Economics for dummies

Economics For Dummies®, 2nd Edition
Visit www.dummies.com/cheatsheet/economics to view this book's cheat sheet.
Table of Contents
Introduction
About This Book
Conventions Used in This Book
What You’re Not to Read
Foolish Assumptions
How This Book Is Organized
Part I: Economics: The Science of How People Deal with Scarcity
Part II: Microeconomics: The Theories of Consumer and Firm Behavior
Part III: Applying the Theories of Microeconomics
Part IV: Macroeconomics: The Science of Economic Growth and Stability
Part V: The Part of Tens
Icons Used in This Book
Where to Go from Here
Part I: Economics: The Science of How People Deal with Scarcity
Chapter 1: Discovering What Economics Is and Why You Should Care
Considering a Little Economic History
Pondering just how nasty, brutish, and short life used to be
Identifying the institutions that raise living standards
Looking toward the future
Framing Economics as the Science of Scarcity
Sending Microeconomics and Macroeconomics to Separate Corners
Getting up close and personal: Microeconomics
Zooming out: Macroeconomics and the big picture


Understanding How Economists Use Models and Graphs
Introducing your first model: The demand curve

Drawing your own demand curve
Chapter 2: Cookies or Ice Cream? Exploring Consumer Choices
Describing Human Behavior with a Choice Model
Pursuing Personal Happiness
Using utility to measure happiness
Taking “selfless” actions into account
Noting how self-interest can promote the common good
You Can’t Have Everything: Examining Limitations
Resource constraints
Technology constraints
Time constraints
Opportunity cost: The unavoidable cost
Making Your Choice: Deciding What and How Much You Want
Exploring Violations and Limitations of the Economist’s Choice Model
Understanding uninformed decision-making
Making sense of irrationality
Chapter 3: Producing the Right Stuff the Right Way to Maximize Human
Happiness
Figuring Out What’s Possible to Produce
Classifying resources
Diminishing returns: Getting less of a good thing
A little here, a little there: Allocating resources
Graphing your production possibilities
Reaching new frontiers with better technology
Deciding What to Produce
Comparing market results and government interventions


Opting for a mixed economy
Promoting Technology and Innovation

Part II: Microeconomics: The Theories of Consumer and Firm Behavior
Chapter 4: Supply and Demand Made Easy
Deconstructing Demand
Prices and other stuff: Looking at what affects quantity demanded
Graphing the demand curve
Opportunity costs: Setting the slope of the demand curve
Elasticity: Looking at extreme demand cases
Sorting Out Supply
Graphing the supply curve
Using elasticity to understand extreme supply cases
Bringing Supply and Demand Together
Market equilibrium: Seeking a balance
Demonstrating the stability of the market equilibrium
Adjusting to new market equilibriums when supply or demand changes
Price Controls: Keeping Prices Away from Market Equilibrium
Setting upper limits with price ceilings
Propping up prices with price floors
Chapter 5: Getting to Know Homo Economicus, the Utility-Maximizing Consumer
Constrained Optimization: Getting the Most Happiness for Your Money
Choosing by Ranking
Getting Less from More: Diminishing Marginal Utility
Choosing Among Many Options When Facing a Limited Budget
Trying to buy as much (marginal) utility as you can
Purchasing the best combination of two goods to maximize total utility
Aiming for equal marginal utility per dollar


Deriving Demand Curves from Diminishing Marginal Utility
Seeing how price changes affect quantities demanded
Graphing the price and quantity changes to form a demand curve

Chapter 6: The Core of Capitalism: The Profit-Maximizing Firm
A Firm’s Goal: Maximizing Profits
Facing Competition
Listing the requirements for perfect competition
Taking prices but setting quantities
Distinguishing between accounting profits and economic profits
Analyzing a Firm’s Cost Structure
Focusing on costs per unit of output
Examining average variable costs
Watching average fixed costs fall
Tracking the movement of average total costs
Focusing on marginal costs
Noticing where marginal cost equals average cost
Comparing Marginal Revenues with Marginal Costs
Finding where marginal revenue equals marginal cost
Visualizing profits
Visualizing losses
Pulling the Plug: When Producing Nothing Is Your Best Bet
Distinguishing between the short run and the long run in
microeconomics
The short-run shutdown condition: Variable costs exceed total revenues
The long-run shutdown condition: Total costs exceed total revenues
Chapter 7: Why Economists Love Free Markets and Competition
Ensuring That Benefits Exceed Costs: Competitive Free Markets
Examining the traits of a properly functioning market


