and Applications 27 Additional Assignable Problems and Applications 28 CHAPTER 2 ◆ THE ECONOMIC PROBLEM 29 Production Possibilities and Opportunity Cost 30 Production Possibilities Frontier 30 Production Efficiency 31 Tradeoff Along the PPF 31 Opportunity Cost 31 Using Resources Efficiently 33 The PPF and Marginal Cost 33 Preferences and Marginal Benefit 34 Allocative Efficiency 35 Economic Growth 36 The Cost of Economic Growth 36 A Nation’s Economic Growth 37 Gains from Trade 38 Comparative Advantage and Absolute Advantage 38 Achieving the Gains from Trade 39 Economic Coordination 41 Firms 41 Markets 42 Property Rights 42 Money 42 Circular Flows Through Markets 42 Coordinating Decisions 42 READING BETWEEN THE LINES

The Rising Opportunity Cost of Food 44 Summary 46 Study Plan Problems and Applications 47 Additional Problems and Applications 49

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CHAPTER 3 ◆ DEMAND AND SUPPLY 51

CHAPTER 4 ◆ ELASTICITY 79

Markets and Prices 52

Price Elasticity of Demand 80 Calculating Price Elasticity of Demand 81 Inelastic and Elastic Demand 82 Elasticity Along a Linear Demand Curve 83 Total Revenue and Elasticity 84 Your Expenditure and Your Elasticity 85 The Factors That Influence the Elasticity of Demand 85

Demand 53 The Law of Demand 53 Demand Curve and Demand Schedule 53 A Change in Demand 54 A Change in the Quantity Demanded Versus a Change in Demand 56 Supply 58 The Law of Supply 58 Supply Curve and Supply Schedule 58 A Change in Supply 59 A Change in the Quantity Supplied Versus a Change in Supply 60 Market Equilibrium 62 Price as a Regulator 62 Price Adjustments 63 Predicting Changes in Price and Quantity 64 An Increase in Demand 64 A Decrease in Demand 64 An Increase in Supply 66 A Decrease in Supply 66 All the Possible Changes in Demand and Supply 68 READING BETWEEN THE LINES

Demand and Supply: The Price of Coffee 70 MATHEMATICAL NOTE

Demand, Supply and Equilibrium 72 Demand Curve 72 Supply Curve 72 Market Equilibrium 73 An Example 73 Summary 74 Study Plan Problems and Applications 75 Additional Problems and Applications 77

More Elasticities of Demand 87 Cross Elasticity of Demand 87 Income Elasticity of Demand 88 Elasticity of Supply 90 Calculating the Elasticity of Supply 90 The Factors That Influence the Elasticity of Supply 91 READING BETWEEN THE LINES

Why a Crackdown on Illicit Drugs Increases Crime 94 Summary 96 Study Plan Problems and Applications 97 Additional Problems and Applications 99

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PART TWO HOW MARKETS WORK 101 CHAPTER 5 ◆ EFFICIENCY AND EQUITY 101 Resource Allocation Methods 102 Market Price 102 Command 102 Majority Rule 102 Contest 102 First-Come, First-Served 102 Lottery 103 Personal Characteristics 103 Force 103 Benefit, Cost and Surplus 104 Demand, Willingness to Pay and Value 104 Individual Demand and Market Demand 104 Consumer Surplus 105 Supply and Marginal Cost 105 Supply, Cost and Minimum Supply-Price 106 Individual Supply and Market Supply 106 Producer Surplus 107 Is the Competitive Market Efficient? 108 Efficiency of Competitive Equilibrium 108 Market Failure 109 Sources of Market Failure 110 Alternatives to the Market 111 Is the Competitive Market Fair? 112 It’s Not Fair if the Result Isn’t Fair 112 It’s Not Fair if the Rules Aren’t Fair 114 Case Study: A Water Shortage in a Natural Disaster 114 READING BETWEEN THE LINES

Is the Global Market for Roses Efficient? 116 Summary 118 Study Plan Problems and Applications 119 Additional Problems and Applications 121

