P. Schmidt (Hochschule Bremen) @ Jacobs University page i

Prof. Dr. Peter Schmidt Springterm 2014

Economics & Statistics

: (0421) 5905-4691 Fax: (0421) 5905-4862

Peter.Schmidt@hs-bremen.de www.schmidt-bremen.de

Economics & Society as a Business Environment

Contents

References

Material: • 10 Economic Principles (Mankiw) .................................................................. 1 • Joint Economic Forecast Autumn 2013: “Economy Picking Up – Put Budget

Surpluses to Good Use”, summary ..................................................................... 9

• National Accounts: • GERMAN ECONOMY: 2013 (DeStatis, January 2014) .................................... 13

• Monitoring economic performance, quality of life and sustainability, Joint Report as requested by the Franco-German Ministerial Council .............. 18

• Economics for Business (Begg and Ward) ...................................... ( → book) (relevant chapters see schedule on webpage)

Economics & Society

P. Schmidt (Hochschule Bremen) @ Jacobs University page ii

Contents

and preliminary Time Schedule:

Please refer to the web page: www.schmidt-bremen.de - EconomicsSociety

Nr Unit / contents

1 Section I: Introduction - 10 Principles of Economics (Mankiw) - Basic Concepts of Economics I

2 - Basic Concepts of Economics II - Chapter 1: Economics for Business

3 Section II: Understanding Markets - Chapter 2: Consumers in the Market Place - Chapter 3: Firms in the Market Place (part I)

4

- Chapter 3: Firms in the Market Place (part II) - Chapter 4: Markets in Action Section III: Competition and Profitability Chapter 5: Market structure and Firm Performance

5

Section IV: Domestic Macroeconomics - Chapter 9 : An introduction to the macro economy - Chapter 10: Measuring Macroeconomic Variables and Policy Issues - Chapter 11: Expenditure and Fiscal Policy

6 - Chapter 12: Money, banking and interest / ECB - Chapter 13: Inflation, Output and Economic Policy

7

Section V Global Economics - 15: Exchange Rates and the Balance of Payments - 16: Globalization Review, questions, exam preparation

Exam

Economics & Society

P. Schmidt (Hochschule Bremen) @ Jacobs University page iii

References

Begg, D and Ward, D: “Economics for Business”

Mankiw, G: “Principles of Economics

Further Literature:

Baye, M: “Managerial Economics and Business Strategy”

Begg, D, Fischer, S, Dornbush, R.: “Economics”

Samuelson, P and Nordhaus, W: “Economics”

Sloman, J; Wride, A, and Garratt, D: “Economics”

Current issues:

Friedman, T.L.: “The World is Flat”,

Meadows, D, Randers, J, Meadows, D: “Limits to Growth - The 30-Year Update”

Sachs, J: “Common Wealth - Economics for a Crowded Planet”

Stiglitz, J: „Globalization and its discontents”

Please also refer to other sources like Newspapers, Journals, current books, web sources

(Economist, WallStreetJournal, … see links on my homepage), news – its highly appreci-

ated if you bring them to class and contribute to our discussion !

Ten Principles of Economics

The word economy comes from the Greek word oikonomos, which means “onewho 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 thehousehold do which tasks and what each member gets in return: Who cooksdinner? Who does the laundry? Who gets the extra dessert at dinner? Who getsto choose what TV show to watch? In short, the household must allocate itsscarce resources among its various members, taking into account each member’sabilities, efforts, and desires.

Like a household, a society faces many decisions. A society must decide whatjobs 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) tovarious jobs, it must also allocate the output of goods and services that they pro-duce. It must decide who will eat caviar and who will eat potatoes. It mustdecide who will drive a Ferrari and who will take the bus.

The management of society’s resources is important because resources arescarce. Scarcity means that society has limited resources and therefore cannotproduce all the goods and services people wish to have. Just as a household can-not give every member everything he or she wants, a society cannot give everyindividual the highest standard of living to which he or she might aspire.

3

scarcitythe limited nature ofsociety’s resources

1

Economics is the study of how society manages its scarce resources. In mostsocieties, resources are allocated not by an all-powerful dictator but through thecombined actions of millions of households and firms. Economists thereforestudy how people make decisions: how much they work, what they buy, howmuch they save, and how they invest their savings. Economists also study howpeople interact with one another. For instance, they examine how the multitudeof buyers and sellers of a good together determine the price at which the good issold and the quantity that is sold. Finally, economists analyze forces and trendsthat affect the economy as a whole, including the growth in average income, thefraction of the population that cannot find work, and the rate at which prices arerising.

Although the study of economics has many facets, the field is unified by sev-eral central ideas. In this chapter, we look at Ten Principles of Economics. Don’tworry if you don’t understand them all at first or if you don’t find them com-pletely convincing. In later chapters, we will explore these ideas more fully. Theten principles are introduced here to give you an overview of what economics isall about. You can think of this chapter as a “preview of coming attractions.”

4 PART 1 INTRODUCTION

economicsthe study of how societymanages its scarceresources

HOW PEOPLE MAKE DECISIONS

There is no mystery to what an economy is. Whether we are talking about theeconomy of Los Angeles, of the United States, or of the whole world, an econ-omy is just a group of people interacting with one another as they go about theirlives. Because the behavior of an economy reflects the behavior of the individu-als who make up the economy, we start our study of economics with four princi-ples of individual decision making.

Principle 1: People Face Trade-offs

The first lesson about making decisions is summarized in the adage “There is nosuch thing as a free lunch.” To get one thing that we like, we usually have togive up another thing that we like. Making decisions requires trading off onegoal against another.

Consider a student who must decide how to allocate her most valuableresource—her time. She can spend all of her time studying economics; she canspend all of her time studying psychology; or she can divide her time betweenthe two fields. For every hour she studies one subject, she gives up an hour shecould have used studying the other. And for every hour she spends studying,she gives up an hour that she could have spent napping, bike riding, watchingTV, or working at her part-time job for some extra spending money.

Or consider parents deciding how to spend their family income. They can buyfood, clothing, or a family vacation. Or they can save some of the family incomefor retirement or the children’s college education. When they choose to spend anextra dollar on one of these goods, they have one less dollar to spend on someother 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 we spend onnational defense (guns) to protect our shores from foreign aggressors, the lesswe can spend on consumer goods (butter) to raise our standard of living athome. Also important in modern society is the trade-off between a clean envi-

- 1 -

ronment and a high level of income. Laws that require firms to reduce pollutionraise the cost of producing goods and services. Because of the higher costs, thesefirms end up earning smaller profits, paying lower wages, charging higherprices, or some combination of these three. Thus, while pollution regulationsgive us the benefit of a cleaner environment and the improved health that comeswith it, they have the cost of reducing the incomes of the firms’ owners, work-ers, and customers.

Another trade-off society faces is between efficiency and equity. Efficiencymeans that society is getting the maximum benefits from its scarce resources.Equity means that those benefits are distributed fairly among society’s mem-bers. In other words, efficiency refers to the size of the economic pie, and equityrefers to how the pie is divided. Often, when government policies are designed,these two goals conflict.

Consider, for instance, policies aimed at achieving a more equal distributionof economic well-being. Some of these policies, such as the welfare system orunemployment insurance, try to help the members of society who are most inneed. Others, such as the individual income tax, ask the financially successful tocontribute more than others to support the government. Although these policieshave the benefit of achieving greater equity, they have a cost in terms of reducedefficiency. When the government redistributes income from the rich to the poor,it reduces the reward for working hard; as a result, people work less and pro-duce fewer goods and services. In other words, when the government tries tocut the economic pie into more equal slices, the pie gets smaller.

Recognizing that people face trade-offs does not by itself tell us what deci-sions they will or should make. A student should not abandon the study of psy-chology just because doing so would increase the time available for the study ofeconomics. Society should not stop protecting the environment just becauseenvironmental regulations reduce our material standard of living. The poorshould not be ignored just because helping them distorts work incentives.Nonetheless, acknowledging life’s trade-offs is important because people arelikely to make good decisions only if they understand the options that they haveavailable.

Principle 2: The Cost of Something Is What You Give Up to Get It

Because people face trade-offs, making decisions requires comparing the costsand benefits of alternative courses of action. In many cases, however, the cost ofsome action is not as obvious as it might first appear.

Consider, for example, the decision to go to college. The benefit is intellectualenrichment and a lifetime of better job opportunities. But what is the cost? Toanswer this question, you might be tempted to add up the money you spend ontuition, books, room, and board. Yet this total does not truly represent what yougive up to spend a year in college.

