Principles of Economics 3e PDF Download – Shapiro, MacDonald & Greenlaw (3rd Edition, OpenStax) BS Economics/BBA

Principles of Economics 3e is the introductory economics textbook from OpenStax, written by David Shapiro, Daniel MacDonald and Steven A. Greenlaw with a team of contributing authors, and you can download it free as a PDF from the official OpenStax site. Its 34 chapters run from scarcity and supply and demand through market structures and microeconomic policy to GDP, unemployment, inflation, money, fiscal policy and international trade.

It is one book that covers both microeconomics and macroeconomics, so it suits a first course for BS Economics and BBA students. OpenStax also publishes the same material as two separate books, Principles of Microeconomics 3e (20 chapters) and Principles of Macroeconomics 3e (21 chapters), so if your course covers only one half, the smaller book is enough. This page gives a summary, key points and practice questions for every chapter, plus a study plan, so you know what to read first before you open the official book.

Book Overview

Chapter List

Chapter 1: Welcome to Economics!

Part 1: What Is Economics? · Difficulty: Easy · Key topics: scarcity, division of labor, specialization, microeconomics, macroeconomics, theories and models, circular flow diagram, economic systems, globalization

The opening chapter defines economics as the study of how humans make decisions in the face of scarcity, where wants for goods, services and resources exceed what is available. It explains why division of labor and specialization raise output, citing Adam Smith, learning effects and economies of scale, and why they only work when people can buy what they do not make. It then separates microeconomics from macroeconomics, shows how economists use theories and models such as the circular flow diagram, and compares traditional, command and market economies before introducing globalization.

Key Points:

• Scarcity means human wants for goods, services and resources exceed what is available; even time is scarce, since everyone has only 24 hours a day.
• Division of labor lets people specialize and then buy what they do not produce, which only works when markets exist.
• Microeconomics studies individuals, firms and industries; macroeconomics studies the whole economy, with goals of growth, low unemployment and low inflation.
• Macroeconomic policy comes in two types: monetary policy and fiscal policy.
• A theory or model is a tool for finding the answer to a problem, not an illustration of the answer.
• Societies are organized as traditional, command or market economies, and most are a mix of the three.
• The book draws much of its data from FRED, the St. Louis Federal Reserve database of nearly 400,000 domestic and international variables.

Memory Tip: Micro is the microscope (one household, one firm, one market) and macro is the satellite photo of the same city (total output, jobs, prices).

Common Mistake: Treating economics as the study of money. The book defines it as the study of decisions under scarcity, and money is only one tool inside that story.

Important Questions:

• What is scarcity? Human wants for goods, services and resources exceed what is available, because labor, land, tools, raw materials and time are limited.
• What is the difference between microeconomics and macroeconomics? Microeconomics looks at parts of the economy such as individuals, firms and industries. Macroeconomics looks at the economy as a whole, including growth, unemployment and inflation.

Chapter 2: Choice in a World of Scarcity

Part 1: What Is Economics? · Difficulty: Easy · Key topics: budget constraint, opportunity cost, marginal analysis, sunk costs, production possibilities frontier, productive efficiency, allocative efficiency, positive and normative statements

This chapter builds the core tools of economic choice. A budget constraint shows what an individual can afford, and its slope is the relative price, so every choice carries an opportunity cost measured by what is given up. Marginal analysis, diminishing marginal utility and sunk costs explain how people decide. The chapter then scales up to society with the production possibilities frontier, the law of diminishing returns and the two kinds of efficiency, and it ends by separating positive statements from normative ones when it answers critics of the economic approach.

Key Points:

• A budget constraint is the frontier of the opportunity set; choices beyond it are not affordable, and its slope reflects relative prices.
• Opportunity cost is what you forgo in exchange; it can be measured in money, in time or in the resources given up.
• Sunk costs are in the past and cannot be recovered, so they should play no part in decisions about the future.
• A production possibilities frontier (PPF) usually curves outward because of increasing opportunity cost; points inside it are wasteful and points outside are unattainable.
• Every point on the PPF shows productive efficiency; allocative efficiency is the one point on the frontier that matches what society wants most.
• Positive statements describe the world as it is; normative statements say how it should be.

Memory Tip: On a PPF, remember “on the curve is efficient, inside is wasteful, outside is impossible”.

Common Mistake: Confusing a budget constraint with a PPF. The first is one person’s affordable set; the second is what a whole society can produce with its resources and technology.

Important Questions:

• What is opportunity cost? The cost of a choice measured by what you give up in exchange, such as the best alternative use of your money or time.
• What is the difference between productive and allocative efficiency? Productive efficiency means producing on the PPF with no waste. Allocative efficiency means choosing the point on the PPF that best matches what society wants.

Chapter 3: Demand and Supply

Part 2: Supply and Demand · Difficulty: Medium · Key topics: demand, supply, equilibrium, shifts in curves, ceteris paribus, four-step process, price ceilings, price floors, consumer surplus, deadweight loss

Chapter 3 introduces the first full analytical model in the book. Demand and supply schedules and curves express the law of demand and the law of supply, and equilibrium occurs where quantity demanded equals quantity supplied, with a shortage or a surplus on either side. The chapter separates shifts of the curves from movements along them, lists the factors behind each, and gives a four-step method for predicting changes in price and quantity. It then applies the model to price ceilings and floors and ends with consumer, producer and social surplus and deadweight loss.

Key Points:

• The law of demand says a higher price leads to a lower quantity demanded; the law of supply says a higher price leads to a higher quantity supplied.
• Equilibrium is where the curves cross; below the equilibrium price there is excess demand (a shortage), above it excess supply (a surplus).
• Demand shifts with tastes, population, income, prices of substitutes and complements, and expectations.
• Supply shifts with input prices, natural conditions, technology, and government taxes, regulations or subsidies.
• Four steps: sketch the market, decide whether supply or demand moves, decide the direction, then compare the new equilibrium with the old.
• A price ceiling below equilibrium causes a shortage; a price floor above equilibrium causes a surplus.
• Total surplus is largest at the equilibrium quantity; deadweight loss is the surplus lost when the economy produces any other quantity.

Memory Tip: If the price is the only thing that changed, you move along a curve; if anything other than the price changed, the whole curve shifts.

Common Mistake: Saying “demand rose” when a price fell and people bought more. That is a rise in quantity demanded, a movement along the curve, not a shift in demand.

Important Questions:

• What are the four steps for analyzing a change in equilibrium? Sketch the original market, decide whether the event shifts supply or demand, decide whether the shift is positive or negative and draw the new curve, then compare the new equilibrium price and quantity with the old ones.
• What happens when a price ceiling is set below the equilibrium price? Quantity demanded exceeds quantity supplied, so a shortage appears, and the ceiling often causes unintended consequences.

Chapter 4: Labor and Financial Markets

Part 2: Supply and Demand · Difficulty: Medium · Key topics: labor market, wage, financial capital, interest rate, minimum wage, usury laws, price controls, information in prices

Chapter 4 applies the demand and supply model to two markets that are not about ordinary goods. In the labor market households supply labor and firms demand it, and the price is the wage or salary. In financial markets the price is the rate of return or interest rate, and households and firms can be on either side. The chapter lists what shifts each curve, discusses the effects of a minimum wage and of interest rate ceilings, and closes by showing how market prices carry information about relative scarcity and why price controls hide it.

Key Points:

• In the labor market households are on the supply side and firms on the demand side; the price is the hourly wage or annual salary.
• Labor demand shifts with demand for the product the labor makes, changes in the production process and changes in government policy.
• In financial capital markets the price is the rate of return or interest rate, and the quantity is the money flowing from suppliers to demanders.
• The supply of financial capital shifts when people change their consumption or when the risk or return of an investment changes relative to others.
• The demand for financial capital shifts with business confidence and consumer confidence about the future.
• Prices tell market participants about relative scarcity without telling them why; price controls hide this information and cause misallocation of resources.

Memory Tip: Households are only suppliers in the labor market, but in financial markets they can be both: saving makes you a supplier, borrowing makes you a demander.

Common Mistake: Treating the interest rate as only a cost. For borrowers it is a cost, but for savers it is the return, and it is the same number seen from two sides.

Important Questions:

• Who supplies and who demands in the labor market? Households supply labor and firms demand it, so the wage is the price that balances the two.
• Why do price controls cause misallocation of resources? Controls hide the true scarcity of a product, labor or capital, so buyers and sellers act on a distorted signal instead of the real market price.

Chapter 5: Elasticity

Part 3: The Fundamentals of Microeconomic Theory · Difficulty: Medium · Key topics: price elasticity of demand, price elasticity of supply, midpoint method, elastic and inelastic, polar cases, tax incidence, income elasticity, cross-price elasticity

Chapter 5 measures how strongly quantity responds to a change in price. Price elasticity is the percentage change in quantity divided by the percentage change in price, calculated with the midpoint method, and demand or supply is described as elastic, inelastic or unitary. The chapter covers the polar cases of perfect elasticity and perfect inelasticity, explains why responses are usually smaller in the short run than in the long run, and uses elasticity to show who bears a tax. The last module extends the idea to income elasticity, cross-price elasticity, the wage elasticity of labor supply and the elasticity of savings.