CHAPTER 6 ◆ GOVERNMENT ACTIONS IN MARKETS 123 A Housing Market with a Rent Ceiling 124 A Housing Shortage 124 Increased Search Activity 124 A Black Market 124 Inefficiency of a Rent Ceiling 125 Are Rent Ceilings Fair? 126 A Labour Market with a Minimum Wage 127 Minimum Wage Brings Unemployment 127 Inefficiency of a Minimum Wage 127 Is the Minimum Wage Fair? 128 Taxes 129 Tax Incidence 129 A Tax on Sellers 129 A Tax on Buyers 130 Equivalence of Tax on Buyers and Sellers 130 Tax Incidence and Elasticity of Demand 131 Tax Incidence and Elasticity of Supply 132 Taxes and Efficiency 133 Taxes and Fairness 134 Production Quotas and Subsidies 135 Production Quotas 135 Subsidies 136 Markets for Illegal Goods 138 A Free Market for a Drug 138 A Market for an Illegal Drug 138 Legalising and Taxing Drugs 139 READING BETWEEN THE LINES

Creating a Fuel Shortage in China 140 Summary 142 Study Plan Problems and Applications 143 Additional Problems and Applications 145

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CHAPTER 7 ◆ GLOBAL MARKETS IN ACTION 147

CHAPTER 8 ◆ PUBLIC CHOICES AND PUBLIC GOODS 171

How Global Markets Work 148 International Trade Today 148 What Drives International Trade? 148 Why Australia Imports Cars 149 Why Australia Exports Coal 150

Public Choices 172 Why Governments Exist 172 Government Failure 172 Public Choice and the Political Marketplace 172 Political Equilibrium 174 What Is a Public Good? 174 Problems That Require Public Choices 176

Winners, Losers and the Net Gain from Trade 151 Gains and Losses from Imports 151 Gains and Losses from Exports 152 Gains for All 152 International Trade Restrictions 153 Tariffs 153 Import Quotas 156 Other Import Barriers 158 Export Subsidies 158 The Case Against Protection 159 The Infant-Industry Argument 159 The Dumping Argument 159 Saves Jobs 160 Allows Us to Compete with Cheap Foreign Labour 160 Penalises Lax Environmental Standards 160 Prevents Rich Countries from Exploiting Developing Countries 162 Avoiding Trade Wars 162 Why Is International Trade Restricted? 162 Compensating Losers 163 READING BETWEEN THE LINES

The Benefits of Free Trade 164 Summary 166 Study Plan Problems and Applications 167 Additional Problems and Applications 169

Providing Public Goods 177 The Free-Rider Problem 177 Marginal Social Benefit of a Public Good 177 Marginal Social Cost of a Public Good 178 Efficient Quantity of a Public Good 178 Inefficient Private Provision 178 Efficient Public Provision 178 Inefficient Public Overprovision 180 Providing Mixed Goods 181 Private Benefits and Social Benefits 181 Government Actions in the Face of External Benefits 182 Bureaucratic Inefficiency 184 Two Types of Political Equilibrium 185 Why Government Is Large and Growing 185 Voters Strike Back 185 READING BETWEEN THE LINES

Reform of University Funding 186 Summary 188 Study Plan Problems and Applications 189 Additional Problems and Applications 191

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CHAPTER 9 ◆ ECONOMICS OF THE ENVIRONMENT 193 Negative Externality: Pollution 194 The Pollution Problem 194 The Demand for a Clean Environment 194 The Sources of Pollution 194 Private Cost and the Social Cost of Pollution 197 Production and Pollution: How Much? 198 Property Rights 198 The Coase Theorem 199 Government Actions in the Face of External Costs 200 The Tragedy of the Commons 202 Unsustainable Use of a Common Resource 202 Inefficient Use of a Common Resource 203 Achieving an Efficient Outcome 204 READING BETWEEN THE LINES

