Eco 2013 -- Mankiw # 2-4

Macroeconomics

Thoughts from a coffee container:

Everywhere, unthinking mobs of ‘independent thinkers’ wield tired clichés like cudgels,pummeling those who dare question ‘enlightened’ dogma. If ‘violence never solved any-thing,’ cops wouldn’t have guns and slaves may never have been freed. If it’s better that 10 guilty men go free to spare one innocent, why not free 100 or 1,000,000? Clichés begin arguments, they don’t settle them. Jonah Goldberg, editor-at-large, National ReviewOnline, Starbucks Cup, “The Way I See It # 22”

Once again Thomas Sowell cuts through the conventional wisdom or dogma (fr. Greek, dok: ‘to seem, to think, to seem good) – “Time and Money and Housing,” www.townhall.com/ columnists/thomassowell/ts20050830 and “Time and Money and Housing: Part II,” www.townhall.com/ columnists/thomassowell/ts20050901. His main focus in the articles is on hypocrisy (fr. Greek, hypókrisis; play acting, play a part) of political correctness – how in California Planning Commissions which purport to serve the general common (public) interest (preserve green areas, slow urban sprawl, etc.), but the ‘real’ benefits accrue to a small special interest group and the costs are imposed the majority of citizens. Once again the ideas formulated by Frédéric Bastiat in his pamphlet, “What is Seen and What is not Seen” helps to explain what is happening [also see: Gwartney and Stroup’s Key Element # 10 – “Ignoring Secondary Effects and Long-term Consequences is the Most Common Source of Error in Economics.” Sowell is discussing the lengthy delays in obtaining permits for development projects and the costs that they impose on large segments of society. Commenting on the fact that the San Mateo (California) Planning Commission has debated for five years on alternative uses of a piece of property, he explains:

None of this delay has cost the members of the Planning Commission a dime. This is whythe delay is still continuing. But whatever is finally done with the racetrack site will be vastly more expensive because five years of delay are not cheap.

There is something called the ‘time value of money’, i.e., money has income earning potential over some period of time, since it may be invested in income earning activities. In any decision-making process involving alternative future outcomes, both time and the prevailing interest rates must be taken into consideration.

Such delays are not uncommon in the more politically correct parts of California. Permission to build an important complex near San Francisco has taken even longer [five years]. Whoever ends up living in those apartments will have to pay far higher rents as a result.

The implications of delays and higher costs, Sowell argues that:

…one-fifth of new home-buyers in California pay at least half of their income for housing. So do nearly one-fourth of California renters. When it costs half of what you make just to put a roof over your head, that is a big restriction on what else

1

you can afford to do.

Here again the ‘Principles’ and/or ‘Key Ideas’ of economics provide the explanations for critical contemporary issues. In this case a scarce resource (income) forces folks to make trade-offs, since ‘there’s no such thing as a free lunch’ and ‘the cost of something is what you give up to get it.’ Sowell asks:

How did this situation come about and why does it continue?

He answers this rhetorical question, simply:

…it is newcomers who have to pay outrageous prices for houses, while it is existing homeowners who vote for laws and policies that drive up housing costs by obstructingthe building of new homes.

Remember, people act in their own self-interest and that in a free market, Smith’s ‘invisible hand’ will bring personal self-interest and the general welfare into harmony. Sowell continues his analysis:

Those who already own homes are not hurt by soaring housing prices. In fact, they benefit when the value of their homes becomes several times what they originally paid for them.

Given this situation and these incentives, it is easy to understand why such things as planning commissions, ‘open space’ laws and ‘historical preservation’ policies proliferate. These roadblocks to building are essentially idealistic-sounding ways ofbeing completely selfish.

Despite much liberal rhetoric about compassion for the poor, it is precisely in such over-whelmingly liberal enclaves as those in California where high housing costs resulting from restrictive laws have imposed the heaviest burden on lower income people.

Nearly half of those California renters who earn $30,000 a year or less pay half or more of their incomes for rent. Among those in this income bracket who have bought a home within the past two years, 72 percent are spending at least half of their income on mortgagepayments.

These hypocritical behaviors are characterized in the popular media as NIMBYism or ‘Not In My Back Yard.

All sorts of lofty talk about ‘open space’ or ‘saving the green foothills’ is used to disguisethe plain fact that those who already have theirs want to keep other people out, especiallyother people not as upscale as themselves.

