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 “Mankiw & Taylor’s Economics is a superb book for all students
approaching this subject for the first time. The book is both intuitive,
with plenty of examples enabling students to link economic theory and
facts, and rigorous, with analytical supplements and extensive exercises
allowing students to go into depth if they wish to. This book will make
students love this subject and it is simply excellent.”
Dr Gaia Garino, Principal Teaching Fellow in Economics, University of Leicester, UK

“A very well written and modern text, covering a wide and exhaustive range of
topics to be taught in introduction to economics classes. The accessible language and
approach is ideal for all students including those to whom English is a second language,
and a key pedagogical strength of the book is the many examples which show students
how to apply key economics topics within their everyday lives.”

Economics
Prof. Erich Ruppert, Faculty of Economics, Business and Law, University of Aschaffenburg, Germany

Now firmly established as one of the leading economics principles texts in the UK and Europe, this exciting, new third edition
by N. Gregory Mankiw (Harvard University) and Mark P. Taylor (Warwick University), has undergone some significant
restructuring and reorganization to more directly match economics students’ course structures and learning and assessment
needs. There are new sections covering microeconomic and macroeconomic topics and concepts in more depth, whilst at
the same time retaining the book’s reputation for clarity, authority and real world relevance.

New to the third edition:

> In direct response to user feedback, the chapter structure has been reorganized to better map to typical UK
and European course structures
> Brand new Case Studies, In the News features, and examples throughout
> Supplementary maths content provided separately
> Enhanced lecturer and student digital support resources including articles from The Economist with associated
discussion questions linked to every chapter and new assessment practice questions which can be used for
tutorial discussion and assignments
> New coverage on information and behavioural economics, business cycles, supply-side policies the role of
empirical evidence, and economic rent
> Fully updated to reflect the economic arguments which have surfaced following the financial crisis
> Fresh, modern text design with accessible layout and approach

About the Authors

Mankiw
Taylor
N. Gregory Mankiw, Professor of Economics, Harvard University, USA
Mark P. Taylor, Professor of Economics and Dean of Warwick Business School, University of Warwick, UK

N. Gregory Mankiw Mark P. Taylor

Economics
Economics is essential reading for all students taking introductory economics modules on undergraduate courses and within
an economics component of postgraduate and MBA courses.

For your lifelong learning solutions, visit www.cengage.co.uk

Purchase your next print book, e-book or e-chapter at www.cengagebrain.com

93795_cvr_ptg01_hires.indd 1 12/20/13 5:13 PM

 CONTENTS vii

PART 12 29 A macroeconomic theory of the open

economy 622
INTEREST RATES, MONEY AND
Supply and demand for loanable funds and for
PRICES IN THE LONG RUN 519 foreign currency exchange 622
Equilibrium in the open economy 625
24 Saving, investment and the financial How policies and events affect an open
system 519 economy 628
Financial institutions in the economy 520 Conclusion 634
Saving and investment in the national income
accounts 527
The market for loanable funds 530
Conclusion 535 PART 14
SHORT-RUN ECONOMIC
25 The basic tools of finance 539 FLUCTUATIONS 637
Present value: Measuring the time value
of money 539 30 Business cycles 637
Managing risk 541 Trend growth rates 638
Asset valuation 548 Causes of changes in the business cycle 645
Conclusion 554 Business cycle models 646
Conclusion 650
26 The monetary system 558
The meaning of money 559 31 Keynesian economics and IS-LM
The role of central banks 565 analysis 655
The European Central Bank and the The Keynesian cross 655
Eurosystem 566 The multiplier effect 659
The Bank of England 567 The IS and LM curves 665
Banks and the money supply 568 General equilibrium using the IS-LM model 667
Conclusion 579 From IS-LM to aggregate demand 669
Conclusion 675
27 Money growth and inflation 583
The classical theory of inflation 584 32 Aggregate demand and aggregate
The costs of inflation 594 supply 679
Conclusion 599 Three key facts about economic fluctuations 679
Explaining short-run economic fluctuations 680
The aggregate demand curve 682
The aggregate supply curve 686
PART 13 Two causes of economic fluctuations 691
THE MACROECONOMICS OF OPEN New Keynesian economics 697
ECONOMIES 605 Conclusion 698

