With love for Annika, Aras, Arda, Eli, Greta, Mason, Max, and Noah, who inspire us every day.
John A. List is the Kenneth C. Griffin Distinguished Service Professor in Economics at the University of Chicago, and Chairman of the Department of Economics. He received his B.S. in economics from the University of Wisconsin–Stevens Point and his Ph.D. in economics from the University of Wyoming. Before joining the University of Chicago in 2005, he was a professor at the University of Central Florida, University of Arizona, and University of Maryland. He also served in the White House on the Council of Economic Advisers from 2002–2003, and is a Research Associate at the NBER.
List was elected a Member of the American Academy of Arts and Sciences in 2011, and a Fellow of the Econometric Society in 2015. He also received the Arrow Prize for Senior Economists in 2008, the Kenneth Galbraith Award in 2010, the Yrjo Jahnsson Lecture Prize in 2012, and the Klein Lecture Prize in 2016. He received an honorary doctorate from Tilburg University in 2014 and from the University of Ottawa in 2017. In addition, List was named a Top 50 Innovator in the Non-Profit Times for 2015 and 2016 for his work on charitable giving.
His research focuses on questions in microeconomics, with a particular emphasis on using field experiments to address both positive and normative issues. For decades his field experimental research has focused on issues related to the inner workings of markets, the effects of various incentive schemes on market equilibria and allocations, and how behavioral economics can augment the standard economic model. This includes research into why inner city schools fail, why people discriminate, why people give to charity, why firms fail, why women make less money than men in labor markets, and why people generally do what they do.
His research includes over 200 peer-reviewed journal articles and several published books, including the 2013 international best-seller, The Why Axis: Hidden Motives and the Undiscovered Economics of Everyday Life (with Uri Gneezy).
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PART I Introduction to Economics 36
Chapter 1 The Principles and Practice of Economics 36 Chapter 2 Economic Methods and Economic Questions 54
Chapter 3 Optimization: Doing the Best You Can 76
Chapter 4 Demand, Supply, and Equilibrium 92
PART II Introduction to Macroeconomics 120
Chapter 5 The Wealth of Nations: Defining and Measuring Macroeconomic Aggregates 120
Chapter 6 Aggregate Incomes 150
PART III Long-Run Growth and Development 174
Chapter 7 Economic Growth 174
Chapter 8 Why Isn’t the Whole World Developed? 210
PART VI Macroeconomic in a Global Economy 370 Chapter 14 Macroeconomics and International Trade 370 Chapter 15 Open Economy Macroeconomics 394
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4.4
Chapter 6: Aggregate Incomes
Chapter 9: Employment and
14.3
Preface
We love economics. We marvel at the way economic systems work. When we buy a smartphone, we think about the complex supply chain and the hundreds of thousands of people who played a role in producing an awe-inspiring piece of technology that was assembled from components manufactured around the globe.
The market’s ability to do the world’s work without anyone being in charge strikes us as a phenomenon no less profound than the existence of consciousness or life itself. We believe that the creation of the market system is one of the greatest achievements of humankind.
We wrote this book to highlight the simplicity of economic ideas and their extraordinary power to explain, predict, and improve what happens in the world. We want students to master the essential principles of economic analysis. With that goal in mind, we identify three key ideas that lie at the heart of the economic approach to understanding human behavior: optimization, equilibrium, and empiricism. These abstract words represent three ideas that are actually highly intuitive.
The breakneck speed of modern technological change has, more than ever, injected economics into the lives—and hands—of our students. The technologies that they use daily illustrate powerful economic forces in action: Uber users observe real-time congestion in the transportation market when they confront surge pricing, and Airbnb travelers explore the relationships among location, convenience, and price by comparing listings near different subway stops in the same city.
