Modern principles macroeconomics 3rd by cowen tabbarrok

THIRD EDITION

W

Dear Student:

Cowen • Tabarrok

e love economics.We talk economics, argue economics, and think about economics every day.We use economics
in our lives, not just when we choose whether to refinance a mortgage but also when we choose strategies for dating,
keeping a good marriage, and parenting. Yeah, we are weird. But now a warning. If you are afraid of being a little weird,
Do Not Read This Book. Once you have been exposed to the economic way of thinking, there is no going back—you will
see the world differently and that will make you different.
Will what you learn be worth the price? That is for you to decide. But we think economics is important. We need
economics to make better investments and better life choices. Citizens in a democracy must evaluate issues of taxes, deficits,
trade, health care policy, and inflation. These issues and many more cannot be understood without an understanding of
economics. Do you want to vote ignorantly or intelligently? The economic way of thinking will help you to understand
the issues of the day and to explain them with confidence to others.
We won’t lie: economics can be difficult. Few things worth knowing come easily and, to understand economics well,
you will need to master new tools and new ideas like supply and demand curves, marginal thinking, and equilibrium. We
have worked hard, however, to strip away as much jargon and unnecessary verbiage as possible. We are going to give you
what is important and not much else. We are also going to have fun. In addition, be sure to check out the new videos that
can help you with the course content and enhance your fun.

MODERN PRINCIPLES:

MACROECONOMICS

Welcome to the world of economics.

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Alex Tabarrok

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MODERN PRINCIPLES:

Tyler Cowen

MACROECONOMICS

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New Videos
Pioneers in teaching economics online, the authors have created a
series of videos that are clever, to the point, and will help you better
understand key economic concepts. The video links are included in
the book along with QR codes for mobile access.

THIRD
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Tyler Cowen • Alex Tabarrok

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Cover images: Earth: Jim Roof/myLoupe.com; Hands: © Oleh Barabash / Alamy.


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C O W E N

•

TAB ARROK

MODERN PRINCIPLES: MACROECONOMICS, THIRD EDITION

The compelling examples enhance the
story and illuminate concepts...
means chapter opening example;
means running example in the chapter.

CHAPTER OPENING

RUNNING EXAMPLE

Chapter 1: The Big Ideas
Page 1 CHAPTER OPENING : A small change in wording has
a big effect on the incentives of captains transporting
convicts to Australia.
Page 3: How can drugs be too safe?

Chapter 2: The Power of Trade and
Comparative Advantage
Page 21: Economics is about cooperation, not just
competition

Chapter 3: Supply and Demand
Page 29 CHAPTER OPENING and RUNNING EXAMPLE : Intuitive
picture of the demand for oil and why it slopes
downward
Page 36: Intuitive picture of the supply of oil and why it
slopes upward.

Chapter 4: Equilibrium: How Supply and Demand

Determine Prices
Page 47 CHAPTER OPENING and RUNNING EXAMPLE : What
pushes and pulls prices toward their equilibrium values?
Page 49: Why does a free market maximize consumer plus
producer surplus?

Chapter 5: Price Ceilings and Floors
Page 67 CHAPTER OPENING and RUNNING EXAMPLE : Why did
Nixon’s price controls lead to shortages and lines?
Page 77: How do rent controls work: and fail?

Chapter 6: GDP and the Measurement
of Progress
Page 109: GDP does not count leisure
Page 110: Why does GDP not count environmental costs?

Chapter 7: The Wealth of Nations and
Economic Growth
Page 126: Economic growth: South Korea versus North
Korea
Page 132: Why do landlocked countries have lower per
capita GDP?

Chapter 8: Growth, Capital Accumulation, and
the Economics of Ideas (Solow Model)
Page 146: Why bombing a country can raise its
growth rate
Page 159: How do spillovers dampen the generation of
new ideas?

Chapter 9: Saving, Investment, and the
Financial System
Page 192: Why was leverage a chief cause of the financial
crisis?
Page 195: How did shadow banking contribute to the
financial crisis?

Chapter 10: Stock Markets and Personal Finance
Page 218: Can speculative bubbles be identified?

Chapter 11: Unemployment and Labor
Force Participation
Page 239: Percent job losses in post-1945 recessions.
Page 243: How did the pill help increase female labor
force participation?