The first problem with this answer is that it includes some things that are notreally costs of going to college. Even if you quit school, you need a place to sleepand food to eat. Room and board are costs of going to college only to the extentthat they are more expensive at college than elsewhere. Indeed, the cost of roomand board at your school might be less than the rent and food expenses that youwould pay living on your own. In this case, the savings on room and board are abenefit of going to college.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 5

efficiencythe property of societygetting the most it canfrom its scarce resources

equitythe property of distribut-ing economic prosperityfairly among the mem-bers of society

The second problem with this calculation of costs is that it ignores the largestcost of going to college—your time. When you spend a year listening to lectures,reading textbooks, and writing papers, you cannot spend that time working at ajob. For most students, the wages given up to attend school are the largest singlecost of their education.

The opportunity cost of an item is what you give up to get that item. Whenmaking any decision, such as whether to attend college, decision makers shouldbe aware of the opportunity costs that accompany each possible action. In fact,they usually are. College athletes who can earn millions if they drop out ofschool and play professional sports are well aware that their opportunity cost ofcollege is very high. It is not surprising that they often decide that the benefit isnot worth the cost.

Principle 3: Rational People Think at the Margin

Economists normally assume that people are rational. Rational people systemat-ically and purposefully do the best they can to achieve their objectives, given theopportunities they have. As you study economics, you will encounter firms thatdecide how many workers to hire and how much of their product to manufac-ture and sell to maximize profits. You will encounter consumers who buy a bun-dle of goods and services to achieve the highest possible level of satisfaction,subject to their incomes and the prices of those goods and services.

Rational people know that decisions in life are rarely black and white butusually involve shades of gray. At dinnertime, the decision you face is notbetween fasting or eating like a pig but whether to take that extra spoonful ofmashed potatoes. When exams roll around, your decision is not between blow-ing them off or studying 24 hours a day but whether to spend an extra hourreviewing your notes instead of watching TV. Economists use the term marginalchanges to describe small incremental adjustments to an existing plan of action.Keep in mind that margin means “edge,” so marginal changes are adjustmentsaround the edges of what you are doing. Rational people often make decisionsby comparing marginal benefits and marginal costs.

For example, consider an airline deciding how much to charge passengers whofly standby. Suppose that flying a 200-seat plane across the United States costs theairline $100,000. In this case, the average cost of each seat is $100,000/200, whichis $500. One might be tempted to conclude that the airline should never sell aticket for less than $500. In fact, however, the airline can raise its profits by think-ing at the margin. Imagine that a plane is about to take off with ten empty seats,and a standby passenger waiting at the gate will pay $300 for a seat. Should theairline sell the ticket? Of course it should. If the plane has empty seats, the cost ofadding one more passenger is minuscule. Although the average cost of flying apassenger is $500, the marginal cost is merely the cost of the bag of peanuts andcan of soda that the extra passenger will consume. As long as the standby passen-ger pays more than the marginal cost, selling the ticket is profitable.

Marginal decision making can help explain some otherwise puzzling eco-nomic phenomena. Here is a classic question: Why is water so cheap, while dia-monds are so expensive? Humans need water to survive, while diamonds areunnecessary; but for some reason, people are willing to pay much more for adiamond than for a cup of water. The reason is that a person’s willingness to payfor any good is based on the marginal benefit that an extra unit of the goodwould yield. The marginal benefit, in turn, depends on how many units a per-son already has. Although water is essential, the marginal benefit of an extra cup

6 PART 1 INTRODUCTION

opportunity costwhatever must be givenup to obtain some item

rational peoplepeople who systemati-cally and purposefullydo the best they can toachieve their objectives

marginal changessmall incrementaladjustments to a plan of action

- 2 -

is small because water is plentiful. By contrast, no one needs diamonds to sur-vive, but because diamonds are so rare, people consider the marginal benefit ofan extra diamond to be large.

A rational decision maker takes an action if and only if the marginal benefit ofthe action exceeds the marginal cost. This principle can explain why airlines arewilling to sell a ticket below average cost and why people are willing to paymore for diamonds than for water. It can take some time to get used to the logicof marginal thinking, but the study of economics will give you ample opportu-nity to practice.

Principle 4: People Respond to Incentives

An incentive is something (such as the prospect of a punishment or a reward)that induces a person to act. Because rational people make decisions by compar-ing costs and benefits, they respond to incentives. You will see that incentivesplay a central role in the study of economics. One economist went so far as tosuggest that the entire field could be simply summarized: “People respond toincentives. The rest is commentary.”

Incentives are crucial to analyzing how markets work. For example, when theprice of an apple rises, people decide to eat more pears and fewer applesbecause the cost of buying an apple is higher. At the same time, apple orchardsdecide to hire more workers and harvest more apples because the benefit of sell-ing an apple is also higher. As we will see, the effect of a good’s price on thebehavior of buyers and sellers in a market—in this case, the market for apples—is crucial for understanding how the economy allocates scarce resources.

Public policymakers should never forget about incentives because many poli-cies change the costs or benefits that people face and, therefore, alter theirbehavior. A tax on gasoline, for instance, encourages people to drive smaller,more fuel-efficient cars. That is one reason people drive smaller cars in Europe,where gasoline taxes are high, than in the United States, where gasoline taxesare low. A gasoline tax also encourages people to take public transportationrather than drive and to live closer to where they work. If the tax were larger,more people would be driving hybrid cars, and if it were large enough, theywould switch to electric cars.

When policymakers fail to consider how their policies affect incentives, theyoften end up with results they did not intend. For example, consider public pol-icy regarding auto safety. Today, all cars have seat belts, but this was not true 50years ago. In the 1960s, Ralph Nader’s book Unsafe at Any Speed generated muchpublic concern over auto safety. Congress responded with laws requiring seatbelts as standard equipment on new cars.

How does a seat belt law affect auto safety? The direct effect is obvious: Whena person wears a seat belt, the probability of surviving a major auto accidentrises. But that’s not the end of the story because the law also affects behavior byaltering incentives. The relevant behavior here is the speed and care with whichdrivers operate their cars. Driving slowly and carefully is costly because it usesthe driver’s time and energy. When deciding how safely to drive, rational peoplecompare the marginal benefit from safer driving to the marginal cost. They drivemore slowly and carefully when the benefit of increased safety is high. It is nosurprise, for instance, that people drive more slowly and carefully when roadsare icy than when roads are clear.

Consider how a seat belt law alters a driver’s cost–benefit calculation. Seatbelts make accidents less costly because they reduce the likelihood of injury or

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 7

incentivesomething that inducesa person to act

BASKETBALL STAR LEBRON JAMESUNDERSTANDS OPPORTUNITY COST

AND INCENTIVES. HE DECIDED TOSKIP COLLEGE AND GO STRAIGHT TO

THE PROS, WHERE HE HAS EARNEDMILLIONS OF DOLLARS AS ONE OF

THE NBA’S TOP PLAYERS.

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“FOR $5 A WEEK YOU CANWATCH BASEBALL WITHOUT

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death. In other words, seat belts reduce the benefits of slow and careful driving.People respond to seat belts as they would to an improvement in road condi-tions—by driving faster and less carefully. The end 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 anaccident but (unlike the drivers) don’t have the benefit of added protection.

At first, this discussion of incentives and seat belts might seem like idle spec-ulation. Yet in a classic 1975 study, economist Sam Peltzman showed that auto-safety laws have had many of these effects. According to Peltzman’s evidence,these laws produce both fewer deaths per accident and more accidents. He con-cluded that the net result is little change in the number of driver deaths and anincrease in the number of pedestrian deaths.

Peltzman’s analysis of auto safety is an offbeat example of the general princi-ple that people respond to incentives. When analyzing any policy, we must con-sider not only the direct effects but also the indirect and sometimes less obviouseffects that work through incentives. If the policy changes incentives, it willcause people to alter their behavior.

List and briefly explain the four principles of individual decision

making.

8 PART 1 INTRODUCTION

HOW PEOPLE INTERACT

The first four principles discussed how individuals make decisions. As we goabout our lives, many of our decisions affect not only ourselves but other peopleas well. The next three principles concern how people interact with one another.

Principle 5: Trade Can Make Everyone Better Off

You have probably heard on the news that the Japanese are our competitors inthe world economy. In some ways, this is true because American and Japanesefirms produce many of the same goods. Ford and Toyota compete for the samecustomers in the market for automobiles. Apple and Sony compete for the samecustomers in the market for digital music players.

Yet it is easy to be misled when thinking about competition among countries.Trade between the United States and Japan is not like a sports contest in whichone side wins and the other side loses. In fact, the opposite is true: Tradebetween two countries can make each country better off.

To see why, consider how trade affects your family. When a member of yourfamily looks for a job, he or she competes against members of other families whoare looking for jobs. Families also compete against one another when they goshopping 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 itselffrom all other families. If it did, your family would need to grow its own food,make its own clothes, and build its own home. Clearly, your family gains muchfrom its ability to trade with others. Trade allows each person to specialize in the CA

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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 atlower cost.