As educators, it’s our job to transform economic concepts into language, visual representations, and empirical examples that our students understand. Today, markets are much more interactive than they were only a decade ago, and they exemplify that it is not just competitive markets with perfect information that are relevant to our economic lives. Our students routinely take part in auctions, purchase goods and services via organized platforms such as Uber, have to struggle with pervasive informational asymmetries as they participate in online exchanges, and have to guard themselves against a bewildering array of mistakes and traps that are inherent in these new transactions.
In this ever-changing world, students must understand not just well-known economic concepts such as opportunity cost, supply, and demand, but also modern ones such as game theory, auctions, and behavioral mistakes. It is these modern concepts, which are small parts in most Principles textbooks, that occupy center stage in ours. Today economic analysis has expanded its conceptual and empirical boundaries and, in doing so, has become even more relevant and useful.
This new world provides incredible opportunities for the teaching of economics as well, provided that we adjust our Principles canon to include modern and empirically based notions of economics. This has been our aim from day one and continues to be our goal in this second edition.
New to the Second Edition
In our new edition of Macroeconomics, we have completely revised the macro portion of the course, not just to bring it up to date with the firehose of current data and events, but, just as importantly, to re-evaluate and improve the pedagogy for the students.
The most important conceptual change begins in Chapter 9 (Employment and Unemployment), which then enables substantial pedagogical improvements in Chapters 12 (Short-Run Fluctuations) and 13 (Countercyclical Macroeconomic Policy). Our framework for the analysis of economic fluctuations centers on the labor market. In this framework, downward wage rigidity plays a vital role as a central mechanism preventing wages from adjusting to a negative labor demand shock and thus generating increases in unemployment during economic contractions.
In the previous edition, we went through most examples of the labor market twice: first with and then without downward nominal wage rigidity. We have now eliminated much of this repetition by studying both cases in Chapter 9, but then in Chapters 12 and 13 focusing the analysis on the case in which downward nominal wage rigidity is present.
To implement this strategy, we frequently deploy an empirically realistic and pedagogically effective two-part labor supply curve, which has a downward nominal wage tied to the
current wage and is infinitely inelastic beyond full employment. Accordingly, the two-part labor supply curve is first horizontal (at the current nominal wage) and then vertical (at full employment). This enables us to present a much simpler unified approach that is far easier to understand and has enabled us to overwhelmingly streamline the analysis in Chapters 12 and 13. We have eliminated some of the most complex figures without loss of conceptual richness.
Our two-part labor supply curve also emphasizes why further rightward shifts of the labor demand curve in the middle of an expansion will not increase employment by very much, and instead will primarily contribute to increases in wages and prices.
The two-part labor supply curve is used consistently in Chapters 12 and 13 in our discussion of short-run fluctuations and fiscal and monetary policy designed to offset such fluctuations.
In addition, we have enriched the macro split with new features, exhibits, and sections that illustrate economic concepts with recent events of interest. These include:
• New Choice & Consequence that forces students to wrestle with the question of causality. We discuss a recent research paper that reports a positive correlation between expensive weddings and high rates of divorce. We ask our students to use this finding as a springboard from which to wrestle with the difference between correlation and causality, and to understand the role of omitted variables (Chapter 2).
• New Letting the Data Speak that tells the story of the fracking revolution and its remarkable impact on oil and gasoline prices. Supply and demand come alive when students can see how the recent rightward shift in the oil supply curve, due to the development of fracking technologies, has played a role in halving the equilibrium price of oil (Chapter 4).
• New section describing the growth of economic inequality, and emphasizing that inequality is not measured in economic aggregates, such as GDP (Chapter 5).
• New Choice & Consequence about the societal consequences of the expulsion of Jewish faculty from universities in Nazi Germany (Chapter 6).
• New Letting the Data Speak on the great productivity puzzle, discussing how we may be experiencing a slow-down of aggregate productivity despite the rapid introduction of a range of new technologies in the economy (Chapter 7).
• New Letting the Data Speak on democracy and growth, showing the positive impact of democratic political institutions on economic growth (Chapter 8).
• Expanded Choice & Consequence on Luddite resistance to new technology and what this can teach us about the disruption that new and more productive robots are bringing to the economy today (Chapter 9).
