TENTH EDITION

Principles of The Pearson Series in Economics

Abel/Bernanke/Croushore Hartwick/Olewiler Parkin Macroeconomics* The Economics of Natural Resource Use Economics* Bade/Parkin Heilbroner/Milberg Perloff Foundations of Economics* The Making of the Economic Society Microeconomics* Berck/Helfand Heyne/Boettke/Prychitko Microeconomics: Theory and Applications The Economics of the Environment The Economic Way of Thinking with Calculus* Bierman/Fernandez Hoffman/Averett Perman/Common/McGilvray/Ma Game Theory with Economic Applications Women and the Economy: Family, Work, Natural Resources and Environmental Blanchard and Pay Economics Macroeconomics* Holt Phelps Blau/Ferber/Winkler Markets, Games and Strategic Behavior Health Economics The Economics of Women, Men and Work Hubbard/O’Brien Pindyck/Rubinfeld Boardman/Greenberg/Vining/ Economics* Microeconomics* Weimer Money, Banking, and the Financial System* Riddell/Shackelford/Stamos/ Cost-Benefit Analysis Hughes/Cain Schneider Boyer American Economic History Economics: A Tool for Critically Understanding Society Principles of Transportation Economics Husted/Melvin Branson International Economics Ritter/Silber/Udell Macroeconomic Theory and Policy Principles of Money, Banking & Financial Jehle/Reny Markets* Brock/Adams Advanced Microeconomic Theory The Structure of American Industry Roberts Johnson-Lans The Choice: A Fable of Free Trade and Bruce A Health Economics Primer Protection Public Finance and the American Economy Keat/Young Rohlf Carlton/Perloff Managerial Economics Introduction to Economic Reasoning Modern Industrial Organization Klein Ruffin/Gregory Case/Fair/Oster Mathematical Methods for Economics Principles of Economics Principles of Economics* Krugman/Obstfeld/Melitz Sargent Caves/Frankel/Jones International Economics: Theory & Policy* Rational Expectations and Inflation World Trade and Payments: An Introduction Laidler Sawyer/Sprinkle Chapman The Demand for Money International Economics Environmental Economics: Theory, Leeds/von Allmen Application, and Policy Scherer The Economics of Sports Industry Structure, Strategy, and Public Cooter/Ulen Leeds/von Allmen/Schiming Policy Law & Economics Economics* Schiller Downs Lipsey/Ragan/Storer The Economics of Poverty and An Economic Theory of Democracy Economics* Discrimination Ehrenberg/Smith Lynn Sherman Modern Labor Economics Economic Development: Theory and Practice Market Regulation Ekelund/Ressler/Tollison for a Divided World Silberberg Economics* Miller Principles of Microeconomics Farnham Economics Today* Stock/Watson Economics for Managers Understanding Modern Economics Introduction to Econometrics Folland/Goodman/Stano Miller/Benjamin Introduction to Econometrics, Brief Edition The Economics of Health and Health Care The Economics of Macro Issues Studenmund Fort Miller/Benjamin/North Using Econometrics: A Practical Guide Sports Economics The Economics of Public Issues Tietenberg/Lewis Froyen Mills/Hamilton Environmental and Natural Resource Macroeconomics Urban Economics Economics Fusfeld Mishkin Environmental Economics and Policy The Age of the Economist The Economics of Money, Banking, and Todaro/Smith Gerber Financial Markets* Economic Development International Economics* The Economics of Money, Banking, and Waldman Gordon Financial Markets, Business School Edition* Microeconomics Macroeconomics* Macroeconomics: Policy and Practice* Waldman/Jensen Greene Murray Industrial Organization: Theory and Econometric Analysis Econometrics: A Modern Introduction Practice Gregory Nafziger Weil Essentials of Economics The Economics of Developing Countries Economic Growth Gregory/Stuart O’Sullivan/Sheffrin/Perez Williamson Russian and Soviet Economic Performance Economics: Principles, Applications Macroeconomics and Structure and Tools*

* denotes titles Log onto www.myeconlab.com to learn more. TENTH EDITION Principles of Economics

Karl E. Case

Ray C. Fair

Sharon M. Oster Yale University

Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo Dedicated To Professor Richard A. Musgrave and Professor Robert M. Solow and Professor Richard Caves

