Dominick Salvatore

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 Theory and
Applications
Fifth Edition

New York Oxford -

OXFORD UNIVERSITY PRESS ~

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Oxford University Press, Inc., publishes works that further Oxford University’s
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Library of Congress Cataloging-in-Publication Data

Salvatore, Dominick.
Microeconomics: theory and applications/Dominick Salvatore.—Sth ed.
p. cm.
Includes bibliographical references and index.
ISBN 978-0-19-533610-8 (cloth: alk. paper) 1. Microeconomics. I. Title.
HB172.S139 2009
338.5—de22 2008032928

Printing number: 987654321

Printed in the United States of America

on acid-free paper
 BRIEF CONTENTS

Contents — vii
List of Examples and At the Frontier — xxvii
Preface — Xxxill
About the Author —xxxix

PART ONE Introduction to Microeconomics 1

™ CHAPTER 1* Introduction 3

© CHAPTER 2* Basic Demand and Supply Analysis 25

Theory of Consumer Behavior and Demand 55

™ CHAPTER 3° Consumer Preferences and Choice 57
~ CHAPTER 4° Consumer Behavior and Individual Demand 87
~ CHAPTER 5* Market Demand and Elasticities 124
~ CHAPTER6 = Choice Under Uncertainty 158

Production, Costs, and Competitive Markets 187

™ CHAPTER 7* Production Theory 189
™ CHAPTER 8* Costs of Production 225
™ CHAPTER 9* Price and Output Under Perfect Competition 261

yNymzel0ey imperfectly Competitive Markets 303

™ CHAPTER 10* Price and Output Under Pure Monopoly 305

@ CHAPTER 11* Price and Output Under Monopolistic Competition

and Oligopoly 345

* Core Chapter
Vi Brief Contents

CHAPTER12 Game Theory and Oligopolistic Behavior 389

CHAPTER 13* Market Structure, Efficiency, and Regulation 412

Pricing and Employment of Inputs 443

CHAPTER 14* Input Price and Employment Under Perfect
Competition 445

CHAPTER 15 _ Input Price and Employment Under Imperfect

Competition 481

CHAPTER 16 Financial Microeconomics: Interest, Investment,

and the Cost of Capital 509

General Equilibrium, Efficiency, and Public Goods 549

CHAPTER 17 General Equilibrium and Welfare Economics 551
CHAPTER 18 _ Externalities, Public Goods, and the Role
of Government 586

’ CHAPTER19_ The Economics of Information 615

Appendix A Mathematical Appenaix 627

Appendix B Answers to Selected Problems 648
Appendix C Glossary 675
Name Index 695
Subject Index 697

* Core Chapter
 CONTENTS

List of Examples and At the Frontier —xxvii

Preface —Xxxili
About the Author xxxix

Introduction to Microeconomics 1
CHAPTER1 — Introduction 3

1] Wants and Scarcity 4

Can Human Wants Ever Be Fully Satisfied? 4
Scarcity: The Pervasive Economic Problem 4
Example 1-1 More Health Care Means Less of Other
Goods and Services 5
1.2 Functions of an Economic System 6
13 Microeconomic Theory and the Price System 7
The Circular Flow of Economic Activity 7
Determination and Function of Prices 9

Example 1-2 Bad Weather and High Demand Send Wheat Prices Soaring 10

What Role for the Government? 11

Example 1-3 Economic Inefficiencies Cause Collapse of
Communist Regimes 1]

1.4 The Margin: The Key Unifying Concept in Microeconomics 12

The Crucial Importance of the Concept of the Margin 12
Example 1-4 Marginal Analysis in TV Advertising 13

Some Clarifications on the Use of the Margin 15

15 Specialization, Exchange, and the International Framework
of Microeconomics 16
Specialization and Exchange 16
The International Framework of Microeconomics 16

Example 1-5 Dell and Other PCs Sold in the United States Are Everything
but American! AN

vii
viii Contents

1.6 Models, Methodology, and Value Judgments 18

Models and Methodology 18
Positive and Normativ e Analysis 19

At the Frontier Do Economists Ever Agree on Anything? 20

Summary 22
Key Terms 22
Review Questions 23
Problems 23
Internet Site Addresses 24

w@ CHAPTER 2 Basic Demand and Supply Analysis 25

21 Market Analysis 26
22 Market Demand 26
Demand Schedule and Demand Curve 26
Changes in Demand 2,
2.3 Market Supply 29
Supply Schedule and Supply Curve og
Changes in Supply 30
2.4 When Is a Market in Equilibrium? 31

Example 2-1 Equilibrium Price by Auction oS

2.5 Adjustment to Changes in Demand and Supply:
Comparative Static Analysis 34
Adjustment to Changes in Demand 34
Adjustment to Changes in Supply 35
Example 2-2 Changes in Demand and Supply and Coffee Prices 36
2.6 Domestic Demand and Supply, Imports, and Prices 37
Example 2-3 The Large U.S. Automotive Trade Deficit Keeps U.S.
Auto Prices Down 39
27], Interfering With Versus Working Through the Market 40
Example 2-4 Rent Control Harms the Housing Market 40
Example 2-5 The Economics of U.S. Farm Support Programs 42
Example 2-6 Working Through the Market with an Excise Tax 44
Example 2-7 Fighting the Drug War by Reducing Demand and Supply 46
At the Frontier Nonclearing Markets Theory 47
Summary 48
Key lerms 49
Review Questions 49
Problems 50
 Contents ix

Appendix The Algebra of Demand, Supply, and Equilibrium 51

Market Equilibrium Algebraically 5).
Shifts in Demand and Supply and in Equilibrium 52
The Effect of an Excise Tax 38)
Internet Site Addresses 54

Pama ey §=Theory of Consumer Behavior and Demand 55

i CHAPTER 3. Consumer Preferences and Choice 57

3.1 Utility Analysis 58

Total and Marginal Utility 58
Cardinal or Ordinal Utility? 60
Example 3-1 Does Money Buy Happiness? 6]

3.2 Consumer’s Tastes: Indifference Curves 62

Indifference Curves—What Do They Show? 62
Characteristics of Indifference Curves 64
The Marginal Rate of Substitution 65
Some Special Types of Indifference Curves 66
Example 3-2 How Ford Decided on the Characteristics of Its Taurus 68
3.3 International Convergence of Tastes 69
Example 3-3 Gillette Introduces the Sensor and Mach3 Razors—Two
Truly Global Products 69
3.4 The Consumer’s Income and Price Constraints:
The Budget Line 70
Definition of the Budget Line 7)
Changes in Income and Prices and the Budget Line 72
Example 3-4 Time as a Constraint 74

3.5 Consumer’s Choice 74

Utility Maximization 74
Example 3-5 Utility Maximization and Government Warnings on Junk Food 76

Corner Solutions dd.

Example 3-6 Water Rationing in the West 78

Marginal Utility Approach to Utility Maximization 80
At the Frontier The Theory of Revealed Preference 8]
summary 8&3
Key lerms 54
Review Questions 84
Problems. 84
Internet Site Addresses 86
Contents

CHAPTER 4 Consumer Behavior and Individual Demand 87

41 Changes in Income and the Engel Curve 88

Income-Consumption Curve and Engel Curve 88

Example 4-1 Engel’s Law After a Century 90

Normal and Inferior Goods 91

Example 4-2 Many People Are Blowing Their Pension Money
Long Before Retirement Si

4.2 Changes in Price and the Individual Demand Curve 94

Example 4-3 Higher Alcohol Prices Would Sharply Reduce Youth
Alcohol Use and Traffic Deaths 96
4.3 Substitution Effect and Income Effect oT
How Are the Substitution Effect and the Income Effect Separated? O7
Example 4-4 Substitution and Income Effect of a Gasoline Tax 100

Substitution Effect and Income Effect for Inferior Goods 101

Example 4-5 — Giffen Behavior Found! 104

44 Substitution Between Domestic and Foreign Goods 104

Example 4-6 What Is an “American” Car? 105
4.5 Some Applications of Indifference Curve Analysis 106
Is a Cash Subsidy Better Than Food Stamps? 106
Consumer Surplus Measures Unpaid Benefits 108
Benefits from Exchange 110
At the Frontier The Characteristics Approach to Consumer Theory 112
Summary — 115
Key Terms 115
Review Questions 116
Problems — 116
Appendix Index Numbers and Changes in Consumer Welfare 117
Expenditure, Laspeyres, and Paasche Indices 117
How Are Changes in Consumer Welfare Measured? 118
Example 4-7 The Consumer Price Index, Inflation, and Changes
in the Standard of Living 120
Example 4-8 Comparing the Standard of Living of Various Countries 12]
Internet Site Addresses 123

”™ CHAPTER 5 Market Demand and Elasticities 124

9.1 The Market Demand for a Commodity 125
Example 5-1 Demand for Big Macs 127
 Contents XI

oe Price Elasticity of Market Demand 128

Measuring the Price Elasticity of Demand 128
Price Elasticity Graphically 130
Price Elasticity and Total Expenditures 131
What Determines Price Elasticity? 152

Example 5-2 Price Elasticity for Clothing Increases with Time 134
33) Income Elasticity of Demand 135

Example 5-3 European Cars Are Luxuries, Flour Is an

Inferior Good 137
5.4 Cross Elasticity of Demand 138
Example 5-4 Margarine and Butter Are Substitutes, Entertainment and
Food Are Complements 139
5.5 Price Elasticity and Income Elasticity of Imports and Exports 140
Example 5-5 Price Elasticity and Income Elasticity for Imports and Exports
in the Real World 141
5.6 Marginal Revenue and Elasticity 142
Demand, Total Revenue, and Marginal Revenue 142
Geometry of Marginal Revenue Determination 143
Marginal Revenue, Price, and Elasticity 145
Example 5-6 US. Consumer Demand for Alcoholic Beverages 147
At the Frontier The Marketing Revolution with Micromarketing 148
Summary 150
Key Terms — 15/
Review Questions 15]
Problems 152

Appendix Empirical Estimation of Demand by Regression Analysis ie

Example 5-7 Estimating and Forecasting U.S. Demand

for Electricity 155

Internet Site Addresses 157

wm CHAPTER 6 Choice Under Uncertainty 158

61 Risk and Uncertainty in Demand Choices 159

Example 6-1 The Risk Faced by Coca-Cola in Changing Its Secret Formula

6.2 Measuring Risk 160

Probability Distributions 161
The Standard Deviation 162

Example 6-2 Risk and Crime Deterrence 164

xii Contents

6.3 Utility Theory and Risk Aversion 165

Different Preferences Toward Risk 165

Maximizing Expected Utility 166

Example 6-3 America’s Gambling Craze 168

6.4 Insurance and Gambling 169

Why Do Some Individuals Buy Insurance? 169
Why Do Some Individuals Gamble? 171

Example 6-4 Gambling and Insuring by the Same Individual—A Seeming

Contradiction 172
6.5 Risk Aversion and Indifference Curves 173
Example 6-5_ Spreading Risks in the Choice of a Portfolio 15
6.6 Reducing Risk and Uncertainty 176
Gathering More Information 176
Diversification 176
Insurance 77
Example 6-6 Some Disasters as Nondiversifiable Risks 178
6.7 Behavioral Economics 178

Example 6-7 Behavioral Economics in Finance 180

At the Frontier Foreign-Exchange Risks and Hedging 18]

Summary 182
Key lerms 183
Review Questions 183
Problems 184
Internet Site Addresses 185

PART THREE Production, Costs, and Competitive Markets 187

™@ CHAPTER 7 _ Production Theory 189

7 Relating Outputs to Inputs 190

Organization of Production 190
Classification of Inputs 191
1h?! Production with One Variable Input 192
Total, Average, and Marginal Product 192
The Geometry of Average and Marginal Product Curves 195
The Law of Diminishing Returns 196
Example 7-1 Economics—The Dismal Science Because
of Diminishing Returns 197
 Contents xiii

73 Production with Two Variable Inputs 198

What Do Isoquants Show? 198
Derivation of Total Product Curves from the Isoquant Map 199
74 The Shape of Isoquants 201
Characteristics of lsoquants 20]
Economic Region of Production 203
Fixed-Proportions Production Functions 204
Example 7-2 Trading Traveling Time for Gasoline Consumption
on the Nation's Highways 205
Ths) Constant, Increasing, and Decreasing Returns to Scale 206
Example 7-3 General Motors Decides Smaller Is Better 209
76 Technological Progress and International Competitiveness 210
Meaning and Importance of Innovations 210
Example 7-4 How Do Firms Get New Technology? 21)

77 Open Innovation Model 212

Example 7-5 Open Innovations at Procter & Gamble 213

Innovations and the International Competitiveness of U.S. Firms 215

Example 7-6 How Xerox Lost and Regained Market Share but Is Now
Struggling to Remain Internationally Competitive 214
At the Frontier The New Computer-Aided Production Revolution
and the International Competitiveness of U.S. Firms 215
Summary 216
Key Terms 217
Review Questions 218
Problems 218
Appendix The Cobb-Douglas Production Function 219
The Formula 219
Illustration 220
Empirical Estimation 222
Example 7-7 Output Elasticity of Labor and Capital and Returns to Scale
in U.S. and Canadian Manufacturing 225
Internet Site Addresses 224

M@ CHAPTER 8 Costs of Production 225

8.1 The Nature of Production Costs 226

Example 8-1 Cost of Attending College 2h
8.2 Costin the Short Run 228
Total Costs 228
XIV Contents

Per-Unit Costs 229

Geometry of Per-Unit Cost Curves 231

Example 8-2 Per-Unit Cost Curves in Corn Production and in Traveling 233

8.3 Cost in the Long Run 234

Isocost Lines 234
Least-Cost Input Combination 236
Cost Minimization in the Long Run and in the Short Run 237

Example 8-3 Least-Cost Combination of Gasoline and Driving Time 238

8.4 Expansion Path and Long-Run Cost Curves 239

Expansion Path and the Long-Run Total Cost Curve 239
Derivation of the Long-Run Average and Marginal Cost Curves 240
The Relationship Between Short- and Long-Run Average
Cost Curves 240
Example 8-4 Long-Run Average Cost Curve in Electricity Generation 243

8.5 Shape of the Long-Run Average Cost Curve 244

Example 8-5 Shape of the Long-Run Average Cost Curves
in Various Industries 245

Example 8-6 Minimum Efficient Scale in Various U.S.

Food Industries 246
8.6 Multiproduct Firms and Dynamic Changes in Costs 247
Economies of Scope 247
The Learning Curve 248
Example 8-7 Learning Curve for the Lockheed L-1011 Aircraft
and for Semiconductors 250
At the Frontier Minimizing Costs Internationally—The New Economies
of Scale 25]

Summary 253
Key lerms 254
Review Questions 254
Problems 255
Appendix Extensions and Uses of Production and Cost Analysis 256
Derivation of the Total Variable Cost Curve from the Total
Product Curve 256
Input Substitution in Production to Minimize Costs 256
Example 8-8 Elasticity of Substitution in Japanese Manufacturing
Industries 258
Input Prices and the Firm’s Cost Curves 259
Internet Site Addresses 260
 Contents

@@ CHAPTER 9 Price and Output Under Perfect Competition 261

91 Market Structure: Perfect Competition 262
Example 9-1 Competition in the New York Stock Market 263
9.2 Price Determination in the Market Period 264
9.3. Short-Run Equilibrium of the Firm 265
Total Approach: Maximizing the Positive Difference Between Total
Revenue and Total Costs 266
Marginal Approach: Equating Marginal Revenue and Marginal Cost 266
Profit Maximization or Loss Minimization? 2/0
9.4 Short-Run Supply Curve and Equilibrium 271
Short-Run Supply Curve of the Firm and the Industry 27)
Example 9-2 Supply Curve of Petroleum from Tar Sands 213
Example 9-3 Short-Run World Supply Curve of Copper 2/4
Short-Run Equilibrium of the Industry and the Firm 2/6
9.5 oO Long-Run Equilibrium of the Firm and the Industry 277
Long-Run Equilibrium of the Firm 2di)
Long-Run Equilibrium of the Industry and the Firm 2/8
Efficiency Implications of Perfect Competition 279

Example 9-4 Long-Run Adjustment in the U.S. Cotton Textile Industry 280

9.6 Constant-, Increasing-, and Decreasing-Cost Industries 281

Constant-Cost Industries 28]
Increasing-Cost Industries 282
Decreasing-Cost Industries 203
97 International Competition in the Domestic Economy 284
9.8 Analysis of Competitive Markets 286
Producer Surplus 286
Consumers’ and Producers’ Surplus, and the Efficiency of Perfect
Competition 20)
Welfare Effects of an Excise Tax 289
Effects of an Import Tariff 290

At the Frontier (1) New Markets and New Competition

on the Internet Diep

At the Frontier (2) Auctioning Airwaves 295

summary 294
Key ferms 295
Review Questions 295
Problems 296
Xvi Contents

Appendix The Foreign-Exchange Market and the Dollar Exchange Rate Oo),

Example 9-5 Foreign-Exchange Quotations 299

Example 9-6 Depreciation of the U.S. Dollar and Profitability of U.S. Firms 300

Internet Site Addresses 30]

Imperfectly Competitive Markets 303

#@ CHAPTER10 Price and Output Under Pure Monopoly 305

1011 Pure Monopoly—The Opposite Extreme from Perfect Competition 306

Definition and Sources of Monopoly 306

Example 10-1 Barriers to Entry and Monopoly by Alcoa 307

The Monopolist Faces the Market Demand Curve for the Commodity 308
Example 10-2 De Beers Abandons Its Diamond Monopoly 31]

10.2 Short-Run Equilibrium Price and Output 312

Total Approach: Maximizing the Positive Difference Between Total Revenue
and Total Costs 312
Marginal Approach: Equating Marginal Revenue and Marginal Cost 314
Profit Maximization or Loss Minimization? 316
Short-Run Marginal Cost and Supply 318
10.3 Long-Run Equilibrium Price and Output 319
Profit Maximization in the Long Run — 319
Example 10-3 Monopoly Profits in the New York City Taxi Industry 320
Comparison with Perfect Competition: The Social Cost of Monopoly 321
Example 10-4 Estimates of the Social Cost of Monopoly in the
United States 28
10.4 Profit Maximization by the Multiplant Monopolist 323
Short-Run Equilibrium 323
Long-Run Equilibrium 325
10.5 Price Discrimination—A Monopolist’s Method of Increasing Profits 326
Charging Different Prices for Different Quantities 226
Example 10-5 _ First-Degree Price Discrimination in Undergraduate Financial
Aid at American Colleges een
Charging Different Prices in Different Markets 328
Example 10-6 Price Discrimination by Con Edison 330
 Contents xvii

10.6 International Price Discrimination and Dumping 331

Example 10-7 Kodak Antidumping Victory over Fuji—But Kodak Still Faces
Competitive Problems S52
10.7 Two-Part Tariffs, Tying, and Bundling 333
Two-Part Tariffs 333
Tying and Bundling 335
Example 10-8 Bundling in the Leasing of Movies B35
10.8 Analysis of Monopoly Markets 336
Per-Unit Tax: Perfect Competition and Monopoly Compared 336
Price Discrimination and the Existence of the Industry 338
Do Monopolists Suppress Inventions? 330
At the Frontier Near-Monopoly Lands Microsoft in the Courts 340

Summary 341
Key Terms 342
Review Questions 342
Problems 343
Internet Site Addresses 344

™@ CHAPTER11_ Price and Output Under Monopolistic Competition

and Oligopoly 345

11.1 Monopolistic Competition: Many Sellers of a Differentiated Product 346

11.2 Monopolistic Competition: Short-Run and Long-Run Analysis 347
Price and Output Decisions Under Monopolistic Competition 347
Product Variation and Selling Expenses 349
Example 1I-1 Advertisers Are Taking on Competitors by Name... and
Are Being Sued 35]
How Useful Is the Theory of Monopolistic Competition? B52
ibs Oligopoly: Interdependence Among the Few Producers in the Industry B52

Example 1l-2 \ndustrial Concentration in the United States 354

11.4 The Cournot and the Kinked-Demand Curve Models 355

The Cournot Model: Interdependence Not Recognized 35D
The Kinked-Demand Curve Model: Interdependence Recognized 358
11.5 Collusion: Cartels and Price Leadership Models 359
A Centralized Cartel Operates as a Monopolist 359
Example 1-3 The Organization of Petroleum Exporting Countries
(OPEC) Cartel 361
Xvili Contents

Market-Sharing Cartel 362

Example 11-4 The Market-Sharing lvy League Cartel and Financial-Aid
Leveraging 303
Price Leadership 364
11.6 Long-Run Adjustments and Efficiency Implications of Oligopoly 366

Long-Run Adjustments in Oligopoly 366

Nonprice Competition Among Oligopolists 36/7
Welfare Effects of Oligopoly 368
Example 11-5 — Firm Size and Profitability 369

11.7 Other Oligopolistic Pricing Practices 370

Limit Pricing as a Barrier to Entry 370
-Cost-Plus Pricing: A Common Shortcut Pricing Practice 371
At the Frontier The Art of Devising Airfares Sie
11.8 The March of Global Oligopolists 376
Example 1I-6_ Globalization of the Automobile Industry Sia
Example 1I-7 Rising Competition in Global Banking 378

Example 1l-8 Globalization of the Pharmaceutical Industry 380

Summary 367
Key lerms 382
Review Questions 382
Problems 383
Appendix The Cournot and Stackelberg Models 384
The Cournot Model—An Extended Treatment 384
The Stackelberg Model 386
Internet Site Addresses 388

i CHAPTER 12 Game Theory and Oligopolistic Behavior 389

121 Game Theory: Definition, Objectives, and Usefulness 390
Example 12-1 Military Strategy and Strategic Business Decisions 39]
12.2 Dominant Strategy and Nash Equilibrium 392
Dominant Strategy 392
Nash Equilibrium 393
Example 12-2 Dell Computers and Nash Equilibrium 394
12.3 The Prisoners’ Dilemma, Price and Nonprice Competition,
and Cartel Cheating 395
The Prisoners’ Dilemma: Definition and Importance 395
 Contents XIX

Price and Nonprice Competition, Cartel Cheating, and the Prisoners’

Dilemma 396
Example 12-3 The Airlines’ Fare War and the Prisoners’ Dilemma 398
12.4 Repeated Games and Tit-for-Tat Strategy 399
(PAS) Strategic Moves 400
Threats, Commitments, and Credibility 400
Entry Deterrence 401

Example 12-4 \Nal-Mart’s Preemptive Expansion Marketing Strategy 402

12.6 Strategic Moves and International Competitiveness 403
Example 12-5 Strategic Moves and Countermoves by Airbus
and Boeing 405
Example 12-6 Companies’ Strategic Mistakes and Failures 406
At the Frontier The Virtual Corporation 407

Summary 408
Key Terms 409
Review Questions 409
Problems 4/0
Internet Site Addresses 4]

? CHAPTER13 Market Structure, Efficiency, and Regulation 412

131 Market Structure and Efficiency 413

13.2 Measuring Monopoly Power 414
The Lerner Index as a Measure of Monopoly Power 414
Concentration and Monopoly Power: The Herfindahl Index 415
Contestable Markets: Effective Competition Even with Few Firms 47
At the Frontier Functioning of Markets and Experimental Economics 418

13.3 Social Costs and Dynamic Benefits of Monopoly Power 420

13.4 Controlling Monopoly Power: Antitrust Policy 422

Example 13-1 Antitrust Policy in Action—The Breakup of AT&T and the Creation
of Competition in Long-Distance Telephone Service 423
Example 13-2 Regulation and the Price of International Telephone
Calls in Europe 424

13.5 Public-Utility Regulation 425

Public Utilities as Natural Monopolies 425
Difficulties in Public-Utility Regulation 427

Example 13-3 Regulated Electricity Rates for Con Edison 428

XX Contents

13.6 The Deregulation Movement 429

Example 13-4 Deregulation of the Airline Industry: An Assessment 430

Example 13-5 Antitrust and the New Merger Boom 43]

13.7 Regulating International Competition: Voluntary Export Restraints 432

Example 13-6 Voluntary Restraints on Export of Japanese Automobiles

to the United States 433

13.8 Some Applications of Market Structure, Efficiency, and Regulation 434

Regulating Monopoly Price 434

Regulation and Peak-Load Pricing 435
Regulation and Transfer Pricing 437
Summary 439
_Key Terms 440
Review Questions 440
Problems 441
Internet Site Addresses 442

Pricing and Employment of Inputs 443

w@ CHAPTER 14 Input Price and Employment Under Perfect
Competition 445

141 Profit Maximization and Optimal Input Employment 446

14.2 The Demand Curve of a Firm for an Input 448
The Demand Curve of a Firm for One Variable Input 448
The Demand Curve of a Firm for One of Several Variable Inputs 450
14.3. The Market Demand Curve for an Input and Its Elasticity 452
The Market Demand Curve for an Input 452

Example 14-1 The Increase in the Demand for Temporary Workers 453

Determinants of the Price Elasticity of Demand for an Input 454

Example 14-2 _ Price Elasticity of Demand for Inputs in Manufacturing
Industries 455
14.4 The Supply Curve of an Input 456
The Supply of Labor by an Individual 456
Example 14-3 Leisure Time in the United States over the Past Century 458
Substitution and Income Effects of a Wage Increase 459
Example 14-4 Labor Force Participation Rates 460
 Contents xxi

The Market Supply Curve for an Input 461

Example 14-5 Backward-Bending Supply Curve of Physicians’ Services
and Other Labor 46]
14.5 Pricing and Employment of an Input 463
Example 14-6 Labor Productivity and Total Compensation in the United States
and Abroad 464
14.6 Input Price Equalization Among Industries, Regions, and Countries 465
Input Price Equalization Among Industries and Regions of a Country 465
Input Price Equalization Among Countries 466
Example 14-7 Convergence in Hourly Compensation in the Leading Industrial
Countries 468
14.7 Economic Rent: An Unnecessary Payment to Bring Forth the Supply
of an Input 468
14.8 Analysis of Labor Markets Under Perfect Competition 470
Substitution and Income Effects of a Wage Rate Change 470
Overtime Pay and the Supply of Labor Services 472
Example 14-8 Higher Tax Rates Reduce Hours of Work 473
Wage Differentials 473
Effect of Minimum Wages 474
At the Frontier Do Minimum Wages Really Reduce Employment? 476

Summary 477
Key lerms 478
Review Questions 475
Problems 479
Internet Site Addresses 480

m@ CHAPTER15 Input Price and Employment Under Imperfect

Competition 481

15.1 Profit Maximization and Optimal Input Employment 482

15.2 The Demand Curve of a Firm for an Input 483
The Demand Curve of a Firm for One Variable Input 483
The Demand Curve of a Firm for One of Several Variable Inputs 485
15.3 The Market Demand Curve and Input Price and Employment 486
Example 15-1 The Dynamics of the Engineers Shortage 486

15.4 Monopsony: A Single Firm Hiring an Input 487

Example 15-2 Occupational Licensing, Mobility, and Imperfect
Labor Markets 490
Xxil Contents

15.5 Monopsony Pricing and Employment of One Variable Input 490

Example 15-3 Monopsonistic Exploitation in Major League Baseball 492

15.6 Monopsony Pricing and Employment of Several Variable Inputs 493

Example 15-4 \mperfect Competition in Labor Markets and the Pay

of Top Executives 494

15.7 International Migration and the Brain Drain 495

Example 15-5 _ British and Russian Brain Drain Is U.S. Brain Gain 496

Example 15-6 The Debate Over U.S. Immigration Policy 497

15.8 Analysis of Imperfect Input Markets 498

Regulation of Monopsony 498
Bilateral Monopoly: A Monopsonistic Buyer Facing a Monopolistic Seller 499
Effect of Labor Unions on Wages 50]
Economics of Discrimination in Employment 502
At the Frontier Discrimination, and Gender and Race Wage Differentials 504
Summary 505
Key lerms 506
Review Questions 507
Problems 507
Internet Site Addresses 508

™@ CHAPTER 16 Financial Microeconomics: Interest, Investment,

and the Cost of Capital 509

16.1 Lending—Borrowing Equilibrium 510

Lending 510
Borrowing 513
The Market Rate of Interest with Borrowing and Lending 514
Example 16-1 Personal Savings in the United States 516
16.2 Saving-Investment Equilibrium 517
Saving-Investment Equilibrium Without Borrowing and Lending abi
Saving-Investment Equilibrium with Borrowing and Lending 518
The Market Rate of Interest with Saving and Investment, Borrowing
and Lending 520
Example 16-2 Personal and Business Savings and Gross and Net Private
Domestic Investment in the United States 522
16.3 Investment Decisions 522
Net Present Value Rule for Investment Decisions: The Two-Period Case 523
Net Present Value Rule for Investment Decisions: The Multiperiod Case 524
Example 16-3 Fields of Education and Higher Lifetime Earnings
in the United States 526
 Contents xxiii

16.4 Determinants of the Market Rates of Interest Spay/

Example 16-4 Nominal and Real Interest Rates in the United States:
1990-2006 529
Example 16-5 _\nvestment Risks and Returns in the United States 530
16.5 The Cost of Capital 530
Cost of Debt 530
Cost of Equity Capital: The Risk-Free Rate Plus Premium |
Cost of Equity Capital: The Dividend Valuation Model 532
Cost of Equity Capital: The Capital Asset Pricing Model (CAPM) 533
Weighted Cost of Capital 534
At the Frontier Derivatives: Useful but Dangerous 535
16.6 Effects of Foreign Investments on the Receiving Nation 537
Example 16-6 Fluctuations in the Flow of Foreign Direct Investments
to the United States 538
16.7 Some Applications of Financial Microeconomics 539
Investment in Human Capital 539
Investment in Human Capital and Hours of Work 540
Pricing of Exhaustible Resources 542
Management of Nonexhaustible Resources 543
Summary 545
Key lerms 546
Review Questions 546
Problems 547
Internet Site Addresses 548

PART SIX General Equilibrium, Efficiency, and Public Goods 549

@ CHAPTER17 General Equilibrium and Welfare Economics 551

171 Partial Versus General Equilibrium Analysis 552

Example 17-1 Effect of a Reduction in Demand for Domestically Produced
Automobiles in the United States 553

Wes General Equilibrium of Exchange and Production 555

General Equilibrium of Exchange 555
General Equilibrium of Production 557
Derivation of the Production-Possibilities Frontier 559

17.3 General Equilibrium of Production and Exchange and Pareto

Optimality 561
Simultaneous General Equilibrium of Production and Exchange 561
Marginal Conditions for Economic Efficiency and Pareto Optimality DOS
XXIV Contents

174 Perfect Competition, Economic Efficiency, and Equity 565

Perfect Competition and Economic Efficiency ee)
Efficiency and Equity 566
Example 17-2 Watering Down Efficiency in the Pricing of Water 567

175 General Equilibrium of Production and Exchange with International Trade 568

Example 17-3 The Basis of and the Gains from International Trade 569

176 Welfare Economics and Utility-Possibilities Frontiers 570

The Meaning of Welfare Economics 570

Example 17-4 “The Painful Prescription: Rationing Hospital Care” 57]

Utility-Possibilities Frontier 5/2

Grand Utility-Possibilities Frontier 5/3
—Example 17-5 From Welfare to Work—The Success of Welfare Reform
in the United States 574
177 Social Policy Criteria 575
Measuring Changes in Social Welfare aye
Arrow’s Impossibility Theorem or)
At the Frontier The Hot Issue of Income Inequality in the
United States Swiss

17.8 Trade Protection and Economic Welfare 580

Example 17-6 Welfare Effects of Removing U.S. Trade Restrictions 581

Summary 582
Key lerms 583
Review Questions 584
Problems 584
Internet Site Addresses 585

@ CHAPTER 18 Externalities, Public Goods, and the Role

of Government 586

18.1 Externalities 587

Externalities Defined boy.

Externalities and Market Failure 588
Example 18-1 The Case for Government Support for Basic Research 589
18.2 Externalities and Property Rights 590
Example 18-2 Commercial Fishing: Fewer Boats but Exclusive Rights? 591
18.3 Public Goods 592
Nature of Public Goods o2
Example 18-3 The Economics of a Lighthouse and Other Public Goods 594
 Contents XXV

Provision of Public Goods ae

At the Frontier Efficiency Versus Equity in the US. Tax System See)
18.4 Benefit—Cost Analysis 597
Example 18-4 Benefit-Cost Analysis and the SST 599
18.5 The Theory of Public Choice 600

Meaning and Importance of Public-Choice Theory 600

The Public-Choice Process 600
Policy Implications of Public-Choice Theory 602
18.6 Strategic Trade Policy 604
Example 18-5 Strategic Trade and Industrial Policies in the United States 605
18.7 Government Control and Regulation of Environmental Pollution 605
Environmental Pollution 606
Optimal Pollution Control 606
Direct Regulation and Effluent Fees for Optimal Pollution Control 608
Example 18-6 The Market for Dumping Rights 608

Example 18-7 Congestion Pricing 610

Summary — 6/1
Key lerrms 6/2
Review Questions 6/2
Problems 6/3
Internet Site Addresses 6/4

™@ CHAPTER 19 The Economics of Information 615

19.1 The Economics of Search 616

Search Costs 616

Searching for the Lowest Price 617
Search and Advertising 618
Example 19-1 No-Haggling Value Pricing in Car Buying 619
At the Frontier The Internet and the Information Revolution 620
19.2 Asymmetric Information: The Market for Lemons and Adverse Selection 622
Asymmetric Information and the Market for Lemons 622
The Insurance Market and Adverse Selection 623
19.3 Market Signaling 623
19.4 The Problem of Moral Hazard 625

Example 19-2 \ncreased Disability Payments Reduce Labor Force

Participation 626
Example 19-3 Medicare and Medicaid and Moral Hazard 626
XXVvi Contents

19.5 The Principal-Agent Problem 628

Example 19-4 Do Golden Parachutes Reward Failure? 628
19.6 The Efficiency Wage Theory 630
Example 19-5 The Efficiency Wage at Ford 632
Summary 632
Key lerms 633
Review Questions 633
Problems 634
Internet Site Addresses 635

Appendix A Mathematical Appendix 637

Appendix B Answers to Selected Problems 648
Appendix C Glossary 678
Name Index 695 —
Subject Index 697
 LIST OF EXAMPLES
AND AT THE FRONTIER

1=4 More Health Care Means Less of Other Goods and Services 3)
1-2 Bad Weather and High Demand Send Wheat Prices Soaring 10
1=3 Economic Inefficiencies Cause Collapse of Communist Regimes 1]
1-4 Marginal Analysis in TV Advertising 13
5 Dell and Other PCs Sold in the United States Are Everything but American! 17
At the Frontier Do Economists Ever Agree on Anything? 20

2-1 Equilibrium Price by Auction 33

2-2 Changes in Demand and Supply and Coffee Prices S16)
2-3 The Large U.S. Automotive Trade Deficit Keeps U.S. Auto Prices Down 39
2-4 Rent Control Harms the Housing Market 40
25 The Economics of U.S. Farm Support Programs 42
2-6 Working Through the Market with an Excise Tax 44
Pi Fighting the Drug War by Reducing Demand and Supply 46
At the Frontier Nonclearing Markets Theory 47

3-1 Does Money Buy Happiness? 6]

a-2 How Ford Decided on the Characteristics of Its Taurus 68
3>3 Gillette Introduces the Sensor and Mach3 Razors—Two Truly Global Products 69
3-4 Time as a Constraint /4
Sie Utility Maximization and Government Warnings on Junk Food 76
3-6 Water Rationing in the West 78
At the Frontier The Theory of Revealed Preference 8]

4-1 Engel’s Law After a Century 90

4-2 Many People Are Blowing Their Pension Money Long Before Retirement 93
4-3 Higher Alcohol Prices Would Sharply Reduce Youth Alcohol Use and Traffic Deaths 96
4-4 Substitution Effect and Income Effect of a Gasoline Tax 100
4-5 Giffen Behavior Found! 104
4-6 — What Is an ‘American’ Car? 105
At the Frontier The Characteristics Approach to Consumer Theory 2
4-7 The Consumer Price Index, Inflation, and Changes in the Standard of Living 120
4-8 Comparing the Standard of Living of Various Countries 12]

XXVil
XXViii List of Examples and At the Frontier

5-1 Demand for Big Macs 127

5=2 Price Elasticity for Clothing Increases with Time 134
5=3 European Cars Are Luxuries, Flour Is an Inferior Good 137
5-4 Margarine and Butter Are Substitutes, Entertainment and Food Are Complements 139
5=5 Price Elasticity and Income Elasticity for Imports and Exports in the Real World 14]
5=0 U.S. Consumer Demand for Alcoholic Beverages 147
At the Frontier The Marketing Revolution with Micromarket ing 148
5-7 Estimating and Forecasting U.S. Demand for Electricity [55

6-1 The Risk Faced by Coca-Cola in Changing Its Secret Formula 160
6-2 Risk and Crime Deterrence 164
6=3 America’s Gambling Craze 168
6-4 — Gambling and Insuring by the Same Individual—A Seeming Contradiction 72
6-5 Spreading Risks in the Choice of a Portfolio 175
6-6 Some Disasters as Nondiversifiable Risks 178
6-7, Behavioral Economics in Finance 180
At the Frontier Foreign-Exchange Risks and Hedging 18]

7=| Economics—The Dismal Science Because of Diminishing Returns 197

Ve Trading Traveling Time for Gasoline Consumption on the Nation’s Highways 205
Ine General Motors Decides Smaller Is Better 209
7-4 How Do Firms Get New Technology? 211
7-5 Open Innovations at Procter & Gamble 213
7-6 How Xerox Lost and Regained Market Share but Is Now Struggling to Remain
Internationally Competitive 214
At the Frontier The New Computer-Aided Production Revolution and the International
Competitiveness of U.S. Firms 215
7-1 Output Elasticity of Labor and Capital and Returns to Scale in U.S. and Canadian
Manufacturing 223;

8-1 Cost of Attending College 227

8-2 Per-Unit Cost Curves in Corn Production and in Traveling 253
S33 Least-Cost Combination of Gasoline and Driving Time 238
8-4 Long-Run Average Cost Curve in Electricity Generation 243
8=5 Shape of the Long-Run Average Cost Curves in Various Industries 245
8-6 Minimum Efficient Scale in Various U.S. Food Industries 246
8-7 Learning Curve for the Lockheed L-1011 Aircraft and for Semiconductors 250
At the Frontier Minimizing Costs Internationally—The New Economies of Scale 251
8-8 _ Elasticity of Substitution in Japanese Manufacturing Industries 258

9-1 Competition in the New York Stock Market 263

9-2 Supply Curve of Petroleum from Tar Sands 273
 List of Examples and At the Frontier XXix

9-3 Short-Run World Supply Curve of Copper 2/4

9-4 Long-Run Adjustment in the U.S. Cotton Textile Industry 280
At the Frontier (1) New Markets and New Competition on the Internet 292
At the Frontier (2) Auctioning Airwaves 293
9-5 Foreign-Exchange Quotations 299
9-6 Depreciation of the U.S. Dollar and Profitability of U.S. Firrns 300

10-1 Barriers to Entry and Monopoly by Alcoa S10!

10-2 De Beers Abandons Its Diamond Monopoly 37]
10-3 Monopoly Profits in the New York City Taxi Industry 320
10-4 _ Estimates of the Social Cost of Monopoly in the United States B25:
10-5 _ First-Degree Price Discrimination in Undergraduate Financial Aid at
American Colleges Bi
10-6 Price Discrimination by Con Edison 330
10-7 ~—_Kodak Antidumping Victory over Fuji—But Kodak Still Faces
Competitive Problems oe
10-8 Bundling in the Leasing of Movies 555
At the Frontier Near-Monopoly Lands Microsoft in the Courts 340

11-1 Advertisers Are Taking on Competitors by Name... and Are Being Sued S55)
11-2 Industrial Concentration in the United States 354
11-3 _ The Organization of Petroleum Exporting Countries (OPEC) Cartel 36]
11-4 ‘The Market-Sharing lvy League Cartel and Financial-Aid Leveraging 363
11-5 _ Firm Size and Profitability 369
At the Frontier The Art of Devising Airfares S/Z
11-6 _ The Globalization of the Automobile Industry iii
11-7 __ Rising Competition in Global Banking 378
11-8 — Globalization of the Pharmaceutical Industry 380

12-1 Military Strategy and Strategic Business Decisions 39]

12-2 Dell Computers and Nash Equilibrium 394
12-3 ‘The Airlines’ Fare War and the Prisoners’ Dilemma 398
12-4 Wal-Mart’s Preemptive Expansion Marketing Strategy 402
12-5 Strategic Moves and Countermoves by Airbus and Boeing 405
12-6 Companies’ Strategic Mistakes and Failures 406
At the Frontier The Virtual Corporation 407

At the Frontier Functioning of Markets and Experimental Economics 418

13-1 Antitrust Policy in Action—The Breakup of AT&T and the Creation of Competition
in Long-Distance Telephone Service 423
13-2 Regulation and the Price of International Telephone Calls in Europe 424
13-3 Regulated Electricity Rates for Con Edison 428
XXX List of Examples and At the Frontier

13-4 Deregulation of the Airline Industry: An Assessment 430

13-5 Antitrust and the New Merger Boom 43]
Voluntary Restraints on Export of Japanese Automobiles to the United States 433
13-6

14-1 The Increase in the Demand for Temporary Workers 453

14-2 Price Elasticity of Demand for Inputs in Manufacturin g Industries 455
14-3 Leisure Time in the United States over the Past Century 458
14-4 Labor Force Participation Rates 460
14-5 Backward-Bending Supply Curve of Physicians’ Services and Other Labor 46]
14-6 — Labor Productivity and Total Compensation in the United States and Abroad 464
14-7. Convergence in Hourly Compensation in the Leading Industrial Countries 468
14-8 — Higher Tax Rates Reduce Hours of Work 473
At the FrontierDo Minimum Wages Really Reduce Employment? 476

15-1 The Dynamics of the Engineers Shortage 456

15-2 Occupational Licensing, Mobility, and Imperfect Labor Markets 490
15-3 Monopsonistic Exploitation in Major League Baseball 492
15-4 Imperfect Competition in Labor Markets and the Pay of Top Executives 494
15-5 — British and Russian Brain Drain Is U.S. Brain Gain 496
15-6 The Debate Over US. Immigration Policy 497
At the Frontier Discrimination, and Gender and Race Wage Differentials 504

16-1 — Personal Savings in the United States 516

16-2 Personal and Business Savings and Gross and Net Private Domestic Investment
in the United States beZ
16-3 Fields of Education and Higher Lifetime Earnings in the United States 526
16-4 Nominal and Real Interest Rates in the United States: 1990-2006 529
16-5 Investment Risks and Returns in the United States 530
At the Frontier Derivatives: Useful but Dangerous 535
16-6 Fluctuations in the Flow of Foreign Direct Investments to the United States Boo

7st Effect of a Reduction in Demand for Domestically Produced Automobiles

in the United States 553
17-2. Watering Down Efficiency in the Pricing of Water 567
17-3 _ The Basis of and the Gains from International Trade 569
17-4 “The Painful Prescription: Rationing Hospital Care” 57
17-5 From Welfare to Work—The Success of Welfare Reform in the United States 5/4
At the Frontier The Hot Issue of Income Inequality in the United States 578
17-6 Welfare Effects of Removing U.S. Trade Restrictions 58]

18-1 The Case for Government Support for Basic Research 589
18-2 Commercial Fishing: Fewer Boats but Exclusive Rights? 59]
18-3 The Economics of a Lighthouse and Other Public Goods 594
 List of Examples and At the Frontier XXXi

At the Frontier Efficiency Versus Equity in the U.S. Tax System 595
18-4 — Benefit-Cost Analysis and the SST 599
18-5 — Strategic Trade and Industrial Policies in the United States 605
18-6 The Market for Dumping Rights 608
18-7 — Congestion Pricing 6/0

19-1 —No-Haggling Value Pricing in Car Buying 679

At the Frontier The Internet and the Information Revolution 620
19-2 Increased Disability Payments Reduce Labor Force Participation 626
19-3 Medicare and Medicaid and Moral Hazard 626
19-4 Do Golden Parachutes Reward Failure? 628
19-5 The Efficiency Wage at Ford 632
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 PREFACE

his is the fifth edition of a text that has enjoyed enviable market success in an
increasingly crowded field and that has been adopted at hundreds of colleges
throughout the United States and the English-speaking world. The text has also
been translated into several languages.
[ had three principal aims in writing this text: to present a judicious blend of the stan-
dard topics of traditional microeconomic theory and the many exciting recent develop-
ments in the field; to bring important but neglected international aspects into the course;
and to devise a number of fresh, realistic, and truly useful examples that could vividly
demonstrate modern microeconomic theory at work.
This is a text for modern undergraduate courses in intermediate microeconomics in
economics and business programs. A prior course in principles of economics is required,
and only simple geometry is used. There is an optional mathematical appendix at the end
of the text for students who have had calculus.

THE MODERN APPROACH TO MICROECONOMICS

A unique feature of this text is that it presents a judicious blend of all the standard topics
of traditional microeconomic theory as well as the many exciting recent developments in
the field. Some of the exciting new theoretical developments covered in this text are:
behavioral economics, learning curves, open innovation maker, new pricing practices,
contestable markets, experimental economics, new advances in game theory, financial
microeconomics, the theory of public choice, industrial policies and firm competitive-
ness, and the economics of information.
Each chapter has a section called “At the Frontier,” which presents recent and excit-
ing applications or more advanced theoretical developments in microeconomics today.
Some of these are Nonclearing Markets Theory; New Markets and New Competition on
the Internet; The New Computer-Aided Production Revolution and the International
Competitiveness of U.S. Firms; Minimizing Costs Internationally—The New Economies
of Scale; Auctioning Airwaves; Near-Monopoly Lands Microsoft in the Courts; The Art
of Devising Airfares; The Virtual Corporation; Derivatives: Useful but Dangerous; and
The Internet and the Information Revolution.

INTERNATIONAL DIMENSION OF MICROECONOMICS

Another unique feature of this text is the introduction of an international dimension into
microeconomics to reflect the globalization of production and distribution in today’s

XXxill
XXXIV Preface

world. Other microeconomics texts approach microeconomics as if the international

economy did not exist. However, many of the commodities we consume are imported,
and firms today purchase many inputs abroad and sell an increasing share of their outputs
overseas. Even more importantly, domestic firms face more and more competition from
foreign producers. None of these issues are reflected in current microeconomic texts, and
I feel it is time to rectify such deficiencies by incorporating international ramifications
throughout the intermediate course.
Modern microeconomics should deal with the effect of imports on domestic prices,
the international convergence of tastes, technological progress and international compet-
itiveness, minimizing costs internationally, the new economies of scale, dumping, immi-
gration and domestic wages, domestic production and strategic trade policies, and other
such topics.

PUTTING THE THEORY TO WORK

Tointroduce more realism than most other microeconomics texts offer, this text includes five
to eight demarked examples in each chapter—not the usual tired examples but truly relevant
and modern ones. These examples (including At the Frontier 146 in all—more than in any
other text) show how theory can be used to analyze and yield possible solutions to important
present-day economic problems. My intention is to demonstrate that only by “putting theory
to work” does theory truly come alive. Examples deepen understanding of the theory and
enhance motivation by displaying the usefulness of theory in specific modern contexts.
Some of the exciting new examples are: Fighting the Drug War by Reducing Demand and
Supply; Equilibrium Price by Auction; Giffen Behavior Found!; Gillette Introduces the Sensor
and Mach3 Razors—Two Truly Global Products; Behavioral Economics in Finance; What Is
an “American” Car’; America’s Gambling Craze; How Do Firms Get New Technology?; The
Market-Sharing Ivy League Cartel and Financial-Aid Leveraging; Strategic Moves and
Countermoves by Airbus and Boeing; Deregulation and the New Merger Boom; From
Welfare to Work—The Success of Welfare Reform in the United States; Congestion Pricing:
The Market for Dumping Rights; and Do Golden Parachutes Reward Failure?

OTHER INNOVATIVE FEATURES OF THIS Book

Ihave tried to balance traditional topics with contemporary concerns in the following ways.
The chapter on Choice Under Uncertainty (Chapter 6) reflects the fact that most
consumer choices in the real world are made under conditions of uncertainty rather than
certainty. The chapter includes a discussion of how risk and uncertainty affect demand
choices, how to measure risk, utility theory and risk aversion, and insurance and
gambling.
The chapter on Game Theory (Chapter 12) presents a clear introduction to advances
that have been made in this field, and it provides significant insights into modern business
behavior in oligopolistic markets. There is a discussion of the prisoners’ dilemma, price
and nonprice competition, threats, commitments, credibility, entry deterrence, repeated
games, and strategic moves.
A chapter on Market Structure, Efficiency, and Regulation (Chapter 13) examines
the
efficiency implications of monopoly, monopolistic competition, and oligopoly. It also
evaluates the case for deregulation of economic activities.
 Preface XXXV

Chapter 16 concentrates on Financial Microeconomics. Financial microeconomics,

in general, and the cost of capital, in particular, are of growing importance in today’s
world, but they are not covered in most other microeconomics texts.
The Economics of Information (Chapter 19)—another important, modern topic—is
covered by a full-length chapter. The chapter deals with the economics of search, asym-
metric information and adverse selection, moral hazard, market signaling, the principal-
agent problem, the efficiency wage theory, and other topics.
Other important topics covered are: the concept of the margin as the key unifying
theme in all of microeconomics, the characteristics approach to consumer demand theory,
behavioral economics, the open innovation model, the new economies of scale, two-part
tariff, tying, bundling, limit pricing, cost-plus pricing, contestable markets, experimental
economics, the theory of public choice, and effluent fees for optimal pollution control.
More advanced optional topics are covered (in chapter appendices): theory of
revealed preference, the characteristics approach to consumer demand theory, index num-
bers and changes in consumer welfare, demand estimation and forecasting,
Cobb—Douglas production function, extensions and uses of production and cost analysis,
the Cournot and Stackelberg models, and others.
The At the Frontier section in each chapter presents very recent applications or more
advanced theoretical developments in microeconomics.

New OR EXPANDED TREATMENT IN THE FIFTH EDITION

e The number of examples has been increased to 146 in this edition; previous exam-
ples were either replaced with more recent ones or updated.
Nonclearing market theories and auctions are examined in Chapter 2.
The theory of revealed preference is presented in Chapter 3.
The characteristics approach to consumer demand theory is introduced in Chapter 4.
Chapter 6, on choice under uncertainty, has been expanded by the inclusion of
behavioral economics
e The new production revolution and the open innovation model are examined in
Chapter 7.
e The new international economies of scale are discussed in Chapter 8.
e Chapter 12, on game theory, has been expanded with new real-world examples.
The functioning of markets and experimental economics is examined in Chapter 13.
The economics of discrimination is discussed in Chapter 15.
Measures of income inequalities and rising income inequalities in the United States
are examined in Chapter 17.
e Efficiency versus equity in U.S. tax reform is discussed in Chapter 18.
e Internet site addresses for the most important topics are presented in each chapter.

ORGANIZATION OF THE TEXT

The text is organized into six parts.

e Part One (Chapters | and 2) introduces microeconomic theory and reviews some
principles of economics. This part shows clearly the importance and relevance of the
international dimension in microeconomic theory and how it will be integrated into
this text.
XXXVI Preface

It
Part Two (Chapters 3-6) presents the theory of consumer behavior and demand.
examines how consumers maximize utility and how an individual’s and the market’s
demand curves are derived. It shows the measurement and usefulness of the various
demand elasticities, and it examines choice under uncertainty.
Part Three (Chapters 7-9) examines the theory of production, cost, and pricing in
competitive markets. The international aspects of domestic production are shown
throughout.
Part Four (Chapters 10-13) focuses on the theory of the firm in imperfectly com-
petitive markets. It brings together the theory of consumer behavior and demand
(from Part Two) and the theory of production and costs (from Part Three) to analyze
how price and output are determined under various types of imperfectly competitive
markets.
Part Five (Chapters 14-16) examines the theory of input pricing and employment
(i.e., how input prices and the level of their employment are determined in the mar-
ket). As in previous parts of the text, the presentation of the theory is reinforced with
many real-world examples and important modern applications.
Part Six (Chapters 17-19) presents the theory of general equilibrium and welfare
economics, examines the role of the government in the economy, and deals with the
economics of information. This part interrelates with material covered in all the pre-
vious parts of the text.

The twelve core chapters are \-5, 7-11, and 13-14. Additional chapters and topics
may be emphasized at the discretion of the instructor.

PEDAGOGICAL FEATURES

This text has been. carefully planned to facilitate student learning using the following
pedagogical features.

The main sections of each chapter are numbered for easy reference, and longer
sections are broken into two or more subsections.
All of the graphs and diagrams are carefully explained in the text and then summa-
rized briefly in the captions.
Diagrams are generally drawn on numerical scales to allow the reading of answers
in actual numbers rather than simply as distances. Consistent, judicious use of color
and shading in the illustrations aid student understanding.
No calculus is used in the text, but an extensive (and optional) Mathematical
Appendix is given at the end of the book.
A glossary of important terms is given at the end of the text.

Each chapter also contains the following teaching aids:

All chapters begin with a list of learning objectives.

A side (margin) glossary of all important terms has been added in this edition.
Concept Checks have been added in each chapter.
Key terms are boldfaced when they are first introduced and are listed at the end of
each chapter; definitions are given in the margin near their first text use and are pro-
vided again, arranged alphabetically, in the Glossary at the end of the text.
A Summary reviews the main points covered in the chapter.
 Preface XXxXVII

° Twelve Review Questions help the student remember the material covered in the
chapter.
° Twelve Problems ask students to apply and put to use what they learned from the
chapter. Answers to selected problems, marked by an asterisk (*), are provided at
the end of the book for the type of quick feedback that is so essential to effective
learning.

ACCOMPANYING SUPPLEMENTS

The following ancillaries are available for use with this book.

!. A substantial /nstructor’s Manual, written by the text author, is available. It

includes chapter objectives, lecture suggestions, detailed answers to all end-of-
chapter questions and problems, a set of 25 multiple-choice questions and answers
for each chapter that I personally feel cover the most important ideas in each
chapter. The Manual also includes additional examples and problems (with
answers) for class discussions and/or examinations. Finally, there is an annotated
list of Supplementary Readings with references on the various topics covered in
each chapter. The Manual was prepared with as much care as the text itself.
A separate Test Bank, prepared by Professor Mary Lesser of Iona College, contains
nearly 1,000 multiple-choice questions with answers and is available to adopters of
the text. This comprehensive Jest Bank, more extensive than that of any competing
text, is also available in computerized form for custom test-making on IBM PCs,
Macintosh, and compatibles.
5. PowerPoint presentations of all figures and tables in the text are available to adopters
of the text.
4. A Study Guide, prepared by Professor Mary Lesser of Iona College, is available from
Oxford University Press to assist students in text content review and practice. It
provides, for each text chapter, a review of concepts from previous chapters, an
annotated chapter outline, fill in the blanks, and a wealth of multiple-choice
questions with answers.
5. A Website for the text has been set up that includes at least one other example for
each chapter and includes updates of other material.

ACKNOWLEDGMENTS
This text grew out of the undergraduate and graduate courses in microeconomics that I
have been teaching at Fordham University during the past 30 years. I was very fortunate
to have had many excellent students who, with their questions and comments, have con-
tributed much to the clarity of exposition of this text.
I owe a great intellectual debt to my brilliant former teachers: William Baumol
(New York University and Princeton University), Victor Fuchs (Stanford University and
National Bureau of Economic Research), Jack Johnston (University of California), and
Lawrence Klein (University of Pennsylvania and Wharton School of Business). It is
incredible how many of the insights that one gains as a superb economist’s student live
on for the rest of one’s life.
XXXVI Preface

y
Many of my colleagues in the Department of Economics at Fordham Universit
that significan tly improved the final product. Professor s
made numerous comments
invalu-
Joseph Cammarosano in particular read through the entire manuscript and made
able notes for improvements. Many valuable suggestio ns were also made by Mary
Burke, Fred Campano, Clive Daniel, Edward Dowling, Duncan James, Sophie Mitra,
Henry Schwalbenberg, Booi Themeli, and Greg Winczewski.
The following professors reviewed the fifth edition of this text and made many valu-
able suggestions for improvements: John Cochran, Metropolitan State College of
Denver: Mehidi Haririan, Bloomsburg University of Pennsylvania; Michael Magura,
University of Toledo; Michael Szenberg, Pace University; Robert Whaples, Wake Forest
University.
The following professors reviewed the previous editions of this book; their numerous
and excellent comments resulted in a much improved text: Mary Acker, Iona College;
Richard Ballman, Augustana College; Taeho Bark, Georgetown University; Joseph Barr,
Framingham State College; William Beaty, Tarelton State University; Gordon Bennett,
University of Southern Florida; Charles Berry, University of Cincinnati; Joseph Brada,
Arizona State University; Charles Breeden, Marquette University; Robert Brooker,
Gannon University; William Buchanan, University of Texas—Permian Basin; John
Cochran, Metropolitan State College; Elizabeth Erikson, University of Akron; G. R.
Ghorashi, Stockton State College; James Giordano, Villanova University; Paulette
Graziano, University of Illinois; Ralph Gunderson, University of Wisconsin—Oshkosh;
Simon Hakim, Temple University; John D. Harford, Cleveland State University; Mehdi
Haririan, Bloomsburgh University of Pennsylvania; Andy Harvey, St. Mary’s University;
Paul M. Hayashi, The University of Texas—Arlington; Roy Hensley, University of Miami;
Thomas R. Ireland, University of Missouri—St. Louis; Joseph Jadlow, Oklahoma State
University; H. A. Jafri, Tarleton State University; Joseph Kiernin, Fairleigh Dickinson
University; Janet Koscianski, Shippensburg University; Vani Kotcherlakota, University of
Nebraska—Kerney; W. E. Kuhn, University of Alabama; Louis Lopilato, Mercy College;
Mike Magura, University of Toledo; Jessica McGraw, University of Texas at Arlington;
Larry Mielnicki, New York University; Stephen Miller, University of Connecticut;
Thomas Mitchell., Southern Ilinois University—Carbodale; Peter Murrell, University of
Maryland; Kathryn Nantz, Fairfield University; Felix Ndukwe, Lafayette College;
Patricia Nichol, Texas Tech University; Lee Norman, Idaho State University; Paul Okello,
University of Texas—Arlington; Edward O’Rieley, North Dakota State University;
Patrick O’Sullivan, State University of New York—Old Westbury; Donal Owen, Texas
Tech University; Ray Pepin, Stonehill College; Martin Richardson, Georgetown University;
Howard Ross, Baruch College; Timothy P. Roth, University of Texas—El Paso; Siamack
Shojai, Manhattan College; Philip Sorensen, Florida State University; Charles Stuart,
University of California—Santa Barbara; Michael Szenberg, Pace University; Allen
Wilkins, University of Wisconsin—Madison; Anne E. Winkler, University of Missouri—
St. Louis; H. A. Zavareei, West Virginia Institute of Technology.
Finally, I would like to express my gratitude to John Challice, Terry Vaughn,
Catherine Rae, and the entire staff of Oxford University Press for their truly expert assis-
tance throughout this project. My thanks also go to Mariana Barrientos, Mara Gabor,
Jennifer Murray, Yumna Omar, and Russen Trendafilov (my graduate assistants) and to
Angela Bates and Josephine Cannariato (the department secretaries at Fordham
University) for their efficiency and cheerful dispositions.

Dominick Salvatore
 ABOUT THE AUTHOR

l) ominick Salvatore is Distinguished Professor of Economics at Fordham

University in New York and Honorary Professor at the Shanghai Finance
University and Hunan University. He is President of the North American
Economic and Finance Association, Past President of the International Trade and Finance
Association, Chairperson of the New York Academy of Sciences, and Research Associate
at the Vienna University of Economics and Business. He is Chairman of the Society for
Policy Modeling and consultant to the United Nations, the World Bank, and the Economic
Policy Institute in Washington, D.C.
Professor Salvatore is the author of 48 books, including Managerial Economics in a
Global Economy, 6th edition (2007), and International Economics, 9th edition (2007). He
also wrote Schaum’s Outline of Microeconomic Theory, 4th edition (2006), which has
been translated into 10 languages and has sold more than one-half million copies.
Professor Salvatore is coeditor of the Journal of Policy Modeling and Open
Economies Review and associate editor of The American Economist (the journal of the
International Honor Society in Economics). His research has been published in more than
100 articles in leading scholarly journals and presented at numerous national and interna-
tional conferences.

XXXIX
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 PART
ONE

D art One (Chapters 1and 2) presents an introduction Introduction to

to microeconomic theory and a review of some
basic tools of economics. Chapter 1 deals with scarcity as
the fundamental economic fact facing every society and
Microeconomics
examines the function and purpose of microeconomic
theory and its methodology. Chapter 1 also discusses the
concept of the margin as the central unifying theme in
microeconomics and examines the importance of
introducing an international dimension, or globalization, in
microeconomic analysis. The “At the Frontier” section
discusses agreement and disagreement among
economists on the most important economic questions of
the day. Chapter 2 is a brief review of the concepts of
demand, supply, and equilibrium. In addition, the chapter
examines the benefits and costs resulting from the
growing interdependence of the United States in the
world economy, while the “At the Frontier” section
discusses nonclearing market theories.
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 CHAPTER |

Introduction
Chapter Outline List of Examples
1.1 Wants and Scarcity I-1 More Health Care Means Less of Other Goods
1.2. Functions of an Economic System and Services
1.3 Microeconomic Theory and the Price 1-2 Bad Weather and High Demand Send
System Wheat Prices Soaring
1.4 The Margin: The Key Unifying Concept in 1-3 Economic Inefficiencies Cause Collapse of
Microeconomics Communist Regimes
1.5 Specialization, Exchange, and the International 1-4 Marginal Analysis in TV Advertising
Framework of Microeconomics 1-5 Dell and Other PCs Sold in the United States
1.6 Models, Methodology, and Value Judgments Are Everything but American!
At The Frontier: Do Economists Ever
Agree on Anything?

After Studying This Chapter, You Should Be Able to:

e Explain why scarcity is the fundamental economic fact of every society
e Identify the functions of any economic system
e Describe the circular flow of economic activity, the determination and function of prices, and the role of
the government in the economic system
e Explain why the concept of the margin is the unifying theme in microeconomics
e Understand the importance of globalization in the study of microeconomics

M icroeconomic theory is perhaps the most important course in all economics and
business programs. Microeconomic theory can help us answer such questions as
why there is a trade-off between spending on health care and spending on other
goods and services; why the price of housing has risen sharply in recent years; why the
price of beef is higher than the price of chicken; why the price of gasoline rose sharply
during the 1970s and declined in the 1980s; why textiles are produced with much machin-
ery and few workers in the United States but with many workers and a small amount of
machinery in India; why there are only a handful of automakers but many wheat farmers
in the United States; why the courts ordered the breakup of AT&T in 1982; why physi-
cians earn more than cab drivers and college professors; why raising the minimum wage
leads to increased youth unemployment; why environmental pollution arises and how it
can be regulated; and why the government provides some goods and services such as

3
4 PART ONE Introduction to Microeconomics

nding how the U.S.

national defense. Microeconomic theory provides the tools for understa
economy and most other economies operate.
s such
Microeconomic theory is also the basis for most “applied” fields of economic
, natural resources and environme ntal econom-
as industrial economics, labor economics
s,
ics, agricultural economics, regional economics, public finance, development economic
and international economics.
In this introductory chapter, we define the subject matter and the methodology of
microeconomics. We begin by examining the meaning of scarcity as the fundamental eco-
nomic fact facing every society. We then discuss the basic functions that all economic systems
must somehow perform and the way they are performed in a free-enterprise economic sys-
tem, such as that of the United States. We also examine why the concept of the margin is the
central unifying theme in microeconomics and the importance of introducing an international
dimension into microeconomic analysis. Subsequently, we examine the role of theory or
models in microeconomics, discuss the basic methodology of economics, and distinguish
between positive and normative analysis. The “At the Frontier” section discusses agreement
and disagreement among economists on the most important economic issues of the day.

La] WANTS AND SCARCITY

Economics The study Economics deals with the allocation of scarce resources among alternative uses to satisfy
of the allocation of human wants. The essence of this definition rests on the meaning of human wants and
scarce resources among resources, and on the scarcity of economic resources in relation to insatiable human wants.
alternative uses.

Can Human Wants Ever Be Fully Satisfied?

Human wants All the Human wants refer to all the goods, services, and conditions of life that individuals desire.
goods and services that These wants vary among different people, over different periods of time, and in different
individuals desire. locations. However, human wants always seem to be greater than the goods and services
available to satisfy them. Although we may be able to get all the hamburgers, beer, pencils,
and magazines we desire, there are always more and better things that we are unable to
obtain. In short, the sum total of all human wants can never be fully satisfied.
Economic resources Economic resources are the inputs, the factors, or the means of producing the goods
Resources that are and services we want. They can be classified broadly into /and (or natural resources),
limited in supply or
labor (or human resources), and capital. These are the resources that firms must pay to
scarce and thus
hire. Land refers to the fertility of the soil, the climate, the forests, and the mineral
command a price.
deposits present in the soil. Labor refers to all human effort, both physical and mental,
that can be directed toward producing desired goods and services. It includes entrepre-
neurial talent that combines other labor, capital, and natural resources to produce new,
better, or cheaper products. Finally, capital refers to the machinery, factories, equipment,
tools, inventories, irrigation, and transportation and communications networks. All of
these “produced” resources facilitate the production of other goods and services. In the
economist’s sense, money is not capital because it does not produce anything. Money
simply facilitates the exchange of goods and services.

Scarcity: The Pervasive Economic Problem

Resources have alternative uses. For example, a particular piece of land could be used for
a factory, housing, roads, or a park. A laborer could provide cleaning services, be a porter,
 CHAPTER 1 — Introduction 5

construct bridges, or provide other manual services. A student could be trained to become
an accountant, a lawyer, or an economist. A tractor could be used to construct a road or a
dam. Steel could be used to build a car or a bridge. Because economic resources are lim-
ited, they command a price. While air may be unlimited and free for the purpose of oper-
ating an internal-combustion engine, clean air to breathe is not free if it requires the
installation and operation of antipollution equipment.
Because resources are generally limited, the amount of goods and services that any
society can produce is also limited. Thus, the society must choose which commodities to
produce and which to sacrifice. In short, society can only satisfy some of its wants. If
human wants were limited or resources unlimited, there would be no scarcity and there
would be no need to study economics.
Over time, the size and skills of the labor force rise, new resources are discovered and

Concept Check
new uses are found for available land and natural resources, the nation’s stock of capital
Why is scarcity the is increased, and technology improves. Through these advances, the nation’s ability to
pervasive economic produce goods and services increases. But human wants always seem to move well ahead
problem of every of society’s ability to satisfy them. Thus, scarcity remains. Scarcity is the fundamental
society? economic fact of every society (see Example 1-1).

EXAMPLE 1-1
More Health Care Means Less of Other Goods and Services

One of the most serious concerns of individuals, businesses, and governments in the
United States and in most other countries today is the explosion of health-care costs.
Nearly $1.9 trillion, or 16% of national income, was spent for health care in 2004 in
the United States, up from 4% in 1940 and 7% in 1970. Health-care costs have thus
risen much faster than income and now exceed $6,200 per person living in the United
States. There is, of course, nothing wrong with spending more on health care if that is
what society wants. But a higher proportion of income spent on health care means that
proportionately less is available for all other goods and services. Resources are scarce
and incomes are limited, and so we cannot have more of everything.
Despite spending more on health care than any other country, both in absolute
amount and as a proportion of national income, millions of Americans have no med-
ical insurance (most other advanced nations have universal health care), infant mortal-
ity is higher, and life expectancy is lower. What is even more serious is that large cost
increases are built into the U.S. health-care system because of an aging population, the
development of new and more expensive medical technologies and medicines, and the
move to third-party (private and government-sponsored health insurance plans), which
reduced the incentive to contain medical expenses.
In the attempt to contain costs, the United States rapidly moved to a system of
managed care, or HMOs (health-maintenance organizations, the term commonly used
for managed-care providers) during the past decade, and these now cover over 170
million people. The government picks up the tab for 40 million elderly and disabled
Americans (through Medicare) and about 38 million poor (through the state—federal
Medicaid scheme). This leaves nearly 46 million people, or 16% of Americans,
uninsured.
6 PART ONE Introduction to Microeconomics

to health-
HMOs try to contain health-care costs by providing a flat fee per person
specialis ts.
care providers (physicians, hospitals, etc.) and limiting patients’ access to
at the
This made physicians angry at their loss of income and made patients furious
restrictions on the treatment that they can receive, and it prompted Congress to intro-
duce a “Patients Bill of Rights” in order to overcome some of these restrictions. The
upshot of all of this is that exploding health-care costs are likely to remain one of the
most serious economic problems facing Americans (and people in other nations).
Sources: M. Feldstein, “The Economics of Health Care: What Have We Learned? What Have I Learned?,”
American Economic Review, May 1995, pp. 28-49; U. E. Reinhardt, “Health Care for the Aging Baby
Boom: Lessons from Abroad,” Journal of Economic Perspectives, Spring 2000, pp. 71-84; “Organizational
Innovations to Contain Health Costs,” Economic Report of the President, 2001, pp. 225-229; “Propelled by
Drugs and Hospital Costs, Health Spending Surged in 2000,” New York Times, January 8, 2002, p. 14;
“Desperate Measures,” The Economist, January 28, 2006, pp. 24-26; and “World’s Best Medical Care?”
New York Times, August 12, 2007, p. 9.

|
2 FUNCTIONS OF AN ECONOMIC SYSTEM

Faced with the pervasiveness of scarcity, all societies, from the most primitive to the most
advanced, must somehow determine (1) what to produce, (2) how to produce, (3) for
whom to produce, (4) how to provide for the growth of the system, and (5) how to ration
Price system The a given quantity of a commodity over time. Let us see how the price system performs
system in which each of these functions under a free-enterprise system (such as our own). In a free-enter-
economic activity is prise system individuals own property and individuals and firms make private economic
determined by
decisions.
commodity and
resource prices.
What to produce refers to which goods and services a society chooses to produce
and in what quantities to produce them. No society can produce all the goods and services
Free-enterprise it wants, so it must choose which to produce and which to forgo. Over time, only those
system The market goods and services for which consumers are willing and able to pay a price sufficiently
organization where high to cover at least the costs of production will generally be produced. Automobile
economic decisions are
manufacturers will not produce cars costing $1 million if no one is there to purchase
made by individuals
and firms. them. Consumers can generally induce firms to produce more of a commodity by paying
a higher price for it. On the other hand, a reduction in the price that consumers are will-
What to produce The ing to pay for a commodity will usually result in a decline in the output of the commod-
goods and services a ity. For example, an increase in the price of milk and a reduction in the price of eggs are
society chooses to
signals to farmers to raise more cows and fewer chickens.
produce and in what
How to produce refers to the way in which resources or inputs are organized to
quantities.
produce the goods and services that consumers want. Should textiles be produced with
a great deal of labor and little capital or with little labor and a great deal of capital?
How to produce The Since the prices of resources reflect their relative scarcity, firms will combine them in
way resources or inputs such a way as to minimize costs of production. By doing so, they will use resources in
are combined to the most efficient and productive way to produce those commodities that society wants
produce goods and
and values the most. When the price of a resource rises, firms will attempt to economize
services.
on the use of that resource and substitute cheaper resources so as to minimize their pro-
duction costs. For example, a rise in the minimum wage leads firms to substitute
machinery for some unskilled labor.
 CHAPTER 1 Introduction 7

For whom to produce For whom to produce deals with the way that the output is distributed among the
The way that output is members of society. Those individuals who possess the most valued skills or own a
distributed among greater amount of other resources will receive higher incomes and will be able to pay
members of society.
and coax firms to produce more of the commodities they want. Their greater monetary
“votes” enable them to satisfy more of their wants. For example, society produces more
goods and services for the average physician than for the average clerk because the for-
mer has a much greater income than the latter.
Economic growth The In all but the most primitive societies there is still another function that the economic
increase in resources, system must perform: It must provide for the growth ofthe nation. Although governments
technology,
can affect the rate of economic growth with tax incentives and with incentives for
commodities, and
research, education, and training, the price system is also important. For example, inter-
incomes over time.
est payments provide the savers an incentive to postpone present consumption, thereby
releasing resources to increase society’s stock of capital goods. Capital accumulation and
Concept Check technological improvements are stimulated by the expectations of profits. Similarly, the
What are the functions incentive of higher wages (the price of labor services) induces people to acquire more
of any economic training and education, which increases their productivity. Through capital accumulation,
system? technological improvements, and increases in the quantity and quality (productivity) of
labor, a nation grows over time.
Finally, an economic system must allocate a given quantity of a commodity over
Rationing over time time. Rationing over time is also accomplished by the price system. For example, the
The allocation of a price of wheat is not so low immediately after harvest that all the wheat is consumed very
commodity over time. quickly, thus leaving no wheat for the rest of the year. Instead, some people (speculators)
will buy some wheat soon after harvest (when the price is low) and sell it later (before the
next harvest) when the price is higher; the available wheat is thus rationed throughout the
year.

MICROECONOMIC THEORY AND THE PRICE SYSTEM

In this section, we define the subject matter of microeconomic theory, briefly examine the
determination and function of prices in a system of free enterprise, and show how gov-
ernments affect the operation of the economic system. We will see that prices play such
an important role that microeconomic theory is often referred to as “price theory.”

The Circular Flow of Economic Activity

Microeconomic theory Microeconomic theory studies the economic behavior of individual decision-making units
The study of the such as individual consumers, resource owners, and business firms, and the operation of
economic behavior of individual markets in a free-enterprise economy. This is to be contrasted with macroeco-
individual decision-
nomic theory, which studies (a) the total or aggregate level of output and national income
making units in a
and (b) the level of national employment, consumption, investment, and prices for the econ-
free-enterprise
economy.
omy viewed as a whole. Both microeconomics and macroeconomics provide very useful
tools of analysis and both are important. While macroeconomics often makes the headlines,
Macroeconomic microeconomics attempts to explain some of the most important economic and social prob-
theory The study of lems of the day. These range from the high cost of energy, to welfare programs, environ-
aggregate levels and mental pollution, rent control, minimum wages, safety regulations, rising medical costs,
variables of economic monopoly, discrimination, labor unions, wages and leisure, crime and punishment, taxation
activity for the
and subsidies, and so on.
economy as a whole.
8 PART ONE Introduction to Microeconomics

Microeconomics focuses attention on two broad categories of economic units:

households and business firms, and it examines the operation of two types of markets:
the market for goods and services, and the market for economic resources. The interac-
tion of households and business firms in the markets for goods and services and in the
markets for economic resources represents the core of the free-enterprise economic sys-
tem. Specifically, households own the labor, the capital, the land, and the natural
resources that business firms require to produce the goods and services households want.
Business firms pay to households wages, salaries, interest, rents, and so on, for the ser-
vices and resources that households provide. Households then use the income that they
receive from business firms to purchase the goods and services produced by business
firms. The income of households are the production costs of business firms. The expen-
Circular flow of ditures of households are the receipts of business firms. The so-called circular flow of
economic activity The economic activity is complete.
flow of resources from The circular flow of economic activity can be visualized in Figure 1.1. The inner loop
households to firms and shows the flow of economic resources from households to business firms and the flow of
the opposite flow of
goods and services from business firms to households. The outer loop shows the flow of
money incomes from
firms to households. money incomes from business firms to households and the flow of consumption expendi-
tures from households to business firms. Thus, the inner loop represents production flows
while the outer loop represents financial flows.
Looking at it from a different perspective, we see that the top part of Figure 1.1 shows
the flow of goods and services from business firms to households and the opposite flow of
consumption expenditures from households to business firms. Here are the markets where
goods and services are bought and sold. The bottom part of Figure 1.1 shows the flow of
resources from households to business firms and the opposite flow of money incomes to
households. Here are the markets where resources or their services are bought and sold.
Concept Check Specifically, the top loop shows consumers’ purchases of foods, clothing, housing,
What is the flow of health care, education, transportation, recreation, vacations, and so on, and the expen-
economic activity in ditures that consumers incur to pay for them. The bottom loop shows the labor time, the
terms of resources and
capital, the land, and the entrepreneurship that individuals provide to firms in return for
incomes?

Markets for
goods and services

FIGURE 1.1 The Circular Flow of Economic Activity Business firms Households
The inner loop shows the flow of resources from households to
business firms and shows the flow of goods and services
from business firms to households. The outer loop shows the
flow of money incomes from business firms to households and
shows the flow of consumption expenditures from households to
Markets for
business firms. The prices of goods and services are determined
resources
in the top half of the figure, and the prices of resources are
determined in the bottom half of the figure.
 CHAPTER1 Introduction 9

wages, interest, rent, and profits, which represent the incomes with which consumers
purchase the goods and services they want.

Determination and Function of Prices

The prices of goods and services are determined in the markets for goods and services (the
top half of Figure 1.1), while the prices of resources and their services are determined in the
markets for resources (the bottom half of Figure 1.1). If households want to purchase more
of a commodity than is placed on the market by business firms, the price of the commodity
will be bid up until the shortage of the commodity is eliminated. This occurs because at a
higher price, households will want to purchase less of the commodity while business firms
will want to produce more of the commodity. For example, if automobile prices rise, con-
sumers will want to purchase fewer automobiles while automakers will want to produce
more automobiles. Automakers can produce more automobiles at higher prices because they
are able to bid resources (labor, capital, and land) away from other uses.
On the other hand, if households want to purchase less of a commodity than business
firms place on the market, the price of the commodity will fall until the surplus of the com-
modity disappears. This occurs because at a lower price, households will want to purchase
more of the commodity while business firms will want to produce less of the commodity.
For example, if consumers want to purchase less beef than farmers send to market, the
price of beef falls until the quantity demanded of beef matches the quantity supplied. In the
process, farmers will hire fewer resources so that some resources will be freed to produce
more of other commodities that consumers value more highly. Thus, it is the system of
commodity prices that determines which commodities are produced and in what quantities
(the “what to produce” question of the previous section) and how resources are used.
Turning to factor markets, if households provide less of a resource or service than
business firms want to hire at a given price, the price of the resource will be bid up until
the shortage of the resource is eliminated. This occurs because at higher resource prices,
households will usually provide more of the resource or service while business firms will
economize on the use of the resource (so as to minimize production costs). For example,
if hospitals want to hire more nurses than are available, nurses’ salaries rise. This results
in more people entering nursing schools and in hospitals economizing on the use of
Concept Check
How are prices nurses (for example, by employing more orderlies at lower salaries to perform some of
determined and what the tasks previously performed by nurses). The process continues until the adjustment
is their function? (i.e., the shortage of nurses) is eliminated. !
On the other hand, if too much of a resource is made available at a given price, the
price falls until the surplus is eliminated. This occurs because at lower resource prices,
households will usually provide less of the resource or service while business firms will
substitute in production the cheaper resource for the more expensive one (so as to mini-
mize production costs). Thus, in a free-enterprise economy it is the system of resource
prices that determines how production is organized and how the income of resource own-
ers is established (the “how to produce” and the “for whom to produce” questions of the
previous section).

| The shortage of nurses may last many years if the demand for hospital care and for nurses outstrips the
increasing number of nurses being trained or if market imperfections and government involvement prevents
wages from rising to the equilibrium level. This is what seems to have happened in fact in many areas of the
United States.
10 PART ONE Introduction to Microeconomics

Price theory It is because of the crucial function of prices in determining what goods are produced
Another name for and in what quantities, how production is organized, and how output or income is distrib-
microeconomic theory uted that microeconomic theory is often referred to as price theory.” Example 1-2 shows
LUISE ES MES how changes in supply and demand affect the price of agricultural commodities in the
HEIRS A ules United States and abroad.

EXAMPLE U2 scat ok maine rere este

Bad Weather and High Demand Send Wheat Prices Soaring

During 1988 and 1989, Kansas suffered the worst drought since the “dust bowl” days
of the early 1930s. Kansas normally produces more than one-third of the nation’s crop
of hard red winter wheat (the wheat used for making bread), and with about 40% of this
crop destroyed by the drought, wheat prices shot up from about $2.50 per bushel in
1987 to over $4.25 in spring 1989. American wheat stocks were heavily depleted, and
American wheat exports fell sharply. The drought in the United States also encouraged
Canada, Argentina, and Australia to plant more wheat and replace U.S. wheat exports
to other nations such as Russia. The wheat market is actually one big global market.
Consumer prices in the United States did not increase very much, however,
because a $1 loaf of bread contains only 4 cents’ worth of wheat (the rest reflects man-
ufacturing and marketing costs) and because food prices represent only one-sixth of
the consumer price index. Most wheat farmers’ income also increased because wheat
prices rose proportionately more than the reduction in crops and because the U.S. gov-
ernment provided a subsidy ranging from $3.17 to $3.80 for each bushel of wheat lost
to drought. The rains came back in 1990, however, and wheat output increased and
wheat prices declined. The cycle of drought, reduced output, and rising prices followed
by good weather, large outputs, and lower prices (and higher government subsidies)
was repeated a number of times since the 1990s.
The weather affected the output of wheat not only in the United States but also in
other large producing countries, such as Canada, Australia and Argentina—thus, influ-
encing the world price, trade, and the consumption of wheat around the world. In
February 2008, the price of wheat in the United States exceeded $10 per bushel (two-
and-half times its price in 2006 and four times that in 2000) because of the combina-
tion of disappointing production levels due to bad weather and increased demand.
This example vividly portrays the workings of the price system, the effect of
government intervention, and the large interdependence that exists in the world econ-
omy today.
Sources: T. Tregarthen, “Drought Sends Farm Prices Soaring,” The Margin, January/February 1989, pp. 22-23;
“Farmers Are Back in the Green,” Business Week, June 11, 1990, pp. 18-19; “Strong Harvests Set to
Restrain Wheat Price Rise,” Financial Times, January 27, 2000, p. 34, and “In Price and Supply, wheat
is the Unstable Staple,” New York Times, February 13, 2008, p. 1.

a)
In imperfectly competitive markets (monopoly, monopolistic competition, and oligopoly)
. > as . . ee)

the price system

does not function as smoothly as indicated above and the determination of commodity and
resource prices and
quantities is more complex.
 CHAPTER 1 Introduction 11

What Role for the Government?

So far our discussion has deliberately excluded government. Bringing government into the
picture will modify somewhat the operation of the system, but it will not, in a free-enter-
prise system such as that of the United States, replace the operation of markets.
Governments affect the circular flow of economic activity by purchasing goods and ser-
vices for public consumption (education, defense, police, and so on) that compete with
privately consumed goods and services. Governments may themselves produce some
goods and services, thereby leaving fewer resources for business firms to use. Most impor-
tantly, governments, through taxes and subsidies, usually redistribute income from the
rich to the poor. By doing so, they can greatly affect the circular flow of economic activ-
ity. Governments also use taxes to discourage the consumption of certain commodities
such as alcohol and tobacco and provide incentives for the consumption of others such as
Mixed economy An housing and education. Thus, the United States operates under a mixed economy com-
economy characterized prising private enterprise and government actions and policies.
by private enterprise Although government policies certainly affect the circular flow of economic activity in
and government actions
a free-enterprise system, they do not replace the price system.° This can be contrasted with
and regulations.
a centrally planned economy such as that of the former Soviet Union, where most economic
decisions were made almost exclusively by government officials or planning committees. In
that type of economy, the government rather than the market sets prices. The result is usually
Concept Check persistent shortages of certain commodities and excess production of others. Thus, central
What is the role of the _. planning is usually less efficient than a free-enterprise system (see Example |-3).
government in a mixed In the United States and other free-enterprise or mixed economies, the price system
economy?
operates so smoothly that people are not even aware of it. Only on rare occasions (usually
as aresult of government interference) do we become aware that something is wrong. The
long lines at most gas stations during the petroleum crisis in 1979 were the result of the
U.S. government’s attempt to keep gasoline prices below the market or equilibrium level.
When price controls were eliminated and the price of gasoline was allowed to rise to the
market level, gasoline lines disappeared. When bad weather sharply reduced the output
of Florida oranges in 1977 and 1981 and that of fresh fruits and vegetables in 1984, no
waiting lines were seen outside food stores in the United States. The prices of oranges and
vegetables simply rose, and this rationed available supplies to match the amounts that
consumers wanted to purchase at the higher prices.

EXAMPLE 1-3
Economic Inefficiencies Cause Collapse of Communist Regimes

In 1957, Communist Party Chair Nikita Khrushchev proudly asserted that the Soviet
Union would “bury” the United States—not with atomic warheads but with superior
productive power. Instead, in 1989 the Soviet Union and former Eastern European

3 Government sometimes does replace the price system in some markets by imposing price controls such as
rent ceilings and minimum wages. In general, however, in a free-enterprise economy such as that of the
United States, government works through the market (with taxes, subsidies, and state-owned enterprises)
rather than supplanting it. See “How We Got Here,” Wall Street Journal, September 27, 1999, pp. R6 and R8;
and Mehdi Haririan, State Owned Enterprises in a Mixed Economy (Boulder: Westview Press, 1989).
124 PART ONE Introduction to Microeconomics

communist regimes collapsed as a result of massive economic failures. Consumer

goods were shabby, assortment was very limited, and shortages of even basic food-
stuffs were common. Automobiles, refrigerators, TV sets, and other durable goods
were primitive by world standards. In computers and machine tools, the former Soviet
Union was a decade behind the United States and its standard of living was less than
one-third that of the United States. These massive economic failures were the direct
result of the command economy that operated throughout the communist world.
Economic decisions were centralized, capital goods or the means of production were
owned by the state, and incentives were lacking or grossly distorted.
The collapse of communism brought severe economic dislocations in the form of
sharply reduced outputs, rising unemployment, rapid inflation, huge budget deficits,
unsustainable international debts, and disrupted trade relations. Poland, Hungary, the
Czech Republic, and the other countries in central and eastern Europe, as well as
Russia and the other republics of the former Soviet Union have been struggling for the
past two decades to set up working market economies. This is a monumental task after
decades of central planning and gross inefficiencies.
The establishment of a market economy requires (1) freeing prices and wages from
government control (so that goods and resources can be efficiently allocated by mar-
kets); (2) transferring productive resources from the state to private ownership (1.e., pri-
vatizing the economy); (3) opening the economy to competition and liberalizing
international trade (i.e., replacing state trading with trade based on market principles);
and (4) establishing the legal and institutional framework necessary for the functioning
of a market economy (such as property rights, a Western-style banking system, a capi-
tal market, cost accounting, business law, etc.). The problems of transition to a market
economy are enormous, and market economies are not yet fully operational in the for-
mer communist nations after nearly two decades of reforms. Despite communism’s
spectacular failure, some of Marx’s ideas persist in the world to this day—and not only
in Castro’s Cuba and Chavez’s Venezuela.
Sources: W. Easterly and Stanley Fischer, “What We Can Learn from the Soviet Collapse,” Finance and
Development, December 1994, pp. 2-5; “Assessing the Reform Record in the Transition Economies,”
International Monetary Fund Survey, January 9, 1995, pp. 1-6; D. Salvatore, “The Problems of Transition,
EU Enlargement, and Globalization,’ Empirica, July 2001, pp. 1-21; and “Behold Marx’s Twitch,”
New York Times, December 28, 2006, p. 9.

THE MARGIN: THE KEY UNIFYING CONCEPT IN MICROECONOMICS

In this section, we provide an overview of the crucial importance of the margin as the cen-
tral unifying theme in all of microeconomics and examine some clarifications on its use.

The Crucial Importance of the Concept of the Margin

Because of scarcity, all economic activities give rise to some benefits but also
involve
some costs. The aim of economic decisions is to maximize net benefits. Net
benefits
increase as long as the marginal or extra benefit from an action exceeds the
marginal or
 CHAPTER 1 Introduction 13

Marginal benefit The extra cost resulting from the action. Net benefits are maximized when the marginal ben-
change in the total efit is equal to the marginal cost (see Example 1-4). This concept applies to all economic
Biber eae decisions and market transactions. It applies to consumers in spending their income, to
firms in organizing production, to workers in choosing how many hours to work, to stu-
dents in deciding how much to study each subject and how many hours to work after
Marginal cost The classes, and to individuals in determining how much to save out of their income. It also
change in the total cost applies in deciding how much pollution society should allow, in choosing the optimal
resulting from an amount of information to gather, in choosing the optimal amount of government regula-
Soe oO: tion of the economy, and so on. Indeed, the concept of the margin and marginal analy-
sis represent the key unifying concepts in all of microeconomics.
Concept of the margin Specifically, the aim of consumers is to maximize the satisfaction or net benefit that
The central unifying they receive from spending their limited income. The net benefit or satisfaction of a con-
theme in all of sumer increases as long as the marginal or extra benefit that he or she receives from con-
aa suming one additional unit of a commodity exceeds the marginal or opportunity cost of
forgoing or giving up the consumption of another commodity. A consumer maximizes
Marginal analysis The satisfaction when the marginal benefit that he or she receives per dollar spent on every
analysis whereby any commodity is equal. More concretely, if the satisfaction or benefit that an individual gets
activity should be from consuming one extra hamburger with a price of $2 is more than twice as large as the
pursued until the
satisfaction of consuming a hot dog with a price of $1, then the individual would increase
marginal benefit equals
net benefits or satisfaction by consuming more hamburgers and fewer hot dogs. As the
the marginal cost.
individual does this, the marginal benefit of consuming each additional hamburger
declines, while the marginal loss in giving up each additional hot dog increases. The indi-
vidual maximizes net benefits when the marginal benefit per dollar spent on each
becomes equal. This central unifying theme of the margin in consumer behavior and
demand is examined in Part Two (Chapters 3—6) of the text.

EXAMPLE 1-4
Marginal Analysis in TV Advertising

Table 1.1 shows a firm’s total and marginal benefits and costs of increasing the num-
ber of TV spots per week. With each additional TV spot, the firm’s total benefits (sales
or revenues) increase, but the extra or marginal benefit declines. The reason is that
each additional TV spot reaches fewer and fewer additional people and becomes less
effective in inducing more consumers to buy the product. At the same time, the extra

TABLE 11 | Benefits and Costs of TV Spots

Number of Total Marginal Total Marginal Net

TV Spots Benefits Benefits Costs Cost Benefit

| $20,000 —_ $4,000 — $16,000

D 34,000 $14,000 8,000 $4,000 26,000
3 42,000 8,000 12,000 4,000 30,000
4 46,000 4,000 16,000 4,000 30,000
5 48,000 2,000 20,000 4,000 28,000
6 49,000 1,000 24,000 4,000 25,000
a
14 PART ONE Introduction to Microeconomics

MB, MC($)

14,000 |-

8,000

4,000 : MC
|

2,000 !
1,000 + . MB
| | | | |
annie 3 4 5 6
Number of TV spots

FIGURE 1.2 Marginal Benefit and Marginal Cost of TV Advertising The marginal
benefit (MB) of each additional TV spot declines while the marginal cost (MC) is constant at
$4,000. The net benefit is maximized at point E at which MB = MC.

or marginal cost of each TV spot remains at $4,000. The last column of the table shows
that the net benefit (total benefits or revenues minus total costs) is maximized at
$30,000 when the firm airs four TV spots per week, at which the marginal benefit
equals the marginal cost. Note that in cases like this where we deal with whole units
(i.e., where we cannot buy a fraction of a TV spot), the net benefit of $30,000 also
results when the firm airs three TV spots per week, but only with four TV spots is the
marginal benefit equal to the marginal cost, and this is the general rule that we follow
to maximize net benefits (see point FE in Figure 1.2).
To be noted is that the very high cost TV advertising today is a far cry from the
first TV ad (a 20-second spot for a Bulova clock that was broadcast on July 1, 1941)
that cost $9. Today the same TV ad would cost about $900. As the cost of reaching
mass audiences rises and direct marketing to individuals becomes more effective (see
“At the Frontier” for Chapter 5), advertisers are shifting some of their advertising
expenditures to these other channels (the ability to measure the effectiveness of adver-
tising on sales remains, however, elusive).
Sources: “Ad Industry Benefits of a Recovery,” Wall Street Journal, February 8, 1993, p. B1; “Target
Micromarkets Is Way to Success,” Wall Street Journal, May 31, 1995; p. Al; “Commercial Breakdown,”
Financial Times, August 1999, p. 11; and “Internet Advertising—The Ultimate Marketing Machine,” The
Economist, July 6, 2006, Special Report.
 CHAPTER 1 Introduction 15

Similarly, it pays for a firm to expand output as long as the marginal or extra revenue
that it receives from selling each additional unit of the commodity exceeds the marginal
or extra cost of producing it. But as the firm produces and sells more units of the
commodity, the marginal revenue may decline while its marginal cost rises. The firm max-
imizes total profits when the marginal revenue is equal to the marginal cost. The applica-
tion of the marginal concept in firms’ production decisions is examined in detail in Part
Three (Chapters 7—9) of the text. The same general concept applies to an individual’s
decision on how many hours to work. The individual will maximize welfare when the
marginal benefit he or she receives from the wages of an extra hour of work just matches
the marginal cost in terms of the leisure or earnings and consumption foregone by not
working the extra hour. The optimal amount of savings by an individual is the amount at
which the marginal benefit from the interest earned from saving an extra dollar just
matches the marginal cost of postponing spending the dollar on present consumption.
These applications of marginal analysis are examined in Part Five (Chapters 14-16).
Concept Check Similarly, the optimal amount of government regulation of the economic system is
What is marginal the amount at which the marginal benefit of such intervention just matches its marginal
analysis? cost. The same concept applies to the gathering of information. Gathering information
provides some benefits but involves some costs. Thus, the optimal amount of information
gathering is the amount at which the marginal benefit equals the marginal cost. These uses
of the marginal concept are examined in Part Six (Chapters 17—19) of the text.

Some Clarifications on the Use of the Margin

Several clarifications are in order on the application of the concept of the margin and mar-
ginal analysis in microeconomics. First, the maximization of net benefits by marginal analy-
sis does not imply that individuals are entirely selfish and does not preclude a certain degree
of altruistic behavior. A more selfish person will maximize satisfaction in terms of material
goods and services that the individual himself or herself consumes. A less selfish person will
maximize satisfaction by using part of his or her income or resources in helping others.
Similarly, a firm may contribute part of its profits to some “worthy causes” or choose to
maximize sales rather than profits. Second, individuals, firms, and governments seldom
have all the information required to maximize net benefits at the margin precisely. The con-
cept of optimization at the margin is nevertheless an invaluable tool of analysis because it
provides the motivation or driving force for most economic actions. Even when individuals
and firms are not explicitly trying to maximize net benefits, they often behave as if they are.
In fact, the assumption has very good predictive power. Third, marginal analysis leads to the
maximization of individual benefits but not to the maximization of the welfare of society as
a whole when private benefits and costs differ from social benefits and costs. One situation
that leads to this arises in the presence of imperfect competition and justifies government
intervention in the economic system to overcome the problem, or at least to minimize its
harmful impact. Indeed, whenever some individuals in society can be made better off with-
out making someone else worse off, there is a case for government intervention at the mar-
Pareto criterion gin to improve society’s welfare. When production and consumption can no longer be
Postulates that a change reorganized so as to improve the welfare of some without at the same time reducing the wel-
increases social welfare fare of others, society is said to be at Pareto optimum. These applications of marginal analy-
if it benefits some sis are examined in Part Four (Chapters 10-13) and Part Six (Chapters 17—19) of the text.
members of society
Despite these clarifications and qualifications, we can clearly see that the concept
without harming
anyone. of the margin and marginal analysis provide the central unifying theme in all of micro-
economics.
16 PART ONE Introduction to Microeconomics

SPECIALIZATION, EXCHANGE, AND THE INTERNATIONAL

aS | FRAMEWORK OF MICROECONOMICS

In this section we discuss specialization and exchange and the need to provide an inter-
national framework for the study of microeconomics.

Specialization and Exchange

Two important characteristics that greatly increase the efficiency of market economies are
Specialization The use specialization in production and exchange. Specialization refers to the use of labor and
of resources where other resources in performing those tasks in which each resource is most efficient.
most efficient. Efficiency and output are then maximized. For example, by concentrating in the produc-
tion of food, farmers produce a much greater output than if they tried to be self-sufficient
and make their own clothing and manufacture all the utensils and equipment they need.
By avoiding being “the jack of all trades” and specializing instead in the production of
food, where they are most efficient, the farmers’ output becomes much greater. Farmers
can then exchange some of their excess food for the clothes, utensils, and equipment that
they need and, as a result, be able to consume more of every good.
But there is an even more important aspect of specialization that increases the effi-
Division of labor The ciency of labor still more. This is division of labor. Division of labor refers to the break-
assignment of each ing up of a task into a number of smaller, more specialized tasks and assigning each of
production task to these tasks to different workers. Such a division of labor is likely to greatly increase work-
different workers.
ers’ efficiency by allowing each of them to become more proficient at performing one task,
developing shortcuts in the performance of the task, and avoiding the time lost from shift-
ing from one task to another.
Exchange The trade of Specialization and division of labor, however, create the need for exchange. When
one commodity for individuals perform only one task in the production of a single commodity, there is a need
another. for them to exchange part of their output for all the other things that they want. This
exchange is greatly facilitated by the use of money. That is, in a monetized economy, indi-
viduals are paid in money for their work and can use this income to purchase in the market
desired goods and services.
Specialization in production occurs not only at the individual level but also at the
regional and national levels. A region or nation can specialize in the production of those
Comparative goods and services in which it has a comparative advantage or is relatively more effi-
advantage The greater cient, and then exchange part of its output for the output of other regions or nations. By
relative efficiency in doing so, each region or nation will end up consuming more than it could if it tried to be
the production of a
self-sufficient. Trade or exchange makes possible specialization in production and pro-
good or service.
vides benefits to all parties to the exchange. This is discussed in detail in Part Three
(Chapters 7—9) of the text.

The International Framework of Microeconomics

As consumers, we purchase Japanese Toyotas and German Mercedes, Italian handbags and
French perfumes, Hong Kong clothes and Taiwanese calculators, Scotch whiskey and
Swiss chocolates, Canadian fish and Mexican tomatoes, Costa Rican bananas and
Brazilian coffee. Often, we are not even aware that the products we consume, or parts of
them, are made abroad. For example, imported cloth is used in American-made suits, many
American brand-name shoes are entirely manufactured abroad, and a great deal
of the
orange juice that we drink is imported. American multinational corporations
produce and
 CHAPTER 1 Introduction 17

import many parts and components from abroad and export an increasing share of their out-
put. Most of the parts and components of the Dell PC are in fact manufactured abroad (see
Example 1-5), and more than one-third of Dell revenues and profits are generated abroad.
General Motors and Ford face stiff competition from Toyota, Nissan, and Honda, and many
Internationalization of
economic activity The
U.S. steel companies are today near bankruptcy as a result of foreign competition and
trend toward producing rising steel imports.
and distributing goods In view of the internationalization of economic activity and the international
throughout the world. repercussions of domestic competitiveness policies, we cannot study microeconomics in

EXAMPLE 1-5
Dell and Other PCs Sold in the United States Are Everything but American!

Dell, headquartered in Round Rock, Texas, coordinates a global production network in

34 countries in the Americas, Europe, and Asia. For most of the PCs sold in the United
States, Dell performs only the final assembly domestically, relying on outside suppli-
ers and contract manufacturers for components, peripherals, printed circuit board
(PCB) assemblies, and subassemblies (box builds). The reason is that most parts and
components are cheaper to produce in other parts of the world and are thus imported
(see Table 1.2). Neither high-value components nor very low-value components
(such as power supplies and keyboards) have to be made close to Dell’s assembly
plants. Only some mid-level components (such as motherboards and other PCB
assemblies) that are too expensive to ship by air to meet volatility in demand, as well
as to risk holding in inventory, are produced locally, but even that is not always the
case. In 2004, more than 90% of all the parts and components going into Dell’s and
HP’s PCs were made outside the United States, and IBM sold its PC business to
Lenovo of China.

Loc ati ons and

pon ent
Com
s
pan
for
ies’s ThaPCst Supply Specific Parts
Dell
TABLE 1.2 and Com

Part/Component Location Company

Monitors Europe and Asia Phillips, Nokia, Samsung, Sony, Acer

PCBs Asia, Scotland, and SCI, Celestica
eastern Europe
Drives Asia, mainly Singapore Seagate, Maxtor, W. Digital
Printers Europe (Barcelona) Acer
Box builds Asia and eastern Europe HonHai/Foxteq
Chassis Asia and Ireland HonHai/Foxteq
TT

Source: J. Dedrick and K. L. Kraemer, “Dell Computer: Organization of aGlobal Production Network”
and “Globalization of the Personal Computer Industry: Trends and Implications,” Working Paper, Irvine,
CA: Center for Research on Information Technology and Organizations CRITO), University of California,
Irvine, 2002; “Lenovo Buys IBM’s PC Unit for $1.75 Billion,” Financial Times, December 9, 2004, p. 16;
and “The Laptop Trail,” Wall Street Journal, June 9, 2005, p. 31.
18 PART ONE Introduction to Microeconomics

of the United
an international vacuum. The large and growing degree of interdependence
conomy approach to the study of
States in the world economy today makes a closed-e
microeconomics unrealistic. This text will explicitly introduce and integrate the interna-
tional dimension into the body of traditional microeconomics to reflect the globaliza tion
of most economic activities in the world today.*

1.6 MopeELs, METHODOLOGY, AND VALUE JUDGMENTS

We will now discuss the meaning and function of theory or models, examine the methodol-
Concept Check ogy of economics and distinguish between positive and normative analysis.
Why is an international
framework essential 1n
studying Models and Methodology
microeconomics?
In microeconomic theory, we seek to predict and explain the economic behavior of indi-
vidual consumers, resource owners, and business firms and the operation of individual
Model Another name markets. For this purpose we use models. A model abstracts from the many details sur-
for theory. rounding an event and identifies a few of the most important determinants of the event.
For example, the amount of a commodity that an individual demands over a given period
of time depends on the price of the commodity, the individual’s income, and the price of
related commodities (i.e., substitute and complementary commodities). It also depends
on the individual’s age, gender, education, background, whether the individual is single or
married, whether he or she owns a house or rents, the amount of money he or she has in
the bank, the stocks the individual owns, the individual’s expectations of future income
and prices, geographic location, climate, and many other considerations.
However, given the consumer’s tastes and preferences, demand theory identifies the
price of the commodity, the individual’s income, and the price of related commodities as
the most important determinants of the amount of a commodity demanded by an individ-
ual. Although it may be unrealistic to focus only on these three considerations, demand
theory postulates that these are generally capable of predicting accurately and explaining
consumer behavior and demand. One could, of course, include additional considerations
or variables to gain a fuller or more complete explanation of consumer demand, but that
would defeat the main purpose of the theory or model, which is to simplify and generalize.
A theory or model usually results from casual observation of the real world. For
example, we may observe that consumers generally purchase less of a commodity when
its price rises. Before such a theory of demand can be accepted, however, we must go
back to the real world to test it. We must make sure that individuals in different places and
over different periods of time do indeed, as a group, purchase less of a commodity when
its price rises. Only after many such successful tests and the absence of contradictory
results can we accept the theory and make use of it in subsequent analysis to predict and
explain consumer behavior. If, on the other hand, test results contradict the model, then
the model must be discarded and a new one formulated.
To summarize, a theory or model is usually developed by casual observation of the
real world, but we must then go back to the real world to determine whether the implica-
tions or predictions of the theory are indeed correct. Only then can we accept the theory

* See D. Salvatore, “Globalization and International Competitiveness,” in S. Shojai, ed., Globalization

: Virtue
or Vice? (New York: Praeger, 2001), pp. 7-21.
 CHAPTER 1 — Introduction 19

or model. According to the Nobel Laureate economist Milton Friedman, a model is not
tested by the realism or lack of realism of its assumptions, but rather by its ability to pre-
dict accurately and explain. The assumptions of the model are usually unrealistic in that
they must necessarily represent a simplification and generalization of reality. However, if
the model predicts accurately and explains the event, it is tentatively accepted. For exam-
ple, demand theory, as originally developed, was based on the assumption that utility (i.e.,
the satisfaction that a consumer receives from the consumption of a commodity) is cardi-
nally measurable (i.e., we can attach specific numerical values to it). This assumption is
clearly unrealistic. Nevertheless, we accept the theory of demand because it leads to the
correct prediction that a consumer will purchase less of a commodity when its price rises
(other things, such as the consumer’s income and the price of related commodities,
remaining equal).
While most assumptions represent simplifications of reality, and to that extent are
unrealistic, most economists take a broader position. According to these economists, the
Methodology of appropriate methodology of economics (and science in general) is to test a theory not only
economics The by its ability to predict accurately, but also by whether the predictions follow logically from
proposition that a the assumptions and by the internal consistency of those assumptions. For example, the the-
model is tested by its
ory of perfect competition postulates that the economy operates most efficiently when con-
predictive ability.
sumers and producers are too small individually to affect prices and output. But this theory
cannot be tested for the economy as a whole. It can only be tested by tracing the loss of wel-
fare of individual consumers when the atomistic assumptions of the theory do not hold.
Thus, an adequate test of the theory requires not only confirming that the predictions are
accurate but also showing how the outcome follows logically or results directly from the
assumptions.
Concept Check Throughout this text we will look at many economic theories or models that seek to
Is the methodology of predict and explain the economic behavior of consumers, resource owners, and business
economics scientific? firms as they interact in the markets for goods, services, and resources. The models pre-
sented are generally those that have already been successfully tested. In a microeconomic
theory course, we are not concerned with the actual testing of these theories or models,
but rather with their presentation, usefulness, and applications.

Positive and Normative Analysis

In discussing the methodology of economic analysis, an important distinction is also made
Positive analysis The between positive and normative analysis. Positive analysis studies what is. It is concerned
study of what is or how with how the economic system performs the basic functions of what to produce, how to
the economic system produce, for whom to produce, how it provides for growth, and how it rations the available
performs the basic supply of a good over time. In other words, how is the price of a commodity, service, or
economic functions.
resource actually determined in the market? How do producers combine resources to min-
imize costs of production? How does the number of firms in a market and the type of prod-
uct they produce affect the determination of the price and quantity sold of the commodity?
How do the number and type of owners and users of a resource affect the price and quantity
of the resource placed on the market? How do specific taxes and subsidies affect the pro-
duction and consumption of various commodities and the use of various resources? What
are the effects of minimum wages on employment and incomes? The level of real wages on
work and leisure? Rent control on the availability of housing? Deregulation of gas on gas
prices and consumption? How does the economic system provide for the growth of the
nation? How does it ration the available supply of a commodity over time? All of these and
many more topics fall within the realm of positive analysis. For the most part, positive
20 PART ONE _ Introduction to Microeconomics

analysis is factual or hypothetically testable and objective in nature, and it is devoid of eth-
ical or value judgments.
Normative analysis Normative analysis, on the other hand, studies what ought to be. It is concerned with
The study of what how the basic economic functions should be performed. Normative analysis is thus based
ought to be or how the on value judgments and, as such, is subjective and controversial. Whereas positive analy-
paste eeonoulc sis is independent of normative analysis, normative analysis is based on positive analysis
Se ae and the value judgments of society. Controversies in positive analysis can be (and are)
Pee usually resolved by the collection of more or better market data. On the other hand, con-
troversies in normative analysis usually.are not, and cannot, be resolved. Take, for exam-
ple, the case of providing national health insurance for everybody. Many people favor it,
but others are opposed, and no amount of economic analysis can resolve the controversy.
Economists can provide an analysis of the economic costs and benefits of national health
insurance. Such an analysis can be useful in clarifying the economic issues involved, but
it is not likely to lead to general agreement on the proposition that national health insur-
ance should or should not be provided for everybody. The economists’ tools of analysis
and-logic can be applied to determine the economic benefits and costs of normative ques-
tions, but it is society as a whole (through elected representatives) that must make nor-
mative decisions
Concept Check It is extremely important in economics to specify exactly when we are leaving the
What is the distinction real world of positive analysis and entering that of normative analysis—that is, when
between positive and disagreements can be resolved by the collection of more or better data (facts) and when
POLIMAUVCRCCONO TENS ethical or value judgments are involved. This book is primarily concerned with positive
analysis. A statement such as “universal national health insurance should be estab-
lished” is a proposition of normative analysis because it is based on value judgments.
Normative analysis are discussed in detail in Chapters 17 and 18.

AT THE FRONTIER
Do Economists Ever Agree on Anything?

Y ou have probably heard some of the many jokes about economists disagreeing
on almost everything. “How many opinions on the same subject do you expect
to find in a room with three economists?” Answer: “four.” In response to an econo-
mist’s answer framed as “on the one hand...and on the other...” President
Truman is supposed to have snapped: “Give me a one-handed economist.” Such jokes
do not seem justified according to the results of a recent study.
Table 1.3 reports the responses to 10 of 40 propositions form 464 respondents to
a questionnaire sent to a random sample of 1,350 economists in 1992. Table 1.3 shows
that the vast majority of economists agreed on the first three propositions (that a ceil-
ing on rents reduces the quantity and quality of housing, that tariffs and import quotas
usually reduce general economic welfare, and that teal policy has a significant stim-
ulative effect on a less than fully employed economy), but strongly disagreed on the
last two propositions. In general, there was much more agreement on questions of
microeconomics (which are overrepresented in the propositions reported in Table 1.3)
 CHAPTER1 Introduction 21

TABLE 1.3] Responses of Economists of Various Propositions

Percentage of
Respondents Who
Proposition Agreed Disagreed’

1. A ceiling on rents reduces the quantity and quality

of housing available. O29 6.5
2. Tariffs and import quotas usually reduce general
economic welfare. 92.6 6.5
3. Fiscal policy (e.g., tax cuts and/or expenditure
increase) has a significant stimulative impact on a
less than fully employed economy. 89.9 Onl
4. Cash payments increase the welfare of recipients to
a greater degree than do transfers-in-kind of equal
cash value. 83.9 ils)pit
5. A large federal budget deficit has an adverse effect
on the economy. oH 115),7/
6. The redistribution of income distribution within
the U.S. is a legitimate role for government. 81.9 16.8
7. A minimum wage increases unemployment among
young and unskilled workers. 78.9 20.5
8. Antitrust laws should be enforced vigorously to
reduce monopoly power from its current level. 71.8 Zio
9. Reducing the regulatory power of the
Environmental Protection Agency (EPA) would
improve the efficiency of the U.S. economy. 36.0 G23
10. The U.S. government should retaliate against
(foreign) dumping and subsidies in international trade. 50.2 47.6

*The sum of the percentages of those who agree and disagree does not add to 100 because of
nonrespondents to the particular question.

than on questions of macroeconomics. More recently, however, behavioral and het-

erodox economists—still a small minority of economists to be sure—have been ques-
tioning even the most generally accepted propositions of economics.
But even on the questions that elicit widespread agreement among economists,
the gap between the public’s (especially non—college graduates) and economists’
views are very wide. There is, however, a great deal of agreement on what are the
major issues that society faces today (i.e., the state of the economy, education, health
care, taxes, crime, globalization, and income inequalities).

Sources: R. M. Alston, J. R. Kearl, and M. B. Vaughan, “Is There a Consensus Among Economists in the
1990s?.” American Economic Review, May 1992, pp. 203-209; R. J. Blendon et al., “Bridging the Gap
Between the Public’s and Economists’ Views of the Economy,” Journal of Economic Perspectives, summer
1997, pp. 105-118; “What Does the Public Know About Economic Policy?” MF Survey, January 9, 2006,
p. 16; “In Economics Departments, A Growing Will to Debate Fundamental Assumptions,” New York
Times, July 11, 2007, p. B6; and D. Rodrik, “Why Do Economists Disagree?,” August 5, 2007,
http://rodrik.typepad.com/dani_rodriks_weblog/2007/08/why-do-economis.html.
22 PART ONE Introduction to Microeconomics

SUMMARY
| _ Economics deals with the allocation of scarce resources among alternative uses to satisfy
human wants. Scarcity of resources and commodities is the fundamental economic fact of every
society.
in_ All societies must decide what to produce, how to produce, for whom to produce,
how to
provide for the growth of the system, and how to ration a given amount of a commodity over
time. Under a free-enterprise or mixed economic system such as that in the United States, it is
the price system that performs these functions, for the most part.
. Microeconomic theory studies the economic behavior of individual decision-making units such
as individual consumers, resource owners, and business firms and the operation of individual
markets in a free-enterprise economy. This is contrasted with macroeconomic theory, which
studies the economy viewed as a whole. Microeconomic theory focuses attention on
households and business firms as they interact in the markets for goods and services and
resources.
. Because of scarcity, all economic activities give rise to some benefits but also involve some
costs. The aim of economic decisions is to maximize net benefits. Net benefits increase as long
as the marginal or extra benefit from an action exceeds the marginal or extra cost resulting from
the action. Net benefits are maximized when the marginal benefit is equal to the marginal cost.
This concept applies to all economic decisions and market transactions. It applies as much to the
consumption decisions of individuals as to the production decisions of firms, the supply choices
of input owners, and government decisions. Indeed, the concepts of the margin and marginal
analysis represent the key unifying concepts in all of microeconomics.
. Specialization and exchange are two important characteristics that greatly increase the
efficiency of individuals and firms in market economies. Many of the commodities we consume
today are imported, and American firms purchase many inputs abroad, sell an increasing share
of their products to other nations, and face increasing competition from foreign firms in the
U.S. market and around the world. The international flow of capital, technology, and skilled
labor has also reached unprecedented dimensions. In view of such internationalization of
economic activity in the world today, it is essential to introduce an international dimension into
the body of traditional microeconomics.
. Theories make use of models. A model abstracts from the details surrounding an event and
seeks to identify a few of the most important determinants of an event. A model is tested by its
predictive ability, the consistency of its assumptions, and the logic with which the predictions
follow from the assumptions. There is more agreement among economists than is commonly
believed.

| KEY TERMS
Economics Microeconomic theory Specialization
Human wants Macroeconomic theory Division of labor
Economic resources Circular flow of economic activity Exchange
Price system Price theory Comparative advantage
Free-enterprise system Mixed economy Internationalization of economic
What to produce Marginal benefit activity
How to produce Marginal cost Model
For whom to produce Concept of the margin Methodology of economics
Economic growth Marginal analysis Positive analysis
Rationing over time Pareto optimum Normative analysis
 CHAPTER 1 Introduction Ds

REVIEW QUESTIONS
1. Will the problem of scarcity disappear over time as 8 . What is the relationship between import prices
standards of living increase? and domestic prices?
2. Distinguish between the real and the financial flows that ). What happens to the dollar price of Japanese exports to
link product and factor markets. the United States and to the yen price of U.S. exports to
3. Explain in terms of the circular flow of economic activity Japan if the Japanese yen increases in value with respect
why some individuals are richer while others are poorer. to the U.S. dollar?
4. Explain why some football players earn more than others. . Two models predict equally well, but one is based on a
Why would a team sign a superstar for millions of dollars larger number of assumptions and the logic with which
when it could sign a good player for much less? the predictions follow from the assumptions is more
5. Does a firm maximize its total revenue when it maximizes intricate than for another model. Why is the second
its total profits? model better?
6. It has been proven that a speed limit of 55 MPH, rather _— — . A model using three variables explains 85% of an event
than 65 MPH, on the nation’s highways saves lives (say, a price increase), while another model, using ten
and fuel. Is there any cost in keeping the speed limit at 55 variables, explains 95% of the event. Which of the two
MPH? models is better? Why?

7. Why is it that imports and exports as a percentage of gross . The government should pass more stringent pollution
national product (GNP) are much smaller in the United control laws. Do you agree? What can economists
States than in Switzerland? contribute to the discussion?

| PROBLEMS
*1. Why do we study microeconomics? or International Financial Statistics available in your
2. Explain why an increasing proportion of income spent on library, show that the interdependence of the U.S.
health care does not necessarily involve a reduction in the economy with the rest of the world has increased
quantity of all other goods and services that can be sharply during the past three decades.
purchased overtime. In what way is exploding health care . a. If two models predict equally well but one is more
costs related to the problem of scarcity? complicated than the other, indicate which one you
Oo . Briefly explain how the sharp increase in petroleum would use and why.
prices since the fall of 1973 affected driving habits and =F Indicate how you would determine which of the two
the production of cars in the United States since then. models is more complex.
4. Explain why India produces textiles with much more labor . a. Explain how you would go about constructing a model
relative to capital than does the United States. to predict total sales of American-made cars in the
5. Explain how the introduction of government affects the United States next year.
circular flow of economic activity. b. Indicate how you would test your model.
*6, Explain the effect of government setting the price of a . Economists often disagree on economic matters,
commodity so economics is not a science. True or false?
a. below equilibrium with a price ceiling; Explain.
b. above equilibrium with a price floor. vA Briefly indicate which aspects of the redistribution
of income from higher- to lower-income people
7. How does the concept of the margin provide a key
involve
unifying concept in microeconomics?
a. positive analysis;
8. Using some data obtained from a publication such as The
b. normative analysis.
Survey of Current Business, The U.S. Statistical Abstract,

* — Answer provided at end of book.

24 PART ONE Introduction to Microeconomics

| INTERNET SITE ADDRESSES

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General directories and indexes of economic information are: see:

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 CHAPTER J

Basic Demand and HPPly Analysis

Chapter Outline Changes in Demand and Supply and Coffee
2.1 Market Analysis Prices
2.2 Market Demand The Large U.S. Automotive Trade Deficit Keeps
2.3. Market Supply U.S. Auto Prices Down
2.4 When Is a Market in Equilibrium? Rent Control Harms the Housing
2.5 Adjustment to Changes in Demand and Supply: Market
Comparative Static Analysis The Economics of U.S. Farm Support
2.6 Domestic Demand and Supply, Imports, and Prices Programs
2.7 Interfering With Versus Working Through the Market Working Through the Market with an
Appendix: The Algebra of Demand, Supply, Excise lax
and Equilibrium Fighting the Drug War by Reducing Demand
and Supply
List of Examples At the Frontier: Nonclearing Markets Theory
2—1 Equilibrium Price by Auction

After Studying This Chapter, You Should Be Able to:

e Know the meaning of demand and the law of demand
e Describe how the market demand and supply of a commodity determine its price
e Explain how changes in demand and supply affect the equilibrium price and quantity of a commodity
e Understand how imports affect product prices
e Describe the meaning of “working through the market” as opposed to “interfering with the market”

| ave you ever stopped to think about how the price of a commodity (say, the price
of your favorite music compact disc) is determined and why it often changes over
time? In this chapter we seek to answer these questions by providing an overview
of how markets function. We begin by defining the concept of a market. Next we discuss
the meaning of demand and a change in demand. After reviewing supply, we examine how
the interaction of the forces of market demand and supply determine the equilibrium price
and quantity of acommodity. Then we examine how the equilibrium price and quantity of
a commodity are affected by changes in demand and supply and by imports. Finally, we
examine the effect of modifications and interferences in the operation of markets. So
widespread is the applicability of the market model, that one could safely start answering

25
26 PART ONE Introduction to Microeconomics

any question of microeconomics by saying that it depends on demand and supply. Note,
however, the “At the Frontier” discussion of nonclearing market theories.

Bei MARKET ANALYSIS

Most of microeconomic analysis is devoted to the study of how individual markets oper-
Market An ate. A market is an institutional arrangement under which buyers and sellers can
institutional exchange some quantity of a good or service at a mutually agreeable price. Markets pro-
arrangement for vide the framework for the analysis of the forces of demand and supply that, together,
economic transactions.
determine commodity and resource prices. As explained in Chapter 1, prices play the
central role in microeconomic analysis.
A market can, but need not, be a specific place or location where buyers and sellers actu-
ally come face to face for the purpose of transacting their business. For example, the New York
Stock Exchange is located in a building at 1 1 Wall Street in New York City. On the other hand,
the market for college professors has no specific location; rather, it refers to all the formal and
informal information networks on teaching opportunities throughout the nation. There is a
market for each good, service, or resource bought and sold in the economy. Some of these
markets are local, some are regional, and others are national or international in character.
Throughout this chapter, we assume that markets are perfectly competitive. A
Perfectly competitive perfectly competitive market is one in which there are so many buyers and sellers of a
market A market product that each of them cannot affect the price of the product, all units of the product are
where no buyer or homogeneous or identical, resources are mobile, and knowledge of the market is perfect.
seller can affect the
For the purpose of the present chapter, this definition of a perfectly competitive market
price of the product.
suffices. A more detailed definition and analysis of this and other types of markets is given
in Chapter 9 and in Part Three of the text.

22 MARKET DEMAND

The concept of demand is one of the most crucial in microeconomic theory and in all of
economics. In this section, we review the concepts of the market demand schedule and the
market demand curve, and examine the meaning of a change in demand.

Demand Schedule and Demand Curve

Market demand A market demand schedule is a table showing the quantity of a commodity that con-
schedule A table sumers are willing and able to purchase over a given period of time at each price of the
showing the quantity of commodity, while holding constant all other relevant economic variables on which
a commodity that
demand depends (the ceteris paribus assumption). Among the variables held constant are
consumers are willing
and able to purchase at
consumers’ incomes, their tastes, the prices of related commodities (substitutes and com-
each price. plements), and the number of consumers in the market.
For example, Table 2.1 provides a hypothetical daily demand schedule for hamburg-
ers in a large market (say, New York City, Chicago, or Los Angeles). At the price of $2.00
per hamburger, the quantity demanded is 2 million hamburgers per day. At the lower price
of $1.50, the quantity demanded is 4 million hamburgers per day. At the price of $1.00,
the quantity demanded is 6 million hamburgers, and at the prices of $0.75 and $0.50,
the
quantity demanded is 7 and 8 million hamburgers, respectively.
 CHAPTER 2 Basic Demand and Supply Analysis Pay |

Market Demand Schedule

TABLE 211 for Hamburgers

Price per Quantity Demanded per Day

Hamburger (million hamburgers)

$2.00
1.50
1.00
0.75
0.50 PY
fs
onan

At lower prices, greater quantities of hamburgers are demanded. Each additional

hamburger consumed per day provides declining marginal or extra benefit, and so con-
sumers would only purchase greater quantities at lower prices. This is practically always
true for all commodities. Lower commodity prices will also bring more consumers into
the market. The inverse price-quantity relationship (indicating that a greater quantity of
the commodity is demanded at lower prices and a smaller quantity at higher prices) is
Law of demand The called the law of demand.
inverse price—quantity By plotting on a graph the various price-quantity combinations given by the market
relationship of the demand schedule, we obtain the market demand curve for the commodity. The price per
demand for a
unit of the commodity is usually measured along the vertical axis, while the quantity
commodity.
demanded of the commodity per unit of time is measured along the horizontal axis. For
Market demand curve example, Figure 2.1 shows the market demand curve for hamburgers corresponding to the
The graphic market demand schedule of Table 2.1. The demand curve has a negative slope; that is, it
representation of a slopes downward to the right. This negative slope is a reflection of the law of demand or
demand curve.
inverse price-quantity relationship.
The various points on the demand curve represent alternative price-quantity combi-
nations. For example, at the price of $2.00 per hamburger, the quantity demanded is 2 mil-
lion hamburgers (point B in Figure 2.1). If the price is $1.50, the quantity demanded is 4
million hamburgers (point C), and so on. A demand curve also shows the maximum price
consumers are willing to pay to purchase each quantity of a commodity per unit of time.
For example, the demand curve of Figure 2.1 shows that the demand price (i.e., the maxi-
mum price that consumers are willing to pay) for 2 million hamburgers is $2.00 per ham-
Concept Check
burger (point B); for 4 million hamburgers, the demand price is $1.50, and so on. Finally,
Why do you think we
have the “law” rather
a particular demand curve refers to a specific period of time. The demand curve of Figure
than the “hypothesis” 2.1 is for one day. The demand curve for hamburgers for a month is correspondingly
of demand? higher.!

Changes in Demand
A demand curve can shift so that more or less of the commodity would be demanded at
any commodity price. The entire demand curve for a commodity would shift with a
change in (1) consumers’ incomes, (2) consumers’ tastes, (3) the price of related com-
modities, (4) the number of consumers in the market, or in any other variable held con-
stant in drawing a market demand curve. For example, with a rise in consumer income

! The demand curve can, but need not, be a straight line.

28 PART ONE _ Introduction to Microeconomics

aS

FIGURE 2.1 Market Demand Curve for Hamburgers Market

demand curve D shows that at lower hamburger prices, greater hamburgers
of
Price
unit
per | : a
0 9 4 a7 % Q
quantities are demanded. This is reflected in the negative Slope of the
demand curve and is referred to as the “law of demand’ Million hamburgers per day

the demand curve for most commodities (normal goods) shifts to the right, because con-
sumers can then afford to purchase more of each commodity at each price. The same is
true if consumers’ tastes change (or if the quality of the product improves) so that they
demand more of the commodity at each price, or if the number of consumers in the mar-
ket increases.
A demand curve also shifts to the right if the price of a substitute commodity rises
or if the price of a complementary commodity falls. For example, if the price of hot dogs
(a substitute for hamburgers) rises, people will switch some of their purchases away
from hot dogs and demand more hamburgers at each and every price of hamburgers (a
rightward shift in the demand for hamburgers). Similarly, if the price of the bun (a com-
plement of hamburgers) falls, the demand for hamburgers also shifts to the right (since
the price of a hamburger with the bun is then lower).
On the other hand, the demand curve for a commodity usually shifts to the left (so
that less of it is demanded at each price) with a decline in consumer income, a decrease in
the price of substitute commodities, or a decrease in the number of consumers in the
market. The demand curve also shifts to the left if the price of complementary commodi-
ties rises or if consumer tastes change so that they demand less of the commodity at
each price.
Figure 2.2 shows D, the original demand curve for hamburgers (from Figure 2.1) and
D’, a higher demand curve for hamburgers. With D’, consumers demand more hamburg-
ers at each price. For example, at the price of $1.00, consumers demand 12 million ham-
burgers per day (point E’) as compared with 6 million demanded (point £) on curve D. The
shift from D to D’ leads consumers to demand 6 million additional hamburgers per day at
each price.
A shift in demand is referred to as a change in demand and must be clearly distin-
guished from a change in the quantity demanded, which refers instead to a movement
along a given demand curve as a result of a change in the commodity price. Thus, the
shift in demand from D to D’ is an increase in demand, while the movement along D,
say, from point E to point F, is a change in the quantity demanded. The change in
demand is caused by the change in the economic variables that are held constant in
drawing a given demand curve (the ceteris paribus assumption), whereas a change in
the quantity demanded is a movement along a given demand curve as a result of a
change in the price of the commodity (with all the other economic variables on which
demand depends remaining constant).
 CHAPTER 2 Basic Demand and Supply Analysis 29

P($)
© 250+
I
o

E200
—
vo
a
B {| 5X0) |=
g
=
= LOO) |=
OOS =
FIGURE 2.2 Change in Demand for Hamburgers = 0.50-b
Consumers demand more hamburgers at each price when a iDy
the demand curve shifts to the right from D to D’. Thus, at | ee ee
P = $1.00, consumers purchase 12 million hamburgers with 0 2 4 ts KOE abel §
D’ instead of only 6 million with D. Million hamburgers per day

2.3 MARKET SUPPLY

We have examined the market demand, now it is time to turn to the supply side.

Supply Schedule and Supply Curve

Market supply A market supply schedule is a table showing the quantity supplied of a commodity at
schedule A table each price for a given period of time. It assumes that technology, resource prices, and, for
showing the quantity agricultural commodities, weather conditions, are held constant (the ceteris paribus
supplied of a
assumption). Table 2.2 gives a hypothetical daily supply schedule for hamburgers.
commodity at each
Starting at the bottom, the table shows that at the price of $0.50 per hamburger, the quan-
commodity price.
tity supplied is 2 million hamburgers per day. At the higher price of $0.75 per hamburger,
the quantity supplied is 4 million hamburgers per day. At the price of $1.00, the quantity
supplied is 6 million hamburgers per day, and so on. Higher hamburger prices allow pro-
ducers to bid resources away from other uses and supply greater quantities of hamburgers.
The various price-quantity combinations of a supply schedule can be plotted on a graph
Market supply curve to obtain the market supply curve for the commodity. For example, Figure 2.3 shows
The graphic the market supply curve for hamburgers corresponding to the market supply schedule of
representation of the Table 2.2. The positive slope of the supply curve (1.e., its upward-to-the-right inclination)
market supply reflects the fact that higher prices must be paid to producers to cover rising marginal, or
schedule.
extra, costs and thus induce them to supply greater quantities of the commodity.
As with the demand curve, the various points on the supply curve represent alternative
price—quantity combinations. For example, at the price of $0.50 per hamburger, the quan-
tity supplied is 2 million hamburgers per day (point R in Figure 2.3). If instead the price is
$0.75, the quantity supplied is 4 million hamburgers (point V), and so on. A supply curve
also shows the minimum price that producers must receive to cover their rising marginal
costs and supply each quantity of the commodity. For example, the supply curve of Figure
2.3 shows that the supply price (i.e., the minimum price that suppliers must receive) in order
to supply 2 million hamburgers per day is $0.50 (point R); for 4 million hamburgers, the
supply price is $0.75 (point N), and so on. A particular supply curve is drawn for a specific
30 PART ONE _ Introduction to Microeconomics

Market Supply Schedule

for Hamburgers

Price per Quantity Supplied per Day

Hamburger (million hamburgers)

$2.00 14
1.50 10
1.00 6
0.75 4
0.50 2

i OXS

unit
amburgers
per

0 oF eG 10 14 Q
Million hamburgers per day

FIGURE 2.3 Market Supply Curve for Hamburgers Market

supply curve S shows that higher hamburger prices induce
producers to supply greater quantities.

period of time. The supply curve of Figure 2.3 is for one day. The supply curve of ham-
burgers for a month is correspondingly larger or farther out.

Changes in Supply
An improvement in technology, a reduction in the price of resources used in the produc-
tion of the commodity, and, for agricultural commodities, more favorable weather condi-
tions (i.e., a change in the ceteris paribus assumption) would cause the entire supply curve
of the commodity to shift to the right. Producers would then supply more of the commod-
ity at each price. For example, Figure 2.4 shows that at the price of $1.00, producers sup-
ply 12 million hamburgers per day (point £’) with S’ as opposed to only 6 million
hamburgers with S.
The shift to the right from S to S” is referred to as an increase in supply. This must be
clearly distinguished from an increase in the quantity supplied, which is instead a move-
ment on a given supply curve in the upward direction (as, for example, from point E to
point J, in Figure 2.4) resulting from an increase in the commodity price (from $1.00 to

? As in the case of demand, the supply curve can, but need not, be a straight line.
 CHAPTER 2. Basic Demand and Supply Analysis 31

hamburgers
of
Price
unit
per
0 2 4 6 8 10 12 14 te ©
Million hamburgers per day

FIGURE 2.4 Change in the Supply of Hamburgers When the

supply curve shifts to the right from S to S’, producers supply more
hamburgers at each price. Thus, at P = $1.00, producers supply
12 million hamburgers with S’ instead of only 6 million with S.