Key Points:

• Price elasticity equals the percentage change in quantity divided by the percentage change in price; the midpoint method gives the same value in both directions.
• Elastic means a greater than proportional response, inelastic a smaller one, and unitary an equal one.
• Zero elasticity (perfectly inelastic) is a vertical curve; infinite elasticity (perfectly elastic) is a horizontal curve.
• Elasticity is not the slope: along a straight-line demand curve the elasticity changes from point to point.
• Demand and supply tend to be less elastic in the short run and more elastic in the long run.
• If supply is more elastic than demand, buyers bear most of a tax; if demand is more elastic, producers bear most of it.
• Income elasticity is positive for normal goods and negative for inferior goods; cross-price elasticity is positive for substitutes and negative for complements.

Memory Tip: Picture elasticity as stretchiness: a rubber band (elastic) stretches a lot when pulled, a steel bar (inelastic) barely moves.

Common Mistake: Using the slope of the demand curve as its elasticity. A flat curve is not always more elastic than a steep one, because elasticity uses percentage changes, not units.

Important Questions:

• How do you calculate price elasticity with the midpoint method? Divide the percentage change in quantity (change over the average of the two quantities) by the percentage change in price (change over the average of the two prices).
• Who bears more of a tax, buyers or sellers? The side that is less responsive to price, meaning the more inelastic side, bears more of the burden.

Chapter 6: Consumer Choices

Part 3: The Fundamentals of Microeconomic Theory · Difficulty: Medium · Key topics: utility, marginal utility, diminishing marginal utility, utility-maximizing choice, income effect, substitution effect, behavioral economics, loss aversion

Chapter 6 explains how households choose what to buy within a budget. It assumes people seek the highest utility, that total utility rises with consumption and that marginal utility diminishes. The chapter finds the utility-maximizing choice in three ways: adding up total utility along the budget line, moving between neighboring points, and comparing marginal utility per dollar across goods. It then traces how changes in income and prices alter choices through the income and substitution effects, and ends with behavioral economics, which uses ideas such as loss aversion to explain decisions that traditional theory finds irrational.

Key Points:

• Utility is satisfaction, and individuals are the only judge of their own utility.
• Diminishing marginal utility means each extra unit of a good adds less satisfaction than the one before.
• A consumer is in equilibrium when the marginal utility per dollar is equal across all goods (MU1/P1 = MU2/P2).
• When income rises, people buy more of normal goods and less of inferior goods.
• A price change works through a substitution effect and an income effect.
• Loss aversion means people value a dollar lost more than a dollar gained; over-withholding income tax to get a refund is the book’s example.

Memory Tip: Marginal utility per dollar is “bang per buck”: keep moving spending toward the good with more bang per buck until the two ratios match.

Common Mistake: Mixing up total and marginal utility. Total utility can still be rising while marginal utility is falling.

Important Questions:

• What is the condition for utility maximization? The marginal utility per dollar must be equal for every good the consumer buys, with the whole budget spent.
• What is loss aversion? A behavioral idea that people feel a loss more strongly than an equal gain, which can lead to choices that traditional consumer theory would call irrational.

Chapter 7: Production, Costs, and Industry Structure

Part 3: The Fundamentals of Microeconomic Theory · Difficulty: Medium · Key topics: explicit and implicit costs, economic profit, production function, marginal product, diminishing marginal productivity, fixed and variable costs, marginal cost, economies of scale

Chapter 7 separates explicit costs, which are payments a firm makes, from implicit costs, which are the opportunity cost of resources it already owns, so that accounting profit differs from economic profit. In the short run some inputs are fixed, the production function shows a marginal product that eventually falls, and total cost splits into fixed, variable, average and marginal cost. In the long run every input is variable, firms choose a production technology, and the long-run average cost curve shows economies of scale, constant returns to scale and diseconomies of scale.

Key Points:

• Accounting profit subtracts only explicit costs; economic profit subtracts both explicit and implicit costs.
• In the short run at least one input (such as capital) is fixed; in the long run all inputs are variable.
• Marginal product is the extra output from one more worker; at some point it falls, which is diminishing marginal productivity.
• Fixed costs are sunk and should play no role in decisions about future output or pricing.
• Marginal cost is the change in total cost from producing one more unit, and it rises with output because of diminishing marginal productivity.
• There are no diminishing returns in the long run, since they are caused by fixed capital.
• Economies of scale mean average cost falls as output rises; constant returns mean it stays flat; diseconomies of scale mean it rises.

Memory Tip: Marginal cost pulls average cost the way a new test score pulls your average: below the average it drags it down, above it pulls it up, so MC cuts AC at its lowest point.

Common Mistake: Mixing up diminishing marginal productivity (a short-run idea about one fixed input) with diseconomies of scale (a long-run idea about all inputs growing together).

Important Questions:

• What is the difference between accounting profit and economic profit? Accounting profit counts only explicit costs. Economic profit also subtracts implicit costs, the opportunity cost of resources the firm owns.
• Why are there no diminishing returns in the long run? Diminishing marginal productivity comes from fixed capital, and in the long run all inputs, including capital, can be changed.

Chapter 8: Perfect Competition

Part 3: The Fundamentals of Microeconomic Theory · Difficulty: Medium · Key topics: price taker, marginal revenue, profit maximization, break even point, shutdown point, entry and exit, long-run equilibrium, productive efficiency, allocative efficiency

Chapter 8 develops the first market structure, perfect competition, in which thousands of sellers offer identical products and entry is easy. Because each firm is a price taker, marginal revenue equals price, and profit is highest where marginal revenue equals marginal cost, giving a profit, a break-even or a loss depending on price against average cost. The chapter then follows entry and exit in the long run, which pushes profit toward zero, distinguishes constant, increasing and decreasing cost industries, and shows that long-run equilibrium achieves both productive and allocative efficiency.

Key Points:

• A perfectly competitive market has many sellers, easy entry and exit, identical products and price-taking firms.
• A price taker that charges even slightly more than the market price sells nothing.
• Profit is maximized where marginal revenue equals marginal cost, and for a competitive firm marginal revenue is the price.
• If price is above average cost at that quantity the firm earns a profit, if below it takes a loss, and if equal it breaks even.
• Entry in response to profits and exit in response to losses drive price toward the zero-profit point at the minimum of average cost.
• The long-run supply curve depends on whether the industry is constant cost, increasing cost or decreasing cost.
• Long-run equilibrium meets two conditions: allocative efficiency and productive efficiency.

Memory Tip: Free entry removes profit: profits attract new firms, new firms push the price down, and the process stops only when profit reaches zero.

Common Mistake: Reading zero economic profit as a failing business. It means revenue covers all costs, including a normal return on the owner’s own resources, so firms have no reason to leave.

Important Questions:

• Why is a perfectly competitive firm called a price taker? It is one of thousands of sellers of an identical product, so it must accept the equilibrium price; any higher price loses every sale.
• What two efficiency conditions does long-run perfect competition meet? Allocative efficiency, so resources go to their best alternative use, and productive efficiency, so goods are produced at the lowest possible cost.

Chapter 9: Monopoly

Part 3: The Fundamentals of Microeconomic Theory · Difficulty: Medium · Key topics: barriers to entry, natural monopoly, intellectual property, patents, legal monopoly, marginal revenue, profit-maximizing output, predatory pricing

Chapter 9 explains how a single seller can exist and how it behaves. Barriers to entry include economies of scale that create a natural monopoly, control of a physical resource, legal restrictions, intellectual property such as patents, trademarks, copyrights and trade secrets, and practices such as predatory pricing. A monopolist is not a price taker, so its total revenue first rises and then declines, and its marginal revenue falls as it sells more. It picks the output where marginal revenue equals marginal cost and charges the price that the demand curve allows for that quantity.

Key Points:

• Barriers to entry prevent or discourage competitors; they include scale economies, control of a resource, legal limits and intellectual property.
• Intellectual property laws are patents, copyrights, trademarks and trade secrets.
• A natural monopoly arises when economies of scale last so long that one firm can supply the whole market at lower cost than two.
• A monopolist is a price maker: choosing a quantity also determines the market price.
• Marginal revenue is below price because selling more pushes down the price on every unit sold.
• The profit-maximizing output is where MR equals MC, and the price is read from the demand curve at that quantity.
• A monopolist is neither productively nor allocatively efficient: compared with a competitive industry it produces less, at a higher average cost, and charges a higher price.

Memory Tip: Use two steps: find where MR equals MC and drop down to the quantity, then go up to the demand curve to read the price.

Common Mistake: Reading the price at the point where MR crosses MC. That point gives only the quantity; the price is higher, on the demand curve.

Important Questions:

• What are the main barriers to entry? Economies of scale (natural monopoly), control of a physical resource, legal restrictions, patents, trademarks and copyrights, and tactics such as predatory pricing.
• Why is a monopolist’s marginal revenue always less than its price? To sell one more unit it must lower the price, and the lower price applies to every unit it sells, not just the extra one.

Chapter 10: Monopolistic Competition and Oligopoly

Part 3: The Fundamentals of Microeconomic Theory · Difficulty: Medium · Key topics: product differentiation, perceived demand curve, oligopoly, collusion, cartel, game theory, prisoner’s dilemma, kinked demand curve, OPEC

Chapter 10 covers the markets that lie between perfect competition and monopoly. In monopolistic competition many firms sell differentiated products, so each faces a downward-sloping perceived demand curve that is more elastic than a monopolist’s, and each sets output where marginal revenue equals marginal cost. In an oligopoly a few firms sell most of the output, and they would earn the most by acting as a cartel, but collusion tends to break down and explicit collusion is illegal. The chapter uses game theory and the prisoner’s dilemma to show when cooperation helps all sides and why it is hard to sustain.