28 Open-economy macroeconomics: Basic 33 The influence of monetary and fiscal

concepts 605 policy on aggregate demand 702
The international flows of goods and capital 606 How monetary policy influences aggregate
The prices for international transactions: Real demand 702
and nominal exchange rates 609 How fiscal policy influences aggregate
A first theory of exchange rate determination: demand 709
Purchasing power parity 612 Using policy to stabilize the economy 713
Conclusion 618 Conclusion 716
viii CONTENTS

34 The short-run trade-off between inflation 37 The financial crisis and sovereign
and unemployment 721 debt 782
The Phillips curve 721 Bubbles and speculation 782
Shifts in the Phillips curve: The role of The sovereign debt crisis 793
expectations 724 Austerity policies – too far too quickly? 797
The long-run vertical Phillips curve as an
argument for Central Bank independence 730
Glossary 805
Shifts in the Phillips curve: the role of supply
Index 814
shocks 732
Credits 820
The cost of reducing inflation 734
Inflation targeting 739
Conclusion 740

35 Supply-side policies 745

Shifts in the aggregate supply curve 745
Types of supply-side policies 749
Conclusion 756

PART 15
INTERNATIONAL
MACROECONOMICS 759
36 Common currency areas and European
monetary union 759
The euro 760
The single European market and the euro 760
The benefits and costs of a common
currency 762
The theory of optimum currency areas 765
Is Europe an optimum currency area? 768
Fiscal policy and common currency areas 772
Conclusion 777
ABOUT THE AUTHORS

AUTHORS
N. GREGORY MANKIW is Professor of Economics at Harvard University. As a student, he studied eco-
nomics at Princeton University and the Massachusetts Institute of Technology (MIT). As a teacher he has taught
macroeconomics, microeconomics, statistics and principles of economics. Professor Mankiw is a prolific writer
and a regular participant in academic and policy debates. In addition to his teaching, research and writing,
Professor Mankiw has been a research associate of the National Bureau of Economic Research, an advisor to
the Federal Reserve Bank of Boston and the Congressional Budget Office. From 2003 to 2005, he served as
chairman of the US President’s Council of Economic Advisors and was an advisor to Presidential candidate Mitt
Romney during the 2012 US presidential election. Professor Mankiw lives in Wellesley, Massachusetts, with his
wife Deborah, their three children and their border terrier Tobin.

MARK P. TAYLOR is Dean of Warwick Business School at the University of Warwick and Professor of
International Finance. He obtained his first degree in philosophy, politics and economics from Oxford University
and his Master’s degree in economics from London University, from where he also holds a doctorate in econom-
ics and international finance. Professor Taylor has taught economics and finance at various universities (including
Oxford, Warwick and New York) and at various levels (including principles courses, advanced undergraduate and
advanced postgraduate courses). He has also worked as a senior economist at the International Monetary Fund
and at the Bank of England and, before becoming Dean of Warwick Business School, was a managing director at
BlackRock, the world’s largest financial asset manager, where he worked on international asset allocation based
on macroeconomic analysis. His research has been extensively published in scholarly journals and he is today
one of the most highly cited economists in the world. Professor Taylor lives with his family in a 15th-century farm-
house near Stratford upon Avon, Warwickshire, where he collects clocks and keeps bees.

CONTRIBUTING AUTHOR
ANDREW ASHWIN has over 20 years experience as a teacher of economics. He has an MBA and is currently
researching for a PhD investigating assessment and the notion of threshold concepts in economics. Andrew is an
experienced author, writing a number of texts for students at different levels and journal publications related to his
PhD research, and learning materials for the website Biz/ed, which was based at the University of Bristol. Andrew
was Chair of Examiners for a major awarding body for business and economics in England and is a consultant for
the UK regulator, Ofqual. Andrew has a keen interest in assessment and learning in economics and has received
accreditation as a Chartered Assessor with the Chartered Institute of Educational Assessors. He is also Editor of
the Economics, Business and Enterprise Association (EBEA) journal. Andrew lives in Rutland with his wife Sue
and their twin sons Alex and Johnny.