$1.50). On the other hand, a decrease in supply refers to a leftward shift in the supply curve
and must be clearly distinguished from a decrease in the quantity supplied of the
commodity (which is a movement down a supply curve and results from a decline in the
commodity price).

as WHEN Is A MARKET IN EQUILIBRIUM?2

We now examine how the interaction of the forces of demand and supply determines the
equilibrium price and quantity of a commodity in a perfectly competitive market. A mar-
ket is in equilibrium when no buyer or seller has any incentive to change the quantity of
Equilibrium price the commodity that he or she buys or sells at the given price. The equilibrium price of a
The price at which the commodity is the price at which the quantity demanded of the commodity equals the
quantity demanded of a quantity supplied and the market clears. The process by which equilibrium is reached in
commodity equals the the marketplace can be shown with a table and illustrated graphically.
quantity supplied.
Table 2.3 brings together the market demand and supply schedules for hamburgers
from Tables 2.1 and 2.2. From Table 2.3, we see that only at P = $1.00 is the quantity
supplied of hamburgers equal to the quantity demanded and the market clears. Thus, P =
$1.00 is the equilibrium price and Q = 6 million hamburgers per day is the equilibrium
quantity.
At prices above the equilibrium price, the quantity supplied exceeds the quantity
Surplus The excess demanded and there is a surplus of the commodity, which drives the price down. For
quantity supplied of a example, at P = $2.00, the quantity supplied (QS) is 14 million hamburgers, the quantity
commodity at higher- demanded (QD) is 2 million hamburgers, so there is a surplus of 12 million hamburgers
than-equilibrium per day (see the first line of Table 2.3). Sellers must reduce prices to get rid of their
prices.
unwanted inventory accumulations of hamburgers. At lower prices, producers supply

3 An algebraic analysis of how equilibrium is determined for this case is given in the appendix to this chapter.
A more general analysis is provided in section A1.11 of the Mathematical Appendix at the end of the book.
32 PART ONE Introduction to Microeconomics

Market Supply Schedule, Market Demand Schedule,

TABLE 2.3and Equilibrium

Quantity Supplied Quantity Demanded Surplus (+)

per Day (million per Day (million or Pressure
Price per
hamburgers) hamburgers) Shortage (—) on Price
Hamburger
14 2» 12 Downward
10 4 6 |Downward
on

1.00 6 6 0 Equilibrium

0.75 4 fl —3 Upward
0.50 2 8 —6 Upward
a

smaller quantities and consumers demand larger quantities until the equilibrium price of
$1.00 is reached, at which the quantity supplied of 6 million hamburgers per day equals the
quantity demanded and the market clears.
On the other hand, at prices below the equilibrium price, the quantity supplied falls
Shortage The excess short of the quantity demanded and there is a shortage of the commodity, which drives
quantity demanded of the price up. For example, at P = $0.50, QS = 2 million hamburgers while QD = 8
a commodity at lower- million hamburgers, so that there is a shortage of 6 million hamburgers per day (see the
than-equilibrium prices. last line of Table 2.3). The price of hamburgers is then bid up by consumers who want
more hamburgers than are available at the low price of $0.50. As the price of ham-
burgers is bid up, producers supply greater quantities while consumers demand smaller
quantities until the equilibrium price of P = $1.00 is reached, at which OS = QD = 6
million hamburgers per day and the market clears. Thus, bidding drives price and quan-
tity to their equilibrium level.
The determination of the equilibrium price can also be shown graphically by bring-
ing together on the same graph the market demand curve of Figure 2.1 and the market
supply curve of Figure 2.3. In Figure 2.5 the intersection of the market demand curve and
the market supply curve of hamburgers at point E defines the equilibrium price of $1.00
per hamburger and the equilibrium quantity of 6 million hamburgers per day.
At higher prices, there is an excess supply or surplus of the commodity (the top
Concept Check shaded area in Figure 2.5). Suppliers then lower prices to sell their excess supplies. The
How is the equilibrium surplus is eliminated only when suppliers have lowered their price to the equilibrium
price determined? level. On the other hand, at below equilibrium prices, the excess demand or shortage (the
bottom shaded area in the figure) drives the price up to the equilibrium level. This occurs
because consumers are unable to purchase all of the commodity they want at below-
equilibrium prices and they bid up the price. The shortage is eliminated only when con-
sumers have bid up the price to the equilibrium level, that is, only at P = $1.00, OS =
QD = 6 million hamburgers per day, and the market is in equilibrium (clears). So, both
demand and supply play a role in determining price.
Equilibrium The Equilibrium is the condition which, once achieved, tends to persist in time. That is,
market condition that, as long as buyers and sellers do not change their behavior and D and S$do not change, the
once achieved, tends to
equilibrium point remains the same.
persist.
At a particular point in time, the observed price may or may not be the equilibrium
price. However, we know that market forces generally push the market price toward
 CHAPTER 2 Basic Demand and Supply Analysis 35

P($)

_ S

= 2.004
fey
vo
a.
a Excess supply
So 1.50 }- or surplus
5
S
g
ye 1.00 =
S)
& 0.75 -
= Excess demand
or shortage

0 Z 4 (0) 7 10 12 14 Q
Million hamburgers per day

FIGURE 2.5 Demand, Supply, and Equilibrium The intersection of D and S at point E
defines the equilibrium price of $1.00 per hamburger and the equilibrium quantity
of 6 million hamburgers per day. At P larger than $1.00, the resulting surplus will drive P
down toward equilibrium. At P smaller than $1.00, the resulting shortage will drive P up
toward equilibrium.

equilibrium. This may occur very rapidly or very slowly. Before the market price reaches
a particular equilibrium price, demand and supply may change (shift), defining a new
equilibrium price. For now we will assume that, in the absence of price controls, the mar-
ket price is the equilibrium price. Example 2—1 shows how the market-clearing, or equi-
Auction The bidding librium, price is actually approximated in the real world by auction or similar
process in the purchase mechanisms.
of commodities.

EXAMPLE 2-1
Equilibrium Price by Auction

One way equilibrium prices are actually reached in the real world is by auction. Over
the centuries, auctions have been used to approximate the market-clearing, or equilib-
rium, price of everything from tulips to fine art and government bonds. How do auctions
work? Suppose that a seller of a product or service faces a group of potential buyers.
The seller knows what his or her minimum acceptable (reservation) price, and each
buyer knows more or less the maximum price he or she is willing to pay for the good or
service. The seller and the buyers, however, do not reveal this information unless and
until it is in their interest to do so.
The actual market, or equilibrium, price for the good or service will settle between
the price that the buyer who is willing to pay the most for the good or service (call him
34 PART ONE Introduction to Microeconomics

or her Buyer 1) and the price that the buyer who is willing to pay the second-highest
price (call him or her Buyer 2)—provided that this price is higher than the seller’s reser-
vation price. Buyer | will then be the one who actually purchases the good or service.
But how would the seller find Buyer 1? One way to do this is by auction. In ascending-
Concept Check price auctions, a low price is announced and buyers are given the opportunity to bid. The
How is price determined price is then increased until only Buyer | is left. This is the market-clearing, or equilib-
in an auction? rium, price. In descending-price, or Dutch, auctions, on the other hand, a high price is
announced and then lowered until the first buyer accepts the price (“hits the panic but-
ton”). This will again be our Buyer I.
Another mechanism for matching buyers and sellers is bilateral bargaining, or
“haggling.” Here, a buyer and seller, each with some knowledge of the market, enter
into unstructured negotiation to find a mutually acceptable price. If that is not reached,
both try again with another party until a sale is made and the market clears. A related
mechanism, familiar to consumers, is the fixed-price list. Here sellers announce a price
list at which they are willing to sell. Potential buyers examine the list and decide
whether or not to buy, from whom to buy, and when. Sellers adjust the price, and buy-
ers decide to purchase until, again, the market clears.
In general, all of the foregoing mechanisms uncover roughly the price at which
buyers and sellers are more or less matched and the market clears. Note that the
process of determining the equilibrium price in the real world is often not as smooth or
clear-cut as might be implied by theory. But that is precisely the function of theory—
that is, to abstract from all details, simplify, and generalize, which is precisely what
price theory does.
Sources: “The Brave New World of Pricing,” Financial Times, August 2, 2001, pp. 24; and “Auction,”
Wikipedia, July, 2007, http://en.wikipedia.org/wiki/Auction.

ADJUSTMENT TO CHANGES IN DEMAND AND SUPPLY:

20 COMPARATIVE STATIC ANALYSIS

What is the effect of a change in the behavior of buyers and sellers, and hence in demand
and supply, on the equilibrium price and quantity of acommodity? Because the behavior of
buyers and sellers often does change, causing demand and supply curves to shift over time,
it is important to analyze how these shifts affect equilibrium. This analysis is called
Comparative static comparative static analysis.
analysis The analysis
of the effect of a
Adjustment to Changes in Demand
change in demand
and/or supply price and We have seen that the market demand curve for a commodity shifts as a result of a change
quantity. in consumers’ income, their tastes, the price of substitutes and complements, and the
number of consumers in the market (i.e., a change in the ceteris paribus assumption)
.
Given the market supply curve of a commodity, an increase in demand (a rightward shift
of the entire demand curve) results both in a higher equilibrium price and a
higher
equilibrium quantity. A reduction in demand has the opposite effect.
Figure 2.6 shows a shift from D to D’ resulting, for example, from an increase
in
consumers’ income. The shift results in a temporary shortage of 6 million
hamburgers
 CHAPTER 2 Basic Demand and Supply Analysis 35

P($)
Ze)

FIGURE 2.6 Adjustment to an Increase in Demand

D and S are the original demand and supply curves (as in hamburgers
of
Price
unit
per
Figure 2.5). The shift from D to D’ results in a temporary
shortage of hamburgers, which drives the price up to 0 2st O57 84 0 a2 4 Q
P = $1.50 at which QS = QD = 10 million hamburgers. Million hamburgers per day

(EE’ in the figure) at the original equilibrium price of P = $1.00 (point £). As a result,
Concept Check the price of hamburgers is bid up to P = $1.50 at which QS = QD = 10 million ham-
What is the effect of an burgers. As the price of hamburgers rises to P = $1.50, the quantity demanded declines
increase in D on the (from point £’ to point J along D’) while the quantity supplied increases (from point E
equilibrium P and Q?
to point J along S) until the new equilibrium point J is reached. At the new equilibrium
point J, both P and Q are higher than at the old equilibrium point E and the market,
once again, clears.

Adjustment to Changes in Supply

The market supply curve of a commodity can shift as a result of a change in technology,
resource prices, or weather conditions (for agricultural commodities). Given the market
demand curve for the commodity, an increase in supply (a rightward shift of the entire
supply curve) results in a lower equilibrium price but a larger equilibrium quantity. A
reduction in supply has the opposite effect.
Figure 2.7 shows a shift from S to S’ resulting, for example, from a reduction in the
Concept Check price of beef. The shift results in a temporary surplus of 6 million hamburgers (ZE’ in the
What is the effect of an figure) at the original equilibrium price of P = $1.00 (point £). To get rid of their surplus,
increase in § on the sellers reduce their price to P = $0.50, at which OS = QD = 8 million hamburgers. As
equilibrium P and Q? the price of hamburgers falls to P = $0.50, the quantity demanded increases (from point
E to point G along D) while the quantity supplied decreases (from point E’ to point G
along S’) until the new equilibrium point G is reached. At new equilibrium point G, P is
lower and Q is higher than at old equilibrium point £ and the market, once again, clears.
Concept Check Starting from Figure 2.5, you should be able to show what happens to the equilibrium
What happens to P and price and quantity if both the demand and supply of hamburgers increase, if both decrease,
Q if both D and S$ or if one increases and the other decreases. We can similarly examine the effect of changes
increase? in demand and supply on the equilibrium price and quantity of any other commodity or ser-
vice (see Example 2-2).
36 PART ONE Introduction to Microeconomics

no =

unit
hamburgers
of
Price
per
Q
Million hamburgers per day

FIGURE 2.7. Adjustment to an Increase in Supply D and S are the

original demand and supply curves. The shift from S to S’ results in a
temporary surplus of hamburgers, which drives the price down to
P = $0.50 at which QS = QD = 8 million hamburgers.

EXAMPLE 2-2
Changes in Demand and Supply and Coffee Prices

Changes in the demand and the supply of coffee explain why world wholesale coffee
prices fell by nearly half from 1998 to 2004, reaching their lowest level in three
decades. The sharp decline in coffee price threw millions of small coffee farmers and
their families in developing countries into extreme poverty, while multinational food
companies (such as Nestlé) and coffee shops (such as Starbucks) posted very high
profits from coffee sales.
The problem in the coffee market arose from the fact that the supply of coffee
increased faster than its demand, causing coffee prices to fall. Since coffee prices fell
faster than quantities increased, the earnings of coffee farmers also declined. This can be
shown with Figure 2.8, where D represents the world’s demand curve for coffee and S rep-
resents the world’s supply curve. Curves D and S intersect at the equilibrium world price
of coffee of $1 per pound and the equilibrium quantity of 10 billion pounds per year (point
EF in the figure), giving coffee farmers a total revenue (income) of $10 billion per year. If,
over time, D shifts to D’ and S shifts to S’, the world price of coffee falls to $0.50 per pound
and the quantity rises to 15 billion pounds per year (shown by new equilibrium point E”
in the figure). This, however, produces a total revenue (income) for coffee farmers of only
$7.5 billion per year. If only D shifted to D’, the price of coffee would be $1.25 (point E’ in
the figure); while if only S shifted to S’, the price of coffee would be $0.25 (point EF *).
During the past few years, the supply of coffee has been increasing at twice the
rate of the increase in demand as a result of new countries (such as Vietnam) starting
to produce and export coffee on a large scale and others (such as Indonesia and Brazil)
sharply increasing exports. This caused the price of coffee that growers received to fall
from $1.40 per pound in 1998 to as low as $0.48 in June 2002, which was lower than
the production costs of many poor small farmers. As more efficient larger farmers
increased their production to make up for the reduction in price, the market supply
curve for coffee shifted to the right, causing coffee prices to fall even lower.
 CHAPTER 2. Basic Demand and Supply Analysis 37

P($)

2 125
5
5
7100
vo
iol)

9%
S(e)
oO

5-050 1-2 - =
o
2=
~ 0.25

|
0 5 10° 195° 15 Q
Billions of pounds per year

FIGURE 2.8 Demand, Supply and Coffee Prices Curves D

and S refer, respectively, to the world’s demand and supply curve
for coffee. Curves D and S intersect at point £, giving the
equilibrium price of coffee of $1.00 and the equilibrium quantity
of 10 billion pounds per year. If D and S shifted, respectively, to D’
to S‘, the new equilibrium point would be E”, giving the price of
$0.50 and the quantity of 15 million pounds per year.

A plan drawn up in May 2000 by the 28-member Association of Coffee Producing

Countries (ACPC) sponsored by Brazil and Colombia (respectively, the world’s largest
and third largest coffee exporter) failed to reduce coffee exports and stabilize prices.
But then bad weather in producing nations and higher demand in consuming nations
came to the rescue, resulting in coffee prices rising above $1.30 per pound in fall 2007
and $1.58 in February 2008.
Sources: “Drowning in Cheap Coffee,’ The Economist, September 29, 2001, pp. 43-44; “Crisis Call to
Coffee Growers,” Financial Times, April 16, 2002, p. 23; “Coffee Reaches Five-Year Highs on Signs of
Smaller Brazil Crop,” Wall Street Journal, February 24, 2005, p. 4; and “Price of Coffee Jumps to 10-Year
High,’ Financial Times, October 15, 2007, p. 18.

Domestic DEMAND AND SUPPLY, IMPORTS, AND PRICES

When the domestic price of a commodity is higher than the commodity price abroad,
the nation will import the commodity until domestic and foreign prices are equalized,
in the absence of trade restrictions and assuming no transportation costs. This is shown
in Figure 2.9. Curves Dr and Sr in Panels A and C refer to the demand and supply
curves for textiles in the United States and in the rest of the world per year, respectively.
Panel A shows that in the absence of trade, the United States would produce and con-
sume 200 million yards of textiles at the price of $3 per yard (point F’). Panel C shows
that the rest of the world produces and consumes 300 million yards at the price of $1
38 PART ONE Introduction to Microeconomics

Panel B Panel C
Panel A
International trade Rest of world
U.S. market
for textiles in textiles market in textiles

P($) P($) P(8)

4
Sr7

yard
textiles
of
Price
per

ese | |
0 100 200 400 rw 300 Dy 0 150 300 450 i
= Million yards of textiles (7)

FIGURE 2.9 Equilibrium Commodity Price with Trade The U.S. demand for textile imports
(D) in Panel B is derived from the excess demand at below-equilibrium prices in the absence of trade
in Panel A. On the other hand, the foreign supply of textile exports to the United States (S) in Panel B
is derived from the foreign excess supply at above-equilibrium prices in the absence of trade in Panel C.
The D and S curves intersect at point E* in Panel B, establishing the equilibrium price of $2 per yard
and the equilibrium quantity of textiles traded of 300 million yards.

per yard (point F’). With free trade in textiles, and assuming (for simplicity) zero trans-
portation costs, the price of textiles will be $2 per yard both in the United States and
abroad. The United States will import 300 million yards of textiles (EG in Panel A), which
is equal to the textile exports of the rest of the world (£’G’ in Panel C). This result, which
is easily visualized by examining Panels A and C only, is formally derived in Panel B.
Panel B shows the U.S. demand for textile imports (D) and the foreign
supply curve of textile exports ($). The U.S. demand for textile imports in Panel B is
Excess demand The derived from the U.S. excess demand for textiles at each price below the U.S. equilib-
excess in the quantity rium price in Panel A. Specifically, at the equilibrium price of $3 per yard, the United
demanded over the States produces and consumes 200 million yards of textiles (point F in Panel A). This
quantity supplied of
corresponds to the vertical intercept of the U.S. demand curve for textile imports (D) in
a commodity.
Panel B. At Py = $2, the United States produces 100 million yards domestically (point
G in Panel A), consumes 400 million yards (point £ in Panel A), and thus imports 300
million yards (EG in Panel A). This corresponds to point E* on the U.S. demand curve
for textile imports (D) in Panel B.
The foreign supply curve of textile exports to the United States (S in Panel B) is
Excess supply The derived from the excess supply of textiles in the rest of the world at prices above the equi-
excess in the quantity librium price in Panel C. Specifically, at the equilibrium price of $1 per yard, the rest of
supplied over the the world produces and consumes 300 million yards of textiles (point F’ in Panel @)eLinis
quantity demanded
corresponds to the vertical intercept of the supply curve of textile exports of the rest of the
of a commodity.
world (S) in Panel B. At Py = $2, the rest of the world produces 450 million yards (point
E’in Panel C), consumes 150 million yards (point G’ in Panel C), and exports 300 million
yards (E’G’ in Panel C). This corresponds to point E* on the supply curve of textile exports
of the rest of the world (S$) in Panel B.
 CHAPTER 2 Basic Demand and Supply Analysis 39

The U.S. demand curve for textile imports (D in Panel B) intersects the foreign sup-
ply curve of textile exports from the rest of the world (§ in Panel B) at point E*, resulting
in the equilibrium quantity of textiles traded of 300 million yards at the equilibrium price
of $2 per yard. Just as for any other commodity, the equilibrium price and quantity of tex-
tiles traded is given at the intersection of the demand and supply curves. Note that in the
absence of any obstruction to trade in textiles and assuming no transportation costs, the
price of textiles is equal in the United States and abroad. Thus, the price of textiles with
trade is lower in the United States and higher in the rest of the world than in the absence
of trade. With transportation costs, the price of textiles in the United States would exceed
the price of textiles in the rest of the world by the cost of transportation.
This analysis clearly shows that in today’s interdependent world, the tendency for the
domestic price of a commodity to rise is moderated by the inflow of imports of the com-
modity. This is certainly the case for automobiles in the United States (see Example 2-3).

EXAMPLE 2-3
The Large U.S. Automotive Trade Deficit Keeps U.S. Auto Prices Down

Table 2.4 shows that even though automobiles were by far the largest U.S. exports, the
United States had an automotive trade deficit of nearly $150 billion in 2006. This rep-
resented nearly one fifth of the total U.S. trade deficit for that year. Without such auto-
mobile imports, automobile prices in the United States would have been more than
$1,000 higher than they were. Table 2.4 also shows that the other major imports of the
United States in 2006 were petroleum, household appliances, and computers, while
the other main exports were chemicals, aircraft, food and beverages, and semiconduc-
tors. Since the price of all traded goods are affected (sometimes a lot) by imports and
exports, it would not make much sense to study microeconomic theory, in general, and
the process whereby equilibrium prices are determined, in particular, without consid-
ering imports and exports in our highly globalized and interdependent world.

Major Goods Exports and Imports of the United States in 2006

emma (billions of dollars)
Imports Value Exports Value

Petroleum 302.4 Automobiles 107.2

Automobiles 256.7 Chemicals 83.0
Household appliances 105.8 Aircraft 12
Computers 101.3 Food and beverages 66.0
Textiles 83.4 Semiconductors 52.4
Food and beverages 74.9 Computers 47.3
Chemicals 53.8 Electrical generating machinery 39.3
Electrical generating machinery 49.8 Scientific and medical equipment 30.0
Telecommunication equipment 40.3 Telecommunication equipment 28.3
Semiconductors 27.4 Household appliances 26.2
TE rc En nc

Source: U.S. Department of Commerce, Survey of Current Business (Washington, DC: U.S. Government Printing Office,
July 2007), pp. 84-86.
40 PART ONE Introduction to Microeconomics

INTERFERING WITH VERSUS WORKING THROUGH THE MARKET

In the analysis presented so far in this chapter, we have implicitly assumed that the market
is allowed to operate without government or other interferences. In that case, demand and
supply determine the equilibrium price and quantity for each commodity or service. If, on
the other hand, the government interfered with the operation of the market by imposing
effective price controls (say, in the form of rent control or an agricultural price-support
program), the market would not be allowed to operate and a persistent shortage or surplus
of the commodity or service would result. Contrast this situation with working through or
within the market (as, for example, with the imposition of an excise tax or the federal
antidrug program). Working through the market would result in a shift in demand or
supply, but the equilibrium price and quantity of the commodity or service would still be
determined by demand and supply, and no persistent shortage or surplus would arise.
Current, real-world examples can illustrate the differences. Example 24 shows the
detrimental effect of rent control in New York City. Example 2—5 shows the waste that
results from U.S. agricultural price-support programs and why many people want to do
away with them. On the other hand, Example 2—6 examines the economic effects of work-
ing through the market with the imposition of an excise tax, while Example 2—7 shows
how the federal antidrug program seeks to reduce drug use in the United States by reduc-
ing the demand and supply of illegal drugs.
By interfering with the working of markets, rent control, price ceilings on gasoline, and
agricultural price-support programs create huge waste and inefficiencies in the economy.
These arise because markets communicate crucial information to consumers about the rela-
tive availability of goods and services, and to suppliers about the relative value that con-
sumers place on various goods and services. Without the free flow of information transmitted
through market prices, persistent shortages and surpluses—and waste—arise. Working
through the market (see Examples 2—6 and 2-7) leads to different (and better) results.

EXAMPLE 2-4
Rent Control Harms the Housing Market

“There is probably nothing that distorts a city worse than rent regulation. It accelerates the
abandonment of marginal buildings, deters the improvement of good ones, and creates won-
drous windfalls for the middle class—all the while harming those it was meant to help, the
poor.’* More than 90% of economists would agree (see Table 1.3). Rent control was
adopted in New York City as an emergency measure during World War II, but it has been
kept ever since. Although rent control is most stringent in New York City, today more than
200 cities (including Washington, D.C., Boston, Los Angeles, and San Francisco) have
some form of rent control. More than 10% of rental housing in the United States is under
Price ceiling The rent control.
maximum price Rent controls are price ceilings or maximum rents set below equilibrium rents.
allowed for a Although designed to keep housing affordable, the effect has been just the opposite—
commodity. a shortage of apartments. For example, Figure 2.10 might refer to the market
for

*“End Rent Control,” New York Times, May 12, 1987, p. 30.
 CHAPTER 2 Basic Demand and Supply Analysis 41

2 S
so)
E
= 1,400 -
a
SB
or 71,000
iS
> 600

ee
Ss Shortage |
S

0 IP, AMG: YANO Q

Millions of apartments
FIGURE 2.10 Rent Control At the controlled rent of
$600 per month, 2.0 million apartments could be rented. Only
1.2 million apartments are available at that rent, so there is a
shortage of 800,000 million apartments. Apartment seekers
would be willing to pay a rent of $1,400 per month when only
1.2 million apartments are available.

apartment rentals in New York City. Without rent control (and assuming, for simplicity,
that all apartments are identical), the equilibrium rent is $1,000 and the equilibrium
number of apartments rented is 1.6 million. At the controlled rent of $600 per month, 2
million apartments could be rented. Only 1.2 million apartments are available at that
rent, so there is a shortage of 800,000 apartments. Indeed, apartment seekers would be
willing to pay arent of $1,400 per month rather than go without an apartment when only
1.2 million apartments are available.°
Rent control introduces many predictable distortions into the housing market.
First, as we have seen, rent control results in a shortage of apartments for rent. This is
evidenced by the great difficulty and time required to find a vacant, rent-controlled
apartment to rent. Second, owners of rent-controlled apartments usually cut mainte-
nance and repairs to reduce costs, and so the quality of housing deteriorates. Because of
the shortages to which rent control gives rise, however, apartments vacated as a result of
inadequate maintenance can be filled easily and quickly. Third, rent control reduces the
return on investment in rental housing, and so fewer rental apartments will be con-
structed.° Fourth, rent control encourages conversion into cooperatives (since their price
is not controlled), which further reduces the supply of rent-controlled apartments.’
Finally, with rent control, there must be a substitute for market price allocation; that is,
nonprice rationing is likely to take place as landlords favor families with few or no chil-
dren or pets and families with higher incomes.

5 A price ceiling at or above the equilibrium price has no effect. For example, rent is $1,000 and the number of
apartments rented is equal to 1.6 million in Figure 2.10 regardless of whether a rent ceiling of $1,000 or
higher is imposed. Only if rent control or the maximum rent allowed by law is below the equilibrium rent of
$1,000 does a shortage of apartments for rent result.
© To overcome this, rent control laws usually exempt new apartments.
7 Many localities have passed laws restricting this practice.
42 PART ONE _ Introduction to Microeconomics

In summary, we can predict that rent control leads to (1) a shortage of rental
Concept Check housing, (2) lower maintenance, (3) inadequate allocation of resources to the con-
What is the effect of a struction of new rental housing, (4) reduction in the stock of rental housing through
price ceiling? conversion into cooperatives and condominiums, and (5) nonprice rationing of apart-
ments for rent. One study revealed that the vacancy rate of rent-controlled apartments
in New York City was less than 1%, expenditures on repairs were only about half as
much as on noncontrolled apartments, and the shortage of new rental housing con-
struction amounted to over $3 billion. One way to eliminate the housing shortage and
other distortions introduced by rent control, and at the same time protect tenants in res-
idence from sudden sharp rent increases, is to decontrol apartments only as they
become vacant. Indeed, New York City passed a law in 1997 that permitted landlords
to increase the rent by as much as 20% when a rent-controlled apartment became
vacant and eliminated all regulations when, upon vacancy, the rent rose beyond
$2,000.
Similar distortions result from the imposition of price ceilings on other commodi-
ties and services. For example, it was estimated that the price ceiling on gasoline in the
United States in the summer of 1979 (at the height of the petroleum crisis) resulted in
$200 million in lost time and 100 million gallons of gas wasted per month from wait-
ing in long lines to obtain gasoline. Black markets also sprung up as some consumers
were willing to pay a higher price for gasoline rather than stand in lines, and some sup-
pliers were willing to accommodate them at higher prices. When price control was
abolished, gasoline prices rose to the equilibrium level and long lines at the pumps and
other market distortions soon disappeared. Similarly, the cap placed on doctor reim-
bursements by third parties (see Example 1-1) led to a shortage of doctor services,
which is reflected in delays that patients experience when trying to see a doctor.
Another example is given by the wait that users experience before the requested infor-
mation appears on their computer screens when “surfing the Net.” This results from the
government’s resistance to levying charges based on Internet usage.
Sources. “End Rent Control,” New York Times, May 12, 1987, p. 30; “A Model for Destroying a City,” Wall
Street Journal, March 12, 1993, p. A8; “Rent Deregulation Has Risen Sharply Under 1997 Law,” New York
Times, August 8, 1997, p. B1; and “The Great Manhattan Rip-off,” The Economist, June 7, 2003, pp. 25-26.

EXAMPLE 2-5
The Economics of U.S. Farm Support Programs

For more than 70 years, American agriculture has been the nation’s largest recipient of
political intervention and economic aid. Demand and supply analysis can again
enlighten us on how the U.S. farm-support program worked and on the gross ineffi-
ciencies to which it led.
The federal government has used the following three basic methods to prop up
farm incomes: (1) From the 1930s until 1973, the federal government operated a price-
Price floor A support program (i.e., it established a price floor or a minimum price above the equi-
minimum price for a librium price) for several agricultural commodities to increase farm incomes.
commodity. This
resulted in a surplus of agricultural commodities, which was then purchased
by the
 CHAPTER 2 Basic Demand and Supply Analysis 43

government. The government used part of the surplus to assist low-income people, to
subsidize school lunch programs, and for foreign aid. But a great deal of the surplus had
to be stored and some spoiled. (2) From the early 1930s, the government also provided
incentives for farmers to keep part of their land idle to avoid ever-increasing surpluses.
(3) Starting in 1973, the government also gave farmers a direct subsidy if the market
price of certain commodities fell below a target price.
We can analyze the effect of these three farm-support programs with the aid of
Figure 2.11 which refers to the wheat market. In the absence of any support program,
wheat farmers produce the equilibrium quantity of 2 billion bushels per year, sell it at
the equilibrium price of $3 per bushel, and realize a total income of $6 billion. If the
government establishes a price floor of $4 per bushel for wheat, farmers supply 2.2 bil-
lion bushels per year, consumers purchase only 1.8 billion bushels, and the govern-
ment must purchase the surplus of 0.4 billion bushels at the support price of $4 per
bushel, for a total cost of $1.6 billion. This does not include the cost of storing the sur-
plus. The price floor has no effect if the market price rises above it.
If, through acreage restriction, output falls from 2.2 to 2.1 billion bushels at the
Concept Check supported price of $4 per bushel, the surplus declines to 0.3 billion bushels, and the
What is the effect of a cost of the price-support program falls to $1.2 billion. With direct subsidies, farmers
price floor? sell the equilibrium quantity of 2 billion bushels at the equilibrium price of $3 per
bushel, and the government then provides farmers a direct subsidy of $1 per bushel at
a total cost of $2 billion (if the government sets the target price for wheat at $4 per
bushel). With a direct subsidy, however, there is no storage problem, and consumers
obtain wheat at the lower market price of $3 per bushel.
The Fair Act of 1996 (more often called the “Freedom to Farm Act’) freed U.S.
farmers from government production controls but was supposed to gradually phase
out farm subsidies. When commodity prices plummeted in 1998, however, U.S.
farmers lobbied Congress and received nearly $3 billion in emergency assistance

P($/bushel)

2.0
Billions of bushels of wheat per year

FIGURE 2.11 Agricultural Support Programs At the price floor of $4

per bushel, farmers supply 2.2 billion bushels, consumers purchase
18 billion bushels, and the government purchases the surplus of 0.4 billion
bushels at a total cost of $1.6 billion.
44 PART ONE Introduction to Microeconomics

farm
payments on top of the huge payments they were still receiving under the other
programs (that were supposed to be phased out). Emergency assistanc e payments
increased to $7.5 billion in 1999, $9 billion in 2000, and $20 billion in 2001.
Furthermore, most of the assistance went to very large growers rather than to small
family farms. Thus, instead of liberalizing agriculture, as agreed at the World Trade
Organization (the Geneva-based international institution that regulates international
trade), the U.S. farming sector was as protected in 2001 as it was in 1996.
The farm bill signed into law by President Bush in May 2002 that runs from 2003
to 2008 increased subsidies to U.S. farmers even more. This represented a reversal of
course from what the president had proposed in 2001 (i.e., to shift U.S. farm policy
away from subsidies and toward freer markets and more open international trade in agri-
cultural products) and created even more trade friction with the European Union and
developing countries. The European Union and Japan are, of course, just as guilty.
Indeed, they provide even more aid to their farmers than the United States. The total
amount of farm aid provided in the year 2005 was $47 billion in the United States, $49
billion in Japan, and $133 billion in the European Union. This comes to over $350
dollars per person living in the United States, Japan, and the European Union, and more
than half of the price that farmers receive for some crops represents government subsi-
dies. In spring 2008, a new $307 billion farm bill was passed that for the most part preserves
the extensive program of subsidies to U.S. farmers over the subsequent five years.
Sources: “Farmers Harvest a Bumper Crop of Subsidies,” Wall Street Journal, August 10, 1999, p. A24:
“Administration Seeks to Shift Farm Policy from Subsidies,’ New York Times, September 20, 2001, p. 12;
“Reversing Course, Bush Signs Bill Raising Farm Subsidies,’ New York Times, May 14, 2002, p. 16;
OECD, Agricultural Policies in OECD Countries (Paris: OECD, 2006); “Senate Approval of Farm Bill
Threatens Clash on Tax,” Financial Times, December 16, 2007, p. 5; and “Farm Bill Goes to Bush,”
New York Times, May 16, 2008, p. 21.

EXAMPLE 2-6
Working Through the Market with an Excise Tax

Excise tax A tax on An excise tax is a tax on each unit of a commodity.® If collected from sellers, the tax
each unit of a causes the supply curve to shift upward by the amount of the tax, because sellers require
commodity. that much more per unit to supply each amount of the commodity. The result is that con-
sumers purchase a smaller quantity at a higher price, while sellers receive a smaller net
price after payment of the tax. Thus, consumers and producers share the burden or
Incidence of tax incidence of a tax.
The relative burden We can analyze the effect of an excise tax collected from sellers through the use of
of a tax on buyers
Figure 2.12. In the figure, D and S are the demand and supply curves of hamburgers with
and sellers.
the equilibrium defined at point E (at which P = $1.00 and Q = 6 million hamburgers,
as in Figure 2.5). If a tax of $0.75 per hamburger is collected from sellers, § shifts up

8
An excise tax can be of a given dollar amount per unit of the commodity or of a
Ve . . . >
given percentage of the
price of the commodity (ad valorem). If all units of the commodity are of equal quality
and price (as we
assume here), the per-unit and the ad valorem excise tax are equal and the distinction
is unnecessary.
 CHAPTER 2 Basic Demand and Supply Analysis 45

hamburgers
of
Price

g
Million hamburgers per day
FIGURE 2.12 Effect of an Excise Tax WithDandS, P= $1.00
and Q = 6 million hamburgers (point £), as in Figure 2.5. If the tax
of $0.75 per hamburger is collected from sellers, S shifts up by $0.75
to S” With D and S$”, Q = 4 million hamburgers and P = $1.50 for
consumers (point C), but sellers receive a net price of only $0.75
after paying the $0.75 tax per unit.

by the amount of the tax to S”, since sellers now require a price $0.75 higher than before
to realize the same net after-tax price. Now D and S" define equilibrium point C with Q =
4 million hamburgers and P = $1.50, or $0.50 higher than before the imposition of the
tax. Thus, at the new equilibrium point, consumers purchase a smaller quantity and pay
a higher price. Sellers also receive the smaller net price of $0.75 (the price of $1.50 paid
by consumers minus the $0.75 collected by the government on each hamburger sold).
In the case shown in Figure 2.12, two-thirds of the burden of the tax falls on
consumers and one-third on sellers. That is, consumers pay $0.50 more and sellers
receive a net price that is $0.25 less than before the imposition of the excise tax.
Thus, even though the tax is collected from sellers, the forces of demand and supply
are such that sellers are able to pass on or shift part of the burden of the tax to con-
sumers in the form of a higher price for hamburgers. Given the supply of a com-
modity, the less sensitive the quantity demanded is to price (1.e., the steeper the
demand curve), the greater is the share of the tax paid by consumers in the form of
higher prices. On the other hand, given the demand for a commodity, the less sensi-
tive the quantity supplied is to price (i.e., the steeper the supply curve), the smaller
is the share of the tax paid by consumers and the larger is the share left to be paid by
sellers (see Problem 12 at the end of the chapter).
If the government collected the tax of $0.75 per hamburger from buyers or con-
sumers rather than from sellers, D would shift down by $0.75 to D” (pencil D” in
Concept Check Figure 2.12 through point N, parallel to D). With D” and S, Q = 4 million hamburgers,
How much of an P = $0.75 (that buyers pay to sellers) and then buyers have to pay the tax of $0.75 per
excise tax falls on hamburger to the government. Again, consumers pay $1.50, which is $0.50 more than
ie erent dene the previous equilibrium price, and sellers receive $0.25 less. Therefore, the net result
compared to sellers? the same whether the tax is collected from sellers or from buyers.
46 PART ONE Introduction to Microeconomics

also to dis-
Sometimes governments use excise taxes not only to raise money but
to health. An excise
courage the use of a product, such as cigarettes, which is harmful
alternat ive would
tax on cigarettes increases their price and discourages their use. An
ng, especial ly to
be for the government to conduct an educational campaign explaini
teenagers, the harm from smoking. In general, governments do both. Another type of
Import tariff commodi ty.
A per-unit tax on excise tax is the import tariff. This is a tax on each unit of the imported
wel-
the imported As such, it has both a production and a consumption effects; these, as well as the
commodity. fare effects of a per-unit tax and an import tariff, are analyzed in Section 9.8.

EXAMPLE 2-7
Fighting the Drug War by Reducing Demand and Supply

The battle against illegal drug use in the United States is being fought by trying to
reduce their demand and supply. The federal government is trying to shift the demand
curve for illegal drugs down and to the left through an educational campaign to explain
the destructive effect of illegal drugs. By itself, this campaign would reduce sales and
the price for illegal drugs (compare equilibrium point E in Figure 2.13) before the gov-
ernment campaign, with equilibrium point E’ after a successful government campaign
to reduce demand. The government is also trying to reduce the supply of illegal drugs
by providing payments (subsidies) to Bolivian, Colombian, and Peruvian farmers (who
raise most of the coca crop from which a majority of the cocaine entering the United
States is extracted) to shift to other crops and by increasing border surveillance and
interdiction (seizures) of illegal drugs entering the United States. By itself, this would
shift the supply curve for illegal drugs upward and to the left and lead to reduced sales
and higher drug prices (compare equilibrium point F with E* in Figure 2.13).
Thus, both a reduced demand and a reduced supply would lower sales of illegal
drugs, but the former would also reduce the price of illegal drugs while the latter would
increase drug prices. If both the demand and the supply of drugs were reduced, drug sales
would fall, but drug prices would remain unchanged (compare equilibrium point E” to £),
increase, or decrease, respectively, depending on whether the downward shift in the
demand curve is equal, smaller, or greater than the upward or leftward shift in the
supply curve.
Therefore, we cannot determine by looking only at drug prices whether the govern-
ment campaign is successful. Specifically, if the reduction in drug prices is due to a
reduction in demand, the campaign can be said to be successful because it is accompa-
nied by reduced sales. But the reduction in drug prices could also result from an
increased drug supply. In that case, the campaign against illegal drugs would not be suc-
cessful. It all depends on whether the price reduction is accompanied by a reduction or
an increase in drug sales. On the other hand, if at the same time that the demand for ille-
gal drugs declines their supply increases, drug prices will definitely fall, but sales can
remain the same, decrease, or increase depending, respectively, on whether the leftward
shift in the demand curve is equal, greater, or smaller than the rightward shift in the sup-
ply curve (you can clearly see this by penciling in these changes in Figure 2.13). Despite
 CHAPTER 2 Basic Demand and Supply Analysis 47

Figure 2.13 Reducing the Demand and Supply

for Illegal Drugs +D and S refer to the demand and
supply curves for illegal drugs before the government
Campaign to reduce demand and supply. With D and S,
the equilibrium price of drugs is P and the equilibrium
of
drug
illegal
Price
an
quantity is Q With a reduction in demand from D to D’,
the equilibrium price of drugs falls to P’ and the sales to
Q”. With a reduction (leftward shift) in supply from S to S’,
the price rises to P* and sales fall to Q* With D’ and S’, 0 ONE Or QO
the price is P and sales Q” Quantity of an illegal drug

some recent dramatic successes in apprehending and jailing of some powerful

Colombian drug lords, the flow of cocaine and other illegal drugs to American cities
and their price remain high.
Sources: United Nations, World Drug Report 2006, New York, UN, 2006; and “At War with the Law of
Demand and Supply,” Financial Times, January 14, 2008, p. 7.

AT THE FRONTIER
Nonclearing Markets Theory

n this chapter we have seen how an excess demand for a commodity is automati-
| cally eliminated by a price rise and an excess supply is eliminated by a price
decline. Markets clear by quantity responses to price changes resulting from a dise-
quilibrium. Some real-world markets, however, do not clear and do not seem to move
toward clearing. For example, financial markets (especially credit markets) often do
not clear. That is, we often observe excessive demand or excessive supply of credit
that persists over time. Sometimes nonclearing markets also arise in labor, commod-
ity, and other markets. To explain these situations, economists have developed
Nonclearing nonclearing markets theory.
markets theory The new theory of nonclearing markets postulates that sometimes markets do not
Theory that seeks clear, because economic agents react to both price signals (as in traditional theory)
to explain the and to quantity signals. In particular, economic agents sometimes deliberately create
persistence of
a disequilibrium situation because of the advantages that they can extract from the
surpluses and
shortages. persistence of a surplus or a shortage of the commodity or service that they sell or buy.
One of the main insights of nonclearing markets theory is that a disequilibrium in one
market can actually create desirable spillover effects in a related market.

Continued...
48 PART ONE Introduction to Microeconomics

Nonclearing Markets Theory Continued

For example, ticket prices for concerts by a superstar, such as Billy Joel or
Madonna, are often deliberately set below the equilibrium price so as to create a short-
age (i.e., excess demand) for tickets. Long lines form in front of ticket booths long
before tickets go on sale and all available tickets are quickly sold out as soon as they
do go on sale. The news media report on the long lines to get tickets and interview
some of the people camped outside ticket booths days before the tickets go on sale,
fans talk about the hot concert coming up, and an aura of anticipation and success is
created. Promoters play this price game in the expectation that all the “hype” about the
concert and the free publicity that it gets will lead to much greater sales of the star’s
recordings, and that these spillovers will more than make up for the loss of revenue by
pricing concert tickets below the equilibrium level. The same occurs in pricing admis-
sion tickets to Disneyland or meals at a chic restaurant. Lines in front of the new
restaurant and word of mouth are the best and cheapest forms of advertising that the
restaurant could have. Most people believe that if it is difficult to get into the restau-
rant, it must be great.
Concept Check These and other examples of nonclearing markets do not mean that the traditional
Bees non teanne theory of clearing markets examined in this chapter is wrong, but only that the tradi-
SeeSteet ea q tonal theory is not applicable in some cases where shortages or surpluses are deliber-
and supply model? ately created and tend to persist over time. The theory of nonclearing markets
acknowledges this fact and tries to explain it. In the ticket example above, it is clear
that excess demand for tickets is fully and voluntarily planned by the price-maker or
promoter as a way to increase overall or combined revenues from the concert and the
sales of the star’s recordings.

Sources: “Nonclearing Markets: Microeconomic Concepts and Macroeconomic Applications,” Journal of

Economic Literature, June 1993, pp. 732-761 and “So Long, Supply and Demand,” Wall Street Journal,
January 1, 2000, p. R31.

[2 summary
1. Most of microeconomic analysis is devoted to the study of how individual markets operate. A market
is in equilibrium when no buyer or seller has any incentive to change the quantity of the good, service,
or resource that he or she buys or sells at the given price. Markets provide the framework for the
analysis of the forces of demand and supply that determine commodity and resource prices. A market
can, but need not, be a specific place or location. A perfectly competitive market is a market in which
no buyer or seller can affect the price of the product, all units of the products are homogeneous,
resources are mobile, and knowledge of the market is perfect.
2. A market demand schedule is a table showing the quantity demanded of a commodity at
each price over a given time period while holding constant all other relevant economic
variables on which demand depends. The market demand curve is the graphic representation of
the demand schedule. It is negatively sloped, which reflects the inverse price-quantity
relationship or the law of demand. A change in consumers’ incomes, tastes for the commodity,
the number of consumers in the market, or the price of substitutes or complements
shifts the
demand curve.
3.A market supply schedule is a table showing the quantity supplied of a commodit
y at each
price over a given time period. The market supply curve is the graphic
representation of the
 CHAPTER 2 Basic Demand and Supply Analysis 49

supply schedule. Because of rising marginal costs, the supply curve is usually positively sloped,
which indicates that producers supply more of the commodity at higher prices. A change in
technology, resource prices, and, for agricultural commodities, weather conditions, shifts the
supply curve.
4. The equilibrium price and quantity of a commodity are defined at the intersection of the market
demand and supply curves of the commodity. At higher than equilibrium prices, there is a
surplus of the commodity, which leads sellers to lower their prices to the equilibrium level.
At lower than equilibrium prices, there is a shortage of the commodity, which leads
consumers to bid prices up to the equilibrium level. Equilibrium is the condition that, once
achieved, tends to persist. In the real world, the approximate equilibrium price is often reached
by auction.
5. An increase in demand (a rightward shift in the demand curve) results in an increase in both the
equilibrium price and quantity of the commodity. A decrease in demand has the opposite effect.
On the other hand, an increase in supply (a rightward shift in the supply curve) results in a
lower equilibrium price but a higher equilibrium quantity. A decrease in supply has the opposite
effect.
6. A nation’s demand for imports is derived from the nation’s excess demand for the importable
commodity at below-equilibrium prices in the absence of trade. On the other hand, the
foreign supply of exports of the commodity is derived from the foreign excess supply of the
commodity at above-equilibrium prices in the absence of trade. The equilibrium price and
quantity of the traded commodity are given at the intersection of the demand and supply
curves of imports of the commodity. In today’s interdependent world, the tendency for the
domestic price of a commodity to rise is moderated by the inflow of imports of the
commodity.
~ . A price ceiling below the equilibrium price (such as rent control) leads to a shortage of the
commodity and possibly black markets. A price floor above the equilibrium price (as for some
agricultural commodities) leads to a surplus of the commodity. Given the supply of a
commodity, the steeper the demand for the commodity, the greater the burden or incidence of a
per-unit tax on consumers. The federal antidrug program relies on reducing the demand and
supply of illegal drugs. Some real-world markets do not clear, and this fact gave rise to a new
nonclearing market theory.

KEY TERMS
Market Equilibrium price Excess supply
Perfectly competitive market Surplus Price ceiling
Market demand schedule Shortage Price floor
Law of demand Equilibrium Excise tax
Market demand curve Auction Incidence of a tax
Market supply schedule Comparative static analysis Import tariff
Market supply curve Excess demand Nonclearing markets theory

REVIEW QUESTIONS
1. Which of the following cause demand to increase? An 2. Will the supply curve shift to the right or to the left if (a)
increase in consumers’ income, an increase in the technology improves or (b) input prices increase? (c) What
price of substitutes, an increase in the price of happens if both (a) and (b) occur?
complements, an increase in the number of consumers 3. Explain why Q D 4 is not the equilibrium quantity in
in the market. Figure 2.5 and how equilibrium is reached.
50 PART ONE _ Introduction to Microeconomics

textiles between the United States and the rest of the world
. Explain why Q D 8 is not the equilibrium quantity in
Figure 2.5 and how equilibrium is reached. was $1? What would be the quantity of textiles traded?

_ Using comparative static analysis, explain how a wheat _a. When is the price ceiling or price floor ineffective?
shortage was avoided in the United States after the drought b. What is an example of an effective price ceiling? What
in Kansas in 1988 and 1989 (described in Example |—2). is its effect?
_ Was the increase in the demand for large automobiles in c. What is an example of an effective price floor? What is
the United States since the collapse of petroleum prices in its effect?
1986 rational? Do you foresee any difficulty for the United . Does it make any difference whether an excise tax is
States if this trend continues? collected from sellers or from buyers? Why?
. Why is the textile price of $1.50 in Figure 2.9 not the . Determine the minimum size of a prohibitive tariff in
equilibrium price? Figure 2.9 in the absence of transportation costs.
(oe). What would be the difference in textile prices between the . How does nonclearing markets theory explain why
United States and the rest of the world if textiles were markets sometimes do not clear?
freely traded but the cost of transporting each yard of

| PROBLEMS
1. Given the following demand schedule of a commodity Q . On the same graph, plot the supply schedule of part
(a) and label it S and the supply curve of part (b) and
label it S’.
. What may have caused S to shift to S’?
. Construct a table similar to Table 2.3 giving the supply
en
schedule of Problem 3(a), and the demand schedule of
show that by substituting the prices given in the table into Problem 1. In the same table identify the equilibrium
the following demand equation or function, you obtain the price and quantity of the commodity, the surplus or
corresponding quantities demanded given in the table: shortage at prices other than the equilibrium price, and
the pressure on price with a surplus or a shortage.
(QD)
= (0) = WO”
b. Show your results of part (a) graphically.
*
2. a. Derive the demand schedule from the following . Using the demand function of Problem | and the supply
demand function: function of Problem 3(a), determine the equilibrium price
and quantity algebraically.
QD’ = 80 — 10P
. a. Repeat the procedure in Problem 4(a) for the supply
b. On the same graph, plot the demand schedule of schedule of Problem 3(b) and the demand schedule of
Problem | and label it D and the demand curve of Problem 2(a).
part (a) of this problem and label it D’. b. Show your results of part (a) graphically.
c. Does D’ represent an increase in demand or an increase c. On the same graph, draw D and S from Problem 4(b)
in the quantity demanded? Why?
and D’ and S’ from Problem 6(b). What general
3. a. Derive the supply schedule from the following supply conclusion can you reach as to the effect of an increase
function: in the demand and supply of a commodity on the
equilibrium price and quantity of the commodity?
QS= 10P
. On separate sets of axes, show that
b. Derive the supply schedule from the following supply a. a decrease in demand reduces the equilibrium price
function: and quantity of the commodity.
b, a decrease in supply increases price but reduces
QS’ = 20 + 10P
quantity.

= Answer provided at end of book.

 CHAPTER 2 Basic Demand and Supply Analysis 51

c. a decrease in both demand and supply will reduce Also show the quantity of textiles traded if the cost of
quantity but may increase, reduce, or leave price transportation for each yard of cloth is $1 and if this
unchanged. cost falls equally on the United States and the rest of
8. On separate sets of axes, show that the world.
a. an increase in both demand and supply will increase . With reference to your answer to Problem 4(a), indicate
quantity and may increase, reduce, or leave price the effect of the government imposing on the
unchanged. commodity a
b. a decrease in demand and an increase in supply will a. price ceiling of P = $2.
reduce price but may increase, decrease, or leave b. price ceiling of P = $3.
quantity unchanged. c. price ceiling higher than P = $3.
c. an increase in demand and a decrease in supply will d. price floor of P = $5.
increase price but may increase, decrease, or leave
e. price floor of P = $4.
quantity unchanged.
f. price floor equal to or smaller than P = $3.
*9 . Indicate what happens in the market for hamburgers if
. Draw a figure showing that
a. the price of hot dogs increases.
a. given the supply of a commodity, the less sensitive
b. a disease develops that kills a large proportion of
the quantity demanded is to price (i.e., the steeper the
cattle.
demand curve), the greater is the share of the tax paid
c. anew breed of cattle is developed with much faster by consumers in the form of higher prices.
growth.
b. given the demand for a commodity, the less sensitive
d. medical research proves that this new breed results in the quantity supplied is to price (i.e., the steeper the
hamburgers with less cholesterol. supply curve), the smaller is the share of the tax paid
e. a direct subsidy on each head of cattle is given to by consumers and the larger is the share paid
farmers raising cattle. by sellers.
. Using Panels A and C of Figure 2.9, show the price of
textiles in the United States and in the rest of the world.

|APPENDIX| THE ALGEBRA OF DEMAND, SUPPLY, AND EQUILIBRIUM

In this appendix, we show the algebraic analysis corresponding to the graphical analysis
of equilibrium, surplus and shortages, shifts in the demand and supply functions, and the
effect of an excise tax shown in this chapter.

Market Equilibrium Algebraically

To show the algebraic determination of equilibrium, we begin by expressing the market
demand curve of Figure 2.1 and the supply curve of Figure 2.3 algebraically, as follows:

QOD = 10 —4P [1]

Os DAS [2]

From equation [1], we see that if P = $2, QD = 2; if P=$1, QD = 6, and if P= $0.50,

QD = 8, as shown by demand curve D in Figure 2.1. Similarly, from equation [2], we see
that if P= $0.50, OS = 2; if P= $1, OS = 6, and if P= $2, OS = 14, as shown by sup-
ply curve S in Figure 2.3. f
To find the equilibrium price (P) we set

OD = OS (3]
52 PART ONE Introduction to Microeconomics

and get

10 —-4P = —2+ 8P
(Pies bt

Thus,

Past [4]

Substituting the equilibrium price of P=$1 either into demand equation [1] or
supply equation [2], we get the equilibrium quantity (Q) of

OD = 10—4($1)=6=Q2 [1A]

or

OS =—2 + 8($1) =6= 0 [2A]

as shown by point E in Figure 2.5.
At the nonequilibrium price of P = $1.50,

OD = 10 — 4($1.50) = 4

while

OS = —2 + 8($1.50) = 10

Thus, we would have a surplus of 6 units, as shown in Figure 2.5.

On the other hand, at P = $0.50,

QD = 10 — 4($0.50) = 8

while

OS'=—2~F 8(50 50/2

Thus, we would have a shortage of 6 units, as shown in Figure 2.5.

Shifts in Demand and Supply and in Equilibrium

The shift in the demand curve from D to D’ in Figure 2.2 can be represented
algebraically by

QD’ = 16 — 4P [5]

The new equilibrium price is determined by setting QD’ equal to OS. That is,

16 —-4P=-2+4 8P [6]
18= 12P
 CHAPTER 2 Basic Demand and Supply Analysis S)e}

Thus,

P = $1.50 [7]

and

OD’= 16 — 4($1.50) = 10 =O [SA]

or

OS = —2 + 8($1.50) =10=Q0 [2B]

as shown by equilibrium point J in Figure 2.6.

On the other hand, the shift in the supply curve from S to S’ in Figure 2.4 can be rep-
resented algebraically by

OS'=4+ 8P [3]
The new equilibrium price is determined by setting QD equal to QS’. That is,

10-4P =4+4 8P [9]

10—4P=4+48P
6 = 12P

Thus,

P = $0.50 [10]

and

QD= 10 — 4($0.50) =8=Q [1B]

or

OS' = 4 + 8($0.50) =8=Q [SA]

as shown by equilibrium point G in Figure 2.6.

The Effect of an Excise Tax

The effect of the excise tax shown by the shift of S to S’ in Figure 2.12 can be represented
algebraically by

OSt= 8 6r [11]

Setting QD equal to QS”, we get the equilibrium price of

10 —4P =—8+ 8P [12]

LS 2P
54 PART ONE Introduction to Microeconomics

Thus,

P = $1.50 [13]

and

OD = 10 4150) [1C]

or

Ke 2 es = [11A]

as shown by equilibrium point C in Figure 2.12.

At QO = 4, sellers get a net price of

OS ==2 4 8P
as I AWE [2C]
= oP
P= $0.15 [12]

as shown by point N in Figure 2.12.

For a more general and advanced algebraic analysis of demand, supply, and equilib-
rium, see Section A.11 of the Mathematical Appendix at the end of the book.

INTERNET SITE ADDRESSES

General directories and indexes of economic information are: Information on tax rates in the various States of the United
YAHOO—Economics: http://www.yahoo.com/ States is found in:
Social_Science/Economics/ http://www.taxadmin.org/fta/rate/sales.htm]
Market conditions and prices for coffee are found in: http://www.taxadmin.org/fta/rate/tax_stru.html
http://www.ico.org/coffee_prices.asp Data on the International transactions of the United States
http://www. ico.org/prices/pr.htm are found in the Bureau of Economic Analysis web site:
For agricultural policies in OECD countries, see: http://bea.gov and clicking “international data.”
http://www.oecd.org/publications/e-book/5 1011 .pdf
 PART
TWO

Dpart Two (Chapters 3-6) presents the theory iIh = O ry of

of consumer behavior and demand. Chapter 3
examines the tastes of the consumer and how the Co N S U Mm epif
consumer maximizes utility or satisfaction in spending
his or her income. These concepts are used and extended 4 eC h avi O [ a N dq
in Chapter 4 to derive the consumer’s demand curve for
a commodity. Chapter 5 shows how, by aggregating D dq
or Summing up individual consumers’ demand curves, = M d a
we get the market demand curve for the commodity.
Chapter 5 also examines in detail the measurement and
usefulness of various demand elasticities. Chapter 6
discusses consumer choices in the face of uncertainty.
Each chapter in Part Two includes an “At the Frontier”
section with some new theories or applications of
consumer behavior and demand, and Chapters 4 and 5
also have an optional appendix presenting some more
advanced topics in consumer demand theory.
 CHAPTER 3

Consumer Preferences and Choice

Chapter Outline 3—2 How Ford Decided on the Characteristics of Its
3.1 Utility Analysis Taurus
3.2 Consumer’s Tastes: Indifference Curves 3-3 Gillette Introduces the Sensor and Mach3
3.3. International Convergence of Tastes Razors—Two Truly Global Products
3.4 The Consumer’s Income and Price Constraints: 3—4 Time as a Constraint
The Budget Line 3-5 Utility Maximization and Government Warnings
3.5 Consumer’s Choice on Junk Food
3-6 Water Rationing in the West
List of Examples At the Frontier: The Theory of Revealed
3—1 Does Money Buy Happiness? Preference

After Studying This Chapter, You Should Be Able to:

e Know how consumer tastes are measured or represented
e Describe the relationship between money and happiness
e Know how the consumer’s constraints are represented
e Understand how the consumer maximizes satisfaction or reaches equilibrium
e Describe how consumer tastes or preferences can be inferred without asking the consumer

n this chapter, we begin the formal study of microeconomics by examining the eco-
nomic behavior of the consumer. A consumer is an individual or a household composed
of one or more individuals. The consumer is the basic economic unit that determines
which commodities are purchased and in what quantities. Millions of such decisions are
made each day on the more than $13 trillion worth of goods and services produced by the
American economy each year.
What guides these individual consumer decisions? Why do consumers purchase
some commodities and not others? How do they decide how much to purchase of each
commodity? What is the aim of a rational consumer in spending income? These are some
of the important questions to which we seek answers in this chapter. The theory of con-
sumer behavior and choice is the first step in the derivation of the market demand curve,
the importance of which was clearly demonstrated in Chapter 2.
We begin the study of the economic behavior of the consumer by examining tastes.
Consumers’ tastes can be related to utility concepts or indifference curves. These are

on|
58 PART TWO. Theory of Consumer Behavior and Demand

the conver-
discussed in the first two sections of the chapter. In Section 3.3, we examine
gives the con-
gence of tastes internationally. We then introduce the budget line, which
ts arise
straints or limitations consumer’s face in purchasing goods and services. Constrain
marketplace
because the commodities that the consumer wants command a price in the
line reflects
(i.e., they are not free) and the consumer has limited income. Thus, the budget
the familiar and pervasive economic fact of scarcity as it pertains to the individual con-
sumer.
Because the consumer’s wants are unlimited or, in any event, exceed his or her
ability to satisfy them all, it is important that the consumer spend income so as to max-
imize satisfaction. Thus, a model is provided to illustrate and predict how a rational
consumer maximizes satisfaction, given his or her tastes (indifference curves) and the
constraints that the consumer faces (the budget line). The “At the Frontier” section pre-
sents a different way to examine consumer tastes and derive a consumer’s indifference
curves.
The several real-world examples and important applications presented in the chapter
demonstrate the relevance and usefulness of the theory of consumer behavior and choice.

3.1 UTILITY ANALYSIS

In this section, we discuss the meaning of utility, distinguish between total utility and
marginal utility, and examine the important difference between cardinal and ordinal util-
ity. The concept of utility is used here to introduce the consumer’s tastes. The analysis of
consumer tastes is a crucial step in determining how a consumer maximizes satisfaction
in spending income.

Total and Marginal Utility

Utility The ability of a
good to satisfy a want. Goods are desired because of their ability to satisfy human wants. The property of a good
that enables it to satisfy human wants is called utility. As individuals consume more of a
good per time period, their total utility (TU) or satisfaction increases, but their marginal
Total utility (TU)
The total satisfaction
utility diminishes. Marginal utility (MU) is the extra utility received from consuming
received from one additional unit of the good per unit of time while holding constant the quantity con-
consuming a good sumed of all other commodities.
or service. For example, Table 3.1 indicates that one hamburger per day (or, more generally, one
unit of good X per period of time) gives the consumer a total utility (TU) of 10 utils, where
Marginal utility (WU)
The extra utility received
a util is an arbitrary unit of utility. Total utility increases with each additional hamburger
from consuming one consumed until the fifth one, which leaves total utility unchanged. This is the saturation
additional unit of a point. Consuming the sixth hamburger then leads to a decline in total utility because of
good. storage or disposal problems.!' The third column of Table 3.1 gives the extra or marginal
utility resulting from the consumption of each additional hamburger. Marginal utility is
Util The arbitrary unit
of measure of utility.
positive but declines until the fifth hamburger, for which it is zero, and becomes negative
for the sixth hamburger.

Phat is, some effort

iy ' ee . nye
(disutility), no matter how small, is
. one . .
required to get rid of the sixth hamburger. Assuming
. o

that the individual cannot sell the sixth hamburger, he or she would not want it even
for ines.
 CHAPTER 3 Consumer Preferences and Choice 59

TABLE 311| Total and Marginal Utility

Qy TUy MUy

0 0
I 10 10
2 16 6
3 20 4
4 22 2
3) 22 0
6 20 —2

Total
utility
X
of

0 i 2 3 es: 5 6 Qy
Quantity of X

MUy

FIGURE 3.1 Total and Marginal Utility In the top panel,

total utility (TU) increases by smaller and smaller amounts (the
shaded areas) and so the marginal utility (MU) in the bottom
panel declines. 7U remains unchanged with the consumption of Marginal
utility
X
of
the fifth hamburger, and so MU is zero. After the fifth hamburger Qx
per day, 7U declines and MU Is negative. MUx

Plotting the values given in Table 3.1, we obtain Figure 3.1, with the top panel
showing total utility and the bottom panel showing marginal utility. The total and marginal
utility curves are obtained by joining the midpoints of the bars measuring TU and MU at
each level of consumption. Note that the TU rises by smaller and smaller amounts (the
shaded areas) and so the MU declines. The consumer reaches saturation after consuming
60 PART TWO. Theory of Consumer Behavior and Demand

of the fifth
the fourth hamburger. Thus, TU remains unchanged with the consumption
zero. After the fifth hamburger , TU declines and so MU is negative.
hamburger and MU is
downward- to-the-ri ght inclinatio n of the MU curve reflects the law
Law of diminishing The negative slope or
marginal utility Each of diminishing marginal utility.
additional unit of a good Utility schedules reflect tastes of a particular individual; that is, they are unique to
eventually gives less and
the individual and reflect his or her own particular subjective preferences and percep-
tions. Different individuals may have different tastes and different utility schedules.
less extra utility.

Utility schedules remain unchanged so long as the individual’s tastes remain the same.

Concept Check
What is the relationship Cardinal or Ordinal Utility?
between diminishing
marginal utility and the The concept of utility discussed in the previous section was introduced at about the same
law of demand? time, in the early 1870s, by William Stanley Jevons of Great Britain, Carl Menger of
Austria, and Léon Walras of France. They believed that the utility an individual receives
from consuming each quantity of a good or basket of goods could be measured cardinally
just like weight, height, or temperature.”
Cardinal utility An Cardinal utility means that an individual can attach specific values or numbers of
actual measure of utils from consuming each quantity of a good or basket of goods. In Table 3.1 we saw
utility, in util. that the individual received 10 utils from consuming one hamburger. He received 16
utils, or 6 additional utils, from consuming two hamburgers. The consumption of the
third hamburger gave this individual 4 extra utils, or two-thirds as many extra utils, as
the second hamburger. Thus, Table 3.1 and Figure 3.1 reflect cardinal utility. They actu-
ally provide an index of satisfaction for the individual.
Ordinal utility The In contrast, ordinal utility only ranks the utility received from consuming
rankings of the utility various amounts of a good or baskets of goods. Ordinal utility specifies that con-
received from
suming two hamburgers gives the individual more utility than when consuming
consuming various
one hamburger, but it does not specify exactly how much additional utility the sec-
amounts of a good.
ond hamburger provides. Similarly, ordinal utility would say only that three ham-
burgers give this individual more utility than two hamburgers, but not how many
more utils.?
Ordinal utility is a much weaker notion than cardinal utility because it only
requires that the consumer be able to rank baskets of goods in the order of his or her
preference. That is, when presented with a choice between any two baskets of goods,
ordinal utility requires only that the individual indicate if he or she prefers the first bas-
ket, the second basket, or is indifferent between the two. It does not require that the
individual specify how many more utils he or she receives from the preferred basket. Jn
short, ordinal utility only ranks various consumption bundles, whereas cardinal utility
provides an actual index or measure ofsatisfaction.

* A market basket of goods can be defined as containing specific quantities of various goods and services.
For
example, one basket may contain one hamburger, one soft drink, and a ticket to a ball game, while another
basket may contain two soft drinks and two movie tickets.
* To be sure, numerical values could be attached to the utility received by the individual from
consuming
various hamburgers, even with ordinal utility. However, with ordinal utility, higher utility
values only
indicate higher rankings of utility, and no importance can be attached to actual numerical differences
in
utility. For example, 20 utils can only be interpreted as giving more utility than
10 utils, but not twice as
much. Thus, to indicate rising utility rankings, numbers such as 5, 10, 20: 8, 15, 17;
or I (lowest), II, and II
are equivalent.
 CHAPTER 3 Consumer Preferences and Choice 61

The distinction between cardinal and ordinal utility is important because a theory
Concept Check of consumer behavior can be developed on the weaker assumption of ordinal utility
What is the distinction without the need for a cardinal measure. And a theory that reaches the same conclusion
between cardinal and as another on weaker assumptions is a superior theory.’ Utility theory provides a con-
ordinal utility?
venient introduction to the analysis of consumer tastes and to the more rigorous indif-
ference curve approach. It is also useful for the analysis of consumer choices in the face
of uncertainty, which is presented in Chapter 6. Example 3-1 examines the relationship
between money income and happiness.

EXAMPLE 3-1
Does Money Buy Happiness?

Does money buy happiness? Philosophers have long pondered this question.
Economists have now gotten involved in trying to answer this age-old question. They
calculated the “mean happiness rating” (based on a score of “very happy” = 4,
“pretty happy” = 2, and “not too happy” = 0) for individuals at different levels of per-
sonal income at a given point in time and for different nations over time. What they
found was that up to an income per capita of about $20,000, higher incomes in the
United States were positively correlated with happiness responses, but that after that,
higher incomes had little, if any, effect on observed happiness. Furthermore, average
individual happiness in the United States remained remarkably flat since the 1950s in
the face of a considerable increase in average income. Similar results were found for
other advanced nations, such as the United Kingdom, France, Germany, and Japan.
These results seem to go counter to the basic economic assumption that higher per-
sonal income leads to higher utility.
Two explanations are given for these remarkable and puzzling results: (1) that
happiness is based on relative rather than absolute income and (2) that happiness
quickly adapts to changes in the level of income. Specifically, higher incomes make
individuals happier for a while, but their effect fades very quickly as individuals adjust
to the higher income and soon take it for granted. For example, a generation ago, cen-
tral heating was regarded as a luxury, while today it is viewed as essential.
Furthermore, as individuals become richer, they become happier, but when society as
a whole grows richer, nobody seems happier. In other words, people are often more
concerned about their income relative to others’ than about their absolute income.
Pleasure at your own pay rise can vanish when you learn that a colleague has been
given a similar pay increase.
The implication of all of this is that people’s effort to work more in order to earn
Concept Check and spend more in advanced (rich) societies does not make people any happier because
How much money do others do the same. (In poor countries, higher incomes do make people happier).
you need to be happy? Lower taxes in the United States encourage people to work more and the nation to
grow faster than in Europe, but this does not necessarily make Americans happier than

4 This is like producing a given output with fewer or cheaper inputs, or achieving the same medical result
(such as control of high blood pressure) with less or weaker medication.
62 PART TWO. Theory of Consumer Behavior and Demand

earning enough to
Europeans. The consensus among happiness researchers is that after
and com-
satisfy basic wants (a per capita income of about $20,000), family, friends,
munity tend to be the most important things in life.
B. S. Frey and A.
Sources: R. A. Easterlin, “Income and Happiness,” Economic Journal, July 2000;
Research?,” Journal of Economic Literature, June
Stutzer, “What Can Economists Learn from Happiness
R. Layard, Happiness: Lessons from a New Science (London: Penguin, 2005); R. Di Tella and
2002;
2006,
R. MacCulloch, “Some Uses of Happiness Data, Journal of Economic Perspectives, Winter
and Utility:
pp. 25-46; and A. E. Clark, P. Frijters, and M. A. Shields, “Relative Income, Happiness,
March
An Explanation for the Easterlin Paradox and Other Puzzles.” Journal of Economic Literature,
2008, pp. 95-144.

3.2 CONSUMER’S TASTES: INDIFFERENCE CURVES

In this section, we define indifference curves and examine their characteristics.

Indifference curves were first introduced by the English economist F. Y. Edgeworth in the
1880s. The concept was refined and used extensively by the Italian economist Vilfredo
Pareto in the early 1900s. Indifference curves were popularized and greatly extended in
application in the 1930s by two other English economists: R. G. D. Allen and John R.
Hicks. Indifference curves are a crucial tool of analysis because they are used to represent
an ordinal measure of the tastes and preferences of the consumer and to show how the
consumer maximizes utility in spending income.

Indifference Curves—What Do They Show?”

Consumers’ tastes can be examined with ordinal utility. An ordinal measure of utility is
based on three assumptions. First, we assume that when faced with any two baskets of
goods, the consumer can determine whether he or she prefers basket A to basket B, B to A,
or whether he or she is indifferent between the two. Second, we assume that the tastes of
the consumer are consistent or transitive. That is, if the consumer states that he or she
prefers basket A to basket B and also that he or she prefers basket B to basket C, then that
consumer will prefer A to C. Third, we assume that more of a commodity is preferred to
Good A commodity of less; that is, we assume that the commodity is a good rather than a bad, and the consumer
which more is preferred is never satiated with the commodity.° The three assumptions can be used to represent an
to less.
individual’s tastes with indifference curves. In order to conduct the analysis by plane
geometry, we will assume throughout that there are only two goods, X and Y,
Bad An item of which An indifference curve shows the various combinations of two goods that give the
less is preferred to more. consumer equal utility or satisfaction. A higher indifference curve refers to a higher level
of satisfaction, and a lower indifference curve refers to less satisfaction. However, we
Indifference curve have no indication as to how much additional satisfaction or utility a higher indifference
The curve showing the curve indicates. That is, different indifference curves simply provide an ordering or rank-
various combinations of
ing of the individual’s preference.
two commodities that
give the consumer
equal satisfaction.
For a mathematical presentation of indifference curves and their characteristics using rudimentary calculus,
see Section A.1 of the Mathematical Appendix at the end of the book.
6 >
Examples of bads are pollution, garbage, and disease,
. . > . .
of which less is preferred to more.
>
 CHAPTER 3. Consumer Preferences and Choice 63

For example, Table 3.2 gives an indifference schedule showing the various combina-
tions of hamburgers (good X) and soft drinks (good Y) that give the consumer equal sat-
isfaction. This information is plotted as indifference curve U, in the left panel of Figure 3.2.
The right panel repeats indifference curve U; along with a higher indifference curve (U2)
and a lower one (Uo).
Indifference curve U; shows that one hamburger and ten soft drinks per unit of time
Concept Check (combination A) give the consumer the same level of satisfaction as two hamburgers and six
Are the indifference soft drinks (combination B), four hamburgers and three soft drinks (combination C), or
curves of various seven hamburgers and one soft drink (combination F’). On the other hand, combination R
individuals the same? (four hamburgers and seven soft drinks) has both more hamburgers and more soft drinks
than combination B (see the right panel of Figure 3.2), and so it refers to a higher level of
satisfaction. Thus, combination R and all the other combinations that give the same level of
satisfaction as combination R define higher indifference curve U>. Finally, all combinations

TABLE 3.2| Indifference Schedule

Hamburgers (X) Soft Drinks (Y) | Combinations

] |
2
4
a Re
SO
WA AAw>

Soft drinks ( Y ) Qy
per unit
of time

of
YQuantity

NI
OTM
B®
oo
rn
©

arene | ee ae
‘ie eee | 7 Oy
ik eard
Hamburgers (X) per unit of time Quantity of X

FIGURE 3.2. Indifference Curves The individual is indifferent among combinations A, B, C, and F
since they all lie on indifference curve U;. U; refers to a higher level of satisfaction than Up, but to a
lower level than Up.
64 PART TWO Theory of Consumer Behavior and Demand

on Up give the same satisfaction as combination T, and combination T refers to both fewer
hamburgers and fewer soft drinks than (and therefore is inferior to) combination B on U.
Although in Figure 3.2 we have drawn only three indifference curves, there is an
indifference curve going through each point in the XY plane (i.e., referring to each possi-
ble combination of good X and good Y). That is, between any two indifference curves, an
additional curve can always be drawn. The entire set of indifference curves is called an
Indifference map indifference map and reflects the entire set of tastes and preferences of the consumer.
The entire set of
indifference curves
reflecting the Characteristics of Indifference Curves
consumer’s tastes
Indifference curves are usually negatively sloped, cannot intersect, and are convex to the
and preferences.
origin (see Figure 3.2). Indifference curves are negatively sloped because if one basket of
goods X and Y contains more of X, it will have to contain less of Y than another basket in
order for the two baskets to give the same level of satisfaction and be on the same indiffer-
ence curve. For example, since basket B on indifference curve Uj in Figure 3.2 contains
more hamburgers (good X) than basketA, basket B must contain fewer soft drinks (good Y )
for the consumer to be on indifference curve U}.
A positively sloped curve would indicate that one basket containing more of both
commodities gives the same utility or satisfaction to the consumer as another basket con-
Concept Check taining less of both commodities (and no other commodity). Because we are dealing with
Why are indifference goods rather than bads, such a curve could not possibly be an indifference curve. For
curves negatively example, in the left panel of Figure 3.3, combination B’ contains more of X and more of Y
sloped? than combination A’, and so the positively sloped curve on which B’ and A’ lie cannot be an
indifference curve. That is, B’ must be on a higher indifference curve than A’ if X and Y are
both goods.’

Qy Qy

2
=oa 6eae
oe
= ee=. RA
5 ei
=) | 3 [
Opals =

eee
0 Qx 0 Qx
Quantity of X Quantity of X
FIGURE 3.3 Indifference Curves Cannot Be Positively Sloped or Intersect
In the left panel, the positively sloped curve cannot be an indifference curve because
it
shows that combination B”, which contains more of X and Y than combination A’, gives
equal satisfaction to the consumer as A’. In the right panel, since C* is on curves
1 and 2,
it should give the same satisfaction as A* and B*, but this is impossible because
B* has
more of X and Y than A* Thus, indifference curves cannot intersect.

7 Only if either X or Y were a bad would the indifference curve be

Fine 33, p ositively y slopedsloped as i the left panel of
as in
 CHAPTER 3 Consumer Preferences and Choice 65

Indifference curves also cannot intersect. Intersecting curves are inconsistent with
the definition of indifference curves. For example, if curve | and curve 2 in the right
panel of Figure 3.3 were indifference curves, they would indicate that basket A*
is equivalent to basket C* since both A* and C* are on curve 1, and also that basket
B* is equivalent to basket C* since both B* and C* are on curve 2. By transitivity, B*
should then be equivalent to A*. However, this is impossible because basket B* con-
tains more of both good X and good Y than basket A*. Thus, indifference curves cannot
intersect.
Indifference curves are usually convex to the origin; that is, they lie above any tan-
gent to the curve. Convexity results trom or is a reflection of a decreasing marginal rate
of substitution, which is discussed next.

The Marginal Rate of Substitution

Marginal rate of The marginal rate of substitution (VRS) refers to the amount of one good that an indi-
substitution (MRS) vidual is willing to give up for an additional unit of another good while maintaining the
The amount of a good
same level of satisfaction or remaining on the same indifference curve. For example, the
that a consumer is
marginal rate of substitution of good X for good Y (MRSyy) refers to the amount of Y that
willing to give up for an
additional unit of the individual is willing to exchange per unit of X and maintain the same level of satisfac-
another good while tion. Note that MRSyy measures the downward vertical distance (the amount of Y that the
remaining on the same individual is willing to give up) per unit of horizontal distance (i.e., per additional unit of X
indifference curve. required) to remain on the same indifference curve. That is, MRSyy = —AY/AX. Because
of the reduction in Y, MRSyy is negative. However, we multiply by —1 and express MRSyy
as a positive value.
For example, starting at point A on U, in Figure 3.4, the individual is willing to give
up four units of Y for one additional unit ofX and reach point B on U;. Thus, MRSyy =
—(—4/1) = 4. This is the absolute (or positive value of the) slope of the chord from point
A to point B on U;. Between pointB and point C on U;, MRSxy = 3/2 = 1.5 (the absolute
slope of chord BC).Between points C and F, MRSxy = 2/3 = 0.67. At a particular point
on the indifference curve, MRSyy is given by the absolute slope of the tangent to the indif-
ference curve at that point. Different individuals usually have different indifference
curves and different MRSyy (at points where their indifference curves have different
slopes).
We can relate indifference curves to the preceding utility analysis by pointing out that
all combinations of goods X and Y on a given indifference curve refer to the same level of
total utility for the individual. Thus, for a movement down a given indifference curve, the
gain in utility in consuming more of good X must be equal to the loss in utility in con-
suming less of good Y. Specifically, the increase in consumption of good X (AX) times the
marginal utility that the individual receives from consuming each additional unit of X
(MUx) must be equal to the reduction in Y (—AY) times the marginal utility of Y(MUy).
That is,

(AX)(MUx) = —(AY)(MUy) [3.1]

so that

MUy/MUy= —AY/AX = MRSyy S23]

Thus, MRSyy is equal to the absolute slope of the indifference curve and to the ratio of the
marginal utilities.
66 PART TWO Theory of Consumer Behavior and Demand

Qy

of
Quantity
Y

FIGURE 3.4 Marginal Rate of Substitution (MRS) Starting at

point A, the individual is willing to give up 4 units of Y for one
additional unit of X and reach point B on U;. Thus, MRSyy = 4 (the
absolute slope of chord AB). Between points B and C, MRSyy =
3/2. Between C and F, MRSyy = 2/3. MRSyy declines as the Qx
individual moves down the indifference curve. Quantity of X

Note that MRSvyy (i.e., the absolute slope of the indifference curve) declines as we
move down the indifference curve. This follows from, or is a reflection of, the convexity
of the indifference curve. That is, as the individual moves down an indifference curve and
is left with less and less Y(say, soft drinks) and more and more X (say, hamburgers), each
remaining unit of Y becomes more valuable to the individual and each additional unit of
X becomes less valuable. Thus, the individual is willing to give up less and less of Y to
obtain each additional unit of X. It is this property that makes MRSyy diminish and indif-
ference curves convex to the origin. We will see in Section 3.5 the crucial role that con-
vexity plays in consumer utility maximization.®

Some Special Types of Indifference Curves

Although indifference curves are usually negatively sloped and convex to the origin,
they may sometimes assume other shapes, as shown in Figure 3.5. Horizontal indiffer-
ence curves, as in the top left panel of Figure 3.5, would indicate that commodity X is
aneuter; that is, the consumer is indifferent between having more or less of the
commodity. Vertical indifference curves, as in the top right panel of Figure 3.5, would
indicate instead that commodity Y is a neuter.
The bottom left panel of figure 3.5 shows indifference curves that are negatively
sloped straight lines. Here, MRSyy or the absolute slope of the indifference curves is con-
stant. This means that an individual is always willing to give up the same amount of good
Y (say, two cups of tea) for each additional unit of good X (one cup of coffee). Therefore,
good X and two units of good Y are perfect substitutes for this individual.

A movement along an indifference curve in the upward direction measures MRSyy, which
also diminishes.
 CHAPTER 3 Consumer Preferences and Choice 67

& Ry iy ol Wes
6 us 6L
4 ¢———_o—__2-—____¢ _. U; 4

2 7S ee 2
| | |
0 Zz 4 6 Qy 0 9 4 6 On

Q) Qy

gl

6L

Al

pie
| er Ui Me
Cie e oe toro: Oe
FIGURE 3.5 Some Unusual Indifference Curves Horizontal indifference curves,
as in the top left panel, indicate thatX is a neuter; that is, the consumer is indifferent
between having more or less of it. Vertical indifference curves, as in the top right
panel, would indicate instead that commodity Y is a neuter. Indifference curves that
are negatively sloped straight lines, as in the bottom left panel, indicate that MRSyy is
constant, and so X and Yare perfect substitutes for the individual. The bottom right
panel shows indifference curves that are concave to the origin (i.e., MRSyy increases).

Finally, the bottom right panel shows indifference curves that are concave rather than
convex to the origin. This means that the individual is willing to give up more and more
units of good Y for each additional unit of X (i.e., MRSyy increases). For example,
between points A and B on U,, MRSxy = 2/2 = 1; between B and C, MRSyy = 3/1 = 3;
and between C and F, MRSyy = 3/0.5 = 6. In Section 3.5, we will see that in this unusual
case, the individual would end up consuming only good X or only good Y.
Even though indifference curves can assume any of the shapes shown in Figure 3.5,
they are usually negatively sloped, nonintersecting, and convex to the origin. These char-
acteristics have been confirmed experimentally.’ Because it is difficult to derive indiffer-
ence curves experimentally, however, firms try to determine consumers’ preferences by
marketing studies, as explained in Example 3-2.

° See, for example, K. R. MacCrimmon and M. Toda, “The Experimental Determination of Indifference
Curves,” Review of Economic Studies, October 1969.
68 PART TWO Theory of Consumer Behavior and Demand

EXAMPLE 3-2
How Ford Decided on the Characteristics of Its Taurus

Firms can learn about consumers’ preferences by conducting or commissioning mar-

keting studies to identify the most important characteristics of a product, say, styling and
performance for automobiles, and to determine how much more consumers would be
willing to pay to have more of each attribute, or how they would trade off more of one
attribute for less of another. This approach to consumer demand theory, which focuses
on the characteristics or attributes of goods and on their worth or hedonic prices rather
than on the goods themselves, was pioneered by Kelvin Lancaster (see “At the Frontier”
in Chapter 4). This is in fact how the Ford Motor Company decided on the characteris-
tics of its 1986 Taurus.
Specifically, Ford determined by marketing research that the two most important
characteristics of an automobile for the majority of consumers were styling (i.e.,
design and interior features) and performance (i.e., acceleration and handling) and
then produced its Taurus in 1986 that incorporated those characteristics. The rest is
history (the Taurus regained in 1992 its status of the best-selling car in America—a
position that it had lost to the Honda Accord in 1989). Ford also used this approach to
decide on the characteristics of the all-new 1996 Taurus, the first major overhaul since
its 1986 launch, at a cost of $2.8 billion, as well as in deciding the characteristics of its
world cars, Focus, launched in 1998, the Mondeo introduced in 2000, and the new
Fiesta in Europe in 2008 and in the United States in 2010. Other automakers, such as
General Motors, followed similar procedures in determining the characteristics of
their automobiles. Since then U.S. automakers have shifted somewhat toward produc-
ing “sports wagons,” which are a cross between sedans and sport-utility vehicles
(SUVs) to reflect recent changes in consumer tastes, and toward more fuel-efficient
and “green” automobiles as a result of the sharp increase in gasoline prices and height-
ened environmental concerns.
Market studies can also be used to determine how consumers’ tastes have changed
over time. In terms of indifference curves, a reduction in the consumer’s taste for com-
modity X (hamburgers) in relation to commodity Y (soft drinks) would be reflected in
a flattening of the indifference curve of Figure 3.4, indicating that the consumer would
now be willing to give up less of Y for each additional unit of X. The different tastes of
different consumers are also reflected in the shapes of their indifference curves. The
consumer who prefers soft drinks to hamburgers will have a flatter indifferences curve
than a consumer who does not.
Sources: “Ford Puts Its Future on the Line,” New York Times Magazine, December 4, 1985, pp. 94-110;
V. Bajic, “Automobiles and Implicit Markets: An Estimate of a Structural Demand Model for Automobile
Characteristics,” Applied Economics, April 1993, pp. 541-551; “Ford Hopes Its New Focus Will Be a
Global Best Seller,’ Wall Street Journal, October 8, 1998, p. B10; S. Berry, J. Levinsohn, and A. Pakes,
“Differentiated Products Demand Systems from a Combination of Macro and Micro Data: The New Car
Market,” National Bureau of Economic Research, Working Paper 648], March 1998: and “Ford’s Taurus
Loses Favor to New-Age Sport Wagon,” New York Times, February 7, 2002, p. B1; “Once Frumpy, Green
Cars Start Showing Some Flash,” New York Times, July 15, 2007, p. 13; “Ford Eyes More Cuts,
as
Recovery Advances,” Wall Street Journal, April 23, 2008, p. Al; and “One World, One Car,
One Name,”
Business Week, March 24, 2008, p. 63.
 CHAPTER 3 Consumer Preferences and Choice 69

INTERNATIONAL CONVERGENCE OF TASTES

A rapid convergence of tastes is taking place in the world today. Tastes in the United
States affect tastes around the world and tastes abroad strongly influence tastes in the
United States. Coca-Cola and jeans are only two of the most obvious U.S. products that
have become household items around the world. One can see Adidas sneakers and
Walkman personal stereos on joggers from Central Park in New York City to Tivoli
Gardens in Copenhagen. You can eat Big Macs in Piazza di Spagna in Rome or Pushkin
Square in Moscow. We find Japanese cars and VCRs in New York and in New Delhi,
French perfumes in Paris and in Cairo, and Perrier in practically every major (and not so
major) city around the world. Texas Instruments and Canon calculators, Dell and Hitachi
portable PCs, and Xerox and Minolta copiers are found in offices and homes more or less
everywhere. With more rapid cominunications and more frequent travel, the worldwide
convergence of tastes has even accelerated. This has greatly expanded our range of con-
sumer choices and forced producers to think in terms of global production and marketing
to remain competitive in today’s rapidly shrinking world.
In his 1983 article “The Globalization of Markets” in the Harvard Business Review,
Theodore Levitt asserted that consumers from New York to Frankfurt to Tokyo want sim-
ilar products and that success for producers in the future would require more and more
standardized products and pricing around the world. In fact, in country after country, we
are seeing the emergence of a middle-class consumer lifestyle based on a taste for com-
fort, convenience, and speed. In the food business, this means packaged, fast-to-prepare,
and ready-to-eat products. Market researchers have discovered that similarities in living
styles among middle-class people all over the world are much greater than we once
thought and are growing with rising incomes and education levels. Of course, some dif-
ferences in tastes will always remain among people of different nations, but with the
tremendous improvement in telecommunications, transportation, and travel, the cross-
fertilization of cultures and convergence of tastes can only be expected to accelerate. This
trend has important implications for consumers, producers, and sellers of an increasing
number and types of products and services.

EXAMPLE 3-3
Gillette Introduces the Sensor and Mach3 Razors—Two Truly
Global Products

As tastes become global, firms are responding more and more with truly global
products. These are introduced more or less simultaneously in most countries of the
world with little or no local variation. This is leading to what has been aptly called
the “global supermarket.” For example, in 1990, Gillette introduced its new Sensor
Razor at the same time in most nations of the world and advertised it with virtually
the same TV spots (ad campaign) in 19 countries in Europe and North America.
In 1994, Gillette introduced an upgrade of the Sensor Razor called SensorExcell
70 PART TWO. Theory of Consumer Behavior and Demand

with a high-tech edge. By 1998, Gillette had sold over 400 million of Sensor and
SensorExcell razors and more than 8 billion twin-blade cartridges, and it had captured
an incredible 71% of the global blade market. Then in April 1998, Gillette unveiled
the Mach3, the company’s most important new product since the Sensor. It has three
blades with a new revolutionary edge produced with chipmaking technology that
took five years to develop. Gillette developed its new razor in stealth secrecy at the
astounding cost of over $750 million, and spent another $300 million to advertise it.
Since it went on sale in July 1998, the Mach3 has proven to be an even greater suc-
cess than the Sensor Razor. Gillette introduced the Mach3 Turbo Razor worldwide
in April 2002, in June 2004 its M3Power Razor, as an evolution of its Mach 3, and
its five-blade Fusion in early 2006. With the merger of Gillette and Procter &
Gamble, the global reach of the M3Power and Fusion are likely to be even greater
Concept Check than for its predecessors.
Why are tastes The trend toward the global supermarket is rapidly spreading in Europe as bor-
converging ders fade and as Europe’s single currency (the euro) brings prices closer across the
internationally? continent. A growing number of companies are creating “Euro-brands”—a single
product for most countries of Europe—and advertising them with “Euro-ads,” which
are identical or nearly identical across countries, except for language. Many national
differences in taste will, of course, remain; for example, Nestlé markets more than
200 blends of Nescafé to cater to differences in tastes in different markets. But the
converging trend in tastes around the world is unmistakable and is likely to lead to
more and more global products. This is true not only in foods and inexpensive con-
sumer products but also in automobiles, tires, portable computers, phones, and many
other durable products.
Sources: “Building the Global Supermarket,’ New York Times, November 18, 1988, p. D1; “Gillette's
World View: One Blade Fits All,” Wall Street Journal, January 3, 1994, p. C3; “Gillette Finally Reveals
Its Vision of the Future, and it Has 3 Blades,” Wall Street Journal, April 4, 1998, p. Al; “Gillette,
Defying Economy, Introduces a $9 Razor Set,” New York Times, October 31, 2001, p. C4; “Selling in
Europe: Borders Fade,’ New York Times, May 31, 1990, p. D1; “Converging Prices Mean Trouble for
European Retailers,” Financial Times, June 18, 1999, p. 27; “Can Nestlé Be the Very Best?,” Fortune,
November 13, 2001, pp. 353-360; “For Cutting-Edge Dads,” US News & World Report, June 14, 2004,
pp. 80-81; “P&G’s $57 Billion Bargain,” BusinessWeek, July 25, 2005, p. 26; and “How Many Blades
Is Enough?” Fortune, October 31, 2005, p. 40; and “Gillette New Edge,” Business Week, February 6,
2006, p. 44.

THE CONSUMER’S INCOME AND PRICE CONSTRAINTS:

3.4 THE BUDGET LINE

In this section, we introduce the constraints or limitations faced by a consumer in satis-

fying his or her wants. In order to conduct the analysis by plane geometry, we assume
that the consumer spends all of his or her income on only two goods, X and Y. We will
see that the constraints of the consumer can then be represented by a line called the bud-
get line. The position of the budget line and changes in it can best be understoo
d by
looking at its endpoints.
 CHAPTER 3 Consumer Preferences and Choice W\

Definition of the Budget Line

In Section 3.2, we saw that we can represent a consumer’s tastes with an indifference
map. We now introduce the constraints or limitations that a consumer faces in attempting
to satisfy his or her wants. The amount of goods that a consumer can purchase over a
given period of time is limited by the consumer’s income and by the prices of the goods
that he or she must pay. In what follows we assume (realistically) that the consumer can-
not affect the price of the goods he or she purchases. In economics jargon, we say that the
Budget constraint consumer faces a budget constraint due to his or her limited income and the given prices
The limitation on the of goods.
amount of goods that a
By assuming that a consumer spends all of his or her income on good X (ham-
consumer can purchase
burgers) and on good Y (soft drinks), we can express the budget constraint as
imposed by his or her
limited income and the
prices of the goods. PyOy + PyOy=I 33)

where Px is the price of good X, Qy is the quantity of good X, Py is the price of good Y,
Qy is the quantity of good Y, and / is the consumer’s money income. Equation [3.3] pos-
tulates that the price ofX times the quantity ofX plus the price of Y times the quantity of
Y equals the consumer’s money income. That is, the amount of money spent on X plus
the amount spent on Y equals the consumer’s income.!°
Suppose that Py = $2, Py = $1, and / = $10 per unit of time. This could, for exam-
ple, be the situation of a student who has $10 per day to spend on snacks of hamburgers
(good X) priced at $2 each and on soft drinks (good Y) priced at $1 each. By spending all
income on Y, the consumer could purchase 10Y and OX. This defines endpoint J on the
vertical axis of Figure 3.6. Alternatively, by spending all income on X, the consumer
could purchase 5X and OY. This defines endpoint K on the horizontal axis. By joining end-
Budget line A line points J and K with a straight line we get the consumer’s budget line. This line shows the
showing the various various combinations ofX and Y that the consumer can purchase by spending all income
combinations of two at the given prices of the two goods. For example, starting at endpoint /, the consumer
goods that a consumer could give up two units of Y and use the $2 not spent on Y to purchase the first unit of X
can purchase by
and reach point L. By giving up another 2Y, he or she could purchase the second unit of
spending all income.
X. The slope of —2 of budget line JK shows that for each 2Y the consumer gives up, he or
she can purchase 1X more.
By rearranging equation [3.3], we can express the consumer’s budget constraint in a
different and more useful form, as follows. By subtracting the term P,Qy from both sides
of equation [3.3] we get

PyQy =I — PxQx [3.3A]

By then dividing both sides of equation [3.3A] by Py, we isolate Qy on the left-hand side
and define equation [3.4]:

Oy= I/Py— (Px/Py)Qx [3.4]

!0 Equation [3.3] could be generalized to deal with any number of goods. However, as pointed out, we deal
with only two goods for purposes of diagrammatic analysis.
We PART TWO Theory of Consumer Behavior and Demand

of
Quantity
Y
FIGURE 3.6 The Budget Line With an income of /= oa
$10, and Py = $1 and Py = $2, we get budget line JK. This 9
shows that the consumer can purchase 1OY and OX(endpoint oN
(point B), or... OY and 5X
J), 8Y and 1X (pointL),6Y and 2X = = BE
(endpoint kK). l/Py= $10/$1 = 10 is the vertical or Y-intercept 12 45 Qx
of the budget line and —P,/Py = —$2/$1 = —2 is the slope. Quantity of X

The first term on the right-hand side of equation [3.4] is the vertical or Y-intercept of the
budget line and —Py/Py is the slope of the budget line. For example, continuing to use Py
= $2, Py = $1, and [= $10, we get J /Py = 10 for the Y-intercept (endpoint J in Figure
3.6) and —Px/Py = —2 for the slope of the budget line. The slope of the budget line refers
to the rate at which the two goods can be exchanged for one another in the market (i.e., 2Y
for 1X).
The consumer can purchase any combination of X and Y on the budget line or in the
shaded area below the budget line (called budget space). For example, at point B the indi-
vidual would spend $4 to purchase 2X and the remaining $6 to purchase 6Y. At point M,
he or she would spend $8 to purchase 4X and the remaining $2 to purchase 2Y. On the
other hand, at a point such as H in the shaded area below the budget line (i.e., in the bud-
get space), the individual would spend $4 to purchase 2X and $3 to purchase 3Y and be
left with $3 of unspent income. In what follows, we assume that the consumer does spend
all of his or her income and is on the budget line. Because of the income and price con-
straints, the consumer cannot reach combinations of X and Y above the budget line. For
example, the individual cannot purchase combination G (4X, 6Y) because it requires an
expenditure of $14 ($8 to purchase 4X plus $6 to purchase 6Y).

Changes in Income and Prices and the Budget Line

A particular budget line refers to a specific level of the consumer’s income and specific
prices of the two goods. If the consumer’s income and/or the price of good X or good Y
change, the budget line will also change. When only the consumer’s income changes, the
budget line will shift up if income (/) rises and down if / falls, but the slope of the budget
line remains unchanged. For example, the left panel of Figure 3.7 shows budget line JK
(the same as in Figure 3.6 with J = $10), higher budget line J’K’ with J = $15, and still
higher budget line J”K” with J = $20 per day. Py and Py do not change, so the three bud-
get lines are parallel and their slopes are equal. If the consumer’s income falls, the bud-
get line shifts down but remains parallel.
 CHAPTER 3 Consumer Preferences and Choice 73

If only the price of good X changes, the vertical or Y-intercept remains unchanged,
and the budget line rotates upward or counterclockwise if Py falls and downward or
clockwise if Py rises. For example, the right panel of Figure 3.7 shows budget line JK (the
same as in Figure 3.6 at Py = $2), budget line JK” with Py = $1, and budget line JN’ with
Py = $0.50. The vertical intercept (endpoint J) remains the same because / and Py do not
change. The slope of budget line JK” is —Py/Py = —$1=$1 = —1. The slope of budget
line JN’ is —1/2. With an increase in Py, the budget line rotates clockwise and becomes
steeper.
On the other hand, if only the price of Y changes, the horizontal or X-intercept will
Concept Check be the same, but the budget line will rotate upward if Py falls and downward if Py rises.
What happens to the For example, with J = $10, Py = $2, and Py = $0.50 (rather than Py = $1), the new ver-
budget line if the price tical or Y-intercept is Qy = 20 and the slope of the new budget line is —Py /Py = —4.
of Y falls more than the With Py = $2, the new Y-intercept is Qy = 5 and —Py=Py = —1 (you should be able to
price of X? sketch these lines). Finally, with a proportionate reduction in Py and Py and constant J,
there will be a parallel upward shift in the budget line; with a proportionate increase in
Py and Py and constant J, there will be a parallel downward shift in the budget line.
Example 3—4 shows that time, instead of the consumer’s income, can be a constraint.

0 5 alt awk Oral) 900 5 10 20 Qx

FIGURE 3.7. Changes in the Budget Line The left panel shows budget line JK (the same as in Figure 3.6
and
with /= $10), higher budget lineJ’k’ with / = $15, and still higher budget line J"K" with | = $20 per day. Py
panel shows budget
Py do not change, so the three budget lines are parallel and their slopes are equal. The right
line JK with Py = $2, budget line JK” with Py = $1, and budget line JN” with Py = $0.50. The vertical or
and Py do not change. The slope of budget line Jk”
y-intercept (endpoint /) remains the same because income
is —Py/Py = —$1/$1 = —1, while the slope of budget line JN’ Is lis
74 PART TWO. Theory of Consumer Behavior and Demand

EXAMPLE 3-4
Time as a Constraint

In the preceding discussion of the budget line, we assumed only two constraints: the
consumers’ income and the given prices of the two goods. In the real world, con-
sumers are also likely to face a time constraint. That is, since the consumption of
goods requires time, which is also limited, time often represents another constraint
faced by consumers. This explains the increasing popularity of precooked or ready-
to-eat foods, restaurant meals delivered at home, and the use of many other time-sav-
ing goods and services. But the cost of saving time can be very expensive—thus
proving the truth of the old saying that “time is money.”
For example, the food industry is introducing more and more foods that are easy
and quick to prepare, but these foods carry with them a much higher price. A meal
that could be prepared from scratch for a few dollars might cost instead more than
$10 in its ready-to-serve variety which requires only a few minutes to heat up. More
and more people are also eating out and incurring much higher costs in order to save
the time it takes to prepare home meals. McDonald’s, Burger King, Taco Bell, and
other fast-food companies are not just selling food, but fast food, and for that cus-
tomers are willing to pay more than for the same kind of food at traditional food out-
lets, which require more waiting time. Better still, many suburbanites are increasingly
reaching for the phone, not the frying pan, at dinner time to arrange for the home
delivery of restaurant meals, adding even more to the price or cost of a meal.
Time is also a factor in considering transportation costs and access to the Internet.
You could travel from New York to Washington, D.C., by train or, in less time but at a
higher cost, by plane. Similarly, you can access the Internet with a regular but slow
telephone line or much faster, but at a higher cost, by DSL or fiber optics.
Sources: “Suburban Life in the Hectic 1990s: Dinner Delivered,’ New York Times, November 20, 1992,
p. B1; “How Much Will People Pay to Save a Few Minutes of Cooking? Plenty,” Wall Street Journal,
July 25, 1985, p. B1; “Riding the Rails at What Price,” New York Times, June 18, 2001, p. 12; and
“Shining Future for Fiber Optics,” New York Times, November 19, 1995, p. B10.

3.5 CONSUMER’S CHOICE

We will now bring together the tastes and preferences of the consumer (given by his or her
indifference map) and the income and price constraints faced by the consumer (given by
his or her budget line) to examine how the consumer determines which goods to purchase
and in what quantities to maximize utility or satisfaction. As we will see in the next chap-
ter, utility maximization is essential for the derivation of the consumer’s demand curve for
a commodity (which is a major objective of this part of the text).

Rational consumer An Utility Maximization

individual who seeks to
maximize utility or Given the tastes of the consumer (reflected in his or her indifference map), the rational
satisfaction in spending consumer seeks to maximize the utility or satisfaction received in spending his or her
his or her income. income. A rational consumer maximizes utility by trying to attain the highest indifference
 CHAPTER 3 Consumer Preferences and Choice TS

curve possible, given his or her budget line. This occurs where an indifference curve is tan-
gent to the budget line so that the slope of the indifference curve (the MRSyy) is equal to
Constrained utility the slope of the budget line (Px/Py). Thus, the condition for constrained utility maxi-
maximization The mization, consumer optimization, or consumer equilibrium occurs where the con-
process by which the
sumer spends all income (i.e., he or she is on the budget line) and
consumer reaches the
highest level of
satisfaction given his or MRSxy = Px/Py [3.5]
her income and the
prices of goods. Figure 3.8 brings together on the same set of axes the consumer indifference curves
of Figure 3.2 and the budget line of Figure 3.6 to determine the point of utility maximiza-
tion. Figure 3.8 shows that the consumer maximizes utility at point B where indifference
curve U; is tangent to budget line JK. At point B, the consumer is on the budget line and
MRSyy = Px/Py = 2. Indifference curve U| is the highest that the consumer can reach with
his or her budget line. Thus, to maximize utility the consumer should spend $4 to purchase
2X and the remaining $6 to purchase 6Y. Any other combination of goods X and Y that the
consumer could purchase (those on or below the budget line) provides less utility. For
example, the consumer could spend all income to purchase combination L, but this would
be on lower indifference curve Up.
At point L the consumer is willing to give up more of Y than he or she has to in the
Concept Check market to obtain one additional unit of X. That is, MRSyy (the absolute slope of indiffer-
Why is utility not ence curve Up at point L) exceeds the value of Px/Py (the absolute slope of budget line
maximized if the JK). Thus, starting from point L, the consumer can increase his or her satisfaction by
indifference curve
purchasing less of Y and more ofX until he or she reaches point B on U, where the slopes
crosses the budget
of U; and the budget line are equal (1.e., MRSyy = Px/Py= 2). On the other hand, starting
line twice?
from point M, where MRSyy < Px/Py, the consumer can increase his or her satisfaction
by purchasing less of X and more of Y until he or she reaches point B on U;, where
MRSyy = Py/Py. One tangency point such as B is assured by the fact that there is an
indifference curve going through each point in the XY commodity space. The consumer

of
Quantity
Y

FIGURE 3.8 Constrained Utility Maximization The consumer

us
maximizes utility at point B, where indifference curve Uj is tangent to U;
budget line JK. At point B, MRSxy = Py/Py = 2. Indifference curve Uj Is
|
‘) Qx
the highest that the consumer can reach with his or her budget line.
Quantity of X
Thus, the consumer should purchase 2X and 6Y.
76 PART TWO. Theory of Consumer Behavior and Demand

prices of
cannot reach indifference curve U> with the present income and the given
goods X and Y."! .
Utility maximization is more prevalent (as a general aim of individuals) than itmay
at first seem. It is observed not only in consumers as they attempt to maximize utility in
spending income but also in many other individuals—including criminals. For example,
a study found that the rate of robberies and burglaries was positively related to the gains
and inversely related to the costs of (i.e., punishment for) criminal activity.'*Utility max-
imization can also be used to analyze the effect of government warnings on consumption,
as Example 3-5 shows.

BNA PEE 37 is anit) pperee aga

Utility Maximization and Government Warnings on Junk Food

Suppose that in Figure 3.9, good X refers to milk and good Yrefers to soda, Py = $1,
Py = $1, and the consumer spends his or her entire weekly allowance of $10 on milk
and sodas. Suppose also that the consumer maximizes utility by spending $3 to pur-
chase three containers of milk and $7 to purchase seven sodas (point B on indifference
curve U,) before any government warning on the danger of dental cavities and obesity
from sodas. After the warning, the consumer’s tastes may change away from sodas and
toward milk. It may be argued that government warnings change the information avail-
able to consumers rather than tastes; that is, the warning affects consumers’ perception

Qy
10

FIGURE 3.9 Effect of Government Warnings The Soda

consumer maximizes utility by purchasing 3 containers of milk 4
and 7 sodas (point B on indifference curve U;) before the
government warning on the consumption of sodas. After the
warning, the consumer’s tastes change and are shown by dashed
indifference curves U’g and U’;. The consumer now maximizes
utility by purchasing 6 containers of milk and only 4 sodas (point 0
B’, where U’, is tangent to the budget line).

'l For a mathematical presentation of utility maximization using rudimentary calculus, see Section A.2
of
the Mathematical Appendix.
'2 See I. Ehrlich, “Participation in Illegitimate Activities: A Theoretical and Empirical Investigation,
” Journal
of Political Economy, May/June 1973; W. T. Dickens, “Crime and Punishment Again:
The Economic
Approach with a Psychological Twist,” National Bureau of Economic Research, Working
Paper No. 1884
April 1986; and A. Gaviria, “Increasing Returns and the Evolution of Violent Crimes:
The Case of
Colombia,” Journal of Development Economics, February 2000.
 CHAPTER 3 Consumer Preferences and Choice THT

as to the ability of various goods to satisfy their wants—see M. Shodell, “Risky

Business,” Science, October 1985.
The effect of the government warning can be shown with dashed indifference
curves Ug and U’;. Note that Uo is steeper than U; at than original optimization point
B, indicating that after the warning the individual is willing to give up more sodas for
an additional container of milk (i.e., MRSyy is higher for U’o than for U; at point B).
Now U’ can intersect U; because of the change in tastes. Note also that U’o involves
less utility than U, at point B because the seven sodas (and the three containers of
milk) provide less utility after the warning. After the warning, the consumer maxi-
mizes utility by consuming six containers of milk and only four sodas (point B’,
where U’; is tangent to the budget line).
The above analysis clearly shows how indifference curve analysis can be used to
examine the effect of any government warning on consumption patterns, such as the
1965 law requiring manufacturers to print on each pack of cigarettes sold in the United
States the warning that cigarette smoking is dangerous to health. Indeed, the World
Health Organization is now stepping up efforts to promote a global treaty to curb cig-
arette smoking. We can analyze the effect on consumption of any new information by
examining the effect it has on the consumer’s indifference map. Similarly, indifference
curve analysis can be used to analyze the effect on consumer purchases of any regula-
tion such as the one requiring drivers to wear seat belts.

Sources: “Some States Fight Junk Food Sales in School,’ New York Times, September 9, 2001, p. 1; and
“Companies Agree to Ban on Sale of Fizzy Drinks in Schools,” Financial Times, May 4, 2006, p. 6.

Corner Solutions
If indifference curves are everywhere either flatter or steeper than the budget line, or if
they are concave rather than convex to the origin, then the consumer maximizes utility by
Corner solution spending all income on either good Y or good X. These are called corner solutions.
Constrained utility In the left panel of Figure 3.10, indifference curves Up, U;, and U2 are everywhere
maximization with the flatter than budget line /K, and U| is the highest indifference curve that the consumer can
consumer spending reach by purchasing 10Y and OX (endpoint J). Point J is closest to the tangency point,
all of his or her income
which cannot be achieved. The individual could purchase 2X and 6Y and reach point B,
on only one or some
goods.
but point B is on lower indifference curve Uo. Since point J is on the Y-axis (and involves
the consumer spending all his or her income on good Y), it is called a corner solution.
The middle panel shows indifference curves that are everywhere steeper than the
budget line, and Uj is the highest indifference curve that the consumer can reach by
spending all income to purchase 5X and OY(endpoint K). The individual could purchase
1X and 8Y at point L, but this is on lower indifference curve Up. Point K is on the hori-
zontal axis and involves the consumer spending all his or her income on good X, so
point K is also a corner solution.
In the right panel, concave indifference curve Uj is tangent to the budget line at point
B, but this is not optimum because the consumer can reach higher indifference curve U2
by spending all income to purchase 10Y and OX (endpoint J). This is also a corner solu-
tion. Thus, the condition that an indifference curve must be tangent to the budget line for
78 PART TWO Theory of Consumer Behavior and Demand

2 Qy Qy
12

10 J
Us
8

6
B “
U

| K
0 9 Reale Sg Mel wens Utama amen 2 3525 s600n
FIGURE-3:10 Corner Solutions — In the left panel, indifference curves are everywhere flatter than
the budget line, and U; is the highest indifference curve that the consumer can reach by purchasing
10Y only (point J). The middle panel shows indifference curves everywhere steeper than the budget
line, and U; is the highest indifference curve that the consumer can reach by spending all income to
purchase 5X (point K). In the right panel, concave indifference curve U; is tangent to the budget line at
point B, but this is not the optimum point because the consumer can reach higher indifference curve
U> by consuming only good Y (point J).

optimization is true only when indifference curves assume their usual convex shape and
are neither everywhere flatter nor steeper than the budget line.
Finally, although a consumer in the real world does not spend all of his or her income
on one or a few goods, there are many more goods that he or she does not purchase
because they are too expensive for the utility they provide. For example, few people pur-
chase a $2,000 watch because the utility that most people get from the watch does not jus-
tify its $2,000 price. The nonconsumption of many goods in the real world can be
explained by indifference curves which, though convex to the origin, are everywhere
either flatter or steeper than the budget line, yielding corner rather than interior solutions.
Corner solutions can also arise with rationing, as Example 3—6 shows.

EXAMPLE 3-6
Water Rationing in the West

Because goods are scarce, some method of allocating them among individuals is
required. In a free-enterprise economy such as our own, the price system accomplishes
this for the most part. Sometimes, however, the government rations goods, such as
water in the West of the United States (as a result of recurrent droughts) and gasoline
Rationing in 1974 and 1979 (at the height of the petroleum crisis). If the maximum amount of the
Quantitative good that the government allows is less than the individual would have purchased or
restrictions, used, the rationing will reduce the individual’s level of satisfaction.
 CHAPTER 3 Consumer Preferences and Choice 79

FIGURE 3.11 Rationing In the absence of rationing, the individual Quantity

Y
of
maximizes satisfaction at point B, where indifference curve U; is tangent to
budget line JK, and consumes 2X and 6Y (as in Figure 3.8). If the
government did not allow the individual to purchase more than 1X per U;
week, the budget line becomes JLK’, with a kink at point L. The highest Si
indifference curve that the individual can reach with budget line JLK’, is 8 Qx
now Up at point L, by consuming 1X and 8Y. Quantity of X

The effect of rationing on utility maximization and consumption can be examined

with Figure 3.11. In the absence of rationing, the individual maximizes satisfaction at
point B, where indifference curve U; is tangent to budget line JK, by consuming 2X
and 6¥ (as in Figure 3.8). Good X could refer to hours per week of lawn watering (in
absence of an automatic water sprinkler system), while good Y could refer to hours per
week of TV viewing. If the government did not allow the individual to use more than
LX per week, the budget line becomes JLK’, with a kink at point L. Thus, rationing
changes the constraints under which utility maximization occurs. The highest indiffer-
ence curve that the individual can reach with budget line JLK’ is now Up at point L, by
consuming 1X and 8¥. In our water rationing case, this refers to one hour of lawn
watering and eight hours of TV viewing per week. With water rationing, the incentive
arises to illegally water lawns at night under the cover of darkness. On the other hand,
gasoline rationing during 1974 and 1979 led to long lines at the gas pump and to black
markets where gasoline could be purchased illegally at a higher price without waiting.
Thus, rationing leads to price distortions and inefficiencies.
If rations were 2X or more per week, the rationing system would not affect this
Concept Check consumer since he or she maximizes utility by purchasing 2X and 6Y (point B in the
Can rationing lead to figure). Rationing is more likely to be binding or restrictive on high-income people
a black market? than on low-income people (who may not have sufficient income to purchase even the
allowed quantity of the rationed commodity). Thus, our model predicts that high-
income people are more likely to make black-market purchases than low-income peo-
ple. Effective rationing leads not only to black markets but also to “spillover” of
consumer purchases on other goods not subject to rationing (or into savings). Both
occurred in the United States during the 1974 and 1979 gasoline rationing periods. As
pointed out in Section 2.7, allowing the market to operate (i.e., letting the price of the
commodity reach its equilibrium level) eliminates the inefficiency of price controls
and leads to much better results.
Sources: “Trickle-Down Economics,” Wall Street Journal, August 23, 1999, p. Al4; “Water Rights May
Become More Liquid,” Wall Street Journal, February 15, 1996, p. A2; W. C. Lee, “The Welfare Cost of
Rationing-by-Queuing Across Markets,” Quarterly Journal of Economics, July 1987, J. Brewer, et al.,
“Water Markets in the West: Prices, Trading, and Contractual Forms,” NBER Working Paper No. 13002,
March 2007, and M. Greenstone, “Tradable Water Rights,” Democracy Journal, No. 8, Spring 2008, pp. 1-2.
80 PART TWO Theory of Consumer Behavior and Demand

Marginal Utility Approach to Utility Maximization

Until now we have examined constrained utility maximization with ordinal utility (.e.,
with indifference curves). If utility were cardinally measurable, the condition for con-
strained utility maximization would be for the consumer to spend all income on X and Y
in such a way that
MUx _ MUy [3.6]
Pye Py
Equation [3.6] reads, the marginal utility of good X divided by the price of good X equals
the marginal utility of good Y divided by the price of good Y. MU /Py is the extra or mar-
ginal utility per dollar spent on X. Likewise, MUy/Py is the marginal utility per dollar
spent on Y. Thus, for constrained utility maximization or optimization, the marginal util-
ity of the last dollar spent on X and Y should be the same.!?
For example, Table 3.3 shows a portion of the declining marginal utility schedule for
good X and good Y (from Table 3.1), on the assumption that MUy is independent of MUy
(i.e., that MUy is not affected by how much Y the individual consumes, and MUy is not
affected by the amount of X consumed). If the consumer’s income is J = $10, Py = $2,
and Py = $1, the consumer should spend $4 to purchase 2X and the remaining $6 to pur-
chase 6Y so that equation [3.6] is satisfied. That is,

6utils 3 utils
$20 mat Bee
If the consumer spent only $2 to purchase 1X and the remaining $8 to purchase
8Y, MUx/Px = 10/2 = 5 and MUy/Py= 1/1 = 1. The last (second) dollar spent on X
thus gives the consumer five times as much utility as the last (eighth) dollar spent on
Y and the consumer would not be maximizing utility. To be at an optimum, the con-
sumer should purchase more of X (MU falls) and less of Y (MUy rises) until he or she
purchases 2X and 6Y, where equation [3.6] is satisfied.'* This is the same result
obtained with the indifference curve approach in Section 3.5. Note that even when the
consumer purchases LX and 4Y equation [3.6] is satisfied (MU x/Py = 10/2 = MUy/Py
= 5/1), but the consumer would not be at an optimum because he or she would be
spending only $6 of the $10 income.

|TABLE 3.3, Marginal Utility of X and Y

Qx MU, Qy MUy

I 10 4 5
Z 6 5 4
3 4 6 3
4 2 7 2
5 0 8 |

iWe will see in footnote 14 that equation [3.6] also holds for the indifference curve approach.
By giving up the eighth and the seventh units of Y, the individual loses 3 utils. By
using the $2 not spent
on Y to purchase the second unit of X, the individual receives 6 utils, for a net gain
of 3 utils. Once the
individual consumes 6Y and 2X, equation [3.6] holds and he or she maximizes utility.
 CHAPTER 3 Consumer Preferences and Choice 81

The fact that the marginal utility approach gives the same result as the indifference
curve approach (i.e., 2X and 6Y) should not be surprising. In fact, we can easily show why
this is so. By cross multiplication in equation [3.6], we get
MUx _ Px
[3.7]
MUy Py
But we have shown in Section 3.2 that MRSyy = MUy/MUy (see equation [3.2]) and in
Section 3.5 that MRSyy = Px/Py when the consumer maximizes utility (see equation
[3.5]). Therefore, combining equations [3.2], [3.5], and [3.7], we can express the condi-
tion for consumer utility maximization as

MUx _ Px
MRSxy = [3.8]
MU ee
Thus, the condition for consumer utility maximization with the marginal utility approach
(1.e., equation [3.6]) is equivalent to that with the indifference curve approach (equation [3.5]),
except for corner solutions. With both approaches, the value of equation [3.8] is 2.

AT THE FRONTIER
The Theory of Revealed Preference

ntil now we have assumed that indifference curves are derived by asking the con-
U sumer to choose between various market baskets or combinations of commodi-
ties. Not only is this difficult and time consuming to do, but we also cannot be sure that
consumers can or will provide trustworthy answers to direct questions about their pref-
Theory of erences. According to the theory of revealed preference (developed by Paul Samuelson
revealed and John Hicks), a consumer’s indifference curves can be derived from observing the
preference The actual market behavior of the consumer and without any need to inquire directly about
theory that preferences. For example, if a consumer purchases basket A rather than basket B, even
postulates that a though A is not cheaper than B, we can infer that the consumer prefers A to B.
consumer’s The theory of revealed preference rests on the following assumptions:
indifference
curve can be 1. The tastes of the consumer do not change over the period of the analysis.
derived from the 2. The consumer’s tastes are consistent, so that if the consumer purchases bas-
consumer’s ket A rather than basket B, the consumer will never prefer B to A.
market behavior.
The consumer’s tastes are transitive, so that if the consumer prefers A to B
and B to C, the consumer will prefer A to C.
The consumer can be induced to purchase any basket of commodities if its
price is lowered sufficiently.

Figure 3.12 shows how a consumer’s indifference curve can be derived by

revealed preference. Suppose that the consumer is observed to be at point A on budget
line NN in the left panel. In this case, the consumer prefers A to any point on or below
NN. On the other hand, points above and to the right of A are superior to A since they
involve more of commodity X and commodity Y. Thus, the consumer’s indifference
curve must be tangent to budget line NN at point A and be above NN everywhere else.
Continued...
82 PART TWO. Theory of Consumer Behavior and Demand

The Theory of Revealed Preference Continued

Qy

0 § Ne py
FIGURE 3.12 Derivation of an Indifference Curve by Revealed Preference _ In the left panel,
the consumer is originally at optimum at point A on NW. Thus, the indifference curve must be tangent
to NN at point A and above NW everywhere else. It must also be to the left and below shaded area
LAM. If the consumer is induced to purchase combination B (which is inferior to A) with budget line
PP, we can eliminate shaded area BPW. Similarly, with combination D on budget line SS, shaded area
DSN can be eliminated. Thus, the indifference curve must be above SDBP In the right panel, the
consumer prefers G to A with budget line P’P’ and prefers J to A with budget line S’S’ Thus, the
indifference curve must be below points G and J

The indifference curve must also be to the left and below shaded area LAM. Such an
indifference curve would be of the usual shape (i.e., negatively sloped and convex to
the origin).
To locate more precisely the indifference curve in the zone of ignorance (i.e., in
the area between LAM and NN), consider point B on NN. Point B is inferior to A
since the consumer preferred A to B. However, the consumer could be induced to
purchase B with budget line PP (i.e., with P;/Py sufficiently lower than with NN).
Since A is preferred to B and B is preferred to any point on BP, the indifference curve
must be above BP. We have thus eliminated shaded area BPN from the zone of igno-
rance. Similarly, by choosing another point, such as D, we can, by following the
same reasoning as for B, eliminate shaded area DSN. Thus, the indifference curve
must lie above SDBP and be tangent to NN at point A.
The right panel of Figure 3.12 shows that we can chip away from the zone of
ignorance immediately to the left of LA and below AM. Suppose that with budget line
P’P’ (which goes through point A and thus refers to the same real income as at A), the
consumer chooses combination G (with more of X and less of Y than at A) because
Py/Py is lower than on NN. Points in the shaded area above and to the right of G are
preferred to G, which is preferred to A. Thus, we have eliminated some of the upper
zone of ignorance. Similarly, choosing another budget line, such as $’S’, we can elim-
inate the area above and to the right of a point such as J, which the consumer prefers
 CHAPTER 3. Consumer Preferences and Choice 83

to A at the higher Px/Py given by $’S’. It follows that the indifference curve on which
A falls must lie below points G and J. The process can be repeated any number of
times to further reduce the upper and lower zones of ignorance, thereby locating the
indifference curve more precisely. Note that the indifference curve derived is the one
we need to show consumer equilibrium because it is the indifference curve that is tan-
gent to the consumer’s budget line.
Although somewhat impractical as a method for actually deriving indifference
curves, the theory of revealed preference (particularly the idea that a consumer’s
tastes can be inferred or revealed by observing actual choices in the market place) has
been very useful in many applied fields of economics such as public finance and
international economics. The appendix to Chapter 4 applies the theory of revealed
preference to measure changes in standards of living and consumer welfare during
inflationary periods.

SUMMARY
1. The want-satisfying quality of a good is called utility. More units of a good increase total
utility (7U) but the extra or marginal utility (MU) declines. The saturation point is reached
when TU is maximum and MU is zero. Afterwards, TU declines and MU is negative. The
decline in MU is known as the law of diminishing marginal utility. Cardinal utility actually
provides an index of satisfaction for a consumer, whereas ordinal utility only ranks various
consumption bundles.
. The tastes of a consumer can be represented by indifference curves. These are based on
iw)

the assumptions that the consumer can rank baskets of goods according to individual
preferences, tastes are consistent and transitive, and the consumer prefers more of a good to less.
An indifference curve shows the various combinations of two goods that give the consumer
equal satisfaction. Higher indifference curves refer to more satisfaction and lower indifference
curves to less. Indifference curves are negatively sloped, cannot intersect, and are convex to the
origin. The marginal rate of substitution (MRS) measures how much of a good the consumer is
willing to give up for one additional unit of the other good and remain on the same indifference
curve. Indifference curves also generally exhibit diminishing MRS.
3. A rapid convergence of tastes is taking place in the world today. Tastes in the United States
affect tastes around the world, and tastes abroad strongly influence tastes in the United States.
With the tremendous improvement in telecommunications, transportation, and travel, the
convergence of tastes can only be expected to accelerate—with important implications for us as
consumers, for firms as producers, and for the study of microeconomics.
4. The budget line shows the various combinations of two goods (say, X and Y) that a consumer can
purchase by spending all income (/) on the two goods at the given prices (Px and Py). The vertical
or Y-intercept of the budget line is given by //Py and —Py/Py is the slope. The budget line shifts up
if J increases and down if J decreases, but the slope remains unchanged. The budget line rotates
upward if Py falls and downward if Px rises.
5. A rational consumer maximizes utility when reaching the highest indifference curve possible
with the budget line. This occurs where an indifference curve is tangent to the budget line so
that their slopes are equal (i.e., MRSxy = Px/Py). Government warnings or new information
may change the shape and location of a consumer’s indifference curves and the consumption
pattern. If indifference curves are everywhere either flatter or steeper than the budget line or
84 PART TWO. Theory of Consumer Behavior and Demand

r to spend all income on either

if they are concave, utility maximization requires the consume
solution s can also arise with
good Y or good X. These are called corner solutions. Corner
postulat es that the consume r maximizes utility when
rationing. The marginal utility approach
and the margina l utility of the last dollar spent on X and ¥ are the
he or she spends all income
and the indifference curve
same. Since MRSyy = MU x/MUy = Px/Py, the marginal utility
approaches are equivalent. Indifference curves can also be derived by the theory of revealed
preference.

KEY TERMS
Utility Good Budget line
Total Utility (TU) Bad Rational consumer
Marginal Utility (MU) Indifference curve Constrained utility maximization
Util Indifference map Consumer optimization
Law of diminishing — Marginal rate of Consumer equilibrium
marginal utility substitution (MRS) Corner solution
Cardinal utility Neuter Rationing
Ordinal utility Budget constraint Theory of revealed preference

REVIEW QUESTIONS
1. The utility approach to consumer demand theory is 8. If Jennifer’s budget line has intercepts 20X and 30Y and
based on the assumption of cardinal utility, while the Py = $10, what is Jennifer’s income? What is Py? What
indifference curve approach is based on ordinal utility. is the slope of the budget line?
SINTON EDEN 9. Must a consumer purchase some quantity of each
i) . If Alan is indifferent between Coke and Pepsi, what would commodity to be in equilibrium?
ae eda
Alan’s indifference curves look like? 10. Janice spends her entire weekly food allowance
3. The indifference curve between a good and garbage is of $42 on hamburgers and soft drinks. The price of a
positively sloped. True or false? Explain. hamburger is $2, and the price of a soft drink is $1.
4, What is the relationship between two goods if the Janice purchases 12 hamburgers and 18 soft drinks, and
marginal rate of substitution between them is zero or her marginal rate of substitution between hamburgers
infinite? Explain. and soft drinks is 1. Is Janice in equilibrium? Explain.
5. What is the marginal rate of substitution between two 11. Why is a consumer likely to be worse off when a
complementary goods? product that he or she consumes is rationed?
6. Are indifference curves useless because it is difficult to 12. In what way is the theory of revealed preference related
derive them experimentally? to traditional consumer theory? What is its usefulness?
7. Why is there a convergence of tastes internationally?

PROBLEMS
1. From the following total utility schedule a. derive the marginal utility schedule.
b. plot the total and the marginal utility schedules.
c. determine where the law of diminishing marginal
utility begins to operate.
d. find the saturation point.
 CHAPTER 3 Consumer Preferences and Choice 85

2. The following table gives four indifference schedules of 6. This problem involves drawing three graphs, one for each
an individual. part of the problem. On the same set of axes, draw the
a. Using graph paper, plot the four indifference curves on budget line of Problem 5 (label it 2) and two other
the same set of axes. budget lines:
b. Calculate the marginal rate of substitution of X for Y a. One with J = $10 (call it 1), and another with
between the various points on Uj. I = $20 (label it 3), and with prices unchanged
Ae = Ih = ail.
c. What is MRSyy at point C on U;?
b. One with Py = $0.50, Py = $1, and J = $15 (label it
d. Can we tell how much better off the individual is on
2A), and another with Py = $2 and the same Py and J
Uz than on U;?
(label it 2B).
ao, a. Starting with a given equal endowment of good
c. One with Py = $2, Py = $1, and J = $15 (label it 2C),
X and good Y by individual A and individual B, draw
and another with Py = Py = $2 and J = $15 (label it
A’s and B’s indifference curves on the same set of
2F).
axes, showing that individual A has a preference for
good X over good Y with respect to individual B. *7. a. On the same set of axes, draw the indifference curves
of Problem 2 and the budget line of
b. Explain why you drew individual A’s and individual B’s
Problem 5(c).
indifference curves as you did in Problem 3(a).
b. Where is the individual maximizing utility? How much
= Draw an indifference curve for an individual
of X and Y should he or she purchase to be at
showing that
optimum? What is the general condition for
a. good X and good Y are perfect complements. constrained utility maximization?
b. item X becomes a bad after 4 units. c. Why is the individual not maximizing utility at point
c. item Y becomes a bad after 3 units. A? At point G?
d. MRS is increasing for both X and Y. d. Why can’t the individual reach U3 or U4?
mA Suppose an individual has an income of $15 per time 8. On the same set of axes (on graph paper), draw
period, the price of good X is $1 and the price of good Yis the indifference curves of problem 2 and budget
alsomlehatisei— lo iey— oleand Py —npill lines

U; U, U; U;
Combination Qy Qy Qy Qy Qy Qy Qy Qy
A s 12 6 12 8 15 10 13
B 4 Ti Wl 9 9 2: 12 10
(e 6 4 9 6 11 9 14 8
F 9 2) 1D 4 1B} 6 18 6.4
G 14 1 15 3) 19 5) 20 6

a. Write the equation of the budget line of this individual in a. 1, 2, and 3 from Problem 6(a); label the points at
the form that indicates that the amount spent on good X which the individual maximizes utility with the various
plus the amount spent on good Y equals the individual’s alternative budget lines.
income. b. 2 and 2A from Problem 6(b); label the points at
b. Write the equation of the budget line in the form that which the individual maximizes utility on the various
you can read off directly the vertical intercept and the alternative budget lines: E and L.
slope of the line. *9_ Given the following marginal utility schedule for good X
c. Plot the budget line. and good Y for the individual, and given that the price of X

* — Answer provided at end of book.

86 PART TWO. Theory of Consumer Behavior and Demand

and the price of Y are both $1, and that the individual and (3) a government warning that cigarette smoking is
spends all income of $7 on X and Y, dangerous to health, all in such a way that the net effect
of all three forces together leads to a net decline in
O “| 2 vende. Dx) & cigarette smoking.
— —_—_a. Draw a figure showing indifference curve
U2 tangent
Vie | ire ose cee eae es —
to the budget line at point B (8X), and a lower
Wien ae | 9 ee eS) — indifference curve (U}) intersecting the budget line at
point A (4X) and at point G (ZX):
a. indicate how much ofX and Ythe individual should b. What happens if the government rations good X and
purchase to maximize utility. allows the individual to purchase no more than 4X?
b. show that the condition for constrained utility No more than 8X? No more than 12X?
maximization is satisfied when the individual is at his . What would happen if the government instead
(eo)
or her optimum. mandated (as in the case of requiring auto insurance,
© determine how much total utility the individual seat belts, and so on) that the individual purchase at
receives when he or she maximizes utility? How much least 4X? 8X? 12X?
utility would the individual get if he or she spent all Show by indifference curve analysis the choice of one
income on X or Y? couple not to have children and of another couple, with
10. Show on the same figure the effect of (1) an increase in the same income and facing the same costs of having
cigarette prices, (2) an increase in consumers’ incomes, and raising children, to have one child.

INTERNET SITE ADDRESSES

The relationship between income and happiness is analyzed http://www.edmunds.com/insideline/do/Features/
by David G. Blanchflower in: articleld=46007
http://www.dartmouth.edu/~blanchflower/papers/ http://www.epinions.com/content_8 1797287556
Wellbeingnew.pdf For water rationing in the U.S. West, see the website for the
http://cep.lse.ac.uk/events/lectures/layard/RL040303.pdf Political Economy Research Center at:
http://www. princeton.edu/main/news/archive/S 15/15/09 http://www.perc.org and
S18/index.xml?section=topstories http://www.cleartheair.org/waterinthewest/chapter6.vtml
http://ideas.repec.org/a/ecj/econjl/ The harmful effects of junk food and the need for
v111ly20011473p465-84.html government regulation are examined at:
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Accord, see: http://www.commercialfreechildhood.org/pressreleases/
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reviews/2001/heilig_ford_taurus.html http://Ir.lls.edu/volumes/v39-issue |/docs/yosifon.pdf
 CHAPTER 4

Consumer Behavior and

Individual Demand
Chapter Outline 4-3 Higher Alcohol Prices Would Sharply
4.1 Changes in Income and the Engel Curve Reduce Youth Alcohol Use and Traffic
4.2 Changes in Price and the Individual Demand Curve Deaths
4.3 Substitution Effect and Income Effect 44 Substitution Effect and Income Effect
4.4 Substitution Between Domestic and Foreign Goods of a Gasoline Tax
4.5 Some Applications of Indifference Curve 4-5 Giffen Behavior Found!
Analysis 4—6 What Is an “American” Car?
Appendix: Index Numbers and Changes in At the Frontier: The Characteristics Approach
Consumer Welfare to Consumer Theory
4-7 The Consumer Price Index, Inflation,
List of Examples and Changes in the Standard of
4—] Engel’s Law After a Century Living
4-2 Many People Are Blowing Their Pension 4-8 Comparing the Standard of Living of Various
Money Long Before Retirement Countries

After Studying This Chapter, You Should Be Able to:

e Know how to derive an individual consumer’s demand curve for a commodity
e Know what a Giffen good is, how it can arise theoretically, and where it has been found
e Understand why a cash subsidy is better than food stamps
e Know the meaning and importance of consumer surplus
e Describe how to measure the benefits of exchange

n Chapter 3 we saw how a consumer maximized utility by reaching the highest possi-
ble indifference curve with the given budget line. In this chapter, we examine how the
consumer responds to changes in income and prices while holding tastes constant.
Incomes and prices change frequently in the real world, so it is important to examine their
individual effects on consumer behavior.
We begin by examining how the consumer responds to changes in his or her income
when prices and tastes remain constant. This will allow us to derive a so-called Engel

87
88 PART TWO Theory of Consumer Behavior and Demand

we examine the con-

curve and to distinguish between normal and inferior goods. Then
sumer’s response to a change in the price of the good and derive the individual’s demand
for the market demand curve of the
curve for the good. This is the basic building block
of which was outlined in Chapter 2.
good (to be derived in Chapter 5), the importance
After deriving an individual’s demand curve, we discuss how to separate the sub-
normal and inferior goods. The
stitution from the income effect of a price change for
ability to separate graphically the income from the substituti on effect of a price change
is one of the most powerful tools of analysis of microeconomic theory, with many
important applications. Subsequently, we examine the degree by which domestic and
foreign goods and services are substitutable and the great relevance of this substitution
in the study of microeconomics. We then consider some important applications of the
theory presented in this chapter. These applications, together with the real-world exam-
ples included in the theory sections, highlight the importance of the theory of consumer
behavior and demand. Finally, the “At the Frontier” section presents the characteristics
approach to consumer theory, which provides some additional insights and uses of con-
sumer theory. The optional appendix to this chapter deals with index numbers and how
they are used to measure changes in consumer welfare.

| ai || CHANGES IN INCOME AND THE ENGEL CURVE

A change in the consumer’s income shifts his or her budget line, and this shift affects
consumer purchases. In this section we examine how a consumer reaches a new opti-
mum position when income changes but prices and tastes do not.