Key Points:

• Products can be differentiated by their characteristics, the location of the seller, intangible aspects and perceptions.
• A monopolistic competitor is a price maker, but its perceived demand is more elastic than a monopolist’s because it faces direct competition.
• A profit-maximizing monopolistic competitor produces where marginal revenue equals marginal cost.
• An oligopoly is a market where a few firms sell most or all of the goods.
• A cartel, such as OPEC, tries to cut output and raise price like a monopolist.
• Each cartel member gains by expanding output on its own, so collusion often breaks down.
• The prisoner’s dilemma shows that all sides can benefit from cooperation, but each has an incentive to act in its own interest.

Memory Tip: Every cartel member wants the others to hold back output while it sells a little more, which is exactly the prisoner’s dilemma.

Common Mistake: Treating a branded product as a sign of monopoly. A firm with a differentiated product still faces direct rivals, which is why its demand is more elastic than a monopolist’s.

Important Questions:

• What separates monopolistic competition from perfect competition? Monopolistic competitors sell differentiated products and face a downward-sloping demand curve, while perfect competitors sell identical products and are price takers.
• Why do cartels tend to break down? Each member can earn more by quietly expanding output, and explicit collusion is also illegal, so it is hard to enforce the agreement.

Chapter 11: Monopoly and Antitrust Policy

Part 4: Microeconomic Policy Issues · Difficulty: Medium · Key topics: mergers, concentration ratio, Herfindahl-Hirschman Index, antitrust laws, restrictive practices, natural monopoly regulation, price cap, deregulation, regulatory capture

Chapter 11 moves from market models to public policy on competition. It explains mergers and acquisitions, the main antitrust laws and two ways to measure how concentrated a market is: the four-firm concentration ratio and the Herfindahl-Hirschman Index. It then looks at restrictive practices such as tie-in sales, bundling and predatory pricing, and at how governments regulate natural monopolies through cost-plus and price cap rules. The chapter ends with the deregulation wave of the late 1970s and early 1980s, newer rules after accounting scandals and the Great Recession, and the danger of regulatory capture.

Key Points:

• A merger joins two firms; an acquisition is one firm buying another.
• The four-firm concentration ratio adds up the market shares of the four largest firms.
• The Herfindahl-Hirschman Index squares each firm’s market share and adds the results, so large firms weigh heavily.
• The antitrust laws covered include the Sherman Antitrust Act, the Clayton Antitrust Act and the Celler-Kefauver Act.
• Restrictive practices include exclusive dealing, tying sales, bundling and predatory pricing.
• Cost-plus regulation sets price at accounting cost plus a normal profit; price cap regulation fixes a price level years ahead.
• Regulatory capture occurs when regulated industries gain strong influence over the regulations that govern them.

Memory Tip: For the HHI, think “square, then sum”: squaring makes one big firm count far more than several small ones.

Common Mistake: Assuming antitrust law bans big firms. The laws protect competition, sometimes by blocking a merger, sometimes by regulating practices and sometimes by breaking up a firm.

Important Questions:

• How do you calculate the four-firm concentration ratio? Add the percentage market shares, that is the share of total sales, of the four largest firms in the market.
• How does a price cap differ from cost-plus regulation? Cost-plus lets a firm charge its accounting costs plus a normal profit, while a price cap sets a price in advance, so the firm keeps extra profit if it cuts costs.

Chapter 12: Environmental Protection and Negative Externalities

Part 4: Microeconomic Policy Issues · Difficulty: Medium · Key topics: externality, social cost, market failure, command-and-control regulation, pollution charges, marketable permits, property rights, international environmental issues

Chapter 12 treats pollution as a negative externality, a cost imposed on third parties that the market ignores. It shows that the tradeoff between output and environmental quality exists in every kind of economy, then compares policy tools: command-and-control rules that set emission limits or required technologies, and market-oriented tools such as pollution charges, marketable permits and clearer property rights. It weighs the benefits and costs of U.S. environmental laws, discusses global problems such as global warming and biodiversity, and ends by placing the choice on the production possibilities frontier.

Key Points:

• An externality is an effect of a buyer-seller exchange on a third party; a negative externality makes social cost exceed private cost.
• Command-and-control rules set specific limits or technologies for firms.
• Command-and-control has three shortcomings: no reward for going beyond the limit, little flexibility, and politically motivated loopholes.
• Market-oriented tools include pollution charges, marketable permits (cap and trade) and better-defined property rights.
• Taken as a whole, the benefits of U.S. environmental regulation have outweighed the costs, but marginal costs rise and marginal benefits fall as rules tighten.
• Global warming and biodiversity spill over borders and need international agreements.
• Countries may choose different points on the PPF, but all should avoid points inside it.

Memory Tip: Make the polluter face the social cost: tax the pollution, sell a permit for it, or give someone a property right to protect.

Common Mistake: Assuming the goal is zero pollution. The book frames it as a tradeoff, where each extra unit of cleanup costs more and brings less benefit.

Important Questions:

• What is a negative externality? A cost that an exchange between a buyer and a seller imposes on a third party who is not part of the exchange, such as pollution.
• What are the shortcomings of command-and-control regulation? It gives no incentive to do better than the limit, it offers limited flexibility in where and how to cut pollution, and it often contains politically motivated loopholes.

Chapter 13: Positive Externalities and Public Goods

Part 4: Microeconomic Policy Issues · Difficulty: Medium · Key topics: positive externalities, social benefit, innovation, patents, research and development, public goods, nonexcludable, non-rival, free rider

Chapter 13 looks at the opposite problem to pollution: benefits that spill over to other people. Competition pushes firms to innovate, but when inventions are easy to copy the inventor loses the reward, and because new technology creates positive externalities its social benefit exceeds its private benefit. The chapter lists the tools governments use to encourage innovation, including direct funding of R&D, tax incentives, protection of intellectual property and cooperation between universities and business. It then defines public goods as nonexcludable and non-rival, explains the free rider problem and shows ways to make users pay.

Key Points:

• A positive externality is a benefit that reaches a third party who does not pay for it, so the social benefit exceeds the private benefit.
• If new inventions are easy to copy, the original inventor has less incentive to invest in research and development.
• Patents reward inventors but should cover only genuinely new inventions and should not last forever.
• Policy tools for innovation are direct R&D funding, tax incentives, intellectual property protection and university-business partnerships.
• A public good is nonexcludable (it is costly or impossible to keep others from using it) and non-rival (one person’s use does not stop another’s).
• Free riders use a public good without paying, which makes it hard for markets to supply.
• The free rider problem can be reduced by government action, social pressure or market arrangements that collect payment.

Memory Tip: Test any good with two questions: can I stop people from using it, and does one person’s use reduce another’s? Two “no” answers make it a public good.

Common Mistake: Calling a good public just because the government provides it. The test is nonexcludable and non-rival, not who pays for it.

Important Questions:

• What are the two characteristics of a public good? It is nonexcludable and non-rival.
• What is the free rider problem? People can enjoy a public good without paying for it, so too few are willing to pay and markets have difficulty producing the good.

Chapter 14: Labor Markets and Income

Part 4: Microeconomic Policy Issues · Difficulty: Hard · Key topics: derived demand, marginal revenue product, monopsony, labor unions, bilateral monopoly, employment discrimination, immigration

Chapter 14 extends the labor market beyond simple demand and supply. A firm’s demand for labor is derived from the value of a worker’s marginal product, and a profit-maximizing firm hires until the wage equals that value. The chapter then examines imperfect labor markets: a monopsony that hires fewer workers at a lower wage, unions that bargain as a group, and a bilateral monopoly where the wage outcome is indeterminate. It closes with employment discrimination, the laws against it and the debate over earnings gaps, and with immigration and its effects on wages and public budgets.

Key Points:

• Labor demand is derived demand; in a competitive output market it is the value of the marginal product, which is marginal product times the output price.
• A firm that is not perfectly competitive uses marginal revenue product, which is marginal product times marginal revenue.
• A monopsony is the sole employer in a labor market; the marginal cost of labor exceeds the wage, so it hires fewer workers at a lower wage than a competitive market.
• Union workers in the United States earn more on average than comparable non-union workers, and union membership has fallen for decades.
• A bilateral monopoly pairs a union with a monopsony; employment is lower than in a competitive market, but the wage could go either way.
• Discrimination means workers with the same education, experience and skill are paid differently because of race, gender, religion, age or disability.
• The overall gains from immigration are real but small, with slightly lower wages for low-skill workers and budget strains for some state and local governments.

Memory Tip: Firms do not want workers for their own sake; they want the output workers make, so the demand for labor rises and falls with the value of that output.

Common Mistake: Assuming a monopsony pays more because it is big. It pays less, because raising the wage to attract one more worker means raising it for all of them.

Important Questions:

• What is a monopsony, and what does it do to wages and employment? A monopsony is the only employer in a labor market. It hires fewer workers and pays a lower wage than a competitive labor market would.
• What is a bilateral monopoly? A labor market with a union on the supply side and a monopsony on the demand side. Employment is lower than in a competitive market, and the wage depends on which side negotiates better.

Chapter 15: Poverty and Economic Inequality

Part 4: Microeconomic Policy Issues · Difficulty: Medium · Key topics: poverty line, poverty rate, poverty trap, safety net, earned income tax credit, quintiles, Lorenz curve, redistribution, estate tax

Chapter 15 separates two ideas that are often mixed up: poverty, the inability to afford life’s necessities, and income inequality, the gap between higher and lower incomes. It shows how the poverty line and poverty rate are set, why a poverty trap appears when benefits fall as earnings rise, and what the U.S. safety net includes. It then measures inequality with quintiles and the Lorenz curve, reviews explanations for the rise in inequality since the late 1970s, and weighs policies such as redistribution, equal opportunity and estate taxes against the risk of weakening incentives.