Chapter 12: Inflation and the Quantity Theory
of Money
Page 249: Why did money growth lead to hyperinflation
in Zimbabwe?
Page 264: Why is inflation painful to stop?

Chapter 13: Business Fluctuations:
Aggregate Demand and Supply
Page 280: Real shocks and the weather in India
Page 292: Aggregate demand shocks and real shocks in
the Great Depression

Chapter 14: Transmission and
Amplification Mechanisms

Page 304: Labor adjustment costs
Page 308: Collateral damage

Chapter 15: The Federal Reserve System and
Open Market Operations
Page 325: The Fed, short run interest rates, and the
Federal Funds rate
Page 328: The Fed and systemic risk

S E E T H E I N V I S I B L E H A N D . C O M

KEY:


C O W E N

•

TAB ARROK

MODERN PRINCIPLES: MACROECONOMICS, THIRD EDITION

S E E T H E I N V I S I B L E H A N D . C O M

Chapter 16: Monetary Policy

Chapter 19: International Trade

Page 351: Can the Fed deal with asset price bubbles?
Page 352: Rules versus discretion: What about a nominal

GDP rule?

Page 413: What is the cost of the sugar tariff?
Page 418: How does trade affect child labor?

Chapter 17: The Federal Budget:
Taxes and Spending
Page 376: Is government spending wasted?
Page 380: Will the U.S. government go bankrupt?

Chapter 18: Fiscal Policy
Page 401: Why did fiscal policy make matters worse
in Argentina?
Page 402: When is fiscal policy a good idea?

Chapter 20: International Finance
Page 428: Thinking about the U.S. trade deficit and your
trade deficit

Chapter 21: Political Economy and Public Choice
Page 455: How do special interests such as U.S. sugar
growers push for favorable legislation?
Page 462: Democracies and the mean voter theorem
Page 465: Democracies and famine


MODERN PRINCIPLES:

MACROECONOMICS

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MODERN PRINCIPLES:

MACROECONOMICS
Third Edition

Tyler Cowen
George Mason University

Alex Tabarrok
George Mason University


Vice President, Editorial: Charles Linsmeier
Vice President, Editing, Design, and Media Production: Catherine Woods
Executive Editor: Carlise Stembridge
Marketing Manager: Tom Digiano
Consulting Editor: Paul Shensa
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Art Director: Diana Blume
Cover and Text Designer: Diana Blume
Director of Editing, Design, and Media Production: Tracey Kuehn
Managing Editor: Lisa Kinne
Project Editor: Fred Dahl, TSIevolve
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Cover Image: © Oleh Barabash/Alamy and Jim Roof/myLoupe.com

Library of Congress Preassigned Control Number:  2014952564
ISBN-13: 978-1-4292-7840-9
ISBN-10: 1-4292-7840-4
© 2015, 2013, 2010 by Worth Publishers
All rights reserved.
Printed in the United States of America
First printing
Worth Publishers
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New York, NY 10010
www.worthpublishers.com


Economics is the study of how to get the most out of life.
Tyler and Alex


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ALEX TABARROK

ABOUT THE AUTHORS
Tyler Cowen (left, in North Korea) is Holbert C. Harris Professor of

Economics at George Mason University. His latest book is The Great Stagnation.
With Alex Tabarrok, he writes an economics blog at MarginalRevolution.com.
He has published in the American Economic Review, Journal of Political Economy,
and many other economics journals. He also writes regularly for the popular
press, including the New York Times, the Washington Post, Forbes, the Wilson
Quarterly, Money Magazine, and many other outlets.
Alex Tabarrok (right, in South Korea) is Bartley J. Madden Chair in Economics
at the Mercatus Center at George Mason University. His latest book is Launching
the Innovation Renaissance. His research looks at bounty hunters, judicial incentives and elections, crime control, patent reform, methods to increase the supply
of human organs for transplant, and the regulation of pharmaceuticals. He is the
editor of the books Entrepreneurial Economics: Bright Ideas from the Dismal Science
and The Voluntary City: Choice, Community, and Civil Society, among others.
His papers have appeared in the Journal of Law and Economics, Public Choice,
Economic Inquiry, the Journal of Health Economics, the Journal of Theoretical Politics,
the American Law and Economics Review, and many others. Popular articles have
appeared in the New York Times, the Wall Street Journal, Forbes, and many other
magazines and newspapers.
ix