ix
 PREFACE

T he third edition of Economics has a different look to the previous two editions. Feedback from users, both
students and instructors, has resulted in some reorganization of the material and some new sections cover-
ing more depth in both micro- and macroeconomic issues. Readers should note that this edition adapts Greg
Mankiw’s best-selling US undergraduate Economics text to reflect the needs of students and instructors in
the UK and European market. As each new edition is written, the adaptation evolves and develops an identity
distinct from the original US edition on which it is based.
We have tried to retain the lively, engaging writing style and to continue to have the novice economics stu-
dent in mind. Economics touches every aspect of our lives and the fundamental concepts which are introduced
can be applied across a whole range of life experiences. ‘Economics is a study of mankind in the ordinary
business of life.’ So wrote Alfred Marshall, the great 19th-century British economist, in his textbook, Principles
of Economics. As you work through the contents of this book you would be well advised to remember this.
Whilst the news might focus on the world of banking and finance, tax and government policy, economics
provides much more than a window on these worlds. It provides an understanding of decision making and the
process of decision making across so many different aspects of life. You may be considering travelling abroad,
for example, and are shocked at the price you have to pay for injections against tropical diseases. Should you
decide to try and do without the injections? Whilst the amount of money you are expected to give up seems
high, it is a small price to pay when you consider the trade-off – the potential cost to you and your family of
contracting a serious disease. This is as much economics as monetary policy decisions about interest rates and
firm’s decisions on investment.
Welcome to the wonderful world of economics – learn to think like an economist and a whole new world
will open up to you.

Maths for Mankiw Taylor Economics is available for purchase as a supplementary resource carefully explaining
and teaching the maths concepts and formulae underlying many of the key chapter topics.

x
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ACKNOWLEDGEMENTS

Michael Barrow, University of Sussex, UK Jassodra Maharaj, University of East London, UK

Brian Bell, London School of Economics, UK Paul Melessen, Hogeschool van Amsterdam, The
Thomas Braeuninger, University of Mannheim, Netherlands
Germany Jørn Rattsø, Norwegian University of Science &
Eleanor Denny, Trinity College Dublin, UK Technology, Norway
Gaia Garino, University of Leicester, UK Frédéric Robert-Nicoud, University of Geneva,
Chris Grammenos, American College of Switzerland
Thessaloniki, Greece Jack Rogers, University of Exeter, UK
Getinet Haile, University of Nottingham, UK Erich Ruppert, Hochschule Aschaffenburg, Germany
Luc Hens, Vrije Uni, Belgium Noel Russell, University of Manchester, UK
William Jackson, University of York, UK Munacinga Simatele, University of Hertfordshire, UK
Colin Jennings, King’s College London, UK Robert Simmons, University of Lancaster, UK
Sarah Louise Jewell, University of Reading, UK Alison Sinclair, University of Nottingham, UK
Arie Kroon, Utrecht Hogeschool, The Netherlands

xiii
PART 1
INTRODUCTION TO
ECONOMICS

1 TEN PRINCIPLES OF
ECONOMICS

WHAT IS ECONOMICS?
The word economy comes from the Greek word oikonomos, which means ‘one who manages a house-
hold’. At first, this origin might seem peculiar. But, in fact, households and economies have much in
common.
A household faces many decisions. It must decide which members of the household do which tasks
and what each member gets in return: Who cooks dinner? Who does the laundry? Who gets the extra slice
of cake at tea time? Who chooses what TV programme to watch? In short, the household must allocate
its scarce resources among its various members, taking into account each member’s abilities, efforts and
desires.
Like a household, a society faces many decisions. A society must decide what jobs will be done and
who will do them. It needs some people to grow food, other people to make clothing and still others to
design computer software. Once society has allocated people (as well as land, buildings and machines)
to various jobs, it must also allocate the output of goods and services that they produce. It must decide
who will eat caviar and who will eat potatoes. It must decide who will drive a Mercedes and who will take
the bus.

The Economic Problem

These decisions can be summarized as representing the economic problem. There are three questions
that any society has to face:
● What goods and services should be produced?
● How should these goods and services be produced?
● Who should get the goods and services that have been produced?
The answer to these questions would be simple if resources were so plentiful that society could produce
everything any of its citizens could ever want, but this is not the case. Society will never have enough

1
2 PART 1 INTRODUCTION TO ECONOMICS

resources to produce the goods and services which will satisfy the wants and needs of its citizens. These
resources can be broadly classified into three categories:
● Land – all the natural resources of the earth. This includes things like mineral deposits such as iron ore,
gold and copper, fish in the sea, coal and all the food products that land yields. David Ricardo (1817) in
his book On the Principles of Political Economy and Taxation referred to land as the ‘original and indes-
tructible powers of the soil’.
● Labour – the human effort both mental and physical that goes in to production. A worker in a factory pro-
ducing precision tools, an investment banker, a road sweeper, a teacher – these are all forms of labour.
● Capital – the equipment and structures used to produce goods and services. Capital goods include
machinery in factories, buildings, tractors, computers, cooking ovens – anything where the good is not
used for its own sake but for the contribution it makes to production.