A Carbon Tax at Work 208 Summary 210 Study Plan Problems and Applications 211 Additional Problems and Applications 213 CHAPTER 10 ◆ MONOPOLY 215 Monopoly and How It Arises 216 How Monopoly Arises 216 A Monopoly’s Goals and Constraints 217 Economic Rent and Rent Seeking 219 A Single-Price Monopoly’s Output and Price Decision 220 Price and Marginal Revenue 220 Output and Price Decision 220 Monopoly and Competition Compared 222 Price Discrimination 225 Profiting by Price Discriminating 225 Perfect Price Discrimination 226 Efficiency, Equity and Rent Seeking with Price Discrimination 227

Monopoly Policy Issues 228 Gains from Monopoly 228 Natural Monopoly Regulation 229 READING BETWEEN THE LINES

Competing for Monopoly Power 232 Summary 234 Study Plan Problems and Applications 235 Additional Problems and Applications 237 CHAPTER 11 ◆ ECONOMIC INEQUALITY 239 Measuring Economic Inequality 240 The Distribution of Disposable Income 240 The Income Lorenz Curve 241 The Distribution of Wealth 242 Wealth or Income? 242 Annual or Lifetime Income and Wealth? 242 Trends in Inequality 243 Poverty 243 Inequality in the World Economy 244 Income Distributions in Selected Countries 244 Global Inequality and Its Trends 245 The Sources of Economic Inequality 246 Human Capital 246 Discrimination 248 Tournament Winners and Superstars 249 Unequal Wealth 250 Income Redistribution 251 Direct Taxes 251 Indirect Taxes 251 Direct Benefits 251 Indirect Benefits 253 The Big Tradeoff 253 The Benefit Trap 253 READING BETWEEN THE LINES

The Top 1 Per Cent 254 Summary 256 Study Plan Problems and Applications 257 Additional Problems and Applications 259

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CONTENTS

PART THREE DECISIONS AND STRATEGIES IN MARKETS 261 CHAPTER 12 ◆ CONSUMER CHOICES AND CONSTRAINTS 261 Consumption Possibilities 262 Budget Line 262 Budget Equation 263 Preferences and Indifference Curves 265 Marginal Rate of Substitution 266 Degree of Substitutability 267 Predicting Consumer Choices 268 Best Affordable Choice 268 A Change in Price 269 A Change in Income 271 Substitution Effect and Income Effect 272 READING BETWEEN THE LINES

Paper Books Versus e-Books 274 Summary 276 Study Plan Problems and Applications 277 Additional Problems and Applications 279

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CHAPTER 13 ◆ PRODUCER CHOICES AND CONSTRAINTS 281 The Firm and Its Economic Problem 282 The Firm’s Goal 282 Accounting Profit 282 Economic Accounting 282 A Firm’s Opportunity Cost of Production 282 Economic Accounting: A Summary 283 The Firm’s Constraints 283 Decision Time Frames 284 Short-Run Technology Constraint 285 Product Schedules 285 Product Curves 285 Total Product Curve 286 Marginal Product Curve 286 Average Product Curve 288 Short-Run Cost 289 Total Cost 289 Marginal Cost 290 Average Cost 290 Marginal Cost and Average Cost 290 Why the Average Total Cost Curve is U-Shaped 290 Cost Curves and Product Curves 292 Shifts in the Cost Curves 292 Long-Run Cost 294 The Production Function 294 Short-Run Cost and Long-Run Cost 294 The Long-Run Average Cost Curve 296 Economies and Diseconomies of Scale 296 READING BETWEEN THE LINES

Cutting the Cost of Producing Electricity 298 Summary 300 Study Plan Problems and Applications 301 Additional Problems and Applications 303

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CONTENTS

CHAPTER 14 ◆ PERFECT COMPETITION 305 What Is Perfect Competition? 306 How Perfect Competition Arises 306 Price Takers 306 Economic Profit and Revenue 306 The Firm’s Decisions 307 The Firm’s Output Decision 308 Marginal Analysis and the Supply Decision 309 Temporary Shutdown Decision 310 The Firm’s Supply Curve 311 Output, Price and Profit in the Short Run 312 Market Supply in the Short Run 312 Short-Run Equilibrium 313 A Change in Demand 313 Profits and Losses in the Short Run 313 Three Possible Short-Run Outcomes 314 Output, Price and Profit in the Long Run 315 Entry and Exit 315 A Closer Look at Entry 316 A Closer Look at Exit 316 Long-Run Equilibrium 317 Changing Tastes and Advancing Technology 318 A Permanent Change in Demand 318 External Economies and Diseconomies 319 Technological Change 321 Competition and Efficiency 322 Efficient Use of Resources 322 Choices, Equilibrium and Efficiency 322 READING BETWEEN THE LINES

