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DETAILED CONTENTS

MICROECONOMICS

PART ONE MARKETS AND CONSUMERS

1 Economic issues and concepts 5

The complexity of the modern economy 6
Resources and scarcity 9
Who makes the choices and how? 12
Government and the market economy 17
Box 1.1 Toasting the complexity of a modern economy 6
Box 1.2 Economic advice: positive and normative statements 8
Box 1.3 The terminology of production possibilities 13
Box 1.4 Economic theories 16
Box 1.5 Government and the market 19

2 Demand and supply 23

Demand 24
Supply 32
The determination of price 35
But are markets really like that? 39
Box 2.1 ‘Tea prices to soar after droughts’ 24
Box 2.2 Stocks and flows 25
Box 2.3 Weather matters 31
Box 2.4 Prices in periods of inflation 37
Box 2.5 Demand and supply: what really happens 39

3 Elasticity of demand and supply 48

Demand elasticity 50
Supply elasticity 60
Measurement of demand and supply 61
Why the measurement of demand is important 65
Box 3.1 Real markets that elasticity will help understand 49
Box 3.2 The terminology of elasticity 52
Box 3.3 Measuring elasticity over a range 56
Box 3.4 Elasticity and income 57
Box 3.5 Elasticity matters 60

4 Consumer choice: indifference theory 73

Early insights 74
Consumer optimization without measurable utility 80
The consumer’s response to price and income changes 87
viii Detailed Contents

The consumer’s demand curve 89

Box 4.1 Happiness and utility: why the Finns are smiling 74
Box 4.2 The paradox of value 77
Box 4.3 Consumers’ surplus 78
Box 4.4 Shapes of indifference curves 84
Box 4.5 Relative prices and inflation 88
Box 4.6 The Slutsky decomposition of income and substitution effects 92

PART TWO MARKETS AND FIRMS

5 The cost structure of firms 103

Costs, revenues, and profit maximization 104
Costs in the short run when the fixed input is indivisible 106
Costs in the short run when the fixed input is divisible 111
Costs in the long run 113
The very long run: endogenous technical change 121
The definition of profit in economics 122
Box 5.1 Dreaming of nuts and bolts 105
Box 5.2 The economy-wide significance of the principle of substitution 115
Box 5.3 Economies of scale in the electronics industry 116
Box 5.4 Economies of scale and scope 117

6 Perfect competition 129

Market structure and firm behaviour 130
Perfectly competitive markets 132
Short-run equilibrium 134
Long-run equilibrium 139
The allocative efficiency of perfect competition 148
Box 6.1 Chocolate assortment 131
Box 6.2 Demand under perfect competition: firm and industry 133
Box 6.3 Scrap or store? What airlines do in a downturn 135
Box 6.4 Who benefits and loses from changes in input costs? 141
Box 6.5 The effects of changing technology 143
Box 6.6 Declining industries 144
Box 6.7 The short-run behaviour of perfectly competitive firms with divisible fixed inputs 147

7 Monopoly 157
A single-price monopolist 159
Short-run monopoly equilibrium 160
The allocative inefficiency of monopoly 163
A multi-price monopolist: price discrimination 165
Long-run monopoly equilibrium 170
Cartels as monopolies 172
Appendix: price discrimination between two markets 181
Box 7.1 Losing at monopoly 158
Box 7.2 Demand for once-off production 163
Box 7.3 Statics and dynamics in the theory of monopoly 164
Box 7.4 BOGOF or rip off? 166
Box 7.5 Examples of price discrimination 169
 Detailed Contents ix

8 Imperfect competition 184

Patterns of concentration in UK industry 185
Imperfectly competitive market structures 187
Monopolistic competition 189
Oligopoly 192
Dynamics of oligopolistic industries 200
Box 8.1 Globalization of production and competition 186
Box 8.2 The price of haircuts and the profits of hairdressers 191
Box 8.3 Supermarket rivalry 193
Box 8.4 Games and their applications 198
Box 8.5 Real-world strategic games 199
Box 8.6 Brand proliferation in alcoholic drinks 201