Income-—Consumption Curve and Engel Curve

By changing the consumer’s money income while holding prices and tastes constant, we
Income-consumption can derive the consumer’s income—consumption curve. The income—consumption curve
curve The locus of is the locus of (1.e., joins) consumer optimum points resulting when only the consumer’s
consumer optimum income varies. From the income—consumption curve we can then derive the consumer’s
points resulting when
Engel curve (discussed below).
only the consumer’s
income varies. For example, the top panel of Figure 4.1 shows that with budget line JK the consumer
maximizes utility or is at an optimum at point B, where indifference curve U is tangent
to budget line JK and the consumer purchases 2X and 6Y (the same as in Figure 3.8). That
is (continuing with the example from Chapter 3), the best way for the student to spend a
daily income allowance of $10 on snacks of hamburgers (good X) and soft drinks (good
Y) is to purchase two hamburgers and six soft drinks per day. If the prices of hamburgers
and soft drinks remain unchanged at Py = $2 and Py = $1 but the daily income siloverce
rises from $10 to $15 and then to $20, budget line JK shifts up to J’K’ and then to J’K”
(the same as in the left panel of Figure 3.7). The three budget lines are parallel because
the prices of X and Y do not change.
With an income of $15 and budget line J’K’, the consumer maximizes utility at point
R, where indifference curve U) is tangent to budget line J’K’ and the consumer purchases
4X and 7Y (see the top panel of Figure 4.1). Indifference curve U> is the same as in the
right panel of Figure 3.2 because tastes have not changed. Finally, with an income of $20
 CHAPTER 4 Consumer Behavior and Individual Dernand
89

= OU

Income-consumption curve

Soft
drinks
(Y)
unit
of
time
per

Ke

0 DOLLA lie ome Ox

Hamburgers (X) per unit of time

—~boasSS

Engel curve
noS

on

Money
income
(/)
unit
of
time
per
0 2 Ae ae) Qy
Hamburgers (X) per unit of time

FIGURE 4.1 Income-Consumption Curve and Engel Curve With

budget lines Jk, J’K’, J”K” and indifference curves U;, Us, and U3 in the top
panel, the individual maximizes utility at points B, R, and S, respectively. By
joining optimum points B, Rk, and S we get the income-consumption curve
(top panel). By then plotting income on the vertical axis and the various
optimum quantities purchased of good X along the horizontal axis, we can
derive the corresponding Engel curve B’R’S’ in the bottom panel.
90 PART TWO. Theory of Consumer Behavior and Demand

S on U3
and budget line JK”, the consumer maximizes utility or is at an optimum at point
points B, R, and
by purchasing 5X and 10Y per unit of time (per day). By joining optimum
S we get (a portion of)the income—consumption curve for this consumer (student). Thus,
the income—consumption curve is the locus of consumer optimum points resulting when
only the consumer’s income varies. |
From the income—consumption curve in the top panel of Figure 4.1, we can derive
Engel curve Shows the Engel curve in the bottom panel. The Engel curve shows the amount of a good that
the amount of a good the consumer would purchase per unit of time at various income levels. To derive the
that a consumer would Engel curve we keep the same horizontal scale as in the top panel but measure money
purchase at various
income on the vertical axis.
income levels.
The derivation of the Engel curve proceeds as follows. With a daily income
allowance of $10, the student maximizes utility by purchasing two hamburgers per day
(point B) in the top panel. This gives point B’ (directly below point B) in the bottom panel.
With an income allowance of $15, the student is at an optimum by purchasing four ham-
burgers (point R) in the top panel. This gives point R’ in the bottom panel. Finally, with a
daily income allowance of $20, the student maximizes utility by purchasing five hamburg-
ers (point S in the top panel and S’ in the bottom panel). By joining points B’, R’, and S’ we
get (a portion of ) the Engel curve in the bottom panel. Thus, the Engel curve is derived from
the income—consumption curve and shows the quantity of hamburgers per day (Qy) that the
student would purchase at various income levels (i.e., with various income allowances).
Since the Engel curve is derived from points of consumer (student) utility maximization,
MRSyy = Px/Py at every point on the curve.
Engel curves are named after Ernst Engel, the German statistician of the second half
of the nineteenth century who pioneered studies of family budgets and expenditure pat-
terns. Sometimes Engel curves show the relationship between income and expenditures
on various goods rather than the quantity purchased of various goods. However, because
prices are held constant, we get the same result (i.e., the same Engel curve).
For some goods, the Engel curve may rise only gently. This indicates that a given
increase in income leads to a proportionately larger increase in the quantity purchased of
the good. These goods are sometimes referred to as “luxuries.” Examples of luxuries may
be education, recreation, and steaks and lobsters (for some people). On the other hand,
the Engel curve for other goods may rise rather rapidly, indicating that a given increase
in income leads to a proportionately smaller increase in the quantity purchased of these
goods. These goods are called “necessities.” Basic foodstuffs are usually regarded as
necessities. A more precise definition of luxuries and necessities is given in Chapter 5.

EXAMPLE 4-1
Engel’s Law After a Century

Table 4.1 gives the percentages of total consumption expenditures on various items
for U.S. families in selected income classes in 2005. The table shows that higher-
income families generally spend a smaller percentage of their income than lower-
income families on food but spend a larger percentage on personal insurance and

Sa
ae ’ ;
At each point along the income—consumption curve the value of the MRSyy is the same. This is because
—Px/Py is the same for each of the budget lines (i.e., parallel lines have identical
slopes).
 CHAPTER 4 Consumer Behavior and Individual Demand 91

Percentage of Total Consumption by Income Class

else for U.S. Families in 2005
Annual Income
Consumption O- $10,000- $20,000- $30,000- $40,000- $50,000- $70,000
Item $9,999 $19,999 $29,999 $39,999 49,000 $69,000 and over
Food 16.3% 15.2% 13.9% 13.3% 13.0% 13.4% 11.4
Housing 39.7 38.9 Boul 34.8 33.6 Biles 31.0
Apparel and 5:0 4.1 3.9 43 Bio) 4.0 4.0
services
Transportation 14.2 14.5 19.9 18.1 19.4 20.1 17.6
Health care 62 (G5) 79 6.9 6.9 5.6 4.7
Entertainment 46 3.9 42. 4.9 4.8 49 5.6
Education 4.6 2.0 Jieil ileal ey 1-3} 2.6
Insurance and 1.8 33 5.4 7.8 9.3 Ae 14.8
pensions
Other nls) 11.6 8.6 8.8 8.2 8.1 8.3
Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Source: U.S. Department of Labor, Bureau of Labor Statistics, Consumer Expenditures in 2005, Report 998
(Washington, D.C.: May 2001), Table 2.

Concept Check Pensions. Less regularity is found in the proportion of expenditures on other goods
Is Engel’s law always and services.
true? The decline in the proportion of total expenditures on food as income rises has
been found to be true not only for the United States in the period of the survey, but also
Engel’s law The
: at other times and in other nations. Thus, food in general is a necessity rather than a
proportion of total Z SES ; ;
expenditures on food luxury. This regularity is sometimes referred to as Engel’s law. Indeed, the higher the
declines as family proportion of income spent on food in a nation, the poorer the nation is taken to be. For
incomes rise. example, in India almost 50% of income is spent on food on the average.

Normal and Inferior Goods

Normal good A good A normal good is one of which the consumer purchases more with an increase in
of which the consumer income. An inferior good is one of which the consumer purchases less with an increase
purchases more with an in income. Good X in Figure 4.1 is a normal good because the consumer purchases
i a mcome: more of it with an increase in income. For example, an increase in the student’s income
Inferior good A good allowance from $10 to $15 leads to an increase in the purchase of hamburgers from two
of which a consumer to four per day. Thus, for a normal good, the income—consumption curve and the Engel
purchases less with an curve are both positively sloped, as in Figure 4.1.
sae cane. Figure 4.2 shows the income—consumption curve and the Engel curve for an infe-
rior good. This results from supposing that the student, instead of spending the daily
income allowance on soft drinks (good Y) and hamburgers (good X’), spends it on soft
drinks and candy bars (good Z), and supposing the student views candy bars as an inferior
92 PART TWO. Theory of Consumer Behavior and Demand

Qy
i155

Income-consumption curve

10

time
of
unit
(Y)
drinks
Soft
per

0 2 4 10 152 Ox
Candy bars (Z) per unit of time

exs)| |
on
6)
3 | | Candy bars: inferior good
ol
v W'
ee Engel curve
= y'

E10
fe)
i
¢
*
S ie a oe
2 0 ps a2
Candy bars (Z) per unit of time
FIGURE 4.2 Income-Consumption Curve and Engel Curve
for an Inferior Good With budget lines Jk’ and J'N and
indifference curves U{ and U3 in the top panel, the individual
maximizes utility at points V and W, respectively. By joining points
V and W we get the income-consumption curve (top panel). By
then plotting income on the vertical axis and the optinum
quantities purchased of good Z along the horizontal axis, we
derive corresponding Engel curve V’W’ in the bottom panel. Since
the income-consumption curve and Engel curve are negatively
sloped, good Z is an inferior good.
 CHAPTER 4 Consumer Behavior and Individual Demand 93

good.” With the price of soft drinks at $1 and the price of candy bars also at $1, the bud-
get line of the student is JK’ with a daily income allowance of $10 and J'N with an
income of $15 (see the top panel of Figure 4.2).
If indifference curves between soft drinks and candy bars are U; and U} the student
maximizes satisfaction at point V, where indifference curve U; is tangent to budget line
JK’ with a daily income allowance of $10. The student maximizes utility at point W, where
indifference curve U; is tangent to budget line J/N with an income of $15 (see the top
panel of Figure 4.2). Thus, the consumer purchases four candy bars with an income of $10
and only two candy bars with an income of $15. Candy bars are, therefore, inferior goods
for this student. The income—consumption curve for candy bars (VW in the top panel of
Figure 4.2) and the corresponding Engel curve (V'W’ in the bottom panel) are both nega-
tively sloped, indicating that the student purchases fewer candy bars as his or her income
allowance increases.
The classification of a good as normal or inferior depends only on how a specific
consumer views the particular good. Thus, the same candy bar can be regarded as a nor-
mal good by another student. Furthermore, a good can be regarded as a normal good by
a consumer at a particular level of income and as an inferior good by the same consumer
at a higher level of income. For example, with an allowance of $40 dollars per day, the
student in the previous section may begin to regard hamburgers as an inferior good,
because he or she now can afford steaks and lobsters. Also note that an inferior good is
not a “bad” because more is preferred to less, and indifference curves remain negatively
sloped (refer back to Section 3.2).
In the real world, most broadly defined goods such as food, clothing, housing, health
care, education, and recreation are normal goods. Inferior goods are usually narrowly
defined cheap goods, such as bologna, for which good substitutes are available. As
pointed out earlier, a normal good can be further classified as a luxury or a necessity,
depending on whether the quantity purchased increases proportionately more or less than
the increase in income.

EXAMPLE 4-2
Many People Are Blowing Their Pension Money Long Before Retirement

There is a retirement crisis brewing in America today, not because people are not
putting enough money into their retirement plans, but because they are taking billions
of dollars out long before old age. Today, workers have many chances to take out their
retirement money in the form of a lump sum before the usual retirement age. They can
do so when they change jobs, when they work for a company that is sold and are thus
ejected from their retirement plan, or by taking early retirement. But instead of putting

2 Other commodities that are, perhaps, even more readily recognized as inferior goods in the United States
today might be bologna and cheaper cuts of meats.
94 PART TWO. Theory of Consumer Behavior and Demand

workers
their money into sound investments on which to live when they retire, many
are blowing their lump-sum retirement-plan payouts on new Cars, appliance s, furni-
ture, and boats, as well as in casinos.
A 1993 Labor Department study of how 60,000 households handled a retirement-
plan lump sum showed that only 21% of the recipients rolled their money into
Individual Retirement Accounts (IRAs), as recommended by financial planners.
Almost 30% spent their lump sums on consumer products or used them to pay medical
or educational expenses for themselves and their children, and another 23% put the
money into a business or house or repaid debts. Younger people were more likely to
spend rather than invest their retirement money into IRAs, but so did more than one-
fifth of those in the 55-64 age group. Experts predict that by the end of the decade
about half of the pension money in traditional firm-sponsored and firm-administered
pension plans will have been distributed to the contributors. Employers prefer distrib-
uting pension money in a lump sum to employees because it saves them the cost of
administering a string of retirement checks and other expenses. The problem is that
many people treat their lump-sum pension money as a win at the lottery and go on
spending spree, leaving little on which to live in their retirement years. Humans, it
seems (and contrary to the usual assumption of rationality made by traditional eco-
nomic theory), often behave quite irrationally! (Choices under uncertainty are exam-
ined in detail in Chapter 6.)
Sources: “Offered a Lump Sum, Many Retirees Blow It and Risk Their Future,” Wall Street Journal,
July 31, 1995, p. Al; “Borrowing on a 401k? Better Think Twice,” Wall Street Journal, October 12, 2001,
p. Cl; and L. A. Muller, “Does Retirement Education Teach People to Save Pension Distribution?” Social
Security Bullettin, No. 4, 2001/2002, pp. 48-65.

4.2 CHANGES IN PRICE AND THE INDIVIDUAL DEMAND CURVE

Commodity prices frequently change in the real world, and it is important to examine
their effect on consumer behavior. A change in commodity prices changes the consumer
budget line, and this affects consumer purchases. In this section we examine how the
consumer reaches a new optimum position when the price of a good changes but the
price of the other good, income, and tastes remain unchanged.
By changing the price of good X while holding constant the price of good Y,
income, and tastes, we can derive the consumer’s price—consumption curve for good X.
Price—consumption The price—consumption curve for good X is the locus of (i.e., joins) consumer opti-
curve The locus of mum points resulting when only the price of good X varies. From the price—consumption
consumer optimum
curve we can then derive the consumer’s demand curve for good X.
points resulting when
For example, the top panel of Figure 4.3 shows once again that with budget line JK,
only the price of a
good varies. the consumer maximizes utility or is at an optimum at point B, where indifference curve
U, is tangent to budget line JK and the consumer purchases 2X and 6Y (the same as in
Figure 3.8). Suppose that the consumer’s income (i.e., the student allowance) remains
unchanged at / = $10 per day and the price of good Y (soft drinks) also remains constant
at Py = $1. A reduction in the price of good X (hamburgers) from Py = $2 to Py = $1
and then to Py = $0.50 would cause the consumer’s budget line to become flatter
or
 CHAPTER 4 Consumer Behavior and Individual Demand 95

Price-consumption curve
(=p)

pO

Soft
(Y)
drinks
of
unit
time
per

0 2 5 6 10 20 Qx
Hamburgers (X) per unit of time

Px($)

hamburgers
of
Price

= or —)

0 2 6 10 Qy
Hamburgers (X) per unit of time
FIGURE 4.3 Price—Consumption Curve and the Individual’s Demand Curve
The top panel shows that with / = $10 and Py = $1, the consumer is at an optimum at
point B by purchasing 2X with Py = $2, at point E by purchasing 6X with Py = $1, and at
point G by purchasing 10X with Py = $0.50. By joining points BEG, we get the price-
consumption curve for good X. In the bottom panel, by plotting the optimum quantities
of good X on the horizontal axis and the corresponding prices of good X on the vertical
axis, we derive the individual's negatively sloped demand curve for good X, dy.

to rotate counterclockwise from JK to JK” and then to JN’ (the same as in the right panel
of Figure 3.7).°
With Py = $1 and budget line JK”, the consumer maximizes utility at point E, where
indifference curve U> is tangent to budget line /K” and the consumer purchases 6X and
AY (see the top panel of Figure 4.3). Indifference curve U> is the same as in the right

3 Remember that the X-intercepts of the budget lines are obtained by //Py. Thus, with J = $10 and Py = $2,
we get endpoint K and budget line JK. With Py = $1, we get endpoint K” and budget line JK”, and with
Py = $0.50, we get endpoint N’ and budget line JN’.
96 PART TWO. Theory of Consumer Behavior and Demand

and bud-
panel of Figure 3.2 because tastes have not changed. Finally, with Px = $0.50
on U4 by pur-
get line JN’, the consumer maximizes utility or is at an optimum at point G
G
chasing 10X and 5Y per unit of time (per day). By joining optimum points B, E, and
. Thus, the
we get (a portion of ) the price—consumption curve for this consumer (student)
price—consumption curve for good X is the locus of consumer optimum points resulting
when only the price ofX changes.*
From the price—consumption curve in the top panel of Figure 4.3, we can derive the
individual consumer’s (student’s) demand curve for good X in the bottom panel. The
Individual’s demand individual’s demand curve for good X shows the amount of good X that the consumer
curve Shows the would purchase per unit of time at various alternative prices of good X while holding
quantity that the everything else constant. It is derived by keeping the same horizontal scale as in the top
individual would panel but measuring the price of good X on the vertical axis.
purchase of a good per
The derivation of the individual’s demand curve proceeds as follows. With
unit of time at various
alternative prices of 1=$10, Py = $1, and Py = $2, the student maximizes utility by purchasing 2X (two ham-
the good while burgers) per day (point B) in the top panel. This gives point B’ (directly below point B) in
keeping everything the hottom panel. With Py = $1, the consumer is at optimum by purchasing 6X (point E)
else constant. in the top panel. This gives point E’ in the bottom panel. Finally, with Py = $0.50, the con-
sumer maximizes utility by purchasing 10X (point G in the top panel and G’ in the bottom
panel). Other points could be similarly obtained. By joining points B’, E’, and G’ we get
Concept Check
the individual consumer’s demand curve for good X, dy, in the bottom panel. Thus, the
Does the individual’s
demand curve reflect demand curve is derived from the price—consumption curve and shows the quantity of the
both the substitution good that the consumer would purchase per unit of time at various alternative prices of the
and income effects? good while holding everything else constant (the ceteris paribus assumption).
We will see in Chapter 5 that the market demand curve for a good (our ultimate aim
in Part Two of the text) is obtained from the addition or the horizontal summation of all
individual consumers’ demand curves for the good. Note that the individual consumer’s
demand curve for a good (d, in the bottom panel of Figure 4.3) is negatively sloped. This
reflects the law of demand, which postulates that the quantity purchased of a good per unit
of time is inversely related to its price. Thus, the individual purchases more hamburgers
per unit of time when their price falls and less of them when their price rises. Also note
that an individual consumer’s demand curve for a good is derived by holding constant the
individual’s tastes, his or her income, and the prices of other goods. If any of these
change, the entire demand curve will shift. This is referred to as a change in demand as
opposed to a change in the quantity demanded, which is a movement along a given
demand curve as a result of a change in the price of the good while holding everything
else constant (refer back to Section 2.2).

EXAMPLE 4-3
Higher Alcohol Prices Would Sharply Reduce Youth Alcohol Use and Traffic Deaths

Road accidents are the single largest cause of deaths among young people
in
America, and about half of the road fatalities are caused by young people
driving
while intoxicated. Efforts to reduce alcohol use by youths have centered
on increas-
ing the minimum legal age for purchasing and drinking alcohol, which
is now 21 in

4) At each
al point
ner along the price—c ; curve, MRSyy = Py/Py.
onsumption However, unlike the case of the
income—consumption curve, these ratios will vary because the budget
lines are no longer parallel.
 CHAPTER 4 Consumer Behavior and Individual Demand 97

all 50 states. The hope is that this will shift the demand curve for alcohol use by
young people to the left (despite the fact that some forge identity cards to get around
the rule). Surprisingly, little use has been made in the United States of an even more
powerful deterrent to youth alcohol use—higher alcohol prices through higher fed-
eral alcohol taxes. In fact, the real price (i.e., the nominal price divided by the price
index to adjust for inflation) of alcoholic beverages has declined by about 40% for
beer and wine and 70% for hard liquor in the United States since 1951. Taxes are cur-
rently only about $2 per quart for beer and $3.60 for hard liquor in the United States,
compared with $18.20 and $34.50 in England.
Using simulations for a sample of high school students, Douglas Coate and
Michael Grossman found that by indexing the tax on beer to the rate of inflation (so
as to keep the real price of beer constant at the 1951 level) would have cut the num-
ber of frequent young beer drinkers by about 20% and that this would have saved
1,660 lives from traffic accidents per year (twice as many as resulting from increas-
ing the minimum legal drinking age from 18 to 21). Of course, raising taxes even
higher so as to increase the real price of alcoholic beverages would have reduced
drinking and road fatalities even more. This is not surprising, since most teenagers
have much less disposable income than adults. Thus, increasing the price of alcoholic
beverages would have a more powerful deterring effect on them than on older
drinkers. What is surprising is that despite the predictions of economic theory and the
confirmation of empirical studies, the government has chosen thus far not to use price
as a powerful deterrent to youth alcohol use.
Sources: “Efforts to Reduce Teen Drinking May Provide Lessons,” Wall Street Journal, August 10, 1995,
p. B1; “Beer, Taxes and Death,” The Economist, September 18, 1993, p. 33; Douglas Coate and Michael
Grossman, “Effects of Alcoholic Beverage Prices and Legal Drinking Ages on Youth Alcohol Use,”
Journal of Law and Economics, April 1988, pp. 145-172; “Traffic Death Rose in 2001, But Rates for
Miles Fell,’ New York Times, August 8, 2002, p. 21; and Center for Disease Control and Prevention,
“Teen Drivers: Fact Sheets,” April 20, 2007, http://www.cdc.gov/ncipce/factsheets/teenmvh.htm.

4.3 SUBSTITUTION EFFECT AND INCOME EFFECT

In this section, we separate the substitution effect from the income effect of a price
change for both normal and inferior goods. This separation will give us an important ana-
lytical tool with wide applicability and will also allow us to examine the exception to the
law of downward sloping demand.

How Are the Substitution Effect and the Income Effect Separated?°
We have seen in the previous section that when the price of a good falls the consumer
buys more of it. This is the combined result of two separate forces at work called the sub-
stitution effect and the income effect. We now want to separate the total effect of a price
change into these two components. We begin by first reviewing how the total effect of a
price change (discussed in Section 4.2) operates.

5 The separation of the substitution effect from the income effect of a price change using rudimentary calculus
is shown in section A.4 of the Mathematical Appendix at the end of the book.
98 PART TWO. Theory of Consumer Behavior and Demand

Qx
Subs.

Income
=

Total effect

FIGURE 4.4 Income and Substitution Effects for a Normal Good

Starting from optimum point B (as in the top panel of Figure 4.3),
we can isolate the substitution effect by drawing imaginary budget
line J*K* tangent to U; at T. The movement along U; from point B to
point 7 is the substitution effect and results from the relative
reduction in Py only (with real income constant). The shift from point
T on U; to point E on U> is then the income effect. The total effect
(BE = 4X) equals the substitution effect (BT = 2X) plus the income
effect (TE = 2X).

In Figure 4.4, / = $10 and Py = $1, and these remain constant. With Py = $2, we
have budget line JK and the consumer maximizes utility at point B on indifference curve
U, by purchasing 2X. When the price of good X falls to Py = $1, the budget line becomes
JK” and the consumer maximizes utility at point E on indifference curve U» by purchas-
ing 6X (so far this is the same as in Figure 4.3). The increase in the quantity purchased
from 2X to 6X is the total effect or the sum of the substitution and income effects. We are
now ready to separate this total effect into its two components: the substitution effect and
the income effect. The substitution effect measures the increase in the quantity
demanded of a good when its price falls resulting only from the relative price decline
and independent ofthe change in real income. On the other hand, the income effect mea-
sures the increase in the quantity purchased of a good resulting only from the increase
in real income that accompanies a price decline.
 CHAPTER 4 Consumer Behavior and Individual Demand 99

Substitution effect First, consider the substitution effect. In Figure 4.4, we see that when the price of
The increase in the X falls from Py = $2 to Py = $1, the individual moves from point B on Uj to point FE on
quantity demanded U> so that his or her level of satisfaction increases. Suppose that as Py falls we could
of a good when its
reduce the individual’s money income sufficiently to keep him or her on original indif-
price falls, resulting
only from the relative
ference curve U;. We can show this by drawing hypothetical or imaginary budget line
price decline and J*K* in Figure 4.4. Imaginary budget line J*K* is parallel to budget line JK” so as to
independent of the reflect the new set of relative prices (i.e., Py/Py = $1/$1 = 1) and is below budget line
change in real income. JK" in order to keep the individual at the original level of satisfaction (i.e., on indiffer-
ence curve U}).° The individual would then maximize satisfaction at point 7, where
indifference curve U; is tangent to imaginary budget line J*K* (so that MRSyy = Py/Py =
> Lid lea):
The movement along indifference curve U; from original point B to imaginary
point T measures the substitution effect only (since the individual remains on the same
indifference curve or level of satisfaction). From Figure 4.4, we see that the substitu-
tion effect, by itself, leads the individual to increase the quantity purchased of good X
from two to four units when Py falls from $2 to $1. That is, the individual substitutes
hamburgers for, say, hot dogs and purchases two additional hamburgers and fewer hot
dogs per unit of time. The substitution effect results exclusively from the reduction
Relative price The in the relative price ofX (from Px/Py = $2/$1 = 2 to Py/Py = $1/$1 = 1) with the
price of one good in level of satisfaction held constant. Because indifference curves are convex, the substi-
terms of that of another. tution effect always involves an increase in the quantity demanded of a good when its
price falls.
Income effect The Next, consider the income effect. The shift from the imaginary point T on U| to the
increase in the quantity actual new point F on U2 can be taken as a measure of the income effect. The shift from
purchased of a good point T to point E does not involve any price change. That is, since the imaginary budget
resulting only from the
line J*K* and the actual new budget line JK” are parallel, relative prices are the same (i.e.,
increase in real income
Px/Py= | inboth). The shift from indifference curve U; to U2 can thus be taken as a mea-
that accompanies a
price decline. sure of the increase in the individual’s real income or purchasing power.’ Because good
X is anormal good, an increase in the consumer’s purchasing power or real income leads
him or her to purchase more of X (and other normal goods). In Figure 4.4, the income
effect, by itself, leads the consumer to purchase two additional hamburgers (i.e., to go
from 4X to 6X).®
Thus, the total effect of the reduction in Py (BE = 4X) equals the substitution effect
(BT = 2X) plus the income effect (TE = 2X). The substitution effect reflects the increase
in Oy resulting only from the reduction in Py and is independent of any change in the con-
sumer’s level of satisfaction or real income. On the other hand, the income effect reflects
the increase in Qy resulting only from the increase in satisfaction or real income. Only the
total effect of the price change is actually observable in the real world, but we have been
able, at least conceptually or experimentally, to separate this total effect into a substitu-
tion effect and an income effect.

6 Budget line /*K* is imaginary in the sense that we do not actually observe it, unless the reduction in Px is in
fact accompanied by a lump-sum tax that removes $3 (JJ* = K”K*) from the money income of the individual.
7 The shift from point T to point E could be observed by giving back to the consumer the hypothetical lump-
sum tax of $3 collected earlier. Only with such an increase in real income or purchasing power can the
consumer move from point 7 on U; to point E on U.
8 It also leads the individual to purchase one additional soft drink (i.e., to go from 3Yto 4Y ). See Figure 4.4.
100 PART TWO. Theory of Consumer Behavior and Demand

are of equal size. In the real

In Figure 4.4, the substitution effect and the income effect
the income effect. The reason Is
world, the substitution effect is likely to be much larger than
of a good falls, the quantity of
that most goods have suitable substitutes, and when the price
substitute the now-cheaper
the good purchased is likely to increase very much as consumers
goods and spending
good for others. On the other hand, with the consumer purchasing many
effect of a price
only a small fraction of his or her income on any one good, the income
likely to be small. There are, however , excepti onal cases in which
decline of any one good is
substit ution effect. Also note that althoug h the substitution
the income effect exceeds the
Concept Check to an increas e in the quan-
effect of a price reduction is always positiv e (i.e., it always leads
Why is the substitution or negative
tity demanded of a good), the income effect can be positiv e if the good is normal
effect usually larger
than the income effect? if the good is inferior.’

EXAMPLE 4-4
Substitution Effect and Income Effect of a Gasoline Tax

One of the biggest political battles being fought in Congress centers on energy pol-
icy in general and the size of the federal gasoline tax in particular. This is not a new
battle. It is a battle that has been fought periodically every five years or so during
the past three decades, every time the price of petroleum and American dependence
on imported petroleum increased. It is surely a battle that will be fought again
before the end of this decade because of the need for an energy policy in the United
States.
Overall, gasoline taxes are now about 47 cents per gallon in the United States, as
compared with more than $2 per gallon in Europe and Japan. Ever since the first petro-
leum crisis in 1973-1974, many in Congress have sought a gasoline tax of 50 cents per
gallon. The tax would increase gasoline prices for American motorists and lead to a
reduction in gasoline consumption and American dependence on foreign oil (which
now stands at more than 60%, up from 35% in 1973). To avoid the deflationary impact
(i.e., the reduction in purchasing power) of the tax on the economy, it has been pro-
posed to either (a) return to consumers the amount of the tax collected on gasoline in
the form of a general tax rebate unrelated to gasoline consumption or (b) reduce other
taxes.
The gasoline tax, coupled with a general tax rebate to avoid the deflationary impact
of a gasoline tax, relies on the distinction between the substitution effect and the income
effect of an increase in gasoline prices. The substitution effect would result as people
switch to cheaper means of transportation (trains, buses, subways), car pools, and more

° We could derive a demand curve along which real, rather than nominal, income is kept constant (i.e.,
showing or reflecting only the substitution effect). Such a demand curve would be steeper than the usual
demand curve (which shows both the substitution and the income effects) if the good is
normal (because
in that case the income effect reinforces the substitution) and flatter than the usual demand
curve if the
good is inferior (because in that case part of the substitution effect would be neutralized by
the opposite
income effect).
 CHAPTER 4 Consumer Behavior and Individual Demand 101

fuel-efficient cars and economize on the use of automobiles in general. The general
income subsidy would then neutralize the reduction in real income associated with the
increase in the price of gasoline. Thus, while the reduction in purchasing power would
be neutralized by the general income subsidy, the increase in the gasoline price would
reduce its consumption. Despite strong opposition to a large increase in the gasoline tax
from road builders, tourist interests, farm groups, the oil industry, and truckers, a large
increase in the gasoline tax seems likely. It has been estimated that the optimal gasoline
tax in the United States is $1.00 per gallon. Americans strongly prefer (and have relied
on) tougher fuel-efficiency rules on automakers to reduce the growth of gasoline con-
sumption. The sharp increase in gasoline prices since 2007 is leading Americans to drive
less and reduce gasoline consumption.
Sources: A. A. Taheri, “Oil Shocks and the Dynamics of Substitution Adjustments in Industrial Fuels in the
U.S.” Applied Economics, August 1994, pp. 751-756; “Oil Prices Generate Political Heat,’ Wall Street
Journal, August 30, 2000, p. A18; “Looking for Ways to Save Gasoline,” Wall Street Journal, July 12,
2001, p. Al; “Want to Cut Gasoline Use? Raise Taxes,” Business Week, May 27, 2002, p. 26; “The
Gasoline Tax: Should It Rise?” Wall Street Journal, August 18, 2007, p. A4; and “Drinking Less,
Americans Finally React to Sting of Gas Prices,’ New York Times, June 19, 2008, p. C3.

Substitution Effect and Income Effect for Inferior Goods

For a normal good, the substitution effect and the income effect of a price decline are both
positive and reinforce each other in leading to a greater quantity purchased of the good.
On the other hand, when the good is inferior, the income effect moves in the opposite
direction from the substitution effect. That is, when the price of an inferior good falls, the
substitution effect continues to operate as before to increase the quantity purchased of the
good.This results from the convex shape of indifference curves. However, the increase in
purchasing power or real income resulting from the price decline leads the consumer to
purchase Jess of an inferior good. But, because the substitution effect is usually larger
than the income effect, the quantity demanded of the inferior good increases when its
price falls and the demand curve is still negatively sloped.
We can separate the substitution effect from the income effect of a price decline for
an inferior good by returning to the candy bar (inferior good Z) example of the previous
section. In the top panel of Figure 4.5, the consumer is originally at optimum at point V,
where indifference curve U'is tangent to budget line JK’ and the consumer purchases
four candy bars (as in the top panel of Figure 4.2). If the price of candy bars declines
from Pz = $1 to Pz = $0.50, the consumer moves to optimum point S, where indiffer-
ence curve U%is tangent to budget line JN’ and the consumer purchases 6Z. The move-
ment from point V to point S (+2Z) is the sum or net effect of the substitution and
income effects.
To separate the substitution effect from the income effect, we now draw the imag-
inary budget line J*N*, which is lower than, but parallel to, budget line JN’ and tangent
to Ujat point T. The movement along U; from the original point V to imaginary point T
is the substitution effect. It results exclusively from the reduction in Pz relative to Py
and is independent of any increase in real income. Thus, the substitution effect, by
itself, leads the individual to purchase four additional units of good Z per unit of time
(from 4Z to 8Z).
102 PART TWO. Theory of Consumer Behavior and Demand

Qy

10 Candy bars: inferior good

0 4 6 8 10 Nat 20 Oz
eee A Candy bars (Z) per unit of time
Substitution

Income

Net
effect

Qy
10 s* Candy bars: Giffen good
J .

0 2 4 8 10 14 20 Qz
(oe res Candy bars (Z) per unit of time
Substitution

| Income
a
' Net !
effect

FIGURE 4.5 Income and Substitution Effects for Inferior Goods Starting from optimum point
V in the top panel, we can isolate the substitution effect by drawing J*N* parallel to JN’ and tangent to
Uj at point T The movement along U‘ from point V to point T is the substitution effect The
movement
from point T on U} to point S on USis the income effect. Since the income effect is negative, good
Z is
inferior. However, since the positive substitution effect exceeds the negative income effect, Q7
increases
when P7 falls. In the bottom panel, the positive substitution effect (VT = 4Z) is smaller than
the negative
income effect (TS* = —6Z), so that Q7 declines by 2Z when Pz falls. Good Z is then a Giffen
good.
 CHAPTER 4 Consumer Behavior and Individual Demand 103

On the other hand, the movement from imaginary point Ton U'to the new point $ on
U4 can be taken as a measure of the income effect. It results exclusively from the increase
in the level of satisfaction of the consumer with relative prices constant (Pz/Py =
$0.50/$1 = 1/2 for imaginary budget line J*N* and for new budget line JN’). The
income effect, by itself, leads the consumer to purchase two fewer units of good Z per unit
of time (from 8Z to 6Z) because good Z is an inferior good.
Thus, the total effect (VS = 2Z given by the movement from point V on U‘to point S
on U) equals the positive substitution effect (VT = 4Z given by the movement from
point V to T on U‘) plus the negative income effect (7S = —2Z given by the movement
from point T on U' to point S on U4). However, since the positive substitution effect
exceeds the negative income effect, the consumer purchases two additional units of good
Z when its price declines. Thus, the demand curve for good Z is negatively sloped, even
though good Z is an inferior good. That is, the consumer purchases 4Z at Pz = $1 and 6Z
at Pz = $0.50.
On the other hand, if the positive substitution effect is smaller than the negative
income effect when the price of an inferior good falls, then the demand curve for the infe-
rior good is positively sloped. This very rarely, if ever, occurs in the real world, and is
Giffen good An referred to as the Giffen good, after the nineteenth-century British economist, Robert
inferior good for which Giffen, who supposedly first discussed it. Note that a Giffen good is an inferior good, but
the positive substitution not all inferior goods are Giffen goods. If it existed, a Giffen good would lead to a posi-
effect is smaller than
tively sloped demand curve for the individual and would represent an exception to the law
the negative income
effect, so less of the
of negatively sloped demand.!°
good 1s purchased The bottom panel of Figure 4.5 is drawn on the assumption that good Z is now a
when its price falls. Giffen good. In this panel, the consumer is originally at optimum point V and hypo-
thetically moves to point T because of the substitution effect (as in the top panel).
However, with alternative indifference curve U3 in the bottom panel (as opposed to U}
Concept Check in the top panel), the income effect is given by the movement from point T to point S*.
What two conditions Point S* is to the left of point T because good Z is an inferior good, so that an increase
are necessary to have in real income leads to less of it being purchased. The total effect is now VS*(—2Z) and
a Giffen good?
is equal to substitution effect VT (4Z) plus income effect TS*(—6Z). Because the posi-
tive substitution effect is smaller than the negative income effect, the quantity
demanded of good Z declines when its price falls, and dz would be positively sloped
over this range. That is, the individual would purchase 4Z at Pz = $1 but only 2Z at
Concept Check
Pz = 190.90.
Why does a Giffen
good represent an Although theoretically interesting, the Giffen paradox rarely, if ever, occurs in the
exception to the law real world. The reason is that inferior goods are usually narrowly defined goods for which
of demand? suitable substitutes are available (so that the substitution effect usually exceeds the oppo-
site income effect). Giffen thought that potatoes in nineteenth-century Ireland provided
an example of the paradox, but subsequent research did not support his belief.'' Example
4—5 presents the first, rigorous empirical evidence of Giffen behavior.
The separation of the substitution effect from the income effect (and all of the analy-
sis in this chapter) could easily be shown for a price increase rather than for a price
decline. These alternatives are assigned as end-of-chapter problems.

10 1f we kept real rather than nominal income constant in deriving the demand curve (..e., if the demand curve
showed or reflected only the substitution effect), there would be no Giffen exception to the law of negatively
sloped demand.
'1 See S. Rosen, “Potatoes Paradoxes,” Journal of Political Economy, December 1999.
104 PART TWO Theory of Consumer Behavior and Demand

EXAMPLE
4-5 _
Giffen Behavior Found!

Jensen and Miller (2007) provided the first, rigorous empirical evidence of the eXxis-
tence of Giffen behavior among extremely poor households in two provinces of China
in 2006. The authors conducted a field experiment in which they provided randomly
selected poor households with price subsidies for the primary dietary staple food (rice
in Hunan province in southern China and wheat flour in Gansu province in northern
China).
The sample consisted of 100-150 households in each of 11 county seats in Hunan
and Gansu provinces, for a total of 1,300 households (650 in each province) with 3,661
individuals. Within each county, households were chosen at random from the list of the
urban poor obtained from the office of the Ministry of Civil Affairs. Households on the
list typically had incomes of between 100 and 200 yuan per person per month, or $0.41
to $0.82 per person per day (which is below even the World Bank’s “extreme” poverty
line of $1 per person per day). Data were gathered at three different times: April,
September, and December 2006. After completing the first (April) survey to choose
the sample, the sample households were informed that they would receive subsidies
from June through October to purchase their staple food; the change in the quantity
purchased of the staple food was recorded.
The authors found strong and clear evidence of the Giffen behavior with respect
to rice in Hunan province. The evidence with respect to wheat flour in Gansu province
was less robust, because some of the theoretical conditions necessary for the Giffen
behavior were not met. By restricting the Gansu sample to households that met those
conditions, the authors were able to find strong evidence of the Giffen behavior in
Gansu province also. Note that Giffen behavior was found precisely where theory
would predict: among very poor consumers, heavily dependent on a staple food, with
limited substitution possibilities.
Source: Robert T. Jensen and Nola H. Miller, “Giffen Behavior: Theory and Evidence,” NBER Working
Paper No, 13243, July 2007.

SUBSTITUTION BETWEEN DOMESTIC AND FoREIGN Goops

The substitution between domestic and foreign goods and services has reached an all-
time high in the world today and is expected to continue to increase sharply in the future.
This increase has been the result of (1) transportation costs having fallen to very low lev-
els for most products, (2) increased knowledge of foreign products due to an
interna-
tional information revolution, (3) global advertising campaigns by
multinational
Corporations, (4) the explosion of international travel, and (5) the rapid
convergence of
tastes internationally. For homogeneous products such as a particular
grade of wheat or
steel, and for many industrial products with precise specifications
such as computer
chips, fiber optics, and specialized machinery, substitutability between
domestic and for-
eign products is almost perfect. Here, a small price difference
can lead quickly to large
 CHAPTER 4 Consumer Behavior and Individual Demand 105

shifts in sales from domestic to foreign sources and vice versa. Indeed, so fluid is the
market for such products that governments often step in to protect these industries
from foreign competition.
Even for differentiated products, such as automobiles and motorcycles, computers
and copiers, watches and cameras, TV films and TV programs, soft drinks and ciga-
rettes, soaps and detergents, commercial and military aircraft, and most other products
that are similar but not identical, substitutability between domestic and foreign
products is very high and continues to rise. Despite the quality problems of the past,
U.S.-made automobiles today are highly substitutable for Japanese and European auto-
mobiles, and so are most other products. Indeed, intraindustry trade in such differenti-
ated products now represents over 60% of total U.S. trade and an even larger percentage
of the trade of most other industrial countries.'? With many parts and components
imported from many nations, and with production facilities and sales around the world
often exceeding sales at home, even the distinction between domestic and foreign prod-
ucts is fast becoming obsolete.

EXAMPLE 4-6
What Is an “American” Car?

Strange as it may seem, the question of what is an American car may be difficult to
answer. Should a Honda Accord produced in Ohio be considered American? What
about a Chrysler minivan produced in Canada (especially after Chrysler was acquired
by Germany’s Mercedes-Benz)? Is a Kentucky Toyota or Mazda that uses nearly 50%
of imported Japanese parts American? It is clearly becoming more and more difficult
to define what is American, and opinions differ widely.
For some, any vehicle assembled in North America (the United States, Canada,
and Mexico) should be considered American because these vehicles use U.S.-made
parts. But the United Auto Workers union views cars built in Canada and Mexico as
taking away U.S. jobs. Some regard automobiles produced by Japanese-owned plants
in the United States as American because they provide jobs for Americans. Others
regard production by these Japanese “transplants” as foreign, because the jobs they
create were taken from the U.S. automakers, because they use nearly 40% of imported
Japanese parts, and because they remit profits to Japan. What if Japanese transplants
increased their use of American parts to 75% or 90%? Was the Ford Probe, built for
Ford by Mazda in Mazda’s Flat Rock Michigan plant, American?
It is difficult to decide exactly what is an American car—even after the
American Automobile Labeling Act of 1992, which requires all automobiles sold in
the United States to indicate what percentage of the car’s parts are domestic or for-
eign. One could even ask if this question is relevant at all in a world growing more
and more interdependent and globalized. In fact, rapid consolidation in the industry
has left only five truly global automakers—General Motors, Ford, Toyota, Daimler

12 ED. Salvatore, International Economics, 9th ed. (Hoboken, N.J.: John Wiley & Sons, 2007), Section 6.4.
106 PART TWO. Theory of Consumer Behavior and Demand

ing a truly world

Chrysler, and Volkswagen—and each has developed or is develop
automob ile sold everywh ere) and using parts
car (essentially the same basic type of
from all over the world.
New York Times, ‘October o).
Sources: “Honda’s Nationality Proves Troublesome for Free-Trade Pact,” The
1992, p. 1; “Want a U.S. Car? Read the Label,” The New York Times, September 18, 1994, Section 3, p. 6:
“Made in America? Not Exactly: Transplants Use Japanese Car Parts,” Wall Street Journal, September |,
1995, p. A3B; “And Then There Were Five,” U.S. News & World Report, March 4, 2000, p. 46; and
2 1986.
“Defining an American Car,’ August 2007, http://autos.msn.com/advice/article.aspx ?contentid=40

SOME APPLICATIONS OF INDIFFERENCE CURVE ANALYSIS

We now can apply the tools developed in this chapter to analyze the economics of the
food stamp program, consumer surplus, and exchange. These applications deal only with
the demand for goods and services, but the tools developed in this chapter have many
other applications (examined in other parts of the text). For example, the distinction
between the substitution and income effects is useful in analyzing the effect of overtime
pay on the number of hours worked and on leisure time. Because this topic deals with the
supply of labor, however, it is appropriately postponed until Chapter 14, which deals with
input price and employment. Indifference curve analysis is also useful in analyzing the
choice between borrowing or lending from present income (examined in Chapter 16), in
general equilibrium and welfare economics (examined in Chapter 17), and in the analysis
of time as an economic good (discussed more extensively in Chapter 19).

Is a Cash Subsidy Better Than Food Stamps?

Food stamp program Under the federal food stamp program, low-income families receive free food stamps,
A federal program which they can use only to purchase food. At its peak in 1988, more than 4.8 million
under which eligible eligible low-income families received free food stamps at a cost of $12.4 billion to the
low-income families
federal government. The important question is whether it would have been better (i.e.,
receive free food
stamps to purchase provided more satisfaction) to have given an equal amount of subsidy in cash to these
food. families.
We can examine this question using Figure 4.6. Suppose that, initially, a typical poor
family has a weekly income of $100. If the poor family spent its entire weekly income on
nonfood items, it could purchase $100 worth of nonfood items per week (point A on the
vertical axis). On the other hand, if the poor family spent the entire $100 on food, it could
purchase 100 units of food per week if the unit price of food were $1 (point C on the hor-
izontal axis). The initial budget line of the family would be AC.
With free food stamps that allow the family to purchase $50 worth of food per week,
the budget line of the family becomes AB’C’, where AB’ = CC’ = 50. Combinations on
dashed segment A’B’ are not available with the food stamp program because the family
would have to spend more than its $100 money income on nonfood items and less than
the $50 of food stamps on food (and this is not possible if it cannot sell its food stamps).
Were the government to provide $50 in cash rather than in food stamps, the budget line
would then be A’C’. Thus, we have three alternative budget lines for the family:
budget
line AC without any aid, budget line AB’C’ with $50 in food stamps, and budget line A’C’
with $50 cash aid instead.
 CHAPTER 4 Consumer Behavior and Individual Demand 107

Money for
nonfood
items

110 rf
100

70
60

30

40 90
Food

FIGURE 4.6 Food Stamps Versus Cash Aid A poor family’s budget line,
AC, becomes AB’C’ with $50 worth of free food stamps per week, and A’C’
with a $50 cash subsidy instead. The family maximizes utility at point B on U;
without any aid, at point B’ on U> with food stamps, and at point B” on U3 with
the cash subsidy. However, another family with the same original income and
budget line AC but with a stronger preference for food may go instead from
point F on U4 to point F’ on U3 either with the cash subsidy or with food stamps.

If the family’s indifference curves are U;, U2, and U3, the family maximizes utility at
point B where U; is tangent to AC before receiving any aid, at point B’ on Uz with food
stamps, and at point B” (preferred to B’) on U3 with the cash subsidy. In this case, the cash
subsidy allows the family to reach a higher indifference curve than do food stamps.!*
C However, another family with the same initial income of $100 (and budget line AC) but
oncept Check eae ae ; 7
Why is a cash subsidy
stronger preference for food and facing indifference curves U,and U3will move instead
generally better than a from point F on U;to point F’ on U3 either with the cash subsidy or with food stamps.
subsidy in kind? Thus, depending on the family’s tastes, a cash subsidy will not be worse than food stamps
and may be better (i.e., provide more satisfaction). Why then does the federal government
continue to use food stamps? One reason is to improve nutrition.'4

'5 Both cost the government $50.

‘4 Note that the indifference curves of the two different families shown in Figure 4.6 would cross if extended.
It is only the individual indifference curves of each family that cannot cross.
108 PART TWO Theory of Consumer Behavior and Demand

Consumer Surplus Measures Unpaid Benefits

Consumer surplus Consumer surplus is the difference between what a consumer is willing to pay for a
The difference between good and what he or she actually pays. It results because the consumer pays for each unit
what the consumer is of the good only as much as he or she is willing to pay for the last unit of the good (which
pe bay tons gives less utility than earlier units). We can see how consumer surplus arises and how it
een ua Ole can be measured with the aid of Figure 4.7.
good and what he or . : : ae
she actually pays for it. The figure shows that $5 is the maximum amount that the consumer 1s willing to pay
for the first unit of good X (say, hamburgers) rather than go without it. Thus, the area of
the first rectangle (with height of $5 and width of 1) measures the marginal value or ben-
efit that the consumer gets from the first hamburger. After all, by being willing to purchase
the first hamburger for $5, the consumer indicates that he or she prefers paying $5 for the
first hamburger rather than keeping the $5 in cash or spending the $5 on other goods. The
second unit of good X (hamburger) gives the consumer less utility than the first, and the
consumer would be willing to pay $4 for it rather than go without it. Thus, $4 (the area of
the second rectangle) can be taken as a measure of the marginal value or benefit of the
second hamburger to the consumer. The third hamburger gives the consumer less utility
than either the first or the second and so the consumer is willing to pay only $3 for it.
Thus, the marginal value or benefit of the third hamburger is $3 and is given by the area
of the third rectangle. For the fourth hamburger, the consumer would be willing to pay $2
(the area of the fourth rectangle), and this is a measure of the marginal value or benefit of
the fourth hamburger, and so on.
To summarize, the consumer would be willing to pay $5 for the first hamburger, $4 for
the second, $3 for the third, and $2 for the fourth, for a total of $14 for all four hamburg-
ers. Thus, $14 is the total benefit that the consumer receives from purchasing four ham-
burgers. However, if the market price is $2 per hamburger, the consumer can purchase all
four hamburgers at a total cost of (i.e., by actually spending) only $8. Because the con-
sumer would be willing to pay $14 for the first four hamburgers rather than go entirely

X
of
Price

FIGURE 4.7 Consumer Surplus The difference between what

the consumer is willing to pay for 4X ($5 + $4 + $3 + $2 — $14) and
what he or she actually pays ($8) is the consumer surplus (the shaded
area that equals $6). If good X could be purchased in infinitesimally
small units, the consumer surplus would equal the area under dy and
above Py = $2 (area AEB = $8),
Quantity of X
 CHAPTER 4 Consumer Behavior and Individual Demand 109

without them, but actually pays only $8, he or she enjoys a net benefit or consumer surplus
equal to the difference ($6).
To put it another way, the consumer is willing to pay $5 for the first hamburger, but
since he or she can purchase it for only $2, he or she receives a surplus of $3 for the first
hamburger. Since the consumer is willing to pay $4 for the second hamburger but pays
only $2, there is a surplus of $2 on the second hamburger. For the third hamburger, the
consumer is willing to pay $3, but since he or she pays only $2, the surplus is $1. For the
fourth hamburger, the consumer is willing to pay $2, and since he or she has to pay $2 for
it, there is no surplus on the fourth hamburger. The consumer would not purchase the fifth
hamburger because he or she is not willing to pay the $2 market price for it.
By adding the consumer surplus of $3 on the first hamburger, $2 on the second, $1
on the third, and $0 on the fourth, we get the consumer surplus of $6 obtained earlier. This
is given by the sum of the shaded areas in the figure. The same result would have been
obtained if the consumer had been asked for the maximum amount of money that he or
she would have been willing to pay for four hamburgers rather than do entirely without
them—all or nothing.
If hamburgers could have been purchased in smaller and smaller fractions of a whole
Concept Check hamburger, then the consumer surplus would have been given by the entire area under
In what way does demand curve dy above the market price of $2. That is, the consumer surplus would have
consumer surplus been the area of triangle AEB, which is (1/2)(4)(4) = $8. This exceeds the consumer sur-
benefit the consumer? plus of $6 that we found by adding only the shaded areas in the figure. Specifically, the
consumer would have been willing to pay $16 (the area of OAEC) for four hamburgers.
Note that OAEC is composed of triangle AEB plus rectangle OBEC. Since the consumer
only pays $8 (OBEC), the consumer surplus is $8 (AEB). If Py fell to $1, the consumer
would purchase five hamburgers and the consumer’s surplus would be $12.50 (the area
under dy and above Py = $1 in the figure) if hamburgers could be purchased by infinitely
small fractions of a whole hamburger.!>
The concept of consumer surplus was first used by Jules Dupuit in 1844 and was sub-
sequently refined and popularized by Alfred Marshall. The concept helped resolve the so-
Water—diamond called water—diamond paradox, which plagued classical economists until 1870. Why is
paradox The question water, which is essential for life, so cheap, whereas diamonds, which are not essential, are
of why water, which is so expensive? The explanation is that because water is so plentiful (relatively cheap) and
essential to life, is so
we use so much of it, the utility of the last unit is very little (washing the car), and we pay
cheap, whereas diamonds,
as little for all units of water as we are willing to pay for the last nonessential unit of it. On
which are not essential,
are sO expensive. the other hand, diamonds are scarce in relation to demand, and because we use very little
of them, the utility and price of the /ast unit are very great. The total utility and the con-
sumer surplus from all the water used are far greater than the total utility and the consumer
Concept Check surplus from all the diamonds purchased. However, demand depends on marginal utility,
Why is water so cheap not on total utility. In a desert, the first glass of water would be worth much more than any
whereas diamonds are glassful of diamonds.
so expensive? The above analysis referred to an individual’s demand curve, but a similar analysis
would also apply to a market demand curve. In subsequent chapters we will use the con-
cept of consumer surplus to measure the benefits and costs of excise taxes, import tariffs,

15 Measuring consumer surplus by the area under the demand curve and above the prevailing market price is only
an approximation (it is based on the assumption that a consumer’s indifference curves are parallel), but for most
purposes it is sufficiently accurate to be a useful tool of analysis. See, R. D. Willig, “Consumer Surplus without
Apology,” American Economic Review, September 1976. See, however, K. S. Lyon and Ming Yan, “Compensating
Variation Consumer’s Surplus Via Successive Approximations,” Applied Economics, June 1995, pp. 547-554.
110 PART TWO. Theory of Consumer Behavior and Demand

as well as to
pollution control, government projects, and other microeconomic policies,
measure the benefits and costs of alternative market structures .

Benefits from Exchange

Suppose that two individuals, A and B, have a given amount of good X and good Y and
decide to trade some of these goods with each other. If the exchange is voluntary, the
strong presumption is that both individuals gain from the exchange (otherwise, the indi-
vidual who loses would simply refuse to trade). We can examine the process of voluntary
exchange by indifference curve analysis.
Suppose that individual A’s tastes and preferences for good X and good Y are
shown by indifference curves U;, U2, and U3 in the top left panel of Figure 4.8.
Individual B’s tastes and preferences are given by indifference curves Uj, U5, and U3
(with origin 0’) in the top right panel. Initially, individual A has an allocation of 3X and
6Y (point C in the top left panel) and individual B has 7X and 2Y (point C’ in the top
right panel).
We now rotate individual B’s indifference diagram by 180 degrees (so that origin 0’
appears in the top right corner) and superimpose it on individual A’s indifference dia-
Edgeworth box gram in such a way that the axes of the two diagrams form the so-called Edgeworth box
diagram A diagram diagram, shown in the bottom panel of Figure 4.8. The length of the box (10X) measures
constructed from the the combined amount of X initially owned by individual A (3X) and individual B (7X).
indifference map
The height of the box (8Y) measures the amount of Y initially owned by individual A
diagrams of two
(6Y) and individual B (2Y). A’s indifference curves are convex to origin 0 (as usual),
individuals, which can
be used to analyze while B’s indifference curves are convex to origin 0’.
voluntary exchange. Any point inside the box indicates how the total amount of X and Y may be dis-
tributed between the two individuals. For example, the initial distribution of X and Y
given by point C indicates that individual A has 3X and 6Y (viewed from origin 0) and
individual B has the remainder of 7X and 2Y (when viewed from origin 0’) for a total
of 10X and 8Y (the dimensions of the box). Individual A is on indifference curve U
and individual B is on indifference curve U’'.
Since at point C (where U; and U/ intersect) the marginal rate of substitution of good
X for good Y (MRSyy) for individual A exceeds MRSyy for individual B, there is a basis for
mutually beneficial exchange between the two individuals. Starting at point C, individual
A would be willing to give up 4Y to get one additional unit ofX (and move to point D on
U,). On the other hand, individual B would be willing to give up LX for about 0.2 addi-
tional units of Y (and move to point H on U;). Because A is willing to give up more of Y
than necessary to induce B to give up LX, there is a basis for trade in which individual A
gives up some of Y in exchange for some of X from individual B.
Whenever the MRSyy for the two individuals differs at the initial distribution of X
and Y, either or both may gain from exchange. For example, starting from point C, if
individual A exchanges 4Y for 1X with individual B, A would move from point C to
point D along indifference curve U;, while B would move from point C on U'to point
D on U3. By moving from indifference curve U' to indifference curve U’, individual B
receives all of the gains from the exchange while individual A gains or loses nothing
(since A remains on U;). At point D, U; and U3 are tangent, and so their slopes
(MRSyy)
are equal. Thus, there is no basis for further exchange (at point D, the amount
of Y
that
A is willing to give up for 1X is exactly equal to what B requires to give
up LX). Any
further exchange would make either one or both individuals worse off
than they are at
point D.
 CHAPTER 4 Consumer Behavior and Individual Demand 111

Q) Qy
Individual A
8b gL Individual B

63-45 6b
fale
Us
| 4 |

5 ae Us
Us

) & ||
2 cn U
1
U
Lie heey l l ot
0 Oe A eel eto 10) Oem 0 ts Gs a8 Oe

-— Qy (Individual B)
lg @ 8 dl 6 5 4 3 D 1 (0)’
8 ] | ] ] | ] | | | Q\

hh eae

Te

6b a
Us
5 =

4 - Us
3 ee

Dy =

1 ees

Qy | | | | | | | | | 8
0) 1 2 3 4 5 6 7 8 9 10
(IndividualA) Qy —_.

FIGURE 4.8 Edgeworth Box Diagram The top left panel shows individual A’s
indifference curves, and the top right panel shows B's indifference curves. The box in the
bottom panel is obtained by rotating B’s indifference map diagram 180 degrees and
superimposing it on A's diagram in such a way that the dimensions of the box equal the
initial Combined amounts of goodsX and Y owned by A and B. Any point in the box refers
to a particular distribution of X and Y between A and B. At point C, MRSyy for the two
individuals differs (U; and U;’ cross) and there is a basis for mutually beneficial exchange
until a point between D and F on curve DEF is reached (where MRSyy for A and B are equal).

Alternatively, if individual A exchanged 1Y for 5X with individual B, individual A

would move from point C on U; to point F on U3, while individual B would move from
point C to point F along U’', In this case, A would reap all the benefits from exchange
while B would neither gain nor lose. At point F, MRSyy for A equals MRSyy for B and
there is no further basis for exchange. Finally, starting again from point C on U; and U;,
ti2 PART TWO Theory of Consumer Behavior and Demand

individuals gain from the

if A exchanges 3Y for 3X with B and gets to point E, both
a
exchange since point E is on U2 and U>.
both individu als can
Starting from any point within CDEF but not on curve DEF,
points D and F. The
Concept Check gain from exchange by moving to a point on curve DEF between
bargaine r), the greater
Until what point does closer individual A gets to point F (i.e., the more shrewd A is as a
mutual beneficial is the proportion of the total gain from the exchang e accruin g to A and the less is left
th, who
exchange take place? for B. The Edgeworth box is named after the English economist F. Y. Edgewor
detail in
in 1881 first outlined its construction. (We will return to exchange in greater
Chapter 17.)

AT THE FRONTIER
The Characteristics Approach to Consumer Theory

Characteristics he characteristics approach to consumer theory, pioneered by Kelvin Lancaster,

approach to T postulates that consumers demand a good because of the characteristics, proper-
consumer theory ties, and attributes of the good, and it is these characteristics that give rise to utility.!®
The theory that For example, a consumer does not demand beef, as such, but rather the characteristics
postulates that a
of protein and calories, which are the direct source of utility. But protein and calories
consumer
demands a good
are also provided (though in different proportions) by pork and chicken. Thus, a good
because of the usually possesses more than one characteristic, and any given characteristic is present
characteristics, in more than one good.
properties, or The characteristics approach to consumer theory can be shown graphically. In the
attributes of top panel of Figure 4.9, the horizontal axis measures the characteristic of protein and
the good.
the vertical axis measures calories. Suppose that the consumer’s income is $10 and
that $10 worth of pork provides the combination of protein and calories given by point
A, while $10 worth of beef gives the combination at point B.'’ The budget line is then
AB. Area OAB is called the feasible region and budget line AB is the efficiency frontier.
That is, the consumer can purchase any combination of protein and calories in area
AOB, but he or she will maximize utility or satisfaction by choosing combinations on
line AB.
If U; is aconsumer’s indifference curve in characteristics space (i.e., with charac-
teristics protein and calories measured along the axes), the consumer maximizes utility
at point C, where indifference curve Uj is tangent to budget line AB. The consumer
reaches point C by obtaining OF characteristics from spending $5 on beef and FC char-
acteristics from spending the remaining $5 on pork. OF = 1/2 0B and 0G = 1/2 OA.
Note that FC equals 0G, both in length and direction.!®
In the bottom panel, a new good is introduced, chicken, which has half as many
calories per unit of protein as beef. If $10 worth of chicken provides the combination of
protein and calories given by point H, the budget line or efficiency frontier becomes

16 Kelvin: Lancaster,
i wa Conswner Demand:
A New Approach (New York: Columbia University Press, 1971)
Note that the characteristics ray for pork has a slope four times larger than the characteristics
ray for
beef. Thus, pork provides four times as many calories per unit of protein as beef.
 Calories
Pork

Beef

/
poe |
0) 1 2, 3 4
Protein

Calories
Pork

Chicken

Protein

FIGURE 4.9 The Characteristics Approach to Consumer Demand Theory In

the top panel, $10 worth of pork gives the combination of protein and calories
indicated by point A and $10 worth of beef gives the combination at point B. Thus,
AB is the budget line. The consumer maximizes utility at point C, where U; is tangent
to AB, by spending $5 on pork and $5 on beef, and receiving OF characteristics from
beef and FC (equals OG) from pork. In the bottom panel, $10 worth of chicken gives
point H, so that the budget line is AH. The consumer maximizes utility at point J on
U2 by spending $5 on pork and $5 on chicken, and obtaining OK characteristics from
chicken and K/ (equals OG) characteristics from pork, with no beef purchased.

Continued...

113
114 PART TWO. Theory of Consumer Behavior and Demand

The Characteristics Approach to Consumer Theory = Continued

tan-
AH. The consumer now maximizes utility at pointJ,where indifference curve U2 1s
cent to budget line AH. The consumer reaches point J by obtaining OK characteri stics
from spending $5 on chicken and KJ (equals 0G) characteristics from spending the
remaining $5 on pork. No beef is now purchased.
The reduction in the price of a good can be shown by a proportionate outward
movement along the characteristics ray of the good, while an increase in income can
be shown by a proportionate outward shift of the entire budget line. These shifts will
allow the consumer to reach a higher indifference curve as in traditional consumer
theory.
The characteristics approach to consumer theory has several important advantages
over traditional demand theory. First, substitution among goods can be easily explained
in terms of some common characteristics of the goods. For example, according to this
theory coffee and tea are substitutes because they both have the characteristic of being
stimulants.
Second, the introduction of a new good can easily be taken care of by drawing a
new ray from the origin reflecting the combination of the two characteristics of the new
good. This was shown by the introduction of chicken in the bottom panel of Figure 4.9.
However, the new good will only be purchased if its price is sufficiently low (e.g.,
chicken in the bottom panel of Figure 4.9). Had $10 worth of chicken provided only the
combination of protein and calories given by point K on the characteristics ray for
chicken, the budget line would become ABK and the consumer would maximize utility
by remaining at point C and purchasing no chicken.
Third, a quality change can be shown by rotating the characteristics ray for the
good. For example, the introduction of a new breed of leaner hogs resulting in pork
with less calories per unit of protein can be shown by a clockwise rotation of the char-
acteristics ray for pork. Finally, by comparing the price of two goods that are identical
except for a particular characteristic, this approach permits the estimation of the
implicit or hedonic price of the characteristic. For example, by comparing the price of
houses that are otherwise identical except for some other characteristic, such as lower
noise pollution, proximity to good schools, parks, and a good transportation network,
we can estimate the implicit or hedonic price of each of these characteristics. Thus, if
the price of a house that is near a park is $10,000 more than the price of another iden-
tical house that is not near a park, the characteristic of being closer to a park is worth
Concept Check
$10,000.
How does the
One disadvantage of the theory is that some characteristics, such as taste and
characteristics
approach to consumer
style, are subjective and cannot be measured explicitly. The problem is even more
demand theory differ serious in dealing with the characteristics of services. Nevertheless, the hedonic
from the traditional approach is very useful because it allows at least an implicit measure of the various
approach? characteristics of each good.

'S FC and 0G are called vectors. Thus, the above is an example of vector analysis, whereby
vector 0C
(not shown in the top panel of Figure 4.9) is equal to the sum of vectors OF and 0G.
 CHAPTER 4 Consumer Behavior and Individual Demand 115

|__| SUMMARY
1. The income—consumption curve joins consumer optimum points resulting when only the
consumer’s income is varied. The Engel curve is derived from the income—consumption curve
and shows the amount of a good that the consumer would purchase per unit of time at various
income levels. A normal good is one of which the consumer purchases more with an increase in
income. An inferior good is one of which the consumer purchases less with an increase in
income. The income—consumption curve and the Engel curve are positively sloped for normal
goods and negatively sloped for inferior goods.
. The price—consumption curve for a good joins consumer optimum points resulting when
only the price of the good varies. This curve shows the amount of the good that the consumer
would purchase per unit of time at various prices of the good while holding everything else
constant. The individual consumer’s demand curve for a good is negatively sloped, reflecting
the law of demand.
. When the price of a good falls, consumers substitute this good for other goods and their
real income rises. If the good is normal, the income effect reinforces the substitution
effect in increasing the quantity purchased of the good. If the good is inferior, the
substitution effect tends to increase while the income effect tends to reduce the quantity
demanded of the good. Because the former usually exceeds the latter, the quantity
demanded of the good increases and the demand curve is negatively sloped. Only if the
income effect overwhelms the opposite substitution effect for an inferior good will the
quantity demanded of the good decrease when its price falls, and the demand curve will
slope upward. This is called a Giffen good. Only recently, however, has an example of
true Giffen behavior been found.
. With the substitutability between domestic and foreign goods and services having reached
an all-time high in the world today, and with the expectation that it will rise even more in
the future, the need to introduce an important international dimension in the study of
microeconomics becomes even clearer.
. A cash subsidy leads to an equal or greater increase in utility than a subsidy in kind (such as
the food stamp program) that costs the same. The consumer surplus is given by the difference
between what the consumer is willing to pay for a good and what the consumer actually
pays for it. Its value can be approximated by the area under the demand curve and above
the market price of the good. An Edgeworth box diagram is constructed by rotating an
individual’s indifference map diagram by 180 degrees and superimposing it on another’s,
so that the dimensions of the box equal the combined initial distribution of the two goods
between the two individuals. The Edgeworth box diagram can be used to analyze voluntary
exchange. The characteristics approach to consumer theory can be used to measure the
implicit or hedonic price of a particular characteristic of a good or service.

KEY TERMS
Income—consumption curve Relative price Characteristics approach to
Engel curve Income effect consumer theory
Normal good Giffen good Income or expenditure
Inferior good Food stamp program index (E)
Price—consumption curve Consumer surplus Laspeyres price index (L)
Individual’s demand curve Water—diamond paradox Paasche price index (P)
Substitution effect Edgeworth box diagram
116 PARTTWO_ Theory of Consumer Behavior and Demand

REVIEW QUESTIONS
1. A consumer buys an Oldsmobile for $20,000 instead of a demand curve showing only the substitution
Toyota for $22,000. Does this mean that the consumer effect? Explain.
prefers the Oldsmobile to a Toyota? Te Will a consumer purchase more or less of an inferior
2. How would indifference curves between money and good when its price declines? Explain.
automobiles differ between two individuals with the same _ Can all goods purchased by a consumer be inferior?
money income but with one having a stronger preference
9, In 2003, the Men’s Hair Company increased the price of
for automobiles than the other?
its shampoo and subsequently sold more shampoo than in
3. Why would the use of gasoline decline if its price rose as a 2002. Is the demand curve for this company’s shampoo
result of a gasoline tax but the effect of the price rise was positively sloped? Explain.
compensated by a tax rebate?
10. Why is the gift of any good likely to provide
4. The income effect of a 20% increase in housing rents is
less satisfaction to the recipient than an equal
larger than the effect of a 20% increase in the price of salt.
cash gift?
True or false? Explain.
. When would the gift of a good provide the recipient as
5. A demand curve showing only the substitution effect can
much satisfaction as an equal cash gift?
never be positively sloped, net even theoretically. True or
false? Explain. . How can a black market in food stamps be explained?
6. Is a demand curve showing both the substitution . What are the advantages and disadvantages of the
and income effects flatter or steeper than the characteristics approach to consumer theory?

|__| PROBLEMS
1. a. Derive the income-consumption curve and Engel . Using the indifference curves of Problem 2 in Chapter 3
curve from the indifference curves of Problem 2 in and the budget lines of problem 6(b) in Chapter 3,
Chapter 3 and the budget lines from Problem 6(a) in separate the substitution effect from the income effect
Chapter 3. Is good X a normal or an inferior good? when the price ofX falls from Py = $2 to Py = $1 and
Why? then from Py = $1 to Py = $0.50.
b. Derive the Engel curve for good Y. Is good Y a normal aS) Separate the substitution effect from the income effect for
or an inferior good? Why? an increase in the price of an inferior good.
2. a. For the budget lines of Problem 6(a) in Chapter 3, draw . Separate the substitution effect from the income effect
indifference curves that show that good X is inferior; for an increase in price of a Giffen good.
derive the income-consumption curve and the Engel *7, It is sometimes asserted that rice in very poor Asian
curve for good X. countries might be an inferior good. Even though there
b. Draw the Engel curve for good Y. Must good Y be is no evidence that this is indeed the case, explain the
normal? reasoning behind this assertion.
*3. a. Derive the price-consumption curve and demand curve o . The average number of children per family has declined
for good X from the indifference curves of Problem 2 in the face of rapidly rising family incomes, so children
in Chapter 3 and the budget lines from Problem 6(b) in must be an inferior good. True or false? Explain.
Chapter 3 when the price of X falls from Py = $2 to Py *9, Use indifference curve analysis to show that a
= $1 and then to Py = $0.50.
poor family can be made to reach a given higher
b. Use the figure for your answer to 3(a) to explain how indifference curve with a smaller cash subsidy than with
you would derive the price-consumption a subsidy in kind (such as, for example, by the
curve and demand curve for good X when the government paying half of the market price of food for
price ofX rises from Px = $0.50 to Py = $1 and then the family). Why might the government still prefer a
(Oe = 2, subsidy in kind?

* = Answer provided at end of book.

 CHAPTER 4 Consumer Behavior and Individual Demand ee

10. With reference to Figure 4.7 in the text, indicate the size distribution of good X and good Y between individual B
of the consumer surplus when Py = $3 if given by the intersection of U, and U4.
a. good X can only be purchased in whole units. 12. Starting with the top panel of Figure 4.9, show
b. good X can be purchased in infinitesimally small a. a 50% reduction in the price of pork and its effect
fractional units. on consumer utility maximization.
11. With reference to Figure 4.8 in the text, indicate how b. a 50% increase in the consumer’s income and its
exchange could take place starting from the initial effect on consumer utility maximization.

APPENDIX INDEX NUMBERS AND CHANGES IN CONSUMER WELFARE

In this appendix, we discuss index numbers and their use in measuring changes in stan-
dards of living or welfare, especially during inflationary periods. For example, workers
and their unions are keen to know if money wages are keeping up with rising prices. Cost-
of-living indices are often used for inflation adjustment in wage contracts, for pensions and
welfare payments and, since 1984, even for tax payments. In this appendix, we will define
three indices and, by comparing the values of these indices in two different time periods,
determine if the standard of living has increased, decreased, or remained unchanged. For
simplicity, we will assume that the consumer spends all income on only two commodities,
X and Y.

Expenditure, Laspeyres, and Paasche Indices

To measure changes in the standard of living or welfare from one time period to another,
we begin by defining three indices: the income or expenditure index, the Laspeyres price
index, and the Paasche price index.
Income or The income or expenditure index (£) is the ratio of period | to base period money
expenditure index (EF) income or expenditures. That is,
The ratio of period-1
to base-period r= x1 Pyy + yy Py 4.1]
money income or x0 Pxo + YoPyo
expenditures.
where x and y refer to the quantities of commodities X and Y purchased, respectively;
P refers to price, and the subscripts “1” and “O” refer to period | and the base period,
respectively.
Thus, the income and expenditure index is the sum of the product of period | quan-
tities and their respective period | prices divided by the sum of the product of base period
quantities and their respective base period prices. In short, E measures the ratio of the
consumer’s period | expenditures or income to the base period expenditures or income. If
E is greater than 1, the individual’s money income or expenditures have increased from
the base period to period 1. However, since prices usually also rise, we cannot determine
simply from the value of E whether the individual’s real income or standard of living has
also increased. To do that, we need to define the Laspeyres and the Paasche price indices
Laspeyres price index and compare their values with that of the income or expenditure index.
(L) The ratio of the
The Laspeyres price index (L) is the ratio of the cost of base period quantities at
cost of purchasing
base-period quantities
period | prices relative to base period prices. That is,
at period-1 prices
Xo Py A yoPy4
relative to base-period [4.2]
prices. x0 Pyro + yo Pyo
118 PART TWO. Theory of Consumer Behavior and Demand

mea-
In the Laspeyres price index, we use the base period quantities as the weights and
sure the cost of purchasing these base period quantities at period | prices relative to base
period prices. i
Paasche price index (P) The Paasche price index (P) is the ratio of the cost of period / quantities at period
The ratio of the cost of | prices relative to base period prices. That is,
purchasing period-|
quantities at period-1 P= MP ler adhays [4.3]
prices relative to
X1 Pro + yi Pyo
base-period prices.
In the Paasche price index, we use period | quantities as the weights and measure the cost
of purchasing period | quantities at period | prices relative to base period prices. Thus,
the difference between the Laspeyres and the Paasche price indices is that the former uses
the base period quantities as the weights while the latter uses the period | quantities.
For example, using the hypothetical data in Table 4.2, we can calculate

—— = = atl 2 OR ee
Xo Pxo =i yoPyo (4)($1) ai (3)($2) $10

7 _— oP tyPn _= (482) + GS) _= $1 = Il) or Live

Xolxo + Yor yo $10 $10

_ : Pa Py
Py a $1 2 _3l 2 ee ie
x1Pio+
yi Py (3)($1) + (6)($2) = $15

How Are Changes in Consumer Welfare Measured?

Because some quantities and prices rise over time and others fall, it is often impossible to
determine by simple inspection of the quantity-price data whether an individual’s stan-
dard of living or welfare has increased, decreased, or remained unchanged from one time
period to the next. To measure changes in the standard of living, we compare the value of
the income or expenditure index to the values of the Laspeyres and the Paasche price
indices.
An individual's standard ofliving is higher in period I than in the base period if E is
greater than L. That is, the individual is better off in period | than in the base period if the
increase in his or her money income (E) exceeds the increase in the cost of living using
base-period quantities as weights (L). For example, since we calculated from Table 4.2
that EF = 1.2, or 120%, while L = 1.1, or 110%, the individual’s standard of living

Hypothetical Quantity Price Data

TABLE 4.2 in a Base Period and in Period 1

Period x Px y Py

0 (base) 4 $1 3 $2

re
ee
 CHAPTER 4 Consumer Behavior and Individual Demand 119

Quantity
Y
of

FIGURE 4.10 Changes in Consumer Welfare An individual is better

off at B; in period 1 than at Bo in the base period because Bp was available
in-period 1 (i.e, Bo is below period 1 budget line /;/,) but was not chosen.
Had the individual been at point A in the base period, we would need the
individual's indifference curves to determine if B, is superior, inferior, 0 EN? 1M) 10 (X)
or equal to A. Quantity of X

increased from the base period to period | because his or her income has risen more than
his or her costs or prices.
On the other hand, the individual's standard of living is higher in the base period
than in period | if E is smaller than P. That is, the individual is better off in the base
period than in period | if the increase in his or her money income (£) is smaller than the
increase in the cost of living using period | quantities as the weights (P). If E is not
smaller than P, the individual’s standard of living is not higher in the base period. For
example, since FE= 120% and P = 80% from Table 4.2, the individual is not better off
in the base period than in period 1. Thus, with E greater than L and E not smaller than
P, the individual of the above numerical example is definitely better off in period | than
in the base period.
Figure 4.10 presents a graphic interpretation of the numerical example of Table 4.2.
In the figure, /o /p is the individual’s budget line in the base period. That is, with X = 4,
Py = $1, Y = 3, and P, = $2, the individual’s total income (/) and expenditure in the
base period is $10 (obtained from 4X times $1 plus 3Y times $2). If the individual had
spent the entire base-period income of $10 on commodity X, he or she could have pur-
chased 10X. If instead the individual had spent his or her entire base-period income of
$10 on commodity Y, he or she could have purchased SY. This defines Jo Jp as the indi-
vidual’s budget line in the base period. The individual’s purchase of 4X and 3Y in the
base period (see the first row of Table 4.2) is indicated by point Bo on budget line Jo Jo.
We can similarly determine from the second row of Table 4.2 that in period | the indi-
vidual’s income is $12 (obtained from 3X times $2 plus 6Y times $1), so that his or her
budget line is /;/;. The individual’s purchase of 3X and 6Y in period | is indicated by
point B; on budget line /)/;.
From Figure 4.10 we can conclude that since point Bo is below budget line /)/;, the
individual must be better off in period 1 than in the base period. That is, since Bo was
available to the individual in period | but was not chosen, the individual must be better off
in period 1. Specifically, in period 1 the individual could have purchased the base period
120 PART TWO. Theory of Consumer Behavior and Demand

his
bundle (Bo) at period | prices by spending only $11 (4X times $2 plus 3Y times $1) of
or her period 1 income of $12. On the other hand, in the base period the individual could
not have purchased period | quantities at base period prices since that would have
required an expenditure of $15 (3X times $1 plus 6Y times $2), which would have
exceeded his or her base period income of $10. Thus, the individual must be better off
with B, in period | than with Bo in the base period.
Had the individual been at a point such as A rather than at point Bo on budget line
IIo in the base period (see Figure 4.10), we could no longer determine without the indi-
vidual’s indifference curves whether the individual was better off in period 1, in the base
period, or was equally well off in period | as in the base period. This would depend on
whether point B, was on a higher, lower, or the same indifference curve as point A,
respectively. You should be able to calculate from comparing point A on Jo Jo in the base
period to point B, on /,/; in period | that E = 120%, L = 140%, and P = 80%. Since E
is not larger than L (so that the individual is not necessarily better off in period 1) but £
is not smaller than P (so that the individual is not necessarily better off in the base
period), we have conflicting results and we cannot tell whether the standard of living is
higher, lower, or equal in period 1 as compared with the base period. This confirms the
inconclusive results of the graphic analysis (in the absence of the individual’s indiffer-
ence curves) in Figure 4.10.
Because the Laspeyres price index (L) uses base period quantities as the weights, L
becomes available sooner than the Paasche price index (P).!? The most common of the
price indices is the Consumer Price Index (CPI), which has been published monthly by
the Bureau of Labor Statistics for more than sixty years. The CPI is a Laspeyres index for
a “typical” urban family of four. It is the weighted average of the price of 400 goods and
services purchased by consumers in the United States. The weights of the various com-
modities in the basket are periodically changed to reflect variations in consumption pat-
terns. Other important (Laspeyres) price indices are the wholesale price index (WPI) and
the GNP deflator. The latter is used to calculate GNP in real terms.

EXAMPLE 4-7
The Consumer Price Index, Inflation, and Changes in the Standard of Living

One application of index numbers is in measuring changes in real earnings and stan-
dards of living over time. According to the Bureau of Labor Statistics, total private
nonagricultural weekly money earnings in the United States was $345.35 in 1990 and
$472.73 in 2000. The CPI rose from 100 in 1990 to 131.8 in 2000. Dividing the weekly
money earnings by the corresponding CPI, we find that weekly real earnings increased
only slightly from $345.35 in 1990 to $358.67 in 2000. Since the CPI is known to have
an upward bias, however, the true increase in real earnings may in fact have been
somewhat greater.
According to the CPI Commission (set up by the Senate Finance Committee in
1995 and reporting in 1996), the consumer price index or CPI overstates the rate of
inflation by about 1.1 percentage points, making the true rate of inflation in the United

Saoren
OgTheer no aie aewee :
Laspeyres price index also uses period 1 prices. However, period | prices become available
much
sooner than period | quantities.
 CHAPTER 4 Consumer Behavior and Individual Demand 241

States in recent years closer to 2% rather than the reported 3%. According to the
Commission’s final report, of the 1.1 percentage point overstatement in the CPI, 0.6
percentage points were due to the failure of the CPI to take into account new products
and quality changes, 0.4 percentage points were due to the failure to consider the sub-
stitution of goods in consumption as a result of changes in relative prices, and the
remaining 0.1 percentage points resulted from not taking into consideration the avail-
ability of new outlets (stores) with cheaper prices. Some of these revisions in the calcu-
lation of the CPI have already been made and the others are in the process of being
implemented.
These revisions in the CPI will save the U.S. government billions of dollars in
lower cost-of-living adjustments to social security recipients; they will also lead to
higher income tax collection (because of the slower increases in standard deductions);
they will result in about $95 billion higher national savings (and lower national debt)
per year, and they eliminate the underestimation in the growth of the real GDP of the
nation. The CPI revisions will also affect the three million private-sector workers with
union contracts tied to the CPI (and are likely to influence how much other employers
pay as well).

Sources: M. J. Boskin et al., Toward a More Accurate Measure of the Cost of Living (Washington,
D.C.: Senate Finance Committee, 1996); M. J. Boskin et al., “The CPI Commission: Findings and
Recommendations,’ American Economic Review, May 1997; M. J. Boskin and D. W. Jorgenson,
“Implications of Overstating Inflation for Indexing Government Programs and Understating Economic
Progress,” American Economic Review, May 1997; D. L. Costa, “Estimating Real Income in the U.S.
from 1888 to 1994: Correcting CPI Bias Using Engle Curves,” Journal of Political Economy, December
2001; B. W. Hamilton, “Using Engel’s Law to Estimate CPI Bias,” American Economic Review, June
2001; and Congressional Budget Office, Explaining the Consumer Price Index, Washington, D.C., CBO,
June 20, 2007.

EXAMPLE 4-8
Comparing the Standard of Living of Various Countries

One of the most commonly used measures of the standard of living or well-being of a
nation is its per capita income. Using per capita income to compare standard of livings
around the world presents some difficulties, however. First, some services provided by
individuals for personal use (such as mowing the lawn) affect well-being but are not
included in the measure of per capita income because the service is not purchased
through the market. Only if the person hires a lawn service will the cost of the service
be included in the GDP measure. Per capita incomes that do not include the imputed
(estimated) value of these nonmarket services underestimate the standard of living in
the nation. The underestimation is larger in poor than in rich countries because in poor
countries more goods and services are produced for personal use rather than being sold
in the market.
A second difficulty in making international comparisons arises because the per
capita GDP of other nations must be converted into dollars. Conversion is troublesome
because the exchange rate between the dollar and other currencies may not correctly
reflect the purchasing power of the dollar in different nations. For example, if the real
122 PART TWO Theory of Consumer Behavior and Demand

exchange rate between the dollar and the Philippines’ pesos (P) is $1 = P2 when mea-
sured in dollars of equivalent purchasing power, a per capita GDP of P6,000 in the
Philippines refers to a per capita income of $3,000. But if the actual exchange rate is
$1 — P3, the same per capita income of P6,000 gives a per capita income of only
$2,000. Thus, it is necessary to use dollars of equivalent purchasing power to convert
the GDP per capita in dollars of different countries for purposes of international
comparison.
Table 4.3 presents data on the per capita income of the United States and the six
other leading industrial nations in the world (Japan, Germany, France, the United
Kingdom, Italy, and Canada), five large developing countries (South Korea, Mexico,
Brazil, China, and India), and Russia for the year 2005. The second column of Table
4.3 gives the per capita income for each of the 13 nations in terms of U.S. dollars
adjusted to include nonmarket goods and services and the true purchasing power of the
dollar in different nations. Although not perfect, the adjusted GDP per capita is a more
acceptable measure of the standard of living of a nation because it measures the true
abitity of the people of a nation to purchase goods and services in the market place.
According to this measure, the United States has the highest standard of living in
the world, exceeding the United Kingdom’s standard of living (the second richest
nation shown in the table) by about 28%, and exceeding the standard of living of
Canada (the nations with the third highest standard of living) by about 30% and that of
other countries by still higher percentages. The third column of Table 4.3 gives the
GDP per capita using the actual or unadjusted rather than adjusted exchange rates.
With unadjusted per capita incomes, the ranking and the differences among the various

Measures of Standard of Living in the

aed United States and Abroad in 2005
Adjusted Unadjusted
per capita per capita
Country Income Income

1. United States $41,950 $43,740

2. United Kingdom 32,690 37,600
3. Canada 32,220 32,600
4. Japan 31,410 38,980
5. France 30,540 34,810
6. Germany 29,210 34,580
7. Italy 28,840 30,010
8. S. Korea 21,850 15,830
9. Russia 10,640 4,460
10. Mexico 10,030 7,310
11. Brazil 8,230 3,460
12. China 6,600 1,740
13. India 3,460 720
eee
Source: World Bank, World Development Report (Washington, D.C.: World Bank,
2007
pp. 288-289).
 CHAPTER 4 Consumer Behavior and Individual Demand 123

countries are much greater, especially between developed and developing countries.
While media sources often present these data, comparisons using the actual or unad-
justed exchange data are obviously not appropriate.
Even the adjusted per capita income figures leave a great deal to be desired as
measures of a nation’s standard of living because the standard of living depends not
only on the quantity of goods and services that individuals consume but also on many
other considerations, such as the level of education, health, leisure, crime, and so on,
of the population. The United Nations is trying to address this problem by devising a
measure of the standard of living that includes some of these other considerations with
its “human development index.”
Sources: The World Bank, World Development Report (Washington, D.C.: World Bank, 2007) and United
Nations Development Program, Human Development Report (New York: United Nations, 2007).

| __|_ INTERNET SITE ADDRESSES

For data on total consumption by income classes for U.S. of the CPI to measure changes in the standard of
families to demonstrate Engel’s law and derive Engel’s living, see:
curves, see: http://www.bls.gov/
http://www.bls.gov/cex/csxannO5.pdf http://www.cbo.gov/ftpdocs/82xx/doc8253/
On teenage drinking and driving, and on what to do 06-22-CPI.pdf
about it, see: http://www.bls.gov/cpi/cpifaq.htm
http://www.cdc.gov/ncipc/factsheets/teenmvh.htm.
http://www. investopedia.com/articles/07/
http://www. firsteagle.com/tdd.htm consumerpriceindex.asp
http://www.iihs.org/research/qanda/underage.html http://www.shadowstats.com/cgi-bin/sgs/
http://www.alcoholalert.com/ article/id=343
teenage-drinking-and-driving.html For the World Development Report 2007 and the UN Human
The level of and the debate on gasoline tax is Development Report, see:
examined at: http://web.worldbank.org/WBSITE/EXTERNAL/
http://www.aei.org/publications/pubID.26625,filter.all/ EXTDEC/EXTRESEARCH/EXTWDRS/EXTWDR2007/0,
pub_detail.asp contentMDK:2105559 1~menuPK:1489854~
http://www.econbrowser.com/archives/2006/02/ pagePK:64167689~piPK:64167673~
just_how_implau.html theSitePK: 1489834,00.html
For a discussion of the sources of bias in measuring http://hdr.undp.org/hdr2006/pdfs/report/
the consumer price index (CPI) as well as the use HDR06-complete.pdf
 CHAPTER D

Market Demand and Elasticities

Chapter Outline 5-2 Price Elasticity for Clothing Increases with Time
5.1 The Market Demand for a Commodity 5—3 European Cars Are Luxuries, Flour Is an
5.2 Price Elasticity of Market Demand Inferior Good
5.3 Income Elasticity of Demand 5-4 Margarine and Butter Are Substitutes,
5.4 Cross Elasticity of Demand Entertainment and Food Are Complements
5.5 Price Elasticity and Income Elasticity 5—5 Price Elasticity and Income Elasticity for
of Imports and Exports Imports and Exports in the Real World
5.6 Marginal Revenue and Elasticity 5-6 U.S. Consumer Demand for Alcoholic
Appendix: Empirical Estimation of Demand by Beverages .
Regression Analysis At the Frontier: The Marketing Revolution
with Micromarketing
List of Examples 5-7 Estimating and Forecasting U.S. Demand
5—1 Demand for Big Macs for Electricity

After Studying This Chapter, You Should Be Able to:

e Know how to derive the market demand curve for a commodity
e Remember that each elasticity of demand measures the percentage change in the quantity demanded, or
the change in demand, with respect to each of the variables that affect demand.
e Describe the factors that determine the price elasticity of demand
e Know the relationship between price, marginal revenue, and elasticity
e Describe some of the important applications (examples) of the various elasticities of demand

n this chapter, we begin by examining how the market demand curve for a commod-
ity is obtained by summing up individual’s demand curves for the commodity. As
shown in Chapter 2, the market demand curve for a commodity, together with the mar-
ket supply curve, determine the equilibrium price of the commodity. After deriving the
market demand curve for a commodity, we discuss the various elasticities of demand,
including price and income elasticities in international trade. Finally, since consumers’
expenditures on a commodity represent the revenues of the producers or sellers of the
commodity, we consider the producer’s side of the market. This is done by examining
total and marginal revenues from the sale of the commodity and their relationship to the
price elasticity of demand.
An important dose of realism is introduced into the discussion by actual real-world
estimates of the various elasticities for many commodities and the way they are used in
the

124
 CHAPTER 5 Market Demand and Elasticities 125

analysis of many current economic issues. The “At the Frontier” section then examines
some new revolutionary marketing research approaches to demand estimation, while the
optional appendix shows how demand is estimated and forecasted by regression analysis.

[
51] THE MARKET DEMAND FOR A COMMODITY

Market demand In this section, we examine how the market demand curve for a commodity is derived
curve Shows the from the individuals’ demand curves. The market demand curve for a commodity is
quantity demanded
simply the horizontal summation of the demand curves of all the consumers in the mar-
of a commodity in the
ket. Thus, the market quantity demanded at each price is the sum of the individual quan-
market per time period
at various alternative tities demanded at that price. For example, in the top of Figure 5.1, the market demand
prices while holding
everything else constant.

Individual | Individual 2 Market

Px($) Px($)

£ 2.00 2400) ===

vo
of

:
rale00 eae 1.00

g
ea)¥ OO aoa is 0.50 - ee ia

| | (atl Mt ios ee | | |
Q 2 6 10) Dy Or ou Boe Ox. 0 f 10 cen oS
Hamburgers (X) per unit of time

Individual Market

Px($) Px($)
B
22.007 2.00 |—
o

2
B
c
= E
=[e) 1.00 -
. LOO |=

g G
& 0.50 |- 0.50 | De

| | | | | |
0 2 6 10 Qx 0 2 6 10 Qy

Number of hamburgers Millions of hamburgers

FIGURE 5.1. From Individual to Market Demand The top part of the figure shows that the market
demand curve for hamburgers, D, is obtained from the horizontal summation of the demand curve for
hamburgers of individual 1 (d;) and individual 2 (d2). The bottom part of the figure shows an individual's
demand curve, dy, and the market demand curve, Dy, on the assumption that there are 1 million individuals
in the market with demand curves for hamburgers identical to dy.
126 PART TWO. Theory of Consumer Behavior and Demand

n of the
curve for hamburgers (commodity X) is obtained by the horizontal summatio
that they are
demand curve of individual | (d,) and individual 2 (d2), on the assumption
the only two consumers in the market. Thus, at the price of $1, the market quantity
1|
demanded of 10 hamburgers is the sum of the 6 hamburgers demanded by individual
and the 4 hamburge rs demanded by individual 2.
If instead there were | million individuals in the market, each with demand curve dy
the market demand curve for hamburgers would be Dy (see the bottom part of Figure 5.1).
Both Dy and dy have the same shape, but the horizontal scale for Dy refers to millions of
hamburgers. Note that dy is the individual’s demand curve for hamburgers derived in
Chapter 4 (see Figure 4.3).
The market demand curve for a commodity shows the various quantities of the com-
modity demanded in the market per unit of time at various alternative prices of the com-
modity while holding everything else constant. The market demand curve for a commodity
is negatively sloped (just as an individual’s demand curve), indicating that price and
quantity are inversely related. That is, the quantity demanded of the commodity increases
when its price falls and decreases when its price rises. The variables held constant in draw-
ing the market demand curve for a commodity are incomes, the prices of substitute and
complementary commodities, tastes, and the number of consumers in the market. A
change in any of these will cause the market demand curve for the commodity to shift (see
Section 2.2).!
Finally, it must be pointed out that a market demand curve is simply the horizontal
summation ofthe individual demand curves only if the consumption decisions of individ-
ual consumers are independent (1.e., in the absence of so-called network externalities).
This is not always the case. For example, people sometimes demand a commodity
because others are purchasing it, either to be “fashionable” and to “keep up with the
Joneses” or because it makes the commodity more useful (as in the case of e-mail, which
Bandwagon effect becomes more useful as more people use it). The result is a bandwagon effect or posi-
The situation where tive network externality and this makes the market demand curve for the commodity
some people demand a flatter or more elastic than otherwise.
commodity because
At other times, the opposite or snob effect (a negative network externality) occurs as
other people purchase it.
many consumers seek to be different and exclusive by demanding less of a commodity,
as more people consume it. That is, as the price of a commodity falls and more people
Snob effect The purchase the commodity, some people will stop buying it in order to stand out and be dif-
situation where some ferent. This tends to make the market demand curve steeper or less elastic than otherwise.
people demand a
There are then some individuals who, to impress other people, demand more of certain
smaller quantity of a
commodities (such as diamonds, mink coats, Rolls Royces, etc.) the more expensive these
commodity as more
people consume it in goods are. This form of “conspicuous consumption” is called the Veblen effect (after
order to be different Thorstein Veblen, who introduced it). For example, some high-income people may be less
and exclusive. willing to purchase a $4,000 mink coat than a $10,000 one when the latter clearly looks
much more expensive. A Rolex does not keep time better than a Timex, but, ah, what it
Veblen effect The says about the wearer! This also results in a steeper, or less elastic, demand curve for the
situation in which some commodity than otherwise.”
people purchase more of
certain commodities the
more expensive they are; ' A change in expectations about the future price of the commodity will also affect its demand curve. For
also called conspicuous example, the expectation that the price of the commodity will be lower in the future will shift the market
consumption. demand curve to the left (so that less is demanded at each price in the current period) as consumers postpone
some of their purchases of the commodity in anticipation of a lower price in the future.
* Conceivably, in some cases, the snob and Veblen effects could even make the market demand
curve for the
commodity positively sloped, though no such cases have yet been found in the real world.
 CHAPTER 5 Market Demand and Elasticities 127

Ed In what follows, we assume that the bandwagon, snob, and Veblen effects are not si g-
Concept Check nificant, so that the market demand curve for the commodity can be obtained simply by the
How do the horizontal summation of the individual demand curves. Example 5-1 examines the market
bandwagon, snob, and demand for Big Macs, Example 5—6 presents the various elasticities of the demand for
Veblen effects influence
alcoholic beverages, while Example 5~7 in the appendix to this chapter discusses the actual
market demand?
estimation and forecast of the demand for electricity in the United States.

EXAMPLE 5-1
Demand for Big Macs

The market demand curve for hamburgers faced by McDonald’s is the sum of the indi-
viduals’ demand curves for hamburgers. What follows shows how the market demand
curve for hamburgers changed over time as a result of competitive pressures and
_ changes in consumers’ tastes and how McDonald’s responded to these changes.
With more than 30,000 restaurants serving nearly 50 million people in 119
countries around the world every day in 2007, McDonald’s dwarfed the competition
in the fast-food burger market (its closest competitor, Burger King, had 11,200
restaurants in 61 countries). In the United States, McDonald’s has 13,700 outlets,
compared with Burger King’s 8,400, and its burger market share is 46%, as com-
pared with Burger King’s 14% and Wendy’s 13%. After nearly three decades of
double-digit gains, however, domestic sales at McDonald’s grew slowly from the
mid-1980s through the 1990s as a result of higher prices, changing tastes, demo-
graphic changes, increased competition from other fast-food chains and other forms
of delivering fast foods, the mad-cow disease in Europe, and, more recently, obesity
concerns in the United States.
Price increases at McDonald’s exceeded inflation in each year since 1986. The
average check at McDonald’s now exceeds $4—a far cry from the 15-cent hamburger
on which McDonald’s got rich—and this sent customers streaming to lower-priced
competitors. Concern over cholesterol and calories has also reduced growth. In addi-
tion, the proportion of the 15- to 29-year-olds (the primary fast-food customers) in the
total population has shrunk from 27.5% to 22.5% during the past decade. Increased
competition from other fast-food chains (especially Burger King and Wendy’s), other
fast-food options (pizza, chicken, tacos, and so on), frozen fast foods, mobile units,
and the vending machines have also slowed down the growth of demand for Big Macs.
In 2002, McDonald’s was even hit by a highly publicized multimillion dollar suit for
allegedly misleading young consumers about the healthfulness of its products (which
inspired the 2004 movie Super Size Me).
McDonald’s did not sit idle but tried to meet its challenges head on by introduc-
ing new menu items and by cutting prices. For example, in 1990 McDonald’s intro-
duced a value menu, with small hamburgers selling for as little as 59 cents (down from
89 cents) and a combination of a burger, french fries, and a soft drink for as much as
half off. In response to increased public concern about cholesterol and calories,
McDonald’s substituted vegetable oils for beef tallow in frying its french fries,
replaced ice cream with lowfat yogurt, introduced bran muffins and cereals to its
breakfast menu, and in 1991 it introduced the McLean Deluxe—a new, reduced-fat,
quarter-pound hamburger, which McDonald’s spent from $50 million to $70 million to
128 PART TWO. Theory of Consumer Behavior and Demand

develop and promote. Then McDonald’s introduced McPizza in 1995, its Arch Deluxe,
in 1996, and the “Made for You” freshly cooked meals in 1999. McDonald’s also set
up a drive-through in an increasing number of its franchises.
All of these efforts failed to stimulate sales, and McDonald’s abandoned most of
these initiatives. McDonald’s just seemed to have lost its golden touch at home, and
that is why it rapidly expanded abroad, where it faced much less competition and
where there was much more room for growth. By 2007 there were more McDonald’s
restaurants abroad (16,200) than in the United States (13,800). In recent years,
McDonald’s has been opening restaurants abroad at a rate four to five times as fast as
in the United States, and it is now earning more than 60% of its profits in other coun-
tries. McDonald’s now predicts that it will have more than 50,000 restaurants around
the world (two-thirds of them outside the United States) by the year 2010.
Since 2003, however, McDonald’s seems to have reinvented itself and once again
sales have experienced rapid growth. It phased out the “super-sized” fries and drinks,
and it introduced several new menu items, such as chicken wraps, premium coffee,
apple slices, and premium salads. In 2006, McDonald’s became the first fast-food
company to put nutritional labels on its products, and in 2007 it started to replace
artery-clogging trans fats with new cooking oils to make its foods healthier.
Sources: “An American Icon Wrestles with a Troubled Future,’ New York Times, May 12, 1991, Section 3,
p. 1; “Too Skinny a Burger Is a Mighty Hard Sell, McDonald’s Learns,” Wall Street Journal, April 15, 1994,
p. Al; “Fallen Arches,” Fortune, April 29, 2002, pp. 74-76; “Big Mac Trims Portions as Worry on Waistline
Grow,” Financial Times, March 3, 2004, p. 8; “McDonald’s to Introduce Nutrition Labels,” Financial Times,
October 26, 2005, p. 15; “McDonald’s Selects Oil to Avoid Trans Fat Risk, Financial Times, January 30,
2007; “McDonald’s Says Latest Results Are Strongest in 30 Years, New York Times, January 25, 2007, p.
C2; and “How Wendy’s Faltered, Opening Way to Buyout,” Wall Street Journal, August 28, 2007, p. Al.

5.2 Price ELASTICITY OF MARKET DEMAND

In this section, we show how to measure the price elasticity of demand, both algebraically
and graphically. We also examine the important relationship between the price elasticity
of demand and the total expenditures of consumers on the commodity. That is, when the
price of a commodity changes, will consumers’ expenditures on the commodity increase,
decrease, or remain unchanged? Finally, we examine the determinants or the factors that
affect the value of the price elasticity of demand.

Measuring the Price Elasticity of Demand?

The price elasticity of demand measures the responsiveness in the quantity demanded
of a commodity to a change in its price. This could be measured by the inverse of the
slope of the demand curve (i.e., by AQ/AP).4 The disadvantage is that the inverse of

* For a discussion of the price elasticity of demand using calculus, see Section A.5 of the
Mathematical
Appendix at the end of the book.
4
Since the turn of the century, the convention in economics (started by Alfred Marshall)
.
. . .

is to plot price on the

vertical axis and quantity on the horizontal axis. Therefore, the quantity response
to a change in price could be
measured by AQ/AP, which is the inverse of the slope of the demand curve.
 CHAPTER 5 Market Demand and Elasticities 129

the slope is expressed in terms of the units of measurement. A change of 100,000 units
in the quantity demanded of a commodity is very large if the commodity is new hous-
ing units, but it is not very large if the commodity is hamburgers. Similarly, a price
change of one dollar is insignificant for houses, but very large for hamburgers. Thus,
measuring the responsiveness in the quantity demanded of a commodity to a change in
price by the inverse of the slope of the demand curve is not very useful. Furthermore,
comparison of changes in quantity to changes in price across commodities is meaning-
less. These problems can be resolved by using percentage rather than absolute changes
in quantity and prices.
In order to have a measure of the responsiveness in the quantity demanded of a com-
modity to a change in its price that is independent of the units of measurement, Alfred
Marshall, the great English economist of the beginning of the twentieth century, refined and
popularized the concept of the price elasticity of demand. This measure is defined in
terms of relative or percentage changes in quantity demanded and price. As such, price
elasticity of demand is a pure number (i.e., it has no units attached to it), and its value is
not affected by changes in the units of measurement. This also allows meaningful com-
parisons in the price elasticity of demand of different commodities.
Price elasticity of The price elasticity of demand is given by the percentage change in the quantity
demand (7) The demanded of a commodity divided by the percentage change in its price. Letting 7 (the
percentage change in Greek letter eta) stand for the coefficient of price elasticity of demand, A Q for the change
the quantity demanded
in quantity demanded, and A P for the change in price, we have the formula for the price
of a commodity during —
elasticity of demand:
a specific period of
time divided by the
percentage change in its
_AQ/Q AQ P
price.
SSE Ihe Oo
Since quantity and price move in opposite directions, the value of 7) 1s negative. To com-
pare price elasticities, however, we use their absolute value (i.e., their value without the
negative sign). Thus, we say that a demand curve with a price elasticity of —2 is more
elastic than a demand curve with a price elasticity of —1 (even though —2 is algebraically
smaller than —1). Note that the inverse of the slope of the demand curve (i.e., AQ/AP)
is acomponent, but only a component, of the price elasticity formula.
Point elasticity of Formula [5.1] measures point elasticity of demand or the elasticity at a particular
demand The price point on the demand curve. More frequently, we are interested in the price elasticity
elasticity of demand at between two points on the demand curve. We then calculate the arc elasticity of
a specific point on the demand. If we used formula [5.1] to measure arc elasticity, however, we would get dif-
demand curve.
ferent results depending on whether the price rises or falls.° To avoid this, we use the
average of the two prices and the average of the two quantities in the calculations.
Arc elasticity of Letting P| refer to the higher of the two prices (with Q; the quantity at P|) and P> refer
demand The price to the lower of the two prices (with Q> the corresponding quantity), we have the for-
elasticity of demand mula for arc elasticity of demand’:
between two points on
the demand curve. ee )Cee)
neSeat
a [5.2]
BPR Or 07)/25 SAP W(Oi4-O>)

5 As we will see below, this results because a different base is used in calculating percentage changes for a
price increase than for a price decrease. wal
6 For the second ratio in the formula, we could use P/Q, where the bar on P and Q refers to their average
value.
130 PART TWO. Theory of Consumer Behavior and Demand

(C=
Using formula [5.1] to measure the elasticity for a price decline from point B
P = $2.00) to point G (Q = 10, P= $0.50) on the market demand curve in Figure 5.1,
we get

U) = 8 2 = = dass
Jas
(—1.50) (2) 3

On the other hand, measuring elasticity for a price increase from point G to point B on the
same demand curve, we get

=
g 0.50 =
4 = —0.27
n=
(1.50) (10) IS

Using formula [5.2] for arc elasticity, we get

G5 2.50Sts
be 20 Ml
(1550) (C12) 18

The price elasticity of demand is usually different at and between different points on
Concept Check the demand curve, and it can range anywhere from zero to very large or infinite. Demand
Why is price elasticity is said to be elastic if the absolute value of 7 is larger than |, wnitary elastic 1f the absolute
only an approximation value of 7 equals 1, and inelastic if the absolute value of 7 is smaller than 1.
to the true elasticity?

Price Elasticity Graphically

We can also measure graphically the price elasticity at any point on a linear or nonlinear
demand curve. To measure the price elasticity at point E on Dy in the left panel of Figure 5.2
(the same as in the right bottom panel in Figure 5.1), we proceed as follows. We draw
tangent AFH to point E on Dy and drop perpendicular EJ to the quantity axis. The slope of
tangent line AFH is negative and constant throughout and can be measured by
8 A fo
AO ae Ji
The first component of the price elasticity formula is the inverse of the slope of the
demand curve or

The second component of the price elasticity formula is

Po JB
Ome!
Reassembling the two components of the elasticity formula, we have

_ AQ eS Rafe: JH 6 i
U)
TAPOo OE Orere ee
That is, the price elasticity of Dy at point E in the left panel of Figure 5.2 is equal to
1.
Since EJH, AKE, and AOH are similar triangles (see the left panel of Figure 5.2),
the
 CHAPTER 5 Market Demand and Elasticities 131

Px($)
= 2.00 £
be 5:
F 3
ES ES|
a t=
5 1.00¢ ) 3S
2 | S
a, 0.50 | a
|
]
Fig H
0 2 6 10 12Q,y
Millions of hamburgers Millions of hamburgers
FIGURE 5.2 Measurement of Price Elasticity of Demand Graphically In the left panel, the price elasticity at
point E on Dy is measured by drawing tangent AEH to point E on Dy and dropping perpendicular E/ to the horizontal
axis. At point E, n = —JH/OJ = —6/6 = —1.In the right panel, the absolute value of n = 1 at point E (the midpoint
of Dy), 7 > 1 above the midpoint, and n < 1 below the midpoint.

price elasticity of Dy at point E can be measured by any of the following ratios of

distances:

RT HeeAKTe aAE Db]

The price elasticity of demand at any other point on Dy can be found in a similar way by
Concept Check drawing a tangent to Dy at that point and then proceeding as indicated above (see Problem
How can the price 2). This provides a convenient and easy way to measure the price elasticity of demand at
elasticity be measured any point on a nonlinear demand curve.
at a point?
The same procedure can be used to measure the price elasticity at any point on a
straight-line demand curve. For example, by inspecting the right panel of Figure 5.2, we
can find that 7 = —9/3 = —3 at point C on Dx, n = —3/9 = —1/3 at point F, and
n = —6/6 = —1 at point FE (the midpoint of Dy). Furthermore, 7 — oo at point A and
7 = 0 at point H (see Problem 3). Thus, while the slope of a straight-line demand curve is
constant throughout, its price elasticity varies between each point on (and its absolute
value declines as we move down) the demand curve. As a general rule, a straight-line
demand curve is unitary elastic at its geometric midpoint, price elastic above its midpoint,
and inelastic below its midpoint (see the right panel of Figure 5.2).
Two other simple rules are useful in considering the price elasticity of demand. The first
is that of two parallel demand curves (linear or nonlinear), the one further to the right has a
smaller price elasticity at each price (see Problem 4(a), with answer at the end of the text).
Second, when two demand curves intersect, the flatter of the two is more price elastic at the
point of intersection (see Problem 4(b), with the answer also provided at the end of the text).

Price Elasticity and Total Expenditures

An important relationship exists between the price elasticity of demand and the total
expenditures of consumers on the commodity. This relationship is often used in econom-
ics. It postulates that a decline in the commodity price results in an increase in total
expenditures if demand is elastic, leaves total expenditures unchanged if demand is uni-
tary elastic, and results in a decline in total expenditures if demand is inelastic.
132 PART TWO. Theory of Consumer Behavior and Demand

|TABLE 5.1) Total Expenditures and Price Elasticity of Demand

Py Qy Total Expenditures Absolute Value

Point (S) (million units) (million $) of

A 2.00 0 0 oe)
(@ 1.50 3 4S 3}

E 1.00 6 6.0 1
F 0.50 9 4.5 1/3
ial (Q) 12) 0)

Specifically, when the price of a commodity falls, total expenditures (price times
quantity) increase if demand is elastic because the percentage increase in quantity (which
by itself tends to increase total expenditures) exceeds the percentage decline in price
(which by itself tends to reduce total expenditures). Total expenditures are maximum
when |7| = 1 and decline thereafter. That is, when |7| < 1, a reduction in the commodity
price leads to a percentage increase in the quantity demanded of the commodity that is
smaller than the percentage reduction in price, and so total expenditures on the commod-
ity decline. This is shown in Table 5.1, which refers to Dy in Figure 5.2.
From Table 5.1 we see that between points A and E, |7| > | and total expenditures
on the commodity increase as the commodity price declines. The opposite is true
between points E and F over which |7| < 1. Total expenditures are maximum at point E
(the geometric midpoint of Dy in Figure 5.2). The general rule summarizing the rela-
tionship among total expenditures, price, and the price elasticity of demand is that total
expenditures and price move in opposite directions if demand is elastic and in the same
direction if demand is inelastic (see Table 5.1).
Figure 5.3 shows a demand curve that is unitary elastic throughout. Thus, 7 =
—JH /JO = —6/6 = —1 at point E on D*, n = —LJ/OL = —3/3 = —1 at point B’, and
n = —HN/0H = —12/12 = —1 at point G’. Note that total expenditures (price times
quantity) are constant ($6 million) at every point on D*. This type of demand curve is a
rectangular hyperbola. Its general equation is
CG
Q=— [5.4]
where Q is the quantity demanded, P is its price, and C is a constant (total expenditures).
Thus, P - Q = C. For example, at point B’, (P)(Q) = ($2)(3) = $6. At point E, ($1)(6) =
$6, and at point G’, ($0.50)(12) = $6 also.

What Determines Price Elasticity?

Because the price elasticity of demand is so useful (i.e., it tells us, among other things,
what happens to the level of total expenditures on the commodity when its price changes),
it is important to identify the forces that determine its value. The size of the price elastic-
ity of demand depends primarily on two factors. First and foremost, the price elasticity of
demand for a commodity is larger the closer and the greater are the number of available
substitutes. For example, the demand for coffee is more elastic than the demand for salt
because coffee has better and more substitutes (tea and cocoa) than salt. Thus,
the same
percentage increase in the price of coffee and salt elicits a larger percentage reduction
in
the quantity demanded of coffee than of salt.
 CHAPTER 5 Market Demand and Elasticities 133

6 12 24 Q
Quantity (million units)
FIGURE 5.3 Unitary Elastic Demand Curve Demand curve D* has unitary elasticity throughout.
Thus, 7 = —JH/OJ = —6/6 = —1 at pointE, n = —LJ/OL = —3/3 = —1 at pointB’,and
n = —HN/OH = —12/12 = —1 at point G’. Total expenditures (P - Q) are the same ($6 million)
at every point on D*. This demand curve is a rectangular hyperbola.

In general, a commodity has closer substitutes and thus a higher price elasticity of
demand the more narrowly the commodity is defined. For example, the price elasticity for
Marlboro cigarettes is much larger than for cigarettes in general, and still larger than for
all tobacco products. If a commodity is defined so that it has perfect substitutes, its price
elasticity of demand is infinite. For example, if a wheat farmer attempted to increase his
or her price above the market price, the farmer would lose all sales as buyers would switch
all their wheat purchases to other farmers (who produce identical wheat).
Second, price elasticity is larger, the longer is the period of time allowed for con-
Concept Check sumers to adjust to a change in the commodity price. The reason for this is that it usually
What factors determine takes time for consumers to learn of a price change and to fully respond or adjust their pur-
the price elasticity of chases. For example, consumers may not be able to reduce much the quantity demanded of
demand?
electricity soon after learning of an increase in the price of electricity. Over a period of sev-
eral years, however, households can replace electric heaters with gas heaters, purchase
appliances that consume less electricity, and so on. Thus, for a given price change, the
quantity response per unit of time is usually much greater in the long run than in the short
run, and so the absolute value of 7 is larger in the former than in the latter time period. This
is clearly shown in Example 5-2.’

7 Sometimes it is stated that the price elasticity of demand is larger the greater is the number of uses of the
commodity. However, no satisfactory reason has been advanced as to why this should be so. It is also
sometimes said that price elasticity is lower the smaller is the importance of the commodity in consumers’
budgets (i.e., the smaller is the proportion of the consumers’ incomes spent on the commodity). However,
empirical estimates often contradict this.
134 PART TWO. Theory of Consumer Behavior and Demand

EXAMPLE 5-2
Price Elasticity for Clothing Increases with Time

The first row of Table 5.2 shows that the price elasticity of demand for clothing in the
United States is —0.90 in the short run but rises to —2.90 in the long run. This means
that a 1% increase in price leads to a reduction in the quantity demanded of clothing of
only 0.90% in the short run but 2.90% in the long run. Although the price elasticity of
demand for gasoline (the last row of Table 5.2) is three times higher in the long run
than in the short run, both elasticities are very small. It seems that people cannot find
suitable substitutes for gasoline even in the long run. The table also shows the short-
run and long-run price elasticities of demand for a selected list of other commodities.
The estimated price elasticity of demand for any commodity is likely to vary (some-
times widely), depending on the nation under consideration, the time period examined,
and the estimation technique used. Thus, estimated price elasticity values should be
used with caution.

TABLE 5.2| Selected Price Elasticities of Demand

Commodity Short Run Long Run

Clothing (U.S.)* —0.90 = 280)

Tobacco products (U.S.)? —0.46 SW,
Jewelry and watches (U.S.)? —0.41 —0.67
Been ss). —1.72 —2.17
Wine (Canada)@ —0.88 = TAF
Household natural gas (U.S.)° —1.40 —2.10
Electricity (household—U.S.)? —0.13 —1.89
Public Transport (England)! —0.51 —0.69
Public Transport (France)/ lhe =O:6l
Gasoline (U.S.)/ —0.25 —0.92
Gasoline (Canada)/ —0.15 —0.60
Gasoline (Australia)/ —0.12 —0.58

Sources:
“M. R. Baye, D. W. Jansen, and T. W. Lee, “Advertising in Complete Demand Systems,”
Applied Economics, vol. 24, 1992.
’H. S. Houthakker and L. S. Taylor, Consumer Demand in the United States: Analyses and
Projections (Cambridge, MA: Harvard University Press, 1970).
°C. A. Gallet and J. A. List, “Elasticity of Beer Demand Revisited,” Economic Letters, October 1998.
“J. A. Johnson, E. H. Oksanen, M. R. Veall, and D. Fretz, “Short-Run and Long-Run Elasticities
for Canadian Consumption of Alcoholic Beverages,” Review of Economics and Statistics,
February 1992.
“G. R. Lakshmanan and W. Anderson, “Residential Energy Demand in the United States,”
Regional Science and Urban Economics, August 1980.
/B. Hagler, “Transportation Elasticities” TDM Encyclopedia (Victoria BC, Canada: Victoria Transport
Policy Institute, 2005), found at http://www.vtpi.org/tdm/tdm11 .htm; and J. E. Hughes, “Evidence of a
Shift in the Short-Run Price Elasticity of Gasoline?” NBER Working Paper No. 12530, September 2006.
 CHAPTER 5 Market Demand and Elasticities 135

Many economic policies (such as reducing American dependence on imported

petroleum) rely crucially on price elasticities. For example, with the U.S. price of gaso-
line of about $3.50 per gallon in 2007 and a short-run price elasticity of 0.25 (see Table
5.2), a $1.00 tax per gallon would increase the price of gasoline from about $3.50 to
$4.50 per gallon, or by about 29%, and reduce the quantity demanded of gasoline by
7.3% [(m)(% AP) = (-0.25)(0.29) = —7.3% = % AQ] in the short run. With the price elas-
ticity equal to 0.92 in the long run, the reduction in the quantity demanded of gasoline
in the long run would be about 27%. In fact, there is evidence (Hughes, 2006) that the
price elasticity of demand for gasoline in the United States has sharply fallen since the
beginning of the decade. This would result in a much smaller response in the quantity
of gasoline demanded in the United States as a result of a $1.00 tax on gasoline.

5.3 INCOME ELAsTicity oF DEMAND®

Engel curve Shows In Section 4.1 we defined the Engel curve as showing the amount of a commodity that a
the amount of a good consumer would purchase per unit of time at various income levels, while holding prices
that a consumer would
and tastes constant. We can measure the responsiveness or sensitivity in the quantity
purchase at various
demanded of a commodity at any point on the Engel curve by the income elasticity of
income levels.
demand. This is defined as
Income elasticity of
demand (7;) The _A9/9 _ Ag 1
percentage change in "Sie Ne: e
the quantity purchased
of a commodity over a where AQ is the change in the quantity purchased, A/ is the change in income, Q is the
specific period of time original quantity, and / is the original money income of the consumer.
divided by the A commodity is normal if 77; is positive and inferior if 77 is negative. A normal good can
percentage change in be further classified as a necessity if 7; 1s less than | and as a luxury if 77; is greater than 1. In
consumers’ income.
the real world, most broadly defined commodities such as food, clothing, housing, health
Necessity A care, education, and recreation are normal goods. Inferior goods are usually narrowly defined
commodity with income inexpensive goods, such as bologna, for which good substitutes are available. Among normal
elasticity of demand goods, food and clothing are necessities while education and recreation are luxuries.
between 0 and 1. This classification of goods into inferior and normal, and necessity and luxury, can-
Luxury A commodity not be taken too seriously, however, because the same commodity can be regarded as a
with income elasticity of luxury by some individuals or at some income levels, and as a necessity or even as an
demand greater than 1. inferior good by other individuals or at other income levels.’ A simple geometric method
can determine if a commodity is a luxury, a necessity, or an inferior good at each income
level/If the tangent to the Engel curve is positively sloped and crosses the income axis, 17)
exceeds | and the good is a luxury at that income level. If the tangent crosses the origin,
ny = 1. If the tangent crosses the horizontal axis, 7; is less than | and the commodity is a
necessity at that income level. Finally, if the tangent to the Engel curve is negatively
sloped, the commodity is an inferior good.

8 For a discussion of the income elasticity of demand using calculus, see Section A.5 of the Mathematical
Appendix at the end of the book.
° Indeed, some economists feel that the necessity-luxury classification of goods is entirely spurious and
meaningless.
136 PART TWO. Theory of Consumer Behavior and Demand

For example, Table 5.3 and Figure 5.4 show that the student in Chapters 3 and 4
would regard hamburgers as a luxury at income levels (allowances) of up to $15 per day.
Hamburgers would become a necessity for daily allowances of between $15 and $30 and
would be regarded as an inferior good at higher incomes (where the student could afford
steaks and lobsters).

Income Elasticity and Classification of Hamburgers (X)

at Various Daily Income Allowances
| Q, %AQ, WAI nI Classification

10 2 a re se ass
15 4 100 50 2.00 Luxury
20 2) 25 33 0.76 Necessity
30 6 20 50 0.40 Necessity
40 _ 4 —33 38) —1.00 Inferior

I($) I($)

40 - 40 - Engel
curve

Concept Check
How is Engel’s law e 30 B S 30
reflected in the shape of a) ci
the Engel curve? Pa =
=
i
ac Ss
oO i)
S S
o A= v 20
=
I)
gfc)
1S) 1S)

£15 Sets

10 10

| [eee |
0 2 AF 5a 6 Qy Wh AOR Oe Oe
Number of hamburgers (X) Number of hamburgers (X)
FIGURE 5.4 Engel Curve and Income Elasticity Because the tangent to the
Engel curve is positively sloped and crosses the income axis up to the daily income
allowance of $15, hamburgers are a luxury for this individual. The tangent goes
through the origin at /= $15 and m = 1 at that income level. Since the tangent is
positively sloped and crosses the quantity axis from / = $15 to $30, hamburgers are
a necessity between these income levels. For / higher than $30, the Engel curve is
negatively sloped and hamburgers become an inferior good for this individual.
 CHAPTER 5 Market Demand and Elasticities i) S37/

The concept and measurement of the income elasticity of demand and Engel curve
can refer to a single customer or to the entire market. When referring to the entire market,
Q and AQ are the total or the market quantity purchased and its change, while J and AI
are the total or aggregate money income of all consumers in the market and its change.!°
As pointed out in Section 4.1, the proportion of total expenditures on food declines
Engel’s law Postulates as family incomes rise. This is referred to as Engel’s law. Indeed, the higher the propor-
that the proportion of tion of income spent on food, the poorer a family or nation is taken to be. For example,
total expenditures on in the United States less than 20% of total family incomes is spent on food as compared
eae VE) with over 50% for India (a much poorer nation). As Example 5-3 shows, the income elas-
ticity of demand can be very different for different products.

EXAMPLE 5-3
European Cars Are Luxuries, Flour Is an Inferior Good

The second and last rows of Table 5.4 show, respectively, that the income elasticity of
demand is 1.93 for European cars and —0.36 for flour in the United States. This means
that a 1% increase in consumers’ income leads to a 1.93% increase in expenditures on
European cars but to a 0.36% reduction in expenditures on flour in the United States.
Thus, European cars are (strong) luxury goods, whereas flour is a (weak) inferior good
in the United States. The table shows that Asian and domestic cars as well as house-
hold electricity are also a luxury, whereas cigarettes and chicken are necessities; beef
is on the borderline.

TABLE 5.4
ees Selected Income Elasticity of Demand

Commodity Income Elasticity

Electricity (household) 1.94

European cars” 93;
Asian cars? 1.65
Domestic cars? 1.63
Beef © 1.06
Cigarettes“ 0.50
Chicken® 0.28
Flour —0.36

Sources:
“H, S. Houthakker and L. S. Taylor, Consumer Demand in the United States:
Analyses and Projections (Cambridge, MA: Harvard University Press, 1970).
bp. S. McCarthy, “Market Price and Elasticities of New Vehicle Demands,” Review
of Economics and Statistics, August 1996, pp. 543-547.
D. B. Suits, “Agriculture,” in W. Adams and J. Brock, eds., Structure ofAmerican
Industry (Englewood Cliffs, NJ: Prentice-Hall, 2000).
4B Calemaker, “Rational Addictive Behavior and Cigarette Smoking,” Journal of
Political Economy, August 1991.

10 Remember, however, that the income elasticity of market demand is not well defined unless it is also
specified on which commodities income increments are spent.
138 PART TWO. Theory of Consumer Behavior and Demand

Note that the income elasticities given in Table 5.4 are measured as the percentage
change in expenditures on the various commodities (rather than the percentage change
in the quantity purchased of the various commodities). To the extent that prices are
held constant, however, we get the same results as if the percentage change in quanti-
ties were used.

5.4 Cross ELasticity oF Demanp"!

We have seen in Section 2.2 that one of the things held constant in drawing the market
demand curve for a commodity is the price of substitute and complementary commodi-
Substitutes Two ties. Commodities X and Y are substitutes if more of X is purchased when the price of Y
commodities are goes up. For example, consumers usually purchase more coffee when the price of tea
substitutes if an rises. Thus, coffee and tea are substitutes. Other examples of substitutes include butter
increase in the price of and margarine, hamburgers and hot dogs, Coca-Cola and Pepsi, electricity and gas, and
one of them leads to
so on.
more of the other being
purchased.
On the other hand, commodities X and Y are complements if less of X is purchased
when the price of Y goes up. For example, consumers usually purchase fewer lemons
Complements Two when the price of tea goes up. Thus, lemons and tea are complements. Other examples of
commodities are commodities that are complements are coffee and cream, hamburgers and buns, hot dogs
complements if an and mustard, cars and gasoline, and so on.
increase in the price of
An increase in the price of a commodity leads to a reduction in the quantity
one of them leads to
less of the other being
demanded of the commodity (a movement along the demand curve for the commodity)
purchased. but causes the demand curve for a substitute to shift to the right and the demand curve for
a complement to shift to the left. For example, an increase in the price of tea will cause
the demand for coffee (a substitute of tea) to shift to the right (so that more coffee is
demanded at each coffee price) and the demand for lemons (a complement of tea) to shift
to the left (so that fewer lemons are demanded at each lemon price).
We can measure the responsiveness or sensitivity in the quantity purchased of com-
Cross elasticity of modity X as a result of a change in the price of commodity Y by the cross elasticity of
demand (yxy) The demand (nyy). This is given by:
percentage change in
the quantity purchased AO s/Cae AQx Py
of a commodity divided NxXY = APy/ Py AP, "Oy [5.6]
by the percentage
change in the price of where AQ is the change in the quantity purchased of X, A Py is the change in the price
another commodity. of Y, Py is the original price of Y, and Qy is the original quantity of X. Note that in mea-
suring 7xy, we hold constant Py, consumers’ incomes, their tastes, and the number of
consumers in the market.
If nxy is greater than zero, X and Y are substitutes because an increase in Py leads to
Concept Check an increase in Qy as X is substituted for Y in consumption. On the other hand, if nyy is
Why are two goods less than zero, X and Y are complements because an increase in Py leads to a reduction in
complements if their (Qy and) Qy. The absolute value (i.e., the value without the sign) of the cross elasticity
cross elasticity is of
negative?

'l For a discussion of the cross elasticity of demand using calculus, see Section A.5 of
the Mathematical
Appendix at the end of the book.
 CHAPTER 5 Market Demand and Elasticities 139

demand measures the degree of substitution or complementarity. For example, if nxy

between coffee and tea is found to be larger than that between coffee and hot chocolate,
this means that coffee and tea are better substitutes than coffee and hot chocolate. If Nxy
is close to zero, X and Y
are independent commodities. This may be the case with cars and
pencils, telephones and chewing gum, pocket calculators and beer, and so on.
Several additional things must be kept in mind with respect to the cross elasticity of
demand. First, the value of nyy need not equal the value of nyy because the responsive-
ness of Qy to a change in Py need not equal the responsiveness of Qy to a change in Py.
For example, a change in the price of coffee is likely to have a greater effect on the quan-
tity of sugar (a complement of coffee) demanded than the other way around, since coffee
is the more important of the two in terms of total expenditures.
Second, a high positive cross elasticity of demand is often used to define an industry
since it indicates that the various commodities are very similar. For example, the cross
elasticity of demand between Chevrolets and Oldsmobiles is very high, and so they
belong to the same (auto) industry. This can lead to some difficulty, however. For exam-
ple, how high must the positive cross elasticity between two commodities be for them to
be in the same industry? Also, if the cross elasticity between cars and station wagons and
between station wagons and trucks is “high,” but the cross elasticity of demand between
cars and trucks is “low,” are cars and trucks in the same industry? In these cases the defi-
nition of the industry usually depends on the problem to be studied.
Third, the above definition of substitutes and complements is sometimes referred to
as a “gross” definition; as such, it refers to the entire market response and reflects both the
income and the substitution effects. For an individual consumer, there is a more rigorous
definition (in terms of the substitution effect only) discussed in more advanced treaties.!7
Example 5-4 gives the estimated gross elasticity of demand between a number of prod-
ucts and shows its usefulness in the analysis of important economic issues.

EXAMPLE 5-4
Margarine and Butter Are Substitutes, Entertainment and Food Are Complements
The first row of Table 5.5 shows that the cross elasticity of demand of margarine with
respect to the price of butter is 1.53%. This means that a 1% increase in the price of
butter leads to a 1.53% increase in the demand for margarine. Thus, margarine and but-
ter are substitutes in the United States. On the other hand, row 6 of Table 5.5 shows
that the cross elasticity of demand of entertainment with respect to food is -0.72. This
means that a 1% increase in the price of entertainment leads to a reduction in the
demand for food by 0.72%. Thus, entertainment and food are complements in the
United States. The table also shows the cross elasticity of demand of other selected
commodities.
Cross-price elasticities of demand have important economic applications—even
in the courtroom, as the celebrated Cellophane Case shows (see U.S. Reports, Vol. 351,
Washington, DC: U.S. Government Printing Office, 1956, p. 400). In that case, the
court decided that DuPont had not monopolized the market for cellophane even though

12 See J. R. Hicks, Value and Capital (New York: Oxford University Press, 1946), p. 44.
140 PART TWO. Theory of Consumer Behavior and Demand

TABLE 5.5, Selected Cross Elasticities of Demand

Commodity With Respect to Price of Cross-Price Elasticity

Margarine Butter 1537

Pork Beef 0.40°
Chicken Pork 0.297
Natural gas Electricity 0.80°
Clothing Food —0.18°
Entertainment Food 0722
European cars U.S. domestic and Asian cars 0.76°
Asian cars U.S. domestic and European cars 0.61°
U.S. domestic cars European and Asian cars 0.28°
Pope eer AY OO ae ee ee ed SS a

Sources:
“D, M. Heien, “The Structure of Food Demand: Interrelatedness and Duality,’ American
Journal of Agricultural Economics, May 1982.
’G. R. Lakshmanan and W. Anderson, “Residential Energy Demand in the United States,”
Regional Science and Urban Economics, August 1990.
“M. R. Baye, D. W. Jansen, and T. W. Lee, “Advertising in Complete Demand Systems,”
Applied Economics, vol. 24, 1992.
4. T. Fujii et al., “An Almost Ideal Demand System for Visitor Expenditures,” Journal of
Transport Economics and Policy, May 1985.
°P. S. McCarthy, “Market Price and Elasticities of New Vehicle Demands,” Review of
Economics and Statistics, August 1996, pp. 543-547.

it had 75% of the market. The reason? The cross-price elasticity of demand between
cellophane and other flexible packaging materials (waxed paper, aluminum foil, and
others) was sufficiently high to indicate that the relevant market was not cellophane as
such, but flexible packaging materials, and DuPont, with only a 20% market share, had
not monopolized that market.

PRicE ELASTICITY AND INCOME ELASTICITY OF IMPORTS

AND ExPorTs

Price elasticity of We have seen that when the price of a commodity falls, consumers purchase more of
demand for imports the commodity. The increase in the quantity purchased of the commodity resulting from
The percentage change a decline in its price (while holding everything else constant) is measured by the price
in the quantity
elasticity of demand. The same is true for U.S. imports and exports. When import prices
purchased of imports
by a nation divided by fall, domestic consumers import more from abroad. When the price of U.S. exports fall,
the percentage change foreigners purchase more American goods and U.S. exports rise. The increase in the
in their prices. quantity of U.S. imports and exports resulting from a price decline is measured, respec-
Price elasticity of tively, by the price elasticity of demand for imports and the price elasticity of
demand for exports demand for exports.
The percentage change One complication arises, however, when we deal with imports and exports. The
in the quantity purchased price of imports to U.S. consumers depends not only on prices in exporting
of a nation’s exports nations
divided by the percentage
change in the price of the
nation’s exports.
 CHAPTER 5 Market Demand and Elasticities 141

Exchange rate The (expressed in foreign currencies) but also on the rate of exchange between the dollar and
price of a unit of a foreign currencies. The rate of exchange between the dollar and a foreign currency is
foreign currency in terms
called the exchange rate. For example, the exchange rate (R) between the U.S. dollar
of the domestic currency.
and the euro (€), the currency of the 16-nation European Monetary Union (Austria,
Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta,
Netherlands, Portugal, Slovakia, Slovenia, and Spain), was about 1.36 in July 2007. This
Concept Check
meant that U.S. consumers had pay $1.36 to get €1. Thus, the price of a music record
What is the relationship
that costs €1 in the European Monetary Union (EMU) was $1.36 to U.S. consumers. If
between the exchange rate
and the price elasticity of
the price of the record fell to €0.50 in the EMU, U.S. consumers had to pay only $0.68
demand for imports and for the record. The price of an EMU record to U.S. consumers would also fall to $1.00,
exports? even if the price remained at €1 in the EMU, if the exchange rate between the dollar and
the euro fell from $1.36 to €1 to $1.00 to €1.'°
Income elasticity of Exchange rates change very frequently in the real world. How exchange rates are
demand for imports The determined and the reasons that they change are not important at this point (they are
percentage change in the explained in the appendix to Chapter 9). What is important is that the dollar price of
demand for imports by a
U.S. imports can change because of a change in foreign-currency prices abroad or
nation over a specific
period of time divided by
because of a change in exchange rates. Regardless of the reason for the change in the
the percentage change in price of U.S. imports, we can measure the increase in quantity of U.S. imports result-
the income of the nation. ing from a fall in their dollar price by the price elasticity of demand for imports.
Similarly, regardless of the reason for the change in the price of U.S. exports, we can
Income elasticity of measure the increase in quantity of U.S. exports resulting from a fall in their dollar
demand for exports price by the price elasticity of demand for U.S. exports. On the other hand, an increase
The percentage change in U.S. income leads to an increase in U.S. imports, while an increase in income in for-
in the demand for the
eign countries leads to an increase in U.S. exports. These can be measured, respec-
exports of a nation over
tively, by the income elasticity of demand of imports and the income elasticity of
a specific period of time
divided by the demand for exports.
percentage change in the
income of other nations.

