Economics For Dummies®, 3rd Edition Published by: John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, www.wiley.com Copyright © 2018 by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada 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, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without the prior written permission of the Publisher Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions Trademarks: Wiley, For Dummies, the Dummies Man logo, Dummies.com, Making Everything Easier, and related trade dress are trademarks or registered trademarks of John Wiley & Sons, Inc., and may not be used without written permission All other trademarks are the property of their respective owners John Wiley & Sons, Inc., is not associated with any product or vendor mentioned in this book LIMIT OF LIABILITY/DISCLAIMER OF WARRANTY: WHILE THE PUBLISHER AND AUTHOR HAVE USED THEIR BEST EFFORTS IN PREPARING THIS BOOK, THEY MAKE NO REPRESENTATIONS OR WARRANTIES WITH RESPECT TO THE ACCURACY OR COMPLETENESS OF THE CONTENTS OF THIS BOOK AND SPECIFICALLY DISCLAIM ANY IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE NO WARRANTY MAY BE CREATED OR EXTENDED BY SALES REPRESENTATIVES OR WRITTEN SALES MATERIALS THE ADVICE AND STRATEGIES CONTAINED HEREIN MAY NOT BE SUITABLE FOR YOUR SITUATION YOU SHOULD CONSULT WITH A PROFESSIONAL WHERE APPROPRIATE NEITHER THE PUBLISHER NOR THE AUTHOR SHALL BE LIABLE FOR DAMAGES ARISING HEREFROM For general information on our other products and services, please contact our Customer Care Department within the U.S at 877-762-2974, outside the U.S at 317-572-3993, or fax 317-5724002 For technical support, please visit https://hub.wiley.com/community/support/dummies Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-on-demand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com Library of Congress Control Number: 2018937401 ISBN 978-1-119-47638-2 (pbk); ISBN 978-1-119-47627-6 (ebk); ISBN 978-1-119-47632-0 (epdf) Economics For Dummies® To view this book's Cheat Sheet, simply go to www.dummies.com and search for “Economics For Dummies Cheat Sheet” in the Search box Table of Contents Cover Introduction About This Book Foolish Assumptions Icons Used in This Book Beyond the Book Where to Go from Here Part 1: Economics: The Science of How People Deal with Scarcity Chapter 1: What Economics Is and Why You Should Care Considering a Little Economic History Framing Economics as the Science of Scarcity Sending Microeconomics and Macroeconomics to Separate Corners Understanding How Economists Use Models and Graphs Chapter 2: Cookies or Ice Cream? Exploring Consumer Choices Describing Human Behavior with a Choice Model Pursuing Personal Happiness You Can’t Have Everything: Examining Limitations Making Your Choice: Deciding What and How Much You Want Exploring Violations and Limitations of the Economist’s Choice Model Chapter 3: Producing Stuff to Maximize Happiness Figuring Out What’s Possible to Produce Deciding What to Produce Promoting Technology and Innovation Part 2: Microeconomics: The Science of Consumer and Firm Behavior Chapter 4: Supply and Demand Made Easy Deconstructing Demand Sorting Out Supply Bringing Supply and Demand Together Price Controls: Keeping Prices Away from Market Equilibrium Chapter 5: Introducing Homo Economicus, the Utility-Maximizing Consumer Choosing by Ranking Getting Less from More: Diminishing Marginal Utility Choosing Among Many Options When Facing a Limited Budget Deriving Demand Curves from Diminishing Marginal Utility Chapter 6: The Core of Capitalism: The Profit-Maximizing Firm A Firm’s Goal: Maximizing Profits Facing Competition Analyzing a Firm’s Cost Structure Comparing Marginal Revenues with Marginal Costs Pulling the Plug: When Producing Nothing Is Your Best Bet Chapter 7: Why Economists Love Free Markets and Competition Ensuring That Benefits Exceed Costs: Competitive Free Markets When Free Markets Lose Their Freedom: Dealing with Deadweight Losses Hallmarks of Perfect Competition: Zero Profits and Lowest Possible Costs Chapter 8: Monopolies: Bad Behavior without Competition Examining Profit-Maximizing Monopolies Comparing Monopolies with Competitive Firms Considering Good Monopolies Regulating Monopolies Chapter 9: Oligopoly and Monopolistic Competition: Middle Grounds Oligopolies: Looking at the Allure of Joining Forces Understanding Incentives to Cheat the Cartel Regulating Oligopolies Studying a Hybrid: Monopolistic Competition Part 3: Applying the Theories of Microeconomics Chapter 10: Property Rights and Wrongs Allowing Markets to Reach Socially Optimal Outcomes