Countries as well as families benefit from the ability to trade with oneanother. Trade allows countries to specialize in what they do best and to enjoy agreater variety of goods and services. The Japanese, as well as the French andthe Egyptians and the Brazilians, are as much our partners in the world econ-omy as they are our competitors.

Principle 6: Markets Are Usually a Good Way to Organize Economic Activity

The collapse of communism in the Soviet Union and Eastern Europe in the 1980smay be the most important change in the world during the past half century.Communist countries worked on the premise that government officials were inthe best position to determine the allocation of scarce resources in the economy.These central planners decided what goods and services were produced, howmuch was produced, and who produced and consumed these goods and ser-vices. The theory behind central planning was that only the government couldorganize economic activity in a way that promoted economic well-being for thecountry as a whole.

Today, most countries that once had centrally planned economies have aban-doned this system and are trying to develop market economies. In a marketeconomy, the decisions of a central planner are replaced by the decisions of mil-lions of firms and households. Firms decide whom to hire and what to make.Households decide which firms to work for and what to buy with their incomes.These firms and households interact in the marketplace, where prices and self-interest guide their decisions.

At first glance, the success of market economies is puzzling. After all, in amarket economy, no one is looking out for the economic well-being of society asa whole. Free markets contain many buyers and sellers of numerous goods andservices, and all of them are interested primarily in their own well-being. Yetdespite decentralized decision making and self-interested decision makers, mar-ket economies have proven remarkably successful in organizing economic activ-ity in a way that promotes overall economic well-being.

In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations,economist Adam Smith made the most famous observation in all of economics: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 goalsin this book is to understand how this invisible hand works its magic.

As you study economics, you will learn that prices are the instrument withwhich the invisible hand directs economic activity. In any market, buyers look atthe price when determining how much to demand, and sellers look at the pricewhen deciding how much to supply. As a result of the decisions that buyers andsellers make, market prices reflect both the value of a good to society and thecost to society of making the good. Smith’s great insight was that prices adjust toguide these individual buyers and sellers to reach outcomes that, in many cases,maximize the welfare of society as a whole.

There is an important corollary to the skill of the invisible hand in guiding eco-nomic activity: When the government prevents prices from adjusting naturally tosupply and demand, it impedes the invisible hand’s ability to coordinate the mil-lions of households and firms that make up the economy. This corollary explains

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 9

market economyan economy that allo-cates resources throughthe decentralized deci-sions of many firms andhouseholds as they inter-act in markets for goodsand services

why taxes adversely affect the allocation of resources: Taxes distort prices andthus the decisions of households and firms. It also explains the even greater harmcaused by policies that directly control prices, such as rent control. And itexplains the failure of communism. In communist countries, prices were notdetermined in the marketplace but were dictated by central planners. These plan-ners lacked the information that gets reflected in prices that are free to respond tomarket forces. Central planners failed because they tried to run the economy withone hand tied behind their backs—the invisible hand of the marketplace.

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 roleand scope of government policy.

One reason we need government is that the invisible hand can work its magiconly if the government enforces the rules and maintains the institutions that are

10 PART 1 INTRODUCTION

FYI

Adam Smith and the Invisible Hand

It may be only a

coincidence that

Adam Smith’s

great book The Wealth of Nations was published in 1776, the

exact year American revolutionaries signed the Declaration of

Independence. But the two documents share a point

of view that was prevalent at the time: Individuals

are usually best left to their own devices, without

the heavy hand of government guiding their actions.

This political philosophy provides the intellectual

basis for the market economy and for free society

more generally.

Why do decentralized market economies work so

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 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 favor, and show them

that it is for their own advantage to do for him what he

requires of them. . . . It is not from the benevolence of the

butcher, the brewer, or the baker that we expect our din-

ner, but from their regard to their own interest. . . .

Every individual . . . neither intends to promote the pub-

lic 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 pro-

motes that of the society more effectually

than when he really intends to promote it.

Smith is saying that participants in the econ-

omy are motivated by self-interest and that

the “invisible hand” of the marketplace

guides this self-interest into promoting gen-

eral economic well-being.

Many of Smith’s insights remain at the center of modern

economics. Our analysis in the coming chapters will allow us to

express Smith’s conclusions more precisely and to analyze fully

the strengths and weaknesses of the market’s invisible hand.

Adam Smith

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key to a market economy. Most important, markets work only if property rightsare enforced. A farmer won’t grow food if he expects his crop to be stolen; arestaurant won’t serve meals unless it is assured that customers will pay beforethey leave; and a music company won’t produce CDs if too many potentialcustomers 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 counts on our ability to enforce our rights.

Yet there is another, more profound reason we need government: The invisi-ble hand is powerful, but it is not omnipotent. Although markets are often agood way to organize economic activity, this rule has some important excep-tions. There are two broad reasons for a government to intervene in the econ-omy and change the allocation of resources that people would choose on theirown: to promote efficiency and to promote equity. That is, most policies aimeither to enlarge the economic pie or to change how the pie is divided.

Consider first the goal of efficiency. Although the invisible hand usually leadsmarkets to allocate resources efficiently, this is not always the case. Economistsuse the term market failure to refer to a situation in which the market on itsown fails to produce an efficient allocation of resources. One possible cause ofmarket failure is an externality, which is the impact of one person’s actions onthe well-being of a bystander. The classic example of an externality is pollution.Another possible cause of market failure is market power, which refers to theability of a single person (or small group) to unduly influence market prices. Forexample, if everyone in town needs water but there is only one well, the ownerof the well is not subject to the rigorous competition with which the invisiblehand normally keeps self-interest in check. In the presence of externalities ormarket power, well-designed public policy can enhance economic efficiency.

The invisible hand may also fail to ensure that economic prosperity is distrib-uted equitably. A market economy rewards people according to their ability toproduce things that other people are willing to pay for. The world’s best basket-ball player earns more than the world’s best chess player simply because peopleare willing to pay more to watch basketball than chess. The invisible hand doesnot ensure that everyone has sufficient food, decent clothing, and adequatehealthcare. Many public policies, such as the income tax and the welfare system,aim to achieve a more equitable distribution of economic well-being.

To say that the government can improve on market outcomes at times doesnot mean that it always will. Public policy is made not by angels but by a politi-cal process that is far from perfect. Sometimes policies are designed simply toreward the politically powerful. Sometimes they are made by well-intentionedleaders who are not fully informed. As you study economics, you will become abetter judge of when a government policy is justifiable because it promotes effi-ciency or equity and when it is not.

List and briefly explain the three principles concerning people’s eco-

nomic interactions.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 11

HOW THE ECONOMY AS A WHOLE WORKS

We started by discussing how individuals make decisions and then looked athow people interact with one another. All these decisions and interactions

market failurea situation in which amarket left on its ownfails to allocateresources efficiently

externalitythe impact of one per-son’s actions on the well-being of a bystander

market powerthe ability of a singleeconomic actor (or smallgroup of actors) to havea substantial influenceon market prices

property rightsthe ability of an individ-ual to own and exercisecontrol over scarceresources

together make up “the economy.” The last three principles concern the workingsof 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 2003, theaverage American had an income of about $37,500. In the same year, the averageMexican earned $8,950, and the average Nigerian earned $900. Not surprisingly,this large variation in average income is reflected in various measures of thequality of life. Citizens of high-income countries have more TV sets, more cars,better nutrition, better healthcare, and a longer life expectancy than citizens oflow-income countries.

Changes in living standards over time are also large. In the United States,incomes have historically grown about 2 percent per year (after adjusting forchanges in the cost of living). At this rate, average income doubles every 35years. Over the past century, average income has risen about eightfold.

What explains these large differences in living standards among countries andover time? The answer is surprisingly simple. Almost all variation in living stan-dards is attributable to differences in countries’ productivity—that is, theamount of goods and services produced from each hour of a worker’s time. Innations where workers can produce a large quantity of goods and services perunit of time, most people enjoy a high standard of living; in nations whereworkers are less productive, most people endure a more meager existence. Simi-larly, the growth rate of a nation’s productivity determines the growth rate of itsaverage income.

The fundamental relationship between productivity and living standards issimple, but its implications are far-reaching. If productivity is the primary deter-minant of living standards, other explanations must be of secondary importance.For example, it might be tempting to credit labor unions or minimum-wage lawsfor the rise in living standards of American workers over the past century. Yetthe real hero of American workers is their rising productivity. As another exam-ple, some commentators have claimed that increased competition from Japanand other countries explained the slow growth in U.S. incomes during the 1970sand 1980s. Yet the real villain was not competition from abroad but flagging pro-ductivity growth in the United States.

The relationship between productivity and living standards also has profoundimplications for public policy. When thinking about how any policy will affectliving standards, the key question is how it will affect our ability to producegoods and services. To boost living standards, policymakers need to raise pro-ductivity by ensuring that workers are well educated, have the tools needed toproduce goods and services, and have access to the best available technology.