One summer, I taught at the University of Montana located in Missoula, a relatively small city (with more bars than any other retail outlets). Nestled in the Bitterroot Valley, surrounded by the Rocky Mountains, even new resident half jokingly talked about sealing up the passes into Missoula – we’ve found paradise and we want to keep others out!

Sowell received an e-mail ‘pointing out’ and ‘correcting’ the errors that Sowell had made in this paper. His response is to be found in the second editorial, “Time and

2

Money and Housing: Part II.” The writer tells Sowell that ‘money isn’t everything.’ Dr. Sowell’s response is:

That is certainly true – and especially when it is someone else’s money.

The e-mailer from Santa Barbara continued:

We have fought very hard to prevent developers from profiting from the beautiful community we have worked so hard, and for so many generations to create and preserve….

To which Sowell responded:

In other words, the people who have lived in Santa Barbara a long time, and who therefore have not had to pay the outrageous housing prices that the home-building restrictions force newcomers to pay, are on a higher moral plane the ‘developers’ – practically a cuss word in coastal California.

The fact that developers, like most people, want to earn money is regarded as sinisterby some and the fact that the money is called ‘profit’ makes it different from moneythat is called something else. It is amazing how many of those who consider themselves‘thinking people’ respond automatically to words the way Pavlov’s dog was conditioned to respond to certain sounds.

What developers want means absolutely nothing economically unless other peopleare prepared to pay for what they offer. In other words, developers are just intermediaries who represent the demand for housing by vastly larger numbers of other people.

Remember what we’ve learned from Adam Smith, Ludwig von Mises, Frederick Hayek and Murray Rothbard: People earn their living by serving the needs of others.

In the housing market, as in other markets, there are always people who want to usethe same resources for different and conflicting purposes. There is nothing unique inin the housing market when there are two sets of people wanting the same things andthere is not enough to satisfy both.

The ‘Law of Scarcity’ necessitates the allocation of scarce resources to their highest and best uses (most productive activities). This socially efficient resource allocation may be best accomplished through ‘voluntary’ free market exchanges (the highest bidder gets to use the resource for the purpose they choose). Gwartney and Stroup remind us that such voluntary market exchanges “promote economic progress.”

The proponents of purpose of home-building restrictions, according to the Santa Barbara e-mailer, is

…to try to preserve natural beauty and avoid the congestion and obstructed views of an urban environment….

To which, Dr. Sowell responds:

Avoiding ‘congestion’ is hypocritical. Since the number of people is the same,

3

whether or not there are housing restrictions, keeping them out of Santa Barbarajust transfers the ‘congestion’ elsewhere.

Please note that this is, once again, a manifestation of NIMBYism – we don’t want the congestion [a benefit for us – no congestion] in our community, let others live with it [bear the costs]. In the first article, Dr. Sowell had noted that the ‘building restrictions’ bear down hardest on the poorest segments of society. In conclusion, Sowell observes:

Ugly as such selfishness may be, it is no worse than the zealotry of the naturecultists who join with them to make life miserable for thousands of other people inorder to give themselves a cheap sense of importance that some confuse withidealism.

Chapter 2 Thinking Like an Economist

Economics and the ‘Scientific (or Inductive) Method’

We’ve all been exposed to what has been called the ‘scientific method’ – an approach to the natural world that begins with careful observation of phenomena. It has been associated with Sir Francis Bacon (and others, such as Galileo) that the Aristotelian method of ‘deductive logic’, which worked well in mathematics, was not easily applied to the natural world, since it required the use of axioms – true statements – from which other statements may be deductively derived. Galileo recognized that it was extremely difficult to prove the truth of the initial statements and that the true statements or not the starting point, but the goal of science. The inductive method has been so fully integrated with science that it is known as the scientific method. The inductive method begins with observation of nature in the hopes of formulating a few true statements about how the natural world works – laws and theories. Mankiw notes that economics employs both ‘theory and observation’, like evolutionary biology and astronomy, it lacks a laboratory making the development of experimental evidence difficult. He states, “Economists, … , usually have to make do with whatever data the world happens to give them.”

