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Principles of
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D. Curtis & I. Irvine
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an Open Text by Douglas Curtis and Ian Irvine
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Table of Contents
Table of Contents
iii
About the Authors
1
Part One: The Building Blocks
5
1 Introduction to key ideas
7
1.1
What’s it all about? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7
1.2
Understanding through the use of models . . . . . . . . . . . . . . . . . . . . . . 12
1.3
Opportunity cost and the market . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1.4
A model of exchange and specialization . . . . . . . . . . . . . . . . . . . . . . . 14
1.5
Economy-wide production possibilities . . . . . . . . . . . . . . . . . . . . . . . 18
1.6
Aggregate output, growth and business cycles . . . . . . . . . . . . . . . . . . . . 20
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Exercises for Chapter 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
2 Theories, data and beliefs
2.1
29
Data analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
iii
iv
Table of Contents
2.2
Data, theory and economic models . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.3
Ethics, efficiency and beliefs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
Exercises for Chapter 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
3 The classical marketplace – demand and supply
47
3.1
The marketplace – trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
3.2
The market’s building blocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
3.3
Demand and supply curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
3.4
Non-price influences on demand . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
3.5
Non-price influences on supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
3.6
Simultaneous supply and demand impacts . . . . . . . . . . . . . . . . . . . . . . 61
3.7
Market interventions – governments and interest groups . . . . . . . . . . . . . . . 62
3.8
Individual and market functions . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
3.9
Useful techniques – demand and supply equations . . . . . . . . . . . . . . . . . . 68
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Exercises for Chapter 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
Part Two: Responsiveness and the Value of Markets
75
4 Measures of response: Elasticities
77
4.1
Price responsiveness of demand . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
4.2
Price elasticities and public policy . . . . . . . . . . . . . . . . . . . . . . . . . . 83
Table of Contents
v
4.3
The time horizon and inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
4.4
Cross-price elasticities – cable or satellite . . . . . . . . . . . . . . . . . . . . . . 87
4.5
The income elasticity of demand . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
4.6
Elasticity of supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
4.7
Elasticities and tax incidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
4.8
Technical tricks with elasticities . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
Exercises for Chapter 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
5 Welfare economics and externalities
103
5.1
Equity and efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
5.2
Consumer and producer surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
5.3
Efficient market outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
5.4
Taxation, surplus and efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
5.5
Market failures – externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
5.6
Other market failures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
5.7
Environmental policy and climate change . . . . . . . . . . . . . . . . . . . . . . 116
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
Exercises for Chapter 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
Part Three: Decision Making by Consumer and Producers
131
6 Individual choice
133
vi
Table of Contents
6.1
Rationality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
6.2
Choice with measurable utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
6.3
Choice with ordinal utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
6.4
Applications of indifference analysis . . . . . . . . . . . . . . . . . . . . . . . . . 150
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
Exercises for Chapter 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
7 Firms, investors and capital markets
157
7.1
Business organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
7.2
Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
7.3
Risk and the investor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
7.4
Risk pooling and diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
Exercises for Chapter 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
8 Production and cost
175
8.1
Efficient production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
8.2
The time frame . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
8.3
Production in the short run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
8.4
Costs in the short run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
8.5
Fixed costs and sunk costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
8.6
Long-run production and costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
8.7
Technological change: globalization and localization . . . . . . . . . . . . . . . . 194
Table of Contents
8.8
vii
Clusters, learning by doing, scope economies . . . . . . . . . . . . . . . . . . . . 196
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
Exercises for Chapter 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
Part Four: Market Structures
203
9 Perfect competition
205
9.1
The perfect competition paradigm . . . . . . . . . . . . . . . . . . . . . . . . . . 205
9.2
Market characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
9.3
The firm’s supply decision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
9.4
Dynamics: Entry and exit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
9.5
Long-run industry supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
9.6
Globalization and technological change . . . . . . . . . . . . . . . . . . . . . . . 221
9.7
Efficient resource allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
Exercises for Chapter 9 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
10 Monopoly
227
10.1 Monopolies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
10.2 Profit maximizing behaviour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
10.3 Long-run choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
10.4 Output inefficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
10.5 Price discrimination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
viii
Table of Contents
10.6 Cartels: Acting like a monopolist . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
10.7 Invention, innovation and rent seeking . . . . . . . . . . . . . . . . . . . . . . . . 250
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
Exercises for Chapter 10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254
11 Imperfect competition
257
11.1 The principle ideas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257
11.2 Imperfect competitors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258
11.3 Imperfect competitors: measures of structure and market power . . . . . . . . . . . 261
11.4 Imperfect competition: monopolistic competition . . . . . . . . . . . . . . . . . . 262
11.5 Imperfect competition: economies of scope and platforms . . . . . . . . . . . . . . 264
11.6 Strategic behaviour: Oligopoly and games . . . . . . . . . . . . . . . . . . . . . . 266
11.7 Strategic behaviour: Duopoly and Cournot games . . . . . . . . . . . . . . . . . . 270
11.8 Strategic behaviour: Entry, exit & potential competition . . . . . . . . . . . . . . . 274
11.9 Matching markets: design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
Exercises for Chapter 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
Part Five: The Factors of Production
287
12 Labour and capital
289
12.1 Labour – a derived demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
Table of Contents
ix
12.2 The supply of labour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
12.3 Labour market equilibrium and mobility . . . . . . . . . . . . . . . . . . . . . . . 297
12.4 Capital – concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
12.5 The capital market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
12.6 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
Exercises for Chapter 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
13 Human capital and the income distribution
313
13.1 Human capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
13.2 Productivity and education . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
13.3 On-the-job training . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
13.4 Education as signalling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
13.5 Education returns and quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
13.6 Discrimination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
13.7 The income distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
13.8 Wealth and capitalism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
Exercises for Chapter 13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332
Part Six: Government and Trade
335
14 Government
337
14.1 Market failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
x
Table of Contents
14.2 Fiscal federalism: Taxing and spending . . . . . . . . . . . . . . . . . . . . . . . 342
14.3 Federal-provincial fiscal relations . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
14.4 Government-to-individual transfers . . . . . . . . . . . . . . . . . . . . . . . . . . 346
14.5 Regulation and competition policy . . . . . . . . . . . . . . . . . . . . . . . . . . 350
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
Exercises for Chapter 14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
15 International trade
361
15.1 Trade in our daily lives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
15.2 Canada in the world economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
15.3 The gains from trade: Comparative advantage . . . . . . . . . . . . . . . . . . . . 364
15.4 Returns to scale and dynamic gains from trade . . . . . . . . . . . . . . . . . . . . 369
15.5 Trade barriers: Tariffs, subsidies and quotas . . . . . . . . . . . . . . . . . . . . . 373
15.6 The politics of protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
15.7 Institutions governing trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 386
Exercises for Chapter 15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387
Part Seven: Introduction to Macroeconomics
391
16 Economic activity & performance
393
16.1 Indicators of macroeconomic activity and performance . . . . . . . . . . . . . . . 394
16.2 Recent Canadian economic performance . . . . . . . . . . . . . . . . . . . . . . . 401
16.3 National accounts and economic structure . . . . . . . . . . . . . . . . . . . . . . 405
Table of Contents
xi
16.4 Measuring GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
16.5 Nominal GDP, real GDP & the GDP deflator . . . . . . . . . . . . . . . . . . . . . 412
16.6 Per capita real GDP and standards of living . . . . . . . . . . . . . . . . . . . . . 415
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 418
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419
Exercises for Chapter 16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420
17 Output, business cycles, growth & employment
423
17.1 Aggregate demand & aggregate supply . . . . . . . . . . . . . . . . . . . . . . . . 424