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BRIEF CONTENTS
Preface............................................................................................................ xxiii
CHAPTER 1  The Big Ideas................................................................................ 1
CHAPTER 2  The Power of Trade and Comparative Advantage..................... 13

Part I: Supply and Demand
CHAPTER 3  Supply and Demand................................................................... 27

CHAPTER 4  Equilibrium: How Supply and Demand Determine Prices.......... 47
CHAPTER 5  Price Ceilings and Floors............................................................ 67

Part 2: Economic Growth
CHAPTER 6  GDP and the Measurement of Progress..................................... 95
CHAPTER 7  The Wealth of Nations and Economic Growth......................... 117
CHAPTER 8  Growth, Capital Accumulation, and the Economics of Ideas:
Catching Up vs. the Cutting Edge............................................................... 143
CHAPTER 9  Saving, Investment, and the Financial System.......................... 175
CHAPTER 10  Stock Markets and Personal Finance...................................... 207

Part 3: Business Fluctuations
CHAPTER 11  Unemployment and Labor Force Participation....................... 223
CHAPTER 12  Inflation and the Quantity Theory of Money.......................... 249
CHAPTER 13  Business Fluctuations: Aggregate Demand and Supply........ 273
CHAPTER 14  Transmission and Amplification Mechanisms......................... 301

Part 4: Macroeconomic Policy and Institutions
CHAPTER 15  The Federal Reserve System and
Open Market Operations............................................................................ 317
CHAPTER 16  Monetary Policy...................................................................... 341
CHAPTER 17  The Federal Budget: Taxes and Spending............................. 365
CHAPTER 18  Fiscal Policy............................................................................ 389

xi


xii •  Contents

Part 5: International Economics

CHAPTER 19  International Trade................................................................. 411
CHAPTER 20  International Finance.............................................................. 427
CHAPTER 21  Political Economy and Public Choice..................................... 453

APPENDIX A  Reading Graphs and Making Graphs..................................... A-1
APPENDIX B  Solutions to Check Yourself Questions...................................B-1
Glossary G-1
References R-1
Index I-1


CONTENTS
Preface    xxiii
CHAPTER 1  The Big Ideas................................................................................ 1
Big Idea One: Incentives Matter  2
Big Idea Two: Good Institutions Align Self-Interest with the Social Interest  2
Big Idea Three: Trade-offs Are Everywhere  3
Opportunity Cost  4

Big Idea Four: Thinking on the Margin  4
Big Idea Five: The Power of Trade  5
Big Idea Six: The Importance of Wealth and Economic Growth  6
Big Idea Seven: Institutions Matter  7
Big Idea Eight: Economic Booms and Busts Cannot Be Avoided
but Can Be Moderated  8
Big Idea Nine: Prices Rise When the Government Prints Too Much Money  9
Big Idea Ten: Central Banking Is a Hard Job  9
The Biggest Idea of All: Economics Is Fun  10
Chapter Review  11

CHAPTER 2  The Power of Trade and Comparative Advantage..................... 13
Trade and Preferences  13
Specialization, Productivity, and the Division of Knowledge  14
Comparative Advantage  15
The Production Possibility Frontier  16
Opportunity Costs and Comparative Advantage  16
Comparative Advantage and Wages  19
Adam Smith on Trade  21

Trade and Globalization  21
Takeaway  21
Chapter Review  22
Work It Out  25

Part I: Supply and Demand
CHAPTER 3  Supply and Demand................................................................... 27
The Demand Curve for Oil  27
Consumer Surplus  30
What Shifts the Demand Curve?  30
Important Demand Shifters  31

Produce Surplus  36
What Shifts the Supply Curve?  37
Important Supply Shifters  37

xiii


xiv •  Contents

Takeaway  40
Chapter Review  41
Work It Out  45

CHAPTER 4  Equilibrium: How Supply and Demand Determine Prices.......... 47
Equilibrium and the Adjustment Process  47
Who Competes with Whom?  49

A Free Market Maximizes Producer Plus Consumer Surplus
(the Gain from Trade)  49
Does the Model Work? Evidence from the Laboratory  52
Shifting Demand and Supply Curves  54
Terminology: Demand Compared with Quantity Demanded
and Supply Compared with Quantity Supplied  56
Understanding the Price of Oil  58
Takeaway  60
Chapter Review  61
Work It Out  66

