Economics & Statistics Prof

Economics & Statistics Prof. Dr. Peter Schmidt : (0421) 5905-4691 [email protected] SoSe (Summer Term) 2019 www.schmidt-bremen.de - MBA Economics

Economics as a Business Environment Programme: Master of Business Administration

. Contents . References . Material:

• 10 Economic Principles (Mankiw) ...... 3 • Barack Obama; from: “The Audacity of Hope” ...... 9 • From GNP/GDP to National Income (Begg) ...... 13 • Domestic Product and National Income ...... 14

• GERMAN ECONOMY 2018 ...... 15

• Monitoring economic performance, quality of life and sustainability, Joint Report as requested by the Franco-German Ministerial Council ...... 18

• Joint Economic Forecast Spring 2019 + Key Forecast Figures ...... (22) will be delivered after its publication in April (http://www.cesifo-group.de/ifoHome/facts/Forecasts/Gemeinschaftsdiagnose.html)

• Economics for Business (Begg and Ward) ...... ( → book) (relevant chapters see schedule on webpage)

Further information: www.schmidt-bremen.de - MBA Economics

P. Schmidt, Hochschule Bremen page 1 Economics as a Business Environment (MBA)

References

Basic Literature:

Begg, D. and Ward, D: “Economics for Business”

Mankiw, G: “Principles of Economics

Further Literature: Baye, M: “Managerial Economics and Business Strategy” Begg, D, Fischer, S, Dornbush, R.: “Economics”

Cleaver, T.: Understanding the World Economy, Samuelson, P and Nordhaus, W: “Economics” Sloman, J; Wride, A, and Garratt, D: “Economics” Hill, C.W.L.: “Global Business Today”

Current issues:

Franco-German Ministerial Council, “Monitoring economic performance, quality of life and sustainability”

Friedman, T.L.: “The World is Flat”, Meadows, D, Randers, J, Meadows, D: “Limits to Growth - The 30-Year Update” Sachs, J: “Common Wealth - Economics for a Crowded Planet”

Stiglitz, J: „Globalization and its discontents” Stiglitz, J.E. and Charlton, A.: Fair Trade For All

P. Schmidt, Hochschule Bremen page 2 4 PART 1 INTRODUCTION

economics Economics is the study of how society manages its scarce resources. In most the study of how society societies, resources are allocated not by an all-powerful dictator but through the manages its scarce combined actions of millions of households and firms. Economists therefore resources study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people interact with one another. For instance, they examine how the multitude of buyers and sellers of a good together determine the price at which the good is sold and the quantity that is sold. Finally, economists analyze forces and trends that affect the economy as a whole, including the growth in average income, the fraction of the population that cannot find work, and the rate at which prices are rising. Although the study of economics has many facets, the field is unified by several central ideas. In this chapter, we look at Ten Principles of Economics. Don’t worry if you don’t understand them all at first or if you don’t find them com- pletely convincing. In later chapters, we will explore these ideas more fully. The ten principles are introduced here to give you an overview of what economics is all about. You can think of this chapter as a “preview of coming attractions.”

1 HOW PEOPLE MAKE DECISIONS There is no mystery to what an economy is. Whether we are talking about the economy of Los Angeles, of the United States, or of the whole world, an economy is just a group of people interacting with one another as they go about their lives. Because the behavior of an economy reflects the behavior of the individu- Ten Principles of Economics als who make up the economy, we start our study of economics with four principles of individual decision making.

Principle 1: People Face Trade-offs The first lesson about making decisions is summarized in the adage “There is no The word economy comes from the Greek word oikonomos, which means “one such thing as a free lunch.” To get one thing that we like, we usually have to who manages a household.” At first, this origin might seem peculiar. But in fact, give up another thing that we like. Making decisions requires trading off one households and economies have much in common. goal against another. A household faces many decisions. It must decide which members of the Consider a student who must decide how to allocate her most valuable household do which tasks and what each member gets in return: Who cooks resource—her time. She can spend all of her time studying economics; she can dinner? Who does the laundry? Who gets the extra dessert at dinner? Who gets spend all of her time studying psychology; or she can divide her time between to choose what TV show to watch? In short, the household must allocate its the two fields. For every hour she studies one subject, she gives up an hour she scarce resources among its various members, taking into account each member’s could have used studying the other. And for every hour she spends studying, abilities, efforts, and desires. she gives up an hour that she could have spent napping, bike riding, watching Like a household, a society faces many decisions. A society must decide what TV, or working at her part-time job for some extra spending money. jobs will be done and who will do them. It needs some people to grow food, Or consider parents deciding how to spend their family income. They can buy other people to make clothing, and still others to design computer software. food, clothing, or a family vacation. Or they can save some of the family income Once society has allocated people (as well as land, buildings, and machines) to for retirement or the children’s college education. When they choose to spend an various jobs, it must also allocate the output of goods and services that they pro- extra dollar on one of these goods, they have one less dollar to spend on some duce. It must decide who will eat caviar and who will eat potatoes. It must other good. decide who will drive a Ferrari and who will take the bus. When people are grouped into societies, they face different kinds of trade- The management of society’s resources is important because resources are offs. The classic trade-off is between “guns and butter.” The more we spend on scarce. Scarcity means that society has limited resources and therefore cannot scarcity national defense (guns) to protect our shores from foreign aggressors, the less produce all the goods and services people wish to have. Just as a household can- the limited nature of we can spend on consumer goods (butter) to raise our standard of living at not give every member everything he or she wants, a society cannot give every society’s resources home. Also important in modern society is the trade-off between a clean envi- individual the highest standard of living to which he or she might aspire.