Key Points:

• The poverty rate is the percentage of the population living below the poverty line, which is based on the income needed to buy the necessities of life; any chosen line is somewhat controversial.
• Poverty and income inequality are not the same thing.
• A poverty trap occurs when government support falls as recipients earn more, so work brings little extra income.
• The U.S. safety net includes TANF, SNAP, the earned income tax credit, Medicaid and WIC.
• Inequality can be measured by quintile income shares or by a Lorenz curve, which compares cumulative actual income with a perfectly equal distribution.
• U.S. income inequality rose from the late 1970s into the 2000s; explanations include more two-earner and single-parent households and the effect of information and communications technology on wages.
• Pushing too hard for equality risks weaker incentives, but a moderate push can raise output through better education and broader political support for markets.

Memory Tip: On a Lorenz curve, the farther the curve bows below the straight line of perfect equality, the more unequal the distribution.

Common Mistake: Using poverty and inequality as if they meant the same thing. They are measured differently and can move in different directions.

Important Questions:

• What is a poverty trap? A situation in which government support payments decline as recipients earn more, so most of the extra income from working is lost.
• How does a Lorenz curve show inequality? It plots the cumulative share of income received against the cumulative share of the population; the more it bends away from the line of perfect equality, the greater the inequality.

Chapter 16: Information, Risk, and Insurance

Part 4: Microeconomic Policy Issues · Difficulty: Medium · Key topics: imperfect information, asymmetric information, lemons, warranties, occupational licenses, insurance, premiums, actuarially fair, moral hazard, deductibles

Chapter 16 relaxes the assumption that buyers and sellers know everything. With imperfect or asymmetric information a buyer fears purchasing a lemon, and a market where quality is hard to judge may fail to exist, although guarantees, warranties, service contracts, reputation, resumes and occupational licenses help. The chapter then explains insurance as risk sharing through premiums, with the rule that what the average person pays in cannot be less than what the average person gets out, the idea of an actuarially fair policy, and moral hazard, which deductibles, copayments and coinsurance are designed to limit.

Key Points:

• Imperfect information means the buyer, the seller or both are less than certain about quality; asymmetric information means one side knows more than the other.
• A lemon is a product that turns out to be low quality; a buyer who fears lemons hesitates to buy.
• Goods markets answer imperfect information with money-back guarantees, warranties, service contracts and reputation.
• Labor markets answer it with resumes, recommendations and occupational licenses.
• Insurance spreads risk: people pay premiums, and those who suffer the bad event receive compensation.
• The fundamental law of insurance: what the average person pays in cannot be less than what the average person gets out.
• Moral hazard arises because insured people have less reason to avoid risk; deductibles, copayments and coinsurance reduce it.

Memory Tip: In a lemons market the seller knows the quality and the buyer does not, and the buyer’s fear is what makes good products hard to sell.

Common Mistake: Treating imperfect and asymmetric information as identical. Imperfect means both sides may be unsure; asymmetric means one side has better information.

Important Questions:

• What is moral hazard? The tendency of people who are insured against a risk to take fewer steps to avoid it, because someone else pays the cost.
• What is the fundamental law of insurance? The amount the average person pays in over time cannot be less than the amount the average person receives, or the insurer would lose money.

Chapter 17: Financial Markets

Part 4: Microeconomic Policy Issues · Difficulty: Medium · Key topics: venture capital, bonds, stocks, initial public offering, dividends, capital gains, risk and liquidity, financial intermediaries, deposit insurance, personal wealth

Chapter 17 explains how financial capital moves between savers and borrowers. Businesses raise early money from owners’ savings, credit cards, angel investors and venture capital, and later by issuing bonds or selling stock in an initial public offering. Households choose investments by average expected return, risk and liquidity, using banks and other financial intermediaries, with deposits protected by the FDIC. The chapter ends with a realistic message on personal wealth: even professionals struggle to pick winning stocks, but most people can build wealth by getting more education and training and by saving early.

Key Points:

• A bond is a contract in which a borrower promises to repay a set amount with interest over a set time; corporate, municipal, state and Treasury bonds differ by issuer.
• Stock represents ownership; a company’s stock is divided into shares, and its first sale to the public is an initial public offering (IPO).
• Shareholders can earn dividends and capital gains.
• Investments differ in average expected return, degree of risk and liquidity; a higher return usually means accepting more risk or less liquidity.
• A bank is a financial intermediary that coordinates the supply and demand for financial capital.
• The FDIC insures bank deposits against the risk of a bank failure.
• Predicting which stocks will rise is extremely hard; the book’s two rules for building wealth are more education and training, and saving early.

Memory Tip: Remember the triangle of return, risk and liquidity: pushing the return up usually costs you either safety or easy access to your cash.

Common Mistake: Treating a stock’s dividend as its whole return. The return also includes any capital gain, the change in the share price, which can be negative.

Important Questions:

• What is the difference between a bond and a stock? A bond is a loan that the borrower must repay with interest. A stock is a share of ownership in a firm, whose return comes from dividends and capital gains.
• Which three characteristics are used to compare investments? Average expected rate of return, degree of risk and liquidity.

Chapter 18: Public Economy

Part 4: Microeconomic Policy Issues · Difficulty: Medium · Key topics: rational ignorance, voter turnout, special interest groups, lobbying, pork-barrel spending, logrolling, voting cycle

Chapter 18 applies economic reasoning to politics. The theory of rational ignorance says a single vote is so unlikely to change an election that voters choose to stay uninformed, which helps explain low turnout. Special interest groups, whose members each have a large stake, lobby hard while the large majority pays little attention, producing pork-barrel spending and logrolling. The chapter also shows that majority voting with three or more choices can produce a voting cycle with no clear winner, and it concludes that realistic policy must weigh the strengths and weaknesses of both markets and government.

Key Points:

• Rational ignorance means voters know one vote is unlikely to change the outcome, so they choose not to become informed or to vote.
• A special interest group is a small group whose members each have a large stake in a political outcome and spend time and energy lobbying for it.
• Special interest politics works because benefits are concentrated on a few people while costs are spread thinly across the many.
• Pork-barrel spending concentrates benefits in one district and spreads the costs over the whole country.
• Logrolling is when legislators agree to vote for each other’s bills, which encourages pork-barrel spending.
• A voting cycle occurs when A beats B, B beats C and C beats A by majority vote, so no majority preference can be found.
• Neither markets nor government is always beneficial or always harmful; policy needs a realistic view of both.

Memory Tip: Concentrated benefits and spread-out costs: the few who gain speak loudly, and the many who pay each lose too little to bother.

Common Mistake: Concluding that low voter turnout means voters are lazy. The theory says staying uninformed is a rational reaction to the tiny influence of one vote.

Important Questions:

• What is rational ignorance? The choice by voters to stay uninformed, because one vote is extremely unlikely to influence the outcome and learning about issues takes effort.
• What is a voting cycle? A situation with at least three choices in which A is preferred to B, B to C and C to A by majority votes, so no choice can be called the majority preference.

Chapter 19: The Macroeconomic Perspective

Part 5: The Macroeconomic Perspective and Goals · Difficulty: Medium · Key topics: gross domestic product, final goods, double counting, nominal and real values, price index, business cycle, recession, GDP per capita, limits of GDP

Chapter 19 introduces the macroeconomic goals and the main measure of an economy’s size. GDP counts the value of final goods and services produced inside a country in a year, and it can be measured by what is bought (consumption, investment, government spending and net exports) or by what is produced, taking care to avoid double counting. Nominal values are converted to real values with a price index and a base year. The chapter then tracks real GDP through the business cycle, compares countries with exchange rates and GDP per capita, and explains why GDP is only a rough indicator of well-being.

Key Points:

• GDP is the value of all final goods and services produced within a country in a year; only final output counts, to avoid double counting.
• Demand divides into consumption, investment, government spending, exports and imports; production divides into durable goods, nondurable goods, services, structures and inventories.
• Nominal values are the commonly announced figures; real values are adjusted for inflation using a price index and an arbitrary base year.
• The business cycle runs from a peak to a trough; a significant decline in GDP is a recession, and a longer, deeper decline is a depression.
• To compare countries, convert GDP to a common currency with the exchange rate, then divide by population to get GDP per capita.
• GDP leaves out leisure, environmental quality, health and education levels, non-market activity and changes in inequality.

Memory Tip: Keep the spending formula in mind: GDP = C + I + G + (X minus M), that is consumption, investment, government spending and net exports.

Common Mistake: Treating the purchase of stocks as “investment” in GDP. In GDP, investment means spending on new capital such as equipment and structures.

Important Questions:

• Why does GDP count only final goods and services? Counting intermediate goods as well would count the same value several times as it passes through the chain of production, which is double counting.
• What is the difference between nominal and real GDP? Nominal GDP uses prices of the year being measured; real GDP adjusts for inflation by using the prices of a base year, so changes reflect output only.