Perfect Competition in Wool 324 Summary 326 Study Plan Problems and Applications 327 Additional Problems and Applications 329

CHAPTER 15 ◆ MONOPOLISTIC COMPETITION 331 What Is Monopolistic Competition? 332 Large Number of Firms 332 Product Differentiation 332 Competing on Quality, Price, Marketing and Branding 332 Entry and Exit 333 Price and Output in Monopolistic Competition 334 The Firm’s Short-Run Output and Price Decision 334 Profit Maximising Might Be Loss Minimising 334 Long Run: Zero Economic Profit 335 Monopolistic Competition and Perfect Competition 336 Is Monopolistic Competition Efficient? 337 Product Development and Marketing 338 Innovation and Product Development 338 Advertising 338 Using Advertising to Signal Quality 340 Brand Names 341 Efficiency of Advertising and Brand Names 341 READING BETWEEN THE LINES

Product Differentiation in the Market for Smartphones 342 Summary 343 Study Plan Problems and Applications 345 Additional Problems and Applications 347

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CHAPTER 16 ◆ OLIGOPOLY GAMES AND STRATEGIES 349

CHAPTER 17 ◆ DECISIONS IN FACTOR MARKETS 373

What Is Oligopoly? 350 Barriers to Entry 350 Small Number of Firms 351 Examples of Oligopoly 351

The Anatomy of Factor Markets 374 Markets for Labour Services 374 Markets for Capital Services 374 Markets for Land Services and Natural Resources 374 Entrepreneurship 374

Oligopoly Games 352 What Is a Game? 352 The Prisoners’ Dilemma 352 An Oligopoly Price-Fixing Game 354 Other Oligopoly Games 358 The Disappearing Invisible Hand? 359 A Game of Chicken 360 Repeated Games and Sequential Games 361 A Repeated Duopoly Game 361 A Sequential Entry Game in a Contestable Market 362 Trade Practices Law 364 Collusion 364 Misuse of Market Power 364 Vertical Restraints 365 Mergers 365 Consumer Protection 365 Social Interest or Special Interest? 365 READING BETWEEN THE LINES

Gillette and Schick in a Duopoly Game 366 Summary 368 Study Plan Problems and Applications 369 Additional Problems and Applications 371

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The Demand for a Factor of Production 375 Value of Marginal Product 375 A Firm’s Demand for Labour 375 A Firm’s Demand for Labour Curve 376 Changes in a Firm’s Demand for Labour 377 Labour Markets 378 A Competitive Labour Market 378 A Labour Market with a Union 380 Scale of the Union–Non-Union Wage Gap 382 Trends and Differences in Wage Rates 383 Capital and Natural Resource Markets 384 Capital Rental Markets 384 Land Rental Markets 384 Nonrenewable Natural Resource Markets 385 READING BETWEEN THE LINES

Resources and Labour Interact 388 MATHEMATICAL NOTE

Present Value and Discounting 390 Rent-Versus-Buy Decision 390 Comparing Current and Future Dollars 390 Compound Interest 390 Discounting a Future Amount 390 Present Value of a Sequence of Future Amounts 391 The Decision 391 Summary 392 Study Plan Problems and Applications 393 Additional Problems and Applications 395