EXAMPLE 5-5
Price Elasticity and Income Elasticity for Imports and Exports in the Real World

The short-run price elasticity of demand for U.S. imports has been estimated to be
about 0.6. Thus, a 1% decline in the dollar price of U.S. imports was expected to lead
to a 0.6% increase in the quantity demanded of imports (and thus to a decline of about
0.4% in U.S. expenditures on imports). On the other hand, the price elasticity of
demand for U.S. exports was estimated to be 0.5 in the short run. This means that a 1%
decline in the price of U.S. exports can be expected to lead to a 0.5% increase in the
quantity of U.S. exports within a year or two of the price change (and to a decline of
0.5% in U.S. export earnings). The price elasticity of demand for imports and exports
for the six other largest advanced economies (Japan, Germany, the United Kingdom,
France, Italy, and Canada) are generally lower than those for the United States.

13 This is only the immediate outcome. Over time, the dollar price of U.S. imports is likely to fall by less than
that just indicated because of other forces at work (which need not be examined here).
142 PART TWO Theory of Consumer Behavior and Demand

for
Turning to income elasticity, we find that the income elasticity of demand
increase
imports was estimated to be 2.3 in the United States. This means that a 1%
or GNP can be expected to lead to an increase of about 2.3% in Us:
in U.S. income
imports. Thus, U.S. imports are normal goods and can be regarded as luxuries.
The income elasticity of imports for the six other largest industrial countries are
,
1.7 for France, 1.3 for Canada, and 1.0 for Japan, Germany, the United Kingdom
and Italy.
Source: D. Salvatore, International Economics, 9th ed. (Hoboken, NJ: John Wiley and Sons, 2007),
Chapters 16 and 17.

5.6 MARGINAL REVENUE AND E-asticity4

Up to this point, we have examined demand from the consumers’ side only. However,
consumers’ expenditures on a commodity are the receipts or the total revenues of the
sellers of the commodity. In this section, we look at the sellers’ side of the market. We
begin by defining marginal revenue and showing how the marginal revenue curve can
be derived geometrically from the demand curve. Then we examine the relationship
between marginal revenue, price, and the price elasticity of demand. Thus, the material
in this section represents the link or bridge between the theory of demand (Part Two of
the text) and the theory of the firm (Chapters 9-13).

Demand, Total Revenue, and Marginal Revenue

Total revenue (7R) The total amount earned by sellers of a commodity is called total revenue (7R); it is equal
The price of a to the price per unit of the commodity times the quantity of the commodity sold. Marginal
commodity times the
revenue (MR) is then the change in total revenue per unit change in the quantity sold; MR
quantity sold of the
is calculated by dividing the change in total revenue (ATR) by the change in the quantity
commodity.
sold (AQ):
Marginal revenue
(MR) The change in DATE
MR =—— (Sen
total revenue per unit AQ
change in the quantity
sold. We can also show that the sum of the marginal revenues on all units of the commod-
ity sold equals total revenue.
In Table 5.6, price (column 1) and quantity (column 2) give the demand schedule of
the commodity. Price times quantity gives total revenue (column 3). The change in total
revenue resulting from each additional unit of the commodity sold gives the marginal
revenue (column 4). As a check on the calculations, we see that the sum of the marginal
Average revenue (AR) revenues equals total revenues (column 5). Note that TR/Q equals average revenue
Total revenue divided (AR), and AR = P (the height of the demand curve).
by the quantity sold.

For the definition of marginal revenue in terms of calculus, see Section A.7 of the Mathematical
l4 = kal > . . >

Appendix
at the end of the book.
 CHAPTER 5 Market Demand and Elasticities 143

TABLE 5.6
she) Demand, Total Revenue, and Marginal Revenue

P Q TR MR Sum of MR’s
(1) (2) (3) (4) (5)
$11 0 $0 mo 1
10 10 $10 $10
9 2) 18 8 18
8 3 24 6 24
Hi 4 28 4 28
6 5 30 D 30
5 6 30 0 30
4 7 28 =) 28
3 8 24 =4 24

The information given in Table 5.6 is plotted in Figure 5.5. The top panel gives the
total revenue curve. The bottom panel gives the corresponding demand (D) and marginal
revenue curves. Since MR is defined as the change in TR per unit change in Q, the MR val-
ues are plotted at the midpoint of each quantity interval in the bottom panel of Figure 5.5.
On the other hand, points on the 7R and D curves are plotted at each level of output. For
example, at P = $11, Q@= 0, and so TR (which equals P times Q) is zero and is plotted at
the origin in the top panel of Figure 5.5. At P = $10, Q = 1, and so TR = $10 and MR
(ATR/ AQ) is also $10. This TR value is plotted at Q = | in the top panel, while the cor-
responding MR is plotted between Q = 0 and Q = | (i.e., at Q = 0.5) in the bottom panel.
The MR curve starts at the same point on the vertical axis as the D curve and is every-
where else below the D curve. This is because to sell one more unit of the commodity, price
must be lowered not only for the additional unit sold but also on all previous units. For
example, we see in Table 5.6 that to sell the second unit of the commodity, price must be low-
ered from $10 to $9 on both units. Therefore, the MR on the second unit is given by P = $9
Concept Check (a point on D) minus the $1 reduction on the price of the first unit. That is, MR = $8, which
Why is demand elastic is lower than P, so the MR curve is below the D curve (see the bottom panel of Figure 5.5).
if marginal revenue 1s When D is elastic, MR is positive because an increase in Q increases TR. When D is unitary
positive? elastic, MR = 0 because an increase in Q leaves TR unchanged (at its maximum level).
When D is inelastic, MR is negative because an increase in Q reduces TR (see the bottom
panel of Figure 5.5). We will make a great deal of use of the relationship between the demand
curve and the marginal revenue curve in Chapters 9-13, where we deal with the theory of the
firm and market structure.

Geometry of Marginal Revenue Determination

The marginal revenue curve for a straight-line and for a nonlinear demand curve can
easily be found geometrically. This is shown in Figure 5.6. In the left panel, we can find
the marginal revenue corresponding to point C on Dy by dropping perpendicular C/ to
the vertical axis and CW to the horizontal axis, and then subtracting distance AJ from
CW. This identifies point C’. Thus, at Q=3, P= WC= $1.50, and MR = WC =
$1.00. Similarly, by dropping perpendiculars EK and EE’ from point E on Dy and sub-
tracting distance AK from EE’, we get point E’. Thus, at Q=6, P = E’E =$1, and
MR = 0. By joining points C’ and E’ we derive the MRy curve shown in the left panel
of Figure 5.6. Note that the MRy curve starts at point A (as the Dy curve) and every
144 PART TWO. Theory of Consumer Behavior and Demand

TR($)

30

(dollars)
Total
revenue

Or

ae a ea De ee ae OP nae ere
ee ee me |
yy ee: Q
Quantity demanded

rules Q
Quantity demanded
unit)
(dollars
marginal
and
Price
per
revenue
MR

FIGURE 5.5 Total Revenue, Demand, and Marginal Revenue _ Total revenue
rises up to 5 units of the commodity sold, remains constant between 5 and 6 units,
and declines thereafter. When D is elastic, MR is positive because 7R increases. When
Dis unitary elastic, MR = O because TR is constant (at its maximum). When D is
inelastic, MR is negative because 7R declines (as Q increases).

point on it bisects (i.e., cuts in half) the distance from the Dy curve to the vertical or
price axis. (Indeed, this provides an alternative but equivalent method of deriving the
MR curve geometrically for a straight-line demand curve.) Thus, JV = 1/2JC, KC’ =
1/2KE, and OE’ = 1/20H (see the figure).
To find the marginal revenue curve corresponding to any point on a nonlinear
demand curve, we draw a tangent to the demand curve at that point and then proceed
 CHAPTER 5 Market Demand and Elasticities 145

Px($)

Px($)

0 gay 3) 6 MRx 2 MRx 10 IZ

(Million units) (Million units)

FIGURE 5.6 Marginal Revenue Determination In the left panel, for point C on the Df curve, MR = CW and
is obtained by subtracting distance AJ from price CW. For point E, MR = O and was obtained by subtracting distance
AK = EE’ from Py. In the right panel, to find the MR at point B we draw a tangent to the Dy curve at point B, and then
we move down distance NR from point B. This identifies point B’ on the MRy curve. By moving down distance RT from
point E on the Dy curve, we define point E’ (MR = O) on the MRy curve.

as described above. Thus, to find the marginal revenue corresponding to point B on Dy

in the right panel of Figure 5.6, we draw the tangent to demand curve Dy at point B and
move distance NR downward from point B. This identifies point B’ on the MRy curve.
Another point on the MR curve is obtained by moving distance RT down from point
E. This identifies point E’. Other points on the MR, curve can be similarly obtained.
By joining these points we get the MR, curve for the Dy curve (see the right panel of
Figure 5.6). Note that when the demand curve is nonlinear, the marginal revenue curve
is also nonlinear.

Marginal Revenue, Price, and Elasticity"

There is an important and often-used relationship among marginal revenue, price, and the
price elasticity of demand given by

MR = P(1 + 1/n) [5.8]

For example, at point C on Dx in the left panel of Figure 5.6, 7 = -WH/OW = —9/3 =
—3, and
MR = $1.50(1 — 1/3) = $1.00

15 Ror a more straightforward derivation of expression [5.8] using simple calculus, see Section A.7 of the
Mathematical Appendix at the end of the book.
146 PART TWO. Theory of Consumer Behavior and Demand

= —E'H/OE’ = —6/6= es
(the same as WC’ found earlier geometrically). At point E, 7
= —12/0 = —oo, an
and MR = $1.00(1 — 1/1) = $1.00(0) = 0. At pointA, 7 = —0H/0
MR = $2.00(1 — 1/00) = $2.00(1 — 0) = $2.00.
, at point B on
Formula [5.8] also applies to nonlinear demand curves. For example
Dy in the right panel of Figure 5.6, 7 = —4/2 = —2 and
MR = $2(1 — 1/2) = $1.00
= —1 and
(the same as found earlier geometrically). Similarly, at point £, 1 = —6/6
.
MR.= $1.000 — 1/1) =0.
the
Formula [5.8] can be derived with reference to the straight-line demand curve 1n
left panel of Figure 5.6. Take, for example, point C on Dx. At point C,
WH GH JO
OW AC AJ

= JO CW == oa
' WwW —
Lk =
is
mS Cea ee eS re (P
— MR)
SS

With this result, we manipulate the equation algebraically, to isolate MR on the left-hand
side:
niP-— MR) = —P
P

P —MR=-——
n
P

—MR =—— —P
n
P

MR = P +—
"
MR = P(\ + 1/n) (expression (5.8))

So far, we have discussed the market demand curve for a commodity (Dy or Dy in
Figure 5.6). If there is only one producer or seller in the market (a monopolist), the firm
Concept Check faces the market demand curve for the commodity. When there is more than one pro-
Is demand elastic if an ducer or seller of the commodity, each firm will face a demand curve that is more elas-
increase in price leads
tic than the market demand curve because of the possible substitution among the
to an increase in total
expenditures? Why products of the different firms. With a very large number of sellers of a homogeneous
or why not? or identical product, the demand curve for the output of each firm might be horizontal
or infinitely elastic (perfect competition). In this case the change in total revenue in sell-
ing one additional unit of the commodity (i.e., the marginal revenue) equals price. This is
confirmed by using formula [5.8]; that is,

MR = P(1 — 1/00)
=P
For example, in Figure 5.7, if the firm sells 5X, its TR = $5. If it sells 6X, TR = $6. Thus,
MR = P = $1, and the demand curve and the marginal revenue curves coincide. (The per-
fectly competitive model will be examined in Chapter 9.)
Example 5—6 gives the price, cross, and income elasticities of demand for beer, wine,
and spirits in the United States and examines the relationship among the various elastici-
ties as well as between price elasticities and total revenue. The “At the Frontier” section
then examines some new revolutionizing approaches to consumer demand estimation and
marketing.
 CHAPTER 5 Market Demand and Elasticities 147

of
Price
X

FIGURE 5.7. Demand Curve for the Output of a

Perfectly Competitive Firm The demand curve for
the output of a perfectly competitive firm is horizontal or | | |
infinitely elastic. Thus, P= MR and the demand curve 0 4 8 Ze Ox
and the marginal revenue curve coincide. Quantity of X

EXAMPLE 5-6
U.S. Consumer Demand for Alcoholic Beverages

Table 5.7 gives the price, cross, and income (expenditures) elasticities of the U.S.
demand for alcoholic beverages (beer, wine, and spirits) estimated from U.S.
Department of Agriculture individual and household food-consumption survey data
for 1987-1988.
From Table 5.7, we see that the price elasticity of demand for beer (7 xx) is
—().23. This means that a 10% increase in the price of beer results in a 2.3% reduc-
tion in the quantity of beer demanded by U.S. consumers and thus to an increase in
consumer expenditures on beer. The price elasticity of wine (7yy) is —0.40 and that
of spirits (zz) is —0.25, so that an increase in their price also leads consumers to
demand a smaller quantity of wine and spirits, but also to spend more on these alco-
holic beverages.

Price, Cross, and Income Elasticities of Demand

TABLE 5.7 Bry. Beer, Wine, and Spirits in the United States

Beer Wine Spirits

nxx = —0.23 nyy = —0.40 Nzz = —0.25

xy = 0.31 Nyx = 0.16 Nzx = 0.07

nxz = 0.15 Nyz = 0.10 nzy = 0.09

Nyp—)5.03 Non 121
Gxt =e 0:02

Legend: X = beer, Y = wine, Z = spirits, /= Income

Sennen
eI naa
148 PART TWO. Theory of Consumer Behavior and Demand

with
Table 5.7 also shows that the cross-price elasticity of demand for beer
means that
respect to wine (7)xy) is 0.31 and with respect to spirits (17xz) 1s 0.15. This
. Thus, a
wine and spirits are substitutes for beer, with wine being a better substitute
10% increase in the price of wine will lead to a 3.1% increase in the demand for beer,
while a 10% increase in the price of spirits leads to a 1.5% increase in the demand for
beer. Note that the cross price elasticity of wine and spirits with respect to beer (.e.,
nyx and nzy in columns two and three of the table) are somewhat different from the
cross price elasticity of demand for beer with respect to wine and spirits (7 xy and 7)xz
in column one).
Finally, Table 5.7 shows that with x; = —0.09, ny = 5.03, and nz, = 1.21,a 10%
increase in consumer income (expenditure) leads to a 0.9% reduction in the demand
for beer, but to a 50.3% increase in the demand for wine, and a 12.1% increase in the
demand for spirits. Thus, beer can be considered an inferior good, while wine and spir-
its can be regarded as luxuries (with wine being a much stronger luxury than spirits).
Source: X. M, Gao, E. J. Wiles, and G. L. Kramer, “A Microeconometric Model of the U.S. Consumer
Demand for Alcoholic Beverages,” Applied Economics, January 1995, pp. 59-69.

AT THE FRONTIER
The Marketing Revolution with Micromarketing

hile regression analysis (discussed in the appendix to this chapter) is by far the
Marketing W most useful and used method of estimating demand, marketing research
research approaches to demand estimation are being revolutionized and becoming increas-
approaches to
ingly important as a result of new technological developments that permit micromar-
demand estimation
keting.
The estimation of
consumer demand There are several traditional marketing approaches to estimate market demand
for a product or curves and elasticities. One involves consumer surveys using interviews or question-
service by consumer naires in which consumers are asked how much of a commodity they would purchase at
surveys, consumer various prices. It is, however, generally agreed that this procedure yields very biased
clinics, or market results, because consumers either cannot or will not give trustworthy answers. Another
experiments. traditional marketing approach to demand estimation is consumer clinics, in which
consumers are given a sum of money and asked to spend it in a simulated store to see
how they react to price changes. However, the sample of consumers must necessarily be
small because this procedure is expensive. Also, the results are questionable because
consumers are aware that they are in an artificial situation. Still another traditional mar-
keting approach to demand estimation is a market experiment, whereby the seller
increases the price of the commodity in one market or store and lowers it in another and
then records the different quantities purchased in the two markets or stores. This proce-
dure is questionable because a small sample is involved, the seller can permanently lose
customers in the high-priced market or store, and only the immediate or short-run
response to the price change is obtained.
 CHAPTER 5 Market Demand and Elasticities 149

Recent technological developments in telecommunications, however, have

greatly changed and completely revitalized marketing research approaches to con-
sumer demand estimation to the point where they have become crucial marketing
tools and are bound to become even more important in the future. One such tool is
micromarketing.
Today, more and more consumer-product companies are narrowing their market-
ing strategy from the region and city to the individual neighborhood and single store.
Micromarketing The aim of such a detailed point-of-sale information, or micromarketing, is to iden-
Narrowing a tify on a store-by-store basis the types of products with the greatest potential appeal for
poe the specific customers in the area. Using census data and checkout scanners, Market
eT Gc Metrics, a marketing research firm, now collects consumer information at more than
30,000 supermarkets around the country. For example, for a particular grocery store in
Georgia, Pennsylvania, Market Metrics found that potential customers were predomi-
nantly white, blue collars, owned two cars, lived in households of three or four people,
and had an average income of $54,421, and 26% of the people were below the age of
15. Based on these demographic and economic characteristics, Market Metrics deter-
mined that the strongest sellers in this market would be baby foods and grooming
items, baking mixes, desserts, dry dinner mixes, cigarettes, laundry supplies, first aid
products, and milk. Less strong would be sales of artificial sweeteners, tea, books, film,
prepared food, yogurt, wine, and liquor. Such store-specific micromarketing is likely
to become more and more common and necessary for successful retailing in the future.
As marketers refine their tools, they are increasingly taking aim at the ultimate
Concept Check narrow target: the individual consumer. Indeed, many companies, led by banks, are
In what way is assembling customer profiles and employing sophisticated technology called neural
oe a networks in order to set up one-to-one marketing (also called relationship marketing
revolution !
or customer-relationship management). This seeks to reach the individual consumer
and establish a learning relationship with each customer, starting from the most valu-
able ones. This is exactly what Amazon.com (the internet book seller) does when it
reminds a customer that a book that might interest her has just come in. One-to-one
marketing requires identifying the company’s customers, differentiating among
them, interacting with them, and customizing the product or service to fit each indi-
vidual customer’s needs.
For example, the Quaker Oats Company tracks how your household redeems
coupons and uses the information to refine the coupons it will offer you in the future,
and Merrill Lynch & Co. provides detailed financial information about its customers
to its brokers in order to help them promote the company’s financial products.
Depositing a $10,000 check may thus eliminate the customer as a likely candidate for
a car loan, but not for a home mortgage loan. It may even determine whether your tele-
phone call gets answered first (if your profile, which comes up immediately on the
bank’s computer screen, identifies you as a valued customer) or last. Although it is not
easy to set up one-to-one marketing and most companies may not yet be capable or
ready for it, it is almost certain that marketing will be getting more and more person-
alized in the future.
Many firms already claim to be “customer driven” or “consumer-centric.” Their
claims are now tested as never before. Trading on shoppers’ ignorance is no longer
possible. Today, window shopping takes place online. Shoppers compare products,
prices, and reputations by finding out what previous buyers of the product have to say.
Continued...
150 PART TWO. Theory of Consumer Behavior and Demand

The Marketing Revolution with Micromarketing —Continued

Although most purchases still take place in brick-and-mortar stores, more than 90% of
shoppers between the ages of 18 and 54 turn to the Internet first for product information.
Ready
Sources: “Know Your Customer,” Wall Street Journal, June 21, 1999, p. R18; “Is Your Company
for One-to-One Marketing?,” Harvard Business Review, January-February 1999, pp. 151-160; “Winning in
Smart Markets,” Sloan Management Review, Summer 1999, pp. 59-69; “The Vanishing Mass Market,
Business Week, July 12, 2004; and “Power at Last,” The Economist, April 2, 2005, p. | iL.

SUMMARY
Ve The market demand curve for a commodity is obtained from the horizontal summation of the
demand curves of all the individual consumers in the market and shows the total quantity
demanded at various prices. It is negatively sloped; and, in drawing it, we must hold constant
the consumers’ incomes, the price of substitutes and complementary commodities, tastes, and
the number of consumers in the market. The market demand curve is flatter or more elastic than
otherwise with a bandwagon effect (a positive network externality), and steeper and less elastic
when a snob effect (a negative network externality) is present, or with conspicuous
expenditures or Veblen effect.
. The price elasticity of demand is measured by the percentage change in the quantity demanded
of a commodity divided by the percentage change in its price. By drawing a tangent to a point
on a nonlinear demand curve and dropping a perpendicular to either axis, we can measure price
elasticity at that point by the ratio of two distances. A straight-line demand curve is unitary
elastic at its midpoint, elastic above the midpoint, and inelastic below the midpoint. Total
expenditures and price move in opposite directions if demand is elastic and in the same
direction if demand is inelastic. A rectangular hyperbola demand curve has unitary elasticity and
constant total expenditures throughout. A demand curve is more elastic (a) the closer and the
better are the available substitutes, and (b) the longer the adjustment period to the price change.
. The income elasticity of demand (7;) measures the percentage change in the quantity purchased
of a commodity divided by the percentage change in consumers’ incomes. A commodity is
usually considered to be a necessity if 77; is between 0 and | and a luxury if 7; exceeds 1. 7;
exceeds | if the tangent to the Engel curve is positively sloped and crosses the income axis. 1,
is between 0 and | if the tangent to the Engel curve is positively sloped and crosses the quantity
axis. If 1; is negative, the commodity is an inferior good and the Engel curve is negatively
sloped. According to Engel’s law, the proportion of total expenditures on food declines as
family incomes rise.
- Commodities X and Y are substitutes if more ofX is purchased when the price of Y goes up,
and complements if less of X is purchased when the price of Y goes up. The cross elasticity of
demand between commodities X and Y (yyy) measures the percentage change in the quantity
purchased ofX divided by the percentage change in the price of Y. If nyy is positive, X and Y
are substitutes. If 7yy is negative, X and Y are complements, and if yyy = 0, X and Y are
independent commodities.
. We can measure the increase in U.S. imports and exports as a result of a decline in their prices
by their respective price elasticities of demand. The only complication is that the price of U.S.
imports and exports is also affected by changes in the exchange rate. The exchange rate gives
the number of units of the domestic currency required to purchase one unit of the foreign
currency. We can also measure the income elasticity of demand for U.S. imports and for the
imports of other nations.
 CHAPTER 5 Market Demand and Elasticities 151

6. The total revenue (TR) of sellers equals price times quantity. Marginal revenue (MR) is the
change in 7R per unit change in the quantity of the commodity sold. MR is positive when
demand (D) is elastic because a reduction in price increases TR. When D is unitary elastic,
MR = 0 because TR is constant (at its maximum). When D is inelastic, MR is negative because
a reduction in price reduces TR. The MR curve for a straight-line D curve bisects the quantity
axis. The MR at a point on a nonlinear D curve is found geometrically by drawing a tangent to
the demand curve at that point. Marginal revenue, price, and price elasticity of demand are
related by MR = P(1 + 1/1). The demand curve facing a perfectly competitive firm is
horizontal and P = MR because 7 is infinite. Today, marketing research approaches to
demand estimation are being revolutionized by new technological developments that
permit micromarketing.

|_| _KEY TERMS

Market demand curve Luxury Income elasticity of demand for exports
Bandwagon effect Engel’s law Total revenue (TR)
Snob effect Substitutes Marginal revenue (MR)
Veblen effect Complements Average revenue (AR)
Price elasticity of demand (7) Cross elasticity of demand (ny) Marketing research approaches to
Point elasticity of demand Price elasticity of demand for imports consumer demand
Arc elasticity of demand Price elasticity of demand for exports Micromarketing
Engel curve Exchange rate Identification problem
Income elasticity of demand (7,) Income elasticity of demand for Multiple regression
Necessity imports

REVIEW QUESTIONS
1. Which is more elastic, an individual’s demand curve for a 53 Suppose that a study has found that the price elasticity
commodity or the market demand curve for a commodity? of demand for subway rides is 0.7 in Washington, D.C.,
Why? Is this always true? Explain. and the mayor wants to cut the operating deficit of the
2. Will a decrease in a commodity price increase expenditures subway system. Should the mayor contemplate increasing
on that commodity? Why? or decreasing the price of a subway ride? Why?

3. If the price of household natural gas increases by 10%, . Can you say with reference to Table 5.4 whether
by how much can we expect the quantity demanded of producers and sellers of beef or pork, products
household natural gas and total expenditures on household would be affected more adversely from a recession?
natural gas to change in the short run and in the long run . Which of the following are more likely to have a
according to the elasticity values in Table 5.2? positive cross elasticity of demand: pencils and
paper, an IBM PC and a Dell PC, or automobiles and
4. Is the price elasticity of demand for Marlboro cigarettes
gasoline?
more or less elastic than the demand for all tobacco
products? Why? By how much would the quantity . What other demand elasticities, besides those examined in
demanded of Marlboro cigarettes change in the long run if this chapter, are likely to be important for beachwear?
the price rose by 5% and the long-run price elasticity of How would you measure such elasticities?
demand is 3.56? If the price of all tobacco products also . If the price of books in England falls by 10%, but at the
increased by 5%, would the quantity demanded of same time the dollar appreciates (i.e., increases in value
Marlboro cigarettes change by more or less as compared with respect to the British pound) by 10%, how is the
to the case when only the price of Marlboro cigarettes U.S. demand for imported books from the United
changed? Kingdom likely to be affected?
152 PART TWO. Theory of Consumer Behavior and Demand

10. If prices and exchange rates remain unchanged, but 11. If the price of a product is $10 and the marginal revenue
income rises by 4% in the United States and 3% in the is $5, what is the price elasticity of demand for the
rest of the world during a given year, by how much
product at that point?
would U.S. imports from and exports to the rest of the _TIf the demand curve faced by a firm is dy = Py = $10,
world change if the income elasticity of demand for what is the price elasticity of demand at Ox = 10?
U.S. imports is 1.94 while the income elasticity of Between Qy = 10 and Qy = 12?
demand for U.S. exports is 0.80? How would the U.S. 13. What are the marketing research approaches to demand
trade balance (exports minus imports) change over the estimation? What is meant by micromarketing?
year if it was balanced at the beginning of the year?

PROBLEMS
1. Measure the price elasticity of the market demand curve in a. by how much would the quantity demanded decrease?
the left panel of Figure 5.2 b. would the consumers’ total expenditures on
a. from point B to point E. Marlboro cigarettes increase, decrease or remain
b. from point E to point B. unchanged?

c. as an average over arc BE. Q . If the price of all other brands of cigarettes also
increased by 10%, what would happen to the
i) . Measure graphically the price elasticity of demand curve
quantity demanded of Marlboro? To consumers’
Dy in the left panel of Figure 5.2
expenditures on Marlboro?
a. at point B.
7. From the following table
b. at point G.
3. Using the general formula for the price elas-
ticity of demand (1.e., equation [5.1]), prove that Ox 100 | 250 I" 350 400 300
a. 1 = 0 at pointA on D\ in the right panel of Figure
I $10,000 |15,000 |20,000 | 25,000 | 30,000
SW,
b. 7 = 0 at point H in the same diagram.
*4_ Explain the following. a. calculate the income elasticity of demand for
a. Of two parallel demand curves, the one further to commodity X between various income levels and
the right has a smaller price elasticity at each determine what type of good is commodity X;
price. b. plot the Engel curve; how can you tell from the
b. When two demand curves intersect, the flatter of the shape of the Engel curve what type of good is
two is more elastic at the point of intersection. commodity X?
5. Using only the total expenditures criterion, determine if *8. a. Explain why in a two-commodity world both
the demand schedules given in the following table are commodities cannot be luxuries.
elastic, inelastic, or unitary elastic. b. What would be the effect on the quantity of cars
purchased if consumers’ incomes rose by 10% and the
income elasticity of demand is 2.5?
9. Which of the following sets of commodities are likely to
have positive cross elasticity of demand?
a. aluminum and plastics
b. wheat and corn
c. pencils and paper
d. private and public education
e. gin and tonic
6. If the price elasticity of demand for Marlboro cigarettes is
f. ham and cheese
—6 and its price rose by 10%
g. men’s and women’s shoes

* = Answer provided at end of book.

 CHAPTER 5 Market Demand and Elasticities 153

*10. Using the values for the price and income elasticity of ke) Using the formula relating marginal revenue, price,
demand for electricity and for the cross elasticity of and elasticity, confirm the values of the marginal
demand between electricity and natural gas given in revenue found geometrically for P = $8, for P = $4,
Tables 5.2, 5.4, and 5.5, answer the following and for P = $2.
q uestions: 12. Explaini why a firm
Fi should never operate in the inelastic
i i
a. Is the demand for electricity elastic or inelastic in range of its demand curve.
the short run? In the long run? How much would *13, The following proposition (proved in Section A.6
the quantity demanded of electricity change as a
. . .

of the Mathematical Appendix at the end of the text)

ky © : i

result of a 10% increase in its price in the short is given:

run? In the long run?
b.: Is electricity
aSa necessity
‘ or a luxury? ? How m uch
JeOE. y Kxnx; + Kyny;= |
would electricity consumption change with a 10%
increase in consumers’ incomes?
where Ky is the proportion of the consumer’s income /
c. Is natural gas a substitute or complement of
spent on commodity X (1.e., Ky = Px Oy /T, nx, is the
electricity? By how much would electricity
income elasticity of demand for commodity X, Ky is the
consumption change with a 10% increase in the
proportion of income spent on Y(i.e., Ky = PyQy//), and
price of natural gas?
nyr is the income elasticity of demand for Y. Also,
11. Given the following demand schedule suppose that a consumer spends 75% of his or her income
on commodity X and the income elasticity of demand for
commodity X is 0.9. Assume that the individual
consumes only commodities X and Y.
a. Find the income elasticity of demand for commodity
Ve
a. find the total revenue and the marginal revenue. b. What kind of commodity is Y? X? How high would
b. plot the total revenue curve, the demand curve, and the income elasticity of demand for X have to be
the marginal revenue curve. before commodity Y becomes inferior?

|APPENDIX| EMPIRICAL ESTIMATION OF DEMAND BY REGRESSION ANALYSIS

The most useful and used method of estimating market demand curves today is regression
analysis. This method uses actual market data of the quantities purchased of the com-
modity at various prices over time (i.e., time series data) or for various consuming units
or areas at one point in time (i.e., cross-sectional data). Indeed, all of the actual demand
elasticities presented in the examples in this chapter were estimated by regression analy-
sis. However, only if the scatter of quantity—price observations (points) fall as in the left
panel of Figure 5.8 can we estimate a demand curve from the data. If the points fall as in
Identification problem the right panel, we face an identification problem and may be able to estimate neither a
The difficulty reliable demand curve nor a supply curve for the commodity from the data.'©
sometimes encountered When quantity—price observations (points) fall as in the left panel of Figure 5.8, we
in estimating the can estimate the average demand curve for the good by correcting for the forces that
market demand or
supply curve of a
commodity from '© Bach quantity—price observation (point) is usually given by the intersection of a different (and unknown)
quantity—price demand and supply curve for the commodity. The reason for this is that demand and supply curves usually
observations. shift over time and are usually different for different consumers and in different places. When the points fall
as in the left panel, we can correct for the forces that cause the demand curve to shift and derive an average
demand curve from the data. When the points fall as in the right panel and the shifts in demand and supply
are not independent, we are unable to do so.
154 PART TWO. Theory of Consumer Behavior and Demand

2D
Price - Price e

e ae Md " e
e omer. are
ry a e
~ e ° e ot bn’,
e
e
v e e

7 ID

0 Quantity 0 Quantity

FIGURE 5.8 Scatter Diagram of Quantity-Price Observations When the

scatter points of quantity—price observations fall as in the left panel, we can estimate
an average demand curve from the data using regression analysis, such as dashed
line_D.However, when the points fall as in the right panel, we may be unable to
estimate or identify either a reliable demand or supply curve.

cause the demand curve to shift (i.e., by correcting for the changes or differences in
Multiple regression A incomes and in the prices of related commodities). This is accomplished by the multiple
statistical technique regression statistical technique.!’ Regression analysis allows the economist to disentan-
that allows the gle the independent effect of the various determinants of demand so as to identify from
economist to
the data the average market demand curve for the commodity (such as dashed line D in
disentangle the
independent effects of
the left panel).
the various To conduct the regression analysis, the researcher collects data on the quantity pur-
determinants of a chased of the good in question, its price, the income of consumers, and the price of one
dependent variable, or more related commodities (substitutes and complements). Regression analysis allows
such as demand. the researcher to correct for the effect of changes or differences in consumers’ incomes
and in the prices of related commodities and permits the estimation of the average
demand function that best fits the data (as, for example, D in the left panel of Figure
5.8). The values of all the collected variables are usually first transformed into loga-
rithms because by doing so the estimated coefficients of the demand function are the var-
ious elasticities of demand.!*
By regression analysis we estimate a demand function of the following form:

Ox Gt DE x Cl chy [5.9]
where Qy, Py, J, and Py usually refer to the logarithm of the quantity purchased of
commodity X per unit of time, its price, the consumers’ income, and the price of related

'’ Regression analysis is explained in a course in statistics. For an introduction to regression analysis, see
D. Salvatore and D, Reagle, Statistics and Econometrics, 2nd ed. (New York: McGraw-Hill, 2002,
Chapters 6 and 7).
'* In order for the estimated coefficients to be elasticities, the value of each variable collected must
first be
transformed into the natural logarithm. Natural logs are those to the base 2.718 (as opposed to common logs,
which are to the base 10). For example, the natural log of 100, written In 100, is 4.61 (i.e.. In 100
= 4.61).
This is obtained by looking up the number 100 in a table of natural logs or more simply using
a pocket
calculator. The time series or the cross-section data of each variable transformed into
natural logs are then
used to run the regression and obtain the various coefficients of the demand function. These
estimated
coefficients are the elasticities. Why this is so is explained in a course of mathematics for
economists.
 CHAPTER 5 Market Demand and Elasticities

commodity Y, respectively. Oy = a (the constant) when Px, I, and Py are all zero. The
estimated coefficient of Py, b, is the price elasticity of demand (when the regression is
performed on the data transformed into logarithms). On the other hand, c is the estimated
income elasticity of demand, while e is the estimated cross elasticity of demand of good
X for good Y.
For the demand curve of good X to obey the law of demand, the estimated b coef-
ficient (7x) must be negative (so that quantity demanded and price are inversely
related). Good X is a necessity if the estimated c coefficient (7)) is positive but smaller
than 1. On the other hand, good X is a luxury if c > | and an inferior good if c < 0. If
the estimated e coefficient (xy) is positive, good Y is a substitute for good X. If e < 0,
good Y is a complement of good X. Regression analysis is also used to forecast future
demand, as Example 5-7 illustrates.

EXAMPLE 5-7
Estimating and Forecasting U.S. Demand for Electricity

Estimating and forecasting the demand for electricity is very important because it takes
many years to build new capacity to meet future needs. One such an estimate was provided
by Halvorsen, who used multiple regression analysis to estimate the market demand equa-
tion for electricity with cross-sectional data transformed into natural logarithms for the 48
contiguous states in the United States for the year 1969.
Table 5.8 reports the estimated elasticity of demand for electricity for residential use
in the United States with respect to the price of electricity, per capita income, the price of
gas, and the number of customers in the market. Although the results of various studies
differ somewhat, the results reported below indicate that the amount of electricity for res-
idential use consumed in the United States would fall by 9.74% as a result of a 10%
increase in the price of electricity, would increase by 7.14% with a 10% increase in per
capita income, would increase by 1.59% with a 10% increase in the price of gas, and is
proportional to the number of customers in the market. Thus, the market demand curve for
electricity is negatively sloped, electricity is a normal good and a necessity, and gas is a
substitute for electricity.
Using the above estimated demand elasticities and projecting the growth in per
capita income, in the price of gas, in the number of customers in the market, and in the
price of electricity, public utilities could forecast the growth in the demand for

Elasticities of Demand for Electricity

TABLE 5.8 for Residential Use in the United States

Variable Value

Price —0.974
Per capita income 0.714
Price of gas 0.159
Number of customers 1.000

Sources: R. Halvorsen, “Demand for Electric Energy in the United States,”

Southern Economic Journal, April 1976.
156 PART TWO. Theory of Consumer Behavior and Demand

electricity in the United States so as to adequately plan new capacities to meet future
needs. For example, if we assume that per capita income grows at 3% per year, the
price of gas at 20% per year, the number of customers at 1% per year, and the price of
electricity at 4% per year, we can forecast that the demand for electricity for residential
use in the United States will expand at a rate of 2.43% per year. This rate is obtained
by adding the products of the value of each elasticity to the projected growth of the
corresponding variable, as indicated in the following equation:
O = (0.714)(3%) + (0.159)(20%) + (1.000)(1%) — (0.974)(4%)
= 2.142 + 3.180 + 1.000 — 3.896
= 6.322 — 3.896
= 2.426
With different projections of the yearly growth in per capita income, the price of gas,
the number of customers in the market, and the price of electricity, we will get corre-
spondingly different results.
The above results are shown in Figure 5.9, where Po and Qo are the original price
and quantity of electricity demanded in the United States on hypothetical demand

Percentage
growth
in price
of electricity

4 F -3.896%

4%

:
Po
2.142% —— Pe
A

= Do

NN - |
g Qo Qi
—_—_—___—_—_>
2.426%
Percentage growth in quantity of electricity
FIGURE 5.9 Forecast of Electricity in the United States Po
and Qo are the original
price and quantity of electricity demanded in the United States on hypotheti
cal demand
curve Do. Demand curve D’ results from projecting a 3% increase in per
capita incomes,
D” by also projecting a 20% increase in the price of gas, and D,
from a 1% increase in the
number of customers in the market as well. If the price elasticity
is also assumed to
increase by 4% (from Pp to P;), the demand for electricity increases
from 2.426% per
year (the movement from point A on Do to point F on D,)
 CHAPTER 5 Market Demand and Elasticities low,

curve Do in the base period (say, the current year). Demand curve D’ results from the
projected increase in per capita income, D” results from the increase in the price of
gas also, and D, results from the increase in the number of customers in the market as
well. Thus, D, takes into account or reflects the cumulative effect of all the growth
factors considered.
Were the price of electricity to remain constant, the demand for electricity would
rise by 6.322% per year (given by the movement from point A on Dp to point G on D, in
the figure). The projected increase in the price of electricity by 4% per year (from Po to
P,), by itself, will result in a decline in the quantity demanded of electricity by 3.896%
(the movement from point G to point F on D;). The net result of all forces at work gives
rise to a net increase in Q of 2.426% per year (the movement from pointA on Dp to point
FonD)).
Until the mid-1990s when the deregulation of the electricity market started in the
United States, the nation’s regulatory commissions set low electricity rates and this
discouraged the building of new power plants. Electrical power companies simply pre-
ferred charging higher electricity rates at times of peak demand rather than building
the new plants. All this began to change during the past decade as the electricity mar-
ket started to be deregulated. Botched-up deregulation, however, led to widespread
electricity shortages, blackouts or brownouts, and sharply higher electricity prices in
California and other western states during 2000 and 2001, and this slowed down, put
on hold, or even reversed the deregulation process. The United States does need to
build from 1,300 to 1,900 new power plants to meet future demand, which is expected
to grow by 45% by the year 2020. Since it takes from 6 to 12 years to build a new plant,
electrical power companies have no time to waste.
Sources: “R. Halvorsen, “Demand for Electric Energy in the United States,’ Southern Economic Journal,
April 1976; “Value Networks—The Future of the U.S. Electric Utility Industry,” Sloan Management
Review, Summer 1997, pp. 21-34; “The Challenge for Utilities: Increase Capacity and Efficiency,” Wall
Street Journal, December 18, 2000, p. C6; “The Trouble with Energy Markets: Understanding California’s
Restructuring Disaster,’ Journal of Economic Perspectives, Winter 2002, pp. 191-212; Enron’s Lessons
for the Energy Market,’ New York Times, May 11, 2002, p. 17; Electricity Demand Is Far Outpacing New
Supply Sources,” Wall Street Journal, October 17, 2007, p. A17; and Energy Information Administration,
Annual Energy Outlook, Washington, DC: EIA, 2007.

INTERNET SITE ADDRESSES

Information about McDonalds can be found at: ?abstract_
http://papers.ssrn.com/sol3/papers.cfm
http://www.mcdonalds.com id=612704
Some income and cross elasticities are found at: http://www.cide.info/conf_old/papers/1115.pdf

http://www. vtpi.org/tdm/tdm 1 1.htm The demand for electricity, deregulation, and shortages are
examined at:
For the elasticity of demand for alcoholic beverages, see:
http://www.eia.doe. gov/cneat/electricity/dsm/dsm_sum.html
-
http://links.jstor.org/sici?sici=1058-7195(199609) 18%
3A3%3C477%3AUCDFAB%3E2.0.CO%3B2-K http://www.opensecrets.org/news/electricity.htm
 CHAPTER 6

Choice Under Uncertainty

Chapter Outline 6-2 Risk and Crime Deterrence
6.1 Risk and Uncertainty in Demand Choices 6-3 America’s Gambling Craze
6.2 Measuring Risk 3 6-4 Gambling and Insuring by the
6.3 Utility Theory and Risk Aversion Same Individual—A Seeming
6.4 Insurance and Gambling Contradiction
6.5 Risk Aversion and Indifference Curves 6-5 Spreading Risks in the Choice of
6.6 Reducing Risk and Uncertainty a Portfolio
6.7 Behavioral Economics 6-6 Some Disasters as Nondiversifiable Risks
6-7 Behavioral Economics in Finance
List of Examples At the Frontier: Foreign-Exchange Risks
6-1 The Risk Faced by Coca-Cola in Changing Its and Hedging
Secret Formula

After Studying This Chapter, You Should Be Able to:

e Know how choice in the face of risk differs from choice in the absence of risk
e Describe how risk is measured
e Understand why some individuals buy insurance and also gamble
e Know how risk and uncertainty can be reduced
e Describe how behavioral economics seeks to improve traditional economic theory

raditional demand theory—as examined until now—implicitly assumed a riskless

ifworld. It assumed that consumers face complete certainty as to the results of the
choices they make. Clearly, this is not the case in most instances. For example, when
we purchase an automobile we cannot be certain as to how good it will turn out to be and
how long it will last. Similarly, when we choose an occupation, we cannot be certain as to
how rewarding it will be in relation to alternative occupations. Thus, the applicability of
traditional economic theory is limited by the fact that it is based on the assumption of a
riskless world, while most economic decisions are made in the face of risk or uncertainty.
In this chapter we extend traditional demand theory to deal with choices subject to risk
or uncertainty. We begin the chapter by distinguishing between risk and uncertainty and
introducing some of the concepts essential for risk analysis. Then we examine methods
for
measuring risk and for analyzing an individual’s attitude toward risk. We go on to discuss
gambling and insurance, risk—return indifference curves and their use in analyzing
choices

158
 CHAPTER 6 Choice Under Uncertainty 159

subject to risk. Subsequently, we summarize ways by which an individual or other eco-

nomic agent can reduce risk. Finally, we discuss behavioral economics. A large dose of
realism is introduced into the analysis by the many real-world examples included in the
chapter. The “At the Frontier” section deals with foreign-exchange risk and hedging.

[61| RISK AND UNCERTAINTY IN DEMAND CHOICES

Certainty The situation Consumer choices are made under conditions of certainty, risk, or uncertainty. Certainty
where there is only one refers to the situation where there is only one possible outcome to a decision, and this out-
possible outcome to a
come is known precisely. For example, investing in Treasury bills leads to only one out-
decision and this
come (the amount of the yield), and this is known with certainty. The reason is that there
outcome is known
precisely; risk-free. is virtually no chance that the federal government will fail to redeem these securities at
maturity or that it will default on interest payments. On the other hand, when there is more
than one possible outcome to a decision, risk or uncertainty is present.
Risk The situation Risk refers to a situation where there is more than one possible outcome to a decision
where there is more and the probability of each specific outcome is known or can be estimated. Thus, risk
than one possible requires that the decision maker know all the possible outcomes of the decision and have
outcome to a decision
some idea of the probability of each outcome’s occurrence. For example, in tossing a
and the probability of
each possible outcome
coin, we can get either a head or a tail, and each has an equal (i.e., a 50-50) chance of
is known or can be occurring (if the coin is balanced). Similarly, investing in a stock can lead to a set of pos-
estimated. sible outcomes, and the probability of each possible outcome can be estimated from past
experience. In general, the greater the variability (i.e., the greater the number and range)
of possible outcomes, the greater the risk associated with the decision or action.
Uncertainty The Uncertainty is the case when there is more than one possible outcome to a decision
situation where there is and where the probability of each specific outcome occurring is not known or even mean-
more than one possible ingful. This may be due to insufficient past information or instability in the structure of
outcome to a decision the variables. In extreme forms of uncertainty, not even the outcomes themselves are
and the probability of
known. For example, drilling for oil in an unproven field carries with it uncertainty if the
each specific outcome
is not known or even investor does not know either the possible oil outputs or their probability of occurrence.!
meaningful. In the analysis of choices involving risk or uncertainty, we will utilize such concepts
as strategy, states of nature, and payoff matrix. A strategy refers to one of several alterna-
tive courses of action that a decision maker can take to achieve a goal. For example, an
Concept Check individual may have to decide on how much of its savings to put in stocks (which can offer
What is the difference high returns but are subject to high volatility and risk) and how much in government
between risk and bonds (which offer lower returns but are also subject to low volatility and risk). States of
uncertainty? nature refer to conditions in the future that will have a significant effect on the degree of
success or failure of any strategy, but over which the decision maker has little or no con-
trol. For example, the economy may be booming, normal, or in a recession in the future.
The decision maker has no control over the states of nature that will prevail in the future,
but the future states of nature can affect the outcome of any strategy that he or she may
adopt. The particular decision made will depend, therefore, on the decision-maker’s
knowledge or estimation of how the particular future state of nature will affect the
outcome or result of each particular strategy (such as the return on stocks and bonds).
Finally, a payoff matrix is a table that shows the possible outcomes or results of each
strategy under each state of nature. For example, a payoff matrix may show the return that

| Although the distinction between risk and uncertainty is theoretically important, in this chapter we follow the
usual convention (when introducing this topic) of using these two terms interchangeably.
160 PART TWO. Theory of Consumer Behavior and Demand

be booming, normal,
the individual would obtain from an investment if the economy will
or in a recession in the future.

6-1
EXAMPLE Ae.
The Risk Faced by Coca-Cola in Changing Its Secret Formula

On April 23,1985, the Coca-Cola Company announced that it was changing its
99-year-old recipe for Coke. Coke is the leading soft drink in the world, and the company
took an unusual risk in tampering with its highly successful product. The Coca-Cola
Company felt that changing its recipe was a necessary strategy to ward off the chal-
lenge from Pepsi-Cola, which had been chipping away at Coke’s market lead over the
years. The new Coke, with its sweeter and less fizzy taste, was clearly aimed at revers-
ing Pepsi’s market gains. Coca-Cola spent over $4 million to develop its new Coke and
conducted taste tests on more than 190,000 consumers over a three-year period. These
tests seemed to indicate that consumers preferred the new Coke over the old Coke by
61% to 39%. Coca-Cola then spent over $10 million on advertising its new product.
When the new Coke was finally introduced in May 1985, there was nothing short
of a consumers’ revolt against the new Coke, and in what is certainly one of the most
stunning multimillion dollar about-faces in the history of marketing, the company felt
compelled to bring back the old Coke under the brand name Coca-Cola Classic. The
irony is that with the Classic and new Cokes sold side by side, Coca-Cola regained
some of the market share that it had lost to Pepsi. While some people believed that
Coca-Cola intended all along to reintroduce the old Coke and that the whole thing was
part of a shrewd marketing strategy, most marketing experts are convinced that Coca-
Cola had underestimated consumers’ loyalty to the old Coke. This did not come up in
the extensive taste tests conducted by Coca-Cola because the consumers tested
were never informed that the company intended to replace the old Coke with the new
Coke rather than sell them side by side. This example clearly shows that even a
well-conceived strategy is risky and can lead to results estimated to have a small prob-
ability of occurrence. While Coca-Cola recuperated from the fiasco, most companies
are not so lucky! In the meantime, the perennial cola battle for market supremacy
between Coke and Pepsi rages on.
Sources: “Coca-Cola Changes Its Secret Formula in Use for 99 Years,” New York Times, April 24, 1985,
p. 1; “ ‘Old’ Coke Coming Back After Outcry by Faithful?’ New York Times, July 11, 1985, p. 13; “Flops,”
Business Week, August 16, 1993, pp. 76-82; “Facing Slow Sales, Coke and Pepsi Gear Up for New
Battle,” Wall Street Journal, April 16, 2001; “A Better Model? Diversified Pepsi Steals Some of Coke’s
Sparkle,” Financial Times, February 28, 2005, p. 15; and “Coke Gets Real: The World’s Most Valuable
Brand Wakes up to a Waning Thirst for Cola,” Financial Times, September 22, aL, 2005,
2 pale

6.2 MEASURING RISK

In the previous section we defined risk as the situation where there is more than one
pos-
sible outcome to a decision and the probability of each possible outcome is
known or can
be estimated. In this section we examine the meaning and characteristics of
probability
distributions, and then we use these concepts to develop a precise measure
of risk.
 CHAPTER 6 Choice Under Uncertainty 161

TABLE 6.1]
AE Probability Distribution of States of the Economy

State of the Economy Probability of Occurrence

Boom 0.25
Normal 0.50.
Recession 0.25
Total 1.00

Probability Distributions
Probability The The probability of an event is the chance or odds that the event will occur. For example,
chance or odds that an if we say that the probability of booming conditions in the economy next year is 0.25, or
event will occur.
25%, this means that there is 1 chance in 4 for this condition to occur. By listing all the
possible outcomes of an event and the probability attached to each, we get a probability
Probability distribution. For example, if only three states of the economy are possible (boom, nor-
distribution The list of mal, or recession) and the probability of each occurring is specified, we have a probabil-
all possible outcomes ity distribution such as the one shown in Table 6.1. Note that the sum of the probabilities
of a decision or strategy
is 1, or 100%, since one of the three possible states of the economy must occur with
and the probability
certainty.
attached to each.
The concept of probability distribution is essential in evaluating and comparing dif-
ferent outcomes or investments. In general, the outcome or payoff from an investment
(e.g., from the purchase of a stock) is generally highest when the economy is booming
and smallest when the economy is in a recession (when the value of the stock is likely to
fall). If we multiply each possible outcome or payoff of an investment by its probability
of occurrence and add these products, we get the expected value of the investment. For
example, if there are two possible outcomes for investment or event X with payoffs X, and
X>, and probabilities Pr; and Pro, then the expected value of X or E(X) is

Expected value of X = E(X) = Pr; X; + Pr X; [6.1]

If there are n possible outcomes, the expected value becomes

E(X) = Pr) X, aie ProX> a P20 Se Rie [6.2]

Expected value The Thus, the expected value of an investment is the weighted average of all possible payoffs
sum of the products of that can result from the investment under the various states of the economy, with the prob-
each possible outcome ability of those payoffs used as weights. The expected value of an investment is a very
of a decision or strategy important consideration in deciding whether or not to make an investment and which of
and the probability of its
two or more investments is preferable.
occurrence.
For example, Table 6.2 presents the payoff matrix of investment A and investment B
and shows how the expected value or mean of each investment is determined. In this case
the expected value of each of the two investments is $500, but the range of outcomes or
payoffs for investment A (from $400 in recession to $600 in boom) is much smaller than
for investment B (from $200 in recession to $800 in boom).
The expected profit and the variability in the outcomes of investment A and investment
B are shown in Figure 6.1, where the height of each bar measures the probability that
a particular outcome (measured along the horizontal axis) will occur. Note that the
162 PART TWO Theory of Consumer Behavior and Demand

Calculation of the Expected Profits of the Two

TABLE 6.2 Investments

(1) (2) (3) (4)

State Probability Outcome Expected Value
of Economy of Occurrence of Investment (2) x (3)
Investment

- Boom 0.25 $600 $150

=
Normal 0.50 500 250
A
’ Recession 0.25 400 100
Expected earnings from investment A $500

Boom 0.25 $800 $200

B Normal 0.50 500 250
Recession 0.25 200 50
Expected earnings from investment B $500

& 0:50: >

ey 050)—

E
=fe) 0.25 = g
=‘ OB
0.25 j=
|

| | | | |
0 400 500 600 Profit 0 200 500 800 Profit
FIGURE 6.1 Probability Distribution of Profits from Investment A and Investment B_ The
expected profit is $500 for both projects A and B, but the range of profits (and therefore the risk) is much
smaller for project A than for project B. For project A the range of profits is from $400 in a recession to
$600 in a boom. For project B, the range of profits is from $200 in a recession to $800 in a boom.

relationship between the state of the economy and profits is much tighter (i.e., less dis-
persed) for investment A than for investment B. Thus, investment A is less risky than
investment B. Since both investments have the same expected profit, investment A is
preferable to investment B if the individual is risk averse (the usual case). Had the
expected value of investment A been lower than for investment B, the individual would
have to decide whether the lower risk from investment A compensates him or her for its
lower expected value. In Section 6.3 we will show how an individual makes such deci-
sions. Before doing that, however, we want to show how to measure risk more precisely.

The Standard Deviation

We have seen above that the tighter or the less dispersed a probability distribution, the
smaller the risk of a particular strategy or decision. The reason is that there is a smaller
Standard deviation
probability that the actual outcome will deviate significantly from the expected value.
(sd) A measure of the
dispersion of possible
We can measure the tightness or the degree of dispersion of a probability distribution by
outcomes from the the standard deviation. Thus, the standard deviation (sd) measures the dispersion of
expected value of a possible outcomes from the expected value. The smaller the value of sd, the tighter or less
distribution. dispersed the distribution—and the lower the risk attached to it.
 CHAPTER 6 Choice Under Uncertainty 163

Calculation of the Standard Deviation of Profits

Holst Dot wwestments Wand B77
Deviation from Deviation Deviation Squares
Expected Value Squared Probability Times Probability

Project A

$600 — $500 = $100 $10,000 0.25 $2,500

500 — 500 = 0 0 0.50 0
400— 500 =—100 10,000 O25 2,500
Sum of deviations squared = Variance = $5,000
Standard deviation = Square root of variance = $70.71

Project B

$800 — $500 = $300 $90,000 0.25 $22,500

500 500! 0 0 0.50 0
200 — 500 = —300 90,000 0.25 22,500
Sum of deviations squared = Variance = $45,000
Standard deviation = Square root of variance = $212.13

To find the value of the standard deviation (sd) of a particular probability distribution,
we follow the three steps outlined below.

|. Subtract the expected value or the mean of the distribution from each possible
outcome or payoff to obtain a set of deviations from the expected value.
i) Square each deviation, multiply the squared deviation by the probability of its
expected outcome, and then sum these products. This weighted average of
squared deviations from the mean is the variance of the distribution.
+
2
Take the square root of the variance to find the standard deviation (sd Ne

Table 6.3 shows how to calculate the standard deviation of the probability distribution
of payoffs or profits for investment A and investment B given in Table 6.2. The expected
Concept Check value was found earlier to be $500 for each investment. From Table 6.3, we see that the
How is risk measured? standard deviation of the probability distribution of payoffs for investment A is $70.71,
while that for investment B is $212.13. These values provide a numerical measure of the
absolute dispersion of payoffs from the expected value of each investment and confirm the
greater dispersion of payoffs and risk for investment B than for investment A, shown earlier
graphically in Figure 6.1. Note that risk analysis is useful not only in analyzing invest-
ments but also in examining any activity involving risk, as Example 6—2 demonstrates.

2 The actual formula for the standard deviation (sd) is

n

= es = JO? Be,
i=l
where )_ is the “sum of,” X; is payoff or outcome i (of n payoffs or outcomes), X is the mean or expected
value of the distribution of X [i.e., E(X)], and Pr; is the probability of occurrence of payoff or outcome 7.
164 PART TWO Theory of Consumer Behavior and Demand

EXAMPLE 6-2
Risk and Crime Deterrence

Risk analysis can be used to analyze crime deterrence. A 1973 study found that crim-
inals often respond to incentives in much the same way as people engaged in legiti-
mate economic activities. For example, the rate of robberies and burglaries was found
to be positively related to the gains and inversely related to the costs of (i.e., punish-
ment for) criminal activity. It was found that for each 1% increase in the probability of
being caught and sent to jail, the rate of robberies declined by 0.85% and for each 1%
increase in the duration of imprisonment, the rate of burglaries declined by 0.9%.
Thus, it seems that increasing the efficiency of the police in apprehending criminals
and the imposition of stiffer sentences discourages crime.
Other studies, however, did not confirm this relationship but found that reducing
the opportunity to commit crimes is a more effective way to reduce criminal activity.
For example, a survey conducted by the New York Times in September 2000 found
homicide rates to be higher in states with the death penalty than in states without it.
Furthermore, homicide rates showed similar up-and-down trends over the years, thus
offering little support to the contention that capital punishment is a deterrent. Some
economists do not accept the results of these studies, however. They point out that
when variations in other factors, such as the rate of unemployment, income inequality,
and the likelihood of apprehension, as well as the existence of the death penalty, are
considered in the analysis, then the death penalty is a significant deterrent.
Obviously, more empirical studies are needed to resolve this controversy, but risk
analysis will necessarily have to be part of any such study. Indeed, risk analysis has
already shown its usefulness in the analysis of crime. For example, it has been shown
that the greater the probability of apprehension for a crime (and hence the lower the
cost of law enforcement), the lighter the sentence. Thus, lovers’ quarrels and brawls
involving alcohol have the highest probability of being caught and also the lightest
sentences. On the other hand, the crime of arson has an exceptionally low probability
of apprehension and consequently the highest average sentence. Furthermore, risk
analysis indicates that by increasing the penalty, law enforcement agencies can reduce
the cost of enforcement. For example, imposing a fine of, say, $100 for a small crime
and catching one violator in ten leads to an expected cost of apprehension for the vio-
lator of $10 ($100 times 0.1). But this has the same deterring effect as imposing a fine
of $1,000 for the same crime and catching only one in 100 violators (which is much
cheaper to do) since the expected cost of apprehension for the criminal is the same
(i.e., $1,000 times 0.01 = $10).
Sources: I. Ehrlich, “Participation in Illegitimate Activities: A Theoretical and Empirical Investigation,”
Journal of Political Economy,” May/June 1973; W. T. Dickens, “Crime and Punishment Again: The
Economic Approach with a Psychological Twist,” National Bureau of Economic Research, Working Paper
No. 1884, April 1986; E. Glaeser and B. Sacerdote, “The Determinants of Punishment: Deterrence,
Incapacitation and Vengeance,’ National Bureau of Economic Research, Working Paper No. 1884, August
2000; “States with no Death Penalty Share Lower Homicide Rates,” New York Times,
September 22, 2001,
p. 1; Learning to Live with Uncertainty,” The Economist, January 4, 2004, pp. 15-16; “In
Murder City,”
The Economist, February 3, 2007, p. 30; and “Does Death Penalty Save Lives? A New
Debate,’ New York
Times, November 18, 2007, p. 1.
 CHAPTER 6 Choice Under Uncertainty 165

6.3 UTILITY THEORY AND Risk AVERSION

In this section we first examine the different views or preferences toward risk of different
individuals and then use this information to examine consumers’ choices in the face of
risk. We will see that in making choices under risk or certainty the consumer maximizes
utility or satisfaction. When risk or uncertainty is present, the consumer maximizes
expected utility.

Different Preferences Toward Risk

Risk averter An Most individuals, faced with two alternative investments of equal expected value or profit,
individual for whom the but different standard deviation or risk, will generally prefer the less risky investment
marginal utility of (1.e., the one with the smaller standard deviation). That is, most individuals seek to mini-
money diminishes.
mize risks or are risk averters. Some individuals, however, may very well choose the
more risky investment (i.e., are risk seekers or lovers), while still others may be indif-
Risk seeker or lover ferent to risk (1.e., are risk neutral). The reason is that different individuals have differ-
An individual for ent preferences toward risk. Most individuals are risk averters because they face
whom the marginal
diminishing marginal utility of money. The meaning of diminishing, constant, and
utility of money
increasing marginal utility of money can be explained with the aid of Figure 6.2.
increases.
In Figure 6.2, money income or wealth is measured along the horizontal axis while
Risk neutral An the utility or satisfaction of money (measured in utils) is plotted along the vertical axis.
individual for whom the
marginal utility of
Uulity of money
money is constant.
U(M
( 4" i Increasin g
Diminishing marginal
utility of money The
decline in the extra Constant
utility received from
4 _—
each dollar increase in
income.
Diminishing
a marginal
utility
oy =

| |
0 10,000 20,000 Money or wealth($)

FIGURE 6.2 Diminishing, Constant, and Increasing Marginal Utility of Money

A $10,000 money income or wealth provides 2 utils of utility to a particular individual
(point A), while $20,000 provides 3 utils (point B) if the total utility of money curve of
the individual is concave or faces down (so that the marginal utility of money declines),
4 utils (point C) if the total utility curve is a straight line (so that the marginal utility is
constant), and 6 utils (point D) if the total utility curve is convex or faces up (so that
marginal utility increases). The individual would then be, respectively, a risk averter,
risk neutral, or a risk seeker.

3 As pointed out in Section 3.1, a util is a fictitious unit of utility. Here, we assume that the utility or
satisfaction that a particular individual receives from various amounts of money income or wealth can be
measured in terms of utils.
166 PART TWO. Theory of Consumer Behavior and Demand

utils ofutility to
From the figure, we can see that $10,000 in money or wealth provides 2
(point B), 4 utils (point
a particular individual (point A), while $20,000 provides 3 utils
money curve for this
C), or 6 utils (point D), respectively, depending on the total utility of
individual being concave or facing down, a straight line, or convex (facing up).
or
If the otal utility curve is concave or faces down, doubling the individual’s income
wealth from $10,000 to $20,000 only increases his or her utility from 2 to 3 utils, so that the
Concept Check
How is a risk-averse marginal utility of money (the slope of the total utility curve) diminishes for this individual.
individual defined? If the total utility of money curve is a straight line, doubling income also doubles utility, so
that the marginal utility of money is constant. Finally, if the total utility of money curve 1s
convex or faces up, doubling income more than doubles utility, so that the marginal utility of
money income increases.
Most individuals are risk averters and face diminishing marginal utility of money
(i.e., their total utility curve is concave or faces down—see Figure 6.2). To see why this
is so, consider an offer to engage in a bet to win $10,000 if “head” turns up in the toss-
ing of a coin or to lose $10,000 if “tail” comes up. Since the probability of a head or a
tailis0.5 or 50% and the amount of the win or loss is $10,000, the expected value of
the money won or lost from the gamble is

0.5($10,000) + 0.5(—$10,000) = 0 [6.3]

Even though the expected value of such a fair game is zero, a risk averter (an indi-
vidual facing diminishing marginal utility of money) would gain less utility by winning
$10,000 than he or she would lose by losing $10,000. Starting from point A in Figure 6.2,
we see that by losing $10,000, the risk-averting individual loses 2 utils of utility if he or
she loses $10,000 but gains only | util of utility if he or she wins $10,000. Even though
Expected utility The the bet is fair (i.e., there is a 50-50 chance of winning or losing $10,000), the expected
sum of the product of utility of the bet is negative. That is,
the utility of each
possible outcome of a
Expected utility = E(U) = 0.5(1 util) + 0.5(—2 utils) = —0.5 [6.4]
decision or strategy and
the probability of its
occurrence. In such a case, the individual will refuse a fair bet.* From this, we can conclude that a risk-
averting individual will not necessarily accept an investment with positive expected mon-
etary value. To determine whether or not the individual would undertake the investment,
Concept Check we need to know his or her utility function of money or income.
Why would a risk-
averse individual not
accept a fair gamble?
Maximizing Expected Utility
To determine whether or not an individual should undertake an investment, he or she
needs to determine the expected utility of the investment. For example, suppose that an
investment has a 40% probability of providing profit of $20,000 and a 60% probability of
resulting in a loss of $10,000. Since the expected monetary return of sucha project is pos-
itive (see Table 6.4), a risk-neutral or a risk-seeking individual would undertake the pro-
ject. However, if the individual is risk averse (the usual case) and his or her utility function
is as indicated in Figure 6.3, the individual would not make the investment because the
expected utility from the investment is negative (see Table 6.5).

:With constant utility, E(U) = 0.5(2 utils) + 0.5(—2 utils) = 0 and the individual
is risk neutral and
indifferent to the bet. With increasing marginal utility, E(U) = 0.5(4 utils) + 0.5(—2
utils) = 1 and the
individual is a risk seeker and would accept the bet.
 CHAPTER 6 Choice Under Uncertainty 167

TABLE 6.4)
ey Expected Return from the Investment

(2) (3)
States of (1) Monetary Expected Return
Nature Probability Outcome (1) x (2)
Success 0.40 $20,000 $8,000
Failure 0.60 —$10,000 —6,000
ee Expected return = $2,000
A ne ee

Utility of money
U (M) Utility
3
function

FIGURE 6.3 The Utility Function of a Risk-Averse Individual An investment

with a 40% probability of providing a return of $20,000 (3 utils of utility) and a
60% probability of resulting in a loss of $10,000 (—4 utils of utility) has an expected
utility of (0.4)(3 utils) + (0.6)(—4 utils) = —1.2 utils, and it would not be made by
the individual.

TABLE 6.5|
Mey Expected Utility from the Investment
(2) (3) (4)
States of (1) Monetary Associated Expected Return
Nature Probability Outcome Utility (1) x (3)

Success 0.40 $20,000 3 1.2

Failure 0.60 —$10,000 —4 —2.4
Expected utility = —1.2
168 PART TWO. Theory of Consumer Behavior and Demand

rse manager will not

Thus, even if the expected monetary return is positive, a risk-ave
negative. The general rule
Concept Check make the investment if the expected utility of the investment is
risk or uncertainty, but
How does a choice is that the individual seeks to maximize utility in a world of no
t risk-averse
made in the face of risk maximizes expected utility in the face of risk.> Needless to say, even differen
utilities of money,
differ from choices individuals have different utility functions and face different marginal
investm ent.
made in the absence of
and so even they can reach different conclusions with regard to the same
in gamblin g.
Being risk averse, it would seem irrational for most individuals to engage
risk?

Yet. America seems to be in the grip of a gambling craze (see Example 6-3).

EXAMPLE 6-3
America’s Gambling Craze

There was a time, not too many years ago, when gambling was considered morally
wrong and was illegal in most parts of the United States. The lust to get something for
nothing, which gambling represents, was considered a weakness of character, and
bookies and number racketeers were regarded not much better than drug dealers. All
of that has changed and gambling has become America’s favorite pastime. Today,
gambling casinos can brag more than 70 million visitors per year—more than Major
League Ballparks. Americans now spend more than $80 billion per year on all sorts
of gambling, from casinos to state lotteries, racetrack and off-track betting, sports bet-
ting, bingo, and so on—more than on movie theaters, books, amusement attractions,
and recorded music combined. Gambling expenditures have been rising at more than
10% per year; there are now more than 41 state lotteries and casinos operating in
13 states. In fact, gambling flourishes in every state but Utah and Hawaii. Many go on
vacation only where there is a casino, gambling is rampant in the nation’s colleges,
and electronics is even bringing gambling into homes, restaurants, and planes. In
short, we have become a nation of gamblers, and gambling has become America’s
craze.
Why the change in America’s tastes in favor of gambling? The boom in legal gam-
bling can be largely attributed to state and local governments’ desire to raise more
money without increasing taxes. If many people would gamble anyway, why not legal-
ize gambling and tax gambling profits to finance education and other social programs?
But in doing so, state and local governments have encouraged gambling and increased
its social costs. Many poor people spend a great deal of their meager incomes on gam-
bling in the hope of a big win that would lift them out of their poverty. But for the vast
majority of them, there is no big win and gambling represents a very regressive tax.
With gambling legalized and even encouraged, more and more people can be expected
to become compulsive or problem gamblers. As a cash business, gambling also lures
Concept Check criminals and organized crime and it corrupts public officials.
Is gambling good for Gambling is also not as much as a net stimulus to the economy as it is often made
the economy? out to be because it takes away from other forms of entertainment and other expenditures
in general. For example, more than three decades ago, Atlantic City in New Jersey

Only For a risk-neutral individual does maximizing the expected monetary value
or return correspond to
maximizing expected utility.
 CHAPTER 6 Choice Under Uncertainty 169

allowed casino gambling in order to revitalize the city. At the time, Atlantic City’s
unemployment rate was twice the state’s unemployment rate. Today, more than 30
years and many casinos later, Atlantic City’s unemployment rate is still twice the
state’s unemployment rate and many other of the city’s ills remain. Why does America
have such a craze for gambling if gambling seems irrational for risk averters? Because
of the exaggerated hope of winning that many people have, because of the entertain-
ment that gambling provides, and because many individuals may be risk averters for
small gambles but risk lovers for big gambles.
Source: “Electronics Is Bringing Gambling into Homes, Restaurants and Planes,” Wall Street Journal,
August 16, 1995, p. Al; “America’s Gambling Fever,” U.S. News & World Report, January 15, 1996,
pp. 51-53; “The Economics of Casino Gambling,” The Journal of Economic Perspectives, Summer 1999,
pp. 173-192; National Gambling Impact Study Commission, Final Report (Washington, D.C.: U.S.
Government Printing Office, August 3, 1999; “Against the Odds,” U.S. News & World Report, May 23,
2005, pp. 47-53; “The Wheel of Fortune,” The Economist, September 24, 2005, p. 74; and “Bad Bet,”
New York Times Magazine, April 13, 2008, pp. 13-14.

6.4 INSURANCE AND GAMBLING

In this section we take a closer look at insurance and gambling. Specifically, we examine
why some individuals insure themselves while others gamble, and, what seems entirely
contradictory, why the same individual sometimes does both, buy insurance and gamble.

Why Do Some Individuals Buy Insurance?

We have seen in the previous section that a risk averter faces a total utility function of
money that is concave or faces down, so that the marginal utility of money for the individ-
ual declines. This means that the individual prefers a given sum of money with certainty
to any risky asset of equal expected value. It also means that an individual is willing to
pay a small amount of money to avoid the small risk of incurring a large loss (i.e., to buy
insurance).
For example, suppose that, as shown in Figure 6.4, an individual owns a small busi-
ness that generates a daily income of $200 (point A) without a fire and $20 after a fire
(point B), and the probability of no fire is p = 0.899 (i.e., 89.9%), so that the probability
Expected income The of a fire is 1 — p=0.111 (11.1%). Then the expected income from the business is
probability of one level
of income (p) times that Expected income = (0.889)($200) + (0.111)($20) = $2.22 + $178.8 = $180.02
income level plus the
probability of an The income of $180.02 or $180 (rounded to the nearest dollar) is not actually
alternative income available to the individual. That is, the individual faces only two alternatives: (1) an
times that alternative
income of $200 with probability of 89.90% or (2) an income of $20 with probability
income level.
of 11.1%. The expected income of $180 is a weighted average of these two alternatives
using the probabilities as weights. However, the individual would never actually have
the income of $180. Different probabilities of occurrence attached to the incomes
of $200 and $20 would result in a different expected daily income. For example, with
p = 0.8, the expected income from the business would be

Expected income = (0.8)($200) + (0.2)($20) = $164

170 PART TWO Theory of Consumer Behavior and Demand

Total utility
(T

l | | oe |
0 90 50 100 150 170180 200 Income

Insurer An FIGURE 6.4 The Utility Function for an Insurer The expected value of the business that
individual who is provides a daily income of $200 (point A) with no fire and $20 with a fire (point B), and with
willing to pay a the probability of 0.989 of no fire and 0.111 of a fire, is: (0.889)($200) + (0.111 ($20) = $180
small sum of money (point C’). The certain daily income of $150 (point C) gives the same utility to the individual as
in order to ensure
owning the business. Insuring against the loss resulting from a fire at a daily cost $30 leaves the
against the small
probability of a
individual with a higher level of utility (point D) than would owning the business without
large loss; a risk insurance (point C’). Thus, the individual will buy the insurance.
averter.

The utility of the expected income is given by the height of straight-line line (chord)
BA at the point directly above the level of the expected income in Figure 6.4. For example,
the utility of expected income of $180 is 11 utils (point C’ on chord AB). This convenient
geometric property results directly from the definition of the expected income (i.e., as
the weighted average of the two alternative incomes using objective probabilities as the
weights). The utility of the expected income does not fall on the total utility curve because
the expected income is not an income that the individual can actually achieve (such as
the income shown by point A or B).
From Figure 6.4 we can see that an income of $150 with certainty (point C on the
individual’s utility function) provides the individual with the same 11 utils of utility as a
business that provides an expected (risky) income of $180 (point C’ on chord AB). The
Risk premium The distance CC’ = $30 is called the risk premium. This is the maximum amount that the
maximum amount that individual would be willing to pay to avoid the risk. Specifically, since a daily income of
a risk-averse individual $150 with certainty provides the same utility to the individual as a risky business with an
would be willing to pay
expected daily income of $180, the individual would be willing to pay up to $30 per day
to avoid a risk.
to insure himself or herself against a large loss from a fire.
Since, in our case, the individual already owns the business (rather than having to
decide whether or not to enter it) and after a fire the business would still generate an
income of $20 per day, he or she would actually be willing to pay up to $50 per day (AC
in Figure 6.4) to insure against the loss of the entire business. If the owner of the business
could insure the business for $30 per day, he or she would definitely do so since that
would put him or her at point D on the utility curve, and point D provides more utility
(11.5 utils) than owning the business without insurance, which provides 11 utils of utility
 CHAPTER 6 Choice Under Uncertainty 171

(point C’). Point D is on the utility curve because it is a daily income that the individual can
actually achieve with insurance.°

Why Do Some Individuals Gamble?

Next we turn to the analysis of gambling. To do so, suppose that the individual of
Figure 6.4, after having purchased the fire insurance for $30 (thus ending up with the cer-
tain daily income of $170 shown by point D in Figure 6.4), faces a total utility function
that is convex or faces up (so that the marginal utility of money increases) for higher
incomes—as shown in Figure 6.5. The individual now contemplates purchasing a lottery
ticket costing $20 with a 20% probability of winning and receiving an extra daily income
of $250.’ After purchasing the ticket for $20, the individual’s daily income would then
either be $150 (shown by point C in Figure 6.5) if the individual does not win or $400 (the
$150 from the business and the $250 from the win, as shown by point G in Figure 6.5) if

Total utility
(TU) TU
Lo

INV | | |
0 150170 200 240 300 400 Income
Gambler An FIGURE 6.5 The Utility Function for a Gambler With the purchase of a lottery ticket
individual who is that costs $20, the individual’s income is either $150 with 80% probability of not winning or
willing to pay a $400 with a 20% probability of winning, resulting in the expected income of ($150)(0.2) +
small sum of money $400(0.2) = $200 (point F’ on chord CG). This provides a higher utility for the individual than
in order to have the
the certain sum of $200 (point A on the total utility curve). Indeed, buying the ticket gives the
small probability of
individual the same utility as the certain income of $240 (point F). Thus, the individual is a
a large gain or win;
a risk seeker or gambler for increases in income.
lover.

6 In Section 6.6 we will see why an insurance company would be willing to sell an insurance policy to the
individual for a premium payment of $30 per day.
7 Although lotteries usually provide one or two large prizes, people usually convert a lump-sum win into an
annuity that provides a certain flow income over time in order to pay a lower tax rate.
2 PART TWO Theory of Consumer Behavior and Demand

expected value of the

he or she wins. Since the probability of winning is 0.2 or 20%, the
individual’s income by purchasing the ticket 1s

Expected value = ($150)(0.8) + ($400)(0.2) = $120 + $80 = $200

From Figure 6.5 we see that the individual’s utility with purchasing the ticket ae
’s
provides an expected income of $200 (point F ’ on chord CG) exceeds the individual
utility of the certain income of $170 without purchasin g the ticket (point D on the total
utility function of the individual). In fact, the utility that the individual receives by buying
the lottery ticket (and continuing to hold on to his or her business) is equal to the certain
daily income of $240 dollars (point F on the total utility function). Another way of look-
ing at it is to realize that the individual prefers to purchase the lottery ticket and hold on
to his or her business with an expected value of $200 (point F’ on chord CG) than having
$200 of certain income (point A on the total utility curve in Figure 6.5). This makes the
individual a risk seeker or risk lover for increases in income. Example 64 explains why
some individuals gamble and buy insurance.

In the real world, we often observe individuals purchasing insurance and also gam-
bling. For example, many people insure their homes against fire and also purchase
lottery tickets. This behavior may seem contradictory. Why should the same individ-
ual act as a risk avoider (purchase insurance) and at the same time as a risk seeker
(gamble)? One possible explanation for this seemingly contradictory behavior is pro-
vided by Milton Friedman and Leonard Savage, who postulate that the total utility of
money curve may look like that in Figure 6.6. This total utility curve is concave or
faces down (so that the marginal utility of money diminishes) at low levels of money
income, and it is convex or faces up (so that the marginal utility of money increases) at
higher levels of income. An individual with an income at or near the point of inflec-
tion on the total utility curve (point A) will find it advantageous both to spend a small
amount of money to insure himself or herself against the small chance of a large loss
Concept Check
(say, through a fire that destroys his or her home) and to purchase a lottery ticket pro-
Why do some
viding a small chance of a large win. Starting with an income level at or near A, the
individuals buy
insurance and also individual would act as a risk avoider for declines in income and as a risk seeker for
gamble? increases in income. Indeed, Figure 6.6 was obtained by bringing together Figure 6.4
and Figure 6.5.
One shortcoming of the above analysis is that it rationalizes more than explains
economic behavior in the face of risk. In fact, Kenneth Arrow has found that many
people do not take out flood insurance even at favorable government-subsidized
rates, whereas flight insurance and lotteries offer examples of people accepting
extremely unfavorable odds. A recent study by Garrett and Sobel, however, did find
that the utility curve of people who buy lottery ticket have the shape predicted by
 CHAPTER 6 Choice Under Uncertainty 173

Do

16

| eas) iV
| | |
0 80 140{180| 240 300 400 Income
160 200
FIGURE 6.6 The Utility Function of an Individual Who Buys Insurance and
Gambles An individual whose income is $200 (point A), which is at or near the
point of inflection of the total utility curve, will act as a risk averter and will spend a
small amount of money to purchase insurance against the small chance of a large loss
of income and at the same time will act as a risk seeker and gamble a small amount
of money (Say, to purchase a lottery ticket) that gives a small chance of a large win.

Friedman and Savage. Furthermore, financial planners and brokers do make a great
deal of use of the concepts discussed above in trying to assess their clients’ tolerance
for risk in providing financial advice.
Sources: M. Friedman and L. J. Savage, “The Utility Analysis of Choices Involving Risk,” Journal of
Political Economy, August 1948; K. Arrow, “Risk Perception in Psychology and Economics,’ Economic
Inquiry, January, 1982. T. A. Garrett and R. S. Sobel, “Gamblers Favor Skewness, Not Risks: Further
Evidence from U.S. Lottery Games,” Economic Letters, April 1999; and “Dealing with Risk,” Business
Week, January 17, 2000, pp. 102—112; “Against the Odds,” U.S. News & World Report, May 23, 2005, pp.
47-53; “The Wheel of Fortune,” The Economist, September 24, 2005, p. 74; and “Bad Odds,” Wall Street
Journal, June 11, 2007, p. RS.

6.5 Risk AVERSION AND INDIFFERENCE CURVES

The extent of an individual’s risk aversion can also be shown by indifference curves
that relate expected income (measured along the vertical axis) to the variability of
expected income (measured by the standard deviation along the horizontal axis). Each
indifference curve shows all the combinations of standard deviation and expected
income that give the individual the same level of utility or satisfaction. Since a higher
variability of income (risk) must be compensated by a higher expected income, these
indifference curves are positively sloped. Figure 6.7 shows two sets of such indiffer-
ence curves. The indifference curves in the left panel are steep and refer to an individ-
ual who has a strong aversion to risk, while those in the right panel are flatter for a less
risk-averse individual.
Specifically, indifference curve U; in the left panel shows that the individual is indif-
ferent among the standard deviation of 0.5 and the expected income of $80 (point A), the
174 PART TWO. Theory of Consumer Behavior and Demand

Expected
income
220

180
160 Up Expected
income
140
120 120
100
80 80
60
40 40
20
| |
0) 0.5 1.0 1.5 Standard 0 0.5 1.0 1.5 Standard
deviation deviation

FIGURE 6.7 Indifference Curves for Risk-Averse Individuals _ An increase in the standard deviation
from 0.5 to 1.0 requires an increase in the expected income of $40 to keep the highly risk-averse individual
shown in the left panel on indifference U; (compare point B with point A), while it requires an increase in the
expected income of only $20 for the less risk-averse individual in the right panel.

standard deviation of 1.0 and the expected income of $120 (point B), and the standard
deviation of 1.5 and the expected income of $180 (point C). Thus, indifference curve U;
shows that, starting at point A, the individual requires an additional $40 in expected
income to just compensate him or her for an increase in the standard deviation from 0.5 to
1.0 (and reach point B) and the individual requires an additional $60 in expected income
to compensate him or her for an increase in the standard deviation from 1.0 to 1.5 (and
reach point C ). On the other hand, starting at point B on Uj, and the standard deviation of
1.0, the higher expected income of $160 puts the individual at point D on higher indiffer-
ence curve U2, while the lower expected income of $80 puts the individual at point E on
lower indifference curve Up. Finally, an increase in the standard deviation from 0.5 to 1.0
at the expected income of $80 shifts the individual from point A on U, to point E on lower
indifference curve Up.
The right panel of Figure 6.7 shows the indifference curves for an individual who is
less risk averse than the individual in the left panel. For example, indifference curve U,
in the right panel shows that the individual is indifferent among the expected income of
$40 and standard deviation of 0.5 (point A), the expected income of $60 and standard
deviation of 1.0 (point B), and the expected income of $100 and standard deviation of 1.5
(point C). On the other hand, for the standard deviation of 1.0, the higher expected
income of $80 puts the individual at point D on higher indifference curve U> (from point
B on U;), while the lower expected income of $40 puts the individual at point EF ona
lower indifference curve Up. Finally, an increase in the standard deviation from 0.5 to 1.0
at the expected income of $40 shifts the individual from point A on U; to point FE on
lower indifference curve Up. The return-risk indifference curves discussed above can be
used to determine the choice of the best investment portfolio for an individual (see
Example 6-5).
 CHAPTER 6 Choice Under Uncertainty WSs

EXAMPLE 6-5
Spreading Risks in the Choice of a Portfolio

Since investors are risk averse, on the average, they will hold a more risky portfolio
of stocks and bonds only if it provides a higher return. The way by which an individ-
ual chooses an optimum investment portfolio can be shown by Figure 6.8.
In the figure, curve ABCD is the individual’s risk—return trade-off function or
indifference curve. It shows that the individual is indifferent among a 10% rate of
return on the investment with zero standard deviation (point A), a 14% rate of return
with standard deviation of 0.5 (point B), a 20% rate of return with a standard deviation
of 1.0 (point C), and a rate of return of 32% with a standard deviation of 1.5 (point D).
Suppose also that there exist only two assets, with risk and return given by points
E and F in Figure 6.8. If the risk of assets E and F are independent of each other, the
investor can choose any mixed portfolio of assets E and F shown on the frontier or
curve ECF. To understand the shape of frontier ECF, note that the return on a mixed
portfolio will be between the return on asset E and on asset F alone, depending on the
particular combination of the two assets in the portfolio. As far as risk is concerned,
there are portfolios (such as that indicated by point C) on frontier ECF that have lower
risks than those composed exclusively of either asset EF or asset F. The reason for this
can be gathered by assuming that the probability of a low return is 1/2 on asset EF and
1/4 on asset F and that, for the moment, we take the probability of a low return as a

Rate of return
(percent)

32

0 0.5 1.0 1.5 20 Risk

FIGURE 6.8 Choosing an Investment Portfolio The

risk-return trade-off function or indifference curve ABCD
shows the various risk-return trade-off combinations among
which the investor is indifferent. On the other hand, frontier
ECF represents the combinations of risk and return that are
obtainable with mixed portfolios of asset E and asset F, with
independent risk. The optimum portfolio for the investor Is
represented by point C, where the risk-return trade-off
function or indifference curve ABCD is tangent to frontier ECF.
176 PART TWO Theory of Consumer Behavior and Demand

the probability of
measure of risk. If these probabilities are independent of each other,
a low return on both assets E and F at the same time is (1/2)(1/ 4) = 1/8, which is
smaller than for either asset E or F separately.
in
Given the risk—return trade-off function or indifference curve ABCD shown
Figure 6.8, we can see that the optimum portfolio for this investor is the mixed port-
folio indicated by point C, where risk—return indifference curve ABCD is tangent to
con-
frontier ECF. Indeed, market evidence shows that a well-diversified portfolio
taining various mixes of stocks, bonds, Treasury bills, real estate, and foreign securi-
ties can even-out a lot of the ups and downs of investing without sacrificing much in
the way of returns. Of course, the type of portfolio that an investor actually chooses
depends on his/her tolerance for risk, as shown by his or her risk—return trade-off func-
tions or indifference curves.
Sources: H. M. Markowitz, “Portfolio Selection.” Journal of Finance, March 1952, pp. 77-91; “For
Volatile Times, the Psychology of Risk,” New York Times, November 23, 1997, p. 3; “What's Your Risk
Tolerance?” Wall Street Journal, January 23, 1998, p. C1W; “Dealing with Risk,” Business Week, January 17,
2600, pp. 102-112; “Gauging Investors’ Appetite for Risk,” Wall Street Journal, September 18, 2001,
p. C14; “Just How Risky is Your Portfolio? Fortune, November 26, 2001, pp. 219-224; and “Why Do
Stocks Pay So Much More than Bonds?” New York Times, February 26, 2006, p. 4.

REDUCING RISK AND UNCERTAINTY

We have seen above that, although some individuals are risk seekers or risk lovers, most
are risk averters. In this section we examine three basic ways by which an individual can
reduce risk or uncertainty. These are (1) gathering more information, (2) diversification or
risk spreading, and (3) insurance.

Gathering More Information

Individuals and decision makers can often make better predictions and sharply reduce
the risk or uncertainty surrounding a particular strategy or event by collecting more
information. For example, by consulting Consumer Reports, consumers can determine
how frequently a particular type of automobile or brand of refrigerators are likely to
require repairs and take this information into consideration in their purchases. Similarly,
investors can obtain information about the riskiness of a bond by checking Moody’s,
Standard & Poor, or other rating agencies’ reports. Gathering information is costly, how-
ever, and the individual or manager should treat it as any other investment. That is, he or
she should continue to gather information until the marginal benefit (return) from it is
equal to the marginal cost. The value of complete information is the difference between
the expected income or value of a choice with complete information and the expected
value without complete information. The economics of information is examined in detail
in Chapter 19.

Diversification
Diversification The Another very important method of reducing risk or uncertainty is diversification, or
spreading of risks. spreading the risks. Diversification involves investing a given amount of resources
in a
 CHAPTER 6 Choice Under Uncertainty We

number of independent projects instead of investing them in a single one. This is an

example of the old saying “Don’t put all of your eggs in one basket.” As long as the
projects are not closely related, investing in a number of them can reduce the risk. If
there is a perfect negative correlation between two activities (so that when one occurs,
the other definitely will not), the risk can be entirely eliminated by engaging in both
activities at the same time. Only if there is a perfect positive correlation between two
events will engaging in both not reduce the risk at all. Under any other circumstance
(1.e., when events are imperfectly correlated or entirely unrelated), diversification can
reduce risks.
For example, a person can reduce risk by investing his or her money in a number of
Concept Check stocks instead of investing it in a single stock because the stocks of different companies
How does do not exhibit perfect positive correlation. This can be accomplished more simply by buy-
diversification reduce ing shares of mutual funds. These are shares of companies that buy a large number of dif-
risk? ferent stocks. Even doing so, however, does not eliminate all risks because in case of a
recession the stocks of all companies tend more or less to fall. That is, while diversifica-
tion can go a long way toward reducing risk, it cannot eliminate all of them. Systemic
risks are nondiversifiable and remain.

Insurance
We have seen in Section 6.4 that risk averters can avoid risk by purchasing insurance. This
involves paying a small sum to avoid the small risk of a big loss. The maximum price that
an individual is willing to pay for insurance is equal to the risk premium. This is the dif-
ference between the expected value of a loss and a certain sum that provides the individ-
ual with the same utility.
For example, suppose that an individual owns a house worth $100,000 and faces a
probability of 1 in 100, or 1%, that the house will burn down during any given year. The
expected value of the loss from a fire during any year is then (0.01)($100,000) = $1,000.
If a fire insurance policy were offered to home owner for $1,000, a risk-averse home
owner will definitely buy it. Such an insurance would be fairly priced or be actuarially
fair because it is equal to the expected loss that it covers. In fact, a risk-averse home
owner would be willing to pay much more for it, depending on his or her degree of risk
aversion (as measured by the risk premium).
Would an insurance company be willing to sell such an insurance policy to home
owners? To answer this question, suppose that the insurance company can sell the fire
insurance to 100 homeowners. By insuring 100 homeowners, each paying an insurance
premium of $1,000, and with the risk of 1% that one of the 100 insured homes will burn
down during a year, the insurance company collects $100,000 in insurance premiums dur-
ing the year and expects to pay out $100,000 for the one house that it expects to actually
burn down during the year. Since the insurance company must also cover its operating
expenses (i.e., the costs of administering the policy), however, it will actually have to
charge a premium in excess of $1,000 for the insurance policy. With competition among
insurance companies, the insurance premium will tend to exceed $1,000 only by the oper-
ating expenses of the insurance company. This will usually be much smaller than the risk
premium that an individual home owner is willing to pay to avoid the risk of a fire, thus
making the insurance policy still very advantageous to the average home owner. Example 6-6
explains why some disasters are nondiversifiable risks.
178 PART TWO. Theory of Consumer Behavior and Demand

EXAMPLE 6-6
Some Disasters as Nondiversifiable Risks

Some risks, such as those arising from a war, affect everyone. Such risks are nondi-
versifiable, and so insurance companies do not offer insurance against them because
they cannot spread their risks. In recent years, some insurance companies have started
viewing major natural disasters (hurricanes, flooding, earthquakes) as nondiversifiable
risks. In the wake of the terrorist attack against the World Trade Center (WTC) in New
York City on September 11, 2001, insurance companies would probably add losses
from future terrorist attacks to the list on nondiversifiable (and hence noninsurable)
risks in the absence of government help. Most insurance companies are reluctant to
offer coverage for terrorist acts because they cannot calculate the risk and thus cannot
set appropriate premiums.
It has been estimated that the insurance claims from the terrorist attack on the WTC
will exceed $50 billion dollars to cover everything from the cost of rebuilding the WTC
to reimbursing businesses for lost sales and paying workers’ compensation claims.
Losses to just 13 insurance companies that provided coverage at the WTC were esti-
mated to exceed $7 billion. The terrorist attack against the WTC is surely the worst
insurance disaster in history. It would result in some insurance companies actually
going bankrupt and others refusing to sell insurance against acts of terrorism in the
future or sharply increasing the cost of coverage without help from Washington.
Lawmakers in Washington are now working on a proposal under which insurers would
cover initial terrorism claims but their losses would be limited, with the government
picking up the remainder.
Even before the attack on the WTC, however, many insurance companies refused
to offer hurricane and earthquake insurance in many parts of the country that face a rel-
atively high probability of occurrence of these catastrophic events in order to limit
payment claims on them. For example, in terms of 1995 prices, insurers paid about $18
billion for losses resulting from the 1994 Los Angeles earthquake, $20 billion for the
September 11, 2001, World Trade Center and Pentagon terrorist attacks, $21 billion for
1992’s Hurricane Andrew, and more than $28 billion for 2005’s Hurricane Katrina. As an
alternative, state-run insurance policies have been offered to households against these
disasters in Florida and California, but they provide less protection and charge rates
about three times higher than previously available commercial rates.
Sources: “For Insurers, Some Failures and Rate Jumps,” New York Times, September 15, 2001, p. C1;
“Under U.S. Plan, Taxpayers Would Cover Terror Claims,” New York Times, October 7, 2001, p. Bl;
“Calculating Tragedy,” The Economist, June 26, 2004, pp. 76-77; “Assessing the Damage,” The Economist,
November 17, 2005, pp. 73-74; and “The Price of Sunshine,” The Economist, June 6, 2006, pp. 76-77.

[67| BEHAVIORAL ECONOMICS

Traditional economic theory assumes that individuals and other economic agents always
behave and act rationally. That is, it assumes they make logical, rational, and
self-interested
decisions that weigh benefits against costs so as to maximize utility, value, or
profit. The
“economic man” is analytic, calculating, unemotional, and selfish. This is often
contradicted
 CHAPTER 6 Choice Under Uncertainty 179

by reality, where actual human beings often act illogically or irrationally, make inconsis-
tent and even self-sabotaging choices, fail to learn from experience, exhibit reluctance to
trade, retreat to unscientific “rules of thumb” in making choices in the face of uncertainty,
and behave in other ways that depart from the standard model of unbounded (i.e., unre-
stricted) rationality.
Behavioral economics Behavioral economics is the study of how people actually make choices in the real
is the study of how world by drawing on insights from psychology and economics. It is a combination of psy-
people actually make
chology and economics that studies what happens when some economic agents exhibit
choices in the real
world by drawing on
human limitations and complications in making economic decisions. It explains why we
insights from often procrastinate, adopt rules of thumb in making complex decisions, make choices that
psychology and are not in our long-term interest, behave altruistically, or otherwise display bounded
economics. rationality. By looking at people’s complex psychological reactions to economic events,
behavioral economics thus enriches traditional economic analysis by offering a fuller pic-
ture of how individuals or other economic agents actually behave or operate in the mar-
ketplace.®
Here are some illustrative examples: People state (and mean it) that they intend to eat
better, start exercising, stop smoking, and save enough for retirement—but in reality they
often do no such things; gamblers keep betting even though they expect to lose; people
often keep buying a stock well past the point where rational valuation justifies it; teachers
often put their professional reputation ahead of attempts to maximize their pay; many peo-
ple give to charity and do volunteer work.
Furthermore, New York City’s taxi drivers choose to work shorter shifts on good days
(days when earnings are higher) than on bad days, so as to reach a target earning per day,
rather than doing the opposite and maximizing weekly earnings; a change in income has
been found to change a worker’s expenditures and saving rate permanently, despite stan-
dard theory (the life-cycle model) postulating that it should not; most people do not
bother to sign up for a voluntary (saving) 401(k) plan even though it is most beneficial to
them, but they do pull out of such a plan if the employer signs them on automatically;
workers resist a reduction in wages even when unemployment is rising, despite traditional
theory postulating that workers would accept less pay to save their jobs.
In a famous experiment, Daniel Kahneman, a Princeton University psychologist and
2002 Nobel Prize recipient in economics for his work in behavioral economics, gave a
coffee mug to some students volunteer and asked another group of student volunteers to
make bids on the mugs. The buyers bid on average $2.87 for the mugs; the sellers, on
average, would not sell the mugs for less than $7.12. Traditional economics says that the
right price is what people are willing to pay. Kahneman’s theory, instead, is that people
tend to overvalue money when they are buying but overvalue goods when they are selling.
His theory also explains why investors hold on much too long to losing stocks and why
shoppers are willing to pay exorbitant fees for service contracts on inexpensive appli-
ances.
Behavioral economics also has shown that the effectiveness of a policy may depend a
Concept Check great deal on how it is formulated, presented, and introduced. For example, traditional eco-
How does behavioral nomics postulates that to sell more soap, a company should strive to make soap more to
economics seek to
improve on traditional
economic theory? 8 The seminal works in behavioral economics are: H. A. Simon “A Behavioral Model of Rational Choice,”
Quarterly Journal ofEconomics, February 1955, pp. 99-118; and D. Kahneman and A. Tversky, “Prospect
Theory: An Analysis of Decision under Risk,” Econometrica, March 1979, pp. 263-291. An important, more
recent work is P. Diamond and H. Vartiainen, Behavioral Economics and Its Applications (Princeton, NJ:
Princeton University Press, 2007).
180 PART TWO Theory of Consumer Behavior and Demand

al economics might sug-

consumers’ likings and to sell it at a lower price, whereas behavior
’s soap at eye level so that customers see
gest getting supermarkets to display the company
, behavior al economi cs does not replace
the company’s brand first and buy it.? To conclude
traditional (neoclassical) economics but tries to enrich it by basing it on more realistic
assumptions and on showing how real people actually make choices in the real world.
Example 6-7 presents an important application of behavior al economi cs to financial
economics.

EXAMPLE 6-7
Behavioral Economics in Finance

Until the late 1980s, the “efficient market hypothesis” was regarded as one of the best
established facts of traditional economics. The efficient market hypothesis postulates
that (1) stock prices are correct in the sense that asset prices reflect the true or rational
value of the security and (2) it is not possible to predict future stock price movements
based on publicly available market information.
Behavioral economics has shown that both of these basic principles of traditional
economics are often violated! Thus, in the late 1980s shares of Royal Dutch were
selling at a different price in Amsterdam than were shares of Shell in London, even
though they were shares of the same company (Royal Dutch/Shell). This represents a
violation of one of the most basic principles of traditional economics: the law of one
price. It meant that irrational forces limited arbitrage (buying in the low-price market
and reselling in the high-price market at a profit until price differences were entirely
eliminated), even in the long run.
Other research showed that the second postulate of the efficient market hypothe-
sis was also sometimes refuted, as indicated by the fact that small firms and firms with
low price—earning ratios earned higher returns than other stocks with the same risk.
Stocks that performed well in the past also tended to be priced too high, whereas stock
that performed badly in the past tended to be priced too low (i.e., some investors over-
react), and some other investors and stocks underreacted. Psychological evidence
indicated that underreaction occurs at short horizons, whereas overreaction takes place
at longer horizons. Shifting to investors, it was found that they were less willing to sell
a loser stock than a winner stock, even though tax laws encourage just the opposite
behavior.
Sources: “A Victory for Economists Who Want Investors to Change Their Behavior,” Wall Street Journal.
September 27, 2006, p. D1; K. Froot, and E. M. Dabora, “How Are Stock Prices Affected by the Location
of Trade?,” Journal of Financial Economics, August 1999, pp. 189-216; W. F. M. De Bondt and R. Thaler,
“Does the Stock Market Overreact?,” Journal of Finance, July 1985, pp. 793-805; A. Shleifer, Inefficient
Markets: An Introduction to Behavioral Finance (New York: Oxford University Press, 2000); and T. Odean,
“Are Investors Reluctant to Realize Their Losses,” Journal of Finance, December 1998, pp. 1775-1798.

” See, J. Conlisk, “Why Bounded Rationality,” Journal of Economic Literature, June 1996,
pp. 669-700;
C. Camerer et al., “Labor Supply of New York City Cab Drivers: One Day at a Time,”
The Quarterly Journal
of Economics, May 1997, pp. 407-441; J. Banks, R. Blundell, and S. Tanner, “Is
There a Retirement-Savings
Puzzle?” American Economic Review, September 1998, pp. 769-788; and D. Laibson,
“Golden Eggs and i
Hyperbolic Discounting,” The Quarterly Journal of Economics, May 1997, pp. 443-477,
:
 CHAPTER 6 Choice Under Uncertainty 181

AT THE FRONTIER
Foreign-Exchange Risks and Hedging

p ortfolios with domestic and foreign securities usually enjoy lower overall
volatility and higher dollar returns than portfolios with U.S. securities only.
Many experts have traditionally recommended as much as 40% of a portfolio to be in
foreign securities. Investing in foreign securities, however, gives rise to a foreign-
exchange risk because the foreign currency can depreciate or decrease in value during
the time of the investment.
For example, suppose that the return on European Monetary Union (EMU) secu-
Foreign-exchange rities is 15%, compared with 10% at home. As a U.S. investor, you might then want to
rate The price of a invest part of your portfolio in the EMU. To do so, however, you must first exchange
unit of a foreign dollars for euros (€), the currency of the EMU, in order to make the investment. If the
currency in terms of foreign-exchange rate is $1 to the euro (that is, $1/€1), you can, for example, pur-
the domestic chase €10,000 of EMU securities for $10,000. In a year, however, the exchange rate
currency.
might be $0.90/€1, indicating a 10% depreciation of the euro (i.e., each euro now buys
Hedging The 10% fewer dollars). In that case, you will earn 15% on your investment in terms of
covering of risks euros, but lose 10% on the foreign-exchange transaction, for a net dollar gain of only
arising from 5% (as compared with 10% on U.S. securities). Of course, the exchange rate at the end
changes in future of the year might be $1.10/€1, which means that the euro appreciated by 10%, or that
commodity and you would get 10% more dollars per euro. In that case, you would earn 15% on the
currency prices. euro investment plus another 10% on the foreign-exchange transaction. As an
Forward contract
investor (rather than a speculator), however, you will probably want to avoid the risk
An agreement to of a large foreign-exchange loss and would not invest in the EMU unless you can
purchase or sell a hedge or cover the foreign-exchange risk.
specific amount of a Hedging refers to the covering of a foreign-exchange risk. Hedging is usually
foreign currency at accomplished with a forward contract. This is an agreement to purchase or sell a spe-
a rate specified cific amount of a foreign currency at a rate specified today for delivery at a specific
today for delivery at
future date. For example, suppose that an American exporter expects to receive €1
a specified future
million in 3 months. At today’s exchange rate of $1/€1, the exporter expects to receive
date.
$1 million in three months. To avoid the risk of a large euro depreciation by the time
the exporter is to receive payment (and thus receive much fewer dollars than antici-
pated), the exporter hedges his foreign-exchange risk. He does so by selling €1 mil-
Concept Check
lion forward at today’s forward rate for delivery in three months, so as to coincide
How is a foreign-
exchange risk covered with the receipt of the €1 million from his exports. Even if today’s forward rate is
by hedging? $0.99/€1, the exporter willingly “pays” | cent per euro to avoid the foreign-exchange
risk. In 3 months, when the U.S. exporter receives the €1 million, he will be able to
immediately exchange it for $990,000 by fulfilling the forward contract (and thus
avoid a possible large foreign-exchange loss). An importer avoids the foreign-
Futures contract
A standardized
exchange risk by doing the opposite (see Problem 12).
forward contract for Hedging can also be accomplished with a futures contract. This is a standard-
predetermined ized forward contract for predetermined quantities of the currency and selected cal-
quantities of the endar dates (for example, for €25,000 for March 15 delivery). As such, futures
currency and contracts are more liquid than forward contracts. There is a forward market in many
selected calendar
currencies and a futures market in the world’s most important currencies (the U.S.
dates.
Continued...
182 PART TWO Theory of Consumer Behavior and Demand

Foreign-Exchange Risks and Hedging Continued

Canadian dollar).
dollar, the euro, Japanese yen, British pound, Swiss franc, and
instru-
Futures markets exist not only in currencies but also in many other financial
on, or derived
ments or derivatives (a broad class of transactions whose value is based
ies
from, a financial market such as stocks, interest rates, or currencies) and commodit
(corn, oats, soybeans, wheat, cotton; cocoa, coffee, orange juice; cattle, hogs, pork bel-
lies; copper, gold, silver, platinum). Hedging in forward or futures markets reduces
transaction costs and risks and increases the volume of domestic and foreign trade in
the commodity, currency, or other financial instrument. Of course, forward and futures
contracts can also be used for speculation, where they can lead to very large wins or
huge losses.

Source: D. Salvatore, International Economics, 9th ed. (Hoboken, NJ: John Wiley & Sons, 2007), Chapter 14.

SUMMARY
1. Most consumer choices are made in the face of risk or uncertainty. Risk refers to the situation
where there is more than one possible outcome to a decision and the probability of each
specific outcome is known or can be estimated. Under uncertainty, on the other hand, the
probability of each specific outcome is not known or even meaningful. Choices involving risk
utilize the concepts of strategy, states of nature, and payoff matrix.
. The probability of an event is the chance or odds that the event will occur. A probability
ie)

distribution lists all the possible outcomes of a decision and the probability attached to each.
The expected value of an event is obtained by multiplying each possible outcome of the event
by its probability of occurrence and then adding these products. The standard deviation (sd)
measures the dispersion of possible outcomes from the expected value and is used as a
measure of risk.
3. While some individuals are risk neutral or risk seekers, most are risk averters. Risk aversion is
based on the principle of diminishing marginal utility of money, which is reflected in a total
utility of money curve that is concave or faces down. A risk averter would not accept a fair bet,
a risk-neutral individual would be indifferent to it, and a risk seeker would accept even some
unfair bets. In investment decisions subject to risk, a risk-averse individual seeks to maximize
expected utility rather than monetary returns. The expected utility of a decision or strategy is
the sum of the product of the utility of each possible outcome and the probability of its
occurrence.
4. A total utility curve that is concave or faces down (so that the marginal utility of money
diminishes) for decreases in income and is convex or faces up (so that the marginal utility of
money increases) for increases in income can be used to rationalize the seeming contradicting
behavior of an individual buying insurance and gambling at the same time. The risk premium is
the maximum amount that a risk-averse individual would be willing to pay to avoid a risk.
5. The extent of an individual’s risk aversion can be shown by indifference curves. Each indifference
curve shows all the combinations of standard deviation and expected income that give the individual
the same level of utility or satisfaction. Since a higher variability of income (risk) must be
compensated by a higher expected income, these indifference curves are positively sloped. The
stronger the risk aversion of an individual, the steeper are his or her indifference curves. Risk—return
indifference curves can be used to determine the choice of the best portfolio.
 CHAPTER 6 Choice Under Uncertainty 183

6. Individuals and decision makers can often make better predictions and sharply reduce the risk
or uncertainty surrounding a particular strategy or event by collecting more information. They
can also do so by diversification or risk spreading. Individuals can also reduce risks by buying
insurance. Insurance premiums are usually higher than those actuarially fair to allow insurance
companies to cover their operating expenses. But they are usually still much lower than the risk
premium that risk-averting individuals are willing to pay. Some risks, such as those arising
from wars, are nondiversifiable and insurance companies refuse to ensure them. The same is
true for major natural disasters and terrorist attacks.
. Behavioral economics is the study of how people actually make choices in the real world by
drawing on insights from psychology and economics. Behavioral economics seeks to enrich
traditional economic analysis by offering a fuller picture of how individuals or other economic
agents actually behave or operate in the marketplace.
. Including foreign securities in an investment portfolio can reduce risk (through diversification)
and increase the rate of return, but also gives rise to a foreign-exchange risk because the
foreign currency can depreciate during the time of the investment. Such foreign-exchange risk
can be covered by hedging. This is usually accomplished with a forward or a futures contract.
A forward contract is an agreement to purchase or sell a specific amount of a foreign currency
at a rate specified today for delivery at a specific future date. A futures contract is a
standardized forward contract for predetermined quantities of the currency and selected
calendar dates.

KEY TERMS
Certainty Risk neutral Gambler
Risk Risk averter Diversification
Uncertainty Diminishing marginal utility of Behavioral economics
Probability money Foreign-exchange rate
Probability distribution Expected utility Hedging
Expected value Expected income Forward contract
Standard deviation (sd) Insurer Futures contract
Risk seeker or lover Risk premium

REVIEW QUESTIONS
il, What is the meaning of risk, uncertainty? Why are these 6. Why is maximization of the expected value not a valid
concepts important in the theory of consumer choice or criterion in decision making subject to risk? Under what
demand? conditions would that criterion be valid?
. What is meant by probability distribution, expected value, 7. What is the meaning of risk aversion, risk seeking or
variance, standard deviation? loving and risk neutrality?
. What is the value of the standard deviation if all the 8. Who is an insurer? A gambler? How can we measure the
outcomes of a probability distribution are identical? Why degree risk aversion or risk loving?
is this so? What does this mean? 9. What is a risk premium? How is it measured?
. How does the process of consumer utility maximization 10. What does a risk—return indifference curve show? What
differ in the case of certainty and risk? is its use?
. What is the meaning of diminishing, constant, and 11. How are risks and returns balanced in choosing a
increasing marginal utility of money? portfolio?
184 PART TWO. Theory of Consumer Behavior and Dernand

12. Why is decision making under uncertainty necessarily 14. What is behavioral economics? What is its relationship
subjective? with traditional economic theory?

13. What can an individual do to reduce risk? 15. Why does investing abroad involve a foreign-exchange
risk? How can such a risk be covered?

PROBLEMS
1. An individual has two investment opportunities, each are excellent. The probability distribution of conditions
involving an outlay of $10,000. The possible earnings are as follows:
from each investment and their respective probabilities Excellent
Conditions: Poor Good
are given in the following table.
Probability: 40% 50% 10%

Investment II
a. Calculate the expected value of each project and
Investment |
identify the preferred project according to this
Earnings $4,000 $6,000 $3,000 $5,000 $7,000 criterion.
Probability 0.6 0.4 ~ 0.4 0.3 0.3 b. Calculate the standard deviation of the expected
value of each project and identify the project with
the highest risk.
a. Calculate the expected earnings of each investment.
*4. An individual is considering two investment projects.
b. Calculate the standard deviation of each investment.
Project A will return a loss of $5 if conditions are poor, a
c. Determine which of the two investments the
profit of $35 if conditions are good, and a profit of $95 if
individual should choose.
conditions are excellent. Project B will return a loss of
2. An individual has to choose between investment A and $15 if conditions are poor, a profit of $45 if conditions
investment B. The individual estimates that the income are good, and a profit of $135 if conditions are excellent.
and probability of the income from each investment are The probability distribution of conditions are as follows:
given in the following table.
Conditions: Poor Good Excellent
Investment A Investment B Probability: 40% 50% 10%

Income Probability Income Probability a. Calculate the expected value of each project and
identify the preferred project according to this
$4,000 0.2 $4,000 0.3 criterion.
5,000 0.3 6,000 0.4
6,000 0.3 8,000 0.3 b. Calculate the standard deviation of the expected
7,000 0.2 value of each project and identify the project with
the highest risk.

a. Calculate the standard deviation of the distribution c. Which of the two projects should a risk-averse
of each investment. individual prefer?
b. Which of the two investments is more risky? 5. a. What is the expected utility of an investment with a
40% probability of gaining 3 utils and a 60%
c. Which investment should the individual choose?
probability of losing | util? Should a risk-averse
3. An individual is considering two investment projects. individual undertake this project? (b) What if the payoff
Project A will return a loss of $45 if conditions are poor, of the project were the same as above, except that the
a profit of $35 if conditions are good, and a profit of utility lost with a loss was 3 utils?
$155 if conditions are excellent. Project B will return a
6. a. An investment has a 40% probability of providing
loss of $100 if conditions are poor, a profit of $60 if
a profit of $20,000, which would give an individual
conditions are good, and a profit of $300 if conditions
4 utils of utility, and a 60% probability of losing

* = Answer provided at end of book.

 CHAPTER 6 Choice Under Uncertainty 185

$10,000, which would result in a loss of 3 utils for the b. Assume that the individual’s utility function for
individual. (a) What is the expected value of the profit is U(X) = X — 0.05X?. Calculate the expected
investment? (b) What is the expected utility of the utility of each project and identify the preferred
investment? (c) Should a risk-averse individual project according to this criterion.
undertake this investment? Why? c. Is this individual risk averse, risk neutral, or risk
*7. An individual is considering two investment projects. seeking? Why?
Project A will return a zero profit if conditions are poor, a 9. Suppose that a risk averse individual’s income
profit of $16 if conditions are good, and a profit of $49 if is $80 per day in Figure 6.6. Explain why this individual
conditions are excellent. Project B will return a profit of would not buy a lottery ticket that would increase his or
$4 if conditions are poor, a profit of $9 if conditions are her income to $200 per day with a win.
good, and a profit of $49 if conditions are excellent. The
10. Suppose that a risk—return indifference curve of
probability distribution of conditions are as follows:
individual A starts on the vertical axis at a rate
Conditions: Poor Good Excellent of return of 10% and is positively sloped, while an
Probability: 40% 50% 10% indifference curve of individual B starts on the vertical
axis at a rate of return of 6% and is also positively
a. Calculate the expected value of each project and sloped but less steep than the indifference curve of
identify the preferred project according to this individual A. Finally, assume that an indifference curve
criterion. of individual C starts on the vertical axis at a rate of
b. The individual’s utility function for profit is equal to 5% and is horizontal. (a) Which individual is risk
the square root of the profit. Calculate the expected neutral? And who is risk averse? Why? (b) Of the two
utility of each project and identify the preferred risk-averse individuals, which is the least risk averse?
project according to this criterion. Why? (c) What does the fact that individual A’s
c. Is this individual risk averse, risk neutral, or risk indifference curve starts on the vertical axis
seeking? Why? at the rate of return of 10% mean?

8. An individual is considering two investment projects. —— . An individual owns a house worth $100,000 with a
Project A will return a zero profit if conditions are poor, a probability of 1% that it will burn down in any year,
profit of $4 if conditions are good, and a profit of $8 if which would result in a total loss. The individual’s risk
conditions are excellent. Project B will return a profit of premium is $1,200, and he can purchase fire insurance

$2 if conditions are poor, a profit of $3 if conditions on the house for $100 above fair or actuarial value of the
are good, and a profit of $4 if conditions are excellent. loss. (a) Would the individual purchase the insurance?
The probability distribution of conditions are as follows: Why? (b) Why would an insurance company be willing
to provide such insurance?
Conditions: Poor Good Excellent *12. A U.S. firm imports $200,000 worth of EMU goods and
Probability: 40% 50% 10% agrees to pay in three months. The exchange rate is
$1.00/€1 today and the three-month forward rate is
a. Calculate the expected value of each project and
$1.01/€1. Explain how the importer can hedge his
identify the preferred project according to this
foreign-exchange risk.
criterion.

| INTERNET SITE ADDRESSES

For a discussion of risk analysis, see: http://en.wikipedia.org/wiki/New_Coke
http://en.wikipedia.org/wiki/Risk_analysis http://www. geocities.com/colacentury/
http://www.sra.org/ http://en.wikipedia.org/wiki/Coca-Cola
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—ID__ 10359—/free-co-factsheet.xhtml
http://www.blackwellpublishing.com/
journal.asp?ref=0272-4332 The Final Report of the National Gambling Impact
Commission, examining gambling in America, as well as
For a discussion of the introduction of the new Coke as well
other information on gambling are found at:
as an analysis of what Coca-Cola is doing to meet its
competition, see: http://govinfo. library.unt.edu/ngisc/
186 PART TWO Theory of Consumer Behavior and Demand

http://en.wikipedia.org/wiki/Gambling http://www.iies.su.se/nobel/papers/Encyclopedia%
http://www.gambling.co.uk/ 202.0.pdf
http://arielrubinstein.tau.ac.il/papers/
For reducing risks and uncertainty, see:
behavioral-economics.pdf
http://www. husdal.com/gis/flexibility.htm
For futures trading and hedging, see the Commodity Futures
http: -mit. lerdi : ae : -
Ee A eee Y Trading Commission and the Chicago Mercantile Exchange
http://greenbook.treasury. gov.uk/annex04.htm Webéites*ats
http://opim. wharton.upenn.edu/risk/downloads/ http://www.cfte.gov
01-15-HK.pdf ; niga Th
Loehrer J ; http://www.cme.com/
or behavioral econ » S&C: se Ae
: ware tos , ; ; http://en.wikipedia.org/wiki/Chicago_Mercantile_
http://en. wikipedia.org/wiki/Behavioral_economics Exchange

asbe pes 1502 pai giraibe an Ce)8 Osa 7 http://www.associatedcontent.com/article/323409/

Sas coping_with_risk_and_uncertainty_of.html
http://www. harvardmagazine.com/on-line/030640.html
 PART
TAREE

art Three (Chapters 7-9) presents the theory of Production,

p production, cost, and pricing in competitive
markets. Chapter 7 examines production theory, or
how firms combine resources or inputs to produce final
Costs, and
commodities. These concepts are then utilized and
extended in Chapter 8 to examine costs of production
Competitive
and to derive the short-run and the long-run cost curves
of the firm. Finally, Chapter 9 brings together the theory Markets
of consumer behavior and demand (from Part Two) with
the theory of production and costs (from Chapters 7 and
8) to analyze how price and output are determined under
perfect competition. The chapter appendices present
more advanced topics in the theory of production, cost,
and pricing. The presentation of the theory is reinforced
throughout with many real-world examples, while the ‘At
the Frontier” sections present some new and important
developments in production and cost theory and in the
operation of perfectly competitive markets.
 aes

16 -

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ory ay A ai

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 CHAPTER /

Production Theory
Chapter Outline Trading Traveling Time for Gasoline
7.1 Relating Outputs to Inputs Consumption on the Nation’s Highways
7.2 Production with One Variable Input General Motors Decides Smaller Is Better
7.3 Production with Two Variable Inputs How Do Firms Get New Technology?
7.4 The Shape of Isoquants Open Innovations at Procter & Gamble
7.5 Constant, Increasing, and Decreasing How Xerox Lost and Regained Market Share
Returns to Scale but Is Now Struggling to Remain Internationally
7.6 Technological Progress and International Competitive
Competitiveness At the Frontier: The New Computer-Aided
7.7 Open Innovation Model Production Revolution and the International
Appendix: The Cobb-Douglas Production Function Competitiveness of U.S. Firms
Output Elasticity of Labor and Capital and
List of Examples Returns to Scale in U.S. and Canadian
7-1 Economics—The Dismal Science Because of Manufacturing
Diminishing Returns

After Studying This Chapter, You Should Be Able to:

e Know the reason for the existence of firms
e Describe how production takes place in the short run with only one variable input
e Describe the production process in the long run
e Know the meaning and reasons for constant, increasing, and decreasing returns to scale
e Know the meaning of technological progress, how it takes place, and its importance

n Part Two, we examined the theory of consumer behavior and demand. Our focus of
attention was the consumer. In Part Three, we examine the theory of production, cost,
and pricing in competitive markets. Here the focus is on the firm. This chapter exam-
ines the theory of production or how firms organize production; that is, we examine how
firms combine resources or inputs to produce final commodities. Chapter 8 builds on the
discussion and analyzes the costs of production of the firm. Then Chapter 9 brings
together the theory of consumer behavior and demand with the theory of production and
costs to analyze how price and output are determined under perfect competition.
This chapter begins with a discussion of the organization of production. We define the
meaning of production, examine why firms exist, consider their aims, classify resources or

189
190 PART THREE Production, Costs, and Competitive Markets

long-run produc-
inputs into various categories, and define the meaning of short-run and
tion. From this, we go on to the theory of production when only one input is variable. This
and the marginal product curve of the
is accomplished by defining the total, the average,
variable input. Production theory is subsequently extended to deal with two variable inputs
by the introduction of isoquants.
From the theory of production where only one or two inputs are variable, we pro-
ceed to examine cases in which all inputs are variable. Here, we define the meaning of
constant, increasing, and decreasing returns to scale, the conditions under which they
arise, and their importance. Finally, we examine technological progress and interna-
tional competitiveness.
The real-world examples included in this chapter highlight the importance and
relevance of the theory of production, while the “At the Frontier” section discusses the
new computer-aided revolution that is now sweeping America. The optional appendix
examines the most used production function (the Cobb-Douglas) and its empirical
estimation.

7 RELATING OUTPUTS TO INPUTS

In this section, we examine the organization of production and classify inputs into various
categories. We begin by focusing on the meaning and organization of production, why
firms exist, and the aim of firms. Then we classify inputs into various broad categories.
This section serves as a general background for the theory of production presented in sub-
sequent sections.

Organization of Production
Production The Production refers to the transformation of resources into outputs of goods and services.
transformation of For example, General Motors hires workers who use machinery in factories to transform
resources or inputs into steel, plastic, glass, rubber, and so on into automobiles. The output of a firm can either be
outputs of goods and
a final commodity such as automobiles or an intermediate product such as steel (which is
services.
used in the production of automobiles and other goods). The output can also be a service
rather than a good. Examples of services are education, medicine, banking, legal counsel,
accounting work, communications, transportation, storage, wholesaling, and retailing.
Production is a flow concept or has a time dimension. In other words, production refers to
the rate of output over a given period of time. This is to be distinguished from the stock of
a commodity or input, which refers to the quantity of the commodity (such as the number
of automobiles) or input (such as the tons of steel) at hand or available at a particular point
in time.
More than 80% of all goods and services consumed in the United States are produced
by firms. The remainder is produced by the government and such nonprofit organizations
Firm An organization as the Red Cross, private colleges, foundations, and so on. A firm is an organization that
that combines and combines and organizes resources for the purpose of producing goods and services for
organizes resources for sale at a profit. There are millions of firms in the United States. These include proprietor-
the purpose of producing
ships (firms owned by one individual), partnerships (owned by two or more individuals),
goods and services for
sale at a profit. and corporations (owned by stockholders). The way the firm is organized is not of pri-
mary concern in the study of microeconomic theory; what the firm does is. Firms arise
because it would be inefficient and costly for workers and for the owners of capital and
 CHAPTER 7 Production Theory 191

land to enter into and enforce contracts with one another to pool their resources for the
Concept Check purpose of producing goods and services.
Why do firms exist? Just as consumers seek to maximize utility or satisfaction, firms generally seek to
maximize profits. Both consumers and firms can be regarded as maximizing entities.
Profits refer to the revenue of the firm from the sale of the output after all costs have been
deducted. Included in costs are not only the actual wages paid to hired workers and pay-
ments for purchasing other inputs, but also the income that the owner of the firm would
earn by working for someone else and the return that he or she would receive from invest-
ing his or her capital in the best alternative use. For example, the owner of a delicatessen
must include in his or her costs not only payments for the rental of the store, hired help, and
for the purchase of the hams, cheeses, beers, milk, crackers, and so on in the store. He or
she must also include as part of costs the foregone earnings of the money invested in the
store as well as the earnings that he or she would receive by working for someone else in a
similar capacity (e.g., as the manager of another delicatessen). The owner earns (economic)
profits only if total revenue exceeds total costs (which include actual expenses and the
alternatives foregone).
The profit-maximizing assumption provides the framework for analyzing the behav-
Inputs The resources or ior of the firm in microeconomic theory. It is from this assumption that the behavior of
factors of production the firm can be studied most fruitfully. This assumption has recently been challenged by
used to produce goods the so-called “managerial theories of the firm,’ which postulate multiple goals for the
and services. firm. That is, after attaining “satisfactory” rather than maximum profits, the large mod-
ern corporation is said to seek to maintain or increase its market share, maximize sales
Labor or human
resources The or growth, maintain a large staff of executives and lavish offices, minimize uncertainty,
different types of create and maintain a good public image as a desirable member of the community and a
skilled and unskilled good employer, and so on. However, because many of these goals can be regarded as
workers that can be indirect ways to earn and increase profits in the long run, we will retain the profit-
used in the production maximizing assumption.
of goods and services.

Capital or investment Classification of Inputs

goods The machinery,
factories, equipment, Firms transform inputs into outputs. Inputs, resources, or factors of production are the
tools, inventories, means of producing the goods and services demanded by society. Inputs can be classified
irrigation, transportation,
broadly into labor or human resources (including entrepreneurial talent), capital or
and communications
investment goods, and land or natural resources. This threefold classification of inputs
networks that can be
used to produce goods is only a convenient way to organize the discussion, however, and it does not convey the
and services. enormous variety of specific resources in each category. For example, labor includes
clerks and assembly-line workers as well as accountants, teachers, engineers, doctors, and
Land or natural scientists. And we must consider the specific types of labor and other inputs required for
resources The land, its
the analysis of production of a particular firm or industry.!
fertility, mineral
Particularly important among inputs is entrepreneurship, which refers to the ability
deposits, and forests
that can be used to of some individuals to see opportunities to combine resources in new and more efficient
produce goods and ways to produce a particular commodity or to produce entirely new commodities. The
services. motivation is the great profit possibilities that an entrepreneur may believe to exist.
The entrepreneur either uses his or her resources to exploit these profit opportunities or,
Entrepreneurship
The introduction of
new technologies and | The reason is that different skills require varying training costs and wages to be supplied. Thus, to analyze
products to exploit the production process of a particular firm or industry, we must consider the specific types of labor and other
perceived profit inputs that are required. Yet, for general theoretical work, it is often convenient to deal with the broad input
opportunities. categories of labor, capital, and land.
192 PART THREE Production, Costs, and Competitive Markets

of
more likely, attempts to convince other people with large sums of money to put some
that money at his or her disposal to introduce new productio n technique s or new products
and share in the potential profits. There are many examples of entrepreneurship during the
late 1970s and early 1980s in the field of microcomputers. This was a time when some
young engineers and computer experts sought to combine new and more powerful chips
Fixed inputs The (the basic memory component of computers) to produce cheaper or better microcomput-
resources that cannot be ers. Some of these entrepreneurs were successful and became rich overnight (e.g., the
varied or can be varied developers of the Apple Computers). Most, however, had to abandon their dreams after
only with excessive huge losses. In any event, entrepreneurs play a crucial role in modern economies. They
cost during the time
are responsible for the introduction of new technology and new products, and for most of
period under
consideration.
the growth of the economy as a whole.
Inputs can be further classified into fixed and variable. Fixed inputs are those that
Variable inputs The cannot be varied or can be varied only with excessive cost during the time period under
resources that can be consideration. Examples of fixed inputs are the firm’s plant and specialized equipment.
varied easily and on For example, it takes many years for General Motors to build a new automobile plant and
short notice during the introduce robots to perform many repetitive assembly-line tasks. Variable inputs, on the
time period under
other hand, are those that can be varied easily and on short notice during the time period
consideration.
under consideration. Examples of these are raw materials and many types of workers, par-
Short run The time ticularly those with low levels of skills. Thus, whether an input is fixed or variable depends
period when at least on the time horizon being considered. The time period during which at least one input is
one input is fixed. fixed is called the short run, and the time period during which all inputs are variable is
called the long run. Obviously, the length of time it takes to vary all inputs (i.e., to be in the
Long run The time long run), varies for firms in different industries. For a street vendor of apples, the long run
period when all inputs may be a day. For an apple farmer, it is at least five years (this is how long it takes for newly
can be varied. planted trees to begin bearing fruit).

72 PRODUCTION WITH ONE VARIABLE INPUT

In this section, we present the theory of production when only one input is variable. Thus, we
are dealing with the short run. We begin by defining the total, the average, and the marginal
product of the variable input and examining their relationship graphically, and then we dis-
cuss the important law of diminishing returns. Production theory with more than one variable
input is taken up in subsequent sections.

Production function
The unique relationship Total, Average, and Marginal Product
between inputs and
outputs represented by A production function is a unique relationship between inputs and outputs. It can be rep-
a table, graph, or resented by a table, a graph, or an equation and shows the maximum output of a com-
equation showing the modity that can be produced per period of time with each set of inputs. Both output and
maximum output of a inputs are measured in physical rather than monetary units. Technology is assumed to
commodity that can be
remain constant. A simple short-run production function is obtained by applying various
produced per period of
amounts of labor to farm one acre of land and recording the resulting output
time with each set of or total
inputs. product (7P) per period of time. This is illustrated by the first two columns
of Table 7.1.
The first two columns of Table 7.1 provide a hypothetical production function
for
Total product (TP) a farm using various quantities of labor (i.e., number of workers per
year) to cultivate
Total output. wheat on one acre of land (and using no other input). When
no labor is used, total output
 CHAPTER 7 Production Theory 193

Total, Average, and Marginal Product of Labor in the Cultivation

of Wheat on One Acre of Land (Bushels Per Year)

Labor Output or Average Product Marginal Product

(Workers per Year) Total Product of Labor of Labor
(1) (2) (3) (4)
0 0 ee bi
1 3 3 3
2 8 4 5)
3 12 4 4
4 14 Sh) 2
5 14 2.8 0
6 12 2) —2

or product is zero. With one unit of labor (1L), total product (TP) is 3 bushels of wheat per
year. With 2L, TP = 8 bushels. With 3L, TP = 12 bushels, and so on.”
From the output or total product schedule we can derive the (per-unit) average and
marginal product schedules for the input. Specifically, the total (physical) output or total
Average product (AP) product (7P) divided by the quantity of labor employed (L) equals the average product
The total product of labor (AP,;). On the other hand, the change in output or total product per-unit change in
divided by the quantity the quantity of labor employed is equal to the marginal product of labor (MP,).*
of the variable input
used. IP
AP; = 7 lio]
Marginal product
(MP) The change in and
total product per unit
change in the variable ATP
MP, L = ——
AL UD
ie"
input used.

Column 3 in Table 7.1 gives the average product of labor (AP, ). This equals TP (col-
umn 2) divided by the quantity of labor used (column 1). Thus, with one unit of labor
(1L), the AP; equals 3/1 or 3 bushels. With 2L, AP, is 8/2 or 4 bushels, and so on. Finally,
column 4 reports the marginal product of labor (MP, ). This measures the change in total
product per-unit change in labor. Since labor increases by one unit at a time in column 1,
the MP, in column 4 is obtained by subtracting successive quantities of the 7P in column
2. For example, 7P increases from 0 to 3 bushels when we add the first unit of labor. Thus,
the MP, is 3 bushels. For an increase in labor from 1L to 2L, TP increases from 3 to 8
bushels. Thus, the MP, is 5 bushels. For an increase in labor from 2L to 3L, the MP, is 4
bushels (12 — 8), and so on.
Plotting the total, average, and marginal product quantities of Table 7.1 gives the cor-
responding product curves shown in Figure 7.1. Note that TP grows to 14 bushels with 4L.
It stays at 14 bushels with 5 and then declines to 12 bushels with 6L (see the top panel
of Figure 7.1). The reason for this is that laborers get into each other’s way and actually

2 The reason for the decline in 7P when six units of labor are used will be discussed shortly.
3 In subsequent chapters, when the possibility arises of confusing the AP and the MP with their monetary
values, they will be referred to as the average physical product and the marginal physical product.
194 PART THREE Production, Costs, and Competitive Markets

no Ine

oo

product
Total
output
or
year)
wheat
of
(bushels
per

0 1 2 3 ee 5 6 E
Quantity of labor
(worker-years)

= EiL,

per BO
year)
wheat
of
(bushels Quantity of labor ¥
product
marginal
and
Average (worker-years) MP,

FIGURE 7.1 Total, Average, and Marginal Product Curves The top panel shows the total
output or total product (7P) curve. The AP; at point A on the 7P curve is 3 bushels (the slope of OA) and
is plotted as A’ in the bottom panel. The AP; curve is the highest between 2L and 3L. The MP, between
A and B on the 7P curve is 5 bushels (the slope of AB) and is plotted between 1 and 2 in the bottom
panel. The MP, is highest at 1.5L, MP, = AP; at 2.5L, MP, = O at 4.5L, and it is negative thereafter

trample the wheat when the sixth worker is employed. In the bottom panel, we see that the
AP, curve rises to 4 bushels and then declines. Since the marginal product of labor refers
to the change in total product per-unit change in labor used, each value of the MP, is plot-
ted halfway between the quantities of labor used. Thus, the MP, of 3 bushels, which results
from increasing labor from OL to 1L, is plotted at 0.5L; the MP, of 5 bushels, which results
from increasing labor from 1L to 2L, is plotted at 1.5L, and so on. The MP; curve rises to
5 bushels at 1.5L and then declines. Past 4.5L, the MP; becomes negative.
 CHAPTER 7 Production Theory 195

The Geometry of Average and Marginal Product Curves

The shape of the average and marginal product of labor curves is determined by the shape
of the corresponding total product curve. The AP, at any point on the 7P curve is equal to
the slope of the straight line drawn from the origin to that point on the TP curve. Thus, the
AP, at point A on the 7P curve in the top panel of Figure 7.1 is equal to the slope of OA.
This equals 3/1 or 3 bushels and is plotted directly below A, as point A’, in the bottom
panel of Figure 7.1. Similarly, the AP; at point B on the TP curve is equal to the slope of
dashed line OB. This equals 8/2 or 4 bushels and is plotted as point B’ in the bottom panel.
At point C, the AP; is again equal to 4. This is the highest AP;. Past point C, the AP,
declines but remains positive as long as the TP is positive.
The MP; between any two points on the 7P curve is equal to the slope of the TP
between the two points. Thus, the MP, between the origin and point A on the TP curve in
the top panel of Figure 7.1 is equal to the slope of 0A. This is equal to 3 bushels and is
plotted halfway between OL and IL (i.e., at 0.5L) in the bottom panel of Figure 7.1.
Similarly, the MP; between points A and B on the TP curve is equal to the slope of AB.
This is equal to 5 (the highest MP7) and is plotted as point G’ at 1.5L in the bottom panel.
The MP, between B and C on the 7P curve is equal to the slope of BC. This equals 4 and
is the same as the highest AP; (the slope of OB and OC). Between points D and E, TP
remains unchanged and the MP, = 0. Past point E, TP falls and MP; becomes negative.
We have drawn the curves in Figure 7.1 under the assumption that labor is used in
whole units. If this were not the case and labor time were infinitesimally divisible, we
would have the smooth TP, AP;, and MP, curves shown in Figure 7.2. In this figure, the
AP_ (given, as before, by the slope of a ray from the origin to the 7P curve) rises up to
point H on the 7P curve in the top panel and then declines. Thus, the AP; curve in the bot-
tom panel rises up to point H’ and declines thereafter (but remains positive as long as TP
is positive). On the other hand, the MP, at any point on the 7P curve is equal to the slope
of the tangent to the 7P curve at that point. The slope of the 7P curve rises up to point G
(the point of inflection) and then declines. Thus, the MP; curve in the bottom panel rises
up to point G’ and declines thereafter. The MP, is zero at point I’ directly below point /,
where the 7P is highest or has zero slope, and it becomes negative when 7P begins to
decline.*
Note that the MP, curve reaches its maximum point before the AP; curve.
Furthermore, as long as the AP; curve is rising, the MP; curve is above it. When the AP;
curve is falling, the MP, curve is below it, and when the AP, curve is highest, the MP,
intersects the AP; curve. The reason for this is that for the AP; to rise, the MP; must be
greater than the average to pull the average up. For the AP; to fall, the MP, must be lower
than the average to pull the average down. For the average product to be at a maximum
(i.e., neither rising nor falling), the marginal product must be equal to the average (the
slope of line 0H). For example, for a student to increase his or her cumulative average test
score, he or she must receive a grade on the next (marginal) test that exceeds his or her
Concept Check
Does the AP curve rise average. With a lower grade on the next test, the student’s cumulative average will fall. If
only as long as the MP the grade on the next test equals the previous average, the cumulative average will remain
curve rises? unchanged.