3 1 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 5 6 PART 1 INTRODUCTION ronment and a high level of income. Laws that require firms to reduce pollution The second problem with this calculation of costs is that it ignores the largest raise the cost of producing goods and services. Because of the higher costs, these cost of going to college—your time. When you spend a year listening to lectures, firms end up earning smaller profits, paying lower wages, charging higher reading textbooks, and writing papers, you cannot spend that time working at a prices, or some combination of these three. Thus, while pollution regulations job. For most students, the wages given up to attend school are the largest single give us the benefit of a cleaner environment and the improved health that comes cost of their education. with it, they have the cost of reducing the incomes of the firms’ owners, work- opportunity cost The opportunity cost of an item is what you give up to get that item. When ers, and customers. whatever must be given making any decision, such as whether to attend college, decision makers should Another trade-off society faces is between efficiency and equity. Efficiency efficiency up to obtain some item be aware of the opportunity costs that accompany each possible action. In fact, means that society is getting the maximum benefits from its scarce resources. the property of society they usually are. College athletes who can earn millions if they drop out of Equity means that those benefits are distributed fairly among society’s mem- getting the most it can school and play professional sports are well aware that their opportunity cost of bers. In other words, efficiency refers to the size of the economic pie, and equity from its scarce resources college is very high. It is not surprising that they often decide that the benefit is refers to how the pie is divided. Often, when government policies are designed, not worth the cost. equity these two goals conflict. the property of distribut- Consider, for instance, policies aimed at achieving a more equal distribution ing economic prosperity Principle 3: Rational People Think at the Margin of economic well-being. Some of these policies, such as the welfare system or fairly among the mem- unemployment insurance, try to help the members of society who are most in bers of society rational people Economists normally assume that people are rational. Rational people systemat- need. Others, such as the individual income tax, ask the financially successful to people who systemati- ically and purposefully do the best they can to achieve their objectives, given the contribute more than others to support the government. Although these policies cally and purposefully opportunities they have. As you study economics, you will encounter firms that have the benefit of achieving greater equity, they have a cost in terms of reduced do the best they can to decide how many workers to hire and how much of their product to manufac- efficiency. When the government redistributes income from the rich to the poor, achieve their objectives ture and sell to maximize profits. You will encounter consumers who buy a bun- it reduces the reward for working hard; as a result, people work less and pro- dle of goods and services to achieve the highest possible level of satisfaction, duce fewer goods and services. In other words, when the government tries to subject to their incomes and the prices of those goods and services. cut the economic pie into more equal slices, the pie gets smaller. Rational people know that decisions in life are rarely black and white but Recognizing that people face trade-offs does not by itself tell us what deci- usually involve shades of gray. At dinnertime, the decision you face is not sions they will or should make. A student should not abandon the study of psy- between fasting or eating like a pig but whether to take that extra spoonful of chology just because doing so would increase the time available for the study of mashed potatoes. When exams roll around, your decision is not between blow- economics. Society should not stop protecting the environment just because ing them off or studying 24 hours a day but whether to spend an extra hour environmental regulations reduce our material standard of living. The poor marginal changes reviewing your notes instead of watching TV. Economists use the term marginal should not be ignored just because helping them distorts work incentives. small incremental changes to describe small incremental adjustments to an existing plan of action. Nonetheless, acknowledging life’s trade-offs is important because people are adjustments to a plan Keep in mind that margin means “edge,” so marginal changes are adjustments likely to make good decisions only if they understand the options that they have of action around the edges of what you are doing. Rational people often make decisions available. by comparing marginal benefits and marginal costs. For example, consider an airline deciding how much to charge passengers who Principle 2: The Cost of Something fly standby. Suppose that flying a 200-seat plane across the United States costs the Is What You Give Up to Get It airline $100,000. In this case, the average cost of each seat is $100,000/200, which is $500. One might be tempted to conclude that the airline should never sell a Because people face trade-offs, making decisions requires comparing the costs ticket for less than $500. In fact, however, the airline can raise its profits by think- and benefits of alternative courses of action. In many cases, however, the cost of ing at the margin. Imagine that a plane is about to take off with ten empty seats, some action is not as obvious as it might first appear. and a standby passenger waiting at the gate will pay $300 for a seat. Should the Consider, for example, the decision to go to college. The benefit is intellectual airline sell the ticket? Of course it should. If the plane has empty seats, the cost of enrichment and a lifetime of better job opportunities. But what is the cost? To adding one more passenger is minuscule. Although the average cost of flying a answer this question, you might be tempted to add up the money you spend on passenger is $500, the marginal cost is merely the cost of the bag of peanuts and tuition, books, room, and board. Yet this total does not truly represent what you can of soda that the extra passenger will consume. As long as the standby passen- give up to spend a year in college. ger pays more than the marginal cost, selling the ticket is profitable. The first problem with this answer is that it includes some things that are not Marginal decision making can help explain some otherwise puzzling eco- really costs of going to college. Even if you quit school, you need a place to sleep nomic phenomena. Here is a classic question: Why is water so cheap, while dia- and food to eat. Room and board are costs of going to college only to the extent monds are so expensive? Humans need water to survive, while diamonds are that they are more expensive at college than elsewhere. Indeed, the cost of room unnecessary; but for some reason, people are willing to pay much more for a and board at your school might be less than the rent and food expenses that you diamond than for a cup of water. The reason is that a person’s willingness to pay would pay living on your own. In this case, the savings on room and board are a for any good is based on the marginal benefit that an extra unit of the good benefit of going to college. would yield. The marginal benefit, in turn, depends on how many units a person already has. Although water is essential, the marginal benefit of an extra cup

2 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 7 8 PART 1 INTRODUCTION is small because water is plentiful. By contrast, no one needs diamonds to sur- death. In other words, seat belts reduce the benefits of slow and careful driving. vive, but because diamonds are so rare, people consider the marginal benefit of People respond to seat belts as they would to an improvement in road condi- an extra diamond to be large. tions—by driving faster and less carefully. The end result of a seat belt law, A rational decision maker takes an action if and only if the marginal benefit of therefore, is a larger number of accidents. The decline in safe driving has a clear, the action exceeds the marginal cost. This principle can explain why airlines are adverse impact on pedestrians, who are more likely to find themselves in an willing to sell a ticket below average cost and why people are willing to pay accident but (unlike the drivers) don’t have the benefit of added protection. more for diamonds than for water. It can take some time to get used to the logic At first, this discussion of incentives and seat belts might seem like idle spec- of marginal thinking, but the study of economics will give you ample opportu- ulation. Yet in a classic 1975 study, economist Sam Peltzman showed that auto- nity to practice. safety laws have had many of these effects. According to Peltzman’s evidence, these laws produce both fewer deaths per accident and more accidents. He con- Principle 4: People Respond to Incentives cluded that the net result is little change in the number of driver deaths and an increase in the number of pedestrian deaths. An incentive is something (such as the prospect of a punishment or a reward) incentive Peltzman’s analysis of auto safety is an offbeat example of the general princi- that induces a person to act. Because rational people make decisions by compar- something that induces ple that people respond to incentives. When analyzing any policy, we must con- ing costs and benefits, they respond to incentives. You will see that incentives a person to act sider not only the direct effects but also the indirect and sometimes less obvious play a central role in the study of economics. One economist went so far as to effects that work through incentives. If the policy changes incentives, it will suggest that the entire field could be simply summarized: “People respond to cause people to alter their behavior. incentives. The rest is commentary.” Incentives are crucial to analyzing how markets work. For example, when the price of an apple rises, people decide to eat more pears and fewer apples List and briefly explain the four principles of individual decision because the cost of buying an apple is higher. At the same time, apple orchards making. decide to hire more workers and harvest more apples because the benefit of selling an apple is also higher. As we will see, the effect of a good’s price on the behavior of buyers and sellers in a market—in this case, the market for apples— is crucial for understanding how the economy allocates scarce resources. Public policymakers should never forget about incentives because many policies change the costs or benefits that people face and, therefore, alter their HOW PEOPLE INTERACT behavior. A tax on gasoline, for instance, encourages people to drive smaller, more fuel-efficient cars. That is one reason people drive smaller cars in Europe, The first four principles discussed how individuals make decisions. As we go where gasoline taxes are high, than in the United States, where gasoline taxes about our lives, many of our decisions affect not only ourselves but other people are low. A gasoline tax also encourages people to take public transportation as well. The next three principles concern how people interact with one another. rather than drive and to live closer to where they work. If the tax were larger, more people would be driving hybrid cars, and if it were large enough, they Principle 5: Trade Can Make Everyone Better Off would switch to electric cars. When policymakers fail to consider how their policies affect incentives, they You have probably heard on the news that the Japanese are our competitors in often end up with results they did not intend. For example, consider public pol- the world economy. In some ways, this is true because American and Japanese icy regarding auto safety. Today, all cars have seat belts, but this was not true 50 firms produce many of the same goods. Ford and Toyota compete for the same years ago. In the 1960s, Ralph Nader’s book Unsafe at Any Speed generated much customers in the market for automobiles. Apple and Sony compete for the same public concern over auto safety. Congress responded with laws requiring seat customers in the market for digital music players. belts as standard equipment on new cars. Yet it is easy to be misled when thinking about competition among countries. How does a seat belt law affect auto safety? The direct effect is obvious: When Trade between the United States and Japan is not like a sports contest in which a person wears a seat belt, the probability of surviving a major auto accident one side wins and the other side loses. In fact, the opposite is true: Trade rises. But that’s not the end of the story because the law also affects behavior by between two countries can make each country better off. altering incentives. The relevant behavior here is the speed and care with which To see why, consider how trade affects your family. When a member of your drivers operate their cars. Driving slowly and carefully is costly because it uses PRESS ©AP/ASSOCIATED family looks for a job, he or she competes against members of other families who the driver’s time and energy. When deciding how safely to drive, rational people are looking for jobs. Families also compete against one another when they go BASKETBALL STAR LEBRON JAMES compare the marginal benefit from safer driving to the marginal cost. They drive shopping because each family wants to buy the best goods at the lowest prices. UNDERSTANDS OPPORTUNITY COST more slowly and carefully when the benefit of increased safety is high. It is no AND INCENTIVES. HE DECIDED TO So in a sense, each family in the economy is competing with all other families. surprise, for instance, that people drive more slowly and carefully when roads SKIP COLLEGE AND GO STRAIGHT TO “FOR $5 A WEEK YOU CAN Despite this competition, your family would not be better off isolating itself are icy than when roads are clear. THE PROS, WHERE HE HAS EARNED WATCH BASEBALL WITHOUT from all other families. If it did, your family would need to grow its own food, Consider how a seat belt law alters a driver’s cost–benefit calculation. Seat MILLIONS OF DOLLARS AS ONE OF BEING NAGGED TO CUT THE make its own clothes, and build its own home. Clearly, your family gains much belts make accidents less costly because they reduce the likelihood of injury or THE NBA’S TOP PLAYERS. GRASS!” from its ability to trade with others. Trade allows each person to specialize in the STREET JOURNAL— CARTOON:WALL THE FROM SYNDICATE FEATURES PERMISSION, CARTOON

