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Macroeconomics
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Macroeconomics
ROBIN STONECASH
JOSHUA GANS
STEPHEN KING
MARTIN BYFORD
KRIS IVANOVSKI
N. GREGORY MANKIW

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Macroeconomics
ROBIN STONECASH
JOSHUA GANS
STEPHEN KING
MARTIN BYFORD
KRIS IVANOVSKI
N. GREGORY MANKIW


Principles of Macroeconomics © 2021 Cengage Learning Australia Pty Limited
8th Edition
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Adapted from Principles of Macroeconomics, 9th edition, by N. Gregory Mankiw, Cengage Learning Australia
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1 2 3 4 5 6 7 24 23 22 21 20

BRIEF
CONTENTS
Preface to this edition xv
Preface to the original edition xviii
To the students xix
About the authors xx
Acknowledgements xxii
Part I Introduction 3 Part 6 The macroeconomics of open

economies 277
Chapter 1 Ten principles of economics 4
Chapter 2 Thinking like an economist 22 Chapter 12 Open-economy macroeconomics:
Basic concepts 278
Chapter 3 Interdependence and the gains
from trade 49 Chapter 13 A macroeconomic theory of the open
economy 303
Part 2
Supply and demand:
How markets work 65 Part 7 Short-run economic f luctuations 327
Chapter 4 The market forces of supply and Chapter 14 Aggregate demand and aggregate
demand 66 supply 328
Chapter 15 The influence of monetary
Part 3 The data of macroeconomics 93
and fiscal policy on aggregate demand 355
Chapter 5 Measuring a nation’s income 94 Chapter 16 The short-run trade-off between
Chapter 6 Measuring the cost of living 115 inf lation and unemployment 380
Part 4
The real economy Chapter 17 Contemporary macroeconomics
in the long run 135 topics 403
Chapter 7 Production and growth 136 Part 8 Final thoughts 437
Chapter 8 Saving, investment and the financial Chapter 18 Five debates over macroeconomic
system 167 policy 438
Chapter 9 The natural rate of unemployment 195
Part 5
Money and prices Glossary 452
in the long run 223 Suggestions for reading 456
Chapter 10 The monetary system 224 Index 458
Chapter 11 Inf lation: Its causes and costs 249

CONTENTS
Preface to this edition xv Study tools 36
Preface to the original edition xviii Appendix: Graphing – a brief review 39
To the students xix
Chapter 3 Interdependence and the gains
About the authors xx
Acknowledgements xxii
from trade 49
Introduction 50
Part I Introduction 3 A parable for the modern economy 50
Production possibilities 51
Chapter 1 Ten principles of economics 4 Specialisation and trade 52
Introduction 5 Comparative advantage: The driving force of specialisation 54
How people make decisions 5 Absolute advantage 54
Principle 1: People face trade-offs 5 Opportunity cost and comparative advantage 54
Principle 2: The cost of something is what you give Comparative advantage and trade 55
up to get it 6
The price of trade 56
Principle 3: Rational people think at the margin 7
Applications of comparative advantage 57
Principle 4: People respond to incentives 8
Should Serena Williams mow her own lawn? 57
How people interact 10
Should Australia trade with other countries? 58
Principle 5: Trade can make everyone better
Study tools 61
off 11
Principle 6: Markets are usually a good way to
Part 2 S
upply and demand:
organise economic activity 12
Principle 7: Governments can sometimes improve
How markets work 65
market outcomes 14 Chapter 4 The market forces of supply and
How the economy as a whole works 15 demand 66
Principle 8: A country’s standard of living depends Introduction 67
on its ability to produce goods and services 15
Markets and competition 67
Principle 9: Prices rise when the government prints
What is a market? 67
too much money 16
What is competition? 67
Principle 10: Society faces a short-run trade-off
between inflation Demand 68
and unemployment 17 The demand curve: The relationship between price
and quantity demanded 68
Study tools 19
Market demand versus individual demand 70
Chapter 2 Thinking like an economist 22 Shifts in the demand curve 71
Introduction 23 Supply 75
The economist as scientist 23 The supply curve: The relationship between price
The scientific method: Observation, theory and and quantity supplied 76
more observation 23 Market supply versus individual supply 76
The role of assumptions 24 Shifts in the supply curve 77
Economic models 25 Supply and demand together 80
Our first model: The circular-flow diagram 25 Equilibrium 80
Our second model: The production possibilities Three steps for analysing changes in equilibrium
frontier 27 82
Microeconomics and macroeconomics 30 Study tools 88
The economist as adviser 30
Positive versus normative analysis 31 Part 3 T
he data of
Economists in government 31 macroeconomics 93
Why economists’ advice is not always
followed 32 Chapter 5 Measuring a nation’s income 94
Economists in business 33 Introduction 95
Why economists disagree 33 The economy’s income and expenditure 95
Differences in scientific judgements 33 The measurement of gross domestic product 97
Differences in values 34 ‘GDP is the market value …’ 97
What Australian economists think 34 ‘… of all …’ 97

‘… final …’ 98 Chapter 8 Saving, investment and the
‘… goods and services …’ 98 financial system 167
‘… produced …’ 98 Introduction 168
‘… within a country …’ 98
Financial institutions in the Australian economy 168
‘… in a given period of time’ 99
Financial markets 169
The components of GDP 99 Financial intermediaries 173
Alternative measures of income 101 Summing up 174
Real versus nominal GDP 102 Saving and investment in the national income accounts 176
A numerical example 103 Some important identities 177
The GDP deflator 104 The meaning of saving and investment 178
GDP and economic wellbeing 106 The market for loanable funds 179
So why do we look at GDP at all? 106 Supply of and demand for loanable
International differences in GDP and the quality of funds 180
life 108
How government policies can affect saving and investment 182
Study tools 112 Policy 1: Taxes and saving 182
Chapter 6 Measuring the cost of living 115 Policy 2: Taxes and investment 184
Introduction 116 Policy 3: Government budgets – surplus or deficit? 185
The consumer price index 116 Study tools 192
How the consumer price index is calculated Chapter 9 The natural rate
117
of unemployment 195
Problems in measuring the cost of living 120
Introduction 196
The GDP deflator versus the consumer price index 124
Identifying unemployment 197
Correcting economic variables for the effects of
How is unemployment measured? 197
inflation 126
Is unemployment measured correctly? 201
Dollar figures from different times 126
How long are the unemployed without
Indexation 127
work? 203
Real and nominal interest rates 127
Why is there unemployment? 203
Study tools 131
Classical unemployment 204
Part 4 T
he real economy Minimum-wage laws 204
Unions and collective bargaining 206
in the long run 135
The theory of efficiency wages 208
Chapter 7 Production and growth 136 Frictional unemployment 212
Introduction 137 The inevitability of frictional unemployment 212
Economic growth around the world 138 Public policy and job search 213
Productivity: Its role and determinants 141 Unemployment benefits 213
Why is productivity so important? 141 Structural unemployment 214
How is labour productivity determined? 142 Study tools 218
The production function 146
Economic growth and public policy 147 Part 5 M
oney and prices
The importance of saving and in the long run 223
investment 147
Diminishing returns to physical capital and the
Chapter 10 The monetary system 224
catch-up effect 148 Introduction 225
Investment from abroad 150 The meaning of money 225
Education 151 The functions of money 226
Health and nutrition 152 Kinds of money 226
Property rights, markets, trust and political Money in the Australian economy 228
stability 153 The Reserve Bank of Australia 231
Free trade 154 Organisation of the RBA 232
Discouraging excessive population growth Changes in the RBA’s role 233
158 Banks and the money supply 236
Research and development 160 The simple case of 100 per cent reserve
Study tools 164 banking 236

Money creation with fractional-reserve Implications of purchasing-power parity 294
banking 237 Limitations of purchasing-power parity 298
The money multiplier 238 Study tools 300
Bank capital, leverage and the Global Financial
Crisis of 2008 239 Chapter 13 A macroeconomic theory of the
Monetary policy in Australia today 241 open economy 303
Problems in controlling the money supply 243 Introduction 304
Study tools 246 Supply of and demand for loanable funds and foreign-currency
exchange 304
Chapter 11 Inf lation: Its causes and costs 249 The market for loanable funds 305
Introduction 250 The market for foreign-currency exchange 306
The causes of inf lation 251 Net foreign investment: The link between the two
The level of prices and the value of money 251 markets 308
Money supply, money demand and monetary Simultaneous equilibrium in two markets 310
equilibrium 251 Government budget deficits 312
The effects of a monetary injection 253 Trade policy 316
A brief look at the adjustment process 255 Political instability and capital flight 319
The classical dichotomy and monetary Study tools 323
neutrality 256
Velocity and the quantity equation 257 Part 7 S
hort-run economic
The inf lation tax 259 f luctuations 327
The Fisher effect 260
The costs of inflation 263 Chapter 14 Aggregate demand and aggregate
A fall in purchasing power? The inflation fallacy 264 supply 328
Shoeleather costs 264 Introduction 329
Menu costs 265 Three key facts about economic f luctuations 329
Relative-price variability and the misallocation of Fact 1: Economic fluctuations are irregular and
resources 266 unpredictable 329
Inflation-induced tax distortions 266 Fact 2: Most macroeconomic quantities fluctuate
Confusion and inconvenience 267 together 331
A special cost of unexpected inflation: Arbitrary Fact 3: As output falls, unemployment rises 331
redistributions of wealth 267 Explaining short-run economic fluctuations 333
Study tools 273 How the short run differs from the long
run 334
Part 6 T
he macroeconomics of The basic model of economic fluctuations 334
open economies 277 The aggregate-demand curve 335
The aggregate-supply curve 338
Chapter 12 Open-economy macroeconomics: Two causes of recession 344
Basic concepts 278 The effects of a shift in aggregate
Introduction 279 demand 344
The international flows of goods and capital 279 The effects of a shift in aggregate supply 347
The flow of goods: Exports, imports and net Study tools 351
exports 279
The flow of financial resources: Net foreign Chapter 15 The influence of monetary
investment 285 and fiscal policy on aggregate
The equality of the current account and the capital demand 355
and financial accounts 287 Introduction 356
Saving, investment and their relationship to the How monetary policy influences aggregate demand 356
international flows 288 The downward slope of the aggregate-demand
The prices for international transactions: Real and nominal curve 359
exchange rates 291 The theory of liquidity preference 360
Nominal exchange rates 291
How fiscal policy influences aggregate demand 363
Real exchange rates 292
Changes in government purchases 363
A first theory of exchange-rate determination: Purchasing- The multiplier effect 363
power parity 293
The crowding out effect 364
The basic logic of purchasing-power
Changes in taxes 366
parity 293

Using policy to stabilise the economy 368 Macroeconomic policy response to the GFC
The case for active stabilisation policy 368 shocks: The theory 421
The case against active stabilisation policy 371 Macroeconomic policy responses to the GFC
Automatic stabilisers 372 shocks: The reality 422
The economy in the long run and the short run 373 Lessons from the GFC 427
Study tools 376 Slow wages growth 428
Study tools 433
Chapter 16 The short-run trade-off
between inf lation and Part 8 Final thoughts 437
unemployment 380 Chapter 18 Five debates over macroeconomic
Introduction 381
policy 438
The Phillips curve 381
Introduction 439
Origins of the Phillips curve 381
That monetary and fiscal policymakers should
Aggregate demand, aggregate supply and the try to stabilise the economy 439
Phillips curve 382
Pro: Policymakers should try to stabilise the
Shifts in the Phillips curve: The role of expectations 384 economy 439
The long-run Phillips curve 384 Con: Policymakers should not try to stabilise the
Expectations and the short-run Phillips curve economy 440
386 That monetary policy should be made by rule
Shifts in the Phillips curve: The role of supply shocks 391 rather than by discretion 440
The cost of reducing inflation 393 Pro: Monetary policy should be made by
The sacrifice ratio 394 rule 441
Rational expectations and the possibility Con: Monetary policy should not be made
of costless disinf lation 395 by rule 441
The Accord approach 396 That the central bank should aim for zero inflation 442
A low-inflation era 398 Pro: The central bank should aim for zero
Study tools 400 inflation 442
Con: The central bank should not aim for zero
Chapter 17 Contemporary macroeconomics inflation 443
topics 403 That the government should balance its budget 444
Introduction 404 Pro: The government should balance its
What does globalisation mean? 404 budget 444
Overview of the main elements of financial crises 410 Con: The government should not balance its
The causes of the GFC 411 budget 445
Rising household debt 412 That the tax laws should be reformed to encourage
Opaque mortgage securitisation 413 saving 447
Ill-designed government policies 415 Pro: The tax laws should be reformed to encourage
saving 447
Loose monetary policy 416
Con: The tax laws should not be reformed to
Global economic trends and imbalances 416
encourage saving 448
The European debt contagion 417
Study tools 450
Policy responses to the GFC 419
What kind of shocks caused the
Glossary 452
GFC? 419
Suggestions for reading 456
The self-correction of the GFC shocks:
Index 458
The theory 420

Guide to the text
As you read this text you will find a number of features in every
chapter to enhance your study of macroeconomics and help you
understand how the theory is applied in the real world.
PART OPENING FEATURES
The chapter list outlines the

chapters contained in each part
for easy reference.
The macroeconomics
of open economies
PART SIX Chapter 12 Open-economy macroeconomics: Basic concepts

Chapter 13 A macroeconomic theory of the open economy
CHAPTER OPENING FEATURES
Identify the key concepts that

the chapter will cover with the
learning objectives at the start of
each chapter. 7
Production and growth
The term productivity refers to the quantity of goods and services that a worker can
produce for each hour of work. In the case of Crusoe’s economy, it is easy to see that
productivity is the key determinant of living standards and that growth in productivity is
the key determinant of improvements in living standards. The more fish Crusoe can catch
per hour,objectives
Learning the more he can eat at dinner. If Crusoe finds a better place to catch fish or a smarter
way
After of doing
reading thisso,chapter,
his productivity
you should rises.
be This
able increase
to: in productivity makes Crusoe better
off – he
LO7.1 could eat the
understand extra fish,
economic or he around
growth could spend less time fishing and devote more time to
the world
other activities
LO7.2 understand hetheenjoys.
role of productivity and its determinants
LO7.3The key roleeconomic
examine of productivity
growth in and
determining living standards is as true for nations as it is
public policy.
for stranded sailors. Recall that an economy’s gross domestic product (GDP) measures three
things at once – the total production, the total income earned in the economy and the total
expenditure on the economy’s goods and services. The reason GDP can measure these three
things simultaneously is that, for the economy as a whole, they must be equal. Put simply,
workers and owners of capital get paid their income for what they produce and use this
income to purchase the goods and services produced in the economy.
The implication is that Australians are more prosperous than Nigerians mainly because
Australian workers are more productive than Nigerian workers. The Chinese have enjoyed
more rapid growth in living standards than Venezualans primarily because Chinese workers
have experienced more rapidly growing productivity. Indeed, one of the Ten Principles of
Economics in chapter 1 is that a country’s standard of living depends on its ability to produce
goods and services.
The above discussion implies that in order to understand the large differences in living
standards across countries or over time, we must focus on the production of goods and
services. But seeing the link between prosperity and productivity is only the first step. It
leads naturally to the next question: Why are some economies so much better at producing
goods and services than others?
136 How is labour productivity determined?