4 Note that the TP curve in Figure 7.2 has an initial portion over which it faces up (so that the MP; increases).
That is, up to point G, labor is used so sparsely on one acre of land that the MP; increases as more labor is
employed. This is usual but not always true. That is, in some cases, the TP curve faces down from the origin
(so that MP, falls from the very start). An example of this is discussed in the appendix to this chapter.
196 PART THREE Production, Costs, and Competitive Markets

MP. 7

FIGURE 7.2 Geometry of Total, Average, and Marginal Product Curves With labor time
infinitesimally divisible, we have smooth 7P, AP;, and MP, curves. The AP; (given by the slope of the
line from the origin to a point on the TP curve) rises up to point H’ and declines thereafter (but
remains positive as long as TP is positive). The MP, (given by the slope of the tangent to the 7P curve)
rises up to point G’, becomes zero at /’, and is negative thereafter When the AP, curve rises, the MP,
is above it; when the AP, falls, the MP, is below it; and when AP, is highest, MP, = AP).

The Law of Diminishing Returns

Law of diminishing The decline in the MP, curve in Figures 7.1 and 7.2 is a reflection of the law of dimin-
returns After a point, ishing returns. This is an empirical generalization or a physical law, not a proposition of
the marginal product of —_economics. It postulates that as more units of a variable input are used with a fixed
any AEE amount of other inputs, after a point, a smaller and smaller return will accrue to each addi-
; tional unit of the variable input. In other words, the marginal (physical) product of the
variable input eventually declines. This occurs because each additional unit of the vari-
able input has less and less of the fixed inputs with which to work.
 CHAPTER 7 Production Theory 197

In Figure 7.2, the law of diminishing returns for labor begins to operate past point G’
(.e., when more than 1.5 is applied to one acre of land). Further additions of labor will even-
tually lead to zero and then to negative MP,. Note that to observe the law of diminishing
returns, at least one input (here, land) must be held constant. Technology is also assumed to
remain unchanged. It should also be noted that when less than 1.5Z is employed, labor is used
too sparsely in the cultivation of one acre of land and the MP; rises. Had land been kept con-
stant at two acres instead of one, the TP, AP;, and MP, curves would retain their general
shape but would all be higher, since each unit of labor would have more land to work with
(see Section 7.3). Example 7-1 discusses the most famous historical application of the law of
diminishing returns.

EXAMPLE 7-1
Economics—The Dismal Science Because of Diminishing Returns

In the early nineteenth century, Thomas Malthus (in his Essay on the Principles of
Population, 1798) and other classical economists predicted that population growth in
the face of fixed stocks of land and other nonhuman resources could doom humanity to
a subsistence standard of living. That is, rapid population growth could reduce the aver-
age and the marginal product of labor sufficiently to keep people always near starvation.
This gloomy prediction earned for economics the label of the “dismal science.”
These predictions have not proved correct, especially for the United States and
Concept Check other industrial nations of the world where standards of living are much higher than they
Has Malthus’s were a century or two ago. The reasons for the sharply increased standard of living are
prediction been as follows: (1) The quantities of capital, land, and minerals used in production have
correct? Why? vastly increased since the beginning of the nineteenth century; (2) population growth
has slowed down considerably in the industrial nations; and (3) most importantly, very
significant improvements in technology have greatly increased productivity.
Contrary to Malthus’s dismal predictions, standards of living have in fact
increased over the past century throughout most of the world. Malthus inappropriately
applied a short-run law (the law of diminishing returns) to the long run (when tech-
nology can improve dramatically) and came up with a spectacularly wrong prediction!
As Table 7.2 shows, food production per capita has increased during the 1980s and

Index of Food Production per Capita in Major

TABLE 7.2 Developing-Country Groups in 1990 and
in 2000 (1978-1981= 100)
Developing-Country Groups Index in 1990 Index in 2000

East Asia and the Pacific (China) 127(133) 160(215)

South Asia (India) 116(119) 146(124)
Latin America (Brazil) 106(115) 118(149)
Middle East and North Africa (Egypt) 101(118) 107(151)
Sub-Saharan Africa (Ethiopia) 94(84) 94(74)
ene nnn nee EEEEEEEEEEEEEE

Source: World Bank and Food and Agriculture Organization, 2002.

198 PART THREE Production, Costs, and Competitive Markets

on of sub-Saharan
1990s in all major developing-country groups. (with the excepti
disease- resistan t grains, better fertilizer,
Africa) as a result of new high-yielding and
product ion per capita in sub-Saharan
more irrigation, and so on. The reduction in food
. Concern with climate change and
Africa was due to internal strife, wars, and droughts
raw materials,
the recent rapid increase in the world demand and price of food and
however, is once again raising the specter of Malthus.
2008, p. 11; “New Limits to
Sources: “Food and the Specter of Malthus,” Financial Times, February 27,
Growth Revive Malthusian Fears, Wall Street Journal, March 24, 2008, p. Al; and “Malthus Redux: Is
Doomsday upon Us, Again,” New York Times, June 15, 2008, p. 3.

| PRODUCTION WITH TWO VARIABLE INPUTS

In this section we examine production theory with two variable inputs by introducing iso-
quants. We also show how to derive total product curves from an isoquant map, thereby
highlighting the relationship between production with one and two variable inputs. We
then examine the shape of isoquants in Section 7.4.

What Do Isoquants Show?

Isoquant A curve An isoquant shows the various combinations of two inputs (say, labor and capital) that
showing the various
can be used to produce a specific level of output. A higher isoquant refers to a larger out-
combinations of two
inputs that can be used put, whereas a lower isoquant refers to a smaller output. If the two variable inputs (labor
to produce a specific and capital) are the only inputs used in production, we are in the long run. If the two vari-
level of output. able inputs are used with other fixed inputs (say, land), we would still be in the short run.
Figure 7.3 gives a hypothetical production function, which shows the outputs (the
Q's) that can be produced with various combinations of labor (L) and capital (K ) per time
period. For example, the left panel of the figure shows that 12 units of output (i.e., 12Q)
can be produced with | unit of labor (1.e., 1) and 5 units of capital (i.e., 5K ) or with 1L
and 4K. The left panel also shows that 12Q can also be produced with 3L and 1K or with
6L and IK per time period. On the other hand, the figure indicates that 26 units of output
(26Q) could be produced with 2L and 5K, 2L and 4K, 3L and 2K, and 6L and 2K. From
the figure, we can also determine the various combinations of L and K to produce 34Q and
38Q. Note that to produce a greater output per time period, more labor, more capital, or
both more labor and more capital are required. For visual aid, equal levels of output are
joined together by a curve in the body of the left panel of Figure 7.3
Plotting the various combinations of labor and capital that can be used to produce 12,
26, 34, and 38 units of output per time period gives the isoquant for each of these levels
of output shown in the right panel of Figure 7.3. The figure shows that 12 units of output
(the lowest isoquant shown) can be produced with | unit of labor (1L) and 5 units of cap-
ital (SK). This defines point J. Twelve units of output can also be produced with 1 and

° Of course, since inputs are not free, a firm would prefer to produce 12Q with 1Z and 4K rather than with
IL and 5K.
 CHAPTER 7 Production Theory 199

Output per time period (Q)

<S g Soe
' ee 38

35 ee
5 34
vo v
= E
s ec y
# 2
s oie 2
CO hl
4 | = N ee
G F
| | | | | | | | | | | |
0 1 Z 3 4 5 6 0 1 2 3 4 5 6
Labor per time period (L) Labor per time period (L)

FIGURE 7.3 Production Function with Two Variable Inputs: Isoquants The isoquants in the right panel are
obtained from the data in the left panel. The lowest isoquant shows that 12 units of output can be produced with 1L
and 5K(pointJ),1L and 4K(point ™), 2L and 1.5K (point NV), 3L and 1K (point C), or 6L and 1K (point F). Higher
isoquants refer to higher levels of output.

4K (point M), 3L and 1K (point C), and 6L and 1K (point F’). Joining these points with a
smooth curve, we obtain the isoquant for 12 units of output. Similarly, by plotting the var-
ious combinations of labor and capital that can be used to produce 26 units of output (2L
and 5K, 2L and 4K, 3L and 2K, and 6L and 2K) and joining the resulting points by a
smooth curve we get the isoquant for 26Q in the right panel of Figure 7.3. The isoquants
for 34Q and 38Q in the figure can be similarly derived from the data in Figure 7.3.

Derivation of Total Product Curves from the Isoquant Map

By drawing a horizontal line across an isoquant map at the level at which the input mea-
sured along the vertical axis is fixed, we can generate the total product curve for the vari-
able input measured along the horizontal axis. For example, by starting with the isoquant
map in the right panel of Figure 7.3 and keeping capital constant at K = 4, we can derive
the total product curve of labor for K = 4. This corresponds to the higher of the two TP
curves in the bottom panel of Figure 7.4. Thus, from point M (1L and 4K) on the isoquant
for 12Q in the top panel, we obtain point M’ on the 7P curve for K = 4 in the bottom
panel. From point V (2L and 4K) on the isoquant for 26Q in the top panel, we derive point
V’ on the TP curve for K = 4 in the bottom panel, and so on. This is equivalent to read-
ing across the row for K = 4 in the left panel of Figure 7.3.
With capital held constant at the lower level of K = 1, we generate the lower total
product curve in the bottom panel of Figure 7.4. This is equivalent to reading across the
row for K = | in the left panel of Figure 7.3. Note that when capital is held constant at a
smaller level, the 7P curve for labor is lower because each unit of labor has less capital
with which to work.
200 PART THREE Production, Costs, and Competitive Markets

FIGURE 7.4 Derivation of Total Product Curves from the

lsoquant Map By keeping capital constant at K = 4 in the
top panel, we can derive the higher of the two total product
curves in the bottom panel. Thus, from point M (1L and 4K) on
the isoquant for 12Q in the top panel, we obtain point M’ on the
TP curve for K = 4 in the bottom panel. From point V (2L and
4K) in the top panel we derive point V’ in the bottom panel, and
so on. With capital constant at K = 1 (i.e, reading across the row
for K = 1 in the left panel of Figure 7.3), we get the lower total
product curve in the bottom panel.

If, instead, we held the quantity of labor constant and changed the quantity of capital
Concept Check used, we would derive the TP curve for capital. This can be obtained by drawing a verti-
Can we derive the total cal line on the isoquant map at the level at which labor is held constant. This is equivalent
product curve of an to reading up to the appropriate column in the left panel of Figure 7.3. The higher the level
input from the isoquant
at which labor is held constant, the higher is the total product curve of capital. From a
map if one input is held
fixed?
given total product curve, we could then derive the corresponding average and marginal
product curves, as shown in the bottom panel of Figure 7.2. Thus, Figure 7.3 could pro-
vide information about the long run as well as the short run, depending on whether labor
 CHAPTER 7 Production Theory 201

and capital are the only two inputs and both are variable (the long run), or whether labor
and capital are used with other fixed inputs (such as land), or either labor or capital is
fixed (the short run).

74 THE SHAPE OF ISOQUANTS

In this section we examine the characteristics of isoquants, define the economic region of
production, and consider the special cases where commodities can only be produced with
fixed input combinations. We will see that the shape of isoquants plays as important a role
in production theory as the shape of indifference curves plays in consumption theory.

Characteristics of Isoquants®
The characteristics of isoquants are crucial for understanding production theory with two
variable inputs. Isoquants are similar to indifference curves. However, whereas an indif-
ference curve shows the various combinations of two commodities that provide the con-
sumer equal satisfaction (measured ordinally), an isoquant shows the various combinations
of two inputs that give the same level of output (measured cardinally, or in actual units of
the commodity).’
Isoquants have the same general characteristics of indifference curves. That is, they
are negatively sloped in the economically relevant range, are convex to the origin, and do
not intersect. These properties are shown in Figure 7.5.8 The nonintersecting property of
isoquants can easily be explained. Intersecting isoquants would mean that two different
levels of output of the same commodity could be produced with the identical input com-
bination (i.e., at the point where the isoquants intersect). This is impossible under our
assumption that the most efficient production techniques are always used.
Isoquants are negatively sloped in the economically relevant range. This means that
if the firm wants to reduce the quantity of capital used in production, it must increase the
quantity of labor in order to continue to produce the same level of output (i.e., remain on

FIGURE 7.5 Marginal Rate of Technical

Substitution (MRTS) Between point / and point
N on the isoquant for 12 units of output (12Q),
the marginal rate of technical substitution of labor
for capital (MRTS,~) equals 2.5. Between point NV
and point C, MRTS,~ = 1/2. At point N, MRTSi« = 1
(the absolute slope of the tangent to the isoquant
at point N). i

® Compare Figure 7.5 with Figure 3.2.

7 The positively sloped portions of the isoquants have been omitted in Figure 7.5 because they are irrelevant.
The reason for this is discussed in the next subsection.
8 The reasoning is exactly the opposite as for the decline in MP,.
202 PART THREE Production, Costs, and Competitive Markets

for 12
the same isoquant). For example, starting at point M (1L and 4K) on the isoquant
units of output (12Q), the firm could reduce the quantity of capital by 2.5K by adding 1L
in production and reach point N on the same isoquant (see Figure 7.5). Thus, the average
slope of the isoquant between points M and N is —2.5K/1L. The average slope between
N and Cis —1/2.
Marginal rate of The absolute value of the slope of the isoquant is called the marginal rate of tech-
technical substitution nical substitution (MRTS). This is analogous to the marginal rate of substitution of one
(MRTS) The absolute good for another in consumption, which is given by the absolute value of the slope of an
value of the slope of the
indifference curve. For a downward movement along an isoquant, the marginal rate of
isoquant. It measures
technical substitution of labor for capital (MRTS;x) is given by —AK/AL.
the amount of capital that the firm can give up by using one additional unit of labor and
still remain on the same isoquant. Because of the reduction in K, MRTSzx is negative.
However, we multiply by —1 and express MRTS_x as a positive value. Thus, the average
MRTSx between points M and N on the isoquant for 12Q is 2.5. Similarly, the average
MRTSx between points N and C is 1/2. The MRTS_x at any point on an isoquant is given
by the absolute value of the slope of the isoquant at that point. Thus, the MRTS;x at
point N is | (the absolute value of the slope of the tangent to the isoquant at point N; see
Figure 7.5).
The MRTS_x is also equal to MP; / MPx. To prove this, we begin by remembering
that all points on an isoquant refer to the same level of output. Thus, for a movement down
a given isoquant, the gain in output from using more labor must be equal to the loss in
output from using less capital. Specifically, the increase in the quantity of labor used (AL)
times the marginal product of labor (MP,) must equal the reduction in the amount of
capital used (AK) times the marginal product of capital (MPx). That is,

(AL)(MP_) = —(AK)(MPx) yes)

Concept Check so that

Is the MRTS of L for K
equal to the MRTS of K MP, i AK _ MRTS
for L? ME ek DK [7.4]

Thus, MRTS_x is equal to the absolute value of the slope of the isoquant and to the ratio
of the marginal productivities.
Although we know that the absolute value of the slope of the isoquant or MRTS;x
equals the ratio of MP; to MPx, we cannot infer from that the actual value of MP,
and MPx. For example, at point N on the isoquant for 12Q in Figure 7.5, we know that
MRTS x = —AK/AL = MP_;/MPx = 1 (so that MP; = MPx), but we do not know what
the individual values of MP; and MPx are. Similarly, we know that between points N and
C on the isoquant for 120, MRTS;x = —AK/AL = MP_/MPx = 1/2 (so that MP; =
1/2MPx), but we do not know what the actual value of either marginal product is. These
values can, however, be calculated from Figure.7.5.
. For example, we can find the value of MP, and MPx between points N and C on the
isoquant for 12Q in Figure 7.5 by comparing point N (2L, 1.5K) and point C (3L, 1K)
referring to 12Q, to point B (2L, 1K) referring to 8Q (see the left panel of Figure 7.3). The
rightward movement from point B to point C keeps capital constant at 1K and increases
labor by 1L, and it results in an increase in output of 4Q (from 8Q to 12Q). Thus,
MP, = 4
On the other hand, the upward movement from point B to point N keeps labor constant
at
2L and increases capital by 1 /2K, and it also results in an increase in output of
4Q. Thus,
 CHAPTER 7 Production Theory 203

the MPx = 8. With MP; = 4 and MPx = 8, MP, /MPx = 4/8 = 1/2 = MRTS_x, as found
earlier.
Within the economically relevant range, isoquants are not only negatively sloped but
also convex to the origin. That is, as we move down along an isoquant, the absolute value
of its slope or MRTS;x declines and the isoquant is convex (see Figure 7.5). The reason
for this can best be explained by separating the movement down along an isoquant (say,
Concept Check from point N to point C along the isoquant for 12Q in Figure 7.5) into its two components:
Why is an isoquant the movement to the right (from point B to point C) and the movement downward (from
convex in its relevant point N to point B). The increase in L with constant K (the movement from point B to
range?
point C) will lead to a decline in the MP, because of diminishing returns. In addition, the
reduction in K (the movement from point N to point B), by itself, will cause the entire
MP, curve to shift down. Thus, MP, declines for both reasons. On the other hand, by
using less K and more L, the MPx rises.’ With the MP, declining and the MPx rising as
we move down along an isoquant, the MRTS;x = MP,,/ MPx will fall and the isoquant is
convex to the origin.

Economic Region of Production

The firm would not operate on the positively sloped portion of an isoquant because it
could produce the same level of output with less capital and less labor. For example, the
firm would not produce 34@Q at point P in Figure 7.6 because it could produce 34Q by
Ridge lines The lines using the smaller quantity of labor and capital indicated by point R. Similarly, the firm
that separate the would not produce 34Q at point S because it could produce 34Q at point T with less L
relevant (i.e., the
and K. Since inputs are not free, the firm would not want to produce in the positively
* negatively sloped) from
sloped range of isoquants.
the irrelevant (or the
positively sloped) Ridge lines separate the relevant (i.e., the negatively sloped) from the irrelevant (or
portions of the the positively sloped) portions of the isoquants. In Figure 7.6, ridge line ORU joins points
isoquants. on the various isoquants where the isoquants have zero slope (and thus zero MRTS x).

FIGURE 7.6 Economic Region of Production Isoquants

are positively sloped to the right of ridge line ORU and to the
left of or above ridge line OTU. The firm would never produce
at a point such as P or S in the positively sloped portion oOlm
the isoquant because it could produce the same output with
less of both inputs.

9 For a mathematical presentation of isoquants and their characteristics, see Section A.8 of the Mathematical
Appendix at the end of the book.
204 PART THREE Production, Costs, and Competitive Markets

y sloped to
The isoquants are negatively sloped to the left of this ridge line and positivel
for 34Q, if the
the right. This means that starting, for example, at point R on the isoquant
the same iso-
firm used more labor it would also have to use more capital to remain on
quant (compare point P to point R on the isoquant for 34Q). Starting from point R, if the
fall (i.e.,
firm used more labor with the same amount of capital, the level of output would
the firm would fall back to a lower isoquant; see the dashed horizontal line at K = 2.8 in
Figure 7.6). The same is true at all other points on ridge line ORU. Therefore, the MP,
must be negative to the right of this ridge line. Note that points on ridge line ORU specify
the minimum quantity of capital required to produce the levels of output indicated by the
various isoquants. Note also that at all points on this ridge line, MRTS_x = MP, /MPx=0/
MPr 0!
On the other hand, ridge line OTU joins points where the isoquants have infinite slope
(and thus infinite MRTS,x). The isoquants are negatively sloped to the right of this ridge
line and positively sloped to the left. This means that starting, for example, at point 7 on
the isoquant for 34Q, if the firm used more capital it would also have to use more labor to
remain on the same isoquant (compare point S$ to point T on the isoquant for 34Q).
Starting at point 7, if the firm used more capital with the same quantity of labor, the level
of output would fall (i.e., the firm would fall back to a lower isoquant; see the dashed ver-
tical line at L = 3 in Figure 7.6). The same is true at all other points on ridge line OTU.
Therefore, the MPx must be negative to the left of or above this ridge line. Note that
points on ridge line OTU indicate the minimum quantity of labor required to produce the
levels of output indicated by the various isoquants. Note also that at all points on this
ridge line, MRTS;x = MP, /MPx = MP_/0 = infinity.
Thus, we conclude that the negatively sloped portion of the isoquants within the
ridge lines represents the economic region of production, where the MP, and the MPx are
both positive but declining. Producers will never want to operate outside this region. As a
result, from this point on, whenever we will draw isoquants, we will usually show only
their negatively sloped portion. Indeed, some special types of production functions have
isoquants without positively sloped portions.

Fixed-Proportions Production Functions

So far, we have drawn isoquants as smooth curves, indicating that there are many differ-
ent (really, an infinite number of ) input combinations that can be used to produce any out-
put level. There are cases, however, where inputs can only be combined in fixed
proportions in production. In such cases, there would be no possibility of input substitu-
tion in production and the isoquants would be at a right angle, or L-shaped.
For example, Figure 7.7 shows that 10 units of output (10Q) can only be
produced at point A with 2L and 1K. Employing more labor will not change output since
MP, = 0 (the horizontal portion of the isoquant). Similarly, using more capital will not
change output since MPx = 0 (the vertical portion of the isoquant). Here, there is no pos-
sibility of substituting L for K in production and the MRTS;.x = 0. Production would only
take place at the constant capital-labor ratio of K/L = 1 /2. A larger output can only be
produced by increasing both labor and capital in the same proportion. For example, 200
can be produced at point B by using 4L and 2K at the constant K /L ratio of 1/2. Similarly
30Q can only be produced at point C with 6L and 3K and Ki Di Ni2e
In the real world, some substitution of inputs in production is usually possible.
The degree to which this is possible can be gathered from the curvature of the
isoquants.
 CHAPTER 7 Production Theory 205

FIGURE 7.7 Fixed-Proportions Production Function

When isoquants are at right angles, or L-shaped, inputs
must be used in fixed proportions in production. Thus,
10 units of output (10Q) can only be produced at point A
with 2L and 1K. Using more labor or capital would not
change output; 20Q can only be produced with 4L and
2K (point B), and 30Q only with 6L and 3K (point C).
Thus, output can only be produced at the constant or
fixed capital-labor ratio or proportion of K/L = 1/2.

In general, the smaller the curvature of the isoquants, the more easily inputs can be sub-
stituted for each other in production. On the other hand, the greater the curvature (i.e., the
closer are isoquants to right angles, or L-shape), the more difficult is substitution. Being
able to easily substitute inputs in production is extremely important in the real world. For
example, if petroleum had good substitutes, users could easily have switched to alterna-
tive energy sources when petroleum prices rose sharply in the fall of 1973. Their energy
bill would then not have risen very much. As it was, good substitutes were not readily
available (certainly not in the short run), and so most energy users faced sharply higher
energy costs. As Example 7—2 shows, gasoline and driving time can also be substituted
for each other, and this can be shown by isoquants.

EXAMPLE 7-2
Trading Traveling Time for Gasoline Consumption on the Nation’s Highways

Higher automobile speed reduces the driving time needed to cover a given distance but
reduces gas mileage and thus increases gasoline consumption. It has been estimated
that reducing the speed limit on the nation’s highways from 65 to 55 mph reduced
gasoline consumption by about 3%. The trade-off between traveling time and gasoline
consumption for a 600-mile trip can be represented by the isoquant shown in Figure
7.8. In the figure, the vertical axis measures hours of traveling time, while the hori-
zontal axis measures gallons of gasoline consumed. Gasoline and travel time are thus
the inputs into the production of automobile transportation.
The isoquant in Figure 7.8 shows that at 50 mph, the 600 miles can be covered in
12 hours and with 16 gallons of gasoline, at 37.5 miles per gallon (point A). At 60 mph,
the 600 miles can be covered in 10 hours and with 20 gallons of gasoline, at 30 miles
per gallon (point B). Driving at 60 mph saves 2 hours of travel time (one scarce
resource) but increases gasoline consumption by 4 gallons (another scarce resource).
Thus, the trade-off or marginal rate of technical substitution (MRTS) of gasoline for
travel time between point A and point B on the isoquant in Figure 7.8 is 1/2. At 66.7
mph (assuming that the speed limit is above it), the 600 miles can be covered in 9 hours
with 30 gallons of gasoline, at 20 miles per gallon (point C). Thus, the MRTS of gaso-
line for travel time between points B and C is 1/10.
206 PART THREE Production, Costs, and Competitive Markets

2 A (50 MPH)
Bie
a!
B (60 MPH)
e 10+ C (66.7 MPH)
Ss gtk 600 miles
tel)
=|
pss)
=
is
iS
6
=
bap | | [
0 16 = 20 30
Gasoline (gallons)

FIGURE 7.8 Speed Limit and Gasoline Consumption |soquant ABC

shows the trade-off between traveling time and gasoline consumption. At
50 MPH, 600 miles can be covered in 12 hours and with 16 gallons of
gasoline (pointA).At 60 MPH, the 600 miles can be covered in 10 hours
and with 20 gallons of gasoline (point B). At 66.7 MPH, 600 miles can be
covered in 9 hours with 30 gallons (point C).

In order to determine the most economical (i.e., the least cost) combination of
gasoline and travel time to cover the 600 miles, we need to know the price of gasoline
and the value of time to the individual. This is addressed in the next chapter, where we
take up costs of production. If the price of gasoline were to increase, the individual
would want to substitute traveling time for gasoline (1.e., drive at a lower speed so as
to increase gas mileage and save gasoline) to minimize the cost of traveling the 600
miles (see Example 8-3). Note that there is also a trade-off between travel speed and
safety (1.e., lower speeds increase travel time but save lives).
Sources: Charles A. Lave, “Speeding, Coordination, and the 55-mph Limit,” American Economic Review,
December 1985, pp. 1159-1164; “Death Rate on U.S. Roads Reported at a Record Low,” New York Times,
October 27, 1998, p. 16; “How Much Is Your Times Worth?” New York Times, February 26, 2003, p. D1;
“At $2 a Gallon, Gas Is Still Worth Guzzling,” New York Times, May 16, 2004, Sect. 4, p. 14; “Politics Is
Forcing Detroit to Support New Rules on Fuel,” New York Times, June 20, 2007, p. Al; and “Can U.S.
Adopt Europe’s Fuel-Efficient Cars?” Wall Street Journal, June 26, 2007, p. B1.

CONSTANT, INCREASING, AND DECREASING RETURNS TO SCALE

Constant returns to The word “scale” refers to the long-run situation where all inputs are changed in the same
scale Output changes in proportion. The result might be constant, increasing, or decreasing returns. Constant
the same proportion as returns to scale refers to the situation where output changes by the same proportion as
inputs.
inputs. For example, if all inputs are increased by 10%, output also rises by 10%. If all
Increasing returns to inputs are doubled, output also doubles. Increasing returns to scale refers to the case
scale Output changes where output changes by a larger proportion than inputs. For example, if all inputs are
by a larger proportion
than inputs.
 CHAPTER 7 Production Theory 207

increased by 10%, output increases by more than 10%. If all inputs are doubled, output
Decreasing returns to more than doubles. Finally, with decreasing returns to scale, output changes by a
scale Output changes smaller proportion than inputs. Thus, increasing all inputs by 10% increases output by
by a smaller proportion
less than 10%, and doubling all inputs, less than doubles output.
than inputs.
Constant, increasing, and decreasing returns to scale can be shown by the spacing of
the isoquants in Figure 7.9. The left panel shows constant returns to scale. Here, doubling
inputs from 3L and 3K to 6L and 6K doubles output from 100 (point A along ray OD) to
200 (point B). Tripling inputs from 3Z and 3K to 9L and 9K triples output from 100 (point
A) to 300 (point C). Thus, 0A = AB = BC along ray OD and we have constant returns to
scale. The middle panel shows increasing returns to scale. Here, output can be doubled or
tripled by less than doubling or tripling the quantity of inputs. Thus, 0A > AB > BC
along ray OD and the isoquants are compressed closer together. Finally, the right panel
shows decreasing returns to scale. In this case, in order to double and triple output we must
more than double and triple the quantity of inputs. Thus, 0A < AB < BC and the isoquants
move farther and farther apart. Note that in all three panels, the capital—labor ratio remains
constant at K/L = | along ray OD.
Constant returns to scale make sense. We would expect two similar workers using
identical machines to produce twice as much output as one worker using one machine.
Similarly, we would expect the output of two identical plants employing an equal number
of workers of equal skill to produce double the output of a single plant. Nevertheless,
increasing and decreasing returns to scale are also possible.
Increasing returns to scale arise because, as the scale of operation increases, a greater
division of labor and specialization can take place and more specialized and productive
machinery can be used. With a large scale of operation, each worker can be assigned to
perform only one repetitive task rather than numerous ones. Workers become more profi-
cient in the performance of the single task and avoid the time lost in moving from one
machine to another. The result is higher productivity and increasing returns to scale. At
higher scales of operation, more specialized and productive machinery can also be used.
For example, using a conveyor belt to unload a small truck may not be justified, but it
greatly increases efficiency in unloading a whole train or ship. In addition, some physical
properties of equipment and machinery also lead to increasing returns to scale. Thus, dou-
bling the diameter of a pipeline more than doubles the flow, doubling the weight of a ship
more than doubles its capacity to transport cargo, and so on. Firms also need fewer super-
visors, fewer spare parts, and smaller inventories per unit of output as the scale of opera-
tion increases.
Decreasing returns to scale arise primarily because, as the scale of operation
increases, it becomes ever more difficult to manage the firm effectively and coordinate the
Concept Check various operations and divisions of the firm. The channels of communication become
Why do decreasing more complex, and the number of meetings, the paper work, and telephone bills increase
returns to scale occur? more than proportionately to the increase in the scale of operation. All of this makes it
increasingly difficult to ensure that the managers’ directives and guidelines are properly
carried out. Thus, efficiency decreases (this is sometimes referred to as “managerial disec-
onomies”). Decreasing returns to scale must be clearly distinguished from diminishing
returns. Decreasing returns to scale refers to the long-run situation when all inputs are
variable. On the other hand, diminishing returns refers to the short-run situation where at
least one input is fixed. Diminishing returns in the short run is consistent with constant,
increasing, or decreasing returns to scale in the long run.
In the real world, the forces for increasing and decreasing returns to scale often oper-
ate side by side. The forces for increasing returns to scale usually prevail at small scales
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 CHAPTER 7 Production Theory 209

of operation. The tendency for increasing returns to scale may be balanced by the ten-
dency for decreasing returns to scale at intermediate scales of operation. Eventually, the
forces for increasing returns to scale may be overcome by the forces for decreasing
returns to scale at very large scales of operation. Whether this is true for a particular firm
can only be determined empirically. In the real world, most firms seem to exhibit near
constant returns to scale (see Table 7.7 in the appendix to this chapter). As Example 7-3
shows, however, General Motors believes that it faces decreasing returns to scale and
wants to shrink.

EXAMPLE 7-3 ie
General Motors Decides Smaller Is Better

General Motors (GM), the largest carmaker in the world, has had a turbulent two
decades. It started by incurring huge losses of $2 billion in 1990 and $4.5 billion in
1991 as the result of a bloated workforce and management, low capacity utilization,
too many divisions and models, and high-cost suppliers. For a corporation that had
been extolled in 1946 as the epitome of a successful company, this was a dramatic
decline indeed! As the data on sales per employee in Table 7-3 seem to indicate, GM
was too large and faced strong diseconomies of scale, Chrysler was too small, and
Ford was just about right.
Since the early 1990s, GM went through a number of reorganizations that cut
more than half of its capacity, shed more than half of its labor force, and lost more than
half of its market share in North America. In 2007, GM’s North American capacity
was about 5 million automobiles, its labor force less than 150,000, and its market share
about 22%. Just closing plants and reducing GM’s size, however, were not sufficient.
Although these increased efficiency, its competitors did not stand still, and GM pro-
ductivity still lagged in relation to that of its domestic competitors. For example, in
1998 GM required 34 worker-days to produce its average car, as compared with
Chrysler’s 32 and Ford’s 30.
To close this productivity gap, GM consolidated its North American and interna-
tional operations; reduced further the number of models it produced; cut average man-
ufacturing time per vehicle; centralized its sales, service, and marketing system; spun

Total Sales, Employees and Sales per Employee

TABLE 7.3 at GM, Ford and Chrysler

Sales Employees Sales per Employee

(in billion dollars) (in thousands) (in thousand dollars)

General Motors 12331 756 162.7

Ford 88.3 333 265.4
Chrysler 29.4 12) 238.8

Source: The Economist, May 2, 1992, p. 78.

210 PART THREE Production, Costs, and Competitive Markets

ed more of
off its auto-components group (Delphi Automotive Systems); and outsourc
lose market share. The year 2005
the assembly task. Nevertheless, GM continued to
necessitated
was also GM’s worst since 1992, with losses of almost $15 billion, which
still another restructuring plan to eliminate another 30,000 jobs by 2008. In 2006, GM
finally made a profit of about $2 billion (as compared with a loss of $12.7 billion for
Ford and with the loss-making Chrysler sold by Daimler-Benz at an almost complete
loss from its acquisition price of $37 billion in 1998). In 2008, GM and Toyota were
neck and neck for the title as the largest automotive company in the world.
Source: “Automobiles: GM Decides Smaller Is Better,” The Margin, November/December 1988, p. 29;
“GM Posts Record ’91 Loss of $4.45 Billion, Sends Tough Message to UAW on Closings,” New York
Times, February 25, 1992, p. 3; “GM Plans to Close Assembly Plants in North America,” Financial Times,
August 31, 2005, p. 13; “GM Posts Worst Loss since 1992,” New York Times, January 17, 2006, p. C1; “Big
Three Face New Obstacles in Restructuring,” Wall Street Journal, January 26, 2007, p. Al; and “Toyota and
GM Are Neck and Neck in the Race to Be Number One,” Financial Times, January 24, 2008, p. 16.

76 TECHNOLOGICAL PROGRESS AND INTERNATIONAL COMPETITIVENESS

In this section, we examine the meaning and importance of technological progress, dis-
cuss the process by which firms get new technology, and examine the crucial role that
technological progress plays in the international competitiveness of firms.

Meaning and Importance of Innovations

In our analyses so far, we have assumed a given technology. Over time, however, techno-
Technological logical progress takes place. Technological progress refers to the development of new
progress The and better production techniques to make a given, improved, or an entirely new product.
development of new
The introduction of innovations is the single most important determinant of a firm’s long-
and better production
term competitiveness at home and abroad. Innovations are basically of two types: prod-
techniques to make a
given, improved, or uct innovation, which refers to the introduction of new or improved products, and
entirely new product. process innovation, the introduction of new or improved production processes. Contrary
to popular belief, most innovations are incremental; that is, they involve more or less con-
Product innovation tinuous small improvements in products or processes rather than a single, major techno-
The introduction of logical breakthrough. Furthermore, most innovations involve the commercial utilization
new or improved
of ideas that may have been around for years. For example, it took a quarter of a century
products.
before firms (primarily Japanese ones) were able to perfect the flat video screen (invented
in the mid-1960s by George Heilmeier of RCA) and introduce the screens commercially
Process innovation in portable personal computers (PCs).
The introduction of Innovations can be examined with isoquants. A new or improved product requires an
new or improved entirely new isoquant map showing the various combinations of inputs to produce each
production processes.
level of output of the new or improved product. On the other hand, a process innovation
can be shown by a shift toward the origin of the firm’s given product isoquants, showing
that each level of output can be produced with fewer inputs after the innovation than
before. Unless a firm aggressively and continuously improves its product or production
process, it will inevitably be overtaken by other more innovative firms. To be
successful
in today’s world, firms must adopt a global competitive strategy, which means
that they
must continuously scout the world for new product ideas and processes.
It is also crucial
 CHAPTER 7 Production Theory 211

for firms to have a presence, first through exports and then by local production, in the
world’s major markets. Larger sales mean increasing returns to scale in production and
distribution, and they allow the firm to spend more on research and development and thus
stay ahead of the competition.
The introduction of innovations is stimulated by strong domestic rivalry and geo-
graphic concentration—the former because it forces firms to constantly innovate or else
lose market share (and even risk being driven entirely out of the market), the latter because
it leads to the rapid spread of new ideas and the development of specialized machinery and
other inputs for the industry. Sharp domestic rivalry and great geographic concentration
make Japanese firms in many high-tech industries fierce competitors in the world economy
today.!°
The risk in introducing innovations is usually high. For example, eight of ten new
products fail within a short time of their introduction. Even the most carefully introduced
innovations can fail, as evidenced by the failure of RJR Nabisco’s “smokeless cigarette”
and Coca-Cola’s change in 1985 of its 99-year-old recipe. In general, the introduction of
a new product or concept (such as McDonald’s hamburgers and Sony Walkmans) is more
likely to succeed than changing an existing product (such as launching a new soup,
cheese, or biscuit globally). Product innovations can also die because of poor planning
and unexpected production problems. This happened, for example, to Weyerhauser.
Encouraged by market testing that showed its diaper product was better than competitors’
products and could be produced more cheaply, Weyerhauser introduced its UltraSoft
diapers in 1990, but the product failed within a year because of unexpected production
problems.!!

EXAMPLE 7-4
How Do Firms Get New Technology?

Table 7.4 provides the results of a survey of 650 executives in 130 industries on the
methods that U.S. firms use to acquire new technology. From the table, we see that
the most important method of acquiring product and process innovations is by
independent research and development (R&D) by the firm. The other methods of
acquiring process innovations, arranged in order of decreasing importance, are:
licensing technology by the firms that originally developed the technology, publica-
tions or technical meetings, reverse engineering (i.e., taking the competitive product
apart and devising a method of producing a similar product), hiring employees of
innovating firms, patent disclosures (i.e., from the detailed information available
from the patent office which can be used to develop a similar technology or product
in such a way as not to infringe on the patent), and information from conversations with
employees of innovating firms (who may inadvertently provide secret information in
the course of general conversations). For product innovations, reverse engineering

10 See M. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990); “Competition: How
American Industry Stacks Up Now,” Fortune, April 18, 1994, pp. 52-64; and “The Five Stages of Successful
Innovation,” Sloan Management Review, Spring 2007, pp. 8-9.
'! See “Diaper’s Failure Shows How Poor Plans, Unexpected Woes Can Kill NewProducts,” Wall Street
Journal, October 9, 1990, p. B1.
212 PART THREE Production, Costs, and Competitive Markets

Methods of Acquiring New Technology by

Madame American ims
Rank
Method of
Acquisition Process Innovation Product Innovation

Independent R&D 1 1
Licensing z 3
Publications or 3 =)
technical meetings
Reverse engineering 4 2
Hiring employees of 3 4
innovating firms
Patent disclosures - 6 6
Conversations with 7 7
employees of
innovating firms
—————————————————————————————

Sources: R. E. Levin, “Appropriability, R&D Spending, and Technological Performance,” American

Economic Review, May 1988, pp. 424-428; “Spy vs. Spy: Are Your Company Secrets Safe?” Fortune,
February 17, 1997, p. 136; “P&G Admits Spying on Unilever,” Financial Times, August 31, 2001, p. 17;
and “Speed Demons,” Business Week, March 27, 2007, pp. 69-76.

becomes more important than licensing, and hiring employees from innovating firms
is more important than publications or technical meetings. Last but not least (and
something that firms would hardly admit—except when caught), firms try to obtain
new technology by industrial espionage.

v7 OPEN INNOVATION MODEL

Closed innovation Companies are today increasingly rethinking the ways in which they get new technology
model The situation and bring products to market. In the past, in what we may call the closed innovation
where companies model, companies generated, developed and commercialized for the most part their own
generate, develop, and
ideas, innovations, or technological breakthroughs. Today, many leading companies are
commercialize their
own ideas, innovations,
moving toward an open innovation model, which involves the commercialization of
or technological both its own ideas and innovations as well as the innovations of other firms and deploy-
breakthroughs. ing external as well as internal, or in-house, pathways to market.
Specifically, a firm today seeks to explore ways in which it can utilize external
Open innovation
model The situation
technologies to fill gaps in its businesses and encourage other firms to use its own tech-
where companies nology through licensing agreements, joint ventures, and other arrangements. By doing
commercialize both so, the firm is not constrained by the technologies it develops through its R&D, but it
their own ideas and can use any technology available to develop and introduce new and innovative products
innovations as well as on the market. Similarly, the firm can profit greatly by licensing its own technology to
the innovations of other others.
firms and deploy
external as well as
internal, or in-house,
pathways to market.
 CHAPTER 7 Production Theory 213

eA The old closed innovation model is not dead, but it is increasingly being integrated
Concept Check into the open model by redirecting the scope of the in-house lab R&D toward utilizing
What are the external technologies and finding ways by which firms in other sectors can profitably
advantages of a firm’s utilize the firm’s own technological breakthroughs. !2
operating under an
open innovation model?

EXAMPLE 7-5
Open Innovations at Procter & Gamble

P&G has recently changed its approach to innovation from the closed to the open
model and has since become one of the most aggressive adopters of the latter with the
slogan “Connect & Develop.” One of the first steps that P&G undertook was to create
the position of director of external innovation, with the goal of sourcing 50% of its
innovations from outside the company by 2007, up from an estimated 10% in 2002.
Recently, P&G introduced the SpinBrush, an electric toothbrush that runs on batteries
and sells for about $5, which quickly became the best-selling toothbrush in the United
States and was developed not in its own labs but by four Cleveland entrepreneurs.
P&G also encourages other firms to use its innovations by instituting the policy that
any new idea or innovation not used by the firm within three years can be offered to
others, even competitors, through a licensing agreement, a joint venture, or a fee, so as
not to kill a promising project but to benefit from them.
The ability to rescue “false negatives,’ or projects that initially do not seem
promising by the firm or that fall outside the firm’s main line of business, is an impor-
tant advantage of the open innovation model over the closed one. The classic example
is Xerox Corporation and its Palo Alto Research center (PARC), which developed
many computer hardware and software technologies (such as Ethernet and the graphi-
cal user interface, or GUI) that were not directly applicable to copiers and printers, in
which the company focused, but that were subsequently put to brilliant use by Apple
Computer and Microsoft, without any benefit to Xerox. On the other hand, IBM has
created a patent “commons” that allows open-source software developers to use the
innovations and build on IBM patents without risk of infringement.
Source: L. Huston and N. Sakkab, “Connect and Develop,” Harvard Business Review, March 2006,
pp. 58-66; and “An Open Secret,” The Economist, October 22, 2005, pp. 12-14.

Innovations and the International Competitiveness of U.S. Firms

Product cycle model There has hardly been a technological breakthrough during the past four decades, from
The introduction of TVs to robots, from copiers to fax machines, from semiconductors to flat video screens,
new products by firms that was not made by an American firm or laboratory. According to the product cycle
in. an advanced nation, model, however, firms that first introduce an innovation eventually lose their export
gp are ben Copied market and even their domestic market to foreign imitators who pay lower wages and
and produced by firms
in lower-wage
Pounce 12H. W. Chesbrough, “The Era of Open Innovation,” Sloan Management Review, Spring 2003, pp. 35-41;
“Floodgates Open to a Sea of Ideas,” Financial Times—Special Report on Innovation, June 8, 2005, p. 1; “At
3M, a Struggle Between Efficiency and Creativity,” JN, June 207, pp. 8-22; and “Thinking Outside the
Company’s Box,” New York Times, March 30, 2008, p. 4.
214 PART THREE Production, Costs, and Competitive Markets

leading firms intro-

generally face lower costs. In the meantime, however, technologically
duce even more advanced products and technologies.
of suc-
The problem is that the period during which firms can exploit the benefits
foreign imitators take the mar-
cessful innovations is becoming shorter and shorter before
ket away. In fact, in many cases American discoveries such as the fax machine and the flat
Concept Check
by foreign (Japanese )
How is innovation video screen were first introduced and exploited commercially
related to international firms. Although many American firms remain world leaders in their industries (e.g.,
competitiveness? Boeing in commercial aircraft, IBM in mainframe computers, Hewlett-Packard in laser
printers, Gillette in razors, Coca-Cola in soft drinks, and McDonald’s in fast food—to
mention only a few), firms in many other industries such as steel, automobiles, consumer
electronics, and semiconductors lost international competitiveness to foreign competitors,
especially the Japanese, during the 1970s and 1980s. One important reason for this was that
American firms generally stressed product innovation, whereas Japanese firms stressed
process innovations. Thus, even when American firms were the first to introduce a new
product, Japanese firms were soon able to produce it better and more cheaply and in a few
years were able to outsell American competitors both at home and abroad. Ae
Under the Japanese competitive threat, American firms, especially the high-tech
ones, underwent a fundamental and painful restructuring during the 1980s that returned
them to a position of leadership in their industries during the late 1980s. Xerox was one
of the first U.S. companies to regain its lost competitiveness (see Example 7—6). The “At
Intraindustry trade
the Frontier” section shows how U.S. industry regained the ground lost to the Japanese
International trade in
during the 1970s and 1980s in a wide range of high-tech products as a result of the new
the differentiated
products of the same revolution in computer-aided production that swept America. In any event, most of the
industry or broad trade taking place among industrial nations is now intraindustry trade in differentiated
product group. manufactured products.

EXAMPLE 7-6
How Xerox Lost and Regained Market Share but Is Now Struggling to Remain
Internationally Competitive

The Xerox Corporation was the first to introduce the copying machine in 1959, based
on its patented xerographic technology. Until 1970, Xerox had no competition and
thus had little incentive to reduce manufacturing costs, improve quality, and increase
customers’ satisfaction. Even when Japanese firms entered the low end of the market
with better and cheaper copiers in 1970 and began to take over this segment of the
market, Xerox did not respond, concentrating instead on the mid and high ends of the
market, where profit margins were much higher. Xerox also used the profits from its
copier business to expand into computers and office systems during the second half of
the 1990s. It was not until 1979 that Xerox finally awakened to the seriousness of the
Japanese threat. From so-called competitive benchmarking missions to Japan to com-
pare relative production efficiency and product quality, Xerox was startled to find that
Japanese competitors were producing copiers of higher quality at far lower costs and
were positioning themselves to move up into the more profitable mid- and high-end
segments of the market.

'3 “Tn the Realm of Technology, Japan Seizes a Greater Role,’ New York Time, May
28, 1991, p. Cl
 CHAPTER 7 Production Theory PAIS)

Faced with this life-threatening situation, Xerox, with the help of its Japanese
subsidiary (Fuji Xerox), mounted a strong response that involved reorganization and
integration of development and production, as well as ambitious company wide quality-
control efforts. Employee involvement was greatly increased, suppliers were brought
into the early stages of product design, and inventories and the number of suppliers were
greatly reduced. Constant benchmarking was then used to test progress in the compa-
nywide quality-control program and customer satisfaction. By taking these drastic
actions, Xerox was able to reverse the trend toward loss of market share to Japanese
competitors, even at the low segment of the market during the second half of the 1990s.
History seemed to repeat itself, however, at the beginning of the new decade when
Xerox once again found itself battling Japan’s Canon for supremacy in the new digital
world of office information technology. This, despite the fact that during the second
half of the 1990s Xerox had recast itself as a digital document and solutions company
that combines hardware, software, and services into a service and consulting package,
industry by industry. It is clear that to remain competitive in today’s globalized envi-
ronment requires constant alertness to the competition and continuous innovations on
the part of the firm.
Sources: The MIT Commission on Industrial Productivity, Made in America (Cambridge, MA: MIT
Press, 1989), pp. 270-277; “Japan Is Tough, but Xerox Prevails,’ New York Times, September 3, 1992, p.
D1; “Xerox Recasts Itself as a Formidable Force in Digital Revolution,’ Wall Street Journal, February 2,
1999, p. Al; “Downfall of Xerox,” Business Week, March 5, 2001, pp. 82—92; “Canon Takes Aim at
Xerox,” Fortune, October 14, 2002, pp. 215-220; and “Xerox’s Inventor-in-Chief,’ Fortune, July 9,
2007, pp. 65-72.

AT THE FRONTIER
The New Computer-Aided Production Revolution
and the International Competitiveness of U.S. Firms

Computer-aided ince the early 1990s, a veritable revolution in production has been taking place
design (CAD) The S in the United States, based on computer-aided design and computer-aided
process that allows manufacturing, which has greatly increased the productivity and international com-
research and petitiveness of U.S. firms. Computer-aided design (CAD) allows research and devel-
development
opment engineers to design a new product or component on a computer screen,
engineers to design
a new product or quickly experiment with different alternative designs, and test the strength and relia-
component on a bility of different materials—all on the screen! Then, computer-aided manufac-
computer screen. turing (CAM) issues instructions to a network of integrated machine tools to produce
a prototype of the new or changed product. These developments allow firms to avoid
Computer-aided
many possible production problems, greatly speed up the time required to develop and
manufacturing
(CAM) The introduce new or improved products, and reduce the optimal lot size or the production
computer runs to achieve maximum production efficiency. This revolution has been taking place
instructions to a mostly in the United States, based primarily on its world leadership and superiority in
network of integrated computer software and computer networks.
machine tools to
produce a product. Continued...
216 PART THREE Production, Costs, and Competitive Markets

The New Computer-Aided Production Revolution and the

International Competitiveness of U.S. Firms Continued

These new developments have led to a new digital factory—an information-age

marvel that is responsible for a quantum leap in the speed, flexibility, and productiv-
ity of U.S. firms resulting from the ingenious marriage of computer software and com-
puter networks in industries as diverse as construction equipment, automobiles, PCs,
and electronic pagers. This new digital factory has unheard of agility that allows it to
customize products down to one unit while achieving mass-production speed and effi-
ciency. For example, as a Dell salesperson specifies an order for a PC for a particular
consumer, the digitized data flow to the assembly line where production begins imme-
diately and is completed in a very short time, so that the customer can have his or her
customized PC in a day or two. This is sometimes called software-controlled contin-
uous flow manufacturing—a process that is basically merging manufacturing and
retailing. This much faster time-to-market and customizing capability is beginning to
provide American firms with tremendous advantage over foreign competitors. As a
result, after losing the competitive war during the 1980s and early 1990s, the United
States regained all of its lost ground, and then some, since the mid-1990s.
Computer-aided design (CAD) is dramatically increasing the pace of innovations.
For example, a designer can call up on the screen a car door she may be working on,
test opening and closing the door, run the window up and down, experiment with
Concepts peck lighter materials, and direct machinery to make a prototype door. Such CAD allowed
What
is the relationshi : apa : f :
Rea ons a Chrysler to design and build its highly successful NEON subcompact car in 33 months
CAM and the digital instead of the usual 45 months. Even more exotically, scientists at Caterpillar, the
factory? largest earth-moving equipment builder in the world, test drive huge machinery that
they are developing in virtual reality long before they are built. The Boeing 777jetliner
was developed entirely in this way. CAD is even used to design and simulate entire
assembly lines, and it can be used to send production orders to suppliers’ machinery so
that, in a sense, they become an extension of the firm’s plant. In short, we are likely to
be at the dawn of the biggest revolution in manufacturing since the perfection of the
industrial lathe in the year 1800. And with the U.S. undisputed superiority in soft-
ware, it is unlikely that foreign competitors can easily copy and match the new
American manufacturing genius anytime soon.

Sources: “The Digital Factory,” Fortune, November 14, 1994, pp. 92-110; “The Totally Digital Factory
May Not Be So Far Away,” Financial Times, November 1, 2000, p. XII; “Incredible Shrinking Plants,”
The Economist, February 23, 2002, pp. 71-73; “The Way to the Future,” Business Week, October 11,
2004; and “Speed Demons, Business Week, March 27, 2006, pp. 69-76.

[|_| SUMMARY
1. Production refers to the transformation of resources or inputs into outputs of goods and
services. A firm is an organization that combines and organizes resources for the purpose of
producing goods and services for sale at a profit. In general, the aim of firms is to maximize
profits. Profits refer to the revenue of the firm from the sale of the output after all costs
have
been deducted. Inputs can be broadly classified into labor, capital, and land, and into fixed
and
variable. Entrepreneurship refers to the introduction of new technologies and products
to
exploit perceived profit opportunities. The time period during which at least one
input is fixed
is called the short run. In the long run, all inputs are variable.
 CHAPTER 7 Production Theory 217

2. The production function is a unique relationship between inputs and output. It can be
represented by a table, graph, or equation showing the maximum output or total product (TP)
of a commodity that can be produced per time period with each set of inputs. Average
product (AP) is total product divided by the quantity of the variable input used. Marginal
product (MP) is the change in total output per-unit change in the variable input. The MP is
above the AP when AP is rising, MP is below AP when AP is falling, and MP = AP
when AP is at a maximum. The declining portion of the MP curve reflects the law of
diminishing returns.
3. An isoquant shows the various combinations of two inputs that can be used to produce a
specific level of output. From the isoquant map, we can generate the total product curve of each
input by holding the quantity of the other input constant.
4. Isoquants are negatively sloped in the economically relevant range, convex to the origin,
and do not intersect. The absolute value of the slope of the isoquant is called the marginal
rate of technical substitution (MRTS). This equals the ratio of the marginal product of
the two inputs. As we move down along an isoquant the absolute value of its slope, or
MRTS, declines and the isoquant is convex. Ridge lines separate the relevant (i.e., the
negatively sloped) from the irrelevant (or positively sloped) portions of the isoquants. With
right-angled, or L-shaped, isoquants, inputs can only be combined in fixed proportions in
production.
5. Constant, increasing, and decreasing returns to scale refer to the situation where output
changes, respectively, by the same, by a larger, and by a smaller proportion than do inputs.
Returns to scale can be shown by the spacing of isoquants. Increasing returns to scale arise
because of specialization and division of labor and from using specialized machinery.
Decreasing returns to scale arise primarily because as the scale of operation increases, it
becomes more and more difficult to manage the firm and coordinate its operations and
divisions effectively. In the real world, most industries seem to exhibit near-constant
returns to scale.
6. The introduction of innovations is the single most important determinant of a firm’s long-
term competitiveness. Product innovations refer to the introduction of new or improved
products, while process innovations refer to the introduction of new or improved production
processes. More and more firms are adopting an open, as opposed to a closed, innovation
model, whereby they commercialize both their own ideas and innovations as well as the
innovations of other firms. Since the early 1990s, a veritable revolution in production has
been taking place in the United States based on computer-aided design and computer-aided
manufacturing, which has greatly increased productivity and international competitiveness
of U.S. firms.

| KEY TERMS
Production Total product (7P) Product innovation
Firm Average product (AP) Process innovation
Inputs Marginal product (MP) Closed innovation model
Labor or human resources Law of diminishing returns Open innovation model
Capital or investment goods Isoquant Product cycle model
Land or natural resources Marginal rate of technical substitution Intraindustry trade
Entrepreneurship (MRTS) Computer-aided design
Fixed inputs Ridge lines Computer-aided manufacturing
Variable inputs Constant returns to scale Cobb-Douglas production function
Short run Increasing returns to scale Output elasticity of labor
Long run Decreasing returns to scale Output elasticity of capital
Production function Technological progress Homogeneous of degree 1
218 PART THREE Production, Costs, and Competitive Markets

REVIEW QUESTIONS
— _ Where on the total product and on the marginal product of and 13K, and output increases from 256 units to 300
labor curves of Figure 7.2 does the law of diminishing units? Why?
returns begin to operate? What gives rise to the law of _Can a firm have a production function that exhibits
diminishing returns? increasing, constant, and decreasing returns to scale
2. What does the total product curve look like if diminishing at different levels of output? Explain.
returns set in after the first unit of labor is employed? _Is technical efficiency sufficient to determine at
(S%). Would a rational producer be concerned with the average what point on an isoquant a firm operates?
or the marginal product of an input in deciding whether or Why?
not to hire the input? _Is diminishing returns to a single factor of production
4. Which of the following points (SL and 7K, 3L and 9K, consistent with constant or nonconstant returns
4L and 5K, and 6L and 6K) cannot be on the same to scale?

isoquant? Why? . What is meant by an innovation? What are the different

5. If the marginal product of labor is 6 and the marginal rate types of innovations?
of technical substitution between labor and capital is 1.5, . What is the difference between technological progress
what is the marginal product of capital? and increasing returns to scale?
6. Is the firm facing increasing, constant, or decreasing . What is the difference between an open innovation
returns to scale if it expands the quantity of labor and model and a closed innovation model?
capital used in production from 10L and 10K to 13L . What is meant by the “digital factory”?

PROBLEMS
1. From the following production function, showing the b. the average and the marginal product curves for
bushels of corn raised on one acre of land by varying the labor from the total product curve of 4(a) above.
amount of labor employed (in worker-years), 2), a. From Problem 3, redraw the isoquant for 20 units of
output (20Q) and show how to measure the marginal
rate of technical substitution of labor for capital (i.e.,
MRTS_x) between the point where 2 units of labor and
4 units of capital (i.e., 2L and 4K) are used (call this
a. derive the average and the marginal product point M) and the point where (3L, 2K) are used (call
of labor. this point N). What is the MRTS_x at point N? At point
C (4L, 1.5K)?
b. plot the total, the average, and the marginal product
curves. b. Find the value of the MP; and MPx for a movement
2. Plot again the total product curve of Problem | on the from point N on the isoquant for 20Q and point N’
assumption that labor time is infinitesimally divisible, and (4L, 2K) and N” (3L, 3K) on the isoquant for 25Q,
and show that MRTS,x = MP_/MPx.
derive graphically the corresponding average and marginal
product curves. c. Explain why the MRTS_x falls as we move down
along the isoquant.
3. From the production function given in Table 7.6.
. a. On the isoquant map of Problem 3, draw the ridge
a. derive the isoquants for 8 units of output, 80, 200, lines.
250, 30Q, and 340. b. Explain why a firm would never produce below the
b. what is the relationship between Table 7.6 and the lower ridge line or above the top ridge line.
table in Problem 1? *7, On the same set of axes draw two isoquants, one
4. From the isoquant map of Problem 3(a), derive indicating that the two inputs must be combined in fixed
proportions in production, and the other showing that
a. the total product curve for labor when the quantity of
inputs are perfect substitutes for each other.
capital is held fixed at K = 4.
 CHAPTER 7 Production Theory 219

TABLE 7.6
ZA} | Production Function with Two Variable Inputs

Capital (K) 6 6 18 25 30 30 BS
5) 8 20 30 34 34 30
4 8 20 30 34 34 30 Q
3 6 18 rs) 30 30 PS)
2 4 13 20 25 25 20
t 1 1 3) 7 8 8 7
K
0 1 2 S 4 5 6
if at Labor (L)

*8. If the price of gasoline is $1.50 per gallon and travel b. Does the production function exhibit diminishing
time is worth $6.00 per hour to the individual, returns? If so, when does the law of diminishing
determine at which speed the cost of traveling the 600 returns begin to operate? Could we ever get
miles is minimum in Figure 7.8. negative returns?
9. Does the production function of Problem 3 exhibit constant, | *11. Indicate whether each of the following statements is
increasing, or decreasing returns to scale? Explain. true or false and give the reason.
*10. Suppose that the production function for a commodity a. A student preparing for an examination should not
is given by study after reaching diminishing returns.
QO =10/LK b. If large and small firms operate in the same industry,
: se ae we must have constant returns toscale.
where Q is the quantity of output, L is the quantity of
labor, and K is the quantity of capital: 12. Explain the importance of the new production
revolution for the international competitiveness of
a. Indicate whether this production function exhibits 5
American firms.
constant, increasing, or decreasing returns to scale.

|APPENDIX THE COBB-DOUGLAS PRODUCTION FUNCTION

In this appendix, we present the Cobb-Douglas production function. This is the simplest
and most widely used production function in empirical work today. We begin with the for-
mula, which is followed by a simple illustration. Next we consider the methods available
to empirically estimate the Cobb-Douglas production function and some of the difficul-
ties involved. We conclude with some empirical results.

Cobb-Douglas The Formula

production function The formula for the Cobb-Douglas production function is ve

The relationship Res Tere
between inputs and
output expressed by
= AL*K®, where O ¥ ‘ F :
Satie Lis labor where Q = output in physical units, L = quantity of labor, K = quantity of capital, and A,
and K is capital. a (alpha), and f (beta) are positive parameters estimated in each case from the data. The

* — Answer provided at end of book.

220 PART THREE Production, Costs, and Competitive Markets

technology, the greater the

parameter A refers to technology. The more advanced the
value of A. The parameter a refers to the percent age increase in Q for a 1% increase 1n L,
while holding K constant. Thus, @ is the output elastici ty of labor. For example, if
Output elasticity of
labor The percentage a = 0.7, this means that a 1% increase in the quantity of labor used (while holding the
increase in output quantity of capital constant) leads to a 0.7% increase in output. Thus, the output elastic-
resulting from a 1% ity of labor (q) is 0.7. Similarly, the parameter 6 refers to the percent age increase in Q for
increase in the quantity
a 1% increase in K, while holding L constant. Thus, f is the output elastici ty of capital.
of labor used. in K, while holding L constant,
For example, if 8 = 0.3, this means that a 1% increase
Output elasticity of leads to a 0.3% increase in Q. Thus, the output elastici ty of K (B) is 0.3.
capital The percentage In the above example, a + 8 = 0.7 + 0.3 = 1. Thus, we have constant returns to
increase in output scale. That is, a 1% increase in both L and K leads to a 1% increase in Q. Specifically, a
resulting from a 1%
1% increase in L, by itself, leads to a 0.7% increase in Q; a 1% increase in K, by itself,
increase in the quantity
leads to a 0.3% increase in Q. Thus, with an increase of both L and K by 1%, Q increases
of capital used.
by a total of 1% also and we have constant returns to scale. Another name for constant
Homogeneous of returns to scale is homogeneous of degree 1.
degree 1 In production, _ On the other hand, if a + B > 1, we have increasing returns to scale. That {Sea la
it refers to constant increase in L and K leads to a greater than 1% increase in Q. For example, if
returns to scale. 1.1% increase in
a = 0.8 and B = 0.3, a 1% increase in L and K leads to a 0.8 + 0.3 =
Q. Finally, if ~«+ B < 1, we have decreasing returns to scale (i.e., an increase in L and K
by 1% leads to an increase in Q of less than 1%).

Illustration
Suppose A = 10, a = 6 = 1/2, and K = 4 and is held constant (so that we are dealing
with the short run). By substituting these values into equation [7.5], we get

QO = 10L"/241/2 = 10/4/L = 20V/L [7.5A]

By then substituting alternative quantities of L used in production into equation

[7.5A], we derive the total product (7P) schedule, and from it, the average product of
labor (AP_) and the marginal product of labor (MP_) schedules. The results are given in
Table 7.7.
Plotting the 7P, the AP;, and the MP; schedules of Table 7.7 as Figure 7.10, we see
that the Cobb-Douglas production function exhibits diminishing AP; and MP, from the
very start or with the first unit of L used, and that the MP; never becomes negative. Note
that the MP, is plotted between the various quantities of labor used. The AP, and the MP;
are functions of or depend only on the K/L ratio. That is, they remain the same regardless
of how much L and K are used in production as long as the K/L ratio remains the same
(as along any given ray from the origin).!4
In the long run, both L and K are variable. Thus,

O = 101K SO)
in = ON EER [7.5B]
Since a + B=0.5 + 0.5 = 1 in this case, we have constant returns to scale. This is shown
in Table 7.8. Here, output grows at the same rate as the rate of increase in both inputs.
For example, doubling the quantity of labor and capital used, from 1 to 2 units, doubles

14 ThisThi g is3 proved in

: more advanced texts.
 CHAPTER 7 Production Theory 221

TABLE 7.7 Total, Average, and Marginal Product of Labor

L TP AP, MP,
0 0 eels
1 20.00 20.00 20.00
2 28.28 14.14 8.28
3 34.64 11.55 6.36
4 40.00 10.00 5:50
5 44.72 8.94 4.72

Tie

AP,

[stint tl |Seer eee | ee sgl

0 1 2 8 4 5 L,K=4

FIGURE 7.10 Total, Average, and Marginal Product of Labor for the Cobb-Douglas
Production Function — This figure shows the /P, the AP;, and the MP, schedules given in
Table 7.7. From the figure, we see that the AP, and the MP, decline from the very start and
the MP, never becomes negative for the Cobb-Douglas production function. Note that
the MP, is plotted between the various quantities of labor used and capital is held constant
atK =4.
222 PART THREE Production, Costs, and Competitive Markets

¥A:3 Production in the Long Run

TABLE 7.8|

L K 10°V (L)(M) Q
0 0 10./(0) (0) 0
1 1 10./() (1) 10
> 2 10./(2) 2) 20
3 3 10./G)G) 30
4 4 10./(4)4) 40
5 g 10/G)) 50

output from 10 to 20 units. Increasing L and K by 50%, from 2 to 3 units, increases Q by

50% from 20 to 30 units, and so on.
We can also define the isoquants for this Cobb-Douglas production function. For
example, the isoquant for 50Q can be defined by substituting 50 for Q in equation [7aB}
By then substituting various quantities of labor into the resulting equation, we get the cor-
responding quantities of capital required to produce the 50Q:

50 = 10/LK
5=J/LK
25=LK [7.5C]

Thus, if (= 10, K=2.5;1t (== 5, K = Ss if D2 OK = 410 5and So one Cthientscmmaints

can be similarly derived. Isoquants are parallel along any ray from the origin and are
equally spaced to reflect constant returns to scale (as in the left panel of Figure 7.9).

Empirical Estimation
One method of estimating the parameters of the Cobb—Douglas production function (i.e.,
A, a, and £) is to apply statistical (i.e., regression) analysis to time series data on the
inputs used and the output produced.!° For example, the researcher may collect data on
the number of automobiles produced by an automaker in each year from 1951 to 1997 and
on the quantity of labor and capital used in each year to produce the automobiles. The
data are usually transformed into natural logarithms (indicated by the symbol In) and the
regression analysis is conducted on the transformed data. The form of the estimated
Cobb-Douglas production function is then

InQ=InA+alnL+fhInK [7.5D]
The researcher thus obtains an estimate of the value of In A, a, and B.!° Of primary inter-
est to the researcher is the value of a and £.!7
Another method of estimating the value of A, a, and B is by regression analysis using
cross-section data. In this case, the researcher collects data for a given year (or other time

'S For a general discussion of regression analysis, see the appendix to Chapter 5.
'© The value of parameter A can then be obtained by finding the antilog of In A.
alr Cobb-Douglas time series estimates, technological progress must also be accounted
for. This is usually
accomplished by including time (f) as an additional explanatory variable in equation [7.5D].
 CHAPTER 7 Production Theory 223

unit) for each of many producers or firms in a particular industry on the quantity of labor
and capital used and the output produced. That is, instead of collecting data for one firm
over many years (time series), the researcher now collects data for a given year for many
firms in the same industry (cross section). As in the previous case, the researcher usually
first transforms the data into natural logarithms and then estimates equation [7.5D] by
regression analysis to obtain the values of parameters A, a, and f. Once again the
researcher is primarily interested in the values of w and f. Table 7.9 in Example 7-7 pre-
sents the values of w and £ estimated for various U.S. manufacturing industries.!*
Input—output relationships can also be obtained from engineering studies. All of these
methods (1.e., regression analysis using time series or cross-section data and engineering
studies) face difficulties. One of these is that we must assume that the best production tech-
niques are used by all firms at all times. Due to a lack of information or erroneous deci-
sions, this may not be the case. Another difficulty arises in the measurement of the capital
input, since machinery and equipment are of different types, ages (vintage), and produc-
tivities. A further shortcoming characteristic of engineering studies is that they typically
cover only some production activities of the firm. Despite these and other problems,
numerous studies have been conducted over the years using these different approaches.
They have provided very useful information on production for the entire economy and for
various industries.

EXAMPLE 7-7
Output Elasticity of Labor and Capital and Returns to Scale in U.S.
and Canadian Manufacturing

Table 7.9 reports the estimated output elasticities of labor (a) and capital (8) for various
U.S. manufacturing industries. The value of a = 0.90 for furniture means that a 1%
increase in the quantity of labor used (holding K constant) results in a 0.90% increase in
the quantity produced of furniture. The value of 6 = 0.21 means that a 1% increase in K
(holding L constant) increases Q by 0.21%. Increasing both L and K by 1% increases Q
by 0.90 + 0.21 = 1.11%. This means that the production of furniture is subject to
increasing returns to scale.
The values of a and f reported in Table 7.9 were estimated by regression analysis
using cross-section data for many firms in each industry for the year 1957. The value
of a ranges from 0.51 for food and beverages to 0.96 for leather. This is the output
elasticity of production and nonproduction workers combined. The value of B ranges
from 0.08 for leather to 0.56 for food and beverages. Note that most industries exhibit
close-to-constant returns to scale (i.e., the value of a + f is close to 1).
A similar study for 107 Canadian industries found that in 1979 the value of
ranged from 0.04 for watches and clocks to 1.26 for distilleries, the value of 8 ranged
from 0.02 for flour and breakfast cereal products to 1.36 for glass manufacturers,
while the values of a + B ranged from 2.20 (very strong economies of scale) for
the feed industry to 0.82 (relatively strong diseconomies of scale) for tread mill.

18 Data for many firms in each of the various U.S. manufacturing industries for the year 1957 were used to
estimate the values of a and f for each industry. Thus, these are cross-section estimates.
224 PART THREE Production, Costs, and Competitive Markets

Estimated Output Elasticity of Labor (a)

TABLE 7.9 and Capital (8) in U.S. Manufacturing

Industry aL B ORs

Furniture 0.90 0.21 eld

Chemicals 0.89 0.20 1.09
Printing 0.62 0.46 1.08
Food, beverages 0.51 0.56 1.07
Rubber, plastics 0.58 0.48 1.06
Instruments 0.84 0.20 1.04
Lumber 0.65 0.39 1.04
Apparel 0.91 0.13 1.04
Leather 0.96 0.08 1.04
Electrical machinery 0.66 0.37 1.03
Nonelectrical machinery 0.62 0.40 1.02
Transport equipment 0.79 0.23 1.02
Textiles 0.88 On 1.00
Paper pulp 0.56 0.42 0.98
Primary metals 0.59 0.37 0.96
Petroleum 0.64 0.31 0.95

Sources: J. Moroney, “Cobb—Douglas Production Functions and Returns to Scale in U.S.

Manufacturing Industry,’ Western Economic Journal, December 1967; and J. R. Baldwin and P. K.
Goreki, The Role of Scale in Canada/U.S. Productivity Differences in the Manufacturing Sector,
1970-1979 (Toronto: Toronto University Press, 1986).

Thus, Canadian manufacturing industries seemed to exhibit a wider range of output

elasticities of labor and capital as well as a wider range of economies and disec-
onomies of scale than U.S. firms.

INTERNET SITE ADDRESSES

For world’s food production and consumption, see: Chrysler: http://www.chrysler.com
http://en. wikipedia.org/wiki/Thomas_Malthus Toyota: http://www.Toyota.com
http://www. fao.org/DOCREP/005/Y 4252E/y4252e05.htm For the open innovation model, see:
For gasoline consumption and substitution, see: http://en.wikipedia.org/wiki/Open_Innovation
http://www.techstandards.co.uk/system/index.html http://www.pdma.org/visions/apr06/
http://sciway.net/statistics/scsa98/en/en17.html open-innovation-primer.php
For production, employment, and earnings information on For competition between Xerox and Canon, see:
General Motors, see: Canon: http://www.usa.canon.com
http://www.npr.org/templates/story/ Xerox: http://www.xerox.com
story.php ?storyId=98 14470 For computer-aided design (CAD) and computer-aided
http://seekingalpha.com/article/296 14 manufacturing (CAM), see:
http://money.cnn.com/2005/06/07/news/fortune500/ Microsoft: http://www.microsoft.com
gm_closings/ Motorola: http://www.mot.com
General Motors: http://www.gm.com Dell: http://www.dell.com
For information on Ford, Chrysler, and Toyota, see: Caterpillar: http://www.caterpillar.com
Ford: http://www.ford.com
 CHAPTER ©

Costs of Production
Chapter Outline Long-Run Average Cost Curve in Electricity
8.1 The Nature of Production Costs Generation
8.2 Cost in the Short Run Shape of the Long-Run Average Cost Curves in
8.3 Cost in the Long Run Various Industries
8.4 Expansion Path and Long-Run Cost Curves Minimum Efficient Scale in Various U.S. Food
8.5 Shape of the Long-Run Average Cost Curve Industries
8.6 Multiproduct Firms and Dynamic Changes in Learning Curve for the Lockheed L-1011
Costs 7 Aircraft and for Semiconductors
At the Frontier: Minimizing Costs Internationally—
List of Examples The New Economies of Scale
8-1 Cost of Attending College Elasticity of Substitution in Japanese
8—2 Per-Unit Cost Curves in Corn Production and in Manufacturing Industries
Traveling
8—3 Least-Cost Combination of Gasoline and
Driving Time

After Studying This Chapter, You Should Be Able to:

e Know the meaning of explicit, implicit, and opportunity costs
e Describe how to derive the short-run and the long-run cost curves of a firm
e Know the meaning and importance of economies of scope and learning curves
e Know the meaning and importance of the new international economies of scale
e Descibe the effect of a change in input prices on production and costs

n this chapter, we consider the costs of production of the firm and their relationship to
production theory (presented in Chapter 7). After examining the nature of costs, we
derive short-run and long-run cost curves for the firm. These curves will be used to
determine the profit-maximizing level of output for a perfectly competitive firm in Chapter
9 and for imperfectly competitive firms in Chapters 10-11. This chapter also introduces
economies of scope and learning curves. The many real-world examples highlight the
importance and relevance of the analysis, while the “At the Frontier” section examines
the growing importance of international economies of scale. In the optional appendix, we
examine in a more technical way the relationship between production and costs and the
effect of input-price changes on production and costs.

225
226 PART THREE Production, Costs, and Competitive Markets

811 THe NATURE OF PRODUCTION COSTS

the firm on
From the firm’s production function (showing the input combinations that
inputs, we can derive the firm S
use to produce various levels of output) and the price of
the firm would incur 1n pro-
cost functions. These functions show the minimum costs that
the firm is too small to
ducing various levels of output. For simplicity, we assume that
constant regardles s
affect the prices of the inputs it uses. Thus, the prices of inputs remain
of the quantity demanded by the firm. (The determination of input prices when the firm
does and does not affect input prices is discussed in Part Five, Chapters 14-16.)
Explicit costs The In economics, costs include explicit and implicit costs. Explicit costs are the actual
actual expenditures of out-of-pocket expenditures of the firm to purchase or hire the inputs it requires in produc-
the firm to purchase or tion. These expenditures include the wages to hire labor, interest on borrowed capital, rent
hire inputs.
on land and buildings, and the expenditures on raw and semifinished materials. Implicit
Implicit costs The costs refer to the value of the inputs owned and used by the firm in its own production
value of the inputs processes. The value of these owned inputs must be imputed or estimated from what these
owned and used by the inputs could earn in their best alternative use.
firm.
‘ Implicit costs include the maximum wages that the entrepreneur could earn in work-
ing for someone else in a similar capacity (say, as the manager of another firm), and the
highest return that the firm could obtain from investing its capital elsewhere and renting
out its land and other inputs to others. The inputs owned and used by the firm in its own
production processes are not free to the firm, even though the firm can use them without
any actual or explicit expenditures. Accountants traditionally include only actual expen-
ditures in costs, whereas economists always include both explicit and implicit costs, or
opportunity costs.!
Opportunity cost The opportunity cost to a firm in using any input is what the input could earn in its
What an input could best alternative use (outside the firm). This is true for inputs purchased or hired by the
earn in its best firm as well as for inputs owned and used by the firm in its own production. For example,
alternative use.
a firm must pay wages of $20,000 per year to one of its employees if that is the amount
the worker would earn in his or her best alternative occupation in another firm. If this firm
Alternative or attempted to pay less, the worker would simply seek employment in the other firm.
opportunity cost Similarly, if the entrepreneur could earn more in managing another firm than in directing
doctrine The doctrine
his or her own firm, it would not make much economic sense to continue to be self-
that postulates that the
employed.” Thus, for a firm to retain any input for its own use, it must include as a cost
cost to a firm in using
any input is what the
the opportunity cost that the input could earn in its best alternative use or employment.
input could earn in its This is the alternative or opportunity cost doctrine. Similarly, the opportunity cost of
best alternative use. attending college includes not only the explicit cost of tuition, books, and so on, but also
the foregone earnings of not working (see Example 8-1).
Private costs The Costs are also classified into private and social. Private costs are the opportunity
costs incurred by costs incurred by individuals and firms in the process of producing goods and services.
individuals and firms.
Social costs are the costs incurred by society as a whole. Social costs are higher than pri-
vate costs when firms are able to escape some of the economic costs of production. For
Social costs The costs example, a firm dumping untreated waste into the air imposes a cost on society (in the
incurred by society as a form of higher cleaning bills, more breathing ailments, and so on) that is not reflected in
whole.

' For tax purposes, the accountant’s definition of costs, which includes only explicit costs, is
usually used.
HOWEVER, in economics, we must always consider both explicit and implicit, or opportunity
costs.
eBThis is true unless the individual valued the freedom associated with being
self-employed more than the
extra income in managing a similar firm for someone else.
 CHAPTER 8 Costs of Production DONT,

the costs of the firm. Private costs can be made equal to social costs by public regulation
Concept Check requiring the firm to install antipollution equipment. In this and subsequent chapters, we
Why must implicit will be primarily concerned with private costs. Social costs will be examined in detail in
costs be taken into Chapter 18.
consideration in
reaching correct
economic decisions?

EXAMPLE 8-1
Cost of Attending College

Table 8.1 reports the average annual explicit and implicit or opportunity costs of attend-
ing a four-year public or private college for residents, commuters, and out-of-state
students in the United States during the 2007-2008 academic year.
Explicit costs include tuition and fees, books and supplies, room and board, trans-
portation, and other expenses. The data show that the explicit costs of attending a pri-
vate college are much higher than for state residents attending a public college and
marginally higher for out-of-state residents attending a public college.
The implicit costs of attending college are the student’s earnings foregone by
attending college rather than entering the labor force. The average entering wage for a
high school graduate without any training or work experience is about $15,080. This
represents, respectively, 87% of the explicit costs of attending a four-year public col-
lege for state residents, 84% for commuters, and 54% for out-of-state residents. The
implicit costs of attending a four-year private college are about 43% of the explicit
costs for residents and commuters.

TABLE 8.1|
‘sam Annual Cost of Attending College
Four-Year Public Four-Year Private
In-State Out-of-State
Resident Commuter Resident Resident Commuter

Explicit costs
Tuition and fees $6,185 $6,185 $16,640 $23,712 $23,712
Books and supplies 988 988 988 988 988
Room and board 7,404 7,419 7,404 8,595 7,499
Transportation 911 1,284 911 768 1,138
Other expenses 1,848 2,138 1,848 He et 1,664
Total expenses $17,336 $18,014 $27,791 $35,374 $35,001
Implicit costs

Foregone earnings $15,080 $15,080 $15,080 $15,080 $15,080

Total opportunity costs $31,437 $32,047 $41,384 $48,381 $48,165

Implicit costs as a %
of explicit costs 87% 84% 54% 43% 43%
LG SESSA AT A ne ne eS ae

Source: College Board, Trends in College Pricing (Washington, DC: 2007), p. 7.

228 PART THREE Production, Costs, and Competitive Markets

[|8.2| COST IN THE SHORT RUN

In this section, we examine the theory of cost in the short run. We first define fixed, vari-
able, and total costs and draw these total cost curves. We then define average fixed cost,
average variable cost, average total cost, and marginal cost and draw these per-unit cost
curves. Finally, we show how per-unit cost curves can be derived graphically from the
corresponding total cost curves.

Total Costs
In the short run, some inputs are fixed and some are variable; this leads to fixed and variable
Total fixed costs costs. Total fixed costs (TFC) are the total obligations of the firm per time period for all
(TFC) The total fixed inputs. These fixed or sunk costs include payments for renting the plant and equip-
obligations of a firm ment (or the depreciation on plant and equipment if the firm owns them), most kinds of
per time period for all
insurance, property taxes, and some salaries (such as those of top management, which are
fixed inputs.
fixed by contract and must be paid over the life of the contract whether the firm produces or
not). Fixed costs are sometimes referred to as sunk costs by economists and overhead costs
Total variable costs by business people. Total variable costs (TVC) are the total obligations of the firm per time
(TVC) The total period for all the variable inputs of the firm. These include payments for raw materials,
obligations of a firm fuels, most types of labor, excise taxes, and so on. Total costs (TC) equal TFC plus TVC.
per time period for all
Within the limits imposed by the given plant, the firm can vary its output in the short
the variable inputs the
run by varying the quantity of the variable inputs used per period of time. This gives rise
firm uses.
to TFC, TVC, and TC schedules and curves. These show, respectively, the minimum fixed,
Total costs (TC) TFC variable, and total costs of producing the various levels of output in the short run. In defin-
plus TVC. ing these cost schedules and curves, all inputs are valued at their opportunity cost, which
includes both explicit and implicit costs.
Table 8.2 presents hypothetical TFC, TVC, and TC schedules. These schedules are
then plotted in Figure 8.1. From Table 8.2, we see that TFC are $30 regardless of the level
of output. This is reflected in Figure 8.1 in the horizontal TFC curve at the level of $30.
TVC are zero when output is zero and rise as output rises. The shape of the TVC curve fol-
lows directly from the law of diminishing returns. Up to point W’ (the point of inflection),
the firm uses so little of the variable inputs with the fixed inputs that the law of diminish-
ing returns is not yet operating. As a result, the TVC curve faces downward or rises at a
decreasing rate. Past point W’ (i.e., for output levels greater than 1.5), the law of diminish-
ing returns operates and the TVC curve faces upward or rises at an increasing rate. Since

TABLE 8.2
wae | Fixed, Variable, and Total Costs

Quantity of Total Fixed Total Variable Total

Output Costs Costs Costs
0 $30 $0 $30
| 30 20 50
2 30 30 60
3 30 45 WS
4 30 80 110
) 30 145 175
 CHAPTER 8 Costs of Production 229

Costs ($)

180

150

90

60

30

Output (Q)
FIGURE 8.1 Total Cost Curves The total fixed cost (TFC) curve is horizontal at the level of
$30, regardless of the level of output. The total variable costs (TVC) are zero when output is zero
and rise as output rises. Past point W’, the law of diminishing returns operates and the 7VC curve
faces upward or rises at an increasing rate. Total costs (TC) equal TFC plus TVC. Thus, the 7C curve
has the same shape as the 7VC curve but is $30 above it at each output level.

TC = TFC +TVC, the TC curve has the same shape as the TVC curve but is $30 (the TFC)
above it at each output level.

Average fixed cost Per-Unit Costs

(AFC) Total fixed
costs divided by output. From total costs we can derive per-unit costs. These are even more important in the short-
run analysis of the firm. Average fixed cost (AFC) equals total fixed costs divided by out-
Average variable cost put. Average variable cost (AVC) equals total variable costs divided by output. Average
(AVC) Total variable total cost (ATC) equals total costs divided by output. ATC also equals AFC plus AVC.
costs divided by output. Marginal cost (MC) equals the change in TC or in TVC per unit change in output.
Table 8.3 presents the per-unit cost schedules derived from the corresponding total
Average total cost cost schedules of Table 8.2. The AFC values given in column 5 are obtained by dividing
(ATC) Total costs the TFC values in column 2 by the quantity of output in column 1. AVC (column 6) equals
divided by output. Also TVC (column 3) divided by output (column 1). ATC (column 7) equals TC (column 4)
equals AFC + AVC. divided by output (column 1). ATC also equals AFC plus AVC. MC (column 8) is given by
the change in TVC (column 3) or in TC (column 4) per unit change in output (column 1).
Marginal Cost (MC) Thus, MC does not depend on TFC.
The change in total The per-unit cost schedules given in Table 8.3 are plotted in Figure 8.2. Note that MC
costs. is plotted between the various levels of output. From Table 8.3 and Figure 8.2, we see that
230 PART THREE Production, Costs, and Competitive Markets

yew Total and Per-Unit Costs

TABLE 8.3}
Average Average Average .
Total Total
Total Fixed Variable Total ted
Quantity Fixed Variable
Costs Cost Cost an nm
of Output Costs Costs
(3) (4) (5) (6) (
(1) (2)

$20 $50 $30 $20 $50

I $30
30 60 15 15 30 1
D) 30
45 75 10 15 25 15
3 30
30 80 110 750 20 27.50 35
4
30 145 175 6 29 35 65
5
ee

Per-unit costs ($)

- 65

60

Or

Output (Q)
FIGURE 8.2 Per-Unit Cost Curves The average fixed cost (AFC) curve falls continuously, while the average
variable cost (AVC), average total cost (A7C), and marginal cost (MC) curves are U-shaped. The MC is plotted
between the various output levels. The ATC curve falls as long as the decline in AFC exceeds the rise in AVC.
The rising portion of the MC curve intersects from below the AVC and the ATC curves at their lowest point.
 CHAPTER 8 Costs of Production 231

the AFC curve falls continuously, while the AVC, ATC, and MC curves first fall and then
rise (i.e., they are U-shaped). Since the vertical distance between the ATC and the AVC
curve equals AFC, a separate AFC curve is superfluous and can be omitted from the
figure.
The reason the AVC curve is U-shaped can be explained as follows. With labor as the
only variable input in the short run, TVC for any output level (Q) equals the given wage
rate (w) times the quantity of labor (L) used. Then,

TVC wL Ww WwW i
A = — — —— a i
i 222 be NTs me ) ee
With w constant and from our knowledge (from Section 7.2) that the average physical prod-
uct of labor (AP; or Q/L) usually rises first, reaches a maximum, and then falls, it follows
that the AVC curve first falls, reaches a minimum, and then rises. Thus, the AVC curve is the
monetized mirror image, reciprocal, or “dual” of the AP; curve. Since the AVC curve is
U-shaped, the ATC curve is also U-shaped. The ATC curve continues to fall after the AVC
curve begins to rise because, for a while, the decline in AFC exceeds the rise in AVC (see
Figure 8.2).
The U-shape of the MC curve can similarly be explained as follows:

Concept Check
Why is the shape of the
MC =
ATVC = A@L) WAL) = BD =
w =a(7] [8.2]
marginal cost curve the AQ AQ AQ AQ/AL MP, MP,
opposite of that of the
marginal product
curve? Since the marginal product of labor (MP, or AQ/AL) first rises, reaches a maximum,
and then falls, it follows that the MC curve first falls, reaches a minimum, and then rises.
Thus, the rising portion of the MC curve reflects the operation of the law of diminishing
returns.?
The MC curve reaches its minimum point at a smaller level of output than the AVC
and the ATC curves, and it intersects from below the AVC and the ATC curves at their low-
Concept Check
Why does the marginal
est points (see Figure 8.2). The reason is that for average costs to fall, the marginal cost
cost curve intersect the must be lower. For average costs to rise, the marginal cost must be higher. Also, for aver-
average variable curve age costs neither to fall nor rise (i.e., to be at their lowest point), the marginal cost must
and the average total be equal to them. Although the AVC, ATC, and MC curves are U-shaped, they sometimes
costs curves at their have a fairly flat bottom (see Example 8-2).
lowest point?

Geometry of Per-Unit Cost Curves

The shapes of the per-unit cost curves are determined by the shapes of the corresponding
total cost curves. The AVC and ATC are given, respectively, by the slope of a line (ray)
from the origin to the TVC and TC curves, while the MC is given by the slope of the TC
and the TVC curves. This is similar to the derivation of the average and marginal product
curves from the total product curve in Section 7.2.
Figure 8.3 shows that the AVC at | and 4 units of output (Q) is given by the slope of
ray OY, which is $20. Note that the slope of a ray from the origin to the TVC curve in the

3 If factor prices increased, the MC and the other cost curves would shift up, as shown in the appendix to this
chapter.
232 PART THREE Production, Costs, and Competitive Markets

Costs ($)

180

150

120

30
20

| |
0 ] 9 3 4 5 Output (Q)

Per-unit costs ($) MC

2) |=

30 |= ATC

20 e
AVG
PAU)

NS) j=

| | | | | |
0 0.5 1 Di ph Puli 28} 3.5 4 5 Output (Q)
FIGURE 8.3 Graphic Derivation of Per-Unit Cost Curves The AVC and ATC are given, respectively,
by the slope of a line from the origin to the TVC and TC curves, while the MC curve is given by the Slope
of the TC or TVC curves. The slope of a ray from the origin to the TVC curve (the AVC) falls up to pointZ
and rises thereafter. The slope of a ray from the origin to the TC curve (the ATC) falls up to point C and
rises thereafter. The slope of the TC and TVC curves (the MC) falls up to point W and W’, respectively,
and then rises and intersects from below the AVC and the ATC curves at their lowest points.
 CHAPTER 8 Costs of Production 233

top panel falls up to point Z (where the ray from the origin is tangent to the TVC curve)
and then rises. Thus, the AVC curve in the bottom panel falls up to point Z’ (i.e., up to
Q = 2.5) and rises thereafter. The bottom panel of Figure 8.3 also shows that the ATC at
Q = 3 is $25 (the slope of ray OC in the top panel). Note that the slope of a ray from the
origin to the TC curve falls up to point C (where the ray from the origin is tangent to the
TC curve) and then rises. Thus, the ATC curve falls up to point C’ (i.e., up to Q = 3) and
rises thereafter.
The top panel of Figure 8.3 also shows that the slope of the TC and TVC curves falls up
to point Wand W’ (the points of inflection) on the TC and TVC curves, respectively, and then
rises. Thus, the MC curve in the bottom panel falls up to W” and rises thereafter. At point Z,
the MC and AVC are both equal to the slope of ray OZ. This is $35/2.5, or $14, and equals
the lowest AVC. At point C, the MC and ATC are both equal to the slope of ray OC. This is
$75/3, or $25, and equals the lowest ATC. Note that the AVC, ATC, and MC curves derived
geometrically in Figure 8.3 are identical to those in Figure 8.2 and correspond to the values
in Table 8.3.
Not shown in Figure 8.3 (in order not to complicate the figure unnecessarily) is the
geometrical derivation of the AFC curve. This, however, is very simple. For example, turn-
ing back for a moment to Figure 8.1, we can see that the AFC for one unit of output is equal
to the slope of the ray from the origin to Q = | on the TFC = $30 curve. This is $30/1, or
$30. At Q = 2, AFC = $30/2 = $15. At O = 3, AFC = $30/3 = $10, and so on. Note that
because TFC are constant, AFC falls continuously as output rises. Thus, the AFC curve is a
rectangular hyperbola (see Figure 8.2). As pointed out earlier, AFC is equal to the vertical
distance between the ATC curve and the AVC curve, and so a separate AFC curve is not
really necessary.

EXAMPLE 8-2
Per-Unit Cost Curves in Corn Production and in Traveling

Figure 8.4 shows the actual estimated AVC, ATC, and MC per bushel of corn raised on
central Iowa farms. The per-unit cost curves in the figure have the same general shape
as the typical curves examined earlier, but with flatter bottoms. Once MC starts rising, it
does so very rapidly. This is true not only in raising corn but also in many other cases.
For example, traveling costs (in terms of travel time) rise very steeply during peak hours
on highways. Similarly, landing costs (in terms of landing time) at airports also rise
rapidly during peak hours (3-5 P.M.).

Sources: D. Suits, “Agriculture,” in W. Adams and J. Brock (eds.), The Structure of the American Economy
(Englewood Cliffs, NJ: Prentice-Hall, 1995), p. 12; A. Carlin and R. Park, “Marginal Cost Pricing of Airport
Runway Capacity,” American Economic Review, June 1970; M. Samuel, “Traffic Congestion: A Solvable
Problem,” Issues in Technology, Spring 1999; and “What’s the Toll? It Depends on the Time of Day,”
New York Times, Business Review, February 11, 2007, p. 7.
234 PART THREE Production, Costs, and Competitive Markets

bushel
$/bushe fie

AIG
0.70 |—

0:507= AVC

Os0n=
FIGURE 8.4 Average and Marginal Cost Curves in
Corn Production This figure shows the actual AVC, wee , | :
ATC, and MC curves per bushel of corn raised on lowa i —W 30 40 50
farms. These curves have flat bottoms, and the MC
curve rises steeply. Thousand bushels
hel

CosT IN THE LONG RUN

In the long run, all inputs and costs are variable; that is, there are no fixed inputs and no
fixed costs. In this section, we define isocost lines and examine how a firm chooses the
combination of inputs to minimize the cost of producing a given level of output when all
factors are variable.

Isocost Lines
Suppose that a firm uses only labor and capital in production. Then the total cost (TC) of
the firm for the use of a specific quantity of labor and capital is equal to the price of labor
(w or the wage rate) times the quantity of labor hired (L), plus the price of capital (r or the
rental price of capital) times the quantity of capital rented (K). If the firm owns the capital,
r is the rent foregone from not renting out the capital (such as machinery) to others. The
total cost of the firm can thus be expressed as

TC=wL+rK [8.3]

That is, the total cost (TC) is equal to the amount that the firm spends on labor (wL) plus
the amount that the firm spends on capital (rK).
Given the wage rate of labor (w), the rental price of capital (r), and a particular total
Isocost line Shows the cost (TC), we can define an isocost line or equal-cost line. This shows the various com-
various combinations of —_binations of labor and capital that the firm can hire or rent for the given total cost. For
i uae ee example, for TC= $80, w = $10, and r = $10, the firm could either hire 8Z or rent 8K,
Perron or any combination of L and K shown on isocost line RS in the left panel of Figure 8.5.
For each unit of capital the firm gives up, it can hire one more unit of labor. Thus,
the
slope of isocost line RS is —1.
 CHAPTER 8 Costs of Production 235

a at
is
aiar}
S
4AE-

| S ‘
0) 4 8 0 4 8 10 WS) JL,

Labor (L)

FIGURE 8.5 Isocost Lines With capital measured along the vertical axis, for 7C; = $80 and w=r= $10,
the Y-intercept of the isocost line is 7C,/r = $80/$10 = 8K and the slope is —w/r = —$10/$10 = —1. This
gives budget line RS in the left and right panels. With 7C> = $100 and unchanged w = r = $10, we have
isocost line R’S’, with Y-intercept of TC2/r = $100/$10 = 10K and slope of —w/r = —$10/$10 = —1 in
the right panel. With 7C; = $80 andr = $10 but w = $5, we have isocost line RT with slope of —1/2.

By subtracting wl from both sides of equation [8.3] and then dividing by r, we get
the general equation of an isocost line in the following more useful form:

K=TC/r —(w/nL [8.4]

The first term on the right-hand side of equation [8.4] is the vertical or Y-intercept of the
isocost line, and —w/r is the slope. Thus, for TC; = $80 and w = r = $10, the vertical or
Y-intercept is TC,/r= $80/$10 = 8K, and the slope is —w/r = —$10/$10 = —1 (see iso-
cost line RS in the left panel of Figure 8.5).
A different total cost will define a different but parallel isocost line, while a differ-
ent relative price of an input will define an isocost line with a different slope. For exam-
ple, an increase in total expenditures to TC, = $100 with unchanged w = r = $10 will
generate isocost line R’S’ in the right panel of Figure 8.5. The vertical or Y-intercept of
isocost line R’S’ is equal to TC2/r = $100/$10 = 10K and its slope is —w/r =
—$10/$10 = —1. With TC; = $80 and r = $10 but w = $5, we have isocost line RT
with slope of —1/2.
Note the symmetry between the isocost line and the budget line. In Section 3.4 we
defined the budget line as showing the various combinations of two commodities that a
consumer could purchase with a given money income. The isocost line shows the various
combinations of two inputs that a firm can hire at a given total cost. However, whereas an
individual’s income is usually given and fixed over a specific period of time (so that we
usually deal with only one budget line), a firm’s total costs of production vary with out-
put (so that we have a whole family of isocost lines).*

4 A& consumer’s budget line can also change over a given period of time because consumers can save or borrow
as well as vary the hours worked and type ofjob. However, these possibilities are usually not considered in
order to keep the analysis simple.
236 PART THREE Production, Costs, and Competitive Markets

Least-Cost Input Combination?

Least-cost input To minimize the cost of producing a given level of output, the firm must produce at the
combination The point where an isocost line is tangent to the isoquant. For example, the left panel of
condition where the Figure 8.6 shows that the minimum cost of producing four units of output (4Q) is $80
marginal product per
(isocost line RS). This is the lowest isocost line that will allow the firm to reach the iso-
dollar spent on each
quant for 4Q. The firm must produce at point D and use 4Z (at the cost of wL = $40) and
input is equal.
4K (at the cost of rK = $40). This is the least-cost input combination. Any other input
combination results in higher total costs for the firm to produce four units of output (.e.,
to reach isoquant 4Q).
Minimizing the cost of producing a given level of output is equivalent to
maximizing the output for a given cost outlay. The right panel of Figure 8.6 shows that
the maximum output or highest isoquant that the firm could reach at the total cost of $80
(i.e., with isocost line RS) is the isoquant for 4Q. Thus, the condition for cost minimiza-
tion is equivalent to the condition for output maximization. For both, the firm must pro-
duce where an isoquant and an isocost are tangent (point D in both panels of Figure 8.6).
The concept of output maximization for a given cost outlay for a producer is completely
analogous to the concept of consumer utility maximization for a given budget constraint,
which was discussed in Section 3.5.
At the point of tangency, the absolute value of the slope of the isoquant or marginal
rate of technical substitution of labor for capital is equal to the absolute value of the slope
of the isocost line. That is,

MRTS i K = w/r [8.5]

K K

10

8 8

6
5
4 4
3

it @) 345 8 ri
FIGURE 8.6 Optimal Input Combination — The left panel shows
that RS is the lowest
isocost with which the firm can reach isoquant 4Q. The firm minimized the
cost of producing
4 units of output at pointD by using 4Z and 4K at a total cost of $80. The
right panel shows
that soquant 4Qis the highest isoquant the firm can reach with isocost line
RS. Thus, the firm
maximizes output with a total cost of $80 by producing at point D
and using 4L and 4K.

For a mathematical presentation of cost minimization using

rudimentary calculus, see Section A.9 of the
Mathematical Appendix at the end of the book.
 CHAPTER 8 Costs of Production 237

Since the MRTS; x = MP,,/MPx, we can rewrite the least-cost input combination as

MP,/MPx = w/r [8.6]

Cross multiplying, we get

MP_/w = MPx/r [8.6B]

Equation [8.6B] indicates that to minimize production costs (or maximize output
Concept Check for a given total cost), the extra output or marginal product per dollar spent on labor
If the price of labor is must be equal to the marginal product per dollar spent on capital. If MP; = 5, MPx =
double the price of 4, and w = r, the firm would not be maximizing output or minimizing costs since it is
capital, why must the getting more extra output for a dollar spent on labor than on capital. To maximize out-
marginal product of
put or minimize costs, the firm would have to hire more labor and rent less capital. As
labor also be double for
the firm does this, the MP, declines and the MPx increases (because of diminishing
the least-cost input
combination? returns). The process would have to continue until condition [8.6B] held. If w were
higher than r, the MP; would have to be proportionately higher than the MPx for con-
dition [8.6B] to hold.
The same general condition would have to hold to minimize production costs, no
matter how many inputs the firm uses. That is, the MP per dollar spent on each input
would have to be the same for all inputs. Another way of stating this is that, for costs to
be minimized, an additional or marginal unit of output should cost the same whether it is
produced with more labor or more capital.

Cost Minimization in the Long Run and in the Short Run

We have seen in the left panel of Figure 8.6 that the minimum cost of producing four
units of output (4Q) is $80 when the firm uses four units of labor (4) at $10 per unit
and four units of capital (4K) at $10 per unit (point D, where the isoquant for 4Q is tan-
gent to the isocost for $80). This is repeated in Figure 8.7. Figure 8.7 also shows that in
the long run (when both L and K can be varied), the firm can produce 10Q with 5L and
5K at the minimum total cost of $100 (point H, where the isoquant for 10Q is tangent to
the isocost for $100). Points D and H can also be interpreted as the points of maximum
output for cost outlays of $80 and $100, respectively. Note that this production function
exhibitsstrong economies of scale (i.e., 4L and 4K produce 4Q, while 5L and 5K
produce 10Q).
If capital were fixed at 4K (in the short run), the minimum cost of producing
Concept Check 10Q would be higher, or $110, because the firm would have to use 7L and 4K (point V,
Why are costs lower in where the isoquant for 10Q crosses the isocost for $110){Thus, the minimum cost of
the long run than in the producing a given level of output is lower in the long run when both L and K are vari-
short run even if factor able than in the short run when only L is variable. Note that at point V, the MRTS;x <
prices remain constant? w/r. This means that the rate at which L can be substituted for Kin production is
smaller than the rate at which L can be substituted for K in the market. Thus, total costs
can be reduced in the long run by using less labor and more capital in production. But
this is impossible in the short run. As Example 8-3 shows, total costs would also be
higher if government regulation prevented the attainment of the long-run cost mini-
mization point.
238 PART THREE Production, Costs, and Competitive Markets

0 4.5 wes) 1@ Wil LE

FIGURE 8.7 Long-Run and Short-Run Cost Minimization
Starting from point D, the firm minimizes the long-run cost of
producing 10Q at point H, where isoquant 10Q is tangent to the isocost
line for $100 and the firm uses 5L and 5K. If capital is fixed at 4K, the
firm minimizes the short-run cost of producing 10Q by using 7L and 4K
(point V, where the isoquant for 10Q crosses the isocost line for $110).

EXAMPLE 8-3
Least-Cost Combination of Gasoline and Driving Time

Figure 8.8 repeats the isoquant of Figure 7.8, showing the various combinations of
gasoline consumption and driving time required to cover 600 miles. If the price of
gasoline is $1.50 per gallon and the opportunity cost of driving time is $6.00 per hour,
the minimum total cost for the trip would be $90. This is given by point B, where the
isocost line (with absolute slope of $1.50/$6.00 = 1/4) is tangent to the isoquant.
Thus, to minimize traveling cost, the individual would have to drive 10 hours at
60 mph and use 20 gallons of gasoline. The individual would spend $30 on gasoline
(20 gallons at $1.50 per gallon) and incur an opportunity cost of $60 for travel time
(10 hours of driving at $6.00 per hour), for a total cost of $90 for the trip.
If the government set the speed limit at 50 mph, the trip would require 16 gallons
of gasoline and 12 hours of driving time (point A). The total cost of the trip would then
be $24 for gasoline (16 gallons at $1.50 per gallon) plus $72 for the driving time
(12 hours at $6.00 per hour), or $96. Thus, enforcing a 50 mph speed limit saves gaso-
line but increases driving time and the total cost of the trip.
 CHAPTER 8 Costs of Production 239

Commuting
time (hours)
15

A (50 MPH)
10 IR Me we Ge B (60 MPH)
roy es C (66.7 MPH)
! 600 Miles

|
|

|
0 16%, 20 30 60
Gasoline (gallons)

FIGURE 8.8 The Minimum Cost of a Trip The minimum cost for the trip is $90 and is given
at point B, where the isoquant is tangent to the isocost. The individual spends $30 on gasoline
(20 gallons at $1.50 per gallon) and $60 in driving time (10 hours at $6.00 per hour).

Thus, the final repeal of the 55-mile-an-hour law in 1995 (which had been imposed
in 1974 at the start of the petroleum crisis to save gasoline) seems a rational response to
the decline in gasoline prices (in relation to other prices) and the increase in real wages
that has taken place since 1981. Opposition to the repeal of the 55-mile-an-hour law
came primarily from those who believe that lower speed limits save lives. The reduction
in gasoline price did, however, bring to a halt progress in energy efficiency.
Sources: C. A. Lave, “Speeding, Coordination, and the 55-mph Limit,” American Economic Review,
December 1985, pp. 1159-1164; “How Much Is Your Time Worth?” New York Times, February 26, 2003,
p. D1; “At $2 a Gallon, Gas Is Still Worth Guzzling,’ New York Times, May 16, 2004, Sect. 4, p. 14;
“Politics Is Forcing Detroit to Support New Rules on Fuel,” New York Times, June 20, 2007, p. Al; and
“Can U.S. Adopt Europe’s Fuel-Efficient Cars?” Wall Street Journal, June 26, 2007, p. B1.

EXPANSION PATH AND LONG-RUN CosT CURVES

In this section, we first define the firm’s expansion path and, from it, derive the firm’s
long-run total cost curve. From the firm’s iong-run total cost curve, we then derive the
firm’s long-run average and marginal cost curves. Finally, we show the relationship
between the firm’s short-run and long-run average cost curves.

Expansion Path and the Long-Run Total Cost Curve

With constant input prices and higher total cost outlays by the firm, isocost lines will be
higher and parallel. By joining the origin with the points of tangency of isoquants and
240 PART THREE Production, Costs, and Competitive Markets

in the top panel of

Expansion path The the isocost lines, we derive the firm’s expansion path. For example,
OBDFHJ N. In this case, the expansion
line joining the origin Figure 8.9, the expansion path of the firm is line
labor ratio (K/L) for all output lev-
with the points of path is a straight line, indicating a constant capital-
s is equal to the slope of the isocost
tangency of isoquants
els. At the tangency points, the slope of the isoquant
and isocost lines with points along
lines. That is, MRTS_x = MP,/MPx = w/r, and MP;/w = MPx/r. Thus,
input prices held of
constant. the expansion path show the least-cost input combinations to produce various levels
output in the long run.
Long-run total cost From the expansion path, we can derive the long-run total cost (LTC) curve of the
(LTC) The minimum
firm. This curve shows the minimum long-run total costs of producing various levels of
total cost of producing
output. For example, point B in the top panel of Figure 8.9 indicates that the minimum
various levels of output
when the firm can build total cost of producing two units of output (2Q) is $60 ($30 to purchase 3L and $30 to
any desired scale of purchase 3K). This gives point B’ in the bottom panel of Figure 8.9, where the vertical
plant. axis measures total costs and the horizontal axis measures output. From point D in the
top panel, we get point D’ in the bottom panel. Other points on the LTC curve are simi-
larly obtained. Note that the LTC curve starts at the origin because in the long run there
are no fixed costs.
Concept Check
How can the long-run
total cost curves be
derived from the firm’s Derivation of the Long-Run Average and Marginal Cost Curves
expansion path?
The long-run average cost (LAC) curve is derived from the LTC curve in the same way
as the short-run average total cost (SATC) curve is derived from the short-run total cost
Long-run average cost (STC) curve. For example, in Figure 8.10, the LAC = $30 for two units of output (2Q) is
(LAC) The minimum obtained by dividing the LTC of $60 (point B’ on the LTC curve in the top panel) by 2.
per-unit cost of This is the slope of the ray from the origin to point B’ on the LTC curve and is plotted as
producing any level of
point B in the bottom panel. Other points on the LAC curve are similarly obtained. Note
output when the firm
can build any desired that the slope of a line from the origin to the LTC curve falls up to point H’ (in the top panel
scale of plant. of Figure 8.10) and then rises. Thus, the LAC curve in the bottom panel falls up to point H
(10Q) and rises thereafter. However, whereas the U-shape of the SATC curve is explained by
the law of diminishing returns, the U-shape of the LAC curve depends on the operation of
increasing, constant, and decreasing returns to scale, respectively, as explained in Section 7.5.
The relationship between the /ong-run total and per-unit cost curves is generally the
same as between the short-run total and per-unit cost curves and is also shown in
Long-run marginal Figure 8.10. The long-run marginal cost (LMC) curve is given by the slope of the LTC
cost (LMC) The curve. From the top panel of Figure 8.10, we see that the slope of the LTC curve (the LMC)
change in long-run total falls up to Q = 7 (the point of inflection) and rises thereafter. Also, the slope of the LTC
costs per unit change in
curve (the LMC) is smaller than the slope of a ray from the origin to the LTC curve (the
output.
LAC) up to point H’ and larger thereafter. At point H,LMC = LAC. Note that the LMC
curve intersects from below the LAC curve at the lowest point of the latter. The LMC is $30
at Q = | because LTC increases from 0 to $60 when output rises from zero (the origin) to
two units. Thus, the change in LTC per unit change in output (the LMC) is $60 /2 = $30. The
LMC is $10 at Q = 3 because LTC increases from $60 to $80 for a two-unit increase in out-
put (from Q = 2 to Q = 4). The other LMC values shown in Figure 8.10 are obtained in the
same way.

The Relationship Between Short- and Long-Run Average Cost Curves

There is an important relationship between the firm’s SATC and LAC curves. Figure
8.11
shows that the LAC curve is tangent to various SATC curves. Each SATC curve
represents
 CHAPTER 8 Costs of Production 241

K
Expansion path

N
16 -
16

10
9 F J
: D
13
SANK,
6
4-
H/
B
6
10 $80
a5 NN $90 Mec
2 Yes $3.20
$100
200721") | |
0 ote oe Gre e5 59110 16 24 We, IE

LTC($)
320

169

100
80
60

thee | | | |
0 2 4 6 10 13 16 Q
FIGURE 8.9 Derivation of the Expansion Path and the Long-Run Total Cost Curve The
expansion path of the firm is line OBDFHJN in the top panel. It is obtained by joining the origin with
the points of tangency of isoquants with the isocost lines holding input prices constant. Points along
the expansion path show the least-cost input combinations to produce various output levels in the
long run. The long-run total cost curve in the bottom panel is derived from the expansion path. For
example, point B’ on the LIC curve is derived from point B on the expansion path. The LTC curve
shows the minimum long-run total costs of producing various levels of output when the firm can
build any desired scale of plant.
242 PART THREE Production, Costs, and Competitive Markets

EGS)

320 |

280 |

240 |-

200

160

120
100
80
60

Per unit
costs ($)

BO) |=

FIGURE 8.10 Derivation of the Long-Run Average and Marginal Cost Curves The slope of a ray from
the origin to the LTC curve in the top panel falls up to point H’ and rises thereafter. Thus, the LAC curve in the
bottom panel falls up to point H and rises thereafter On the other hand, the slope of the LIC in the top panel
(the LMC in the bottom panel) falls up to the point of inflection (at Q = 7) and then rises.

the plant to be used to produce a particular level of output at minimum cost. The LAC
curve is then the tangent to these SATC curves and shows the minimum cost of produc-
ing each level of output. For example, the lowest LAC (of $30) to produce two units of
output results when the firm operates plant | at point B on its SATC, curve. The lowest LAC
(of $20) to produce four units of output results when the firm operates plant 2 at point D
on its SATC) curve. Four units of output could also be produced by the firm operating
 CHAPTER 8 Costs of Production 243

LAC($)

| | | | | | | | | i | |
1 2 3 4 5 On me eee Oe eel Se a ee me ae)
Figure 8.11 Relationship Between Short- and Long-Run Average Cost Curves The LAC curve is tangent to
the SATC curves, each representing the plant size to produce a particular level of output at minimum cost. With only
six plants, the LAC curve would be ABCDE” FGHUMNR (the solid portion of the SATC curves). With the infinite or very
large number of plant sizes that the firm could build in the long run, the LAC curve would be the smooth curve
passing through points BDFHJN.

plant | at point D* on its SATC, curve (see the figure). However, this would not repre-
sent the lowest cost of producing 4Q in the long run. Other points on the LAC curve are
similarly obtained. Thus, the LAC curve shows the minimum per-unit cost of producing
any level of output when the firm can build any desired scale of plant. Note that the LAC
to produce 3Q is the same for plant | and plant 2 (point C).
With only six plant sizes, the LAC curve would be ABCDE”FGHIJMNR (the solid
Concept Check portion of the SATC curves). With the infinite or very large number of plant sizes that the
Why is the long-run firm could build in the long run, the LAC curve would be the smooth curve passing
average cost curve the through points BDFHJN (that is, the “kink” at points C, E”, G, J, and M would be elimi-
“envelope” of the firm’s nated by having many plant sizes). Mathematically, the LAC curve is the “envelope” to
short-run curve curves?
the SATC curves.
The long run is often referred to as the planning horizon. In the long run, the firm
Planning horizon has the time to build the plant that minimizes the cost of producing any anticipated level
The time period when a of output. Once the plant has been built, the firm operates in the short run. Thus, the firm
firm can build any plans in the long run and operates in the short run. Example 8—4 shows the long run aver-
desired scale of plant; age cost curve in the generation of electricity.
the long run.

EXAMPLE 8-4
Long-Run Average Cost Curve in Electricity Generation
Figure 8.12 shows the actual estimated LAC curve for a sample of 114 firms generat-
ing electricity in the United States in 1970. The figure shows that the LAC is lowest at
244 PART THREE Production, Costs, and Competitive Markets

EAE

kilowatt-hours
1,000
Dollars
per

Billions of kilowatt-hours

FIGURE 8.12 Long-Run Average Cost Curve in Electricity

Generation — This figure shows the actual estimated LAC curve for a
sample of 114 firms generating electricity in the United States in 1970.
The lowest point on the LAC curve is at the output level of about 32
billion kilowatt-hours. However, the LAC curve is nearly L-shaped.

the output level of about 32 billion kilowatt-hours. The LAC, however, is nearly
L-shaped, indicating that LAC do not increase much for outputs greater than 32 billion
kilowatt-hours. Electrical companies were able to avoid the increasing costs that they
would have incurred in producing more power themselves to satisfy increasing con-
sumer demand by buying more and more power from independent power producers.
But all of this is changing very rapidly in the face of deregulation and the end of
monopoly power by electrical companies (see Chapters 9 and 12). Furthermore, recent
technological advances have greatly reduced the average cost of producing electricity
with micro-turbine generators, and this may soon provide even small businesses with
the choice of generating their own electricity efficiently.
Sources: L. Christensen and H. Green, “Economies of Scale in U.S. Electric Power Generation,” Journal of
Political Economy, August 1976, p. 674; and “Electric Utilities Brace for an End to Monopolies,” New York
Times, August 18, 1994, p. 1; “Energy: Power Unbound,” Wall Street Journal, September 14, 1998, pp. R4,
R10; The Royal Academy of Engineering, The Cost of Generating Electricity (London: Royal Academy of
Engineering, 2004); and OECD, Projected Costs of Generating Electricity (Paris: OECD, 2005).

| 85 | SHAPE OF THE LONG-RUN AVERAGE Cost CURVE

In Figures 8.10 and 8.11, the LAC curve has been drawn as U-shaped, just like the SATC
curve. The reason for this similarity, however, is entirely different. The SATC curve turns
upward when the rise in AVC (resulting from the operation of the law of diminishing
returns) exceeds the decline in AFC (see Figure 8.2 and the discussion relating to it).
However, in the long run, all inputs are variable (i.e., there are no fixed inputs) and so the
 CHAPTER 8 Costs of Production 245

law of diminishing returns is not applicable. The U-shape of the LAC curve depends
instead on increasing and decreasing returns to scale. That is, as output expands from very
low levels, increasing returns to scale prevail and cause the LAC curve to fall. As output
continues to expand, the forces for decreasing returns to scale eventually begin to over-
take the forces for increasing returns to scale and the LAC curve begins to rise.
As seen in Section 7.5, increasing returns to scale means that output rises propor-
tionately more than inputs, and so the cost per unit of output falls if input prices remain
constant. On the other hand, decreasing returns to scale means that output rises propor-
tionately less than inputs, and so the cost per unit of output rises if input prices remain
constant. Therefore, decreasing LAC and increasing returns to scale are two sides of the
same coin.° Similarly, increasing LAC and decreasing returns to scale are equivalent.
When the forces for increasing returns to scale are just balanced by the forces for decreas-
ing returns to scale, we have constant returns to scale and the LAC curve is horizontal.
Empirical studies seem to indicate that in many industries the LAC curve has a very
shallow bottom or is nearly L-shaped, as in Figure 8.12. This means that economies of
scale are rather quickly exhausted, and constant or near-constant returns to scale prevail
over a considerable range of output. This permits relatively small and large firms to coex-
ist in the same industry (see Example 8-5). The smallest quantity at which the LAC curve
Minimum efficient reaches its minimum is called the minimum efficient scale (MES). The smaller the
scale (MES) The MES, the smaller the prevalence of economies of scale and the larger the number of firms
smallest quantity at that can operate efficiently in the industry (see Example 8-6).
which the LAC curve
Were increasing returns to scale to prevail over a very large range of output, large
reaches its minimum.
(and more efficient) firms would drive smaller firms out of business. In an extreme case,
only one firm could most efficiently satisfy the entire market demand for the commodity.
This is usually referred to as a “natural monopoly.” In such cases, the government allows
only one firm to operate in the market, but the firm is subject to regulation. Examples are
provided by public utilities (such local electrical water and gas companies). Natural
monopolies are discussed in detail in Chapter 13. On the other hand, the reason we do not
often observe steeply rising LAC in the real world is that firms may generally know when
their LAC would begin to rise rapidly and avoid expanding output in that range.

EXAMPLE 8-5
Shape of the Long-Run Average Cost Curves in Various Industries

Table 8.4 gives the long-run average cost for small firms as a percentage of the long-
run average cost of large firms in seven U.S. industries or sectors. The table shows that
the LAC of small hospitals is 29% higher than for large hospitals. This implies that
small hospitals operate in the declining portion of the LAC curve. For Ph.D.-granting
institutions, the LAC for small universities is about 19% higher than for large ones.
For most other industries, the LAC of small firms is not much different from the LAC
for large firms in the same industry. These results are consistent with the widespread

6 Increasing returns to scale and decreasing costs and economies of scale are synonymous only if the firm
keeps the capital-labor ratio unchanged as it expands its scale of operation.
246 PART THREE Production, Costs, and Competitive Markets

Long-Run Average Cost (LAC) of small Firms

TABLE 8.4 Sy Percentage of LAC of Large Firms

Industry Percentage

Hospitals 129
Higher education i)
Commercial Banking
Demand deposits 116
Installment loans 102
Electric power 12:
Airline (local service) 100
Railroads 100
Trucking 95
en

near-constant returns to scale reported in Table 7.9 and with L-shaped or at least
flat-bottomed LAC curves. Only in trucking does the LAC curve seem mildly U-shaped
(since small firms have lower LAC costs than large ones).
These above results are also consistent with those of a more extensive study con-
ducted in India and in Canada. Of the 29 industries examined in India, 18 were found
to have L- or nearly L-shaped LAC curves, 6 were found to have horizontal LAC curves
or nearly so, and only 5 were found to be U-shaped. Of 94 manufacturing industries
studied in Canada, 31 had a LAC curve that was L-shaped, 23 had a LAC that was hori-
zontal, 18 had a LAC curve falling throughout, 14 had rising LAC, and only for 8 was
the LAC curve U-shaped.
Sources: H. E. Frech and L. R. Mobley, “Resolving the Impasse on Hospital Scale Economies: A New
Approach,” Applied Economics, March 1995; H. Cohen, “Hospital Cost Curves with Emphasis on Measuring
Patient Care Output,” in H. Klarman (ed.), Empirical Studies in Health Economics (Baltimore: Johns Hopkins
Press, 1979); R. K. Koshal and M. Koshal, “Quality and Economies of Scale in Higher Education,” Applied
Economics, Vol. 27, 1995; F. Bell and N. Murphy, Costs in Commercial Banking (Boston: Federal Reserve
Bank of Boston, Research Report No. 41, 1968); L. Christensen and W. Greene, “Economies of Scale in U.S.
Electric Power Generation,’ Journal of Political Economy, August 1976; G. Eads, M. Nerlove, and W.
Raduchel, “A Long-Run Cost Function for the Local Service Airline Industry,” The Review of Economics and
Statistics, August 1969; Z. Griliches, “Cost Allocation in Railroad Regulation,’ The Bell Journal of
Economics and Management Science, Spring 1972; R. Koenker, “Optimal Scale and the Size Distribution of
American Trucking Firms,” Journal of Transport Economics and Policy, January 1977; V. K. Gupta, “Cost
Functions, Concentration, and Barriers to Entry in Twenty-Nine Manufacturing Industries in India.’ Journal
of Industrial Economics, November 1968; B. Robidoux and J. Lester, “Econometric Estimates of Scale
Economies in Canadian Manufacturing,’ Applied Economics, January 1992.

EXAMPLE 8-6
Minimum Efficient Scale in Various U.S. Food Industries

Table 8.5 shows the minimum efficient scale (MES) as a percentage of output in various
U.S. food industries in 1986. The table shows that the MES was 12.01% of the total
cane sugar industry output. Thus, economies of scale seem to be very important in this
 CHAPTER 8 Costs of Production 247

Minimum Efficient Scale (MES) as a Percentage

TABLE 8.5
of Output in Various U.S. Food Industries

MES as Percentage MES as Percentage

Industry of Output Industry of Output

Cane sugar 12.01 Beer OT,

Breakfast cereals 9.47 Frozen food O92
Roasted coffee 5.82 Processed meat 0.26
Canned soup 2.59 Canned vegetables 0.17
Biscuits 2.04 Bread 0.12
Margarine eS Mineral water 0.08

Source: J. Sutton, Sunk Costs and Market Structure (Cambridge, MA: MIT Press, 1991), pp. 106-105.

industry. One way to interpret this is to say that if all firms in the industry were identical
in size and were just large enough to produce at the smallest output at which their LAC
curve was minimum, only eight firms could exist in this industry. This is to be contrasted
with the mineral water industry, where the MES was 0.08% of the total industry output,
so that economies of scale seem to be very small indeed and a very large number of firms
could exist in the industry. For all the other industries studied, the MES is between these
two extremes.

ec | MULTIPRODUCT FIRMS AND DYNAMIC CHANGES IN COSTS

Until now, we have assumed that a firm produced a single product. In this section, we
examine how a firm producing more than one product may face lower costs for each prod-
uct than if it produced only one or fewer products. We also examine the reduction in costs
that often occur as a firm gains experience or “learns” in the production of a given product.

Economies of Scope
In the real world, we often observe firms producing more than one product rather than a
single product. For example, automobile companies produce cars and trucks, computer
firms produce desktops and portables, universities produce teaching and research, and
Economies of scope chicken farms produce poultry and eggs. Economies of scope are present if it is cheaper
The lowering of costs for a single firm to produce various products jointly than for separate single-product firms
that a firm often to produce the products independently.’ For example, economies of scope exist if the total
experiences when it cost (TC) ofjointly producing cars (C) and trucks (7) is smaller than if cars and trucks
produces two or more
were produced independently by different firms. That is, economies of scope exist if
products jointly rather
than separate firms
TOG (TCC) ATCO;T)) [8.7]
producing the products
independently.
7 See J. C. Panzar and R. D. Willig, “Economies of Scope,” American Economic Review, May 1981; and E. E.
Bailey and A. F. Friedlaender, “Market Structure and Multiproduct Industries: A Review Article,’ Journal of
Economic Literature, September 1982.
248 PART THREE Production, Costs, and Competitive Markets

produce cars and

In other words, economies of scope are present if it is more expensive to
trucks independently rather than jointly. If the opposite is the case (i.e., it is less expen-
sive to produce cars and trucks independ ently than jointly), so that the direction of the
Diseconomies of scope above inequality sign is reversed, we would have disecono mies of scope.
pro-
The higher costs that a Economies of scope may arise when products can be produced with common
firm can experience duction facilities or other inputs, thus lowering costs. For example, automobil es and
when it produces two or
trucks can be produced with the same metal sheet and engine assembly facilities, and
more products jointly
rather than separate
their joint production leads to a better utilization of those production facilities and lower
firms producing the costs than when automobiles and trucks are produced independently by different firms.
products independently. Similarly, a small commuter airline may face lower costs if it also provides cargo services
than if it provided only commuter service. Economies of scope also arise when a firm pro-
duces a second product in order to utilize the by-products (which before, the firm had to
dispose at a cost) arising from the production of the first product. In addition, economies
Concept Check of scope can result from better marketing strategies and the better utilization of a common
What is the difference administration. Firms must constantly be alert to the possibility of profitably extending
between economies of
their product lines to exploit such economies of scope. Indeed, one reason for the exis-
scale and economies of
tence of multiproduct conglomerates is the synergy or the increase in efficiency and lower
scope?
costs arising from economies of scope.
Economies of scope must be clearly distinguished from economies of scale. There is
simply no direct relationship between the two. For example, full-service banking arose
because of the economies of scope in providing savings and checking deposits, loans,
currency exchange, and data processing to customers by the same bank, and not because
of economies of scale (which have been found to be fully exhausted for banks as small as
with $25 million in deposits).* Sometimes, however, expected synergies and economies
of scope fail to materialize and the conglomerate either fails or deliberately splits into
separate entities. This is exactly what happened to ITT in 1995 when it decided to split
into three different companies: an insurance company, an industrial product manufactur-
ing business, and a casino, hotel, and sports company.’ In 2000, AT&T announced its
intention of splitting itself into four separate companies (business services, consumer
products, wireless, and broadband). !°

The Learning Curve

As a firm gains experience in the production of a commodity or service, its average cost
of production usually declines. In other words, for a given level of output per time period,
the increasing cumulative total output over many time periods often provides the manu-
facturing experience that enables the firm to significantly lower its average cost of pro-
Learning curve The duction. The learning curve shows the decline in the average input cost of production
curve showing the with rising cumulative total outputs of the firm over time. For example, it might take
decline in average costs
1,000 hours for an aircraft manufacturer to assemble the 100th aircraft, but only 700
with rising cumulative
total outputs over time.
hours to assemble the 200th aircraft because as managers and workers gain production
experience they usually become more efficient, especially when the production process is
relatively new. Contrast this with economies of scale{|which refers to declining long-run
average cost as the firm’s output per time period increases.

g T. G. Gilligan, M. Smirlock, and W. Marshall, “Scale and Scope Economies in the Multiproduct
Banking
Firm,” Journal of Monetary Economics, October 1984.
paint The Quintessential Conglomerate, Plans to Split Up,” New York Times, June 14,
1995, p. D1.
“AT&T Gives Details of Pending Breakup,” New York Times, May 12, 2001, p. C3.
 CHAPTER 8 Costs of Production 249

30) |= B

10.

a = D
rs Learning < 20 - Increasing returns
Ola
i)
curve 6
1)
v Ww NS) j= Learning
is ale
3 :

| | | | | | |
0 L020 40 0 2 A 6 10
Cumulative total output Output per time period

FIGURE 8.13 Learning and Increasing Returns Compared The left panel shows that as the
total cumulative output of the firm doubles from 10 to 20 units over time, the average cost declines
from $10 to $7 (the movement from point H to point T on the learning curve). The right panel
shows that LAC declines from $20 to $15 as output increases from 4 to 6 units per time period
(the movement from point D to point F along the LAC curve) due to increasing returns to scale. But
LAC falls from $20 to $12.50 to produce 4 units of output per time period as the firm learns from
larger cumulative total outputs (the downward shift of the LAC curve from point D to point D*).

The left panel of Figure 8.13 shows a learning curve that indicates that the average
Concept Check cost declines from $10 for producing the 10th unit of the product (point H), to $7 for pro-
What is the difference ducing the 20th unit (point 7), and to $5 for producing the 40th unit of the product (point
between learning W). Average cost declines at a decreasing rate so that the learning curve is convex to the
curves and economies origin. This is the usual shape of learning curves; that is, firms usually achieve the largest
of scale?
decline in average input costs when the production process is relatively new and smaller
declines as the firm matures.
The difference between the reduction in average costs due to learning and to increas-
ing returns to scale is clarified by examining the right panel of Figure 8.13. In the figure,
the reduction in long-run average cost (LAC) due to increasing returns to scale is shown
by a movement, say from point D to point F, along the LAC curve (the same as in Figure
8.11) as output per time period increases. The reduction in LAC due to learning is instead
shown by the downward shift in the LAC curve, say from point D to point D*, for a given
level of output per time period, but as the firm learns from a larger total cumulative out-
put over many periods.
Learning curves have been documented in many manufacturing and service sectors
including manufacturing of airplanes, appliances, ships, computer chips, refined petro-
leum products, and the operation of power plants. Learning curves have also been used
to forecast the need for personnel, machinery, and raw materials and for scheduling pro-
duction, determining the price at which to sell output, and even to evaluate suppliers’
price quotations. For example, in its early days as a producer of computer chips, Texas
Instruments adopted an aggressive price strategy based on the learning curve. Believing
that the learning curve in chip production was steep, the firm kept unit prices very low
to increase its total cumulative output rapidly, thereby learning by doing. The strategy
250 PART THREE Production, Costs, and Competitive Markets

was successful and the rest is history (Texas Instruments became one of the world’s
major players in this market).
How rapidly the learning curve (i.e., average input cost) declines can differ widely
among firms and is greater the smaller the rate of employee turnover, the fewer produc-
tion interruptions (which would lead to “forgetting”), and the greater the ability of the
firm to transfer knowledge from the production of other similar products. The average
cost typically declines by 20% to 30% for each doubling of cumulative output for many
firms (see Example 8-7)."!

EXAMPLE 8-7
Learning Curve for the Lockheed L-1011 Aircraft and for Semiconductors

Figure 8.14 shows the learning curve for the L-1011 aircraft that Lockheed produced
between 1970 and 1984 in the United States. The figure shows that the number of

1,000—

900 |—

© 3800b
S
Ss
& 700K
St
£
2 6004
a=)

~ 500K
vo

iS)
=
E 400+
=
52 Mi Learnin §
a 300 curve for
the L-1011
200 |-

100-

eb a Ta lh Ni halal Le |
0 1020
30 40 50 100 150
Number of aircraft produced
FIGURE 8.14 Learning Curve for the Lockheed 1011 Aircraft The figure
shows that the number of worker-hours (in thousands) that Lockheed used to
produce its L-1011 aircraft declined at a about the rate of 20% and essentially
came to an end when cumulative production reached about 100 aircraft.

ul The Oss bees Paper on learning

F curves is; K. Arrow, “The
Economic Implication of Learning by Doing,” Review
of Economic Studies, June 1962. See also L. Argote and D. Epple, “Learning
Curves in Manufacturing,” Science
REOTUAY 23, 1990, and D. A. Irwin and P. J. Klenow, “Learning-by-Doing
Spillovers in the Semiconductor
Industry,” Journal of Political Economy, December 1994,
 CHAPTER 8 Costs of Production 251

worker-hours (in thousands) that Lockheed used was 900 to produce the 10th aircraft,
550 for the 20th, 400 for the 40th, 350 for the 50th, 300 for the 100th, and slightly
lower than 300 to produce the 150th aircraft. This implies a learning rate of about
20%. Thus, a 10% increase in cumulative production would lead to a 2% reduction in
cost. Learning essentially came to an end with the production of the 100th aircraft.
After producing 150 of the L-1011, the rate of production slowed down considerably
and the worker-hours required to produce each aircraft went back up to about 500,000
(not shown in the figure). This implies organizational forgetting when the rate of pro-
duction slows down significantly (Lockheed stopped producing the L-1011 in 1984
after producing 250 aircraft).
Learning has also been important in the production of semiconductors (the mem-
ory chips that are used in personal computers, cellular telephones, electronic games,
etc.). The semiconductor industry introduced seven generations of dynamic random
access memory chips (DRAM) between 1974 and 1992. A study found that the learn-
ing rate in the production of each generation of DRAMs also averaged about 20%, so
that a doubling of cumulative output reduced the average cost of production by about
20%. The study also found that there was no discernible difference in the speed of
learning of U.S. and Japanese firms, but that intergenerational learning was low. That
is, having a lower cost in the production of one generation of DRAMs was no guaran-
tee of continued success cess in the production of the next generation. Related to the
learning curve is Moore’s Law, which accurately predicted in 1965 that semiconduc-
tors (chip) performance would double roughly every 18 months!
Sources: C. L. Benkard, “Learning and Forgetting: The Dynamics of Aircraft Production,’ American
Economic Review, September 2000; D. A. Irwin and P. J. Klenow, “Learning-by-Doing Spillovers in the
Semiconductor Industry,’ Journal of Political Economy, December 1994; “Moore’s Law at 40: Happy
Birthday,” The Economist, March 26, 2005, p. 65; “More Life for Moore’s Law,” Business Week, June 20,
2005, pp. 108-109; and “Moore’s Law Triumphant,” Forbes, February 26, 2007, p. 33.