land all the natural resources of the earth

labour the human effort both mental and physical that goes in to production
capital the equipment and structures used to produce goods and services

Scarcity and Choice

What resources society does have need to be managed. The management of society’s resources is
important because resources are scarce. Scarcity means that society has limited resources and therefore
cannot produce all the goods and services people wish to have. Just as a household cannot give every
member everything he or she wants, a society cannot give every individual the highest standard of living
to which he or she might aspire.
Economics is the study of how society manages its scarce resources and attempts to answer the
three key questions we noted above. In most societies, resources are allocated through the combined
actions of millions of households and firms through a system of markets. Economists:
● Study how people make decisions: how much they work, what they buy, how much they save and how
they invest their savings.
● Study how people interact with one another. For instance, they examine how the multitude of buyers
and sellers of a good together determine the price at which the good is sold and the quantity that is sold.
● Analyse forces and trends that affect the economy as a whole, including the growth in average income,
the fraction of the population that cannot find work and the rate at which prices are rising.

scarcity the limited nature of society’s resources

economics the study of how society manages its scarce resources

Although the study of economics has many facets, the field is unified by several central ideas. In the
rest of this chapter we look at the Ten Principles of Economics. Don’t worry if you don’t understand them
all at first, or if you don’t find them completely convincing. In the coming chapters we will explore these
ideas more fully. The ten principles are introduced here just to give you an overview of what economics is
all about. You can think of this chapter as a ‘preview of coming attractions’.

HOW PEOPLE MAKE DECISIONS

There is no mystery to what an ‘economy’ is. Whether we are talking about the economy of a group
of countries such as the European Union (EU), or the economy of one particular country, such as India,
or of the whole world, an economy is just a group of people interacting with one another as they go
about their lives. The economy refers to all the production and exchange activities that take place every
day – all the buying and selling. The level of economic activity is how much buying and selling goes on in
the economy over a period of time.
 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 3

the economy all the production and exchange activities that take place every day
economic activity how much buying and selling goes on in the economy over a period of time

Because the behaviour of an economy reflects the behaviour of the individuals who make up the eco-
nomy, we start our study of economics with four principles of individual decision making.

Principle 1: People Face Trade-offs

The first lesson about making decisions is summarized in an adage popular with economists: ‘There is no
such thing as a free lunch.’ To get one thing that we like, we usually have to give up another thing that we
also like. Making decisions requires trading off the benefits of one goal against those of another.
Consider a student who must decide how to allocate her most valuable resource – her time. She can
spend all of her time studying economics which will bring benefits such as a better class of degree; she
can spend all her time enjoying leisure activities which yield different benefits; or she can divide her time
between the two. For every hour she studies, she gives up an hour she could have devoted to spending
time in the gym, riding a bicycle, watching TV, napping or working at her part-time job for some extra
spending money.
Consider parents deciding how to spend their family income. They can buy food, clothing or a family
holiday. Or they can save some of the family income for retirement or perhaps to help the children buy a
house or a flat when they are grown up. When they choose to spend an extra euro on one of these goods,
they have one less euro to spend on some other good.
When people are grouped into societies, they face different kinds of trade-offs. The classic trade-off is
between spending on defence and spending on food. The more we spend on national defence to protect
our country from foreign aggressors, the less we can spend on consumer goods to raise our standard
of living at home. Also important in modern society is the trade-off between a clean environment and a
high level of income. Laws that require firms to reduce pollution raise the cost of producing goods and
services. Because of the higher costs, these firms end up earning smaller profits, paying lower wages,
charging higher prices, or some combination of these three. Thus, while pollution regulations give us the
benefit of a cleaner environment and the improved levels of health that come with it, they have the cost
of reducing the incomes of the firms’ owners, workers and customers.
Another trade-off society faces is between efficiency and equity. Efficiency means that society is get-
ting the most it can (depending how this is defined) from its scarce resources. Equity means that the
benefits of those resources are distributed fairly among society’s members. In other words, efficiency
refers to the size of the economic cake, and equity refers to how the cake is divided. Often, when govern-
ment policies are being designed, these two goals conflict.

equity – the property of distributing economic prosperity fairly among the members of society