PART THREE MARKETS FOR INPUTS

9 Demand and supply of inputs 213

Overview of input markets 214
The operation of input markets 228
Economic rent 230
Box 9.1 Incomes and income distribution 214
Box 9.2 Produced inputs and the supply chain 217
Box 9.3 Demand for inputs where there is more than one variable input 221
Box 9.4 The principles of derived demand 224
Box 9.5 The supply of labour 226
Box 9.6 Origin of the term ‘economic rent’ 231

10 The labour market 238

Wage differentials 239
Heterogeneity, incentives, and monitoring costs 252
Box 10.1 UK real wages stagnate 240
Box 10.2 The rental and purchase price of labour 244
Box 10.3 Why are women paid less than men? 245

11 Capital, investment, and new technology 262

Capital as an input 263
The investment decision 270
New technologies 274
The information and communication technology (ICT) revolution 276
Box 11.1 Capital stock growth, UK 1998–2017 264
Box 11.2 The value of a brand 266
Box 11.3 The future value of a present sum 268
Box 11.4 Real and nominal interest rates 272
Box 11.5 The option to invest 273
Box 11.6 Intangible assets matter 276

12 Risk, uncertainty, and finance  286

Risk and consumer choice 287
Financial choices and risk 299
Financial crises 303
x Detailed Contents

Box 12.1 Risky financial markets 287

Box 12.2 Risk and uncertainty 291
Box 12.3 Behavioural finance 294
Box 12.4 Used-car prices: the problem of ‘lemons’ 299
Box 12.5 Derivatives: trading risk 302
Box 12.6 Neither a borrower nor a lender be! 304

PART FOUR GOVERNMENT AND THE MARKET

13 Successes and failures of markets 311

Basic functions of government 312
How well do markets work? 313
Why markets fail 318
Excludable and rivalrous goods 319
Box 13.1 The theory of second best 317
Box 13.2 Pricing of galleries and museums 320
Box 13.3 Endangered wildlife 322
Box 13.4 UK competition framework 334

14 The role of government 342

Government objectives 343
Tools and performance 348
The costs of government intervention 358
Government failure 363
Box 14.1 The impact of a per-unit tax in a perfectly competitive industry 349
Box 14.2 The effect of taxes on profits 350
Box 14.3 The great Microsoft antitrust case 357

MACROECONOMICS

PART FIVE MACROECONOMICS: ISSUES AND FRAMEWORK

15 Macroeconomic issues and measurement 375

Why do we need macroeconomics? 376
The circular flow of income, output, and spending 385
GDP, GNI, and GNP 386
Compensation of employees 391
Interpreting income and output measures 393
Box 15.1 The UK macroeconomy as seen by a policymaker 376
Box 15.2 Value added through stages of production 384
Box 15.3 Calculation of nominal and real GDP 395

16 A basic model of the determination of GDP in the short term 405

The macroeconomic problem: inflation and unemployment 405
Key assumptions 408
What determines aggregate spending? 411
Equilibrium GDP 419
Changes in GDP 422
 Detailed Contents xi

Box 16.1 The terminology of business cycles 407

Box 16.2 Savings make the news 413
Box 16.3 A hydraulic analogue of GDP determination 421
Box 16.4 The multiplier: a numerical example 426
Box 16.5 The derivation of the multiplier 426

17 GDP determination with government and trade 433

Government spending and taxes 434
Net exports 437
Equilibrium GDP 439
Changes in aggregate spending 443
Box 17.1 Deficits in the news 435
Box 17.2 The multiplier in an open economy with taxes 444
Box 17.3 The Keynesian revolution 445

18 Money and monetary institutions 455

The nature of money 456
The origins of money 457
How does money get into the economy? 461
Two models of banking 465
Box 18.1 In mint condition … to coin a phrase! 458
Box 18.2 Gresham’s law 459
Box 18.3 Definitions of UK monetary aggregates 464
Box 18.4 The implications of electronic money for the monetary system 470