CHAPTER 5  Price Ceilings and Floors............................................................ 67
Price Ceilings  67
Shortages  68
Reductions in Quality  69
Wasteful Lines and Other Search Costs  69
Lost Gains from Trade (Deadweight Loss)  71
Misallocation of Resources  72
The End of Price Ceilings  76

Rent Controls (Optional Section)  77
Shortages  77

Reductions in Product Quality  78
Wasteful Lines, Search Costs, and Lost Gains from Trade  79
Misallocation of Resources  80
Rent Regulation  80

Arguments for Price Ceilings  80
Universal Price Controls  81
Price Floors  83
Surpluses  83
Lost Gains from Trade (Deadweight Loss)  84
Wasteful Increases in Quality  86
The Misallocation of Resources  87

Takeaway  88
Chapter Review  88
Work It Out  94

Part 2: Economic Growth
CHAPTER 6  GDP and the Measurement of Progress..................................... 95


Contents •  xv

What Is GDP?  97
GDP Is the Market Value . . .  97
. . . of All Final . . .  97
. . . Goods and Services . . .  98
. . . Produced . . .  98
. . . within a Country . . .  98
. . . in a Year . . .  98

Growth Rates  99
Nominal vs. Real GDP  99
The GDP Deflator  100
Real GDP Growth  101
Real GDP Growth per Capita  102

Cyclical and Short-Run Changes in GDP  103
The Many Ways of Splitting GDP  104
The National Spending Approach: Y = C + I + G + NX  104
The Factor Income Approach: The Other Side of the Spending Coin  106
Why Split?  107

Problems with GDP as a Measure of Output and Welfare  107
GDP Does Not Count the Underground Economy  107
GDP Does Not Count Nonpriced Production  108
GDP Does Not Count Leisure  109
GDP Does Not Count Bads: Environmental Costs  110
GDP Does Not Measure the Distribution of Income  110

Takeaway  111
Chapter Review  112
Work It Out  116

CHAPTER 7  The Wealth of Nations and Economic Growth......................... 117
Key Facts about the Wealth of Nations and Economic Growth  118
Fact One: GDP per Capita Varies Enormously among Nations  118
Fact Two: Everyone Used to Be Poor  119
Fact Three: There Are Growth Miracles and Growth Disasters  121
Summarizing the Facts: Good and Bad News  123

Understanding the Wealth of Nations  123
The Factors of Production  123

Incentives and Institutions  125
Institutions  127
The Ultimate Causes of the Wealth of Nations  131

Takeaway  133
Chapter Review  133
Work It Out  138

CHAPTER 7 APPENDIX:  The Magic of Compound Growth
Using a Spreadsheet................................................................................... 139
CHAPTER 8  Growth, Capital Accumulation, and the Economics
of Ideas: Catching Up vs. the Cutting Edge................................................ 143
The Solow Model and Catching-Up Growth  144


xvi •  Contents

Capital, Production, and Diminishing Returns  145
Capital Growth Equals Investment Minus Depreciation  147
Why Capital Alone Cannot Be the Key to Economic Growth  148
From Capital Accumulation to Catching-Up Growth  150

The Investment Rate and Conditional Convergence  151
The Solow Model and an Increase in the Investment Rate  151
The Solow Model and Conditional Convergence  153

New Ideas and Cutting-Edge Growth  154
Better Ideas Drive Long-Run Economic Growth  155
Solow and the Economics of Ideas in One Diagram  156

The Economics of Ideas  157
Research and Development Is Investment for Profit  157
Spillovers, and Why There Aren’t Enough Good Ideas  159
Government’s Role in the Production of New Ideas  160
Market Size and Research and Development  161

The Future of Economic Growth  161
Takeaway  163
Chapter Review  164
Work It Out  169

CHAPTER 8 APPENDIX:  Excellent Growth................................................. 170
CHAPTER 9  Saving, Investment, and the Financial System.......................... 175
The Supply of Savings  176
Individuals Want to Smooth Consumption  177
Individuals Are Impatient  178
Marketing and Psychological Factors  178
The Interest Rate  179

The Demand to Borrow  179
Individuals Want to Smooth Consumption  179
Borrowing Is Necessary to Finance Large Investments  180
The Interest Rate  181