3 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 9 10 PART 1 INTRODUCTION activities he or she does best, whether it is farming, sewing, or home building. why taxes adversely affect the allocation of resources: Taxes distort prices and By trading with others, people can buy a greater variety of goods and services at thus the decisions of households and firms. It also explains the even greater harm lower cost. caused by policies that directly control prices, such as rent control. And it Countries as well as families benefit from the ability to trade with one explains the failure of communism. In communist countries, prices were not another. Trade allows countries to specialize in what they do best and to enjoy a determined in the marketplace but were dictated by central planners. These plan- greater variety of goods and services. The Japanese, as well as the French and ners lacked the information that gets reflected in prices that are free to respond to the Egyptians and the Brazilians, are as much our partners in the world econ- market forces. Central planners failed because they tried to run the economy with omy as they are our competitors. one hand tied behind their backs—the invisible hand of the marketplace.

Principle 6: Markets Are Usually a Good Way Principle 7: Governments Can Sometimes to Organize Economic Activity Improve Market Outcomes The collapse of communism in the Soviet Union and Eastern Europe in the 1980s If the invisible hand of the market is so great, why do we need government? may be the most important change in the world during the past half century. One purpose of studying economics is to refine your view about the proper role Communist countries worked on the premise that government officials were in and scope of government policy. the best position to determine the allocation of scarce resources in the economy. One reason we need government is that the invisible hand can work its magic These central planners decided what goods and services were produced, how only if the government enforces the rules and maintains the institutions that are much was produced, and who produced and consumed these goods and services. The theory behind central planning was that only the government could organize economic activity in a way that promoted economic well-being for the country as a whole. Today, most countries that once had centrally planned economies have aban- doned this system and are trying to develop market economies. In a market market economy FYI economy, the decisions of a central planner are replaced by the decisions of mil- an economy that allo- lions of firms and households. Firms decide whom to hire and what to make. cates resources through Households decide which firms to work for and what to buy with their incomes. the decentralized deci- Adam Smith and the Invisible Hand These firms and households interact in the marketplace, where prices and self- sions of many firms and households as they inter- interest guide their decisions. It may be only a requires of them. . . . It is not from the benevolence of the act in markets for goods coincidence that butcher, the brewer, or the baker that we expect our din- At first glance, the success of market economies is puzzling. After all, in a and services market economy, no one is looking out for the economic well-being of society as Adam Smith’s ner, but from their regard to their own interest. . . . a whole. Free markets contain many buyers and sellers of numerous goods and great book The Wealth of Nations was published in 1776, the Every individual . . . neither intends to promote the pub- services, and all of them are interested primarily in their own well-being. Yet exact year American revolutionaries signed the Declaration of lic interest, nor knows how much he is promoting it. . . . He despite decentralized decision making and self-interested decision makers, mar- Independence. But the two documents share a point intends only his own gain, and he is in this, ket economies have proven remarkably successful in organizing economic activ- of view that was prevalent at the time: Individuals as in many other cases, led by an invisible ity in a way that promotes overall economic well-being. are usually best left to their own devices, without hand to promote an end which was no part In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, the heavy hand of government guiding their actions. of his intention. Nor is it always the worse economist Adam Smith made the most famous observation in all of economics: This political philosophy provides the intellectual for the society that it was no part of it. By Households and firms interacting in markets act as if they are guided by an basis for the market economy and for free society pursuing his own interest he frequently pro- “invisible hand” that leads them to desirable market outcomes. One of our goals more generally. motes that of the society more effectually in this book is to understand how this invisible hand works its magic. Why do decentralized market economies work so than when he really intends to promote it. As you study economics, you will learn that prices are the instrument with well? Is it because people can be counted on to treat Smith is saying that participants in the econ- which the invisible hand directs economic activity. In any market, buyers look at one another with love and kindness? Not at all. Here omy are motivated by self-interest and that the price when determining how much to demand, and sellers look at the price is Adam Smith’s description of how people interact in the “invisible hand” of the marketplace when deciding how much to supply. As a result of the decisions that buyers and a market economy: Adam Smith guides this self-interest into promoting gen- sellers make, market prices reflect both the value of a good to society and the Man has almost constant occasion for the help eral economic well-being. cost to society of making the good. Smith’s great insight was that prices adjust to of his brethren, and it is vain for him to expect it from Many of Smith’s insights remain at the center of modern guide these individual buyers and sellers to reach outcomes that, in many cases, their benevolence only. He will be more likely to prevail if economics. Our analysis in the coming chapters will allow us to maximize the welfare of society as a whole. he can interest their self-love in his favor, and show them express Smith’s conclusions more precisely and to analyze fully There is an important corollary to the skill of the invisible hand in guiding eco- that it is for their own advantage to do for him what he the strengths and weaknesses of the market’s invisible hand. nomic activity: When the government prevents prices from adjusting naturally to supply and demand, it impedes the invisible hand’s ability to coordinate the mil- PHOTO: © BETTMANN/CORBIS lions of households and firms that make up the economy. This corollary explains