19 Money, interest, and GDP: the LM curve 476

Money values and relative values 477
Kinds of asset 480
The rate of interest and the price of bonds 481
Money demand and supply 483
Equating money demand and supply 488
The LM curve 491
Box 19.1 Money matters 477
Box 19.2 UK government bonds or ‘gilts’ 482
Box 19.3 The quantity theory of money 488
Box 19.4 The derivation of the LM curve 492

20 Investment, the interest rate, and GDP: the IS–LM model 500
Investment in the economy 501
The IS curve 504
The IS–LM model 507
The monetary transmission mechanism 509
Box 20.1 The changing nature of UK business investment 502
Box 20.2 Algebraic derivation of the IS curve 506

21 GDP and the price level: aggregate demand and aggregate supply 517
Aggregate demand 518
The derivation of the AD curve 522
Aggregate supply 525
Macroeconomic equilibrium 529
The long run 532
xii Detailed Contents

The Phillips curve 535

Breaking an entrenched inflation 543
Box 21.1 AD and macro policy 519
Box 21.2 The wealth effect 521
Box 21.3 More on the SRAS curve 526
Box 21.4 Supply shocks 532
Box 21.5 An alternative derivation of the Phillips curve 536
Box 21.6 The formation of inflation expectations 540

22 The determination of GDP with steady inflation 553

Three price level regimes 554
IS–LM in a world of steady inflation 561
The aggregate demand curve in a world of steady inflation 562
The aggregate supply curve 566
AD*–AS* equilibrium 571
Comparisons and contrasts between two macro models 572
Box 22.1 Printing press finance and hyperinflations 557
Box 22.2 A nominal money supply policy 565
Box 22.3 Short-run costs in a modern firm 568
Box 22.4 Are cyclically constant prices compatible with profit maximization? 570
Box 22.5 Keynes versus the classics revisited 573
Box 22.6 How relevant is the concept of a long-run equilibrium? 574

PART SIX MACROECONOMICS OF THE GLOBAL ECONOMY

23 Business cycles, unemployment, and inflation 583

The business cycle 584
Unemployment 592
Non-targeted inflation 601
Box 23.1 The accelerator theory of investment 588
Box 23.2 How is unemployment measured? 593

24 Exchange rates and the balance of payments 616

The foreign exchange market 617
The determination of the exchange rate 620
The equilibrium rate 622
Exchange rate experience 626
The balance of payments 631
Box 24.1 The UK exchange rate 618
Box 24.2 Fixed exchange rates 623
Box 24.3 ‘News’ and the exchange rate 627
Box 24.4 Exchange rates and the quantity theory of money 629
Box 24.5 Trade and modern mercantilism 635
Box 24.6 Balance-of-payments crises 636

25 Fiscal and monetary policies 642

Fiscal policy 643
Monetary policy 650
Forward guidance 659
 Detailed Contents xiii

Box 25.1 UK government spending and revenue 643

Box 25.2 UK government debt and debt interest 648
Box 25.3 More on the neutrality of money 651
Box 25.4 The ECB and the Fed 654

26 Economic growth and sustainability 668

Background issues 669
Determinants of growth 672
Benefits and costs of growth 672
Theories of economic growth 676
Endogenous growth at the microeconomic level 684
Growth and sustainability 689
Box 26.1 Are economic growth and cycles related? 669
Box 26.2 The end of work? 675
Box 26.3 Malthus and the classical theory of growth 678
Box 26.4 The Solow–Swan growth model 681
Box 26.5 Endogenous growth and the aggregate production function 683
Box 26.6 Long waves in British economic growth? 688
Box 26.7 To eliminate growth or control it? 691

27 International trade 702

Sources of the gains from trade 703
Interpersonal, inter-regional, and international trade 703
The terms of trade 711
The theory of commercial policy 712
Global commercial policy 721
Box 27.1 The gains from trade and the balance of trade 707
Box 27.2 The gains from trade with varying opportunity costs 708
Box 27.3 The forces of gravity 711
Box 27.4 An FTA or a customs union: two different worlds for Brexit 724

Glossary 733
Index 753
WHY STUDY ECONOMICS?