Principle 9: Prices Rise When the Government Prints Too Much Money

In Germany in January 1921, a daily newspaper cost 0.30 marks. Less than 2years later, in November 1922, the same newspaper cost 70,000,000 marks. Allother prices in the economy rose by similar amounts. This episode is one of his-tory’s most spectacular examples of inflation, an increase in the overall level ofprices in the economy.

12 PART 1 INTRODUCTION

productivitythe quantity of goodsand services producedfrom each hour of aworker’s time

inflationan increase in the overalllevel of prices in theeconomy

- 5 -

Although the United States has never experienced inflation even close to thatin Germany in the 1920s, inflation has at times been an economic problem. Dur-ing the 1970s, for instance, the overall level of prices more than doubled, andPresident Gerald Ford called inflation “public enemy number one.” By contrast,inflation in the 1990s was about 3 percent per year; at this rate, it would takemore than 20 years for prices to double. Because high inflation imposes variouscosts on society, keeping inflation at a low level is a goal of economic policymak-ers around the world.

What causes inflation? In almost all cases of large or persistent inflation, theculprit is growth in the quantity of money. When a government creates largequantities of the nation’s money, the value of the money falls. In Germany in theearly 1920s, when prices were on average tripling every month, the quantity ofmoney was also tripling every month. Although less dramatic, the economic his-tory of the United States points to a similar conclusion: The high inflation of the1970s was associated with rapid growth in the quantity of money, and the lowinflation of the 1990s was associated with slow growth in the quantity of money.

Principle 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment

Although a higher level of prices is, in the long run, the primary effect ofincreasing the quantity of money, the short-run story is more complex and morecontroversial. Most economists describe the short-run effects of monetary injec-tions as follows:

• Increasing the amount of money in the economy stimulates the overall levelof spending and thus the demand for goods and services.

• Higher demand may over time cause firms to raise their prices, but in themeantime, it also encourages them to increase the quantity of goods andservices they produce and to hire more workers to produce those goods andservices.

• More hiring means lower unemployment.

This line of reasoning leads to one final economywide trade-off: a short-runtrade-off between inflation and unemployment.

Although some economists still question these ideas, most accept that societyfaces a short-run trade-off between inflation and unemployment. This simplymeans that, over a period of a year or two, many economic policies push infla-tion and unemployment in opposite directions. Policymakers face this trade-offregardless of whether inflation and unemployment both start out at high levels(as they were in the early 1980s), at low levels (as they were in the late 1990s), orsomeplace in between. This short-run trade-off plays a key role in the analysis ofthe business cycle—the irregular and largely unpredictable fluctuations in eco-nomic activity, as measured by the production of goods and services or the num-ber of people employed.

Policymakers can exploit the short-run trade-off between inflation and unem-ployment using various policy instruments. By changing the amount that thegovernment spends, the amount it taxes, and the amount of money it prints, pol-icymakers can influence the combination of inflation and unemployment thatthe economy experiences. Because these instruments of economic policy arepotentially so powerful, how policymakers should use these instruments to con-trol the economy, if at all, is a subject of continuing debate.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 13

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business cyclefluctuations in economicactivity, such as employ-ment and production

List and briefly explain the three principles that describe how the

economy as a whole works.

14 PART 1 INTRODUCTION

FYI

How to Read This Book

Economics is fun,

but it can also be

hard to learn. My

aim in writing this text is to make it as fun and easy as possible.

But you, the student, also have a role to play. Experience shows

that if you are actively involved as you study this book, you will

enjoy a better outcome both on your exams and in the years

that follow. Here are a few tips about how best to read this

book.

1. Summarize, don’t highlight. Running a yellow marker over

the text is too passive an activity to keep your mind

engaged. Instead, when you come to the end of a section,

take a minute and summarize what you just learned in your

own words, writing your summary in the wide margins

we’ve provided. When you’ve finished the chapter, compare

your summaries with the one at the end of the chapter. Did

you pick up the main points?

2. Test yourself. Throughout the book, Quick Quizzes offer

instant feedback to find out if you’ve learned what you are

supposed to. Take the opportunity to write down your

answer and then check it against the answers provided in

the back of the book. The quizzes are meant to test your

basic comprehension. If your answer is incorrect, you proba-

bly need to review the section.

3. Practice, practice, practice. At the end of each chapter,

Questions for Review test your understanding, and Problems

and Applications ask you to apply and extend the material.

Perhaps your instructor will assign some of these exercises as

homework. If so, do them. If not, do them anyway. The more

you use your new knowledge, the more solid it becomes.

4. Go online. The publisher of this book maintains an extensive

website to help you in your study of economics. It includes

additional examples, applications, and problems, as well as

quizzes so you can test yourself. Check it out. The website is

http://mankiw.swlearning.com.5. Study in groups. After you’ve read the book and worked

problems on your own, get together with classmates to dis-

cuss the material. You will learn from each other—an exam-

ple of the gains from trade.

6. Don’t forget the real world. In the midst of all the numbers,

graphs, and strange new words, it is easy to lose sight of

what economics is all about. The Case Studies and In the

News boxes sprinkled throughout this book should help

remind you. Don’t skip them. They show how the theory is

tied to events happening in all of our lives. If your study is

successful, you won’t be able to read a newspaper again

without thinking about supply, demand, and the wonderful

world of economics.

CONCLUSION

You now have a taste of what economics is all about. In the coming chapters, wewill develop many specific insights about people, markets, and economies. Mas-tering these insights will take some effort, but it is not an overwhelming task.The field of economics is based on a few basic ideas that can be applied in manydifferent situations.

Throughout this book, we will refer back to the Ten Principles of Economicshighlighted in this chapter and summarized in Table 1. Whenever we do so, anicon will be displayed in the margin, as it is now. But even when that icon isabsent, you should keep these building blocks in mind. Even the most sophisti-cated economic analysis is built using the ten principles introduced here.

- 6 -

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 15

11T A B L E

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 Organize Economic Activity

7: Governments Can Sometimes Improve Market Outcomes

How the Economy as a Whole Works

8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and

Services

9: Prices Rise When the Government Prints Too Much Money

10: Society Faces a Short-Run Trade-off between Inflation and Unemployment

KEY CONCEPTS

• The fundamental lessons about individual deci-sion making are that people face trade-offsamong alternative goals, that the cost of anyaction is measured in terms of forgone opportuni-ties, that rational people make decisions by com-paring marginal costs and marginal benefits, andthat people change their behavior in response tothe incentives they face.

• The fundamental lessons about interactions amongpeople are that trade can be mutually beneficial,that markets are usually a good way of coordi-

nating trade among people, and that the govern-ment can potentially improve market outcomes ifthere is some market failure or if the market out-come is inequitable.

• The fundamental lessons about the economy as awhole are that productivity is the ultimate sourceof living standards, that money growth is theultimate source of inflation, and that societyfaces a short-run trade-off between inflation andunemployment.

SUMMARY

scarcity, p. 3economics, p. 4efficiency, p. 5equity, p. 5opportunity cost, p. 6rational people, p. 6

market power, p. 11productivity, p. 12inflation, p. 12business cycle, p. 13

marginal changes, p. 6incentive, p. 7market economy, p. 9property rights, p. 11market failure, p. 11externality, p. 11

16 PART 1 INTRODUCTION

1. Describe some of the trade-offs faced by each ofthe following:a. a family deciding whether to buy a new carb. a member of Congress deciding how much to

spend on national parksc. a company president deciding whether to

open a new factoryd. a professor deciding how much to prepare

for class

2. You are trying to decide whether to take a vaca-tion. Most of the costs of the vacation (airfare,hotel, and forgone wages) are measured in dol-lars, but the benefits of the vacation are psycho-logical. How can you compare the benefits tothe costs?

3. You were planning to spend Saturday workingat your part-time job, but a friend asks you to goskiing. What is the true cost of going skiing?Now suppose you had been planning to spendthe day studying at the library. What is the costof going skiing in this case? Explain.

4. You win $100 in a basketball pool. You have achoice between spending the money now orputting it away for a year in a bank account thatpays 5 percent interest. What is the opportunitycost of spending the $100 now?

5. The company that you manage has invested $5million in developing a new product, but thedevelopment is not quite finished. At a recentmeeting, your salespeople report that the intro-duction of competing products has reduced theexpected sales of your new product to $3 mil-

lion. If it would cost $1 million to finish devel-opment and make the product, should you goahead and do so? What is the most that youshould pay to complete development?

6. Three managers of the Magic Potion Companyare discussing a possible increase in production.Each suggests a way to make this decision.

HARRY: We should examine whether ourcompany’s productivity—gallons ofpotion per worker—would rise orfall.

RON: We should examine whether ouraverage cost—cost per worker—would rise or fall.

HERMIONE: We should examine whether theextra revenue from selling the addi-tional potion would be greater orsmaller than the extra costs.