Although productivity is uniquely important in determining Robinson Crusoe’s standard of
living, many factors determine Crusoe’s productivity. Crusoe will catch more fish, for instance,
FEATURES WITHIN CHAPTERS if he has more fishing rods, if he has been trained in the best fishing techniques, if his island
has a plentiful fish supply or if he has figured out the best places and times on his island to
fish. Each of these determinants of Crusoe’s productivity – which we can call physical capital,
human capital, natural resources and technological knowledge – has a counterpart in more
complex and realistic economies. Let’s consider each of these factors in turn.
Definitions or explanations of Physical capital

Workers are more productive if they have tools with which to work. The stock of equipment
important key terms are located physical capital

the stock of
equipment and
and structures that are used to produce goods and services is called physical capital, or
just capital. For example, when woodworkers make furniture, they use saws, lathes and
drill presses. More tools allow work to be done more quickly and more accurately. That is,
in the margin for quick reference.
structures that are
used to produce a worker with only basic hand tools can make less furniture each week than a worker with
goods and services
sophisticated and specialised woodworking equipment.
A full list of key terms are also As you may recall from chapter 2, the inputs used to produce goods and services are called
the factors of production. An important feature of physical capital is that, unlike labour, it is a
produced factor of production. That is, capital is an input into the production process that in
available in the glossary, which the past was an output from the production process. The woodworker uses a lathe to make the
leg of a table. Earlier, the lathe itself was the output of a firm that manufactures lathes. The
lathe manufacturer in turn used other equipment to make its product. Thus, capital is a factor
can be found at the back of the of production used to produce all kinds of goods and services, including more capital.
book. 142
Part 4 The real economy in the long run

processes. Similarly, labour relates to the quantity of workers in terms of the number of hours
they supply, while human capital expresses the quality and intellectual capacity of people
with regard to economic activities. To use a relevant metaphor, technological knowledge
is the quality of society’s textbooks, whereas human capital is the zeal and ingenuity with
which individuals write these textbooks and learn from them.
Based on the above discussion, it will probably not surprise you that labour productivity
depends on physical capital and human capital, as well as technological knowledge. You
will, however, soon see that physical capital only has a temporary effect: Ongoing increases
FEATURES WITHIN CHAPTERS in the number of machines per worker cannot permanently sustain economic growth. This
is in contrast to human capital and technological knowledge, both of which improve the
quality of the production inputs rather than just adding more inputs.
Analyse practical applications CASE Are natural resources or global warming limits to growth?
of concepts through the STUDY The world’s population is far larger today than it used to be (in 1800 it was around one
billion, one-seventh of what it is now), and most people are enjoying a much higher
case studies and test your standard of living. A perennial debate concerns whether this growth in population and
living standards can continue in the future.
understanding with the

Many commentators have argued that natural resources provide a limit to how
much the world’s economies can grow. At first, this argument might seem hard to
ignore. If the world has only a fixed supply of non-renewable natural resources,
associated questions. how can population, production and living standards continue to grow over time?
Eventually, won’t supplies of oil and minerals start to run out? When these shortages
start to occur,
Although thewon’t they stop
accounting economic
identity S = I growth and, saving
shows that perhaps, and even force living
investment are equal for
standards to fall?
the economy as a whole, this does not have to be true for every individual household or
In the early 1970s, a group of researchers at the Massachusetts Institute of
firm. Mary’s saving can be greater than her investment, and she can deposit the excess in
Technology (MIT) in the US were commissioned to undertake analysis of whether
a bank. Jerry’s saving can be less than his investment and he can borrow the shortfall from
this would in fact happen. They published a book called The Limits to Growth. They
a bank.
concludedBanks andbyother
that aboutfinancial
2020, weinstitutions
would reach make
peakthese individual
production – thatdifferences
we would between
not be
saving
able to and investment
continue possible
to increase ourbyoutput
allowing of one
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as we saving
would run to finance
out of keyanother
inputsperson’s
of
investment.
non-renewable resources. The researchers were criticised – their computer modelling
made simplistic assumptions, they didn’t consider technological advances and so on.
It appears that they weren’t entirely accurate about their predictions … and yet … We
LO8.3 The market for loanable funds
are experiencing changes to our climate that may force us to limit our production to
prevent catastrophic changes to our environment.
Gain insights into recent policy Having
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copper. At the time, these were crucial commodities – tin was used to make many food
the economy has
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ESA Policy Opinion discussed
containers, and copper was used to make telephone wire. Some peopleSurvey of Australian
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Useful macroeconomic facts them? The reason
resources may be that economists have not yet convinced the general public that
less necessary.
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FYI
these policies are undesirable. One of the purposes ofpermit
But are all these technological efforts enough to continued
this book
One way to answer this question is to look at the prices of natural resources. In a market
the economist’s view of these and other subjects and, perhaps, to persuade you that it is the
economic
is to help growth?
you understand
right one. value

Present Question: If you put $100 in a bank
will provide you with additional 144

Imagine that someone offered to give
account (that pays interest) today, how
much money will you have in N years?
you
Part 4 The real economy in the long $100
run today or $100 in 10 years.
information and material to CHECK YOUR UNDERSTANDING
Which would you choose? This is an easy
That is, what will be the future value of
this $100?
just before you
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Getting $100 today discourages
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: Let’sand
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economic
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advisers to the federal government might disagree
make sense to reward
interest rate them with in
expressed monopolies
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interest rate of 5 simultaneous
per cent means discoveries
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chapter. years and earn interest along the way. The
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If interest
lesson: Money today is more valuable than if this interest paid remains in the bank
protection inhibits a key driver of prosperity, namely learning from others. As the authors
is paid eachexcessive
year, andpatent
Conclusion: Let’s get going

the same amount of money in the future.
argue:Now‘Imitation
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of this you book have introduced youearlier
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economics. We are now ready to get to work. Inbecome
today or $200 in 10 years. Which would you the next(1chapter,
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wayproceed
to comparethroughsums of book,
this money from
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+ r) × $100 on3many
after yearsofandyoursointellectual
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skills. It may be helpful to keep in mind some advice fromthe
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present value of any future sum of money cent, then the value of the $100 in 10 years’
is the amount The studythat
today of economics
would bedoes not seem to require any specialised
needed, gifts of an
Expand your knowledge
10
time will be (1.05) × $100, which is $163.
unusually
at current interest highto
rates, order. Is it not
produce … a very easy subject compared with the higher
that
Using experiments to evaluate aid andQuestion
ignite: prosperity
Now suppose you are going
IN THE future sum. branches
To learn of howphilosophy
to use the or pure science? An easy subject, at which very few
to be paid $200 in N years. What is the
of economics related to NEWS To
are
figureofout
concept what
excel!
present
must
increasingly
The policies
paradox
value,
possess
turning
a couple of simple problems. a
let’s
rare
to
are
finds
work itseffective
through inperhaps,
explanation,
combination
randomised of gifts.
low-income nations,
in that the economists
master-economist
present value of this future payment?
He must
controlled be mathematician,
experiments historian,
used in
statesman, philosopher – in some degree. He must understand symbols and speak
contemporary events In the medical trials.
in words. He must contemplate the particular in terms of the general, and touch
abstract and
What it takes toconcrete in the same flight of thought.
lift families So heHe must
and study the
a bunch ofpresent
his colleagues
news. These boxes provide news Because ofin
out
substantially
differences
over
in GDP
the light of the
of poverty
time. Japan
his institutions
growth
past for
must
rates,ofthe
the purposes
islie
a country
the ranking
had future.
that has
entirely outside
Noof
a radical
his
countries
part of man’s
idea:
risen relative
regard.
method
by with
income
Test nature
aid or thechanges
He must be
doctors to
same
others
purposeful
use between
to test and 1950is,
and
179
Chapter 8 Saving, investment and the financial system
drugs (that
by Michaeleen Doucleff
articles about economics in the 1990 and 2015
15 May
continues. Two
disinterested
has fallen sinceinthen.a simultaneous
The risemood;
sometimes as near the earth as a politician.
countries that have fallen behind are
as aloof
of China and and
randomized
New
The
incorruptible
other
idea
South
control
Zealand
as an
East artist,
Asianyetcountries still
trials).
is quiteand Argentina.
simple. In 1950,
Give some
Eighteen years ago, Dean Karlan was a
real world. New
This Zealand
fresh,
high
like as the
an
was one
is abright-eyed
tall order.
United
economist.
economics
But of
with
graduate
at theStates
thepractice,
richest countries
studentyou
and well above
Massachusetts
infamilies
the United
Institute
the world,
Kingdom.
follow
aid with average
in will become more and more accustomed to thinking
but others
Today, average
both groups,
incomeThen
nothing.
and seeincome
nearly as
if the in New
Zealand is well below
of Technology. He wantedaverage income what
to answer in the USaid andactually made aIndifference
in Australia. in the had
1950, Venezuela
long run.
almost
seemed fourlike
times the income
a simple question: of its South American neighbour, Brazil. Today, Venezuela’s
Karlan, who’s now a professor at
average ‘Doesincome
globalisaid only justKarlan
work?’ over half
says.that of Brazil’s. Australia’s story is somewhere in
Yale University, says many people were
between He wasthese two. In
reading 1900, Australia
a bunch of studies had the highest per capita income in the world, but
skeptical. ‘I have many conversations with
by 1970 it had fallen to around seventh in the rankings.
on the topic. But none of them actually By 1991, Australia was
to dono longer in
Today, you can find economists involved in manypeople areas ofwho say, ‘You
government wantmaking.
decision what? 35
the topEconomists
answered10 and thehad
havefallen
question. behind
‘We
a valuable
weremost
role to play western
tearing European
in government
Whyprecisely
would countries
because
you want intorelative
they understand
do that?’ terms. Since
Chapter 2 Thinking like an economist
then,
our Australia’s
hair relatively
outdecisions
that all reading strong
paperseconomic
thesetrade-offs,
involve because
and becausegrowth
they are (we have
skilled
One issue had nosome
in evaluating
is that recession
trade-since
thosefamilies go 1992)
it was
has seen frustrating,’
offs.Australia’s
Economists arehe says.
ranking ‘[We]
also ablerise, never really
to useattacking theTen
another of the top 10 again.
Principles of Economics – people
home empty-handed, withrespond
no aid. So
to incentives
felt like the papers – to identify
were really possible unintended consequences of policy proposals. We saw an
satisfactory.’
These data show that the world’s richest countries have no
the idea seems guarantee
unethical. Butthat they will
Karlan
example
One of this in
problem the that
was ‘babyno bonus’
onecase
wasstudy in Chapter 1, and unintended consequences of
stay the richest and
well-meaning thatisthe
policies world’s
a theme poorest
that we countries
disagrees.are ‘The
not doomed
whole point forever to remain
of this is to in
actually testing global aid programs —will return to often throughout this book.
poverty. But what
In Australia,
methodically — to explains
economists
see if they these changes
skilled
really over help
time?more
in macroeconomics Why dothe
work people,’
in some hecountries
Treasurysays.
and zoom
‘Ifthe
we findahead
out
while others lag behind? These are precisely
Department of Finance to provide advice thewhat
on taxationquestions
andworks that
andwe
fiscal policy, andtake
what upReserve
indoesn’t,
the next.in five years
Bank studying monetary and financial issues. Economists skilled in microeconomics
haven’t
workbeen
in the taking the scientific
Productivity Commissionmethod
advising the government on microeconomic reform, around
So Karlan and collaborators
Test your progress through each to problems
and at theof poverty,’Competition
Australian he says. and Consumer Commission advising on issues related
the world, including those at the Abdul
Take,
CHECK YOUR UNDERSTANDING
to competition
for instance,policy. Economists
a charity thatingives
all areas of government are supported by their
Latif Jameel Poverty Action Lab at MIT
section by answering the Check colleagues
a family
the family
What has
a cow.
that is used
at The
a year
the Australian
in alater
been the approximate
and say,
Bureaucheck
charity might
wide variety
of Statistics,
of government
annual
on who construct the statistical information
growth
and the nonprofit Innovations for
‘Wow! The decision making and economic research.
Poverty
rate of realAction,
GDP decided
per person totake
intry out the
Australia
Political
doingparties seek the inputwith
of economists in developing the policies that they to
your understanding questions as
family is so much better this
and elections.
China over theall,past
After half century?
economic Before
‘credibility’ is often a idea
reading with
the rest
prominent oneofinof
issue thethe toughest
chapter,
election canproblems
campaigns. you
cow. Cows must be the reason.’
Politicians,
suggest of all parties,
any possible rely on the economists
explanations in the
for the differences outParliamentary
there: Budget
helping
in economic Office to
families
growth provide
ratesgetbetween
out of
But maybe itcostings
non-partisan
wasn’t the cow that
and China overofthis theirperiod?
proposed policies, andextreme independent analysis of economic and
you progress through the chapter. Australia
improved
budgetary
bumper
theissues.
family’s life. Maybe it had a
poverty.
An anti-poverty program in
The influence
crop that of economists
year on policy
or property goes beyondBangladesh,
values their role as advisers and policymakers;
called BRAC, looked like
wenttheir
up research and writings can affect policy indirectly. Economist John Maynard Keynes
in the neighborhood.
it was successful. It seemed to help
offered thisreally
observation:
LO7.2 Productivity: Its role and determinants
Researchers
experiments, Karlan
weren’t doing those
The ideassays.
nearly 400 000 families who were
of economists and political philosophers, both when they are right and
living off less than $1.25 each day.
when they are wrong, are more powerful than is commonly understood. Indeed,
Explaining the large variation in living standards around the world is, in one sense, very
the world is ruled by little else. Practical men, who believe themselves to be
easy. As we will see,
quitethe explanation
from intellectualcan be summarised in aof single word – productivity. But,
ICONS
exempt influences, are usually the slaves some defunct
in another sense, economist.

the international variation is deeply puzzling. To explain why incomes are
Madmen in authority, who hear voices in the air, are distilling their
161
frenzy from some academic scribbler of a few years back.
so much higher in some countries than in others, we must look at the many (economic as
These words were written in 1935, but they remain true today. Indeed, the ‘academic Chapter 7 Production and growth
well as non-economic) factors that determine a nation’s productivity.
scribbler’ now influencing public policy is often Keynes himself.
The Key figure icon highlights KEY Why isWhy

productivity
economists’ so
Economists
important?
advice is not always followed
who advise the government know that their growth
recommendations are not always
Let’s begin our study of productivity and economic by developing a simple model
FIGURES
content relating to a key figure in heeded. Frustrating as this can be, it is easy to understand. The process by which economic
based policy
loosely on Daniel Defoe’s famous novel, Robinson Crusoe. Robinson Crusoe, as you
is actually made differs in many ways from the idealised policy process assumed in
may recall, is a sailor
economics textbooks. stranded on a desert island. Because Crusoe lives alone, he catches his
economics. own fish,Throughout
grows histhis
question:
own vegetables
text, whenever we anddiscuss
makes his own
economic clothes.
policy, We focus
we often can think
on oneof Crusoe’s
activities – hisWhat is the bestand
production policy for the government
consumption to pursue?
of fish, We act as
vegetables if policy
and were set
clothing – as being a
by a benevolent queen. Once the queen determines the ‘right’ policy, she has no difficulty
simple economy. By examining Crusoe’s economy, we can learn some lessons that also apply
putting her ideas into action.
to more complex and realistic economies.
In the real world, determining the right policy is only part of a leader’s job, sometimes
What determines
the easiest Crusoe’s
part. After standard
the prime ministerofhears
living?
fromThe answer is
her economic obvious.
advisers whatIfpolicy
Crusoe is good
at catching fish, best,
they deem growing vegetables
she turns to otherand making
advisers for clothes, he lives
related input. The well.
prime Ifminister’s
he is bad at doing
communications advisers will tell her how best to explain the proposed policy to the public,
these things, he lives poorly. Because Crusoe gets to consume only what he produces, his
and they will try to anticipate any misunderstandings that might make the challenge more
living difficult.
standard ispress
Her tied advisers
to his productive
will tell her ability.
how the news media will report on her proposal
and what opinions will likely be expressed on the nation’s editorial pages. Her legislative
advisers will tell her how parliament will view the proposal, what amendments members of
the Senate will suggest, and the likelihood that the two houses of parliament will pass some
141
32
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Chapter
WCN 02-200-202
7 Production and growth
Part 1 Introduction