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PART FOUR MONITORING MACROECONOMIC PERFORMANCE 397 CHAPTER 18 ◆ MEASURING GDP AND ECONOMIC GROWTH 397 Gross Domestic Product 398 GDP Defined 398 GDP and the Circular Flow of Expenditure and Income 399 Why Is Domestic Product ‘Gross’? 400 Measuring Australia’s GDP 401 The Expenditure Approach 401 The Income Approach 402 Nominal GDP and Real GDP 403 Calculating Real GDP 403 The Uses and Limitations of Real GDP 404 The Standard of Living Over Time 404 The Standard of Living Across Countries 406 Limitations of Real GDP 407 READING BETWEEN THE LINES

Real GDP Shows Slowing Economy 410 APPENDIX Graphs in Macroeconomics 412

The Time-Series Graph 412 Making a Time-Series Graph 412 Reading a Time-Series Graph 412 Ratio Scale Reveals Trend 413 A Time-Series with a Trend 413 Using a Ratio Scale 413 MATHEMATICAL NOTE

Chain Volume Measure of Real GDP 414 Value Production in Prices of Adjacent Years 414 Find the Average of Two Percentage Changes 414 Link (Chain) to the Base Year 415 Exercise 415 Summary 416 Study Plan Problems and Applications 417 Additional Problems and Applications 419

CHAPTER 19 ◆ MONITORING JOBS AND INFLATION 421 Employment and Unemployment 422 Why Unemployment Is a Problem 422 Labour Force Survey 423 Three Labour Market Indicators 423 Other Definitions of Underutilised Labour 425 All Underutilised Labour 426 Unemployment and Full Employment 427 Frictional Unemployment 427 Structural Unemployment 427 Cyclical Unemployment 427 ‘Natural’ Unemployment 428 Real GDP and Unemployment Over the Cycle 428 The Changing Natural Unemployment Rate 429 The Price Level, Inflation and Deflation 430 Why Inflation and Deflation Are Problems 430 The Consumer Price Index 431 Reading the CPI Numbers 431 Constructing the CPI 431 Measuring the Inflation Rate 432 Distinguishing High Inflation from a High Price Level 433 The Biased CPI 433 The Magnitude of the Bias 434 Some Consequences of the Bias 434 Alternative Price Indexes 434 Core Inflation 435 The Real Variables in Macroeconomics 435 READING BETWEEN THE LINES

The Australian Labour Market 436 Summary 438 Study Plan Problems and Applications 439 Additional Problems and Applications 441

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PART FIVE UNDERSTANDING THE MACROECONOMY 443 CHAPTER 20 ◆ ECONOMIC GROWTH 443 The Basics of Economic Growth 444 Calculating Growth Rates 444 The Magic of Sustained Growth 444 Applying the Rule of 70 445 Economic Growth Trends 446 Growth in the Australian Economy 446 Real GDP Growth in the World Economy 447 How Potential GDP Grows 449 What Determines Potential GDP? 449 What Makes Potential GDP Grow? 451 Why Labour Productivity Grows 454 Preconditions for Labour Productivity Growth 454 Physical Capital Growth 455 Human Capital Growth 455 Technological Advances 455 Growth Theories, Evidence and Policies 457 Classical Growth Theory 457 Neoclassical Growth Theory 457 New Growth Theory 458 New Growth Theory Versus Malthusian Theory 460 Sorting Out the Theories 460 The Empirical Evidence on the Causes of Economic Growth 460 Policies for Achieving Faster Growth 460 READING BETWEEN THE LINES

Productivity and Real GDP 462 Summary 464 Study Plan Problems and Applications 465 Additional Problems and Applications 467

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CHAPTER 21 ◆ FINANCE, SAVING AND INVESTMENT 469 Financial Institutions and Financial Markets 470 Finance and Money 470 Physical Capital and Financial Capital 470 Capital and Investment 470 Wealth and Saving 470 Financial and Capital Markets 471 Financial Institutions 472 Insolvency and Illiquidity 473 Interest Rates and Asset Prices 474 The Loanable Funds Market 474 Funds That Finance Investment 474 The Real Interest Rate 475 The Demand for Loanable Funds 476 The Supply of Loanable Funds 477 Equilibrium in the Loanable Funds Market 478 Changes in Demand and Supply 478 Government in the Loanable Funds Market 481 A Government Budget Surplus 481 A Government Budget Deficit 481 The Global Loanable Funds Market 483 International Capital Mobility 483 International Borrowing and Lending 483 Demand and Supply in the Global and National Markets 483 READING BETWEEN THE LINES