Who do you think is right? Why?

7. The Social Security system provides income forpeople over age 65. If a recipient of Social Secu-rity decides to work and earn some income, theamount he or she receives in Social Security ben-efits is typically reduced.a. How does the provision of Social Security

affect people’s incentive to save whileworking?

b. How does the reduction in benefits associ-ated with higher earnings affect people’sincentive to work past age 65?

PROBLEMS AND APPLICATIONS

1. Give three examples of important trade-offs thatyou face in your life.

2. What is the opportunity cost of seeing a movie?

3. Water is necessary for life. Is the marginal bene-fit of a glass of water large or small?

4. Why should policymakers think about incen-tives?

5. Why isn’t trade among countries like a gamewith some winners and some losers?

6. What does the “invisible hand” of the market-place do?

7. Explain the two main causes of market failureand give an example of each.

8. Why is productivity important?

9. What is inflation and what causes it?

10. How are inflation and unemployment related inthe short run?

QUESTIONS FOR REVIEW

- 7 -

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 17

8. A recent bill reforming the government’s anti-poverty programs limited many welfare recipi-ents to only 2 years of benefits.a. How does this change affect the incentives

for working?b. How might this change represent a trade-off

between equity and efficiency?

9. Your roommate is a better cook than you are,but you can clean more quickly than your room-mate can. If your roommate did all of the cook-ing and you did all of the cleaning, would yourchores take you more or less time than if youdivided each task evenly? Give a similar exam-ple of how specialization and trade can maketwo countries both better off.

10. Suppose the United States adopted central plan-ning for its economy, and you became the chiefplanner. Among the millions of decisions thatyou need to make for next year are how manycompact discs to produce, what artists to record,and who should receive the discs.a. To make these decisions intelligently, what

information would you need about the com-pact disc industry? What information wouldyou need about each of the people in theUnited States?

b. How would your decisions about CDs affectsome of your other decisions, such as howmany CD players to make or cassette tapes toproduce? How might some of your otherdecisions about the economy change yourviews about CDs?

11. Nations with corrupt police and court systemstypically have lower standards of living thannations with less corruption. Why might that bethe case?

12. Explain whether each of the following govern-ment activities is motivated by a concern aboutequity or a concern about efficiency. In the caseof efficiency, discuss the type of market failureinvolved.a. regulating cable TV prices

b. providing some poor people with vouchersthat can be used to buy food

c. prohibiting smoking in public placesd. breaking up Standard Oil (which once owned

90 percent of all oil refineries) into severalsmaller companies

e. imposing higher personal income tax rates onpeople with higher incomes

f. instituting laws against driving while intoxi-cated

13. Discuss each of the following statements fromthe standpoints of equity and efficiency.a. “Everyone in society should be guaranteed

the best healthcare possible.”b. “When workers are laid off, they should be

able to collect unemployment benefits untilthey find a new job.”

14. In what ways is your standard of living differentfrom that of your parents or grandparents whenthey were your age? Why have these changesoccurred?

15. Suppose Americans decide to save more of theirincomes. If banks lend this extra saving to busi-nesses, which use the funds to build new facto-ries, how might this lead to faster growth in pro-ductivity? Who do you suppose benefits fromthe higher productivity? Is society getting a freelunch?

16. Imagine that you are a policymaker trying todecide whether to reduce the rate of inflation. Tomake an intelligent decision, what would youneed to know about inflation, unemployment,and the trade-off between them?

17. Look at a newspaper or at the website http://www.economist.com to find three stories aboutthe economy that have been in the news lately.For each story, identify one (or more) of the TenPrinciples of Economics discussed in this chapterthat is relevant and explain how it is relevant.Also, for each story, look through this book’sContents and try to find a chapter that mightshed light on the news event.

For further information on topics in this chapter, additional problems,applications, examples, online quizzes, and more, please visit our website athttp://mankiw.swlearning.com.

- 8 -

Joint Economic Forecast Autumn 2013:

Economy Picking Up –

Put Budget Surpluses

To Good Use

Press summary

Embargo until::

Thursday, 17 October 2013, 11:00 a.m. CEST

Joint Economic Forecast Project Group

Completed in Essen on 15 October 2013

2

Summary Economy Picking Up – Put Budget Surpluses To Good Use The German economy is on the verge of an upturn driven by do-mestic demand. The improving global economic climate and de-creasing uncertainty are fuelling investment. Private consumption is benefitting from favourable employment and income prospects. Real gross domestic product looks set to grow by 1.8 percent in 2014, after an increase of just 0.4 percent this year. Consumer prices are expected to rise by a moderate 1.6 percent this year and by 1.9 percent next year. The German public budget will continue to show a surplus. The world economy picked up in the first half year of 2013. Produc-tion primarily expanded more rapidly in the advanced economies, while the pace of growth in emerging economies, in contrast, barely picked up. Growing confidence on the part of companies in most countries suggests that the economic uptick will continue in the se-cond half of the year. Although economic activity in the advanced economies remains con-strained by structural problems, there have been signs of a recovery since the beginning of the year. The US economy has coped very well with cuts to the public budget. Japan’s new government has succeeded in clearly stimulating the country’s economy with its highly expansive economic policy, while the British economy has managed to put stag-nation behind it. Finally, production in the euro area recently in-creased for the first time in 18 months. In emerging economies the growth dynamic remains strong overall, but has slowed down consid-erably in recent years. The lack of good institutions is proving a grow-ing constraint. This is particularly true of the large emerging econo-mies Brazil, Russia, India and China. Weaker growth in China, an economy that has heavily influenced the pace of world economic growth over the last decade, is of the greatest important in this respect. The central banks in all of the advanced economies have announced their intention to remain on an expansive course this year and next. This announcement was credible since price dynamic and inflation expectations are already low or, in the case of Japan, a higher price

- 9 -

3

dynamic would even be welcome. It is more difficult to predict when central banks will deem that the time has come to cautiously downscale the expansiveness of monetary policy. In the forecasting period, however, this problem only applies to monetary policy in the USA. The situation in the US labour market, however, will continue to improve in the winter half-year and the US Federal Reserve Bank is then expected to begin to scale back monetary expansion. In the US the stalemate in Congress is currently blocking all financial policy decisions once again. Should no agreement on the debt ceiling for the federal budget be reached, then the USA’s ability to pay its capital market creditors is even at stake. It is assumed, however, that an agreement will ultimately be reached on raising the debt ceiling. However, this will probably not offer a stable solution to the financial policy blockade. In the euro area, the measures and timeframe for reaching overall consolidation goals remain unclear. This forecast as-sumes that financial policy will become less constrictive. The slightly faster pace of world economic growth in the first half of 2013 will be sustained in the second half of the year, as well as in 2014. The improvement seen in sentiment also has fundamental roots: some of the factors constraining economic activity since the financial crisis are slowly becoming less significant. World production will ex-pand by 2.1% in 2013, and thus at around the same pace as in 2012. In 2014 growth is expected to amount to 2.8%. The economic environ-ment does pose significant risks to this forecast. Should the federal debt ceiling in the USA not be raised by mid-October, spending would have to be cut by the size of the current government deficit which is around 4% of gross domestic product. This would trigger a severe re-cession in the USA with serious implications for the world economy. The forecast of a gradual recovery of the euro area from the crisis is also by no means guaranteed. The German economy is on the verge of an upturn in autumn 2013. Livelier growth in the world economy and decreasing uncertainty about the crisis in the euro area are creating an environment in which favourable domestic economic conditions have a greater bearing. The sharp increase in output in the second quarter of this year could not be sustained since it was due to catch-up effects after the long, hard win-

4

ter. Current indicators, however, point to an underlying upward ten-dency in the economy. Rising employment and considerable increases in wages have been responsible for a robust development in private consumption for some time. This development looks set to continue over the remainder of the forecasting period, since employment will increase considerably. Ex-ports will be stimulated by a further upturn in the world economy. Ex-ports in non-European countries have been rising rather dynamically for some time, and deliveries to the euro area will gain impetus as its economy stabilises. Overall, however, the increase in German exports will be moderate. Imports, on the other hand, will be stimulated by strong domestic demand. The contribution of international trade to growth is expected to remain negative on balance. Against a background of decreasing uncertainty over a renewed inten-sification of the crisis in the euro area and a brighter sales outlook in world markets, investment activity over the forecast period looks set to pick up slowly. Favourable financing conditions will therefore con-tinue to impact the economy. Construction activity will be supported by the favourable investment environment, and especially low interest rates. Overall, gross domestic product is expected to increase by 0.4 percent this year (68 percent projection interval: 0.2 to 0.6 percent). The low average annual increase is mainly due to significant declines in pro-duction in the winter half year of 2012/2013. Gross domestic product is expected to increase by 1.8 percent in the year ahead (68 percent projection interval: 0.6 to 3.0 percent). The German economy will ex-pand faster than production potential in 2014 and the capacity utilisa-tion rate is expected to increase significantly. The upward development in prices is expected remain moderate dur-ing the forecasting period, with inflation rates of 1.6 percent in this year and 1.9 percent in the year ahead. The number of employed per-sons is expected to increase by 235,000 persons on average this year, and by 260,000 persons in 2014. Since, however, the size of the poten-tial workforce is increasing, this will not be reflected in any significant