Mankiw argues, as a justification that the methodology of economics is analytically ‘scientific,’ by noting that the very:

…essence of science, however, is the scientific method – the dispassionate development and testing of theories about how the world works. This method of inquiry is as applicable to studying a nation’s economy as it is to studying the earth’s gravity or a species evolution. (20)

Sadly, adherence to the scientific method, as outlined by Sir Francis Bacon, has become increasingly less frequent, in both the physical and the social sciences – the claim for human-induced global warming is simply the most recent example. Michael Crichton has commented on this in his latest novel, State of Fear. His comments have been excerpted and appear on his website [www.crichton-official.com/fear/fear_main.shtml.] Earlier, in his lecture – “Aliens Cause Global Warming” – at Caltech (Michelin Lecture, January 17, 2003, he had expressed his concerns:

4

I want to discuss the history of several widely-publicized beliefs and to point to what I consider an emerging crisis in the whole enterprise of science – namely the increasing uneasy relationship between hard science and public policy. [Emphasis added]

Julian Simon, in his last book, Hookwinking the Nation, has identified a number of reasons ‘scientists’ abandon the scientific method and pursue the implementation of public policies – money, notoriety, saving the world from disaster.

In terms of global warming, it must be noted that the world’s temperatures have cooled and warmed at least four times [continental glaciation] during the Quaternary Period (the last million years or so. The Quaternary is subdivided into: (i) the Pleistocene, which lasted for about 990,000 years; and (ii) the peak of the last ice age occurred about 24,000 years ago and warming set in thereafter. The most recent period, the Holocene (encompassing the most recent 12,000 to 15,000 years) has been the era of man. The beginning of the Holocene marked the end of the last glacial epoch. For more precise dating of the end of the Pleistocene and the beginning of the Holocene, see: Hans E. Suess. 1956. “Absolute Chronology of the Last Glaciation,” Science, Vol. 123, No. 3192 (2 March). Note that Suess uses the term: “Last Glaciation”, implying both earlier alternating periods of ‘glaciations’ and warmings.

If one is to believe that human activities have caused the current global warming, the activities our early hunter/gather ancestors (Paleolithic/Mesolithic cultures) must have been responsible for the warming of the Holocene. For this to be true, it would be necessary to ignore the so-called ‘bottle-neck’ in human evolution, when the number of people collapsed and the human race was on the brink of extinction. But this would leave unanswered, the causes of the three previous warming periods (interglacial periods) of the Pleistocene. The most recent phase of human evolution, the Neolithic cultures, have been correlated with both the Holocene AND domestication of plants. The evidence for the thorough domestication of lentils, peas, barley and wheat on the Anatolian Plateau (Turkey) dates from about 8,400 years ago – domestication of plants is one of the characteristics that anthropologists use to define the Neolithic or (New Stone) Age. Domestication of food producing animals occurred more recently, the cow, for example dates from about 7,500 years ago.

Economist as Scientist

Mankiw discusses the “ways in which economists apply the logic of science.” He asserts that an economist:

…might live in a country experiencing rapid increases in prices and be moved by this observation to develop a theory of inflation. The theory might assert that high inflation arises when the government prints too much money….To test this theory, the economist could collect and analyze data on prices and money from many different countries. Ifgrowth in the quantity (21)

In such a manner he maintains that the economists adhere to the scientific method, just as do practitioners of chemistry and physics.

5

yet unlike them, and more like evolutionary biologists and astronomers, economists lack experimental laboratories.

Both the physical sciences and economics use abstractions from or simplifications of the real world – known as, models – to help explain external realities. The fist model Mankiw formulates is the so called circular flow model or diagram representing the manner by which individual elements in the economy (‘households’ and ‘firms’) interact.[See: Figure 1, Chapter 2, pg. 23] The ‘household’ serves as a source [supplier] of the ‘factors of production’ (land, labor, capital and entrepreneurship) that ‘firms’ require [demand], in order to carry on their productive activities. Simultaneously, the ‘household’ serves as a ‘consumer’ of the products (outputs) that the firms have created. Alternatively, a firm is a provider of goods and services [supplier] that meet the needs and wants of households [demand]. For their use of the factors of production by firms, households are compensated by payments or income (rents, wages/salaries, interest/dividends, and profits) made by the firms. The voluntary exchanges of the factors of production by households for compensations provided by the firms take place in Resource Markets. Households use their incomes to purchase the goods and services produced/provided by firms. These transactions take place in Goods and Services Markets. If we add-up (sum) the value of ALL compensation to ALL households in a nation it is equal to Gross Domestic Product (GDP). If we add-up (sum) the value of the ALL the revenues of ALL firms in a nation it is equal to Gross Domestic Product (GDP). [See: Figure 1, Chapter 10, pg. 205]