17.2 Equilibrium output and potential output . . . . . . . . . . . . . . . . . . . . . . . 431
17.3 Growth in potential output . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432
17.4 Business cycles and output gaps . . . . . . . . . . . . . . . . . . . . . . . . . . . 433
17.5 Adjustments to output gaps? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436
17.6 The role of macroeconomic policy . . . . . . . . . . . . . . . . . . . . . . . . . . 436
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 439
Exercises for Chapter 17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440
18 Aggregate expenditure & aggregate demand
443
18.1 Short-run aggregate demand and output . . . . . . . . . . . . . . . . . . . . . . . 444
18.2 Aggregate expenditure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446
18.3 Aggregate expenditure and equilibrium output . . . . . . . . . . . . . . . . . . . . 454
18.4 The multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458
18.5 Equilibrium output and aggregate demand . . . . . . . . . . . . . . . . . . . . . . 462
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 467
xii
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Exercises for Chapter 18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 468
19 The government sector
473
19.1 Government in Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475
19.2 Government expenditure & taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . 476
19.3 The government’s budget function . . . . . . . . . . . . . . . . . . . . . . . . . . 483
19.4 Fiscal policy & government budget balances . . . . . . . . . . . . . . . . . . . . . 486
19.5 Automatic and discretionary fiscal policy . . . . . . . . . . . . . . . . . . . . . . 491
19.6 The public debt and the budget balance . . . . . . . . . . . . . . . . . . . . . . . . 494
19.7 Aggregate demand & equilibrium GDP . . . . . . . . . . . . . . . . . . . . . . . 498
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 501
Exercises for Chapter 19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503
Part Eight: Financial Markets & Economic Activity
507
20 Money, banking & money supply
509
20.1 Money and the functions of money . . . . . . . . . . . . . . . . . . . . . . . . . . 509
20.2 Measures of the Canadian money supply . . . . . . . . . . . . . . . . . . . . . . . 515
20.3 Banking in Canada today . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
20.4 Money created by banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
20.5 The monetary base and the money supply . . . . . . . . . . . . . . . . . . . . . . 525
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 532
Exercises for Chapter 20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 534
Table of Contents
21 Financial markets, interest rates, foreign exchange rates & AD
xiii
535
21.1 Portfolio choices between money and other assets . . . . . . . . . . . . . . . . . . 536
21.2 The demand for money balances . . . . . . . . . . . . . . . . . . . . . . . . . . . 539
21.3 Financial market equilibrium & interest rates . . . . . . . . . . . . . . . . . . . . 543
21.4 Foreign exchange rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 547
21.5 Interest rates, exchange rates, and aggregate demand . . . . . . . . . . . . . . . . 548
21.6 The monetary transmission mechanism . . . . . . . . . . . . . . . . . . . . . . . . 555
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 563
Exercises for Chapter 21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 564
22 Central banking and monetary policy
567
22.1 Central banking and the Bank of Canada . . . . . . . . . . . . . . . . . . . . . . . 568
22.2 Central bank operating techniques . . . . . . . . . . . . . . . . . . . . . . . . . . 570
22.3 Monetary policy targets and instruments . . . . . . . . . . . . . . . . . . . . . . . 578
22.4 Monetary policy rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 585
22.5 Monetary policy indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 592
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 594
Exercises for Chapter 22 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 596
Part Nine: Real GDP, Business Cycles, Policy and Growth
599
23 Inflation, real GDP, monetary policy & fiscal policy
601
23.1 Inflation and aggregate demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602
23.2 Aggregate supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 605
xiv
Table of Contents
23.3 The equilibrium inflation rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609
23.4 Adjustments to output gaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 610
23.5 Monetary and fiscal policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 613
23.6 Recession, disinflation and deflation . . . . . . . . . . . . . . . . . . . . . . . . . 624
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 631
Exercises for Chapter 23 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 633
24 Exchange rates, monetary policy, and fiscal policy
635
24.1 The balance of payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 635
24.2 The foreign exchange market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 643
24.3 Flexible exchange rates and fixed exchange rates . . . . . . . . . . . . . . . . . . 649
24.4 Monetary and fiscal policy under flexible exchange rates . . . . . . . . . . . . . . 652
24.5 Monetary and fiscal policy under fixed exchange rates . . . . . . . . . . . . . . . . 655
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 658
Exercises for Chapter 24 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 660
25 Economic growth
663
25.1 Patterns of economic growth across countries . . . . . . . . . . . . . . . . . . . . 663
25.2 Growth in potential output . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 667
25.3 Growth in per capita GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 671
25.4 Technology & growth in real per capita GDP . . . . . . . . . . . . . . . . . . . . 676
25.5 Recent growth studies and policy issues . . . . . . . . . . . . . . . . . . . . . . . 678
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 682
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 683
Table of Contents
xv
Exercises for Chapter 25 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 684
Glossary: Microeconomic Terms
687
Glossary: Macroeconomic Terms
703
Solutions To Exercises
717
Chapter 1 Solutions
717
Chapter 2 Solutions
719
Chapter 3 Solutions
722
Chapter 4 Solutions
727
Chapter 5 Solutions
732
Chapter 6 Solutions
735
Chapter 7 Solutions
740
Chapter 8 Solutions
742
Chapter 9 Solutions
746
Chapter 10 Solutions
750
Chapter 11 Solutions
755
xvi
Table of Contents
Chapter 12 Solutions
757
Chapter 13 Solutions
759
Chapter 14 Solutions
762
Chapter 15 Solutions
764
Chapter 16 Solutions
769
Chapter 17 Solutions
771
Chapter 18 Solutions
776
Chapter 19 Solutions
781
Chapter 20 Solutions
786
Chapter 21 Solutions
789
Chapter 22 Solutions
793
Chapter 23 Solutions
797
Chapter 24 Solutions
802
Chapter 25 Solutions
806
About the Authors
Doug Curtis is a specialist in macroeconomics. He is the author of numerous research papers on
fiscal policy, monetary policy, and economic growth and structural change. He has also prepared
research reports for Canadian industry and government agencies and authored numerous working
papers. He completed his PhD at McGill University, and has held visiting appointments at the
University of Cambridge and the University of York in the United Kingdom. His current research
interests are monetary and fiscal policy rules, and the relationship between economic growth and
structural change. He is Professor Emeritus of Economics at Trent University in Peterborough,
Ontario, and also held an appointment as Sessional Adjunct Professor in the Department of Economics at Queen’s University in Kingston, Ontario from 2003 until 2013.
Ian Irvine is a specialist in microeconomics, public economics, economic inequality and health
economics. He is the author of numerous research papers in these fields. He completed his PhD
at the University of Western Ontario, has been a visitor at the London School of Economics, the
University of Sydney, the University of Colorado, University College Dublin and the Economic
and Social Research Institute. His current research interests are in tobacco use and taxation, and
Canada’s Employment Insurance and Welfare systems. He has done numerous studies for the
Government of Canada, and is currently a Professor of Economics at Concordia University in
Montreal.
Our Philosophy
Principles of Economics focuses upon the material that students need to cover in a first introductory course. It is slightly more compact than the majority of principles books in the Canadian
marketplace. Decades of teaching experience and textbook writing has led the authors to avoid the
encyclopedic approach that characterizes the recent trends in textbooks.
Consistent with this approach, there are no appendices or ‘afterthought’ chapters. No material
is relegated elsewhere for a limited audience; the text makes choices on what issues and topics
are important in an introductory course. This philosophy has resulted in a combined book of 15
Microeconomic chapters and 13 Macroeconomic chapters.
Examples are domestic and international in their subject matter and are of the modern era – consumers buy iPods, snowboards and jazz, not so much coffee and hamburgers. Globalization is a
recurring theme.
While this book avoids calculus, and uses equations sparingly, it still aims to be rigorous. In
contrast to many books on the market, that simply insert diagrams and discuss concepts in a di1
2
About the Authors
agrammatic framework, our books almost invariably analyze the key issues in each chapter by
introducing a numerical example or case study at the outset. Students are introduced immediately
to the practice of taking a set of data, examining it numerically, plotting it, and again analyzing the
material in that form. This process is not difficult, but it is rigorous, and stresses that economics
is about data analysis as well as ideas and theories. The end-of-chapter problems also involve a
considerable amount of numerical and graphical analysis. A small number of problems in each
chapter involve solving simple linear equations (intersecting straight lines); but we provide a sufficient number of questions for the student to test his or her understanding of the material without
working through that subset of questions.
Structure of the Text
Principles of Economics combines the textbooks Principles of Microeconomics and Principles of
Macroeconomics.
Principles of Microeconomics provides a concise, yet complete, coverage of introductory microeconomic theory, application and policy in a Canadian and global environment. Our beginning is
orthodox: We explain and develop the standard tools of analysis in the discipline.
Economic policy is about the well-being of the economy’s participants, and economic theory
should inform economic policy. So we investigate the meaning of ‘well-being’ in the context
of an efficient use of the economy’s resources early in the text.
We next develop an understanding of individual optimizing behaviour. This behaviour in turn is
used to link household decisions on savings with firms’ decisions on production, expansion and
investment. A natural progression is to explain production and cost structures.
From the individual level of household and firm decision making, the text then explores behaviour
in a variety of different market structures from perfect competition to monopoly.
Markets for the inputs in the productive process – capital and labour – are a natural component of
firm-level decisions. But education and human capital are omnipresent concepts and concerns in
the modern economy, so we devote a complete chapter to them.
The book then examines the role of a major and important non-market player in the economy –
the government, and progresses to develop the key elements in the modern theory of international
trade.