Euro Crisis and the Global Market 486 Summary 488 Study Plan Problems and Applications 489 Additional Problems and Applications 491

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CHAPTER 22 ◆ MONEY, THE PRICE LEVEL AND INFLATION 493 What Is Money? 494 Medium of Exchange 494 Unit of Account 494 Store of Value 495 Money in Australia Today 495 The Banking System 497 Authorised Deposit-Taking Institutions 497 The Reserve Bank of Australia 498 The Payments System 500 How Banks Create Money 501 Creating Deposits by Making Loans 501 Limits to Money Creation 501 The Money Creation Process 502 The Money Multiplier 503 The Money Market 504 The Influences on Money Holding 504 The Demand for Money 505 Shifts in the Demand for Money Curve 505 Money Market Equilibrium 506 The Quantity Theory of Money 508 READING BETWEEN THE LINES

The Cost of Bank Regulation 510 MATHEMATICAL NOTE

The Money Multiplier 512 The Australian Money Multiplier 513 Summary 514 Study Plan Problems and Applications 515 Additional Problems and Applications 517

CHAPTER 23 ◆ THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS 519 The Foreign Exchange Market 520 Trading Currencies 520 Exchange Rates 520 Questions About the Australian Dollar Exchange Rate 520 An Exchange Rate Is a Price 520 The Demand for One Money Is the Supply of Another Money 521 Demand in the Foreign Exchange Market 521 Demand Curve for Australian Dollars 522 Supply in the Foreign Exchange Market 523 Supply Curve for Australian Dollars 523 Market Equilibrium 524 Exchange Rate Fluctuations 525 A Change in Demand for Australian Dollars 525 A Change in Supply of Australian Dollars 526 Changes in the Exchange Rate 526 Fundamentals, Expectations and Arbitrage 528 The Real Exchange Rate 529 Exchange Rate Policy 530 Flexible Exchange Rate 530 Fixed Exchange Rate 530 Crawling Peg 531 Financing International Trade 533 Balance of Payments Accounts 533 Borrowers and Lenders 535 Debtors and Creditors 535 Is International Borrowing a Problem? 535 Current Account Balance 536 Net Exports 536 Where Is the Exchange Rate? 537 READING BETWEEN THE LINES

China’s Exchange Rate Policy 538 Summary 540 Study Plan Problems and Applications 541 Additional Problems and Applications 543

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CHAPTER 24 ◆ AGGREGATE SUPPLY AND AGGREGATE DEMAND 545 Aggregate Supply 546 Quantity Supplied and Supply 546 Long-Run Aggregate Supply 546 Short-Run Aggregate Supply 547 Changes in Aggregate Supply 548 Aggregate Demand 550 The Aggregate Demand Curve 550 Changes in Aggregate Demand 551 Explaining Macroeconomic Trends and Fluctuations 554 Short-Run Macroeconomic Equilibrium 554 Long-Run Macroeconomic Equilibrium 554 Economic Growth and Inflation in the AS-AD Model 555 The Business Cycle in the AS-AD Model 556 Fluctuations in Aggregate Demand 558 Fluctuations in Aggregate Supply 559 Macroeconomic Schools of Thought 560 The Classical View 560 The Keynesian View 560 The Monetarist View 561 The Way Ahead 561 READING BETWEEN THE LINES

Aggregate Supply and Aggregate Demand in Action 562 Summary 564 Study Plan Problems and Applications 565 Additional Problems and Applications 567 CHAPTER 25 ◆ EXPENDITURE MULTIPLIERS: THE KEYNESIAN MODEL 569 Fixed Prices and Expenditure Plans 570 Expenditure Plans 570 Consumption and Saving Plans 570 Marginal Propensities to Consume and Save 572 Slopes and Marginal Propensities 572 Consumption as a Function of Real GDP 573 Import Function 573

