1. MicroeconomicsIn this chapter you will learn:

The importance of property rights and incentives;How markets work;What happens when markets fail;How to develop a theory and a model;The Invisible Hand Paradigm and efficiency;How growth can overcome scarcity;Market failures;Coordination failures.

1.1 IntroductionMicroeconomics deals with the study of how markets work. In most cases, markets function fairly well. For example, consider the commodity, "new automobile." There are firms that know how to produce new cars, sell them, and make a normal profit from doing so. And there are buyers who wish to own and drive a new car. GM, for example, knows what it costs to design, build, and sell a new car. This makes up its cost structure. The company receives its revenue when it sells the cars it has produced and its profit is the difference between its revenue and its cost. The price of a new car is determined in the marketplace for new cars where buyers and sellers interact with one another. Competition keeps the price and quality at acceptable levels. If a company can charge a lower price or provide better quality, other companies must respond. In fact, there is a strong incentive for a company to innovate in order to either reduce its price or improve the quality of its product under competition. A shakeout will typically occur under competitive pressure that eliminates the weak firms from the industry.

The price is determined in the market. Changes in the conditions of the market will cause people to alter their behavior and this will cause the price to respond. For example, the price of an automobile adjusts fairly rapidly to changes in supply and demand conditions in the car market. In a recession when demand for new cars is weak, auto dealers lower their price by giving discounts. In a severe recession, the discounts are especially large. This is a normal response to weak demand. When the economy is fairly healthy and demand for new cars is strong, we usually observe upward pressure on car prices. Again, this is a normal response to strong demand. There are other factors that affect the car market. For example, strife in the Middle East in 2005 caused the price of gas to go over $4 in many markets. The EPA, new highways, and safety regulations are other factors that affect the car market.

However, there are other cases where the market doesn't function properly and there are even cases where the market doesn't exist at all! Consider the commodity "safe passage through a busy intersection" and imagine there is no government involvement. Cars, trucks, and pedestrians would all like to use the intersection at once. Unfortunately, it can be quite hectic at times. How might the commodity "safe passage" be produced and sold? A private company could produce a traffic light that would regulate the flow of car, truck, and pedestrian traffic through the intersection. This would make up the cost side of the equation for the company. What about its revenue? Where would the company's revenue come from? It would have to charge each user of the intersection a fee or toll for using the intersection. How would it collect the tolls? Tollbooths would have to be erected and this would have several implications. First, some people would avoid the intersection by taking a different route. Second, tollbooths would slow travelers down considerably. Indeed, tollbooths that would capture everyone going through

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the intersection would probably not be workable. Finally, suppose a firm were able to collect enough tolls to make it work. Once the single firm was in place, it would have a monopoly on the good “safe passage” and could raise the toll without fear of competition. So the private market for the commodity "safe passage" would not exist.

Who then will provide such a commodity? The government. So in cases where a market either doesn't exist, or functions improperly, there is a role for some other institution and government is one such institution, but not the only one. For example, there are creative ways of addressing a pollution problem that involves creating a new market, which we will look at later. The government need not get involved directly, however. Other examples where this might occur are national defense, clean air and water, the airwaves, inoculation programs, providing police and fire protection and special emergency services like "911," or rescue workers. Many insurance markets do not exist. For example you would like to buy an insurance policy that would insure you against not having a job when you graduate, but such a product does not exist.

The purpose of studying microeconomics is to learn to model economic behavior and the interaction in the marketplace, to use these models to make predictions or forecasts of how a market will be affected by certain activities, to test those predictions and hopefully come to a better understanding of how markets work. In undertaking this process, one learns how markets work and what happens when they do not work properly. So the first step in any economic analysis is the construction of a model of the situation we are interested in. Scientific principles will be our guide in the sense that we will use the same principles of modeling as a scientist uses.

Example: Weather forecasters use complicated mathematical models of the weather in order to predict changes in weather patterns and this allows them to make predictions about the weather conditions in the near future. We will build models of economic behavior in order to do the same thing, understand economic behavior and markets and make predictions about how markets will be affected by various phenomena.

Application: In the recession of 2008, and for at least two years after, the demand for vacations fell dramatically. Hotel chains responded by advertising more, charging lower prices for a room, giving discounts to groups, e.g., conferences, and laying off staff. So a decrease in income reduced the demand for travel and hence the need for hotels.

Markets are based on property rights. A property right involves the ownership of something, e.g., an idea, a commodity, your own labor. For example, a dealership initially owns the property right to the truck you would like to buy. When you buy the truck, there is a transfer of the property right over the ownership of the truck from the dealer to you. Laws exist in the U.S., for example, to protect the property right of private ownership. If the transaction is not protected, it would not take place. If the dealer could repossess the truck even though you paid for it, and you knew this could happen, then you probably wouldn't be willing to buy the truck. There are countries like Uganda in the early 1970's, Zaire in the late 1970's and 80's, Russia in the 1990's, and Somalia in the 2000s, and Syria in the 2010s, where property rights were not enforced. Ownership becomes meaningless in such a situation.

Property rights are important because they can be used to provide people with incentives. You own the property right to your labor and this allows you to work as hard as you want and earn income. What incentive would you have to work hard if you did not own the property right to your own labor? None. For example, soldiers chosen by a draft do not own the property right to their own labor, the military does, and this allows the military to tell the soldier what to do and when to do it. Understandably, a soldier in such a system may feel little incentive to work hard unless absolutely forced to. Other means like the threat of punishment must be used to get the

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soldier to work hard. Slavery is another example where the individual does not own the property right to his or her own labor. Communism is another example.

If you patent an idea, you own the property right to that idea. You can then benefit from developing the idea. Patents and copyrights protect the individual's rights to his or her intellectual property. If you patent your idea, you can sue someone who tries to use the idea without paying you for it. If these rights are enforced, people have an incentive to come up with innovative ideas. On the other hand, if the ideas are not protected, they don't. In some cases you do not own the property right and this can create a problem. For example, people do not own any property right to "clean air" and this may lead to a pollution problem.

How do markets work when they are functioning properly? Consider the market for apples. This "market" is mostly internal to a supermarket, although occasionally, you will see people selling bushels of apples by the side of the road. Essentially, the owner of the supermarket owns the property right to the apple and there are laws that protect this property right from theft. A person who likes apples can purchase the property right from the owner of the supermarket. What determines the price of an apple? There are literally hundreds, if not thousands, of buyers and sellers who interact in the "apple market" each day and it is this interaction which determines the price of an apple. What would happen if a news story came out stating that an important chemical used in the production of apples was carcinogenic? The theory of consumer demand we will develop would predict the demand for apples would fall and so, too, would the market price.