Principles of Macroeconomics provides complete, concise coverage of introductory macroeconomic theory and policy. It examines the Canadian economy as an economic system, and embeds current Canadian institutions and approaches to monetary policy and fiscal policy within that
system. Particular attention is given to the recent structure, performance, and evolution of the
Canadian economy, and to the current targets and instruments of Canadian monetary and fiscal
policy.
About the Authors
3
These are exciting and challenging times in which to study macroeconomics. We focus on shortrun macroeconomic performance, analysis, and policy motivated by the recessions of the early
1980s and 1990s, the financial crisis and recession of 2008-2009, and the prolonged recovery that
is still incomplete in several industrial countries in 2017. The early effects of the novel coronavirus,
the COVID-19 pandemic, on employment, income, output and prices provided a whole new set
of challenges for economic analysis and policy. To that end, the text examines macroeconomic
institutions, performance, and policies in ways that help students understand and evaluate critically
the news media coverage and broader public discussion of:
• Recessions and recoveries, unemployment, inflation, deflation and conditions in financial
markets—topics of ongoing reporting, discussion, and debate.
• Monetary and fiscal policy announcements and discussions focused on inflation targets, interest rate settings, budget balances, tax rates, expenditures, and public debt targets as these
affect economic performance.
• Exports, imports, international capital flows, foreign exchange rates, commodity prices and
the importance of the international sector of the Canadian economy.
• Economic growth, productivity growth, and the importance of productivity growth for standards of living in Canada and other countries.
A basic modern Aggregate Demand and Supply model of real GDP and the inflation rate is developed based on:
• Expenditure decisions by households and businesses in an open economy.
• Government sector expenditures, taxes and budgets.
– Current Canadian monetary policy based on inflation targets, interest rate policy instruments, and current Bank of Canada operating techniques, including the potential
for quantitative or credit easing.
– Canadian fiscal policy based on deficit and debt ratio targets, the government’s budget
function, the temporary shift to fiscal stimulus in 2009, the subsequent fiscal austerity designed to achieve a balanced budget by 2015 and the implications for economic
performance and the public debt.
Numerical examples, diagrams, and basic arithmetic are used in combination to illustrate and explain economic relationships. Students learn about: The importance of consumption, capital expenditures, and government budgets; money supply; financial asset prices, yields, and interest
rates; employment and unemployment; and other key relationships in the economy. Canadian and
selected international data are used to provide real world examples and comparisons.
Part One
The Building Blocks
1. Introduction to key ideas
2. Theories, models and data
3. The classical marketplace – demand and supply
Economics is a social science; it analyzes human interactions in a scientific manner. We begin
by defining the central aspects of this social science – trading, the marketplace, opportunity cost
and resources. We explore how producers and consumers interact in society. Trade is central to
improving the living standards of individuals. This material forms the subject matter of Chapter 1.
Methods of analysis are central to any science. Consequently we explore how data can be displayed
and analyzed in order to better understand the economy around us in Chapter 2. Understanding the
world is facilitated by the development of theories and models and then testing such theories with
the use of data-driven models.
Trade is critical to individual well-being, whether domestically or internationally. To understand
this trading process we analyze the behaviour of suppliers and buyers in the marketplace. Markets
are formed by suppliers and demanders coming together for the purpose of trading. Thus, demand
and supply are examined in Chapter 3 in tabular, graphical and mathematical form.
Chapter 1
Introduction to key ideas
In this chapter we will explore:
1.1 What it’s all about
1.2 Understanding through the use of models
1.3 Opportunity cost and the market
1.4 A model of exchange and specialization
1.5 Production possibilities for the economy
1.6 Aggregate output, growth and cycles
1.1 What’s it all about?
The big issues
Economics is the study of human behaviour. Since it uses scientific methods it is called a social
science. We study human behaviour to better understand and improve our world. During his
acceptance speech, a recent Nobel Laureate in Economics suggested:
Economics, at its best, is a set of ideas and methods for the improvement of society. It
is not, as so often seems the case today, a set of ideological rules for asserting why we
cannot face the challenges of stagnation, job loss and widening inequality.
Christopher Sims, Nobel Laureate in Economics 2011
This is an elegant definition of economics and serves as a timely caution about the perils of ideology. Economics evolves continuously as current observations and experience provide new evidence about economic behaviour and relationships. Inference and policy recommendations based
on earlier theories, observations and institutional structures require constant analysis and updating
if they are to furnish valuable responses to changing conditions and problems.
Much of today’s developed world still faces severe challenges as a result of the financial crisis
that began in 2008. Unemployment rates among young people are at historically high levels in
several economies, many government balance sheets are in disarray, and inequality is on the rise.
In addition to the challenges posed by this severe economic cycle, the world simultaneously faces
structural upheaval: Overpopulation, climate change, political instability and globalization challenge us to understand and modify our behaviour.
7
8
Introduction to key ideas
These challenges do not imply that our world is deteriorating. Literacy rates have been rising
dramatically in the developing world for decades; child mortality has plummeted; family size is a
fraction of what it was 50 years ago; prosperity is on the rise in much of Asia; life expectancy is
increasing universally and deaths through wars are in a state of long-term decline.
These developments, good and bad, have a universal character and affect billions of individuals.
They involve an understanding of economies as large organisms with interactive components.
Aggregate output in a national economy
A national economy is a complete multi-sector system, made up of household, business, financial,
government and international sectors. Each of these sectors is an aggregate or sum of a many
smaller economic units with very similar characteristics. The government sector, for example
aggregates the taxing and spending activities of local, provincial and national governments. Similarly, the household sector is an aggregate of the income, spending and saving of all households but
not the specifics of each individual household. Economic activity within any one of these sectors
reflects, in part, the conditions and choices made in that sector. But it is also affects and is affected
by conditions and actions in the other sectors. These interactions and feedbacks within the system
mean that the workings of the macro-economy are more complex than the operation of the sum of
its parts.
Macroeconomics: the study of the economy as a system in which interactions and
feedbacks among sectors determine national output, employment and prices.
For example, consider a simple economy with just household, business and financial sectors. The
household sector earns income by providing labour to the other sectors. Households make choices
about spending or saving this income. Businesses make decisions about the sizes of their establishments, their labour forces, and their outputs of goods and services. The financial sector provides
banking services: bank deposits, loans, and the payments system used by all three sectors.
Suppose households decide to spend more on goods and services and save less. That decision
by itself does not change household sector income, but it does increase business sector sales and
revenues. It also reduces the flow of household savings into bank deposits in the financial sector.
As a result the business sector has an incentive to increase employment and output and perhaps to
borrow from the financial sector to finance that expansion. Increased employment in the business
sector increases incomes in the household sector and further increases household expenditure and
savings. These inter-sector linkages and feedbacks produce a response in aggregate economy
greater than the initial change.
Expanding this simple example to include more sectors increases its complexity but does not
change the basics. A change in behaviour within a sector,or disturbance from outside that sector, changes aggregate levels of output, employment and prices. A complete multisector macroeconomic theory and model is required to understand the effects, on the aggregate economy, of
1.1. What’s it all about?
9
changes in either internal or external economic conditions. It is also essential for the design of
policies to manage the macroeconomic conditions.
Mitigating the effects of a large random shock from outside the economy, like the COVID-19
pandemic, disrupts all sectors of the economy. Flows of income, expenditure, revenue,and output
among sectors are reduced sharply both by the pandemic and by government and financial sectors
policy responses.
Application Box 1.1: COVID-19 and the Economy
The COVID-19 pandemic attacked Canada in early 2020. It revealed the complexities and
interdependencies that drive the macro economy. Control and elimination of the disease
depends on stopping person to person transmission. This is why the government mandated
personal and social distancing for individuals plus self-isolation and quarantine in some cases.
In addition businesses, mainly in the service sector, that relied on face to face interactions with
customers or live audiences were forced to close.
As a result, businesses lost sales revenues and cut output. They reduced employment to cut
labour costs, but overhead costs remained. Households lost employment and employment
incomes. They reduced their discretionary spending, but their overhead costs continued. As
a result the economy faced a unique, simultaneous collapse in overall private supply and demand and the risk of a deep recession. The government and financial sectors intervened with
fiscal and monetary policy support. Government introduced a wide range of new income supports for the household sector, and loan and subsidy programs to support businesses, funded
by large increases in the government’s budget deficit. The central bank lowered interest rates
and increased the monetary base to support the government’s borrowing requirements, and
the credit demands on private banks and other financial institutions. The banking system
lost the normal growth in customer deposits, but worked to accommodate the needs of their
business and household clients.