Analyzing the efficiency of free markets
Measuring everyone’s gains with total surplus
When Free Markets Lose Their Freedom: Dealing with Deadweight Losses

Coming up short: The deadweight loss from a price ceiling
Death and taxes: Finding the deadweight loss of a tax
Hallmarks of Perfect Competition: Zero Profits and Lowest Possible Costs
Understanding the causes and consequences of perfect competition
Peering into the process of perfect competition
Graphing how profits guide firm entry and exit
Chapter 8: Monopolies: How Badly Would You Behave If You Had No
Competition?
Examining Profit-Maximizing Monopolies
Zeroing in on the problems monopolies cause
Identifying the source of the problem: Decreasing marginal revenues
Choosing an output level to maximize profits
Comparing Monopolies with Competitive Firms
Looking at output and price levels
Deadweight losses: Quantifying the harm caused by monopolies
Losing efficiency
Considering Examples of Good Monopolies
Encouraging innovation and investment with patents
Reducing annoyingly redundant competitors
Keeping costs low with natural monopolies
Regulating Monopolies
Subsidizing a monopoly to increase output
Imposing minimum output requirements
Regulating monopoly pricing
Breaking up a monopoly into several competing firms


Chapter 9: Oligopoly and Monopolistic Competition: Middle Grounds
Oligopolies: Looking at the Allure of Joining Forces
Sharing power over prices

Cartel behavior: Trying to imitate monopolists
Noting the criteria for coordinating a cartel
Understanding Incentives to Cheat the Cartel
Fleshing out the Prisoner’s Dilemma
Enforcing the agreement: Resolving the dilemma with credible threats
Seeing that OPEC is trapped in a Prisoner’s Dilemma
Using an enforcer to help OPEC members stick to quotas
Regulating Oligopolies
Breaking up dominant firms
Attempting to apply antitrust laws
Studying a Hybrid: Monopolistic Competition
Benefiting from product differentiation
Facing profit limits
Part III: Applying the Theories of Microeconomics
Chapter 10: Property Rights and Wrongs
Allowing Markets to Reach Socially Optimal Outcomes
Examining Externalities: The Costs and Benefits Others Feel from Your
Actions
Noting the effects of negative externalities
Accepting positive amounts of negative externalities
Dealing with negative externalities
Calculating the consequences of positive externalities
Subsidizing things that provide positive externalities
Tragedy of the Commons: Overexploiting Commonly Owned Resources


Having a cow: Overgrazing on a commonly owned field
Sleeping with the fishes: Extinctions caused by poor property rights
Avoiding the tragedy
Chapter 11: Market Failure: Asymmetric Information and Public Goods

Facing Up to Asymmetric Information
Realizing that asymmetric information limits trade
Souring on the lemons problem: The used car market
Issuing insurance when you can’t tell individuals apart
Providing Public Goods
Taxing to provide public goods
Enlisting philanthropy to provide public goods
Providing a public good by selling a related private good
Ranking new technology as a public good
Chapter 12: Taking the Pulse of Health Economics and Finance
Defining Health Economics and Health Finance
Noting the Limits of Health Insurance
Adverse selection: Looking at who buys insurance
Combating adverse selection
Comparing Healthcare Internationally
Inflated Demand: Suffering from “Free” and Reduced-Cost Healthcare
Diverting funds to lower-value uses
Rationing healthcare
Facing shortages and higher prices
Trying to combat inefficiency with bureaucracy
Investigating Singapore’s Secrets
Exploring cost-saving features
Weighing costs and benefits of medical procedures
Supporting cost-cutting innovations


Trying to copy Singapore’s success
Part IV: Macroeconomics: The Science of Economic Growth and Stability
Chapter 13: Measuring the Macroeconomy: How Economists Keep Track of
Everything

