We review the key aspects of supply and demand and the price system, done in six chapters. We present incentives as the most important idea in microeconomics. Microeconomics should be intuitive, should teach the skill of thinking like an economist, and should be drawn from examples from everyday life. Along these lines, these chapters run as follows.

Chapter 1: The Big Ideas in Economics What is economics all about? We present the core ideas of incentives, opportunity cost, trade, the importance of economic growth, thinking on the margin, and some of the key insights of economics such as that tampering with the laws of supply and demand has consequences and good institutions align self-interest with the social interest. The point is to make economics intuitive and compelling and to hook the student with examples from everyday life.

Chapter 2: The Power of Trade and Comparative Advantage Why is trade so important and why is it a central idea of economics? We introduce ideas of gains from trade, the production possibilities frontier, and comparative advantage to show the student some core ideas behind the economic way of thinking. The key here is to illustrate the power of economic concepts in explaining the prosperity of the modern world. An instructor can either use this material to entice the student, or postpone the subject and move directly to the supply and demand chapters.

Chapter 3: Supply and Demand This chapter focuses on demand curves, supply curves, how and why they slope, and how they shift. The chapter presents some basic fundamentals of economic theory, using the central example of the market for oil. We also take special care to illustrate how demand and supply curves can be read “horizontally” or “vertically.” That is, a demand curve tells you the quantity demanded at every price and the maximum willingness to pay (per unit) for any quantity.

It takes a bit more work to explain these concepts early on, but students who learn to read demand curves in both ways get a deeper understanding of the curves and they find consumer and producer surplus, taxes, and the analysis of price controls much easier to understand.

Chapter 4: Equilibrium: How Supply and Demand Determine Prices Market clearing is an essential idea for both microeconomics and macroeconomics. In this chapter, students learn how a well functioning market operates, how prices clear markets, the meaning of maximizing gains from trade, and how to shift supply and demand curves. The chapter concludes with a section on understanding the price of oil, a topic that recurs throughout the text.

Chapter 5: Elasticity and Its Applications Elasticity is often considered a dull topic so we begin this chapter with a shocking story:

In fall 2000, Harvard sophomore Jay Williams flew to the Sudan where a terrible civil war had resulted in many thousands of deaths. Women and children captured in raids by warring tribes were being enslaved and held for ransom. Working with Christian Solidarity International, Williams was able to pay for the release of 4,000 people. But did Williams do the right thing?

xxii

What is a discussion of modern slavery doing in a principles of economics book? We want to show students that economics is a social science, that it asks important questions and provides important answers for people who want to understand their world. We take economics seriously and in Modern Principles we analyze serious topics.

Once we have shocked readers out of their complacency, we offer them an implicit deal—we are going to develop some technical concepts in economics, which at first may seem dry, but if you learn this material, there is going to be a payoff. We will use the tools to understand the economics of slave redemption as well as why the war on drugs can generate violence, why gun buyback programs are unlikely to work, and how to evaluate proposals to increase drilling in the Arctic National Wildlife Refuge.

Chapter 6: Taxes and Subsidies We analyze commodity taxes and subsidies, two core topics, to test, refine, and improve an understanding of microeconomics. We have all heard the question “Who pays?” and the statement “Follow the money,” but few people understand how to apply these ideas correctly. The economist knows that the final incidence of a tax depends not on the laws of Congress but on the laws of economics, and this can be taught as yet another invisible hand result. Teaching the incidence of taxes and subsidies also gives yet another way of driving home the concept of elasticity, its intuitive meaning, and its real-world importance. We also include in this chapter a timely discussion of wage subsidies to which we compare the minimum wage.

Chapter 7: The Price System: Signals, Speculation, and Prediction “A price is a signal wrapped up in an incentive.” That’s one of the most important ideas of economics, even if it takes a little work on the part of the students. And that is an idea that we drive home in this chapter. Partial equilibrium analysis can sometimes obscure the big picture of markets and how they fit together. General equilibrium analysis, either done mathematically or with an Edgeworth box, captures neither the “marvel of the market” (to use Hayek’s phrase) nor the student’s interest. We give a fast paced, intuitive, general equilibrium view of markets and how they tie together. We are linked to the world economy, and goods and services are shipped from one corner of the globe to another, yet without the guidance of a central planner. We show how the price of oil is linked to the price of candy bars. We also show how markets can predict the future, even the future of a movie like American Pie 2! For those familiar with Leonard Read’s classic essay, this chapter is “I, Pencil” for the twenty-first century.