This unprecedented support from government fiscal policy and central bank monetary policy
will offset part of the loss in national output and income. But it will not reverse it. Recovery
will begin with the reopening of business and the growth of employment at some time in the
uncertain future. The size of the estimated effect of COVID-19 on the Canadian economy
is stark. In its Monetary Policy Report, April 2020, The Bank of Canada estimates that real
GDP in Canada will be 1% to 7.5% lower in 2020Q1 and lower by 15-30% in 2020Q2 than
in 2019Q4. The Monetary Policy Report is available on the Bank of Canada’s website at ww
w.bankofcanada.ca.
Individual behaviours
Economic actions, at the level of the person or organization, form the subject matter of microeconomics. Formally, microeconomics is the study of individual behaviour in the context of scarcity.
10
Introduction to key ideas
Not all individual behaviours are motivated by self-interest; many are motivated by a concern for
the well being of society-at-large. Philanthropic societies are goal-oriented and seek to attain their
objectives in an efficient manner.
Microeconomics: the study of individual behaviour in the context of scarcity.
Individual economic decisions need not be world-changing events, or motivated by a search for
profit. Microeconomics is also about how we choose to spend our time and money. There are quite
a few options to choose from: Sleep, work, study, food, shelter, transportation, entertainment,
recreation and so forth. Because both time and income are limited we cannot do all things all the
time. Many choices are routine or are driven by necessity. You have to eat and you need a place
to live. If you have a job you have committed some of your time to work, or if you are a student
some of your time is committed to lectures and study. There is more flexibility in other choices.
Critically, microeconomics seeks to understand and explain how we make choices and how those
choices affect our behaviour in the workplace, the marketplace, and society more generally.
A critical element in making choices is that there exists a scarcity of time, or income or productive
resources. Decisions are invariably subject to limits or constraints, and it is these constraints that
make decisions both challenging and scientific.
Microeconomics also concerns business choices. How does a business use its funds and management skill to produce goods and services? The individual business operator or firm has to decide
what to produce, how to produce it, how to sell it and in many cases, how to price it. To make and
sell pizza, for example, the pizza parlour needs, in addition to a source of pizza ingredients, a store
location (land), a pizza oven (capital), a cook and a sales person (labour). Payments for the use of
these inputs generate income to those supplying them. If revenue from the sale of pizzas is greater
than the costs of production, the business earns a profit for the owner. A business fails if it cannot
cover its costs.
In these micro-level behaviours the decision makers have a common goal: To do as well as they
can, given the constraints imposed by the operating environment. The individual wants to mix
work and leisure in a way that makes her as happy or contented as possible. The entrepreneur
aims at making a profit. These actors, or agents as we sometimes call them, are maximizing. Such
maximizing behaviour is a central theme in this book and in economics at large.
Markets and government
Markets play a key role in coordinating the choices of individuals with the decisions of business.
In modern market economies goods and services are supplied by both business and government.
Hence we call them mixed economies. Some products or services are available through the marketplace to those who wish to buy them and have the necessary income—as in cases like coffee
and wireless services. Other services are provided to all people through government programs like
law enforcement and health care.
1.1. What’s it all about?
11
Mixed economy: goods and services are supplied both by private suppliers and government.
Markets offer the choice of a wide range of goods and services at various prices. Individuals can
use their incomes to decide the pattern of expenditures and the bundle of goods and services they
prefer. Businesses sell goods and services in the expectation that the market price will cover costs
and yield a profit.
The market also allows for specialization and separation between production and use. Rather than
each individual growing her own food, for example, she can sell her time or labour to employers in
return for income. That income can then support her desired purchases. If businesses can produce
food more cheaply than individuals the individual obviously gains from using the market – by both
having the food to consume, and additional income with which to buy other goods and services.
Economics seeks to explain how markets and specialization might yield such gains for individuals
and society.
We will represent individuals and firms by envisaging that they have explicit objectives – to maximize their happiness or profit. However, this does not imply that individuals and firms are concerned only with such objectives. On the contrary, much of microeconomics and macroeconomics
focuses upon the role of government: How it manages the economy through fiscal and monetary
policy, how it redistributes through the tax-transfer system, how it supplies information to buyers
and sets safety standards for products.
Since governments perform all of these society-enhancing functions, in large measure governments
reflect the social ethos of voters. So, while these voters may be maximizing at the individual
level in their everyday lives, and our models of human behaviour in microeconomics certainly
emphasize this optimization, economics does not see individuals and corporations as being devoid
of civic virtue or compassion, nor does it assume that only market-based activity is important.
Governments play a central role in modern economies, to the point where they account for more
than one third of all economic activity in the modern mixed economy.
Governments supply goods and services in many spheres, for example, health and education. The
provision of public education is motivated both by a concern for equality and a realization that an
educated labour force increases the productivity of an economy. Likewise, the provision of law
and order, through our legal system broadly defined, represents more than a commitment to a just
society at the individual level; without a legal system that enforces contracts and respects property
rights, the private sector of the economy would diminish dramatically as a result of corruption,
uncertainty and insecurity. It is the lack of such a secure environment in many of the world’s
economies that inhibits their growth and prosperity.
Let us consider now the methods of economics, methods that are common to science-based disciplines.
12
Introduction to key ideas
1.2 Understanding through the use of models
Most students have seen an image of Ptolemy’s concept of our Universe. Planet Earth forms the
centre, with the other planets and our sun revolving around it. The ancients’ anthropocentric view
of the universe necessarily placed their planet at the centre. Despite being false, this view of our
world worked reasonably well – in the sense that the ancients could predict celestial motions, lunar
patterns and the seasons quite accurately.
More than one Greek astronomer believed that it was more natural for smaller objects such as the
earth to revolve around larger objects such as the sun, and they knew that the sun had to be larger
as a result of having studied eclipses of the moon and sun. Nonetheless, the Ptolemaic description
of the universe persisted until Copernicus wrote his treatise “On the Revolutions of the Celestial
Spheres” in the early sixteenth century. And it was another hundred years before the Church
accepted that our corner of the universe is heliocentric. During this time evidence accumulated as
a result of the work of Brahe, Kepler and Galileo. The time had come for the Ptolemaic model of
the universe to be supplanted with a better model.
All disciplines progress and develop and explain themselves using models of reality. A model is
a formalization of theory that facilitates scientific inquiry. Any history or philosophy of science
book will describe the essential features of a model. First, it is a stripped down, or reduced, version
of the phenomenon that is under study. It incorporates the key elements while disregarding what
are considered to be secondary elements. Second, it should accord with reality. Third, it should be
able to make meaningful predictions. Ptolemy’s model of the known universe met these criteria: It
was not excessively complicated (for example distant stars were considered as secondary elements
in the universe and were excluded); it corresponded to the known reality of the day, and made
pretty good predictions. Evidently not all models are correct and this was the case here.
Model: a formalization of theory that facilitates scientific inquiry.
In short, models are frameworks we use to organize how we think about a problem. Economists
sometimes interchange the terms theories and models, though they are conceptually distinct. A
theory is a logical view of how things work, and is frequently formulated on the basis of observation. A model is a formalization of the essential elements of a theory, and has the characteristics
we described above. As an example of an economic model, suppose we theorize that a household’s
expenditure depends on its key characteristics: A corresponding model might specify that wealth,
income, and household size determine its expenditures, while it might ignore other, less important,
traits such as the household’s neighbourhood or its religious beliefs. The model reduces and simplifies the theory to manageable dimensions. From such a reduced picture of reality we develop an
analysis of how an economy and its components work.
Theory: a logical view of how things work, and is frequently formulated on the basis
of observation.
1.3. Opportunity cost and the market
13
An economist uses a model as a tourist uses a map. Any city map misses out some detail—traffic
lights and speed bumps, for example. But with careful study you can get a good idea of the best
route to take. Economists are not alone in this approach; astronomers, meteorologists, physicists,
and genetic scientists operate similarly. Meteorologists disregard weather conditions in South
Africa when predicting tomorrow’s conditions in Winnipeg. Genetic scientists concentrate on the
interactions of limited subsets of genes that they believe are the most important for their purpose.
Even with huge computers, all of these scientists build models that concentrate on the essentials.
1.3 Opportunity cost and the market
Individuals face choices at every turn: In deciding to go to the hockey game tonight, you may have
to forgo a concert; or you will have to forgo some leisure time this week in order to earn additional
income for the hockey game ticket. Indeed, there is no such thing as a free lunch, a free hockey
game or a free concert. In economics we say that these limits or constraints reflect opportunity
cost. The opportunity cost of a choice is what must be sacrificed when a choice is made. That
cost may be financial; it may be measured in time, or simply the alternative foregone.
Opportunity cost: what must be sacrificed when a choice is made.
