The prisoners were dying of scurvy, typhoid fever, and smallpox, but nothing was killing them more than bad incentives.

That is the opening from Chapter 1 of Modern Principles, and only an economist could write such a sentence. Only an economist could see that incentives are operating just about everywhere, shaping every aspect of our lives, whether it be how good a job you get, how much wealth an economy produces, and, yes, how a jail is run and how well the prisoners end up being treated. We are excited about this universal and powerful applicability of economics, and we have written this book to get you excited too.

In the first two editions, we wanted to accomplish several things. We wanted to show the power of economics for understanding our world. We wanted to create a book full of vivid writing and powerful stories. We wanted to present modern economics, not the musty doctrines or repetitive examples of a generation ago. We wanted to show—again and again—that incentives matter, whether discussing the tragedy of the commons, political economy, or what economics has to say about wise investing. Most generally, we wanted to make the invisible hand visible, namely to show there is a hidden order behind the world and that order can be illuminated by economics.

One of the most remarkable discoveries of economic science is that under the right conditions the pursuit of self-interest can promote the social good. Nobel laureate Vernon Smith put it this way:

At the heart of economics is a scientific mystery … a scientific mystery as deep, fundamental and inspiring as that of the expanding universe or the forces that bind matter…. How is order produced from freedom of choice?

We want students to be inspired by this mystery and by how economists have begun to solve it. Thus, we will explain how markets generate cooperation from people across the world, how prices act as signals and coordinate appropriate responses to changes in economic conditions, and how profit maximization leads to the minimization of industry costs (even though no one intends such an end).

We strive to make the invisible hand visible, and we do so with the core idea of supply and demand as the organizing principle of economics. Thus, we start with supply and demand, including producer and consumer surplus and the two ways of reading the curves, and then we build equilibrium in its own chapter, then elasticity, then taxes and subsidies, then the price system, then price ceilings and floors, then international trade, and then externalities. All of this material is based on supply and demand so that students are continually gaining experience using the same tools to solve more and deeper problems as they proceed. The interaction of supply and demand generates market prices and quantities, which in turn lies behind the spread of information from one part of a market economy to another. Thus, we show how the invisible hand works through the price system.

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In Chapter 7 we show how the invisible hand links romantic American teenagers with Kenyan flower growers, Dutch clocks, British airplanes, Colombian coffee, and Finnish cell phones. We also show how prices signal information and how markets help to solve the great economic problem of arranging our limited resources to satisfy as many of our wants as possible.

The focus on the invisible hand, or the price system, continues in Chapter 8. As in other texts, we show how a price ceiling causes a shortage. But a shortage in one market can spill over into other markets (e.g., shortages of oil in the 1970s meant that oil rigs off the coast of California could not get enough oil to operate). In addition, a price ceiling reduces the incentive to move resources from low-value uses to high-value uses, so in the 1970s we saw long lines for gasoline in some states yet at the same time gas was plentiful in other states just a few hours away. Price ceilings, therefore, cause a misallocation of resources across markets as well as a shortage within a particular market. We think of Chapter 7 and Chapter 8 as a package: Chapter 7 illustrates the price system when it is working and Chapter 8 illustrates what happens when the price system is impeded.

Students who catch even a glimpse of the invisible hand learn something of great importance. Civilization is possible only because under some conditions the pursuit of self-interest promotes the public good.

In discussing the invisible hand, we bring more Hayekian economics into the classroom without proselytizing for Hayekian politics. That is, we want to show how prices communicate information and coordinate action while still recognizing that markets do not always communicate the right information. Thus, our chapters on the price system are rounded out with what we think is an equally interesting and compelling chapter on externalities. The subtitle of Chapter 10, “When the Price Is Not Right,” harkens directly back to Chapter 7. By giving examples where the price signal is right and examples where the price signal is wrong, we convey a sophisticated understanding of the role of prices.