Editor in Chief: Donna Battista Image Manager: Rachel Youdelman AVP/Executive Editor: David Alexander Photo Researcher: Diahanne Lucas Dowridge Editorial Project Managers: Melissa Pellerano, Lindsey Full-Service Project Management/Composition: GEX Sloan Publishing Services Editorial Assistant: Megan Cadigan Typeface: 10/12 Minion AVP/Executive Marketing Manager: Lori DeShazo Text Permission Project Supervisor: Michael Joyce Marketing Assistant: Kimberly Lovato Director of Media: Susan Schoenberg Managing Editor: Nancy Fenton Content Lead, MyEconLab: Noel Lotz Senior Production Project Manager: Nancy Freihofer Senior Media Producer: Melissa Honig Senior Manufacturing Buyer: Carol Melville Supplements Production Coordinator: Alison Eusden Senior Art Director: Jonathan Boylan Printer/Binder: Courier, Kendallville Cover Design: Jonathan Boylan Cover Printer: Lehigh Phoenix

Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on appropriate page within text.

Copyright © 2012, 2009, 2007, 2004, 2003, Pearson Education, Inc. All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request to Pearson Education, Inc., Rights and Contracts Department, 501 Boylston Street, Suite 900, Boston, MA 02116, fax your request to 617 671-3447, or e-mail at www.pearsoned.com/legal/permission.htm.

Many of the designations by manufacturers and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps.

Library of Congress Cataloging-in-Publication Data Case, Karl E. Principles of economics / Karl E. Case, Ray C. Fair, Sharon M. Oster. — 10th ed. p. cm. Includes bibliographical references and index. ISBN-13: 978-0-13-255291-2 ISBN-10: 0-13-255291-4 1. Economics. I. Fair, Ray C. II. Oster, Sharon M. III. Title. HB171.5.C3123 2012 330—dc22 2010049925

10 9 8 7 6 5 4 3 2 1

ISBN 13: 978-0-13-255291-2 ISBN 10: 0-13-255291-4 About the Authors

Karl E. Case is Professor of Economics Emeritus at Wellesley College where he has taught for 34 years and served several tours of duty as Department Chair. He is a Senior Fellow at the Joint Center for Housing Studies at Harvard University and a founding partner in the real estate research firm of Fiserv Case Shiller Weiss, which produces the S&P Case-Shiller Index of home prices. He serves as a member of the Index Advisory Committee of Standard and Poor’s, and along with Ray Fair he serves on the Academic Advisory Board of the Federal Reserve Bank of Boston. Before coming to Wellesley, he served as Head Tutor in Economics (director of undergradu- ate studies) at Harvard, where he won the Allyn Young Teaching Prize. He was Associate Editor of the Journal of Economic Perspectives and the Journal of Economic Education, and he was a member of the AEA’s Committee on Economic Education. Professor Case received his B.A. from Miami University in 1968; spent three years on active duty in the Army, and received his Ph.D. in Economics from Harvard University in 1976. Professor Case’s research has been in the areas of real estate, housing, and public finance. He is author or coauthor of five books, including Principles of Economics, Economics and Tax Policy, and Property Taxation: The Need for Reform, and he has published numerous articles in profes- sional journals. For the last 25 years, his research has focused on real estate markets and prices. He has authored numerous professional articles, many of which attempt to isolate the causes and consequences of boom and bust cycles and their relationship to regional and national economic performance.

Ray C. Fair is Professor of Economics at Yale University. He is a member of the at Yale and a Fellow of the Econometric Society. He received a B.A. in Economics from Fresno State College in 1964 and a Ph.D. in Economics from MIT in 1968. He taught at from 1968 to 1974 and has been at Yale since 1974. Professor Fair’s research has primarily been in the areas of macroeconomics and econometrics, with particular emphasis on macroeconometric model building. He also has done work in the areas of finance, voting behavior, and aging in sports. His publications include Specification, Estimation, and Analysis of Macroeconometric Models (Harvard Press, 1984); Testing Macroeconometric Models (Harvard Press, 1994); and Estimating How the Macroeconomy Works (Harvard Press, 2004). Professor Fair has taught introductory and intermediate macroeconomics at Yale. He has also taught graduate courses in macroeconomic theory and macroeconometrics. Professor Fair’s U.S. and multicountry models are available for use on the Internet free of charge. The address is http://fairmodel.econ.yale.edu. Many teachers have found that having stu- dents work with the U.S. model on the Internet is a useful complement to an introductory macroeconomics course.

