- Elasticity = % change in quantity ÷ % change in price (or income, or another good's price).
- Above 1 is elastic, below 1 inelastic.
- The midpoint method gives the same answer whichever way the price moves.
- Substitutes, luxuries, narrow markets and long horizons make demand more elastic.
- elasticity
- a measure of how much quantity responds to a change in one of its determinants
- price elasticity of demand
- % change in quantity demanded ÷ % change in price
- elastic
- elasticity greater than 1
- inelastic
- elasticity less than 1
- midpoint method
- calculating a percentage change by dividing by the average of the start and end values
- income elasticity of demand
- % change in quantity demanded ÷ % change in income
- cross-price elasticity of demand
- % change in quantity of one good ÷ % change in the price of another
- price elasticity of supply
- % change in quantity supplied ÷ % change in price
Watch out: Confusing elasticity with slope. The slope measures the change in units; elasticity measures it in percentages. Along a straight-line demand curve the slope is the same everywhere, but elasticity is not: demand is more elastic where the price is high and the quantity low.
- Total revenue = price × quantity.
- Inelastic demand: price and revenue move together. Elastic demand: they move in opposite directions.
- A better harvest can lower farm revenue, because food demand is inelastic.
- OPEC's power faded because supply and demand are more elastic in the long run; interdiction can raise drug spending when demand is inelastic.
- total revenue
- the amount buyers pay and sellers receive: price × quantity sold
- interdiction
- efforts to stop goods, here illegal drugs, entering a country
- short run
- here, a period too short for buyers and sellers to fully adjust
- long run
- a period long enough for buyers and sellers to adjust, so elasticities are usually larger
Watch out: Assuming that a higher price always means more revenue (or that selling more always means more revenue). It depends on elasticity: with elastic demand, a price rise reduces revenue; with inelastic demand, a bigger harvest can reduce it.
- Consumer surplus = willingness to pay − price; producer surplus = price − cost.
- On a graph: consumer surplus under demand and above price; producer surplus above supply and below price.
- A lower price raises consumer surplus; a higher one raises producer surplus.
- Cost includes the value of the seller's time.
- welfare economics
- the study of how the way resources are shared out affects people's well-being
- willingness to pay
- the most a buyer will pay for a good
- consumer surplus
- willingness to pay minus the amount actually paid
- cost
- the value of all a seller gives up to produce a good, including their time
- producer surplus
- the amount a seller is paid minus the seller's cost
Watch out: Treating surplus as profit or as money changing hands. Consumer surplus is a measure of benefit as the buyer sees it, never paid to anyone. And a seller's cost includes the value of their time, not just what they spend.
- Total surplus = value to buyers − cost to sellers.
- Free markets give goods to those who value them most, production to those with lowest costs, and the surplus-maximising quantity.
- So a competitive equilibrium is efficient: Smith's invisible hand.
- Limits: market power, externalities, and the separate question of equality.
- total surplus
- consumer surplus plus producer surplus: value to buyers minus cost to sellers
- efficiency
- the property of an allocation that maximises total surplus
- equality
- the property of distributing economic well-being evenly
- benevolent social planner
- Mankiw's imaginary all-knowing, well-meaning decision maker, used to judge market outcomes
- market power
- the ability of a single buyer or seller, or a small group, to influence prices
- externality
- an effect of a market on people who are not buyers or sellers in it
- laissez faire
- the policy of leaving markets alone
Watch out: Reading "efficient" as "fair" or "good in every way". An efficient outcome makes the pie as big as possible; it doesn't say whether the slices are fair, and it assumes there is no market power and no external effect.
- Ceilings are maximums, floors minimums; they matter only when binding.
- Binding ceilings cause shortages and rationing; binding floors cause surpluses.
- Examples: petrol queues, rent control, the minimum wage.
- Economists usually prefer subsidies, which have costs of their own.
- price ceiling
- a legal maximum on the price at which a good can be sold
- price floor
- a legal minimum on the price at which a good can be sold
- binding
- set so that it changes the market outcome (a ceiling below equilibrium, a floor above it)
- shortage
- quantity demanded greater than quantity supplied
- surplus
- quantity supplied greater than quantity demanded
- minimum wage
- a price floor on wages
Watch out: Thinking a ceiling always lowers prices and a floor always raises them. A ceiling above the equilibrium, or a floor below it, does nothing. And when they do bind, the quantity traded falls in both cases.