Opportunity costs play a determining role in markets. It is precisely because individuals and organizations have different opportunity costs that they enter into exchange agreements. If you are
a skilled plumber and an unskilled gardener, while your neighbour is a skilled gardener and an
unskilled plumber, then you and your neighbour not only have different capabilities, you also have
different opportunity costs, and you could gain by trading your skills. Here’s why. Fixing a leaking pipe has a low opportunity cost for you in terms of time: You can do it quickly. But pruning
your apple trees will be costly because you must first learn how to avoid killing them and this
may require many hours. Your neighbour has exactly the same problem, with the tasks in reverse
positions. In a sensible world you would fix your own pipes and your neighbour’s pipes, and she
would ensure the health of the apple trees in both backyards.
If you reflect upon this ‘sensible’ solution—one that involves each of you achieving your objectives
while minimizing the time input—you will quickly realize that it resembles the solution provided
by the marketplace. You may not have a gardener as a neighbour, so you buy the services of a
gardener in the marketplace. Likewise, your immediate neighbour may not need a leaking pipe
repaired, but many others in your neighbourhood do, so you sell your service to them. You each
specialize in the performance of specific tasks as a result of having different opportunity costs
or different efficiencies. Let us now develop a model of exchange to illustrate the advantages
of specialization and trade, and hence the markets that facilitate these activities. This model is
developed with the help of some two-dimensional graphics.
14
Introduction to key ideas
1.4 A model of exchange and specialization
Production and specialization
We have two producers and two goods: Amanda and Zoe produce vegetables (V ) and or fish (F).
Their production capabilities are defined in Table 1.1 and in Figure 1.1, where the quantity of V
appears on the vertical axis and the quantity of F on the horizontal axis. Zoe and Amanda each
have 36-hour weeks and they devote that time to producing the two goods. But their efficiencies
differ: Amanda requires two hours to produce a unit of V and three hours for a unit of F. As a
consequence, if she devotes all of her time to V she can produce 18 units, or if she devotes all
of her time to F she can produce 12 units. Or, she could share her time between the two. This
environment can also be illustrated and analyzed graphically, as in Figure 1.1.
Table 1.1: Production possibilities in a two-person economy
Hours/
Hours/
Fish
Vegetable
fish
vegetable
specialization
specialization
Amanda
3
2
12
18
Zoe
2
4
18
9
Each producer has a time allocation of 36 hours. By allocating total time to one activity,
Amanda can produce 12F or 18V , Zoe can produce 18F or 9V . By splitting their time each
person can also produce a combination of the two.
Two-dimensional graphics are a means of portraying the operation of a model, as defined above.
We will use these graphical representations throughout the text. In this case, Amanda’s production
capability is represented by the line that meets the vertical axis at 18 and the horizontal axis at
12. The vertical point indicates that she can produce 18 units of V if she produces zero units of
F – keep in mind that where V has a value of 18, Amanda has no time left for fish production.
Likewise, if she devotes all of her time to fish she can produce 12 units, since each unit requires
3 of her 36 hours. The point F = 12 is thus another possibility for her. In addition to these two
possibilities, which we can term ‘specialization’, she could allocate her time to producing some
of each good. For example, by dividing her 36 hours equally she could produce 6 units of F and
9 units of V . A little computation will quickly convince us that different allocations of her time
will lead to combinations of the two goods that lie along a straight line joining the specialization
points.
1.4. A model of exchange and specialization
15
Figure 1.1: Absolute advantage – production
Vegetable
18
Amanda’s PPF
9
Zoe’s PPF
12
18
Fish
Amanda’s PPF indicates that she can produce either 18V (and zero F), or 12F (and zero
V ), or some combination. Zoe’s PPF indicates she can produce either 9V (and zero F), or
18F (and zero V ), or some combination. Amanda is more efficient in producing V and Zoe
is more efficient at producing F.
We will call this straight line Amanda’s production possibility frontier (PPF): It is the combination of goods she can produce while using all of her resources – time. She could not produce
combinations of goods represented by points beyond this line (to the top right). She could indeed
produce combinations below it (lower left) – for example, a combination of 4 units of V and 4 units
of F; but such points would not require all of her time. The (4, 4) combination would require just
20 hours. In sum, points beyond this line are not feasible, and points within it do not require all of
her time resources.
Production possibility frontier (PPF): the combination of goods that can be produced using all of the resources available.
Having developed Amanda’s PPF, it is straightforward to develop a corresponding set of possibilities for Zoe. If she requires 4 hours to produce a unit of V and 2 hours to produce a unit of F, then
her 36 hours will enable her to specialize in 9 units of V or 18 units of F; or she could produce a
combination represented by the straight line that joins these two specialty extremes.
Consider now the opportunity costs for each person. Suppose Amanda is currently producing 18 V
and zero F, and considers producing some F and less V . For each unit of F she wishes to produce,
it is evident from her PPF that she must sacrifice 1.5 units of V . This is because F requires 50%
more hours than V . Her trade-off is 1.5 : 1.0. The additional time requirement is also expressed in
the intercept values: She could give up 18 units of V and produce 12 units of F instead; this again
16
Introduction to key ideas
is a ratio of 1.5 : 1.0. This ratio defines her opportunity cost: The cost of an additional unit of F is
that 1.5 units of V must be ‘sacrificed’.
Applying the same reasoning to Zoe’s PPF, her opportunity cost is 0.5 : 1; she must sacrifice one
half of a unit of V to free up enough time to produce one unit of F.
So we have established two things about Amanda and Zoe’s production possibilities. First, if
Amanda specializes in V she can produce more than Zoe, just as Zoe can produce more than
Amanda if Zoe specializes in F. Second, their opportunity costs are different: Amanda must sacrifice more V than Zoe in producing one more unit of F. The different opportunity costs translate
into potential gains for each individual.
The gains from exchange
We shall illustrate the gains that arise from specialization and exchange graphically. Note first that
if these individuals are self-sufficient, in the sense that they consume their own production, each
individual’s consumption combination will lie on their own PPF. For example, Amanda could
allocate half of her time to each good, and produce (and consume) 6F and 9V . Such a point necessarily lies on her PPF. Likewise for Zoe. So, in the absence of exchange, each individual’s PPF
is also her consumption possibility frontier (CPF). In Figure 1.1 the PPF for each individual is
thus also her CPF.
Consumption possibility frontier (CPF): the combination of goods that can be
consumed as a result of a given production choice.
Figure 1.2: Absolute advantage – consumption
Vegetable
18
Amanda’s PPF
Consumption possibilities
for Amanda and Zoe
A (8,10)
9
Z (10,8)
Zoe’s PPF
12
18
Fish
With specialization and trade at a rate of 1 : 1 they consume along the line
joining the specialization points. If Amanda trades 8V to Zoe in return for
8F, Amanda moves to the point A(8,10) and Zoe to Z(10,8). Each can
consume more after specialization than before specialization.
1.4. A model of exchange and specialization
17
Upon realizing that they are not equally efficient in producing the two goods, they decide to specialize completely in producing just the single good where they are most efficient. Amanda specializes
in V and Zoe in F. Next they must agree to a rate at which to exchange V for F. Since Amanda’s
opportunity cost is 1.5 : 1 and Zoe’s is 0.5 : 1, suppose they agree to exchange V for F at an intermediate rate of 1 : 1. There are many trading, or exchange, rates possible; our purpose is to
illustrate that gains are possible for both individuals at some exchange rate. The choice of this rate
also makes the graphic as simple as possible. At this exchange rate, 18V must exchange for 18F.
In Figure 1.2, this means that each individual is now able to consume along the line joining the
coordinates (0, 18) and (18, 0).1 This is because Amanda produces 18V and she can trade at a rate
of 1 : 1, while Zoe produces 18F and trades at the same rate of 1 : 1.
The fundamental result illustrated in Figure 1.2 is that, as a result of specialization and trade, each
individual can consume combinations of goods that lie on a line beyond her initial consumption
possibilities. Their consumption well-being has thus improved. For example, suppose Amanda
trades away 8V to Zoe and obtains 8F in return. The points ‘A’ and ‘Z’ with coordinates (8, 10)
and (10, 8) respectively define their final consumption. Pre-specialization, if Amanda wished to
consume 8F she would have been constrained to consume 6V rather than the 10V now possible.
Zoe benefits correspondingly.2
The foregoing example illustrates that trade is not a zero-sum game; it has a positive net value
because both parties to the trade can gain. A zero-sum gain is where the gains to one party exactly
offset the losses to another. This is an extraordinarily important principle in trade negotiations,
whether international or domestic.
A zero-sum game is an interaction where the gain to one party equals the loss to
another party.