Chapter 20: Economic Growth

Part 5: The Macroeconomic Perspective and Goals · Difficulty: Medium · Key topics: modern economic growth, Industrial Revolution, labor productivity, aggregate production function, capital deepening, human capital, technology, convergence

Chapter 20 asks why some economies grow and others do not. Sustained growth in GDP per capita, about 2% a year in the leading economies since the early nineteenth century, is a recent event tied to the Industrial Revolution, trade and better institutions. The chapter links growth to labor productivity and to the aggregate production function, with its three ingredients of human capital, physical capital and technology, and shows how small differences in growth rates compound into large differences in income. It ends with convergence, the process in which poorer countries catch up, and the diminishing returns that make it possible.

Key Points:

• Since the early nineteenth century the leading economies have raised GDP per capita by an average of about 2% per year.
• Modern economic growth followed the Industrial Revolution, with higher worker productivity, more trade and the development of governance and market institutions.
• Productivity is the value of output per worker or per hour; its growth is the main determinant of long-term growth and higher wages.
• The aggregate production function combines human capital, physical capital and technology.
• Capital deepening means more capital per worker, whether human capital (skills) or physical capital.
• In economics, technology includes small inventions and better management or institutions, not only major scientific discoveries.
• Convergence happens when low-income countries catch up, helped by diminishing returns to capital in rich countries; Japan, South Korea and China are examples.

Memory Tip: Think of compound interest: growth of 2% against 3% a year looks tiny in one year but gives very different incomes after a generation.

Common Mistake: Expecting the same investment to give the same gain everywhere. With diminishing returns, an extra machine adds more in a low-capital country than in a high-capital one, which is the logic of convergence.

Important Questions:

• What are the three components of the aggregate production function? Human capital, physical capital and technology, working together in a market-oriented economy with supportive institutions.
• What is economic convergence? The process by which countries with lower GDP per capita catch up with countries that have higher GDP per capita.

Chapter 21: Unemployment

Part 5: The Macroeconomic Perspective and Goals · Difficulty: Medium · Key topics: labor force, unemployment rate, participation rate, discouraged workers, cyclical unemployment, frictional unemployment, structural unemployment, natural rate, sticky wages

Chapter 21 defines and explains unemployment. A person counts as unemployed only if willing, able and actively looking for work, and the unemployment rate divides the unemployed by the labor force, not by the adult population; the chapter explains how the Current Population Survey and the payroll survey measure it and which groups are hit hardest. It separates cyclical unemployment, which follows the business cycle, from the natural rate made up of frictional and structural unemployment, and it reviews reasons wages are sticky: implicit contracts, efficiency wages, adverse selection of wage cuts, the insider-outsider model and relative wage coordination.

Key Points:

• The adult population divides into the labor force and those out of it; the labor force divides into the employed and the unemployed.
• The unemployment rate is the number of unemployed divided by the labor force, not by the whole adult population.
• The Current Population Survey, run by the Census Bureau, measures the unemployment rate; the establishment payroll survey also tracks jobs.
• The U.S. unemployment rate rises in recessions but never falls to zero; rates differ by group, being higher for the young and the less educated.
• Cyclical unemployment rises and falls with the business cycle.
• Wages may be sticky downward because of implicit contracts, efficiency wage theory, adverse selection of wage cuts, the insider-outsider model and relative wage coordination.
• The natural rate of unemployment includes frictional unemployment (changing jobs) and structural unemployment (demand shifting away from a skill).

Memory Tip: Sort unemployment by its cause: F for “finding” a new job (frictional), S for “skills” no longer in demand (structural), C for the “cycle” (cyclical).

Common Mistake: Counting everyone without a job as unemployed. People who are not actively looking, including discouraged workers, are counted as out of the labor force.

Important Questions:

• How is the unemployment rate calculated? Divide the number of unemployed people by the number of people in the labor force (employed plus unemployed).
• What is the natural rate of unemployment? The rate of unemployment that the economic, social and political forces of the economy would cause even when it is not in a recession, including frictional and structural unemployment.

Chapter 22: Inflation

Part 5: The Macroeconomic Perspective and Goals · Difficulty: Medium · Key topics: price level, index numbers, base year, Consumer Price Index, substitution bias, core inflation, GDP deflator, hyperinflation, indexing

Chapter 22 shows how economists measure and judge inflation. They price a basket of goods and services over time, turn the cost into index numbers with a base year of 100, and measure inflation as the percentage change. The chapter explains the Consumer Price Index and its substitution bias and quality bias, and alternatives such as the core index, the Producer Price Index and the GDP deflator. It then reviews U.S. and international experience, shows who gains and who loses from unexpected inflation, and ends with indexing in wage contracts, loans, tax brackets and Social Security.

Key Points:

• The price level is tracked with a basket of goods and services; index numbers set a base year equal to 100.
• The inflation rate is the percentage change in the price level or index between two periods.
• A fixed basket has two problems: substitution bias (people buy less of what gets dearer) and quality or new goods bias.
• The Consumer Price Index is the most cited measure; the core index excludes volatile items, and the PPI and GDP deflator are not based on consumer baskets.
• U.S. inflation has often run at about 2% to 4%; the highest periods were after the two World Wars and in the 1970s, and the Great Depression brought deflation.
• Unexpected inflation hurts people whose income does not rise with prices and helps people who owe money.
• A payment is indexed if it adjusts automatically for inflation, as with cost-of-living adjustments, adjustable-rate mortgages, tax brackets and Social Security.

Memory Tip: To compare prices across years, never subtract index numbers; take the new minus the old, divided by the old, to get a percentage change.

Common Mistake: Subtracting two index numbers and calling the result the inflation rate. The result must be a percentage change.

Important Questions:

• How do you calculate the inflation rate from a price index? Subtract the earlier index from the later index, divide by the earlier index and multiply by 100 to get the percentage change.
• What are substitution bias and quality or new goods bias? Substitution bias arises because a fixed basket ignores buying more of what gets cheaper; quality or new goods bias arises because it cannot reflect better products or brand-new goods.

Chapter 23: The International Trade and Capital Flows

Part 5: The Macroeconomic Perspective and Goals · Difficulty: Hard · Key topics: trade balance, current account, trade deficit, trade surplus, financial capital flows, national saving and investment identity, level of trade

Chapter 23 measures a country’s trade and links it to flows of money. The trade balance is exports minus imports, and the current account adds trade in services, investment income and unilateral transfers. The chapter reviews U.S. trade balances over time and shows that a trade deficit must be matched by a net inflow of financial capital, and a surplus by a net outflow. It states the national saving and investment identity, explains why trade deficits and surpluses are neither automatically good nor bad, and separates the level of trade from the trade balance.

Key Points:

• The trade balance is exports minus imports; a surplus means exports exceed imports and a deficit means imports exceed exports.
• In high-income economies services are more than half of production, but most global trade is still in goods.
• The current account balance adds trade in goods and services to income from investments and unilateral transfers.
• A current account deficit means a country is a net borrower from the rest of the world; a surplus means it is a net lender.
• The national saving and investment identity is S + (M minus X) = I + (G minus T).
• A recession tends to raise the trade balance and a boom tends to lower it.
• The level of trade (exports as a share of GDP) depends on history, geography and economy size, and is different from the trade balance.

Memory Tip: A trade deficit and a capital inflow are two sides of one coin: the dollars sent abroad for imports return as foreign investment.

Common Mistake: Assuming a trade deficit always signals weakness and a surplus strength. The book says either can work out well or badly, depending on how the capital flows are invested.

Important Questions:

• What is the national saving and investment identity? Financial capital supplied equals financial capital demanded: S + (M minus X) = I + (G minus T), where S is private saving, M imports, X exports, I investment, G government spending and T taxes.
• Are trade deficits always harmful? No. A deficit means borrowing from abroad, which can be healthy if the money is invested in productive capital and harmful if it is wasted.

Chapter 24: The Aggregate Demand/Aggregate Supply Model

Part 6: A Framework for Macroeconomic Analysis · Difficulty: Hard · Key topics: aggregate demand, aggregate supply, potential GDP, short-run and long-run aggregate supply, equilibrium, stagflation, Keynes’ law, Say’s law

Chapter 24 builds the main model of macroeconomics. It starts with Say’s law, that supply creates its own demand, and Keynes’ law, that demand creates its own supply, then constructs the upward-sloping short-run aggregate supply curve, a vertical long-run line at potential GDP and a downward-sloping aggregate demand curve made of consumption, investment, government spending and net exports. It explains shifts in each curve, with stagflation as the result of a leftward supply shift, shows where growth, unemployment and inflation appear in the diagram, and divides the SRAS curve into Keynesian, intermediate and neoclassical zones.

Key Points:

• Aggregate demand is the sum of consumption, investment, government spending and net exports, and the AD curve slopes downward.
• The SRAS curve slopes upward because output prices rise while input prices stay fixed; the long-run AS curve is vertical at potential GDP.
• Equilibrium output and price level are where the AD and AS curves intersect.
• Aggregate supply shifts right with higher productivity and left with higher input prices; a leftward shift brings stagflation (lower output, higher unemployment, higher inflation).
• Aggregate demand shifts with consumer and business confidence, government spending and taxes, and changes in exports and imports.
• Cyclical unemployment is large when equilibrium is far below potential GDP; the natural rate is built into potential GDP.
• In the flat Keynesian zone changes in AD move output, not prices; in the vertical neoclassical zone they move prices, not output.

Memory Tip: K for Keynes sits on the flat left zone of the SRAS curve, and S for Say sits on the steep right zone.

Common Mistake: Reading the AD and AS curves as micro supply and demand curves. They look alike, but the reasons for their slopes and what they measure are different.