4 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 11 12 PART 1 INTRODUCTION key to a market economy. Most important, markets work only if property rights property rights together make up “the economy.” The last three principles concern the workings are enforced. A farmer won’t grow food if he expects his crop to be stolen; a the ability of an individ- of the economy as a whole. restaurant won’t serve meals unless it is assured that customers will pay before ual to own and exercise they leave; and a music company won’t produce CDs if too many potential control over scarce resources Principle 8: A Country’s Standard of Living Depends customers avoid paying by making illegal copies. We all rely on government- on Its Ability to Produce Goods and Services provided police and courts to enforce our rights over the things we produce— and the invisible hand counts on our ability to enforce our rights. The differences in living standards around the world are staggering. In 2003, the Yet there is another, more profound reason we need government: The invisi- average American had an income of about $37,500. In the same year, the average ble hand is powerful, but it is not omnipotent. Although markets are often a Mexican earned $8,950, and the average Nigerian earned $900. Not surprisingly, good way to organize economic activity, this rule has some important excep- this large variation in average income is reflected in various measures of the tions. There are two broad reasons for a government to intervene in the econ- quality of life. Citizens of high-income countries have more TV sets, more cars, omy and change the allocation of resources that people would choose on their better nutrition, better healthcare, and a longer life expectancy than citizens of own: to promote efficiency and to promote equity. That is, most policies aim low-income countries. either to enlarge the economic pie or to change how the pie is divided. Changes in living standards over time are also large. In the United States, Consider first the goal of efficiency. Although the invisible hand usually leads incomes have historically grown about 2 percent per year (after adjusting for markets to allocate resources efficiently, this is not always the case. Economists changes in the cost of living). At this rate, average income doubles every 35 use the term market failure to refer to a situation in which the market on its market failure years. Over the past century, average income has risen about eightfold. own fails to produce an efficient allocation of resources. One possible cause of a situation in which a What explains these large differences in living standards among countries and market failure is an externality, which is the impact of one person’s actions on market left on its own over time? The answer is surprisingly simple. Almost all variation in living stan- the well-being of a bystander. The classic example of an externality is pollution. fails to allocate productivity dards is attributable to differences in countries’ productivity—that is, the Another possible cause of market failure is market power, which refers to the resources efficiently the quantity of goods amount of goods and services produced from each hour of a worker’s time. In ability of a single person (or small group) to unduly influence market prices. For and services produced nations where workers can produce a large quantity of goods and services per externality example, if everyone in town needs water but there is only one well, the owner from each hour of a unit of time, most people enjoy a high standard of living; in nations where the impact of one per- worker’s time of the well is not subject to the rigorous competition with which the invisible son’s actions on the well- workers are less productive, most people endure a more meager existence. Simi- hand normally keeps self-interest in check. In the presence of externalities or being of a bystander larly, the growth rate of a nation’s productivity determines the growth rate of its market power, well-designed public policy can enhance economic efficiency. average income. The invisible hand may also fail to ensure that economic prosperity is distrib- market power The fundamental relationship between productivity and living standards is uted equitably. A market economy rewards people according to their ability to the ability of a single simple, but its implications are far-reaching. If productivity is the primary deter- produce things that other people are willing to pay for. The world’s best basket- economic actor (or small minant of living standards, other explanations must be of secondary importance. ball player earns more than the world’s best chess player simply because people group of actors) to have For example, it might be tempting to credit labor unions or minimum-wage laws are willing to pay more to watch basketball than chess. The invisible hand does a substantial influence for the rise in living standards of American workers over the past century. Yet not ensure that everyone has sufficient food, decent clothing, and adequate on market prices the real hero of American workers is their rising productivity. As another exam- healthcare. Many public policies, such as the income tax and the welfare system, ple, some commentators have claimed that increased competition from Japan aim to achieve a more equitable distribution of economic well-being. and other countries explained the slow growth in U.S. incomes during the 1970s To say that the government can improve on market outcomes at times does and 1980s. Yet the real villain was not competition from abroad but flagging pro- not mean that it always will. Public policy is made not by angels but by a politi- ductivity growth in the United States. cal process that is far from perfect. Sometimes policies are designed simply to The relationship between productivity and living standards also has profound reward the politically powerful. Sometimes they are made by well-intentioned implications for public policy. When thinking about how any policy will affect leaders who are not fully informed. As you study economics, you will become a living standards, the key question is how it will affect our ability to produce better judge of when a government policy is justifiable because it promotes effi- goods and services. To boost living standards, policymakers need to raise pro- ciency or equity and when it is not. ductivity by ensuring that workers are well educated, have the tools needed to produce goods and services, and have access to the best available technology.

List and briefly explain the three principles concerning people’s eco- Principle 9: Prices Rise When the Government nomic interactions. Prints Too Much Money In Germany in January 1921, a daily newspaper cost 0.30 marks. Less than 2 HOW THE ECONOMY AS A WHOLE WORKS inflation years later, in November 1922, the same newspaper cost 70,000,000 marks. All an increase in the overall other prices in the economy rose by similar amounts. This episode is one of his- We started by discussing how individuals make decisions and then looked at level of prices in the tory’s most spectacular examples of inflation, an increase in the overall level of how people interact with one another. All these decisions and interactions economy prices in the economy.

5 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 13 14 PART 1 INTRODUCTION

Although the United States has never experienced inflation even close to that in Germany in the 1920s, inflation has at times been an economic problem. Dur- ing the 1970s, for instance, the overall level of prices more than doubled, and President Gerald Ford called inflation “public enemy number one.” By contrast, FYI inflation in the 1990s was about 3 percent per year; at this rate, it would take more than 20 years for prices to double. Because high inflation imposes various How to Read This Book costs on society, keeping inflation at a low level is a goal of economic policymakers around the world. Practice, practice, practice. What causes inflation? In almost all cases of large or persistent inflation, the Economics is fun, 3. At the end of each chapter, culprit is growth in the quantity of money. When a government creates large but it can also be Questions for Review test your understanding, and Problems quantities of the nation’s money, the value of the money falls. In Germany in the hard to learn. My and Applications ask you to apply and extend the material. early 1920s, when prices were on average tripling every month, the quantity of aim in writing this text is to make it as fun and easy as possible. Perhaps your instructor will assign some of these exercises as money was also tripling every month. Although less dramatic, the economic his- But you, the student, also have a role to play. Experience shows homework. If so, do them. If not, do them anyway. The more tory of the United States points to a similar conclusion: The high inflation of the “WELL IT MAY HAVE BEEN that if you are actively involved as you study this book, you will you use your new knowledge, the more solid it becomes. Go online. 1970s was associated with rapid growth in the quantity of money, and the low 68 CENTS WHEN YOU GOT enjoy a better outcome both on your exams and in the years 4. The publisher of this book maintains an extensive IN LINE, BUT IT’S 74 CENTS inflation of the 1990s was associated with slow growth in the quantity of money. that follow. Here are a few tips about how best to read this website to help you in your study of economics. It includes NOW!” book. additional examples, applications, and problems, as well as quizzes so you can test yourself. Check it out. The website is 1. Summarize, don’t highlight. Running a yellow marker over Principle 10: Society Faces a Short-Run Trade-off http://mankiw.swlearning.com. the text is too passive an activity to keep your mind between Inflation and Unemployment 5. Study in groups. After you’ve read the book and worked engaged. Instead, when you come to the end of a section, problems on your own, get together with classmates to dis- Although a higher level of prices is, in the long run, the primary effect of take a minute and summarize what you just learned in your cuss the material. You will learn from each other—an exam- increasing the quantity of money, the short-run story is more complex and more own words, writing your summary in the wide margins ple of the gains from trade. controversial. Most economists describe the short-run effects of monetary injec- we’ve provided. When you’ve finished the chapter, compare 6. Don’t forget the real world. In the midst of all the numbers, tions as follows: your summaries with the one at the end of the chapter. Did graphs, and strange new words, it is easy to lose sight of you pick up the main points? • Increasing the amount of money in the economy stimulates the overall level what economics is all about. The Case Studies and In the 2. Test yourself. Throughout the book, Quick Quizzes offer of spending and thus the demand for goods and services. News boxes sprinkled throughout this book should help instant feedback to find out if you’ve learned what you are • Higher demand may over time cause firms to raise their prices, but in the remind you. Don’t skip them. They show how the theory is supposed to. Take the opportunity to write down your meantime, it also encourages them to increase the quantity of goods and tied to events happening in all of our lives. If your study is answer and then check it against the answers provided in services they produce and to hire more workers to produce those goods and successful, you won’t be able to read a newspaper again the back of the book. The quizzes are meant to test your services. without thinking about supply, demand, and the wonderful basic comprehension. If your answer is incorrect, you proba- • More hiring means lower unemployment. world of economics. bly need to review the section. This line of reasoning leads to one final economywide trade-off: a short-run trade-off between inflation and unemployment. Although some economists still question these ideas, most accept that society faces a short-run trade-off between inflation and unemployment. This simply means that, over a period of a year or two, many economic policies push infla- List and briefly explain the three principles that describe how the tion and unemployment in opposite directions. Policymakers face this trade-off economy as a whole works. regardless of whether inflation and unemployment both start out at high levels (as they were in the early 1980s), at low levels (as they were in the late 1990s), or someplace in between. This short-run trade-off plays a key role in the analysis of CONCLUSION the business cycle—the irregular and largely unpredictable fluctuations in eco- business cycle nomic activity, as measured by the production of goods and services or the num- fluctuations in economic You now have a taste of what economics is all about. In the coming chapters, we ber of people employed. activity, such as employ- will develop many specific insights about people, markets, and economies. Mas- Policymakers can exploit the short-run trade-off between inflation and unem- ment and production tering these insights will take some effort, but it is not an overwhelming task. ployment using various policy instruments. By changing the amount that the The field of economics is based on a few basic ideas that can be applied in many government spends, the amount it taxes, and the amount of money it prints, pol- different situations. icymakers can influence the combination of inflation and unemployment that Throughout this book, we will refer back to the Ten Principles of Economics the economy experiences. Because these instruments of economic policy are highlighted in this chapter and summarized in Table 1. Whenever we do so, an potentially so powerful, how policymakers should use these instruments to con- icon will be displayed in the margin, as it is now. But even when that icon is

CARTOON: 1978. COPYRIGHTED TRIBUNE CHICAGO RESERVED. RIGHTS ALL COMPANY. PERMISSION. WITH USED trol the economy, if at all, is a subject of continuing debate. absent, you should keep these building blocks in mind. Even the most sophisti- cated economic analysis is built using the ten principles introduced here.