END-OF-CHAPTER FEATURES
At the end of each chapter you will find several tools to help you to review, practise and
extend your knowledge of the key learning objectives.
Review your understanding of the key
TOOLS
Summary
LO5.1 Because every transaction has a buyer and a seller, the total expenditure in the
chapter topics with the Summary.
TOOLS
Summary
economy must equal the total income in the economy.
LO5.2 Gross domestic product (GDP) measures an economy’s total expenditure on newly
LO5.1 Because every transaction has a buyer and a seller, the total expenditure in the
TOOLS
produced goods and services and the total income earned from the production of
Summary
economy must equal the total income in the economy.
these goods and services. More precisely, GDP is the market value of all final goods and
LO5.2 Gross domestic product (GDP) measures an economy’s total expenditure on newly
LO5.1 Because every transaction
services produced within a has a buyer
country in aand
given a seller,
periodthe total expenditure in the
of time.
produced goods and services and the total income earned from the production of
LO5.3 economy must among
GDP is divided equal thefourtotal income in of
components the economy. – consumption, investment,
expenditure
these goods and services. More precisely, GDP is the market value of all final goods and
LO5.2 Gross domestic
government productand
purchases (GDP)
netmeasures an economy’sincludes
exports. Consumption total expenditure
spending on newly
goods and
services produced within a country in a given period of time.
produced
services bygoods and services
households, with theandexception
the total of income earned
purchases of from the production
new housing. of
Investment
LO5.3 GDP is divided among four components of expenditure – consumption, investment,
these
includesgoods and services.
spending on new More precisely,
equipment andGDP is the market
structures, including value of all finalpurchases
households’ goods and
government purchases and net exports. Consumption includes spending on goods and
services produced
of new housing. within a country
Government in a given
purchases include period of time.
spending on goods and services by
STUDY
services by households, with the exception of purchases of new housing. Investment
LO5.3 GDP
local,isstate
divided
andamong
federalfour components
governments. Netofexports
expenditure
equal –theconsumption,
value of goods investment,
and services
includes spending on new equipment and structures, including households’ purchases
government purchases and
produced domestically and sold
net exports. Consumption
abroad (exports) minusincludes
the value spending
of goods onand
goods and
services
of new housing. Government purchases include spending on goods and services by
STUDY
services
produced byabroad
households, with
and sold the exception
domestically of purchases of new housing. Investment
(imports).
local, state and federal governments. Net exports equal the value of goods and services
LO5.4 includes
Nominal spending
GDP useson new equipment
current and structures,
prices to value the economy’sincluding households’
production of goodspurchases
and
produced domestically and sold abroad (exports) minus the value of goods and services
of new housing.
services. Real GDPGovernment purchases
uses constant base-yearinclude spending
prices to value onthegoods and services
economy’s by
production
STUDY
produced abroad and sold domestically (imports).
local,
of goodsstateand
andservices.
federal governments.
The GDP deflator Net –exports equalfrom
calculated the the
value of goods
ratio and services
of nominal to real
LO5.4 Nominal GDP uses current prices to value the economy’s production of goods and
produced
GDP – measuresdomestically andofsold
the level abroad
prices (exports)
in the economy. minus the value of goods and services
services. Real GDP uses constant base-year prices to value the economy’s production
LO5.5 produced
GDP is a good abroad and sold
measure domestically
of economic (imports).
wellbeing because higher incomes mean people
of goods and services. The GDP deflator – calculated from the ratio of nominal to real
LO5.4 Nominal
can buy moreGDP ofuses
thecurrent prices
things that addtotovalue
theirthe economy’s
wellbeing. But production of goods
it is not a perfect and
measure
GDP – measures the level of prices in the economy.
services. RealFor
of wellbeing. GDP uses constant
example, base-year
GDP excludes pricesoftoleisure
the value value the
andeconomy’s
the value ofproduction
a clean
LO5.5 GDP is a good measure of economic wellbeing because higher incomes mean people
of goods and as
environment, services.
well asThethe GDP deflator
negative impact – calculated
of greater from
levelsthe ratio of inequality
of income nominal to orreal
can buy more of the things that add to their wellbeing. But it is not a perfect measure
GDP
crime.– measures the level of prices in the economy.
of wellbeing. For example, GDP excludes the value of leisure and the value of a clean
LO5.5 GDP is a good measure of economic wellbeing because higher incomes mean people
environment, as well as the negative impact of greater levels of income inequality or
can buy more of the things that add to their wellbeing. But it is not a perfect measure
Key concepts
crime.
of wellbeing. For example, GDP excludes the value of leisure and the value of a clean
Quickly navigate to Key concepts

environment,
consumption, p. 100as well as the negative impact of greater levels
investment, p. 100of income inequality or
Key concepts
crime. p. 104
GDP deflator, net exports, p. 100
government
consumption,purchases,
p. 100 p. 100 nominal GDP,
investment, p.p. 103
100
introduced in the chapter with this list Key concepts
gross domestic
GDP deflator,
gross national
government
p.product
104 (GDP), p. 97
product (GNP),
purchases, p. 100p. 98
real GDP, p. 103
net exports,
value added,
nominal
p. 100
GDP,p.p.101
103
consumption, p. 100 investment, p. 100
of key terms.
gross domestic product (GDP), p. 97 real GDP, p. 103
GDP deflator, p. 104 net exports, p. 100
Practice questions
gross national product (GNP), p. 98
government purchases, p. 100
value added, p. 101
nominal GDP, p. 103
gross domestic product (GDP), p. 97 real GDP, p. 103
Questions
gross national for
Practice questions review
product (GNP), p. 98 value added, p. 101
1 Explain why an economy’s income must equal its expenditure.
Questions for review
Practice questions
2 Which contributes more to GDP – the production of a tonne of wheat or the production of
Test your knowledge and consolidate

a tonne of coal? Why?
1 Explain why an economy’s income must equal its expenditure.
3 A farmer sells milk to a cheesemaker for $2. The cheesemaker uses the milk to make
Questions for review
2 Which contributes more to GDP – the production of a tonne of wheat or the production of
cheese, which is sold for $6. What is the contribution to GDP?
a tonne of coal? Why?
your learning through Apply and

1
4 Explain
Over thewhy lastan economy’s
three income
years, Kane paidmust
$5000equal its expenditure.
buying new parts to restore his vintage car.
3 A farmer sells milk to a cheesemaker for $2. The cheesemaker uses the milk to make
2 Which
Today he contributes more
sells the car to GDP –for
at auction the production
$20 000. Howof a tonne
does of wheat
this sale affector the production
current GDP? of
cheese, which is sold for $6. What is the contribution to GDP?
5 a tonne
List of coal?
the four Why?
components of GDP. Give an example of each.
4 Over the last three years, Kane paid $5000 buying new parts to restore his vintage car.
revise and Practice questions,

3
6 A
Infarmer
the yearsells
2020,milkthe
to economy
a cheesemaker
producesfor $2.
200The cheesemaker
serves of fish anduses
chipsthe
formilk
$9.50to make
each. In the
Today he sells the car at auction for $20 000. How does this sale affect current GDP?
cheese,
year 2021,which
the is sold for produces
economy $6. What is theserves
250 contribution to GDP?
of fish and chips for $12.75 each. Calculate
5 List the four components of GDP. Give an example of each.
4 Over
nominaltheGDP,
last three years,
real GDP andKane
the paid
GDP$5000 buying
deflator newyear.
for each parts(Use
to restore
2020 ashis vintage
the car. By
base year.)
6 In the year 2020, the economy produces 200 serves of fish and chips for $9.50 each. In the
containing multiple choice questions Today
6 In
he sells thedoes
what percentage
the fourfor
it desirable
theGDP
raise yearand
car at
components
2020,
a country to
yetthe
auction
each
ofhave
be economy
for $20
of these
GDP.aGive
undesirable.
000.
three
largeanGDP?
How does
statistics
example
Give of
rise this
aneach.
fromsale
oneaffect
year current
year 2021, the economy produces 250 serves of fish and chips for $12.75 each. Calculate
5 List
GDP?Why is
to the next?
example of something that would
nominal GDP, real GDP and the GDP deflator for each year. (Use 2020 as the base year.) By
produces 200 serves of fish and chips for $9.50 each. In the
what percentage does each of these three statistics rise from one year to the next? Why is
and problems and applications. year 2021, the economy produces 250 serves of fish and chips for $12.75 each. Calculate
it desirable for a country to have a large GDP? Give an example of something that would
nominal GDP, real GDP and the GDP deflator for each year. (Use 2020 as the base year.) By
raise GDP and yet be undesirable.
what percentage does each of these three statistics rise from one year to the next? Why is
it desirable for a country to have a large GDP? Give an example of something that would
raise GDP and yet be undesirable.
Multiple choice
1 GDP includes:
112
a Consumption, Investment, Government Transfers, Exports
Part 3 The data of macroeconomics b Consumption,
112
Multiple choice Private Investment, Government Investment, Exports and Imports
c Consumption, Private and Government Investment, Government Expenditure and Net
1
Part 3 The data of macroeconomics
GDPExports
includes:
a Consumption, Investment, Government Transfers,
d Revenue and Exports
Imports
112
2 b the
If Consumption,
nominal GDPPrivate Investment,
of HobbitLand Government
in 2020 is $2 350Investment,
000 and theExports and Imports
GDP deflator in 2020 is
c Consumption,
Part 3 The data of macroeconomics 103 and the base year Private
forand
the Government
GDP deflatorInvestment,
is 2016, what Government
is real GDP Expenditure
in 2020: and Net
a $2 Exports
281 553
d $2
b Consumption,
420 500 Investment, Government Revenue and Imports
2 cIf the $2nominal
350 000GDP of HobbitLand in 2020 is $2 350 000 and the GDP deflator in 2020 is
103$1
d and the
807 692base year for the GDP deflator is 2016, what is real GDP in 2020:
a $2 281
3 Which 553
of the following should not be included in GDP:
b Your
a $2 420 500
purchase of a new pair of pants.
c Qantas’
b $2 350 000 purchase of a new ticketing kiosk.
cd A $1bank’s
807 692 purchase of an existing building for a new office.
3 d WhichTheofRoyal
the following
Australianshould
Navy’snot be included
purchase in GDP:
of a new patrol boat.
a Your purchase
4 According of a new pair
to the information of pants.
in Table 5.4, Australia has a higher life expectancy and
b Qantas’
higher meanpurchase
years of of a new ticketing
schooling and yet kiosk.
Norway is ranked as number 1 on the Human
c A bank’s purchase
Development Index and of Australia
an existing building 2.
is number forWhich
a newof office.
the following must be true?
d Australia’s
a The Royal Australian Navy’s
schooling isn’t as purchase of a new patrol boat.
good as Norway’s.
4 b According
Norway’s to real
the information
GDP per person in Table 5.4, Australia has a higher life expectancy and
is higher.
chigher mean years
Australia’s of schooling
distribution of incomeand yet Norway is ranked as number 1 on the Human
is worse.
Development
d Norway doesn’t Indextreat
and Australia
its old peopleis number
as well2.as
Which of the
Australia following must be true?
does.
5 a Australia’s
If Australia schooling isn’t
is experiencing as good
rising as Norway’s.
inflation, then
a b Norway’s
nominal GDP real is
GDP per person
growing is higher.
faster than real GDP.
cb Australia’s distribution of income is worse.
nominal GDP is growing faster than the GDP deflator.
d c Norway
real GDPdoesn’t treatfaster
is growing its oldthan
people as well
nominal as Australia does.
GDP.
5 If d Australia
real GDP is is
experiencing
growing faster risingthaninflation,
the GDP then
deflator.
a nominal GDP is growing faster than real GDP.
b nominal GDP is growing faster than the GDP deflator.
Problems and applications
c real GDP is growing faster than nominal GDP.
1 d real
What GDP is growing
components of GDPfaster thanwould
(if any) the GDP
each deflator.
of the following transactions affect? Explain.
a A family buys a new LED TV.
b Aunt Maria buys a new iPad.
c Kia sells a Rio from its inventory.
1 What
d You components
buy a movieoftheatre
GDP (ifticket.
any) would each of the following transactions affect? Explain.
a The
e A family buys a new
government LED South
of New TV. Wales creates a new light rail system in Sydney.
fb Your
Aunt parents
Maria buys buyaanew iPad.
bottle of South Australian wine.
c Ford
g Kia sells
Motora Rio from its shuts
Company inventory.
down its factory in Campbellfield, Victoria.
2 d You
The buy a movie
‘government theatre ticket.
purchases’ component of GDP does not include spending on transfer
e The government
payments like welfareofbenefits.
New South Walesabout
Thinking creates
thea definition
new light rail system
of GDP, in Sydney.
explain why transfer
fpayments
Your parents buy a bottle of South Australian wine.
are excluded.
3 g Ford
Why do youMotor Company
think shutspurchases
households’ down its factory
of newin Campbellfield,
housing Victoria.
are included in the investment
2 The ‘government
component of GDPpurchases’ component
rather than of GDP does
the consumption not include
component? Canspending
you thinkon oftransfer
a reason
payments
that like welfare
households’ benefits.
purchases Thinking about
of refrigerators the definition
should of GDP, in
also be included explain why transfer
investment rather
payments
than are excluded.
in consumption? To what other consumption goods might this logic apply?
3
4 Why
As thedochapter
you think households’
states, GDP does purchases of new
not include housing
the value are included
of volunteer in the
work. investment
Do you think GDP
component
should includeof GDP
suchrather than theWould
transactions? consumption
this makecomponent?
GDP a better Can you think
measure of of a reason
economic
that households’ purchases of refrigerators should also be included in investment rather
wellbeing?
5 than in
Look onconsumption?
the ABS website To what
to findother consumption
the base goods
year for real GDP.might
Whythis logicthink
do you apply?the ABS
4 As the chapter
updates the basestates,
yearGDP does not include the value of volunteer work. Do you think GDP
periodically?
should include such transactions? Would this make GDP a better measure of economic
wellbeing?
5 Look on the ABS website to find the base year for real GDP. Why do you think the ABS
updates the base year periodically?
113
Chapter 5 Measuring a nation’s income
113
Chapter 5 Measuring a nation’s income

Guide to the online
resources
FOR THE INSTRUCTOR
Cengage is pleased to provide you with a selection of resources

that will help you prepare your lectures and assessments. These
teaching tools are accessible via cengage.com.au/instructors for
Australia or cengage.co.nz/instructors for New Zealand.
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The Cengage Mobile App puts your course directly into students’ hands with course
materials available on their smartphone or tablet. Students can read on the go, complete
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MindTap for Principles of Economics is full of innovative resources to support critical
thinking, and help your students move from memorisation to mastery! Includes:
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• Key point summaries
• Chapter outline
• Check your understanding questions
• Questions for review and practice questions

COGNERO TEST BANK
This bank of questions has been developed in conjunction with the text for creating
quizzes, tests and exams for your students. Deliver these through your LMS and in your
classroom.
POWERPOINT™ PRESENTATIONS
Use the chapter-by-chapter PowerPoint slides to enhance your lecture presentations and
handouts by reinforcing the key principles of your subject.
ARTWORK FROM THE TEXT

Add the digital files of graphs, tables, pictures and flow charts into your course
management system, use them in student handouts, or copy them into your lecture
presentations.
FOR THE STUDENT
MINDTAP
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MindTap gives you the resources you need to study – all in one place and available when
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If your instructor has chosen MindTap for your subject this semester, log in to MindTap to:
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your instructor.

PREFACE
TO THIS
EDITION
Studying economics should invigorate and enthral. It should challenge students’ preconceptions
and provide them with a powerful, coherent framework for analysing the world they live in. Yet,
all too often, economics textbooks are dry and confusing. Rather than highlighting the important
foundations of economic analysis, these books focus on the ‘ifs’ and ‘buts’. The motto underlying
this book is that it is ‘the rule, not the exception’ that is important. Our aim is to show the power of
economic tools and the importance of economic ideas for people’s prosperity and wellbeing.
This book has been designed particularly for students in Australia. However, we are keenly
aware of the diverse mix of students studying this subject. When choosing examples and
applications, we have kept an international focus. Whether the issue is the international capital
flows in Indonesia or inflation targeting in Australia, examples have been chosen for their relevance
and to highlight that the same economic questions are being asked in many countries. The specific
context in which economics is applied may vary but the lessons and insights offered by the
economic way of thinking are universal.
To boil economics down to its essentials, we had to consider what is truly important for students
to learn in their first course in economics. As a result, this book differs from others not only in its
length but also in its orientation.
It is tempting for professional economists writing a textbook to take the economist’s point of
view and to emphasise those topics that fascinate them and other economists. We have done our
best to avoid that temptation. We have tried to put ourselves in the position of students seeing
economics for the first time. Our goal is to emphasise the material that students should and do find
interesting about the study of the economy.
One result is that more of this book is devoted to applications and policy, and less is devoted to
formal economic theory, than is the case with many other books written for the principles course.
For example, after students learn about the demand for and supply of loanable funds in chapter
8, they immediately apply these tools to answer important macroeconomic questions facing the
Australian economy, such as: How do changes in government tax policy affect the nation’s ability to
invest in new capital equipment? These principles are extended to the open economy in chapter 13,
where students learn about the demand for and supply of foreign exchange and immediately apply
the new tools to explain capital flight from Indonesia during the Asian economic crisis.
Throughout this book we have tried to return to applications and policy questions as often
as possible. Most chapters include case studies illustrating how the principles of economics are
applied. In addition, ‘In the news’ boxes offer excerpts from newspaper articles showing how
economic ideas shed light on the current issues facing society. It is our hope that after students
finish their first course in economics, they will think about news stories from a new perspective and
with greater insight.
To write a brief and student-friendly book, we had to consider new ways to organise the
material. This book includes all the topics that are central to a first course in economics, but the
topics are not always arranged in the traditional order. What follows is a whirlwind tour of this text.
This tour will, we hope, give instructors some sense of how the pieces fit together.
Chapter 1, ‘Ten principles of economics’, introduces students to the economist’s view of the
world. It previews some of the big ideas that recur throughout economics, such as opportunity cost,
marginal decision making, the role of incentives, the gains from trade and the efficiency of market
allocations. Throughout the book, we refer regularly to the Ten Principles from Economics in
xv
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202 Preface to this edition

