Observation, Theory, and More Observation

Isaac Newton, the famous 17Th-century scientist and mathematician, allegedly became intrigued one day when he saw an apple fall from a tree. This observation motivated Newton to develop a theory of gravity that applies not only to an apple falling to the earth but to any two objects in the universe. Subsequent testing of Newton’s theory has shown that it works well in many circumstances (although, as Einstein would later emphasize, not in all circumstances ). Because Newton’s theory has been so successful at explaining observation, it is still taught today in undergraduate physics courses the world.

This interplay between theory and observation also occurs in the field of economics. An economist might live in a country experiencing rapid increases in prices and be moved by this observation to develop a theory of inflation. The theory might assert that high inflation arises when the government prints too much money. (As you may recall, this was one of the Ten Principles of Economics in Chapter 1.) To test this theory, the economist could collect and analyze data on prices and money from many different countries. If growth in the quantity of money were not at all related to the rate which prices are rising, the economist would start to doubt the validity of this theory of inflation. If money growth and inflation were strongly correlated in Internationale

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RENT CONTROL IN THE SHORT RUN AND LONG RUN

One common example of a price ceiling is rent control. In many cities the local government places a ceiling on rents that landlords may charge their tenants. The goal of this policy is to help the poor by making housing more affordable. Economists often criticize rent control arguing that it is a highly inefficient way to help the poor raise their standard of living. One economists called rent control the best way to destroy city other than bombing. The adverse effects of rent control are less apparent to the general population because these effects occur over many years. In the short run landlords have a fixed number of apartments to rent and they cannot adjust this number quickly as market conditions change. Moreover the number of people searching for housing in a city may not be highly responsive to rents in the short run because people take time to adjust their housing arrangements. Therefore the short-run supply and demand for housing are relatively inelasti...

Why Did OPEC Fail to Keep the Price of Oil High

Many of the most disruptive events for the world’s economics over the past several decades have originated in the world market for oil. In the 1970s members of the Organization of Petroleum Exporting Countries (OPEC) decided to raise the world price of oil to increase their income. These countries accomplished this goal by jointly reducing the amount of oil they supplied. From 1973 to 1974, the price of oil (adjusted for overall inflation) rose more than 50 percent. Then, a few years later,OPEC did the same thing again. From 1979 to 1981, the price of oil approximately doubled. Measured in 2004 dollars, the price of crude oil reached $91 per barrel, and the price of gasoline was $3 per gallon. Yet OPEC found it difficult to maintain a high price. From 1982 to 1985, the price of oil steadied declined about 10 percent per year. Dissatisfaction and disarray soon prevailed among the OPEC countries. In 1986, cooperation among OPEC members completely broke down and the pric...

Markets Are Usually a Good Way to Organize Economic Activity

The collapse communism in the So vied Union and Eastern Europe in the 1980s may be the most important change in the world during the past half century. Communist countries worked on the premise that government officials were in the best position to determine the allocation of scarce resources in the economy. These 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 organize economic activity in a way that promoted economic well-being for the country as a whole. Today, most countries that once had centrally planned economies have aban-doned this system and are trying to develop market economics. In a market economy, the decisions of a central planner are replaced by the decisions of millions of firms and households. Firms decide whom to hire and what to make. Households decide which fi...

Elasticity and Tax Incidence

When a good is taxed buyers and sellers of the good share the burden of the tax. But how exactly is the tax burden divided? Only rarely will it be shared equally. To see how the burden is divided consider the impact of taxation in the two markets. In both cases figure shows the initial demand curve the initial supply curve and a tax that drives a wedge between the amount paid by buyers and the amount received by sellers. Not drawn in either panel of the figure is the new supply or demand curve. Which curve shifts depends on on whether the tax is levied on buyers or sellers. As we have seen this is irrelevant for the incidence of the tax. The difference in the two panels is the relative elasticity of supply and demand. A tax in a market with very elastic supply and relatively inelastic demand. That is sellers are very responsive to changes in the price of the good so the supply curve is relatively flat whereas buyers are not very responsive so the demand curve is rel...