- A tax drives a wedge between what buyers pay and what sellers receive.
- Buyers and sellers share the burden, whichever side the law taxes.
- The less elastic side bears more.
- Mankiw: workers bear most of the payroll tax.
- tax incidence
- how the burden of a tax is distributed among the people in a market
- tax wedge
- the gap a tax creates between the price buyers pay and the price sellers receive
- payroll tax
- a tax on the wages firms pay their workers
Watch out: Believing that the side named in the law pays the tax. Whether the tax is collected from buyers or sellers, the prices adjust until both share it, in proportions set by the elasticities.
- A tax lowers consumer and producer surplus by more than the revenue it raises.
- The difference, the deadweight loss, comes from trades that no longer happen.
- More elastic supply or demand means a larger deadweight loss.
- The size of the labour-tax loss depends on how elastic labour supply is.
- deadweight loss
- the fall in total surplus that results from a market distortion such as a tax
- tax revenue
- tax per unit × quantity sold
- tax wedge
- the gap between the price buyers pay and the price sellers receive
- gains from trade
- the surplus buyers and sellers get from trades that take place
- marginal tax rate
- the tax on the last unit of income
Watch out: Thinking a tax only moves money from buyers and sellers to the government. That transfer is the revenue. The deadweight loss is extra: it comes from trades that no longer happen, so nobody, including the government, receives it.
- Deadweight loss grows with the square of the tax: double it, ×4; triple it, ×9.
- Revenue rises then falls as the tax grows: the Laffer curve.
- Laffer and Reagan's supply-side argument is still debated; Mankiw describes most economists as sceptical.
- Behaviour, not just the rate, decides a tax's cost and revenue.
- Laffer curve
- the relationship between the size of a tax and the revenue it raises: first rising, then falling
- supply-side economics
- the view that tax cuts encourage people to work and produce more
- deadweight loss
- the fall in total surplus caused by a tax
Watch out: Assuming a higher tax rate always raises more revenue. Past some point the shrinking market outweighs the higher rate. But the opposite mistake is common too: as Mankiw reports, many economists hold that an overall tax cut normally lowers revenue, and that the Laffer effect applies only where rates are very high.
- Absolute advantage: fewer inputs. Comparative advantage: lower opportunity cost.
- Opportunity cost comes from the ratio of the times (or inputs) needed.
- One producer can have the absolute advantage in both goods, but not the comparative advantage in both.
- So, whenever costs differ, everyone has a comparative advantage in something.
- absolute advantage
- the ability to produce a good using fewer inputs than another producer
- comparative advantage
- the ability to produce a good at a lower opportunity cost than another producer
- opportunity cost
- whatever must be given up to obtain something
- specialisation
- concentrating on the goods in which one has a comparative advantage
Watch out: Thinking that someone better at everything has nothing to gain from trade. Advantage in trade comes from opportunity cost, not speed. Because each person's cost of one good is the inverse of their cost of the other, whenever their costs differ each has a comparative advantage in something.
- Specialising by comparative advantage raises total output; trade lets both consume more.
- Both sides gain only if the price lies between their opportunity costs.
- The same logic applies to people (Brady and the lawn) and to countries.
- Smith and Ricardo laid the foundations; economists' case for free trade still rests largely on it.
- gains from trade
- the extra output and consumption made possible by specialising and trading
- imports
- goods produced abroad and sold at home
- exports
- goods produced at home and sold abroad
- terms of trade
- here, the price of one good in units of the other agreed in a trade
Watch out: Thinking trade is a contest in which one side's gain is the other's loss. Specialising by comparative advantage increases total output, so both sides can gain. How the gain is split depends on the price, which must lie between the two opportunity costs.
- Compare the world price with the domestic price to see whether a country exports or imports.
- Exporting: producers gain, consumers lose. Importing: consumers gain, producers lose.
- Either way, total surplus rises: gains exceed losses.
- Extra benefits: variety, economies of scale, competition, ideas.
