Economics For Dummies, 3rd Edition

Understand the science of wealth and prosperity

• Find FREE quizzes for every chapter online
• Learn about good markets, bad monopolies, and inflation
• Decode budget deficits and trade gains

This book gives you everything you need to understand our rapidly evolving economy—as well as the economic fundamentals that never change. What's the best way to fight poverty? How can governments spur employment and wage growth? What can be done to protect endangered species and the environment? This book explains the answers to those questions—and many more—in plain English.

Inside...

• Get the fascinating scoop on behavioral economics
• Understand the model of supply and demand
• See how governments use monetary and fiscal policy to fight recessions
• Discover game theory and the secrets of cooperation

Sean Flynn, PhD, is an associate professor of economics at Scripps College in Claremont, California. A specialist in behavioral economics, Dr. Flynn has provided economic commentary for numerous news outlets, including NPR, ABC, FOX Business, and Forbes.

Introduction 1

About This Book 1

Foolish Assumptions 3

Icons Used in This Book 3

Beyond the Book 4

Where to Go from Here 4

Part 1: Economics: The Science of How People Deal with Scarcity 5

Chapter 1: What Economics Is and Why You Should Care 7

Considering a Little Economic History 8

Pondering just how nasty, brutish, and short life used to be 8

Identifying the institutions that raise living standards 9

Looking toward the future 10

Framing Economics as the Science of Scarcity 10

Sending Microeconomics and Macroeconomics to

Separate Corners 11

Getting up close and personal: Microeconomics 11

Zooming out: Macroeconomics and the big picture 14

Understanding How Economists Use Models and Graphs 16

Introducing your first model: The demand curve 17

Drawing your own demand curve 20

Chapter 2: Cookies or Ice Cream? Exploring Consumer Choices 21

Describing Human Behavior with a Choice Model 22

Pursuing Personal Happiness 23

Using utility to measure happiness 23

Taking “selfless” actions into account 23

Self-interest can promote the common good 24

You Can’t Have Everything: Examining Limitations 25

Resource constraints 25

Technology constraints 25

Time constraints 26

Opportunity cost: The unavoidable cost 26

Making Your Choice: Deciding What and How Much You Want 27

Exploring Violations and Limitations of the Economist’s Choice Model 29

Understanding uninformed decision-making 29

Making sense of irrationality 30

Chapter 3: Producing Stuff to Maximize Happiness 33

Figuring Out What’s Possible to Produce 34

Classifying resources 35

Clarifying human capital 35

Diminishing returns 36

Allocating resources 37

Graphing your production possibilities 38

Reaching new frontiers with better technology 41

Deciding What to Produce 42

Comparing market results and government interventions 43

Opting for a mixed economy 49

Promoting Technology and Innovation 52

Part 2: Microeconomics: The Science of Consumer and Firm Behavior 55

Chapter 4: Supply and Demand Made Easy 57

Deconstructing Demand 58

Prices and other stuff: Looking at what affects quantity demanded 59

Graphing the demand curve 60

Opportunity costs: Setting the slope of the demand curve 62

Elasticity: Looking at extreme demand cases 63

Sorting Out Supply 65

Graphing the supply curve 65

Using elasticity to understand extreme supply cases 69

Bringing Supply and Demand Together 70

Market equilibrium: Seeking a balance 71

Demonstrating the stability of the market equilibrium 72

Adjusting to new market equilibriums when supply or demand changes 74

Price Controls: Keeping Prices Away from Market Equilibrium 76

Setting upper limits with price ceilings 77

Propping up prices with price floors 79

Chapter 5: Introducing Homo Economicus, the Utility-Maximizing Consumer 83

Choosing by Ranking 84

Getting Less from More: Diminishing Marginal Utility 85

Choosing Among Many Options When Facing a Limited Budget 88

Trying to buy as much (marginal) utility as you can 88

Purchasing the best combination of two goods to maximize total utility 91

Aiming for equal marginal utility per dollar 93

Deriving Demand Curves from Diminishing Marginal Utility 95

Seeing how price changes affect quantities demanded 96

Graphing the price and quantity changes to form a demand curve 97

Chapter 6: The Core of Capitalism: The Profit- Maximizing Firm 101

A Firm’s Goal: Maximizing Profits 102

Facing Competition 103

Listing the requirements for perfect competition 103

Taking prices but setting quantities 104

Distinguishing between accounting profits and economic profits 106

Analyzing a Firm’s Cost Structure 107

Focusing on costs per unit of output 108

Examining average variable costs 110

Watching average fixed costs fall 111

Tracking the movement of average total costs 111

Focusing on marginal costs 112

Noticing where marginal cost equals average cost 113

Comparing Marginal Revenues with Marginal Costs 115

Finding where marginal revenue equals marginal cost 116

Visualizing profits 118

Visualizing losses 120

Pulling the Plug: When Producing Nothing Is Your Best Bet 121

Distinguishing between the short run and the long run in microeconomics 122

The short-run shutdown condition: Variable costs exceed total revenues 123

The long-run shutdown condition: Total costs exceed total revenues 125

Chapter 7: Why Economists Love Free Markets and Competition 127

Ensuring That Benefits Exceed Costs: Competitive Free Markets 128

Examining the traits of a properly functioning market 129

Analyzing the efficiency of free markets 130

Measuring everyone’s gains with total surplus 132

When Free Markets Lose Their Freedom: Dealing with Deadweight Losses 138

Coming up short: The deadweight loss from a price ceiling 139

Death and taxes: Finding the deadweight loss of a tax 140

Hallmarks of Perfect Competition: Zero Profits and Lowest Possible Costs 143

Understanding the causes and consequences of perfect competition 144

Peering into the process of perfect competition 145

Graphing how profits guide firm entry and exit 146

Chapter 8: Monopolies: Bad Behavior without Competition 151

Examining Profit-Maximizing Monopolies 152

Zeroing in on the problems monopolies cause 152

Identifying the source of the problem: Decreasing marginal revenues 153

Choosing an output level to maximize profits 158

Comparing Monopolies with Competitive Firms 161

Looking at output and price levels 162

Deadweight losses: Quantifying the harm caused by monopolies 163

Losing efficiency 164

Considering Good Monopolies 165

Encouraging innovation and investment with patents 165

Reducing annoyingly redundant competitors 165

Keeping costs low with natural monopolies 166

Regulating Monopolies 167

Subsidizing a monopoly to increase output 167

Imposing minimum output requirements 167

Regulating monopoly pricing 168

Breaking up a monopoly into several competing firms 171

Chapter 9: Oligopoly and Monopolistic Competition: Middle Grounds 173

Oligopolies: Looking at the Allure of Joining Forces 174

Sharing power over prices 174

Cartel behavior: Trying to imitate monopolists 175

Considering the criteria for coordinating a cartel 176

Understanding Incentives to Cheat the Cartel 176

Fleshing out the Prisoner’s Dilemma 177

Enforcing the agreement: Resolving the dilemma with credible threats 180

Seeing that OPEC is trapped in a Prisoner’s Dilemma 181

Using an enforcer to help OPEC members stick to quotas 182

Regulating Oligopolies 183

Breaking up dominant firms 184

Attempting to apply antitrust laws 184

Studying a Hybrid: Monopolistic Competition 185

Benefiting from product differentiation 185

Facing profit limits 186

Part 3: Applying the Theories of Microeconomics 191

Chapter 10: Property Rights and Wrongs 193

Allowing Markets to Reach Socially Optimal Outcomes 194

Examining Externalities: The Costs and Benefits Others Feel from Your Actions 195