Important Questions:

• What is stagflation? A combination of lower output, higher unemployment and higher inflation, which results when the aggregate supply curve shifts to the left.
• What are Say’s law and Keynes’ law? Say’s law says supply creates its own demand. Keynes’ law says demand creates its own supply, so changes in aggregate demand change real GDP and employment.

Chapter 25: The Keynesian Perspective

Part 6: A Framework for Macroeconomic Analysis · Difficulty: Hard · Key topics: components of aggregate demand, sticky wages and prices, menu costs, expenditure multiplier, recessionary gap, inflationary gap, Phillips curve, fiscal policy

Chapter 25 explains the Keynesian view of the economy. Aggregate demand has four components, each with its own causes of change, and Keynesian economics rests on two ideas: aggregate demand is more likely than supply to cause short-run events such as recessions, and wages and prices can be sticky. Stickiness creates a macroeconomic externality, and menu costs are one reason prices adjust slowly. The chapter introduces the expenditure multiplier and the Phillips curve tradeoff, then shows how expansionary or contractionary fiscal policy would answer a recessionary or inflationary gap.

Key Points:

• Consumption changes with income, taxes, expectations and wealth; investment changes with expected profitability and interest rates; government spending is a political choice; net exports depend on relative growth and prices.
• Keynesian economics has two main ideas: demand is the likelier cause of short-run events, and wages and prices can be sticky.
• Menu costs are the costs of changing prices, including relabeling, record keeping and telling customers.
• Unemployment from sticky wages and prices is a macroeconomic externality: at the macro level a fall in demand adjusts through quantities, not only prices.
• The expenditure multiplier means an initial change in spending leads to a larger change in total output.
• The Phillips curve shows a short-run tradeoff between unemployment and inflation, but it may shift after a few years.
• The Keynesian remedy is expansionary fiscal policy in a recession and contractionary fiscal policy when the economy runs above potential GDP.

Memory Tip: Recessionary gap means output is below potential, so push demand up; inflationary gap means output is above potential, so push demand down.

Common Mistake: Reading Keynesian policy as support for price controls. The book says it calls for action on aggregate demand, not laws that fix prices and quantities in individual markets.

Important Questions:

• What are the two main ideas of Keynesian economics? First, aggregate demand is more likely than aggregate supply to be the main cause of a short-run event such as a recession. Second, wages and prices can be sticky, so unemployment can result in a downturn.
• What is the Phillips curve? A curve showing the tradeoff between unemployment and inflation; from a Keynesian view it slopes downward in the short run, so higher unemployment goes with lower inflation.

Chapter 26: The Neoclassical Perspective

Part 6: A Framework for Macroeconomic Analysis · Difficulty: Hard · Key topics: vertical long-run aggregate supply, potential GDP, rational expectations, adaptive expectations, natural rate of unemployment, long-run growth, stabilization policy

Chapter 26 presents the neoclassical view that, in the long run, the economy returns to potential GDP through flexible prices, so the long-run aggregate supply curve is vertical. It contrasts rational expectations, where people have good information and prices adjust quickly, with adaptive expectations, where information is limited and adjustment is slow. The policy section explains why neoclassical economists stress long-term growth and the natural rate of unemployment rather than fighting recession, see no social benefit from inflation, and doubt the effectiveness and timing of active stabilization policy. The chapter ends by balancing the Keynesian and neoclassical models.

Key Points:

• Neoclassical economists argue that the economy adjusts back to potential GDP in the long run through flexible prices, so long-run aggregate supply is vertical.
• Under rational expectations people have excellent information and prices adjust quickly; under adaptive expectations information is limited and adjustment is slow.
• Neoclassical economists stress long-term growth over fighting recessions, because they believe recessions fade within a few years.
• They focus on lowering the natural rate of unemployment caused by institutions and policies, more than on cyclical unemployment.
• With a vertical AS curve, changes in aggregate demand affect only the price level, not output.
• Keynesians see demand as the cause of business cycles and favor active policy; neoclassical economists see productivity growth as the key to potential GDP and favor a limited role for stabilization policy.

Memory Tip: Keynesian means short run and demand-driven; neoclassical means long run and supply-driven (productivity).

Common Mistake: Treating the two views as enemies. Many mainstream economists use the Keynesian view for the short run and the neoclassical view for the long run.

Important Questions:

• What is the difference between rational and adaptive expectations? Rational expectations assume people know a lot about the economy, so adjustments are fast. Adaptive expectations assume limited information, so adjustments can be slow.
• Why does a vertical long-run AS curve mean demand changes only affect prices? Output is fixed at potential GDP, so a shift in aggregate demand cannot raise real output in the long run and can only raise or lower the price level.

Chapter 27: Money and Banking

Part 7: Monetary and Fiscal Policy · Difficulty: Medium · Key topics: barter, functions of money, commodity money, fiat money, M1 and M2, financial intermediaries, bank balance sheet, reserves, money multiplier

Chapter 27 explains what money is and how banks create it. Without money, trade needs a double coincidence of wants, so money serves as a medium of exchange, unit of account, store of value and standard of deferred payment, and it can be commodity money or fiat money. The chapter defines M1 and M2, then shows banks as financial intermediaries with balance sheets that list assets such as loans, bonds and reserves against liabilities such as deposits. Finally it derives the money multiplier, one divided by the reserve ratio, to show how lending and deposits create much of an economy’s money.

Key Points:

• Barter requires a double coincidence of wants, which money removes.
• Money serves four functions: medium of exchange, unit of account, store of value and standard of deferred payment.
• Commodity money has value in other uses; fiat money has no intrinsic value and is legal tender by government decree.
• M1 is currency plus checking-account (demand) deposits; M2 adds savings deposits, time deposits such as CDs and money market funds.
• A bank balance sheet (T-account) lists assets (loans, bonds, reserves) against liabilities (deposits); net worth is assets minus liabilities.
• A bank faces negative net worth if the value of its assets falls below its liabilities.
• The money multiplier is 1 divided by the reserve ratio, the fraction of deposits a bank holds as reserves.

Memory Tip: Remember the four jobs of money as M-U-S-D: medium of exchange, unit of account, store of value and deferred payment.

Common Mistake: Treating a bank’s deposits as its assets. Deposits are liabilities because the bank owes that money to depositors; the bank’s loans are its assets.

Important Questions:

• What are the functions of money? Medium of exchange, unit of account, store of value and standard of deferred payment.
• How is the money multiplier calculated? It equals 1 divided by the reserve ratio, so a bank holding 10% of deposits in reserve allows each $1 of reserves to support up to $10 of money.

Chapter 28: Monetary Policy and Bank Regulation

Part 7: Monetary and Fiscal Policy · Difficulty: Hard · Key topics: central bank, Federal Reserve, bank run, deposit insurance, open market operations, discount rate, reserve requirement, interest rate on reserve balances, quantitative easing, velocity of money

Chapter 28 shows how central banks and regulators manage money and banks. It describes the Federal Reserve and other central banks, then explains bank runs, deposit insurance and bank supervision. The chapter compares the traditional tools of a limited reserves environment (open market operations, reserve requirements and the discount rate) with today’s ample reserves environment, where the interest rate on reserve balances is the main tool. It then links expansionary and contractionary policy and quantitative easing to economic outcomes, and ends with pitfalls such as lags, excess reserves, shifting velocity and inflation targeting.

Key Points:

• A central bank’s main task is monetary policy, which changes interest rates and credit conditions; examples are the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England.
• A bank run happens when rumors, true or false, make depositors rush to withdraw their money; the FDIC guarantees U.S. deposits up to $250,000.
• Bank supervision means inspecting bank balance sheets to check that net worth is positive and assets are not too risky.
• In a limited reserves environment the tools are open market operations, reserve requirements and the discount rate, and open market operations are used most.
• In the ample reserves environment since the financial crisis, the FOMC mainly changes the interest rate on reserve balances (IORB).
• Expansionary policy raises money and credit and lowers interest rates to fight recession; contractionary policy does the reverse to hold down inflation; quantitative easing expanded credit in 2008–2009.
• Monetary policy is imprecise: effects come with long and variable lags, banks may hold excess reserves, and velocity can shift (MV = PQ).

Memory Tip: Easy money means low interest rates and more spending, which fights recession; tight money means high rates and less spending, which fights inflation.

Common Mistake: Assuming a central bank can force banks to lend. If banks choose to hold excess reserves, monetary policy cannot make them lend.

Important Questions:

• What are the three traditional tools of monetary policy? Open market operations (buying and selling government bonds), reserve requirements and the discount rate.
• What is quantitative easing? An unconventional policy, used by central banks around the world during the 2008–2009 recession, to expand the supply of credit.

Chapter 29: Exchange Rates and International Capital Flows

Part 7: Monetary and Fiscal Policy · Difficulty: Hard · Key topics: exchange rate, foreign exchange market, appreciation, depreciation, foreign direct investment, portfolio investment, purchasing power parity, soft peg, hard peg

Chapter 29 explains how currencies are traded and priced. In the foreign exchange market, demand and supply for a currency come from exporters, tourists and investors, and a currency that buys more of another has appreciated. The chapter shows how exchange rates respond to speculation in the extreme short run, to rates of return in the short run, to inflation differences in the medium run and to purchasing power parity in the long run. It then explains why central banks care about exchange rates and compares floating exchange rates, soft pegs and hard pegs and their tradeoffs.