Example: Labor market. Which fields have seen the biggest increase in salary offers to new graduates in recent years? Health care professionals. Why? It is due to the strong demand for health care. For example, there has been a dramatic increase in the demand for pharmacists in the last fifteen years so that starting salaries are now well over $80,000 for a newly minted pharmacist with a six-year pharmacy degree. Let's take this analysis one step further. How will students adjust to this information? Some may switch their intended major toward health care fields like pharmacy. As a result of this increase in the supply of health care professionals we would expect the growth in salaries to slow down as the market adjusts. This is precisely what happened to nursing in the 1990s.

This is what microeconomics is all about; using theory to explain the facts that we observe and then trying to use the theory in order to make predictions. Why is this important for a person in business to understand? The primary importance of this is that it can help you make predictions about your own market that will allow your company to survive competition and grow. If you can predict the impact of a new federal regulation on your industry, for example, you can position your company to benefit. If you can forecast how a change in the tax code will affect your customers, as another example, you can predict how your company will be affected and this will allow you to adjust your price, your product, and your market strategy accordingly. Microeconomics is at the heart of doing business.

The goal of these lectures is to help you understand how markets work and what happens when they do not work properly. Along the way we will encounter two kinds of statement, positive statements and normative statements. Positive statements are about facts, while normative statements are about opinions. The statement, “The top 1% wealthiest people in the US have gotten much wealthier in the last thirty years, while the bottom 50% have only seen a small increase in their income,” is a positive statement. We can look it up and decide if it’s true, or not. On the other hand, the statement, “We should redistribute from the rich to the poor because the rich have gotten so much richer while the poor have not,” is a normative statement because it’s an opinion. Arguments involving opinions cannot be resolved by resorting to facts.

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Arguments involving positive statements can.To analyze a problem we will use a variety of models. A model of an individual consumer,

an individual firm, or an individual market is called a “partial” equilibrium model because it only deals with a small part of the economy, e.g., one consumer, one market. A model that deals with the entire economy is said to be a “general” equilibrium model, e.g., the model of the production possibility frontier, the Solow Growth model of Chapter 2. As we progress through the course we will encounter both types of model.

1.2 Models and TheoriesSuppose we observe the economy getting better, incomes are increasing, and jobs are being created. And suppose we also observe prices for used cars falling. How might we explain that? One possibility is that a lot of car owners want to sell a car on the used car market and buy a new car because they got a better job or a raise. More formally, we would say the demand for new cars is increasing in income, while the demand for used cars is decreasing in income. This is an example of a model.

The notion of developing a model in order to explain facts and make predictions is based on a certain view about how to do science. In science a theory is made up of assumptions (A), test conditions (TC), and predictions (P). The assumptions form the model. The assumptions plus the test conditions (A + TC) imply certain predictions (P). The test conditions and predictions must be observable, the assumptions need not be observable. The theory can then be stated as an "if – then" proposition: if our model or assumptions are correct and we observe the test conditions, then our prediction will be observed. (If A is true and TC is observed, then P will occur.)

Example: The law of demand states that people buy more at a low price and less at a high price. Under the law of supply, suppliers will supply more of a product when the price is high than when the price is low. Suppose A = laws of supply and demand hold for gasoline, TC = war in the Gulf, then the prediction we should observe is higher gas prices, P = higher gas prices. Here’s the theory: if the laws of supply and demand hold for the gasoline market and we observe a war in the Persian Gulf, then we predict that gasoline prices will increase.

Example: Let A = laws of supply and demand hold for the beef market, TC = outbreak of "mad cow" disease, P = lower beef prices. Our theory: if the laws of supply and demand hold for beef and we observe an outbreak of "mad cow" disease, then beef prices will fall. This actually happened in Great Britain in the mid 1990's.

Example: Let A = laws of supply and demand hold for peaches, TC = frost in early spring which destroys much of the peach crop, P = higher price. The theory is that if the laws of supply and demand hold for peaches and we observe a dramatic frost, then the price of peaches will rise. This occurred in 2012 in Georgia.

In order for a theory to be a good one, it must make predictions that can be confronted with data and its predictions should be accurate. If a model makes predictions that are false, we should reject it. For example, the model of the solar system which assumes the earth is at the center of the solar system, which was popularized by Ptolemy almost 2000 years ago, makes inaccurate predictions about the orbits of the planets and other nearby stars. Astronomers rejected the "earth centric" theory as a model of the universe because its predictions were observed to be wrong by Galileo and Copernicus. On the other hand, our model of consumer demand, for example, makes accurate predictions about consumer behavior so we should not reject it.

Some critics of economics have raised the issue of the realism of our models, or assumptions.

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It is argued that economic models are unrealistic and should not be taken seriously as a result. For example, they argue that economists are being unrealistic when we assume that firms maximize profit; firms don't always maximize profit, according to the critics, and so our economic model of the firm is necessarily wrong when it assumes they do. Furthermore, they argue that one model is better than another model if it is more realistic than the other model. This argument is hard to defend. Why?

Consider the following scenario. Suppose you are in a strange city and you are lost. What can you do? You can walk around randomly hoping to find your destination by accident. This is probably not a good way of proceeding. You could ask someone for directions. But the person might not know how to get to your destination or might make a mistake in giving you directions. They might also lead you astray for the fun of it, or some other nefarious purpose. Finally, you can buy a map. The map is a model of the city. It makes certain predictions that can be tested. For example, if you follow a certain route the map predicts you will arrive at your destination. Is the map realistic? No, of course not. It's in two dimensions; it's flat! Is a city flat? No! Does the map tell you which streets are "one way" streets or not? Most likely not. Does the map tell you where the road construction is and which streets are closed so you can avoid them? No. So a map is a terribly unrealistic model of a city. Yet, it makes good predictions and may be the best way of choosing a route to your destination. The key point: a map is necessarily unrealistic yet makes good predictions and is, therefore, a good model. So don't judge a model on the basis of its realism, only on the basis of its predictions.

1.3 ScarcityScarcity simply means there is a finite amount of resources available. Scarcity of resources forces choices to be made because our wants are unlimited. If we literally had an infinite amount of resources, scarcity would not exist and we would not have to make any choices. For example, where are you going for your next vacation? Most people would like to go to Hawaii, Amsterdam, or some other nice place like Lewiston, ID for a vacation. However, most can't. Why? Their income is scarce.