Examining Externalities: The Costs and Benefits Others Feel from Your Actions Tragedy of the Commons: Overexploiting Commonly Owned Resources Chapter 11: Asymmetric Information and Public Goods Facing Up to Asymmetric Information Providing Public Goods Chapter 12: Health Economics and Healthcare Finance Defining Health Economics and Healthcare Finance Noting the Limits of Health Insurance Comparing Healthcare Internationally Inflated Demand: Suffering from “Free” and Reduced-Cost Healthcare Investigating Singapore’s Secrets Chapter 13: Behavioral Economics: Investigating Irrationality Explaining the Need for Behavioral Economics Complementing Neo-Classical Economics with Behavioral Economics Examining our Amazing, Efficient, and Error-Prone Brains Surveying Prospect Theory Countering Myopia and Time Inconsistency Gauging Fairness and Self-Interest Part 4: Macroeconomics: The Science of Economic Growth and Stability Chapter 14: How Economists Measure the Macroeconomy Getting a Grip on the GDP (and Its Parts) Diving In to the GDP Equation Making Sense of International Trade and Its Effect on the Economy Chapter 15: Inflation Frustration: Why More Money Isn’t Always Good Buying an Inflation: When Too Much Money Is a Bad Thing Measuring Inflation Pricing the Future: Nominal and Real Interest Rates Chapter 16: Understanding Why Recessions Happen Introducing the Business Cycle Striving for Full-Employment Output Returning to Y*: The Natural Result of Price Adjustments Responding to Economic Shocks: Short-Run and Long-Run Effects Heading toward Recession: Getting Stuck with Sticky Prices Achieving Equilibrium with Sticky Prices: The Keynesian Model Chapter 17: Fighting Recessions with Monetary and Fiscal Policy Stimulating Demand to End Recessions Generating Inflation: The Risk of Too Much Stimulation Figuring Out Fiscal Policy Dissecting Monetary Policy Chapter 18: Grasping Origins and Effects of Financial Crises Understanding How Debt-Driven Bubbles Develop Seeing the Bubble Burst After the Crisis: Looking at Recovery Part 5: The Part of Tens Chapter 19: Ten Seductive Economic Fallacies The Lump of Labor The World Is Facing Overpopulation Sequence Indicates Causation Protectionism Is the Best Solution to Foreign Competition The Fallacy of Composition If It’s Worth Doing, Do It 100 Percent Free Markets Are Dangerously Unstable Low Foreign Wages Mean That Rich Countries Can’t Compete Tax Rates Don’t Affect Work Effort Forgetting Unintended Consequences Chapter 20: Ten Economic Ideas to Hold Dear Self-Interest Can Improve Society Free Markets Require Regulation Economic Growth Relies on Innovation Freedom and Democracy Make Us Richer Education Raises Living Standards Intellectual Property Boosts Innovation Weak Property Rights Cause All Environmental Problems International Trade Is a Good Thing Government Can Provide Public Goods Preventing Inflation Is Easy Chapter 21: Ten (Or So) Famous Economists Adam Smith David Ricardo Karl Marx Alfred Marshall John Maynard Keynes Kenneth Arrow and Gerard Debreu Milton Friedman Paul Samuelson Robert Solow Gary Becker Robert Lucas Appendix: Glossary About the Author Advertisement Page Connect with Dummies Index End User License Agreement Introduction Economics is all about humanity’s struggle to achieve happiness in a world full of constraints There’s never enough time or money to everything people want, and things like curing cancer are still impossible because the necessary technologies haven’t been developed yet But people are clever They tinker and invent, ponder and innovate They look at what they have and what they can with it and take steps to make sure that if they can’t have everything, they’ll at least have as much as possible Having to choose is a fundamental part of everyday life The science that studies how people choose — economics — is indispensable if you really want to understand human beings both as individuals and as members of larger organizations Sadly, though, economics has typically been explained so badly that people either dismiss it as impenetrable gobbledygook or stand falsely in awe of it — after all, if it’s hard to understand, it must be important, right? I wrote this book so you can quickly and easily understand economics for what it is — a serious science that studies a serious subject and has developed some seriously good ways of explaining human behavior out in the (very serious) real world Economics touches on nearly everything, so the returns on reading this book are huge You’ll understand much more about people, the government, international relations, business, and