Getting a Grip on the GDP (and All Its Parts)
Leaving some things out of GDP
Tallying up what counts in GDP
Accounting for the tides of incomes and assets
Following the funds, around and around
Counting stuff when it’s made, not when it’s sold
Watching GDP rise with the good, the bad, and the ugly
Diving In to the GDP Equation
“C” is for consumption (that’s good enough for me!)
“I” is for investment in capital stock
The big “G” (government, that is)
Measuring foreign trade with “NX”
Making Sense of International Trade and Its Effect on the Economy
“Trade deficit” ain’t fightin’ words
Considering assets — not just cash
Wielding a comparative advantage
Chapter 14: Inflation Frustration: Why More Money Isn’t Always a Good Thing
Buying an Inflation: When Too Much Money Is a Bad Thing
Balancing money supply and demand
Giving in to the inflation temptation
Tallying up the effects of inflation
Measuring Inflation
Creating your very own market basket
Calculating the inflation rate


Setting up a price index
Determining the real standard of living with the price index
Identifying price index problems
Pricing the Future: Nominal and Real Interest Rates

Using the Fisher equation
Realizing that predictions aren’t perfect
Chapter 15: Understanding Why Recessions Happen
Introducing the Business Cycle
Striving for Full-Employment Output
Returning to Y*: The Natural Result of Price Adjustments
Responding to Economic Shocks: Short-Run and Long-Run Effects
Defining some critical terms
The tao of P: Looking at price adjustments in the long run
A shock to the system: Adjusting to a shift in aggregate demand
Dealing with fixed prices in the short run
Putting together the long and short of it
Heading toward Recession: Getting Stuck with Sticky Prices
Cutting wages or cutting workers
Adding up the costs of wages and profits
Returning to Y* with and without government intervention
Achieving Equilibrium with Sticky Prices: The Keynesian Model
Adjusting inventories instead of prices
Boosting GDP in the Keynesian model
Chapter 16: Fighting Recessions with Monetary and Fiscal Policy
Stimulating Demand to End Recessions
Aiming for full-employment output
Back to work: Shifting the AD curve to the right
Generating Inflation: The Risk of Too Much Stimulation


An exercise in futility: Trying to increase output beyond Y*
A temporary high: Tracing the movement of real wages
Failing to stimulate: What happens when a stimulus is expected
Figuring Out Fiscal Policy

Increasing government spending to help end recessions
Dealing with deficits
Dissecting Monetary Policy
Identifying the benefits of fiat money over the gold standard
Realizing that you can have too much money!
Getting the basics about bonds
Seeing the link between bond prices and interest rates
Changing the money supply to change interest rates
Lowering interest rates to stimulate the economy
Understanding how rational expectations can limit monetary policy
Chapter 17: Grasping the Origins and Aftermath of Financial Crises
Understanding How Debt-Driven Bubbles Develop
Embracing borrowing in a booming economy
Offering larger loans as collateral values rise
Relaxing lending standards
Borrowing more in hopes of profit
Watching the process gain momentum
Seeing the Bubble Burst
Deleveraging: Trying to ditch debt as prices fall
Comprehending bank collapses caused by bursting bubbles
Leading into a recession
After the Crisis: Looking toward Recovery
Enduring a broken banking system
Struggling with structural mismatches
Noting the limits of government policy


Part V: The Part of Tens
Chapter 18: Ten Seductive Economic Fallacies
The Lump of Labor

The World Is Facing Overpopulation
Order Indicates Causes
Protectionism Is the Best Solution to Foreign Competition
The Fallacy of Composition
If It’s Worth Doing, Do It 100 Percent
Free Markets Are Volatile
Low Foreign Wages Mean That Rich Countries Can’t Compete
Tax Rates Don’t Affect Work Effort
Forgetting That Policies Have Unintended Consequences
Chapter 19: Ten Economic Ideas to Hold Dear
Self-Interest Can Improve Society
Free Markets Require Regulation
Economic Growth Relies on Innovation
Freedom and Democracy Make Us Richer
Education Raises Living Standards
Intellectual Property Rights Boost Innovation
Weak Property Rights Cause All Environmental Problems
International Trade Is a Good Thing
Government Can Provide Public Goods
Preventing Inflation Is Easy
Chapter 20: Ten Great Ways to Become Informed about Economic Issues
Sort Through the Popular Press
Peruse Economics Blogs
Absorb Think-Tank Policy Papers
Review the Latest Research
Investigate Entrepreneurship
Talk to All Stakeholders
Dissect the Tax System
Peruse Your City’s Budget
Uncover Government Policy Papers