6 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 15 16 PART 1 INTRODUCTION

QUESTIONS FOR REVIEW

How People Make Decisions TABLE 1 1: People Face Trade-offs 1. Give three examples of important trade-offs that 6. What does the “invisible hand” of the market- you face in your life. place do? 2: The Cost of Something Is What You Give Up to Get It Ten Principles of Economics 3: Rational People Think at the Margin 2. What is the opportunity cost of seeing a movie? 7. Explain the two main causes of market failure 4: People Respond to Incentives 3. Water is necessary for life. Is the marginal bene- and give an example of each. How People Interact fit of a glass of water large or small? 8. Why is productivity important? 5: Trade Can Make Everyone Better Off 4. Why should policymakers think about incen- 9. What is inflation and what causes it? 6: Markets Are Usually a Good Way to Organize Economic Activity tives? 10. How are inflation and unemployment related in 7: Governments Can Sometimes Improve Market Outcomes 5. Why isn’t trade among countries like a game the short run? with some winners and some losers? How the Economy as a Whole Works 8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services 9: Prices Rise When the Government Prints Too Much Money 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment PROBLEMS AND APPLICATIONS

1. Describe some of the trade-offs faced by each of lion. If it would cost $1 million to finish devel- the following: opment and make the product, should you go a. a family deciding whether to buy a new car ahead and do so? What is the most that you b. a member of Congress deciding how much to should pay to complete development? spend on national parks 6. Three managers of the Magic Potion Company c. a company president deciding whether to are discussing a possible increase in production. open a new factory Each suggests a way to make this decision. d. a professor deciding how much to prepare SUMMARY for class HARRY: We should examine whether our company’s productivity—gallons of 2. You are trying to decide whether to take a vaca- potion per worker—would rise or nating trade among people, and that the govern- tion. Most of the costs of the vacation (airfare, • The fundamental lessons about individual deci- fall. sion making are that people face trade-offs ment can potentially improve market outcomes if hotel, and forgone wages) are measured in dol- among alternative goals, that the cost of any there is some market failure or if the market out- lars, but the benefits of the vacation are psycho- RON: We should examine whether our action is measured in terms of forgone opportuni- come is inequitable. logical. How can you compare the benefits to average cost—cost per worker— would rise or fall. ties, that rational people make decisions by com- • The fundamental lessons about the economy as a the costs? paring marginal costs and marginal benefits, and whole are that productivity is the ultimate source 3. You were planning to spend Saturday working HERMIONE: We should examine whether the that people change their behavior in response to of living standards, that money growth is the at your part-time job, but a friend asks you to go extra revenue from selling the addi- the incentives they face. ultimate source of inflation, and that society skiing. What is the true cost of going skiing? tional potion would be greater or • The fundamental lessons about interactions among faces a short-run trade-off between inflation and Now suppose you had been planning to spend smaller than the extra costs. people are that trade can be mutually beneficial, unemployment. the day studying at the library. What is the cost Who do you think is right? Why? that markets are usually a good way of coordi- of going skiing in this case? Explain. 7. The Social Security system provides income for 4. You win $1000 in a basketball pool. You have a people over age 65. If a recipient of Social Secu- choice between spending the money now or rity decides to work and earn some income, the putting it away for a year in a bank account that amount he or she receives in Social Security ben- pays 5 percent interest. What is the opportunity KEY CONCEPTS efits is typically reduced. cost of spending the $1000 now? a. How does the provision of Social Security 5. The company that you manage has invested $5 affect people’s incentive to save while scarcity, p. 3 marginal changes, p. 6 market power, p. 11 million in developing a new product, but the working? economics, p. 4 incentive, p. 7 productivity, p. 12 development is not quite finished. At a recent b. How does the reduction in benefits associ- efficiency, p. 5 market economy, p. 9 inflation, p. 12 meeting, your salespeople report that the intro- ated with higher earnings affect people’s equity, p. 5 property rights, p. 11 business cycle, p. 13 duction of competing products has reduced the incentive to work past age 65? opportunity cost, p. 6 market failure, p. 11 expected sales of your new product to $3 mil- rational people, p. 6 externality, p. 11

7 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 17

8. A recent bill reforming the government’s anti- b. providing some poor people with vouchers poverty programs limited many welfare recipi- that can be used to buy food ents to only 2 years of benefits. c. prohibiting smoking in public places a. How does this change affect the incentives d. breaking up Standard Oil (which once owned for working? 90 percent of all oil refineries) into several b. How might this change represent a trade-off smaller companies between equity and efficiency? e. imposing higher personal income tax rates on 9. Your roommate is a better cook than you are, people with higher incomes but you can clean more quickly than your room- f. instituting laws against driving while intoxi- mate can. If your roommate did all of the cook- cated ing and you did all of the cleaning, would your 13. Discuss each of the following statements from chores take you more or less time than if you the standpoints of equity and efficiency. divided each task evenly? Give a similar exam- a. “Everyone in society should be guaranteed ple of how specialization and trade can make the best healthcare possible.” two countries both better off. b. “When workers are laid off, they should be 10. Suppose the United States adopted central plan- able to collect unemployment benefits until ning for its economy, and you became the chief they find a new job.” planner. Among the millions of decisions that 14. In what ways is your standard of living different you need to make for next year are how many from that of your parents or grandparents when compact discs to produce, what artists to record, they were your age? Why have these changes and who should receive the discs. occurred? a. To make these decisions intelligently, what 15. Suppose Americans decide to save more of their information would you need about the com- incomes. If banks lend this extra saving to busi- pact disc industry? What information would nesses, which use the funds to build new facto- you need about each of the people in the ries, how might this lead to faster growth in pro- United States? ductivity? Who do you suppose benefits from b. How would your decisions about CDs affect the higher productivity? Is society getting a free some of your other decisions, such as how lunch? many CD players to make or other devices to 16. Imagine that you are a policymaker trying to produce? How might some of your other decide whether to reduce the rate of inflation. To decisions about the economy change your make an intelligent decision, what would you views about CDs? need to know about inflation, unemployment, 11. Nations with corrupt police and court systems and the trade-off between them? typically have lower standards of living than 17. Look at a newspaper or at the website http:// nations with less corruption. Why might that be www.economist.com to find three stories about the case? the economy that have been in the news lately. 12. Explain whether each of the following govern- For each story, identify one (or more) of the Ten ment activities is motivated by a concern about Principles of Economics discussed in this chapter equity or a concern about efficiency. In the case that is relevant and explain how it is relevant. of efficiency, discuss the type of market failure Also, for each story, look through this book’s involved. Contents and try to find a chapter that might a. regulating cable TV prices shed light on the news event.

For further information on topics in this chapter, additional problems, applications, examples, online quizzes, and more, please visit our website at http://mankiw.swlearning.com.