even environmental issues About This Book The Scottish historian Thomas Carlyle called economics the “dismal science,” but I’m going to my best to make sure that you don’t come to agree with him I’ve organized this book to try to get as much economics into you as quickly and effortlessly as possible I’ve also done my best to keep it lively and fun In this book, you find the most important economic theories, hypotheses, and discoveries without a zillion obscure details, outdated examples, or complicated mathematical “proofs.” Among the topics covered are How the government fights recessions and unemployment How and why international trade is good for both individuals and nations Why poorly designed property rights are responsible for environmental problems such as global warming, pollution, and species extinctions How profits guide businesses to produce the goods and services you take for granted How economic incentives affect healthcare costs, prices, and efficiency Why competitive firms are almost always better for society than monopolies How the Federal Reserve controls the money supply, interest rates, and inflation all at the same time socially optimal output level, 194–195 Tragedy of the Commons, 202–204 property taxes, justification for, 70 proportions, irrational behavior related to, 31 proposer, in ultimatum game, 253 prospect theory anchoring and credit card bills, 246–247 defined, 386 endowment effect, 247 framing effects and advertising, 245–246 overview, 244 shrinking packages and loss aversion, 245 status quo bias, 247–248 protectionism, 367 public goods as cause of market failure, 13 defined, 206, 386 enlisting philanthropy to provide, 216–217 government role in providing, 216, 374 overview, 215–216 ranking new technology as, 219–220 selling related private good to provide, 217–218 taxing to provide, 216 public sector, adverse selection response from, 226 purchasing behavior See consumer behavior Q quantitative easing (QE), 350–352 quantity demanded See also demand defined, 17, 58, 386 on demand curve, 18–20, 60–62, 97–99 effect of price on, 96–97 elements affecting, 59 inverse relationship with prices, 60 quantity supplied See supply and demand; supply curve quantity theory of money, 281, 376, 378, 386 R radio, as public good, 217–218 ranking, choosing by, 84–85 rational expectations defined, 386 fiscal policy, relation to, 340 as limiting monetary policy, 348–350 overview, 16, 380–381 stimulus policies, effect on, 334–336 rationality defined, 238, 386 in neoclassical economics, 239 rationing healthcare, 229–231 real estate bubbles See asset-price bubbles real GDP, during recessions and Great Depression, 312–313 real interest rates, 293–294, 386 real prices, 291, 387 real wages, 331–332, 334, 387 recessions See also fiscal policy; Keynesian model; monetary policy; stimulus policies after financial crises, 353–354 business cycle, 298–299 defined, 15, 297, 298, 328, 387 full-employment output, 299–300 government intervention, 322–323 Great Recession, 350–352 inflation, generating, 328–336 in macroeconomics, 15–16 overview, 15–16, 297–298 post-bubble, overview, 359–360 post-bubble, recovery from, 360–362 price adjustments, 300–301 real GDP during, 312–313 real wages, 331–332 responding to economic shocks, 297, 301–309 sticky prices, 297–298, 309–312 recognition heuristic, 241 recovery defined, 298, 387 from post-bubble recessions, 360–362 redundant competitors, monopolies as eliminating, 165–166 regulation of free markets, need for, 372 of monopolies, 167–171 of oligopolies, 183–184 relative price increase, 288 Remember icon, explained, rent, as income stream, 261 rent control, 77–78 reputation, role in used car market, 210 research government funding of, 52 medical, effect of self-rationing on, 234–235 resources See also property rights allocating, 37–41, 45–46 automatic direction of, in free markets, 44–45 circular flow for, 259–260, 262–263 classifying, 35 competition, relation to use of, 46 constraints on, in economic choice model, 25 production possibilities frontier, 38–42 role in production possibilities, 34, 35, 37 scarcity of, 10–11, 21, 387 responder, in ultimatum game, 253 retailers, response to recessions, 307 retirement savings, 248 revenues See marginal revenues; total revenue Ricardo, David, 274–275, 376 rich countries, price controls in, 79 Robinson, Joan, 186, 188, 326 Rockefeller, John D., 184 rolling over the debt, 339 running a loss, 106, 121–125, 160–161 running a profit, 106 S safety features, marginalism related to, 368 sales price See prices Samuelson, Paul, 379 Saudi Arabia, capacity