Sharon M. Oster is the Dean of the Yale School of Management, where she is also the Frederic Wolfe Professor of Economics and Management. Professor Oster joined Case and Fair as a coau- thor in the ninth edition of this book. Professor Oster has a B.A. in Economics from Hofstra University and a Ph.D. in Economics from Harvard University. Professor Oster’s research is in the area of industrial organization. She has worked on problems of diffusion of innovation in a number of different industries, on the effect of regulations on business, and on competitive strategy. She has published a number of articles in these areas and is the author of several books, including Modern Competitive Analysis and The Strategic Management of Nonprofits. Prior to joining the School of Management at Yale, Professor Oster taught for a number of years in Yale’s Department of Economics. In the department, Professor Oster taught introductory and intermediate microeconomics to undergraduates as well as several graduate courses in indus- trial organization. Since 1982, Professor Oster has taught primarily in the Management School, where she teaches the core microeconomics class for MBA students and a course in the area of com- petitive strategy. Professor Oster also consults widely for businesses and nonprofit organizations and has served on the boards of several publicly traded companies and nonprofit organizations.

v Brief Contents

PART I Introduction to Economics 1 PART V The Core of Macroeconomic Theory 457 1 The Scope and Method of Economics 1 23 2 The Economic Problem: Scarcity and Choice 25 Aggregate Expenditure and Equilibrium Output 459 24 3 Demand, Supply, and Market Equilibrium 47 The Government and Fiscal Policy 477 25 4 Demand and Supply Applications 79 The Money Supply and the Federal Reserve System 501 5 Elasticity 97 26 Money Demand and the Equilibrium Interest Rate 525 The Market System: Choices PART II 27 Made by Households and Aggregate Demand in the Goods and Money Firms 117 Markets 541 28 Aggregate Supply and the Equilibrium Price 6 Household Behavior and Consumer Choice 121 Level 559 7 The Production Process: The Behavior of Profit- 29 The Labor Market In the Macroeconomy 581 Maximizing Firms 147 8 Short-Run Costs and Output Decisions 167 PART VI Further Macroeconomics 9 Long-Run Costs and Output Decisions 189 Issues 599 10 Input Demand: The Labor and Land Markets 215 30 Financial Crises, Stabilization, and Deficits 599 11 Input Demand: The Capital Market and the 31 Household and Firm Behavior in the Macroeconomy: Investment Decision 233 A Further Look 615 12 General Equilibrium and the Efficiency of Perfect 32 Long-Run Growth 635 Competition 253 33 Alternative Views in Macroeconomics 649 PART III Market Imperfections and the Role of Government 269 PART VII The World Economy 663 34 13 Monopoly and Antitrust Policy 269 International Trade, Comparative Advantage, and Protectionism 663 14 Oligopoly 293 35 Open-Economy Macroeconomics: The Balance of 15 Monopolistic Competition 313 Payments and Exchange Rates 687 16 Externalities, Public Goods, and Social Choice 329 36 Economic Growth in Developing and Transitional 17 Uncertainty and Asymmetric Information 353 Economies 713 18 Income Distribution and Poverty 367 Glossary 735 19 Public Finance: The Economics of Taxation 389 Index 751 PART IV Concepts and Problems in Photo Credits 781 Macroeconomics 409

20 Introduction to Macroeconomics 409 21 Measuring National Output and National Income 423 22 Unemployment, Inflation, and Long-Run Growth 441 vi Contents