Our second goal in writing Modern Principles of Economics is to show—again and again—that incentives matter. In fact, incentives are the theme throughout Modern Principles, whether discussing the supply of oil, the effects of price controls, or the gains from international trade. We also include Chapter 22, “Managing Incentives.” In this chapter, we explain topics such as the trade-offs between fixed salaries and piece rates, when tournaments work well, and how best to incentivize executives. This chapter can be read profitably by anyone with an interest in incentive design—by managers, teachers, even parents! Chapter 22 will be of special interest to business and MBA students (and professors).

“Modern” is our third goal in writing Modern Principles. For example, we include an entire chapter on price discrimination, in which we cover not just traditional models but also tying and bundling. Students today are familiar with tied goods like cell phones and minutes, or printers and ink, as well as with bundles like Microsoft Office. A modern economics textbook should help students to understand their world.

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We include business examples and topics throughout the text. We cover business issues as diverse as why businesses cluster and how network externalities push businesses to compete “for the market” rather than “in the market,” to how successful cartels such as the NBA deal with the incentive to cheat, to how businesses actually go about price discriminating. Our chapter on incentives, already mentioned, is critical for managers in a variety of fields.

We also present a modern perspective on the costs and benefits of market power. A significant amount of market power today is tied to innovation, patents, and high fixed costs. Understanding the trade-offs involved with pricing AIDS drugs at marginal cost, for example, is critically important to understanding pharmaceutical policy. Similar issues arise with music, movies, software, chip design, and universities. Our material on monopoly and innovation is consistent with and provides a foundation for modern theories of economic growth.

Our chapters on monopoly and price discrimination (Chapter 13 and Chapter 14) are filled with business applications, real-world examples, and insightful discussions of policy.

Our game theory chapters (Chapter 15 and Chapter 16) are especially geared toward modern real-world choices and problems. Naturally, we cover cartel behavior. We also cover network externalities extensively. In many high-tech and online markets, the value of a good depends on how many other people are using the same good. Students are very familiar with examples such as Facebook and they want to know how the principles of economics apply to these contemporary goods. We even challenge students by showing how the principles of network externalities apply to cultural goods and even to the songs they listen to!

A modern text needs to place economics in context. We have a whole chapter on normative judgments (Chapter 21). It covers the assumptions behind cost-benefit analysis, the idea of a Pareto improvement, and the ethical judgments that have been used to praise or condemn economic reasoning. Rightly or wrongly, commentators often mix economic and moral judgments and we teach students to recognize which is which. We stress to the student that economics cannot answer normative issues but the student should be aware of what those normative issues are.

We offer an entire chapter (Chapter 23) on the stock market, a topic of direct practical concern to many students. We teach the basic trade-off between risk and return (no free lunches) and explain why it is a good idea to diversify investments. We also explain the microeconomics of bubbles, which of course bridges to current macroeconomic issues.

We knew that to reflect modern macroeconomics, we had to cover the Solow model and the economics of ideas, real business cycles, and New Keynesian economics. While most textbooks now cover the rudiments of economic growth, the importance of ideas as a driving factor is rarely even mentioned. Other textbooks do not offer a balanced treatment of real business cycle theory and New Keynesian theory, instead favoring one theory and relegating the other to a few pages that are poorly integrated with the overall macro model. In contrast, we believe that adequately explaining business fluctuations, unemployment, and both the potential and limits of monetary and fiscal policy requires a balanced but unified treatment that draws on ideas from both models.

We also knew that financial crises and bubbles are very real, and that fluctuations in output and employment are a social and economic issue around the world. In fact, we included substantial material on banking panics, bubbles, wealth shocks, and the importance of financial intermediation in the very first draft of Modern Principles. Our book incorporates these topics from the ground floor rather than attempting to squeeze such material into hastily added boxes or appended paragraphs. In the third edition, we include more material on the shadow banking system and on the importance of housing and other sources of collateral shocks.

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Modern Principles offers the following features and benefits: