Chapter 1: Introduction (pages 3-14)

Summary in haiku form

Each doing what’s best for them.
Is that good for all?

Summary in one paragraph

Economics is about the actions and interactions of optimizing individuals. These individuals are simply trying to satisfy their own preferences—they are not just selfish jerks, and economics is not just about money—and the Big Question in economics is about what a world full of optimizing individuals looks like. Sometimes that world looks heavenly: individual self-interest leads to good outcomes for the group as a whole, as expressed in the metaphor of the Invisible Hand. But sometimes individual self-interest leads to bad outcomes for the group as a whole, as in the case of traffic congestion or other instances of the Tragedy of the Commons. We’ll see plenty of examples in the chapters ahead as we build up from individual optimization (decision theory) to strategic interactions between individuals (game theory) and finally to market interactions between many individuals (price theory).

Notes on specific pages

Page 4: “The only reason I don’t sell my children is that I think they’ll be worth more later.”

Here’s a compendium of similar “you might be an economist if…” jokes.

Page 4: “The main assumption in economics is that every single person is an optimizing individual.”

It’s difficult to overstate the importance of this assumption. If individuals are optimizing, for example, we can abolish Social Security because rational individuals will save for their own retirement. Few people are willing to push the idea of optimizing individuals to this sort of logical extreme: even many “libertarians” want to privatize Social Security, not abolish it; but the alternative to the idea of optimizing individuals (that people are not optimizing individuals and that other people—in the guise of the government—know what’s best for them) is not all that appealing either. This choice between the frying pan and the fire creates one of the central tensions in economics.

Page 9: Macroeconomics versus microeconomics

The “9 out of 5” line is adapted from Paul Samuelson, who in 1966 wrote that “Wall Street indexes predicted nine out of the last five recessions!” Samuelson won the 1970 Nobel Prize “for the scientific work through which he has developed static and dynamic economic theory and actively contributed to raising the level of analysis in economic science”

The “wrong about specific things” line from PJ O’Rourke is adapted from his book Eat the rich: A treatise on economics (1999).

Page 11: The tragedy of the commons

It’s better to wait on this until we return to the topic in Chapter 8, but “The tragedy of the commons” (easier to read in PDF) refers to a 1968 article in Science by Garrett Hardin.

Page 12: “I, Pencil”

I, Pencil” is a must-read fairy tale by Leonard Read about the miracle of the invisible hand. Originally published in The Freeman in 1958, the work is often mis-attributed to Milton Friedman, who retold the story in Free to Choose and wrote the afterward in this 50th-anniversary PDF of “I, Pencil”. (Friedman won the 1976 Nobel Prize “for his achievements in the fields of consumption analysis, monetary history and theory and for his demonstration of the complexity of stabilization policy.”)

A good compare-and-contrast article with “I, Pencil” is “Health care that works” by Nicholas Kristof (NYT 9/2/09). Note that they both talk about the postal service!

Page 12: Hot dogs

See interesting articles like “Ovens on Feet Beckon Germans to Bratwurst“, “The Half-Million-Dollar Wiener“, “A Prominent Collection at the Met: Food Carts“, and “Dispute at the Met Escalates as the Police Ticket Seven Food Vendors“.

Page 13: The invisible hand

Adam Smith was a Scottish philosopher and “the father of modern economics”. The metaphor of the “invisible hand” comes from The Wealth of Nations, first published in 1776. (You can still buy it today, and though not always a page-turner it’s remarkably readable.)

Chapter 2: Decision Tree (pages 15-26)

Summary in haiku form

Pick the best option
From among all your choices.
What’s hard about that?

Summary in one paragraph

Optimizing individuals look at all their options and pick the best one. We can learn about individual optimization by using decision trees to see, e.g., that sunk costs—which appear in all the outcome boxes—cannot be the sole basis for a decision. Although companies are actually collections of individuals, each with their own goals, economists often assume that companies act like individuals whose goal is profit-maximization.

Notes on specific pages

Page 21: Marginal analysis

“Marginal” means thinking about one more or one less, so the “marginal benefit” from a few more minutes of fishing is the extra benefit from those few additional minutes; the “marginal utility” of one more dollar’s worth of apples is the extra utility (i.e., pleasure) from spending $13 on apples instead of $12; and the “value of the marginal product of labor” is the extra amount of revenue a firm can get from hiring one more unit of labor (e.g., one more hour’s worth of labor).