8 9 10 11 12 Peter Schmidt

C:\Daten\Hochschu\VWL\Quellen und Themen\GDP_Begg.doc 20.06.09; 07:58 – Seite 1

13 Domestic Product and National Income G - D =

DP + NIA =

PM + SB =

The way from GDP to National Income

GDP M

F NNY (national Income)

P. Schmidt National Accounting

14 National Accounts Production of gross domestic product 2016 2017 2018 National accounts provide a comprehensive quantitative picture of economic development within a country, i.e. in At current prices (EUR bn.) German this case Germany. The most important national accounts Gross value added 2,847.7 2,954.7 3,055.3 aggregate is the gross domestic product (GDP). The GDP Agriculture, forestry and fishing 21.1 25.5 22.9 measures the domestic production of goods and services Industry, excluding construction 747.8 772.5 788.2 economy minus the intermediate consumption of goods and services. Construction 133.9 144.3 160.8 Services 1,944.9 2,012.4 2,083.4 National accounts provide important data to the political + Taxes on products 319.2 329.9 340.1 2018 community, administration and businesses for assessing – Subsidies on products 7.2 7.3 7.1 and shaping economic, Þnancial, social and other policies. = Gross domestic product 3,159.8 3,277.3 3,388.2 The national accounting system within the European Union Price-adjusted, chain-linked1 is based on harmonised European rules that are laid down Gross value added 2.2 2.2 1.5 in a legally binding form in the European System of National Agriculture, forestry and fishing – 2.2 3.0 – 1.5 and Regional Accounts (ESA 2010). Industry, excluding construction 4.8 2.4 1.0 Gross domestic product Construction 1.8 2.4 3.6 Price-adjusted, change on the previous year in % This leaßet only shows a small part of the whole national Services 1.3 2.1 1.6 Average 2007-2017 accounts publication programme. More results as well as Taxes on products 2.2 1.8 1.2 % deÞnitions and general information on national accounts in Subsidies on products – 8.1 1.3 – 2.9 6 Germany are available on the internet at www.destatis.de. Gross domestic product 2.2 2.2 1.5 1 Change on the previous year in %. 4 1 Production=== Use= Distribution Production of gross dom estic product 2018 in % 2 +1.2 1.5 Agriculture, forestry Final consumption Compensation of Construction Agriculture, forestry and fishing and fishing expenditure employees 0 Property and entre- 5 + preneurial income Industry 1 Gross fixed capital + -2 Industry, excl. formation Taxes on production 26 and imports less construction Services 3,388.2 Changes in inventories subsidies -4 + EUR bn. + + Consumption of fixed capital -6 Balance of exports and – Taxes less subsidies imports (net exports) 68 Services 2007 08 09 10 11 12 13 14 15 16 17 2018 on products (net taxes) Balance of primary income from the rest of the world 1 As measured by gross value added (GVA) at current prices of the relevant Gross domestic product industry as percentage of total GVA at current prices. 15 Use of gross domestic product Distribution of gross domestic product Key data for total economy

2016 2017 2018 2016 2017 2018 2016 2017 2018

At current prices (EUR bn.) At current prices (EUR bn.) Gross domestic product (GDP) price- Final consumption expenditure of house- adjusted1 2.2 2.2 1.5 holds and NPISHs 1,675.6 1,732.2 1,777.5 Net wages and salaries 869.1 902.9 946.5 GDP at current prices in EUR bn. 3,159.8 3,277.3 3,388.2 + Government final consumption expenditure 615.5 638.9 663.1 + Income taxes and social contributions 2 + Gross fixed capital formation 634.0 665.7 705.7 (of employees) 442.7 463.7 486.3 GDP per capita in EUR 38,370 39,650 40,883 + Changes in inventories1 – 12.8 – 7.2 8.3 = Gross wages and salaries 1,311.9 1,366.6 1,432.8 Total population in 1,000 82,349 82,657 82,877 = Domestic use 2,912.3 3,029.5 3,154.5 + Balance of exports and imports 247.5 247.8 233.7 + Employers’ social contributions 289.1 302.2 313.7 Persons in employment (domestic concept) in 1,000 43,642 44,269 44,831 Memorandum item: Exports 1,450.2 1,541.9 1,595.6 = Compensation of employees 1,601.0 1,668.8 1,746.5 Imports 1,202.8 1,294.1 1,361.9 Unemployed persons in 1,0003 1,774 1,621 1,491 + Property and entrepreneurial income 762.7 787.6 785.6 = Gross domestic product 3,159.8 3,277.3 3,388.2 Economically active population as % of total = Net national income (factor costs) 2,363.7 2,456.4 2,532.1 Price-adjusted, chain-linked2 population3 55.0 55.4 55.7 Final consumption expenditure of house- – Subsidies1 28.0 28.4 27.7 Unemployed persons as % of economically holds and NPISHs 2.1 1.8 1.0 2 + Taxes on production and imports 334.6 345.1 356.1 active population 3.9 3.5 3.2 Government final consumption expenditure 4.0 1.6 1.1 Gross fixed capital formation 3.5 2.9 3.0 = Net national income 2,670.3 2,773.1 2,860.5 Gross national income in EUR bn. 3,222.4 3,346.3 3,460.4 1, 3 Changes in inventories 0.2 0.1 0.4 + Consumption of fixed capital 552.1 573.1 599.9 Disposable income of households in EUR bn. 1,807.7 1,869.9 1,929.8 Domestic use 3.0 2.0 1.8 = Gross national income 3,222.4 3,346.3 3,460.4 Balance of exports and imports3 – 0.5 0.3 – 0.2 Saving ratio (saving as % of disposable income of households) 9.8 9.9 10.3 Memorandum item: Exports 2.3 4.6 2.4 – Balance of primary income from the rest of the world 62.7 68.9 72.2 Imports 4.1 4.8 3.4 Labour productivity (per capita)1,4 0.9 0.7 0.2 = Gross domestic product 3,159.8 3,277.3 3,388.2 Gross domestic product 2.2 2.2 1.5 Labour productivity (per hour)1,4 1.4 0.9 0.1 1 Paid by general government. – 2 Received by general government. 1 Inclusive acquisitions less disposals of valuables. – 2 Change on the previous Compensation of employees per employee1 2.2 2.6 3.0 year in %. – 3 Contribution to GDP growth in %-points. Compensation of employees per hour 1 Use of gross domestic product 2018 in % Compensation of employees, property and worked by employees 2.6 2.4 2.6 entrepreneurial income Unit labour costs (per capita)1,5 1.3 1.9 2.8 Balance of e xports and i mports 1991 = 100 Unit labour costs (per hour)1,5 1.2 1.5 2.6 Gross capital 7 250 Wage ratio, unadjusted (compensation of formation employees as % of net national income at 21 factor costs) 67.7 67.9 69.0 200 Government deficit ratio (Net lending/net 3,388.2 Property and entre- borrowing as % of GDP at current prices) 0.9 1.0 1.7 preneurial income EUR bn. 1 Change on the previous year in %. – 2 Average population based on the 2011 150 Census (on 9th of May: 80,219,695 inhabitants). – 3 Results of the labour force 20 52 Compensation survey (microcensus) according to the deÞnition of the IL2. – 4 Price-adjusted Government of employees GDP per person in employment resp. per hour worked by persons in employment. – 5 Compensation of employees per employee resp. per hour worked by emplo- final consumption Private final consumption 100 expenditure expenditur e (households yees in relation to labour productivity per person in employment resp. per hour and NPISHs) worked by persons in employment. 1991 95 2000 05 10 15 2018 16 Macroeconomic data for Germany Economic development since 1950 Economic growth in international perspective1 in % Year1 Gross Gross Net national Gross domestic product 2015 2016 2017 2018 domestic national income at per per person in product income factor costs inhabitant employment Change of price–adjusted GDP on the previous year in % EUR bn. EUR Austria 1.1 2.0 2.6 2.7 1 2 Growth Net lending/Net borrowing Former territory of the Federal Republic without Saarland and Belgium 1.7 1.5 1.7 1.5 Berlin (West) 1950 49.7 50.4 40.1 1,059 2,539 Cyprus 2.0 4.8 4.2 3.9 2.2 2.2 2.2 1955 91.9 92.3 72.7 1,868 4,084 Estonia 1.9 3.5 4.9 3.5 Finnland 0.1 2.5 2.8 2.9 1.7 1.7 Former territory of the Federal Republic 1.5 1960 154.8 154.9 122.8 2,792 5,938 France 1.1 1.2 2.2 1.7 1965 234.8 234.3 183.3 4,005 8,774 Germany 1.7 2.2 2.2 1.5 1.0 1970 360.6 361.6 282.1 5,945 13,562 0.9 Greece – 0.4 – 0.2 1.5 2.0 0.8 1975 551.0 552.0 430.5 8,912 20,992 0.6 1980 788.5 790.0 609.3 12,808 28,757 Ireland 25.1 5.0 7.2 7.8 1985 984.4 990.7 762.4 16,132 35,657 Italy 0.9 1.1 1.6 1.1 1990 1,306.7 1,317.9 1,017.9 20,658 42,970 Latvia 3.0 2.1 4.6 4.1 Germany Lithuania 2.0 2.4 4.1 3.4 1991 1,579.8 1,595.8 1,226.5 19,754 40,727 Luxembourg 3.9 2.4 1.5 3.1 1995 1,898.9 1,895.1 1,429.2 23,354 50,026 2014 2016 2018 2014 2016 2018 Malta 9.5 5.2 6.7 5.4 2000 2,116.5 2,102.4 1,554.9 25,983 53,022 2005 2,300.9 2,321.3 1,716.8 28,288 58,507 Netherlands 2.0 2.2 2.9 2.8 2010 2,580.1 2,630.9 1,923.2 32,137 62,898 Portugal 1.8 1.9 2.8 2.2 Employment 3 Inflation4 2015 3,048.9 3,114.6 2,279.8 37,324 70,787 Slovakia 4.2 3.1 3.2 4.0 2016 3,159.8 3,222.4 2,363.7 38,370 72,402 Slovenia 2.3 3.1 4.9 4.3 2017 3,277.3 3,346.3 2,456.4 39,650 74,032 Spain 3.6 3.2 3.0 2.6 1.9 2018 3,388.2 3,460.4 2,532.1 40,883 75,578 1.8 Euro area 2.1 1.9 2.4 2.1 1 The results of the different territories are not fully comparable as the underlying 1.4 Bulgaria 3.5 3.9 3.8 3.5 1.3 1.3 concepts and deÞnitions are not the same. Croatia 2.4 3.5 2.9 2.8 0.9 0.8 0.9 Gross domestic product (GDP) at current prices Czech Republic 5.3 2.5 4.3 3.0 0.5 as part of the GDP of the Euro area in 2018 in % Denmark 1.6 2.0 2.3 1.2 0.3 Hungary 3.5 2.3 4.1 4.3 Germany Poland 3.8 3.1 4.8 4.8 3,388.2 EUR bn. Romania 3.9 4.8 7.3 3.6 29% Sweden 4.5 2.7 2.1 2.4 2014 2016 2018 2014 2016 2018 Euro area EU 27 2.3 2.1 2.6 2.2 11,606 China 6.9 6.7 6.9 6.6 EUR bn. Japan 1.4 1.0 1.7 1.1 1 Change of price-adjusted gross domestic product (GDP) on the previous United Kingdom 2.3 1.8 1.7 1.3 year. – 2 Net lending/Net borro wing of general g overnment as % of GDP. – 3 Change of persons in employment (domestic concept) on the previous USA 2.9 1.6 2.2 2.9 year.–4Change of consumer price index (CPI) on the previous year. 1 European Commission, Economic Forecasts Autumn 2018, except 17for Germany. Monitoring economic performance, quality of life and sustainability