- 10 -

5

decrease in unemployment. The unemployment looks set to decline only slightly from 6.9 percent in 2013 to 6.8 percent in 2014. The total public budget will close the year with a surplus of around 3 billion euros, or 0.1 percent of gross domestic product. Next year this surplus will rise to almost 8 billion euros, or 0.3 percent of gross do-mestic product as the economic situation improves. This forecast is based on the budget and finance plans as they currently stand. Risks for the German economy primarily lie in the fact that the situa-tion in the euro area remains fragile and the possibility that the crisis may flare up again cannot be excluded. The instruments created in re-cent years to stabilize the financial markets, and the European Central bank’s announcement of its willingness to intervene, under specific conditions, in the government bonds market in order to stabilise it, have only calmed down the situation temporarily, but do not represent a long-term solution. Any relaxation of political efforts to build a sus-tainable framework for European Monetary Union, or any abate in the consolidation and reform efforts in the crisis-afflicted countries could result in renewed tensions in the financial markets. Important decisions are waiting to be taken in German economic poli-cy in autumn 2013. Since the German Bundestag elections did not yield any clear majority, the course to be pursued by the future gov-ernment will only emerge over the weeks ahead. This forecast was made based on economic policy under status quo conditions. During the election campaign, however, many proposals were put forward which – should they be implemented – would bring changes to eco-nomic, financial and social policy. These changes would involve both distribution issues, as well as the promotion of economic growth. Financial policy in recent years has attempted to consolidate the pub-lic budget and has therefore created a favourable economic situation. In 2012 Germany presented a structurally almost balanced budget for the first time since 2000 and this will also apply to 2013. Based on the assumption that the increase in public spending will be very limited in the mid-term and that there will be no changes to tax rules, the gov-ernment surplus will increase considerably to reach 1½ percent of nominal gross domestic product by 2018. Part of this surplus, howev-

6

er, is subject to cyclical considerations and should be used to pay off debts, as stipulated in principle by the German debt brake. The cycli-cally-adjusted public sector balance will be 1 percent of nominal gross domestic product in 2018. This corresponds to 33 billion euros. This amount represents the budgetary scope enjoyed by financial policy, without the need to raise taxes. Financial policy should put the budget surplus to good use. It could be used to reduce “cold” progression in income tax (i.e., increasing bur-den on the taxpayers who are shifted by inflation into higher tax brackets) and to make investments in the fields of infrastructure, edu-cation and research. Additional scope could be created by eliminating subsidies. With its announcement that it would defend the euro with all of the resources at its disposal, the ECB calmed down the situation in the fi-nancial markets and created a breathing space for economic policy. Its intervention, however, may possibly have had negative effects on the intensity of reform processes, by lessening pressure from the financial markets. With its monetary policy the ECB reacted to the subdued develop-ments in money and credit growth and dropped the interest rate for Eurosystem main financing operations by 25 points to 0.5 percent on 2 May 2013. However, the limits of expansive monetary policy in the euro area are now emerging. There will be no further noticeable stabi-lising impulses for the economy from further interest rate decreases in the crisis-afflicted countries, because the problems in their banking sectors have not yet been resolved. The institutes see a clean-up of these banking sectors as the key to an economic recovery. The owners and creditors of the banks should be called upon in the first instance, and in exceptional cases deposit holders beyond the limit of deposit protection. The national states would subsequently have to accept re-sponsibility for the remaining old liabilities. A limited form of Euro-pean burden-sharing should only be a last resort.

- 11 -

7

Members of the Joint Economic Forecast Project Group: Deutsches Institut für Wirtschaftsforschung e.V. www.diw.de Press contact Tel.: (030) 89789 252 E-Mail: sfiedler@diw.de in co-operation with: Österreichisches Institut für Wirtschaftsforschung www.wifo.ac.at ifo Institut – Leibniz-Institut für Wirtschaftsforschung an der Universität München e.V. www.ifo.de Press contact Tel.: (089) 9224 1604 E-Mail: marquardt@ifo.de

in co-operation with: KOF Konjunkturforschungsstelle der ETH Zürich www.kof.ethz.ch Institut für Wirtschaftsforschung Halle www.iwh-halle.de Press contact Tel.: (0345) 77 53 720 E-Mail: Stefanie.Orphal@iwh-halle.de

in co-operation with: Kiel Economics www.kieleconomics.de Rheinisch-Westfälisches Institut für Wirtschaftsforschung www.rwi-essen.de Press contact Tel.: (0201) 81 49 213 E-Mail: sabine.weiler@rwi-essen.de

in co-operation with: Institut für Höhere Studien Wien www.ihs.ac.at

Joint Economic Forecast Autumn 2013 (17.10.2013)

Federal Republic of Germany 2011 2012 2013 2014

(1) (1)Percentage change over previous yeara)

Private consumption 2,3 0,8 0,9 1,4Government consumption 1,0 1,0 0,9 1,0Gross fixed capital formation (GFCF) 6,9 -2,1 -0,5 5,2 Machinery and equipment 5,8 -4,0 -2,2 7,0 Construction 7,8 -1,4 0,2 4,2 GFCF in other products 5,1 3,4 3,0 4,7Domestic demand 2,8 -0,3 0,8 2,1 Exports of goods and services 8,0 3,2 0,5 5,0 Imports of goods and services 7,4 1,4 1,2 6,2Gross domestic product (GDP) 3,3 0,7 0,4 1,8

Employmentb) (1.000 persons) 41152 41608 41843 42102Unemployment (1.000 persons) 2976 2897 2952 2942Unemployment ratec) (in %) 7,1 6,8 6,9 6,8Consumer pricesd)(% change on the previous year) 2,1 2,0 1,6 1,9General government financial balancee)

- EUR billion -21,5 2,3 3,0 7,7 - in % of GDP -0,8 0,1 0,1 0,3Balance on current account - EUR billion 161,2 185,6 196 200 - in % of GDP 6,2 7,0 7,2 7,01) Forecast by the Institutes.- a) Price adjusted.- b) Domestic employment.-c) Federal Employment Agency concept.- d) Consumer price index (2010=100).e) On national accounts definition (ESA 1995).Source: Federal Statistical Office, Federal Employment Agency, forecast by the Institutes.

- 12 -

Member of the Joint Economic Forecast: Deutsches Institut für Wirtschaftsforschung e.V. - www.diw.de Pressekontakt Tel.: (030) 89789‑252 E-Mail: sfiedler@diw.de in co-operation with: Österreichisches Institut für Wirtschaftsforschung www.wifo.ac.at ifo Institut – Leibniz-Institut für Wirtschaftsforschung an der Universität München e.V. - www.ifo.de in co-operation with:KOF Konjunkturforschungsstelle der ETH Zürich www.kof.ethz.ch Institut für Wirtschaftsforschung Halle www.iwh-halle.de Pressekontakt Tel.: (0345) 77 53 720 E-Mail: Stefanie.Orphal@iwh-halle.de in co-operation with: Kiel Economics -- www.kieleconomics.de Rheinisch-Westfälisches Institut für Wirtschaftsforschung www.rwi-essen.de in co-operation with: Institut für Höhere Studien Wien www.ihs.ac.at

- 13 -

Statistisches Bundesamt

German economy 2013

Gross domestic productPrice-adjusted, change on the previous year in %

-6

-4

-2

0

2

4

6

2002 03 04 05 06 07 08 09 10 11 12 2013

Average 2002-2012

+1.2+0.4

Federal Statistical Office

National AccountsNational accounts provide a comprehensive quantitative picture of economic development within a country, i.e. in this case Germany. The most important national accounts aggregate is the gross domestic product (GDP). The GDP measures the domestic production of goods and services minus the intermediate consumption of goods and services.

National accounts provide important data to the political community, administration and businesses for assessing

The national accounting system within the European Union is based on harmonised European rules that are laid down in a legally binding form in the European System of National and Regional Accounts (ESA 1995)

The national accounts results are published in a lot of

the whole national accounts publication programme. More

national accounts in Germany are available on the internet at www.destatis.de.

Agriculture, forestryand fishing

Industry

Services

Taxes less subsidieson products (net taxes)

Final consumptionexpenditure

Gross fixed capitalformation

Changes in inventories

Balance of exports andimports (net exports)

Compensation ofemployeesProperty and entre-preneurial income

Taxes on productionand imports lesssubsidies

Consumption of fixedcapital

Balance of primaryincome from the restof the world

Production Use Distribution

Gross domestic product

= =

+

+

+

+

+

–

==

Production of gross domestic product

2011 2012 2013

At current prices (EUR bn.)