chapter 1 to remind students that these principles are the foundation for most economic analysis. A
key icon in the margin calls attention to these references.
Chapter 2, ‘Thinking like an economist’, examines how economists approach their field of
study. It discusses the role of assumptions in developing a theory and introduces the concept of
an economic model. It also discusses the role of economists in making policy. The appendix to this
chapter offers a brief refresher course on how graphs are used and how they can be abused.
Chapter 3, ‘Interdependence and the gains from trade’, presents the theory of comparative
advantage. This theory explains why individuals trade with their neighbours, and why nations
trade with other nations. Much of economics is about the coordination of economic activity
through market forces. As a starting point for this analysis, students see in this chapter why
economic interdependence can benefit everyone. This is done using a familiar example of trade in
household chores among flatmates.
The next chapter introduces the basic tools of supply and demand. Chapter 4, ‘The market
forces of supply and demand’, develops the supply curve, the demand curve, the notion of market
equilibrium, elasticity and its applications to different markets, and uses the tools of supply,
demand and government to examine price controls, such as rent control and the award wage
system, and tax incidence.
Beginning in chapter 5, the book turns to the topics of macroeconomics. The coverage starts
with the issues of measurement. Chapter 5, ‘Measuring a nation’s income’, discusses the meaning
of gross domestic product and related statistics from the national income accounts. Chapter 6,
‘Measuring the cost of living’, discusses the measurement and use of the consumer price index, and
considers other measures of inflation.
The next three chapters describe the behaviour of the real economy in the long run over which
wages and prices are flexible. Chapter 7, ‘Production and growth’, examines the determinants
of the large variation in living standards over time and across countries. Chapter 8, ‘Saving,
investment and the financial system’, discusses the types of financial institutions in our economy
and examines the role of these institutions in allocating resources. Chapter 9, ‘The natural rate
of unemployment’, considers the long-run determinants of the unemployment rate, including
minimum-wage laws, the market power of unions, the role of efficiency wages and the efficacy of
job search.
Having described the long-run behaviour of the real economy, the book then turns to the long-
run behaviour of money and prices. Chapter 10, ‘The monetary system’, introduces the economist’s
concept of money and the role of the central bank in influencing the amount of money in the
economy. Chapter 11, ‘Inflation: Its causes and costs’, develops the link between money growth and
inflation and discusses the social costs of inflation.
The next two chapters present the macroeconomics of open economies. Chapter 12, ‘Open-
economy macroeconomics: Basic concepts’, explains the relationship among saving, investment
and the trade balance, the distinction between the nominal and real exchange rate, and the theory
of purchasing-power parity. Chapter 13, ‘A macroeconomic theory of the open economy’, presents
a classical model of the international flow of goods and capital. The model sheds light on various
issues, including the link between budget deficits and trade deficits and the macroeconomic effects
of trade policies. Because instructors differ in how much they emphasise this material, these
chapters were written so they could be used in different ways. Some instructors may choose to
cover chapter 12 but not chapter 13; others may skip both chapters; and others may choose to defer
the analysis of open-economy macroeconomics until the end of their courses.
After fully developing the long-run theory of the economy in chapters 7 to 13, the book turns
its attention to explaining short-run fluctuations around the long-run trend. This organisation
simplifies the teaching of the theory of short-run fluctuations because, at this point in the course,
students have a good grounding in many basic macroeconomic concepts. Chapter 14, ‘Aggregate
demand and aggregate supply’, begins with some facts about the business cycle and then
introduces the model of aggregate demand and aggregate supply. Chapter 15, ‘The influence of
xvi
Preface to this edition Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

monetary and fiscal policy on aggregate demand’, explains how policymakers can use the tools at
their disposal to shift the aggregate-demand curve. Chapter 16, ‘The short-run trade-off between
inflation and unemployment’, explains why policymakers who control aggregate demand face a
trade-off between inflation and unemployment. It examines why this trade-off exists in the short
run, why it shifts over time, and why it does not exist in the long run.
Chapter 17, ‘Contemporary macroeconomics topics’, is devoted to globalisation – how events in
one national economy flow over into other countries through interconnections in financial markets.
The Global Financial Crisis of 2008 is covered as an extreme example of interconnected economies.
Slow wages growth in Australia is discussed, as are the causes of the GFC.
The book concludes with chapter 18, ‘Five debates over macroeconomic policy’. This capstone
chapter considers five controversial issues facing policymakers: the proper degree of policy
activism in response to the business cycle, the choice between rules and discretion in the conduct
of monetary policy, the desirability of reaching zero inflation, the importance of balancing the
government’s budget, and the need for tax reform to encourage saving. For each issue, the chapter
presents both sides of the debate and encourages students to make their own judgements.
Robin E. Stonecash
Joshua S. Gans
Stephen P. King
Martin C. Byford
Kris Ivanovski
xvii
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202 Preface to this edition

PREFACE TO
THE ORIGINAL
EDITION
During my twenty-year career as a student, the course that excited me most was the two-semester
sequence on the principles of economics I took during my freshman year in college. It is no
exaggeration to say that it changed my life.
I had grown up in a family that often discussed politics over the dinner table. The pros and
cons of various solutions to society’s problems generated fervent debate. But, in school, I had
been drawn to the sciences. Whereas politics seemed vague, rambling and subjective, science was
analytic, systematic and objective. While political debate continued without end, science made
progress.
My freshman course on the principles of economics opened my eyes to a new way of thinking.
Economics combines the virtues of politics and science. It is, truly, a social science. Its subject
matter is society – how people choose to lead their lives and how they interact with one another.
But it approaches its subject with the dispassion of a science. By bringing the methods of science to
the questions of politics, economics tries to make progress on the fundamental challenges that all
societies face.
I was drawn to write this book in the hope that I could convey some of the excitement about
economics that I felt as a student in my first economics course. Economics is a subject in which a
little knowledge goes a long way. (The same cannot be said, for instance, of the study of physics or
the Japanese language.) Economists have a unique way of viewing the world, much of which can
be taught in one or two semesters. My goal in this book is to transmit this way of thinking to the
widest possible audience and to convince readers that it illuminates much about the world around
them.
I am a firm believer that everyone should study the fundamental ideas that economics has to
offer. One of the purposes of general education is to make people more informed about the world
in order to make them better citizens. The study of economics, as much as any discipline, serves
this goal. Writing an economics textbook is, therefore, a great honour and a great responsibility.
It is one way that economists can help promote better government and a more prosperous future.
As the great economist Paul Samuelson put it, ‘I don’t care who writes a nation’s laws, or crafts its
advanced treaties, if I can write its economics textbooks.’
N. Gregory Mankiw
July 2000
xviii
Preface to the original edition

TO THE STUDENTS
‘Economics is a study of mankind in the ordinary business of life.’ So wrote Alfred Marshall, the
great nineteenth-century economist, in his textbook Principles of Economics. Although we have
learned much about the economy since Marshall’s time, this definition of economics is as true today
as it was in 1890, when the first edition of his text was published.
Why should you, as a student in the twenty-first century, embark on the study of economics?
There are three main reasons.
The first reason to study economics is that it will help you understand the world in which you
live. There are many questions about the economy that might spark your curiosity. Why are houses
more expensive in Sydney than in Perth? Why do airlines charge less for a return ticket if the
traveller stays over a Saturday night? Why are some people paid so much to play tennis? Why are
living standards so meagre in many African countries? Why do some countries have high rates of
inflation while others have stable prices? Why are jobs easy to find in some years and hard to find in
others? These are just a few of the questions that a course in economics will help you answer.
The second reason to study economics is that it will make you a more astute participant in the
economy. As you go about your life, you make many economic decisions. While you are a student,
you decide how many years you will continue with your studies. Once you take a job, you decide
how much of your income to spend, how much to save and how to invest your savings. Someday
you may find yourself running a small business or a large corporation, and you will decide what
prices to charge for your products. The insights developed in the coming chapters will give you a
new perspective on how best to make these decisions. Studying economics will not by itself make
you rich, but it will give you some tools that may help in that endeavour.
The third reason to study economics is that it will give you a better understanding of the
potential and limits of economic policy. As a voter, you help choose the policies that guide the
allocation of society’s resources. When deciding which policies to support, you may find yourself
asking various questions about economics. What are the burdens associated with alternative forms
of taxation? What are the effects of free trade with other countries? What is the best way to protect
the environment? How does a government budget deficit affect the economy? These and similar
questions are always on the minds of policymakers whether they work for a local council or the
prime minister’s office.
Thus, the principles of economics can be applied in many of life’s situations. Whether the future
finds you reading the newspaper, running a business or running a country, you will be glad that you
studied economics.
Robin E. Stonecash
Joshua S. Gans
Stephen P. King
Martin C. Byford
Kris Ivanovski
N. Gregory Mankiw
xix
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202 To the students

ABOUT
THE
AUTHORS
Robin Stonecash is Director and the Departments of He has also undertaken
of Executive Education and the Ageing and Disability and consulting activities
Global EMBA at the University Community Services. (through his consulting
of Sydney’s Business School. Professor Stonecash lives firm, CoRE Research),
She was previously Director in Sydney with her husband, advising governments and
of Executive Education at Mark. private firms on the impact
the Business School at the of microeconomic reform
Joshua Gans holds the
University of Technology, and competition policy in
Jeffrey S. Skoll Chair in
Sydney, and Director of Australia. In 2007, he was
Technical Innovation and
Stonecash Associates, a awarded the Economic Society
Entrepreneurship and is
boutique consulting firm. of Australia’s Young Economist
a Professor of Strategic
She studied economics at Award for the Australian
Management at the Rotman
Swarthmore College, the economist under 40 who has
School of Management,
University of Wisconsin made the most significant
University of Toronto. He
and the University of contribution to economic
studied economics at the
New South Wales. She knowledge. In 2008, he was
University of Queensland
has taught a variety of elected as a Fellow of the
and Stanford University.
courses in microeconomics, Academy of Social Sciences
He currently teaches
macroeconomics and Australia.
digital economics and
international trade to Professor Gans lives in
entrepreneurship to MBA
undergraduates and graduates. Toronto with his partner,
students. Professor Gans’
She currently consults on Natalie Lippey, and children,
research ranges over many
strategy and negotiation as Belanna, Ariel and Annika.
fields of economics, including
well as teaching economics,
economic growth, game Stephen King is a
strategy and negotiation to
theory, regulation and the Commissioner with Australia’s
MBA and executive students.
economics of technological Productivity Commission
Professor Stonecash’s
change and innovation. His and an adjunct Professor
research interests currently
work has been published in of Economics at Monash
focus on agribusiness in
academic journals including University. He has previously
Australia and New Zealand
the American Economic been Dean of Business
and the impact of leadership
Review, Journal of Economic and Economics at Monash
programs on leadership
Perspectives, Journal of University, a member of
effectiveness. Her work has
Political Economy and the the Economic Regulation
been published in several
Rand Journal of Economics. Authority of Western
journals, including Economic
Joshua also has written the Australia, a member of the
Record, Prometheus and Public
popular books Parentonomics, National Competition Council
Performance and Management
Information Wants to be Shared, and a Commissioner at the
Review. Professor Stonecash
The Disruption Dilemma, Australian Competition
has also done several studies
Prediction Machines, Innovation and Consumer Commission.
on the efficiency gains
+ Equality and Economics After starting (and stopping)
from outsourcing. She has
in the Age of COVID-19. studying Forestry and
consulted widely for private
Currently, he is department Botany, Stephen completed
companies and government
editor at Management Science. an economics degree at
organisations such as AusAID
xx
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the Australian National Civil Engineering degree. N. Gregory Mankiw is
University. He completed his Realising that he had made a Professor of Economics at
PhD at Harvard University in terrible error in his choice of Harvard University. As a
1991. Stephen has taught a vocation, Martin went back to student, he studied economics
variety of courses, including university to study economics. at Princeton University and
teaching introductory He completed a PhD at the MIT. As a teacher, he has
economics for 11 years at University of Melbourne taught macroeconomics,
Harvard University, Monash in 2007. Martin has taught microeconomics, statistics and
University and the University introductory microeconomics principles of economics. He
of Melbourne. at RMIT campuses in Australia even spent one summer long
Professor King has and Singapore. ago as a sailing instructor on
researched and published in a Dr Byford’s research is Long Beach Island.
wide range of areas, including primarily in the fields of Professor Mankiw is a
law and economics, game industrial organisation and prolific writer and a regular
theory, corporate finance, microeconomic theory. He participant in academic and
privatisation and tax policy. has published in academic policy debates. His work has
From 2012 to 2016, he had journals including the been published in scholarly
a regular column in The Journal of Economic Theory, journals, such as the American
Conversation and he has a International Journal of Economic Review, Journal of
YouTube channel where you Industrial Organization and Political Economy and Quarterly
can view companion videos Journal of Economics and Journal of Economics, and in
for introductory economics. Management Strategy. Martin more popular forums, such
Stephen regularly provides also contributes to economic as The New York Times, The
advice to government, private policy debates on a diverse Boston Globe and The Wall
firms and the Courts on a range of topics, including the Street Journal. He is also the
range of issues relating to design of the banking system author of the best-selling
regulation and competition and labour market reform. intermediate-level textbook
policy. He is a Lay Member of Dr Byford lives in Melbourne Macroeconomics (Worth
the High Court of New Zealand with his wife, Siobhan, and Publishers). In addition to
and a Fellow of the Academy their son, Robert. his teaching, research and
of Social Sciences in Australia. writing, Professor Mankiw
Kris Ivanovski is a Scholarly
Professor King lives in is a research associate of the
Teaching Fellow within the
Melbourne with his wife, Mary. National Bureau of Economic
Department of Economics
Their two children, Jacqui Research, an adviser to the
at Monash University. He
and Rebecca, have grown up, Federal Reserve Bank of
has a demonstrated history
graduated, and run away from Boston and the Congressional
of working in the higher
home. Budget Office, and a member
education industry and is
of the ETS test development
Martin Byford is Senior skilled in Policy Analysis,
committee for the advanced
Lecturer of Economics at RMIT Stata, Economic Research,
placement exam in economics.
University. Prior to joining Data Analysis, and Statistical
Professor Mankiw lives
RMIT, he was Assistant Modelling. Kris’ strong
in Wellesley, Massachusetts,
Professor of Economics at education experience includes
with his wife and three
the University of Colorado at roles at the University of
children.
Boulder. Martin discovered Melbourne and Deakin, as well
economics during the final as a PhD focused in Economics
year of a combined Arts and from Monash University.
xxi
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ACKNOWLEDGEMENTS
In adapting this book, we have benefited from the input of a wide range of talented people. We
would like to thank all those people who helped us with this task. We wish to thank Professor
Lance Fisher of the Macquarie University, Ian Macfarlane and Glenn Stevens, former and current
Governors of the Reserve Bank of Australia, Trevor Stegman of the University of New South Wales
and Ian Harper of the University of Melbourne for useful discussions. We would also like to thank
those economists who read and commented on portions of this manuscript, including:
Dr Jayanath Ananda, Central Queensland University

Dr Dinusha Dharmaratna, Monash College
Ratbek Dzhumashev, Monash Unversity
Aunchisa Foo, University of Western Australia.
Parvinder Kler, Griffith University
Tommy Tang, QUT Business School
Additionally, we would like to extend our thanks to the reviewers from the previous editions, whose
feedback has helped guide the direction of each edition. We would also like to thank Isaac Callaway
for his contribution to the text.
We give special acknowledgement to Sue Hornby, formerly of the Australian Graduate School
of Management, Frank Lowy Library, now head librarian for the Reserve Bank of Australia. She
provided excellent research assistance. Thanks also to Pat Matthews.
Finally, we would like to thank Jan Libich for his contributions to previous editions of the text.
xxii
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PART ONE
01_Stonecash_8e_45658_SB_txt.indd 2 24/08/20 5:57 PM

Introduction
Chapter 1 Ten principles of economics

Chapter 2 Thinking like an economist
Chapter 3 Interdependence and the gains from trade

1
Ten principles
of economics
Learning objectives
After reading this chapter, you should be able to:
LO1.1 recognise that people face trade-offs when they make decisions, and discuss
how the nature of these trade-offs influences their behaviour
LO1.2 explain why trade among people or nations can be good for everyone, and
discuss why markets are a good, but not perfect, way to allocate resources
LO1.3 identify the factors that drive some significant trends in the overall economy.
4