Equilibrium in the Market for Loanable Funds  182
Shifts in Supply and Demand  182

The Role of Intermediaries: Banks, Bonds, and Stock Markets  184
Banks  184
The Bond Market  185
The Stock Market  188

What Happens When Intermediation Fails?  189
Insecure Property Rights  190
Controls on Interest Rates  190
Politicized Lending and Government-Owned Banks  191
Bank Failures and Panics  192

The Financial Crisis of 2007–2008: Leverage, Securitization,
and Shadow Banking  192
Leverage  192
Securitization  194
The Shadow Banking System  195


Contents •  xvii

Takeaway  197
Chapter Review  197
Work It Out  201

CHAPTER 9 APPENDIX:  Bond Pricing and Arbitrage................................. 202
CHAPTER 10  Stock Markets and Personal Finance...................................... 207
Passive vs. Active Investing  208
Why Is It Hard to Beat the Market?  209
How to Really Pick Stocks, Seriously  211

Diversify  211
Avoid High Fees  213
Compound Returns Build Wealth  214
The No-Free-Lunch Principle, or No Return without Risk  215

Other Benefits and Costs of Stock Markets  218
Bubble, Bubble, Toil, and Trouble  218

Takeaway  220
Chapter Review  220
Work It Out  222

Part 3: Business Fluctuations
CHAPTER 11  Unemployment and Labor Force Participation....................... 223
Defining Unemployment  225
How Good an Indicator Is the Unemployment Rate?  225

Frictional Unemployment  227
Structural Unemployment  228
Labor Regulations and Structural Unemployment  229
Labor Regulations to Reduce Structural Unemployment  234
Factors that Affect Structural Unemployment  235

Cyclical Unemployment  235
The Natural Unemployment Rate  238

Labor Force Participation  239
Lifecycle Effects and Demographics  239
Incentives  240

Takeaway  244
Chapter Review  245
Work It Out  248

CHAPTER 12  Inflation and the Quantity Theory of Money.......................... 249
Defining and Measuring Inflation  250
Price Indexes  250
Inflation in the United States and around the World  251

The Quantity Theory of Money  253
The Cause of Inflation  255
An Inflation Parable  258


xviii •  Contents

The Costs of Inflation  258
Price Confusion and Money Illusion  259
Inflation Redistributes Wealth  260
Inflation Interacts with Other Taxes  264
Inflation Is Painful to Stop  264

Takeaway  265
Chapter Review  266
Work It Out  268

CHAPTER 12 APPENDIX:  Get Real! An Excellent Adventure..................... 269
CHAPTER 13  Business Fluctuations: Aggregate Demand and Supply........ 273
The Aggregate Demand Curve  275
Shifts in the Aggregate Demand Curve  277

The Solow Growth Curve  278
Shifts in the Long-Run Aggregate Supply Curve  278

Real Shocks  280
Oil Shocks  281
More Shocks  283

Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve  284
Shocks to the Components of Aggregate Demand  289

→

A Shock to C   289
Why Changes in →
v Tend to Be Temporary  290
Other AD Shocks  290

Understanding the Great Depression: Aggregate Demand Shocks and
Real Shocks  292
Aggregate Demand Shocks and the Great Depression  292
Real Shocks and the Great Depression  293

Takeaway  295
Chapter Review  296
Work It Out  300

CHAPTER 14  Transmission and Amplification Mechanisms......................... 301
Intertemporal Substitution  301
Uncertainty and Irreversible Investments  304

Labor Adjustment Costs  304
Time Bunching  305
Collateral Damage  306
Takeaway  309
Chapter Review  309
Work It Out  312

CHAPTER 14 APPENDIX:  Business Fluctuations and the
Solow Model............................................................................................... 313


Contents •  xix

Part 4: Macroeconomic Policy and Institutions
CHAPTER 15  The Federal Reserve System and Open Market Operations.... 317
What Is the Federal Reserve System?  317
The U.S. Money Supplies  318
Fractional Reserve Banking, the Reserve Ratio, and the Money Multiplier  321
How the Fed Controls the Money Supply  323
Open Market Operations  323
Discount Rate Lending and the Term Auction Facility  325
Payment of Interest on Reserves  328

The Federal Reserve and Systemic Risk  328
Revisiting Aggregate Demand and Monetary Policy  329
Who Controls the Fed?  330
Takeaway  331
Chapter Review  332
Work It Out  336