Chapter 8: Price Ceilings and Floors There is no better way to understand how the price system works than to see what happens when the price system does not work very well. That price controls bring shortages is one of the most basic and most solid results of microeconomics. When it comes to price controls, however, the bad consequences extend far beyond shortages. Price controls lead to quality reductions, wasteful lines, excess search, corruption, rent-seeking behavior, misallocated resources, and many other secondary consequences. Price controls are an object lesson in many important economic ideas and we teach the topic as such. Sometimes we’re all better off if the university charges more for parking! Price controls also offer a good chance to teach some political economy lessons about why bad economic policies happen in the first place.

xxiii

Sometimes governments prop up prices instead of keeping them down— the minimum wage for labor is one example, and airline regulation before the late 1970s is another. As with price ceilings, price floors bring misallocated resources, distortions in the quality of the good or service being sold, and rent seeking. Maybe the government can prop up the price of an airline ticket, as it did in 1974, but each airline will offer lobster dinners to lure away customers.

Chapter 9: International Trade We build on the basics of international trade—the division of knowledge, economies of scale, and comparative advantage—covered in Chapter 2, to show students how they can use the tools of supply and demand to understand the microeconomics of trade. We consider the costs of protectionism, international trade and market power, trade and wages, and most of all trade and jobs. Is protectionism ever a good idea? The chapter also offers a brief history of globalization as it relates to trade. We emphasize that the principles covering trade across nations are the same as those that govern trade within nations.

Chapter 10: Externalities: When the Price Is Not Right When do markets fail or otherwise produce undesired results? Prices do not always signal the right information and incentives, most of all when external costs and benefits are present. A medical patient may use an antibiotic, for instance, without taking into account the fact that disease-causing microorganisms evolve and mutate, and that antibiotic use can in the long run lead to bacteria that are antibiotic-resistant. Similarly, not enough people get flu vaccinations, because they don’t take into account how other people benefit from a lower chance of catching a contagious ailment. Private markets sometimes can “internalize” these external costs and benefits by writing good contracts, and we give students the tools to understand when such contracts will be possible and when not. Market contracts, tradable permits, taxes, and command and control are alternative means of treating externalities. Building on our previous understanding of the invisible hand, we consider when these approaches will produce efficient results and when not.

Chapter 11: Costs and Profit Maximization under Competition This chapter makes cost theory intuitive once again. Costs are indeed an important economic concept; prices and costs send signals to firms and guide their production decisions, just as a price at Walmart shapes the behavior of consumers. But how exactly does this work? We’ve all seen textbooks that serve up an overwhelming confusion of different cost curves, all plastered on the same graph and not always corresponding in a simple or direct manner to economic intuition.

This chapter reduces the theory of cost and the theory of production to the essentials. A firm must make three key decisions: What price to set? What quantity to produce? When to enter and exit an industry? A simple notion of average cost suffices to cover decisions of firm entry and exit, while avoiding a tangle of excess concepts. Unlike many books, we stress the importance of “wait and see” and option value strategies. We can show firm-level and industry-level supply responses; constant, decreasing, and increasing cost industries; and how comparative statics differ for these cases.

xxiv

Chapter 12: Competition and the Invisible Hand Profit maximization leads competitive firms to produce where P = MC, but why is this condition truly important? Most textbooks don’t teach the marvelous result that when each firm produces where P = MC, total industry costs are minimized. Competitive firms minimize total industry costs despite the fact that no firm intends this result and perhaps never even understands this result. As Hayek says, the minimization of total industry costs is “a product of human action but not of human design.” We also show in this chapter how profit and loss signals result in a balancing of industries in a way that solves the great economic problem of getting the most value from our finite resources.

This material is so important that we have given it its own chapter. This chapter gives a deeper insight into Adam Smith’s invisible hand, and how it relates to profit maximization, than does any other principles text.

Chapter 13: Monopoly When they can, firms use market power to maximize profit and this chapter shows how. (Some budding entrepreneurs in the class may take this as a how-to manual!) We build on concepts such as cost curves and elasticity to flesh out the economics and also the public policy of monopoly. If you own the intellectual property rights to an important anti-AIDS drug, just how much power do you have? It’s good for you, but does this help or hurt broader society? Monopolies sometimes bring higher rates of innovation but in other cases, such as natural monopolies on your water supply, monopolies raise prices and reduce quantity with few societal benefits. Again, formal economic concepts such as elasticity and cost help us see the very real costs and benefits of such regulations as we experience them in our daily lives.