Introduction
The word economy comes from the Greek word oikonomos, which means ‘one who manages a
household’. At first, this origin might seem peculiar. But, in fact, households and economies
have much in common.
A household faces many decisions. It must decide which members of the household
do which tasks and what each member receives in return: Who cooks dinner? Who does
the laundry? Who gets the extra dessert at dinner? Who gets to use the car? In short,
the household must allocate its scarce resources (time, dessert, petrol) among its various
members, taking into account each member’s abilities, efforts and desires.
Like a household, a society faces many decisions. A society must decide what jobs will
be done and who will do them. It needs some people to grow food, other people to make
clothing and still others to design computer software. Once society has allocated people
(as well as land, buildings and machines) to various jobs, it must also allocate the output of
the goods and services that they produce. It must decide who will eat caviar and who will
eat potatoes. It must decide who will drive a Porsche, and who will take the bus.
The management of society’s resources is important because resources are scarce.
Scarcity means that society has limited resources and therefore cannot produce all the scarcity
goods and services people wish to have. Just as each member of a household cannot get the limited nature of
society’s resources
everything he or she wants, each individual in society cannot attain the highest standard of
living to which he or she might aspire.
Economics is the study of how society manages its scarce resources. In most societies, economics
resources are allocated not by an all-powerful dictator but through the combined choices of the study of how
society manages its
millions of households and firms. Economists, therefore, study how people make decisions – scarce resources
how much they work, what they buy, how much they save and how they invest their savings.
Economists also study how people interact with one another. For instance, they examine
how the many buyers and sellers of a good interact to determine the price at which the good
is sold and the quantity that is sold. Finally, economists analyse the forces and trends that
affect the economy as a whole, including the growth in average income, the fraction of the
population that cannot find work and the rate at which prices are rising.
The study of economics has many facets, but it is unified by several central ideas. In
the rest of this chapter, we look at Ten Principles of Economics. Don’t worry if you don’t
understand them all at first or if you are not completely convinced. We explore these ideas
more fully in later chapters. The 10 principles are introduced here to give you an overview of
what economics is all about.
LO1.1 How people make decisions

There is no mystery about what an economy is. Whether we are talking about the economy
of Sydney, of Australia or of the whole world, an economy is just a group of people interacting
with one another as they go about their lives. Because the behaviour of an economy reflects
the behaviour of the individuals who make up the economy, our first four principles concern
individual decision making.
Principle 1: People face trade-offs

You may have heard the saying, ‘There’s no such thing as a free lunch’. To get something
that we like, we usually have to give up something else that we also like. Making decisions
requires trading off one goal against another.
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Consider Carol, a student, who must decide how to allocate her most valuable resource –
her time. She can spend all her time studying economics; she can spend all of her time
studying psychology; or she can divide her time between the two fields. For every hour
she studies one subject, she gives up an hour she could have used studying the other.
And for every hour Carol spends studying, she gives up an hour that she could have spent
sleeping, bike riding, watching YouTube clips, or working at her part-time job for some
extra spending money.
Consider parents deciding how to spend their family income. They can buy food or
clothing, or have a holiday. Or they can save some of their income for retirement or their
children’s education. When they choose to spend an extra dollar on one of these goods, they
have one less dollar to spend on some other good.
When people are grouped into societies, they face different kinds of trade-offs. The
classic trade-off is between ‘guns and butter’. The more society spends on national
defence (guns) to protect our shores from foreign aggressors, the less we can spend on
consumer goods (butter) to raise our standard of living. Also important in modern society
is the trade-off between a clean environment and a high level of income. Laws that
require firms to reduce pollution usually raise the cost of producing goods and services.
Because of these higher costs, these firms end up earning smaller profits, paying lower
wages, charging higher prices or some combination of these three. Thus, while pollution
regulations give us a cleaner environment and the improved health that comes with it,
this benefit comes at the cost of reducing the wellbeing of the regulated firms’ owners,
workers and customers.
efficiency Another trade-off society faces is between efficiency and equity. Efficiency means that
the property of society is getting the greatest possible benefit from its scarce resources. Equity means
society getting the
most it can from its that those benefits are distributed uniformly among society’s members. In other words,
scarce resources efficiency refers to the size of the economic pie, and equity refers to how the pie is divided
between individuals.
equity
the property of When government policies are being designed, these two goals often conflict. Consider,
distributing economic for instance, policies aimed at achieving a more equitable distribution of economic
prosperity uniformly
among the members wellbeing. Some of these policies, such as the age pension or unemployment benefits, try
of society to help those members of society who are most in need. Others, such as the individual
income tax, ask the financially successful to contribute more than others to support the
government. Although these policies achieve greater equity, they reduce efficiency. When
the government redistributes income from the rich to the poor, it reduces the reward for
working hard; as a result, people may work less and produce fewer goods and services. In
other words, as the government tries to cut the economic pie into more equitable slices, the
pie itself shrinks in size.
Recognising that people face trade-offs does not by itself tell us what decisions they
will or should make. A student should not abandon the study of psychology just because
doing so would increase the time available for the study of economics. Society should
not stop protecting the environment just because environmental regulations reduce our
material standard of living. The government should not ignore the disadvantaged just
because helping them would distort work incentives. Nonetheless, people are likely to make
good decisions only if they understand the options that they have available. Our study of
economics, therefore, starts by acknowledging life’s trade-offs.
Principle 2: The cost of something is what you give up to get it

Because people face trade-offs, making decisions requires comparing the costs and benefits
of alternative courses of action. In many cases, however, the cost of some action is not as
obvious as it might first appear.
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Consider the decision whether to go to university. The benefits include intellectual
enrichment and a lifetime of better job opportunities. But what is the cost? To answer this
question, you might be tempted to add up the money you or your parents spend on fees,
books, rent and food. Yet this total does not truly represent what you give up to spend a year
at university.
There are two problems with this calculation. First, it includes some things that are not
really costs of university education. Even if you quit university, you would need a place to
sleep and food to eat. Rent and food are costs of going to university only to the extent that
they may be more expensive because you are at university. Second, this calculation ignores
the largest cost of going to university – your time. When you spend a year listening to
lectures, reading textbooks and writing assignments, you cannot spend that time working
at a job and earning money. For most students, the wages given up to attend university are
the largest cost of their education.
The opportunity cost of an item is the best alternative you give up to get that item. opportunity cost
When making any decision, decision makers should take into account the opportunity the best alternative
that must be given up
costs of each possible action. In fact, they usually do. For example, some young athletes can to obtain some item
earn millions if they forgo university and play professional sports. Their opportunity cost of
university is very high. Not surprisingly, they often decide that the benefit of a university
education is not worth the opportunity cost.
Principle 3: Rational people think at the margin

Economists normally assume that people are rational. Rational people systematically and rational people
purposefully do the best they can do to achieve their objectives, given the opportunities people who
systematically and
they have. As you study economics, you will encounter firms that decide how many workers purposefully do the
to hire and how much of their product to manufacture and sell to maximise profits. You will best they can to
achieve their objectives
encounter individuals who decide how much time to spend working, and what goods and
services to buy with the resulting income to achieve the highest possible level of satisfaction.
Rational people know that decisions in life are rarely black and white but usually involve
shades of grey. At dinnertime, you don’t ask yourself ‘Should I fast or eat like a pig?’ More
likely, the question you face is ‘Should I eat that extra spoonful of mashed potatoes?’ When
exams roll around, your decision is not between blowing them off and studying 24 hours
a day, but whether to spend an extra hour reviewing your notes instead of posting selfies
on Instagram. Economists use the term marginal change to describe a small incremental marginal change
adjustment to an existing plan of action. Keep in mind that margin means ‘edge’, so marginal a small incremental
adjustment to a
changes are adjustments around the edges of what you are doing. Rational people often plan of action
make decisions by comparing marginal benefits and marginal cost.
For example, suppose you are considering watching a movie tonight. You pay $12 a
month for a streaming service that gives you unlimited access to its films and TV shows,
and you typically watch eight movies a month. What cost should you take into account
when deciding whether to watch another movie? You might at first think the answer
is $12/8, or $1.50, which is the average cost
Source: Shutterstock.com/rafapress
of a movie. More relevant for your decision,

however, is the marginal cost – the extra cost
that you would incur by streaming another film.
Here, the marginal cost is zero because you pay
the same $12 for the service regardless of how
many movies you watch. In other words, at the
margin, streaming a movie is free. The only cost
of watching a movie tonight is the time it takes
away from other activities, such as working at a
Many streaming services set the
job or (better yet) reading this textbook.
marginal cost of a movie equal to zero.
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Thinking at the margin also works for business decisions as well. Consider an airline
deciding how much to charge passengers who fly standby. Suppose that flying a 200-seat
plane from Brisbane to Perth costs the airline $100 000. In this case, the average cost of
each seat is $100 000/200, which is $500. One might be tempted to conclude that the airline
should never sell a ticket for less than $500. But the airline can often increase its profits
by thinking at the margin. Imagine that a plane is about to take off with 10 empty seats
and a standby passenger waiting at the gate will pay $300 for a seat. Should the airline sell
the ticket? Of course it should. If the plane has empty seats, the cost of adding one more
passenger is tiny. Although the average cost of flying a passenger is $500, the marginal cost
is merely the cost of the sandwich and coffee that the extra passenger will consume and
the small bit of jet fuel needed to carry the extra passenger’s weight. As long as the standby
passenger pays more than the marginal cost, selling the ticket is profitable. Thus, a rational
airline can increase profits by thinking at the margin.
Marginal decision making can help explain some otherwise puzzling economic
phenomena. Here is a classic question: Why is water so cheap, while diamonds are so
expensive? Humans need water to survive, while diamonds are unnecessary. Yet people are
willing to pay much more for a diamond than for a cup of water. The reason is that a person’s
willingness to pay for a good is based on the marginal benefit that an extra unit of the good
would yield. The marginal benefit, in turn, depends on how many units a person already has.
Although water is essential, the marginal benefit of an extra cup is small because water is
plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so rare,
the marginal benefit of an extra diamond is large.
A rational decision maker takes an action if and only if the action’s marginal benefit
exceeds its marginal cost. This principle explains why people use streaming services as
much as they do, why airlines are willing to sell tickets below average cost, and why people
are willing to pay more for diamonds than for water. It can take some time to get used to the
logic of marginal thinking, but the study of economics will give you ample opportunity to
practise.
Principle 4: People respond to incentives

incentive An incentive is something that induces a person to act, such as the prospect of a
something that
punishment or reward. Because rational people make decisions by comparing costs and
induces a person to act
benefits, they respond to incentives. You will see that incentives play a central role in the
study of economics. One economist went so far as to suggest that the entire field could be
summarised simply: ‘People respond to incentives. The rest is commentary.’
Incentives are key to analysing how markets work. For example, when the price of apples
rises, people decide to eat fewer apples. At the same time, apple orchards decide to hire more
workers and harvest more apples. In other words, a higher price in a market provides an
incentive for buyers to consume less and an incentive for sellers to produce more. As we
will see, the influence of prices on the behaviour of consumers and producers is crucial to
understanding how the economy allocates scarce resources.
Public policymakers should never forget about incentives. Many policies change the
costs or benefits that people face and, as a result, alter their behaviour. A tax on petrol, for
instance, encourages people to drive smaller, more fuel-efficient cars. That is one reason
people drive smaller cars in Europe and Australia, where petrol taxes are higher, than in
the United States, where petrol taxes are low. A petrol tax also encourages people to take
public transportation rather than drive, to live closer to where they work, or to switch to
electric cars.
When policymakers fail to consider how their policies affect incentives, they often end
up facing unintended consequences. For example, consider public policy towards seat belts
and car safety. Today, all cars have seat belts, but this was not the case in the 1950s. In the
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late 1960s, the rising death toll from motor vehicle accidents generated much public concern
over car safety. State and federal governments responded with laws requiring new cars to
be equipped with seat belts, and requiring drivers and passengers to wear their seat belts.
How does a seat belt law affect car safety? The direct effect is obvious. When a person
wears a seat belt, the likelihood of surviving a major accident rises. But that is not the
end of the story. The law also affects behaviour by altering incentives. The relevant
behaviour here is the speed and care with which drivers operate their cars. Driving
slowly and carefully is costly because it uses the driver’s time and energy. When deciding
how safely to drive, rational people compare, perhaps unconsciously, the marginal
benefit from safer driving with the marginal cost. As a result, they drive more slowly
and carefully when the benefit of increased safety is high. For example, when roads are
wet or visibility is poor, people drive with greater care and attention than they do when
conditions are clear.
Consider how a seat belt law alters a driver’s cost–benefit calculation. Seat belts
make accidents less costly by reducing the risk of injury or death. In other words, seat
belts reduce the benefits of slow and careful driving. People respond to wearing seat
belts as they would to an improvement in road conditions – by driving faster and less
carefully. The result of a seat belt law, therefore, is a larger number of accidents. The
decline in safe driving has a clear, adverse impact on pedestrians, who are more likely
to find themselves in an accident but (unlike the drivers) don’t have seat belts to give
them protection.
At first, this discussion of incentives and seat belts might seem like idle speculation. Yet,
in a classic 1975 study, economist Sam Peltzman argued that car safety laws in the United
States have, in fact, had many of these effects. According to Peltzman’s evidence, US laws
give rise to both fewer deaths per accident, and also to more accidents. He concluded that
the net result was little change in the number of driver deaths and an increase in the number
of pedestrian deaths.
Peltzman’s analysis of car safety is an offbeat and controversial example of the
general principle that people respond to incentives. When analysing any policy, we must
consider not only the direct effects but also the less obvious, indirect effects that work
through incentives. If the policy changes incentives, it will cause people to alter their
behaviour.
Choosing when the stork comes CASE

In the decade between 2004 and 2014, the Australian Government made a payment STUDY
to parents for every baby born. These payments were known as the ‘baby bonus’, and
ranged in value between $3000 and $5437 across the lifetime of the scheme. The story of
the baby bonus has lessons for how people respond to incentives and why governments
(and others) need to anticipate these responses.
In May 2004, the then Treasurer, Peter Costello, announced a $3000 payment (rising
to $5000 in 2008) for every child born after 1 July 2004. This meant that the parents
of someone whose birthday was 30 June 2004 or earlier would receive nothing. But
hold off a day or so, and they would get $3000. This created an incentive for parents
to delay births, if they could. And by agreeing with their doctors to schedule planned
caesareans and inductions a little later, births could be moved.
The graph in Figure 1.1 shows what happened.
Notice that there was a dip in births in the last week of June followed by a sharp rise
on 1 July 2004. Indeed, that day had the most number of recorded births on a single
day in Australian history. And if you think this might just be ‘fiddling the books’, 2 July
had the seventh-highest number of births.
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FIGURE 1.1 Births in Australia, June–July 2004
No. of
births
900
800
700
600
500
400
June 3 June 10 June 17 June 24 July 1 July 7 July 14 July 21 July 28
Source: Joshua Gans and Andrew Leigh, ‘Born on the First of July’, Journal of Public Economics, Vol. 93,
Nos 1–2, February 2009, pp. 246–63.
In their paper ‘Born on the First of July’, Joshua Gans and Andrew Leigh estimated
that 1167 births were shifted from June to July that year, all as a result of the baby bonus.
Medical organisations raised concerns about the health consequences of maternity
hospital congestion caused by this, while economists argued that the policy should have
been ‘phased in’ so there were no big jumps in payments on any given day. Nonetheless,
politicians have failed to heed these warnings. On 1 July 2006, the Howard government
raised the baby bonus by $834. Gans and Leigh again found shifts in birth timing, but of a
lower magnitude (around 700 births).
Source: Joshua Gans and Andrew Leigh, ‘Born on the First of July’, Journal of Public Economics,
Vol. 93, Nos 1–2, February 2009, pp. 246–63.
Questions 2 How would you expect people to

1 The federal government ended respond to these incentives?
baby bonus payments in 2014. What
incentives are created by the ending
of the payments?