Key Points:

• An exchange rate is the price of one currency in terms of another.
• Demand for dollars comes from U.S. exporters, foreign tourists and foreign investors; supply comes from foreign firms that sold imports in the U.S., U.S. tourists abroad and U.S. investors abroad.
• A currency that can buy more of another has appreciated; one that buys less has depreciated.
• Speculation drives rates in the extreme short run, rates of return in the short run, and inflation differences in the medium run.
• Purchasing power parity links long-run exchange rates to price levels in the two countries.
• Exchange rates affect imports and exports, and so aggregate demand; swings can also hurt firms, especially banks.
• A hard peg reduces exchange rate swings, but monetary policy must then focus on the exchange rate, not on recession or inflation.

Memory Tip: A stronger currency makes imports cheaper and exports more expensive; a weaker currency does the opposite.

Common Mistake: Assuming a stronger currency is always better for the economy. Exporters lose sales when their goods become more expensive abroad.

Important Questions:

• What creates the demand for U.S. dollars in the foreign exchange market? U.S. export firms converting foreign earnings, foreign tourists in the U.S., and foreign investors who want to invest in the U.S. economy.
• What is a hard peg? An exchange rate policy in which the government chooses and holds a fixed exchange rate, which reduces fluctuations but limits the use of monetary policy for other goals.

Chapter 30: Government Budgets and Fiscal Policy

Part 7: Monetary and Fiscal Policy · Difficulty: Medium · Key topics: government spending, taxation, progressive and regressive taxes, budget deficit, national debt, expansionary fiscal policy, automatic stabilizers, crowding out, policy lags, balanced budget

Chapter 30 covers what governments spend, collect and borrow. It shows that federal spending and taxes have stayed roughly between 18% and 22% of GDP, that four areas make up about 70% of federal spending, and that individual income and payroll taxes provide over 80% of revenue. It explains progressive, proportional and regressive taxes, deficits and the national debt, and how expansionary and contractionary fiscal policy work through aggregate demand. The chapter ends with automatic stabilizers, practical problems such as crowding out and time lags, and the debate over a balanced budget amendment.

Key Points:

• Federal spending and taxes have typically stayed between about 18% and 22% of GDP in recent decades.
• National defense, Social Security, healthcare and interest payments together make up about 70% of federal spending.
• Individual income taxes and payroll taxes together bring in more than 80% of federal revenue.
• A progressive tax takes a higher share from higher incomes, a proportional tax takes the same share, and a regressive tax takes a lower share.
• A deficit or surplus is measured each year; the national debt is the sum of past deficits and surpluses.
• Expansionary fiscal policy fights recession by raising spending or cutting taxes; contractionary policy fights inflation when output is above potential.
• Automatic stabilizers act without new legislation, while discretionary policy faces crowding out and recognition, legislative and implementation lags.

Memory Tip: Progressive means a higher income pays a higher share, proportional means the same share, and regressive means a higher income pays a lower share.

Common Mistake: Mixing up the deficit and the debt. The deficit is the gap in one year; the debt is the total built up over many years.

Important Questions:

• What is crowding out? When expansionary fiscal policy raises interest rates, discouraging firms and households from borrowing and spending, which reduces aggregate demand.
• What are automatic stabilizers? Taxing and spending mechanisms that, by their design, shift in response to economic events without any new legislation.

Chapter 31: The Impacts of Government Borrowing

Part 7: Monetary and Fiscal Policy · Difficulty: Hard · Key topics: national saving and investment identity, crowding out, trade balance, twin deficits, Ricardian equivalence, private saving, human capital, research and development

Chapter 31 uses the national saving and investment identity to trace what government borrowing does. If the budget deficit changes, then private saving, private investment in physical capital or the trade balance, or some mix of the three, must change as well. The chapter shows how large, lasting deficits can raise aggregate demand and prices, crowd out private investment and create a dependence on foreign capital that can reverse. It then examines Ricardian equivalence, the theory that private saving offsets government borrowing, and finishes with how fiscal policy can instead support growth through education, public capital and R&D.

Key Points:

• If the budget deficit changes, private saving, private investment in physical capital or the trade balance (or a mix) must change too.
• The government need not balance its budget every year, but large deficits that last risk negative outcomes.
• Three risks are an inflationary rise in aggregate demand, crowding out of private investment, and dependence on foreign capital inflows that may turn into outflows.
• Twin deficits describes a budget deficit and a trade deficit moving together, linked through inflows of foreign financial capital.
• Ricardian equivalence says changes in private saving offset changes in government borrowing; the evidence suggests it holds only partially.
• Growth comes from physical capital, human capital and technology, and government can invest in public physical capital, education and R&D.
• Ways to raise human capital include more spending on teachers and education reform; ways to raise R&D include direct spending and tax incentives.

Memory Tip: A deficit has to be financed from somewhere: more private saving, less private investment or more foreign borrowing (a bigger trade deficit).

Common Mistake: Assuming all government borrowing hurts growth. The book separates borrowing that crowds out private investment from spending that builds human capital, public capital and R&D.

Important Questions:

• What is Ricardian equivalence? The theory that changes in private saving will offset changes in government borrowing, so deficits would have no effect on private investment or the trade balance. Evidence shows it holds only partially.
• What is crowding out? A situation in which government borrowing uses up financial capital that private firms would have used for investment in physical capital, slowing growth.

Chapter 32: Macroeconomic Policy Around the World

Part 8: International Economics · Difficulty: Medium · Key topics: low-, middle- and high-income countries, GDP per capita, growth fundamentals, East Asian Tigers, unemployment in low-income countries, inflation, balance of trade concerns, foreign aid

Chapter 32 takes the macroeconomic tools to the whole world. Countries are grouped as low-, middle- or high-income by GDP per person, and the chapter shows that the fundamentals of growth, human capital, physical capital and technology working in a market-oriented economy, are the same everywhere while priorities differ by income level. It explains why unemployment means something different where many people work outside regular wage jobs, why smaller economies face more volatile inflation, and which concerns remain about trade imbalances and sudden swings in international capital flows.

Key Points:

• Most countries aim for low unemployment, low inflation and a stable trade balance.
• Economists group countries as low-, middle- or high-income by GDP per person; regional comparisons are often inaccurate because countries within a region differ.
• The fundamentals of growth are the same everywhere: human capital, physical capital and technology interacting in a market-oriented economy.
• High-income countries focus on new technology, middle-income countries on human capital and links to global markets, and low-income countries on health, infrastructure and investment.
• Cyclical unemployment can be addressed with expansionary fiscal and monetary policy; the natural rate is harder because it involves tradeoffs in employment laws.
• In many low- and middle-income countries, people are neither unemployed in the U.S. sense nor in regular wage jobs.
• High-income economies have learned that central banks can control inflation; smaller economies face more volatile inflation because of international movements of capital and goods.

Memory Tip: Use the rule of 72: divide 72 by the annual growth rate to estimate the years an economy takes to double; at 3% growth that is about 24 years.

Common Mistake: Applying the U.S. definition of unemployment to every country. Where many people do informal or barter work, the unemployment rate says little about who is working.

Important Questions:

• What are the fundamentals of economic growth in every country? Improvements in human capital, physical capital and technology, working together in a market-oriented economy.
• Why is the unemployment rate hard to interpret in low-income countries? Many people are not unemployed in the sense used in the U.S. and Europe, but they do not hold regular wage-paying jobs either, and some are part of a barter economy.

Chapter 33: International Trade

Part 8: International Economics · Difficulty: Medium · Key topics: absolute advantage, comparative advantage, opportunity cost, gains from trade, specialization, intra-industry trade, value chain, economies of scale, tariffs, World Trade Organization

Chapter 33 explains why countries trade. A country has an absolute advantage when it can produce more of a good, but the gains from trade come from comparative advantage, the ability to produce a good at a lower opportunity cost. The chapter shows that even a country that is more productive in every good still gains by specializing, then explains intra-industry trade between similar high-income economies, driven by specialized learning, economies of scale and the splitting up of the value chain. It closes with tariffs, dumping and the role of the World Trade Organization in lowering barriers.

Key Points:

• Absolute advantage means being more productive; comparative advantage means producing at a lower opportunity cost.
• Gains from trade come from comparative advantage, by specializing in the good that costs the least to give up.
• Even a country with an absolute advantage in all goods benefits from trade, because other countries can offer goods at a lower opportunity cost.
• Intra-industry trade means a country imports and exports the same kind of product, such as cars, machinery or computers, mostly between similar high-income economies.
• The gains from intra-industry trade come from specialized learning and economies of scale.
• Splitting up the value chain means different stages of making a good happen in different countries.
• Tariffs protect sensitive industries or respond to dumping; the WTO is a forum for negotiating lower trade barriers.

Memory Tip: Absolute advantage asks who makes more; comparative advantage asks who gives up less. Trade is decided by the second question.

Common Mistake: Thinking a country that is better at everything has nothing to gain from trade. It still gains by specializing where its opportunity cost is lowest.

Important Questions:

• What is the difference between absolute and comparative advantage? Absolute advantage is the ability to produce more of a good. Comparative advantage is the ability to produce it at a lower opportunity cost in terms of other goods.
• What is intra-industry trade? Trade in which countries import and export the same type of product at the same time, mainly between high-income economies with similar workers and technology.

Chapter 34: Globalization and Protectionism

Part 8: International Economics · Difficulty: Medium · Key topics: protectionism, tariffs, import quotas, nontariff barriers, infant industry argument, dumping, World Trade Organization, free trade agreements, jobs and wages

Chapter 34 examines the case for and against restricting trade. Protectionism uses tariffs, import quotas or nontariff barriers, and the chapter shows that it acts as an indirect subsidy from consumers to producers by raising the domestic price. It then looks at how trade shifts jobs and wages and at labor practices in low-income countries, reviews arguments for restricting imports such as infant industries, dumping, environmental standards and safety, and explains how trade policy is set globally, regionally and nationally through bodies such as the WTO. It ends with the income-distribution tradeoffs of trade policy.