Conseil d‘Analyse Économique 113 rue de Grenelle 75007 Paris Joint Report as requested by the Tel.: 0033 1 / 4275 5300 Fax: 0033 1 / 4275 5127 Franco-German Ministerial Council E-Mail: [email protected] Internet: http://www.cae.gouv.fr

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December 2010

18 Preface III IV Preface

PREFACE 3. The two involved institutions prepared this report with the following division of labour: The CAE took the lead in preparing Chapter II and section 2 of Chapter IV, while the GCEE 1. The Franco-German Ministerial Council decided on February 4, 2010 to ask the French took the lead in drafting Chapter III and section 3 of Chapter IV. Sections 1, 4 and 5 of Chap- Conseil d’Analyse Économique (CAE) and the German Council of Economic Experts ter IV are a joint product. Chapter I constitutes an introduction and summary of the report. (GCEE) to follow-up on the outcome of the “Commission on the Measurement of Economic Performance and Social Progress” (Stiglitz-Sen-Fitoussi Commission, or SSFC). 4. The CAE would like to thank Professor Christian Saint-Etienne for having kindly agreed to be the coordinator for the French Council. The CAE and GCEE have fulfilled this request by preparing a report on The CAE is also grateful to Philippe Cunéo and Claire Plateau from INSEE for their com- „Monitoring economic performance, quality of life and sustainability“. ments and contributions to this report. The whole staff of the Conseil d’Analyse Économique has helped by providing research and logistic support and must be thanked, especially Chris- tine Carl for editing the French version and Agnès Mouze for documentation. It discusses how comprehensiveness and accuracy of an indicator set might be traded off op- timally with parsimony and cost to provide a reliable basis for regular, timely and digestible French contributions owe a lot to the work of CAE’s scientific advisers, Associate Professor reporting on three key issues regarding economic performance, quality of life and sustainabil- Jézabel Couppey-Soubeyran, Professor Jerôme Glachant, Professor Lionel Ragot, Professor ity. Stephane Saussier, Professor Thomas Weitzenblum and Associate Professor Anne Yvrande- Billon. They must be thanked for it. 2. As the world is emerging from its worst economic crisis of the last six decades, there is a broad consensus among policy makers and the general public that this should be a moment The General-Secretary Pierre Joly can be praised for his contributions and for coordinating of pause and sincere reflection. From the vantage point of economics and statistics, three in- this joint report on the French side. timately related key questions should form the focus of such considerations: First, how can we improve our monitoring of economic performance in order to allow policy makers to 5. The GCEE would like to express his profound gratitude to Professor Dr. Christoph M. gauge the current state of affairs and to react timely and appropriately when crises emerge? Schmidt. His intense efforts as the main author and coordinator on the German side helped Second, how can we broaden our perspective from its current focus on economic performance immensely in producing the report. to an assessment of the quality of life more generally, in order to appreciate what really counts for human welfare? And third, how can we design warning signals that alert us whenever the The GCEE would also like to thank staff from the German Statistical Office, specifically from current manner of organizing our lives endangers sustainability, in order to correct our course the national and environmental accounts units, for providing helpful comments. As usual the of action for the sake of our own future and that of generations to come? members of the branch that work with the GCEE on a daily basis have helped prepare this report. We would like to thank Anita Demir, Diplom-Volkswirt Wolfgang Glöckler, Diplom- The first and arguably most important conclusion of our study is that a single-indicator ap- Volkswirtin Birgit Hein, Christoph Hesse, Klaus-Peter Klein, Uwe Krüger, Sabrina Mäncher, proach to measuring human progress is inherently insufficient. Complexity of life and the Volker Schmitt and Hans-Jürgen Schwab for their reliable and valuable input. demands on statistical reporting are too diverse to allow a meaningful condensation of the current state of affairs into a single comprehensive indicator. Instead, we suggest that com- Last but not least, the GCEE would like to express his gratitude for the tireless efforts of its prehensive statistical reporting should entail a dashboard of indicators. The dashboard we staff without which the German contribution to the report would not have been possible. propose is meant to be a starting point for discussion. It is intended to be rich enough to facili- Therefore, the GCEE specifically thanks Diplom-Volkswirtin and Diplom- tate a sensible discussion of the relevant facets of human welfare, but it is also not over- Wirtschaftssinologin Ulrike Bechmann, Hasan Doluca, M.S., Dr. Malte Hübner, Dr. Anabell whelmingly extensive. Moreover, it provides a balanced representation of the three areas ad- Kohlmeier, Dr. Heiko Peters, Dr. Stefan Ried, Diplom-Volkswirt Dominik Rumpf, dressed by the key questions, economic performance, quality of life and sustainability. This Dr. Christoph Swonke, Dr. Marco Wagner and Dr. Benjamin Weigert. Special thanks go to approach acknowledges that monitoring material well-being is an indispensable prerequisite Dr. Ulrich Klüh, whose input as Secretary-General until July 31 contributed considerably in for sensible economic policy, that life is about more than material well-being, but that human preparing this report. Thanks also go to Dr. Jens Clausen, who as Secretary-General from Au- progress in non-material aspects is quite difficult to capture, and that it is wise to take a long- gust 1 on contributed to this report by coordinating the work of the staff and providing valu- term perspective by outlining the consequences of unmodified human behavior. able inputs.