Describe an important trade-off you recently faced. Give an example of some action that
has both a monetary and non-monetary opportunity cost. Describe an incentive your
parents offered you in an effort to influence your behaviour.
LO1.2 How people interact

The first four principles discussed how individuals make decisions. As we go about our lives,
many of our decisions affect not only ourselves but other people as well. The next three
principles present some key ideas about how people interact with one another.
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Principle 5: Trade can make everyone better off
You may have heard on the news how Australian workers compete with overseas workers
for jobs, and Australian businesses compete with overseas firms for sales. In some ways, this
competition is real because Australian workers and firms produce many of the same goods
that are produced overseas. A company mining iron ore in the Pilbara competes for the same
customers as iron ore producers in Brazil, South Africa and Peru. Banks in Victoria compete
with those in Hong Kong and New York to provide financial services.
Yet it is easy to be misled when thinking about competition among countries. Trade
between Australia and another country is not like a sports contest, where one side wins
and the other side loses. The opposite is true: trade between two countries can make each
country better off.
To see why, consider how trade affects your family. When a member of your family looks
for a job, he or she competes against members of other families who are looking for jobs.
Families also compete against one another when they go shopping, because each family
wants to buy the best goods at the lowest prices. So, in a sense, each family in the economy
is competing with all other families.
Despite this competition, your family would not be better off isolating itself from all
other families. If it did, your family would need to grow its own food, sew its own clothes
and build its own home. Clearly, your family gains much from trading with others. Trade
allows each person to specialise in the activities he or she does best, whether it is farming,
sewing or home building. By trading with others, people can buy a greater variety of goods
and services at lower cost.
Like families, countries also benefit from being able to trade with one another. Trade
allows countries to specialise in what they do best and to enjoy a greater variety of goods
and services. The Chinese, the Japanese, the Germans and the Indonesians are as much our
partners in the world economy as they are our competitors.
Outsourcing your own job

IN THE
The principle that ‘trade can make everyone better off’ is illustrated by this case
of an American software developer who outsourced his own job to China.
NEWS
Software developer Bob outsources own job and whiles away
shifts on cat videos
by Caroline Davies
When a routine security check by a US-based company showed someone was
repeatedly logging on to their computer system from China, it naturally sent alarm bells
ringing. Hackers were suspected and telecoms experts were called in.
It was only after a thorough investigation that it was revealed that the culprit was
not a hacker, but ‘Bob’ (not his real name), an ‘inoffensive and quiet’ family man and the
company’s top-performing programmer, who could be seen toiling at his desk day after
day and staring diligently at his monitor.
For Bob had come up with the idea of outsourcing his own job – to China. So, while a
Chinese consulting firm got on with the job he was paid to do, on less than one-fifth of
his salary, he whiled away his working day surfing Reddit, eBay and Facebook.
The extraordinary story has been revealed by Andrew Valentine, senior investigator
at US telecoms firm Verizon Business, on its website, securityblog.verizonbusiness.com.
Verizon’s risk team was called by the unnamed critical infrastructure company last
year, ‘asking for our help in understanding some anomalous activity that they were
witnessing in their VPN logs’, wrote Valentine.
The company had begun to allow its software developers to occasionally work from
home and so had set up ‘a fairly standard VPN [virtual private network] concentrator’ to
facilitate remote access.
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When its IT security department started actively monitoring logs being generated
at the VPN, ‘What they found startled and surprised them: an open and active VPN
connection from Shenyang, China! As in this connection was live when they discovered
it,’ wrote Valentine.
What was more, the developer whose credentials were being used was sitting at his
desk in the office.
‘Plainly stated, the VPN logs showed him logged in from China, yet the employee is
right there, sitting at his desk, staring into his monitor.’
Verizon’s investigators discovered ‘almost daily connections from Shenyang, and
occasionally these connections spanned the entire workday’.
The employee, whom Valentine calls Bob, was in his mid-40s, a ‘family man,
inoffensive and quiet. Someone you wouldn’t look twice at in an elevator.’
But an examination of his workstation revealed hundreds of pdf invoices from a third
party contractor/developer in Shenyang.
‘As it turns out, Bob had simply outsourced his own job to a Chinese consulting firm.
Bob spent less than one-fifth of his six-figure salary for a Chinese firm to do his job for
him.’
He had physically FedExed his security RSA ‘token’, needed to access the VPN, to China
so his surrogates could log in as him.
When the company checked his web-browsing history, a typical ‘work day’ for Bob
was: 9am, arrive and surf Reddit for a couple of hours, watch cat videos; 11.30am, take
lunch; 1pm, eBay; 2pm-ish, Facebook updates, LinkedIn; 4.40pm–end of day, update
email to management; 5pm, go home.
The evidence, said Valentine, even suggested he had the same scam going across
multiple companies in the area.
‘All told, it looked like he earned several hundred thousand dollars a year, and only
had to pay the Chinese consulting firm about fifty grand annually’.
Meanwhile, his performance review showed that, for several years in a row, Bob had
received excellent remarks for his codes which were ‘clean, well written and submitted
in a timely fashion’.
‘Quarter after quarter, his performance review noted him as the best developer in
the building,’ wrote Valentine.
Bob no longer works for the company.
Source: ‘Software developer Bob outsources own job and whiles away shifts on cat videos’, by
Caroline Davies, The Guardian, 16 January 2013.
Copyright Guardian News & Media Ltd 2020.
Principle 6: Markets are usually a good way to organise economic activity

The collapse of communism in the Soviet Union and Eastern Europe in the late 1980s and
early 1990s was one of the last century’s most transformative events. Communist countries
operated on the premise that government workers were in the best position to guide
economic activity. These workers, called central planners, decided what goods and services
were produced, how much was produced and who produced and consumed these goods and
services. The theory behind central planning was that only the government could organise
economic activity in a way that promoted economic wellbeing for the country as a whole.
market economy
an economy that Most countries that once had centrally planned economies have abandoned this system
allocates resources and instead have adopted market economies. In a market economy, the decisions of a
through the
decentralised decisions central planner are replaced by the decisions of millions of firms and households. Firms
of many firms and decide whom to hire and what to make. Households decide which firms to work for and what
households as they
interact in markets for
to buy with their incomes. These firms and households interact in the marketplace, where
goods and services prices and self-interest guide their decisions.
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At first glance, the success of market economies is puzzling. In a market economy, no
one is looking out for the economic wellbeing of society as a whole. Decisions are made by
millions of self-interested households and firms. It might sound like chaos. Yet this is not the
case. Market economies have proven remarkably successful in organising economic activity
to promote overall prosperity.
In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, economist
Adam Smith explained the success of market economies. He noted that households and
firms interacting in markets act as if they are guided by an ‘invisible hand’ that leads them to
desirable market outcomes. One of our goals in this book is to understand how this invisible
hand works its magic.
As you study economics, you will learn that prices are the instrument with which the
invisible hand directs economic activity. In any market, buyers look at the price when
deciding how much to demand, and sellers look at the price when deciding how much to
supply. As a result of these decisions, prices reflect both the value of a good to society and
the cost to society of making the good. Smith’s great insight was that prices adjust to guide
these individual buyers and sellers to reach outcomes that, in many cases, maximise the
wellbeing of society as a whole.
Smith’s insight has an important corollary: When a government prevents prices
from adjusting naturally to supply and demand, it impedes the invisible hand’s ability to
coordinate the millions of households and firms that make up the economy. This corollary
explains why taxes adversely affect the allocation of resources. Taxes distort prices and
thus the decisions of households and firms. It also explains the problems caused by policies
that directly control prices, such as rent control. And it explains the failure of communism.
In communist countries, prices were not determined in the marketplace but were dictated
by government central planners. These planners lacked the necessary information about
consumers’ tastes and producers’ costs, which in a market economy is reflected in prices.
Central planners failed because they tried to run the economy with one hand tied behind
their backs – the invisible hand of the marketplace.
FYI
Adam Smith and the role of markets KEY
FIGURES
Adam Smith is often seen as the founder of modern economics.
When his great book An Inquiry into the Nature and Causes of the
Wealth of Nations was published in 1776, England and Europe
were going through a period of major social, political and economic
upheaval. The Industrial Revolution was changing the economic
landscape just as the American and the French revolutions were
to change the political and social landscape. Smith’s book reflects
a point of view that was gaining importance at the time – that
individuals are usually best left to their own devices, without the
heavy hand of government directing their actions. This political
philosophy provides the intellectual foundation for the market
Adam Smith
economy, and for a free society more generally.
Why do decentralised market economies work well? Is it
because people can be counted on to treat one another with love and kindness? Not at
all. Here is Adam Smith’s description of how people interact in a market economy:
Man has almost constant occasion for the help of his brethren, and it is in vain for him to
expect it from their benevolence only. He will be more likely to prevail if he can interest
their self-love in his favour, and show them that it is for their own advantage to do for him
what he requires of them … Give me that which I want, and you shall have this which you
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want, is the meaning of every such offer; and it is in this manner that we obtain from one
another the far greater part of those good offices which we stand in need of.
It is not from the benevolence of the butcher, the brewer, or the baker that we expect
our dinner, but from their regard to their own interest. We address ourselves, not to their
humanity but to their self-love, and never talk to them of our own necessities but of their
advantages. Nobody but a beggar chooses to depend chiefly upon the benevolence of his
fellow-citizens …
Every individual … neither intends to promote the public interest, nor knows how much
he is promoting it … He intends only his own gain, and he is in this, as in many other cases,
led by an invisible hand to promote an end which was no part of his intention. Nor is it
always the worse for the society that it was no part of it. By pursuing his own interest he
frequently promotes that of the society more effectually than when he really intends to
promote it.
Smith is saying that participants in the economy are motivated by self-interest and that
the ‘invisible hand’ of the marketplace guides this self-interest into promoting general
economic wellbeing.
Many of Smith’s insights remain at the centre of modern economics. Our analysis
in the coming chapters will allow us to express Smith’s ideas and conclusions more
precisely and to analyse fully the strengths and weaknesses of a market-based
economy.
Principle 7: Governments can sometimes improve market outcomes

If the invisible hand of the market is so great, why do we need government? One purpose of
studying economics is to refine your view about the proper role and scope of government policy.
One reason we need government is that the invisible hand can work its magic only if
government enforces the rules and maintains the institutions that are key to a market
property rights economy. Most important, markets work only if property rights are enforced so individuals
the ability of an
can own and control scarce resources. A farmer won’t grow food if she expects her crop to
individual to own and
exercise control over be stolen; a restaurant won’t serve meals unless it is assured that customers will pay before
scarce resources they leave; and a film company won’t produce movies if too many potential customers avoid
paying by making illegal copies. We all rely on government-provided police and courts to
enforce our rights over the things we produce – and the invisible hand depends on our ability
to enforce those rights.
Another reason we need government is that, although the invisible hand is powerful,
it is not omnipotent. There are two broad rationales for a government to intervene in the
market failure economy and change the allocation of resources that people would choose on their own: to
a situation in which
a market left on its
promote efficiency and to promote equity. That is, most policies aim either to enlarge the
own fails to allocate economic pie or to change how the pie is divided.
resources efficiently Consider first the goal of efficiency. Although the invisible hand usually leads markets
externality
to allocate resources to maximise the size of the economic pie, this is not always the case.
the uncompensated Economists use the term market failure to refer to a situation in which the market on
impact of one its own fails to allocate resources efficiently. As we will see, one possible cause of market
person’s actions
on the wellbeing failure is an externality, which is the impact of one person’s actions on the wellbeing of a
of a bystander. A bystander. The classic example of an externality is pollution. When the production of a good
positive externality
makes the bystander pollutes the air and creates health problems for those who live near the factories, the market
better off. A negative on its own may fail to take this cost into account. Another possible cause of market failure
externality makes the
bystander worse off. is market power, which refers to the ability of a single person or firm (or a small group
of them) to unduly influence market prices. For example, suppose that everyone in town
market power needs water but there is only one well. The owner of the well does not face the rigorous
the ability of a single
economic actor competition with which the invisible hand normally keeps self-interest in check; she may
(or small group of take advantage of this opportunity by restricting the output of water so she can charge a
actors) to have a
substantial influence
higher price. In the presence of externalities or market power, well-designed public policy
on market prices can enhance economic efficiency.
14

Now consider the goal of equity. Even when the invisible hand is yielding efficient
outcomes, it can nonetheless leave big differences in economic wellbeing. A market economy
rewards people according to their ability to produce things that other people are willing to
pay for. The world’s best soccer player earns more than the world’s best chess player simply
because people are willing to pay more to see soccer than chess. The invisible hand does not
ensure that everyone has sufficient food, decent clothing and adequate health care. Many
public policies, such as the tax and social welfare systems, aim to achieve a more equitable
distribution of economic wellbeing.
To say that the government can improve on market outcomes at times does not mean
that it always will. Public policy is made by politicians operating in a political process that is
far from perfect. Sometimes policies are designed simply to reward the politically powerful.
Sometimes they are made by well-intentioned leaders who are not fully informed. As you
study economics, you will become a better judge of when a government policy is justifiable
because it promotes efficiency or equity and when it is not.

Why is a country better off not isolating itself from all other countries? Why do we have
markets and, according to economists, what roles should governments play in them?
LO1.3 How the economy as a whole works

We started by discussing how individuals make decisions and then looked at how people
interact with one another. All these decisions and interactions together make up ‘the
economy’. The last three principles concern the workings of the economy as a whole.
Principle 8: A country’s standard of living depends on its ability to produce goods

and services
The differences in living standards around the world are staggering. In 2017, the average
Australian had an income (in US dollars) of about $50 000. In the same year, the average
South Korean earned $37 000, the average New Zealander earned $39 000 and the average
Indian earned $7000. Not surprisingly, this large variation in average income is reflected
in various measures of the quality of life. Citizens of high-income countries have more
computers, more cars, better nutrition, better health care, and longer life expectancy than
do citizens of low-income countries.
Changes in living standards over time are also large. In Australia, incomes have
historically grown about 2 per cent per year (after adjusting for changes in the cost of
living). At this rate, average real income doubles every 35 years.
What explains these large differences in living standards among countries and over
time? The answer is surprisingly simple. Almost all variation in living standards is
attributable to differences in countries’ productivity – that is, the amount of goods and productivity
services produced by each hour of a worker’s time. In nations where workers can produce a the quantity of goods
and services produced
large quantity of goods and services per hour, most people enjoy a high standard of living; from each hour of
in nations where workers are less productive, most people must endure a more meagre a worker’s time
existence. Similarly, the growth rate of a nation’s productivity determines the growth rate
of its average income.
The relationship between productivity and living standards is simple, but its implications
are far-reaching. If productivity is the primary determinant of living standards, other
15
Chapter
02-200-202

explanations must be less important. For example, it might be tempting to credit labour
unions or award wage laws for the rise in living standards of Australian workers over the
past century. Yet the real hero of Australian workers is their rising productivity.
The relationship between productivity and living standards also has profound
implications for public policy. When thinking about how any policy will affect living
standards, the key question is how it will affect our ability to produce goods and services.
To boost living standards, policymakers need to raise productivity by ensuring that workers
are well educated, have the tools needed to produce goods and services and have access to
the best available technology.
Principle 9: Prices rise when the government prints too much money
In January 1921, a daily newspaper in Germany cost 0.30 of a mark. Less than two years
later, in November 1922, the same newspaper cost 70 000 000 marks. All other prices in
the economy rose by similar amounts. This episode is one of history’s most spectacular
inflation examples of inflation, an increase in the overall level of prices in the economy.
an increase in the
Although Australia and New Zealand have never experienced inflation even close to that
overall level of prices
in the economy in Germany in the 1920s, inflation has at times been an economic problem. During the 1970s,
for instance, the overall level of prices more than doubled, and political leaders lived under
the catchcry ‘Fight Inflation First!’ In contrast, in the first two decades of the twenty-first
century, inflation has run at about 2.5 per cent per year; at this rate, it would take almost 30
years for prices to double. Because high inflation imposes various costs on society, keeping
inflation at a reasonable rate is a goal of economic policymakers around the world.
Source: © Tribune Content Agency All rights reserved.
What causes inflation? In almost all cases of large or persistent inflation, the culprit
is growth in the quantity of money. When a government creates large quantities of the
nation’s money, the value of the money falls. In Germany in the early 1920s, when prices
were on average tripling every month, the quantity of money was also tripling every month.
Although less dramatic, the economic history of Australia, New Zealand and the United
States points to a similar conclusion – the high inflation of the 1970s was associated with
rapid growth in the quantity of money, and the return of low inflation in the 1990s was
associated with slower growth in the quantity of money.
16

Principle 10: Society faces a short-run trade-off between inflation
and unemployment
While an increase in the quantity of money primarily has the effect of raising prices in the
long run, in the short run the story is more complex. Most economists describe the short-run
effects of money growth as follows:
• Increasing the amount of money in the economy stimulates the overall level of
spending and thus the demand for goods and services.
• Higher demand may over time cause firms to raise their prices, but in the meantime, it
also encourages them to hire more workers and produce a larger quantity of goods and
services.
• More hiring means lower unemployment.
This line of reasoning leads to one final economy-wide trade-off: a short-run trade-off
between inflation and unemployment.
Although some economists still question these ideas, most accept that society faces
a short-run trade-off between inflation and unemployment. This simply means that, over
a period of a year or two, many economic policies push inflation and unemployment in
opposite directions. Policymakers face this trade-off regardless of whether inflation and
unemployment both start out at high levels (as they did in the 1980s), at low levels (as they
did in the late 1990s), or someplace in between. This short-run trade-off plays a key role in
the analysis of the business cycle – the irregular and largely unpredictable fluctuations in business cycle
economic activity, as measured by the production of goods and services or the number of fluctuations in
economic activity,
people employed. such as employment
Policymakers can exploit the short-run trade-off between inflation and unemployment and production
using various policy instruments. By changing the amount that the government spends, the
amount it taxes, and the amount of money it prints, policymakers can influence the overall
demand for goods and services. Changes in demand in turn influence the combination of
inflation and unemployment that the economy experiences in the short run. Because these
instruments of economic policy are so powerful, how policymakers should use them to
control the economy, if at all, is a subject of continuing debate.