Note: both households and firms are pursuing their own self-interest – households may choose to work for one firm, rather than another because it pays a higher wage, provides better benefits or is more convenient; while, firms may choose to produce guns rather than butter or sell in the local, national or in international markets, whichever leads to higher profits. Reflecting Mankiw’s Principle # 1 – “People Face Tradeoffs” – allocate household resources to firm A or to firm B; Principle # 2 – “The Cost of Something is What You Give Up to Get It” – the benefits firm B would have paid the household had the household not allocated its labor to firm A; Principle # 4 – “People Respond to Incentives” – firm A decides to produce a given product because it is able to maximize its profits; Principle # 5 – “Trade (or Exchange) Can Make Everyone Better Off” – voluntary trade or exchange between firms and households make both better off, or the transactions would not take place; Principle # 6 – “Markets are Usually a Good Way to Organize Economic Activity” – prices direct resources to their ‘highest and best (most desired) uses; and Principle # 8 – A Country’s Standard of Living Depends on It’s Ability to Produce Goods and Services”.

The second economic model that Mankiw presents is the ‘production possibilities curve’ [See: Figure 2, Chapter 2, pg. 25]. The assumption of the model is that a nation’s scarce resources may ONLY be allocated to the provision two goods and services or sets of goods and services. The production possibility frontier or curve indicates the various possible combinations of the two products or outputs (say, the Samuelson example: guns and butter) that a nation (economy) is capable of producing, where ‘butter’ represents ‘all other goods’. If the resources required for the production of guns and butters may be used

6

with equal efficiency in each industry (they are perfectly substitutable), the frontier will be a straight line, downward sloping to the right. Alternatively, if the resources necessary for the production of guns and butter may not be used with equal efficiency in each industry (they are imperfectly substitutable), the production possibilities curve bowed outward to the origin. Locations along the curve are said to be economically efficient (maximum output possible given the existing set or resources available). Points outside the curve are impossible; while points inside the frontier are economically inefficient (resources remain unused or unemployed). Movement along the curve indicates that if society wants MORE of one good or service, it must forego SOME of the other good or service, i.e., it must make a trade-off. The value of the ‘guns’ that must be given up in order to obtain an additional unit of butter is referred to as the ‘opportunity cost’ of butter.

Note: Principle # 1 – “People Face Tradeoffs” – in order for society to have more national defense (guns), it must give up (or sacrifice) some butter; and Principle # 2 -- “The Cost of Something is What You Give Up to Get It” – the value of the forgone butter is the opportunity cost of additional units of national defense.

Each of these models is a picture of what is happening at ‘the moment’ and do not reflect any change through time. They are a representation of the momentary. To account for a change in a society’s capacity to produce involves time, say an improvement in technology (a ‘new and improved’ way of converting inputs into butter), the position of the curve will change [See: Figure 3, Chapter 2, pg. 27].

Economics, Economists and Public Policy

John Neville Keynes subdivided economics’ methodology into three different approaches, economics as:

a positive disciple – analysis of the ‘world as it is’;

a normative discipline – analysis of the ‘world the way it ought to be;

an art.

The differentiating characteristic between ‘positive’ and ‘normative’ economics is that a normative approach involves the expression and implementation of policy stances that embody a ‘value’ (opinion) component – ‘the current minimum wage is too low and must be raised immediately to provide a living wage for women, minorities, young workers’. The only issue is: who’s ‘values’ are to become the ‘norm’ and imposed on others? A positive view of the ‘minimum wage’ issue might be: ‘raising the minimum wage will result in fewer jobs being available for women, minorities, young workers and raise prices for consumers.’ Remember Milton Friedman’s admonition: “It is better to be employed at $ 5.75 an hour than unemployed at $ 8.50 and hour.”

Why Economists Disagree

7

Mankiw identifies several reasons for economists to disagree on a particular approach: (i) ‘differences in scientific judgment’ [this should be an extremely rare event, since theories are ‘testable’ using the inductive (or scientific) method!]; (ii) ‘differences in values’ [this is probably the most significant factor, despite claims of ‘unbiased’ analysis and adherence to the inductive approach; and (iii) ‘perception versus reality’ [Mankiw is far to kind, as a cursory review of the ‘Introduction’ and first chapter of Julian Simon’s Hoodwinking the Nation will reveal.]