What is true of the individual is also true of society. Society also faces scarcity and this forces the US to make choices. The US would like a great space program that can land an astronaut on Mars safely, well funded welfare programs for people truly in need, health care for everyone at low cost, inexpensive education for everyone, a military second to none, and so on. However, the resources available to the government are scarce and this forces it to choose among the various alternatives.

Application: What are the choices confronting Washington state? The state collects revenue from sales taxes, property taxes, the Business and Occupation tax, and a variety of other taxes and fees. What does the state spend its revenue on? 50% of the budget goes to lower education, K - 12. Next in importance is spending on welfare programs and social services, building and repairing roads and bridges, and finally, higher education. The problem for college students is that the percentage of the budget spent on higher education has steadily fallen since the early 1980's. This has caused tuition to rise, especially in the 1990's and since 2008, so that more of the cost of higher education is being shifted away from the taxpayer to the student.

Application: Health care in the US. The United States spends more on health care per person than any other country in the world. In 2014 we spent $3.2 trillion (Kaiser Foundation) on health care, which is close to $10,000 per person, or about 17.4% of GDP. (Forbes Magazine.) Health care costs have been rising since World War Two at about the rate of 4% - 6% per year,

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which is about 2% above inflation. Spending more on health care means that we have less to spend on other things. This will increase as the population ages.

In order to study these issues we need a general equilibrium model of an economy. How can we begin building a model of economic behavior? First, it is useful to ask what do we mean when we say the word "economy?" To describe an economy we would list the following items: population; the tastes or preferences people have for various goods and services; the technology used in production; the various resources available for production, e.g., capital, labor, land, minerals, and other natural resources; people's endowments and abilities; how production is organized, e.g., hub and spoke system of airlines as opposed to a system of direct flights; and we might also list the geography and location of the economy, e.g., does the country share a border with a friendly neighbor, e.g., Canada (for the US), or a hostile one, e.g., Russia (for Ukraine).

We can combine the resources the economy has available and the technology used to produce outputs to derive the Production Possibility Frontier or PPF for short. It is a description or a snapshot of the maximum amount of production the economy can produce given the resources and technology available.

Suppose society can produce two goods or outputs, consumer electronics and apples. If it puts all of its resources into apple production it can produce at point A. If it puts all of its resources into the producing consumer electronic goods it can produce a maximum at point B.

If it produces both goods it will be somewhere in the interior of the diagram, either on the curve or inside it. The production possibility frontier is made up of points like A-F-D-B. At D society is producing some of both goods and cannot produce more of one good without producing less of the other. Points inside the frontier like C are attainable but inefficient since some resources are not being used. At a point like C society is not using all of its resources so we say that some of the resources are unemployed. Points like E are unattainable for the moment; society does not have enough resources or the technology to produce at a point like E.

Several remarks are in order. First, the PPF is drawn by assuming everything listed above, e.g., population, technology, resources, and so on, is fixed. So the PPF is a snapshot of the economy at a point in time. Second, the PPF is downward sloping depicting a technological tradeoff between the two outputs being produced. For example, if society is producing at point D and wants to produce more apples it will have to shift resources from electronics production to apple production and move toward point F. Third, the shape of the PPF is dictated by a number of factors. If we are at point B and society shifts resources, e.g., labor, from electronics toward apple production, the most productive resources will probably be shifted first as we move from B to D and the increase in apple production will be large. However, as more and more is shifted from electronics to apples so that we're at point F, it becomes increasingly difficult to get further increases in apple production by continuing to shift more resources from electronics to apples. This is the primary reason the PPF is concave from below.

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Over time the structure of society, including the economy, will evolve. If economic growth is taking place, then the standard of living is improving. The prime reason for growth is technological progress. As progress occurs, the PPF will shift out as in the diagram above and more of all goods can be made available. More goods become available and some new goods are produced as well. So scarcity of resources is a relative concept. As economic growth occurs, we would expect the economy to produce in a more efficient manner and this will tend to alleviate but not eliminate scarcity.

Application: “Read my lips. No new taxes.” This was President Bush’s pledge at the 1988 Republican National Convention when he accepted the nomination. Unfortunately, the massive deficits the federal government was running at the time, larger than any we had experienced, forced him to recant by raising taxes in 1990. He also began reducing government spending on defense by closing unneeded military bases. Both decisions were the right thing to do in order to balance the budget.

1.4 TechnologyWhat do we mean by technology? Seems sort of silly to ask the question but what exactly is “technology.” Consider the following example of the automobile and the chronology of its development. Especially notice the evolution of the technology; it’s not static and unchanging, but continually evolving. Also, notice how the industry and the market responded to this evolution.

Example: A Brief and Idiosyncratic History of the Music Industry and its Technology1877 Edison invents the phonograph.1915 The 78 rpm record is introduced.1940 John Lennon is born.1948 The 33 1/3 rpm record is introduced and a year later 45 rpm singles hit the US

market selling for about $0.45 each.1953 Les Paul invents the electric guitar.1958 Eric Clapton learns to play the guitar.1964 The Beatles dominate the charts having as many as 5 of the top ten songs.1965 The audio cassette tape is introduced. Listeners can make copies of their favorite

songs. This also allows them to "rip" or break up an LP record into individual songs and create "mixed" tapes. Copyright owners view this as a threat.

1966 Eight track tape players are introduced.1966 The Kinks release "Face to Face" and the Beach Boys release "Pet Sounds."

These are the first so-called concept albums.1966 Fans are introduced to a new instrument with a strange sound independently by

George Harrison of the Beatles and Roger McGuin of the Byrds, the sitar.

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1966 Eric Clapton forms the first "supergroup," Cream, with Jack Bruce and Ginger Baker.

1967 The Beatles release "Sgt. Pepper's Lonely Hearts Club Band." It is noteworthy for the wildly innovative special effects as well as the longest piano chord ever recorded.

1969 The Who release "Tommy," the first rock opera. George Harrison and Ravi Shankar organize the first charity rock concert to raise money for Bangladesh.

1969 The Beatles break up after producing more #1 hits than any other group in history.1970 The Rolling Stones hire the "Hell's Angels" biker club to provide security at a

concert. The inevitable follows.1973 Pink Floyd releases "Dark Side of the Moon." It will spend 591 consecutive

weeks on Billboard's Top 200, a record for a record. 1983 Digitally mastered compact disks are introduced to the American market. Records

are slowly phased out. PC's and Mac desktop computers will eventually allow music fans to "rip" their favorite songs and "burn" their own CDs.