Consider, for instance, policies aimed at achieving a more equal distribution of economic well-being.
Some of these policies, such as the social security system or unemployment insurance, try to help those
members of society who are most in need. Others, such as income tax, ask the financially successful to
contribute more than others to support government spending. Although these policies have the benefit of
achieving greater equity, they have a cost in terms of reduced efficiency. When the government redistrib-
utes income from the rich to the poor, it reduces the reward for working hard; as a result, people work less
and produce fewer goods and services. In other words, when the government tries to cut the economic
cake into more equal slices, the cake gets smaller.
Recognizing that people face trade-offs does not by itself tell us what decisions they will or should
make. A student should not abandon the study of economics just because doing so would increase the
time available for leisure. Society should not stop protecting the environment just because environmental
regulations reduce our material standard of living. The poor should not be ignored just because helping
4 PART 1 INTRODUCTION TO ECONOMICS

them distorts work incentives. Nevertheless, acknowledging life’s trade-offs is important because people
are likely to make good decisions only if they understand the options that they have available.

A typical supermarket shelf offering a

variety of cereals. What are the trade-offs
an individual faces in this situation?

SELF TEST Does the adage ‘there is no such thing as a free lunch’ simply refer to the fact that someone has
to have paid for the lunch to be provided and served? Or does the recipient of the ‘free lunch’ also incur a cost?

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

Because people face trade-offs, making decisions requires comparing the costs and benefits of alternat-
ive courses of action. In many cases, however, the cost of some action is not as obvious as it might first
appear.
Consider, for example, the decision whether to go to university. The benefit is intellectual enrichment
and a lifetime of better job opportunities. But what is the cost? To answer this question, you might be
tempted to add up the money you spend on tuition fees, books, room and board. Yet this total does not
truly represent what you give up to spend a year at university.
The first problem with this answer is that it includes some things that are not really costs of going to
university. Even if you decided to leave full-time education, you would still need a place to sleep and food
to eat. Room and board are part of the costs of higher education only to the extent that they might be
more expensive at university than elsewhere. Indeed, the cost of room and board at your university might
be less than the rent and food expenses that you would pay living on your own. In this case, the savings
on room and board are actually a benefit of going to university.
The second problem with this calculation of costs is that it ignores the largest cost of a university
education – your time. When you spend a year listening to lectures, reading textbooks and writing essays,
you cannot spend that time working at a job. For most students, the wages given up to attend university
are the largest single cost of their higher education.
The opportunity cost of an item is what you give up to get that item. When making any decision, such
as whether to go to university, decision makers should be aware of the opportunity costs that accompany
each possible action. In fact, they usually are. University-age rugby, basketball or golf players who can earn
large sums of money if they opt out of higher education and play professional sport are well aware that
their opportunity cost of going to university is very high. It is not surprising that they often decide that the
benefit is not worth the cost.

opportunity cost – whatever must be given up to obtain some item; the value of the benefits foregone (sacrificed)
 CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 5

SELF TEST Assume the following costs are incurred by a student over a three-year course at a university:
● Tuition fees at €9,000 per year = €27,000 ● Accommodation, based on an average cost of €4,500 a year =
€13,500 ● Opportunity cost based on average earnings foregone of €15,000 per year = €45,000 ● Total cost =
€85,500 ● Given this relatively large cost why does anyone want to go to university?

Principle 3: Rational People Think at the Margin

Decisions in life are rarely straightforward and usually involve problems. At dinner time, the decision you
face is not between fasting or eating as much as you can, but whether to take that extra serving of pizza.
When examinations roll around, your decision is not between completely failing them or studying 24 hours
a day, but whether to spend an extra hour revising your notes instead of watching TV. Economists use the
term marginal changes to describe small incremental adjustments to an existing plan of action. Keep
in mind that ‘margin’ means ‘edge’, so marginal changes are adjustments around the edges of what you
are doing.

marginal changes small incremental adjustments to a plan of action

In many situations, people make the best decisions by thinking at the margin. Suppose, for instance,
that you were considering whether to study for a Master’s degree having completed your undergraduate
studies. To make this decision, you need to know the additional benefits that an extra year in education
would offer (higher wages throughout your life and the sheer joy of learning) and the additional costs that
you would incur (another year of tuition fees and another year of foregone wages). By comparing these
marginal benefits and marginal costs, you can evaluate whether the extra year is worthwhile.
Individuals and firms can make better decisions by thinking at the margin. A rational decision maker
takes an action if and only if the marginal benefit of the action exceeds the marginal cost.