Noting the effects of negative externalities 196

Accepting positive amounts of negative externalities 198

Dealing with negative externalities 199

Calculating the consequences of positive externalities 200

Subsidizing things that provide positive externalities 201

Tragedy of the Commons: Overexploiting Commonly Owned Resources 202

Overgrazing on a commonly owned field 202

Extinctions and poor property rights 203

Avoiding the tragedy 204

Chapter 11: Asymmetric Information and Public Goods 205

Facing Up to Asymmetric Information 206

Realizing that asymmetric information limits trade 206

Souring on the lemons problem: The used car market 207

Issuing insurance when you can’t tell individuals apart 211

Providing Public Goods 215

Taxing to provide public goods 216

Enlisting philanthropy to provide public goods 216

Providing a public good by selling a related private good 217

Ranking new technology as a public good 219

Chapter 12: Health Economics and Healthcare Finance 221

Defining Health Economics and Healthcare Finance 222

Noting the Limits of Health Insurance 222

Adverse selection: Looking at who buys insurance 223

Combating adverse selection 224

Comparing Healthcare Internationally 227

Inflated Demand: Suffering from “Free” and Reduced-Cost Healthcare 228

Diverting funds to lower-value uses 228

Rationing healthcare 229

Facing shortages and higher prices 230

Combatting inefficiency with bureaucracy 231

Investigating Singapore’s Secrets 233

Exploring cost-saving features 233

Weighing costs and benefits of medical procedures 234

Supporting cost-cutting innovations 234

Trying to copy Singapore’s success 235

Chapter 13: Behavioral Economics: Investigating Irrationality 237

Explaining the Need for Behavioral Economics 238

Complementing Neo-Classical Economics with Behavioral Economics 239

Examining our Amazing, Efficient, and Error-Prone Brains 240

Deciphering heuristics 240

Deconstructing brain modularity 242

Cogitating on cognitive biases 242

Surveying Prospect Theory 244

Shrinking packages and loss aversion 245

Framing effects and advertising 245

Anchoring and credit card bills 246

Examining the endowment effect 247

Stipulating status quo bias 247

Countering Myopia and Time Inconsistency 248

Focusing on myopia 249

Tattling on time inconsistency 249

Beating self-control problems with precommitments 250

Gauging Fairness and Self-Interest 251

Defining fairness 251

Examining the experimental evidence for fairness 251

Digesting the experimental evidence on fairness 253

Part 4: Macroeconomics: The Science of Economic Growth and Stability 255

Chapter 14: How Economists Measure the Macroeconomy 257

Getting a Grip on the GDP (and Its Parts) 258

Leaving some things out of GDP 259

Tallying up what counts in GDP 259

Accounting for streams of incomes, and assets 260

Following the funds, around and around 262

Counting stuff when it’s made, not when it’s sold 263

Watching GDP rise with the good, the bad, and the ugly 264

Diving In to the GDP Equation 265

“C” is for consumption (that’s good enough for me!) 266

“I” is for investment in capital stock 268

The big “G” (government, that is) 269

Measuring foreign trade with “NX” 270

Making Sense of International Trade and Its Effect on the Economy 271

“Trade deficit” ain’t fightin’ words 272

Considering assets — not just cash 273

Wielding a comparative advantage 274

Chapter 15: Inflation Frustration: Why More Money Isn’t Always Good 277

Buying an Inflation: When Too Much Money Is a Bad Thing 279

Balancing money supply and demand 279

Giving in to the inflation temptation 282

Tallying up the effects of inflation 286

Measuring Inflation 287

Creating your very own market basket 288

Calculating the inflation rate 289

Setting up a price index 290

Determining the real standard of living with the price index 291

Identifying price index problems 292

Pricing the Future: Nominal and Real Interest Rates 293

Using the Fisher equation 294

Realizing that predictions aren’t perfect 294

Chapter 16: Understanding Why Recessions Happen 297

Introducing the Business Cycle 298

Striving for Full-Employment Output 299

Returning to Y*: The Natural Result of Price Adjustments 300

Responding to Economic Shocks: Short-

Run and Long-Run Effects 301

Defining some critical terms 301

The tao of P: Looking at price adjustments in the long run 303

A shock to the system: Adjusting to a shift in aggregate demand 304

Dealing with fixed prices in the short run 305

Putting together the long and short of it 308

Heading toward Recession: Getting Stuck with Sticky Prices 309

Cutting wages or cutting workers 310

Adding up the costs of wages and profits 310

Returning to Y* with and without government intervention 311

Achieving Equilibrium with Sticky Prices: The Keynesian Model 312

Adjusting inventories instead of prices 314

Boosting GDP in the Keynesian model 322

Chapter 17: Fighting Recessions with Monetary and Fiscal Policy 325

Stimulating Demand to End Recessions 326

Aiming for full-employment output 326

Back to work: Shifting the AD curve right 328

Generating Inflation: The Risk of Too Much Stimulation 328

Trying to increase output beyond Y* 329

Tracing the movement of real wages 331

Failing to stimulate: What happens when a stimulus is expected 333

Figuring Out Fiscal Policy 336

Increasing government spending to help end recessions 337

Dealing with deficits 338

Dissecting Monetary Policy 340

Identifying the benefits of fiat money over the gold standard 341

Realizing you can have too much money! 342

Getting the basics about bonds 344

Seeing the link between bond prices and interest rates 345

Changing the money supply to change interest rates 346

Lowering interest rates to stimulate the economy 346

Understanding how rational expectations can limit monetary policy 348

Examining quantitative easing and the Great Recession 350

Chapter 18: Grasping Origins and Effects of Financial Crises 353

Understanding How Debt-Driven Bubbles Develop 354

Embracing borrowing in a booming economy 355

Offering larger loans as collateral values rise 355

Relaxing lending standards 356

Borrowing more in hopes of profit 356

Watching the process gain momentum 357

Seeing the Bubble Burst 357

Deleveraging: Trying to ditch debt as prices fall 358

Comprehending bank collapses caused by bursting bubbles 358

Leading into a recession 359

After the Crisis: Looking at Recovery 360

Enduring a broken banking system 360

Struggling with structural mismatches 361

Noting the limits of government policy 362

Part 5: The Part of Tens 363

Chapter 19: Ten Seductive Economic Fallacies 365

The Lump of Labor 365

The World Is Facing Overpopulation 366

Sequence Indicates Causation 366

Protectionism Is the Best Solution to Foreign Competition 367

The Fallacy of Composition 368

If It’s Worth Doing, Do It 100 Percent 368

Free Markets Are Dangerously Unstable 369

Low Foreign Wages Mean That Rich Countries Can’t Compete 369

Tax Rates Don’t Affect Work Effort 370

Forgetting Unintended Consequences 370

Chapter 20: Ten Economic Ideas to Hold Dear 371

Self-Interest Can Improve Society 371

Free Markets Require Regulation 372

Economic Growth Relies on Innovation 372

Freedom and Democracy Make Us Richer 372

Education Raises Living Standards 372

Intellectual Property Boosts Innovation 373

Weak Property Rights Cause All Environmental Problems 373

International Trade Is a Good Thing 373

Government Can Provide Public Goods 374

Preventing Inflation Is Easy 374

Chapter 21: Ten (Or So) Famous Economists 375

Adam Smith 375

David Ricardo 376

Karl Marx 376

Alfred Marshall 377

John Maynard Keynes 378

Kenneth Arrow and Gerard Debreu 378

Milton Friedman 378

Paul Samuelson 379

Robert Solow 379

Gary Becker 380

Robert Lucas 380

Appendix: Glossary 383

Index 389

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