Chapter 14: Price Discrimination and Pricing Strategy Modern Principles devotes an entire chapter to this topic, which is fun, practical, and contains lots of economics. Students, in their roles as consumers, face (or, as sellers, practice!) price discrimination all the time, and that includes from their colleges and universities—remember in-state vs. out-of-state tuition? A lot of what students already “know” can be turned into more systematic economic intuition, including the concepts of demand and elasticity, and whether marginal cost is rising or falling. The pricing of printers and ink, pharmaceuticals, and cable TV all derive naturally from this analysis. Once students understand price discrimination, their eyes will be open to a world of economics in practice every day.

Chapter 15: Oligopoly and Game Theory Can OPEC nations really collude to force up the price of oil? Or is the price of oil set by normal competitive forces of supply and demand in world markets? Understanding when businesses “control price” and when they do not is one of the biggest gaps in understanding between someone with economics training and someone without such training. Cartels usually collapse because of cheating by cartel members, new entrants into the market, and legal prosecution from governments. Despite the challenges that cartels like OPEC face, many businesses nevertheless would love to cartelize their markets, even if they find it difficult to succeed for very long.

The incentive to cheat on cartels is a key to introducing game theory and also the prisoner’s dilemma, which we cover in depth in this chapter. We consider the basic logic of the game, the motive for defecting, and how repeated interaction may induce cooperation, including in this context cooperation among the colluding cartel members. The appendix formally outlines the concept of Nash equilibrium. This chapter also introduces the concrete examples of a price-matching game and customer loyalty programs, such as frequent flier miles, to show how sellers may use game-theoretic tricks to maintain collusion.

xxv

Chapter 16: Competing for Monopoly: The Economics of Network Goods Students are eager to understand the world they live in. Modern Principles talks not about the market for ice cream but the market for oil, printers and ink, smartphones, Google, Facebook, and Match.com. In this chapter we focus on network goods, which have obtained a greater foothold in most of our lives with the coming of the digital age.

A lot of us use Microsoft Word because so many other people also do, thus making it easier to share word processing files. Facebook beat out MySpace and other social network services because it had more useful features and innovated more rapidly. Once Facebook had a big enough lead, more and more users switched to that system, so they could follow their friends more easily. Markets like this have some unusual properties. They tend to have lots of monopoly and lots of innovation, namely competition “for the market” vs. competition “in the market.” If the dominant supplier switches, the market may change suddenly in fits and starts, rather than gradually. We show students how dating services work—in economic terms—and why friends so often seek out and enjoy the same musical songs. This hands-on chapter serves up a lot of topics of immediate interest to students and relates them to core microeconomic concepts.

Chapter 17: Monopolistic Competition and Advertising We cover monopolist competition in depth, focusing on the intuitions behind the concept. Monopolistic competition is in fact the most common market structure that students (and faculty!) encounter in daily life. Brands matter, and there is some market control over pricing, but it is far from absolute monopoly power. We show the basics of a monopolistic competition model, including how demand and the cost curves interact, and explain this in terms of markets that a person faces in everyday life. We also consider the motives and effects of advertising— a common feature of monopolistically competitive markets—in some detail. Advertising may boost price competition, may signal the quality of products, and may sometimes persuade or even trick consumers into buying goods and services they otherwise would be less interested in.

Chapter 18: Labor Markets Work touches almost all of our lives and most of the fundamental matters and conditions of work are ruled by economics. Wages. Working conditions. Bonuses. Investments in human capital and education. It’s the marginal product of labor that has the strongest influence over the wage of a particular job. Risky jobs, like going out on dangerous fishing boats, pay more. Labor unions boost the wages of some workers but will hurt the wages of others. There is also the controversial topic of discrimination in labor markets. We show how some kinds of discrimination may survive, while others will tend to fall away, due to the pressure of market forces.

Chapter 19: Public Goods and the Tragedy of the Commons Public goods and externalities help us understand when private property rights do not always lead to good outcomes. The concepts of excludability and nonrivalry help us classify why governments have to provide national defense but why movie theaters are usually left to the private sector.

xxvi

Why is it that the world is running out of so many kinds of fish? Economics has the best answer and it involves the tragedy of the commons. We show that economics is the single best entry point for understanding many common dilemmas of the environment.

Chapter 20: Political Economy and Public Choice If economics is so good, why doesn’t the world always listen? Political economy is one of the most important topics. Economics has a lot to say about how politics works and the results aren’t always pretty. Voters have a rational incentive to be ignorant or underinformed, and the end result is that special interests have a big say over many economic policies. Dairy farmers have a bigger say over milk subsidies than do the people who drink milk, and that is why the United States has milk price supports.