1986 Bob Geldorf organizes Band Aid to alleviate starvation in Africa. 1999 Napster, and eventually Apple with its "iTunes," allows people to trade, buy, and

sell music over the internet, legally, and of course, otherwise. 2003 Apple introduces a new version of its popular IPOD allowing music lovers to

carry 10,000 songs "in their pocket."2005 The Beatles sue Apple over use of the apple logo, but lose.2008 Record industry is hard hit by music sharing, artists publishing their own music,

and a massive drop in CD sales in the 2000s.fast forward:2015 Apple offers its music service free for three months but doesn’t pay artists

royalties. Taylor Swift puts both feet down and Apple relents.

Notice how the technology has changed over time. Instruments made in the 17th century were crude by today's standard with some exceptions like the violins made by Antonio Stradivari. The recording technology has changed significantly as well. The Beatles innovated with 4 track recording for their Sgt Pepper album. Later, 8 track recording was replaced by 64 tracks and so on. Finally, the playback technology has also changed. Vinyl records were the only method of replaying music until the early 1960s. Then tape was introduced, CDs followed, and finally music was digitized and stored on a simple device for playback like an iPod.

Each new technology drives out the previous technology. No one listens to 8 track tapes anymore. One other disturbing innovation is the ability to repackage the artist's music and share the music with non-payers. Copyright of a work of art or music and protection of that copyright is a huge problem in a digitized world.

Example: Bar codes. Bar codes on labels encode a considerable amount of information. Recent innovations will expand on this functionality. Grocery store coupons, boarding passes at airports, tickets at professional sports events or concerts, and UPS package tracking, all involve the bar code technology. For example, there are new markings appearing on some supermarket coupons called GS1 DataBars. This provides stores with better ways of handling inventory and providing coupons for customers.

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Application: 10 greatest inventions.1 Curators of the Science Museum in London provided a list of the top inventions that changed our world and asked for the general public to cast their vote for top invention on their web site. Their list included the Newcomen steam engine built in 1712; the German V-2 Rocket engine, from World War II used later to send rockets into space; the electric telegraph, which was the first practical use of electricity; Alan Turing’s 1950 Pilot ACE computer, one of the earliest electronic computers and the precursor to the laptop: penicillin (a petri dish used by Alexander Fleming which actually has some mold in it is on display); a model of DNA’s double helix discovered by Watson and Crick in 1953; and the first X-ray machine, which was surprisingly built by Russell Reynolds, a schoolboy at the time, and his father, in 1896; the Model T Ford, the first mass produced car in 1908; the Apollo 10 capsule that orbited the moon in 1969; and Stephenson’s steam locomotive called the Rocket from 1929. What do you think is the most important invention? The wheel, Arabic numerals, which were more economical and efficient than Roman numerals, lenses, the printing press, splitting the atom, and my favorite, compound interest.

1.5 Measuring the Performance of the EconomyHow does a firm measure its success, or failure? One measure is its sales revenue. This is equal to the price that it charges per unit multiplied by the number of units it sells. If Baskin and Robbins charges $1.25 per ice cream cone and sells 259 cones on a particular day, its sales revenue is $1.25 x 259 = $323.75 that day. If the owner's costs are $125, her accounting profit is $198.75 per day. If her sales are relatively stable, the owner may be fairly happy with her business. On the other hand, if her sales are falling, say, because a new ice cream shop has opened up, or people are becoming more diet conscious, then she might have to respond to the drop in demand. The statistic she observes is her sales revenue. If sales are rising, her business is growing; if sales are falling, her business is contracting.

The same is true for the economy as a whole. We usually measure the performance of the entire economy in a similar manner. Output is the typical measure and output is measured by GNP or GDP. (Don't worry about the difference between the two.) Annual GDP is the total value of all goods and services produced domestically in a given year. If there are two goods, apples (A), and electronic goods (E), then GDP = PAA + PEE, where PA and PE are the prices per unit of A and E, respectively. Why? Because PAA is the value of apple production (price per unit PA times the number of units A) and PEE is the value of electronic goods (price per unit PE times the number of units E). GDP is the sum of the two. If there were more goods in the economy we would continue to add more terms to the sum, one for each good.

The equation GDP = PAA + PEE represents the total GDP that can be produced in a given year and we can graph it as a straight line. The resulting line represents geometrically the amount the economy can produce in a given year.2

The slope of the GDP line is electronics/apples = - PA/PE, which is the "rise over the run," where means "change in." Any point on the GDP line yields the same level of GDP. Which point will we actually observe? The answer to this has to do with how much of each good is produced. 1 "On Display, 10 Inventions That Changed the World," NYTimes, 6/24/09.

2 To graph the equation: Fix GDP and find the intercepts. Set E = 0 to get GDP = PAA or A = GDP/PA as the horizontal intercept. Then set A = 0 to get GDP = PEE or E = GDP/PE as the vertical intercept. The GDP line is simply the straight line connecting the two intercepts.

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As GDP grows over time, the line shifts out. Suppose both sectors, electronics and apples, grow at the same rate over time. Then our measure of the size of the economy, GDP, will increase at the same rate. We can capture this graphically by shifting the GDP line out as in the diagram on the right above.

1.6 The Invisible Hand TheoremIn a competitive economy where people are completely free to choose their occupation, what job to take, how hard they want to work, and so on, we have the following rather remarkable result. It is known as the Invisible Hand Theorem and is originally due to Adam Smith, who first proposed it in the book entitled, The Wealth of Nations, written in 1776.3 The Invisible Hand Theorem is the following.

If everyone specializes in what they believe they do best and competes and trades with everyone else in the economy, then society's output will be as large as it can possibly be, given the available resources and technology,

In other words, according to the theorem, it is impossible for society to rearrange inputs across sectors of the economy and produce more of everything. This is depicted as point A in the diagram below where the GDP line is tangent to the production possibility frontier (PPF). Basically, the theorem says the competitive economy will be somewhere on the GDP line and that the line touches the PPF at one point only, point A. If we try to shift inputs around, we will only produce less, not more. But this would be inefficient. So one implication of the theorem is that a competitive economy is efficient.

Why "invisible hand?" Adam Smith's main point in his theorem was that people do not undertake this sort of behavior because they want GDP to be large. They undertake this behavior, e.g., working hard at what they do best, because it is in their own best interest. They do not undertake it because it is in the interest of society. For example, a finance major doesn't say to herself, "I should major in finance because that is in society's best interest." She majors in finance because that is in her own best interest. So people acting in their own best interest behave in a way that is good for society as a whole, without even realizing it ; they

3 One of the main themes of Smith’s book is that a nation’s wealth rests in her resources and what she can produce. A nation was wealthier if she had more resources to produce. The prevailing view at the time, known as Mercantilism, used an analogy drawn from observation of an individual. Why is one man wealthier than another? Because he has more gold and silver. So under Mercantilism one nation was wealthier than another if it had more gold and silver. This has severe implications for policy. For example, one country would not want to buy the goods of another country because it would have to give up some of its gold to pay for the goods. Another implication is that war may be justified if the nation can acquire more gold from its enemy. Smith’s book was revolutionary in its argument that the wealth of a country stems from what it can produce, rather than its stock of gold.

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do this as if led by an "invisible hand," to paraphrase Smith. The invisible hand represents their own self interest.

Adam Smith’s Invisible Hand Theorem has dramatic implications for the role of government in the economy. If the Invisible Hand Theorem is true, there would be no role for government to play. However, Adam Smith did not think his theorem was literally correct, a fact that is sometimes overlooked. In his book, Smith mentions a number of activities that governments can undertake in order to make the free market system function more effectively. He mentions, for example, defending the country from invasion, providing a legal system, and building roads and bridges. Of course, modern governments undertake these activities and much more.

The theorem does not have value because it is literally true. It has value because it is a sort of road map for understanding how the economy functions. We can develop a model of a perfectly functioning, competitive economy and match it up against the real world. If the model of a perfect economy matches up well with certain features of a real economy, so much the better because then no government intervention is necessary in those areas. However, if the model does not match up with the real world in certain other areas, we can try to figure out what the problem is and this can provide a role for government to play. Of course, whether the government actually does make things better is another matter entirely.

1.7 The Role of Prices. Prices play at least three roles in any economy. First, they provide information to people who wish to transact in the market or make investments. If you can search and observe prices, you can decide where to shop and how much to buy more efficiently. In addition, investors can obtain information on prices that help them decide where to invest. Second, prices help to allocate resources. If the price is too high, sellers have to cut their price in order to make sales. If the price is too low, buyers will bid the price up in order to obtain the good. The movement of the price is what equilibrates supply and demand and helps in allocating resources across sectors of the economy. Third, prices can be used to calculate GDP and we can use this measure to calculate the economy’s growth rate.

Prices are an economical way of conveying information. Consider our two good example of apples and electronics. Recall, that - PA/PE is the slope of the GDP line. What happens if the supply of apples is greater than the demand and the demand for electronics is greater than the supply at the going prices? If PA is too high, then firms selling A have to cut their price to make sales. They also need to cut their production by laying off workers, selling some of their machinery and equipment, and so on. This releases resources of labor and capital to other sectors of the economy. If PE is too low, buyers will bid up the price. Firms producing electronics can also increase their production by hiring more labor and buying more capital equipment. Resources will shift from the production of apples to the production of electronics as producers

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and investors try to make more profit. As this process occurs, PA will fall and PE will rise so the ratio of PA to PE, PA/PE, will fall and the GDP line will become flatter or less steep. We will move from A to B in the diagram.

In addition, the falling price in apple production signals investors to shift their money out of apples. The rising price in electronics production will also signal investors to shift their resources into electronics. Resources will typically move from a sector of the economy where the price and profit is falling to another sector where the price and profit is rising. Note that if prices could not be charged or were fixed and could not be changed, this process would be unable to signal people about what was happening in the market. Price would also be incapable of equilibrating the markets.

So prices provide information efficiently and allocate resources.4 Prices should be allowed to fluctuate to reflect the current market conditions. Any kind of interference in the price adjustment process can weaken the signal prices give making it harder for people to make economic decisions and may make it more difficult to allocate resources.

Example: Fixed prices. How are goods allocated in economies that either cannot charge prices, or cannot change prices in response to changing market conditions, e.g., North Korea, Soviet Union, China, Cuba, and even the United States after the famous wage and price freeze of 1971? People stand in a line or a queue outside the store. Each person who can get into the store receives one unit of whatever good is being handed out, e.g., bread, shoes, toilet paper, and so on. The length of the line outside the store becomes a measure of economic activity that is very much like a price in the sense that it provides people with a signal. In a sense, changes in the length of the line are signaling people in a way very similar to changes in price. If a good becomes more scarce, its price goes up or the line appears to get longer. If the good is in plentiful supply, the price falls or the line gets shorter. Now imagine you want to buy shoes at the lowest "price," i.e., the shortest line, in a country where prices are fixed. How would you do it? Where is the line for new shoes the shortest? You wouldn't know and it would be virtually impossible to find out. You would have to go from shoe store to shoe store and observe the length of every line. But if prices can be charged and can respond to changes in market conditions, you can find out which store has the lowest price very easily. Just buy a newspaper, or make a few phone calls!

Finally, prices can be used to measure GDP and we can use changes in GDP (GDP) to measure how much the economy grows. In other words, the GDP line will shift out with

4 The idea that prices convey information efficiently is due to von Hayek. This idea became the basis for the Efficient Markets hypothesis of Eugene Fama in pricing securities.

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economic growth as the PPF shifts out. We can measure this process be calculating the growth rate in GDP. The growth rate is defined as

growthrate of GDP=GDPt−GDPt−1

GDPt−1x100 %

where GDPt is GDP in year t, e.g., t = 2000, and GDP = (Gt - Gt-1) is the change in GDP from year t-1 to year t. The following examples illustrate how the formula works.

Example: GDPt = $1.5trillion, GDPt-1 = $1trillion.The growth rate = 100% x (1.5 - 1)/1 = 100% x 0.5 = 50%.

Example: GDPt = $3, GDPt-1 = $1, then the growth rate = 100% x (3 - 1)/1 = 200%.

Example: GDP1996 = $35, GDP1995 = $34, then growth rate = 100% x (35 - 34)/34 = 100% x 1/34 = 2.94%.

In general, the growth rate of a variable X from time t-1 to time t is defined as:

growthrate=X t−X t−1

X t−1x 100 %

Example: Suppose the growth rate in sales for your company was 2.5% this year and sales last year was $120m. What must sales be this year? Let X = sales and use the formula:

growthrate of sales=sale st−sale s t−1

sale s t−1X 100 %

Substitute into the growth rate formula, 𝟎. 𝟎𝟐𝟓 = (𝑺𝒂𝒍𝒆𝒔t – 𝟏𝟐𝟎)/ 𝟏𝟐𝟎. Or, 0.025 x 120 = salest - 120,and 0.025 x 120 + 120 = $123m = sales t. So sales increased from $120 in the first year to $123 in the second year.