TWO WAYS REDUCE THE QUANTITY OF SMOKING DEMANDED

Public policymakers often want to reduce the amount that people smoke. There are two ways that policy can attempt to achieve this goal. One way to reduce smoking is to shift the demand curve for cigarettes and other tobacco products. Public service announcements mandatory health warnings on cigarette packages, and the prohibition of cigarettes advertising on television are all policies aimed at reducing the quantity of cigarettes demanded at any given price. If successful these shift the demand curve for cigarettes to the left as in panel. Alternatively, policymakers can try to raise the price of cigarettes. If the government taxes the manufacture of cigarettes for example cigarettes companies pass much of his tax on to consumers in the from of higher prices. A higher price encourages smokers to reduce the numbers of cigarettes they smoke. In this case the reduced amount of smoking does not represent a shift in the demand curve. Instead it represents a movement alo...

Does Drug Interdiction Increase or Decrease Drug-Related Crime

A persistent problem facing our society is the use of illegal drugs such as heroin cocaine, ecstasy and crack. Drug use has several adverse effects. One is that drug dependence can ruin the lives of drug users and their families. Another is that drug addicts often turn to robbery and other violent crimes to obtain the money needed to support their habit. To discourage the use of illegal drugs the U,S, government devotes billions of dollars each year to reduce the flow of drug into the country. Let’s use the tools of supply and demand to examine this policy of drug interdiction. Suppose the government increase the number of federal agents devoted to the war o drugs. What happens in the market for illegal drugs? As is usual, we answer this question in three steps. First we consider whether the supply or demand curve shifts. Second we consider the direction of the shift. Third we see how the shift affects the equilibrium price and quantity. Although the purpose of ...

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CAN CONGRESS DISTRIBUTE THE BURDEN OF PAYROLL TAX

If you have ever received a paycheck you probably noticed that taxes were deducted from the amount you earned. One ot these taxes is called FICA an acronym for the Federal Insurance Contribution Act. The federal government uses the revenue from the FICA tax pay for Social Security and Medicare the income support and healthcare programs for the elderly. FICA is an example of a payroll tax which is a tax on the wages that firms pay their workers. In 2005 the total FICA tax for the typical worker was of earnings. Who do you think bears the burden of this payroll tax firms or workers. When Congress passed this legislation it tried to mandate a division of the tax burden. According to the law half of the tax is paid by firms and half is paid by workers. That is half of the tax is paid out of firms revenues and half is deducted from workers paychecks. The amount that shows up as a deduction on your pay stup is the worker contribution. Our analysis of tax incidenc...

The Variety of Demand Curves

Economists classify demand curves according to their elasticity. Demand is elastic when elaelsticity is greater than 1, so that quantity moves proprotionately more than the price. Demand is inelastic when the elasticity is less than 1, so that quantity moves proprotionately less than the price. If the elasticity is exactly 1, so that quantity moves the same amount proprotionately as price demand to have unit elasticity. Because the price elasticity of demand measures how much quantity demanded responds to change in the price, it is closely related to the slope of the demand curve. The following rule of thumb is a useful guide. The flatter the demand curve that passes through a given point the greater the price elasticity of demand. The steeper the demand curve that passes through a given point, the smaller the price elasticity of demand. In the extreme case of a zero elasticity, shown in panel demand is perfectly inelastic and the demand curve is vertical. In thi...

The Relationship between Price and Quantity Supplied

The quantity supplied of any good or service is the amount that sellers are willing and able to sell. There are many determines of quantity supplied but once again, price plays a special role in our analysis. When the price of ice cream is high selling ice cream is profitable and so the quantity supplied is large. Sellers of ice cream work long hours buy many ice-cream machines and hire many workers. By contrast when the price of ice cream is low the business is less profitable and so sellers produce less ice cream. At a low price some sellers may even choose to shut down and their quantity supplied falls to zero. Because the quantity supplied rises as the price rises and falls as the price falls we say that the quantity supplied is positively related to the price of the good. This relationship between price and quantity supplied is called the law of supply: Other things equal when price of a good rises the quantity supplied of the good also rises and when the price falls th...

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