Market design
In the preceding example we have shown that specialization provides scope for gains that can accrue to those participating in the exchange. But this tells us little about how a market for these
products comes into being: how does the exchange take place, and how is information transmitted? The answer is that while some markets have evolved historically to their current state, many
markets are designed by an institution or a firm. Fruit and vegetable markets have been with us for
thousands of years – since we ceased being purely a hunter-gatherer society. They exist in every
community in the world economy. In contrast, the Dutch tulip auction was designed in the early
1600s and exists in basically the same form to this day: the auctioneer begins with a high price,
lowers it at known time intervals (measured in seconds or minutes) until some buyer signals that
1 When two values, separated by a comma, appear in parentheses, the first value refers to the horizontal-axis variable, and the second to the vertical-axis variable.
2 In the situation we describe above one individual is absolutely more efficient in producing one of the goods and
absolutely less efficient in the other. We will return to this model in Chapter 15 and illustrate that consumption gains
of the type that arise here can also result if one of the individuals is absolutely more efficient in producing both goods,
but that the degree of such advantage differs across goods.
18
Introduction to key ideas
she is willing to purchase the lot on offer. Supermarkets in contrast offer goods at a fixed price.
Government contracts are normally signed after a tendering process, in which interested suppliers
submit bids. Amazon Inc. is currently experimenting with cashierless ‘bricks and mortar’ stores
that monitor all transactions electronically. Craig’s List and E-Bay have their own sets of rules.
In each of these cases markets are designed, frequently with a specific objective on the part of
the supplier or the mediating institution: Amazon wants to increase its share of all goods trades;
governments wish to limit costs. Markets do not all grow spontaneously and the structure of a
market will influence how the gains from trade are distributed.
1.5 Economy-wide production possibilities
The PPFs in Figures 1.1 and 1.2 define the amounts of the goods that each individual can produce
while using all of their fixed productive capacity—time in this instance. The national, or economywide, PPF for this two-person economy reflects these individual possibilities combined. Such a
frontier can be constructed using the individual frontiers as the component blocks.
First let us define this economy-wide frontier precisely. The economy-wide PPF is the set of goods
and services combinations that can be produced in the economy when all available productive
resources are in use. Figure 1.3 contains both of the individual frontiers plus the aggregate of
these, represented by the kinked line ace. The point on the V axis, a = 27, represents the total
amount of V that could be produced if both individuals devoted all of their time to it. The point
e = 30 on the horizontal axis is the corresponding total for fish.
Figure 1.3: Economy-wide PPF
Vegetable
27
a
PPF for whole economy
c (18,18)
18
Amanda’s PPF
9
Zoe’s PPF
e
12
18
30
Fish
From a, to produce Fish it is more efficient to use Zoe because her opportunity cost is less (segment ac). When Zoe is completely specialized, Amanda
produces (ce). With complete specialization this economy can produce 27V
or 30F.
1.5. Economy-wide production possibilities
19
Economy-wide PPF: the set of goods and services combinations that can be produced in the economy when all available productive resources are in use.
To understand the point c, imagine initially that all resources are devoted to V . From such a point, a,
consider a reduction in V and an increase in F. The most efficient way of increasing F production
at the point a is to use the individual whose opportunity cost is lower. Zoe can produce one unit
of F by sacrificing just 0.5 units of V , whereas Amanda must sacrifice 1.5 units of V to produce
1 unit of F. Hence, at this stage Amanda should stick to V and Zoe should devote some time to
fish. In fact as long as we want to produce more fish Zoe should be the one to do it, until she has
exhausted her time resource. This occurs after she has produced 18F and has ceased producing V .
At this point the economy will be producing 18V and 18F – the point c.
From this combination, if the economy wishes to produce more fish Amanda must become involved. Since her opportunity cost is 1.5 units of V for each unit of F, the next segment of the
economy-wide PPF must see a reduction of 1.5 units of V for each additional unit of F. This
is reflected in the segment ce. When both producers allocate all of their time to F the economy
can produce 30 units. Hence the economy’s PPF is the two-segment line ace. Since this has an
outward kink, we call it concave (rather than convex).
As a final step consider what this PPF would resemble if the economy were composed of many
persons with differing efficiencies. A little imagination suggests (correctly) that it will have a segment for each individual and continue to have its outward concave form. Hence, a four-person
economy in which each person had a different opportunity cost could be represented by the segmented line abcde, in Figure 1.4. Furthermore, we could represent the PPF of an economy with a
very large number of such individuals by a somewhat smooth PPF that accompanies the 4-person
PPF. The logic for its shape continues to be the same: As we produce less V and more F we progressively bring into play resources, or individuals, whose opportunity cost, in terms of reduced V
is higher.
20
Introduction to key ideas
Figure 1.4: A multi-person PPF
Vegetable
a
b
c
d
e
Fish
The PPF for the whole economy, abcde, is obtained by allocating productive
resources most efficiently. With many individuals we can think of the PPF
as the concave envelope of the individual capabilities.
The outputs V and F in our economic model require just one input – time, but if other productive
resources were required the result would be still a concave PPF. Furthermore, we generally interpret the PPF to define the output possibilities when the economy is running at its normal capacity.
In this example, we consider a work week of 36 hours to be the ‘norm’. Yet it is still possible
that the economy’s producers might work some additional time in exceptional circumstances, and
this would increase total production possibilities. This event would be represented by an outward
movement of the PPF.
1.6 Aggregate output, growth and business cycles
The PPF can be used to illustrate several aspects of macroeconomics: In particular, the level of an
economy’s output, the growth of national and per capita output over time, and short-run businesscycle fluctuations in national output and employment.
Aggregate output
An economy’s capacity to produce goods and services depends on its endowment of resources and
the productivity of those resources. The two-person, two-product examples in the previous section
reflect this.
The productivity of labour, defined as output per worker or per hour, depends on:
• The skill, knowledge and experience of the labour force;
1.6. Aggregate output, growth and business cycles
21
• The capital stock: Buildings, machinery, equipment, and software the labour force has to
work with; and
• The current state of technology.
The productivity of labour is the output of goods and services per worker.
An economy’s capital stock is the buildings, machinery, equipment and software
used in producing goods and services.
The economy’s output, which we define by Y , can be defined as the output per worker times the
number of workers; hence, we can write:
Y = (number of workers employed) × (output per worker).
When the employment of labour corresponds to ‘full employment’ in the sense that everyone willing to work at current wage rates and normal hours of work is working, the economy’s actual
output is also its capacity output Yc . We also term this capacity output as full employment output:
Full employment output Yc = (number of workers at full employment) ×
(output per worker).
Suppose the economy is operating with full employment of resources producing outputs of two
types: Goods and services. In Figure 1.5, PPF0 shows the different combinations of goods and
services the economy can produce in a particular year using all its labour, capital and the best
technology available at the time.
22
Introduction to key ideas
Figure 1.5: Growth and the PPF
Services

Smax
Smax
A
PPF1
a
PPF0
X1
S1
S0
X0
b
G0 G1
B
Gmax G′max
Goods
Economic growth is illustrated by an outward shift in the PPF from PPF0
to PPF1 . PPF1 shows the economy can produce more in both sectors than
with PPF0 .
An aggregate economy produces a large variety of outputs in two broad categories. Goods are the
products of the agriculture, forestry, mining, manufacturing and construction industries. Services
are provided by the wholesale and retail trade, transportation, hospitality, finance, health care,
education, legal and other service sectors. As in the two-product examples used earlier, the shape
of the PPF illustrates the opportunity cost of increasing the output of either product type. We are
not concerned with who supplies the products for the moment: It may be the private sector or the
government.
Point X0 on PPF0 shows one possible structure of capacity output. This combination may reflect
the pattern of demand and hence expenditures in this economy. Output structures and therefore the
shapes of PPFs differ among economies with different income levels. High-income economies
spend more on services than goods and produce higher ratios of services to goods. Middle income
countries produce lower ratios of services to goods, and low income countries much lower ratios
of services to goods. For example, in 2017, the structure of national output in Canada was 70
percent services and 30 percent goods, while in Mexico the structure was 48 percent services and
52 percent goods.
Different countries also have different PPFs and different output structures, depending on their
resource endowments, labour forces, capital stocks, technology and expenditure patterns.
1.6. Aggregate output, growth and business cycles
23
Economic growth
Three things contribute to growth in the economy. The labour supply grows as the population
expands; the stock of capital grows as spending by business (and government) on buildings, machinery, information technology and so forth increases; and labour-force productivity grows as a
result of experience, the development of scientific knowledge combined with product and process
innovations, and advances in the technology of production. Combined, these developments expand
capacity output over time. In Figure 1.5 economic growth shifts the PPF out from PPF0 to PPF1 .
This basic description covers the key sources of growth in total output. Economies differ in their
rates of overall economic growth as a result of different rates of growth in labour force, in capital
stock, and improvements in technology. But improvements in standards of living require more than
growth in total output. Increases in output per worker and per person are necessary. Sustained
increases in living standards require sustained growth in labour productivity, which in turn is based
on advances in the technology along with the amount of capital each worker has to work with.