CAE / SVR - Report 2010 CAE / SVR - Report 2010 19 Preface V VI Content

6. All views expressed in this report as well as all remaining errors should only be attrib- Content uted to the authors mentioned below. Page CHAPTER I Conceptual Foundations and Guiding Principles ...... 1 Paris and Wiesbaden on December 6, 2010 1. The challenge ...... 2 2. State of affairs ...... 6 Conseil d’Analyse Économique Elements of economic performance and social progress ...... 7 Unresolved issues ...... 9 Christian de Boissieu Jean-Philippe Cotis 3. Principles and obstacles ...... 11 4. Key results ...... 13 Economic performance and material well-being ...... 14 Michel Didier Christian Saint-Etienne Quality of life ...... 17 Sustainability ...... 20 5. The road ahead ...... 25 Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung Appendix ...... 27 References ...... 28 Peter Bofinger Wolfgang Franz CHAPTER II Economic Performance and Material Well-Being ...... 31 Christoph M. Schmidt Beatrice Weder di Mauro Wolfgang Wiegard 1. Economic performance and current material well-being ...... 32 Measurement problems ...... 32 From production to material well-being ...... 35 2. Making GDP a better measure of economic performance ...... 37 Services ...... 37 Quality changes and trade issues ...... 42 Deficiencies that are harder to correct ...... 43 Intermediate conclusions ...... 45 3. Labour market issues ...... 46 4. Defining a wider set of indicators for material well-being ...... 47 Income and consumption ...... 47 Income distribution ...... 49 Wealth and time allocation ...... 52 Intermediate conclusions ...... 54 5. Concluding remarks ...... 54 Appendix ...... 56 References ...... 58

CHAPTER III Quality of Life ...... 61 1. Conceptual questions: the blue pill or the red pill? ...... 61 Top-down approaches: seductive, but unconvincing ...... 61 Bottom-up approaches: reasonable, but challenging ...... 64 2. Empirical implementation: a tough task ...... 66 Addressing heterogeneous preferences ...... 67 Purely statistical approaches ...... 68

CAE / SVR - Report 2010 CAE / SVR - Report 2010 20 Content VII

Page CHAPTER I 3. Practical implementation: France and Germany ...... 70 Choosing dimensions ...... 70 Quality of life in France and Germany ...... 72 Conceptual Foundations and Guiding Principles 4. Elements of our dashboard: a detailed discussion ...... 76 Health ...... 76 Education ...... 80 Personal activities ...... 83 Political voice and governance ...... 87 Social connections and relationships ...... 89 Environmental conditions ...... 90 Personal and economic insecurity ...... 92 1. 5. Recommendations for future work ...... 93 The challenge Résumé ...... 96 2. State of affairs References ...... 98 Elements of economic performance and social progress Unresolved issues 3. Principles and obstacles CHAPTER IV Sustainability ...... 101 4. Key results 1. Conceptual issues: dimensions of sustainability ...... 101 Economic performance and material well-being 2. Macroeconomic sustainability ...... 104 Quality of life Growth sustainability ...... 105 Sustainability External sustainability ...... 107 Fiscal sustainability ...... 109 5. The road ahead 3. Financial sustainability ...... 115 Appendix Financial crises and sustainability ...... 117 Identifying appropriate indicators ...... 118 References 4. Environmental sustainability ...... 125 The need to monitor environmental sustainability ...... 126 Greenhouse gas emissions ...... 128 Resource productivity and resource consumption ...... 132 Biodiversity ...... 139 5. Concluding remarks ...... 142 Appendix ...... 145 References ...... 152

CAE / SVR - Report 2010 21 18 Conceptual Foundations and Guiding Principles Conceptual Foundations and Guiding Principles 27

Chart 3 Appendix

Non-m aterial quality-of-life indicators1) Chart 5

First data shown2) 2000 Latest data available3) Dashboard for Monitoring Economic Performance, Quality of Life and Sustainability

Germany

Health Economic Performance (A) QualityofLife(B) Sustainability(C) Potential years of life lost (PYLL)4) 2

Personal and economic insecurity 1 Education GDP per capita Health: Potential years of life lost Private sector net fixed capitel Not-at-risk-of-poverty rate5) Students (ISCED 1-6) aged 0 formation (% of GDP) between 15 and 24 years6) -1 GDP per hours worked Education : Students (ISCED 1-6) aged between 15 and 24 years R&D investment (% of GDP) -2 Employment rate (15 - 64 age Cyclically adjusted fiscal balance Personal activities: Employees group) (% of GDP) working on shift work Environmental conditions Personal activities Urban population exposure to Employees working Net national income per capita Fiscal sustainability gap S2 air pollution by particulate matter7) on shift work8) Political voice and governance: Voice and Accountability Final consumption expenditure Total private credit to GDP gap per capita (including government Social connections and relationships: consumption) Frequency of time spent with people Social connections and relationships Political voice and governance at sport, culture, communal Real equity price gap Frequency of time spent with people at Voice and Accountability organization 9) Distribution measure of net income sport, culture, communal organization per consumption unit (income quintile share ratio (S80/S20); Environmental conditions: Urban Real property price gap internationally harmonized) population exposure to air pollution by particulate matter Level of greenhouse gas emissions

Personal and economic insecurity: Not-at-risk-of-poverty rate Greenhouse gas emissions per France capita

Health Resource productivity (GDP relative to non-renewable Potential years of life lost (PYLL)4) 2 Domestic Material Input, DMI)

Personal and economic insecurity 1 Education Resource consumption Not-at-risk-of-poverty rate5) 0 Students (ISCED 1-6) aged (non-renewable Domestic Material between 15 and 24 years6) Consumption-DMC, per capita ) -1 Biodiversity -2 (preliminaryindicator : bird index)

Environmental conditions Personal activities Urban population exposure to Employees working air pollution by particulate matter7)10) on shift work8)

Social connections and relationships Political voice and governance Frequency of time spent with people at Voice and Accountability sport, culture, communal organization9)

1) Own calculations; values are not comparable across countries. Average = 0; value higher than 0 implies better conditions and vice versa.– 2) Health: 1991, Personal activities: 1992, Political voice and governance: 1996, Education: Germany: 1992, France: 1993, En- viromental conditions: Germany: 1999, France: 2001, Personal and economic insecurity: Germany: 1992, France: 1995 .– 3) Health: 2006, Education and Personal activities: 2009, Political voice and governance and Enviromental conditions: 2008; Personal and economic insecurity: Germany: 2009, France: 2008.– 4) PYLL is a summary measure of premature mortality which provides an explicit way of weighting deaths occuring at younger ages, which are, a priori, preventable. In relation to 100,000 population, calculated by the OECD Secretariat based on age-specific death statistics provided by the World Health Organization.– 5) One minus share of persons with an equivalised disposable income below the risk-of-poverty threshold, which is set at 60 % of the national median equivalised disposable income after social transfers.– 6) In relation to the population in the same age group. – 7) The indicator shows the population weigh ted annual mea n concentration of particulate matter at urban background stations in agglomerations.– 8) As a percentage of total employees.– 9) Only data available: 1999.– 10) For 2000: 2001 data.

Sources for calculations: EU, OECD, SOEP, The World Bank, World Values Survey

CAE / SVR - Report 2010 CAE / SVR - Report 2010 22