AT THE FRONTIER
Minimizing Costs Internationally—The New
Economies of Scale

D uring the past decade, there has been a sharp increase in international trade in
parts and components. Today, more and more products manufactured by inter-
national corporations have parts and components made in many different nations. The
reason is to minimize production costs. For example, the motors of some Ford Fiestas
are produced in the United Kingdom, the transmissions in France, the clutches in
Spain, and the parts are assembled in Germany for sales throughout Europe. Similarly,
Japanese and German cameras are often assembled in Singapore to take advantage of
the cheaper labor there.
Foreign “sourcing” of inputs is often not a matter of choice to earn higher profits,
but simply a requirement to remain competitive. Firms that do not look abroad for
cheaper inputs face loss of competitiveness in world markets and even in the domestic
Continued...
252 PART THREE Production, Costs, and Competitive Markets

Minimizing Costs Internationally Continued

market. This is the reason that $625 of the $860 total cost of producing an IBM PC was
outsourced from abroad and most of the major components going into the production
of a Boeing 777 are made abroad. Of 162 major multinationals surveyed, 139 out-
sourced some activities in 2005. U.S. firms now spend more than $100 billion on out-
sourcing and by doing so they cut costs by 10-15%. Outsourcing now accounts for
more than one-third of total manufacturing costs by Japanese firms and this saves them
more than 20% of production costs. Such low-cost offshore purchase of inputs is likely
to continue to expand rapidly in the future and is being fostered by joint ventures,
licensing arrangements, and other nonequity collaborative arrangements. Indeed, this
represents one of the most dynamic aspects of the global business environment of
today.
Not only are more and more inputs imported, but more and more firms are open-
ing production facilities in more and more nations. For example, Nestle, the largest
Swiss company and the world’s second largest food company, has production facili-
ties in 59 countries, America’s Gillette has facilities in 22 countries. In 2006, Ford had
major manufacturing operations in Canada, Mexico, the United Kingdom, Germany,
Brazil, Argentina, China, and South Africa and component factories in 26 other coun-
tries and employed more people abroad than in the United States (respectively
150,000 and 130,000). Bertelsman AG, the $7 billion German media empire, owns
printing plants around the world and the Literary Guild Book Club, and it also prints
books at competitors’ plants and sells them through Time-owned Book-of-the-Month
Club.
So widespread and growing is international trade in inputs and the opening of pro-
duction facilities abroad that we are rapidly moving toward truly multinational firms
with roots in many nations rather than in only one country, as in the past. This change
affects not only the multinational companies. Indeed, more and more firms that, until a
few years ago, operated exclusively in the domestic market are now purchasing increas-
ing quantities of inputs and components and shifting some oftheir production to foreign
nations. For example, Malachi Mixon, the American medical equipment company, now
buys parts and components in half adozen countries, from China to Colombia, when ten
years ago it did all of its shopping at home. The popular Mazda Miata automobile,
which is manufactured in Japan, was conceived in Mazda’s California design lab by an
American engineer at the same time that Mazda opened production facilities for other
models in the United States.
Firms must constantly explore sources of cheaper inputs and overseas production
to remain competitive in our rapidly shrinking world. Indeed, this process can be
regarded as manufacturing’s new (international) economies of scale in today’s global
economy. Just as companies were forced to rationalize operations within each country
International
in the 1980s, they now face the challenge of integrating their operations for their entire
economies of scale
system of manufacturing around the world to take advantage of the new international
The lower costs
resulting from a economies of scale. What is important is for the firm to focus on those components
firm’s integration that are indispensable to the company’s competitive position over subsequent product
of its entire system generations and “outsource” other components for which outside suppliers have a
dis-
of manufacturing tinctive production advantage.
operations around The new international economies of scale can be achieved in five basic areas: prod-
the world.
uct development, purchasing, production, demand management, and order
fulfillment.
 CHAPTER 8 Costs of Production 253

In product development, the firm can design a core product for the entire world econ-
Concept Check omy by building into the product the possibility of variations and derivatives to meet
What is the difference the needs of local markets. Firms can achieve new economies of scale by purchasing
ieee traditional raw materials, parts, and components on a global rather than on a local basis—no mat-
eee, ter where their operations are located. Firms can also coordinate production in low-cost
; manufacturing centers with final assembly in high-cost locations near markets. They
can forecast the demand for their products and undertake demand management on a
world rather than on a national basis. Firms can achieve important economies of scale
by shipping products from the plants closest to customers more quickly and with
smaller inventory on a global basis. International economies of scale are likely to
become even more important in the future as we move closer and closer to a truly
global economy.

Manufacturing Site Location,” MIT Sloan Management Review, Summer 1994; R. J. Trent and R. M.
Monczka, “Achieving Excellence in “Global Sourcing,’ MIT Sloan Management Review, Fall 2005,
pp. 24-32; and W. M. Becker and V. M. Freeman, “Going from Global Trends to Global Strategy,
McKinsey Quarterly, No. 3, 2006, pp. 17-27.

SUMMARY
1. In economics, costs include explicit and implicit costs. Explicit costs are the actual
expenditures of the firm to purchase or hire inputs. Implicit costs refer to the value (imputed
from their best alternative use) of the inputs owned and used by the firm in its own production
process. The opportunity cost to a firm in using any input (whether owned or hired) is what the
input could earn in its best alternative use. Costs are also classified into private and social.
Private costs are those incurred by individuals and firms, while social costs are those incurred
by society as a whole.
2. In the short run we have fixed, variable, and total costs. Total fixed costs (TFC) plus total
variable costs (TVC) equal total costs (TC). The shape of the 7VC curve follows directly from
the law of diminishing returns. Average fixed cost (AFC) equals TFC/Q, where Q is output.
Average variable cost (AVC) equals TVC/Q. Average total cost (ATC) equals TC/Q. ATC =
AFC plus AVC also. Marginal cost (MC) equals the change in TC or in TVC per-unit change in
output. The AVC, ATC, and MC curves first fall and then rise (i.e., they are U-shaped). AVC and
MC move inversely to the AP; and the MP_, respectively. The AVC and the ATC are given,
respectively, by the slope of a line from the origin to the TVC and to the TC curves, while the
MC is given by the slope of the TC and the TVC curves.
Ww. Given the wage rate of labor (w), the rental price of capital (r), and a particular total cost (TC),
we can define the isocost line. This line shows the various combinations of L and K that the
firm can hire in the long run. With K plotted along the vertical axis, the Y-intercept of the
isocost line is TC/r and its slope is —w/r. To minimize production costs or maximize output,
the firm must produce where an isoquant is tangent to an isocost line. At this point, MRTS_x =
w/r, and MP,/w = MPx/r. This means the MP per dollar spent on L must be equal to the MP
per dollar spent on K. The minimum cost of producing a given level of output is usually lower
in the long run than in the short run.
4. The expansion path joins the origin with the points of tangency of isoquants and isocost lines
with input prices held constant. It shows the least-cost input combination to produce various
output levels. From the expansion path, we can derive the long-run total cost (LTC) curve.
This shows the minimum long-run total costs of producing various levels of output when the
254 PART THREE Production, Costs, and Competitive Markets

then derive the

firm can build any desired plant. From the long-run total cost curve, we can
long-run average and marginal cost curves. The long-run average cost (LAC) equals LTC/Q,
while the long-run marginal cost (LMC) equals ALTC/AQ . The LAC curve is tangent to
the short-run average total cost curves. The firm plans in the long run and operates in the
short run.
5. The U-shape of the long-run average cost curve of the firm results from the operation of
increasing, constant, and decreasing returns to scale, respectively. Empirical studies seem
to indicate that in many industries the LAC curve has a very shallow bottom or is nearly
L-shaped. This means that economies of scale are quickly exhausted, and constant or near-
constant returns to scale prevail over a considerable range of output. This permits relatively
small and large firms to coexist in the same industry. The smallest quantity at which the LAC
curve reaches its minimum is called the minimum efficient scale (MES).
6. Economies of scope are present if it is cheaper for a firm to produce various products jointly
than for separate firms to produce the same products independently. The opposite situation
refers to diseconomies of scope. The learning curve shows the decline in the average cost of
production with rising cumulative total outputs over time by the firm. During the past decade,
there has been a sharp increase in international trade in parts and components, and more
and more firms have opened production facilities abroad to keep production costs as low as
possible and thus be able to meet the growing international competition. This process can be
regarded as manufacturing’s new (international) economies of scale in today’s global economy.

KEY TERMS
Explicit costs Total costs (TC) Long-run average cost (LAC)
Implicit costs Average fixed cost (AFC) Long-run marginal cost (LMC)
Opportunity cost Average variable cost (AVC) Planning horizon
Alternative or opportunity cost Average total cost (ATC) Minimum efficient scale (MES )
doctrine Marginal cost (MC) Economies of scope
Private costs Isocost line Diseconomies of scope
Social costs Least-cost input combination Learning curve
Total fixed costs (TFC) Expansion path International economies
Total variable costs (7VC) Long-run total cost (LTC) of scale

REVIEW QUESTIONS
— . An individual quits his job as a manager of a small 4. How should a firm utilize each of two plants to minimize
photocopying business in which he was earning $30,000 production costs for the firm as a whole?
per year and opens his own shop by renting a store for . If the marginal cost of a firm is rising, does this mean that
$5,000 per year, using $10,000 of his own money to rent its average cost is also rising?
the photocopying machines, and hiring a helper for
. Is it always better to hire a more qualified and productive
$10,000 per year. What are the individual’s accounting
worker than a less qualified and productive worker?
costs? What are his economic costs?
Explain.
i). State colleges are more efficient than independent colleges
. Is a firm minimizing costs if the marginal product of
in providing college education because they charge lower
labor is six, the marginal product of capital is five,
tuition. True or false? Explain.
the wage rate is $2, and the interest on capital
. Is the annual retainer paid by a firm to a lawyer a fixed or
is $1? If not, what must the firm do to minimize
a variable cost?
costs?
 CHAPTER 8 Costs of Production 255

8. Must a firm’s long-run average cost curve be U-shaped if itl, Should a firm purchase abroad some parts and
its long-run marginal cost curve is U-shaped? components needed to produce its product, even if that
9. What does the long-run marginal cost curve of a firm creates employment opportunities abroad instead of at
look like if its long-run average cost curve is L-shaped? home?
10. What is the difference between economies of scale, . What is meant by “international economies of scale”?
economies of scope, and the reduction in average costs as
a result of learning?

|__| PROBLEMS
*]. A woman working in a large duplicating (photocopying) c. How can the AFC, AVC, ATC, and MC curves be
establishment for $15,000 per year decides to open a derived geometrically?
small duplicating business of her own. She runs the *4, Electrical utility companies usually operate their most
operation by herself without hired help and invests no modern and efficient equipment around the clock and use
money of her own. She rents the premises for $10,000 their older and less efficient equipment only to meet
per year and the machines for $30,000 per year. She periods of peak electricity demand.
spends $15,000 per year on supplies (paper, ink,
a. What does this imply for the short-run marginal cost of
envelopes), electricity, telephone, and so on. During the
these firms?
year her gross earnings are $65,000.
b. Why do these firms not replace all of their older
a. How much are the explicit costs of this business?
equipment with newer equipment in the long run?
b. How much are the implicit costs?
. Suppose that the marginal product of the last worker
c. Should this woman remain in business after the year if employed by a firm is 30 units of output per day and the
she is indifferent between working for herself or for daily wage that the firm must pay is $20, while the
others in a similar capacity? marginal product of the last machine rented by the firm is
2. a. Plot the total fixed costs (TFC) curve, the total variable 80 units of output per day and the daily rental price of the
costs (TVC) curve, and the total costs (TC) curve given machine is $40.
in the following table. a. Why is this firm not maximizing output or minimizing
costs in the long run?
Quantity Total b. How can the firm maximize output or minimize costs?
of Variable Total . With reference to Figure 8.7, answer the following
Output Costs Costs questions.
a. If capital were fixed at 5 units, what would be the
0 $0 $30
minimum cost of producing 10 units of output in the
] 20 50
short run?
p) 30 60
b. If capital were variable but labor fixed at 4 units, what
3 48 78
would be the minimum cost of producing 10 units of
4 90 120
5 170 200 output?
2 Suppose that w = $10 and r = $10 and the least-cost
input combination is 3L and 3K to produce 2 units of
b. Explain the reason for the shape of the cost curves in
output (2Q), 4 and 4K to produce 4Q, 4.5L and 4.5K to
2(a) above.
produce 6Q, SL and 5K to produce 8Q, 7.5L and 7.5K
3. a. Derive the average fixed costs (AFC), the for 10Q, and 12L and 12K for 12Q. Draw the isocost
average variable costs (AVC), the average total costs lines, the isoquants, and the expansion path of the firm.
(ATC), and the marginal costs (MC) from the total cost
b. From the expansion path of 7(a), derive the long-run
schedules given in the table of Problem 2.
total cost curve of the firm.
b. Plot the AVC, ATC, and MC curves of 3(a) on a graph
cS Redraw your figure of 7(b) and on it draw the STC
and explain the reason for their shape. How are AFC curve from the data given for Problem 2(a), the STC
reflected in the figure?

* — Answer provided at end of book.

256 PART THREE Production, Costs, and Competitive Markets

curve tangent to the LTC curve at Q = 8, and the STC a. Approximately how much gasoline and driving time
curve tangent to the LTC curve at Q = 12. would the individual use for the trip of 600 miles?
_From the LTC curve of the firm of Problem 7(b), Ss What would be the minimum total cost of the trip?
derive the LAC and the LMC curves of the firm. _a. Draw a figure showing that the best plant for a range
Redraw the figure of 8(a), and on the same figure draw of outputs may not be the best plant to produce a
the ATC and the MC curves of Problem 3(b). Also draw given level of output.
the ATC curve that forms the lowest point of the LAC b. Why might the firm build the first rather than the
curve at Q = 8 and the corresponding SMC curve. On the second type of plant?
same figure, draw the ATC curve that is tangent to the a2? Given the following learning curve equation,
LAC curve at Q = 12 and the corresponding SMC curve.
AG. — 1000 Oa >
. Under what condition would the LTC curve be
a positively sloped straight line through the origin? where AC refers to the average cost of production and
s What would then be the shape of the LAC and the LMC Q to the total cumulative output of the firm over time,
curves? find the AC of the firm for producing the
. Would this be consistent with U-shaped STC curves? a. 100th unit of the product.
(e)
(ay Draw a figure showing your answer to 9(a), 9(b), and b. 200th unit of the product.
Ac). c. 400th unit of the product.
10. Suppose that in Figure 8.8 the opportunity cost of driving d. Draw the learning curve from the results obtained
time remained at $6.00 per hour but the price of gasoline from parts (a) to (c).
increased to $4.50 per gallon.

APPENDIX, EXTENSIONS AND USES OF PRODUCTION AND Cost ANALYSIS

This appendix shows how the total variable cost curve can be derived from the total prod-
uct curve, examines input substitution in production to minimize costs, and shows the
effect of an increase in input prices on the firm’s cost curves.

Derivation of the Total Variable Cost Curve from the Total

Product Curve
The top panel of Figure 8.15 reproduces the total product (7P) curve of Figure 7.2. With
labor (L) as the only variable input and with the constant wage rate of $10, the total variable
cost (TVC) of producing various quantities of output is given by TVC = $10L (the lower
horizontal scale in the top panel). If we now transpose the axes and plot TVC on the vertical
axis and output on the horizontal axis, we obtain the TVC curve shown in the bottom panel
of Figure 8.15. Thus, the shape of the TVC curve is determined by the shape of the TP curve.
Note that the slope of the TP curve (or MP_) rises up to point G (the point of inflec-
tion) in the top panel and then declines. On the other hand, the slope of the TVC curve (the
MC) falls up to point G’ (the point of inflection) in the bottom panel and then rises. At
points G and G’, the law of diminishing returns begins to operate. The MC is the monetized
mirror image or dual of the MP. That is, MC falls when MP, rises, MC is minimum when
MP, is highest, and MC rises when MP, falls. The same inverse relationship exists
between the AVC and the AP;. Note also that the TVC curve is dashed above point /' in the
bottom panel because no firm would want to incur higher TVC to produce smaller outputs.

Input Substitution in Production to Minimize Costs

We now examine how a firm minimizes the cost of producing any given level of output
by
substituting a cheaper for a more expensive input in production. Figure 8.16 shows that with
 CHAPTER 8 Costs of Production ASVI

6 Labor units
$10 $15 $20 $30 $40 $50 $60 TAG,

|
|
|
0 3 5 8 12, 14
Output (7P)
FIGURE 8.15 Derivation of the TVC Curve from the TP Curve The top panel reproduces the 7P curve
of Figure 6.2. With labor (L) as the only variable input and with the constant wage rate of $10, TVC = $10L
(the lower horizontal scale in the top panel). If we now transpose the axes and plot TVC on the vertical axis
and output on the horizontal axis, we obtain the TVC curve shown in the bottom panel. At points G and G’,
the law of diminishing returns begins to operate.

TC = $140 and w = r= $10, the firm minimizes the cost of producing 10Q by using 7K and
7L (pointA, where isocost line FG is tangent to isoquant 10Q). At point A, K/L = 1.
If r remains at $10 but w falls to $5, the isocost line becomes FH and the firm can
reach an isoquant higher than 10Q with TC = $140. The firm can now reach isoquant 10Q
with TC = $100. This is given by isocost FH’, which is parallel to FH (i.e., w/r = 1/2 for
258 PART THREE Production, Costs, and Competitive Markets

10

FIGURE 8.16 Input Substitution in Production With TC = $140 and w = r = $10, the firm
minimizes the cost of producing 10Q by using 7K and 7L (point A, where isocost FG is tangent to
isoquant 10Q). At pointA,K/L = 1. If rremains at $10 but w falls to $5, the firm can reach isoquant 10Q
with TC = $100. The least-cost combination of L and K is then given by point B, where isocost F’H’ is
tangent to isoquant 10Q. At point B, K/L = 1/2.

both) and is tangent to isoquant 10Q at point B. At point B, K/L = 1/2. Thus, with a
reduction in w (and constant r), a lower TC is required to produce a given level of output.
To minimize production costs, the firm will have to substitute L for K in production, so
that K/L declines.
The ease with which the firm can substitute L for K in production depends on the
shape of the isoquant and can be measured by the elasticity of substitution (see Example
8-8). The flatter the isoquant, the easier it is to substitute L for K in production. On the
other hand, if the isoquant is at a right angle, or L-shaped (as in Figure 7.7), no input sub-
stitution is possible (i.e., MRTS;x = 0). In such a case, K/L will then always be constant
regardless of input prices.

EXAMPLE 8-8
Elasticity of Substitution in Japanese Manufacturing Industries

A more precise method of measuring the ease with which a firm can substitute one input
for another in production than looking at the curvature of the isoquant is with the elastic-
ity of substitution. This is given by the percentage change in K/L with respect to the per-
centage change in P;/Px. The larger the value of this elasticity, the easier it is for the firm
to substitute L for K in production. Table 8.6 gives the value of the elasticity of substitu-
tion of nonskilled labor for capital (oyx), skilled labor for capital (osx), and nonskilled
 CHAPTER 8 Costs of Production 259

Elasticity of Substitution in Japanese

TABLE 8.6 Manufacturing Industries

Industry ONK OSK ONS

Food 0.14 0.62 0.38

Pulp and paper 0.76 0.75 1-32
Metal products 0.99 0.86 72
Non-electrical machinery 0.31 0.56 1.44
Electrical machinery 052 0.60 0.96
Precision instruments 0.67 0.62 115

labor for skilled labor (ays), in a number of Japanese manufacturing industries from 1970
to 1988.
The table shows that for the food industry, a 1% reduction in the wages of
unskilled labor relative to the price of capital would lead to a 0.14% reduction in the
capital-to-unskilled-labor ratio (while holding the wages of skilled labor constant), as
firms substitute nonskilled labor for capital in production. This means that the isoquant
between nonskilled labor and capital is almost L-shaped, offering little possibility of
factor substitution in production. On the other hand, the elasticity of substitution
between nonskilled and skilled workers of 1.72 for metal products implies a fairly flat
isoquant and a strong possibility of substituting nonskilled for skilled workers. The
table also shows that, except for the food industry, it is easier to substitute nonskilled
for skilled labor than to substitute nonskilled or skilled labor for capital.
Source: K. Hashimoto and J.A. Heath, “Estimating Elasticities of Substitution by the CDE Production
Function: An Application to Japanese Manufacturing Industries,’ Applied Economic, February 1995, p. 170.

Input Prices and the Firm’s Cost Curves

In deriving the firm’s cost curves, input prices are kept constant. Per-unit costs differ at
different levels of output because the physical productivity of inputs varies as output
varies. If input prices do change, the AC and the MC curves of the firm will shift—up if
input prices rise and down if input prices fall. These shifts are called external disec-
onomies and economies, respectively, and are examined in detail in Chapter 9.
For example, point B in Figure 8.16 shows that 10Q is produced at TC = $100 when
w = $5, so that AC = $10. With w = $10, the production of 10Q requires TC = $140 (point
A in Figure 8.16), so that AC’ = $14. This is shown in Figure 8.17 by point B’ and A’ on
average cost curves AC and AC’, respectively. Note that the marginal cost curve will also
shift up from MC to MC’ when w rises.
For simplicity, we assumed in Figure 8.17 that the firm produces at the lowest point
on its average cost curve before and after the increase in w. Be that as it may, the mini-
mum cost of producing a given level of output is always achieved by substituting the
cheaper input (in this case, capital) for the input that has become more expensive (labor)
until the tangency of the given isoquant with the new (steeper) isocost is reached (point A
in Figure 8.16, at which, once again, MRTS;x = w/r).
260 PART THREE Production, Costs, and Competitive Markets

AC, MC ($)

AC’
MC'
a MC
AC
14

10

| |
0 6 10 14 Q

FIGURE 8.17 Input Prices and the AC and MC Curves PointB’

on curve AC shows that with w = $5, AC = $10 for Q = 10 (from
point B in Figure 8.16). PointA’on curve AC’ shows that with w = $10,
AC = $14 for Q = 10 (from point A in Figure 8.16). Thus, an increase in
w from $5 to $10 shifts AC and MC up to AC’ and MC’.

INTERNET SITE ADDRESSES

For the cost of a college education, see: For how far afield companies go to reduce costs, see:
http://www.collegeboard.com/prod_downloads/press/ Southwest Airlines: http://www.southwest.com
cost06/trends_college_pricing_06.pdf Domino’s Pizza: http://www.dominos.com
For gasoline consumption and substitution, see: Federal Express: http://www.fedex.com
http://www.techstandards.co.uk/system/index.html GE Information Services: http://www.geis.com
http://sciway.net/statistics/scsa98/en/en17.html Learning curves are discussed at National Bureau of
For economies of scale and economies of scope, see: Economic Research:
http://en. wikipedia.org/wiki/Economies_of_scale http://www.nber.org/papers/w7 127
http://en.wikipedia.org/wiki/Economies_of_scope For Moore’s Law, see:

http://www.tutor2u.net/economics/content/essentials/ http://blogs.forbes.com/digitalrules
economies_scale_scope.htm For competition in industry for commercial aircraft, see:
Estimates of scale economies in electricity generation are Lockheed: http://www.lockheedmartin.com
found at: Boeing: http://www.boeing.com
http://www.springerlink.com/content/ q8t1364727721892/ More information on outsourcing is found at:
http://Adeas.repec.org/a/eee/ecolet/v 1 ly 1983i3p285-289.html http://en.wikipedia.org/wiki/Outsourcing
For e conomies or diseconomies of scale at General Motors, http://www.networkworld.com/topics/outsourcing.html
Ford, and Chrysler, see:
http://www.outsourcing.org/Directory/Business_Process/
http://www.gm.com http://www. businessweek.com/magazine/content/06_05/
http://www.ford.com 63969401 .htm
http://www.chrysler.com http://www.cio.com/topic/1513/Outsourcing
 CHAPTER Q

Price and Output Under

Perfect Competition
Chapter Outline List of Examples
9.1 Market Structure: Perfect Competition Competition in the New York Stock Market
9.2 Price Determination in the Market Period Supply Curve of Petroleum from Tar Sands
9.3. Short-Run Equilibrium of the Firm Short-Run World Supply Curve of Copper
9.4 Short-Run Supply Curve and Equilibrium Long-Run Adjustment in the U.S. Cotton
9.5 Long-Run Equilibrium of the Firm and the Textile Industry
Industry At the Frontier (1): New Markets and New
9.6 Constant-, Increasing-, and Decreasing-Cost Competition on the Internet
Industries At the Frontier (2): Auctioning Airwaves
9.7 International Competition in the Domestic Foreign-Exchange Quotations
Economy Depreciation of the U.S. Dollar and Profitability
9.8 Analysis of Competitive Markets of U.S. Firms
Appendix: The Foreign-Exchange Market and
the Dollar Exchange Rate

After Studying This Chapter, You Should Be Able to:

e Know the meaning and importance of perfect competition
e Describe how perfectly competitive firms determine their best level of output in the short run
e Know how to derive the short-run supply curve of a perfectly firm
e Describe the long-run equilibrium of the perfectly competitive firm and industry
e Know why perfect competition is the most efficient form of market organization

n this chapter, we bring together the theory of consumer behavior and demand (from
Part Two) and the theory of production and costs (from Chapters 7 and 8) to analyze
how price and output are determined under perfect competition. As explained in
Chapter 1, the analysis of how price and output are determined in the market is a primary
aim of microeconomic theory.
The chapter begins by identifying the various types of market structure and defining
perfect competition. It then examines price determination in the market period, or the very
short run, when the supply of the commodity is fixed. Subsequently, we discuss how the

261
262 PART THREE Production, Costs, and Competitive Markets

commodity prices. In the

firm determines its best level of output in the short run at various
, and show how the
process, we derive the short-run supply curve of the firm and industry
and supply curves determi nes the equilib rium price of the
interaction of industry demand
now we know what lies
commodity. This was already demonstrated in Chapter 2, but
behind the market demand and supply curves and how they are derived.
the
From the analysis of the market period and the short run, we go on to examine
and define constant-, increasing -, and decreasin g-cost
long-run equilibrium of the firm
compe-
industries. Subsequently, we consider the very significant effect of international
tition on the. domestic economy. The chapter concludes with an analysis of perfectly
competitive markets. This analysis, together with the real-world examples presented in
the theory sections as well as the “At the Frontier” discussion of the auction of airwaves,
highlights the great importance and relevance of the analytical tools developed in the
chapter. In the optional appendix, the foreign-exchange market and the dollar exchange
rate are examined and their importance to the operation of the firm in today’s highly
integrated world is discussed.

MARKET STRUCTURE: PERFECT COMPETITION

In economics, we usually identify four different types of market structure: perfect competi-
tion, monopoly, monopolistic competition, and oligopoly. This chapter examines perfect
competition. The other three types of market organization are considered in the next three
chapters (monopoly in Chapter 10 and monopolistic competition and oligopoly
in Chapters 11 and 12). Chapter 13 then analyzes the efficiency implications of market
imperfections and regulation.
Perfect competition Perfect competition refers to the type of market organization in which (1) there are
The form of market many buyers and sellers of a commodity, each too small to affect the price of the com-
organization where no modity; (2) the commodity is homogeneous; (3) there is perfect mobility of resources; and
buyer or seller can
(4) economic agents have perfect knowledge of market conditions (i.e., prices and costs).
affect the price of the
product, all units of the
Let us now examine in detail the meaning of each of the four aspects of the definition.
product are First, in perfect competition, there are many buyers and sellers of the commodity, each
homogeneous, of which is too small (or behaves as if he or she is too small) in relation to the market to
resources are mobile, have a perceptible effect on the price of the commodity. Under perfect competition, the
and knowledge of the equilibrium price and quantity of the commodity are determined at the intersection of the
market is perfect. market demand and supply curves of the commodity. The equilibrium price will not be
affected perceptibly if only one or a few consumers or producers change the quantity
demanded or supplied of the commodity.
Second, the commodity is homogeneous, identical, or perfectly standardized, so that
the output of each producer is indistinguishable from the output of others. An example of
this might be grade A winter wheat. Thus, buyers are indifferent as to the output of which
producer they purchase.
Third, resources are perfectly mobile. This means that resources or inputs are free to
move (i.e., they can move at zero cost) among the various industries and locations within
the market in response to monetary incentives. Firms can enter or leave the industry in the
long run without much difficulty. That is, there are no artificial barriers (such as patents) or
natural barriers (such as huge capital requirements) to entry into and exit from the
industry.
Fourth, consumers, firms, and resource owners have perfect knowledge of all
relevant
prices and costs in the market. This ensures that the same price prevails in each
part of the
market for the commodity and for the inputs required in the production of the
commodity.
 CHAPTER 9 Price and Output Under Perfect Competition 263

Needless to say, these conditions have seldom if ever existed in any market. The clos-
Concept Check est we might come today to a perfectly competitive market is the stock market (see
What is the importance Example 9-1) and the foreign exchange market (in the absence of intervention by national
and use of the perfectly monetary authorities) examined in the appendix. Another example might be U.S. agricul-
competitive model? ture at the turn of the century, when millions of small farmers raised wheat. Despite its rar-
ity, the perfectly competitive model is extremely useful to analyze market situations that
approximate perfect competition. More importantly, the perfectly competitive model pro-
vides the point of reference or standard against which to measure the economic cost or
inefficiency of departures from perfect competition. These departures can take the form of
monopoly, monopolistic competition, or oligopoly. In the case of monopoly, there is a sin-
gle seller of a commodity for which there are no good substitutes. Under monopolistic
competition, there are many sellers of a differentiated commodity. In oligopoly, there are
few sellers of either a homogeneous or a differentiated commodity. Imperfectly competi-
tive markets are examined in Part Four (Chapters 10-13).
The economist’s definition of perfect competition is diametrically opposite to the
everyday usage of the term. In economics, the term “perfect competition” stresses the
impersonality of the market. One producer does not care and is not affected by what other
producers are doing. The output of all producers is identical, and an individual producer
can sell any quantity of the commodity at the given price without any need to advertise.
On the other hand, in everyday usage, the term “competition” stresses the notion of
rivalry among producers or sellers of the commodity. For example, GM managers speak
of the fierce competition that their firm faces from other domestic and foreign auto pro-
ducers with regard to style, mileage per gallon, price, and so on. Because of this, GM
mounts elaborate and costly advertising campaigns to convince consumers of the superi-
ority of its vehicles. This is not, however, what the economist means by competition.
Under perfect competition, the firm is a price taker and can sell any quantity of the
commodity at the given market price. If the firm raised its price by the slightest amount,
it would lose all of its consumers. On the other hand, there is no reason for the firm to
reduce the commodity price since the firm can sell any quantity of the commodity at the
given market price. Thus, the perfectly competitive firm faces a horizontal or infinitely
elastic demand curve (as in Figure 5.7) at the price determined at the intersection of the
market demand and supply curves for the commodity (as in Figure 2.5).

EXAMPLE 9-1
Competition in the New York Stock Market

The market for stocks traded on the New York and other major stock exchanges is as
close as we come today to a perfectly competitive market. In most cases the price of a
particular stock is determined by the market forces of demand and supply of the stock,
and individual buyers and sellers of the stock have an insignificant effect on price (.e.,
they are price takers). All stocks within each category are more or less homogeneous.
The fact that a stock is bought and sold frequently is evidence that resources are
mobile. Finally, information on prices and quantities traded is readily available.

' An example of a differentiated commodity is the different brand names of the same commodity.
264 PART THREE Production, Costs, and Competitive Markets

ion about
In general, the price of a stock reflects all the publicly known informat
lity of the stock. This is known as the efficient
the present and expected future profitabi
and resource s flow into uses in which the
market hypothesis. Funds flow into stocks,
Thus, stock prices provide the signals for
rate of return, corrected for risk, is highest.
the efficient allocation of investments in the economy . Despite the fact that the stock
market is close to being a perfectly competitive market, imperfections occur even here.
For example, the sale of $1 billion worth of stocks by IBM or any other large corpora-
tion will certainly affect (depress) the price of its stocks. Furthermore, stock prices can
sometimes become grossly overvalued (i.e., we could have a “bubble market’) and
thus subject to a subsequent steep correction (fall). This is, in fact, what happened in
the New York stock market at the end of the 1990s.
Today, more and more Americans trade foreign stocks, and more and more for-
eigners trade American stocks. This has been the result of a communications revolution
that linked stock markets around the world into a huge global capital market and
around-the-clock trading. While this provides immense new earning possibilities and
sharply increased opportunities for portfolio diversification, it also creates the danger
that a crisis in one market will very quickly spread to other markets around the world.
This actually happened when the New York Stock Exchange collapse in October 1987
caused sharp declines in stock markets around the world and again 10 years later (in the
fall of 1997), when the collapse of stock markets in Southeast Asia led to a sharp decline
in the New York stock market and in stock markets in other nations. In 2002, history
repeated itself when sharp declines in the New York stock market (as a result of low cor-
porate profits and huge financial scandals) quickly spread to other stock markets around
the world. It happened again in August 2007 as a result of the financial crisis triggered
by the subprime (high-risk) mortgage problem in the U.S. housing market.
In recent years, the New York Stock Exchange seems to have lost some of its for-
mer ability to predict changing economic conditions and its importance as the central
source of capital for corporate America, as the latter borrowed increasing amounts
from banks for takeovers and mergers. Indeed, global markets for securities, featuring
automated, round-the-world, round-the-clock trading could eventually eclipse Wall
Street’s capital-raising dominance.
Sources: New York Stock Exchange, You and the Investment World (New York: The New York Stock
Exchange, 1998); “The Future of Wall Street,’ Business Week, November 5, 1990, pp. 119-124; “Luck or
Logic? Debate Rages On Over ‘Efficient Market Theory’,” The Wall Street Journal, November 4, 1993,
p. Cl; “Worrying About World Markets,” Fortune, July 24, 1995, pp. 43-45; “Unreality Check for the Bull
Market,” The Wall Street Journal, May 25, 1999, p. C1; “Another Scandal, Another Scare.’ The Economist,
June 29, 2002, pp. 67-69; “Mortgage Losses Echo in Europe and on Wall Street,’ New York Times, August
10, 2007, p. 1; and “The Capital of Capital No More,” New York Times Magazine, October 11, 2007, pp.
62-65,

ee || Price DETERMINATION IN THE MARKET PERIOD

Market period The The market period, or the very short run, refers to the time period during which no input
time period during can be varied (i.e., all costs are fixed) and so the market supply of a commodity
which the market is also
fixed. The market period may be a day, a week, a month, or longer, depending
supply of a commodity on the
industry. For example, if milk is delivered every morning to New York
is fixed. City, and no other
deliveries can be arranged for the rest of the day, the market period is one
day. For wheat,
 CHAPTER 9 Price and Output Under Perfect Competition 265

P($)

FIGURE 9.1 Price Determination in the Market Period With

the quantity supplied fixed at 350, the market supply curve of the 20) z
commodity is S. With D as the market demand curve, the equilibrium
price is $35. At prices higher than $35, there will be unsold quantities,
and this will cause the price to fall to the equilibrium level. At prices
below $35, the quantity demanded exceeds the quantity supplied,
and the price will be bid up to $35. With D’ as the demand curve, 0
P= $50. WithD”,P = $20. 350

the market period extends from one harvest to the next. For Michelangelo’s paintings, the
length of the market period is infinite because the supply is fixed forever.
During the market period, costs of production are irrelevant in the determination
of price, and the entire stock of a perishable commodity is put up for sale at whatever
price it can fetch. Thus, with perfect competition among buyers and sellers, demand
alone determines price, while supply alone determines quantity. This is shown in
Figure 9.1.
In the figure, S is the fixed or zero-elastic market supply curve for 350 units of the
commodity. With D as the market demand curve, the equilibrium price is $35. Only at
Concept Check this price does the quantity demanded equal the quantity supplied, and the market clears.
How is the commodity At higher prices, there will be unsold quantities, and this will cause the price to fall to
price determined in the the equilibrium level. For example, at the price of $40, only 300 units would be
market period? demanded (see the figure); hence, the quantity supplied would exceed the quantity
demanded and the commodity price would fall. On the other hand, at lower than the
equilibrium price, the quantity demanded exceeds the quantity supplied, and the price
will be bid up to $35. For example, at the price of $30, 400 units of the commodity
would be demanded; hence, the quantity demanded would exceed the quantity supplied
and the price would be bid up to $35 (the equilibrium price at which the quantity
demanded equals the quantity supplied). With D’ as the demand curve, P = $50. With
DY ean,

SHORT-RUN EQUILIBRIUM OF THE FIRM

Even though analysis of the market period is interesting, we are primarily interested in the
short run and in the long run, when the quantity produced and sold of the commodity can
be varied. In this section, we examine the determination of output by the firm in the short
run. We first do so with the total approach and then with the marginal approach. Finally,
we focus on the process of profit maximization or loss minimization by the firm.
266 PART THREE Production, Costs, and Competitive Markets

Total Approach: Maximizing the Positive Difference

Between Total Revenue and Total Costs
for the
We have seen in Section 7.1 that profit maximization provides the framework
analysis of the firm. The equilibrium output of the firm is the output that maximizes the
total profits of the firm. Total profits equal total revenue minus total costs. Thus, total
profits are maximized when the positive difference between total revenue and total costs
is largest. This is shown in Figure 9.2.
The short-run total cost (STC) curve in the top panel of Figure 9.2 is the one of
Figure 8.1. The vertical intercept ($30) gives the fixed costs of the firm. Within the limits
imposed by the given plant, the firm can vary its output by varying the quantity of the vari-
able inputs it uses. This generates the STC curve of the firm. The STC curve shows the
minimum total costs of producing the various levels of output in the short run. Past point
W, the law of diminishing returns begins to operate and the STC curve faces upward or
rises at an increasing rate (see Section 8.2).
The total revenue curve is a straight line through the origin because the firm can sell
any-quantity of the commodity at the given price (determined at the intersection of the
market demand and supply curves of the commodity). With P = $35, the total revenue
(TR) of the firm is $35 if the firm sells one unit of output. The 7R = $70 if the firm sells
two units of output, TR = $105 with Q = 3, TR = $140 with Q = 4, and so on. Put more
succinctly, TR = ($35)(Q). Thus, the TR of the firm is a straight line through the origin
with slope equal to the commodity price of $35 (see the top panel of Figure 9.2).
At zero output, TR = 0 while STC = $30. Thus, the firm incurs a total loss of $30
equal to its fixed costs. This gives the negative intercept of ( — )$30 of the total profit
curve in the bottom panel. At Q = 1, TR = $35 and STC = $50, so that total profits
are —$15. At Q = 1.5, TR = STC = $52.50 (point W in the top panel), and total profits
Break-even point The are zero (point W’ in the bottom panel). This is called the break-even point. Between
point where total Q = 1.5 and Q =5, TR exceeds STC and the firm earns a profit. Total profits equal the
revenues equal total positive difference between TR and STC. Total profits are largest at $31.50 when Q = 3.5
costs and profits
(i.e., where the TR and the STC curves are parallel and the total profit curve has zero
are zero.
slope). At Q smaller than 3.5, say, Q = 3, TR = $105 and STC = $75, so that total profits
are $30. At OQ = 4, TR = $140, STC = $110, and total profits are again $30. AtQ = 5,7R
= STC = $175, so that total profits are zero (points T and T’, respectively). At Q greater
than 5, TR is smaller than STC and the firm incurs a loss. Thus, the level of output at
which the firm maximizes total profits is Q = 3.5 (point E and E’ in the top and bottom
panels, respectively). Figure 9.2 is summarized in Table 9.1.7

Marginal Approach: Equating Marginal Revenue

and Marginal Cost?
Although the total approach to determine the equilibrium output of the firm is useful, the
marginal approach is even more valuable and more widely used. This approach is shown
in Figure 9.3. In the figure, the demand curve facing the firm (d) is horizontal or infinitely
elastic at the given price of P = $35. That is, the perfectly competitive firm is a price taker

Es SE
When the firm has no knowledge of : the exact shape of its
;
STC curve, it uses a break-even chart to determine
the minimum sales volume to avoid losses (see Problem 4, with the answer
at the end of the book).
Fora mathematical presentation of profit maximization using rudimentary calculus,
see Section A.10 of the
Mathematical Appendix at the end of the book.
 CHAPTER 9 Price and Output Under Perfect Competition 267

se eee eee / STC

Total profits

FIGURE 9.2 Short-Run Equilibrium of the Firm: Total Approach The STC curve in the top
panel is that of Figure 8.1. The 7R curve is a straight line through the origin with slope of P= $35.
At Q = 0, 7R= O and SIC = $30, so that total profits are $30 and equal the firm's TFC (see the
bottom panel). AtQ= 1, 7R = $35 and STC = $50, so that total profits are —$15. AtO = 15, TR=
STC = $52.50, and total profits are zero. This is the break-even point. Between Q = 15 andQ=5,
TR exceeds STC and the firm earns (positive) economic profits. Total profits are greatest at $31.50
when Q = 3.5 (and the 7R and the STC curves are parallel). AtQ = 5, TR = STC = $175 so that
total profits are zero (points T and 7’). At Q greater than 5, 7R is smaller than STC and the firm
incurs a loss.
268 PART THREE Production, Costs, and Competitive Markets

EE Total Revenue, Total Costs, and Total Profits

TABLE 9.1, es iC

Quantity of Total Total Total

Output Price Revenue Costs Profits

0 $35 $0 $30 $—30

1 35 35 50 =15
1S 35 5 52.50 0
2 35 70 60 +10
3 35) 105 15) +30
*3.5 35 122.50 91 +31.50
4 35 140 110 +30
5 35 175 175 0
5.5 35 192.50 220 ot)

*Output at which firm maximizes total profits.

50

445)

40

35 F

30 +

20

15

-| . | | i | — | | oe ey ae

be |
be ah | | | |
RACER
| al! —+
|
| a eel ie
0 1 2 2 oot 5 6 Q
FIGURE 9.3 Short-Run Equilibrium of the Firm: Marginal Approach _ The demand
curve
facing the firm (d) is horizontal or infinitely elastic at the given price of P=
$35. Since Pis
constant, marginal revenue (MR) equals P. The firm maximizes total profits
where P = MR = MC
and MC is rising. This occurs at Q = 3.5 (point E). AtQ = 3.5,0=
$35 and AIC = oo6
Therefore, profit per unit is $9 (EE’), and total profits are $31.50
(shaded rectangle FE AB).
 CHAPTER 9 Price and Output Under Perfect Competition 269

and can sell any quantity of the commodity at P = $35. Since marginal revenue (MR)
is the change in total revenue per-unit change in output, and price (P) is constant, then
P= MR (see Section 5.6). For example, with P = $35 and O= il, JOR = S35, Witla
P = $35 and Q = 2, TR = $70. Thus, the change in TR per-unit change in output (the
Slope of the TR curve or marginal revenue) is MR = P = $35 (see Figure 9.3).
The short-run marginal cost (MC) and the average total cost (ATC) curves of the firm in
Figure 9.3 are those of Figure 8.2 (and derived from the STC curve of Figures 8.1 and 9.2).
The MC = ASTC/AQ, while ATC = STC/Q. As explained earlier, total profits are maxi-
mized where the TR and the STC curves are parallel and their slopes are equal. Since the
slope of the TR curve is MR = P and the slope of the STC curve is MC, this implies that when
total profits are at a maximum, P = MR = MC. Furthermore, since the STC curve faces
upward where profits are maximum, the MC curve must be rising. Thus, the firm is in short-
run equilibrium or maximizes total profits by producing the output where P = MR = MC,
and MC is rising.
For example, the best level of output for the firm in Figure 9.3 is Q = 3.5 (point E),
and this is the same result as with the total approach. At Q = 3.5, P = $35 and ATC = $26.
Therefore, profit per unit is $9 (EE’ in the figure), and total profits are ($9)(3.5) = $31.50
(shaded rectangle EE’AB). Until point E, MR exceeds MC and so the firm earns higher
profits by expanding output. On the other hand, past point E, MC exceeds MR and the firm
earns higher profits by reducing output. This leaves point E as the profit-maximizing level
of output. Note that at point E, P or MR = MC and MC is rising so that the conditions for
profit maximization are fulfilled.
Also note that profit per unit is largest ($10) at point Z where Q = 3, P = $35, and
ATC = $25. The firm, however, seeks to maximize total profits, not profit per unit, and
Concept Check
this occurs at Q = 3.5, where total profits are $31.50, as opposed to $30 at Q=3.
How does a perfectly
The total profits of the firm at various levels of output with P = $35 are summarized in
competitive firm
determine the best Table 9.2. The MR, MC, and ATC values given in the table are read off Figure 9.3 at various
level of output in output levels. For example, at Q = 1, MR = $35, MC = $12.50, and ATC = $50. At Q = 2,
the short run? MR = $35, MC = $11, and ATC = $30, and so on.
The rule that a firm maximizes profits at the output level at which the marginal rev-
enue to the firm equals its marginal cost is a specific application of the general marginal

Profit Maximization for the Perfectly Competitive Firm:

TABLE 9.2 Per-Unit Approach

Profit Total Relationship

Q P—MR MC ATIC Per Unit Profits Between MR and MC

1 $35 $12.50 $50 $—15 $—15

1.50 35 10 35) 0 0 MR > MC
35) 11 30 =-9 +10
3 35 DS, hs) +10 +30
+350 35 35 26 +9 +31.50 MR=MC
4 35 50 PSN +7.50 +30
5) 35) 35) 0 0 MR < MC
3) 35 40 —5 —27.50

*Output at which firm maximizes total profits.

270 PART THREE Production, Costs, and Competitive Markets

concept that any activity should be pursued until the marginal benefit from the activity
equals the marginal cost.

Profit Maximization or Loss Minimization?

We have seen that the best or optimum level of output of the firm is given at the point
where P (or MR) equals MC, and MC is rising. At this level of output, however, the firm
can either make a profit (as in Figure 9.3), break even, or incur a loss. In Figure 9.3, P was
higher than the ATC at the best level of output, and the firm made a profit. If P were
smaller than the ATC at the best level of output, the firm would incur a loss. However, as
long as P exceeds the average variable cost (AVC), it pays for the firm to continue to pro-
duce, because by doing so it would minimize its losses. That is, the excess of P over the
AVC can be used to partially cover the fixed costs of the firm. Were the firm to shut down,
it would incur a greater loss equal to its total fixed costs. This is shown in Figure 9.4.
_ In the figure, the MC and the ATC curves are the same as in Figure 9.3. Figure 9.4
also includes the AVC curve of the firm (from Figure 8.2). In Figure 9.4, we assume that
P = MR = $20. The best level of output of the firm is then 2.75 units, given at point F,
where P = MR = MC = $20, and MC is rising. At Q = 2.75, ATC exceeds P and the firm
incurs a loss equal to F’F (about $5.50) per unit, and a total loss equal to the area of

2305
FIGURE 9.4 Profit Maximization or Loss Minimization At P— $20, the best level
of output of the firm is 2.75 units (point F, where P= MR = MC, and
MC is rising). AtQ =
2.75, average total cost (ATC) exceeds P and the firm will incur
a loss of F’F (about $5.50)
per unit, and a total loss equal to rectangle FFNR (about $15).
If, however, the firm were to
shut down, it would incur the greater loss of $30 equal to
its total fixed costs (the area of
the larger rectangle F’F”GR). The shutdown point (Z) is at
P = AVC.
 CHAPTER 9 Price and Output Under Perfect Competition 271

rectangle F’FNR (about $15). Were the firm to shut down, it would incur the greater loss
of $30 (its total fixed costs, given by the area of the larger rectangle F'F'"GR).
Concept Check Put another way, by continuing to produce Q = 2.75 at P = $20, the firm will cover
Does a perfectly FF" (about $5.50) of its fixed costs per unit and FF”GN (about $15) of its total fixed
competitive firm shut
costs. Thus, it pays for the firm to stay in business even though it incurs a loss. That is, by
down if it incurs a loss
remaining in business, the firm will incur losses that are smaller than its total fixed costs
in the short run?
(which would be the firm’s losses by shutting down). Only if P were smaller than the AVC
at the best level of output would the firm minimize losses by shutting down. By doing so,
Shutdown point The the firm would limit its losses to an amount no larger than its total fixed costs. Finally, if
output level at which P = AVC, the firm would be indifferent between producing or shutting down, because in
price equals average either case it would incur a loss equal to its total fixed costs. The point where P = AVC
variable cost and losses
(point Z in the figure) is called the shutdown point.*
equal total fixed costs,
whether the firm
produces or not.

SHORT-RUN SUPPLY CURVE AND EQUILIBRIUM

In this section, we derive the short-run supply curve of a perfectly competitive firm and
industry. We also examine how the equilibrium price of the commodity is determined at
the intersection of the market demand and supply curves for the commodity. This is the
price at which the perfectly competitive firm can sell any quantity of the commodity.

Short-Run Supply Curve of the Firm and the Industry

We have seen so far that a perfectly competitive firm always produces at the
point where P = MC and MC 1s rising, and this is so as long as P > AVC. As a result,
the rising portion of the firm’s MC curve above the AVC curve is the firm’s short-run
supply curve of the commodity. This is shown in the left panel of Figure 9.5.
The left panel of Figure 9.5 reproduces the firm’s MC curve above point Z (the
shutdown point) from Figure 9.4. This is the perfectly competitive firm’s short-run supply
Concept Check curve (s) because it shows the quantity of the commodity that the firm would supply in the
How is the short-run short run at various prices. For example, the firm supplies 3 units of the commodity at the
supply curve of a price of $25 (point C in the left panel). The reason is that at P = $25, P = MR = MC = $25,
perfectly competitive and MC is rising. At P = $35, the firm supplies 3.5 units of the commodity (point £), while
firm determined?
at P = $50, it supplies 4 units (point 7). The firm will supply no output at prices below the
shutdown point (point Z in the figure). Thus, the rising portion of the firm’s MC curve
above the shutdown point is the firm’s short-run supply curve of the commodity (s in the
left panel of Figure 9.5). It shows the quantity of the commodity that the firm would sup-
ply in the short run at various prices. The firm’s short-run supply curve is positively
sloped because the MC curve is positively sloped, and the MC curve is positively sloped
because of diminishing returns.
The horizontal summation of the supply curves of all firms in the industry then gives
the industry short-run supply curve for the commodity. This is given by the UMC = S
curve in the right panel of Figure 9.5, where the symbol © refers to the “summation of.”

4 Recall that STC = TVC + TFC and total profits equal TR — STC. When P = AVC, TR = TVC, so the firm’s
total losses would equal its TFC whether it produces or shuts down. Thus, point Z, at which P = AVC (and
TR = TVC), is the firm’s shutdown point.
272 PART THREE Production, Costs, and Competitive Markets

Firm $ Industry

MC=s X~MC=S

50 Z = aie ie
MR = $50

oar = z s
MR = $35
ae a
MR = $25
| |

!
| |
ei Ze |
| | |
| | I
| | NY | |
0 Vasey he ene Q 0 250 300 350 400 Q

FIGURE 9.5 Short-Run Supply Curve of the Firm and Industry The left panel reproduces the firm's
MC curve above pointZ(the shutdown point) from Figure 8.4. This is the perfectly competitive firm's short-run
supply curve s. For example, at P= $25, Q = 3 (point C); at P = $35, Q = 3.5 (point E); atP = $50, Q=4
(point T). The right panel shows the industry's short-run supply curve on the assumption that there are 100
identical firms in the industry and input prices are constant. This is given by the 2MC = S curve. Thus, at
P= $25, Q = 300 (point C*); atP = $35, Q= 350 (point E*); atP = $50, Q= 400 (point 7*).

The perfectly competitive industry’s short-run supply curve in the right panel is based on
the assumption that there are 100 identical firms in the industry (and input prices do not
vary with industry output). For example, at P = $25, each firm supplies 3 units of the
commodity (point C in the left panel) and the entire industry supplies 300 units (point C*
in the right panel). At P = $35, each firm supplies 3.5 units (point E) and the industry
supplies 350 units (point E*). At P = $50, Q = 4 for the firm (point 7) and Q = 400 for
the industry (point T*). Note that no output of the commodity is produced at prices below
P = $14 (points Z and Z* in the figure).°
The derivation of the perfectly competitive industry short-run supply curve of the
commodity as the horizontal summation of each firm’s short-run supply curve is based on
the assumption that input prices are constant regardless of the quantity of inputs that each
firm and the industry demand. That is, it is based on the assumption that the firm is able
to hire a greater quantity of the inputs (to produce the larger output) at constant input
prices. If input prices were to rise as firms demanded more of the inputs, the industry
supply curve would be steeper or less elastic than indicated in the right panel of Figure
9.5. An increase in the commodity price will then result in a smaller increase in the quan-
tity supplied of the commodity (see Problem 8, with the answer at the end of the book).
The responsiveness or sensitivity in the quantity supplied of a commodity to a change
Price elasticity of in its price can be measured by the price elasticity of supply. This is analogous to the
supply The percentage price elasticity of demand and is given by the percentage change in the quantity supplied
change in the quantity
supplied of a commodity
during a specific period
of time divided by the
percentage change in its
price. > Point Z in the left panel of Figure 9.5 corresponds to point Z’ in Figure 8.2.
 CHAPTER 9 Price and Output Under Perfect Competition 273

of the commodity divided by the percentage change in its price. That is, letting € (the
Greek letter epsilon) refer to the price elasticity of supply, we have

i OEY OE Be
[9.1]
IPE INE @

The only difference between the price elasticity of supply and that of demand is that in the
numerator of the elasticity formula we now have the percentage change in the quantity
supplied of the commodity rather than the percentage change in the quantity demanded.
However, since quantity and price are usually directly related along the supply curve the
price elasticity of supply is usually positive. Note that in the very short run or market
period (when the supply curve is vertical), the price elasticity of supply is zero.° Example
9-2 examines the supply curve of petroleum from tar sands, while Example 9-3 shows
how to derive the short-run world supply curve for copper.

EXAMPLE 9-2
Supply Curve of Petroleum from Tar Sands

The industry supply curve of petroleum from tar sands (often called “synthetic fuel” or
“shale oil”) was estimated to be as indicated by curve S in Figure 9.6 in 1978. Large
cost overruns, however, made actual production costs much higher, so that the supply
curve looked like S’ by 1984.
The supply curve estimated in 1978 (S) showed that it would not be economical to
produce oil from tar sands at prices below $10 per barrel. The quantity of oil supplied,
in millions of barrels per day, would be 2 at the price of $10 per barrel, 6 at the price
of $16 per barrel, and 16 at $18 per barrel. The maximum that would be supplied at any
price would be about 16 million barrels per day, at a time when the international price
of petroleum was $13 per barrel.
In 1980, Congress created the Synthetic Fuel Corporation to stimulate the pro-
duction of oil from tar sands in Alaska and reduce American dependence on imported
petroleum. By the end of 1984, $3 billion of federal subsidies had been spent on four
projects. Because of large cost overruns, however, the actual cost of extracting petro-
leum from tar sands was found to be more than three times higher than anticipated and
about double the price of $28 per barrel for imported oil (supply curve S’ in Figure 9.6)
in 1984. This led Exxon, one of the co-sponsors of the project, to withdraw from the
project. The entire synthetic fuel project was abandoned at the end of 1985 when the
U.S. government refused to provide further subsidies.
But with the average price of petroleum shooting up from $31 per barrel in 2003
to $56 in 2005, and $72 in 2007 (and reaching $120 in April 2008), it has become
profitable to extract increasing amounts of high-cost petroleum form the tar sands in

6 For a discussion of the price elasticity of supply using calculus, see Section A.5 of the Mathematical
Appendix at the end of the book.
274 PART THREE Production, Costs, and Competitive Markets

P($)
@

60 |-

40 |-

Oi

20 |-

10-7

te | | | aa
0 2 74 8 12 16 Q
Millions of barrels per day

FIGURE 9.6 The Supply Curve of Oil from Tar Sands ~The supply
curve of oil from tar sands estimated in 1978 (S) rises gently up to 16 million
barrels per day, where it becomes vertical. The actual supply curve S’ in 1984
showed much higher costs per barrel.

Canada’s provience of Alberta, which has more than 170 billion potential recoverable
barrels of petroleum (as compared with 262 billion barrels in Saudi Arabia).
Sources: N. Ericson and P. Morgan, “The Economic Feasibility of Shale Oil: An Activity Analysis,” Bell
Journal of Economics, August 1978; “Exxon Abandons Shale Oil Project,’ New York Times, May 3, 1982,
p. 1; “Congressional Conferees End Financing of Synthetic Fuels Program,” New York Times, December
17, 1985, p. B11; “Unlocking Oil in Canada’s Tar Sands,” New York Times, December 1994, p. D5; “Oils
Sands Are Shifting in Alberta,” Wall Street Journal, February 5 2008, p. A8; and “Record Run Brings
Crude Close to $120 a Barrel,” Financial Times, April 26, 2008, p. 16.

EXAMPLE 9-3
Short-Run World Supply Curve of Copper

Table 9.3 gives the production (in thousand metric tons) and the estimated marginal
cost of production (in cents per pound) of the copper producers in the major copper-
producing countries of the world. Summing up the production in the various countries
at the marginal cost of production in each country gives the short-run world supply
curve of copper (Sc) shown in Figure 9.7. The supply curve slopes up as countries fac-
ing higher marginal costs of production are included.
Note that the short-run world supply curve of copper has a steplike appearance
because we assume that all the producers in a country have the same marginal costs.
 CHAPTER 9 Price and Output Under Perfect Competition

Copper Production and Costs by Country in 2000

TABLE 9.3 (in thousand metric tons and cents per pound)

Cumulative Cents
Country Production Production Per Pound

1. Chile 4,500 4,500 54

2. Russia 520 5,020 54
3. Indonesia 850 5,870 60
4. China 510 6,380 60
5. Kazakhstan 380 6,760 60
6. Zambia 260 7,020 60
7. Australia 760 7,780 70
8. United States 1,450 9,230 76
9. Peru 530 9,760 716
10. Mexico 390 10,150 76
11. Canada 650 10,800 80
12. Poland 480 11,280 87
13. All Others 1,600 12,880 87

Sources: U.S. Geological Survey, Mineral Commodity Summaries and Mineral Industry Surveys
(Washington, D.C.: U.S. Government Printing Office, 2001), 2001; and Daniel E. Eldstein, “Copper,” U.S.
Geological Survey Mineral Yearbook (Washington, D.C.: U.S. Government Printing Office, 2001), Chapter
10. For the latest data, see http://minerals.usgs.gov/minerals/pubs/commodity/copper/.

P(¢/Ib)
Sc

90 12 & others

80

70

60
Nation 1 and 2

50

40

Ee 21h hs | NA LOA | Sse

0 2,000 4,000 6,000 8,000 10,000 12,000
Quantity (thousand metric tons)

FIGURE 9.7. The Short-Run World Supply Curve of Copper The short-run world supply curve
of copper is obtained by summing up horizontally the marginal cost curve of the various countries.
The short-run world supply curve of copper slopes up as countries facing higher marginal costs of
production are included.
276 PART THREE Production, Costs, and Competitive Markets

firm’s marginal
The Sc curve would have a smoother shape if we knew the individual
that Chile and Russia are the low-cost producer s (at 54
cost curve. The Sc curve shows
metric tons in
cents per pound), but their combined capacity is limited 5,020 thousand
the
the short run. The marginal costs of each producer vary because of differences in
ore content of individual mines and in labor, transport ation, and other costs. The mar-
ginal cost of production is 60 cents per pound for Indonesia, China, Kazakhstan, and
Zambia for a combined short-run output of 2,000 thousand metric tons. The marginal
cost of production is 70 cents per pound for Australia, 76 cents for the United States
(the world’s second largest producer after Chile), Peru and Mexico, 80 cents for
Canada, 87 cents for Poland and all other world’s smaller producers. The maximum
short-run world supply of copper is 12,880 thousand tons at which the Sc curve
becomes vertical. Note that the Sc curve is very elastic at low copper prices and
becomes progressively less so at higher prices.
Since the year 2000, the need to greatly increase the production of copper to meet
the rapidly increasing demand for the metal (especially by China) has led to rapidly
rising marginal costs and prices.

Short-Run Equilibrium of the Industry and the Firm’

In Section 5.1, we showed how the market demand curve for a commodity was derived
from the horizontal summation of the demand curves of all the individual consumers of
Concept Check the commodity in the market. We have now shown how to derive the industry or market
When is a perfectly supply curve of the commodity. In a perfectly competitive market, the equilibrium price
competitive firm in of the commodity is determined at the intersection of the market demand curve and the
long-run equilibrium?
market supply curve of the commodity. This was explained in Section 2.4. Thus, we have
traveled a complete circle and returned to the point of departure. Now, however, we
know what lies behind the market demand curve and the market supply curve of the
commodity and how they are derived (i.e., we no longer simply assume these curves as
given, as in Chapter 2).
Given the price of the commodity, the perfectly competitive firm can sell any quantity
of the commodity at that price. As noted earlier, the firm will produce at the point where P
or MR = MC, provided that MC is rising and P > AVC. This is shown in Figure 9.8.
The right panel of Figure 9.8 shows the short-run market supply curve S (from
Figure 9.5) and hypothetical market demand curve D for the commodity. These curves
intersect at point £*, and result in the equilibrium price of $35 and the equilibrium quan-
tity of 350 units. At P = $25, the quantity demanded (400 units) exceeds the quantity sup-
plied (300 units), and the resulting shortage will drive the commodity price up to P =535;
On the other hand, at P = $50, the quantity supplied (400 units) exceeds the quantity
demanded (300 units), and the resulting surplus will drive the price down to P = $35. The
left panel shows that at P = $35, the perfectly competitive firm will produce 3.5 units
(point FE, as in Figure 9.3). Note that each firm produces 1/100 of the total industry or
market output.

For a mathematical presentation of how equilibrium is determined in a perfectly

competitive industry using
rudimentary calculus, see Section A.11 of the Mathematical Appendix at the
end of the book.
 CHAPTER 9 Price and Output Under Perfect Competition PLTy|

Firm Industry

$ $
Ss

50 Dx !
re) Gi IP's IMUR 50

35 fj P= = MR 355

25) = Oe |=
|
|
|
|
Af, INV | |
0 3 4 Q 0 300 400 450 Q
3.5 350

FIGURE 9.8 Short-Run Equilibrium of the Firm and the Industry With S (from Figure 9.5) and D
in the right panel, P= $35 and Q= 350 (point E*), and the perfectly competitive firm would produce
3.5 units (point E in the left panel, as in Figure 9.3). If D shifted up to D’, P= $50 and Q = 400
(point 7”), and the firm would produce 4 units of output (point 7 in the left panel).

If the market demand curve then shifted up to D’ (for example, as a result of an

increase in consumers’ incomes), there would be a shortage of 100 units of the commod-
ity at P = $35 (E*E’ in the right panel of Figure 9.8). This would cause the equilibrium
price to rise to $50 and the equilibrium quantity to 400 units (point 7*). Then, at P = $50,
the perfectly competitive firm maximizes profits at point T by producing 4 units of output
(see the left panel). This is based on the assumption that there are 100 identical firms in
the perfectly competitive industry and that input prices remain constant.

LONG-RUN EQUILIBRIUM OF THE FIRM AND THE INDUSTRY

Having analyzed how equilibrium is reached in the market period and in the short run,
we can now go on to examine how the perfectly competitive firm and industry reach
equilibrium in the long run. This will set the stage for the analysis of constant, increasing-,
and decreasing-cost industries in Section 9.6.

Long-Run Equilibrium of the Firm

In the long run, all inputs are variable and the firm can build the most efficient plant to pro-
duce the best or most profitable level of output. The best (i.e., the profit-maximizing) level
of output of the firm in the long run is the one at which price or marginal revenue equals
long-run marginal cost. The most efficient plant is the one that allows the firm to produce
the best level of output at the lowest possible cost. This is the plant represented by the
SATC curve tangent to the LAC curve of the firm at the best level of output, as shown in
Figure 9.9.8

8 Since in the long run all costs are variable, the firm must at least cover all of its costs to remain in business.
278 PART THREE Production, Costs, and Competitive Markets

0 il 2 8 4 6 8 10 i, Wye 16 Q

FIGURE 9.9 Long-Run Equilibrium of the Firm AtP=MR = $35, the firm Is in
short-run equilibrium at point E (as in Figure 9.3). In the long run, the firm can increase its
profits by producing at pointJ’,where P or MR = LMC (and LMC is rising), and operating
plant SATCs at point J. In the long run, the firm will make profits of $22 (JJ) per unit and
$286 in total ($22 times 13 units of output). Since at pointJ’; P= MR = SMC = LMC,
the firm is also in short-run equilibrium.

The LAC curve in Figure 9.9 is the one of Figure 8.11, and the SATC; curve is that of
Figures 8.2, 8.11, and 9.3. At P = MR = $35 in Figure 9.9, the firm is in short-run equi-
librium at point E by producing 3.5 units of output. Note that SMC refers to the short-run
MC to distinguish it from LMC. The firm makes a profit of $9 per unit (vertical distance
EE’) and $31.50 in total (as in Figure 9.3).
In the long run, the firm can increase its profits significantly by producing at point J’,
where P or MR = LMC (and LMC is rising). The firm should build plant SATCs and oper-
ate it at point J (at SATC = $13). Plant SATCs is the best plant (i.e., the one that allows the
firm to produce the best level of output at the lowest SATC). In the long run, the firm will
make profits of $22 (J'J) per unit and $286 in total ($22 times 13 units of output). This
compares with total profits of $31.50 in the short run. Note that when the firm is in long-
run equilibrium, it will also be in short-run equilibrium since P or MR = SMC = LMC
(see point J’ in the figure).” This analysis assumes that input prices are constant.

Long-Run Equilibrium of the Industry and the Firm

Even though the firm would be in long-run equilibrium at point J’ in Figure 9.9, the
industry would not. This is because the large profits that this and other firms earn at point
J’ will attract more firms to the industry. As new firms enter the industry (entry is free
and resources are mobile), aggregate output expands. This will shift the short-run indus-
try supply curve to the right until it intersects the market demand curve at the commod-
ity price at which all firms make zero economic profits (i.e., they earn only a normal

°’Note that SMCs = LMC at P = MR = $35 because the STCs curve is tangent to
the LTC curve (neither
curves shown in Figure 9.9) at O = 13.
 CHAPTER 9 Price and Output Under Perfect Competition 279

$ Firm § Industry

Pepe 2 SMC . LMC °

ieee SATC, fs ae

10 P=MR- 10}------
veil
BE pM
fe Een ae ee eee eee hye |
0 7 ie GE! ie Ee ye) 0 2,000 2,200 Q
FIGURE 9.10 Long-Run Equilibrium of the Industry and Firm The industry (in the right
panel) and the firm (in the left panel) are in long-run equilibrium at point H, where P = MR =
SMC = LMC = SATC = LAC = $10. The firm produces at the lowest point on its LAC curve
(operating optimal plant SA7TC4 at point H) and earns zero profits.

return) in the long run. Then, and only then, will the industry (and the firm) be in equi-
librium. In fact, the building of the best plant by the firm and the entrance of new firms
into the industry will take place simultaneously in the long run. The final result (equilib-
rium) is shown in Figure 9.10.
In the figure, the industry (in the right panel) and the firm (in the left panel) are in
long-run equilibrium at point H, where P = MR = LMC = SMC = LAC = SATC = $10.!°
The firm produces at the lowest point on its LAC curve (operating optimal plant SATC, at
point H) and earns zero economic profits. Zero economic profit means that the owner of
the firm receives only a normal return on investment when the industry and firm are in
long-run equilibrium. That is, the owner receives a return on the capital invested in the
firm equal only to the amount that he or she would earn by investing the capital in a sim-
ilarly risky venture. If the owner manages the firm, zero economic profits also includes
what he or she would earn in the best alternative occupation (i.e., managing a similar firm
for someone else). Thus, zero profits in economics means that the total revenues of the
firm just cover all costs (explicit and implicit).'!

Efficiency Implications of Perfect Competition

We have seen that when the perfectly competitive industry is in long-run equilibrium, the
firm not only earns zero profits but produces at the lowest point on its LAC curve (point H
in the left panel of Figure 9.10). Thus, resources are used most efficiently to produce the
goods and services most desired by society at the minimum cost. Since firms also earn
zero profits, consumers purchase the commodity at the lowest possible price ($10 at point
H in the figure). In this sense, perfect competition is the most efficient form of market
organization. This is to be contrasted to the situation under imperfect competition (dis-
cussed in the next four chapters), where we will see that firms seldom, if ever, produce at

10 Note that the supply curve labeled S in the right panel of Figure 9.10 is much larger than the supply curve S
in the right panel of Figure 9.8 because more firms have entered the industry in the long run and industry output
is larger.
'! As pointed out in Section 7.1, the meaning of profit in economics is to be distinguished clearly from the
everyday use of the term (which considers implicit costs as part of profits). In economics, profits always refer
only to the excess of total revenue over total costs, and total costs include both explicit and implicit costs
(see Section 8.1). In short, in economics, profits mean above-normal returns.
280 PART THREE Production, Costs, and Competitive Markets

includes a
the lowest point on their LAC curve, and they charge a price that also usually
profit margin.
=
To summarize, when a perfectly competitive industry 1s in equilibrium, P = LAC
LMC for each firm in the industry. Since P = LAC, the perfectly competiti ve firm earns
zero economic profits, and so there is distributional efficiency. Since P = LMC, each firm.
produces at the lowest point on its LAC curve, and so there is production efficiency.
Finally, since P = LMC, there is allocative efficiency in the sense that the amount of the
commodity supplied represents the best use of the economy’s resources.
We have seen so far that when a perfectly competitive firm earns (economic) profits,
more firms will enter the industry in the long run and this will lower the commodity price
until all firms just break even (i.e., earn zero economic profits). On the other hand, if the
Concept Check perfectly competitive firm incurs a loss in the short run and would continue to incur a loss
Why is perfect in the long run even by constructing the best plant, some firms would leave the industry.
competition the best This would shift the industry supply curve to the left until it intersected the industry
form of market
demand curve at the (higher) commodity price at which the remaining firms made zero
organization?
economic profits but incurred no losses. The final result would be as shown in Figure 9.10,
except that there would now be fewer firms in the industry and the industry output would
be smaller. As it is, Figure 9.10 indicates that if all firms had identical cost curves, there
would be 200 identical firms in the industry when in long-run equilibrium. Each firm
would produce 10 units of output and break even.
Perfectly competitive firms need not have identical cost curves (although we assume
so for simplicity), but the minimum point on their LAC curves must occur at the same cost
per unit. If some firms had more productive inputs and, thus, lower average costs than
other firms in the industry, the more productive inputs would be able to extract from their
employer higher rewards (payments) commensurate to their higher productivity, under
the threat of leaving to work for others. As a result, their LAC curves would shift upward
until the lowest point on the LAC curve of all firms is the same. Thus, competition in the
input markets as well as in the commodity market will result in all firms having identical
(minimum) average costs and zero economic profits when the industry is in the long-run
equilibrium. Example 9—4 examines the long-run adjustment in the U.S. cotton textile
industry.

EXAMPLE 9-4
Long-Run Adjustment in the U.S. Cotton Textile Industry

In a study of U.S. industries between the world wars, Lloyd Reynolds found that the
U.S. cotton textile industry was the one that came closest to being perfectly competi-
tive. Cotton textiles were practically homogeneous, there were many buyers and sell-
ers of cotton cloth, each was too small to affect its price, and entry into and exit from
the industry was easy. Reynolds found that the rate of return on investments in the
cot-
ton textile industry was about 6% in the South and 1% in the North (because
of higher
costs for raw cotton and labor in the North), as contrasted to an average rate
of return
of 8% for all other manufacturing industries in the United States over the
same period
of time.
Because of the lower returns, the perfectly competitive model would
predict that
firms would leave the textile industry in the long run and enter other
industries. The
 CHAPTER 9 Price and Output Under Perfect Competition 281

model would also predict that because returns were lower in the North than in the
South, a greater contraction of the textile industry would take place in the North than
in the South. Reynolds found that both of these predictions were borne out by the facts.
Capacity in the U.S. textile industry declined by over 33% between 1925 and 1938,
with the decline being larger in the North than in the South. Thus, textile firms, cotton
farms, and firms using cloth did seem to make use of this knowledge and did respond
to these economic forces in their managerial decisions.
Most U.S. textile firms were able to remain in business after World War II only as
a result of U.S. restrictions on cheaper textile imports and, subsequently, as a result of
the introduction of labor-saving innovations that sharply cut their labor costs. But with
the reduction in trade protection negotiated at the Uruguay Round (1986-1993), U.S.
textile firms have come under renewed pressure, especially from China, which is
expected to produce half of the world textiles before the end of the decade.
Sources: L. Reynolds, “Competition in the Textile Industry,” in W. Adams and T. Traywick, eds., Readings
in Economics (New York: Macmillan, 1948); “Apparel Makes Last Stand,” New York Times, September 26,
1990, p. D2; W. McKibbin and D. Salvatore, “The Global Economic Consequences of the Uruguay
Round,” Open Economies Review, April 1995, pp. 111-129; “U.S. Textiles Makers Unravel under Debt,
Import Pressure,” Wall Street Journal, December 27, 2001, p. A2; and “Free of Quota, China Textiles
Flood the U.S.,” New York Times, March 3, 2005, p. 3.

9.6 CONSTANT-, INCREASING-, AND DECREASING-COST INDUSTRIES

In the previous section, we examined how a perfectly competitive industry and firm reach
equilibrium in the long run. Starting from a position of long-run equilibrium, we now
examine how the perfectly competitive industry and firm adjust in the long run to an
increase in the market demand for the commodity. This allows us to define constant-,
increasing-, and decreasing-cost industries and to analyze their operation graphically.

Constant-Cost Industries
Starting from the long-run equilibrium condition of the industry and the firm (point 7) in
Figure 9.10, if the market demand curve for the commodity increases, the equilibrium price
will rise in the short run and firms earn economic profits (1.e., they receive above-normal
returns). This will attract more firms into the industry, and the short-run industry or market
supply curve of the commodity increases (shifts to the right). If input prices remain constant
(as more inputs are demanded by the expanding industry), the new long-run equilibrium
price for the commodity will be the same as before the increase in demand and supply. Then
the long-run industry supply curve (LS) for the commodity is horizontal at the minimum
Constant-cost LAC. This is a constant-cost industry, which is shown in Figure 9.11.
industry An industry In Figure 9.11, point H in the right and left panels shows the long-run equilibrium
with a horizontal long- position of the perfectly competitive industry and firm, respectively (as in Figure I).
run supply curve. before the increase in demand (D) and supply (S). The increase in D to D’ results in the
short-run equilibrium price of $20 (point H’ in the right panel). At P = $20, each of the
200 identical firms in the industry will produce Q = 10.5 (given by point H’ in the left
panel at which P = SMC, = $20) for a total industry output of 2,100 units.
282 PART THREE Production, Costs, and Competitive Markets

Firm Industry

FIGURE 9.11 Constant-Cost Industry Point H is the original long-run equilibrium point of the
industry and firm. An increase in D to D’ results in P = $20, and all firms earn economic profits. As
more firms enter the industry, S shifts to S’ and P = $10 if input prices remain constant. By joining
points H and H” in the right panel, we derive horizontal long-run supply curve LS for the
(constant-cost) industry.

Because each firm earns profits at P = $20 (see the left panel), more firms enter the
industry in the long run, shifting S to the right. If input prices remain constant, S shifts to
5S’, reestablishing the original equilibrium price of $10 (point H” in the right panel). At
P = $10, each firm produces at the lowest point on its LAC and earns zero economic profit
(point H in the left panel). By joining points H and H” in the right panel, we derive the
long-run supply curve of the industry (LS). Since LS is horizontal, this is a constant cost
industry (with 220 identical firms producing a total output of 2,200 units).
Constant costs are more likely to result in industries that utilize general rather than
specialized inputs and that account for only a small fraction of the total quantity
demanded of the inputs in the economy. In these cases, the industry may be able to hire a
greater quantity of the general inputs it uses without driving input prices upward.

Increasing-Cost Industries
If input prices rise as more inputs are demanded by an expanding industry, the long-run industry
Increasing-cost supply curve for the commodity will be positively sloped and we have an increasing-cost
industry An industry industry. This means that greater outputs of the commodity per time period will be supplied in
with a positively sloped
the long run only at higher commodity prices (see Figure 9.12).
long-run supply curve.
Starting from point H in the right and left panel of Figure 9.12, the increase in D to D’
results in P = $20 (point H’ in the right panel), at which all firms earn economic profits
(point H’ in the left panel). More firms enter the industry in the long run, and more inputs
are demanded as industry output expands. So far, this is identical to Figure 9.11. If input
prices now rise, each firm’s per-unit cost curves shift up (as explained in the appendix
to Chapter 8), and S shifts to the right to S’ so as to establish equilibrium P = minimum
LAC’ = $15 (see point H” in both panels of Figure 9.12). All profits are squeezed out as
costs rise and price falls. By joining points H and H” in the right panel, we get the long-run
 CHAPTER 9 Price and Output Under Perfect Competition 283

Industry
age
$
:
SMC,

SATC's, SMC", 20
9

15

10

SMC4,
|

NN ere 0 2 100 0
0 8 10 | Side 12 QO
10.5 2,000 2,150
FIGURE 9.12 Increasing-Cost Industry Point H is the original long-run equilibrium point of the
industry and firm. An increase in D to D’ results in P = $20 and all firms earn economic profits. As more
firms enter the industry, S shifts to S’ and P = $15 if input prices rise. By joining points H and H” in the
right panel, we derive positively sloped long-run supply curve LS for the (increasing-cost) industry.

industry supply curve (LS). Since LS is positively sloped, the industry is an increasing-cost
industry (with 217.5, or 218, identical firms).
Increasing costs are more likely to result in industries that utilize some specialized
input, such as labor with unique skills (e.g., highly trained lab technicians to conduct
experiments in genetics) or custom-made machinery to perform very special tasks (e.g.,
oil-drilling platforms). These industries may have to pay higher prices to bring forth a
greater supply of the specialized inputs they require, creating an increasing-cost industry.

Decreasing-Cost Industries
If input prices fall as more inputs are demanded by an expanding industry, the long-run
Decreasing-cost industry supply curve for the commodity will be negatively sloped and we have a decreasing-
industry An industry cost industry. This means that greater outputs of the commodity per time period will be
with a negatively supplied in the long run at lower commodity prices (see Figure 9.13).
sloped long-run supply
The movement from point H to point H’ in both panels of Figure 9.13 is the same as
curve.
in Figures 9.11 and 9.12. Since at point H’ firms earn profits, more firms enter the indus-
try in the long run. Industry output expands, and more inputs are demanded. If input prices
fall, each firm’s per-unit cost curves shift down, and S shifts to the right to S’ so as to estab-
lish equilibrium P = minimum LAC’ = $5 (point H” in both panels). By joining points H
and H” in the right panel, we derive LS, the industry long-run supply curve. Since LS is
negatively sloped, we have a decreasing-cost industry (with 230 identical firms).
Decreasing costs may result when the expansion of an industry leads to (1) the estab-
lishment of technical institutes to train labor for skills required by the industry at a lower
cost than firms in the industry do; (2) the setting up of enterprises to supply some equip-
ment used by the industry that was previously constructed by the firms in the industry for
themselves at higher cost; (3) the exploitation of some cheaper natural resource that the
industry can substitute for more expensive resources but which was not feasible to exploit
when the demand for the natural resource was smaller.
284 PART THREE Production, Costs, and Competitive Markets

Firm Industry

SMC4

20 = AY

2,100

FIGURE 9.13. Decreasing-Cost Industry Points H and H’ are the same as in the preceding two figures. Starting
from point H’, as more firms enter the industry, S shifts to S’ and P = $5 if input prices fall. By joining points H and H”
in the right panel, we derive the negatively sloped long-run supply curve LS for the (decreasing-cost) industry.

Concept Check In the real world, we have examples of constant-, increasing-, and decreasing-cost
What are constant-, industries. In fact, a particular industry could exhibit constant, increasing, or decreasing
increasing-, and costs over different time periods and at various levels of demand.'* It should also be noted
decreasing-cost that the shifts in firms’ per-unit cost curves in the left panel of Figures 9.12 and 9.13 were
industries?
vertical (so the lowest point on both the LAC and LAC’ curves occurred at Q = 10). This
External economy A is the case if the prices of all inputs change in the same proportion. Otherwise, per-unit
downward shift in all cost curves would also shift to the right or to the left.
firms’ per-unit cost The downward shift in the firm’s per-unit cost curves (due to a fall in input prices) as
curves resulting from a
the industry expands is called an external economy, while the upward shift in the firm’s
decline in input prices
as the industry expands.
per-unit cost curves (due to an increase in input prices) as the industry expands is called
an external diseconomy. These terms are to be clearly distinguished from economies or
External diseconomy diseconomies of scale, which are internal to the firm and refer instead to a downward or
An upward shift in all an upward movement along a given LAC curve (as the firm expands output and builds
firms’ per-unit cost larger scales of plants). The assumption here is that as only a single firm expands output,
curves resulting from
input prices remain constant. External economies and diseconomies are examined in
an increase in input
prices as the industry
detail in Chapter 18.
expands.

INTERNATIONAL COMPETITION IN THE Domestic ECONOMY

Domestic firms in most industries face a great deal of competition from abroad.
Most U.S.-made goods today compete with similar goods from abroad and in turn
compete with foreign-made goods in foreign markets. Steel, textiles, cameras, wines,
automobiles, television sets, computers, and aircraft are but a few of the domestic

Of the three cases, increasing-cost industries may be, perhaps, somewhat more
common than the other two
cases. Some important examples of decreasing-cost industries are computers, VCRs,
and many other
consumer electronics products,
 CHAPTER 9 Price and Output Under Perfect Competition 285

Px($)

Se

Sp
|
Imports
~~ B >|

|
|
| |
0 200 400 600 Qy
FIGURE 9.14 Consumption, Production, and Imports Under Free
Trade In the absence of trade, equilibrium is at point E, where D, and
Sy intersect, so that P, = $5 and Q, = 400. With free trade at the world
price of P, = $3, domestic consumers purchase /R = 600X, of which
IK = 200X are produced domestically and KR = 400X are imported.

products that compete with foreign products for consumers’ dollars in the U.S.
economy today. Competition from imports allows domestic consumers to purchase
more of a commodity at a lower price than in the absence of imports. This is shown
by Figure 9.14.
In the figure, Dy and Sy refer to the domestic market demand and supply curves of
commodity X. In the absence of trade, the equilibrium price is given by the intersection of
the Dy and Sy at point E, so that domestic consumers purchase 400X (all of which is pro-
duced domestically) at Py = $5. With free trade at the world price of Py = $3, the price
of commodity X to domestic consumers will fall to the world price. The foreign supply
curve of this nation’s imports of commodity X, Sp, is horizontal at Py = $3 on the
assumption that this nation’s demand for imports of commodity X is small in relation to
the foreign supply. From the figure, we can then see that domestic consumers will pur-
chase JR or 600X at Py = $3 with free trade (and no transportation costs), as compared
with 400X at Py = $5 in the absence of trade (given by point £).
Figure 9.14 also shows that with free trade, domestic firms produce only /K or
200X, so that KR or 400X are imported at Py = $3. Resources in the nation will then
shift from the production of commodity X to the production of other commodities that
the nation can produce relatively more efficiently (i.e., in which the nation has a com-
parative advantage). By doing this, the nation will be able to obtain more of commodity
286 PART THREE Production, Costs, and Competitive Markets

of domestic resources to pro-

X through exchange than if it had used the same amount
duce commodity X domestically.'°

9.8 ANALYSIS OF COMPETITIVE MARKETS

of analysis
In this section, we examine a number of important applications of the tools
and measurem ent of producer sur-
developed in this chapter. These include the definition
further demonstra te the efficiency of
plus, using consumers’ and producers’ surplus to
perfect competition, and showing the effects of a per-unit tax and an import tariff. These
applications, together with those from Chapter 2 (which presented an introductory
overview of the perfectly competitive model) on rent control, U.S. farm-support pro-
grams, and the incidence of (i.e., who pays for) an excise tax, clearly demonstrate the
great usefulness of the perfectly competitive model.

Producer Surplus
Producer surplus is a concept analogous to that of the consumer surplus examined in
Section 4.5. Consumer surplus is the difference between what consumers are willing to
pay for a commodity and what they actually pay, and it is measured by the area under the
Producer surplus The demand curve and above the commodity price. Producer surplus is defined as the excess
excess of the market of the commodity price over marginal cost, and it is measured by the area between the
price of a commodity commodity price and the producer’s marginal cost curve. This is shown in Figure 9.15.
over the marginal cost
Figure 9.15 shows that a perfectly competitive firm facing a price of $5 produces 4X
of production.
(given by point E at which dy = MRy = Py = $5 = MCy). This is derived from the opti-
mization rule that a firm should expand production as long as price or marginal revenue
exceeds marginal cost and until marginal revenue and marginal cost are equal. Since the
firm sells all four units of commodity X at the market price of $5, but faces a marginal cost
(or minimum price at which it will supply the first unit of the commodity) of only $2 on
the first unit produced, the firm receives a surplus of $3 (given by the area of the first
shaded rectangle in the figure) on the first unit sold. With Py = $5 but a marginal cost of
$3 to produce the second unit of commodity X, the firm receives a surplus of $2 (the area
of the second shaded rectangle) on the second unit sold. With Py = $5 and MC = $4
on the third unit of commodity X produced, the firm receives a surplus of $1 (the area of
the third shaded rectangle) on the third unit of X sold. Finally, since Py = MCy = $5
on the fourth unit, producer surplus is zero on the fourth unit of X. The firm will not pro-
duce the fifth unit of commodity X because the marginal cost of producing the fifth unit
($6) exceeds the commodity price of $5 (see the figure).
By adding the producer surplus of $3 on the first unit of commodity X, $2 on the sec-
ond unit, $1 on the third unit, and $0 on the fourth unit, we get the total producer surplus of
$6 that the firm receives from the sale of 4X. If commodity X could be produced and sold in
infinitesimally small units, the total producer surplus would be given by the total area
between the price of the commodity and the firm’s marginal cost curve. This is the area of

'S If the nation’s demand for the imports of commodity X is large in relation to the total world
supply of the
exports of commodity X to the nation, then Sp would be positively sloped and intersect Dx
ata higher price
so that the domestic production of commodity X would be higher while domestic consumption
and imports |
would be smaller than indicated in Figure 9.14. Try to pencil in this change in Figure 9,14.
 CHAPTER 9 Price and Output Under Perfect Competition 287

MCy

dy = MRy
FIGURE 9.15 Producer Surplus AtP, = $5 the firm
produces 4X (point £). Since the marginal cost is $2 on the first
unit of X produced, the firm receives a surplus of $3 (given by the
area of the first shaded rectangle). With MC, = $3 on the second
unit of X, producer surplus is $2 (the area of the second shaded
rectangle). With MC, = $4 on the third unit, producer surplus is $1
(the area of the third shaded rectangle). With MC, = $5 on the
fourth unit, producer surplus is zero. Total producer surplus on 4X
is $6. If commodity X were infinitesimally divisible, total producer
surplus would be $8 (the area of triangle BEC). Qx

triangle BEC, which is equal to $8 (as compared with $6 found above). At the market price
of Py = $5 and with output of 4X, the total revenue of the firm is $20 (given by the area of
rectangle BEFO in the figure). Of this, CEFO or $12 represents the opportunity cost of the
variable inputs used or the minimum cost that the producer will incur to produce 4X. The
difference of $8 (the area of triangle BEC) thus represents the producer surplus or the
amount that is not necessary for the producer to receive in order to induce him or her to
supply 4X.
If the market price of commodity X fell to $4, we can see from the figure that the
best level of output of the firm would be 3X and the total producer’s surplus would be
$4.50 (given by the area of the triangle formed by Py = $4 and the MCy curve). On the
other hand, if the price of commodity X rose to $6, the best level of output of the firm
would be 5X and the total producer’s surplus would be $12.50 (given by the area of the
triangle formed by Py = 6 and the MCy curve in Figure 9.15). This analysis applies to
each producer in a perfectly competitive market. Indeed, the concepts of consumer and
producer surplus are used in the next section to further demonstrate the efficiency of a
perfectly competitive market and in the last two sections of this chapter to show the wel-
fare effects of an excise tax and an import tariff.

Consumers’ and Producers’ Surplus, and the Efficiency

of Perfect Competition
We have seen in Section 9.4 that in a perfectly competitive market, equilibrium occurs at
the intersection of the industry or market demand and supply curves for the commodity.
At this point, the marginal benefit to consumers from the last unit of the commodity pur-
chased just matches the marginal cost to producers, and the combined consumers’ and
producers’ surplus is at a maximum. This is another way of proving that perfect competi-
tion is the most efficient form of market structure, and is shown in Figure 9.16.
In Figure 9.16, Dy and Sx refer, respectively, to the industry or market demand and sup-
ply curves for commodity X. The intersection of Dy and Sx defines equilibrium point E at
which Py = $5 and Qy = 400. The total consumers’ surplus (the sum of the surpluses of all
the consumers of commodity X in the market) is given by triangle AEB (the area under Dy and
above Py), which is equal to $800. The total producers’ surplus (the sum of the surpluses of all
288 PART THREE Production, Costs, and Competitive Markets

Px($)

Producers’
surplus
FIGURE 9.16 The Efficiency of Perfect Competition
Expanding output from 300X to 400X increases consumers’
plus producers’ surplus by HE/—= $100. Expanding output past
the competitive equilibrium output of 400X reduces the total
surplus, because the marginal benefit to consumers is less than
the marginal cost of producers. Thus, consumers’ plus
producers’ surplus is maximized when a perfectly competitive l | | | |
market Is in equilibrium. 0 200 400 600 Qx

the producers of commodity X in the market) is given by triangle BEC (the area below Px and
above Sx), which is also $800. Thus, the total combined consumers’ and producers’ surplus is
given by area AEC = $1,600.
We can use Figure 9.16 to show that when a perfectly competitive market is in equi-
librium, consumers’ plus producers’ surplus is maximized. For example, expanding out-
put from 200X to 300X leads to a combined increase of consumers’ and producers’
surplus equal to GHJK = $300. The increase in consumers’ and producers’ surplus
arises because the marginal benefit to consumers exceeds the marginal cost to producers
for each additional unit produced and consumed. Expanding output from 300X to 400X
leads to a further increase in consumers’ plus producers’ surplus of HEJ = $100. If out-
put expands past the equilibrium output of 400X, the total surplus declines because con-
sumers value the extra output at less than the marginal cost of producing it. Only at the
competitive equilibrium output of 400X does the marginal benefit to consumers equal
the marginal cost of producers and is the total combined consumers’ and producers’ sur-
plus maximized. This can also be regarded as the benefit from exchange or trading (1.e.,
from buying and selling commodity X).
We will see in Part Four (Chapters 10-13) that imperfect competitors restrict output
and charge a higher price so that the total combined consumers’ and producers’ surplus is
smaller than under perfect competition. So important are the benefits of competition that
market economies have been reducing the number and size of government regulations
during the past decade. Even China has increasingly been relying on markets and less on
planning.'4

'4 See “The Global March of Free Markets,” New York Times, July 19, 1987, Section
3, p. 1; and “Support Is
Growing in China for Shift to Free Markets?’ New York Times, June 28, 1992, p. 1.
 CHAPTER 9 Price and Output Under Perfect Competition 289

Welfare Effects of an Excise Tax

We will now use changes in consumers’ and producers’ surplus to measure the net loss
in welfare resulting from an excise tax. The production and consumption effects of
an excise tax as well as its incidence (i.e., who pays for the tax) were discussed in
Section 2.7. Here, we expand that discussion to include a measurement of the loss in
consumers’ and producers’ surplus resulting from the imposition of the tax. This is
shown in Figure 9.17.
In Figure 9.17, Dy and Sy are, respectively, the market demand and supply curves for
commodity X. The intersection of Dy and Sy defines the equilibrium price of $5 and the
equilibrium quantity of 400X (just as in Figure 9.16). A tax of $2 per unit causes the Sy
curve to shift up by $2 to S{, because producers must now pay the $2 tax in addition to the
previous marginal cost of producing each unit of commodity X shown by the Sy curve.
This defines the new equilibrium point H at which Py = $6 to consumers and Qy = 300.
Producers, however, receive a net price of only $4 after paying the tax of $2 per unit. Thus,
the tax raises the price to consumers from $5 to $6 and lowers the net price received by
producers from $5 to $4, so consumers and producers in this case share equally the burden
of the tax. So far, this is the same as in Section 2.7.
We can now go further, however, and measure the welfare effect of the tax by the
change in consumers’ and producers’ surplus resulting from the tax. From Figure 9.17 we

Px($)

FIGURE 9.17 Welfare Effects of an Excise Tax With D,

and S,, equilibrium is at pointEat which P, = $5 and Qy = 400.
A tax of $2 per unit on commodi Xtyshifts S, up to Sy’
and defines new equilibrium point H at which P, = $6 to
consumers, Q, = 300, and producers receive a net price of
$4 per unit. The loss of consumers’ surplus is LHEB = $350,
the loss of producers’ surplus is BEJN = $350, for a
combined loss of LHEJN = $700. Since tax revenues are
300 units), there is a l
LHJN = $600 ($2 per unit on
0 300 400 Qx
deadweight loss of HEJ = $100.
290 PART THREE Production, Costs, and Competitive Markets

consumers’ surplus equal to

can see that the imposition of the tax leads to a reduction in
$350, for an over-
LHEB = $350 and a reduction in producers’ surplus equal to BEJN =
produce rs’ surplus of $700. Since the government
all combined loss of consumers’ and
commodi ty, or a total of $600 (the area of rectan-
collects $2 per unit on 300 units of the
HEJ) in consumers’
gle LHJN), the tax results in a net loss of $100 (the area of triangle
ment were to
Deadweight loss The and producers’ surplus. This deadweight loss remains even if the govern
d in the form of a general income subsidy to con-
excess of the combined return the entire amount of tax collecte
distorti ons resultin g from the tax. Specific ally,
loss of consumers’ and sumers. The loss results because of the
producers’ surplus from some of society’s resources shift from the product ion of commod ity X to the product ion
a tax.
of other commodities that consumers value less. The provisi on of a per-unit product ion
subsidy to producers would have the opposit e effect of an excise tax (see Problem 11 at
the end of this chapter).
Concept Check
How are the welfare
effects of an excise tax
measured? Effects of an Import Tariff
We-can show the effects of an import tariff using Figure 9.18. In Figure 9.18, Dx and Sy
refer, respectively, to the domestic market demand and supply curves of commodity X.
Sp is the foreign supply curve of exports of commodity X to the nation at the world price
of $3 (on the assumption that the quantity demanded of imports of commodity X by the
nation is very small in relation to the total foreign supply of exports of the commodity).
With free trade at the world price of Py = $3, domestic consumers purchase /R = 600X,
of which IK = 200X are produced domestically and KR = 400X are imported (so far this
is the same as in Figure 9.14 in Section 9.7).
Suppose that from the free trade position, the nation imposes a 33% import tariff,
or a tariff of $1 on each unit of commodity X imported. The new foreign supply curve
for the nation’s imports now becomes S- + T, where T refers to the tariff. The price of
commodity X to domestic consumers now becomes $4 (see Figure 9.18). At Py = $4,
domestic consumers purchase NU = 500X, of which NJ = 300X are produced domesti-
cally and JU = 200X are imported. Thus, the consumption effect of the tariff (i.e., the
reduction in domestic consumption resulting from the tariff) is RW = —I100X, the
production effect (i.e., the expansion of domestic production resulting from the tariff) is
KV = 100X, the trade effect (i.e., the decline in imports) is RW + KV = —200X, and the
revenue effect (i.e., the revenue collected by the government) is JUWV = $200 (JV = $1
on each of the 200X imported).
We can also measure the welfare effects of the tariff. From Figure 9.18, we see that
the tariff leads to a reduction in consumers’ surplus equal to NURI = $550. Of this,
Concept Check
How are the effects of
NJKI = $250 represents a transfer to producers in the form of an increase in producers’
an import tariff surplus, JUWV = $200 is the tariff revenue collected by the nation’s government, and the
measured? sum of triangles URW = $50 and JKV = $50 represents the protection cost or deadweight
loss of the tariff. This results from the production and consumption distortions arising
from the tariff.
Results would be similar if, starting from the free trade position in Figure 9.18, the
nation imposed an import quota that directly restricted the quantity of imports of com-
modity X into the nation to JU = 200X. If the nation auctioned off import licenses to the
highest bidder, it would collect the same revenue (JUWV = $200) as with the 33% or $1
tariff on each unit of imports. If the nation does not auction off import licenses (as is often
the case), the nation’s importers or the foreign exporters would earn that much greater
 CHAPTER 9 Price and Output Under Perfect Competition 291

Px ($)

Sx

4
Sr His Gf

R
3 Sr
| |
| |
| |
|
|
| |

l : ||
| |
| | |
| | |
0) 200 300 400 500 600 Qy

FIGURE 9.18 Effects of an Import Tariff D, and S, represent the

domestic market demand and supply curves of commodity X. At the free
trade price P, = $3, domestic consumers purchase /R = 600X, of
which IK = 200X are produced domestically and KR = 400X are
imported. With a $1 import tariff, P, to domestic consumers rises to $4.
At P, = $4, domestic consumers purchase NU = 500X, of which NJ =
300X are produced domestically and JU = 200X are imported. Thus,
the consumption effect of the tariff is RW = — 100X, the production
effect is KV = 100X, the trade effect is RW + KV = —200X, and the
revenue effect is JUWV = $200. Consumers’ surplus declines by NURI =
$550, of which NJK/ = $250 represents an increase in producers’
surplus, JUWV = $200 is the tariff revenue, and URW = $50 plus
JKV = $50 represents the deadweight.loss of the tariff.

profits. This is exactly what happened when the United States negotiated an agreement
with Japan during the 1980s under which Japan “voluntarily” reduced its automobile
exports to the United States. Japanese automakers were, therefore, able to sell automo-
biles in the United States at the world price plus the equivalent tariff (1.e., the tariff that
would have reduced imports by the same amount as the quota) and earn huge profits. If
trade restrictions were necessary to allow domestic automakers to improve quality and
meet Japanese competition, then it would have been better for the United States to impose
an equivalent import tariff and collect the tariff revenue.'°

!5 See D. Salvatore, International Economics, 8th ed. (New York: John Wiley & Sons, 2003), Section 9.3a.
292 PART THREE Production, Costs, and Competitive Markets

AT THE FRONTIER (1)

New Markets and New Competition on the Internet

he Internet has created new markets and new competition. The three icons of
a e-commerce are Amazon.com, eBay, and Priceline. Amazon.com sells books,
videos, and gifts by traditional methods—only without the bricks and mortar
of storefronts. In October 1999, Amazon opened its Website to merchants of all
kinds, essentially becoming an Internet shopping bazaar. eBay’s auctions originally
matched buyers and sellers of collectibles, such as Beanie Babies and baseball
cards, but they now include most products; eBay has now more than 150 million
customers in over 15 countries around the world, and in the United States it opened
50 regional marketplaces for large items, such as cars, boats, and refrigerators, that
are not well suited for its national Website. In 2007, eBay had a market capitaliza-
tion in excess of $185 billion, which exceeded that of Wal-Mart, Coca-Cola,
and IBM.
Priceline allows buyers to name the price they are willing to pay for flights, hotel
rooms, mortgages, cars, and groceries. The only condition is that the buyer be flexi-
ble as to seller or brand name. For example, in the purchase of an airline ticket to a
certain city, the buyer cannot specify the airline or the time of flight but has to take
what is offered by the carrier that accepts the bid. This allows airlines to sell empty
seats without losing their regular customers. As customers learned to make realistic
bids and as Priceline added more airlines and flights, more and more bids have been
successful (although they are still less than half). Students at the University of
Pennsylvania’s Wharton School of Business registering for elective courses have
even been able to log on to Wharton’s course auction Website and bid on the courses
they want.
Several new, smaller sites have also been established that not only led to lower
prices than at Priceline but even identify the price of the winning bid and the company
that accepted the bid—something that Priceline won’t (really cannot) do because it
has promised the companies not to do so. Now a new crop of start-ups, such as
Become.com, Smarter.com, and BuySafe, is pushing the price-comparison concept
even further, offering extra discounts, greater convenience, and protection against
fraud. The Internet has certainly been a fertile ground for creating new markets and
competition by launching entirely new ways of doing business!

Sources: “Wired for the Bottom Line,” Newsweek, September 20, 1999, pp. 43-49; “eBay Plans to Open
50 Web Markets for Regional Use,” Wall Street Journal, October 1, 1999, p. Bo; “Business School Puts
Courses in the Hands of an On-Line Market,” New York Times, September 9, 1999, p. G3; “The Brave
New World of Pricing,” Financial Times, August 2, 2001, p. 2; “How to Beat Priceline: New Sites Post
Secret Bids,” Wall Street Journal, April 9, 2002, p. D1; The Next Generation of Price-Comparison Sites,”
Wall Street Journal, September 14, 2005, p. D1; “Collective Bargain Hunting,” New York Times Magazine,
eae 18, 2005, p. 32; and “Google Shares Power Past $600 Mark,” Financial Times, October
vy.
7 Pa2oe
 CHAPTER 9 Price and Output Under Perfect Competition 293

AT THE FRONTIER (2)

Auctioning Airwaves

S ince the time of its creation in 1927 until December 1994, the Federal
Communications Commission (FCC) handed out airwaves (radio frequency)
licenses free of charge, through either lotteries or merit-based hearings, favoring local
radio and TV stations, on the theory that they would be more attuned to community
programming needs. During the 1980s, pressure began to mount to scrap the old sys-
tem and allow market forces to allocate these scarce resources (airwaves). Between
December 5, 1994, and March 1995, the U.S. government auctioned off to the highest
bidder thousands of licenses to blanket the nation with new personal communications
services (PCS) for the huge sum of $7.7 billion.
Although similar to an art auction—except that all licenses rather than a single
one were up for bidding at the same time—auctioning airwaves licenses was unlike
anything ever done before. The plan carved the nation into 51 regions and 492 subre-
gions (metropolitan areas) and auctioned two licenses for each of the 51 regions and
up to five licenses for each of the 492 subregions. A large company or group of com-
panies could bid for a nationwide license by combining bids for a license for each
region. Thus, each metropolitan area could have as many as seven new wireless ser-
vices (five for the metropolitan area alone and another two from the region of which
the metropolitan area is part), and each of these would compete with the one or two
already-established cellular telephone companies (which were allowed to bid and did
bid for some of the new wireless licenses).
Since March 1995, 14 other auctions of wireless licenses were held, which netted
the government an additional $59 billion, and more auctions were planned for the
future. It is estimated that during this decade more than 100 million Americans will
create a $100 billion-a-year industry for wireless services. Such large revenues are
needed in order for the industry to recoup the original investments. These include the
nearly $50 billion already paid for the licenses as well as the even larger investments
that wireless companies are collectively making in order to set up the new digital
transmission systems. Thus, it may take a decade before wireless companies can
break even and possibly become profitable. In the end, the difference between a profit
and a loss could be the price of the license itself. Wireless companies may simply
Winner’s curse have paid too much for these licenses. This is called the winner’s curse.
The overbidding The winner’s curse arises because if the average for all the bids equals the true
or the paying ofa (but unknown) value of a license (based on the future stream of incomes that it is
price higher than the ex nected to generate), then the price paid by the highest bidder would exceed the aver-
Bee iusninoyy) age bid and the true value of the license. This is exactly what happened in the bidding
echo aie _ for oil leases in the Gulf of Mexico during the 1950s and 1960s. The winner’s curse
an auction. can also arise when publishers bid for a novel. The most optimistic company is likely
to be the highest bidder, and its bid will exceed the average bid and true value of the
asset. The only way to avoid the winner’s curse is for a company to adopt a prudent
bidding approach and not to overbid.
The winner’s curse seems to have happened in this instance, as evidenced by the
fact that, starting in 1996, several of the less-known large bidders for the licenses
Continued...
294 PART THREE Production, Costs, and Competitive Markets

Auctioning Airwaves = Continued

for the
started to default on payments. It seems that many successful bidders overpaid
the sale of multiple licenses for each
licenses, in view of the strong competition that
market generates. The government then reauction ed these licenses. Legislati on has
also been passed requiring TV broadcasters to go all-digital by February 2009 and to
relinquish their analog airwaves so that they can also be auctioned off by the govern-
ment at an estimated price of as much as $20 billion.

Sources: “U.S. Lays Out Rules for a Big Auction of Radio Airwaves,” New York Times, September 24,
1993, p. 1; “Winners of Wireless Auctions to Pay $7 Billion,” New York Times, March 14, 1995, p. D1;
“Clinton Orders a New Auction of Airwaves,” New York Times, October 14, 2001, p. 1; “Everybody Wants
a Piece of the Air,’ Business Week, July 4, 2005, pp. 38-39; “A Scramble for the Perfect Wave,” Business
Week, June 25, 2007, p. 54; “Auction of Wireless Spectrum Brings U.S. $19 Billion,” New York Times,
March 19, 2008, p. C2; P. Milgrom, “Auctions and Bidding: A Primer,” Journal of Economic Perspectives,
Summer 1989, pp. 3—22; and S. Thiel, “Some Evidence on the Winner’s Curse,” American Economic
Review, December 1988, pp. 884-895.

| SUMMARY
1. Economists identify four different types of market organization: perfect competition, monopoly,
monopolistic competition, and oligopoly. In a perfectly competitive market, no buyer or seller
affects (or behaves as if he or she affects) the price of a commodity, all units of the commodity are
homogeneous or identical, resources are mobile, and knowledge of the market is perfect.
2. The market period, or the very short run, refers to the period of time during which the market
supply of a commodity is fixed. During the market period, costs of production are irrelevant in
the determination of the price of a perishable commodity and the entire supply of the
commodity is put up for sale at whatever price it can fetch. Thus, demand alone determines
price (while supply alone determines quantity).
3. The TR of a perfectly competitive firm is a straight line through the origin with slope of MR = P.
The best or profit-maximizing level of output occurs where the positive difference between
TR and STC is greatest. The same result is obtained where P or MR = MC and MC is rising,
provided that P > AVC. If P is smaller than ATC at the best level of output, the firm will incur
a loss. As long as P exceeds AVC, it pays for the firm to continue to produce because it covers
all variable costs and part of its fixed costs. If the firm were to shut down, it would incur a loss
equal to its total fixed costs. The shut down point is where P = AVC.
4. The rising portion of the firm’s MC curve above the AVC curve (the shutdown point) is the
firm’s short-run supply curve for the commodity. The industry short-run supply curve is the
horizontal summation of the firms’ short-run supply curves. The equilibrium price is at the
intersection of the market demand and supply curves of the commodity. The firm will then
produce the output at which P or MR = MC, and MC is rising (as long as P exceeds AVC).
With an increase in demand, the equilibrium price will rise and firms will expand their output.
If input prices rise, the MC curve of each firm shifts up, and so the short-run supply curve of
each firm and of the industry are less elastic.
5. In the long run, the industry and the firm are in long-run equilibrium where P = MR — SMC
=
LMC = SATC = LAC. Each firm operates at the lowest point on its LAC curve and earns Zero
profits. Competition in the input markets as well as in the commodity market will result
in all firms
having identical average costs and zero profits when the industry is in long-run equilibrium.
6. One of three possible cases can result as industry output expands and
more inputs are
demanded. If input prices remain constant, the industry long-run supply curve
is horizontal
 CHAPTER 9 Price and Output Under Perfect Competition 295

and we have a constant-cost industry. If input prices rise (external diseconomy), the
industry long-run supply curve is positively sloped and we have an increasing-cost industry.
This may be more common than the former two cases. If input prices fall (external
economy), the industry long-run supply curve is negatively sloped and we have a decreasing-
cost industry.
~ - Domestic firms in most industries face a great deal of competition from imports. International
trade leads to a decline in the domestic price of the commodity, and larger domestic
consumption and lower domestic production of the commodity than in the absence of trade.
oo. Producer surplus equals the excess of the commodity price over the producer’s marginal cost of

production. The combined consumers’ and producers’ surplus is maximized when a perfectly
competitive market is in equilibrium. A tax leads to a deadweight loss. An import tariff
increases the domestic price of the importable commodity, reduces domestic consumption
and imports, increases domestic production, generates tax revenues, and leads to a deadweight
loss.
9. The Internet has created new markets and new competition. Between 1994 and 2007, the U.S.
government auctioned off to the highest bidder thousands of licenses to offer new personal
communications services (PCS) for nearly $50 billion. Some of the new wireless companies
that purchased these licenses may have overpaid (and faced the winner’s curse).

KEY TERMS
Perfect competition Increasing-cost industry Winner’s curse
Market period Decreasing-cost industry Foreign-exchange market
Break-even point External economy Exchange rate
Shutdown point External diseconomy Depreciation
Price elasticity of supply Producer surplus Appreciation
Constant-cost industry Deadweight loss

REVIEW QUESTIONS
— . If perfect competition is rare in the real world, why do we Te Why should a nation trade if such trade benefits domestic
study it? consumers but harms domestic producers?
_ A firm’s total revenue is $100, its total cost is $120, and its . What is the difference between economic profit and
total fixed cost is $40. Should the firm stay in business? producer surplus?
Why? What is the combined consumers’ and producers’ surplus
ies). Why might a firm remain in business in the short run even at the output level of SOOX in Figure 9.15? Why is this
if incurring a loss but always leave the industry if incurring not the best level of output?
a loss in the long run? . Is the deadweight loss from an excise tax greater when
. At what level of output is profit per unit maximized for a the market demand and supply curves of the commodity
perfectly competitive firm? Why will the firm not produce are elastic or inelastic? Why?
this level of output? . What is the size of a prohibitive tariff in Figure 9.18? What
Why would a firm enter a perfectly competitive industry if would be the effects of such a prohibitive tariff?
it knows that its profits will be zero in the long run? WE, What is meant by the winner’s curse in an auction? How
Must a perfectly competitive industry be in long-run can this be avoided?
equilibrium if a perfectly competitive firm is in long-run 13}. Assuming a two-currency world—the U.S. dollar and the
equilibrium? Must each perfectly competitive firm be in British pound sterling—what does a depreciation of the
equilibrium if the industry is in long-run equilibrium? Why? dollar mean for the pound? Explain.
296 PART THREE Production, Costs, and Competitive Markets

@|_ PROBLEMS
1. Suppose that the market demand function of a perfectly b. construct a table similar to Table 9.2 showing P, MR,
competitive industry is given by QD = 4,750 — 50P and ATC, and MC at each level of output.
the market supply function is given by QS = 1,750 + SOP, . For your figure in Problem Sa, determine the best level of
and P is expressed in dollars. output, the profit or loss per unit, total profit or losses, and
a. Find the market equilibrium price. whether the firm should continue to produce at
b. Find the quantity demanded and supplied in the market a. P = $42.
at P = $50, $40, $30, $20, and $10. OS lee
ie) Draw the market demand curve, the market supply Cea)
curve, and the demand curve for one of 100 identical
_ Graph the quantity supplied (Q) at various prices (P) by
perfectly competitive firms in this industry. firms 1, 2, and 3 given below, and derive the industry
OQ. . Write the equation of the demand curve of the firm. supply curve on the assumptions that the industry is
a. If the market supply function of a commodity is composed only of these three firms and input prices
QOS = 3,250, are we in the market period, the short remain constant.
run, or the long run?
Price and Quantity Supplied By Firms 1, 2, and 3
b. If the market demand function is QD = 4,750 — 50P
and P is expressed in dollars, what is the market P Q; Q> Q3
equilibrium price (P)?
$1 0) 0) 0
Qa _ If the market demand increases to Q D’ = 5,350 —
2 20 0) 0)
50P, what is the equilibrium price?
3 40 10 10
d. If the market demand decreases to QD’ = 4,150 —
4 60. 20 2
50P, what is the equilibrium price?
e.Draw a figure showing parts (b), (c), and (d) of this ao. Starting from Figure 9.5, suppose that as each of the 100
problem. identical firms in the perfectly competitive industry
ies). Using the STC schedule provided in the table for Problem increases output (as a result of an increase in the market
2(a) in Chapter 8 and P = $26 for a perfectly competitive price of the commodity), input prices rise, causing the
firm, SMC curve of each firm to shift upward by $15. Draw a
a. draw a figure similar to Figure 9.2 and determine the figure showing the original and the new MC curve and
best level of output for the firm. the quantity supplied by each firm and by the industry as
b. construct a table similar to Table 9.1 showing TR, STC, a whole at the original price of P = $35 and at P = $50.
and total profits at each level of output. On the same figure, show the supply curve of each firm
and of the industry.
A, Suppose that a perfectly competitive firm has no
knowledge of the exact shape of its STC curve. It knows . a. For the perfectly competitive firm of Problem 5, draw
that its total fixed costs are $200, and it assumes that its
a figure similar to Figure 9.9 showing the short-run
average variable costs are constant at $5. and long-run equilibrium on the assumption that the
firm, but not the industry, is in long-run equilibrium.
a. If the firm can sell any amount of the commodity at
Assume P = $30, the lowest LAC = $12.50 at O = 8,
the price of $10 per unit, draw a figure and
the best level of output is Q = 10, and LAC = $15
determine the sales volume at which the firm breaks
with SATCs and SMC; = LMC = $30 when the firm,
even.
but not the industry, is in long-run equilibrium.
b. How can an increase in the price of the commodity, in
b. Draw a figure similar to Figure 9.10 for the firm of
the total fixed costs of the firm, and in average variable
part (a) showing the long-run equilibrium point for
costs, be shown in the figure of part (a) of this problem?
the firm and the industry.
c. What is an important shortcoming of this analysis? S10: Starting from long-run equilibrium in a perfectly
#5, Using the per-unit cost schedules derived from the table competitive increasing-cost industry, show on one
for Problem 2(a) in Chapter 7 and P = $26, diagram the effect on price and quantity of an increase in
a. draw a figure similar to Figure 9.3 and show the best demand in the market period, in the short run, and in the
level of output of the firm. long run.

* = Answer provided at end of book.

 CHAPTER 9 Price and Output Under Perfect Competition 297

11. Starting with Dy and Sy in Figure 9.17, show all the effects 13. Starting with Dy and Sy of Figure 9.18, draw a figure
of a production subsidy of $2 per unit given by the similar to Figure 9.18 showing all the effects of a 100%
government to all producers of commodity X. import tariff on commodity X if the free trade price of
12. Starting with Dy and Sy in Figure 9.17, determine the commodity X is $2.
effect of a price ceiling of $4 using the concepts of the
consumers’ and producers’ surplus.

THE FOREIGN-EXCHANGE MARKET AND THE DOLLAR

APPENDIX
EXCHANGE RATE

A firm will import a commodity as long as the domestic currency price of the imported com-
modity is lower than the price of the identical or similar domestically produced commodity
and until they are equal (in the absence of transportation costs, tariffs, or other obstructions
to the flow of trade). In order to make the payment, the domestic importer will have to
exchange the domestic currency for the foreign currency. Since the U.S. dollar is also used
as an international currency, however, a U.S. importer could also pay in dollars. In that case,
it is the foreign exporter that will have to exchange dollars into the local currency.
The market where one currency is exchanged for another is called the foreign-
Foreign-exchange exchange market. The foreign-exchange market for any currency, say the U.S. dollar, is
market The market formed by all the locations (such as London, Tokyo, Frankfurt, and New York) where dol-
where national lars are bought and sold for other currencies. These international monetary centers are
pruropcies.are bought connected by telephone and the Internet and are in constant contact with one another. The
and sold. : : ; ae
rate at which one currency is exchanged for another is called the exchange rate. This is
the price of a unit of the foreign currency in terms of the domestic currency. For example,
Exchange rate The the exchange rate (R) between the U.S. dollar and the euro (€), the currency of the
price of a unit of a 16-nation European Monetary Union (Austria, Belgium, Cyprus, Finland, France,
foreign currency in Germany, Greece, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Slovakia,
fermsiof the domestic Slovenia, and Spain), is the number of dollars required to purchase one euro. That is,
currency.
R=$/€. Thus, if R= $/€ = 1, this means that one dollar is required to purchase one euro.
Under a flexible exchange rate system of the type we have today, the dollar price of the
euro (R) is determined (just like the price of any other commodity in a competitive market)
by the intersection of the market demand and supply curves of euros. This is shown in
Figure 9.19, where the vertical axis measures the dollar price of euros, or the exchange rate
(R = $/€), and the horizontal axis measures the quantity of euros. The market demand and
supply curves for euros intersect at point £, defining the equilibrium exchange rate of R = 1,
at which the quantity of euros demanded and the quantity of euros supplied are equal at
€300 million per day. At a higher exchange rate, the quantity of euros supplied exceeds the
quantity demanded, and the exchange rate will fall toward the equilibrium rate of R = 1.
At an exchange rate lower than R = 1, the quantity of euros demanded exceeds the quan-
tity supplied, and the exchange rate will be bid up toward the equilibrium rate of R = 1.
The U.S. demand for euros is negatively inclined, indicating that the lower the
exchange rate (R), the greater the quantity of euros demanded by the United States. The
reason is that the lower the exchange rate (i.e., the fewer the number of dollars required to
purchase one euro), the cheaper it is for the United States to import from and invest in the
European Monetary Union (EMU), and thus the greater the quantity of euros demanded by
U.S. residents. On the other hand, the U.S. supply of euros is usually positively inclined,
indicating that the higher the exchange rate (R), the greater the quantity of euros earned
by or supplied to the United States. The reason is that at higher exchange rates, residents
298 PART THREE Production, Costs, and Competitive Markets

FIGURE 9.19 The Foreign-Exchange Market and the Dollar Exchange

Rate The vertical axis measures the dollar price of euros (R = $/€), and
the horizontal axis measures the quantity of euros. Under a flexible exchange
rate system, the equilibrium exchange rate is R = 1 and the equilibrium
quantity of euros bought and sold is €300 million per day. This is given by l | | |
point £, at which the U.S. demand and supply curves for euros intersect. () 100 200 300 400

of the EMU receive more dollars for each of their euros. As a result, they find U.S. goods
and investments cheaper and more attractive and spend more in the United States, thus
supplying more euros to the United States.
If the U.S. demand curve for euros shifted up (for example, as a result of increased
U.S. tastes for EMU’s goods) and intersected the U.S. supply curve for euros at point A
(see Figure 9.19), the equilibrium exchange rate would be R = 1.10, and the equilibrium
quantity would be €400 million per day. The dollar is then said to have depreciated since
Depreciation An it now requires $1.10 (instead of the previous $1.00) to purchase one euro. Depreciation
increase in the thus refers to an increase in the domestic price of the foreign currency. On the other hand,
domestic-currency if through time the U.S. demand for euros shifted down so as to intersect the U.S. supply
price of a foreign
curve of euros at point B (see Figure 9.19), the equilibrium exchange rate would fall to
currency.
R =0.90 and the dollar is said to have appreciated (because fewer dollars are now
Appreciation A required to purchase one euro). An appreciation thus refers to a decline in the domestic
decrease in the price of the foreign currency. Shifts in the U.S. supply curve of euros through time would
domestic-currency
similarly affect the equilibrium exchange rate and equilibrium quantity of euros.
price of a foreign
In the absence of interferences by national monetary authorities, the foreign-
currency.
exchange market operates just like any other competitive market, with the equilibrium
price and quantity of the foreign currency determined at the intersection of the market
demand and supply curves for the foreign currency. Sometimes, monetary authorities
attempt to affect exchange rates by a coordinated purchase or sale of a currency on the
foreign-exchange market. For example, U.S. and foreign monetary authorities may sell
dollars for foreign currencies to induce a dollar depreciation (which makes U.S. goods
cheaper to foreigners) in order to reduce the U.S. trade deficit. These official foreign-
exchange market interventions are only of limited effectiveness, however, because
the
foreign-exchange resources at the disposal of national monetary authorities are very small
in relation to the size of daily transactions on the foreign-exchange market (now esti-
mated to be over $1 trillion per day!). Such huge volume of transactions has been made
possible by sharp improvements in telecommunications and the coming into existence of
a 24-hour foreign-exchange market around the world.!°

'° See D. Salvatore, International Economics, 9th ed. (Hoboken, NJ: John
Wiley & Sons), Chapter 14.
 CHAPTER 9 Price and Output Under Perfect Competition 299

EXAMPLE 9-5
Foreign-Exchange Quotations

Table 9.4 gives the exchange rate for various currencies with respect to the U.S. dol-
lar for Wednesday, April 30, 2008 and for Tuesday April 29, 2008—defined first as
the dollar price of the foreign currency (as in the text) and then, alternatively, as the

TABLE 9.4.
wea Foreign Exchange Quotations
Foreign Currency Dollars in Foreign Currency Dollars in
in Dollars Foreign Currency in Dollars Foreign Currency

Currency Wed. Tue. Wed. Tue. Currency Wed. Tue. Wed. Tue.

NORTH AMERICA/CARIBBEAN Singapore (Dollar) .71380 1344 1.3550 1.3616

Canada (Dollar) 9954 9879 1.0046 1.0122 So. Korea (Won) .000994 .000998 1006.10 1002.50
Dominican Rep (Peso) .0294 .0294 34.05 34.05 Taiwan (Dollar) .0328 .0329 30.49 30.40
Mexico (Peso) .095400 .094900 10.4822 10.5374 Thailand (Baht) 03150 — .03150 31.75 BIAS
Vietnam (Dong) .000062 .000062 .16120 .16120
CENTRAL AMERICA
Costa Rice (Colon) O01: 0010 51775 51g 5) EU ROTH
El Salvador (Colon) 1143 —-.1143.--8.7520 8.7520 | Britain (Pound) 1.9893 1.9681 50275081
Guatemala (Quetzal) 1337 —-.1337.—«72.4800':=«-7.4800:| CzechRep(Koruna) =» 0619 0615 16.16 16.26
Honduras (Lempira) 0529 0529 -—s-18.90 18.99 |.Denmark (Krone) 2095 2085 4.7733 BEA
Nicaragua (Cordoba) 0517. 0516. —-19.35._—-19,38._ | Europe (Euro) 1.5642 1.5564 6393 .6425
Panama (Balboa) 1.00 1.00 1.00 1.00 Hungary (Forint) 0061 0061. 163:93) 163.93
Norway (Krone) .1965 1943 5.0891 5.1467
SOUTH AMERICA Poland (Zloty) 4531 4495 2 2.22
Argentina (Peso) 3160 3160 3.1646 3.1646 Russia (Ruble) 0422 .0422 23.6987 23.6967
Bolivia (Boliviano) 1360 .1360 ~=—-7.3529 7.3529 ~| Slovak Rep (Koruna) 0484 0482 20.66 20.75
Brazil (Real) 5913 5854 1.6912 1.7082 Sweden (Krona) 1675 1662 5.9701 6.0168
Chile (Peso) 002100 .002100 476.19 476.19 Switzerland (Franc) .9673 9632 1.0338 1.0382
Colombia (Peso) 000565 .000561 1769.50 1783.50 | Turkey (Lira) 7852 ISO EDT BOG yale 2ONS
Paraguay (Guarani) .000244 .000244 4092.50 4092.50 MIDDLE EAST/AFRICA

Peru (New Sol) 3478 3500) 2.875 2.857 | Bahrain (Dinar) 26528 2.6521 1.87707 3771

Israel (Shekel) 2926 2890 3.4176 3.4602

pOEN EO CTE Jordan (Dinar) 1.4113 1.4112 1086 7086
Australia (Dollar) 9472 9340 1.0657 1.0707 ee
: Kenya (Shilling) 0161 .0160 62.15 62.50
China (Yuan) 1430 1431 6.9930 6.9881 vei
Kuwait (Dinar) B40 oKooy 2664 ~=-.2663
Hong Kong (Dollar) 1283 1283. 7.7942 7.7942
5 Lebanon (Pound)
, j .000661 .000661 1512.00 1512.00
India (Rupee) 0247 0247 40.486 40.486 :
; ; Saudi Arabia (Riyal) .2666 .2666 3.7509 3.7509
Indonesia (Rupiah) .000108 .000109 9237.50 9213.00 ae ;
So. Africa (Rand) 41323 1315 7.5586 7.6046
Japan (Yen) 009600 .009600 104.17 104.17 UAE, (Ditham) aoe Saas
Malaysia (Ringgit) 3165 BIBS S962 onto 16 Sia Baibars SRA NTE Fsaeaes
New Zealand (Dollar) .7848 WIB8) 1.2742 > 1.2924 a-Russian Central Bank rate.
Pakistan (Rupee) 0154 .O155 64.94 64.52 All prices as of 3:00 p.m. Eastern Time.
Philippines (Peso) 0236 0237 42.37 42.19 Sources: Moneyline Tolerate and other sources

Source: Reprinted by permission of The New York Times, © 2008. All rights reserved worldwide.
300 PART THREE Production, Costs, and Competitive Markets

we find that the

foreign-currency price of the dollar. For example, next to Europe,
$1.5642 /€1 on Wednes day and $1.5564 on Tuesday.
exchange rate of the euro (€) was
that the euro price of the dollar was €0.6393 /$ on
On the same line, we find
Wednesday and €0.6425 on Tuesday.

EXAMPLE 9-6
Depreciation of the U.S. Dollar and Profitability of U.S. Firms

A depreciation of the dollar, by making U.S. goods and services cheaper to foreigners
in terms of their currency, allows U.S. firms to sell more abroad without lowering the
dollar price of their products, and thus increases their profits and their share of foreign
markets. U.S. firms also receive more dollars for their foreign-currency profits earned
abroad. Against these benefits are the higher dollar prices that U.S. firms must pay for
imported inputs. How much a U.S. firm gains from a depreciation of the dollar, there-
fore, depends on the amount of its foreign sales as opposed to its expenditures on
imported inputs.
For example, the Black & Decker Corporation, a maker of power tools and appli-
ances with about half of its sales abroad, found that the depreciation of the dollar dur-
ing 1990 led to a 5% increase in its foreign sales and earnings. On the other hand, the
Gillette Corporation, which has plants in many countries and uses almost exclusively
local inputs to supply each market, benefited mostly through the repatriation of foreign
profits. Merck & Company, which has plants in 19 nations and conducts most of its
business in local currencies, was in a similar position. In between was Compaq (now
part of Hewlett-Packard), which found some of its price advantage abroad resulting
from the depreciation of the dollar during 1990 eaten away by the higher cost of its
imported disk drives and circuit-board parts.
On the other hand, the 20% appreciation of the dollar vis-a-vis the euro from the
time of its launching at the beginning of 1999 until January 2002, meant that U.S.
exporters received 20% fewer dollars per euro earned in Europe, while U.S. importers
paid 20% less imports from Europe. The opposite occurred in 2008, when the dollar
had depreciated (and was undervalued) with respect to the euro by about 20%. Thus,
a change in the exchange rate benefits some and harms others but affects all firms
with foreign transactions and all individuals (American and foreigners) traveling
abroad.
Source: How Dollar’s Plunge Aids Some Companies, Does Little for Others.’ Wall Street Journal, October
22, 1990, p. Al; “Exporters in U.S. Confront a New Reality.” Wall Street Journal, April 28, 1998, p. A2;
D. Salvatore, “The Euro: Expectations and Performance,” Eastern Economic Journal, January 2002,
pp. 121-136; “Dollar Dive Helps US Companies,” Wall Street Journal, April 21, 2003, p. C2; “Bulging
Profits in US Often Originate Abroad,” New York Times, August 4, 2007, p. C3; and “Dollar Doesn’t
Stretch Far in Buying Global Goods,” New York Times, March 15, 2008, pes:
 CHAPTER 9 Price and Output Under Perfect Competition 301

INTERNET SITE ADDRESSES

For information on the New York Stock Exchange,
see: http://www.zealllc.com/2005/copper.htm
http://www.nyse.com For a discussion of the economic effects of an import tariff, see:
Petroleum production from tar sands is examined at:
http://www.usitc. gov/publications/pub3906. pdf
http://www.fumento.com/environment/oilsands.html|
http://en.wikipedia.org/wiki/Tariff
http://www.wired.com/wired/archive/12.07/oil.html
On auctioning of the airwaves, see:
http://en.wikipedia.org/wiki/Tar_sands
http://www.news.com/2100-1033-251576.html
Information on the world supply of copper is found at:
http://www.msnbc.msn.com/id/20060516/site/
http://www.minecost.com/curves.htm newsweek/
http://minerals.usgs.gov/minerals/pubs/commodity/copper/ http://www.capitaleye.org/inside.asp?ID=294
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 PART
FOUR

D art Four (Chapters 10-13) presents the theory of the Imperfectly

firm in imperfectly competitive markets. It brings
together the theory of consumer behavior and demand
(from Part Two) and the theory of production and costs
Competitive
(from Chapters 7 and 8) to analyze how price and output
are determined under various types of imperfectly
Markets
competitive markets. Chapter 10 shows price and output
determination under pure monopoly. Chapter 11 does the
same for monopolistic competition and oligopoly. Chapter
12 describes how game theory is useful in analyzing
oligopolistic behavior. Finally, Chapter 13 examines the
efficiency implications of various market structures and
regulation. As in previous parts of the text, the presentation
of the theory is reinforced with many real-world examples
and important applications, while the At the Frontier
section in each chapter presents some new and
important developments in the operation of imperfectly
competitive markets.
 CHAPTER IO

Price and Output Under

Pure Monopoly
Chapter Outline 10-2 De Beers Abandons Its Diamond
10.1 Pure Monopoly—The Opposite Extreme from Monopoly
Perfect Competition 10-3 Monopoly Profits in the New York City
10.2 Short-Run Equilibrium Price and Output Taxi Industry
10.3 Long-Run Equilibrium Price and Output 10-4 Estimates of the Social Cost of Monopoly
10.4 Profit Maximization by the Multiplant in the United States
Monopolist 10-5 First-Degree Price Discrimination in
10.5 Price Discrimination—A Monopolist’s Method Undergraduate Financial Aid at
of Increasing Profits American Colleges
10.6 International Price Discrimination and 10-6 Price Discrimination by Con Edison
Dumping 10-7 Kodak Antidumping Victory over
10.7 Two-Part Tariffs, Tying, and Bundling Fuji—But Kodak Still Faces Competitive
10.8 Analysis of Monopoly Markets Problems
10-8 Bundling in the Leasing of Movies
List of Examples At the Frontier: Near-Monopoly Lands
10-1 Barriers to Entry and Monopoly by Alcoa Microsoft in the Courts

After Studying This Chapter, You Should Be Able to:

e Know the meaning and importance of monopoly
e Describe how a monopolist determines the best level of output in the short run
e Describe the long-run equilibrium of the monopolist
e Know how to measure the social costs of monopoly
e Know how the monopolist can use price discrimination and other pricing practices to increase profits

n this chapter, we bring together the theory of consumer behavior and demand (from Part
Two) and the theory of production and costs (from Chapters 7 and 8) to analyze how
price and output are determined under pure monopoly. Monopoly is the opposite extreme
from perfect competition in the spectrum or range of market structure or organization. The
monopoly model is useful for analyzing cases that approximate monopoly, and it provides
insights into the operation of other imperfectly competitive markets (1.e., monopolistic com-
petition and oligopoly).

305
306 PART FOUR Imperfectly Competitive Markets

of monopoly,
The chapter begins by defining pure monopoly, describing the sources
the market demand curve for the commodi ty. It
and explaining why the monopolist faces
and output in the short run and in the long run,
then examines the determination of price
of the monopol ist with that of a perfectl y com-
and it compares the long-run equilibrium
examine how
petitive firm and industry. Subsequently, we extend the monopoly model to
ion among various plants to minimiz e production
a monopolist (1) should allocate product
costs, and (2) can increase total profits by charging different prices for differen t quantities
Finally, we discuss some other pricing prac-
and in different markets at home and abroad.
tices that monopolists often use to increase their profits and present several importa nt
applications of the pure monopoly model. As in previous chapters , these applicat ions,
together with the real-world examples presented in the chapter, highlight the importance
and relevance of the analytical tools developed in the chapter. The At the Frontier section
examines the operation of one of the most talked-about near monopolies in the American
economy today—Microsoft Corporation’s Windows operating system.