Get to Know Government Data
Appendix: Glossary
Cheat Sheet


Economics For Dummies®, 2nd Edition
by Sean Flynn, PhD

Economics For Dummies®, 2nd Edition
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About the Author
Sean Flynn is an assistant professor of economics at Scripps College in Claremont, California.
A recurring commentator on radio and television, Sean holds a BA in economics from the
University of Southern California and a PhD in economics from UC Berkeley, where he completed
his dissertation under the supervision of Nobel Laureate George Akerlof.
As one of America’s leading economic educators, Sean is a coauthor (along with Campbell


McConnell and Stanley Brue) of the world’s best-selling college economics textbook, Economics:
Principles, Problems, and Policies (McGraw-Hill). The book’s popularity is such that it’s also
the world’s best-selling college textbook of any subject.
Sean’s academic research focuses on the often puzzling and seemingly irrational behavior of stock
market investors, but he’s also investigated topics as wide-ranging as the factors that affect tipping
behavior in restaurants and why you see a lot of unionized workers only in certain industries. He’s
also a leading expert on closed-end mutual funds.
Sean’s (rather serious) hobby is the Japanese martial art of aikido, which he has taught for over 15
years to hundreds of students in the United States and abroad. A former national forms champion
himself, Sean has coached five of his students to U.S. national aikido titles in either forms or fullcontact sparring.

Dedication
To my father, Thomas Ray Flynn, who always impressed upon me the importance of good
economic policy both for improving our quality of life and as our last, best hope for lifting billions
out of poverty and disease.

Author’s Acknowledgments
I’d like to thank the many great economists who managed to get things into my head despite my

very thick skull.
Among my teachers, I can’t help but thank Caroline Betts, Tim Cason, Richard Ciccetti, Michael
DePrano, Richard Easterlin, Robert Kalaba, Timur Kuran, Jeffrey Nugent, and Morton Shapiro for
the excellent education I received as an undergraduate at the University of Southern California.
I was equally blessed at UC Berkeley, where I got to complete a doctorate under the tutelage of
some true intellectual giants, including George Akerlof, David Card, J. Bradford DeLong, Jan
deVries, Barry Eichengreen, Richard Gilbert, Daniel McFadden, Maurey Obstfeld, Matthew
Rabin, David Romer, Christina Romer, and Janet Yellen. It was especially fun when Professors
McFadden and Akerlof won their Nobel Prizes during my last two years at Cal.
However, my fellow economics students often did more than my professors to explain things to me
when I wasn’t getting them, and they continue to educate me even now. So a very heartfelt thank
you to Corinne Alexander, Lorenzo Blanco, Mark Carlson, Carlos Dobkin, Tim Doede, Mike
Enriquez, Fabio Ghironi, Petra Geraats, Aaron Green, Galina Hale, Alan Marco, Carolina
Marquez, Marcelo Moreira, Petra Moser, Marc Muendler, Stefan Palmqvist, Doug Park, Raj
Patel, Steve Puller, Desiree Schaan, Doug Schwalm, Mark Stehr, Sam Thompson, Carla Tully,


Jeff Weinstein, and Marta Wosinska.
I’ve also got to thank my current and former students at Scripps College, Vassar College, and UC
Berkeley. Having to answer your many insightful questions made me a much better economist.
A big thank you to my literary agent Linda Roghaar and my old friend Mike Jones for getting me
this book deal. They heard Dummies and immediately thought of me.
Tracy Boggier, Joan Friedman, Alissa Schwipps, Chad Sievers, and the entire production team at
Wiley also deserve huge praise. All their edits, suggestions, and formatting have turned out a book
that’s far better than anything I could have come up with on my own.
I also have to deeply thank Dr. Robert Harris, the technical editor of this book. His comments and
suggestions have made it far better than it would have been otherwise.
Finally, many thanks to my parents for always making me do my homework.