Some of you may be excited by the prospect of studying economics, but others among you will answer
the question posed in the heading with: ‘It was part of my course of study, so I had no choice’. To both
the reluctant conscripts and the willing volunteers we offer hope and encouragement.
Economics is highly relevant both to decision-making in most jobs that you are likely to do in life
and to understanding many of the major issues facing today’s world—free markets versus govern-
ment intervention, resource exhaustion, pollution and environmental degradation, climate change,
artificial intelligence (AI) and the future of work, Brexit, trade wars, government taxes and spending,
employment, unemployment and recessions, inflation, income inequality in advanced nations, rapid
growth in some of the world’s emerging economies, and stagnation among many of the world’s poor-
est nations. Thus, economics is both a preparation for taking decisions in a business or other organiza-
tion, and training in how to understand many of the ‘big issues’ of our time.
One of the most important events in the first three-quarters of the twentieth century was the rise of
communism. One of the most important events in the last quarter of that century was communism’s
fall. The century-long battle between free markets and government planning as alternatives for orga-
nizing economic activity was settled in almost all countries with a degree of decisiveness that is rare
for great social issues. Understanding why market-oriented capitalist economies perform so much
better than fully planned or highly government-controlled economies is a core issue in economics.
Economic theories are expressly designed to help us understand the successes (and, where they occur,
the failures) of free-market economies.
The triumph of market-oriented economies suggests that income- and wealth-creating activities
are usually best accomplished through the efforts of private citizens operating in largely unregulated
markets. But this is not the end of the story, for at least three fundamental reasons.
First, although market economies certainly work better than fully planned economies, they do not
work perfectly. One of today’s great social issues is how best to allocate the responsibilities of govern-
ment, leaving it to do what it can do best and leaving free markets to do what they can do best. Econo-
mists ask: ‘What are the important roles that governments can play in improving the functioning of
a basically market-oriented economy?’ During the three decades or so up to 2007 the consensus was
moving in favour of more market freedom. However, the global financial crisis of 2007–8 raised ques-
tions about the extent to which markets can be left alone. Substantial reforms of banking and financial
market regulation have been introduced since the crisis, but there is also an ongoing debate in official
and academic circles about the regulatory policies needed to avoid, or at least mitigate, any future cri-
ses in the financial system—crises that can have ramifications far beyond the bounds of the financial
system, spreading to have adverse effects on the entire economy and the people in it.
Secondly, market economies often produce severe short-term cycles as well as long-term growth.
Long-term growth has raised the living standards of the ordinary working person from the horrors
and degradations described by Charles Dickens in the nineteenth century to those of the property-
owning workers of today, whose living standards are higher than those of 99.9 per cent of all the
people of all classes who ever lived on Earth. Yet capitalist growth is uneven growth, because economic
activity cycles around its rising trend. In recessions, unemployment is high and living standards typi-
cally stand still or even fall temporarily. Although each cycle tends to leave living standards higher
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xvi Why Study Economics?