Furthermore, if the growth in output is to benefit society at large, workers across the board need to
see an increase in their earnings. As we shall explore in Chapter 13, several developed countries
have seen the fruits of growth concentrated in the hands of the highest income earners.
Recessions and booms
A prime objective of economic policy is to ensure that the economy operates on or near the PPF
– it should use its resources to capacity and have minimal unemployment. However, economic
conditions are seldom tranquil for long periods of time. Unpredictable changes in business expectations of future profits, in consumer confidence, in financial markets, in commodity and energy
prices, in trade agreements and disputes, in economic conditions in major trading partners, in government policy and many other events disrupt patterns of expenditure and output. Some of these
changes disturb the level of total expenditure and thus the demand for total output. Others disturb the conditions of production and thus the economy’s production capacity. Whatever the exact
cause, the economy may be pushed off its current PPF. If expenditures on goods and services
decline, the economy may experience a recession. Output would fall short of capacity output and
unemployment would rise. Alternatively, times of rapidly growing expenditure and output may
result in an economic boom: Output and employment expand beyond capacity levels.
An economic recession occurs when output falls below the economy’s capacity output.
A boom is a period of high growth that raises output above normal capacity output.
Recent history provides examples. Following the financial crisis of 2008-09 that hit the US and
many other developed economies, many economies were pushed into recessions. Expenditure on
new residential construction collapsed for lack of income and secure financing, as did business
investment, consumption spending and exports. Lower expenditures reduced producers’ revenues,
forcing cuts in output and employment and reducing household incomes. Lower incomes led
24
Introduction to key ideas
to further cutbacks in spending. In Canada in 2009 aggregate output declined by 2.9 percent,
employment declined by 1.6 percent and the unemployment rate rose from 6.1 percent in 2008 to
8.3 percent by 2010. The world’s economies have been slow to recover, and even by 2019 the
output in several developed economies was no higher than it was in 2008. Canada’s recession
was not nearly as severe as the recessions in economies such as Spain, Italy and Greece; but output
between 2009 and 2019 has been below the potential of the Canadian economy. In the third quarter
of 2019 the national output was about 0.7 percent below potential output and the unemployment
rate was 5.5 percent.
Figure 1.6: Booms and recessions
Services
Smax
a
PPF
W
X
S0
Z
b
G0
Gmax
Goods
Economic recessions leave the economy below its normal capacity; the
economy might be driven to a point such as Z. Economic expansions, or
booms, may drive capacity above its normal level, to a point such as W.
An economy in a recession is operating inside its PPF. The fall in output from X to Z in Figure 1.6
illustrates the effect of a recession. Expenditures on goods and services have declined. Output is
less than capacity output, unemployment is up and some plant capacity is idle. Labour income and
business profits are lower. More people would like to work and business would like to produce and
sell more output, but it takes time for interdependent product, labour and financial markets in the
economy to adjust and increase employment and output. Monetary and fiscal policy may be productive in specific circumstances, to stimulate demand, increase output and employment and move
the economy back to capacity output and full employment. The development and implementation
of such policies form the core of macroeconomics.
Alternatively, an unexpected increase in demand for exports would increase output and employment. Higher employment and output would increase incomes and expenditure, and in the process
spread the effects of higher output sales to other sectors of the economy. The economy would
Conclusion
25
move outside its PPF, for example to W in Figure 1.6, by using its resources more intensively than
normal. Unemployment would fall and overtime work would increase. Extra production shifts
would run plant and equipment for longer hours and work days than were planned when it was designed and installed. Output at this level may not be sustainable, because shortages of labour and
materials along with excessive rates of equipment wear and tear would push costs and prices up.
Again, we will examine how the economy reacts to such a state in our macroeconomic analysis.
Output and employment in the Canadian economy over the past twenty years fluctuated about
growth trend in the way Figure 1.6 illustrates. For several years prior to 2008 the Canadian economy operated slightly above its capacity; but once the recession arrived monetary and fiscal policy
were used to fight it – to bring the economy back from a point such as Z towards a point such as X
on the PPF.
Macroeconomic models and policy
The PPF diagrams illustrate the main dimensions of macroeconomics: Capacity output, growth
in capacity output and business cycle fluctuations in actual output relative to capacity. But these
diagrams do not offer explanations and analysis of macroeconomic activity. We need a macroeconomic model to understand and evaluate the causes and consequences of business cycle fluctuations. As we shall see, these models are based on explanations of expenditure decisions by households and business, financial market conditions, production costs and producer pricing decisions
at different levels of output. Models also capture the objectives of fiscal and monetary policies and
provide a framework for policy evaluation. A full macroeconomic model integrates different sector
behaviours and the feedbacks across sectors that can moderate or amplify the effects of changes in
one sector on national output and employment.
CONCLUSION
We have covered a lot of ground in this introductory chapter. It is intended to open up the vista
of economics to the new student in the discipline. Economics is powerful and challenging, and
the ideas we have developed here will serve as conceptual foundations for our exploration of the
subject.
26
Key Terms
KEY TERMS
Macroeconomics studies the economy as system in which linkages and feedbacks among
sectors determine national output, employment and prices.
Microeconomics is the study of individual behaviour in the context of scarcity.
Mixed economy: goods and services are supplied both by private suppliers and government.
Model is a formalization of theory that facilitates scientific inquiry.
Theory is a logical view of how things work, and is frequently formulated on the basis of
observation.
Opportunity cost of a choice is what must be sacrificed when a choice is made.
Production possibility frontier (PPF) defines the combination of goods that can be produced
using all of the resources available.
Consumption possibility frontier (CPF): the combination of goods that can be consumed
as a result of a given production choice.
A zero-sum game is an interaction where the gain to one party equals the loss to another
party.
Economy-wide PPF is the set of goods combinations that can be produced in the economy
when all available productive resources are in use.
Productivity of labour is the output of goods and services per worker.
Capital stock: the buildings, machinery, equipment and software used in producing goods
and services.
Full employment output Yc = (number of workers at full employment) ×
(output per worker).
Recession: when output falls below the economy’s capacity output.
Boom: a period of high growth that raises output above normal capacity output.
Exercises for Chapter 1
27
EXERCISES FOR CHAPTER 1
Exercise 1.1 An economy has 100 identical workers. Each one can produce four cakes or three
shirts, regardless of the number of other individuals producing each good.
(a) How many cakes can be produced in this economy when all the workers are cooking?
(b) How many shirts can be produced in this economy when all the workers are sewing?
(c) On a diagram with cakes on the vertical axis, and shirts on the horizontal axis, join these
points with a straight line to form the PPF.
(d) Label the inefficient and unattainable regions on the diagram.
Exercise 1.2 In the table below are listed a series of points that define an economy’s production
possibility frontier for goods Y and X .
Y
1000
900
800
700
600
500
400
300
200
100
0
X
0
1600
2500
3300
4000
4600
5100
5500
5750
5900
6000
(a) Plot these pairs of points to scale, on graph paper, or with the help of a spreadsheet.
(b) Given the shape of this PPF is the economy made up of individuals who are similar or
different in their production capabilities?
(c) What is the opportunity cost of producing 100 more Y at the combination (X = 5500,Y =
300).
(d) Suppose next there is technological change so that at every output level of good Y the economy can produce 20 percent more X . Enter a new row in the table containing the new values,
and plot the new PPF.
Exercise 1.3 Using the PPF that you have graphed using the data in Exercise 1.2, determine if the
following combinations are attainable or not: (X = 3000,Y = 720), (X = 4800,Y = 480).
Exercise 1.4 You and your partner are highly efficient people. You can earn $20 per hour in the
workplace; your partner can earn $30 per hour.
(a) What is the opportunity cost of one hour of leisure for you?
(b) What is the opportunity cost of one hour of leisure for your partner?
(c) Now consider what a PPF would look like: You can produce/consume two things, leisure
and income. Since income buys things you can think of the PPF as having these two ’products’ – leisure and consumption goods/services. So, with leisure on the horizontal axis and
income in dollars is on the vertical axis, plot your PPF. You can assume that you have 12
28
Exercises for Chapter 1
hours per day to allocate to either leisure or income. [Hint: the leisure axis will have an
intercept of 12 hours. The income intercept will have a dollar value corresponding to where
all hours are devoted to work.]
(d) Draw the PPF for your partner.
Exercise 1.5 Louis and Carrie Anne are students who have set up a summer business in their
neighbourhood. They cut lawns and clean cars. Louis is particularly efficient at cutting the grass
– he requires one hour to cut a typical lawn, while Carrie Anne needs one and one half hours. In
contrast, Carrie Anne can wash a car in a half hour, while Louis requires three quarters of an hour.