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Introduction
Economics is all about humanity’s struggle to achieve happiness in a world full of constraints.
There’s never enough time or money to do everything people want, and things like curing cancer
are still impossible because the necessary technologies haven’t been developed yet. But people
are clever. They tinker and invent, ponder and innovate. They look at what they have and what they
can do with it and take steps to make sure that if they can’t have everything, they’ll at least have as
much as possible.
Having to choose is a fundamental part of everyday life. The science that studies how people
choose — economics — is indispensable if you really want to understand human beings both as
individuals and as members of larger organizations. Sadly, though, economics has typically been
explained so badly that people either dismiss it as impenetrable gobbledygook or stand falsely in
awe of it — after all, if it’s hard to understand, it must be important, right?
I wrote this book so you can quickly and easily understand economics for what it is — a serious
science that studies a serious subject and has developed some seriously good ways of explaining
human behavior out in the (very serious) real world. Economics touches on nearly everything, so
the returns on reading this book are huge. You’ll understand much more about people, the
government, international relations, business, and even environmental issues.

About This Book
The English poet Thomas Carlyle called economics the “dismal science,” but I’m going to do my
best to make sure that you don’t come to agree with him. I’ve organized this book to try to get as
much economics into you as quickly and effortlessly as possible. I’ve also done my best to keep it
lively and fun.
In this book, you find the most important economic theories, hypotheses, and discoveries without a
zillion obscure details, outdated examples, or complicated mathematical “proofs.” Among the
topics covered are

How the government fights recessions and unemployment
How and why international trade is good for both individuals and nations
Why poorly designed property rights are responsible for environmental problems such as
global warming, pollution, and species extinctions
How profits guide businesses to produce the goods and services you take for granted
How economic incentives affect healthcare costs, prices, and efficiency


Why competitive firms are almost always better for society than monopolies
How the Federal Reserve controls the money supply, interest rates, and inflation all at the
same time
Why government policies such as price controls and subsidies often cause much more
harm than good
How the simple supply and demand model can explain the prices of everything from
comic books to open-heart surgeries
You can read the chapters in any order, and you can immediately jump to what you need to know
without having to read a bunch of stuff that you couldn’t care less about.
Economists like competition, so you shouldn’t be surprised that there are a lot of competing views.
Indeed, it’s only through vigorous debate and careful review of the evidence that the profession
improves its understanding of how the world works. This book contains core ideas and concepts
that economists agree are true and important — I try to steer clear of fads or ideas that foster a lot
of disagreement. (If you want to be subjected to my opinions and pet theories, you’ll have to buy
me a drink.)

Conventions Used in This Book
Economics is full of two things you may not find very appealing: jargon and algebra. To minimize
confusion, whenever I introduce a new term, I put it in italics and follow it closely with an easyto-understand definition. Also, whenever I bring algebra into the discussion, I use those handy
italics again to let you know that I’m referring to a variable. For instance, I indicates investment,
so you may see a sentence like this one: I think that I is too big.
I try to keep equations to a minimum, but sometimes they help make things clearer. In such

instances, I sometimes have to use several equations one after another. To avoid confusion about
which equation I’m referring to at any given time, I give each equation a number, which I put in
parentheses. For example,
(1) MTV = ESPN + CNN 2
Finally, the following conventions are used throughout the text of all For Dummies books to make
things consistent and easy to understand:
All Web addresses appear in this font.
Bold is used to highlight the action parts of numbered steps.


What You’re Not to Read
The whole point of a For Dummies book is to give you quick access to the essentials so you don’t
have to wade through a bunch of stories, factoids, and anecdotes. On the other hand, sometimes
stories, factoids, and anecdotes can be both fun and enlightening. Consequently, I’ve clearly
identified all the “skippable” material. This information is the stuff that, although interesting and
related to the topic at hand, isn’t essential for you to know:
Text in sidebars: The sidebars are shaded boxes that share interesting stories and
observations but aren’t necessary reading.
Anything with a Technical Stuff icon attached: This information is interesting but not
critical to your understanding of what’s being explained.
The stuff on the acknowledgements page: Unless you’re one of my friends who needs
an ego stroke, there’s nothing here for you.
Naturally, I’d like to believe that you’ll choose to read everything I’ve written, but don’t worry.
I’ll never know.