10.1 Pure MoNOPOLY—THE Opposite EXTREME FROM PERFECT COMPETITION

In this section, we first define pure monopoly and discuss the sources of monopoly power.
We then examine the shape of the demand and marginal revenue curves facing the
monopolist and compare them with those of a perfectly competitive firm.

Definition and Sources of Monopoly

Pure monopoly The Pure monopoly is the form of market organization in which a single firm sells a com-
form of market modity for which there are no close substitutes. Thus, the monopolist represents the
organization in which industry and faces the industry’s negatively sloped demand curve for the commodity. As
there is a single seller
opposed to a perfectly competitive firm, a monopolist can earn profits in the long run
of a commodity for
which there are no
because entry into the industry is blocked or very difficult. Monopoly is at the opposite
close substitutes. extreme from perfect competition in the spectrum or range of market organizations.
Whereas the perfect competitor is a price taker and has no control over the price of the
commodity it sells, the monopolist has complete control over price. The monopolist’s
ability to control or affect price is evidence of its monopoly power.
Monopoly can arise from several causes. First, a firm may own or control the entire
supply of a raw material required in the production of a commodity, or the firm may pos-
sess some unique managerial talent. For example, until World War II, the Aluminum
Company of America (Alcoa) controlled practically the entire supply of bauxite (the
basic raw material necessary for the production of aluminum), giving it almost a complete
monopoly in the production of aluminum in the United States (see Example 10-1).
Second, a firm may own a patent for the exclusive right to produce a commodity or
to use a particular production process. Patents are granted by the government for 17
years as an incentive to inventors.' Some argue that if an invention could be copied
freely (thus leaving little, if any, reward for the inventor), the flow of inventions and tech-
nical progress would be greatly reduced. Examples of monopolies that were originally
based on patents are the Xerox Corporation for copying machines and Polaroid for
instant cameras. An alternative to patents might be for the government to financially
reward the inventor directly and allow inventions to be freely used. However, it is often
difficult to determine the value of an invention: government archives are full
of patents
that found no commercial use.
ee Fee
As opposed arte patents
to copyrights, are not renewable. Improvement patents are available, however
 CHAPTER 10 Price and Output Under Pure Monopoly 307

EXAMPLE 10-1 Le
Barriers to Entry and Monopoly by Alcoa

The Aluminum Company of America (Alcoa) is a classic example of how a monop-

oly was created and maintained for almost 50 years. The monopoly was created in the
late nineteenth century when Alcoa acquired a patent on the method to remove oxy-
gen from bauxite to obtain aluminum. This patent expired in 1906, but in 1903, Alcoa
had patented another more efficient method to produce aluminum. This patent
expired in 1909. By that time, Alcoa had signed long-term contracts with producers
of bauxite prohibiting them from selling bauxite to any other American firm. At the
same time, Alcoa entered into agreements with foreign producers of aluminum not
to export aluminum into each other’s market. Alcoa even went as far as purchasing
electricity only from those power companies that agreed not to sell energy for the
production of aluminum to any other firm.
In 1912, the courts invalidated all of these contracts and agreements. Nevertheless,
Alcoa retained monopoly power by always expanding productive capacity in anticipation
of any increase in demand and by pricing aluminum in such a way as to discourage new
entrants. The monopoly was finally broken after World War II, when Alcoa was not
allowed to purchase government-financed aluminum plants built during the war. This is
how Reynolds and Kaiser aluminum came into existence. During the 1960s, Reynolds
diversified into plastics, gold, and consumer products, while Alcoa stuck to pure
aluminum. But in May 2000, Alcoa acquired Reynolds Metals Company, thus remaining
the world’s largest producer of aluminum. In 2007, Alcoa had revenues of $30 billion,
123,000 employees, operations in 44 countries, and nearly 16% of the world aluminum
market, but the merger of Rio Tinto of Britain and Alcan of Canada created the largest alu-
minum company in the world, and Russia’s Rusal became second, leaving Alcoa third.
During the early 1990s, the world price of aluminum declined by almost 50%
because of oversupply resulting in part from the sharp increase in aluminum exports by
Russia, as internal demand by its military—industrial complex vanished after the col-
lapse of communism. In response to this price collapse, the representatives of 17
nations, including Russia, the European Union countries, the United States, and other
major aluminum exporters, agreed in January 1994 to voluntarily cut production for
two years, and this led to a partial recovery in aluminum prices. In agreeing to voluntar-
ily cut production, the major exporting nations came very close to behaving like an
international monopoly (cartel—cartels are examined in detail in Chapter 11). Despite
the relatively high concentration in the aluminum market (e.g., Alcoa and Canadian-
European APA, together, have a 27.4% share of the world market), prices rose and fell
during the rest of the 1990s and early 2000s primarily because of demand and supply
considerations. In 2002, China became the largest producer of primary aluminum, with
nearly 60% of world output. Rapidly growing internal demand, however, absorbed all
of its increase in supply and contributed to a world aluminum price increase.
Sources: R. Lanzilotti, “The Aluminum Industry,” in W. Adams (ed.), The Structure ofAmerican Industry
(New York: Macmillan, 1961); “Reynolds Metals, Alcoa Split on Strategy,” Wall Street Journal, November 7,
1990, p. A4; “Aluminum Pact Set to Curb World Output,” Wall Street Journal, January 31, 1994; “Global Merger
Could Steady Aluminum Market,” Wall Street Journal, August 11, 1999, p. A13; “Alcoa’s Outlook Is Bright
Due to Cost Cuts, Shortages,” Wall Street Journal, January 1, 2000, p. B4; and “The China Factor: Aluminum
Industry Impact,” Journal of Minerals, September 2004, pp. 1-6; and “Takeovers Recast Fast-Changing
Sector,” Special Report on Aluminum, Financial Times, October 9, 2007, p. 1.
308 PART FOUR Imperfectly Competitive Markets

average cost curve may fall)

Third, economies of scale may operate (i.e., the long-run
supplying the entire
over a sufficiently large range of outputs so as to leave a single firm
monopol y. Example s of natural monopolies are
Natural monopoly market. Such a firm is called a natural
compani es. To have more than one firm supply-
The case of declining electrical, water, gas, and transportation
tation services in a given market would lead to
long-run average costs ing electricity, water, gas, and transpor
over a sufficiently large overlapping distribution systems and much higher per-unit costs.
range of outputs so as to
Fourth, some monopolies are created by government franchise itself. For example,
leave a single firm
supplying the entire licenses are often required by local governments to start a radio or television station, to open a
market. liquor store, to operate a taxi, to be a plumber, a barber, a funeral director, and so on. The pur-
pose of these licenses is to ensure minimum standards of competency. Nevertheless, because
the number of licenses issued (e.g., the number of taxi medallions issued in most metropolitan
areas) is often restricted by the regulatory agency, licenses also protect present license holders
Concept Check from new competition (i.e., confer monopoly power to them as a group). In most cases, local
What gives rise to (1.e., governments turn the regulatory function (such as the issuance of licenses) over to the profes-
what are the sources of) sional association involved. Examples include the medical and bar associations.
monopoly? - Aside from the few cases just mentioned and for public utilities, pure monopoly is
rare in the United States today, and attempts to monopolize the market are forbidden by
antitrust laws.* Nevertheless, the pure monopoly model is useful for analyzing situations
that approach pure monopoly and for other types of imperfectly competitive markets (i.e.,
monopolistic competition and oligopoly).
A monopolist does not have unlimited market power, however, but faces many forms
of direct and indirect competition. On a general level, a monopolist competes for the con-
sumers’ dollars with the sellers of all other commodities in the market. Furthermore,
while close substitutes do not exist for the particular commodity supplied by the monop-
olist, imperfect substitutes are likely to exist. For example, although DuPont was the only
producer of cellophane in the late 1940s, the company faced a great deal of competition
from the producers of allother flexible packaging materials (waxed paper, aluminum foil,
and so on). In addition, the market power of the monopolist (or the would-be monopolist)
is sharply curtailed by fear of government antitrust prosecution, by the threat of potential
competitors, and by international competition.

The Monopolist Faces the Market Demand Curve for the Commodity?
Because a monopolist is the sole seller of a commodity for which there are no close sub-
stitutes, the monopolist faces the negatively sloped industry demand curve for the com-
modity. In other words, while the perfectly competitive firm is a price taker and faces a
demand curve that is horizontal or infinitely elastic at the price determined by the intersec-
tion of the industry or market demand and supply curves for the commodity, the monopo-
list 7s the industry and, thus, it faces the negatively sloped industry demand curve for the
commodity. This means that to sell more units of the commodity, the monopolist must
lower the commodity price. As a result, marginal revenue (defined as the change in total
revenue per-unit change in the quantity sold) is smaller than price, and the monopolist’s
marginal revenue curve lies below its demand curve (see Section 5.6).* This is
shown in
Table 10.1 and Figure 10.1.

* It should be noted that “monopoly” per se is not illegal; only “monopolizing”

or “attempting to monopolize the
fs are illegal under U.S. antitrust laws (Section 2, Sherman Antitrust Act. 1890).
: For the relationship between demand and marginal revenue for a monopolist
in terms of calculus, see
penney A.7 of the Mathematical Appendix at the end of the book.
c
At this point, a review of the material in Section 5.6 may be helpful.
 CHAPTER 10 Price and Output Under Pure Monopoly 309

Hypothetical Demand, Total Reven

ue, and
TABLE 1011 Marginal Revenue Faced
by a Monopolist
P Q TR MR
$9 0 $0 as
8 1 8 $8
yf 2 14 6
6 3 18 4
5 4 20 2,
4 5 20 0
3 6 18 —2
D, W 14 —4
1 8 8 —6
0 9 0 —8

FIGURE 10.1 Hypothetical Demand and Marginal Revenue Curves of a Monopolist Since D is
negatively sloped, MR is lower than P. The MR values are plotted at the midpoint of each quantity interval.
The MR curve starts at the same point as the D curve and at every point bisects the distance between D
and the vertical axis. MR is positive when D is elastic. MR = O when Dis unitary elastic and TR is at a
maximum. MR is negative when D is inelastic.
310 PART FOUR Imperfectly Competitive Markets

demand schedule
The first two columns of Table 10.1 give a hypothetical market
order to sell more of the commodity, the
for the commodity faced by a monopolist. In
times quantity gives total revenue
monopolist must lower the commodity price. Price
revenue per-unit change in the quan-
(the third column of the table). The change in total
(the fourth column) . For example,
tity of the commodity sold gives the marginal revenue
ty, so TR = $8. To sell two units
at P = $8, the monopolist sells one unit of the commodi
of the commodity, the monopolist must lower the price to $7 on both units of the com-
modity. TR is then $14. The change in TR resulting from selling the additional unit of the
commodity is then MR = $14 — $8 = $6. This equals the price of $7 for the second unit
of the commodity sold minus the $1 reduction in price (from $8 to $7) on the first unit
(since to sell two units of the commodity, the monopolist must lower the price of the
commodity to $7 for both units).
The information contained in Table 10.1 is plotted in Figure 10.1. Since MR is
defined as the change in 7R per-unit change in Q, the MR revenue values are plotted
at the midpoint of each quantity interval. Note that the MR curve starts at the same
point on the vertical axis as the demand curve and at every point bisects (1.e., cuts in
half) the distance between D and the vertical or price axis.? The MR is positive when
D is elastic (i.e., in the top segment of the demand curve) because an increase in Q
increases TR. MR = 0 when D is unitary elastic (i.e., at the geometric midpoint of D)
because an increase in Q leaves TR unchanged (at its maximum level). MR is nega-
tive when D is inelastic (i.e., the bottom segment of D) because an increase in Q
reduces TR (see Figure 10.1 and Section 5.6).
Contrast this situation with the case of a perfectly competitive firm (examined in
Chapter 9), which faced a horizontal or infinitely elastic demand curve for the com-
modity at the price determined at the intersection of the market demand and supply
curves for the commodity. Since the perfect competitor is a price taker and can sell any
quantity of the commodity at the given price, price equals marginal revenue, and the
demand and marginal revenue curves are horizontal and coincide.
The relationship between price, marginal revenue, and elasticity (7) can be exam-
ined with formula [5.8] introduced in Section 5.6:

MR = P(1+1/n) [5.8]

Using the formula, we see that since 1 = —oo for the perfect competitor, MR always
equals P. That is, MR = P(1 + 1/oo) = P(1 + 0) = P. Since |n| < 00 (i.e., since the
demand curve is not infinitely elastic) for the monopolist, MR < P. That is, for any value
of |7| smaller than infinity, MR will be smaller than P, and the MR curve will be below
the market demand curve. Furthermore, we can see from the formula that when
1 = —1, MR =0, when |n| > 1, MR > 0; and when |n| < 1, MR < 0. Since MR <0
when |7| < 1, the monopolist can increase its TR by selling a smaller quantity of the
commodity. Thus, the monopolist would never operate over the inelastic portion of the
demand curve. By reducing output, the monopolist would increase total revenue, reduce
total costs, and thus increase total profits. Example 10-2 examines how the De Beers
Consolidated Mines diamond monopoly operated for over a century until 2001.

This is true only when, as in this case, the demand curve that the mono
‘
straight :
line. P'olist faces 1sis a negatively
i sloped
 CHAPTER 10 Price and Output Under Pure Monopoly 311

EXAMPLE 10-2
De Beers Abandons Its Diamond Monopoly

In 1887, Cecil Rhodes created the De Beers Consolidated Mines Company, which con-
trolled about 90% of the total world supply of rough uncut diamonds with its South
African mines. Until 2001, De Beers produced about half of the world’s diamonds in its
mines in South Africa, Botswana, and Namibia, and it marketed about 80% of the
world’s diamonds through its London-based Central Selling Organization (CSO).
Producers in Russia, Australia, Botswana, Angola, and other diamond-producing
nations sold most of their production to De Beers, which then regulated the supply of
cut and polished diamonds to final consumers on the world market so as to keep prices
high. When there was a recession in the world’s major markets and demand for dia-
monds was low, De Beers withheld diamonds from the market (i.e., stockpiled them) in
order to avoid price declines until demand and prices rose. In short, De Beers acted as
a monopolist and earned huge profits for itself and other producers by manipulating the
world supply of diamonds. De Beers also advertised diamonds to drum up demand with
the famous slogan “diamonds are forever” from the 1971 James Bond movie by the
same name. De Beers controls two-thirds of the world’s $8 billion market of uncut
rough stones, and worldwide retail sales of diamond jewelry by De Beers and other
firms exceed $60 billion (half of which is in the United States).
De Beers has had a monopoly in the marketing of diamonds since 1887 through
wars, financial crisis, racial strife, hostile governments, and attempts by indepen-
dent producers to circumvent the monopoly. When the former Soviet Union and
Zaire started to sell large quantities of industrial diamonds on the world market out-
side the CSO in the early 1980s, De Beers immediately flooded the market from its
own stockpiles (in excess of $5 billion in 2001), thereby driving prices sharply
down and thus convincing the newcomers to join the cartel. And when large quanti-
ties of diamonds smuggled from Angola flooded Antwerp in 1992, De Beers pur-
chased up to $400 to $500 million worth of these diamonds to prevent a collapse in
prices. But faced with increased production by Russia (which sold only half of its
diamonds through CSO) and new suppliers from Australia and Canada, and embar-
rassed by disclosures that to prop up prices it had bought “blood or conflict dia-
monds” from rebels in Angola, De Beers abandoned its cartel arrangement in 2001
and began concentrating instead on an advertising-driven strategy through its mar-
keting arm, the Diamond Trading Company (DTC), to increase sales of its dia-
monds as branded luxuries. In 2001 De Beers also reorganized itself into a private
company, with two independent units, one that continued to sell uncut stones and
the other (De Beers LV) a retail joint venture with LYMH Moét Hennessy Louis
Vuitton.
Sources: “How De Beers Dominates the Diamonds,” The Economist, February 23, 1980, pp. 101-102;
“Can De Beers Hold to Its Own Hammerlock?” Business Week, September 21, 1992, pp. 45—46;
“Disputes Are Forever,” The Economist, September 17, 1994, p. 73; “The Rough Trade in Rough
Stones,” Forbes, March 27, 1995, pp. 47—48; “De Beers Halts Its Hoarding of Diamonds,” New York
Times, July 13, 2000, p. C1; “$17.6 Billion Deal to Make De Beers Private Company,” Financial
Times, February 16, 2001, p. W1; “Bumpy Start for De Beers’ Retail Diamond Venture,” New York
Times, November 11, 2002, p. W1; and “De Beers Sees More Jewelry Demand,” Financial Times,
April 12, 2005, p. 26.
312 PART FOUR Imperfectly Competitive Markets

10.2 SHORT-RUN EQUILIBRIUM PRICE AND OUTPUT

st in the
In this section, we examine the determination of price and output by a monopoli
short run. We will do this first with the total approach and then with the marginal
approach. We will also show that a monopolis t, like a perfect competito r, can incur losses
in the short run. Finally, we demonstra te that, unlike the case of the perfectly competiti ve
firm, the monopolist’s short-run supply curve cannot be derived from its short-run mar-
ginal cost curve.

Total Approach: Maximizing the Positive Difference

Between Total Revenue and Total Costs
As with the perfectly competitive firm, profit maximization provides the framework for
the analysis of monopoly. The equilibrium price and output of a monopolist are the ones
that maximize total profits. Total profits equal total revenue minus total costs. Total rev-
enue is given by price times quantity. The total costs of the monopolist are similar to those
discussed in Chapter 8 and need not differ from those of the perfectly competitive firm (if
the monopolist does not affect input prices). Thus, except for the case of natural monop-
oly, the basic difference between monopoly and perfect competition lies on the demand
side rather than on the production or cost side.
Table 10.2 gives the total revenue (7R), the short-run total costs (STC), and the total
profits of a monopolist in the short run at various levels of output. The total revenue sched-
ule is that of Table 10.1. As usual, short-run total costs rise slowly at first and then more
rapidly (when the law of diminishing returns begins to operate). The best or optimum level
of output for the monopolist in the short run is where total profits are maximized. For the
monopolist of Table 10.2, this is at three units of output per time period. At this level of out-
put, the monopolist charges the price of $6 and earns the maximum total profit of $4.50 per
time period.
The data of Table 10.2 are plotted in Figure 10.2. The top panel shows that, unlike the
case of a perfectly competitive firm, the monopolist’s TR curve is not a straight line, but
has the shape of an inverted U. The reason is that the monopolist must lower the price to
sell additional units of the commodity. The monopolist’s STC faces upward or increases
at an increasing rate past Q = 2 because of diminishing returns.

TABLE 10.2,
(04 Total Revenue, Short-Run Total Costs, and Total Profits

Total
Q P TR STC Profits

: 8 8 10 2)
2 7 14 12 >
i 6 18 13.50 4.50
5 20 19 i
5 4 20 30 S
: : We 48 ~30
*Output at which firm maximizes total profit.
 CHAPTER 10 Price and Output Under Pure Monopoly 313

STC

Total profits

FIGURE 10.2 Short-Run Equilibrium of the Monopolist: Total Approach The monopolist’s 7R
curve has the shape of an inverted U because the monopolist must lower the commodity price to sell
additional units. The S7C has the usual shape. Total profits are maximized at Q = 3, where the positive
difference between 7R and STC is greatest ($4.50). This is the point where the 7R and the STC curves
are paralle (see the top panel) and the total profit curve is highest (see the bottom panel). Total profits
are positive between Q = 1.5 and Q = 41 and negative at other output levels. At Q = O, total loss is
$6 and eq uals total fixed costs.
314 PART FOUR Imperfectly Competitive Markets

the TR
Total profits are maximized at Q = 3, where the positive difference between
and the STC curves is greatest ($4.50). This is the point where the 7K and the STC curves
are parallel (see the top panel) and the total profits curve reaches its highest point (see the
bottom panel). Total profits are positive between Q = 1.5 and Q = 4.1 and negative at
other output levels. At Q = 0, TR = 0, while STC = $6. Thus, by shutting down, the
monopolist would incur the total loss of $6, which equals its total fixed costs. Note that
the monopolist maximizes total profits at an output level smaller than the one at which TR
is maximum (i.e., at Q = 3 rather than at Q = 4.1—see Figure 10.2).

Marginal Approach: Equating Marginal Revenue

and Marginal Cost®
Although the total approach to determine the equilibrium price and output of the monop-
olist is useful, the marginal approach is even more valuable and widely used. According
to the marginal approach, a monopolist maximizes total profits by producing the level of
output at which marginal revenue equals marginal cost. The difference between the com-
modity price and the monopolist’s average total cost at the best or optimum level of out-
put gives the profit per unit. Profit per unit times output gives total profits. Thus, to be able
to use the marginal approach and to determine the level of total profits, we must calculate
the marginal cost and the average total cost of the monopolist.’
From the monopolist’s short-run total cost schedule given in Table 10.2, we can derive
the marginal cost and the average total cost schedules given in Table 10.3. Marginal cost
equals the change in short-run total costs per-unit change in output. That is, MC =
ASTC/AQ. For example, at Q = 1, STC = $10, while at OQ= 2, STC = $12. Therefore,
MC= ($12 — $10)/1 = $2. The other MC values in Table 10.3 are similarly obtained. On
the other hand, average total costs equal short-run total costs divided by the level of output.
That is, ATC = STC/Q. For example, at Q = 1, STC = $10, and so ATC = $10/1 = $10.
AUO-2 a1 G— ol sand so Al G51 2/200:

Short-Run Total Cost, Marginal Cost,

TABLE 10.3 (pee Average Total Cost
A
STC
MC
ATC

| : $4 $10
5 12
3 13.50 2 ?
: a 1.50 at
5.50
5 30 4.75
6 48
iN 2
ee 18 ;

For a mathematical presentation of profit maximization using rudimentary calculus,

see Section A.10
of the Mathematical Appendix at the end of the book.
ToSince we already
: :know the monopolistist? i
’s MR (see Figure 10.1), all we need to calculate now is the
monopolist’s marginal cost to determine the best or profit-maximizing
level of output. This is given at the
point where MR = MC. The average total cost is only required to measure
the monopolist’s profit at the best
level of output.
 CHAPTER 10 Price and Output Under Pure Monopoly 315

0 1 2 3 4 5 Q
FIGURE 10.3 Short-Run Equilibrium of the Monopolist: Marginal Approach The best or
optimum level of output of the monopolist is three units. This is given by point G, where MR = MC
(and the MC curve intersects the MR curve from below). At Q = 3, P = $6 (point A on the
demand curve), ATC = $4.50 (point B on the ATC curve), and the monopolist earns $1.50
(AB) per unit of output sold and $4.50 in total (shaded area ABCF). At Q < 3, MR > MC and
total profits rise by increasing Q. AtQ > 3, MC > MR and total profits rise by reducing Q.

By plotting the monopolist’s D and MR schedules of Table 10.1 and the MC and
ATC schedules of Table 10.3 on the same set of axes, we get Figure 10.3. Note that MR
and MC are plotted between the various levels of output, while D and ATC are plotted
at the various output levels. In Figure 10.3, the best or optimum level of output of the
monopolist is three units. This is given by point G, where MR = MC. At Q = 3, P = $6
(point A on the demand curve), while ATC = $4.50 (point B on the ATC curve). Thus,
the monopolist earns $1.50 (AB) per unit of output sold and $4.50 in total (shaded area
ABCF in the figure). Note that at point G, the MC curve cuts the MR curve from below.
This is always true for profit maximization, whether the MC curve is rising or falling at
the point of intersection (see Section 10.8).
At outputs smaller than three units, MR exceeds MC (see the figure). Therefore, by
Concept Check expanding output, the monopolist would be adding more to TR than to STC, and total prof-
How does a monopolist its would rise. On the other hand, at outputs larger than three units, MC exceeds MR. A
determine the price and reduction in output would reduce STC more than 7R and total profits would also rise. Thus,
best level of output in the monopolist must produce where MR = MC (in this case three units of output) to max-
the short run? imize total profits. This is the same result obtained earlier by the total approach.
316 PART FOUR Imperfectly Competitive Markets

Profit Maximization for the Monopoilist:

UASERUY vaccinal Approach
Profit Total Relationship
Q Pp AIC Per Unit Profits MR hCG of MR to MC

1 $8 $10 $—2 $—2 $7 $3

2) Al 6 1 2 5 1.50| MR > MC
*3 6 4.50 1.50 4.50 3 3 MR = MC
A 5 4.75 0.25 1 | 8
5 4 6 =) =i@ =i 15 MR < MC

*Output at which firm maximizes total profits.

Table 10.4 summarizes the marginal approach numerically. Note that the
MR and the MC values given in the table are read off Figure 10.3 af various out-
put levels, just as P and ATC. For example, at Q = 3, P = $6, ATC = $4.50, and
MR = MC = $3. Table 10.4 shows that the monopolist maximizes total profits
(equal to $4.50) at Q = 3, where MR = MC = $3 (as shown in Figure L038)

Profit Maximization or Loss Minimization?

Like the perfect competitor, the monopolist can earn a profit, break even, or incur
a loss in the short run. The monopolist will continue to produce in the short run
(minimizing losses) as long as price exceeds the average variable cost at the best
or optimum level of output. Were the monopolist to shut down, it would incur the
higher loss equal to its total fixed costs (TFC ).
To show this, assume that, for whatever reason, the monopolist’s demand
curve shifts down from its level in Figure 10.3 while its cost curves remain
unchanged, so that ATC > P at the best level of output. The monopolist will now
incur losses at the best level of output. To determine whether the monopolist will
minimize losses by continuing to produce, we now need to calculate the monop-
olist’s average variable costs. Average variable costs (AVC) equal total variable
costs (TVC) divided by output (Q). We can obtain the monopolist’s total variable
costs by subtracting its total fixed costs from its short-run total costs. That is,
LV CaS) Car:
The monopolist’s TVC and AVC are calculated in Table 10.5 from the STC of
Tables 10.2 and 10.3. Specifically, since STC = $6 at Q = 0 in Table 10.5, TFC =
$6. The TVC schedule is then obtained by subtracting TFC from STC at various
output levels, and AVC is calculated by TVC/Q. For example, at Q = 1, TVC =
STC — TFC = $10 — $6= $4 and AVC = TVC/Q = $4/1 = $4.AtQ=2,TVC=
$12 — $6 = $6 and AVC = $6/2 = $3. The other TVC and AVC values in Table
10.5 are calculated in a similar way.
In Figure 10.4, the MC and the ATC curves are those of Figure 10.3, and the
AVC curve is obtained by plotting the AVC schedule given in Table 10.5. These
per-unit cost curves are unchanged from Figure 10.3. The monopolist, how-
ever, now faces lower demand curve D’ with marginal revenue curve MR’. The
best or optimum level of output of the monopolist is now 2.5 units. This is given
by point G’, where MR’ = MC (the MC curve intersects the MR’ curve from
below in Figure 10.4). At Q = 2.5, P = $4 (point A’ on demand curve D’) and
 CHAPTER 10 Price and Output Under Pure Monopoly 317

Short-Run Total Cost, Total Fixed Costs, Total

TABLE 10.5 Variable Costs, and Average Variable Costs

Q STC TFC TVC AVC

0 $6 $6 $0 iy:
} 10 6 4 $4
2 12 6 6 3
3 13.50 6 7.50 2.50
4 19 6 13 3.25

ATC

AVC

2.5

FIGURE 10.4 Profit Maximization vs. Loss Minimization With D’, the best
or optimum level of output of the monopolist is Q = 2.5 (given by point G’,
where MR’ = MC and the MC curve intersects the MR’ curve from below). At
Q = 25, AIC > P, and the firm incurs a loss of $1 (B’A’) per unit and $2.50 in
total (the area of rectangle B’A’F’C’). If, however, the firm were to shut down, it
would incur the greater loss of $6 equal to its total fixed costs (the area of
rectangle B’H'J’'C’). The shutdown point (Z’) is at P = AVC.

ATC = $5 (point B’ on the ATC curve). Thus, the monopolist incurs a loss of $1 (B’A’)
per unit of output sold and $2.50 in total (the area of rectangle B’A’F'C’).
At 0 =2.5, AVC = $2.60 (point H’ on the AVC curve). Since price ($4) exceeds aver-
age variable costs ($2.60) at the best level of output (2.5 units), the monopolist covers
$1.40 (A'H’) of its fixed costs per unit and $3.50 (the area of rectangle A’H’J'F’) of its
total fixed costs. If the monopolist were to shut down, it would incur the greater loss of $6
(its total fixed costs, given by the area of rectangle B’H’J'C’). Only if P were smaller than
Concept Check
How can a monopolist
AVC at the best level of output would the monopolist minimize total losses by shutting
make a loss in the down (and incurring a loss equal only to its total fixed costs). At P = AVC, the monopo-
short run? list would be indifferent between producing or shutting down because in either case it
318 PART FOUR Imperfectly Competitive Markets

would incur a loss equal to its total fixed costs. Thus, the point where P = AVC (point Z’
in the figure) is the monopolist’s shutdown point.

Short-Run Marginal Cost and Supply

While the rising portion of the marginal cost curve over the average variable cost curve
(the shutdown point) is a perfect competitor’s short-run supply curve (when input prices
are constant), this is not the case for the monopolist. The reason is that the monopolist
could supply the same quantity of a commodity at different prices depending on the price
elasticity of demand. Thus, for the monopolist there is no unique relationship between
price and quantity supplied, or no supply curve.
This is shown in Figure 10.5, where D is the original demand curve and D” is an
alternative and less elastic demand curve facing the monopolist. In the figure, MR is the
marginal revenue curve for demand curve D, while MR” is the marginal revenue curve
for demand curve D”. Since the MC curve intersects the MR and MR” curves from below

7.50

MR"

| | l MR

0 I 2 3 4 Q
FIGURE 10.5 Short-Run Marginal Cost and Supply Dis the
original demand curve, and
Di Is an alternative and less elastic demand curve facing the
monopolist. Since the MC curve
intersects the MR and MR” curves from below at point G”, the
best level of output is three
units, whether the monopolist faces D or D”. However, with
D the monopolist charges P =
$6, whereas with D” it would charge P = $7.50. Thus, under
monopoly there is no unique
relationship between price and output (i.e., the supply curve
is undefined)
 CHAPTER 10 Price and Output Under Pure Monopoly 319

at the same point (point G”), the best level of output is three units whether the monopo-
list faces D or D”. However, with D, the monopolist would sell the three units of output
at P = $6 (as in Figure 10.3), whereas with D”, the monopolist would sell the three units
of output at P = $7.50 (see Figure 10.5). Thus, the same quantity (i.e., Q = 3) can be sup-
plied at two different prices (i.e., at P = $6 or P = $7.50) depending on the price elastic-
ity of demand (i.e., depending on whether the monopolist faced demand curve D or D”).
Concept Check
Why is it that we Therefore, under monopoly, costs are related to the quantity supplied of the commodity,
cannot derive the short- but there is no unique relationship between price and output (i.e., we cannot derive the
run supply curve of a monopolist’s supply curve from its MC curve). Note that the monopolist would charge a
monopolist? higher price if it faced the less elastic demand curve (i.e., D”).

10.3 LONG-RUN EQUILIBRIUM PRICE AND OUTPUT

In this section, we analyze the behavior of the monopolist in the long run and compare it
with the behavior of a perfectly competitive firm and industry. We also measure the wel-
fare costs of monopoly.

Profit Maximization in the Long Run

In the long run, all inputs are variable and the monopolist can build the most efficient
plant to produce the best level of output. The best or profit-maximizing level of output is
given by the point where the monopolist’s Jong-run marginal cost curve intersects the
marginal revenue curve from below. The most efficient plant is the one that allows the
monopolist to produce the best level of output at the lowest possible cost. This is the plant
represented by the SATC curve tangent to the LAC curve at the best level of output. As
before, we assume that the monopolist does not affect input prices.
Figure 10.6 shows that the monopolist maximizes profits in the long run by producing
QO = 4; this is given by point M, where the LMC curve intersects the MR curve from below.
The monopolist should build plant SATC> and operate it at point N with SATC = $3.50.
Plant SATC; is the most efficient plant (1.e., the one that allows the monopolist to produce
O = 4 at the lowest SATC). In the long run, the monopolist will charge P = $5 (point R),
and earn a profit of $1.50 (RN) per unit and $6 in total (as opposed to $4.50 in the short run
with SATC,|—the same as Figure 10.3).
Even though profits will attract additional firms into the perfectly competitive indus-
try until all firms just break even in the long run, the monopolist can continue to earn prof-
its in the long run because of blocked entry. However, the value of these long-run profits
will be capitalized into the market value of the firm. Thus, it is the original owner of the
monopoly that directly benefits from the monopoly power. A purchaser of the firm would
have to pay a price that reflected the present (discounted) value of the monopoly profits,
and so would only break even in the long run. That is, monopoly profits become part of
the opportunity costs of the original monopolist (see Example 10-3).
Note also that the monopolist, as opposed to a perfectly competitive firm, does not
produce at the lowest point on its LAC curve (see Figure 10.6). Only if the monopolist’s
MR curve happened to go through the lowest point on its LAC would this be the case
(see Problem 7 at the end of the chapter). Furthermore, a monopolist may earn long-run
profits. Thus, as compared with a perfectly competitive firm when the industry is in long-
run equilibrium (see Section 9.5), monopoly is inefficient because the monopolist is not
likely to produce at the lowest point on its LAC curve and consumers are likely to pay a
320 PART FOUR Imperfectly Competitive Markets

LAC

p SMC2 SATCs LAC

3.50

| sce | “MR | | | l l
0 1 9 3 4 5 6 7 8 9 Q
FIGURE 10.6 Long-Run Equilibrium of the Monopolist In the long run, the monopolist maximizes profits by
producing at point M(Q = 4), where the LMC curve intersects the MR curve from below. The monopolist should
build plant SA7C>, and operate it at point N at SATC = $3.50. The monopolist will earn a profit of $1.50 (RN) per
unit and $6 in total (as opposed to $4.50 in the short run).

price that also usually includes a profit margin. In short, P > LAC implies economic
profits, and so there is distributional inefficiency; LAC # LMC implies that LAC is not at
a minimum, and so there is production inefficiency; and P > LMC means that there is
¥A Concept Check
Why will the
allocative inefficiency in the sense that the quantity of the commodity
:
supplied does not
monopolist not usually represent the best use of the economy’s resources. These social costs of monopoly are
produce at the lowest measured in the next subsection for a perfectly competitive industry that faces constant
point on its LAC curve? returns to scale and is subsequently monopolized.

EXAMPLE 10-3
Monopoly Profits in the New York City Taxi Industry

New York City, as most other municipalities (cities) in the United States, requires a
license (medallion) to operate a taxi. Since medallions are limited in number, this
confers a monopoly power (i.e., the ability to earn economic profits) to owners of
medallions. The value of owning a medallion is equal to the present discounted value
of the expected future stream of earnings from the ownership of a medallion—a
process called capitalization. For example, the number of medallions in New York
City remained at 11,787 from 1937 until 1996, when it was increased by 400 to
12,187; it increased to 13,087 by 2007, and the value of a medallion rose from $10
in 1937 to the incredible sum of $600,000 in May 2007 (up from $195,000 in 2001),
or by about 18% per year. The price of a medallion is lower (and sometimes much
lower) in other cities, reflecting the lower earning power of a medallion in
other
 CHAPTER 10 Price and Output Under Pure Monopoly 321

cities. In 2007, it was estimated to be about $365,000 in Boston and $77,000 in

Chicago, where taxis are less scarce.
Proposals to increase the number of medallions in New York City have been suc-
cessfully blocked by a powerful taxi industry lobby. Note that only the original owner
benefits from the monopoly rights. A buyer of the rights would now have to pay a price
that would fully reflect the future stream of earnings from the monopoly power, and so
the buyer would only break even in the long run. The only way to prevent further wind-
fall gains to present owners of the monopoly rights (medallions) is for the government
to issue additional medallions. Were the city to freely grant a license to operate a taxi
for the asking, the price of the medallion would drop to zero. While not doing that,
New York City has allowed a sharp growth during the 1980s in the number of radio
cabs, which can only respond to radio calls and cannot cruise the streets for passen-
gers. This has sharply increased competition in the New York City taxi industry and
reduced profits to taxi owners from 32% in 1993 to 11% in 2001.
Sources: “Owners Bewail Flood of Cabs in New York,” New York Times, April 10, 1989, p. B1; “Panel Clears
Plan to Enlarge Taxicab Fleet,’ New York Times, January 27, 1996, p. B1; “Medallion Financial Sees Growth
in Taxi Tops,” Wall Street Journal, July 19, 1999, p. B7A; “Yellow Taxis Battle to Keep Livery Cabs off
Their Turf,” New York Times, May 10, 2001, p. 1; “Taken for a Ride?” The Economist (April 24, 2004), p. 30;
and “Taxi Medallions Fetch a Record $600,000 Each,” http://www.nysun.com/article/55479.

Comparison with Perfect Competition: The Social Cost

of Monopoly
To measure the long-run social cost of monopoly, we assume that a perfectly competitive
industry operating under constant returns to scale is suddenly monopolized and the mar-
ket demand and cost curves remain unchanged. We will see that in that case output will
be smaller and prices will be higher than under perfect competition. In addition, there will
be a redistribution of income from consumers to the monopolist and a welfare loss due to
less efficient resource use. These results are shown in Figure 10.7.
In Figure 10.7, D is the perfectly competitive industry market demand curve, and LS is
the perfectly competitive industry long-run supply curve under constant costs. The long-run
perfectly competitive equilibrium is at point E, where D intersects LS. At point E, Q = 6 and
P = $3. Consumers collectively would be willing to pay LE/O ($36) for six units of the com-
modity, but need only pay E/OC ($18). Thus, the consumers’ surplus is LEC or $18 (see
Section 9.8).
When the perfectly competitive industry is monopolized, the LS curve becomes the
monopolist’s LAC and LMC curves (the monopolist would simply operate the plants of
the previously perfectly competitive firms).® The best level of output for the monopolist
in the long run is then given by point M, where MR = LMC. Thus, with monopoly, Q = 3,

8 Specifically, a perfectly competitive, constant-cost industry in long-run equilibrium has a horizontal LS curve
at the minimum LAC of the individual firms (see Figure 9.11). A monopolist taking over the industry could
change output by changing the number of plants previously operated by the independent firms at minimum
LAC (where LAC = LMC). Thus, the horizontal LS supply curve of the competitive industry is the LAC and
LMC curves of the monopolized industry. These curves show the constant LAC and LMC at which the
monopolist can change output.
522 PART FOUR Imperfectly Competitive Markets

ig, LS = LAC = LMG

: |
|

|
i MR D
3 6
FIGURE 10.7. The Social Cost of Monopoly With perfect
competition, D is the market demand curve, and LS is the supply
curve under constant costs. Equilibrium is at point E, where D
intersects LS, and Q = 6 and P = $3. When the perfectly competitive
industry is monopolized, the LS curve becomes the monopolist’s LAC
and LMC curve. Equilibrium is at point M, where MR = LMC. At point
M,Q= 3,P = $6, total profits are RMCF, and REM is the social cost
or deadweight loss to society due to the less efficient resource use
under monopoly.

P = $6 (which exceeds LMC = $3), and the monopolist will earn total profits equal to
RMCF ($9). The consumers’ surplus is now only LRF ($4.50), down from LEC ($18)
under perfect competition. Of the RECF ($13.50) reduction in the consumers’ surplus,
RMCF ($9) represents a redistribution of income from consumers to the monopolist in the
form of profits, and REM ($4.50) is the social cost or deadweight loss to society due to the
less efficient resource use under monopoly.
Specifically, monopoly profits are not a net loss to society as a whole, because they
represent simply a redistribution of income from consumers of the commodity to the
monopolist producer. This redistribution is “bad” only to the extent that society “val-
ues” the welfare of consumers more than that of the monopolist. As we will see later,
all of the monopolist’s profits could be taxed away and redistributed to consumers of the
commodity. On the other hand, the area of welfare triangle REM represents a true wel-
fare or deadweight loss to society as a whole, which is inherent to monopoly and which
society cannot avoid under monopoly.
Welfare triangle REM arises because the monopolist artificially restricts the output of
the commodity so that some resources flow into the production of other commodities that
society values less. Specifically, consumers pay P = $6 for the third unit of the commod-
ity produced by the monopolist. This is a measure of the social value or marginal benefit of
this unit of the commodity to consumers. The marginal cost (MC) to produce this unit of
the commodity, however, is only $3. This means that society forgoes one unit of the
monopolized commodity valued at $6 for a unit of another commodity valued at $3. Thus,
some of society’s resources are used to produce less valuable commodities under monop-
Concept Check oly. Since under perfect competition, production takes place at point FE, where P = LMC
How are the social (see Figure 10.7), welfare triangle REM represents the social cost or welfare (deadweight)
costs of monopoly loss from the less efficient use of society’s resources under monopoly. Example
10-4 gives
measured? estimates of the social costs of monopoly in the United States.
 CHAPTER 10 Price and Output Under Pure Monopoly S25

EXAMPLE 10-4
Estimates of the Social Cost of Monopoly in the United States

In 1954, Harberger measured the area of the welfare triangle (REM in Figure 10.7) in
each manufacturing industry in the United States on the assumption that the marginal
cost was constant and that the price elasticity of the demand curve was 1. He found that
the total social cost of monopoly was only about one-tenth of 1% of GNP. With some
refinements of the estimating method, Scherer found that the social welfare loss from
monopoly was between 0.5% and 2% of GNP, and most likely about 1%. The reason
for these relatively low estimates is that there are few firms in the American economy
with a great deal of monopoly power. In fact, Siegfried and Tiemann found that 44%
of the total welfare loss due to monopoly power in the United States in 1963 came
from the auto industry; the remainder of the loss was mostly due to a few other indus-
tries such as petroleum refining, plastics, and drugs.
There are, however, other losses resulting from monopoly power that are not
included in the above estimates. One loss is that, in the absence of competition,
monopolists do not keep their costs as low as possible, and they prefer the “quiet life”
(X-inefficiency). For example, when U.S. steel firms started to face increased foreign
competition during the 1970s and 1980s, they were able to sharply reduce costs.
Another loss is that monopolists waste a lot of resources (from society’s point of view)
lobbying, engaging in legal battles, and advertising in the attempt to create and retain
monopoly power, and to avoid regulation and prosecution under antitrust laws. These
losses are sometimes referred to as the social costs of “rent seeking.” In fact, some econ-
omists believe that these other social costs of monopoly are larger than those measured
by the welfare triangle. The method of measurement and actual estimates of the size of
these social costs are subject to a great deal of disagreement and controversy.
Sources: A. Harberger, “Monopoly and Resource Allocation,” American Economic Review, May 1954;
F. Scherer, Industrial Market Structure and Economic Performance (Chicago: Rand McNally, 1980),
pp. 459-464; and J. Siegfried and T. Tiemann, “The Welfare Cost of Monopoly: An Interindustry
Analysis,” Economic Inquiry, June 1974. For the social costs of rent seeking, see W. Rogerson, “The
Social Costs of Monopoly and Regulation: A Game-Theoretic Analysis,” Bell Journal of Economics
(now The Rand Journal of Economics), Autumn 1982; and F. Fisher, “The Social Costs of Monopoly and
Regulation: Posner Reconsidered,” Journal of Political Economy, April 1985; for more recent estimates
of the social or welfare costs of food and tobacco oligopolies, see S. Bhuyan and R. A. Lopez, “What
Determines Welfare Losses from Oligopoly Power in the Food and Tobacco Industries?,” Agricultural
and Resource Economics Review, October 1998.

Prorit MAXIMIZATION BY THE MULTIPLANT MONOPOLIST

So far, the discussion has been based on the implicit assumption that the monopolist operated
a single plant. This is not always or even usually the case. In this section, we examine how a
multiplant monopolist should distribute its best level of output among its various plants, both
in the short run and in the long run, to minimize its costs of production and maximize profits.

Short-Run Equilibrium
A multiplant monopolist will minimize the total cost of producing the best level of output
in the short run when the marginal cost of the last unit of the commodity produced in each
324 PART FOUR Imperfectly Competitive Markets

Plant 2 $ Multiplant monopolist

Plant 1
SMC,($) SMC9($) SMC
SMC SMC,

6 6
5 —

4|- Me
3 ad =
3
2 =

| jae | | L | |
ee
Oe EZR ss 16), Oe ee” rey 0 2 4 6 er 8)
FIGURE 10.8 Short-Run Equilibrium of the Multiplant Monopolist +The SMC curves of each of two plants ofa
monopolist are SMC, and SMC in the left and center panels, respectively. The horizontal summation of SMC, and
SMC) yields SMC in the right panel. SMC shows the monopolist’s minimum SMC of producing each additional unit of
the commodity, The best level of output is Q = 4, given by point G, where the SMC curve intersects the MR curve from
below. To minimize STC, the monopolist should produce three units of the commodity in plant 1and one unit in plant 2
so that SMC, = SMCa = SMC = MR = $3.

plant is equal to the marginal revenue from selling the combined output. This is shown in
Figure 10.8, which refers to a two-plant monopolist.
The left and center panels of Figure 10.8 show the SMC curve of each of the two
plants operated by the monopolist. The horizontal summation of SMC; and SMC,
yields SMC in the right panel. The SMC curve shows the monopolist’s minimum SMC
of producing each additional unit of the commodity. Thus, the monopolist should pro-
duce the first and second unit of the commodity in plant | (at a SMC of $2 and $2.50,
respectively), the third and fourth unit in plant | and plant 2 (one unit in each plant, at
SMC = $3), and so on.
If the monopolist were to produce all four units of the commodity in plant 1, it would
incur a SMC = $4 for the fourth unit (instead of a SMC = $3 with plant 2). Thus, the
monopolist should produce three units of the commodity in plant 1 and one unit in plant
2. By adding the three units of the commodity produced in plant | and the one unit pro-
duced in plant 2, we get point G on the SMC curve in the right panel of Figure 10.8. Thus,
the SMC curve in the right panel is obtained from the horizontal summation of the SMC,
and SMC) curves in the left and center panels, respectively. The SMC shows the monop-
olist’s minimum SMC of producing each additional unit of the commodity.
The best level of output for this monopolist is four units of the commodity and is given
by point G, where the SMC curve intersects the MR curve from below. The monopolist
should produce three units of the commodity in plant 1 and one unit of the commodity in
plant 2 so that SMC, = SMC) = SMC = MR = $3 (see the figure). This minimizes the total
Concept Check cost of producing the best level of output of four units at $10.50 ($2 + $2.50 + $3 4 $3)
How does a monopolist in the short run. If the monopolist were to produce all four units in plant 1, it would incur a
utilize each plant in the STC = $11.50 ($2 + $2.50 + $3 + $4). The STC would be even higher if the monopolist
short run? produced all four units in plant 2 (see the center panel of the figure).
Whether the monopolist earns a profit, breaks even, or incurs a loss by producing
three units of the commodity in plant | and one unit of the commodity in plant 2 depends
on the value of the SATC at Q = 4. Even if the monopolist were to incur a
loss at its best
 CHAPTER 10 Price and Output Under Pure Monopoly 325

level of output, it would pay to continue to produce in the short run as long as P > AVC
(see Section 10.2).

Long-Run Equilibrium
In the long run, a monopolist can build as many identical plants of optimal size (i.e.,
plants whose SATC curves form the lowest point of the LAC curve) as required to produce
the best level of output. This is shown in Figure 10.9. The left panel shows one of the
plants of the monopolist. The monopolist will operate this plant at point E’, where
SATC, = SMC; = LAC; = LMC, = $1 and Q = 3. To produce larger outputs, the monop-
olist will build additional identical plants and run them at the optimal rate of output of
Q = 3. If input prices remain constant, the LMC curve of the monopolist is horizontal at
LAC = LMC = $1 (see the right panel).
The best level of output of the monopolist in the long run is then given by point E,
where LMC = MR = $1 in the right panel. At point E, Q = 6, P = $4, LAC = $1, and the
monopolist earns a profit of $3 per unit and $18 in total. The monopolist will produce three
units of output in each of two identical plants (point £’ in the left panel). If the best level of
output is not a multiple of three, the monopolist will either have to run some plants at out-
puts greater than three units or build and run an extra plant at less than three units of output.
If input prices rise when the multiplant monopolist builds additional plants to
increase output, then the LAC curve of each plant shifts upward (as in Figure 9.12) and the
LMC curve of the monopolist will be upward sloping.

$ Multiplant monopolist

Plant |

|
0 0 3 6 Q

FIGURE 10.9 Long-Run Equilibrium of the Multiplant Monopolist ~The left panel shows one of the plants
of the monopolist. The monopolist will operate this plant at point F’, where LAC, = LMC, = $1 and Q; = 3.
To produce larger outputs, the monopolist will build additional identical plants and run them at Q = 3. If input
prices remain constant, the LMC curve of the monopolist is horizontal at LMC = $1 (see the right panel). The
best level of output is at point £, where the LMC = MR = $1. At point E, Q= 6, P= $4, LAC = $1, and the
monopolist earns a total profit of $18 and operates two plants.
326 PART FOUR lmperfectly Competitive Markets

Price DISCRIMINATION—A MOoNoPOList’S METHOD

10.5 OF INCREASING PROFITS

Price discrimination In this section, we examine various types of price discrimination. Price discrimination
Charging different refers to the charging of different prices for different quantities of a commodity or in dif-
prices (for different ferent markets which are not justified by cost differences. By practicing price discrimina-
quantities of a
tion, the monopolist can increase its total revenue and profits. We first examine the
commodity or in
charging of different prices by the monopolist for different quantities sold and then the
different markets) that
are notjustified by cost charging of different prices in different markets.
differences.

Charging Different Prices for Different Quantities

If a monopolist could sell each unit of the commodity separately and charge the highest
price each consumer would be willing to pay for the commodity rather than go without it,
the monopolist would be able to extract the entire consumers’ surplus from consumers.
First-degree price This is called first-degree (perfect) price discrimination.
discrimination The For example, in Figure 10.10, the consumer would be willing to pay LRZO ($22.50)
charging of the highest for three units of the commodity. Since he or she only pays RZOF ($18), this consumer’s
price for each unit of a
surplus is LRF ($4.50). If the monopolist, however, charged $8.50 for the first unit (the
commodity that each
consumer is willing to
highest price that this consumer would pay rather than forego entirely the consumption
pay rather than go of the commodity), $7.50 for the second unit of the commodity, and $6.50 for the third
without it. unit, then the monopolist would receive $22.50 (the sum of the areas of the rectangles
above the first three units of the commodity), thereby extracting the entire consumer’s

FIGURE 10.10 _ First- and Second-Degree Price Discrimination

Since the consumer is willing to pay $22.50 for three units of the
commodity, but only pays $18, this consumer's surplus is $4.50. If the
monopolist charged $8.50 for the first unit, $7.50 for the second, and
$6.50 for the third, it would receive $22.50, thus extracting the entire
consumer's surplus. This is first-degree price discrimination. If
the monopolist set P = $7 for the first two units and P = $6 for
additional units, it would sell three units and extract $2 of the
Z
consumer's surplus. This is second-degree price discrimination.
0 1 2 3 6 Q
 CHAPTER 10 Price and Output Under Pure Monopoly 327

surplus from this consumer.” The result would be the same if the monopolist made an
all-or-nothing offer to the consumer either to purchase all three units of the commodity
for $22.50 or none at all.
Concept Check To be able to practice first-degree price discrimination, however, the monopolist must
Why is first-degree (1) know the exact shape of each consumer’s demand curve and be able to charge the
price discrimination not highest price that each and every consumer would pay for each unit of the commodity,
practical? and (2) be able to prevent arbitrage, or someone purchasing many units of the commod-
ity at decreasing prices and reselling some of the units to others at higher prices. Even if
this were possible, it would probably be prohibitively expensive to carry out. Thus, first-
degree price discrimination is not very common in the real world. Something close to
first-degree price discrimination is, however, used in making undergraduate financial-aid
offers by American colleges (see Example 10-5).

EXAMPLE 10-5
First-Degree Price Discrimination in Undergraduate Financial Aid at American Colleges

It now costs well over $100,000 for a four-year college education at many private
colleges in the United States and more than $50,000 at public colleges. Financial aid
is, however, available based on need. The greater the need, the more financial aid
received. The way it works (as you may very well know) is as follows. In order to be
considered for financial aid, students must provide information on their family’s
finances on the Free Application for Federal Student Aid (FAFSA) form. Using a gov-
ernment formula, the college then determines the Expected Family Contribution (EFC)
toward college expenses. The lower the family’s income and the higher the expenses of
attending a particular college, the higher the financial aid offered to the student. By bas-
ing the amount of financial aid on a family’s ability to pay, colleges thus practice some-
thing that comes very close to first-degree price discrimination. Many private colleges
go well beyond this, however, in determining the aid package offered to each particular
student and, in the process, have contributed to skyrocketing tuition costs.
Private colleges all over the country are now making financial-aid offers to prospec-
tive students based not only on demonstrated family need but also on the particular stu-
dent “price sensitivity” to college costs, calculated by statistical models using dozens
of factors measuring how eager the student is to attend a particular college. The more
eager the student, the less the financial aid offered by the college. By offering less aid
to more eager students, given their family’s financial situation, the college is in effect
charging a higher tuition and thus increasing its tuition revenue. This is referred to as
“financial aid leveraging” and is similar to “yield management” used to price and fill
airline seats and hotel rooms (discussed in “At the Frontier” section in Chapter 11).
Thus, students who apply for early admission, those who go for on-campus interviews,
or those who want to major in a very specific field are usually offered less financial aid
(i.e., incur more of the college costs themselves). The National Center for Enrollment
Management (NCEM), a consulting group that advises many colleges on financial-aid
leveraging, estimated that its average college client’s tuition revenue increased by about

9 Note that the consumer is willing to pay an amount equal to the area under the demand curve between zero
and one on the horizontal axis for the first unit of the commodity. This is equal to the area of the rectangle
above the first unit of the commodity in Figure 10.10.
328 PART FOUR Imperfectly Competitive Markets

r colleges now
a half-million dollars. About 60% of the nation’s 1,500 private four-yea
use some form of financial-aid leveraging.
Wall Street Journal, APO
Sources: “Colleges Manipulate Financial-Aid Offers, Shortcoming Many,”
1, 1999, p. 15; “Second Thoughts on Early SEG
1996, p. Al; “Howls of Ivy,” Barron’s, March
Week, March 11, 2002, p. 96; and “Yale Seeks Shelter for pacts to End Early Admissions,” Wall
Business
24, 2007, p. BP
Street Journal, May 3, 2002, p. A2; “The New College Try,” New York Times, September
Analysis &
and D. M. Lang, “Financial Aid and Student Bargaining Power,” B.E. Journal of Economic
Policy, No. 1, 2007, pp. 1-21.

Second-degree price More practical and common is second-degree (multipart) price discrimination.
discrimination This refers to the charging of a uniform price per unit for a specific quantity of the com-
Charging a lower price modity, a lower price per unit for an additional batch or block of the commodity, and so on.
for each additional
By doing so, the monopolist will be able to extract part, but not all, of the consumer’s sur-
batch or block of a
plus. For example, in Figure 10.10, the monopolist could set the price of $7 per unit on the
commodity.
first two units of the commodity and a price of $6 on additional units of the commodity. The
monopolist would then sell three units of the commodity to this individual for $20 and
extract $2 from the total consumer’s surplus of $4.50. In general, this is also difficult to do
because it requires that the monopolist be able to identify each consumer’s demand curve
and prevent arbitrage. Second-degree price discrimination 1s often practiced by public util-
ities, such as electrical power companies (this is examined in Example 10—6 at the end of
the next section).

Charging Different Prices in Different Markets ©

Third-degree price Charging a different price in different markets is called third degree price discrimination.
discrimination For simplicity, we will assume that there are only two markets. To maximize profits, the
Charging a higher price monopolist must produce the best level of output and sell that output in the two markets in
for a commodity in the
such a way that the marginal revenue of the last unit sold in each market is the same. This
one market of two that
has the less elastic will require the monopolist to sell the commodity at a higher price in the market with the
demand in such a way less elastic demand. This is shown in Figure 10.11.
as to equalize the MR The left panel of Figure 10.11 shows D; and MR), which are, respectively, the mar-
of the last unit of the ket demand and the corresponding marginal revenue curves faced by the monopolist in
commodity sold in the the first market. The middle panel shows the D> and MR> for the second market. From the
two markets. horizontal summation of D; and D>, and from MR, and MR>, we get D and MR for the
firm as a whole (monopolist) in the right panel. We sum horizontally D; and D>, and MR,
and MR>, because the firm can sell the commodity in and obtain extra revenues from both
markets. Note that until Q = 2.5, MR; = MR, and until O = 5, D, = D.
The best level for output for the monopolist is seven units and is given by the point
where the firm’s marginal cost curve (MC) intersects the firm’s total marginal revenue
curve (MR) from below (point £ in the right panel). To maximize total profits, the monop-
olist should then sell four units of the commodity in market | (given by point £; in the left
panel) and the remaining three units in market 2 (given by point E> in the middle panel)
so that MR; = MR, = MR = MC = $3 (see the figure). If the MR for the last unit of
the
commodity sold in one market were different from the MR of the last unit sold in the other

10 a 3 : : Wing cies t : :
For a mathematical presentation of price discrimination using rudimentary calculus, see Section A.12 of the
Mathematical Appendix at the end of the book.
 CHAPTER 10 Price and Output Under Pure Monopoly 329

Market |

$ Market 2

| | IN KK |
0 Donte eOg 26 Sb 2.5 5 7 Q
FIGURE 10.11 Third-Degree Price Discrimination Dy in the left panel is the demand curve faced by the
monopolist in market 1 (with MR; as the corresponding marginal revenue curve). D> and MA, in the middle
panel refer to market 2. By summing horizontally D; and Dz, and MR; and MR>, we get the D and MR curves for
the monopolist in the right panel. The best level of output is seven units, given where the MC curve intersects
the MR curve from below. To maximize total profits the monopolist should sell Q = 4 at P = $7 in market 1 and
Q = 3 atP = $450 in market 2, so that MR; = MR2 = MR = MC = $3. With AC = $4 (pointZ in the right
panel), the monopolist’s total profits are $13.50.

market, the monopolist could increase its total revenue and profits by redistributing sales
from the market with the lower MR to the market with the higher MR until MR; = MR>.
The monopolist should charge P = $7 for each of the four units of the commodity sold
in market | (point R on D;) and P = $4.50 for each of the three units of the commodity in
market 2 (point V on D2). This assumes that resale is not possible. Note that the price is
higher in market 1, where demand is less elastic. The total revenue of the monopolist would
be $41.50 ($28 from selling four units of the commodity at P = $7 in market | plus $13.50
from selling three units of the commodity at P = $4.50 in market 2). With total costs of $28
(seven units at AC = $4, given by point Z in the right panel), the monopolist earns a profit
of $13.50 (the total revenue of $41.50 minus the total costs of $28). If the monopolist sold
the best level of output of seven units at the price of $5.33 (point W on D in the right panel)
in both markets (i.e., if it did not practice third degree price discrimination), the monopo-
list would earn a profit of WZ = $1.33 per unit (the price of $5.33 minus the average cost
Concept Check
of $4) and $9.31 in total (the $1.33 profit per unit times the seven units sold) as compared
How can a monopolist
with $13.50 with third degree price discrimination. Any other output or distribution of sales
increase profits by
third-degree price between the two markets would similarly lead to lower total profits for the monopolist. This
discrimination? type of analysis is valid for the long run as well as for the short run."

'! Tf the monopolist knows the price elasticity of demand for the commodity in the two markets, it can determine the
price to charge in each market to maximize total profits by utilizing formula [5.8]. See Problem 10, with the answer
at the end of the book.
330 PART FOUR Imperfectly Competitive Markets

three conditions
For a firm to be able to practice third-degree price discrimination,
the firm must not be
must be met. First, the firm must have some monopoly power (1.e.,
separate so as to
a price taker). Second, the firm must be able to keep the two markets
service must
avoid arbitrage. Third, the price elasticity of demand for the commodity or
two markets. All three conditio ns are met in the sale of electrici ty. For
be different in the
l power compani es can set prices (subject to governm ent regulati on).
example, electrica
The market for the industria l use of electrici ty is kept separate from that of househo ld
use by meters installed in each product ion plant and home. The price elasticit y of
demand for electrici ty for industria l use is higher than for househo ld use because indus-
trial users have better substitutes and more choices available (such as generating their
own electricity) than households. Thus, electrical power companies usually charge lower
prices to industrial users than to households (see Example 10-6).
Note that without market power the firm would be a price taker and could not practice
any form of price discrimination. If the firm were unable to keep the markets separate,
users in the lower-priced market could purchase more of the service than they needed and
resell some of it in the higher-priced market (thus underselling the original supplier of the
service). Finally, if the price elasticity of demand were the same in both markets, the best
that the firm could do would be to charge the same price in both markets.
There are many other examples of third-degree price discrimination: (1) the lower
fees doctors usually charge low-income people than high-income people for basically
identical services; (2) the lower prices that airlines, trains, and cinemas usually charge
children and the elderly than other adults; (3) the lower postal rates for third-class mail
than for equally heavy first-class mail; (4) the lower prices that producers usually charge
abroad than at home for the same commodity, and so on.
Third-degree price discrimination is more likely to occur in service industries than in
manufacturing industries because it is more difficult (often impossible) for a consumer to
purchase a service in the low-price market and resell it at a higher price in the other mar-
ket (thus undermining the monopolist’s differential pricing in the two markets). For
example, a low-income person could not possibly resell a doctor’s visit at a higher fee to
a high-income person. On the other hand, if an elderly person were charged a lower price
for an automobile, he or she could certainly resell it at a higher price to other people. It is
not clear that a supermarket’s charging of $0.95 for two bars of soap and $0.50 for one bar
is price discrimination, however, because the supermarket saves on clerks’ time in mark-
ing the merchandise and on cashiers’ time in ringing up customers’ bills. That is, the
charging of different prices to different consumers in different markets is not price
discrimination if the different prices are based on different costs.

EXAMPLE 10-6
Price Discrimination by Con Edison

Table 10.6 gives the price per kilowatt-hour (kWh) that Con Edison charged residen-
tial users and small and large commercial users for various quantities of electricity
consumed in New York City, from June to September and for other months in 2007.
Since Con Edison charged different rates for different categories of customers
(i.e., res-
idential and commercial) and for different quantities of electricity purchased, it
is clear
that Con Edison practiced both second- and third-degree price discrimination.
 CHAPTER 10 Price and Output Under Pure Monopoly 3511

TABLE 10.6 Dt Rates Charged by Con Edison in 2007

cents per kilowatt-hour)

kWh Cents/kWh kWh Cents/kWh

Residential Rates (Single Residence)

January 0-250 7.219 Above 250 8.114
Other months 0-250 7.219 Above 250 6.643
Commercial Rates (Small Business)
January 0-900 9.67 Above 900 8.65
Other months 0-900 8.27 Above 900 7.26
Commercial Rates (Large Business)
Low tension 0—15,000 2.02 Above 15,000 2202)
High tension 0—-15,000 1.87 Above 15,000 1.87

Source: Con Edison, New York City, 2007.

Note that charging higher rates for electricity during peak rather than off-peak
hours, or peak-load pricing, is different from third-degree price discrimination
because higher peak electricity rates are based on or reflect the higher costs of gener-
ating electricity at peak hours, when older and less efficient plants and equipment have
to be brought into operation to meet demand (peak-load pricing is examined in detail
in Section 13.8).
Another way for a seller to practice third-degree price discrimination is by offering
coupons to consumers for the purchase of some products (such as a box of breakfast
cereal) at a discount. This allows a firm to sell the product at a lower price to only the
20% to 30% of consumers who bother to clip, save, and use coupons (these are the con-
sumers who have a higher price elasticity of demand). In 2007, more than $330 billion
in grocery coupons were distributed in the United States, but only a small percentage of
them were redeemed. Offering coupons is a form of third-degree price discrimination
that the firm can use to increase profits. Firms often also offer rebates and airlines
charge many different fares for a given trip for the same reason, and (as we have seen in
Example 10-5) colleges offer varying tuition discounts in the form of financial aid.
Sources: Con Edison, Electric Rates, New York, 2007; C. Narasimhan, “A Price Discriminatory Theory of
Coupons,” Marketing Science, Spring 1984; “The Art of Devising Airfares,” New York Times, March 8,
1987, p. D1; and “The New College Try,’ New York Times, September 24, 2007, p. 23.

10.6 INTERNATIONAL PRICE DISCRIMINATION AND DUMPING

Price discrimination can also be practiced between the domestic and the foreign market.
Dumping International International price discrimination is called dumping. Dumping refers to the charging of a
price discrimination, or lower price abroad than at home for the same commodity because of the greater price elas-
the sale of a commodity ticity of demand in the foreign market. By so doing, the monopolist earns higher profits
at a lower price abroad
than by selling the best level of output at the same price in both markets. The price elastic-
than at home.
ity of demand for the monopolist’s product abroad is higher than at home because of the
competition from producers from other nations in the foreign market. Foreign competition
is usually restricted at home by import tariffs or other trade barriers. These import restrictions
B32 PART FOUR Imperfectly Competitive Markets

foreign mar-
serve to segment the market (i.e., keep the domestic market separate from the
commodi ty back to the monopoli st’s home country
ket) and prevent the reexport of the
price
(which would undermine the monopolist’s ability to sell the commodity at a higher
10.11 if
at home than abroad). International price discrimination can be viewed in Figure
D, referred to the demand curve faced by the monopolist in the domestic market and D2
referred to the demand curve that the monopolist faced in the foreign market.
Besides dumping resulting from international price discrimination (often referred to as
persistent dumping to distinguish it from other types of dumping), there are two other forms
of dumping. These are predatory dumping and sporadic dumping. Predatory dumping is the
temporary sale of a commodity at below cost or at a lower price abroad in order to drive for-
eign producers out of business, after which prices are raised abroad to take advantage of the
newly acquired monopoly power. Sporadic dumping is the occasional sale of the commod-
ity at below cost or at a lower price abroad than domestically in order to unload an unfore-
seen and temporary surplus of a commodity without having to reduce domestic prices.
Trade restrictions to counteract predatory dumping are justified and allowed to pro-
tect domestic industries from unfair competition from abroad. These restrictions usually
take the form of antidumping duties to offset price differentials. However, it is often dif-
ficult to determine the type of dumping, and domestic producers invariably demand pro-
tection against any form of dumping. In fact, the very threat of filing a dumping complaint
discourages imports and leads to higher domestic production and profits. This is referred
to as the “harassment thesis.” Persistent and sporadic dumping benefit domestic con-
sumers (by allowing them to purchase the commodity at a lower price), and these bene-
fits may exceed the possible losses of domestic producers.
Over the past decades, Japan was accused of dumping steel, televisions, and com-
puter chips in the United States, and Europeans of dumping cars, steel, and other prod-
ucts. Most industrial nations (especially those of the European Economic Community)
have a tendency of persistently dumping surplus agricultural commodities arising from
their farm-support programs. Export subsidies are also a form of dumping which, though
illegal by international agreement, often occur in disguised forms. When dumping is
proved, the violating firm usually chooses to raise its prices (as Volkswagen did in 1976
and Japanese TV exporters did in 1977) rather than face antidumping duties. Example
10—7 examines Kodak’s antidumping court victory over Fuji.

EXAMPLE 10-7
Kodak Antidumping Victory over Fuji—But Kodak Still Faces Competitive Problems

In August 1993, the Eastman Kodak Company of Rochester, New York, charged that
the Fuji Photo Film Company of Japan had violated U.S. federal law by selling paper
and chemicals for color-film processing in the United States at less than one-third of
the price that it charged in Japan and that this had materially injured Kodak.
Specifically, Kodak charged that Fuji used its excessive profits from its near monopoly
in photographic supplies in Japan to dump photographic supplies in the United States
in order to undermine the competitive position of Kodak and other U.S. competitors.
By 1993, Fuji had captured more than 10% of the U.S. photographic supply
market,
mostly from Kodak. Kodak asked the U.S. Commerce Department to impose
stiff
tariffs on Fuji’s imports of these products into the United States.
In August 1994, Fuji signed a five-year agreement under which it agreed
to sell
color paper and chemical components at or above a fair price determin
ed quarterly by
 CHAPTER 10 Price and Output Under Pure Monopoly 333

the U.S. Department of Commerce from Fuji cost of production figures in Japan and
the Netherlands, where Fuji produces the photographic supplies exported to the United
States. This “fair” price was about 50% higher than the pre-agreement price that Fuji
charged in the United States. The immediate effect of the agreement was higher prices
for photographic supplies for U.S. consumers.
In the face of continued loss of U.S. market share, Kodak again accused Fuji in 1995
of unfairly restricting its access to the Japanese market and again demanded the imposi-
tion of stiff tariffs on Fuji photographic exports to the United States. The World Trade
Organization (the institution created in 1993 to regulate international trade and adjudi-
cate trade disputes among its member nations), however, dismissed the case in 1997.
In the meantime, Fuji spent over $1 billion on new plants to produce photographic
supplies in the United States, which made Fuji a domestic supplier and, to a large extent,
no longer subject to U.S. antidumping rules. Kodak, on the other hand, has gone through
a series of restructurings from 1998 to 2006 that cut costs by nearly $2 billion by elimi-
nating 35,000 jobs, or about 35% of its worldwide labor force and shifting to higher-end
products, such as digital cameras. But even here, Kodak dropped from first place in the
U.S. market in 2005 to third place in 2006 (after Canon and Sony but ahead of Fuji,
which is in seventh place) because of its inability to adapt quickly to new market
demands in the face of fast technological changes and increasing Japanese competition.
Sources: “Kodak Asks 25% Tariffs on Some Fuji Imports,” New York Times, August 31, 1993, p. D1; “Fuji
Photo Pact on U.S. Prices,” Wall Street Journal, August 22, 1994, p. A4; “Kodak Is Loser in Trade Ruling
on Fuji Dispute,” New York Times, December 6, 1997, p. 1; “Kodak Losing U.S. Market Share to Fuji,”
Wall Street Journal, May 28, 1999, p. A3; “Great Pictures, But where are the Profits?” Financial Times,
September |, 2005, p. 15; and http://www.macworld.com/news/2007/02/05/cameras/index.php?pf=1.

10.7 Two-Part TARIFFS, TYING, AND BUNDLING

In this section, we examine some other pricing practices by monopolists: two-part tariffs,
tying, and bundling.

Two-Part Tariffs
Two-part tariff A two-part tariff is another pricing practice that monopolists sometimes use to extract
The pricing practice consumer surplus. It requires consumers to pay an initial fee for the right to purchase a
whereby a monopolist product, as well as a usage fee or price for each unit of the product they purchase. An
maximizes its total example of this is amusement parks where visitors are charged an admission fee as well
profits by charging a
as a fee or price for each ride they take. Other examples are telephone companies that
usage fee or price equal
to its marginal cost and charge a monthly fee plus a message-unit fee; computer companies that charge monthly
an initial or membership rentals plus a usage fee for renting their mainframe computers; and golf and tennis clubs
fee equal to the entire that charge an annual membership fee plus a fee for each round or game played. In each
consumer surplus. case, the monopolist wants to charge the initial fee and the usage fee that extracts as much
of consumers’ surplus as possible and thus maximizes total profits.
The monopolist maximizes total profits by charging a usage fee or per-unit price
equal to its marginal cost and an initial or membership fee equal to the entire consumer
surplus. To see this, assume that initially there is a single consumer in the market with
demand curve D in the left panel of Figure 10.12. The monopolist should then charge the
usage fee or price (P) equal to the marginal cost (MC) of $2 and an initial or membership
fee of $8 (area AEB), which equals the entire consumer surplus at P = $2. The monopo-
list would earn lower profits at any other price. For example, charging P = $3 would
334 PART FOUR Imperfectly Competitive Markets

0 Qe wad
FIGURE 10.12 Two-Part Pricing by a Monopolist With only one consumer in the market (left
panel), the monopolist maximizes its total profits by charging P = MC = $2 and the initial or
membership fee of AEB = $8. The monopolist can bring the consumer in the right panel into the
market by lowering the initial or membership fee to $6 (equal to the surplus of A*E’B" of the second
consumer at P = MC = $2) for each consumer and earn a total profit of $12.

provide the monopolist with a profit of $1 for each of the three units of the product or ser-
vice that the monopolist would sell at P = $3, but it would allow the monopolist to charge
an initial or membership fee of only $4.50 (equal to the consumer surplus of AE’B’ for
P = $3). Thus, with P = $3, the monopolist’s total profit would be $7.50 ($3 from the sale
of the three units of the product or service and $4.50 from the initial or membership fee)
as compared with a profit of $8 (from the initial or membership fee for P = MC = $2).
On the other hand, with a usage fee or price of only $1, the monopolist would incur a loss
of $1 on each of the five units of the product or service that it would sell at P = $1, but it
could charge an initial or membership fee of $12.50 (equal to the consumer surplus of
AE"B"). This would leave the monopolist with a net profit of $7.50, which is also less
than the total profit of $8 with P = $2.
Suppose now that there was a second customer with demand curve D* in the right
Concept Check panel of Figure 10.12 who could be brought into the market. At P = MC = $2, the con-
How can a monopolist sumer surplus for this second customer would be $6 (A*E*B* in the right panel of
use a two-part tariff, Figure 10.12), and this is as high an initial fee that the second consumer would be willing
tying, and bundling to pay. The monopolist would then have to lower the initial fee to $6 for both consumers to
to increase profits? bring this second consumer into the market and thus earn the higher total profit of $12 (from
the $6 initial fee from each consumer). This leaves $2 of consumer surplus to the first con-
sumer. The monopolist could extract this remaining $2 surplus from the first consumer if it
could somehow charge the first consumer a price higher than marginal cost. Another way
would be to charge the first consumer an initial fee of $8 and provide a special discount
membership of $6 for the second consumer. If both consumers were identical and faced the
same demand curve, no such difficulty would arise and the monopolist would set P = MC
and charge each consumer an initial fee equal to their (identical) consumer surplus. !

' For a more in-depth discussion of a two-part tariff, see W. Oi, “A Disneyland Dilemma:
Two-Part Tariff for
a Mickey Mouse Monopoly,” Quarterly Journal of Economics, February 1971, pp.
77-96.
 CHAPTER 10 Price and Output Under Pure Monopoly 330

Tying and Bundling

Tying The requirement Tying refers to the requirement that a consumer who buys or leases a monopolist’s prod-
that a consumer who uct also purchase another product needed in the use of the first. For example, when the
buys or leases a
Xerox Corporation was the only producer of photocopiers in the 1950s, it required those
monopolist’s product
leasing its machines to also purchase paper from Xerox. Similarly, until it was ordered by
also puchase another
product needed in the court to discontinue the practice, IBM required by contract that the users of its com-
the use of the first. puters purchase IBM punch cards. Sometimes tying of purchases is done to ensure that
the correct supplies are used for the equipment to function properly or to ensure quality.
More often, tying is used as a form of two-part tariff, whereby the monopolist can charge
a price higher than marginal cost for supplies and thus extract more of the consumer sur-
Bundling A common plus from the heavier users of the equipment (those who use more supplies). Often, the
form of tying in which courts intervene to forbid these restrictions on competition. For example, McDonald’s
the monopolist requires was forced to allow its franchises to purchase their materials and supplies from any
customers buying or McDonald’s-approved supplier rather than only from McDonald’s. This increased com-
leasing one of its petition while still ensuring quality and protection of the brand name.'?
products or services Bundling is a common form of tying in which the monopolist requires customers
also to buy or lease
buying or leasing one of its products or services also to buy or lease another product or
another product or
service when customers service when customers have different tastes but the monopolist cannot price discriminate
have different tastes but (as in tying). By selling or leasing the products or services as a package—a bundle—
the monopolist cannot rather than separately, the monopolist can increase its total profits. A classic example of
price discriminate. bundling is in movie leasing (see Example 10-8).

EXAMPLE 10-8
Bundling in the Leasing of Movies

Table 10.7 shows the prices that theater | and theater 2 would be willing to pay to lease
movie A and movie B. If the film company cannot price discriminate and leases each
movie separately to the two theaters, it will have to lease each movie at the lower of the
two prices at which each theater is willing to lease each film. Specifically, the film com-
pany would have to charge $10,000 for movie A and $3,000 for movie B for a total of
$13,000 to lease both movies to each theater (if the film company charged more for either
movie, one of the theaters would not lease the movie). But theater 1 would have been
willing to pay $15,000 to lease both movies and theater 2 would have been willing to pay

Maximum Price Each Theater Would Pay to

TABLE 10.7 | Lease Each Film Separately and as a Bundle

Theater 1 Theater 2

Movie A $12,000 $10,000

Movie B 3,000 4,000

13 See B. Klein and L. F. Saft, “The Law and Economics of Franchise Tying Contracts,” Journal of Law and
Economics, May 1985, pp. 345-361.
336 PART FOUR Imperfectly Competitive Markets

theaters
$14,000 for both movies. The film company can thus lease both movies to both
as a package or a bundle for $14,000 (the lowest of the total amounts at which the two
theaters are willing to lease the two movies) rather than individua lly for $13,000. Thus,
by leasing the two movies together as a bundle rather than individual ly, the film company
can extract some of the surplus from theater | without price discriminating between the
two theaters.
Such profitable bundling is possible only when one theater is willing to pay more for
leasing one movie but less for leasing the other movie with respect to the other theater (i.e.,
when the relative valuation for the two movies differs between the two theaters or the
demand for the two movies by each theater is negatively correlated). If, in our example,
both theaters had been willing to pay only $9,000 to lease movie A, then the maximum
price that the film company could charge either theater without price discrimination would
be $12,000, whether it leased the movies as a bundle or separately. For bundling to be prof-
itable, one theater must be willing to pay more for one movie and less for another movie
with respect to the other theater. This occurs only if the two theaters serve different audi-
ences with different tastes and have different relative valuations for the two movies.
Other examples of bundling are complete dinners versus a la carte pricing at
restaurants, travel packages (which often include flights, hotel accommodations, and
meals) and the sale of wire and wireless telephone services, Internet access and cable
TV as a single package by telecommunications companies.
Sources: R. L. Schmalensee, “Commodity Bundling by Single-Product Monopolies,” Journal of Law and
Economics, April 1982, pp. 67-71; A. Lewbel, “Bundling of Substitutes or Complements,” /nternational
Journal of Industrial Organization, No. 3, 1985, pp. 101-107; “The Benefits of Bundling,” Economic
Intuition, Winter 1999, pp. 6-7; and “Product Bundling,’ Wikipedia, October 2007, pp. 1-2, http://en.
wikipedia.org/wiki/Product_bundling.

10.8 ANALYSIS OF MONOPOLY MARKETS

Now we consider some analyses of monopoly markets. First, we compare the effect of a
per-unit tax on a monopolist and on a perfect competitor, then we show that some com-
modities could only be supplied with price discrimination, and finally we answer the
question of whether monopolists suppress inventions.

Per-Unit Tax: Perfect Competition and Monopoly Compared

One additional way to compare monopoly with perfect competition is with respect to
the incidence of a per-unit tax. A per-unit excise tax (such as on cigarettes, gasoline, and
liquor) will fall entirely on consumers if the industry is perfectly competitive and will
fall only partly on consumers under monopoly, if both the monopolist and the perfectly
competitive industry operate under constant costs.'+ For simplicity, we assume
that the
perfectly competitive industry and the monopolist face the same demand
and cost
14 The fact
re that a per-unit
aren excise
: tax falls
; ;
entirely on consumers under perfect competition but falls only partly
on consumers with monopoly does not mean, however, that monopoly
is “better” than perfect competition
When all inefficiencies associated with monopoly are considered
, we would see that perfect competition leads
to a . higher; level oof social welfare than monopoly.
mono Furthermore, the incidence of a per- unit tax is entirely on
consumers only if the perfectly competitive industry operates under
constant costs,
 CHAPTER 10 Price and Output Under Pure Monopoly 337

(terweiger) SLR ieee)

0 a te 6 8 Q
FIGURE 10.13 Per-Unit Tax: Perfect Competition and Monopoly
Compared Before the per-unit tax, the perfectly competitive
industry operates at point E, where D and S intersect, so that Q =
6 and P = $3. With a $2 per-unit tax, S shifts up to S’, and Q = 4
and P = $5, so the tax falls entirely on consumers. Before the tax,
the monopolist is in equilibrium at point M. Q = 3, P = $6, and the
monopolist earns a profit of $3 (RM) per unit and $9 in total. With
a tax of $2 per unit, Q= 2, P= $7, and half of the per-unit tax
falls on the monopolist.

conditions. Thus, S in Figure 10.13 refers to the long-run supply curve of the perfectly
competitive industry and to the LAC = LMC curve of the monopolist under constant costs.
Before the imposition of the per-unit tax, the perfectly competitive industry operates
at point E, where D and S intersect, so that Q = 6 and P = $3. If a tax of $2 per unit is
imposed, S$ shifts upward by $2 to S’. The perfectly competitive industry would then
operate at point E’, where D and S’ intersect, so that Q = 4 and P = $5. Thus, when the
industry is perfectly competitive and operates under constant costs, the entire amount of
the per-unit tax ($2 in this case) falls on consumers in the form of higher prices (so that
P = $5 instead of $3).
The case is different under monopoly. Before the imposition of the tax, the monopo-
list produces at point M, where MR and S (the LMC = LAC of the monopolist) intersect.
O = 3, P = $6 (point R), LAC = $3, and the monopolist earns a profit of $3 (RM) per unit
and $9 in total. If the same tax of $2 per unit is imposed on the monopolist, S shifts
upward to S’ (= LMC’ = LMC + 2 = LAC’ = LAC + 2). The monopolist would then oper-
ate at point M’, where MR and S’ intersect. At point M’, Q = 2, P = $7 (point R’), LAC’ =
$5, and the monopolist earns $2 per unit (R’M’) and $4 in total. Thus, with monopoly, the
price to consumers rises by only $1 (one-half of the per-unit tax). The remaining half of the
tax falls on the monopolist, so that it now only earns a profit of $2, rather than $3, per unit.
Note also that with the tax, the decline in output under monopoly is half that with perfect
competition (i.e., output falls from six to four units with perfect competition, but only from
three to two units under monopoly).!°

'5 From Figure 10.13, we can also see that the flatter or more elastic the market demand curve faced by the
monopolist, the smaller the incidence or proportion of the tax paid by consumers.
338 PART FOUR Imperfectly Competitive Markets

Price Discrimination and the Existence of the Industry

Sometimes price discrimination is necessary for an industry to exist. For example, in
Figure 10.14, D, is the demand curve for the commodity for one group of consumers
(i.e., in market 1), while D> is the demand curve for another group (market 2). The hori-
zontal summation of D, and D yields D (ABC). Since the LAC curve is above D at every
level of output, the commodity or service would not be supplied in the long run in the
absence of price discrimination or a subsidy.
With third-degree price discrimination (to the extent that the two markets can be kept
separate), the firm could sell one unit of the commodity at P = $4 in market | and sell
three units of the commodity at P = $1.50 in market 2. The total output would then be
four units sold at the (weighted) average price of $2.13, which equals the LAC of produc-
ing four units in the long run (point F in the figure).!°

Do Monopolists Suppress Inventions?

A useful invention is one that allows the production of a given-quality product at lower
cost or a higher-quality product at the same cost. Many people believe that a monopolist
would suppress such inventions. Why, they argue, would a monopolist want to introduce

FIGURE 10.14 Price Discrimination and the Existence of an Industry

The demand curve is D; in market 1 and D> in market 2. The horizontal
summation of D; and D2 gives D (ABC). Since the LAC curve is above D at
every output level, the commodity or service would not be supplied in the
long run without price discrimination or a subsidy. With third-degree price
discrimination, the firm could sell Q = 1 at P = $4 in market] and sell
Q = 3 atP = $1.50 in market 2 and break even (since at point F, the
weighted average P = $213 equals LAC).

'© The weighted average price of $2.13 is obtained by [(1)($4) + (3)($1 -50)]/4
= $8.50/4. The sale of QO= 1 in
market | and Q = 3 in market 2 was obtained from inspection of the figure.
This is the only output and distribution
of sales (in whole units of the commodity) between the two markets by
which this firm covers all costs
 CHAPTER 10 Price and Output Under Pure Monopoly 339

FIGURE 10.15 Monopoly and Inventions The price per

kilowatt-hour (kWh) of light is measured vertically and the 80
quantity of kWhs horizontally. D is the market demand curve for awl
kWhs of light. MC is the marginal cost of providing kWhs with the
original bulbs and MC’ with new bulbs (which last twice as long
but cost the same to produce). With the original bulbs, Q = 4 40
kWhs, P = $0.80 per kWh, AC = $0.40, and profit is $0.40 per
kWh and $1.60 in total. If original bulbs last 1/2 kWh, the 20
monopolist sells eight of them at P = $0.40. With new bulbs,
Q=5 kWhs, P = $070, AC’ = $0.20, and profit is $0.50 per | |
kWh and $2.50 in total. The monopolist sells five new bulbs 2 a
at $0.70 each. Kilowatt-hours of lighting

a longer-lasting light bulb that costs the same to produce when that would reduce the
number of light bulbs sold, and the total revenue and profits of the monopolist? Such rea-
soning is wrong. We will see that the introduction of an invention usually increases rather
than reduces profits, and so the monopolist has an economic incentive to introduce inven-
tion rather than to suppress it. This is shown in Figure 10.15.
The vertical axis of the figure measures the price of a kilowatt-hour (kWh) of electric
light, and the horizontal axis measures the quantity (in thousands of hours) of kWhs pro-
vided either with original light bulbs or with new and longer-lasting light bulbs.'’ Thus, the
axes do not refer to the price and quantity of light bulbs; instead they refer to the main
attribute or characteristic of light bulbs, which is to provide light. D is the market demand
curve for kWhs of light with either the original or new light bulbs, and MR is the corre-
sponding marginal revenue curve. The MC = AC curve shows the marginal and average
cost of producing kWhs oflight with the original light bulbs (produced under conditions of
constant cost). The best level of output for the monopolist is 4 kWhs and is given by point
M where MC = MR. At Q = 4 kWhs, P = $0.80 per kWh, AC = $0.40 per kWh, and the
monopolist earns a profit of $0.40 per kWh and $1.60 in total. If each original light
bulb provides or lasts 1/2 kWh, the monopolist sells eight of the original light bulbs at
P = $0.40 each.
Suppose that the monopolist considers introducing a new light bulb that costs the
same to produce but provides twice as many kWhs (i.e., lasts twice as long) as the origi-
nal light bulbs. This is shown by the MC’ = AC’ curve. This curve is half as high as the
MC = AC curve, indicating that each kWh of light could now be provided at half the cost.
The best level of output for the monopolist is 5 kWhs and is given by point M’ where
MC’ = MR. At Q = 5 kWhs, P = $0.70 per kWh, AC’ = $0.20 per kWh, and the monop-
olist earns a profit of $0.50 per kWh and $2.50 in total (as compared with $1.60 previ-
ously). Since each of the new light bulbs provides or lasts for | kWh (twice as much as
the original light bulbs), the monopolist sells five light bulbs at P = $0.70 each. Even
though the monopolist sells fewer of the new light bulbs, it earns larger total profits, and

'7 See “Bulb Lighted by Radio Waves May Last for Up to 14 Years,” New York Times, June 1, 1992, p. 1.
340 PART FOUR Imperfectly Competitive Markets

Consumers are also better off

so it has an economic incentive to introduce the invention.
of light and consume
because after the invention they pay $0.70 instead of $0.80 per kWh
5 kWh instead of 4 kWhs.
does not seem to
Thus, the widespread belief that monopolists suppress inventions
based on the
be true.!® This is a good example of how dispassionate economic analysis
Only when the
marginal principle can dispel some commonly held, yet incorrect, beliefs.
of the invention
monopolist is unsuccessful in patenting an invention and the introduction
the invention.
would lead to loss of monopoly power would the monopolist seek to suppress

AT THE FRONTIER
Near-Monopoly Lands Microsoft in the Courts

oon after its introduction in 1995, Microsoft’s Windows 95 operating system had
S captured nearly 90% of the U.S. (and world) PC market and faced only weak
competition from Apple Macintosh and IBM OS/2 operating systems. Inevitably, the
threat from Windows 95 gave rise to predictable cries of monopoly from competitors.
The introduction of Windows 95 put at especial risk small software companies that
provided specialized programs for such tasks as hooking up to the Internet, retrieving
lost files, turning the PC into a fax machine, and allocating memory inside the PC
efficiently—since most of these functions were now provided as part of Windows 95.
This was good news for computer users but drove many small software companies out
of business and represented a serious threat to the others.
In fall 1998, the U.S. Justice Department sued Microsoft, accusing it of illegally
using its Windows operating system near-monopoly to overwhelm rivals and hurt con-
sumers. In April 2000, the federal district judge trying the case ruled that Microsoft
had violated antitrust laws with predatory behavior, and in June of that year the same
judge ordered the breakup of Microsoft. The company, however, appealed. In
November 2001, the U.S. Justice Department and Microsoft reached a settlement
agreement that not only left Microsoft intact but also continued to permit Microsoft’s
strategy of “bundling” applications with its Windows operating system. Both repre-
sented substantial victories for Microsoft. In 2004, the federal appeals court upheld
the 2001 ruling, thus putting an end to Microsoft antitrust problems in the United
States. In fact, with the introduction of Windows 98 and in 2001 Windows XP,
Microsoft even increased its near-monopoly position in software.
But Microsoft also faced an antitrust suit in Europe. In 2004, the European
Commission (the European antitrust regulator) fined Microsoft $600 million, ordered
it to offer a version of the Windows operating system without its media player soft-
ware and to share more technical information with other software makers. Since 2006,
the European Commission imposed an additional $2.5 billion in fines on Microsoft for
not complying with the 2004 ruling before closing the case in February 2008.
Microsoft’s legal problems in Europe, however, are not over. In February 2008,
Microsoft faced two new suits and fines on the lack of “interoperability” between
Microsoft’s suite of Office applications, such as Excel, Word, and PowerPoint, and

18 This,
The however, does
f eta:
not mean that the monopolist innovates as much as competitive firms
 CHAPTER 10 Price and Output Under Pure Monopoly 341

competing products as well as on Microsoft’s bundling of other products and func-

tions into its new Vista operating system.
Besides antitrust problems on both sides of the Atlantic, Microsoft faced many pri-
vate suits. One of the largest was that brought by the Netscape Communications
Corporation in 2002. Netscape was the commercial pioneer in Web browsing software,
whose fortune faded as a result of the competition from Microsoft and which was
acquired by AOL in 1999. Netscape’s broad antitrust suit charged that its decline had
been the direct result of Microsoft’s illegal tactics. This suit was settled in March 2003,
with Microsoft paying AOL a $750 million penalty and granting AOL a seven-year
royalty-free license to its Internet browsing software and a long-term license to its soft-
ware for delivering music and video over the Internet. By the end of 2007, Microsoft
payouts to settle all antitrust and private suits had reached almost $5 billion; but with
over $50 billion in cash at hand, Microsoft was hardly hurt.

Sources: “Windows 95,” Business Week, July 10, 1995, pp. 94-107; “U.S. Judge Says Microsoft Violated
Antitrust Laws with Predatory Behavior,” New York Times, April 4, 2000, p. 1; “Microsoft Breakup
Ordered for Antitrust Law Violations,” New York Times , June 8, 2000, p. 1; “Settlement or Sellout?,”
Business Week, November 19, 2001, p. 114; “An AOL Unit Sues Microsoft, Saying Tactics Were Illegal,”
New York Times, January 23, 2002, p. C1;’Microsoft to Pay AOL $750 Million to End Long War,” New
York Times, May 30, 2003, p. 1; “Europeans Rule Against Microsoft,’ New York Times, March 25, 2004,
p. Cl; “Court Lets Settlement Stand in Microsoft Antitrust Case, New York Times, July 1, 2004, p. C7;
“Microsoft Payouts Set to Top $4.5 Billion,” Financial Times, April 12, 2005, p. 21; and “Microsoft’s
Record Fine,’ Financial Times, February 28, 2008, p. 1.

| ~ | SUMMARY
1. A monopolist is a firm selling a commodity for which there are no close substitutes. Thus, the
monopolist faces the industry’s negatively sloped demand curve for the commodity, and
marginal revenue is smaller than price. Monopoly can be based on control of the entire supply
of a required raw material, a patent or government franchise, or declining long-run average
costs over a sufficiently large range of outputs so as to leave a single firm supplying the entire
market. In the real world, there are usually many forces that limit the monopolist’s market
power.
2. The best level of output for the monopolist in the short run is the one that maximizes total profits.
This occurs where the positive difference between TR and STC is greatest. The same result is
obtained where the MC curve intersects the MR curve from below. If P is smaller than ATC, the
monopolist will incur a loss in the short run. However, if P exceeds AVC, it pays for the
monopolist to continue to produce because production covers part of the fixed costs. There is no
unique relationship between price and output or supply curve for the monopolist.
3. The best, or profit-maximizing, level of output for the monopolist in the long run is given by the
point where the LMC curve intersects the MR curve from below. The best plant is the one whose
SATC curve is tangent to the LAC at the best level of output. The monopolist can make long-run
profits because of restricted entry and does not usually produce at the lowest point on the LAC
curve. The long-run profits of the monopolist will be capitalized into the market value of the
firm and benefit only the original owner of the monopoly. As compared with perfect
competition, monopoly restricts output, results in a higher price, redistributes income from
consumers to the monopolist, and leads to less efficient use of society’s resources.
4. A multiplant monopolist minimizes the total cost of producing the best level of output in the
short run when the marginal cost of the last unit of the commodity produced in each plant is
equal to the marginal revenue from selling the combined output. In the long run, a monopolist
342 PART FOUR Imperfectly Competitive Markets

form the
can build as many identical plants of optimal size (i.e., plants whose SATC curves
lowest point of the LAC curve) as required to produce the best level of output.

5. Under first-degree price discrimination, the monopolist sells each unit of the commodity
go
separately and charges the highest price that each consumer is willing to pay rather than
without the commodity. By doing so, the monopolist extracts the entire consumers’ surplus.
More practical and common is second-degree price discrimination. This refers to the charging
of a lower price per unit of output for each additional batch or block of the commodity. By
doing so, the monopolist will be able to extract part of the consumers’ surplus. Third-degree
price discrimination refers to the charging of a higher price for a commodity in the market with
the less elastic demand in such a way as to equalize the MR of the last unit of the commodity
sold in the two markets. To do this, the firm must have some control over prices, it must be able
to keep the two markets separate, and the price elasticity of demand must be different in the
two markets.
6. International price discrimination is called (persistent) dumping. Under this type of dumping,
the monopolist sells the commodity at a higher price at home (where the market demand curve
is less elastic) than abroad where the monopolist faces competition from other nations and the
_market demand curve for the monopolist’s product is more elastic.
7. A two-part tariff is the pricing practice under which a monopolist maximizes total profits by
charging a usage fee or price equal to its marginal cost and an initial or membership fee equal
to the entire consumer surplus. Tying refers to the requirement that a consumer who buys or
leases a monopolist’s product also purchase another product needed in the use of the first.
Bundling is a common form of tying in which the monopolist requires customers buying
or leasing one of its products or services to also buy or lease another product or service
when customers have different tastes but the monopolist cannot price discriminate
(as in tying).
8. A per-unit excise tax will fall on consumers in its entirety under perfect competition but only in
part under monopoly with constant costs. Price discrimination may be necessary to permit the
existence of an industry. The commonly held view that monopolists suppress inventions is not
generally true. The introduction of Windows 95 by Microsoft is as close as we come today to a
pure monopoly in a major U.S. industry.

a|_ KEY TERMS

Pure monopoly Second-degree (multipart) Two-part tariff
Natural monopoly price discrimination Tying
Price discrimination Third-degree price Bundling
First-degree or (perfect) price discrimination
discrimination Dumping

REVIEW QUESTIONS
1. a. What forces limit the monopolist’s market power in the 3. a. How does the shape of the monopolist’s total
real world? revenue curve differ from that of a perfectly
b. Why would a monopolist advertise its product if it has a competitive firm?
monopoly power over the product? b. Why doesn’t the monopolist produce where total
2. a. Why would a monopolist never operate in the inelastic revenue is maximum?
range of its demand curve? 4. Suppose that a monopolist sells a commodity at the price
b. What would be the best level of output for a monopolist of $10 per unit and that its marginal cost is also $10. Is the
that faced zero average and marginal costs? monopolist maximizing total profits? Why?
 CHAPTER 10 Price and Output Under Pure Monopoly 343

5. If the monopolist’s total profits were entirely taxed away batches on which it charges a uniform price are larger
and redistributed to consumers, would any social cost of or smaller? Why?
monopoly remain? Why?
b. How does a two-part tariff differ from bundling?
6. If LS = LAC = LMC = §3 in Figure 10.7 shifted upward
to $5, what would be . If the monopolist of Figure 10.11 sold the best level
of output at the same price in market | and market 2
a. the consumers’ surplus?
(i.e., if the monopolist did not practice third-degree
b. the monopolist’s total profits? price discrimination), how much would it sell in
c. the social cost of monopoly? each market?
7. How could the government entirely eliminate the social — —_ . Is persistent dumping good or bad for consumers in the
cost of monopoly in Figure 10.7? importing country? Against what type of dumping would
8. Under what condition would a multiplant monopolist keep the nation want to protect itself? Why?
some of its plants idle? . Assuming that everything is the same, will a per-unit tax
9. a. Will a monopolist’s total revenue be larger with reduce output more under perfect competition or under
second-degree price discrimination when the monopoly? Why?

|__| PROBLEMS
1. Given that the demand function of a monopolist is #4, Suppose the demand curve facing the monopolist
Q=1/5(55 — P) changes to Q’ = 1/5(30 — P), while cost curves remain
a. derive the monopolist’s demand and marginal unchanged.
revenue schedules from P = $55 to P = $20, at $5 a. Draw a figure similar to Figure 10.4 showing the
intervals. best level of output.
b. On the same set of axes, plot the monopolist’s b. Does the monopolist make a profit, break even, or
demand and marginal revenue curves, and show the incur a loss at the best level of output? Should the
range over which D is elastic and inelastic, and the monopolist shut down? Why? Where is the
point where D is unitary elastic. monopolist’s shut down point?
c. Using the formula relating marginal revenue, price, Nn . Suppose that the monopolist has unchanged cost curves
and elasticity, find the price elasticity of demand at but faces two alternative demand functions:
P = $40.
Q = 1/5(55 — P) and QO” = 1/5(45 — P)
2. Using the TC schedule of Table 8.2 and the demand
schedule of Problem 1 a. Draw a figure similar to Figure 10.5 showing the
a. construct a table similar to Table 10.2 showing TR, best level of output with each demand function.
STC, and total profits at each level of output, and b. Which of the two demand functions is more elastic?
indicate by an asterisk the best level of output for Where is the monopolist’s supply curve?
the monopolist. . Starting with the cost curves in Figure 8.11 and the
b. draw a figure similar to Figure 10.2 and determine demand and marginal revenue curves of problem 1, draw
the best level of output for the monopolist. a SATC curve (label it SATC’> and its associated SMC
curve (label it SWC’) showing that the monopolist is in
3. Using the per-unit cost curves of Figure 8.2 and
long-run equilibrium at Q = 5.
the demand and marginal revenue curves from
Problem 1(b) Uh Draw two figures and label the best level of output
a. draw a figure similar to Figure 10.3 and show the as Q* and label per-unit profit as AB for a monopolist
best level of output for the firm. that

b. From your figure in part (a), construct a table similar a. produces at the lowest point on its LAC curve.
to Table 10.4 showing P, ATC, profit per unit, total b. overutilizes a plant larger than the one that forms the
profits, MR, and MC at each level of output. lowest point on its LAC curve.

* — Answer provided at end of book.

344 PART FOUR Imperfectly Competitive Markets

8. Given that the market demand function facing a two- much would the consumers’ surplus be in
plant monopolist is Q@= 20 — 2P and the short-run this case?
marginal cost for plant 1 and plant 2 at various levels of c. Answer part (a) if the monopolist charged P = $5.50
output are for the first three units of the commodity and
P = $4 for the next three units. What type of
Q 0 1 2 3 4 price discrimination is this?
d. With MC = $4, what two-part tariff should the
SMC, ($) sb 2 4 6 8 monopolist use to maximize total profits? What if
SMC) ($) ee 2:50 pees)0 men 0 ee 2.00 VGA
*10. With reference to Figure 10.11, use formula [5-8] to
draw a figure showing D, MR, SMC,, SMC), and MC prove that if the monopolist charges P = $4.50 in
schedules of this monopolist. What is the best level of market 2, it must charge P = $7 in market | to
output for the monopolist? How much should the maximize total profits with third-degree price
monopolist produce in plant | and how much in plant 2?
discrimination.
9. Given the following demand curve of a consumer for a 11. With reference to Figure 10.13, compare the effect of a
monopolist’s product $4 per-unit tax if the industry is perfectly competitive or
Q=14-—2P a monopoly.
a. find the total revenue of the monopolist when it *12. Starting from Table 10.3 and Figure 10.3, construct a
sells six units of the commodity without practicing table and draw a figure showing
any form of price discrimination. What is the value a. how a lump-sum tax can be used to eliminate all of
of the consumers’ surplus? the monopolist’s profits.
b. What would be the total revenue of the monopolist b. what would happen if the government imposed a
if it practiced first-degree price discrimination? How per-unit tax of $2.50.

| INTERNET SITE ADDRESSES

Information on Alcoa and aluminum prices are found at: Third-degree price discrimination is examined at:
http://www.alcoa.com http://www.coned.com
http://www.alcoa.com/global/en/news/news_detail. http://media.corporate-ir.net/media_files/irol/
asp?pageID=20070430005939en&news Year=2007 61/61493/total.pdf
http://www. world-aluminium.org/About+IAI/Members http://couponing.about.com/b/a/256970.htm
http://www.econstats.com/spot/rt_alum.htm On the antidumping case that Kodak brought against Fuji as
http://www. infomine.com/investment/historicalcharts/ well as their present competition, see:
showcharts.asp?c=Aluminum http://www.macworld.com/news/2007/02/05/cameras/
http://www.purchasing.com/article/CA6479841.html index.php?pf=1
Information on the taxi market and the price of a taxi http://www.academon.com/lib/essay/kodak.html
medallion in New York, Boston, and Chicago is found at: An excellent graphical presentation of price discrimination,
http://en.wikipedia.org/wiki/Taxicabs_of_the_United_ peak-load pricing, two-part tariff, and bundling is
States#New_York_City found at:
http://www.nysun.com/article/55479 http://en.wikipedia.org/wiki/Product_bundling
http://www.bostonnow.com/news/local/2007/05/07/ http://en.wikipedia.org/wiki/Two_part_tariff
cab_drive_crazy/ http://en.wikipedia.org/wiki/Tying_%28commerce%29
http://hgchicago.org/mm06.html The Microsoft antitrust cases are examined at:
The operation of the De Beers diamond company is http://www.usdoj.gov/atr/cases/ms_index.htm
discussed at:
http://www.eurunion.org/News/press/2005/2005083.htm
http://en.wikipedia.org/wiki/De_Beers
http://www.npr.org/templates/story/
http://www.debeersgroup.com/debeersweb
story.php?storyId=14465 160
 CHAPTER 1]

Price and Output Under Monopolistic

Competition and Oligopoly
Chapter Outline List of Examples
11.1 Monopolistic Competition: Many Sellers of a 11-1 Advertisers Are Taking on Competitors by
Differentiated Product Name...and Are Being Sued
lg Monopolistic Competition: Short-Run and Industrial Concentration in the United
Long-Run Analysis States
Nee Oligopoly: Interdependence Among the Few The Organization of Petroleum Exporting
Producers in the Industry Countries (OPEC) Cartel
11.4 The Cournot and the Kinked—Demand Curve The Market-Sharing Ivy Cartel and
Models Financial-Aid Leveraging
bi Collusion: Cartels and Price Leadership Models Firm Size and Profitability
11.6 Long-Run Adjustments and Efficiency At the Frontier: The Art of Devising Airfares
Implications of Oligopoly Globalization of the Automobile Industry
1 ay Other Oligopolistic Pricing Practices Rising Competition in Global Banking
11.8 The March of Global Oligopolists Globalization of the Pharmaceutical Industry
Appendix: The Cournot and Stackelberg Models

After Studying This Chapter, You Should Be Able to:

e Describe the difference between perfect competition and monopolistic competition
e Know how the Cournot model explains duopolists’ behavior
e Describe how the kinked—demand curve model explains price rigidity
e Know how the different types of cartels operate
e Know the welfare implications of oligopoly

n this chapter, we bring together the theory of consumer behavior and demand (from
Part Two) and the theory of production and costs (from Chapters 7 and 8) to analyze
how price and output are determined under monopolistic competition and oligopoly.
These fall between the two extremes of perfect competition and pure monopoly in the
spectrum or range of market organizations, and, as such, they contain elements of both.

345
346 PART FOUR Imperfectly Competitive Markets

of output fora monopolis-

As with perfect competition and monopoly, the best level
marginal cost. But, as in
tic competitor and oligopolist is where marginal revenue equals
This means that
the case of monopoly, price exceeds marginal revenue and marginal cost.
at restrict output
monopolistically competitive and oligopolistic firms are able to somewh
but their market
and charge consumers a higher price than perfect competitors would,
power is not as great as that of the monopolist. ra
The chapter begins by examining the meaning and importanc e of monopolis tic com-
petition; it shows how the equilibrium price and quantity are determined in the short run
and in the long run, and analyzes product variation and selling expenses. Then, after dis-
cussing the meaning and sources of oligopoly, we examine various models of oligopoly
pricing and output. We will see that there is no general theory of oligopoly but a number
of models of various degrees of realism. Subsequently, we discuss the long-run efficiency
implications of oligopoly, review some other oligopolistic pricing practices, and examine
the growth in the number and size of international oligopolists. In the next chapter, we
consider oligopolistic behavior utilizing game theory. Chapter 13 deals with market struc-
ture, efficiency, and regulation.

MONOPOLISTIC COMPETITION: MANY SELLERS

11.1 OF A DIFFERENTIATED PRODUCT

In Chapter 9 we defined perfect competition as the form of market organization in which

there are many sellers of a homogeneous product. In Chapter 10 we defined pure monop-
oly as a single seller of a commodity for which there are no close substitutes. Between
Monopolistic these two extreme forms of market organization lies monopolistic competition. This
competition The refers to the case in which there are many sellers of a heterogeneous or differentiated
market organization product and entry into or exit from the industry is rather easy in the long run.
where there are many
Differentiated products are products that are similar but not identical. The similar-
sellers of a differentiated
product and entry into
ity of differentiated products arises from the fact that they satisfy the same basic con-
the market is easy. sumption needs. Examples are the numerous brands of breakfast cereals, toothpaste,
cigarettes, detergents, and cold medicines on the market today. The differentiation may be
Differentiated real (as in the case of the various breakfast cereals with various nutritional and sugar con-
products Products that
tents) or imaginary (as in the case of the different brands of aspirin, all of which contain
are similar but not
identical. the same ingredients). Product differentiation may also be based entirely on some sellers
being more or less conveniently located or on the kind of service they provide (i.e., more
or less friendly).
As the name implies, monopolistic competition is a blend of competition and monop-
oly. The competitive element arises because there are many sellers of the differentiated
product, each of which is too small to affect the other sellers. Firms can also enter and
leave a monopolistically competitive industry rather easily in the long run. The monopo-
listic element arises from product differentiation. That is, since the product of each seller
is similar but not identical, each seller has a monopoly power over the specific product it
sells. This monopoly power, however, is severely limited by the existence of close substi-
tutes. Thus, if a seller of a particular brand of aspirin charged a price more than a few pen-
nies higher than competitive brands, it would lose a great deal of its sales.
Monopolistic competition is most common in the retail and service sectors of the
economy. Nationally, clothing, cotton textiles, and food processing are industries
that
come closest to monopolistic competition. Locally, the best examples of monopolist
ic
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 347

competition are the many gasoline stations, barber shops, grocery stores, drug stores,
newspaper stands, restaurants, pizzerias, and liquor stores, all located near one another.
Each of these businesses has some monopoly power over its competitors due to the
uniqueness of its product, better location, slightly lower prices, better service, greater
range of products, and so on. Yet, this market power is very limited due to the availability
of close substitutes.
Because each firm produces a somewhat different product under monopolistic com-
petition, we cannot define the industry (which refers to the producers of an identical prod-
uct). Chamberlin, who introduced the theory of monopolistic competition in the early
1930s, sought to overcome this difficulty by lumping all the sellers of similar products
Product group into a product group. For simplicity, we will continue to use the term “industry” here,
The sellers of a but in this broader sense (i.e., to refer to all the sellers of the differentiated products in a
differentiated product.
product group). However, because of product differentiation, we cannot derive the indus-
try demand and supply curves as we did under perfect competition, and we do not have a
single equilibrium price for the differentiated product, but a cluster of prices. Thus, our
graphic analysis will have to be confined to the “typical” or “representative” firm rather
than to the industry. Under monopolistic competition, firms can affect the volume of their
sales by changing the product price, by changing the characteristics of the product, or by
varying their selling expenses (such as advertising). We will deal with each of these
choice-related variables next.

MONOPOLISTIC COMPETITION: SHORT-RUN

11.2 AND LONG-RUN ANALYSIS

In this section, we examine how a monopolistically competitive firm determines its best
level of output and price in the short run and in the long run on the assumption that the
firm has already decided on the characteristics of the product to produce and on the sell-
ing expenses to incur. Later, we examine product variation and selling expenses and eval-
uate the theory of monopolistic competition.

Price and Output Decisions Under Monopolistic Competition

Because a monopolistically competitive firm produces a differentiated product, the
demand curve it faces is negatively sloped; but since there are many close substitutes for
the product, the demand curve is highly price elastic. The price elasticity of demand is
higher the smaller is the degree of product differentiation. As in the case of monopoly,
since the demand curve facing a monopolistic competitor is negatively sloped, the corre-
sponding marginal revenue curve is below it, with the same price intercept and twice the
absolute slope. As for firms under any type of market structure, the best level of output for
the monopolistically competitive firm in the short run is where marginal revenue equals
marginal cost, provided that price exceeds the average variable cost. This is shown in the
left panel of Figure 11.1.
The left panel of Figure 11.1 shows that the best level of output for the typical or rep-
resentative monopolistically competitive firm in the short run is six units and is given by
point £, at which MR = SMC. At Q <6, MR > SMC and the total profits of the firm
increase by expanding output. At Q > 6, SMC > MR and the total profits of the firm
increase by reducing output. To sell the best level of output (i.e., six units) the firm charges
348 PART FOUR Imperfectly Competitive Markets

ilibri ium $ r n equi ilibrium

Long-ru
Short-run equilibr

SMC’ SATC'

©
OmOn~y
eOUm

OnvenesmDU6 tan OhaatO

FIGURE 11.1 Short-Run and Long-Run Price and Output Determination Under Monopolistic
Competition The left pane! shows that in the short run the firm produces six units, given by point £, where
MR = SMC. AtOQ = 6, P = $9 (point A on the D curve) and SATC = $7 (point B), so that the firm maximizes
profits of AB = $2 per unit and ABCF = $12 in total (the shaded area). The right panel shows that in the long run
the firm produces four units, given by point E’, where MR’ = LMC = SMC’. AtQ = 4,P =LAC SAIC =
(point A’), so that the firm breaks even. This compares to Q = 7, where P = lowest LAC = $5 (point E”) under
long-run perfectly competitive equilibrium.

a price of $9 per unit (point A on the D curve). Since at Q = 6, SATC = $7 (point B in the
figure), the monopolistic competitor earns a profit of AB = $2 per unit and ABCF = $12
in total (the shaded area in the figure). As in the case of a perfectly competitive firm and
monopolist, the monopolistic competitor can earn profits, break even, or incur losses in the
short run. If at the best level of output, P > SATC, the firm earns a profit; if P = SATC, the
firm breaks even; and if P < SATC, the firm incurs losses, but it minimizes losses by con-
tinuing to produce as long as P > AVC. Finally, since the demand curve facing a monopo-
listic competitor is negatively sloped, MR = SMC < P at the best level of output, so that
(as in the case of monopoly) the rising portion of the MC curve above the AVC curve does
not represent the short-run supply curve of the monopolistic competitor.
Since the firm in the left panel of Figure 11.1 earns profits in the short run, more firms
will enter the market in the long run because entry is easy. With more firms sharing the
market, the demand curve facing each monopolistic competitor shifts to the left (as its
market share decreases) until it becomes tangent to the firm’s LAC curve. Thus, in the
long run, all monopolistically competitive firms break even and produce on the negatively
sloped portion of their LAC curve (rather than at the lowest point, as in the case of perfect
competition). This is shown in the right panel of Figure 11.1.
In the right panel of Figure 11.1, D’ is the new demand curve facing the monopolis-
tically competitive firm in the long run. Demand curve D’ is lower and more price elastic
than demand curve D that the firm faced in the short run. This is because, as more firms
enter the monopolistically competitive market in the long run (attracted by potential prof-
its), the monopolistic competitor is left with a smaller share of the market and faces
greater competition from the greater range of (differentiated) products that becomes
available in the long run. Demand curve D’ is tangent to the LAC and SATC’
curves at
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 349

point A’—the output at which MR’ = LMC = SMC’ (point E’ in the figure). Thus, the
Concept Check monopolistic competitor sells four units of the product at the price of $6 per unit and
Why does a breaks even in the long run (as compared to Q = 6 and P = $9 and profits of $2 per unit
monopolistic and $12 in total in the short run). At any other price, the monopolistically competitive
competitor break even
firm would incur losses in the long run, and with a different number of firms it would not
when in long-run
break even.
equilibrium?
The fact that the monopolistically competitive firm produces to the left of the lowest
point on its LAC curve when in long-run equilibrium means that the average cost of pro-
duction and price of the product under monopolistic competition are higher than under
perfect competition ($6 at point A’ as compared with $5 at point E”, respectively, in the
right panel of Figure 11.1). This difference, however, is not large, because the demand
Concept Check
curve faced by the monopolistic competitor is very elastic. In any event, the slightly
Why are efficiency and
welfare loss not very higher LAC and P under monopolistic competition than under perfect competition can be
large under regarded as the cost that consumers willingly pay for having a variety of differentiated
monopolistic products appealing to different consumer tastes, rather than a single undifferentiated
competition? product.
The difference between the level of output indicated by the lowest point on the LAC
curve and the monopolistic competitor’s output when in long-run equilibrium measures
Excess capacity A excess capacity. In the right panel of Figure 11.1, excess capacity is three units, given by
larger-than-optimal Q = 7 at the lowest point on the LAC curve minus Q = 4, indicated by point A’ on the
plant. LAC curve, at which the firm produces in the long run. Excess capacity permits more
firms to exist (1.e., it leads to some overcrowding) in monopolistically competitive mar-
kets as compared with perfect competition. Consumers, however, seem to prefer that
firms selling some services operate with some unused capacity (i.e., they are willing to
pay a slightly higher price for getting a haircut, filling up on gasoline, checking out at a
grocery store, and eating at a restaurant) so as to avoid waiting in long lines.

Product Variation and Selling Expenses

Under monopolistic competition, a firm can increase its expenditures on product variation
and selling effort to increase the demand for its product and make it more price inelastic.
Product variation Product variation refers to changes in some of the characteristics of the product that a
Differences in some of monopolistic competitor undertakes in order to make its product more appealing to con-
the characteristics of a sumers. For example, producers may reduce the sugar and increase the fiber content of
product. breakfast cereals. Selling expenses are all those expenses that the firm incurs to advertise
Selling expenses the product, increase its sales force, provide better service for its product, and so on.
Expenditures to induce Product variation and selling expenses can increase the firm’s sales and profits, but they
consumers to purchase also lead to additional costs. A firm should spend more on product variation and selling
more of its product. effort as long as the MR from these efforts exceeds the MC and until MR = MC (see
Example 1—4). While spending more on product variation and selling effort (nonprice
competition) can increase profits in the short run, monopolistically competitive firms will
break even in the long run because of imitation and the entrance of new firms. This is
shown in Figure 11.2.
In Figure 11.2, D’ and MR” are demand and marginal revenue curves that are higher
than D’ and MR’ in the right panel of Figure 11.1 as a result of greater product variation and
selling expenses. The LAC curve is that of Figure 11.1, while LAC* and LMC* are the
long-run average and marginal cost curves resulting from greater product variation and
selling expenses. Note that the vertical distance between LAC* and LAC increases on the
(realistic) assumption that to sell greater quantities of the product requires larger expenses
350 PART FOUR Imperfectly Competitive Markets

LMC“

0 3 5 7 9 Q
FIGURE 11.2 Long-Run Equilibrium with Product Variation and
Selling Expenses Curves D” and MR”, as well as LAC* and LMC’, are
higher than in the right panel of Figure 111 because of the firm's greater
expenses on product variation and selling effort. While these efforts can
increase the firm’s profits in the short run, in the long run the firm breaks
even. This is shown by pointA*,at which Q = 5 units and P = LAC’ =
$8, and MR” = LMC (point E*). At pointA* the firm charges a higher
price and sells a greater quantity than at pointA’ in the right panel of
Figure 11.11, but the firm will nevertheless only break even in the long run.

per unit on product variation and selling effort. While these efforts can lead to larger short-
run profits, however, our typical or representative firm will break even in the long run
because other firms can also increase product variation and selling expenses, and more
firms can also enter the market in the long run. The long-run equilibrium of our represen-
tative firm is given by point A* in Figure 11.2, at which Q = 5 and P = LAC* = $8 and
MR" = LMC* (point E*). At point A* the firm charges a higher price and sells a greater
quantity than at point A’ in the right panel of Figure 11.1, but the firm will nevertheless
break even in the long run. If all firms selling similar products increase their expenses on
product variation and selling effort, each firm may retain only its share of an expanding
market in the long run.
Two important questions arise with respect to selling expenses in general and adver-
tising in particular. First, is advertising manipulative, and does it create false needs?
Second, does advertising increase or reduce the degree of competition in a market? The
ema view that advertising creates false needs has been forcefully advanced by
Galbraith.! Why, Galbraith asks, would firms keep spending millions on advertising if it
didn’t work? Recent studies on cigarette and beer consumption in the United States and
Canada, however, have shown that although advertising does affect brand choices, it does
not seem to be very effective in increasing the overall consumption of a product. With
regard to the second question, a recent study has found that industries with higher-than-
average advertising expenditures relative to sales had lower rates of price increases and

' J. K. Galbraith, The Affluent Society (Boston: Houghton Mifflin, 1958).

 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 35

higher rates of output increases than the average for 150 major U.S. industries studied
from 1963 to 1977.2 Thus, on balance (and as Example 11-1 clearly indicates), advertising
seems to enhance, rather than restrict, competition. Even though some advertising is
manipulative and can act as a barrier to entry, a great deal of it is informative and increases
market competition. More will be said about advertising in Chapter 19, which deals with
the economics of information.

EXAMPLE 11-1
Advertisers Are Taking on Competitors by Name... and Are Being Sued

Since 1981 when the National Association of Broadcasters abolished its guidelines
against making disparaging remarks against competitors’ products, advertisers have
taken their glovess off and begun to praise the superior qualities of their products, not
compared to “brand X” as before 1981 but by identifying competitors’ products by
name. The Federal Trade Commission welcomed the change because it anticipated
that this would increase competition and lead to better-quality products at lower prices.
Some of these hopes have in fact been realized. For example, the price of eyeglasses
was found to be much higher in states that prohibited advertising by optometrists and
opticians than in states that allowed such advertising, without any increase in the prob-
ability of having the wrong eyeglass prescription. Similarly, the price of an uncon-
tested divorce dropped from $350 to $150 in Phoenix, Arizona, after the Supreme
Court allowed advertising for legal services.
Although less sportsmanlike and possibly resulting in legal suits, advertisers have
been willing to take on competitors by name because the technique seems very effec-
tive. For example, Burger King’s sales soared when it began to attack McDonald’s by
name, when AT&T attacked MCI pricing, and when Unilever named Proctor &
Gamble’s competitive products specifically. Sectors where comparative advertising are
most common include food, retail, automobiles, airlines and, more recently, law. U.S.
and European courts have generally allowed comparison advertising, unless dishonest
or inaccurate. Thus, the courts threw out the suit and countersuit between Gillette and
Wilkinson allowing each to claim superior blades, RBS Bank’s to claim its credit cards
as superior to Barkleys’, and Rayner to claim its tickets were a lot cheaper than British
Airway’s. A Belgian Court, however, ruled as defamatory Rayner’s advertisement with
a picture of the Brussels landmark the “Mannequin Pis,” a statue of a boy urinating,
and the line “Pissed off by Sabene’s high fares?”
Sources: “Advertisers Remove the Cover from Brand X,” U.S. News & World Report, December 19,
1983, pp. 75-76; L. Benham, “The Effect of Advertising on the Price of Eyeglasses,” Journal of Law and
Economics, October 1973, pp. 337-352; “Lawyers Are Facing Surge in Competition as Courts Drop
Curbs,” Wall Street Journal, October 18, 1978, p. 1; “A Comeback May Be Ahead for Brand X,” Business
Week, December 1989, p. 35; “Long-Distance Risks of AT&T MCI War,” Wall Street Journal, April 14,
1993, p. B9; “Marketeers Increasingly Dispute Health Claims of Rivals’ Products,” Wall Street Journal,
April 4, 2002, p. B1; and http://www.bynoother.com/2003/08/comparativ_ady.html

2B. W. Eckard, “Advertising, Concentration Changes, and Consumer Welfare,’ Review of Economics
and Statistics, May 1988, pp. 340-343; and “Cigarette Advertising and Competition,” The Margin,
March/April 1990, p. 22.
352 PART FOUR Imperfectly Competitive Markets

How Useful Is the Theory of Monopolistic Competition?

it was hailed
When the theory of monopolistic competition was introduced 70 years ago,
have grown somewha t dis-
as a significant theoretical breakthrough. Today, economists
enchanted with it. There are several reasons for this disenchantment.
to
First, it may be difficult to define the market and determine the firms and products
include in the theory. For example, should moist paper tissues be included with other
paper tissues or with soaps? Are toothpaste, dental floss, toothpicks, and water picks part
of the same market or product group?
Second, and more important, in markets where there are many small sellers, prod-
uct differentiation has been found to be slight. As a result, the demand curve facing the
monopolistic competitor is close to being horizontal. Under these circumstances, the
perfectly competitive model provides a good approximation to the monopolistically
competitive solution, and it is also much easier to use for analysis.°
Third, in many markets where there are strong brand preferences, it usually turns out
that there are only a few producers, so that the market is oligopolistic rather than monop-
olistically competitive. For example, while there are numerous brands of breakfast cere-
als, cigarettes, toothpaste, detergents, soaps, and many other consumer products on the
market today (so that the markets may seem to be monopolistically competitive), on
closer examination we find that these products are produced by only four or five very
large firms (so that the market is in fact oligopolistic). Millions of dollars are likely to be
needed to develop and promote a new product in these markets, and this represents a sig-
nificant barrier to entry into the market. In fact, only a handful of firms have been able to
enter these markets during the past two decades.
Fourth (and related to the third point), even in a market where there are many small
sellers of a product or service (say, gasoline stations), a change in price by one seller may
have little or no effect on most other gasoline stations located far away from it, but the price
change will have a significant impact on competitors in the immediate vicinity. These
nearby stations are, therefore, likely to react to a reduction in price or to an increased pro-
motional effort on the part of the nearby station. The nearby station is also likely to be
aware of this fact and consider it in deciding to change its price or in undertaking a new
promotional effort. In cases such as this, the oligopoly model is more appropriate than the
model of monopolistic competition.
Despite these serious criticisms, the monopolistically competitive model does
provide some important insights, such as the emphasis on product differentiation
and selling expenses, which are also applicable to oligopolistic markets, to which we
turn next.

OLIGOPOLY: INTERDEPENDENCE AMONG THE FEW

PRODUCERS IN THE INDUSTRY
Oligopoly The market Oligopoly is the form of market organization in which there are few sellers of a homoge-
organization where there neous or differentiated product. If there are only two sellers, we have a duopoly. If the
are few firms selling a
product.

;The short-run and long-run analysis of monopolistic competition presented

Duopoly An oligopoly here is a simplification of the
full-fledged monopolistically competitive model introduced by Chamberlin in 1933
of two firms. (see E. Chamberlin, The
Theory of Monopolistic Competition (Cambridge, MA: Harvard University Press,
1933).
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 55

Pure oligopoly An product is homogeneous, we have a pure oligopoly. If the product is differentiated, we
oligopoly where the have a differentiated oligopoly. Although entry into an oligopolistic industry is possible,
product of the firms in it is not easy (as evidenced by the fact that there are only a few firms in the industry). While
the industry is
there are many firms selling a homogeneous product under perfect competition, many
homogeneous.
firms selling a differentiated product in monopolistic competition, and only a single firm
Differentiated selling a product with no good substitutes under monopoly, under oligopoly there are few
oligopoly An sellers of a homogeneous or differentiated product.
oligopoly where the
Oligopoly is the most prevalent form of market organization in the manufacturing
product is
sector of the United States and other industrial countries. Some oligopolistic industries in
differentiated.
the United States are cigarettes, beer, aircraft, breakfast cereals, automobiles, tires, soap
and detergents, office machinery, and many others. Some of the products (such as steel
and aluminum) are homogeneous, whereas others (such as cigarettes, beer, breakfast cere-
als, and soaps and detergents) are differentiated. For simplicity, we will deal mostly with
pure oligopolies (where products are homogeneous) in this chapter.
Because there are only a few firms selling a homogeneous or differentiated product
in oligopolistic markets, the action of each firm affects the other firms in the industry, and
vice versa. For example, when GM introduced zero-interest financing or price rebates in
the sale of its automobiles, Ford and other car manufacturers selling on the American
market immediately followed with zero-interest financing and price rebates of their own.
Furthermore, since price competition can lead to ruinous price wars, oligopolists usually
prefer to compete on the basis of product differentiation, advertising, and service. Yet,
even here, if GM mounts a major advertising campaign, Ford and Chrysler are likely to
soon respond in kind. Every time that Coca-Cola or Pepsi mounts a major advertising
campaign, the other usually responds with a large advertising campaign of its own.
From what has been said, it is clear that the distinguishing characteristic of oligopoly
is the interdependence or rivalry among firms in the industry. This interdependence is the
natural result of fewness. Since an oligopolist knows that its own actions will have a sig-
nificant impact on the other oligopolists in the industry, each oligopolist must consider the
possible reaction of competitors in deciding its pricing policies, the degree of product dif-
ferentiation to introduce, the level of advertising to undertake, the amount of service to
provide, and so on. Because competitors can react in many different ways (depending on
the nature of the industry, the type of product, etc.), we do not have a single oligopoly
model but many—each based on the particular behavioral response of competitors to the
actions of the first. Because of interdependence, policy decisions on the part of the firm
are also much more complex under oligopoly than under other forms of market organiza-
Concept Check
Why do we have many
tion. In this chapter, we present some of the most important oligopoly models. We must
oligopoly models rather keep in mind, however, that each model is usually applicable only to some specific situa-
than a single one? tions, rather than generally, and that most models are more or less unrealistic.
The sources of oligopoly are generally the same as for monopoly: (1) economies of
scale may operate over a sufficiently large range of outputs so as to leave only a few firms
supplying the entire market; (2) huge capital investments and specialized inputs are usu-
ally required to enter an oligopolistic industry (say, automobiles, aluminum, steel, and
similar industries), and this acts as an important natural barrier to entry; (3) a few firms
may own a patent for the exclusive right to produce a commodity or to use a particular
production process; (4) established firms might have a loyal following of customers based
on product quality and service that new firms may find very difficult to match; (5) a few
firms may own or control the entire supply of a raw material required in the production of
the product; and (6) the government may award a franchise to only a few firms to operate
in the market. These are not only the sources of oligopoly but also represent the barriers
354 PART FOUR Imperfectly Competitive Markets

so restricted, the indus-

to other firms entering the market in the long run. If entry were not
try would not remain oligopolistic in the long run. ;
by a few large firms is measured by
The degree by which an industry is dominated
concentration ratios, which give the percentag e of total industry sales of the 4, 8, or
Concentration ratio
12 largest firms in the industry (see Example 11-2). An industry in which the 4-firm
The percentage of total
tic, and industries where this
industry sales of the concentration ratio is close to 100 is clearly oligopolis
ratio is higher than 50% or 60% are also likely to be oligopolis tic. The 4-firm concen-
an em tie
industry.
tration ratio for most manufacturing industries in the United States is between 20% and
80%. As we will see, however, concentration ratios must be used and interpreted with
great caution since they may greatly overestimate the market power of the largest firms
in an industry.

EXAMPLE 11-2 --
Industrial Concentration in the United States

Table 11.1 gives the 4-firm and the 8-firm concentration ratios for various industries in
the United States from the 2002 Census of Manufacturers (the latest available).
There are several reasons, however, for using these concentration ratios cau-
tiously. First, in industries where imports are significant, concentration ratios may

TABLE 11.1| Concentration Ratios in the United States, 2002

Industry 4-Firm Ratio 8-Firm Ratio

Cigarettes 95 99
Breweries 91 _ 94
Electric lamp bulbs and parts 89 94
Aircraft 81 94
Motor vehicles 81 9
Breakfast cereals 78 91
Office machines 1S 86
Tires i 87
Soap and detergents 61 2,
Soft drinks 52 64
Computers 50 65
Men’s clothing 49 62
Iron and steel mills 44 58
Petroleum refining 41 64
Cement 39 60
Book printing 38 54
Pharmaceuticals and medicines 34 49
Stationary 29 45
Canned fruits and vegetables 24 38
Women’s dresses 22, 32
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 355

greatly overestimate the relative importance of the largest firms in the industry. For
example, since automobile imports represent about 29% of U.S. auto sales, the real
4-firm concentration ratio in the automobile industry (which includes Honda’s U.S.
output as the fourth-largest U.S. producer) is not 81% (as indicated in the table) but
58% (i.e., 81% times 0.71). Second, concentration ratios refer to the nation as a whole,
even though the relevant market may be local. For example, the 4-firm concentration
ratio for the cement industry is 39%, but, because of very high transportation costs,
only two or three firms may actually compete in many local markets. Third, how
broadly or narrowly a product is defined is also very important. For example, the con-
centration ratio in the office machines industry as a whole is smaller than that in the
personal computer segment of the market. Fourth, concentration ratios do not give any
indication of potential entrants into the market and of the degree of actual and poten-
tial competition in the industry. Indeed, as the theory of contestable markets discussed
in Chapter 13 shows, vigorous competition can take place even among few sellers. In
short, concentration ratios provide only one dimension of the degree of competition in
the market, and, although useful, they must be consulted with great caution.
Source: U.S. Bureau of Census, 2002 Census of Manufacturers, Concentration Ratios in Manufacturing
(Washington, DC: U.S. Government Printing Office, May 2006), Table 2, pp. 2-65.

a4 THE COURNOT AND THE KINKED-DEMAND Curve MopeLs

Now we examine two of the earliest and best-known oligopoly models: the Cournot
model and the kinked—demand curve model. In the Cournot model, oligopolists never rec-
Concept Check ognize their interdependence or rivalry. As such, the Cournot model is quite unrealistic.
Why is the Cournot Nevertheless, the model is useful in highlighting the interdependence that exists among
model unrealistic? Why
oligopolistic firms (even though they do not actually recognize it). The Cournot model is
do we study it then?
also the forerunner of more realistic models. In the kinked—demand curve model, oligop-
olists do recognize their interdependence or rivalry. This model also faces many short-
comings, but it represents a step forward in the direction of greater realism in the analysis
of oligopolistic behavior.