• New Choice & Consequence on minimum wage laws and employment (Chapter 9).
• New Letting the Data Speak feature on financing start-ups (Chapter 10).
• New Choice & Consequence on obtaining reserves outside of the federal funds market (Chapter 11).
• New Letting the Data Speak on the response of consumption to tax cuts (Chapter 13).
• New Choice & Consequence on the Trump administration’s fiscal policy proposals (Chapter 13).
• New Choice & Consequence about the political forces that influence trade policy (Chapter 14).
• New graphical Exhibit describing the relationship between interest rates and net capital outflows, unifying material from several chapters for the analysis of open economy macroeconomics (Chapter 15).
Introductory economics classes draw students with diverse interests and future career paths: with this textbook, we show them how to apply economic thinking creatively to improve their work, their choices, and their daily lives.
One of our main objectives in writing this textbook was to show that the fundamentals of economics are not just exciting, but also alive with myriad personal applications. In the first edition, the themes of optimization, equilibrium, and empiricism were our primary tools for communicating both the surprising power and broad applicability of economics. We believe that the intervening years have confirmed these conceptual priorities; these concepts have become even more relevant for our students.
At a time when competing empirical claims abound and news sources across the political spectrum are denounced as “fake,” our students need the skills to systematically question and evaluate what they read. That is why, in our Evidence-Based Economics segments,
we examine both the implications and the limitations of academic studies. We hope that our textbook will help form a new generation of careful thinkers, smart decision-makers, engaged citizens, and even a few future economists!
Our Vision: Three Unifying Themes
The first key principle is that people try to choose the best available option: optimization We don’t assume that people always successfully optimize, but we do believe that people try to optimize and often do a relatively good job of it. Because most decision makers try to choose the alternative that offers the greatest net benefit, optimization is a useful tool for predicting human behavior. Optimization is also a useful prescriptive tool. By teaching people how to optimize, we improve their decisions and the quality of their lives. By the end of this course, every student should be a skilled optimizer—without using complicated mathematics, simply by using economic intuition.
The second key principle extends the first: economic systems operate in equilibrium, a state in which everybody is simultaneously trying to optimize. We want students to see that they’re not the only ones maximizing their well-being. An economic system is in equilibrium when each person feels that he or she cannot do any better by picking another course of action. The principle of equilibrium highlights the connections among economic actors. For example, Apple stores stock millions of iPhones because millions of consumers are going to turn up to buy them. In turn, millions of consumers go to Apple stores because those stores are ready to sell those iPhones. In equilibrium, consumers and producers are simultaneously optimizing, and their behaviors are intertwined.
Our first two principles—optimization and equilibrium—are conceptual. The third is methodological: empiricism. Economists use data to test economic theories, learn about the world, and speak to policymakers. Accordingly, data play a starring role in our book, though we keep the empirical analysis extremely simple. It is this emphasis on matching theories with real data that we think most distinguishes our book from others. We show students how economists use data to answer specific questions, which makes our chapters concrete, interesting, and fun. Modern students demand the evidence behind the theory, and our book supplies it.
For example, we begin every chapter with an empirical question and then answer that question using data. One chapter begins by asking:
Why are you so much more prosperous than your great-great-grandparents were?
Later in that chapter, we demonstrate the central role played by technology in explaining U.S. economic growth and why we are much better off than our relatives a few generations ago.
In our experience, students taking their first economics class often have the impression that economics is a series of theoretical assertions with little empirical basis. By using data, we explain how economists evaluate and improve our scientific insights. Data also make concepts more memorable. Using evidence helps students build intuition, because data move the conversation from abstract principles to concrete facts. Every chapter sheds light on how economists use data to answer questions that directly interest students. Every chapter demonstrates the key role that evidence plays in advancing the science of economics.
Features
All of our features showcase intuitive empirical questions.