Foolish Assumptions
I wrote this book assuming some things about you:
You’re sharp, thoughtful, and interested in how the world works.
You’re a high school or college student trying to flesh out what you’re learning in class, or
you’re a citizen of the world who realizes that a good grounding in economics will help

you understand everything from business and politics to social issues like poverty and
environmental degradation.
You want to know some economics, but you’re also busy leading a very full life.
Consequently, although you want the crucial facts, you don’t want to have to read through
a bunch of minutia to find them.
You’re not totally intimidated by numbers, facts, and figures. Indeed, you welcome them
because you like to have things proven to you instead of taking them on faith because some
pinhead with a PhD says so.
You like learning why as well as what. That is, you want to know why things happen and
how they work instead of just memorizing factoids.


How This Book Is Organized
This book is divided into five parts to make the material easier to understand and access. In this
section, I explain what you have to look forward to in each of these parts.

Part I: Economics: The Science of How People Deal
with Scarcity
Economics is all about how people deal with scarcity, which is a situation that occurs when the
quantities of goods and services that are available for consumption are less than the amounts that
people desire to consume. There’s never enough time, and there’s a limited supply of natural
resources such as oil and iron. Consequently, people have to be clever about getting the most out
of life — choosing wisely about what to do with the limited resources they’re given. Part I
explains how people go about dealing with scarcity and the tradeoffs that it forces them to make.
The rest of economics is just seeing how scarcity forces people to make tradeoffs in more specific
situations.

Part II: Microeconomics: The Theories of Consumer
and Firm Behavior
Microeconomic theory attempts to understand and predict the behavior of individual people and

individual firms. It studies what motivates them and how they act to achieve their goals given the
constraints they face. In this part, you discover what motivates firms to produce output, how
buyers and sellers interact in markets to allocate that output, and how markets can break down and
do perverse things if not properly managed.
You also explore how consumer decisions about what goods and services to purchase and in
which quantities to purchase them are driven by a desire on the part of consumers to maximize the
total amount of utility, or satisfaction, that they can get from their limited budgets. I also delve in
to the details of supply and demand, competition, monopolies, and Adam Smith’s “invisible hand.”

Part III: Applying the Theories of Microeconomics
In this part, I present three chapters that show how well microeconomic theory can illuminate
many real-world behaviors. Among other things, you explore why health insurance costs so much,
why it’s so difficult to find a quality used car, and how a few simple changes in the way property
rights are defined and enforced can mean the difference between extinction and survival for many
species of wild animals as well as entire rainforests and other ecosystems.


Part IV: Macroeconomics: The Science of Economic
Growth and Stability
Macroeconomics views the economy from on high, at the national or international level. It deals
with the choices countries face about economic growth and development as well as choices about
how to best manage their economies to avoid recessions. It also deals with the misery caused by
unemployment and inflation. In this part, you find out about monetary and fiscal policy, the Federal
Reserve, the effects of taxation on the economy, and international trade and trade policy.

Part V: The Part of Tens
Every For Dummies book ends with top-ten lists that are both helpful and fun. In this part, I give
you ten economic ideas to hold dear, ten false economic assertions that are repeated all the time in
the media and by politicians, and ten ways to become a better economist.

Icons Used in This Book
To make this book easier to read and simpler to use, I include a few icons that can help you find
and fathom key ideas and information.

This icon alerts you that I’m explaining a fundamental economic concept or fact. It saves
you the time and effort of marking the book with a highlighter.

Economics is chock full of theories, and sometimes it’s helpful to kick those theories out
into the real world and see how they actually work. This icon alerts you to the presence of a
helpful, real-world example.

This icon tells you that the ideas and information that it accompanies are a bit more
technical or mathematical than other sections of the book. This information can be interesting
and informative, but I’ve designed the book so that you don’t need to understand it to get the
big picture about what’s going on. Feel free to skip this stuff.

This icon points out time and energy savers. I place this icon next to suggestions for ways to
do or think about things that can save you some effort.


This icon discusses any troublesome areas in economics you need to know. Keep an eye
open for them for to alert you of potential pitfalls.

Where to Go from Here
This book is set up so that you can understand what’s going on even if you skip around. The book
is also divided into independent parts so that you can, for instance, read all about microeconomics
without having to read anything about macroeconomics. The table of contents and index can help
you find specific topics easily. But, hey, if you don’t know where to begin, just do the oldfashioned thing and start at the beginning.

Part I

Economics: The Science of How People Deal
with Scarcity