Page 22: Pirate economics

The expert on pirate economics is Peter Leeson, author of The Invisible Hook: The Hidden Economics of Pirates (2009) as well as papers such as “”Pirational choice: The economics of infamous pirate practices” and “this interview he argues that pirates were (and are) “economic actors, businessmen really” and that this explains why real pirates didn’t make people walk the plank (!).

Principal-agent theory looks at the incentives involved when an employer (the principal) is dealing with an employee (the agent), or similarly when stockholders are dealing with company managers. Since the incentives of the agent may not match those of the principal, the challenge is for the principal to design an incentive structure that gives the agent appropriate incentives to act in accordance with the principal’s goals. (For example, an employer could pay an employee on commission.)

p24: On drug companies, see “Questcor Finds Profits, at $28,000 a Vial” (NY Times, Dec 29 2012). Also “Drug Firms Face Billions in Losses in ’11 as Patents End” (NY Times, March 6 2011).

Page 26: “Higher prices don’t always lead to higher profits”

In 2009 tech columnist David Pogue wrote about the Apple “App Store Effect“, claiming that “if you cut a software program’s price in half, you sell far more than twice as many copies. If you cut it to one-tenth, you sell far more than 10 times as many. And so on.”

Chapter 3: Time (pages 27-38)

Summary in haiku form

A tricky question,
Today versus tomorrow.
Use present value.

Summary in one paragraph

Optimizing individuals often have to make choices over time, e.g., between money today and money tomorrow. These cannot be directly compared because of inflation and also because most individuals have a preference for sooner rather than later. In order to compare money today and money tomorrow we can use the interest rate at the bank to convert everything into a common unit: present value, the amount of money you’d need to put in the bank today in order to finance one or more payments in the future. We can use the concept of present value to find a “money today” equivalent for future payments received as lump sums, annuities, or perpetuities, with the surprising conclusion that a perpetuity—a perpetual stream of annual payments, e.g., $100 a year forever—is not worth an infinite amount of money.

Notes on specific pages

Page 32: “Present value is the value today of one or more future payments.”

Fine examples of present value can be found in the 2009 Social Security Trustees Report or the 2009 Medicare Trustees Report. These are giant documents, so just search for the phrase “present value” until you find the sections about how the present value of the 75-year deficits (i.e., the amount required to keep these programs solvent for the next 75 year) are $5.3 trillion for Social Security, $13.4 trillion for Medicare HI (hospital care), $23.2 trillion for Medicare Part B (out-patient) and $9.4 trillion for Medicare Part D (prescriptions drugs). (If you think these are big numbers, consider the “infinite-horizon” deficits, which are $15.1 trillion for Social Security, $36.4 trillion for Medicare HI, $50.1 trillion for Medicare Part B, and $20.3 trillion for Medicare Part D.) For a summary of the status of Social Security and Medicare, scroll down to Charts B and C in this summary from the Social Security and Medicare Boards of Trustees.

You can also look in the glossary at the end of these reports to get their definition: “Present value. The present value of a future stream of payments is the lump-sum amount that, if invested today, together with interest earnings would be just enough to meet each of the payments as it fell due. At the time of the last payment, the invested fund would be exactly zero.” Note that they’re assuming investments in U.S. government bonds, which as the safest investment in the world also have the lowest interest rate.

Page 30: “Inflation, a general increase in prices over time.”

The U.S. Bureau of Labor Statistics has an inflation calculator that you can use to look at the Consumer Price Index (one measure of inflation), and there’s an optional chapter in the textbook on inflation, but remember that even without inflation there is still a positive interest rate because people have a preference for sooner rather than later!

Page 35: “You can still blow it all today even if you take the annuity!”

Google “sell annuity” and you’ll find dozens of firms eager to pay cash upfront in exchange for annuities or other “structured payments”.

Chapter 4: Risk (pages 39-52)

Summary in haiku form

Should I risk a fine?
Or feed the parking meter?
Expected value.