That said, democratic systems still outperform the available alternatives. We present the median voter theorem and also explain why political competition produces results that are at least somewhat acceptable to the “person in the street. “

Chapter 21: Economics, Ethics, and Public Policy Most principles students leave the classroom still underequipped to understand real-world policy debates over economic issues. So often the debate descends into ethics: Are markets fair? Is the distribution of income just? Is it important that individual rights be respected? When is paternalism justified? We do not try to provide final, takeaway answers to these questions, but we do give the students the tools to unpack how these questions intersect with the economic issues they have been studying.

Should we give physically handicapped individuals better access to public facilities, or should the government simply send them more cash? Should there be a free market in transplantable human organs such as kidneys? For all the power of economics, virtually any public debate on questions like these will quickly bring in lots of ethical questions. We think that students should be familiar with the major ethical objections to “the economic way of thinking,” and the strengths and weaknesses of those objections. We introduce the ideas of John Rawls and Robert Nozick, as well as the philosophy of utilitarianism. In our view this chapter is an important supplement to the power of economic reasoning.

Chapter 22: Managing Incentives Incentives matter! That may be the key single lesson of economics but a lot of textbooks don’t have a complete chapter on incentives. Business applications, sports applications, and personal life all provide plenty of illustrations of economic principles. You get what you pay for, so if you can’t measure quality very well, a lot of incentive schemes will backfire. Piece rates make a lot of workers more productive but strong incentives can impose risk on workers and induce them to quit their jobs altogether. As with grading on a curve, sometimes a boss wishes to pay workers relative to the performance of other workers. A lot of the most important incentives are about pride, fun, and fame, not just money.

xxvii

Economists can never be doing enough to communicate what they know about incentives to a broader public. By making it easy, we want to increase the incentives here!

Chapter 23: Stock Markets and Personal Finance The stock market is the one topic that just about every student of economics cares about, and yet it is neglected in many textbooks. We view the stock market as a “teaching moment” as well as an important topic in its own right. What other economic topic commands so much attention from the popular press? Yet not every principles course gives the student the tools to understand media discussions or to dissect fallacies. We remedy that state of affairs. This chapter covers passive vs. active investing, the trade-off between risk and return, “how to really pick stocks,” diversification, why high fees should be avoided, compound returns, and asset price bubbles. The operation of asset markets is something students need to know if they are to understand today’s economy and the financial crisis.

And, yes, we do offer students some very direct and practical investment advice. Most people should diversify and “buy and hold,” and we explain why. In terms of direct, practical value, we try to make this book worth its price!

Chapter 24: Asymmetric Information: Moral Hazard and Adverse Selection Some of the most important microeconomic problems in practical life concern asymmetric information. For instance, sometimes sellers know things that buyers do not. Imagine taking your car to an automechanic and being told it needs $500 worth of repairs—how do you know whether to believe the mechanic? The problem with asymmetric information is that it increases transactions costs and makes mutually beneficial market trades harder to pull off. We introduce a general class of issues known as principal–agent problems, namely that some individuals may try to take advantage of each other in market settings. These problems also include adverse selection, which plagues insurance markets, the sale of used cars, and the sale of art on eBay. Sometimes it is hard to assure quality as a buyer and, for related reasons, it can be hard to get a fair price as a seller of quality merchandise. We show that problems of asymmetric information are extremely common, but also that markets often can overcome them to a considerable degree. We also use the concepts of moral hazard and adverse selection to help explain some aspects of recent debates over President Obama’s Affordable Care Act (Obamacare).

We close this chapter with the concept of signaling. Signaling occurs when a person undertakes a costly action to signal quality or reliability. A man may spend a lot of money on an engagement ring to show he is a serious courter who will make a reliable husband and life companion. One advantage of going to school is that you show the world you have discipline and the ability to finish projects and meet deadlines, above and beyond whatever you may learn there. We consider how signaling helps solve or at least alleviate many problems of asymmetric information.

Chapter 25: Consumer Choice This chapter adds an extensive and foundational treatment of indifference curves to the book. It starts with the notions of diminishing marginal utility and relative price ratios to derive indifference curves. A budget constraint is added to indifference curves to generate the standard propositions of consumer theory, including marginal rates of substitution, income effects, substitution effects, and the idea of a consumer optimum. The chapter includes novel applications, such as a unique and relevant application to Costco and why a company might charge consumers entry fees for membership.

xxviii