- world price
- the price of a good in world markets
- exports
- goods produced at home and sold abroad
- imports
- goods produced abroad and sold at home
- economies of scale
- lower costs per unit from producing in large quantities
- small economy
- one that takes the world price as given
Watch out: Saying "trade benefits everyone". It doesn't: in an importing industry, domestic producers and their workers lose. The claim is that total gains exceed total losses, so the country as a whole is better off.
- A tariff raises the domestic price: buyers lose, producers and the government gain, and there is a deadweight loss.
- Quotas work like tariffs, except the extra money goes to licence holders.
- Arguments for restrictions (jobs, security, infant industries, unfair competition, bargaining) all have economists' replies.
- Multilateral agreements such as GATT and the WTO have cut tariffs widely.
- tariff
- a tax on goods produced abroad and sold at home
- import quota
- a limit on the quantity of a good that can be imported
- deadweight loss
- the fall in total surplus caused by a distortion such as a tariff
- infant-industry argument
- the claim that new industries need temporary protection to grow
- multilateral approach
- cutting trade barriers through agreements among many countries
Watch out: Treating a quota as a cheaper way to protect an industry than a tariff. It has the same costs to buyers and the same deadweight loss; the only difference is that the extra money goes to licence holders instead of the government. Mankiw notes this makes quotas granted to foreign firms worse for the home country than an equivalent tariff.
- Living standards depend on productivity: output per hour of work.
- Four determinants: physical capital, human capital, natural resources, technological knowledge.
- Y = A F(L, K, H, N); with constant returns, output per worker depends on inputs per worker.
- Small growth differences compound into large income differences.
- productivity
- the quantity of goods and services produced from each unit of labour input
- physical capital
- the stock of equipment and structures used to produce goods and services
- human capital
- the knowledge and skills workers acquire through education, training and experience
- natural resources
- inputs provided by nature, such as land, rivers and mineral deposits
- technological knowledge
- society's understanding of the best ways to produce goods and services
- production function
- the relationship between the quantity of inputs and the quantity of output
- constant returns to scale
- doubling all inputs doubles output
Watch out: Thinking a country's income depends mainly on how much natural resources it has. Some countries with few resources, such as Japan, are rich because of their capital, skills and technology; they import the resources they need.
- Saving and investment build capital, but diminishing returns make the growth boost temporary.
- Poor countries can grow faster: the catch-up effect.
- Policies: foreign investment, education, health, property rights and stability, free trade, research.
- Population growth can dilute capital or spur ideas; Malthus's gloomy forecast has not come true so far.
- diminishing returns
- the benefit from an extra unit of an input falls as the quantity of the input rises
- catch-up effect
- countries that start poor tend to grow faster than countries that start rich
- foreign direct investment
- capital investment owned and operated by a foreign entity
- foreign portfolio investment
- investment financed with foreign money but operated by domestic residents
- brain drain
- the emigration of many of a country's most highly educated workers
- public good
- here, knowledge that, once discovered, others can use too
- property rights
- the ability of people to control and use what they own
Watch out: Thinking a higher saving rate raises growth forever. Because of diminishing returns, it raises growth for a while and leaves the economy at a higher level of income; long-run growth then depends on technological progress.
- Frictional unemployment: the time it takes to match workers and jobs; unemployment insurance can lengthen it.
- Structural unemployment: wages held above equilibrium by minimum wages, unions or efficiency wages.
- Efficiency wages: health, turnover, quality and effort; Ford's 5-dollar day.
- Economists disagree on whether unions help or harm the economy.
- frictional unemployment
- unemployment from the time workers take to find jobs that suit them
- structural unemployment
- unemployment because there are fewer jobs than workers at the going wage
- job search
- the process of matching workers with appropriate jobs
- unemployment insurance
- a government programme that partly protects workers' incomes when they lose their jobs
- union
- a worker association that bargains with employers over wages, benefits and working conditions
- collective bargaining
- the process by which unions and firms agree the terms of employment
- strike
- the organised withdrawal of labour by a union
- efficiency wages
- above-equilibrium wages paid by firms to raise worker productivity
Watch out: Treating all unemployment as a sign that something is broken. Some frictional unemployment comes from a healthy, changing economy, as people move between jobs and industries. Structural unemployment, by contrast, means there aren't enough jobs at the going wage.