Gross value added 2,334.9 2,386.8 2,451.2

Agriculture, forestry and fishing 18.5 20.0 18.8

Industry, excluding construction 607.8 616.9 625.2

Construction 109.2 111.3 114.9

Services 1,599.5 1,638.6 1,692.4

+ Taxes on products 281.5 285.6 290.7

– Subsidies on products 6.5 6.0 6.2

= Gross domestic product 2,609.9 2,666.4 2,735.8

Price-adjusted, chain-linked1

Gross value added 3.3 0.8 0.4

Agriculture, forestry and fishing – 22.5 1.6 – 0.1

Industry, excluding construction 5.5 – 0.4 – 0.0

Construction 4.6 – 2.4 – 1.2

Services 2.7 1.4 0.6

Taxes on products 3.5 – 0.1 0.5

Subsidies on products 2.0 – 6.4 1.8

Gross domestic product 3.3 0.7 0.4

1 Change on the previous year in %.

Production of gross domestic product 2013 in %1

Industry, excl.construction

Construction

Services

Agriculture, forestry and fishing

2,735.8EUR bn.

69

26

5

1

1 As measured by gross value added (GVA) at current prices of the relevantindustry as percentage of total GVA at current prices.

- 14 -

Use of gross domestic product

2011 2012 2013

At current prices (EUR bn.) Final consumption expenditure of house-

holds and NPISHs 1,498.4 1,533.9 1,572.0+ Government final consumption expenditure 499.6 514.4 534.6+ Gross fixed capital formation 473.2 470.6 471.4+ Changes in inventories1 3.2 – 10.3 – 8.9= Domestic use 2,474.3 2,508.5 2,569.1+ Balance of exports and imports 135.7 157.9 166.7

Memorandum item: Exports 1,321.4 1,381.0 1,382.4Imports 1,185.8 1,223.1 1,215.7

= Gross domestic product 2,609.9 2,666.4 2,735.8

Price-adjusted, chain-linked2

Final consumption expenditure of house-holds and NPISHs 2.3 0.8 0.9Government final consumption expenditure 1.0 1.0 1.1Gross fixed capital formation 6.9 – 2.1 – 0.8Changes in inventories1, 3 – 0.1 – 0.5 0.0Domestic use 2.8 – 0.3 0.7Balance of exports and imports3 0.7 0.9 – 0.3

Memorandum item: Exports 8.0 3.2 0.6Imports 7.4 1.4 1.3

Gross domestic product 3.3 0.7 0.4

1 Inclusive acquisitions less disposals of valuables. – 2 Change on the previous year in %. – 3 Contribution to GDP growth in %-points.

Use of gross domestic product 2013 in %

Gross capitalformation

Private final consumptionexpenditure (householdsand NPISHs)

Balance of exports and imports

2,735.8bn.EUR

6

17

5720

Governmentfinal consumptionexpenditure

Distribution of gross domestic product

2011 2012 2013

At current prices (EUR bn.)

Net wages and salaries 723.4 751.9 773.8

+ Income taxes and social contributions (of employees) 358.3 374.8 387.6

= Gross wages and salaries 1,081.7 1,126.6 1,161.4

+ Employers’ social contributions 244.3 251.0 255.7

= Compensation of employees 1,325.9 1,377.6 1,417.1

+ Property and entrepreneurial income 686.1 676.6 695.3

= Net national income (factor costs) 2,012.0 2,054.3 2,112.3

– Subsidies1 27.2 24.6 25.7

+ Taxes on production and imports2 293.0 298.3 303.3

= Net national income 2,277.9 2,328.0 2,389.9

+ Consumption of fixed capital 391.1 402.1 408.8

= Gross national income 2,668.9 2,730.1 2,798.7

– Balance of primary income from the rest of the world 59.0 63.7 62.9

= Gross domestic product 2,609.9 2,666.4 2,735.8

1 Paid by general government. – 2 Received by general government.

Compensation of employees, property andentrepreneurial income1991 = 100

50

100

150

200

91 93 95 97 99 2001 03 05 07 09 11 2013

Compensationof employees

Property and entre-preneurial income

Key data for total economy

2011 2012 2013

Gross domestic product (GDP) price-adjusted1 3.3 0.7 0.4

GDP at current prices in EUR bn. 2,609.9 2,666.4 2,735.8

GDP per capita in EUR2 31,914 32,550 33,338

Total population in 1,000 81,779 81,917 82,062

Persons in employment (domestic concept) in 1,000 41,152 41,608 41,841

Unemployed persons in 1,0003 2,502 2,316 2,280

Economically active population as % of total population3 53.3 53.5 53.7

Unemployed persons as % of economically active population 5.7 5.3 5.2

Gross national income in EUR bn. 2,668.9 2,730.1 2,798.7

Disposable income of households in EUR bn. 1,641.5 1,679.9 1,715.2

Saving ratio (saving as % of disposable income of households) 10.4 10.3 10.0

Labour productivity (per capita)1,4 1.9 – 0.4 – 0.2

Labour productivity (per hour)1,4 1.8 0.5 0.2

Compensation of employees per employee1 3.0 2.6 2.0

Compensation of employees per hour worked by employees1 2.7 3.3 2.3

Unit labour costs (per capita)1,5 1.0 3.1 2.2

Unit labour costs (per hour)1,5 0.9 2.8 2.1

Wage ratio, unadjusted (compensation of employees as % of net national income at factor costs) 65.9 67.1 67.1

Government deficit ratio (Net lending/net borrowing as % of GDP at current prices) – 0.8 0.1 – 0.1

1 Change on the previous year in %. – 2 Results of the 2011 Census not included. –

the ILO. – 4 Price-adjusted GDP per person in employment resp. per hour worked by persons in employment. – 5 Compensation of employees per employee resp. per hour worked by employees in relation to labour productivity per person inemployment resp. per hour worked by persons in employment.

- 15 -

Macroeconomic data for Germanyin %

Growth1

1 Change of price-adjusted gross domestic product (GDP) on the previousyear. – 2 Net lending/Net borrowing of general government as % of GDP. –3 Change of persons in employment (domestic concept) on the previousyear. – 4 Change of consumer price index (CPI) on the previous year.

2009 2011 2013

-5.1

4.0

3.3

0.70.4

Net lending/Net borrowing2

2009 2011 2013

-3.1

-4.2

-0.8

0.1

-0.1

Employment3

2009 2011 2013

0.10.5

1.41.1

0.6

Inflation4

2009 2011 2013

0.3

1.1

2.1 2.01.5

Economic development since 1950

Year1 Gross domestic product

Gross national income

Net national income at factor costs

Gross domestic productper inhabitant

per person in employment

EUR bn. EURFormer territory of the Federal Republic without Saarland and Berlin (West)

1950 49.7 50.4 40.1 1,059 2,539

1955 91.9 92.3 72.7 1,868 4,084Former territory of the Federal Republic

1960 154.8 154.9 122.8 2,792 5,9381965 234.8 234.3 183.3 4,005 8,7741970 360.6 361.6 282.1 5,945 13,5621975 551.0 552.0 430.5 8,912 20,9921980 788.5 790.0 609.3 12,808 28,7571985 984.4 990.7 762.4 16,132 35,6571990 1,306.7 1,317.9 1,017.9 20,658 42,970

Germany1991 1,534.6 1,541.6 1,217.2 19,186 39,6411995 1,848.5 1,832.6 1,423.9 22,636 48,9002000 2,047.5 2,025.9 1,540.9 24,912 51,9912005 2,224.4 2,249.6 1,713.7 26,974 57,0712010 2,495.0 2,549.4 1,922.2 30,517 61,4732011 2,609.9 2,668.9 2,012.0 31,914 63,4212012 2,666.4 2,730.1 2,054.3 32,550 64,0842013 2,735.8 2,798.7 2,112.3 33,338 65,386

1 The results of the different territories are not fully comparable as the underlying

Gross domestic product (GDP) at current pricesas part of the GDP of the Euro area in 2013 in %

29%

Germany2,735.8 EUR bn.

Euro area9,612.3EUR bn.