PART I Introduction To Economics 1 Demand, Supply, and Market 3 Equilibrium 47 The Scope and Method of 1 Firms and Households: The Basic Decision- Economics 1 Making Units 47 Why Study Economics? 2 Input Markets and Output Markets: The Circular To Learn a Way of Thinking 2 Flow 48 To Understand Society 4 Demand in Product/Output Markets 50 To Understand Global Affairs 5 Changes in Quantity Demanded versus Changes in To Be an Informed Citizen 5 Demand 51 ECONOMICS IN PRACTICE iPod and the World 6 Price and Quantity Demanded: The Law of Demand 51 The Scope of Economics 6 Microeconomics and Macroeconomics 6 Other Determinants of Household Demand 54 ECONOMICS IN PRACTICE The Diverse Fields of Economics 7 Kindle in the College Market? 55 ECONOMICS IN PRACTICE Trust and Gender 9 Shift of Demand versus Movement Along a The Method of Economics 9 Demand Curve 56 Descriptive Economics and Economic Theory 10 From Household Demand to Market Demand 58 Theories and Models 10 Supply in Product/Output Markets 60 Economic Policy 13 Price and Quantity Supplied: The Law of An Invitation 15 Supply 61 Summary 15 Review Terms and Concepts 16 Problems 16 Other Determinants of Supply 62 Appendix: How to Read and Understand Graphs 17 Shift of Supply versus Movement Along a Supply Curve 63 2 The Economic Problem: Scarcity From Individual Supply to Market Supply 65 and Choice 25 Market Equilibrium 66 Scarcity, Choice, and Opportunity Cost 26 Excess Demand 66 Scarcity and Choice in a One-Person Economy 26 Excess Supply 68 Scarcity and Choice in an Economy of Two or Changes in Equilibrium 69 More 27 ECONOMICS IN PRACTICE High Prices for ECONOMICS IN PRACTICE Frozen Foods and Tomatoes 70 Opportunity Costs 28 Demand and Supply in Product Markets: A The Production Possibility Frontier 33 Review 72 The Economic Problem 38 Looking Ahead: Markets and the Allocation of Resources 72 ECONOMICS IN PRACTICE Trade-Offs among the ECONOMICS IN PRACTICE Rich and Poor 39 Why Do the Prices of Newspapers Rise? 73 Economic Systems and the Role of Government 39 Summary 74 Review Terms and Concepts 75 Problems 76 Command Economies 40 Laissez-Faire Economies: The Free Market 40 4 Demand and Supply Mixed Systems, Markets, and Governments 42 Applications 79 Looking Ahead 42 The Price System: Rationing and Allocating Summary 43 Review Terms and Concepts 43 Problems 44 Resources 79 Price Rationing 79 vii viii Contents

ECONOMICS IN PRACTICE Prices and Total PART II The Market System: Choices Made by Expenditure: A Lesson From the Lobster Industry in Households and Firms 117 2008–2009 81 Constraints on the Market and Alternative Household Behavior and Consumer Rationing Mechanisms 82 6 Choice 121 Prices and the Allocation of Resources 86 Price Floor 86 Household Choice in Output Markets 121 Supply and Demand Analysis: An Oil Import The Determinants of Household Demand 122 Fee 86 The Budget Constraint 122 ECONOMICS IN PRACTICE The Price Mechanism at The Equation of the Budget Constraint 125 Work for Shakespeare 87 The Basis of Choice: Utility 126 Supply and Demand and Market Efficiency 89 Diminishing Marginal Utility 126 Consumer Surplus 89 Allocating Income to Maximize Utility 127 Producer Surplus 90 The Utility-Maximizing Rule 129 Competitive Markets Maximize the Sum of Diminishing Marginal Utility and Downward- Producer and Consumer Surplus 91 Sloping Demand 129 Potential Causes of Deadweight Loss From Under- Income and Substitution Effects 130 and Overproduction 92 The Income Effect 130 Looking Ahead 93 The Substitution Effect 131 Summary 93 Review Terms and Concepts 94 Problems 94 Household Choice in Input Markets 132 The Labor Supply Decision 132 Elasticity 97 ECONOMICS IN PRACTICE Substitution and Market 5 Baskets 133 Price Elasticity of Demand 98 The Price of Leisure 134 Slope and Elasticity 98 Income and Substitution Effects of a Wage Types of Elasticity 99 Change 134 Calculating Elasticities 100 Saving and Borrowing: Present versus Future Calculating Percentage Changes 100 Consumption 135 Elasticity Is a Ratio of Percentages 101 ECONOMICS IN PRACTICE What Happens When The Midpoint Formula 101 the Cost of Self-Discovery Falls? 136 Elasticity Changes Along a Straight-Line Demand A Review: Households in Output and Input Curve 103 Markets 137 Elasticity and Total Revenue 105 Summary 138 Review Terms and Concepts 138 Problems 138 The Determinants of Demand Elasticity 107 Appendix: Indifference Curves 141 Availability of Substitutes 107 The Importance of Being Unimportant 107 The Production Process: The ECONOMICS IN PRACTICE Who Are the Elastic 7 Smokers? 108 Behavior of Profit-Maximizing The Time Dimension 108 Firms 147 ECONOMICS IN PRACTICE Elasticities at a The Behavior of Profit-Maximizing Firms 148 Delicatessen in the Short Run and Long Run 109 Profits and Economic Costs 148 Other Important Elasticities 109 Short-Run versus Long-Run Decisions 150 Income Elasticity of Demand 110 The Bases of Decisions: Market Price of Outputs, Cross-Price Elasticity of Demand 110 Available Technology, and Input Prices 151 Elasticity of Supply 111 The Production Process 152 Looking Ahead 111 Production Functions: Total Product, Marginal Summary 112 Review Terms and Concepts 112 Problems 113 Product, and Average Product 152 Appendix: Point Elasticity (Optional) 115 Production Functions with Two Variable Factors of Production 155 Contents ix