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Real GDP with a Fixed Price Level 574 Aggregate Planned Expenditure 574 Actual Expenditure, Planned Expenditure and Real GDP 575 Equilibrium Expenditure 576 Convergence to Equilibrium 577 The Multiplier 578 The Basic Idea of the Multiplier 578 The Multiplier Effect 578 Why Is the Multiplier Greater Than 1? 579 The Size of the Multiplier 579 The Multiplier and the Slope of the AE Curve 580 Imports and Income Taxes 581 The Multiplier Process 581 Business Cycle Turning Points 582 The Multiplier and the Price Level 583 Adjusting Quantities and Prices 583 Aggregate Expenditure and Aggregate Demand 583 Deriving the Aggregate Demand Curve 583 Changes in Aggregate Expenditure and Aggregate Demand 584 Equilibrium Real GDP and the Price Level 585 READING BETWEEN THE LINES

Changes in Expenditure Plans 588 MATHEMATICAL NOTE

The Algebra of the Keynesian Model 590 Aggregate Expenditure 590 Equilibrium Expenditure 591 The Multiplier 591 Government Expenditure Multiplier 592 Autonomous Tax Multiplier 592 Balanced Budget Multiplier 593 Summary 594 Study Plan Problems and Applications 595 Additional Problems and Applications 597

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CHAPTER 26 ◆ AUSTRALIAN MACROECONOMIC FLUCTUATIONS 599 Inflation Cycles 600 Demand-Pull Inflation 600 Cost-Push Inflation 602 Expected Inflation 604 Forecasting Inflation 605 Inflation and the Business Cycle 605 Inflation and Unemployment: The Phillips Curve 606 The Short-Run Phillips Curve 606 The Long-Run Phillips Curve 607 Changes in the Natural Unemployment Rate 607 The Business Cycle 609 Mainstream Business Cycle Theory 609 Real Business Cycle Theory 610 READING BETWEEN THE LINES

Inflation Expectations 614 Summary 616 Study Plan Problems and Applications 617 Additional Problems and Applications 619

PART SIX MACROECONOMIC POLICY 621 CHAPTER 27 ◆ FISCAL POLICY 621 Government Budgets 622 Budget Making 622 Highlights of the 2011/12 Budget 622 The Budget in Historical Perspective 623 Supply-Side Effects of Fiscal Policy 628 Full Employment and Potential GDP 628 The Effects of the Income Tax 628 Taxes on Expenditure and the Tax Wedge 629 Taxes and the Incentive to Save and Invest 630 Tax Revenues and the Laffer Curve 631 The Supply-Side Debate 631 Fiscal Stimulus 632 Automatic Fiscal Policy and Cyclical and Structural Budget Balances 632 Discretionary Fiscal Stimulus 633

READING BETWEEN THE LINES

Swan’s Fiscal Policy 638 Summary 640 Study Plan Problems and Applications 641 Additional Problems and Applications 643 CHAPTER 28 ◆ MONETARY POLICY 645 Monetary Policy Objectives and Framework 646 Monetary Policy Objective 646 Statement on the Conduct of Monetary Policy 646 Actual Inflation 646 Responsibility for Monetary Policy 647 The Conduct of Monetary Policy 648 The Monetary Policy Instrument 648 The Bank’s Interest Rate Decision 649 Hitting the Cash Rate Target 649 Monetary Policy Transmission 651 Quick Overview 651 Interest Rate Changes 651 Exchange Rate Fluctuations 652 Money and Bank Loans 653 The Long-Term Real Interest Rate 653 Expenditure Plans 653 The Change in Aggregate Demand, Real GDP and the Price Level 654 The Reserve Bank Fights Recession 654 The Reserve Bank Fights Inflation 656 Loose Links and Long and Variable Lags 657 Extraordinary Monetary Stimulus 659 The Key Elements of the Crisis 659 The Policy Actions 660 Painfully Slow Recovery 660 Policy Strategies and Clarity 660 READING BETWEEN THE LINES

The Reserve Bank Fights Recession in 2011 662 Summary 664 Study Plan Problems and Applications 665 Additional Problems and Applications 667 Glossary G1 Index I1