Economic growth in international perspective1

2010 2011 2012 2013

Change of price-adjusted GDP on the previous year in %

Austria 1.8 2.8 0.9 0.4

Belgium 2.3 1.8 – 0.1 0.1

Cyprus 1.3 0.4 – 2.4 – 8.7

Estonia 2.6 9.6 3.9 1.3

Finland 3.4 2.7 – 0.8 – 0.6

France 1.7 2.0 0.0 0.2

Germany 4.0 3.3 0.7 0.4

Greek – 4.9 – 7.1 – 6.4 – 4.0

Ireland – 1.1 2.2 0.2 0.3

Italy 1.7 0.5 – 2.5 – 1.8

Latvia – 1.3 5.3 5.0 4.0

Luxembourg 3.1 1.9 – 0.2 1.9

Malta 4.0 1.6 0.8 1.8

Netherlands 1.5 0.9 – 1.2 – 1.0

Portugal 1.9 – 1.3 – 3.2 – 1.8

Slovakia 4.4 3.0 1.8 0.9

Slovenia 1.3 0.7 – 2.5 – 2.7

Spain – 0.2 0.1 – 1.6 – 1.3

Euro area 1.9 1.6 – 0.7 – 0.4

Bulgaria 0.4 1.8 0.8 0.5

Croatia – 2.3 0.0 – 2.0 – 0.7

Czech Republik 2.5 1.8 – 1.0 – 1.0

Denmark 1.6 1.1 – 0.4 0.3

Hungary 1.1 1.6 – 1.7 0.7

Lithuania 1.6 6.0 3.7 3.4

Poland 3.9 4.5 1.9 1.3

Romania – 1.1 2.2 0.7 2.2

Sweden 6.6 2.9 1.0 1.1

United Kingdom 1.7 1.1 0.1 1.3

EU 28 2.0 1.7 – 0.4 0.0

China 11.6 9.4 7.8 7.5

Japan 4.7 – 0.6 2.0 2.1

USA 2.5 1.8 2.8 1.6

1 European Commission, Economic Forecasts Autumn 2013, except for Germany.

- 16 -

Further informationFor subject-related information please contact the National Accounts Infoteam: Phone + 49 (0) 611 / 75 26 26

For written requests please use our e-mail address gdp-info@destatis.de or our contact form www.destatis.de/contact

For general information on the Statistisches Bundesamt (Federal Statistical Office) please consult www.destatis.de or call our information service:Phone: +49 (0) 611 / 75 24 05

Publicationswww.destatis.de/publications

www.destatis.de/genesis

Published January 2014Order Number: 0000018-14700-1

© Statistisches Bundesamt, Wiesbaden 2014Reproduction and distribution, also of parts, are permitted provided that the source is mentioned

- 17 -

Monitor ing economic performance,qual i ty of l i fe and sustainabi l i ty

Joint Report as requested by theFranco-German Ministerial Council

December 2010

Conseil d‘Analyse Économique113 rue de Grenelle75007 ParisTel.: 0033 1 / 4275 5300Fax: 0033 1 / 4275 5127E-Mail: pierre.joly@pm.gouv.frInternet: http://www.cae.gouv.fr

Sachverständigenrat zur Begutachtungder gesamtwirtschaftlichen EntwicklungStatistisches Bundesamt65180 WiesbadenTel.: 0049 611 / 75 2390 / 3640 / 4694Fax: 0049 611 / 75 2538E-Mail: srw@destatis.deInternet: http://www.sachverstaendigenrat.org

Released in January 2011Price: € 15, - [D]Order number: 7700009-11900-1ISBN: 978-3-8246-0942-0© SachverständigenratPrinted by: Bonifatius GmbH Druck-Buch-Verlag, D-33042 Paderborn

- 18 -

Preface III

CAE / SVR - Report 2010

PREFACE

1. The Franco-German Ministerial Council decided on February 4, 2010 to ask the French Conseil d’Analyse Économique (CAE) and the German Council of Economic Experts (GCEE) to follow-up on the outcome of the “Commission on the Measurement of Economic Performance and Social Progress” (Stiglitz-Sen-Fitoussi Commission, or SSFC).

The CAE and GCEE have fulfilled this request by preparing a report on

„Monitoring economic performance, quality of life and sustainability“.

It discusses how comprehensiveness and accuracy of an indicator set might be traded off op-timally with parsimony and cost to provide a reliable basis for regular, timely and digestible reporting on three key issues regarding economic performance, quality of life and sustainabil-ity.

2. As the world is emerging from its worst economic crisis of the last six decades, there is a broad consensus among policy makers and the general public that this should be a moment of pause and sincere reflection. From the vantage point of economics and statistics, three in-timately related key questions should form the focus of such considerations: First, how can we improve our monitoring of economic performance in order to allow policy makers to gauge the current state of affairs and to react timely and appropriately when crises emerge? Second, how can we broaden our perspective from its current focus on economic performance to an assessment of the quality of life more generally, in order to appreciate what really counts for human welfare? And third, how can we design warning signals that alert us whenever the current manner of organizing our lives endangers sustainability, in order to correct our course of action for the sake of our own future and that of generations to come?

The first and arguably most important conclusion of our study is that a single-indicator ap-proach to measuring human progress is inherently insufficient. Complexity of life and the demands on statistical reporting are too diverse to allow a meaningful condensation of the current state of affairs into a single comprehensive indicator. Instead, we suggest that com-prehensive statistical reporting should entail a dashboard of indicators. The dashboard we propose is meant to be a starting point for discussion. It is intended to be rich enough to facili-tate a sensible discussion of the relevant facets of human welfare, but it is also not over-whelmingly extensive. Moreover, it provides a balanced representation of the three areas ad-dressed by the key questions, economic performance, quality of life and sustainability. This approach acknowledges that monitoring material well-being is an indispensable prerequisite for sensible economic policy, that life is about more than material well-being, but that human progress in non-material aspects is quite difficult to capture, and that it is wise to take a long-term perspective by outlining the consequences of unmodified human behavior.

IV Preface

CAE / SVR - Report 2010

3. The two involved institutions prepared this report with the following division of labour: The CAE took the lead in preparing Chapter II and section 2 of Chapter IV, while the GCEE took the lead in drafting Chapter III and section 3 of Chapter IV. Sections 1, 4 and 5 of Chap-ter IV are a joint product. Chapter I constitutes an introduction and summary of the report.

4. The CAE would like to thank Professor Christian Saint-Etienne for having kindly agreed to be the coordinator for the French Council.

The CAE is also grateful to Philippe Cunéo and Claire Plateau from INSEE for their com-ments and contributions to this report. The whole staff of the Conseil d’Analyse Économique has helped by providing research and logistic support and must be thanked, especially Chris-tine Carl for editing the French version and Agnès Mouze for documentation.

French contributions owe a lot to the work of CAE’s scientific advisers, Associate Professor Jézabel Couppey-Soubeyran, Professor Jerôme Glachant, Professor Lionel Ragot, Professor Stephane Saussier, Professor Thomas Weitzenblum and Associate Professor Anne Yvrande-Billon. They must be thanked for it.

The General-Secretary Pierre Joly can be praised for his contributions and for coordinating this joint report on the French side.

5. The GCEE would like to express his profound gratitude to Professor Dr. Christoph M. Schmidt. His intense efforts as the main author and coordinator on the German side helped immensely in producing the report.

The GCEE would also like to thank staff from the German Statistical Office, specifically from the national and environmental accounts units, for providing helpful comments. As usual the members of the branch that work with the GCEE on a daily basis have helped prepare this report. We would like to thank Anita Demir, Diplom-Volkswirt Wolfgang Glöckler, Diplom-Volkswirtin Birgit Hein, Christoph Hesse, Klaus-Peter Klein, Uwe Krüger, Sabrina Mäncher, Volker Schmitt and Hans-Jürgen Schwab for their reliable and valuable input.

Last but not least, the GCEE would like to express his gratitude for the tireless efforts of its staff without which the German contribution to the report would not have been possible. Therefore, the GCEE specifically thanks Diplom-Volkswirtin and Diplom-Wirtschaftssinologin Ulrike Bechmann, Hasan Doluca, M.S., Dr. Malte Hübner, Dr. Anabell Kohlmeier, Dr. Heiko Peters, Dr. Stefan Ried, Diplom-Volkswirt Dominik Rumpf, Dr. Christoph Swonke, Dr. Marco Wagner and Dr. Benjamin Weigert. Special thanks go to Dr. Ulrich Klüh, whose input as Secretary-General until July 31 contributed considerably in preparing this report. Thanks also go to Dr. Jens Clausen, who as Secretary-General from Au-gust 1 on contributed to this report by coordinating the work of the staff and providing valu-able inputs.

- 19 -

Preface V

CAE / SVR - Report 2010

6. All views expressed in this report as well as all remaining errors should only be attrib-uted to the authors mentioned below.

Paris and Wiesbaden on December 6, 2010

Conseil d’Analyse Économique

Christian de Boissieu Jean-Philippe Cotis

Michel Didier Christian Saint-Etienne

Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung

Peter Bofinger Wolfgang Franz

Christoph M. Schmidt Beatrice Weder di Mauro Wolfgang Wiegard

VI Content

CAE / SVR - Report 2010

ContentPage

CHAPTER I Conceptual Foundations and Guiding Principles ........................................................... 1

1. The challenge .....................