Simon, in an article published in Science in 1980, has identified four (4) reasons that “false statements of bad news dominate public discussions”, they are:

● “There is a funding incentive for scholars and institutions to produce bad news aboutpopulation, resources, and the environment.

● Bad news sells books, newspapers, and magazines; good news is not half so interesting.● There are a host of psychological explanations…(1) Many people have a propensity to

compare the present and the future with an ideal state of affairs rather than with the past or some other feasible state; the present and future inevitably look bad in such a comparison. (2) The cumulative nature of exponential growth models has the power to seduce and bewitch.

● Some people publicize dire predictions in the idealistic belief that such warnings can mobilize institutions and individuals to make things even better; they think thatnothing bad can come of such prophecies. But we should not shrug off false bad news as harmless exaggeration.” [Quoted in Hoodwinking the Nation, 2]

In the ‘Introduction’ to Hoodwinking the Nation, has added six (6) more entry’s to his list of ‘false statements of bad news’:

● “Many people prefer bucolic surroundings to resource development.● We may carry psychological propensities deep in our psyche that predispose us to

warnings of doom.● Journalists and interest groups use marvelously evocative inflammatory rhetoric to

arouse fear – ‘population bomb,’ ‘empty pumps,’ ‘save our children,’ ‘end of theworld as we know it,’ and ‘end of the age of affluence.’

● Simple racism may also a role, especially with respect to population growth in other parts of the world.

● Some activists display an attitude toward the facts that induces them to exaggerateand even lie when they are convinced that the eleventh-hour danger to thepublic justifies such dishonest practices. And joining the environmental move-ment is seen by many as a last chance to do good, just as joining the Communist Party in the 1930s seemed an opportunity for social contribution by many generous-minded people.

● A set of unsound ideas undergird the newspaper and television stories and provide theintellectual infrastructure that give these stories credibility. These ideas fall intotwo categories: misunderstandings of the nature of resource creation and population economics, and misunderstandings of the nature of a modern complexsocial-economic system.” [Hoodwinking the Nation, 3]

Modern science (post-sixteenth century) has been characterized by the use of the ‘inductive’ or ‘scientific method’, which has greatly advanced knowledge about the physical world and out place in it. Perhaps as importantly, such knowledge has enabled

8

us to improve our standards of living … more and better food, clothing and housing at lower ‘real’ costs. Mankiw’s views on why ‘economists disagree’, reveals a substantial retreat from the use of the ‘inductive’ or ‘scientific method’. Science, the formulation of theories and statement of laws, is not based on a plebiscite (vote). All too often, the majority has been incorrect, e.g., Galileo or Copernicus. Note: Mankiw’s Table 2 on page 32 – How many physicists deny Newton’s Law of Gravity? How many biologists (with the exception, perhaps, of the Soviet biologist, Lysenko) disagree with Mendel’s theory of inheritance? or, Ohm’s Law in physics (electricity)? In science, a theory prevails, unless it is shown not to be valid (fails to accurately predict postulated outcomes). To say that the majority of economists (93%) agree that: ‘Tariffs and quotas usually reduce general economic welfare,’ reduces the discipline to the status of an election! Tariffs and quotas either do, or they don’t reduce general welfare!

Appendix – Graphing

Problems in measurement – there are four scales of measurement: (i) the nominal scale; (ii) the ordinal scale; (iii) the interval scale; and (iv) the ratio scale. For the ‘nominal’ scale, the defining relation is equivalence, and examples of appropriate statistics are: the mode, frequencies, and the contingency coefficient; for the ‘ordinal’ scale, the defining characteristics are equivalence and less/greater than (<>), and the appropriate statistics are: the median, percentile, Spearman’s ρs; Kendall τ, and Kendall W. These two measurement scales REQUIRE the use of nonparametric statistical techniques.