Example: Suppose the deficit last year was $210 billion and the deficit this year is $220 billion. What is the growth rate in the deficit from last year? (220 – 210)/210 = 0.05 or 4.76%.

Some sectors grow dramatically for awhile like pharmaceutical drugs, cell phones, and video streaming, while others are actually in decline and getting smaller like train travel. The growth rate of the economy is an average calculated across all these different sectors of the economy. Some of the new theories of economic growth we will briefly discuss in the next chapter suggest that some markets may fail to function properly and this can slow the growth process down. So perhaps fostering economic growth is one role the government can play, although this remains controversial.

1.8 Breakdowns in the Invisible Hand Theorem: A Potential Role for Government.There are a number of areas where the private market system does not work well or simply fails to exist. In some cases we can design an institution, reform an existing one, or come up with a policy the government can pursue to make the private market work more efficiently, or more

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equitably.

1.8.1 Public goodsIf you think you benefit from eating apples, you simply go to the grocery store, buy the apple, and eat it, and enjoy its benefits. However, there are some goods you benefit from but cannot buy because the market doesn’t exist. For example, you benefit from breathing fresh, clean air, but you cannot buy the good “clean air.” Another example is public infrastructure, e.g., roads, bridges, highways, harbors, airports, and sidewalks. It would be difficult, if not impossible for the private sector to provide such commodities.5

There is a large class of commodities called public goods that cannot be supplied by the private sector. Examples include the airwaves, police and fire protection, search and rescue units in wilderness areas, clean air and water, national defense, air travel safety, uncongested roads, public infrastructure lighthouses, inoculations, disaster relief, the beauty of natural habitats and wilderness areas, international peacekeeping operations, diplomacy, and possibly the Internet. These goods cannot generally be supplied by the private sector, yet, people obviously benefit from them.

Sometimes the private sector will try to provide such a good. Charity is one such example. A lot of people benefit from the goods provided by a charitable donation. However, it is usually the case that too little of the good will be provided.

1.8.2 Externalities.A second problem with the market system involves what is known as an externality. An externality is any situation where an agent takes an action that affects another agent, either beneficially or adversely. A researcher discovers a cure for a dreadful disease that helps millions of people suffering from the disease. A teacher inspires her students to work harder and learn more. A gunman randomly shoots innocent bystanders in a restaurant or school. Someone sneezes and you catch a cold. You hold the door for someone coming behind you. A car cuts you off in traffic and your engine stalls. Someone plays music loudly in the spring that you enjoy. Pollution is a prime example of an externality. One firm pollutes the air or water and this causes difficulties for people living nearby. No firm has an individual incentive to clean up its pollution since this will raise its cost and make it harder for the firm to compete.

Externalities can be beneficial or harmful. Some externalities work through the market and are called pecuniary externalities, while others occur outside the market and are known as non-pecuniary externalities, which are more difficult to deal with than pecuniary externalities.

Example: pecuniary externality. A fast food company, McDonald's, introduced a chicken sandwich to its menu in the early 1980's and within six months the other major fast food companies had also introduced chicken items to their menus. The increase in demand for chicken by the fast food industry was so great nation-wide that it caused the price of chicken at the grocery store to increase as a result. This in turn affected consumers of chicken in general. Since it worked through the market, it is a pecuniary externality.

Example: non-pecuniary externality. The Exxon Valdez dumped oil in Prince William Sound that killed fish and wildlife and ruined the local natural habitat. (This also has a pecuniary aspect to it since fishermen had to fish elsewhere thus raising their cost and lowering their net income.) 5 We have not been taking care of our infrastructure in the US for at least thirty years. This has led to significant deterioration. Thousands of bridges, for example, are under restricted use, meaning large trucks cannot use them This can be very costly. See: http://seattletimes.com/html/businesstechnology/2021059837_bridgebizxml.html on the costs of the bridge collapse just north of Seattle in May, 2013.

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More recently, BP spilled millions of barrels of oil in the Gulf of Mexico and it may take years for it to be cleaned up and the habitat restored.

It is widely believed to be the case that the government should only intervene when there is a non-pecuniary externality present, not when there is a pecuniary externality . When an externality occurs within a market, the price will change and this will reallocate resources. This is what markets are supposed to do. Sometimes the externality will lower the price and sometimes it will raise the price. But the fact that the price responds is the key. No one would seriously suggest, for example, that the government do something about the price of chicken going up in the supermarket due to the introduction of chicken items in fast food restaurants.

There is one possible exception to this rule. The pecuniary externality may adversely affect the income distribution. For example, during the Persian Gulf War in 1991 the price of home heating oil increased dramatically and this adversely affected poor people living on the east coast, which imports most of its energy. Many could literally not afford to heat their homes that winter. In this case, society may decide to intervene by subsidizing home heating oil.

Another general rule: actions that cause beneficial, non-pecuniary externalities should be promoted, while actions that cause harmful, non-pecuniary externalities should be discouraged. Pollution causes harmful externalities and should be reduced. Research causes beneficial externalities and should be subsidized.6

1.8.3 Market power and monopoly Some markets are characterized by firms that have market power. In such cases, the firms will exploit the consumer. The extreme case is when there is a single firm, a monopolist, that will exploit its position in a socially harmful way. The firm may charge high prices, produce low quality, provide little customer service, and stifle competition and innovation. It is widely believed that some sort of government intervention is called for like regulating the monopolist, or possibly breaking the monopolist up into several companies. Utility companies and cable television companies are prime examples.

There is another side to the story, however. We also want people to feel they can have an idea and develop it without others stealing it. This is why we grant patents and copyrights. A patent essentially creates a monopoly; the owner of the patent is the only one who can exploit the idea protected by the patent. So there is a tradeoff between new products, protected by patents and copyrights, and monopoly pricing of those products.7 Another thing to keep in mind is that a monopolist will earn above average profits because it can exploit the market. This will almost always attract competition eventually. The popularity of the cell/mobile phone would surely have eliminated AT&Ts monopoly on phone service. Watching tv shows on the internet is taking business away from cable companies who monopolized such services before.8 And Apple’s iOS in its iPhone and iPad is having a dramatic impact on Microsoft’s monopoly on operating systems. Competition will lead to a “natural” break up of the monopolist.