than all previous cycles, the ups and downs of uneven market-driven growth can be upsetting to those
affected by it. During the 1990s and 2000s it appeared that the authorities had learned to avoid major
cycles in activity, but the recession of 2008–9 made clear that sharp downturns can still occur, that
these are costly in terms of lost output and employment, and that governments have only limited
power to moderate their effects.
Thirdly, capitalist growth is unequal growth. Although most people agree that it is desirable to cre-
ate higher incomes and wealth, they also care about how these are distributed among all citizens. Pov-
erty for a minority amid plenty for the majority has always been a problem in wealthy countries—just
as poverty for the majority and plenty for the minority has always been a problem for poor countries.
A recent phenomenon in some of the richest countries has been rapidly rising real incomes for the few
very best off while the average worker sees little or no real income rise. We ask: ‘What are the sources
of these distributional shifts and can governments do anything to affect the income and wealth distri-
butions that market economies create?’
Economic growth in the world since World War Two was supported by falling barriers to trade
and greater international economic integration. Lower transport costs and cheaper communications
created opportunities for restructuring of supply chains in a process now called globalization. This
process has helped to take billions of people out of poverty in emerging markets, such as India and
China, but it has also had some negative effects on real income growth of unskilled workers in the old
industrial countries. A backlash against these trends has led to nationalism in trade affairs and protec-
tionism as a political solution in some places. The US trade war with China and the UK’s vote to leave
the EU are both aspects of this change of direction. How this will develop is far from clear at the time
of writing, but economics can help in understanding what is going on and what the policy options are.
Economists have been in the forefront of analysing, explaining, and, where appropriate, offering
solutions to all the issues mentioned above—and many more. They have often succeeded in these
tasks, mainly because economics has a core of useful theories that explain how markets work and
evaluate their performance. Although some economic analysis is extremely abstract, and sometimes
even economists wonder about its value, the basic core of economic theory that is the secret of the
subject’s success can be understood by anyone who is willing to make the effort. This basic theory has
an excellent record in illuminating issues in ways that lead to both deeper understanding and useful
policy recommendations.
When you start to read this book, you are setting out on the study of a subject that, as the above
discussion suggests, is highly relevant to understanding and improving the world in which we live.
Approached in the right way, your study will be an adventure. The basic theory must be mastered.
Whether or not you find this effort fun, you will find surprisingly early in your studies that theories
can be used to understand many practical issues. The world is complex, and fully understanding its
economic aspects requires much more economic theory than can be packed into one elementary text-
book. But mastery of the subject to the level of this one book will contribute greatly to your under-
standing of many important issues and many of the policies directed at dealing with them. It will
also provide you with a toolbox that will prove useful in the world of work, whatever occupation you
eventually enter.
Good luck and good studying!
Richard Lipsey and Alec Chrystal
Vancouver, BC, and Cambridge, England
HOW TO USE THIS BOOK

This book is enriched with learning features designed to help you develop the knowledge and skills
you need to study economics. This guided tour shows you how to use your textbook fully and get the
most out of your study.

Learning objectives
Each chapter opens with a bulleted list of learning
objectives outlining the main concepts and ideas you
will encounter in this part of the text. These serve as
helpful signposts for learning and allow you to clearly
track your progress and revision.

Boxes
Boxes found throughout the book give you practi-
cal illustrations of the theory described in the main
body of the text. They include real-life examples and
empirical demonstrations as well as more detailed
explanations of key points, all to ensure that you fully
grasp core economic theory.

Key terms
Key terms are printed in bold the first time they
appear in the text to alert you to each new concept.
These terms are then compiled and defined in the
glossary at the end of the book.
xviii How to Use this Book

Case studies
All chapters, except Chapter 1, conclude with a mini-
mum of two topical case studies. These cases will
help you to contextualize your understanding of core
chapter themes and encourage you to apply your
learning to real-life situations.

End-of-chapter summaries
At the end of each chapter, the key points and con-
cepts are summarized to help fix them in your mind.
This feature reinforces your understanding of the
material you have just covered and are an excellent
revision tool.

Topics for review

Each chapter ends with a list of topics for review
which prompt you to evaluate your understanding of
these subjects. They will prove very helpful when you
come to revision.

End-of-chapter questions
Problem-solving exercises and essay-type ques-
tions at the end of each chapter help you to develop
your analytical skills. Use them to test what you have
learned so far before moving on to the next chapter,
or as a basis for group discussion or further revision.
HOW TO USE THE ONLINE
RESOURCES

The Online Resources which accompany this book provides students with ready-to-use learn-
ing resources. They are free of charge and are designed to maximize the learning experience.
www.oup.com/uk/lipsey14e/

FOR STUDENTS
Self-test questions
A suite of questions for each chapter in the book allows you to test your knowledge of the key themes
in the text.

Interactive chapters
Additional course material is provided in an interactive format to assist and support your learning.

Web links
A selection of regularly updated web links, chosen by the authors with comments that explain their
value, allows you to conduct further research on those topics that are of particular interest to you.