• In Evidence-Based Economics (EBE), we show how economists use data to answer the question we pose in the opening paragraph of the chapter. The EBE uses actual data from field experiments, lab experiments, or naturally occurring data, while highlighting some of the major concepts discussed within the chapter. This tie-in with the data gives students a substantive look at economics as it plays out in the world around them.
The questions explored aren’t just dry intellectual ideas; they spring to life the minute the student sets foot outside the classroom—Is Facebook free? Is college worth it? Are tropical and semitropical areas condemned to poverty by their geographies? What caused the recession of 2007–2009? Are companies like Nike harming workers in Vietnam?
CHOICE &CONSEQUENCE
The Power of Exponential Growth
You have two choices. You can either start a job with a salary of $1,000 per month and a 6 percent increase in your salary every month, or you can start with a salary of $2,000, but never get a raise. Which one of these two options do you prefer?
The answer might naturally vary from person to person. If you have an immediate need for money, you may be attracted by the prospect of a $2,000 paycheck. But before you rush to sign on the dotted line for the $2,000-permonth job, think of the implications of the 6 percent monthly increase. With a 6-percent-per-month increase, your monthly salary will already exceed $2,000 after only a year. After 4 years, it will be approximately $16,400 a month. So if you were thinking of staying in this job for more than a year, starting with a lower salary might be a much better idea.
The first option is attractive, at least for those of you intending to stay with it for a while, precisely because of exponential growth. The 6-percent-per-month increases in salary do not apply to the base salary (if they did, this would have increased your salary by $60 every month). Rather, they compound, meaning that each 6 percent applies to the amount that has accumulated up to that point. Thus after 1 month, your salary will be $1,060. After 2 months, it is $1,060 * 1 06 = $1,123 60 After 3 months, it is $1,123 60 * 1 06 = $1,191 02, and so on. We will next see that exponential growth plays the same role in countries’ growth trajectories as in your potential income from these two hypothetical jobs.
Organization
M07_ACEM2056_02_SE_CH07_pp140-175.indd 144
An even more dramatic illustration of the power of exponential growth comes from the story of the invention of the game of chess in ancient India. According to legend, the inventor of the game exploited the power of exponential growth when asked for a reward for his invention by the king.1 He proposed that the king place a single grain of wheat on the first square of the chessboard, two on the second, four on the third, and eight on the fourth. Then, continue doubling the number of grains for all sixty-four squares on the board, and he would receive the total amount of wheat on the board. The king, hearing the request, thought it trivial—but when his treasurers calculated the final tally, they returned to him in shock. The total amount, they found, was more than 18,000,000,000,000,000,000 grains of wheat—far more than they could ever produce in their entire kingdom. Indeed, today, this amount of wheat would allow you to distribute a ton of wheat to every person in the world every day for 6 months. A good story to remember both as a reminder of the power of exponential growth and as a pointer for you if you have to make choices between different options with varying growth prospects.
5/25/17
Part I Introduction to Economics lays the groundwork for understanding the economic way of thinking about the world. In Chapter 1, we show that the principle of optimization explains most of our choices. In other words, we make choices based on a consideration of benefits and costs, and to do this we need to consider trade-offs, budget constraints, and opportunity cost. We then explain that equilibrium is the situation in which everyone is simultaneously trying to individually optimize. In equilibrium, there isn’t any perceived benefit to changing one’s own behavior. We introduce the free-rider problem to show that individual optimization and social optimization do not necessarily coincide.
Because data plays such a central role in economics, we devote an entire chapter— Chapter 2—to economic models, the scientific method, empirical testing, and the critical distinction between correlation and causation. We show how economists use models and data to answer interesting questions about human behavior. For the students who want to brush up their graphical skills, there is an appendix on constructing and interpreting graphs, which is presented in the context of an actual experiment on incentive schemes.
Chapter 3 digs much more deeply into the concept of optimization, including an intuitive discussion of marginal analysis. We use a single running example of choosing an apartment, which confronts students with a trade-off between the cost of rent and the time spent commuting. We demonstrate two alternative approaches—optimization using total value and optimization using marginal analysis—and show why economists often use the latter technique.