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PHOTO CREDITS Copyright holders for the photos used in this book are shown below. Chapter 1 1 Andresr | Shutterstock; 5 AFP | Getty Images Australia Pty Ltd; 6 (left) © JJM Stock Photography | Alamy; (right) © Dave Massey | Dreamstime.com; 7 Bloomberg | Getty Images Australia Pty Ltd. Chapter 2 29 © Kadmy | Dreamstime.com; 32 Barbara Reddoch | Dreamstime.com; 41 (left) © Bloomberg via Getty Images; (right) © David R. Frazier Photolibrary, Inc. | Alamy. Chapter 3 51 © Beau Lark | Corbis; 65 © Eyeidea | Dreamstime.com; 67 Australian Financial Review © 2011 Fairfax Syndication. Chapter 4 79 Bloomberg | Getty Images Australia Pty Ltd. Chapter 5 101 Picturebank | Alamy; 117 Picture Contact BV | Alamy. Chapter 6 123 AFP | Getty Images. Chapter 7 147 Allan Baxter | Getty Images; 161 © Horizon International Images Limited | Alamy. Chapter 8 171 © Newspix | News Ltd | 3rd Party Managed Reproduction & Supply Rights; 175 Rachael Bowes | Alamy; 179 Mark Smith © Newspix | News Ltd. Chapter 9 193 (left) David Hannah | Getty Images; 193 (right) © John White Photos | Alamy; 201 AAPIMAGE; 204 Bridgeman Art Library | Photolibrary; 205 Jeff Rotman | Getty Images. Chapter 10 215 © Zach Liepa.

Chapter 12 261 © Chris Hackett | Getty Images; 270 (left) © Corbis (right) © .shock | fotolia; 274 Mario Tama | Staff | Getty Images. Chapter 13 281 Photograph by David Messent | Getty Images; 297 Glowimages | Getty Images; 299 Associated Press. Chapter 14 305 © Karen Kasmauski | Corbis; 315 © Darren Staples | Reuters | Picture Media; 317 (left) © Digital Vision; (right) © imagebroker | Alamy. Chapter 15 331 © Jeff Greenberg | Alamy. Chapter 16 349 (left) AFP | Getty Images; (right) Bloomberg via Getty Images. Chapter 17 373 © redbrickstock.com | Alamy. Chapter 18 397 © Alex Segre | Alamy; 406 (left) 2010 Getty Images; (right) © Bloomberg via Getty Images; 407 (left) © 2010 AFP. AFP | Getty Images; (right) Image Source | Getty Images. Chapter 19 421 © Dmitriy Shironosov | Alamy; 422 © Corbis. Chapter 20 443 © JLImages | Alamy; 455 Science and Society Picture Library; 456 © AP Photo | Jose Silva Pinto. Chapter 21 469 Andrew Watson | Getty Images; 473 (top) Frontpage | Shutterstock.com; (bottom) Frontpage | Shutterstock.com; 485 Scott J. Ferrell | Congressional Quarterly | Getty Images. Chapter 22 493 George M. | Fotolia. Chapter 23 519 © Greg Balfour Evans | Alamy.

Chapter 11 239 (left) © Travel Pictures | Alamy; (right) © DWSPL | Alamy. xxxi

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PHOTO CREDITS

Chapter 24 545 © redbrickstock.com | Alamy; 552 (column 1) (left) Bloomberg via Getty Images; (right) AAP IMAGE; (column 2) (top left) Getty Images; (top right) Bloomberg via Getty Images; (bottom left) Bloomberg via Getty Images; (bottom right) Bloomberg via Getty Images. Chapter 25 569 Bloomberg via Getty Images. Chapter 26 599 © Newspix | News Ltd | 3rd Party Managed Reproduction & Supply Rights.

Chapter 27 621 © Phillip Minnis | Alamy; 637 (top) Roll Call | Getty Images; (middle) © Robert J. Barro; (bottom) © Estate of Mischa Richeter and Harald Bakken. Chapter 28 645 © Bloomberg via Getty Images.