What factors determine a country’s standard of living? How does printing more money
affect a country’s economy in the long run and in the short run?
Conclusion: The big ideas underpinning economics

You now have a taste of what economics is all about. In the coming chapters, we will develop
many specific insights about people, markets and economies. Mastering these insights will
take some effort, but the task is not overwhelming. The field of economics is based on a few
big ideas that can be applied in many different situations.
17
Chapter
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Throughout this book, we will refer to the Ten Principles of Economics introduced in this
chapter and summarised in Table 1.1. Keep these building blocks in mind: Even the most
sophisticated economic analysis is founded on these 10 principles.
TABLE 1.1 Ten principles of economics

How people make decisions 1: People face trade-offs.
2: The cost of something is what you give up to get it.
3: Rational people think at the margin.
4: People respond to incentives.
How people interact 5: Trade can make everyone better off.
6: Markets are usually a good way to organise economic activity.
7: Governments can sometimes improve market outcomes.
How the economy as a whole 8: A country’s standard of living depends on its ability to produce
works goods and services.
9: Prices rise when the government prints too much money.
10: S
ociety faces a short-run trade-off between inflation and
unemployment.
18

STUDY TOOLS
Summary
LO1.1 The fundamental lessons about individual decision making are that people face trade-
offs among alternative goals, that the cost of any action is measured in terms of forgone
opportunities, that rational people make decisions by comparing marginal costs and
marginal benefits, and that people change their behaviour in response to the incentives
they face.
LO1.2 The fundamental lessons about interactions among people are that trade can be
mutually beneficial, that markets are usually a good way of coordinating trade among
people, and that governments can potentially improve market outcomes if there is
some market failure or if the market outcome is inequitable.
LO1.3 The fundamental lessons about the economy as a whole are that productivity is
the ultimate source of living standards, that money growth is the ultimate source
of inflation, and that society faces a short-run trade-off between inflation and
unemployment.
Key concepts
business cycle, p. 17 market economy, p. 12
economics, p. 5 market failure, p. 14
efficiency, p. 6 market power, p. 14
equity, p. 6 opportunity cost, p. 7
externality, p. 14 productivity, p. 15
incentive, p. 8 property rights, p. 14
inflation, p. 16 rational people, p. 7
marginal change, p. 7 scarcity, p. 5
Apply and revise

1 Give three examples of important trade-offs that you face in your life.
2 What alternatives would you include when determining your opportunity cost of a dinner at
a fancy restaurant?
3 Water is necessary for life. Is the marginal benefit of a glass of water large or small?
4 Why should policymakers think about incentives?
5 Why isn’t trade among countries like a game with some winners and some losers?
6 What does the ‘invisible hand’ of the marketplace do?
7 What are ‘efficiency’ and ‘equity’, and what do they have to do with government policy?
8 Why is productivity important?
9 What is inflation, and what causes it?
10 How are inflation and unemployment related in the short run?
Practice questions
Multiple choice
1 Economics is best defined as the study of
a how society manages its scarce resources.
b how to run a business most profitably.
c how to predict inflation, unemployment and stock prices.
d how the government can stop the harm from unchecked self-interest.
2 Your opportunity cost of going to a movie is
a the price of the ticket.
b the price of the ticket plus the cost of any drink and popcorn you buy at the theatre.
c the total cash expenditure needed to go to the movie plus the value of your time.
d zero, as long as you enjoy the movie and consider it a worthwhile use of time and
money.
19
Chapter
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3 A marginal change is one that
a is not important for public policy.
b incrementally alters an existing plan.
c makes an outcome inefficient.
d does not influence incentives.
4 Adam Smith’s ‘invisible hand’ refers to
a the subtle and often hidden methods that businesses use to profit at consumers’
expense.
b the ability of free markets to reach desirable outcomes, despite the self-interest of
market participants.
c the ability of government regulation to benefit consumers, even if the consumers are
unaware of the regulations.
d the way in which producers or consumers in unregulated markets impose costs.
5 Governments may intervene in a market economy in order to
a protect property rights.
b correct a market failure due to externalities.
c achieve a more equal distribution of income.
d all of the above
6 If a nation has high and persistent inflation, the most likely explanation is
a the central bank creating excessive amounts of money.
b unions bargaining for excessively high wages.
c the government imposing excessive levels of taxation.
d firms using their monopoly power to enforce excessive price hikes.

1 Describe some of the trade-offs faced by each of the following:
a a family deciding whether to buy a new car
b a politician deciding how much to increase spending on national parks
c a company director deciding whether to open a new factory
d a professor deciding how much to prepare for a lecture
e a recent university graduate deciding whether to undertake graduate studies.
2 You are trying to decide whether to take a holiday. Most of the costs of the holiday
(airfare, hotel, forgone wages) are measured in dollars, but the benefits of the holiday are
psychological. How can you compare the benefits with the costs?
3 You were planning to spend Saturday working at your part-time job, but a friend asks you
to go swimming at the beach. What is the true cost of going swimming? Now suppose that
you had been planning to spend the day studying at the library. What is the cost of going
swimming in this case? Explain.
4 You win $100 in a lottery. You have a choice between spending the money now and putting
it away for a year in a bank account that pays 5 per cent interest. What is the opportunity
cost of spending the $100 now?
5 The company that you manage has invested $5 million in developing a new product, but
the development is not quite finished. At a recent meeting, your salespeople report that the
introduction of competing products has reduced the expected sales of your new product to
$3 million. If it would cost $1 million to finish development, should you go ahead and do so?
What is the most that you should pay to complete development?
6 There has been some discussion about changes to unemployment benefits that will result
in payments being withdrawn after two years for those able to work.
a How do these changes in the laws affect the incentives for working?
b How might these changes represent a trade-off between equity and efficiency?
7 Explain whether each of the following government activities is motivated by a concern
about equity or a concern about efficiency. In the case of efficiency, discuss the type of
market failure involved.
a regulating fixed-line telephone prices
b providing some poor people with vouchers that can be used to buy food
c prohibiting smoking in public places
20

d breaking up Google and Facebook into smaller companies, each focused on a different
product (for example, search, advertising, mobile operating systems)
e imposing higher personal income tax rates on people with higher incomes
f instituting laws against driving while intoxicated.
8 Discuss each of the following statements from the standpoints of equity and efficiency:
a ‘Everyone in society should be guaranteed the best health care possible.’
b ‘The minimum wage should provide each worker with sufficient income to enjoy a
comfortable standard of living.’
9 In what ways is your standard of living different from that of your parents or grandparents
when they were your age? Why have these changes occurred?
10 Suppose Australians decided to save more of their incomes. If banks lend this money to
businesses, which use the money to build new factories, how might higher saving lead
to faster productivity growth? Who do you suppose benefits from higher productivity? Is
society getting a free lunch?
11 Printing money to cover expenditures is sometimes referred to as an ‘inflation tax’. Who do
you think is being ‘taxed’ when more money is printed? Why?
21
Chapter
02-200-202

2
Thinking like
an economist
Learning objectives
After reading this chapter, you should be able to:
LO2.1 explain how economists apply the methods of science and use models, to shed
light on the world
LO2.2 differentiate between positive and normative statements, and discuss the role of
economists in making policy
LO2.3 explain why economists sometimes disagree with one another.
22

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no related content on Scribd:
"I do, I do!" he hurriedly exclaimed; "yes, Hester, I love you .... but ....
how shall I tell it you? .... We must forget this .... we must meet no more...."
"Not meet, when you love me? Impossible! The whole world shall not
separate us."
"It is the world which will separate us."
"What .... your wife!" she said scornfully, almost savagely.
"Alas!"
"I recognise no barrier in a wife. I scorn the whole system of

marriage..... It is iniquitous! Two hearts that love to be separated by a
sophism of convention! If you love her, keep to her. If you love me, you are
mine." Hester rose from the sofa as she spoke: her whole frame trembled
with passion.
Cecil remained seated; his eyes fixed on the ground, in a helpless state
of irresolution.
"Cecil, one word—and but one. Are you afraid of the idle gossip of the
world, and are your instincts cowed at it?"
"Hester! I feel, Hester, we must part for ever."
"Then you love me not?"
He did not answer.
A loud knocking at the street door startled them. She ran to the window,
and looked out.
"It is Sir Chetsom. Cecil, this instant must decide my fate. Do you reject
my love?"
"Believe me, this is a situation——"
"He is coming up stairs. One word—yes, or no?"

He twirled his hat, and sought for an expression which should soften the
blow, but could find none. She looked at him with intense eagerness, and
reading in his hesitation her worst fears, gave a low heart-breaking sob, and
rushed into the other room. In a few seconds the door opened, and the
servant announced,—
"Sir Chetsom Chetsom."
Cecil brushed past him with a hurried bow, and made a precipitate
retreat.
"What the devil is all this?" muttered the astonished baronet. "Hester
not here!"
Hester's maid appeared, and informed him that her mistress would be
down immediately, if he would only be good enough to wait.
"Where is your mistress, then?"
"In her dressing-room, Sir Chetsom."
Without saying another word, Sir Chetsom, to the horror of the maid,
recovered the speed of his youth to ascend the stairs, and to rush into the
dressing-room. On all ordinary occasions he preserved les convenances
with great punctilio; but he was at this moment in an exasperation of
jealousy, and only thought of clearing up his doubts. Cecil's exit, and
Hester's absence, were alone startling circumstances; but when to these be
added the jealousy which for a long time Sir Chetsom had felt towards
Cecil, his exasperation may be conceived.
He found Hester extended on a couch, bathed in tears. She rose angrily

at his approach, and with a gesture of great dignity pointed to the door. As
he seemed noways disposed to obey her, she said,—
"I would be alone .... alone, Sir Chetsom."
"My dear Hester, what is all this? In tears! what has distressed you?"
Her only answer was to pass into her bedroom, and lock herself in.
Sir Chetsom felt foolish. He tapped at the door; but she gave no answer.
He threatened to break it open; but she remained silent.
He then began to wheedle and entreat, to threaten, to promise, to storm,

and to implore, alternately. All in vain: not a word could he extort from her.
He went down into the drawing-room, there to await her pleasure; sulky
and suspicious, angry yet anxious.
Hester, meanwhile, gave full scope to the paroxysm of her grief. In

Cecil's manner, she had read her condemnation. She understood his
momentary aberration. She saw that although he had not been able to
withstand the excitement of that moment, yet it was not his heart, but his
senses she had captivated. She saw that he loved his wife!
Fierce were the convulsions into which this conviction threw her, and
many were the tears she shed; but after an hour's misery she grew calmer,
and began to think of her condition.
Sir Chetsom was below, awaiting her. He was jealous; he was angry. He
was ready to quarrel with her, and she felt that a good quarrel was just the
thing she wanted.
Prepared, therefore, for a "scene," she descended into the drawing-

room.
"Oh! at last," said Sir Chetsom, coldly.
"Yes, Sir Chetsom, at last. I presume I may choose my own time for
seeing my visitors; those who do me the honour of calling upon me will be
pleased to accept that condition, or else be pleased to stay away."
"Indeed, madam!" replied he, greatly astonished at her tone, and

foreseeing that she was ready to burst forth at a word.
"So it is, Sir Chetsom. In which class am I to place you?"
"Hester, I don't understand this language."

"Then I will say good-morning. I dislike talking to those who do not
comprehend me."
She rose and moved towards the door.
"Hester! Hester!"
She turned round again.
"Stay a moment.—Sit down again. There, now let us talk over matters
quietly."
"Begin. What have you to say?"
"I found you in tears just now."
"You did; what then?"
She said this so angrily, that he was forced to pause a moment, and
change his tone to say,—
"I wish—as a friend—my love prompts me to ask the cause of those

tears?"
"Wretchedness!"
"You wretched?"
"Intensely!"
"My poor Hester! What has occurred?—Is Mr. Chamberlayne—has he

anything to do with it?"
She made no reply.
"Answer me, dear girl. Do. I have a right to know."
She continued silent.

"I insist upon knowing."
"Insist then," she replied, quietly.
"I do insist!" he said, raising his voice.
"But your insistance is useless."
"Eh? Hester, do not go too far—Remember—"
"What? What am I to remember?"
"That you—that I may enforce——"
An ironical laugh was her answer.
"Hester, you forget—I am here as your protector—you owe everything

to me.—Be careful, I am willing to overlook a great deal——"
"Are you willing to quit the room?" she said, her eyes flashing as she
spoke. "There is the door. May you never enter it again! Go! I command
you! You insist—you enforce? And do you imagine that I am to give up my
youth and beauty to age and folly—that I am to sacrifice myself, and to
such as you, and then to be told that you insist! Undeceive yourself, Sir
Chetsom. I am my own mistress. I follow my own caprices. My caprice
once was to live with you. Now my caprice is to show you the door. Go! I
owe you nothing. I have not sold myself. I have not bound myself. Go!—
Why do you stand there gaping at me—do you not comprehend my words?
or do you fancy that it is something so strange I should wish never to see
you again? You imagine, perhaps, that I am not calm now, that I am
unaware of what I do in relinquishing the protection of Sir Chetsom
Chetsom? Undeceive yourself. If I am angry, I know perfectly what I do. I
know the extent of my folly—shall I tell you what it is? It is that I ever
listened to you! It is that I ever sullied my name by accepting your
protection! Now, do you understand me?"
She sank in a chair, exhausted. Poor Sir Chetsom was troubled and
confused. The scorn of her manner which lent such momentum to her
words, quite crushed the feeling of anger which continually rose within
him. She had often threatened to quit him; but never in such terms, and
never seemed so earnest.
"My dear Hester," he said, submissively, taking a seat near her, "you
have misunderstood me."
"I do not wish to understand you then."
"But are you serious?—do you wish to leave me?"
"Very serious."
"But what have I done? I am sure my life is spent in trying to make you
happy. Every wish of yours, as soon as it is expressed, I endeavour to
gratify."
"Then my wish is never to see you again; gratify that!"
"My dear Hester, be reasonable! You are angry now—I don't know
wherefore—I won't inquire, if it displeases you—but you will get over this
to-morrow, you will have forgotten it. To-morrow I will come and see you."
"I will not see you; so spare yourself the trouble."
"Not see me! Is everything over then between us? Is this your calm
decision?"
"It is. I have told you so before. What makes you doubt it? Do you
suppose your society is so fascinating that I cannot relinquish it? Try me!"
"I will," said Sir Chetsom, buttoning his coat, and rising in concentrated
anger.
"Do so."
"You will repent this. You force me to it, recollect! You force me!"
"Good-morning!"
"I am not joking, I am serious now."
"Good-morning."
"If I once quit this house it will be never to return."
"Sir Chetsom I have the pleasure of wishing you good-morning!"
There was no replying to the cutting coolness of her manner. He took up

his hat, buttoned his coat up to the chin, fidgeted his gloves, and at last
making an effort, said:—
"Very well, very well!" and left the room.
Hester felt considerably relieved. She had taken a savage pleasure in

this contest, and utterly reckless of consequences, found in that very
recklessness a satisfaction, which helped to console her mortified vanity
and wounded affection. Towards Cecil, she felt hate and scorn; towards Sir
Chetsom, contemptuous anger, she knew not why. She had played her
whole existence in that quarrel; and knew that she was a beggar without a
moment's anxiety.
The next Day, Sir Chetsom sent her a note, in which he deplored what
had passed between them, but was willing to attribute it to some
extraordinary irritation; and he moreover offered to settle six hundred a year
upon her for her life, if she would only consent to remain his friend as
heretofore.
The irritation in Hester's mind had not abated, and she returned this
laconic answer:—
"CADOGAN PLACE, 13th June 1841.
"Not for six thousand.
"H. M."
Sir Chetsom was alarmed. The idea of her quitting him was more than
he could endure. Completely fascinated by her, the more he knew of her, the
more hopelessly he became her slave. He could not imagine living without
her.
He called; was refused admittance; called again; was refused again;

wrote, and received back his letter unopened.
He was in despair. So great was his preoccupation, that he actually went

out with his whiskers unoiled and undyed! Hester's servant at length took
pity on his sorrow, and consented to let him enter the house, against her
orders.
He stole up to her boudoir, and throwing himself at her feet, said,—
"Hester, I cannot exist without you."
"But I can without you," she said, smiling.
"You smile; then I am forgiven."
"Yes; but I keep to my resolution."
"Hester, hear me out; if, after what I have to say, you still keep your
resolution, I shall have nothing to do but to leave you in peace. Here, then, I
offer you my hand—be Lady Chetsom, and make me happy."
At that moment a strange image rose in Hester's mind. She had that
afternoon met Cecil driving in the Park. He raised his hat in cold politeness,
but made no attempt to speak to her. The recollection of this scene now
presented itself, as the sort of background to Sir Chetsom on his knees
offering a title, offering wealth, offering consideration to the friendless,
forsaken, ambitious girl.
"Will you accept me?" again whispered Sir Chetsom.
"I shall plague your life out," she said.
"Then that is a settled matter!"