1.8.4 Income distributionThere are two facts of the last thirty years that have recently come to light. First, the income

6 As another example, if one person stands up at a football game, they can see better. However, that may block someone else’s view and they will be forced to stand up so they can see. Before you know it, everyone is standing up and no one can see any better than when they were all sitting down!7 Hasbro, owner of Parker Brothers, has a monopoly on the board game Monopoly.8 Consider watching HBO Now over the internet versus HBO Go delivered via cable. If the former is less expensive, competition will take business away from cable companies.

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distribution is widening. This means the rich control more income and the poor less and this is getting worse. Second, this is happening in countries worldwide. In the diagram this is depicted for the US. It would appear that the greatest growth in income since the late 1970s is for the top 1% wealthiest people in the US. Their income has grown by 277% since 1979. The poorest 20%, however, experienced income growth of only 18%, or 0.005 per year, since the late 1970s. So over time the income distribution will tend to widen as a result of these different growth rates. This is a source of concern since inequality is greater now than in any period since the 1920s.

There are theories that connect the income distribution to the economy’s growth rate. For example, if the lower 50% of the population has difficulty getting loans, it is more difficult for them to start a business, finish school, or pay for extra training. Over time this group will experience less income growth and the income distribution will widen as a result. But, in addition, they are not fully developing their human capital. This may reduce the efficiency of the economy and slow the growth rate, especially since it is half the population.

1.8.5 Asymmetric informationIn many situations involving risk and uncertainty, one side of the market has better information than the other side and it may have no incentive to reveal that information. Information is said to be asymmetric. This can affect insurance markets. Typically, buyers of insurance know more about the risk they face than sellers. This leads to problems like moral hazard, where the existence of the insurance changes behavior so as to make the bad situation more likely to occur, and adverse selection, where more of the bad risks want to buy the insurance than the good risks.

Suppose one side of a market has more information about the potential transaction than the other side of the market. This may allow the side with better information to behave strategically and thus take advantage of the other side. However, the participants on the other side of the market are not stupid. They will respond to their "information disadvantage" by altering the nature of the transaction so that it is to their advantage. They do this in anticipation of the perverse behavior of the participants on the other side of the market.

A prime example of this is any situation involving insurance markets. A good "state of nature" may occur, e.g., no car accident happens, or a bad "state of nature" may occur, e.g., an accident occurs. Risk averse individuals wish to buy insurance to protect themselves against bad

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states of nature. However, only the individual knows whether she is a careful driver or not because information is asymmetric. The existence of the insurance may cause drivers to drive less safely so moral hazard may exist and people who are bad drivers are more likely to buy the insurance than the good drivers so adverse selection also exists. How do insurance companies respond? They collect information. The more information they can obtain, the more carefully they can classify the risk and charge the appropriate price for the insurance.

In some markets it is very difficult to assess the risk because information is either private, hence asymmetric, or costly to collect. Some insurance markets either function poorly or do not exist. For example, private companies do not offer unemployment insurance so this market does not exist. Why? Suppose the risky event is "losing your job because of a recession." You could lose your job for a variety of reasons, one of which is a recession. It might be impossible for the insurance company to tell if you lost your job because a recession occurred, or because you just got ticked off at your boss and he fired you. So private companies do not offer this sort of insurance. Unfortunately, the risk still exists, which provides a justification for unemployment insurance. As another example, you would like to buy insurance when you begin college that will pay off if you cannot find a job upon graduation, Call it “graduation job insurance.”9 However, such insurance does not exist, which may provide a justification for subsidized student loan programs. These are examples of social insurance. Other examples include flood insurance, unemployment insurance, social security, and possibly health insurance.

1.9 The Market Paradigm: A CaveatThere is no question that a market-oriented economic system can provide literally thousands of goods and services in an efficient manner. Specialization and trading on competitive markets provides us with new and innovative products like the iPad, smart phone, microwave, HDTV, anti-lock brakes, internet shopping, laser surgery, and so on. Economies based on the market system tend to be more efficient than economies that are not, and they also tend to grow faster in the long run. There is no comparison between a market-oriented economy and an economy based on Communism, for example, where central planners make production and allocation decisions. Just compare East Germany and West Germany in the early 1990s. Even now, what was East Germany still lags behind the West.

However, there are situations where markets do not work well that go beyond the usual problems like monopoly and externalities. There are cases where economic agents take actions that seem rational from theit own perspective, but lead to an unfortunate outcome for the group, or the economy as a whole. Generically, this type of situation is known as a Coordination Problem.

It is best from the economy’s perspective if no individual firm raises its price because this keeps inflation down. However, it is in the interest of the individual firm to raise their price. Since this is true for all firms individually, they will all raise their price and inflation will get worse.

It is best from the economy’s perspective if no individual firm lays off any workers because

9 This would be like auto insurance. With auto insurance you buy the insurance and pay a premium every six months. In the good state, there is no accident and no payment from the insurance company. In the bad state of an accident, the company pays to fix your car. With “graduation job insurance” you buy the insurance and pay a premium every month. The good state is where you find a job after graduation, like not having a car accident. In the bad state you cannot find a job and the insurance pays you a monthly benefit. How hard would you look for a job if you were receiving a monthly benefit from the insurance? Probably not very hard, which is one reason the insurance doesn’t exist, yet the risk still does. Hence the need for some sort of social insurance.

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that keeps unemployment down. However, it is in the interest of the individual firm to cut cost as a recession begins by laying off some of its workers. Since this is true for all firms individually, they will all lay off some of their work force and this will increase unemployment and make the recession worse.

It is in the interest of all consumers as a group to limit water use in a drought. However, it is in the individual’s interest to use as much water as they wish. Since this is true of all individuals, water use will not fall in a drought.

Whenever what is best for the group differs from what is best for the individual, there may be a coordination failure. We will call this phenomenon where the individual and group interest diverge, “rational irrationality,” following John Cassidy in “How Markets Fail: The Logic of Economic Calamities.” The action taken is rational for the individual, but it leads to an outcome for the group that looks irrational.10

The so-called Prisoner’s Dilemma is an example of this. Imagine two criminals are caught at the scene of a crime and are taken to the police station where they are placed in separate rooms. Each prisoner has a choice. They can confess to a minor crime, or they can refuse to talk. If both prisoners refuse to talk, then the police will only charge them with a minor offense with jail time of one year. However, if a prisoner confesses and makes a deal to give up the other prisoner, he gets off with only probation and no jail time, while the other prisoner gets five years. The group incentive is for them to both refuse to talk since each will only get a year in jail. However, if prisoner A confesses, A will only get probation, while B will get five years in jail. The same is true for prisoner B. If he confesses, he will only get probation, while A gets five years in jail. What should A do? If there is the slightest bit of doubt in his mind about B, he should confess and try to make a deal. But B has the same individual incentive. The outcome is that both will confess and both will end up getting five years in jail. It is best from the group perspective to refuse to talk, but it is best to confess from the perspective of the individual.