Data at the interval scale and the ratio scale of measurement REQUIRE the use of parametric statistical techniques, however, nonparametric statistical techniques MAY BE used, but this requires very large data sets which may be prohibitively expensive in order to achieve confidence in the results. The defining relations of the interval scale are: equivalence, less/greater than (<>), and a known ratio of any two intervals and examples of appropriate statistics are: the arithmetic mean, standard deviation, Pearson product-moment correlation, and multiple product-moment correlation. Alternatively, the defining characteristics of the ratio scale are: equivalence, less/greater than (<>), a known ratio of any two intervals, and a known ratio of any two scale values, and the examples of appropriate statistics are: the geometric mean and the coefficient of variation. [A best source for understanding the ‘scales of measurement’ and the appropriate statistical techniques to be used with them is:

Sidney Siegel. 1956. Nonparametric Statistics for the Behavioral Sciences. New York:McGraw-Hill Book Company, Inc. Chapter 3 “Choosing an Appropriate Statistical Test,” pp. 18-34, especially, Measurement, pp. 21-30; and Parametric and Nonparametric Statistical Tests, pp. 30-4.

It is important to note that the majority of economic models postulate that outcomes are determinate (this means that decision makers possess perfect information, even about the future). Alternative models that relax the assumption of determinacy, replacing it with the possibility for indeterminate outcomes, which REQUIRE the use of

9

probabilistic models! The simplest relationship between two variables, Y – the dependent variable; and X – the independent variable, may be expressed as a straight line:

Y = b0 ± b1X + ε.

In this model, b0 represents the Y – intercept, i.e., the value of the dependent variable (Y), when the value of the independent variable (X) is equal to zero; and b1 represents the slope of the line. The slope may be expressed as:

rise ΔYSlope = b1 = --------- = ---------- .

Run Δ X

Some things to consider:

Just because there is an apparent relationship between two variables, it does not necessarily mean ‘cause and effect’, i.e., Y is caused by X! In economic models the problem of omitted variables (or even missing data) may result in misleading interpretations or conclusions and the case of reverse causality may led to misinterpretation or relationships and erroneous conclusions and bad policy implementation/outcomes.

Chapter 3. Interdependence and the Gains From Trade

Gwartney and Stroup have emphasized the points made in this chapter as the 3rd

of their Key Principles of economics – Voluntary Exchange Promotes Economic Progress by pointing out that there is a mutuality of gain from trade. This is in direct contrast with the notion that in a voluntary exchange one party may take advantage of the other! This is a post hoc explanation, at the moment of the trade both parties “agree to an exchange because they anticipate that it will improve their well-being….Trade is productive; it permits each of the trading partners to get more of what they want.” (8) Mankiw places this idea as his 5th Principle – Trade Can Make Everyone Better Off. This has been recognized since the time of Adam Smith and his conceptualization of the ‘invisible hand’ and the idea of ‘specialization of task’ or ‘division of labor’.

Once again, Mankiw employs the concepts of ‘production possibility curves’ and the trade-offs, reflected in the attendant ‘opportunity costs’, that they involve – in order to get something, one must give up something else. David Ricardo’s ‘Law of Comparative Advantage’ is introduced as a basis for exchange, indicating how both parties, whether individuals, regions of a country or nations, benefit from exchange, i.e., pursue their self-interest, responding to incentives.

Chapter 4. The Market Forces of Supply and Demand

10

Those who desire to purchase items (demand) and those who want to sell items (supply) come together in markets to effect exchanges. In situations where there are many buyers (demanders) and many sellers (suppliers), such that neither party is able to exert a significant influence on the market price, the market is said to be ‘competitive’. Mankiw, then goes on to state that in this chapter, markets are assumed to be ‘perfectly competitive’. He provides “two primary characteristics” of a perfectly competitive market: (i) “the goods being offered for sale are all the same” and (ii) “the buyers and sellers are so numerous that no single buyer or seller can influence the market price.” Unfortunately, he leaves out several other ‘primary’ assumptions: (i) each participant in the market has ‘perfect’ information (clairvoyance); (ii) all transactions occur at a moment in time; and (iii) all transactions take place at a point in space. Several other market structures, those involving the availability of less than ‘perfect’ information, product-differentiation, and less than ‘many sellers’ are described by Mankiw:

● Monopoly – a market in which there are many buyers, but there is only a singleseller [it should be noted that most, if not all monopolies, are the creations of government];

● Oligopoly – a market in which there are many buyers, but there are only a fewsellers, with duopoly (two) providing the limiting case; and

● Monopolistic competition – a market in which there are many buyers and manysellers of a differentiated product (they are not all the same) and productpromotion (advertising) helps in establishing differences.