Chapter 4 introduces the demand and supply framework via a running example of the market for gasoline. We show how the price of gasoline affects the decisions of buyers, like commuters, and sellers, like ExxonMobil. As we develop the model, we explore how individual buyers are added together to produce a market demand curve and how individual sellers are added together to generate a market supply curve. We then show how buyers and sellers jointly determine the equilibrium market price and the equilibrium quantity of goods transacted in a perfectly competitive market. Finally, we show how markets break down when prices aren’t allowed to adjust to equate the quantity demanded and the quantity supplied.
Part II Introduction to Macroeconomics provides an introduction to the field. In Chapter 5 we explain the basic measurement tools. Here we explore the derivation of the
aggregate output of the economy, or the gross domestic product (GDP), with the production, expenditure, and income methods, explaining why all these methods are equivalent and lead to the same level of total GDP. We also consider what isn’t measured in GDP, such as production that takes place at home for one’s family. Finally, we discuss the measurement of inflation and the concept of a price index.
In Chapter 6 we show how income (GDP) per capita can be compared across countries using two similar techniques—an exchange rate method and a purchasing power method. We explain how the aggregate production function links a country’s physical capital stock, labor resources (total labor hours and human capital per worker), and technology to its GDP and thus draw the link between income per capita and a country’s physical capital stock per worker, human capital, and technology. We then use these tools to investigate the roles of physical capital, human capital, and technology in accounting for the great differences in prosperity across countries.
In Part III, Long-Run Growth and Development, we turn to a comprehensive treatment of growth and development. In Chapter 7, we show that economic growth has transformed many countries over the past 200 years. For example, in the United States today, GDP per capita is about 25 times higher than it was in 1820. In this discussion, we explain the “exponential” nature of economic growth, which results from the fact that new growth builds on past growth, and implies that small differences in growth rates can translate into huge differences in income per capita over several decades. We explain how sustained economic growth relies on advances in technology and why different countries have experienced different long-run growth paths. We also emphasize that economic growth does not benefit all citizens equally. For some citizens, poverty is the unintentional by-product of technological progress. For the instructors who want a more in-depth treatment of growth and the determinants of GDP, we present a simplified version of the Solow Model in an optional appendix to the chapter.
Why do some nations not invest enough in physical and human capital, adopt the best technologies, and organize their production efficiently? Put another way, why isn’t the whole world economically developed? Chapter 8 probes this question and considers the fundamental causes of prosperity. We discuss several potential fundamental causes, in particular, geography, culture, and institutions, and argue why the oft-emphasized geographic factors do not seem to account for much of the wide cross-country gaps in economic prosperity.
In Part IV, Equilibrium in the Macroeconomy, we discuss three key markets that play a central role in macroeconomic analysis: the labor market, the credit market, and the market for bank reserves. Chapter 9 begins with the labor market—labor demand and labor supply. We first describe the standard competitive equilibrium, where the wage and the quantity of labor employed are pinned down by the intersection of the labor demand and labor supply curves. We then show how downward rigid wages lead to unemployment. We use this framework to discuss the many different factors that influence unemployment, including both frictional and structural sources.
Chapter 10 extends our analysis by incorporating the credit market. We explain how the modern financial system circulates funds from savers to borrowers. We describe the different types of shocks that can destabilize a financial system. We analyze how banks and other financial intermediaries connect supply and demand in the credit market, and we use banks’ balance sheets to explain the risks of taking on short-term liabilities and making long-term investments.
Chapter 11 introduces the monetary system. We begin by explaining the functions of money. The chapter then introduces the Federal Reserve Bank (the Fed) and lays out the basic plumbing of the monetary system, especially the role of supply and demand in the market for bank reserves. We explain in detail the Fed’s role in controlling bank reserves and influencing interest rates, especially the interest rate on bank reserves (the federal funds rate). The chapter explains the causes of inflation and its social costs and benefits.