There are economic situations that are very similar to the Prisoner's Dilemma. Imagine two airlines are competing with one another. They would both be better off if they maintained their price. However, United would be even better off if it cut its price since it would gain market share from Delta. The same is true for Delta. But if both companies cut their fare, they will both lose money. So it is better for both if they both maintain their price, but individually it is better for each to cuts its own price. What is the outcome? Both will cut their price and lose money for a while.

We will call this “rational irrationality,” following John Cassidy in “How Markets Fail: The Logic of Economic Calamities.” The action taken is rational for the individual, but it leads to an outcome for the group that looks irrational. We can use this idea to explain certain acts taken that were in the individual interest of a single investment bank that turned out to be horrendously bad when all the banks took the action. For example, by 2005 everyone in investment banking knew full well that the system was taking on too much risk. It was perhaps in the interest of a single bank to take on more risk, but not in the interest of the group if all did it, and the system literally collapsed in 2008. But, to quote Chuck Prince, CEO of Citigroup, “[A]s long as the music is playing you’ve got to get up and dance.” Citigroup was falling behind its competitors and Prince ordered his people to take on more risk by issuing these new securities. That turned out to be a really bad idea as Citigroup had to be bailed out.11 Some banks were issuing mortgage 10 Standing up to see better at a football game is a coordination failure.11 The federal government took a 36% share in Citigroup when they bailed Citi out, the biggest bank in the world at the time, 2008. They were also given control of half the seats on the Board of Citi and the other directors could be removed if the bank performed poorly as a condition for receiving the bailout. Essentially, the federal government

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backed securities, i.e., derivatives, even as the credit and housing bubble was bursting! Even Alan Greenspan admitted that his strong belief in the free market system was wrong. Indeed, Adam Smith himself was very skeptical about bankers.

The general solution to a coordination failure is for there to be an entity that can take charge, centralize control, and force individuals to do what is in the group’s interest since everyone will benefit. The Fed, or central bank, can fulfill this role in implementing monetary policy. It can be the lender of last resort and coordinate interest rates to reduce inflation and stabilize the economy. The US government played this role in building the coalition to fight the Gulf War in 1991. It also played this role in fighting the Cold War.

1.10 ConclusionMost markets typically function properly. However, there are a number of instances where the market system does not work so well. Examples include public goods, externalities, situations involving asymmetric information, monopoly, and problems associated with the income distribution. In some extreme cases the private market doesn't exist at all. There are also settings where the structure of the situation leads normally rational individuals to take decisions that turn out to be good from their individual perspective, but bad from the perspective of the group.

This strongly suggests that there is a role for government in the economy. It can protect property rights, foster innovation, ensure fairness by helping people in need, protect against unfair trading practices, and maintain the safety of products. It can provide public goods like national defense and national parks. It can oversee monopolists and large corporations who have a tendency to exercise market power. It can provide social insurance for retirement and unemployment.

Important ConceptsProperty rightsTheories and models Positive versus normative statementsScarcity and production possibilityTechnology and technological innovationMeasuring the performance of the economyThe Invisible Hand Theorem and the optimality of competitionThe role of pricesDefining a growth rateMarket failures: externalities, public goods, uncertainty, monopoly, income distributionRational irrationality and the Prisoner’s Dilemma problem

Review Questions1. What is a property right and why is it important?

was running the bank. Fortunately, the money was repaid two years later with a profit of $12 billion in 2010. See http://wallstreetonparade.com/2012/08/the-untold-story-of-the-bailout-of-citigroup/ and also http://www.nytimes.com/2011/12/04/business/secrets-of-the-bailout-now-revealed.html?pagewanted=all .

Several other big banks had to be bailed out by the federal government in 2008 as well, which was the last year of George Bush’s presidency. This means that the government owned shares in our biggest banks, until those shares were bought back by the banks. This is somewhat ironic since it happened under George W. Bush, a staunch advocate of the deregulated “free enterprise” system. Negotiations to take an equity stake in both GM and Chrysler also began under the Bush Presidency.

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2. Explain the nature of scarcity. Why does it exist? Can it be overcome? How does economic growth affect it?

3. What are the components of a theory? How do the assumptions differ from the predictions? Can we say a model or theory is bad because it is unrealistic?

4. Explain the Invisible Hand Theorem. How does it apply to a real economy?5. List the different roles a price can play. Suppose prices are not allowed to change. What

do you think would happen?6. What is a growth rate and how is it calculated?7. Describe the different reasons the Invisible Hand Theorem might not hold.8. What is social insurance? Why does it exist?9. What is an externality? 10. What are coordination failures?

Practice Questions1. The drinking age should be 12. This is an example of

a. an externality.b. a public good.c. a positive statement.d. a normative statement.

2. Theories can never be truly realistic, however, they can be wrong.a. true b. false.

3. If a company's sales are $15,000 per month and this drops to $12,000, what is the growth rate of sales when the drop occurs?

a. $3,000 c. (12,000 - 15,000)/12,000 = - 25%b. (12,000 - 15,000)/15,000 = - 20% d. (15,000 - 12,000)/15,000 = 20%

4. The Invisible Hand Theorem is valuable to us becausea. it is an accurate depiction of economic reality.b. it explains how scarcity can be overcome.c. it can be used to study potential market failures and possible solutions to those

problems.d. it explains the nature of monopoly decision making.

5. Externalities involvea. one agent's action affecting another agent.b. goods that cannot be produced by the market system.c. situations of uncertainty.d. goods that are produced by the market.

6. Outsourcing is wherea. firms bring imports into the country.b. tariffs are used to keep goods out.c. quotas are used to keep goods out.d. firms move jobs to other countries to reduce labor costs.

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e. firms move jobs to other countries to improve worker productivity.

7. Everyone benefits from trade.a. True. b. False.

8. A person is killed by a drunk driver. This is an example ofa. A public bad.b. A public good.c. Market failure.d. A non-pecuniary externality.e. A pecuniary externality.

Answers1. d. It is a normative statement.2. a. Theories are always unrealistic because they abstract from unimportant details. They can be wrong if they are inconsistent with the facts.3. b. The growth rate is negative because sales are falling.4. c.5. a.6. d.7. False. Not everyone benefits; some workers lose.8. d.

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