Demand

Buyers respond in their own self-interest. Demand is the relationship between quantity and price, viewed from the perspective of the buyer, such that the quantity of a good or service taken off the market (purchased) depends upon the price of the good/ services. The quantity demanded is the amount of a good/service that consumers are willing and able to purchase. It should be clear that at higher prices, the fewer the number of units of the good consumers are only willing to take since they will be forced to forego alternative items (‘opportunity cost’; ‘there is no such thing as a free lunch’). This implies that the relationship between price and quantity will be inverse (‘trade-offs’):

Y (quantity demanded) = b0 - b1 X (price).

A change in price (ΔP), all other things held constant, will result in a change in quantity demanded (ΔQ). Notice that market demand is the horizontal summation of individual demands (see: Figure 2, pg. 67).

If the assumption of all other things held constant, is relaxed, then the demand curve itself will shift … for example, if an individual’s income changes there is likely to be a change in demand. Note the main factors that are associated with a change in demand: income; prices of related goods; tastes (and preferences); expectations; or a change in the number of buyers (change in the population). Pay particular attention to Figure 4, pg. 70.

Supply

11

Sellers respond in their own self-interest. Supply is also the relationship between quantity and price, viewed from the perspective of the seller, such that the quantity of a good or service placed on the market (supplied) depends upon the price that that good or service can command on the market.

It should be clear that at higher prices, businesses will be willing to place additional units of the good on the market – incentives matter. This implies that the relationship between price and quantity will be direct:

Y (quantity supplied) = b0 + b1 X (price).

Comments concerning the supply function, parallel those of demand, e.g., market supply is the horizontal summation of the individual supply curves; change in quantity supplied (a movement along a curve); and change in supply (a shift of the curve itself). The factors influencing shifts in the supply curve include: change in input prices; change in technology; change in expectations; and change in the number of vendors.

Equilibrium

Equilibrium is a market state such that at the price ‘markets will be cleared’, the level at which quantity supplied equals the quantity demanded. It is a state that once attained, tends to be maintained. Read pages 76-7 carefully, so as to understand deviations from equilibrium and government’s role in causing such deviations through ‘price controls’ – either ‘price supports’ (subsidies) for farmers at above market clearing levels [sugar quotas also serve this purpose] and for workers [‘minimum wage legislation’] ‘price ceiling’ for retailers after a disaster (to prevent ‘price gouging’ and renters at below market clearing levels (to make housing more affordable); see: Figure 9, pg. 77; also, see: pp. 114-23. Notice that the intentions are good, but the outcomes, the unintended consequences may be dire (shortages, dilapidated living conditions in a slum). We must keep the 10th Key Element propounded by Gwartney and Stroup (borrowing from Frederic Bastiat – “Things Seen and Things Unseen” – Ignoring Secondary Effects and Long-term Consequences [‘don’t matter, because we’re all dead’! Thanks, Lord Keynes!] is the Most Common Source of Error in Economics.

The title to the major subheading on page 83 is extremely important: “Conclusion: How Prices Allocate Resources.” Perhaps Mankiw could have inserted Scarce between Allocate and Resources in order to reinforce how and why prices are as they are in any given situation!

Chapter 11 – Measuring a Nation’s Income

The term Gross Domestic Product (or GDP) is used to provide a measure of the size of a nation’s economy. Other measures may be employed to indicate the current state of the economy: inflation (rate of change in the average price level); unemployment rate and retail sales (levels of well-being); and trade balance (levels of present vs. future well

12

being). Mankiw rightly notes (pg. 204) the dual nature of measures of GDP – one is a measure of everyone’s income; and the other is a measure of their expenditures on goods and services. He states,

The reason that GDP can perform this trick of measuring both total income and total expenditures is that these two things are really the same. For an economy as a whole income must equal expenditure. [Emphasis in original]

Consider the Circular Flow Diagram (Figure 1, pg. 205): Notice the Flows (money) – one is payments made by firms for the use of household resources [lower left (payments for land, labor, capital and entrepreneurship)] – the summation (∑) of all of these payments, sometimes known as ‘returns to factor owners’, will be equal to Gross Domestic Product. Notice on the lower right, this summed value is referred to as INCOME, which is also equal to Gross Domestic Product. Income is equal to the summation of payment to households (factor owners)! This represents the income approach to GDP.

The alternative approach to calculating GDP, the ’expenditure approach’, is displayed in the upper right hand side of the diagram, labeled ‘Spending’.

13