ECONOMICS IN PRACTICE Learning about Growing Long-Run Adjustments to Short-Run Pineapples in Ghana 156 Conditions 200 Choice of Technology 156 ECONOMICS IN PRACTICE The Long-Run Average ECONOMICS IN PRACTICE How Fast Should a Cost Curve: Flat or U-Shaped? 201 Truck Driver Go? 157 Short-Run Profits: Moves In and Out of Looking Ahead: Cost and Supply 158 Equilibrium 201 Summary 158 Review Terms and Concepts 159 Problems 159 ECONOMICS IN PRACTICE The Fortunes of the Appendix: Isoquants and Isocosts 162 Auto Industry 204 The Long-Run Adjustment Mechanism: Investment Short-Run Costs and Output Flows Toward Profit Opportunities 204 ECONOMICS IN PRACTICE 8 Decisions 167 Why Are Hot Dogs So Expensive in Central Park? 205 Costs in the Short Run 168 Output Markets: A Final Word 206 Fixed Costs 168 Summary 206 Review Terms and Concepts 207 Problems 207 Variable Costs 169 Appendix: External Economies and Diseconomies and the Long-Run Total Costs 175 Industry Supply Curve 210 Short-Run Costs: A Review 177 ECONOMICS IN PRACTICE Average and Marginal Input Demand: The Labor and Costs at a College 178 10 Land Markets 215 Output Decisions: Revenues, Costs, and Profit Maximization 179 Input Markets: Basic Concepts 215 Perfect Competition 179 Demand for Inputs: A Derived Demand 215 Total Revenue and Marginal Revenue 180 Inputs: Complementary and Substitutable 216 Comparing Costs and Revenues to Maximize Diminishing Returns 216 Profit 180 ECONOMICS IN PRACTICE Sometimes Workers Play ECONOMICS IN PRACTICE Case Study in Marginal Hooky! 217 Analysis: An Ice Cream Parlor 182 Marginal Revenue Product 217 The Short-Run Supply Curve 184 Labor Markets 219 Looking Ahead 185 A Firm Using Only One Variable Factor of Summary 185 Review Terms and Concepts 186 Problems 186 Production: Labor 219 A Firm Employing Two Variable Factors of Long-Run Costs and Output Production in the Short and Long Run 222 ECONOMICS IN PRACTICE 9 Decisions 189 What is Denzel Washington’s Marginal Revenue Product in Broadway’s Short-Run Conditions and Long-Run Fences? 223 Directions 190 Many Labor Markets 224 Maximizing Profits 190 Land Markets 224 Minimizing Losses 192 Rent and the Value of Output Produced on The Short-Run Industry Supply Curve 194 Land 225 Long-Run Directions: A Review 194 ECONOMICS IN PRACTICE Time Is Money: Long-Run Costs: Economies and Diseconomies of European High-Speed Trains 226 Scale 195 The Firm’s Profit-Maximizing Condition in Input Increasing Returns to Scale 196 Markets 226 ECONOMICS IN PRACTICE Economies of Scale in Input Demand Curves 227 the World Marketplace 197 Shifts in Factor Demand Curves 227 ECONOMICS IN PRACTICE Economies of Scale in Looking Ahead 228 Solar 198 Summary 229 Review Terms and Concepts 230 Problems 230 Constant Returns to Scale 199 Decreasing Returns to Scale 200 U-Shaped Long-Run Average Costs 200