(a) If they decide to specialize in the tasks, who should cut the grass and who should wash cars?
(b) If they each work a twelve hour day, how many lawns can they cut and how many cars can
they wash if they each specialize in performing the task where they are most efficient?
(c) Illustrate the PPF for each individual where lawns are on the horizontal axis and car washes
on the vertical axis, if each individual has twelve hours in a day.
Exercise 1.6 Continuing with the same data set, suppose Carrie Anne’s productivity improves so
that she can now cut grass as efficiently as Louis; that is, she can cut grass in one hour, and can
still wash a car in one half of an hour.
(a) In a new diagram draw the PPF for each individual.
(b) In this case does specialization matter if they are to be as productive as possible as a team?
(c) Draw the PPF for the whole economy, labelling the intercepts and the ‘kink’ point coordinates.
Exercise 1.7 Going back to the simple PPF plotted for Exercise 1.1 where each of 100 workers
can produce either four cakes or three shirts, suppose a recession reduces demand for the outputs
to 220 cakes and 129 shirts.
(a) Plot this combination of outputs in the diagram that also shows the PPF.
(b) How many workers are needed to produce this output of cakes and shirts?
(c) What percentage of the 100 worker labour force is unemployed?
Chapter 2
Theories, data and beliefs
In this chapter we will explore:
2.1 Data analysis
2.2 Data, theory and economic models
2.3 Ethics, efficiency and beliefs
Economists, like other scientists and social scientists, observe and analyze behaviour and events.
Economists are concerned primarily with the economic causes and consequences of what they
observe. They want to understand an extensive range of human experience, including: money,
government finances, industrial production, household consumption, inequality in income distribution, war, monopoly power, health, professional and amateur sports, pollution, marriage, the
arts, and much more.
Economists approach these issues using theories and models. To present, explain, illustrate and
evaluate their theories and models they have developed a set of techniques or tools. These involve
verbal descriptions and explanations, diagrams, algebraic equations, data tables and charts and
statistical tests of economic relationships.
This chapter covers some of these basic techniques of analysis.
2.1 Data analysis
The analysis of behaviour necessarily involves data. Data may serve to validate or contradict
a theory. Data analysis, even without being motivated by economic theory, frequently displays
patterns of behaviour that merit examination. The terms variables and data are related. Variables
are measures that can take on different magnitudes. The interest rate on a student loan, for example,
is a variable with a certain value at a point in time but perhaps a different value at an earlier or later
date. Economic theories and models explain the causal relationships between variables. In contrast,
Data are the recorded values of variables. Sets of data provide specific values for the variables we
want to study and analyze. Knowing that gross domestic product (a variable) declined in 2009 is
just a partial description of events. If the data indicate that it decreased by exactly 3%, we know a
great deal more – the decline was large.
Variables: measures that can take on different values.
29
30
Theories, data and beliefs
Data: recorded values of variables.
Sets of data help us to test our models or theories, but first we need to pay attention to the economic
logic involved in observations and modelling. For example, if sunspots or baggy pants were found
to be correlated with economic expansion, would we consider these events a coincidence or a key
to understanding economic growth? The observation is based on facts or data, but it need not have
any economic content. The economist’s task is to distinguish between coincidence and economic
causation. Merely because variables are associated or correlated does not mean that one causes the
other.
While the more frequent wearing of loose clothing in the past may have been associated with
economic growth because they both occurred at the same time (correlation), one could not argue
on a logical basis that this behaviour causes good economic times. Therefore, the past association
of these variables should be considered as no more than a coincidence. Once specified on the
basis of economic logic, a model must be tested to determine its usefulness in explaining observed
economic events.
Table 2.1: House prices and price indexes
Year
House
Percentage
Percentage
Real
Index for
5-year
prices in
change in PH
change in
percentage
price of
mortgage
dollars
consumer
change
housing
rate
(PH )
prices
in PH
2001
350,000
100
7.75
2002
360,000
102.9
6.85
2003
395,000
112.9
6.6
2004
434,000
124.0
5.8
2005
477,000
136.3
6.1
2006
580,000
165.7
6.3
2007
630,000
180.0
6.65
2008
710,000
202.9
7.3
2009
605,000
172.9
5.8
2010
740,000
211.4
5.4
2011
800,000
228.6
5.2
35,000/360,000=9.7%
-105,000/710,000=-14.8%
3%
1.6%
6.7%
-16.4%
Note: Data on changes in consumer prices come from Statistics Canada,
CANSIM series V41692930; data on house prices are for N. Vancouver
from Royal Le Page; data on mortgage rates from http://www.ratehub.
ca. Index for house prices obtained by scaling each entry in column 2 by
100/350,000. The real percentage change in the price of housing is: The
percentage change in the price of housing minus the percentage change in
consumer prices.
2.1. Data analysis
31
Data types
Data come in several forms. One form is time-series, which reflects a set of measurements made
in sequence at different points in time. The first column in Table 2.1 reports the values for house
prices in North Vancouver for the first quarter of each year, between 2001 and 2011. Evidently
this is a time series. Annual data report one observation per year. We could, alternatively, have
presented the data in monthly, weekly, or even daily form. The frequency we use depends on the
purpose: If we are interested in the longer-term trend in house prices, then the annual form suffices.
In contrast, financial economists, who study the behaviour of stock prices, might not be content
with daily or even hourly prices; they may need prices minute-by-minute. Such data are called
high-frequency data, whereas annual data are low-frequency data.
Table 2.2: Unemployment rates, Canada and Provinces, monthly 2012, seasonally adjusted
Jan
Feb
Mar
Apr
May
Jun
CANADA
7.6
7.4
7.2
7.3
7.3
7.2
NFLD
13.5
12.9
13.0
12.3
12.0
13.0
PEI
12.2
10.5
11.3
11.0
11.3
11.3
NS
8.4
8.2
8.3
9.0
9.2
9.6
NB
9.5
10.1
12.2
9.8
9.4
9.5
QUE
8.4
8.4
7.9
8.0
7.8
7.7
ONT
8.1
7.6
7.4
7.8
7.8
7.8
MAN
5.4
5.6
5.3
5.3
5.1
5.2
SASK
5.0
5.0
4.8
4.9
4.5
4.9
ALTA
4.9
5.0
5.3
4.9
4.5
4.6
BC
6.9
6.9
7.0
6.2
7.4
6.6
Source: Statistics Canada CANSIM Table 282-0087.
Time-series: a set of measurements made sequentially at different points in time.
High (low) frequency data: series with short (long) intervals between observations.
In contrast to time-series data, cross-section data record the values of different variables at a
point in time. Table 2.2 contains a cross-section of unemployment rates for Canada and Canadian provinces economies. For January 2012 we have a snapshot of the provincial economies
at that point in time, likewise for the months until June. This table therefore contains repeated
cross-sections.
32
Theories, data and beliefs
When the unit of observation is the same over time such repeated cross sections are called longitudinal data. For example, a health survey that followed and interviewed the same individuals over
time would yield longitudinal data. If the individuals differ each time the survey is conducted, the
data are repeated cross sections. Longitudinal data therefore follow the same units of observation
through time.
Cross-section data: values for different variables recorded at a point in time.
Repeated cross-section data: cross-section data recorded at regular or irregular intervals.
Longitudinal data: follow the same units of observation through time.
Graphing the data
Data can be presented in graphical as well as tabular form. Figure 2.1 plots the house price data
from the second column of Table 2.1. Each asterisk in the figure represents a price value and
a corresponding time period. The horizontal axis reflects time, the vertical axis price in dollars.
The graphical presentation of data simply provides a visual rather than numeric perspective. It
is immediately evident that house prices increased consistently during this 11-year period, with a
single downward ‘correction’ in 2009. We have plotted the data a second time in Figure 2.2 to
illustrate the need to read graphs carefully. The greater apparent slope in Figure 2.1 might easily
be interpreted to mean that prices increased more steeply than suggested in Figure 2.2. But a
careful reading of the axes reveals that this is not so; using different scales when plotting data or
constructing diagrams can mislead the unaware viewer.
2.1. Data analysis
Figure 2.1: House prices in dollars 1999-2012
900 000
House price
800 000
700 000
600 000
500 000
400 000
2010
2012
2010
2012
2008
2006
2004
2002
2000
1998
300 000
Year
Figure 2.2: House prices in dollars 1999-2012
1 600 000
1 400 000
1 000 000
800 000
600 000
400 000
Year
2008
2006
2004
2002
0
2000
200 000
1998
House price
1 200 000
33
34
Theories, data and beliefs
Percentage changes
The use of percentages makes the analysis of data particularly simple. Suppose we wanted to compare the prices of New York luxury condominiums with the prices of homes in rural Mississippi.
In the latter case, a change in average prices of $10,000 might b…
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