Principle 4: People Respond to Incentives

Because people make decisions by comparing costs and benefits, their behaviour may change when
the costs or benefits change. That is, people respond to incentives. When the price of an apple rises, for
instance, people decide to eat more pears and fewer apples because the cost of buying an apple is higher.
At the same time, apple farmers decide to hire more workers and harvest more apples, because the benefit
of selling an apple is also higher. As we shall see, the effect of price on the behaviour of buyers and sellers
in a market – in this case, the market for apples – is crucial for understanding how the economy works.
Public policymakers should never forget about incentives, because many policies change the costs or
benefits that people face and, therefore, alter behaviour. A tax on petrol, for instance, encourages people
to drive smaller, more fuel efficient cars. It also encourages people to switch and use public transport
rather than drive, or to move closer to where they work. When policymakers fail to consider how their
policies affect incentives, they often end up with results they did not intend. For example, the UK govern-
ment provided tax relief on business premises that were not being used as an incentive to the owners to
find new uses or owners for the buildings. The government decided to remove the tax relief and sugges-
ted that in doing so there would now be an incentive for owners of premises to get them back into use
as quickly as possible so that they avoided losing the tax relief. Unfortunately, as the new policy came
into being the economy was going through a severe recession. It was not easy for owners of premises to
find new tenants let alone get new businesses created in these empty properties. Some property owners
decided that rather than have to pay tax on these properties it was cheaper to demolish them. Is this the
outcome the government wanted? Almost certainly not.
This is an example of the general principle that people respond to incentives. Many incentives that
economists study are straightforward and others more complex. No one is surprised, for example, that
people might switch to driving smaller cars where petrol taxes and thus the price of fuel is relatively high.
6 PART 1 INTRODUCTION TO ECONOMICS

Yet, as the example of the removal of tax allowances on empty business premises shows, policies can
have effects that are not obvious in advance. When analysing any policy, we must consider not only the
direct effects but also the indirect effects that work through incentives. If the policy changes incentives, it
will cause people to alter their behaviour.

SELF TEST Many people across the EU are without work and claiming benefits. Governments throughout the
EU are trying to cut spending but find themselves having to spend more on welfare benefits for the unemployed.
What sort of incentives might governments put in place to encourage workers off welfare and into work? What
might be the unintended consequences of the incentives you identify?

HOW PEOPLE INTERACT

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

Principle 5: Trade Can Make Everyone Better Off

America and China are competitors to Europe in the world economy. In some ways this is true, because
American and Chinese firms produce many of the same goods as European firms. Toy manufacturers
compete for the same customers in the market for toys. Fruit farmers compete for the same customers
in the market for fruit.
Yet it is easy to be misled when thinking about competition among countries. Trade between Europe
and the United States and China is not like a sports contest, where one side wins and the other side loses
(a zero-sum game). In fact, the opposite is true: trade between two economies can make each economy
better off.
To see why, consider how trade affects your family. When a member of your family looks for a job, he or
she competes against members of other families who are looking for jobs. Families also compete against
one another when they go shopping, because each family wants to buy the best goods at the lowest
prices. So, in a sense, each family in the economy is competing with all other families.
Despite this competition, your family would not be better off isolating itself from all other families. If it
did, your family would need to grow its own food, make its own clothes and build its own home. Clearly,
your family gains much from its ability to trade with others. Trade allows each person to specialize in the
activities he or she does best, whether it is farming, sewing or home building. By trading with others,
people can buy a greater variety of goods and services at lower cost.
Countries as well as families benefit from the ability to trade with one another. Trade allows countries to
specialize in what they do best and to enjoy a greater variety of goods and services. The Japanese and the
Americans, as well as the Koreans and the Brazilians, are as much Europe’s partners in the world economy
as they are competitors.

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

The collapse of communism in the Soviet Union and Eastern Europe in the 1980s may be the most import-
ant change in the world during the past half century. Communist countries worked on the premise that
central planners in the government were in the best position to guide economic activity and answer the
three key questions of the economic problem. These planners decided what goods and services were
produced, how much was produced, and who produced and consumed these goods and services. The
theory behind central planning was that only the government could organize economic activity in a way
that promoted economic well-being for the country as a whole.
Today, most countries that once had centrally planned economies such as Russia, Poland, Angola,
Mozambique and the Democratic Republic of Congo have abandoned this system and are trying to develop
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