Summary in one paragraph

Optimizing individuals also have to makes choices about uncertainty, e.g., whether to buy insurance or whether to go gambling. An important concept is expected value, which can be thought of as the average outcome of a risky situation. If you want to get formal about it, the Law of Large Numbers says that repeating a bet a large number of times is likely to produce an average outcome close to the expected value; this explains why casinos and insurance companies are not necessarily risky businesses. Expected value calculations also demonstrate the problem of adverse selection: when buyers and sellers don’t both have the same information—for example, consumers who know more about their health than insurance companies—the resulting information asymmetry can lead to an outcome where individual optimization does not lead to good outcomes for the group as a whole.

Notes on specific pages

Page 40: “Optimizing individuals can have one of three different attitudes about risk.”

We’ll return to the topic in Chapter 16, but Daniel Kahneman shared the 2002 Nobel Prize (with Vernon Smith) “for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty.” (Basically, Kahneman and co-author Amos Tversky—who would almost have shared the prize had he lived long enough—showed that people don’t really act like optimizing individuals, e.g., they treat small losses as “more important” than small gains.)

Page 41: “Why is he winning so much? He owns the casino!”

A fun read here is “Casinos have great night” (The Onion, May 28, 2003).

Page 47: James Tobin and the theory of optimal investments

Jim Tobin won the 1981 Nobel Prize “for his analysis of financial markets and their relations to expenditure decisions, employment, production and prices.” The jokes about “Congratulations, you win the Nobel Prize” started with a true story recounted as follows in his 2002 NY Times obituary: After he won the Nobel Prize, reporters asked him to explain the portfolio theory. When he tried to do so, one journalist interrupted, ”Oh, no, please explain it in lay language.” So he described the theory of diversification by saying: ”You know, don’t put your eggs in one basket.” Headline writers around the world the next day created some version of ”Economist Wins Nobel for Saying, ‘Don’t Put Eggs in One Basket.’ ”

Page 49: George Akerlof and adverse selection

George Akerlof shared the 2001 Nobel Prize (with Michael Spence and Joseph Stiglitz) “for their analyses of markets with asymmetric information.” Akerlof’s Nobel-prize-winning ideas about adverse selection were rejected by three journals before finally being published in the Quarterly Journal of Economics. Read more about this and other terrific rejection stories in “How are the mighty fallen: Rejected classic articles by leading economists” (Joshua S. Gans and George B. Shepherd, Journal of Economic Perspectives 8:165-179, 1994).

Page 52: “It does help explain why economists spend so much time debating health care policy.”

Some interesting articles on health care policy include this short-and-sweet article on the “public option” by Victor Fuchs, often called the father of health economics, and a longer article, “Rethinking Social Insurance“, which is actually Martin Feldstein’s presidential address to the American Economic Association in January 2005. (Feldstein was thought to be one of the three top candidates to take over leadership of the Federal Reserve when Alan Greenspan retired. Ben Bernanke was the lucky winner; Felstein was arguably an even luckier loser, and so was Glenn Hubbard, whose students at CBS—Columbia Business School—made this terrific consolation-prize video.) There are of course a million other articles you can find by economists and others.

Chapter 5: From One to Some (pages 53-64)

Summary in haiku form

An econ surprise:
Comparative advantage.
Just let people trade!

Summary in one paragraph

Moving from a world with just a single individual to a world with multiple individuals allows us to study the benefits of trade. The example of comparative advantage—called the only surprising example in economics—shows that trade between two people can provide mutual benefits even when one person is better than the other at everything. This shows that it can sometimes be difficult to see potential benefits from trade, but the Coase Theorem says that optimizing individuals have an incentive to keep trading until they exhaust all possible gains from trade. This suggests that a world full of optimizing individuals will be orderly rather than chaotic, and in fact we see this order in phenomena like the law of one price, which predicts that goods that are easy to trade will be sold at approximately the same price all over the world.

Notes on specific pages

Page 60: Ronald Coase and the Coase Theorem

Ronald Coase won the 1991 Nobel Prize “for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy.”

Paul Krugman won the 2008 Nobel Prize “for his analysis of trade patterns and location of economic activity.”

Efficient market hypothesis

Need to add links to Links to Ricardo, BB King.