CHAPTER 15 APPENDIX:  The Money Multiplier Process in Detail............. 337
CHAPTER 16  Monetary Policy...................................................................... 341
Monetary Policy: The Best Case  342
Reversing Course and Engineering a Decrease in AD  343
The Fed as Manager of Market Confidence  345

The Negative Real Shock Dilemma  346
When the Fed Does Too Much  348
Dealing with Asset Price Bubbles  351
Rules vs. Discretion  352

Takeaway  353
Chapter Review  354
Work It Out  363

CHAPTER 17  The Federal Budget: Taxes and Spending............................. 365
Tax Revenues  365
The Individual Income Tax  366
Social Security and Medicare Taxes  369
The Corporate Income Tax  370
The Bottom Line on the Distribution of Federal Taxes  370

Spending  372
Social Security  372
Defense  374
Medicare and Medicaid  374
Unemployment Insurance and Welfare Spending  375
Everything Else  376

Is Government Spending Wasted?  376

The National Debt, Interest on the National Debt, and Deficits  378
Will the U.S. Government Go Bankrupt?  380
The Future Is Hard to Predict  380


xx •  Contents

Revenues and Spending Undercount the Role of Government
in the Economy  382
Takeaway  382
Chapter Review  383
Work It Out  387

CHAPTER 18  Fiscal Policy............................................................................ 389
Fiscal Policy: The Best Case  390
The Multiplier  391

The Limits to Fiscal Policy  392
Crowding Out  392
A Drop in the Bucket: Can Government Spend Enough to Stimulate Aggregate Demand?  397
A Matter of Timing  397
Government Spending vs. Tax Cuts as Expansionary Fiscal Policy  399
Fiscal Policy Does Not Work Well to Combat Real Shocks  399

When Fiscal Policy Might Make Matters Worse  401
So When Is Fiscal Policy a Good Idea?  402
Takeaway  403
Chapter Review  404
Work It Out  409

Part 9: International Economics
CHAPTER 19  International Trade................................................................. 411
Analyzing Trade with Supply and Demand  411
Analyzing Tariffs with Demand and Supply  412

The Costs of Protectionism  413
Winners and Losers from Trade  416

Arguments Against International Trade  417
Trade and Jobs  417
Child Labor  418
Trade and National Security  420
Key Industries  420
Strategic Trade Protectionism  421

Takeaway  422
Chapter Review  422
Work It Out  426

CHAPTER 20  International Finance.............................................................. 427
The U.S. Trade Deficit and Your Trade Deficit  428
The Balance of Payments  429
The Current Account  430
The Capital Account, Sometimes Called the Financial Account  430
The Official Reserves Account  431


Contents •  xxi

How the Pieces Fit Together  431

Two Sides, One Coin  431
The Bottom Line on the Trade Deficit  433

What Are Exchange Rates?  434
Exchange Rate Determination in the Short Run  434
Exchange Rate Determination in the Long Run  437

How Monetary and Fiscal Policy Affect Exchange Rates and How Exchange
Rates Affect Aggregate Demand  440
Monetary Policy  440
Fiscal Policy  442

Fixed vs. Floating Exchange Rates  443
The Problem with Pegs  444

What Are the IMF and the World Bank?  444
International Monetary Fund  445
The World Bank  445

Takeaway  446
Chapter Review  447
Work It Out  452

CHAPTER 21  Political Economy and Public Choice..................................... 453
Voters and the Incentive to Be Ignorant  454
Why Rational Ignorance Matters  455

Special Interests and the Incentive to Be Informed  455
A Formula for Political Success: Diffuse Costs, Concentrate Benefits  457
Voter Myopia and Political Business Cycles  459

Two Cheers for Democracy  461
The Median Voter Theorem  462
Democracy and Nondemocracy  464
Democracy and Famine  465
Democracy and Growth  467

Takeaway  469
Chapter Review  469
Work It Out  474

APPENDIX A  Reading Graphs and Making Graphs..................................... A-1
APPENDIX B  Solutions to Check Yourself Questions...................................B-1
Glossary    G-1
References    R-1
Index    I-1


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PREFACE:
TO THE INSTRUCTOR
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: Macroeconomics, 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.

Make the Invisible Hand Visible
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. 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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