Key Points:

• The three tools for restricting trade are tariffs, import quotas and nontariff barriers; using any of them is protectionism.
• Protectionism raises the domestic price of the protected good, so consumers pay more and domestic producers earn more.
• Trade shifts jobs toward industries where a country has a comparative advantage; it should raise average wages through productivity, but some workers lose.
• The infant industry argument says young industries need temporary protection; it worked in parts of East Asia, but often the infants never grow up.
• Anti-dumping arguments often seem a convenient excuse for protection.
• Trade policy is set by agencies, legislatures, regional negotiations and the WTO; trade agreements also shield governments from their own special interests.
• Trade has income-distribution effects, but the book argues government should cushion workers rather than clamp down on trade.

Memory Tip: A tariff is a tax on imports, a quota is a cap on quantity, and a nontariff barrier is any other rule, such as a safety standard, that holds goods out.

Common Mistake: Assuming protection only helps workers. It raises prices for consumers and moves income from consumers to producers.

Important Questions:

• What are the three tools for restricting imports? Tariffs (taxes on imports), import quotas (limits on quantity) and nontariff barriers (other rules that make importing harder).
• What is the infant industry argument? The claim that small domestic industries should be protected from foreign competition for a time so they can grow into strong competitors.

Appendices A-E: Mathematics, Indifference Curves, Present Discounted Value, the Expenditure-Output Model and Balance Sheets

Appendices · Difficulty: Medium · Key topics: algebraic models, growth rates, indifference curves, present discounted value, expenditure-output model, multiplier, open market operations, bank balance sheets

The five appendices support the main chapters. Appendix A reviews algebraic models, growth rates and reading graphs, and is meant to be read after Chapter 1. Appendix B offers indifference curves as an alternative to numbered utility, covering utility maximization, income changes, substitution and income effects and labor-leisure choices. Appendix C explains present discounted value and applies it to stocks and bonds. Appendix D develops the expenditure-output (Keynesian cross) model with its aggregate expenditure schedule, equilibrium and multiplier. Appendix E follows Happy Bank’s balance sheet to show how open market operations change reserves, loans and the money supply.

Key Points:

• Appendix A says economics is not math, but math disciplines thinking by forcing you to say exactly what you mean.
• Indifference curves describe preferences without putting numbers on utility, and extend to labor-leisure and intertemporal choices.
• Present discounted value is the amount you should be willing to pay now for a stream of expected future payments; at a 10% interest rate, $110 a year from now is worth $100 today.
• Stock prices rest on expected future profits, and bond prices on future interest payments and repayment of face value.
• The expenditure-output model, the Keynesian cross, was the standard Keynesian tool from the 1930s to the 1970s and makes no explicit mention of aggregate supply or the price level.
• In Appendix E, Happy Bank starts with $460 million in assets, $400 million in deposits and $60 million in net worth; when the central bank buys $20 million of its bonds, the bank lends out the extra reserves.

Memory Tip: Present discounted value works backward from compound interest: for each year of waiting, divide the future payment by one plus the interest rate.

Common Mistake: Comparing a future payment with money today at face value. Money today can earn interest, so a payment received later is worth less now.

Important Questions:

• What is present discounted value? The amount you should be willing to pay in the present for a stream of expected future payments, found by using an interest rate to discount those payments.
• When should the expenditure-output appendix be read? After the chapters on the aggregate demand/aggregate supply model and the Keynesian perspective, since it is another way to explain Keynesian ideas.

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How to Study This Book

Principles of Economics 3e has 34 chapters in eight parts, plus five appendices. The book names its own parts: What Is Economics? (Chapters 1–2), Supply and Demand (3–4), The Fundamentals of Microeconomic Theory (5–10), Microeconomic Policy Issues (11–18), The Macroeconomic Perspective and Goals (19–23), A Framework for Macroeconomic Analysis (24–26), Monetary and Fiscal Policy (27–31) and International Economics (32–34). This page follows those parts with one block per chapter and names the part in each meta line. The five appendices are summarized together in the last block.

The book runs in the traditional order from microeconomics to macroeconomics, so you can match it to your course. A microeconomics course uses Chapters 1 to 18 and often Chapters 33 and 34 on international trade. A macroeconomics course starts with the shared foundations in Chapters 1 to 5 (scarcity, supply and demand, labor and financial markets, and elasticity) and then moves to Chapters 19 to 34. OpenStax publishes exactly these two selections as separate books, Principles of Microeconomics 3e with 20 chapters and Principles of Macroeconomics 3e with 21 chapters, so this combined book contains all of both.

Read Chapter 3 carefully before anything else. The supply and demand model comes back in Chapters 4, 5, 8, 9 and 12, and again in the foreign exchange market of Chapter 29. Chapter 5 on elasticity feeds the tax and pricing discussions that follow, and Chapter 6 on consumer choice leads into the costs of Chapter 7. Chapter 7 must be understood before the market structures of Chapters 8 to 10, and Chapter 8 (perfect competition) is the benchmark for judging the monopoly of Chapter 9 and the policy chapters 11 and 12. On the macro side, Chapter 19 (GDP) comes before Chapters 20 to 23, Chapters 21 and 22 prepare the ground for the AD/AS model of Chapter 24, and Chapters 25 and 26 both build on Chapter 24. Chapter 27 comes before Chapter 28, and the saving and investment identity of Chapter 23 returns in Chapter 31.

Read each appendix at the right moment. Appendix A (mathematics, growth rates and graphs) should be read after Chapter 1, as the book itself advises. Appendix B (indifference curves) pairs with Chapter 6, Appendix C (present discounted value) with Chapter 17, Appendix D (the expenditure-output model) with Chapters 24 and 25, and Appendix E (open market operations on bank balance sheets) with Chapter 28.

Expect the hardest work in Chapters 7 to 10, where cost curves, marginal revenue and profit-maximizing output must be drawn and read as graphs, in Chapter 14 (labor markets with monopsony and unions), and in Chapters 23, 24, 28 and 29, where several ideas have to be combined. Draw each diagram yourself as you read. The book’s Work It Out boxes take you through calculations step by step, the Clear It Up boxes answer the questions students most often ask, and the Bring It Home case study that opens each chapter is finished at the end of it, once you have the tools to explain it.

The end-of-chapter material is large: 327 Self-Check questions, 482 Review Questions, 317 Critical Thinking Questions and 125 Problems across the 34 chapters, 1,251 questions in all, with more practice in the appendices. Self-Check answers are in the book’s Answer Key and can be revealed in the web view, while answers to the Review, Critical Thinking and Problems sets are given only to instructors. Do each Self-Check as you finish a module, since the authors designed them to make you think beyond the text, and use a study group for the rest.

You can skim Chapter 1’s overview of economic systems and the public choice material in Chapter 18 if your course leaves them out, and Chapter 17 on financial markets and personal wealth is lighter, though BBA students will find it useful. This is a principles text: it does not use calculus, it does not teach econometrics, and it stops short of the intermediate theory taught in later years. Most of its data and policy examples come from the United States and it has no chapter on Pakistan, so pair it with local sources for Pakistan’s budget, inflation or trade. Some figures will have dated since the latest update, and the preface itself warns that economic data and related developments change frequently.

Used In These Programs

This book is used for the Principles of Economics course in BS Economics and BBA. Browse all books tagged Economics or the whole Economics category in University Books.

Who Should Read This

Principles of Economics 3e is written for a first-year university student in a first economics course, and it fits two kinds of reader. In a BS Economics program it is the foundation for intermediate microeconomics and macroeconomics, public finance, money and banking and international trade. In a BBA program it covers the economics a manager needs: costs, market structures, pricing and elasticity, the business cycle, interest rates and exchange rates. It assumes graphs and basic algebra, not calculus, so it does not replace the mathematical texts used in later years. Students who want a gentler start can use the Punjab board Economics 1st Year ICOM book or the Economics 2nd Year ICOM book as a warm-up, and those who need to refresh algebra can read Key to Business Mathematics ICOM Part 1 alongside it.

Applicable Universities

This book is useful for students at Pakistani universities offering BS Economics, BBA and related business programs, including University of the Punjab, University of Karachi, Quaid-i-Azam University, Virtual University, COMSATS, Lahore School of Economics, IBA Karachi, and other HEC-recognized institutions.

FAQs

Related Books

• Economics 1st Year ICOM Book – Punjab Board (an introductory economics textbook from the Punjab board syllabus, a warm-up before Chapter 1)
• Economics 2nd Year ICOM Book – Punjab Board (second-year economics from the same board syllabus, useful as extra reading alongside this book)
• Economics Class 10 – Punjab Board (PCTB) (school-level economics for readers who want the basic vocabulary first)
• Key to Business Mathematics ICOM Part 1 – Punjab Board (algebra and business mathematics practice for BBA students)

Principles of Economics 3e gives BS Economics and BBA students a complete, free tour of both microeconomics and macroeconomics, from scarcity to international trade. Browse more Economics books or all University Books.

Principles of Economics 3e, by David Shapiro, Daniel MacDonald, Steven A. Greenlaw and contributing authors. OpenStax, Rice University. Free under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International licence (CC BY-NC-SA 4.0). Access for free at https://openstax.org/details/books/principles-economics-3e