to threaten OPEC, 183 savings effect of hyperinflation on, 283 as paying for increased government spending, 338 retirement, effect of status quo bias on, 248 in Singapore healthcare system, 233 scarcity defined, 387 economics as science of, 10–11, 21 security, collateral as, 355 self-control problems, 250 self-interest behavioral economic research on, 251–254 in economic choice model, 23–24 as improving society, 371 in neoclassical economics, 251 selfless actions, 23–24 self-rationing, in healthcare, 234–235 self-serving bias, 243 sequence indicates causation fallacy, 366–367 shocks See economic shocks short run fixed prices in, 305–307 in microeconomics, 122–123 responses to economic shock in, 301, 307–308 shortages in low-cost healthcare systems, 230–231 price controls for, 77–78 in stable equilibrium, 73–74 short-run aggregate supply curve (SRAS) fixed prices in short run, 305–306 full-employment output, 329–330 inflationary expectations, 348–349 long-run and short-run responses to shock, 308–309 negative demand shocks, 327 short-run shutdown condition, 123–124, 387 shrinking package sizes, 245 Singapore, healthcare in, 228, 232–236 Smith, Adam, 12, 24, 132, 193, 251, 375–376 social benefits of free markets See also socially optimal output level efficiency of free markets, 130–132 overview, 128 total surplus, 132–138 traits of properly functioning market, 129–130 social demand, 201 social marginal cost, 197 socialism, 53–54 socially optimal output level defined, 387 determining, 131–132 minimum output requirements, 167–168 monopolies as free from pressure of, 152 monopolies versus competitive firms, 163–164 negative externalities, 198 overview, 128 property rights, relation to, 194–195 society, self-interest as improving, 371 Solar City, 250 solar panels, myopic decision-making regarding, 250 Solow, Robert, 379–380 special interests, in government intervention, 48, 49 specialization, in comparative advantage concept, 274–276 SRAS See short-run aggregate supply curve stable equilibrium, 72–74, 320, 344 stagflation, 350 standard of deferred payment, money as, 283–284, 286 standard of living See living standards Standard Oil Company, 184 statistical discrimination, 215 status quo anchoring, 246–247 defined, 387 framing effects, 245–246 in prospect theory, 244 status quo bias, 247–248, 387 steering heuristic, 241 step function, 133 sticky prices See also Keynesian model defined, 387 overview, 297–298 reasons for, 309–312 role in effect of stimulus policies, 333 stimulus policies aggregate demand, increasing, 326–328 inflation, 285 limitations of, 328–336, 362 lowering interest rates, 346–348 price stickiness, 333–334 rational expectations, effect on, 333–336, 348–350 real wages, 331–332 trying to increase output beyond Y*, 329–330 stocks, assets as, 261 store of value, money as, 286 strategic situation, 175 See also cartels; oligopolies structural mismatches, in recovery process, 360, 361–362 subsidies for goods with positive externalities, 201–202 government intervention through, 48, 49 for monopolies, 167 for technologies that can’t be patented, 220 substitute goods, 100 sunk costs, irrational behavior related to, 30–31 supply and demand See also aggregate supply; money supply cost-benefit analysis based on, 130–132 defined, 387 demand, understanding, 58–65 elasticity, 69–70 excess supply, 72–73, 79–81 market equilibrium, 70–76 in Marshall's research, 377 in microeconomics, 12 overview, 57–58 perfectly elastic supply, 69, 70 perfectly inelastic supply, 69–70 price controls, 76–81 in properly functioning market, 129–130 supply, understanding, 65–70 supply curve, graphing, 65–69 when asset-price bubbles burst, 358 supply curve cost changes, 67–69 cost-benefit analysis based on, 130–132 defined, 387 graphing, 65–69 long-run aggregate, 302–304, 308–309, 327, 329 market, 104 in market equilibrium, 70–76 negative externalities, 196–198 overview, 57 positive externalities, 200–201 price and production cost, 66–67 price changes, 67 in properly functioning market, 129 shifts in, 67–69, 75–76, 140–141 short-run aggregate, 305–306, 308–309, 327, 329–330, 348–349 socially optimal output level, 131–132, 194–195 supply and demand, 12 taxes, effect on, 140–141 supply elasticity, 69–70 surplus See also consumer surplus; total surplus budget, 269 price controls for, 79–81 producer, 132–133, 136–138, 386 in stable equilibrium, 72–73 trade, 272 System decision-making, 242 System decision-making, 242 systematic errors brain modularity, 242 cognitive biases, 242–243 defined, 238, 387 offering more options in cases of, 239 T target level of