Flashcard glossary
The key glossary terms from the text are presented in an interactive format to help you remember and
revise important concepts.
xx How to Use the Online Resources

FOR LECTURERS
PowerPoint slides
A suite of PowerPoint slides is provided for use in lecture presentations. Arranged by chapter theme,
the slides may also be used as handouts in class and can be easily adapted to suit your teaching style.

Test bank
A suite of test questions is provided which you can use for assessment purposes.

Instructor’s manual
This comprehensive guide for instructors provides you with further discussion of the core themes in
each chapter as well as the answers to all the questions set in the textbook.

Figures from the text

You can download all the figures found in the textbook electronically and you can use them to sup-
port student learning.
APPROACHES TO STUDYING
ECONOMICS

You need to study a book on economics in a different way from how you would study a book on, say,
history or English literature. Economic theory has a logical structure that builds on itself from stage to
stage. Thus, if you understand some concept or theory only imperfectly, you will run into increasing
difficulty when, in subsequent chapters, this concept or theory is taken for granted and built upon.
Because of its logical structure, quite long chains of reasoning are encountered; if A then B; if B then
C; if C then D; and if D then E. Each step in the argument may seem simple enough, but the cumula-
tive effect of several steps, one on top of the other, may be bewildering on first encounter. Thus, when
having followed the argument step by step, you encounter the statement: ‘It is now obvious that if A
then E’, it may not seem at all obvious to you. This is a problem that everyone encounters with chains
of reasoning. The only way to deal with it is to follow the argument through several times. Eventually,
as the reasoning becomes familiar, it will become obvious that if A then E.
Economics has its own technical language or jargon. At first you may feel that you are merely being
asked to put complicated names to commonsense ideas. To some extent this is true. It is a necessary
step, however, because loose thinking about vaguely formed ideas is a quick route to error in eco-
nomics. Furthermore, when you begin to put several ideas together to see what follows from them,
jargon—a clearly defined term to refer to each idea—becomes a necessary part of your equipment.
A book on economics is to be worked at and understood step by step. It is usually a good procedure
to read a chapter quickly in order to see the general run of the argument, and at this stage you might
omit the captions to the figures. You then need to re-read the chapter carefully, making sure that the
argument is understood step by step. On this reading, you must study the captions to all the figures
carefully. If you do not understand the captions, you have not understood the economics. You should
not be discouraged if, occasionally at this stage, you find yourself spending quite a bit of time on only
a few pages.
A pencil and paper are valuable adjuncts to your reading. Difficult arguments should be followed
by building up your own diagram while the argument unfolds, rather than relying on the printed
diagram, which is complete from the beginning. Numerical examples can be invented to illustrate
general propositions.
In short, the technical vocabulary aside, you must seek to understand economics, not to memorize
it. Theories, principles, and concepts are always turning up in slightly unfamiliar guises. If you have
understood your economics, this poses no problem; if you have merely memorized it, it spells disaster.

Email us
Economics is a subject about which one never stops learning. We are grateful to many users—students
and teachers—who have taken the trouble to email us pointing out possible errors, making comments,
and offering suggestions. We hope that readers will continue to teach us with as many further com-
ments and criticisms as they have in the past. We try to acknowledge every such communication.
OUTLINES FOR SHORT OR
MODULAR COURSES

This book provides a comprehensive coverage of basic economics suitable for a full one-year course.
We have, however, designed the text to be flexible enough to cover shorter courses. To illustrate, we
give our suggestions for the chapter content of several shorter courses.

A short Introduction to Economics course (twenty weeks)

Chapters 1–14 for basic micro, and 15–25 for basic macro.

An Introduction to Microeconomics course (one semester)

Chapters 1–14

An Introduction to Macroeconomics course (one semester)

Chapters 1 and 15–25. (Alternatively, for a course with a growth emphasis include Chapter 26; for a
course with an international emphasis, the key chapters are 24 and 27, with addition of our web-based
material on developing countries.)
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