Sir Chetsom was the happiest of men.
But his happiness only lasted a fortnight, and was then suddenly cut
short by that inflexible lady—Atropos. Driving home one evening, his
horse shied at something in the road, and ran away with him down
Constitution Hill, then stumbled and threw Sir Chetsom against the railings.
A concussion of the brain was the consequence.
By this accident, Hester not only lost the honour of becoming Lady
Chetsom, but she was absolutely left penniless, as Sir Chetsom died
intestate.
To this had her ambition brought her! With no resources, with no

friends, without even a good name, she had to begin the world anew.
Literature was the desperate resource which alone awaited her; and she
resolved to live by her pen.
BOOK VII.
CHAPTER I.
GEORGE MAXWELL.
Pietro.—"This Malevole is one of the most prodigious affectations that ever conversed
with nature. A man, or rather a monster: more discontent than Lucifer, when he was thrust
out of the Presence. His appetite is as insatiable as the grave: as far from any content as
from heaven."
JOHN MARSTON.—The Malcontent.
Mrs. Meredith Vyner was radiant again; if not happy, she was at least
sprightly, occupied, and flattered. She had not forgotten Marmaduke, she
had not forgiven him; but although his image sometimes lowered upon her,
she banished it with a smile of triumph, for she was loved!
The silent, shy, and saturnine George Maxwell had taken Marmaduke's
place, as cavalier servente; and across his dark, forbidding face there shone
a gleam of sunshine, as he now watched the sylph-like enchantress, who for
so long had made him more and more misanthropical by her gay
indifference to him, and who at last had perceived his love.
Marmaduke, his hated favoured rival, was dismissed; and not only was
a rival dismissed, but he, George, was admitted in his place.
The history of these two may be told in a few words. Maxwell, silent
and watchful so long as Marmaduke was a visitor at the house, suddenly
became more talkative and demonstrative when he found Marmaduke's
visits cease. Hopes rose within him. He spoke with another accent, and with
other looks to Mrs. Vyner. She was not long in understanding him. Once
opening her eyes to his love, she saw as in a flash of light, the whole history
of his passion, she understood the conduct of the silent, jealous lover, and
deeply flattered at such constancy and unencouraged affection, began to
turn a favourable eye upon him. Smarting herself from wounded affection,
she could the more readily and truly sympathize with him. In a few weeks
—for passion grows with strange rapidity, and days are epochs in its history
—she gave him to understand that he was not indifferent to her. Of
Marmaduke she spoke freely to him, telling him the same story she had told
her husband; and he believed her: what will not lovers believe!
No word of love as yet had passed their lips, and yet they understood
each other. Indeed, so plain was the avowal of her looks, that a man less shy
and suspicious than Maxwell would long ago have declared his passion,
certain of a return. But he was withheld by the very fierceness of his
passion, and by his horror at ridicule. Maxwell was one of those men who
never enter the water till they can swim—who never undertake anything till
they are certain of succeeding, held back by the fear of failure. One trait in
his character will set this disposition clearly forth: he had a fine tenor voice,
and sang with some mastery, but he never could be prevailed upon to sing
before any one, except his family, because he was waiting till he could
execute as well as Rubini or Mario. Meanwhile, he was intensely jealous of
those who, not having reached that standard, did sing; and his scornful
criticisms on their curious presumption, was nothing but miserable spite at
their not having so sensitive a vanity as his own.
Maxwell was in truth a bad, mean-spirited, envious, passionate man, in

whom vanity, ludicrously susceptible and exacting, fostered the worst of
passions, jealousy and revenge. He was misanthropical: not because his
own high-thoughted soul turned from the pettiness of mankind with
intolerant disgust,—not because he had pryed too curiously into the
corruptions of human nature, without at the same time having been
fortunate enough to know familiarly all that is great, and loving, and noble
in the human heart—but simply because his life was a perpetual demand
upon the abnegation, affection, and admiration of others, and because that
demand could not, in the nature of things, be satisfied. It has been said that
a man who affects misanthropy is a coxcomb, for real misanthropy is
madness. Not always madness: seldom so; it is generally inordinate and
unsatisfied vanity. A man hates his fellow-creatures because they,
unwittingly, are always irritating him by refusing to submit to the exactions
of his vanity: he construes their neglect into insult, their indifference into
envy. He envies them for succeeding where he dare not venture; he hates
them for not acknowledging his own standard of himself. Maxwell was one
of these.
Conceive such a man suddenly caught in the meshes of a brilliant

coquette like Mrs. Meredith Vyner! Conceive him after two years of angry
expectation, during which she has never bestowed a smile on him which
was not unmeaning, now awakening to the conviction that his merits are
recognised, that his love is returned, that he has inspired a guilty passion!
The guilt added intensity to his joy: it was so immense a triumph!
What a pair! Love has been well said to delight in antitheses, otherwise
we might stare at the contrast afforded by this little, hump-backed, golden-
haired, coquettish, heartless woman, and this saturnine, gloomy, stupid,
bad-hearted man.
Poor Meredith Vyner could not comprehend it. The evidence of his eyes
told him plainly how the case stood; but his inexperienced mind refused to
accept the evidence of his senses. What could she see in so grim and
uninteresting an animal? Marmaduke was quite another man; affection for
him was intelligible at least; but Maxwell! And what could Maxwell see in
her? Why, she was the very contradiction of all he must feel in his own
breast!
In that contradiction was the charm: Maxwell did himself instinctively,

but involuntarily, that justice; he would assuredly have hated a duplicate of
himself, even more intensely than he hated others.
Meredith Vyner endeavoured once or twice to come to an "explanation"

with his wife; for he was master in his own house, and would be, or he was
greatly deceived. But she answered him with a few galling sarcasms
(adding general allusions to the miseries of young wives subject to the
absurd jealousies of foolish, old men), and ending in—hysterics! There was
no combating hysterics, and Vyner was always defeated.
CHAPTER II.
ROSE AGAIN SEES JULIUS.
Mrs. Vyner again went into society as usual, the only difference being
that she was generally accompanied by Maxwell instead of her husband.
Rose often stayed at home, but sometimes went with her. Time had not
made her forget Julius St. John, but it had brought back the elasticity of her
spirits; and except an occasional sigh of regret, or a short reverie, she was
much the same as she had been before.
One Saturday on which they went to Dr. Whiston's soirée, Rose

accompanied them, and was delighted to see Cecil there in high spirits, and
beautifully dressed. Blanche's condition of course prevented her being
there.
"But she is quite well, is she not?"
"Charming, and looks lovelier than ever."
"I have not been to see her this week. Mama has not been able to let me
have the carriage. How gets on your new picture?"
"Famously. How beautiful you are looking to-night, Rose!"
"Of course I am; do I ever fail? But tell me, what is the subject of your
picture?"
He put his finger on his lips.

"That's a secret. I let none know anything about it, as I intend surprising
you all."
"Papa is so proud of you now, that I think if you were to go to him, all
would be made up."
"That's kind, certainly; now I no longer need him, he is willing to

acknowledge his son-in-law. No, Rosy, no; I have made advances enough;
he must make them now."
"But think how delightful it would be for us all!"
"I know that; besides, I know it must come. He will make the first
advance; and he shall make it."
The secret of Cecil's holding back was not pride, but calculation. He
fancied that if Vyner made the first advances to him, he could make terms;
and his recent losses at the gaming-table had made him sensible of the
precariousness of his present resources.
As they moved through the crowd, and were passing into the second
room, they came face to face with Mrs. St. John and Julius.
There was no avoiding a recognition. Rose blushed deeply, and felt

extremely embarrassed; but recovering herself, she held out her hand to
Mrs. St. John, who took it coldly.
Cecil and Julius shook hands cordially.
"Have you long been returned?" asked Rose in a low voice.
"Six weeks," was the laconic reply. "I hope Mr. Vyner is quite well, and
Mrs. Vyner?'
"Mama is here—in the other room," she said, with an effort.
She made a movement as if to pass on; her eye met Julius's as she
bowed, but his face, though deadly pale, gave no sign of agitation.
In another instant, they were in the next room; and Rose, with well
acted indifference, occupied herself with the specimens exhibited on the
table, addressing common-place remarks to Cecil, much to his
astonishment.
"Is it all over, then, Rose?" he said.
"All. Oh, do look at this machine for teaching the blind to write—how
very curious."
"Are you serious, Rose?"
"Serious! Didn't you see the cut direct?"
"You take it calmly!"
"Would you have a scene? Shall I faint? Shall I pretend to be stabbed to

the heart? Shall I act a part?"
"Pretend! Are you not acting now?"
"Not I. If you think their reception has pained me, pray undeceive
yourself; it is no more than I expected. Months ago I made up my mind. I
know what to think of him. I am glad he has behaved so; very glad, very
glad. It now puts everything beyond a doubt. Very glad."
She muttered "very glad" to herself as she sat down in a chair just left
by a dowager, and tried to cheat herself into the belief that she really was
glad. In truth, she was at that moment more indignant than unhappy. The
coldness of her reception, both by mother and son, had exasperated her. Had
he looked pleased to see her, had he even looked very pained, she would
have at once given him to understand that his retreat had been precipitate,
and that she was ready to accept him with delight. But his coldness piqued
her; she refrained from addressing a word to him; and was now indulging in
somewhat bitter reflections on his conduct.
Meanwhile, Mrs. Vyner had been eloquent in her admiration of Cecil

and his genius, to Lady F——, with whom she was talking. Maxwell, from
time to time, threw in a sarcasm, and was evidently uneasy at hearing any
one praised so highly.
"Well, but you know, my dear sir," said Lady F——, "he must be
monstrous clever, or he would never make so much money."
Maxwell shrugged his shoulders, and said, with considerable

significance in the tone,—
"That depends upon how he makes it."
Mrs. Vyner looked at him surprised. A little while afterwards, when

they were standing retired apart from the company, she asked him what he
meant by his reply to Lady F——, respecting Cecil's money-making.
"I mean this: he doesn't make money by his genius," Maxwell replied,
with sneering emphasis.
"By what, then?"
Maxwell refused at first to answer.
"What can you be hinting at? By what means does he make his money?"
"By ... there, I may as well tell you; you must soon hear it ... by
gambling."
A shudder of disgust ran over her frame.
"Are you sure—quite sure of this?"
"Quite: I had it from a man who plays nightly at the same table with
him."
"How horrible! isn't it?"
"No," he replied, with a sardonic smile: "it's genius."

She looked at him astonished: at that moment, she hated him. Well
would it have been for her if she had taken the warning of that moment, and
flung from her the viper that was crawling to her heart. But she forgot it.
Maxwell's smile passed away, and was replaced by one of tenderness for
her.
Rose and her mother were both thoughtful as they rode home that night.
The next day, Rose communicated to her father what Cecil had said at
Dr. Whiston's, and begged him to write to Cecil, and announce his
forgiveness. Vyner, who would have been well pleased to do so, spoke with
his wife about it.
"He is a credit to us now," added Vyner.
"Oh! yes, a great credit."
"Don't you think so?"
"How should I not? Vyner is an old name—a good name—it can gain
no fresh éclat from honours, but it may from infamy."
"From infamy, Mary?"
"Cecil Chamberlayne, your creditable son-in-law, is a gambler."
"Good heavens!"
"His cab and tiger, his dinners, his trinkets—all come from that
infamous source: it is his means of livelihood."
"My poor, poor Blanche!" exclaimed the wretched father, as the tears
came into his eyes. "But she shall not stay with him .... I will take her away
... She shall come to us .... she shall."
In vain his wife interposed; he ordered the carriage, and drove at once to
Cecil's house.
CHAPTER III.
WOMAN'S LOVE.
Blanche was trimming a baby cap, when her father entered the room.
With a cry of delight she sprang up, and rushed into his arms. He hugged
her fondly, and the tears rolled down his cheeks as he pressed his child
sadly to his bosom.
It was some time before either of them spoke.
"My poor child!" he said at last.
"Your happy child, papa; I am so happy! I knew you would forgive me

soon. Oh! why is not Cecil here to join with me in gratitude?"
"Blanche," he said with an effort, "I am come to take you away with me:
will you come?"
She looked her answer.
"That is right, ... that is right .... Pack up your things, then, at once."
"Pack up what things?" she asked in astonishment.
"Whatever you want to take with you .... Come .... don't stay in this
house a moment longer than you can help."
Her astonishment increased.
"Do you mean me to leave my home?"
"Yes."
"And .... my husband?"
"Yes."
"Leave my husband?—leave my Cecil? Why, papa, what can have put

that into your head? Do you suppose, I am not happy here? ... He is the best
of husbands!"
Meredith Vyner had recourse to his snuff-box, as in all emergencies. He

inserted thumb and index finger into it, and trifled mechanically with the
grains, while seeking for some argument.
"Do, dear papa, relieve me from this suspense .... What is it you mean?"
"Are you serious, Blanche?—is he a good husband?'
"I adore him; he is the kindest creature on earth."
Vyner took a huge pinch. That did not clear his ideas, and he sat silently
brushing off the grains which had congregated in the wrinkles of his
waistcoat, very much puzzled what to say.
"Papa, there is something on your mind. If it is anything against Cecil

.... anything a wife ought not to hear, spare me, and do not utter it. If it is
anything else, spare me the suspense, and tell me at once what it is."
"Blanche, my dearest child, I came here to save you from ruin, and I
will save you. You must quit your husband."
"Why?"
"Is not my word sufficient? I say you must. Your welfare depends upon
it."
"Why?—I say again—why?"
"Are you—no, you cannot be aware of how your husband gains a

livelihood."
She coloured violently and trembled. He noticed it, and read the avowal
in her agitation.
"You do know it then?"
She burst into tears.
"Well, my dear child, since you know it, that saves me an unpleasant
explanation. But you must leave him; you cannot stay here longer: you
cannot share his infamy; you shall not be dragged into his ruin. It has been a
miserable match; I have always grieved over it; always knew it would end
wretchedly. But to come to this!—to this! No, Blanche, you cannot remain
here. Come and live at home; there at least you will not live in infamy."
She wept bitterly, but offered no remark.
"Come, Blanche," he said, taking her hand, "you will leave this place,
will you not? You will live with us. I cannot promise to make you happy,
but at least I can save you from the wretched existence of a gambler's wife.
Come—come."
"I cannot!" she sobbed.
"Rouse yourself: conquer this emotion. Think of your future—think of

your child!"
She shuddered.
"Think of the child you are to bring into the world. Must it also share in
the ruin which its father will inevitably draw upon you? My dear Blanche,
you must have courage; for your own sake—for your child's sake—you
must quit this house. Come home to me. I am unhappy myself; I want to
have some one about me I can love: Rose is the only one: Violet is away:
your mother—but don't let me speak of her. You see, Blanche, dear, I want
you; you will fill a place at home; you will be so petted; and the little one
will have every comfort—and his aunt Rose—but don't sob so, my child: do
restrain yourself. You will come, eh?"

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Part I Introduction 3 Part 6 The macroeconomics of open

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PART OPENING FEATURES

The chapter list outlines the

PART SIX Chapter 12 Open-economy macroeconomics: Basic concepts

CHAPTER OPENING FEATURES

Identify the key concepts that

136 How is labour productivity determined?

Definitions or explanations of Physical capital

important key terms are located physical capital

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right one. value

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Part I Introduction 3 Part 6 The macroeconomics of open