inventories, 314–315 tastes, role in quantity demanded, 59 taxes deadweight losses from, 140–143 in disposable income calculation, 267 economic fallacies related to, 370 government budget, role in, 269 as government intervention, 48 inflation functioning as, 287 negative externalities, dealing with, 199–200 paying for increased government spending, 337 property, justification for, 70 public goods, providing through, 216 revenues from, as securing government borrowing, 339 TC See average total costs; total costs Technical Stuff icon, explained, technology competition as encouraging improvements, 46–47 in economic choice model, 25–26 government support of, 52–53 innovation as propelling economic growth, 379–380 new, as public good, 219–220 new, shifting PPF outward for, 41–42 Third World, effect of price controls on, 79 threats, resolving Prisoner’s Dilemma with, 180–183 time constraints, in economic choice model, 26 time inconsistency, 248–250, 387 Tip icon, explained, total consumption, calculating, 318 total costs (TC) See also average total costs defined, 107 long-run shutdown condition, 125 monopoly profits, 159–160 role in profit, 105, 118–120 total revenue (TR) long-run shutdown condition, 125 monopoly marginal revenues, 153–157 monopoly profits, 159–160 role in profit, 105, 118–120 short-run shutdown condition, 123–124 total surplus computing, 137, 138 consumer surplus of continuous good, 135–136 consumer surplus of discrete good, 133–134 deadweight losses, 138–143 defined, 387 importance of, 137–138 in Marshall's research, 377 overview, 132–133 producer surplus, 136–137 total utility diminishing marginal utility, 28 diminishing marginal utility, 28 marginal utility, relation to, 86–87 maximizing, when facing limited budget, 91–95 trade, asymmetric information as limiting, 206–207 See also international trade trade balance, 271 trade deficit, 272–273 trade surplus, 272 traditional economy, 50 Tragedy of the Commons, 202–204, 387 trusted third parties, buying information from, 209–210 trusts, 184 See also cartels U ultimatum game, 252–253, 387 unconventional monetary policy, 351–352 underproduction, 200–202 unemployment See also full-employment output economic fallacies related to, 365–366 frictional, 299–300 price adjustments in long run, 303 relation to inventory levels, 316 sticky prices problem, 310, 311 uninformed decision-making, 29–30 unintended consequences, 370 unit of account, money as, 286 unit of output, costs per, 108–110 United Kingdom, NHS in, 229–230, 232 United States Federal Reserve, 346–349, 351–352 foreign property ownership in, 273–274 healthcare in, 227, 228 housing bubble in, 361 medical research in, 235 price controls in, 78–81 upward price stickiness, lack of, 333 used car market, asymmetric information in, 205, 207–211 utility See also consumer behavior; diminishing marginal utility; marginal utility cardinal, 85 defined, 84, 387 marginal, 27–29 measuring happiness with, 23 ordinal, 85 overview, 12 total, 28, 86–87, 91–95 V value, money as store of, 286 variable costs average, 110–115 defined, 107, 387 role in production decisions, 108 short-run shutdown condition, 123–124 vehicle history reports, 209–210 W wages defined, 387 downward stickiness, 333 foreign, economic fallacies related to, 369–370 government stimulus policies, relation to, 329–332 as income stream, 261 inflation, impact on, 334 Marxist view of, 376–377 nominal, 331–332, 386 real, 331–332, 334, 387 sticky prices problem, 309–311 stimulus policies, effect on, 334–336 wait times, when rationing healthcare, 230 Walmart, 307 Wannamaker, John, 246 Warning icon, explained, warranties, in used car market, 210 wealth, defined, 387 wealth inequality, 47, 48 Weimar hyperinflation, Germany, 283, 284 welfare economics, 377 Wendy’s, 190 Y Y* See full-employment output; Keynesian model; recessions Z zero economic profits, 144, 146, 188–189 zero-coupon bonds, 344 WILEY END USER LICENSE AGREEMENT Go to www.wiley.com/go/eula to access Wiley’s ebook EULA ... Microeconomics and Macroeconomics to Separate Corners The main organizing principle I use in this book is to divide economics into its two broad pieces, macroeconomics and microeconomics: Microeconomics... microeconomics in Part II and macroeconomics in Part III But first, this section gives you an overview of microeconomics and macroeconomics Getting up close and personal: Microeconomics Microeconomics... Sheet, simply go to www.dummies.com and search for Economics For Dummies Cheat Sheet” for a handy reference guide that answers common questions about economics To gain access to the additional tests