In Part V, Short-Run Fluctuations and Macroeconomic Policy, we use a modern framework to analyze and explain short-run fluctuations. Our analysis is inclusive and integrative, enabling us to combine the most relevant and useful insights from many different
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[1715] Lindenschmit, “Alt. u. h. Vorz.,” Heft. i. Taf. ii. 10, 11, 12.
[1716] Suss. Arch. Coll., vol. xiv. p. 171; Arch. Journ., vol. xx. p. 192.
[1717] Arch., vol. xxii. p. 424; Arch. Journ., vol. vi. p. 387; “Arch. Inst.,” Norwich vol., p. xxvi. I have assumed that the mould described in these passages is one and the same.
[1718] Arch., vol. v. pl. vii.; Arch. Journ., vol. iv. p. 336, pl. iii. 5, 6, 7, 8.
[1719] Arch. Journ., vol. iv. pl. ii. 5, 6, 7, 8.
[1720] “Itin. Cur.,” pl. xcvi, 2nd ed.
[1721] Proc. Soc. Ant., 2nd S., vol. ii. p. 132; Arch. Journ., vol. xix. p. 358.
[1722] Arch. Journ., vol. xviii. p. 166.
[1723] Ibid.
[1724] “Surrey Arch. Soc. Coll.,” vol. vi.
[1725] Bastian und A. Voss, “Die Bronzeschwerter des K. Mus.,” p. 76.
[1726] Ulfsparre, “Svenska Fornsaker,” pl. viii. 93.
[1727] Mém. Soc. Ant. Norm., 1827-8, pl. xviii.
[1728] Chantre, “Alb.,” pl. liv. 5.
[1729] Keller, 7ter Bericht, p. 16, Taf. xvii.
[1730] “Matériaux,” vol. xii. p. 184.
[1731] “Aarböger for Nord. Oldk.,” 1866, p. 124.
[1732] Proc. Soc. Ant., 2nd S., vol. v. p. 409.
[1733] Arch. Journ., vol. vi. p. 382; Arch. Assoc. Journ., vol. iii. pp. 10 and 58.
[1734] Arch. Assoc. Journ., vol. xiv. p. 258.
[1735] Proc. Soc. Ant., 2nd S., vol. iii. p. 232.
[1736] Proc. Soc. Ant., 2nd S., vol. ii. p. 132. I am indebted to the Council for the use of this cut; Arch. Journ., vol. xix. p. 358.
[1746] Suss. Arch. Coll., vol. ix. p. 120, whence this cut is borrowed; Arch. Journ., vol. xiii. p. 184, vol. xv. p. 90.
[1763] “Primitive Warfare, Sect. III.;” Journ. R. U. S. Inst., vol. xiii.
[1764] “Preh. Times,” p. 73.
[1765] Worsaae, in “Aarb. for Nord. Oldk.,” 1879, p. 327.
[1766] See A. Bertrand in Rev. Arch., vol. xxvi. p. 363.
[1767] See Chantre, “Age du Bronze,” 2ème ptie. p. 281.
[1768] “Habitations Lacustres de la Savoie,” 1864, 1867, 1869.
[1769] See Thurnam in Arch., vol. xliii. p. 494.
[1770] Arch., vol. xliii. p. 497.
[1771] See “Ancient Stone Impts.,” p. 411. I may take this opportunity of correcting the statement that the Assynt necklace is inlaid with gold. It is merely engraved with various patterns, in which micaceous grains of sand got lodged and were mistaken for gold.
[1772] “Ancient Stone Impts.,” p. 402.
[1773] Dawkins’s “Early Man in Britain,” p. 352; Quart. Journ. Suff. Inst., vol. i. p. 31.
[1774] See also Rolleston’s App. to “British Barrows;” Lubbock’s “Prehist. Times;” Dawkins’s “Early Man in Britain,” &c., &c.
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