The Cournot Model: Interdependence Not Recognized*

The first formal oligopoly model was introduced by the French economist Augustin
Cournot more than 160 years ago.° For simplicity, Cournot assumed that there were only
two firms (duopoly) selling identical spring water. Consumers came to the springs with
their own containers, so that the marginal cost of production was zero for the two firms.
With these assumptions, the analysis is greatly simplified without losing the essence of
the model.®

4 A more advanced and complete treatment of the Cournot model, as well as an important extension of it
(the Stackelberg model), is provided in the appendix to this chapter.
5 A. Cournot, Recherches sur les principes mathematiques de la theorie des richess (Paris: 1838). English
translation by N. Bacon, Researches into the Mathematical Principles of the Theory of Wealth (New York:
Macmillan, 1897). .
© The model, however, can be extended to deal with more than two firms and nonzero marginal costs.
356 PART FOUR Imperfectly Competitive Markets

Cournot model The The basic behavioral assumption made in the Cournot model is that each firm, while
duopoly model in trying to maximize profits, assumes that the other duopolist holds its output constant at
which each firm the existing level. The result is a cycle of moves and countermoves by the duopolists until
assumes that the other
each sells one-third of the total industry output. This is shown in Figure 11.3.
keeps output constant.
In the left panel of Figure 11.3, D is the market demand curve for spring water.
Initially, firm A is the only firm in the market, and thus, it faces the total market demand
curve. That is, D = da. The marginal revenue curve of firm A is then mrg (see the figure).
Since the marginal cost is zero, the MC curve coincides with the horizontal axis. Under
these circumstances, firm A maximizes total profits where mr, = MC = 0. Firm A sells
six units of spring water at P = $6 so that its total revenue (7R) is $36 (point A in the left
panel). This is the monopoly solution. Note that point A is the midpoint of demand curve
D = dg, at which price elasticity is 1 and TR is maximum (see Section 5.6). With total
costs equal to zero, total profits equal TR = $36.
Next, assume that firm B enters the market and believes that firm A will continue to
sell six units. The demand curve that firm B faces is then dg in the left panel, which is
obtained by subtracting the six units sold by firm A from market demand curve D (i.e.,
shifting D six units to the left). The marginal revenue curve of firm B is then mrg. Firm
B maximizes total profits where mrg = MC = 0. Therefore, firm B sells three units at
P = $3 (point B, the midpoint of dg). This is also shown in the right panel of Figure 11.3.
Assuming that firm B continues to sell three units, firm A reacts and faces da, in the

mrp myra

FIGURE 11.3. The Cournot Model In the left panel, D is the market demand curve for spring water.
The Marginal cost of production is assumed to be zero. When only
firm A is the market, D = dy and the
firm maximizes profits by selling Q = 6 at P = $6 (pointA, given
by mr, = MC = Q). When firm B
enters the market, it will face dg (given by shifting market demand
curve D to the left by the six units sold
by A). Firm B maximizes profits by selling Q = 3 atP =
$3 (point B the midpoint of dg at which mre =
MC = 0). Duopolist A now faces da(given by D minus 3
in the right panel) and maximizes profits by sl
selling Q = 4.5 at P = $4.50 (pointA’).The process continues until ea ch duopol ist jts at point E on d_
polist
and sellsQ = 4 atP = $4
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly Ba7

right panel of Figure 11.3 (obtained by subtracting the three units supplied by firm B
from market demand curve D). Firm A will then maximize profits by selling 4.5 units
(point A’, at the midpoint of da, in the right panel). Firm B now reacts once again and
maximizes profits on its new demand curve, which is obtained by shifting market
demand curve D to the left by the 4.5 units supplied by firm A (not shown in the right
panel of Figure 11.3).
The process continues until each duopolist faces demand curve dp and maximizes
profits by selling four units at P = $4 (point E in the right panel of Figure 11.3).’ This
is equilibrium because whichever firm faces demand curve dg and reaches point E first,
the other will also face dg (obtained by subtracting the 4 units sold by the first duopolist
from market demand curve D) and maximize profits at point E. With each duopolist sell-
ing four units, a combined total of eight units will be sold in the market at P = $4 (point
E* on D in the right panel of Figure 11.3). If the market had been organized along per-
fectly competitive lines, sales would have been twelve units, given by point C, where
market demand curve D intercepts the horizontal axis. The reason for this is that since
we have assumed costs to be zero, price will also have to be zero for each competitive
firm to break even, as required, when the perfectly competitive industry is in long-run
equilibrium.
Thus, the duopolists supply one-third or four units each (and two-thirds or eight units
together) of the total perfectly competitive market quantity of twelve units. Note that the
Cournot duopoly outcome of P = $4 and Q = 8 lies between the monopoly equilibrium
of P = $6 and Q = 6 and the competitive equilibrium of P = $0 and Q = 12. The final
Cournot equilibrium reflects the interdependence between the duopolists, even though
they (rather naively) do not recognize it.
In a more advanced treatment, we could show that with three oligopolists, each
would supply one-fourth (i.e., three units) of the perfectly competitive market of twelve
units and three-fourths (i.e., nine units) in total. Note that when Q = 9, P = $3 on mar-
ket demand curve D (point F in the right panel of Figure 11.3). Thus, as the number of
firms increases, the total combined output of all the firms together increases and price
falls (compare equilibrium point A with only firm A in the market, with equilibrium point
E* with firms A and B, and equilibrium point F with three firms). Eventually, as more
firms enter, the market will no longer be oligopolistic. In the limit, with many firms, total
output will approach twelve units and price will approach zero (the perfectly competitive
solution—point C in the right panel of Figure 11.3).
The same result (i.e., zero profit) would occur even with only two firms (duopoly), if
each firm assumed that the other kept its price rather than its quantity constant (as in the
Cournot model). In that case, the first firm enters the market and maximizes its profits by
producing six units at the price of $6. The second firm, assuming that the first will keep
Bertrand model The its price constant, will lower its price just a little and captures the entire market (because
duopoly model in
the product is homogeneous). The first firm will then react by lowering its price even
which each firm
assumes that the other
more and recaptures the entire market. If the duopolists do not recognize their interde-
will keep its price pendence (as in the Cournot model), the process will continue until each firm sells six
constant. units at zero price and makes zero profits. This is the Bertrand model.°

7 How this equilibrium is reached is shown in the appendix to this chapter. All that is important at this point is
to show that when each duopolist faces demand curve dg and sells four units at P = $4 (.e., is at point E),
each duopolist and the market as a whole is in equilibrium.
8 J. Bertrand, “Theorie Mathematique de la Richesse Sociale,” Journal de Savantes, 1983.
358 PART FOUR Imperfectly Competitive Markets

The Kinked-Demand Curve Model: Interdependence Recognized

to
Kinked—demand The kinked—demand curve model, introduced by Paul Sweezy in 1939,° attempts
curve model The explain the price rigidity that is often observed in some oligopolist ic markets. Sweezy
model that seeks to postulated that if an oligopolist raised its price, it would lose most of its customers
explain price rigidity by
because the other firms in the industry would not match the price increase. On the other
postulating a demand
hand, an oligopolist could not increase its share of the market by lowering its price, since
curve with a kink at the
prevailing price. its competitors would immediately match the price reduction. As a result, according to
Sweezy, oligopolists face a demand curve that is highly elastic for price increases and less
elastic for price reductions. That is, the demand curve faced by oligopolists has a kink at
the established price; and, because of this, oligopolists tend to keep prices constant even
in the face of changed costs and demand conditions. This is shown in Figure 11.4.
In Figure 11.4, the demand curve facing the oligopolist is d or HBC and has a “kink”
at the prevailing price of $8 and Q = 4 (point B). The demand curve is much more elas-
tic above than below the kink on the assumption that competitors will not match price
increases but quickly match price cuts.'° Thus, the oligopolist’s marginal revenue curve is
mr, or HJKFG. Segment HJ of the mr curve corresponds to segment HB of the demand
curve, and segment FG of the mr curve corresponds to segment BC of the demand curve
(see the figure). The kink at point B on the demand curve results in discontinuity /F in the
mr curve.
With SMC as the short-run marginal cost curve, the oligopolist will maximize profits
by selling four units of output (given by point K, where the SMC curve intersects the dis-
continuous segment of the mr curve) at P = $8. Any shift in the oligopolist’s SMC curve
that falls within the discontinuous segment of the mr curve will leave the oligopolist’s
price and output unchanged. That is, the oligopolist’s best level of output will continue to

FIGURE 11.4 The Kinked-Demand Curve Model The demand

af

OMG
ul "

Curve facing the oligopolist is d or HBC and has a “kink” at the prevailing 5.50
price of $8 and Q = 4 (point B), on the assumption that competitors
match price cuts but not price increases. The marginal revenue curve is
mr or HJKFG. The oligopolist maximizes profits by selling Q = 4 at P =
$8 (given by point K, where the SMC curve intersects the discontinuous |
segment of the mr curve). Any shift between SMC’ and SMC” will leave |

L
price and output unchanged. 0 4

ie Sweezy, “Demand under Conditions of Oligopoly,” Journal of

Political Economy, August 1939, pp. 568-573.
That is, since competitors do not match price increases, the quantity
demanded from the oligopolist that
increases price falls a great deal. On the other hand, since competito
rs quickly match price reductions, the
quantity demanded from the oligopolist that cuts price does
not increase very much. This makes the demand
curve faced by an oligopolist more elastic for price increases
than for price reductions.
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 359

be four units and price $8 for any shift in the SMC curve up to SMC’ or down to SMC”
(see the figure). Only if the SMC curve shifts above the SMC’ curve will the oligopolist
raise its price, and only if the SMC curve shifts below the SMC" curve will the oligopolist
lower its price (see Problem 3). Similarly, a rightward or leftward shift in the demand
curve will induce the oligopolist to increase or decrease output, respectively, but to keep
its price unchanged if the kink remains at the same level (see Problem 4, with the answer
at the end of the book). Note that the marginal principle postulating that the best level of
output for the firm occurs where MR = MC is still valid, even though the MR curve is dis-
continuous in this case.
When the kinked—demand curve model was first introduced, it was hailed by some
Concept Check economists as a general theory of oligopoly. Yet the model failed to live up to its expecta-
Does the kinked— tions. For example, Stigler found no evidence that oligopolists were reluctant to match
demand curve model price increases as readily as price reductions, and thus he seriously questioned the exis-
really explain price tence of the kink.'' Researchers in other oligopolistic industries found the same thing.
rigidity?
Even more serious is the criticism that although the kinked—demand curve model can
rationalize the existence of rigid prices where they occur, it cannot explain at what price
the kink occurs in the first place. Since one of the major aims of microeconomic theory is
to explain how prices are determined, this theory is, at best, incomplete.

L115| COLLUSION: CARTELS AND PRICE LEADERSHIP MODELS

In the oligopoly models we have examined so far, oligopolists did not collude. In view of
the interdependence in oligopolistic markets, however, there is a natural tendency to
Collusion An collude. With collusion, oligopolistic firms can avoid behavior that is detrimental to their
agreement among the general interest (for example, price wars) and adopt policies that increase their profits.
suppliers of a Collusion can be overt (1.e., explicit), as in a centralized cartel, or tacit (i.e., implicit), as
commodity to restrict
in price leadership models. In this section we examine oligopolistic models with collu-
competition.
sion and provide several real-world examples. (Antitrust laws forbidding collusion in the
United States are examined in Chapter 13.)

A Centralized Cartel Operates as a Monopolist

Cartel An organization A cartel is a formal organization of producers of a commodity. Its purpose is to coordi-
of suppliers of a nate the policies of the member firms so as to increase profits. Cartels are illegal in the
commodity aimed at United States under the provision of the Sherman Antitrust Act passed in 1890 (see
restricting competition Section 13.4) but not in some other nations. Of the many types of cartels, the centralized
and increasing profits.
cartel is at one extreme. The centralized cartel sets the monopoly price for the commod-
Centralized cartel A ity, allocates the monopoly output among the member firms, and determines how the
formal agreement of monopoly profits are to be shared. The centralized cartel is shown in Figure 11.5.
the suppliers of a In Figure 11.5, D is the total market demand curve and MR is the corresponding mar-
commodity to operate ginal revenue curve for a homogeneous commodity produced by, say, four firms that
as a monopoly.
have formed a centralized cartel. The USMC curve for the cartel is obtained by summing
horizontally the SMC curve of the four firms on the assumption that input prices remain

'1 G, Stigler, “The Kinky Oligopoly Demand Curve and Rigid Prices,” Journal of Political Economy,
October 1947, pp. 432-449.
360 PART FOUR imperfectly Competitive Markets

FIGURE 11.5 Centralized Cartel Dis the market demand curve and
MR is the corresponding marginal revenue curve for a homogeneous
commodity produced by the four firms in a centralized cartel. The ZSMC
curve for the cartel is obtained by summing horizontally the four firms’
SMC curves on the assumption that input prices are constant. The
centralized authority will set P = $8 and Q = 4 (given by point E,
where the =SMC curve intersects the MR curve from below). This is
the monopoly solution.

constant. The centralized authority will set P = $8 and sell Q = 4 (given by point E,
where the SSMC curve intersects the MR curve from below). This is the monopoly solu-
tion. To minimize production costs, the centralized authority will have to allocate output
among the four firms in such a way that the SMC of the last unit produced by each firm is
Concept Check equal. If the SMC of one firm is higher than for the other firms, the total costs of the car-
In what way is a tel as a whole can be reduced by shifting some production from the firm with higher SWVC
centralized cartel to the other firms until the SMC of the last unit produced by all firms is equal. The cartel
similar to a monopoly? will also have to decide on the distribution of profits.
If all firms are the same size and have identical cost curves, then it is very likely that
each firm will be allocated the same output and will share equally in the profits generated
by the cartel. In Figure 11.5, each firm would be allocated one unit of output. The result
would be the same if a monopolist acquired the four firms and operated them as a multi-
plant monopolist. If the firms in the cartel are different sizes and have different costs, it will
be more difficult to agree on the share of output and profits. Then the allocation of output
is likely to be based on past output, present capacity, and bargaining ability of each firm,
rather than on the equalization of the SMC of the last unit of output produced by all mem-
ber firms. Sometimes the market is divided among the firms in the industry as indicated in
the next subsection.
Cartels often fail; there are several reasons for this. First, it is very difficult to orga-
nize all the producers of a commodity if there are more than a few producers. Second, as
pointed out earlier, it is difficult to reach agreement among the member firms on how to
allocate output and profits when firms face different cost curves. Third, there is a strong
incentive for each firm to remain outside the cartel or cheat on the cartel by selling more
than its quota at the high price resulting from the limited output of the other cartel mem-
bers. Fourth, monopoly profits are likely to attract other firms into the industry and under-
mine the cartel agreement.
: Even though cartels are illegal in the United States, many trade associations and
pro-
fessional associations perform many of the functions usually associated with
cartels.
Some cartellike associations are actually sanctioned by the government. An
example of
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 361

this was the American Medical Association, which, by rigidly restricting the number of
students admitted to medical schools and forbidding advertising by physicians, ensured
for many years very high doctors’ fees and incomes. Another example is the New York
Taxi and Limousine Commission, which restricts the number of taxis licensed, thus con-
ferring monopoly profits to the original owners of the “medallions” (see Example 10-3).
The best example of a successful international cartel is OPEC (the Organization of
Petroleum Exporting Countries) during the 1970s and early 1980s (see Example 11-3).

EXAMPLE 11-3
The Organization of Petroleum Exporting Countries (OPEC) Cartel

The Organization of Petroleum Exporting Countries (OPEC) is a cartel of petroleum

exporters that seeks to increase the petroleum earnings of its members. Thirteen
nations are presently members of OPEC: Algeria, Angola, Equador, Indonesia, Iran,
Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and
Venezuela (Gabon was also a member but left).
As a result of supply shocks during the Arab-Israeli war in the fall of 1973 and
the Iranian revolution during 1979-1980, OPEC was able to increase the price of
petroleum from $2.50 per barrel in 1973 to more than $40 per barrel in 1980. This
stimulated conservation in developed nations (lowering of thermostats, switching to
small, fuel-efficient automobiles, etc.), expanded exploration and production (by the
United Kingdom and Norway in the North Sea, by the United States in Alaska, by
Mexico in newly discovered fields, and by Canada from the tar sands in Alberta), and
switching to other energy sources (such as coal). As a result, from 1974 to 2008,
OPEC’s share of world oil production fell from 55% to 40% and its share of world
petroleum exports declined from more than 90% to 45%. Although OPEC meets reg-
ularly for the purpose of setting petroleum prices and production quotas, petroleum
prices remained below $20 per barrel under the conditions of excess supply that gen-
Concept Check erally prevailed from 1985 to 1999 (except during Iraq’s invasion of Kuwait in 1991).
Is OPEC a centralized The average price of petroleum was between $20 and $30 from 2000 to 2003, but then
cartel? it rose to an average of $56 in 2005, $72 in 2007, and reached $120 in April 2008.
There are several reasons for the sharp increase in crude prices since 2003, the
most important being the sharp increase in petroleum consumption (especially by
China) relative to production, the war in Iraq, the fear of supply disruption from a
terrorist attack on production facilities in the Middle East. How high petroleum
prices will be in the future depends on how strong world demand grows relative to
supply, the political situation in the Middle East and in other petroleum-exporting
countries, and how successful and willing OPEC is (with the cooperation of other,
non-OPEC oil exporters, such as Russia, Mexico and Norway) to meet the world’s
growing demand of crude oil.
Sources: “OPEC’s Painful Lessons,” New York Times (December 29, 1985), p. F3; “OPEC Sets New
Policy on Quota,” New York Times (November 29, 1989), p. D1; “OPEC Plan to Lift Oil Prices Goes
Awry,” Wall Street Journal (March 3, 1995), p. A2; “Mid East and Venezuela Turmoil Sends Oil Prices
into Wild Swing,” New York Times (April 9, 2002), p. 1; “Fuel Gold,” The Economist (March 12, 2005),
p. 71; “OPEC” http://en.wikipedia.org/wiki/OPEC, 2008; and “Record Run Brings Guide Close to
$1200 Barrell,” Financial Times, April 26, 2008.
362 PART FOUR Imperfectly Competitive Markets

Market-Sharing Cartel
The difficulties encountered by the members of a centralized cartel (such as agreeing on
the price to charge, allocating output and profits among members, and avoiding cheating)
Market-sharing cartel make a market-sharing cartel more likely to occur. In a market-sharing cartel the mem-
An organization of ber firms agree only on how to share the market. Each firm then operates in only one area
suppliers of a or region agreed upon without encroaching on the others’ territories. An example is the
commodity that divides
agreement in the early part of this century between Du Pont (American) and Imperial
the market among its
Chemical (English) for the former to have exclusive selling rights for their products in
members.
North America (except for British colonies) and the latter in the British Empire. Under
certain simplifying assumptions, a market-sharing cartel can also result in the monopoly
solution. This is shown in Figure 11.6.
In Figure 11.6, we assume that there are two identical firms selling a homogeneous
product and deciding to share the market equally. D is the total market demand for the
commodity; d is the half-share demand curve of each firm, and mr is the corresponding
marginal revenue curve. If each firm has the same SMC curve as shown in the figure,
according to the marginal principle, each will sell two units of output at P = $8 (given
by point E’, at which mr = SMC). Thus, the duopolists together will sell the monopolist
output of four units at P = $8 (see the figure). In the real world there may be more than
two firms, each may have different cost curves, and the market may not be shared equally.
Thus, we are not likely to have the neat monopoly solution shown above. The firm with
greater capacity or operating in an inferior territory may demand a greater share of the
market. The result will then depend on bargaining, and the possibility of incursions into
each other’s territory cannot be excluded.

0 2 3 4 6 2 Q
FIGURE 11.6 Market-Sharing Cartel Dis the total market demand for a
homogeneous commodity, d is the half-share demand curve of each
firm, and mr is the
corresponding marginal revenue curve. If each duopolist also has
the same SMC curve
shown in the figure, each will sell two units of output at P = $8
(given by point E’, at
which mr = SMC). Thus, the duopolists together will sell the monopoli
st output of four
units atP = $8.
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 363

The firms in a market-sharing cartel can also operate in the same geographic area by
deciding which firm is to fill each particular contract. These market-sharing cartels are
likely to be unstable due to cheating. Some loose market-sharing cartels are sanctioned by
law. For example, local medical and bar associations essentially set the fees that doctors
and lawyers are to charge. Similarly, many states had fair trade laws (until they became
illegal in the mid-1970s), that allowed manufacturers to set the price each retailer was to
charge for a product. The market was then shared by means other than price.

EXAMPLE 11-4
The Market Sharing Ivy League Cartel and Financial-Aid Leveraging

For more than three decades prior to 1991, the presidents and top financial officers of the
eight Ivy League colleges (Brown, Columbia, Cornell, Dartmouth, Harvard, Princeton,
Yale, and the University of Pennsylvania), as well as the Massachusetts Institute of
Technology (MIT), held yearly meetings at which they exchanged sensitive information
about intended tuition increases, the amount of student financial aid packages, and
increases in faculty salaries. The result was tuition increases, student financial aid pack-
ages, and faculty salary increases that were closely bunched together. For example, the
charge for tuition, room, board, and fees at the eight Ivy League colleges and MIT ranged
only from $16,841 to $17,100 for the 1988-1989 academic year. The same was true for
increases in faculty salaries and for the amount of student aid packages. Specifically, the
colleges agreed not to outbid each other in granting aid to top students who had been
accepted to more than one school, thus leaving students and their families no reason to
shop around for better financial aid packages. In 1986, this “Ivy League cartel” tried to
bring Stanford University into the fold—an attempt that failed because (as court docu-
ments later showed) Stanford was worried that the Ivies were colluding illegally. Indeed,
this is what the U.S. Justice Department subsequently charged.
In May 1991, the Ivy League colleges (while admitting no wrongdoing) signed a
consent decree with the Justice Department to stop colluding on tuition, financial aid,
and faculty salaries in order to avoid a costly trial, thereby putting an end to their car-
tel arrangement. The result was clear and immediate: Average increases in private-
college tuition, which had soared fivefold between 1971-1972 and 1989-1990 in the
face of only a tripling of consumer prices, subsided and were much smaller after
1990. MIT, however, refused to sign the consent decree and chose instead to fight the
case in court, where it argued that antitrust laws did not apply to the noncommercial
and charitable activities of universities. But in a ten-day trial in August 1992 that cost
MIT $1 million, the court found MIT guilty of price fixing and restricting competi-
tion by reducing students’ ability to get the best financial aid possible. In September
1993, however, a three-judge U.S. Court of Appeals panel reversed the lower court
ruling, setting the stage for a settlement, reached in December 1993, under which the
Ivy League Universities could meet to discuss their financial-aid policies, as long as
they did not discuss individual grants to specific students and accepted students
regardless of need (the so-called need-blind admission). As pointed out in Example
10-5, most private colleges (not just Ivies) today engage in “financial leveraging.”
Thus, the market-sharing cartel of the Ivies has been replaced with broad first-degree
364 PART FOUR Imperfectly Competitive Markets

increases their tuition

price (tuition) discrimination by most private colleges, which
revenues.

Wall Street Journal, May 8,

Sources: “Ivy League Discussions on Finances Extended to Tuition and Salaries,”
3, 1992, p. 1; “Antitrust
1992, p. Al; “M.LT. Ruled Guilty in Antitrust Case.” New York Times, September
Journal, December 12,
Case Against MIT Dropped Allowing Limited Exchange of Aid Data?” Wall Street
ing Many,” Wall Street Journal, April 1,
1993, p. A12; “Colleges Manipulate Financial-Aid Offers, Shortchang
1996, p. Al; D. M. Lang, “Financial Aid and Student Bargaining Power,” B.E. Journal of Economic Analysis
in Student Aid
& Policy, No. 1, 2007, pp. 1-21; and College Board, Trends in College Pricing and Trends
(Washington DC: 2007).

Price Leadership
One way by which firms in an oligopolistic market can make necessary price adjustments
Price leadership The without fear of starting a price war and without overt collusion is by price leadership.
form of market collusion The firm generally recognized as the price leader starts the price change and the other
whereby a firm initiates a firms in the industry quickly follow. The price leader is usually the dominant or largest
price change and the
firm in the industry. Sometimes, it is the low-cost firm (see Problem 9, with the answer at
other firms in the
the end of the book) or any other firm (called the barometric firm) recognized as the true
industry soon match it.
interpreter or barometer of changes in demand and cost conditions in the industry war-
Barometric firm A ranting a price change. In either case, an orderly price change is accomplished by other
firm that is recognized firms following the leader.
as a true interpreter or In the price leadership model by the dominant firm, the dominant firm sets the price
barometer of the
for the commodity that maximizes its profits, allows all the other (small) firms in the
industry.
industry to sell all they want at that price, and then comes in to fill the market. Thus, the
small firms in the industry behave as perfect competitors or price takers, and the dominant
firm acts as the residual supplier of the commodity. This is shown in Figure 11.7.
In the figure, D (ABCFG) is the market demand curve for the homogeneous commod-
Concept Check ity sold in the oligopolist market. Curve USMC, is the (horizontal) summation of the mar-
How does price ginal cost curves of all the small firms in the industry. Since the small firms in the industry
leadership seek to can sell all they want at the industry price set by the dominant firm (i.e., they are price tak-
overcome the charge of ers), they behave as perfect competitors and always produce at the point where P =
illegal collusion?
USMC;. Thus, the USMC, curve (above the average variable cost of the small firms) repre-
sents the short-run supply curve of the commodity for all the small firms in the industry as
a group (on the assumption that input prices remain constant).
The horizontal distance between D and ZSMC, at each price then gives the (residual)
quantity of the commodity demanded from and supplied by the dominant firm at each
price. For example, if the dominant firm set P = $7, the small firms in the industry together
supply HB or five units of the commodity, leaving nothing to be supplied by the dominant
firm. This gives the vertical intercept (point H) on the demand curve of the dominant firm
(d). If the dominant firm set P = $6, the small firms in the industry supply JL or four units
of the commodity, leaving two units (LC = JK) to be supplied by the dominant firm (point
K on the d curve). Finally, if the dominant firm set P = $2, the small firms together supply
zero units of the commodity (point M), leaving the entire market quantity demanded of
MF or ten units to be supplied by the dominant firm. Thus, the demand curve of the domi-
nant firm is d or HKFG.
. With demand curve d, the marginal revenue curve of the dominant firm is mra
(which
bisects the distance from the vertical axis to the d curve). If the short-run marginal
cost
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 365

12%

— | ne
0 2 4 6 8 10 Wy @

FIGURE 11.7 Price Leadership by the Dominant Firm D (ABCFG) is the market
demand curve and XSMC, is the marginal cost curve of all the small firms in the industry.
Since the small firms can sell all they want at the price set by the dominant firm, they
behave as perfect competitors and produce where P = XSMC.. The horizontal distance
between the D and XSSMC,; curves then gives the (residual) quantity supplied by the
dominant firm at each price. Thus, the demand curve of the dominant firm (d) is HKFG,
and the corresponding marginal revenue curve is rq. With SMC, the dominant firm will set
P = $6 (given by point E, where mrg = SMCq) to maximize its profits. At P = $6, the small
firms will supply four units of the commodity and the dominant firm Jk = LC or two units.

curve of the dominant firm is SMC , the dominant firm will set P = $6 (given by point E,
where mrg = SMC,) to maximize its profits. Note that the industry price set by the dom-
inant firm is determined on the demand curve of the dominant firm (d), not on the market
demand curve (D). At P = $6, the small firms together will supply JZ or four units of the
commodity (see the figure). The dominant firm will then come in to fill the market by
selling JK = LC or two units of the commodity at P = $6 which it set.
Among the firms that have operated as price leaders are Alcoa (in aluminum),
American Tobacco, American Can, Chase Manhattan Bank (in setting the prime rate),
GM, Goodyear Tire and Rubber, Gulf Oil, Kellogg (in breakfast cereals), U.S. Steel
(now USX), and so on. Many of these industries are characterized by more than one large
366 PART FOUR Imperfectly Competitive Markets

one large firm to

firm, and the role of the price leader has sometimes changed from
leader in tobacco
another. For example, Reynolds has also behaved at times as the price
and National Steel, and General Mills (in the
products. Continental Can, Bethlehem
ve markets
breakfast cereals market) also behaved as the price leaders in their respecti
Finally, note that one importan t advantag e of price leader-
during some periods of time.
ished informal ly by tacit collusion , which is much more dif-
ship is that it can be accompl
ficult to prove than overt or explicit collusion .
On the international level, Saudi Arabia was the dominant price leader for petroleum
during the 1970s. Saudi Arabia set petroleum prices and satisfied only that portion of the
world demand that was left unfilled by others. But with other petroleum exporting coun-
tries greatly exceeding their export quotas and cheating by selling oil at discount prices,
Saudi Arabia’s share of the world’s export market shrunk considerably. As the holder of
the world’s largest proven petroleum reserves and largest exporter, Saudi Arabia threat-
ened to flood the market if other petroleum exporting countries continued to exceed their
export quotas and sell at a discount. In 1986, Saudi Arabia made good on its threat and
sharply increased petroleum production and exports, which caused a collapse in world oil
prices to below $10 a barrel. Some degree of price and production discipline was subse-
quently reestablished, so that the price of petroleum more than doubled (to $22 a barrel)
in 1992. As discussed in Example | 1-3 above, however, the price of petroleum has exhib-
ited great volatility since then.!*

LONG-RUN ADJUSTMENTS AND EFFICIENCY IMPLICATIONS OF OLIGOPOLY

Most of the analysis of oligopoly until this point has referred to the short run. In this sec-
tion, we analyze the long-run adjustments and efficiency implications of oligopoly. We
examine the long-run plant adjustments of existing firms and the entry prospects of other
firms into the industry, we discuss nonprice competition, and we examine the long-run
welfare effects of oligopoly.

Long-Run Adjustments in Oligopoly

As in other forms of market organization, oligopolistic firms can build the best plant to pro-
duce their anticipated best level of output in the long run. However, in view of the uncer-
tainty generally surrounding oligopolistic industries, it is even more difficult than under
other forms of market organization for firms to determine their best level of output and
plant in the long run. An oligopolist would leave the industry in the long run if it would
incur a loss even after building the best scale of plant. On the other hand, if existing firms
earn profits, more firms will seek to enter the industry in the long run, and, unless entry is
blocked or somehow restricted, industry output will expand until industry profits fall to
zero. There may then be so many firms in the industry that the actions of each no longer
affect the others. In that case, the industry would no longer be oligopolistic.!°

ae DR nT ae :
Crude Oil Prices Fall Slightly on Traders’ Belief that OPEC Again Failed to Set Output
Strategy,” Wall
Street Journal, September 22, 1992, p. C14; “OPEC Plan to Lift Oil Prices Goes Awry,”
Wall Street Journal
March 3, 1995, ; p. A2; : “Who’s to Blame,”2 Business
Bu, \ Week, , Jul July 3, 22001, p . 36-37; and “B ki ‘
Fortune, November 12, 2001, pp. 78-88. a ars
13 As we will; see in
; the theory of : contestable
markets discussed in Section 13.2, vigorous competition can
take place even among few sellers.
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 367

For an industry to remain oligopolistic in the long run, entry must be somewhat
restricted. This may result from many reasons, some natural and some artificial. These
are generally the same barriers that led to the existence of the oligopoly in the first place.
One of the most important natural barriers to entry is the smallness of the market in rela-
tion to the optimum size of the firm. For example, only three or four firms can most effi-
ciently supply the entire national market for automobiles. Potential entrants know that
by entering this market they would probably face huge losses and possibly also impose
losses on the other established auto makers (see Problem 11).
Another important natural barrier to entry in oligopolistic markets are the usually
huge investment and specialized inputs required (as, for example, to enter automobile,
steel, aluminum, and similar industries). Many artificial barriers to entry may also exist.
These include control over the source of an essential raw material (such as bauxite to
produce aluminum) by the few firms already in the industry, unwillingness of existing
firms to license potential competitors to use an essential industrial process on which they
hold a patent, and the inability to obtain a government franchise (for example, to run a
Limit pricing The bus line or a taxi fleet). Still another artificial barrier to entry is limit pricing, whereby
charging of a existing firms charge a price low enough to discourage entry into the industry.'* By
sufficiently low price to doing so, they voluntarily sacrifice some short-term profits to maximize their profits in
discourage entry into
the long run (see Section 11.7).
the industry.

Nonprice Competition Among Oligopolists

Most oligopoly models presented in this chapter predict infrequent price changes in oli-
gopolistic markets. This conforms to what is often observed in the real world. To be sure,
costly price wars do sometimes erupt as a result of miscalculations on the part of one of
the oligopolists, but they usually last only short periods. To avoid the possibility of start-
ing a price war, oligopolists prefer to leave price unchanged and compete instead on
Nonprice competition the basis of nonprice competition (advertising, product differentiation, and service).
Competition based on Only when demand and cost conditions make a price change absolutely essential will
advertising and product oligopolists change prices. An orderly price change is then usually accomplished by
differentiation rather
price leadership.
than on price.
As pointed out in Section 11.2, a firm may use advertising to try to increase (i.e., to
shift to the right) the demand curve for its product. If successful, the firm will then be able
to sell a greater quantity of the product at an unchanged price. The problem is that other
firms, upon losing sales, are likely to retaliate and also increase their advertising expen-
ditures. The result may be simply to increase all firms’ costs, with each firm retaining
more or less its share of the market and earning less profits. For example, when the gov-
ernment banned cigarette advertising on television, all tobacco companies benefitted by
spending less on advertising—a step that each firm alone was not willing to take before
the ban. Although some advertising provides useful information to consumers on new or
improved products and uses, a great deal does not. Examples might be the huge advertis-
ing expenditures (running in the hundreds of millions of dollars per year) of beer produc-
ers, automakers, and others.
The same is generally true for product differentiation. That is, producers often differ-
entiate their product in order to increase sales, but this usually leads to retaliation and

14 See J. Bain, Industrial Organization, rev. ed. (New York: John Wiley & Sons, 1967). Perhaps, more
than an artificial barrier to entry, limit pricing is a practice that is designed to exploit barriers that do exist
(e.g., economies of scale).
368 PART FOUR Imperfectly Competitive Markets

cosmetic (e.g., the yearly

higher costs and prices. Sometimes product changes are simply
automobile model changes). Other changes may truly improve the product, for example,
ced at the same price. Some product
when a new and longer-lasting razor blade is introdu
Advertising,
differentiation is introduced to better serve particular segments of the market.
be combin ed in many differen t ways
product differentiation, and market segmentation can
tion in oligopol istic markets .
and used with still other forms of nonprice competi

Welfare Effects of Oligopoly

We now turn to some of the long-run welfare effects of oligopoly. First, as in the case of
monopoly and monopolistic competition, oligopolists usually do not produce at the low-
est point on their LAC curve. This would only occur by sheer coincidence if the oligopo-
list’s MR curve intersected the LAC curve at the lowest point of the latter. Only under
perfect competition will firms produce at the lowest point on the LAC curve in the long
run. Oligopoly, however, often results because of the smallness of the market in relation
to the optimum size of the firm, and so it does not make much sense to compare oligop-
oly to perfect competition. Automobiles, steel, aluminum, and many other products could
only be produced at prohibitive costs under perfectly competitive conditions.
Second, as in the case of monopoly, oligopolists can earn long-run profits, and so
Concept Check price can exceed LAC. This is to be contrasted with the case of perfect competition and
How can an oligopolist monopolistic competition where P = LAC in the long run. However, some economists
earn profits in the believe that oligopolists utilize a great deal of their profits for research and development
long run? (R&D) to produce new and better products and to find cheaper production methods.
These are the primary sources of growth in modern economies. These same economists
point out that monopolists do not have as much incentive to engage in R&D, and perfect
competitors and monopolistic competitors are too small and do not have the resources to
do so on a large scale (more will be said on this in Section 13.3).
Third, as in imperfect competition in general, P > LMC under oligopoly, and so
Concept Check there is underallocation of resources to the industry. Specifically, since the demand curve
Why does an facing oligopolists is negatively sloped, P > MR. Thus, at the best level of output (given
oligopolist tend to by the point where the LMC intersects the firm’s MR curve from below), P > LMC. This
invest more in R&D means that society values an additional unit of the commodity more than the marginal
than a perfect cost of producing it. But again, P = LMC only under perfect competition, and economies
competitor does?
of scale may make perfect competition infeasible.
Fourth, while some advertising and product differentiation are useful because they
provide information and satisfy the consumers’ tastes for diversity, they are likely to be
pushed beyond what is socially desirable in oligopolistic markets. It is difficult, however,
to determine exactly how much advertising and product differentiation is socially desir-
able in the real world. For example, the cost of model changes equals about one-fourth of
the price of a new automobile during many years.!> To the extent that consumers purchase
new automobiles and choose to have the options introduced into the new models, we
can
infer that most of the costs of model changes are wanted by consumers and do not repre-
sent a waste of resources. Nevertheless, the demand for some model changes and for
some new options is surely created by advertising and may not represent true needs.

' See F, Fisher, Z. Griliches, and C. Kaysen, “The Cost of Automobile Model Changes
Since 1949,” The
Journal of Political Economy, October 1962, pp. 433-451; and V. Bajic,
“Automobiles and Implicit Markets:
An Estimate of a Structural Demand Model for Automobile Characteri
stics,” Applied Economics April 1993
pp. 541-551.
: :
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 369

Turning to oligopoly theory itself, we can now see why we said earlier that there is no
general theory of oligopoly. All the oligopoly models that we have examined are somewhat
incomplete and unsatisfactory. This is unfortunate because oligopoly is the most prevalent
form of market organization in production in all modern economies. Some progress in oli-
gopoly theory is provided by game theory (examined in the next chapter).

EXAMPLE 11-5
Firm Size and Profitability

Do larger firms, because of their size and possible market power, earn larger profits
than smaller firms? This question has been of great interest to both business and goy-
ernment and has been hotly debated over the years. To answer this question, we calcu-
lated the rank correlation between size (measured by sales) and profits in 2006 for the
20 largest U.S. corporations from the data shown in Table 11.2. The rank correlation,
which can range from 0% to 100%, was found to be 49.7% in 2006, but it was only
21% in 2001 and 39.3% in 2005. Thus, the profitability of larger firms seems to have
increased from 2001 (a recession year) to 2006 (a year of high growth) in the United
States. It should be noted that life at the top is also slippery: 30 to SO companies are
displaced from the Fortune 500 in a typical year.

Sales and Profits for the 20 Largest U.S.

Corporations in 2006 (in millions of dollars)

Company Sales Profits

Wal-Mart Stores Spy 1S) 11,284

Exxon Mobil 347,254 39,500
General Motors 207,349 —-1,978
Chevron 200,567 17,138
ConocoPhillips 172,451 15,550
General Electric 168,307 20,829
Ford Motor 160,126 —12,613
Citigroup 146,777 Dilgs3s
Bank of America Corp. LA ONT DN 333)
American International Group 113,194 14,048
J.P. Morgan Chase & Co. OOS 14,444
Berkshire Hathaway 98,539 11,015
Verizon Communications 93,221 6,197
Hewlett-Packard 91,658 6,198
IBM 91,424 9,492
Valero Energy 91,051 5,463
Home Depot 90,837 5,761
McKesson 88,050 dol
Cardinal Health 81,895 1,000
Morgan Stanley 76,688 7,472
UE
EEEN EEE EEIEIIII ESE a a aa

Source: “Fortune 500 Largest U.S. Corporations,” Fortune, April 27, 2007, pp. F1-F49.
370 PART FOUR Imperfectly Competitive Markets

11.7 OTHER OLIGOPOLISTIC PRICING PRACTICES

In this section, we examine two other pricing practices often used by oligopolists: limit
pricing and cost-plus pricing.

Limit Pricing as a Barrier to Entry

Limit pricing was defined earlier as the charging of a price low enough to discourage entry
into the industry. By doing so, existing firms voluntarily sacrifice some short-run profits to
maximize their profits in the long run. We can show this with Figure 11.8.
In the left panel of Figure 11.8, D is the total market demand curve for the commod-
ity. Suppose that existing firms are already selling four units of the commodity at P = $8
(point A). The entrance of a new firm would increase industry output and cause the price to
fall. That is, a potential entrant assumes that it faces the segment of demand curve D to the
right of point A. Subtracting the four units of the commodity supplied by existing firms
from the market demand curve (D) gives the potential entrant’s demand curve (d2). If,
instead, existing firms were selling six units of the commodity at P = $6 (point B), the
potential entrant’s demand curve would be dj.
For simplicity, we assume that per-unit costs of existing firms and for the potential
entrant are constant. We also assume (quite realistically) that the per-unit costs of the
potential entrant are somewhat higher than for the established firms. These costs are shown
in the right panel of Figure 11.8, where the horizontal LAC = LMC curve refers to the
constant costs of the established firms and the horizontal LAC* = LMC* curve refers to
the constant and higher costs of the potential entrant.

P($) $

aS 12

\ B ;
. ‘ 6 LAC* = LMC*

: a: [ACS IMG

2 ic 9

1 C1i
a 5 4 MR D
| | l
0 9 4 6 1070 0 9 4 6 10 Q
FIGURE 11.8 Limit Pricing In the left panel, D is the total market demand curve for the commodity,
The demand curve of a potential entrant is d2 if existing firms sell Q = 4, and
dj if they sell Q = 6. In
the right panel, the LAC = LMC curve refers to the constant costs of the
established firms, while LAC* =
LMC* refers to the constant and higher costs of the potential entrant.
Existing firms maximize profits by
selling Q = 4 at P= $8 (given by point £, at which MR — LMC). The
demand curve facing the potential
entrant Is then da and it could earn profits. To discourage entrance
, existing firms can set the price at $6
So that d} lies everywhere below LAC*
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 371

Existing firms maximize profits by selling Q = 4 at P = $8 (given by point E, at

which LMC = MR) and earn profits of AE or $4 per unit and $16 in total. The demand
curve facing the potential entrant is then d. Since over the range A*B* of d>, P > LAC*,
the potential entrant would find it profitable to enter the industry. However, this would
increase industry output and lower price so that the profits of existing firms would fall. To
avoid this, existing firms may choose to sell Q = 6 at P = $6 so that the demand curve
facing the potential entrant is d,. Since d; lies everywhere below the LAC* curve, the
potential entrant would incur losses at all output levels and would not enter the industry.
Therefore, P = $6 is the entry-limit price. This is the highest price that existing firms can
charge without inducing entry. By setting the limit price, existing firms sacrifice some
profits in the short run (they now make a profit of $12 rather than $16) in order to maxi-
mize their profits in the long run.
Note that existing firms may only charge the limit price when they believe entry is
imminent and will set their profit-maximizing price of P = $8 at other times. Sometimes
existing firms, faced with the entry of another firm, may voluntarily reduce their output to
accommodate the new entrant and avoid a price reduction. Finally, note that limit pricing
assumes some form of collusion (such as price leadership) on the part of existing firms.!°

Cost-Plus Pricing: A Common Shortcut Pricing Practice

In the real world, firms often lack exact information to set the price that maximizes their
profits (given by the point where the firm’s MC curve intersects its MR curve from below).
Cost-plus pricing The In these cases, firms usually use cost-plus pricing. Here, the firm estimates the average
setting of a price equal variable cost for a “normal” output level (usually between 70% and 80% of capacity out-
to average cost plus a put) and then adds a certain percentage or markup over average variable cost to deter-
markup.
mine the price of the commodity. The markup is set sufficiently high to cover average
Markup The variable and fixed costs and also provide a profit margin for the firm. The markup varies
percentage over average depending on the industry and demand conditions. For example, the markup is about 20%
cost in cost-plus in the steel industry in general, but it is higher for products facing less elastic demand or
pricing. in periods of high demand.
Cost-plus pricing is fairly common in oligopolistic industries, and, under certain con-
ditions, it is not inconsistent with profit maximization. That is, to the extent that the markup
is varied inversely with the elasticity of demand of the product, it leads to a price which is
approximately the profit-maximizing price. This can be shown as follows:
= P —AVC
m (et)
PPVAVC
where P is price, AVC is average variable cost, and m is the markup over AVC, expressed
as a percentage of AVC.
Solving for P, we get

m(AVC) = P — AVC
P=AVC + m(AVC) [11.2]
P=AVC(1 +m)

16 For more dynamic theories of limit pricing that predict that the limit price will be above existing firms’
LAC, see R. T. Masson and J. Shaanan, “Stochastic-Dynamic Limiting Pricing: An Empirical Test,” Review of
Economics and Statistics, August 1982, pp. 413-422.
Sie PART FOUR Imperfectly Competitive Markets

But from Section 5.6 we know that

MR Plea) pest
of demand.
where MR is marginal revenue, P is price, and 77 is the price elasticity
Solving for P we get
MR
Senay
Since profits are maximized where MR = MC, we can substitute MC for MR in the
above formula and get
MC
P=
1+ 1/7

To the extent that the firm’s MC is constant over a wide range of outputs, MC = AVC.
Substituting AVC for MC in the above formula, we get

pete [11.4]
eae Wag;

Formula [11.4] for profit maximization equals formula [11.2] for the markup, if
1+m=1/(1 + (1/n)) or if m = —1/(y + 1). Thus, the firm will maximize profits if
its markup is inversely related to the price elasticity of demand for the commodity. For
example, when 7 = —3, m should be 1/2, or 50%. For n = —5,m = 1/4, or 25%. This
means that if AVC = $100, P should equal $125 (so that the markup is 25% of AVC) for
the firm to cover all costs and maximize profits.
Cyert and March found that firms in the retailing sector adjusted prices on the basis
of feedback from the market and did reduce the markup and price when the demand for a
product declined and became more elastic.'’ Thus, using cost-plus pricing with a markup
that varies inversely with the price elasticity of demand is consistent with profit maxi-
mization. In any event, those firms that choose a markup and price that is not near the
profit-maximizing price are less likely to grow and may go out of business in the long run,
as compared to firms that choose the appropriate markup. Cost-plus pricing is one of
many rules of thumb that firms are forced to use in the real world because of the frequent
lack of adequate data.

AT THE FRONTIER
The Art of Devising Airfares

Introductory Comment: The following selection illustrates most of the concepts

presented in this chapter as they are actually applied in the real world. It shows the
importance of market structure in output and pricing decisions, price leadership, price
discrimination, the pricing of multiple products, and how they are all interrelated to
‘an analysis in pricing as it is actually conducted in a major oligopolistic indus-
try today.

'7R. M. Cyert and J. G. March, A Behavioral Theory of the Firm (Englewoo

d Cliffs, N.J.: Prentice-Hall 1963)
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 373

THE ART OF DEVISING AIRFARES

In the airline business, it is sometimes called the “dark science.” The latest round of
fare wars, however, has put the spot light on how carriers use state-of-the-art computer
software, complex forecasting techniques, and a little intuition to divine how many
seats and at what prices they will offer on any flight.
The aim of this inventory or yield management is to squeeze as many dollars as
possible out of each seat and mile flown. This means trying to project just how many
tickets to sell at a discount without running out of seats for the business traveler, who
usually books at the last minute and therefore pays full fare. Too many wrong projec-
tions can lead to huge losses of revenue, or even worse. The inability of People
Express (airline) to manage its inventory of seats properly, for example, was one of the
major causes of its demise.
“It’s a sophisticated guessing game,” says Robert E. Martens, vice president of
pricing and production planning at American Airlines, the carrier that has the most
sophisticated technology for yield management, according to airline analysts and con-
sultants. “You don’t sell a seat to a guy for $69 when he is willing to pay $400.”
With the industry now adopting very low discount but nonrefundable fares, the
complex task of managing seat inventory may become easier because airlines will be
better able to predict how many people will show up for a flight. Some airlines have
already seen a reduction in their no-shows, which means that they can overbook less
and spare more customers from being bumped. The nonrefundable fares could also
enable carriers to sell more discount seats weeks before a flight, rather than putting
them on sale at the last minute in an effort to fill up the plane.
American’s inventory operations illustrate just how complicated the process can
be. At the airline’s corporate headquarters, 90 yield managers are linked by terminals
to five International Business Machines mainframe computers in Tulsa, Oklahoma.
The managers monitor and adjust the fare mixes on 1,600 daily flights as well as
528,000 future flights involving nearly 50 million passengers. Their work is hectic: A
fare’s average life span is two weeks, and industrywide about 2,000 fares change daily.

Few Discounts on Fridays

American and other airlines base their forecasts largely on historical profiles on each
flight. Business travelers, for example, book heavily on many Friday afternoon flights,
but often not until the day of departure. The airlines reserve blocks of seats for those
frequent fliers. Few, if any, discounts are made available. “Good luck on getting a
‘Q fare’ from New York to Chicago on Fridays afternoon,” said James J. Hurtigan,
president of United Airlines, using the industry parlance for the low-priced super
saver ticket. “It’s like winning the New York lottery.” The same route on a midday on
a Wednesday, however, begs for passengers, so the airline might discount more than
80% of its seats to draw leisure travelers and others with more flexible schedules.

Passengers Angered
Many passengers, attracted by the advertisements trumpeting deep discounts but
unaware that fare allocations change from flight to flight, have expressed anger at the
carriers and travel agents when the cheap seats were unavailable. To help clear up the
confusion, Continental Airlines is now running ads noting the relative demand for

Continued...
374 PART FOUR Imperfectly Competitive Markets

The Art of Devising Airfares Continued

ing,
certain routes, thus giving some sense of the supply of discount seats. Overbook
their no-shows and involves
too, is based on the computerized history of flights and
myriad factors that include destination, time of day, and cost of ticket. . .
The airlines have used inventory management for decades, but its importance 1n
helping carriers to enhance their revenue coincides with new software developed in the
past three or four years, analysts and airline executives said. Some of the software has
been developed in-house; other systems have been obtained from such companies as
the Unis Corporation and the Control Data Corporation. “It’s probably the No. | man-
agement tool required to compete properly in this highly competitive airline environ-
ment,” said Lee R. Howard, executive vice president of Airline Economics, a
Washington-based consulting firm.
Effective inventory management alone can improve an airline’s revenues by 5% to
20% annually, analysts estimated. Mr. Martens said American’s system was worth
“hundreds of millions of dollars” a year to the airline. The airline’s total sales exceeded
$6 billion last year. “The revenue implications for yield management are enormous,”
said Julius Maltudis, airline analyst at Salomon Brothers. Inventory management
improves a carrier’s load factor, or ratio of seats filled. Every 1% increase in the load
factor translates into $10 million in revenue for the typical major carrier, analysts said.

“Crystal-Ball Gazing”
As sophisticated as it is, however, yield management is still subject to variables beyond
its control. “Yield management is about 70% technology and 30% crystal-ball gazing,”
said Robert W. Cuggin, assistant vice president of marketing development at Delta
Airlines. Bad weather or a last-minute switch to a plane of a different size can wreak
havoc with weeks of planning, he said.
At American, inventory management begins 330 days before departure. Yield
managers use a profile of a flight’s history to parcel out an alphabet soup of fares,
rationing full-fare seats first, then moving down the price scale. In the following weeks,
the computer alerts managers if sales in a particular fare class picked up unexpectedly.
If a travel agent books a large group of passengers in advance, for example, the com-
puter would flag the large order, and yield managers would restrict or expand the num-
ber of seats in that category. Otherwise, managers begin checking all fare mixes 180
days before departure, adding or subtracting seats in each according to demand.
The process continues right up to two hours before boarding, according to
America’s director of yield management, Dennis McKaige. Airlines typically put more
discount seats on sale just before an advance purchase requirement expires, he said.
Therefore, a new batch of cheap tickets that require a 30-day advance purchase might
go on sale 31 days before departure. A cut-rate fare offered on Monday might be sold
out by Wednesday, then suddenly reoffered hours before take off on Thursday if pas-
sengers projections based on previous flights fail to materialize, Mr. McKaige said.
There are some instances when an airline actually gives preference to discount
travelers over customers paying full fare. American has recently developed software
to increase the yield on flights through its hubs. American gives preference to a
passenger flying on a discount fare from Austin, Texas, to London, through Dallas,
over another passenger paying full fare from Austin to Shreveport, Louisiana,
through Dallas. The London passenger. who pays $241 each way, is worth more
to
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 375

the airline than the passenger flying to Shreveport, who pays the full fare of $87 each
way. For the bargain hunter, finding a discount will increasingly depend on the sea-
son, day and time of travel, the destination, and the length of stay.

The New Fare Cuts

Continental, a unit of Texas Air, ignited the latest round of rock-bottom fares in
January with “Maxsaver tickets,’ which require a minimum two-day advance pur-
chase and are nonrefundable. “The spread between our highest and lowest fares is
much lower than other airlines,” said James O’Donnel, vice president of marketing at
Continental. “While our yield management job is no less important than other air-
lines’, it is easier.’ Mr. O’Donnel said the carrier’s system was more automated than
those used by some of its competitors.
The two-day purchase requirement has siphoned off some business travelers who
would otherwise have paid full fare. (American and several other airlines abandoned
plans to raise their lowest discount fares and increase the advance purchase require-
ment on the cheapest tickets to 30 days, from 2. The airlines backed away from the
change when support for the proposal collapsed.) Airline officials said that nonre-
fundable tickets were here to stay. Mr. Martens said that since the nonrefundable,
Maxsaver-type fares were introduced, American’s no-show rate has dropped “‘sub-
stantially below” the usual range of 12% to 15%. Passengers who are willing to com-
mit themselves to a particular flight in exchange for lower prices allow yield managers
to refine their operations by concentrating on the remaining coach seats.

Concluding Remarks: Yield management (1.e., the idea of selling as many tickets
as possible at high fares and fill the rest of the seats at cut rates) is here to stay in the
pricing of airline tickets and is constantly being refined with the use of ever more pow-
erful computers and software. Indeed, yield management is considered the single
most important technological improvement in airline management in the last decade
and is often credited with making the difference between profit and loss for many air-
lines. For example, The New York Times found that on a single flight in 1997, the 33
passengers who held Chicago—Los Angeles tickets paid 27 different fares, ranging
from $87 to $728. In 2008, a New York—Los Angeles roundtrip ticket might cost $287
to one flier and $2,247 to another.
The great variety and frequent changes in airfares is, however, creating great con-
fusion and frustration for air travelers as they are routinely unable to book seats at the
lowest advertised fares. This led to increasing complaints of false advertisement, which
the Transportation Department (the sole authority charged with regulating the airline
industry since it was deregulated in 1978) has regularly investigated. Yield manage-
ment has now come to haunt airlines, as more and more travelers shop around on the
Internet for the lowest airfares available and fewer and fewer passengers pay full fare.

Sources: Eric Schmidt, “The Art of Devising Air Fares,’ New York Times, March 4, 1987, pp. D1—D2.
Reprinted by permission of the New York Times Corporation. See also “Computers as Price Setters
Complicate Travelers’ Lives,” New York Times, January 24, 1994, p. 1; “Special Offers by Airlines Come
Under U.S. Review,” New York Times, January 23, 1995, p. 10; “So, How Much Did You Pay for Your
Ticket?.” New York Times, April 12, 1998, Sect. 4, p. 2; “Airlines Now Offer ‘Last Minute’ Fare Bargains
Weeks Before Flights,” Wall Street Journal, March 15, 2002, p. B1; “Airline Seats Have Become a
Commodity,” Financial Times, July 13, 2005, p. 5; and S. Borenstein and N. L. Rose, “How Airlines
Market Work,” NBER, Working Paper No. 13452, September 2007.
376 PART FOUR Imperfectly Competitive Markets

11.8 THE MARCH OF GLOBAL OLIGOPOLISTS

ies has acceler-
During the past decade the trend toward the formation of global oligopol
have been getting bigger and bigger through inter-
ated as the world’s largest corporations
and more industrie s and sectors the pressure to
nal growth and mergers. Indeed, in more
seems irresistib le. No longer are corporat ions
become one of the largest global players
the-larg est national company in their industry or
satisfied to be the largest or the next-to-
sector. More and more corporations operate on the belief that their very survival requires
that they become one of a handful of world corporations or global oligopolists in their
sector. Many smaller corporations are merging with larger ones in the belief that either
they grow or they become a casualty of the sharply increased global competition. Strong
impetus toward globalization has been provided by the revolution in telecommunications
and transportation, the movement toward the globalization of tastes, and the reduction of
barriers to international trade and investments. Rapid globalization has occurred in prac-
tically every sector, including industry, banking, entertainment and telecommunications,
consumer products, food, drugs, electronics, and commercial aircraft.
In industry, the total sales in real terms (i.e., after taking inflation into account) of the
world’s 25 largest industrial corporations increased 70% faster than the combined index
of real total industrial production in all industrial countries during the past 30 years. Thus,
there has been a clear tendency for the largest industrial corporations to become larger. e
The movement toward globalization is very clear in automobiles, where only a handful of
global independent players are likely to survive (see Example 11-6). Globalization has
proceeded even more rapidly in tires, where Bridgestone (Japanese), Michelin (French),
and Goodyear (American) command more than half of total world’s sales and further con-
solidation is expected.
The sector in which the size of the largest firms has grown the most during the past
decades is international banking. From 1966 to 2007, total deposits of the world’s 10
largest banks grew from $87 billion to more than $10,000 billion. Even after accounting
for the quadrupling of prices and exchange rate changes (to convert local currency values
into dollar values), this means that the size of the world’s 10 largest banks increased by
more than 16 times during the past three decades. It is often pointed out, however, that
after a certain size, stability and profitability are more important than size per se.
Nevertheless, the growth in the size of the world’s largest banks has been nothing but
spectacular (see Example | 1-7).
Another sector where corporations have grown sharply in size and gone global has
been the entertainment and communication industry. The merger of Time Inc. with Warner
Communications and its subsequent acquisition by America Online (AOL) for $110 billion
to form Time Warner Inc., Walt Disney’s acquisition of Capital Cities/ABC, and Viacom’s
acquisitions (CBS, MTV, infinity Broadcasting, Simon & Schuster, Blockbuster, and
Paramount Pictures) formed, respectively, the world’s first-, second-, and third-largest
communications company (all three American).'? Many mergers involved the purchase of
American companies by foreigners: Japan’s Sony Corporation purchased American CBS

'8 See “The Fortune Global 500,” in Fortune for August 1970, May 1980, July 1990, and
July 2007.
!9 Tn 2005, however, Viacom, reversing direction, decided to split itself into
a radio and broadcast TV
operations (which includes the CBS network) from its MTV cable network and
Paramount film studio in order
better to meet the competition from new technologies, which includes the Internet,
satellite radio, and digital
video recorders. See, “Viacom Board Agrees to Split of Company, New York
Times, June 15, 2005 p. C4;
“Time Warner May Sell AOL,” New York Post, March 27, 2007. p. 1; and
oe
http://w ww.mediaowners.com/company/waltdisney.html,
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly Shy

Records and MGM; Germany’s Bertelsmann acquired RCA Records as well as Doubleday
and Bantam Books; Ruppert Murdoch’s (from Australia but now residing in the United
States) News Corporation owns Harper & Row Publishers, Triangle Publications,
Twentieth-Century Fox, and the Wall Street Journal; and Vivendi (French) acquired
Seagram and US Networks. The industry is now dominated by Time Warner Inc., Walt
Disney Company, Viacom, News Corporation, Bertlsmann, and Vivendi. The reason given
for most mergers in the entertainment and communications industry is to become more
competitive globally. “Competitive,” according to the current conventional wisdom, means
being equipped to become one of the five to eight giant corporations expected to dominate
the industry worldwide. These enterprises, the reasoning goes, will be able to produce
and distribute information and entertainment in virtually any medium: books, magazines,
news, television, movies, videos, electronic data networks, and so on. This is expected to
provide important synergies or cross-benefits from joint operation.””
The same type of globalization has been taking place in consumer products, food, drugs,
electronics, and commercial aircraft. In 1990, Gillette introduced its new Sensor razor, which
took 20 years and $300 million to develop, and it captured an incredible 71% of the world
razor market by 1999 when it introduced its Mach3. In 2005, Gillette was acquired by Procter
& Gamble. Nestlé, the world’s largest food company, has production plants in 59 countries
and sells its food products in more than 100 countries. America’s Procter & Gamble,
Switzerland’s Nestlé, and Britain’s Unilever are among the world’s 100 largest corporations.
Coca-Cola has 40% of the U.S. market and an incredible 33% of the world’s soft drink mar-
ket. Despite the need to cater to local food tastes (Nestlé has more than 200 blends of
Nescafé to cater to different local tastes), there is a clear trend toward global supermarkets.
The same is true in chemicals, electronics, commercial aircraft, petroleum, and drugs (see
Example 11-8), for which handful of huge corporations literally controls the world market.
It no longer makes any sense to talk about or be concerned only with national
rather than global competition in these sectors. A large corporation can even be a
monopolist in the national market and face deadly competition from larger and more
efficient global oligopolists. The ideal global corporation is today strongly decentral-
ized, to allow local units to develop products that fit into the local cultures, and yet at
its core is very centralized, to coordinate activities around the globe.7!

EXAMPLETI-6-
Globalization of the Automobile Industry

The automotive industry is rapidly globalizing, with six companies producing more
than 65% of the total world sales of automobiles of nearly 60 million units (see
Table 11.3). From the more than 40 independent producers during the 1980s, only
about 10 or so relatively large automakers remain today. General Motors has acquired

20 “Media Mergers: An Urge to Get Bigger and More Global,” New York Times, March 19, 1989, p. 7;
“Corporations’ Dreams Converge in One Idea: It’s Time to Do a Deal,” Wall Street Journal, February 26,
1997, p. Al; “The New Media Colossus,” Wall Street Journal, December 15, 2000, p. BI; and “The Urge to
Merge,” Fortune (February 21, 2005), pp. 21-26.
21 “A View from the Top: Survival Tactics for the Global Business Arena,” Management Review, October 1992,
pp. 49-53; “The Fallout from Merger Mania,” Fortune, March 2, 1998, pp. 26-27; “If at First,’ The Economist
(September 3, 2005), p. 13; and “Europe: Bourses Rise, Gripped by ‘Merger Mania,’” International Herald
Tribune, December 11, 2006, p. 1.
378 PART FOUR Imperfectly Competitive Markets

TABLE 11.3| World’s Largest Auto Producers in 2006

Vehicles Produced
Company (in millions)

General Motors 8.93

Toyota 8.04
Ford 6.27
Renault/Nissan 5.72
Volkswagen Group 5.69
DaimlerChrysler Pa)
Total 39.24

Source: http://en.wikipedia.org/wiki/Automaker, October 29, 2007.

Saab and Daewoo; Ford acquired Jaguar, Land Rover, Volvo, and Mazda; Renault
merged with Nissan; Volkswagen acquired Seat, Skoda and Audi; Daimler-Benz
absorbed Chrysler. Only Toyota grew without mergers.
Some of the biggest automobile mergers, however, did not work out and have
either been dissolved or are in the process of doing so. In 2008, Ford sold Jaguar and
Land Rover to Tata of India, and DaimlerChrysler sold Chrylser to Cerberus, a U.S.
private equity fund. Be that as it may, there now remain only a handful of smaller inde-
pendent automakers in the market today: Honda, PSA, Fiat, Chrysler and Daimler AG
(after the split), and BMW. Economies of scale are so pervasive in the automobile
industry, however, that more mergers are likely to take place in the near future. There
are, of course, some very small but highly luxurious and expensive makes, but even
these are owned by some of the larger companies (for example, Rolls Royce is owned
by BMW and Ferrari is part of Fiat). Until 2005, Toyota was considered the best auto-
mobile company in the world: It made the best-quality cars and earned huge profits.
But its growth has slowed down since then, and its reputation was somewhat tarnished
because of quality problems. Nevertheless, in 2008 Toyota was about to surpass GM
to become the world’s largest automaker.
Source: “U.S. Car Makers Lose Market Share,’ Wall Street Journal (January 6, 2004), p. A3; “The Quick
and the Dead,” The Economist (January 29, 2005), pp. 10-11; “GM Slips into Toyota’s Rearview Mirror,”
Wall Street Journal, April 25, 2007, p. A7; “Chrysler Deal Heralds New Direction for Detroit,” Wall Street
Journal, May 15, 2007, p. Al; “Back to the Future,” Forbes, October 15, 2007, pp. 39-40; “Dings and
Dents of Toyota,” Wall Street Journal, November 3, 2007, p. C1; and “Toyota and GM are Neck and Neck
in the Race to Be Number One,” Financial Times, January 1, 2008, p. 16.

EXAMPLE 11-7
Rising Competition in Global Banking

This decade is likely to see aggressively intensified competition in the high-stakes

world of international banking, with fewer than 10 of the 40-45 large international
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 379

banks now aspiring to become global powerhouses actually attaining their goal. From
the 1950s through the 1970s, world banking was dominated by U.S. banks; during the
1980s, Japanese banks made a run for the top; but now many of the world’s largest
banks are European.
American banks were weakened by soured loans on real estate and to developing
countries during the 1980s and for highly leveraged takeovers during the 1990s.
Japanese banks suffered from years of bad loans, low profits, and antiquated technol-
ogy during the 1990s, and they were generally less competitive than European banks
and much less efficient than American banks. European banks entered the 1990s
in better shape than their American counterparts. They were better capitalized and
had made much fewer bad loans than American banks to developing countries, espe-
cially in Latin America, during the 1980s. They were also not restricted by law, as
American Banks were until 1999, from entering the insurance and securities fields.
European banks, however, generally lagged in technology and in the introduction of
new financial instruments, such as derivatives, when compared with American banks.
European banks were also much more exposed, and incurred much higher losses
than, American banks from the financial and economic crisis in Southeast Asia dur-
ing the latter part of the 1990s. The European banking sectors did start to consolidate
after the mid-1990s, but mergers generally took place within countries rather than
across countries because of persisting nationalism. This changed during the 2000s,
when some very large cross-country mergers took place, and more are expected in the
next few years.
In 2007, the world’s largest bank (with assets of over $2 trillion) was Barclays
Bank of England, and the second was Swiss bank UBS. Of the world’s top 10 largest
banks, three were English, two French, two American (Citi and Bank of America), and
one each, Swiss, Japanese, and German. But size is not everything in banking, and once
a bank is, say, one of the top 10 largest in the world, efficiency is what then matters the
most. Size is important in banking because, with deregulation, each bank must increas-
ingly compete with foreign banks at home and abroad to be successful. Global banks
must be able to meet the rising financial needs for lending, underwriting, currency and
security trading, insurance, financial advice, and other financial services for customers
and investors with increasingly global operations (i.e., they must provide one-stop
banking for global corporations). Global banks must also be highly innovative and
introduce new financial products and technologies to meet changing customer needs.
Overcapacity—too many banks chasing too few customers—will also increase compe-
tition. Large U.S. banks are strong on innovations and, with the repeal of the 1933
Glass—Steagal Act (which prevented them from entering the insurance and securities
fields) are now able to compete with foreign banks more effectively at home and
abroad.

Sources: “Competition Rises in Global Banking,” Wall Street Journal, March 25, 1991, p. Al;
“International Banking Survey,” The Economist, April 30, 1994, pp. 1-42; “Congress Passes Wide-
Ranging Bill Easing Bank Laws,” New York Times, November 5, 1999, p. 1; “Banking in the 21st
Century,” Global Finance, January 2000, p. 41; and “The World’s Biggest Banks,” Global Finance,
October 2007, p. 100.
380 PART FOUR Imperfectly Competitive Markets

EXAMPLE 11.8
Globalization of the Pharmaceutical Industry
uti-
The past decade has witnessed more than a dozen huge mergers of large pharmace
Pfizer’s (the
cal companies—as well as many failed attempts. The largest merger was
largest drug company in the world—American) acquisition of Warner-Lambert (also
American) for $110 billion in 2000. In 2006, Pfizer had annual sales of $45 billion:
GlaxoSmithKlein, the second-largest drug company in the world (British) had sales of
$37 billion. All of the world’s 10 largest pharmaceutical companies have been the
result of one or more mergers. The only exception is Merck, the eighth-largest drug
company in the world (American), with 2006 sales of $23 billion. Still, the top 10
pharmaceutical companies control less than half of total world drug sales, and so there
still seems to be a great deal of room for further mergers in the industry in the future.
There are three major reasons for the urge to merge in the pharmaceutical indus-
try. The first and most important arises from the incredibly high cost (over $1 billion
in 2007) of developing and marketing new drugs. Despite average profit rates of about
15% in the industry, these huge development costs are becoming out of reach for even
the largest drug companies. Hence the need for further consolidation and globalization
in the industry, even by today’s largest industry players. The second reason is that
management typically expects savings equivalent to 10% of the combined sales of the
postmerger company. These can run in the billions of dollars per year for the largest
companies. The third reason is that the combined sales force of the merged company
can reach that many more doctors and hospitals and thus increase sales. Although
making a great deal of sense theoretically, most mergers in the pharmaceutical indus-
try did not deliver the benefits expected. In all cases the merged company lost market
share and faced reduced profits after the merger.
Because of price regulation (and thus lower profit margins) and fragmented
national markets, European drug companies are losing international competitiveness to
U.S. firms. All companies now face very strong competition from generics, as patents
(usually granted for 20 years from the date the application is filed) expire on many
blockbuster drugs. Generic drugs usually sell for as little as 10-20% of the patented
drug. By 2007, more than 60% of all prescriptions were filled by generic drugs (up from
20% in 1984) in the United States (saving consumers more than $10 billion). In recent
years several drug companies were also hit by huge lawsuits for the alleged harmful
side effects of their drugs. In 2004, Merck was forced to withdraw from the market its
painkiller Vioxx (which had brought in $2.5 billion per year in revenues) for causing
heart attacks, and in 2007 it agreed to pay $4.85 billion to settle 45,000 lawsuits that had
been brought against it. Furthermore, some expected drug successes turned out instead
to be huge flops. For example, in 2007 Pfizer withdrew Exubera, an insulin drug for dia-
betics, which cost $2.8 billion to develop, for lack of sales.
Source: “Drug Makers See ‘Branded Generics’ Eating into Profits,” Wall Street Journal (April 18,
2003),
p. Al; “Delicate Balance Needed in Uniting of Drug Companies,” New York Times (April 27,
2004), p. C1;
“Merck to Pay $253 Million after Losing Vioxx Suit,” Financial Times (August 21,
2005), p. 1; “Insulin
Flop Cost Pfizer $2.8 Billion” Wall Street Journal, October 19, 2007, p. Al; “Drug
Drought,” Forbes,
October 29, 2007, pp. 44-47; “More Generics Slow the Surge in Drug Prices,”
New York Times, August 8,
2007, p. 1; and “Merck Is Said to Agree to Pay $4.85 billion for Vioxx Claims,”
New York Times
November 9, 2007, p. 1.
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 381

|__| SUMMARY
1. Monopolistic competition is the form of market organization in which there are many sellers of a
differentiated product, and entry into and exit from the industry are rather easy in the long run.
Differentiated products are those that are similar but not identical and satisfy the same basic need.
The competitive element arises from the many firms in the market. The monopoly element results
from product differentiation. The monopoly power, however, is severely limited by the availability
of many close substitutes. Monopolistic competition is most common in the retail sector of the
economy. Because of product differentiation, we cannot derive the market demand curve and we
have a cluster of prices. The choice-related variables for a monopolistically competitive firm are
product variation, selling expenses, and price.
2. Since a monopolistically competitive firm produces a differentiated product for which there
are many close substitutes, the demand curve that the firm faces is negatively sloped but
highly price elastic. The best level of output in the short run is given by the point at which
MR = SMC, provided that P > AVC. If firms earn profits in the short run, more firms enter the
market in the long run. This shifts the demand curve facing each firm to the left until all firms
break even. Because of product differentiation, P and LAC are somewhat higher than if the
market had been organized along perfectly competitive lines, there is excess capacity, and this
allows more firms to exist in the market. A monopolistically competitive firm can increase the
degree of product variation and selling expenses in an effort to increase the demand for its
product and make it less elastic. The optimal level of these efforts is given by the point at
which MR = MC. In the long run, however, the monopolistically competitive firm breaks
even. Recently, economists have preferred to use the perfectly competitive and oligopoly
models.
3. Oligopoly is the form of market organization in which there are few sellers of either a
homogeneous or a differentiated product, and entry into or exit from the industry is possible
but difficult. Oligopoly is the most prevalent form of market organization in the manufacturing
sector of industrial countries, including the United States. The distinguishing characteristic
of oligopoly is the interdependence or rivalry among the firms in the industry. The sources
of oligopoly as well as the barriers to entry are economies of scale, the huge investments
and specialized inputs required to enter the industry, patents and copyrights, the loyalty
of customers to existing firms, control over the supply of a required raw material, and
government franchise. The degree by which an industry is dominated by a few large
firms is measured by concentration ratios. These ratios, however, can be very misleading
as a measure of the degree of competition in the industry and must be used with great
caution.
4. Cournot assumed that two firms sell identical spring water produced at zero marginal cost. Each
duopolist, in its attempt to maximize profits, assumes the other will keep output constant at the
existing level. The result is a sequence of moves and countermoves until each duopolist sells
one-third of the total output that would be sold if the market were perfectly competitive. If each
duopolist assumes that the other keeps its price (instead of its quantity) constant, then the price
will fall to zero. This is the Bertrand model. In the kinked-demand, or Sweezy, model, it is
assumed that oligopolists match the price reductions but not the price increases of competitors.
Thus, the demand curve has a kink at the prevailing price. Oligopolists maintain the price as
long as the SMC curve intersects the discontinuous segment of the MR curve. Some empirical
studies do not support the existence of the kink, and the model does not explain how the price is
set in the first place.
5. A centralized cartel is a formal organization of suppliers of a commodity that sets the price and
allocates output and profits among its members so as to increase their joint profits. A market-
sharing cartel is an organization of suppliers of a commodity that overtly or tacitly divides the
market among its members. Cartels can result in the monopoly solution but are unstable and often
fail. A looser form of collusion is price leadership by the dominant, the low-cost, or the
382 PART FOUR |mperfectly Competitive Markets

allowed to sell
barometric firm. Under price leadership by the dominant firm, the small firms are
firm comes in to fill the
all they want at the price set by the dominant firm, and then the dominant
market.
the
6. In the long run, oligopolistic firms can build their best scale of plant and firms can leave
industry. Entry, however, has to be blocked or restricted if the industry is to remain
oligopolistic. There can be several natural and artificial barriers to entry. Oligopolists seldom
change prices for fear of starting a price war and prefer instead to compete on the basis of
advertising, product differentiation, and service. In oligopolistic markets, production does not
usually take place at the lowest point on the LAC curve, P > LAC, P > LMC, and too much
may be spent on advertising, product differentiation, and service. Oligopoly, however, may
result from the limitation of the market, and it may lead to more research and development.
7. Limit pricing refers to existing firms charging a sufficiently low price to discourage entry into
the industry. Cost-plus pricing refers to the setting of a price equal to average variable cost plus
a markup. The pricing of airline tickets illustrates most of the concepts presented in this chapter
as they are actually applied in a real-world oligopolistic market.
8. During the past decade, the trend toward the formation of global oligopolies has accelerated as the
-world’s largest corporations have been getting even bigger through internal growth and mergers.
More and more, corporations operate on the belief that their survival requires that they become one
of a handful of world corporations, or global oligopolists, in their sector. This globalization of
production and distribution has important implications for the concept of efficiency (to be explored
in Section 13.3).

KEY TERMS
Monopolistic competition Concentration ratios Limit pricing
Differentiated products Cournot model Nonprice competition
Product group Bertrand model Cost-plus pricing
Excess capacity Kinked—demand curve model Markup
Product variation Collusion Reaction function
Selling expenses Cartel Cournot equilibrium
Oligopoly Centralized cartel Nash equilibrium
Duopoly Market-sharing cartel Stackelberg model
Pure oligopoly Price leadership
Differentiated oligopoly Barometric firm

REVIEW QUESTIONS
1. a. Why is itthat we cannot define the industry in b. Is advertising good or bad for consumers? Why?
monopolistic competition? 5. Why does excess capacity arise in monopolistic
b. How can cross elasticities of demand help competition? What is its economic significance?
define a product group under monopolistic competition? 6, What is the distinction between interdependence and
2. Can the short-run supply curve of a monopolistically rivalry in oligopoly?
competitive firm be derived? Why?
7. How much would be produced by each oligopolist and in
3. ase effect will product variation and selling expenses total in Figure 11.3 if there were
ave on
a. four firms in the market?
a. the firm’s demand and cost curves?
b. five firms in the market?
b. short-run and long-run equilibrium? 8 . What general conclusion can you draw from
4. a. What is the usefulness and cost of product variation? the results in
the text and from your answer to Question 7 with regard
to
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 383

the proportion of the perfectly competitive total quantity b. What are its disadvantages?
sold by
. Why do we study cartels and price leadership if they are
a. each oligopolist? illegal?
b. all oligopolists together? 11. Why is there no general theory of oligopoly?
9. a. What is the usefulness of the kinked—demand curve . What are the advantages and disadvantages of
model? oligopoly?

| PROBLEMS
1. Suppose that SATC were $10 and AVC were $8 at the and (3) each firm’s SMC function is given by $(1/4)Q,
best level of output for the firm in the left panel of Figure and input prices are constant.
ible
a. Find the best level of output and price for this
a. How much profit or loss per unit and in total would centralized cartel.
the firm have if it continued to produce? b. How much should each firm produce if the cartel
b. Should the firm continue to produce in the short wants to minimize production costs?
run? Why? c. How much profit will the cartel make if the
c. What would be the total loss of the firm if it stopped average total cost of each firm at the best level
producing in the short run and if it didn’t stop of output is $4?
producing? . Redraw Figure 11.6, and show on it the MR and the
*2. Excess capacity is inversely related to the price elasticity SMC curves for the cartel as a whole. How are the best
of demand faced by a monopolistically competitive firm. levels of output and price for the cartel as a whole
True or false? Explain. determined? On the same figure, draw the SATC curve of
- Starting with the assumptions of the Cournot model, one of the duopolists if SATC = $6 at Q = 2 and
explain what would happen if each duopolist assumed Q = 4. How much profit does each duopolist earn?
that the other kept its price rather than its output constant A Start with Figure 11.6 where the duopolists share equally
(as in the Cournot model). the market for a homogeneous product.
4. Draw a figure showing the best level of output and price a. Draw a figure such that duopolist 1’s short-run
for the oligopolist of Figure 11.4 if its SMC marginal cost (SMC}) is as shown in Figure 11.6
curve shifts and duopolist 2’s short-run marginal cost is given
a. upward by $3.50; by SMC>z = 6 + 2Q. What quantity of the
commodity will each duopolist produce? What
b. downward by $4.
price would each like to charge? What is the actual
5. Draw a figure showing the best level of output and price result likely to be?
for the oligopolist of Figure 11.4 if the government sets a
b. If SATC, = $5 at Q = 2 and SATC? = $8 at Q = 1,
price ceiling of
how much profit will each duopolist earn?
ay, SSOP
10. Assume that (1) in a purely oligopolistic industry, there is
b. $7. one dominant firm and 10 small identical firms; (2) the
*6, Draw a figure showing the best level of output and price market demand curve for the commodity is Q = 20 — 2P,
for the oligopolist of Figure 11.4 if the demand curve it where P is given in dollars; (3) SMCqg = 1.5 + Q/2,
faces shifts while SMC, = | + Q/4; and (4) input prices remain
a. upward by $0.50 but the kink remains at P = $8. constant. Based on the above assumptions
b. downward by $0.50 but the kink remains at P = $8 a. draw a figure similar to Figure 11.7 showing the
and the SMC curve shifts up to SMC’. market demand curve, SMC,, SMC,, and the demand
curve that the dominant firm faces.
7. Assume that (1) the four identical firms in a purely
oligopolistic industry form a centralized cartel; b. What price will the dominant firm set? How much
(2) the total market demand function facing the will the small firms supply together? How much will
cartel is QD = 20 — 2P, and P is given in dollars; the dominant firm supply?

* = Answer provided at end of book.

384 PART FOUR Imperfectly Competitive Markets

demand of
11. Draw a figure showing that when two identical *12. If an oligopolist knows that the price elasticity of
ne
firms share the market equally for a homogeneous the product it sells (77) is —4 and its AVC = $10, determi
product they both earn profits, but if a third identical a. the markup that the oligopolist should use in pricing
firm entered the industry, they would all face its product;
losses. How is this related to the existence of b. the price the oligopolist should charge.
oligopoly?

APPENDIX THE COURNOT AND STACKELBERG MODELS

This appendix is a more advanced and complete treatment of the Cournot model presented
in Section 11.4, as well as an important extension of the model known as the Stackelberg
model.

The Cournot Model—An Extended Treatment

We begin by writing the equation for market demand curve D shown in both panels of
Figure 11.3 as

C= 1) E. [11.5]

where Q is the total quantity of spring water sold in the market per unit of time (say, per
week) and P is the market price. For example, applying formula [11.5], Q@= 0 when
P = $12 (the vertical intercept of market demand curve D in the right panel of Figure
11.3, repeated below for ease of reference as the left panel of Figure 11.9). On the other
hand, when P = $0, Q = 12 (point C on market demand curve D in the left panel of
Figure 11.9).
Given the quantity of spring water supplied by duopolist B (Qg), duopolist A will
supply one-half of the difference between 12 (the total that would be supplied to the mar-
ket at P = $0) and Qg in order to maximize total profits. That is,
Pl CR
Qa 5 [11.6]

For example, when Qg = 0, Qa = 12/2 = 6 (point A on dg in the left panel of

Figure 11.9). On the other hand, when Qp = 3, Qa = (12 — 3)/2 = 4.5 (point A’ on da
in the left panel of Figure 11.9). With total costs equal to zero, duopolist A always maxi-
mizes total revenue and total profits by producing one-half of 12 minus the amount sup-
plied by duopolist B (formula [11.6]). The reason is that (as shown in the left panel of
Figure 11.3) this is the quantity at which mr = MC = 0.
Similarly, duopolist B maximizes total revenue and total profits by selling

De
Q,=— [11.7]
For example, when Qa = 6, Op = (12 — 6)/2 = 3 (point B on dg in the left panel
of
Figure 11.9) because (as shown in the left panel of Figure 11.3) this is the quantity at
Reaction function A which mr = MC = 0.
formula that shows how Equation [11.6] is duopolist A’s reaction function. This shows how duopolist
A
a duopolist reacts to the reacts to duopolist B’s action and is plotted in the right panel of Figure 11.9. It
shows that
other duopolist’s action. if Og = 0, Qa = 6 (given by point A at which duopolist A’s reaction function
crosses the
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 385

QB
12

Firm A’s reaction function:

]
-- ID =512=0R)
=
=
Qed
fe)
es. Firm B’s reaction function:
a :
z 5 ey lijo
ON by)
4 SS a =

3
|

e |
Q 0 4] 6 ie),
4.5
Output of firm A

FIGURE 11.9 Duopolists’ Demand Curves and Reaction Functions in the Cournot Model The left
panel shows the demand curves faced by duopolists A and B and the quantity sold by each, given the quantity
sold by the other (exactly as in the right panel of Figure 11.3). The right panel shows duopolist A’s and B’s
reaction functions. The intersection of the two reaction functions at point E gives the Cournot equilibrium
of Qa = Qp = 4 (in the right panel), so that Qn + Qg = 8 andP = $4 (point Fin the left panel).

horizontal or Qa axis in the right panel of Figure 11.9) in order for duopolist A to max-
imize total revenue and total profits. If Qg = 3, Qa = 4.5 (pointA’ on duopolist A’s reac-
tion function).
Similarly, equation [11.7] is duopolist B’s reaction function and is also plotted in the
right panel of Figure 11.9. It shows that if 0, = 6, Qp = 3 (given by point B on duopolist
B’s reaction function in the right panel of Figure 11.9) in order for duopolist B to maximize
total revenue and total profits. Thus, a duopolist’s reaction function shows the quantity that
the duopolist should sell to maximize its total profits, given the amount sold by the other
duopolist.
Cournot equilibrium The two reaction functions intersect at point FE, giving the Cournot equilibrium of
The situation where Ov = Og = 4. That is, if Qg = 4, then Qa = 4 (point EF on duopolist A’s reaction func-
there is no tendency for tion) for duopolist A to maximize total profits. Similarly, if Q, = 4, then Qg = 4 (point
each of two duopolists E on duopolist B’s reaction function) for duopolist B to maximize total profits. Thus,
to change the quantity
point E (where the two reaction functions intersect) is the Cournot equilibrium point
each sells.
because there is no tendency for either duopolist to change the quantity it sells. A situa-
tion such as the Cournot equilibrium where each player’s strategy is optimal, given the
Nash equilibrium The strategy chosen by the other player, is called a Nash equilibrium.
situation when each The right panel of Figure 11.9 can also be used to show the time path or movement
player has chosen his or toward equilibrium. With Qg = 0, Qa = 6 (point A on duopolist A’s reaction function).
her optimal strategy,
With QO, = 6, Og = 3 (point B on duopolist B’s reaction function). With Og = 3, Qa =
given the strategy
4.5 (point A’ on duopolist A’s reaction function). Note the direction of the arrows from
chosen by the other
player.
point A to point B and from point B to point A’ which move the duopolists toward the final
Cournot equilibrium point £ at the intersection of the two reaction functions.
386 PART FOUR imperfectly Competitive Markets

ically by arerri ae
The Cournot equilibrium point E can be obtained algebra
duopolist A’s reaction function
olist B’s reaction function (i.e., equation [11.7]) into
(equation [11.6]). Doing this, we get
ees On)/2
aie 2
12-—6+Q,/2
_ 2,

= OMe Bee)

Multiplying both sides by 4, we get

40, = 12+ Qa
so that

30, = 12
and

n= oe [11.9]

With O, = 4
12-4
On =— 5 al
[11.10]

so that

Ox = 4 = Qs: (Cournot equilibrium) [11.11]

and

Q0=0,5 Op =4--4=3 [11.12]

Solving equation [11.5] for P, we get

P=12-Q [11.13]
With Q = 8 at Cournot equilibrium, the price at which each duopolist will sell spring
water is

P=12 28= 34 [11.14]

which is shown by point F in the left panel of Figure 11.9.

The Stackelberg Model

In 1934, the German economist Heinrich von Stackelberg made an important extension
Stackelberg model to the Cournot model. This became known as the Stackelberg model. Stackelberg
The extension of the
assumed that one of the duopolists, say duopolist A, knows that duopolist B behaves in
Cournot model in
which one duopolist
the naive Cournot fashion (i.e., A knows B’s reaction function) and uses that knowledge
knows how the other in choosing its own output. Duopolist A is then called the Stackelberg leader, and duop-
behaves and earns olist B is referred to as the Stackelberg follower, All the other assumptions of
the
higher profits. Cournot model hold. The Stackelberg model shows that duopolist A (the Stackelberg
 CHAPTER 11 Price and Output Under Monopolistic Competition and Oligopoly 387

leader) will have higher profits than under the Cournot solution at the expense of
duopolist B (the Stackelberg follower).
To examine the Stackelberg model, we begin by rewriting equation [11.5] for market
demand function D:

Q=12-P [11.5]
Since Q refers to the total output of duopolists A and B, we can rewrite equation
[11.5] as

Qx+Qg = 12-P [11205]

Because duopolist A knows duopolist B’s reaction function, we can substitute equa-
tion [11.7] for Qg into equation [11.15]. When we do this, we get

OLA
WO jAS 1 [11.16]
O,+6—Q04/2=12—P
Qa/2=6—P
oh bse [11.17]
Equation [11.17] is now the demand function facing duopolist A when duopolist
A knows duopolist B’s reaction function and behavior. Plotting equation [11.17], we get
the (residual) demand curve facing duopolist A, da, and its corresponding marginal
revenue curve, mrs (which, as usual, is twice as steep as the corresponding demand
curve), as shown in Figure 11.10. Since marginal cost equals zero, duopolist A maxi-
mizes its total revenue and profits by selling six units of output (given by point E* where
mr.) MC =D).
With Qa = 6, Og = 3 (according to B’s reaction function given by equation [11.7]).
With OQ = Qa+ Op = 64+3 =9, P = 12 —Q = 12 — 9 = 3.Thus, duopolistA earns
a total revenue and total profit of $18 (six units at P = $3), while duopolist B earns a total
revenue and total profit of $9 (three units times P = $3). This compares with the four
units of output sold by each duopolist at P = $4 (with each earning a total revenue and
profit of $16) under the Cournot model. Thus, duopolist A (the Stackelberg leader) gains
at the expense of duopolist B (the Stackelberg follower) with respect to the Cournot solu-
tion. Note, however, that what duopolist A gains is less than what duopolist B loses. Of
course, if duopolist B were the Stackelberg leader and duopolist A were the Stackelberg
follower, duopolist B would earn $18 and duopolist A would earn $9. By allowing one of

P($)

FIGURE 11.10 Demand and Marginal Revenue Curves of

Stackelberg Duopolist A daand mraare, respectively, the demand
curve and the marginal revenue curve facing Stackelberg duopolist A.
Since MC = O, duopolist A maximizes its total revenue and total profits
by selling six units. This is given by point E* where mra = MC = ©.
Duopolist B would then sell three units. With Q = 9,P = $3, duopolist
A earns $18 and duopolist B earns $9.
388 PART FOUR Imperfectly Competitive Markets

superior to the Cournot

the firms to behave strategically, the Stackelberg model is thus
model.
same as point B on
When duopolist A is the Stackelberg leader, the solution is the
duopolist B’s reaction function in Figure 11.9. However , while point B is not the Cournot
Stackelb erg solution. Note that under the Stackelberg
equilibrium, it does represent the
is the Stackelb erg leader), the combine d total revenue
solution (whether duopolist A or B
and profits of both firms would be $27 ($18 + $9). By colludin g and operatin g as a cen-
tralized cartel or monopoly (see Section 11.5), the combine d output of both firms could
be cut from nine units in the Stackelb erg solution to six units, which could be sold at
P = $6, so that the total combine d revenue and profits that both firms could share would
be $36 (rather than $27). This is sometimes referred to as the Chamberlin model.*?

INTERNET SITE ADDRESSES

For concentration ratios in U.S. manufacturing For competition in the pharmaceutical industry, see:
industries, see: http://en.wikipedia.org/wiki/Pharmaceutical_company
http://www.census.gov/prod/ec02/ Generic drugs: http://www.fda.gov/cder/ogd/
ec023 Isr1.pdf Pfizer: http://www.pfizer.com
For OPEC, see: GlaxoSmithKlein: http://www.gsk.com/
http://www.opec.org Sanofi-Aventis: http://sanofi-aventis.com
http://en.wikipedia.org/wiki/OPEC Novartis: http://www.novartis.com
http://www.eia.doe.gov/oiaf/ieo/oil.html Johnson & Johnson: http://www.jj.com
For the Fortune Global 500 companies, see: Merck: http://www.merck.com
http://fortune.com/global500 Procter & Gamble: http://www.pg.com
For competition in the automobile industry, see: For the Internet site of other companies discussed in this
http://en. wikipedia.org/wiki/Automaker chapter, see:
http://www.thetruthaboutcars.com/?p=5928 McDonald’s: http://www.mcdonalds.com
For competition in international banking, see: AT&T: http://www.att.com
Bank of America: http://www.bankamerica.com Coca-Cola: http://www.coca-cola.com
Citigroup: http://www.citigroup.com American Airlines: http://www.aa.com
Deutsche Bank: http://www.deutschebank.com Time Warner: http://www.timewarner.com/corp
J.P. Morgan Chase: http://www.jpmorganchase.com Viacom: http://www. viacom.com/default.aspx
Union Bank of Switzerland: http://www.ubs.com Walt Disney: http://www.webdisney.com

2 See D. Salvatore, “Schaum’s Outline,” in Microeconomic Theory,

4th ed. (New York: McGraw-Hill, 2006)
pp. 240, 251-253.
 CHAPTER 12

Game Theory and Oligopolistic Behavior

Chapter Outline List of Examples
12.1 Game Theory: Definition, Objectives, and 12-1 Military Strategy and Strategic Business
Usefulness Decisions
12.2 Dominant Strategy and Nash 12-2 Dell Computers and Nash Equilibrium
Equilibrium 12-3 The Airlines’ Fare War and the Prisoners’
12.3. The Prisoners’ Dilemma, Price and Dilemma
Nonprice Competition, and 12-4 Wal-Mart’s Preemptive Expansion Marketing
Cartel Cheating Strategy
12.4 Repeated Games and Tit-for-Tat Strategy 12-5 Strategic Moves and Countermoves by Airbus
12.5 Strategic Moves and Boeing
12.6 Strategic Moves and International 12-6 Companies’ Strategic Mistakes and Failures
Competitiveness At the Frontier: The Virtual Corporation

After Studying This Chapter, You Should Be Able to:

Describe what game theory is and how it is used in economics
Know the meaning of dominant strategy and Nash equilibrium
Know the meaning of the prisoners’ dilemma and its use in economics
Describe the tit-for-tat strategy in economic competition
Describe firms’ strategic moves in the form of threats, commitments, and credibility

n this chapter, we extend our analysis of firm behavior in oligopolistic markets using
game theory. As we will see, game theory offers many insights into oligopolistic inter-
dependence and strategic behavior that could not be examined with the traditional
tools of analysis presented in the previous chapter.
The chapter begins with an explanation of the basic concepts, objectives, and useful-
ness of game theory. It then defines a dominant strategy and a Nash equilibrium and
examines their usefulness in the analysis of oligopolistic behavior. Next, the chapter
describes the prisoners’ dilemma and its applicability to the analysis of price and nonprice
competition and cartel cheating. We conclude our discussion of game theory by analyz-
ing multiple and strategic moves in domestic and international competition, with and
without risk. The examples and applications presented in the chapter clearly highlight the

389
390 PART FOUR Imperfectly Competitive Markets

stic behav-
importance of game theory to the understanding of many aspects of oligopoli
section looks at the vir-
ior that could not otherwise be explained. The “At the Frontier”
tual corporation—the firm of the future—as the product of strategic alliances.

121 GAME THEORY: DEFINITION, OBJECTIVES, AND USEFULNESS

We have seen that oligopolists must consider the reactions of the other firms in the
industry to their own actions. Some have likened the behavior of oligopolists to that of
players in a game and to the strategic actions of warring factions. It is this crucial
aspect of oligopolistic interdependence that game theory seeks to capture and explain
(see Example 12-1).
Game theory was introduced by John von Neumann and Oskar Morgenstern in 1944,
Game theory The and it was soon hailed as a breakthrough in the study of oligopoly.' In general, game theory
theory that examines is concerned with the choice of an optimal strategy in conflict situations. Specifically,
the choice of optimal game theory can help an oligopolist choose the course of action (e.g., the best price to
strategies in conflict charge) that maximizes its benefits or profits after considering all possible reactions of its
situations.
competitors. For example, game theory can help a firm determine (1) the conditions under
which lowering its price would not trigger a ruinous price war; (2) whether the firm
should build excess capacity to discourage entry into the industry, even though this low-
ers the firm’s short-run profits; and (3) why cheating in a cartel usually leads to its col-
Concept Check
lapse. Game theory can be of great use in the analysis of such conflict situations. In short,
How does game theory
help us understand game theory shows how an oligopolistic firm can make strategic decisions to gain a com-
strategic behavior in petitive advantage over its rivals or how it can minimize the potential harm from a strate-
oligoplistic markets? gic move by arival. Before we examine concrete examples, however, let us consider some
of the common elements in all game theory.
Players The decision Every game theory model includes players, strategies, and payoffs. The players are
makers in the theory of the decision makers (here, the managers of oligopolist firms) whose behavior we are try-
games whose behavior ing to explain and predict. Strategies are the potential choices to change price, to develop
we are trying to explain
new or differentiated products, to introduce a new or a different advertising campaign, to
and predict.
build excess capacity, and all other such actions that affect the sales and profitability of
Strategies The potential the firm and its rivals. The payoff is the outcome or consequence of each strategy. For
choices that can be made each strategy adopted by a firm, there is usually a number of strategies (reactions) avail-
by the players (firms) in able to a rival firm. The payoff is the outcome or consequence of each combination of
the theory of games.
strategies by the two firms. The payoff is usually expressed in terms of the profits or
Payoff The outcome or losses of the firm that we are examining as a result of the firm’s strategies and the rivals’
consequence of each responses. A table that gives the payoffs from all the strategies open to the firm and the
combination of
rivals’ responses is called the payoff matrix.
strategies by the players
We must distinguish between zero-sum games and nonzero-sum games. A zero-
in game theory.
sum game is one in which the gain of one player comes at the expense and is exactly
Payoff matrix The equal to the loss of the other player. An example of this occurs if firm A increases its
table of all the market share at the expense of firm B by increasing its advertising expenditures (in the
outcomes of the face of unchanged advertising by firm B). But if firm B also increases its advertising
players’ strategies.

Zero-sum game A I J. von Neumann

ae and O. Morgenstern,
Theory of Games and Economic; Behavior (Princeton, NJ: Princeton
game where the gains University Press, 1944), A more recent and in-depth presentation of game theory with
applications to
of one player equal the economics is found in M. J. Osborne and A. Rubinstein, A Course in Game Theory
(Cambridge, MA: MIT
losses of the other. Press, 1994).
.
 CHAPTER 12 Game Theory and Oligopolistic Behavior 391

expenditures, firm A might not gain any market share at all. On the other hand, if firm
A increases its price and firm B does not match the price increase, firm A might lose
market to firm B. Games of this nature, where the gains of one player equal the losses
of the other (so that total gains plus total losses sum to zero) are called zero-sum games.
If the gains or losses of one firm do not come at the expense of or provide equal bene-
Nonzero-sum game A fit to the other firm, however, we have a nonzero-sum game. An example of this might
game where the gains of arise if increased advertising leads to higher profits of both firms and we use profits
one player do not come rather than market share as the payoff. In this case we would have a positive-sum game.
at the expense of or are
If increased advertising raises costs more than revenues and the profits of both firms
not equal to the losses
of the other player. decline, we have a negative-sum game.

EXAMPLE 12-1
Military Strategy and Strategic Business Decisions

According to William E. Peackock, the former president of two St. Louis companies
and former assistant secretary of the army under President Carter, decision making in
business has much in common with military strategy and can thus be profitably ana-
lyzed using game theory. Although business managers’ actions are restricted by laws
and regulations to prevent unfair practices and the objective of managers, of course, is
not to literally destroy the competition, there is much that they can learn from military
strategists. Peackock points out that throughout history, military conflicts have pro-
duced a set of basic Darwinian principles that can serve as an excellent guideline to
business managers about how to compete in the marketplace. Neglecting these princi-
ples can make the difference between business success and failure.
In business as in war, it is crucial for the organization to have a clear objective and
to explain this objective to all of its employees. The benefits of a simple marketing
strategy that all employees can understand are clearly evidenced by the success of
McDonald’s. Both business and war also require the development of a strategy for
attacking. Being aggressive is important because few competitions are ever won by
being passive. Furthermore, both business and warfare require unity of command to
pinpoint responsibility. Even in decentralized companies with informal lines of com-
mand, there are always key individuals who must make important decisions. Finally,
in business as in war, the element of surprise and security (keeping your strategy
secret) is crucial. For example, Lee Iacocca stunned the competition in 1964 by intro-
ducing the immensely successful (high payoff ) Mustang. Finally, in business as in war,
spying to discover a rival’s plans or steal a rival’s new technological breakthrough 1s
becoming more common.
More than ever before, today’s business leaders must learn how to tap employees’
ideas and energy, manage large-scale rapid change, anticipate business conditions five
or ten years down the road, and muster the courage to steer the firm in radical new
directions when necessary. Above all, firms must think and act strategically in a world
of increasing global competition. Game theory can be particularly useful and can offer
important insights in the analysis of oligopolistic interdependence. Indeed, more and
more firms are making use of war-games simulations in their decision making. At the
B02 PART FOUR Imperfectly Competitive Markets

in game theory made by

same time, politicians and military leaders are using advances
Nobel Prize winners, 1n
Robert Aumann and Thomas Schelling, the 2005 economics
their war games.
, 1984), elke Valley of
Sources: W. E. Peackock, Corporate Combat (New York: Facts on File Publication
Attract Big Warriors, eae Street
Spies,” Forbes, October 26, 1992, pp. 200-204; “Business War Games
Shape Strategy, Harvard
Journal, December 22, 1994, p. B1; “The Right Game: Use Game Theory to
Business Review, July-August 1995, pp. 57-71; “From Battlefield to Boardroom ,” Financial Times,
February 10, 2003, p . 7; “Global Gamesmans hip, ” Harvard Business Review, May 2003, pp. 62-71;
Espionage and Industrial
“War Games,” The Economist, October 15, 2005, p. 82; H. Nasheri, Economic
Street Journal,
Spying (New York: Cambridge University Press, 2005), and “Leaders of the Pack,” Wall
March 3-4, 2007, p. R9.

12.2 DoMINANT STRATEGY AND NASH EQUILIBRIUM

In this section, we discuss the meaning of a dominant strategy and the Nash equilibrium,
and examine their usefulness in the analysis of oligopolistic interdependence.

Dominant Strategy
Let’s begin with the simplest type of game with an industry (duopoly) composed of two
firms, firm A and firm B, and a choice of two strategies for each—advertise or don’t
advertise. Firm A, of course, expects to earn higher profits if it advertises than if it does-
n’t. But the actual level of profits of firm A depends also on whether firm B advertises.
Thus, each strategy by firm A (i.e., advertise or don’t advertise) can be associated with
each of firm B’s strategies (also to advertise or not to advertise). The four possible out-
comes from this simple game are illustrated by the payoff matrix in Table 12.1.
In the payoff matrix in Table 12.1, the first number in each of the four cells refers
to the payoff (profit) for firm A, while the second is the payoff (profit) for firm B. From
Table 12.1, we see that if both firms advertise, firm A will earn a profit of 4, and firm B
will earn a profit of 3 (the top left cell of the payoff matrix).* The bottom left cell of the
payoff matrix shows that if firm A doesn’t advertise and firm B does, firm A will have a
profit of 2, and firm B will have a profit of 5. The other payoffs in the second column of
the table can be interpreted in the same way.

TABLE 1211| Payoff Matrix for the Advertising Game

Firm B

Advertise Don’t Advertise

BienA Advertise s3 33
Don’t Advertise 5 3;
ee ENON a I Noe

> The profits of 4 and 3 could refer, for example, to $4 million and $3 million, respectively.
 CHAPTER 12 Game Theory and Oligopolistic Behavior 393

What strategy should each firm choose? Let’s consider firm A first. If firm B does
advertise (i.e., moving down the left column of Table 12.1), we see that firm A will earn a
profit of 4 if it also advertises and 2 if it doesn’t. Thus, firm A should advertise if firm B
advertises. If firm B doesn’t advertise (i.e., moving down the right column in Table 12.1),
firm A would earn a profit of 5 if it advertises and 3 if it doesn’t. Thus, firm A should adver-
tise whether firm B advertises or not. Firm A’s profits will always be greater if it advertises
than if it doesn’t, regardless of what firm B does. We can then say that advertising is the
Dominant strategy dominant strategy for firm A. The dominant strategy is the optimal choice for a player no
The optimal strategy matter what the opponent does.
for a player no matter
The same is true for firm B. Whatever firm A does (i.e., whether firm A advertises or
what the other player
not), it will always pay for firm B to advertise. We can see this by moving across each row
does.
of Table 12.1. Specifically, if firm A advertises, firm B’s profit would be 3 if it advertises
and | if it does not. Similarly, if firm A does not advertise, firm B’s profit would be 5 if it
advertises and 2 if it doesn’t. Thus, the dominant strategy for firm B is also to advertise.
In this case, both firm A and firm B have the dominant strategy of advertising and this
will, therefore, be the final equilibrium. Both firm A and firm B will advertise regardless
of what the other firm does and will earn a profit of 4 and 3, respectively (the top left cell
in the payoff matrix in Table 12.1). The advertising solution or final equilibrium for both
firms holds whether firm A or firm B chooses its strategy first or if both firms decide on
their best strategy simultaneously.

Nash Equilibrium
Not all games have a dominant strategy for each player, however. An example of this is
shown in the payoff matrix in Table 12.2. This table is the same as the payoff matrix in
Table 12.1, except that the first number in the bottom right cell was changed from 3 to 6.
Now firm B has a dominant strategy but firm A does not. The dominant strategy for firm
B is to advertise whether firm A advertises or not, because the payoffs for firm B are the
same as in Table 12.1. Firm A, however, has no dominant strategy now. If firm B adver-
tises, firm A earns a profit of 4 if it advertises and 2 if it does not. Thus, if firm B adver-
tises, firm A should also advertise. On the other hand, if firm B does not advertise, firm A
earns a profit of 5 if it advertises and 6 if it does not.’ Thus, firm A should advertise if firm
B does, and it should not advertise if firm B doesn’t. Firm A no longer has a dominant
strategy. What firm A should do now depends on what firm B does.

TABLE 12.2, Payoff Matrix for the Advertising Game

Firm B

Advertise Don’t Advertise

ly Advertise An 3), I
eae Don’t Advertise O25 6,2
en nnn EEE EEE

3 This might result, for example, if firm A’s advertisement is not effective or if advertising adds more to firm
A’s costs than to its revenues.
394 PART FOUR Imperfectly Competitive Markets

first try to deter-

In order for firm A to determine whether to advertise, firm A must
advertise if firm B does
mine what firm B will do (and advertise if firm B does and not
has the dominant
not). If firm A knows the payoff matrix, it can figure out that firm B
e
strategy of advertising. Therefore, the optimal strateg for firm A is also to advertis
e the
(because firm A will earn a profit of 4 by advertising and 2 by not advertising—se
12.2). This is the Nash equilibr ium, named after John Nash, the
first column of Table
Princeton Universi ty mathema tician and 1994 Nobel prize winner who first formali zed
the notion in 1951.
Nash equilibrium The The Nash equilibrium is a situation in which each player chooses an optimal strat-
situation when each egy, given the strategy chosen by the other player. In our example, the high advertising
player has chosen his or strategy for firm A and firm B is the Nash equilibrium, because given that firm B
her optimal strategy,
chooses its dominant strategy of advertising, the optimal strategy for firm A is also to
given the strategy chosen
advertise. Note that when both firms had a dominant strategy, each firm was able to
by the other player.
choose its optimal strategy regardless of the strategy adopted by its rival. Here, only
firm B has a dominant strategy; firm A does not. As a result, firm A cannot choose its
-optimal strategy independently of firm B’s strategy. Only when each player has chosen
Concept Check
its optimal strategy given the strategy of the other player do we have a Nash equilib-
What is the relationship
between a dominant
rium. The Cournot equilibrium examined in Section 11.4 was an example of a Nash
strategy and Nash equilibrium. Not all games have a Nash equilibrium, and some games can have more
equilibrium? than one Nash equilibrium (see Problem 3, with the answer at the end of the book).

EXAMPLE 12-2
Dell Computers and Nash Equilibrium

Dell Computers of Austin, Texas, a company created by 27-year-old Michael Dell

in 1984, ended the 2006 fiscal year with revenues of $57.1 billion, making it the
largest PC computer company in the United States and the second largest in the
world after Hewlett-Packard (H-P). By offering a 30-day money-back guarantee on
next-day, free on-site service through independent contractors for the first year of own-
ership, and unlimited calls to a toll-free technical support line, Dell established a
solid reputation for reliability, thus taking the fear and uncertainty out of mail-order
computers. Ordering a computer from Dell by mail is now like ordering a Big Mac at
MacDonald’s—you know exactly what you will get. By eliminating retailers, Dell was
also able to charge lower prices than its larger and more established competitors. Dell
ships computers by mail by adding only a 2% shipping charge to the sale price. When
receiving a mail order, Dell technicians simply pick up the now-standard components
from the shelf to assemble the particular PC ordered. It is simple, quick, and inexpen-
sive. Thus, Dell developed a dominant strategy—one that seemed optimal regardless
of what competitors did.
Until the early 1990s, traditional computer firms, such as IBM, H-P, and Apple
always thought that customers were willing to pay a substantial retail markup for the
privilege of being able to go to a store and touch the machine before buying it. But by
reducing fears and uncertainty from ordering computers through the mail, Dell
was
able to convince a growing number of customers to bypass the retailers
and order
directly from Dell by mail at lower prices. Given Dell’s dominant and profitable
strategy,
 CHAPTER 12 Game Theory and Oligopolistic Behavior 395

other computer firms in the United States quickly followed and set up their own mail-
order departments and 800-phone lines. Their dominant strategy of selling exclu-
Concept Check
How did Dell’s sively through retail outlets seemed knocked out by Dell’s new market strategy, so the
dominant strategy lead computer industry was in Nash equilibrium. Dell, however, was more adept at selling
to Nash equilibrium in computers through the mail and retained almost 50% of the mail-order computer
the PC market? business.
By 2005, Dell reached its peak, with 19% of the world PC market and 32% of the
U.S. market, and it was growing and earning profits while other PC markers were
shrinking and incurring losses. In fact, IBM left the PC market at the end of 2004 when
it sold its laptop business to Lenovo of China. Starting in 2006, however, Dell started
to lose market share to H-P and other PC firms as consumers in the United States
started to gravitate to stores to purchase laptops, and consumers in emerging market
never fully embraced Internet shopping for lack of experience and adequate delivery
services. By 2007, Dell’s share of the world PC market had fallen to 15.2% (as com-
pared to a rise to 19.1% for H-P) and its share of the U.S. market had fallen to 26.8%
(while H-P’s share increased to 25.5%). This led Dell to rethink its made-to-order,
direct-to-customers PC sales model, and in 2007 it began also to sell its laptops at Wal-
Mart and other stores in the United States and abroad.
Sources: “The Computer Is in the Mail (Really),”’ Business Week, January 23, 1995, pp. 76-77; “Michael
Dell Turns the PC World Inside Out,’ Fortune, September 8, 1997, pp. 76-86; “IBM Plans to Stop
Selling Its PC’s in Retail Outlets,” New York Times, October 20, 1999, p. C6; “Dell Domination,”
Fortune, January 21, 2002, pp. 71-75; “IBM Strikes a Deal with Rival Lenovo,” Wall Street Journal,
December 9, 2004, p. A3; “Dell to Rely Less on Direct Sales,” Wall Street Journal, May 25, 2007,
p. A3; and “Profit Fells as Dell Tries to Grow and Limit Costs,” New York Times, February 29,
2008, p. C3.

THE PRISONERS’ DILEMMA, PRICE AND NONPRICE COMPETITION,

12.3 AND CARTEL CHEATING

In this section, we examine the meaning of the prisoners’ dilemma and see how it can be
applied to explain oligopolistic behavior in the form of price and nonprice competition
and cartel cheating.

The Prisoners’ Dilemma: Definition and Importance

Prisoners’ dilemma Oligopolistic firms often face a problem called the prisoners’ dilemma. This refers to a
The situation where situation in which each firm adopts its dominant strategy but each could do better (e.g.,
each player adopts his earn larger profits) by cooperating. Consider the following situation. Two suspects are
or her dominant arrested for armed robbery; if convicted, each could receive a maximum sentence of 10
strategy but could do
years imprisonment. Unless one or both suspects confess, however, the evidence is such
better by cooperating.
that they could only be convicted of possessing stolen goods, which carries a maximum
sentence of one year in prison. Each suspect is interrogated separately and no communi-
Concept Check cation is allowed between the two suspects. The district attorney promises each suspect
What is the prisoners’ that by confessing, he or she will go free while the other suspect (who does not confess)
dilemma? will receive the full 10-year sentence. If both suspects confess, each gets a reduced
396 PART FOUR Imperfectly Competitive Markets

Negative Payoff Matrix for Suspect A

and Suspect B (years of detention)
Suspect B

Confess Don’t Confess

Confess 55 0, 10
Suspect A inl
Don’t Confess 10, 0 .

sentence of five years, imprisonment. The (negative) payoff matrix in terms of detention
years is given in Table 12.3.
From Table 12.3, we see that confessing is the best or dominant strategy for suspect
A no matter what suspect B does. The reason is that if suspect B confesses, suspect A
receives a 5-year jail sentence if he also confesses and a 10-year sentence if he does not.
Similarly, if suspect B does not confess, suspect A goes free if he confesses and receives
a one-year sentence if he does not. Thus, the dominant strategy for suspect A is to con-
fess. Confessing is also the best (and the dominant) strategy for suspect B. The reason is
that if suspect A confesses, suspect B gets a five-year jail sentence if he also confesses
and a 10-year jail sentence if he does not. Similarly, if suspect A does not confess, sus-
pect B goes free if he confesses and gets one year if he does not. Thus, the dominant
strategy for suspect B is also to confess.
With each suspect adopting his or her dominant strategy of confessing, each ends up
receiving a five-year jail sentence. But if each suspect did not confess, each would get
only a one-year jail sentence! Each suspect, however, is afraid that if he or she does not
confess, the other will confess, and so he or she would end up receiving a 10-year jail sen-
tence. Only if each suspect were sure that the other would not confess, and he or she does
not confess, would each get only a one-year sentence. Because it is not possible to reach
an agreement not to confess (remember, the suspects are already in jail and cannot com-
municate), each suspect adopts his or her dominant strategy to confess and receives a five-
year jail sentence. Even if an agreement not to confess could be reached, the agreement
could not be enforced. Therefore, each suspect will end up confessing and receiving a
five-year jail sentence.

Price and Nonprice Competition, Cartel Cheating,

and the Prisoners’ Dilemma
The concept of the prisoners’ dilemma can be used to analyze price and nonprice com-
petition in oligopolistic markets, as well as the incentive to cheat in a cartel (i.e., the ten-
dency to cut prices secretly or to sell more than the allocated quota). Oligopolistic price
competition in the presence of the prisoners’ dilemma can be examined with the payoff
matrix in Table 12.4.
‘ The payoff matrix of Table 12.4 shows that if firm B charged a low price (say,
$6),
firm A would earn a profit of 2 if it also charged the low price ($6) and
| if it charged a
high price (say, $8). Similarly, if firm B charged a high price ($8),
firm A would earn a
profit of 5 if it charged the low price and 3 if it charged the high price.
Thus, firm A should
 CHAPTER 12 Game Theory and Oligopolistic Behavior 397

TABLE 12.4
ipx-a | Payoff Matrix for Pricing Game

Firm B
Low Price High Price

Low Price i) 1
Firm A ;?
High Price = Mw 3)

adopt its dominant strategy of charging the low price. Turning to firm B, we see that if
firm A charged the low price, firm B would earn a profit of 2 if it charged the low price
and | if it charged the high price. Similarly, if firm A charged the high price, firm B would
earn a profit of 5 if it charged the low price and 3 if it charged the high price. Thus, firm
B should also adopt its dominant strategy of charging the low price. However, both firms
could do better (i.e., earn the higher profit of 3) if they cooperated and both charged the
high price (the bottom right cell).
Thus, the firms are in a prisoners’ dilemma: Each firm will charge the low price and
earn a smaller profit because if it charges the high price, it cannot trust its rival also to
charge the high price. Specifically, suppose that firm A charged the high price, with the
expectation that firm B would also charge the high price (so that each firm would earn a
profit of 3). Given that firm A has charged the high price, however, firm B now has an
incentive to charge the low price, because by doing so it can increase its profits to 5 (see
the bottom left cell). The same is true if firm B started by charging the high price, with the
expectation that firm A would also do so. The net result is that each firm charges the low
price and earns a profit of only 2. Only if the two firms cooperate and both charge the high
price will they earn the higher profit of 3 (and overcome their dilemma).
Although the payoff matrix of Table 12.4 was used to examine oligopolistic price
competition in the presence of the prisoners’ dilemma, by simply changing the head-
ing of the columns and rows of the payoff matrix we can use the same payoff matrix to
examine nonprice competition and cartel cheating. For example, if we change the head-
ing of “low price” to “advertise” and the heading of “high price” to “don’t advertise” in
Table 12.4, we can use the same matrix to analyze advertising as a form of nonprice com-
petition in the presence of the prisoners’ dilemma. We see that each firm would adopt its
dominant strategy of advertising and (as in the case of charging a low price) would earn
a profit of 2. Both firms, however, would do better by not advertising because they
would then earn (as in the case of charging a high price) the higher profit of 3. The firms
then face the prisoners’ dilemma. Only by cooperating in not advertising would each
increase its profits to 3. For example, when cigarette advertising on television was
banned in 1971, all tobacco companies benefitted by spending less on advertising and
earning higher profits. While the intended effect of the law was to encourage people not
to smoke, the law had the unintended effect of solving the prisoners’ dilemma for cig-
arette producers!
Similarly, if we now change the heading of “low price” or “advertise” to “cheat”
and the heading of “high price” or “don’t advertise” to “don’t cheat” in the columns and
Concept Check
rows of the payoff matrix of Table 12.4, we can use the same payoffs in the table to ana-
How can the concept of
the prisoners’ dilemma lyze the incentive for cartel members to cheat in the presence of the prisoners’
be used to analyze price dilemma. In this case, each firm adopts its dominant strategy of cheating and (as in the
competition? case of charging the low price or advertising) earns a profit of 2. But by not cheating,
398 PART FOUR Imperfectly Competitive Markets

profit of 3. The cartel mem-

however, each member of the cartel would earn the higher
do not cheat will each
bers then face the prisoners’ dilemma. Only if cartel members
of 3. A cartel can prevent or reduce the probability of
share the higher cartel profits
of each member and punishi ng cheater s. However, the
cheating by monitoring the sales
difficult it is for the
larger the cartel and the more differentiated the product, the more
cartel to do this and prevent cheating.

EXAMPLE 12-3
The Airlines’ Fare War and the Prisoners’ Dilemma

In April 1992, American Airlines, then the nation’s largest carrier, with 20% share of the
domestic market, introduced a new, simplified fare structure that included only four
kinds of fares instead of 16, and it lowered prices for most business and leisure travelers.
Coach fares were cut by an average of 38%, and first-class fares were lowered by 20% to
50%. Other domestic airlines quickly announced similar fare cuts. American and other
carriers hoped that the increase in air travel resulting from the fare cuts would more than
offset the price reductions and eventually turn losses into badly needed profits (during
1990 and 1991, domestic airlines lost more than $6 billion, Pan Am and Eastern Airlines
went out of business, and Continental, TWA, and America West filed for bankruptcy
protection).
Rather than establishing price discipline, however, American’s new fare structure
Concept Check started a process of competitive fare cuts that led to another disastrous price war dur-
How and why do ing the summer of 1992. It started when TWA, operating under protection from credi-
price wars arise in the tors and badly needing quick revenues, began to undercut American’s fares by 10% to
U.S. airline industry? 20% as soon as they were announced. American and other airlines responded by
matching TWA price cuts. Then, on May 26, 1992, Northwest, in an effort to stimulate
summer leisure travel, announced that an adult and child could travel on the same
flight within continental United States for the price of one ticket. The next day,
American countered by cutting all fares by 50%. The other big carriers immediately
matched American’s 50% price cut for all summer travel. Another full-fledged price
war had been unleashed.
Even though deep price cuts increased summer travel sharply, all airlines incurred
losses (i.e., the low fares failed to cover the industry average cost). Three attempts to
increase air fares by 30% above presale levels in the fall of 1992 failed when one or
more of the carriers did not go along. Having become used to deep discounts, passen-
gers were simply unwilling to pay higher fares, especially in a weak economy. Similar
price wars erupted in summer 1993 and 1994. In short, U.S. airlines seemed to be in a
prisoners’ dilemma and, unable to cooperate, faced heavy losses. Only with the strong
rebound in air travel in 1995 did airlines refrain from engaging in another disastrous
price war and thus earned profits.
But tranquility and profits did not last long. The 2001 economic recession and
the September 11 terrorist attack on the World Trade Center resulted in a sharp decline
in air travel, and the subsequent pressure from low-cost carrier Southwest and the
emergence of discount carriers such as Sky West, JetBlue, and AirTran, sparked
 CHAPTER 12 Game Theory and Oligopolistic Behavior 399

renewed fare wars, leading to total industry losses of $35.1 billion from 2001 to 2005.
This, together with the doubling of jet fuel prices, caused Delta and Northwest to
join United and U.S. Airways into Chapter 11 bankruptcy in 2005. Only in 2006 did
U.S. airlines return to profitability, by increasing fares, and the load factor (i.e., the
percentage of occupied seats), and streamlining their fleet. The further increase in jet
fuel prices and fare competition however, plunged American airlines back into the red
in 2008.
Sources: “American Air Cuts Most Fares in Simplification of Rate System,” New York Times, April 10,
1992, p. 1; “The Airlines Are Killing Each Other Again,” Business Week, June 8, 1992, p. 32;
“Airlines Cut Fares by up to 45%,” New York Times, September 14, 1993, p. D1; “The Age of ‘Wal-
Mart’ Airlines Crunches the Biggest Carriers,” Wall Street Journal, June 18, 2002, p. Al; “Flying on
Empty,” The Economist, September 17, 2005, pp. 59-60; “Higher Fares Lift US Ailrines, Financial
Times, October 19, 2007, p. 18; and “Survival of the Biggest,’ Business Week, February 25, 2008,
pp. 28-29.

12.4 REPEATED GAMES AND TIT-FOR-TAT STRATEGY

We have seen how two firms facing the prisoners’ dilemma can increase their profits
by cooperating. Such cooperation, however, is not likely to occur in the single-move
prisoners’ dilemma games discussed so far. Cooperation is more likely to occur in
repeated or many-move games, which are more realistic in the real world. For example,
oligopolists do not decide on their pricing strategy only once, but many times over many
Repeated games years. Axelrod found that in such repeated games the best strategy is that of tit-for-tat.t
Prisoners’ dilemma Tit-for-tat behavior can be summarized as follows: Do to your opponent what he or she
games of more than has just done to you. That is, begin by cooperating and continue to cooperate as long as
one move.
your opponent cooperates. If he betrays you, the next time you betray him back. If he then
Tit-for-tat The best cooperates, the next time you also cooperate. This strategy is retaliatory enough to dis-
strategy in repeated courage noncooperation but forgiving enough to allow a pattern of mutual cooperation to
prisoners’ dilemma develop. In fact, Axelrod found through computer simulated experiments that tit-for-tat is
games, which postulates the best strategy in repeated prisoners’ dilemma games.
“Do to your opponent
For an optimal tit-for-tat strategy, however, certain conditions must be met. First, a
what he or she has just
done to you.”
reasonably stable set of players is required. If the players change frequently, there is little
chance for cooperative behavior to develop. Second, there must be a small number of
players (otherwise, it becomes difficult to keep track of what each is doing). Third, it is
assumed that each firm can quickly detect (and is willing and able to quickly retaliate for)
cheating by other firms. Cheating that goes undetected for a long time encourages cheat-
ing. Fourth, demand and cost conditions must be relatively stable (for if they change
rapidly, it is difficult to define what is cooperative behavior and what is not). Fifth, it must
be assumed that the game is repeated indefinitely, or at least a very large and uncertain
number of times. If the game is played for a finite number of times, each firm has an
incentive not to cooperate in the final period because it cannot be harmed by retaliation.
Each firm knows this and thus will not cooperate on the next-to-the-last move. Indeed, in

4 See R. Axelrod, The Evolution of Cooperation (New York: Basic Books, 1984).
400 PART FOUR Imperfectly Competitive Markets

start cheating, the entire sit-

an effort to gain a competitive advantage by being the first to
uation will unravel and cheating begins from the first move.°
not to cooperate. For
There are, of course, times when a firm finds it advantageous
for not paying its
Concept Check example, if a supplier is near bankruptcy, a firm may find every excuse
were defective or did
Why is tit-for-tat the bills to the near-bankrupt firm (claiming, for example, that supplies
not meet specification) in the hope of avoiding payment altogether if the firm does go
best strategy in
and custome rs in the
repeated games? out of business. It is the necessity to deal with the same suppliers
future and their ability to retaliate for noncooperative behavior that often forces a firm to
cooperate. With a tit-for-tat strategy, however, it is possible for firms to coopera te with-
out actually resorting to collusion. As we will see in the next chapter, this can be a night-
mare for antitrust officials.

12.5 STRATEGIC MOVES

In this section, we examine strategic games involving threats, commitments, credibility,

and entry deterrence. In the next section, we discuss strategic games and international
competitiveness, and in the final section we examine risk in game theory. These concepts
greatly enrich game theory and provide an important element of realism and relevance.

Threats, Commitments, and Credibility

Oligopolistic firms often adopt strategies to gain a competitive advantage over their rivals,
even if it means constraining their own behavior or temporarily reducing their own prof-
its. For example, an oligopolist may threaten to lower its prices if its rivals lower theirs,
even if this means reducing its own profits. This threat can be made credible, for example,
by a written commitment to customers to match any lower price by competitors.
Strategic move A Schelling defined such a strategic move as one that “influences the other person’s choice
player’s strategy of in a manner favorable to one’s self by affecting the other person’s expectations of how
constraining his or her one’s self would behave.”° There must be a commitment that the firm making the threat is
own behavior to make a
ready to carry it out for the threat to be credible.
threat credible so as to
gain a competitive For example, suppose that the payoff matrix of firms A and B is given by Table 12.5.
advantage. This payoff matrix indicates that firm A has the dominant strategy of charging a high

TABLE 12.5 | Payoff Matrix for Pricing Game with a Threat

Firm B

Low Price High Price

Feta Low Price D 2 a 1

SS SS
High Price
Si ree See aE 3ee
ih
ee Selenite es5 =3

> See D. Kreps, P. Milgron, J. Roberts, and R. Wilson, “Rational Cooperation in the
Finitely Repeated
Prisoners’ Dilemma,” Journal of Economic Theory, vol. 27, 1982, pp. 245-252.
® See T. Schelling, The Strategy of Conflict (New York: Oxford University Press,
1960). Another important
volume examining strategic moves is M. Porter, C ompetitive Strategy (New
York: Free Press, 1980).
 CHAPTER 12 Game Theory and Oligopolistic Behavior 401

price. The reason is that if firm B charged a low price, firm A would earn a profit of 2 if it
charged a low price and a profit of 3 if it charged a high price. Similarly, if firm B charged
a high price, firm A would earn a profit of 2 if it charged a low price and a profit of 5 if it
charged a high price. Therefore, firm A charges a high price regardless of what firm B
does. Given that firm A charges a high price, firm B will want to charge a low price
because by doing so it will earn a profit of4 (instead of 3 with a high price). This is shown
by the bottom left cell of Table 12.5. Now firm A can threaten to lower its price and also
charge a low price. However, firm B does not believe this threat (i.e., the threat is not cred-
ible) because by lowering its price firm A would lower its profits from 3 (with a high
price) to 2 with the low price (the top left cell in the table).
Concept Check One way to make its threat credible is for firm A to develop a reputation for carrying
How can a firm make a out its threats, even at the expense of its profits. Although this may seem irrational, if
credible threat against firm A actually carried out its threat several times, it would earn a reputation for making
its competitors? credible threats. This is likely to induce firm B to also charge a high price, which would
possibly lead to higher profits for firm A in the long run. In that case, firm A would earn
a profit of 5 and firm B a profit of 3 (the bottom right cell) as opposed to a profit of 3 for
firm A and 4 for firm B (the bottom left cell). Even if firm B earns a profit of 3 by charg-
ing the high price (as compared with a profit of 4 by charging the low price), the profit is
still higher than the profit of 2 that it would earn if firm A carries out the threat of charging
the low price if firm B does the same (see the top left cell of the table). By showing a com-
mitment to carry out its threats, firm A makes its threats credible and increases its profits
over time. The same result would follow if firm A develops a reputation for being irra-
tional and charging a low price to deter entry into the industry—even if this means lower
profits in the long run.

Entry Deterrence
One important strategy that an oligopolist can use to deter market entry is to threaten to
lower its price and thereby impose a loss on the potential entrant. Such a threat, however,
works only if it is credible. Entry deterrence can be examined with the payoff matrices of
Tables 12.6 and 12.7.
The payoff matrix of Table 12.6 shows that firm A’s threat to lower its price is not
credible and does not discourage firm B from entering the market. The reason is that firm
A earns a profit of 4 if it charges the low price and a profit of 7 if it charges the high price.
Unless firm A makes a credible commitment to fight entry even at the expense of profits,
it would not deter firm B from entering the market. Firm A could make a credible threat
by expanding its capacity before it is needed (i.e., to build excess capacity). The new pay-
off matrix might then look like the one in Table 12.7.

TABLE 12.6,
Aad Payoff Matrix Without Credible Entry Deterrence
Firm B

Enter Don’t Enter

’ Low Price 4,2 6, 0

Poms High Price T52 10, 0
402 PART FOUR Imperfectly Competitive Markets

TABLE 12.7| Payoff Matrix with Credible Entry Deterrence

Firm B

Enter Don’t Enter

res Low Price 4,—2 6, 0

High Price
EE tipee ind SA0PnG 2) 8,0
Aeyell Brak piven rh ele Ree eee ee

The payoff matrix of Table 12.7 is the same as in Table 12.6, except that firm A’s
profits are now lower when it charges a high price because idle or excess capacity
increases firm A’s costs without increasing its sales. On the other hand, in the payoff
matrix of Table 12.7, we assume that charging a low price would allow firm A to increase
sales and utilize its newly built capacity, so that costs and revenues increase leaving firm
A’s profits the same as in Table 12.6 (i.e., the satne as before firm A expanded capacity)’
Building excess capacity in anticipation of future need now becomes a credible threat,
because with excess capacity firm A will charge a low price and earn a profit of4 instead
of a profit of 3 if it charged the high price. By charging a low price now, however, firm
B would incur a loss of 2 if it entered the market, and so firm B would stay out. Entry
deterrence is now credible and effective. An alternative to building excess capacity could
be for firm A to cultivate a reputation for irrationality in deterring entry by charging a
low price even if this means earning lower profits indefinitely.®

EXAMPLE 12-4
Wal-Mart’s Preemptive Expansion Marketing Strategy

Rapid expansion during the 1980s (from 153 stores in 1976 to more than 4,000 in
2007) propelled Wal-Mart, the discount retail-store chain started by Sam Walton in
1969, to become the nation’s (and the world’s) largest and most profitable retailer, at
a time when most other retailers were making razor-thin profits or incurring losses as
a result of stiff competition. How did Wal-Mart do it? By opening retail discount
stores in small towns across America and adopting an everyday low-price strategy.
The conventional wisdom had been that a discount retail outlet required a population
base of at least 100,000 people to be profitable. Sam Walton showed otherwise: By
relying on size, low costs, and high turnover, Wal-Mart earned high profits even in

’ Revenues and profits need not increase exactly by the same amount, so that
profits can change even when firm
A charges a low price. The conclusion would remain the same, however (i.e.,
firm B would be deterred from
entering the market), as long as firm A earns a higher profit with a low price
than with a high price after
Increasing its Capacity.
* For a more detailed analysis of the use of excess capacity to deter entry,
see J. Tirole, The Theory of
Industrial Organization (Cambridge, MA: MIT Press, 1988).
im
 CHAPTER 12 Game Theory and Oligopolistic Behavior 403

towns of only a few thousand people. Since a small town could support only one large
discount store, Wal-Mart did not have to worry about competition from other
national chains (which would drive prices and profit margins down). At the same time,
Concept Check Wal-Mart was able to easily undersell small local specialized stores out of existence
What is Wal-Mart’s (Wal-Mart has been labeled the “Merchant of Death” by local retailers), thereby estab-
marketing strategy? lishing a virtual local retailing monopoly.
The success of Wal-Mart did not go unnoticed by other national discount retailers
such as Kmart and Target, and so a frantic race started to open discount stores in
rural America ahead of the competition. By adopting such an aggressive expansion or
preemptive investment strategy, Wal-Mart continued to expand at breathtaking speed
and to beat the competition most of the time. Sales at Wal-Mart increased from $80 bil-
lion in 1994 to $351 billion in 2006 (thus heading the list of the Fortune 500 compa-
nies). Pricier than Wal-Mart and dowdier than Target, Kmart, instead, filed for
bankruptcy in January 2002 and merged with Sears Roebuck in 2004 to form Kmart
Holdings.
Since 1992, Wal-Mart has also expanded abroad, first in Canada and Mexico
(where it is already the largest retailer) and then in Argentina, Brazil, China, Korea,
Puerto Rico, Germany, England, and Japan. In 2007, Wal-Mart had 2,980 stores
abroad, which generated 20% of its total revenue. Success, however, proved more dif-
ficult abroad (in fact Wal-Mart exited Korea and Germany in 2006) after failing to
adapt to local tastes and achieve economies of scale. European retailers responded by
also consolidating. For example, in fall 1999, French retailers Carrefour and Promedes
merged, creating Europe’s biggest and the world’s second-largest retailer, with annual
sales of $99 billion and operating nearly 15,000 stores (of them 5,500 in France) in 30
countries. Rival retailers are also luring customers away from Wal-Mart in the United
States by offering greater convenience, more selection, and higher quality or better ser-
vice. The Wal-Mart era thus seems to be waning amid big shifts in retailing in the
United States and abroad.
Sources: “Big Discounters Duel Over Hot Market,” Wall Street Journal, August 23, 1995, p. A8; “French
Retailers Create New Wal-Mart Rival,’ Wall Street Journal, August 31, 1999, p. A14; “Wal-Mart Around
the World,” The Economist, December 8, 2001, pp. 55-57; “Kmart Takeover of Sears Is Set,’ New York
Times, November 11, 2004, p. 1; “Wal-Mart,” Forbes, April 12, 2005, pp. 77-85; “Carrefour at the
Crossroad,” The Economist, October 31, 2005, p. 71; and “Wal-Mart Era Wanes Amid Big Shifts in
Retail,” Wall Street Journal, October 3, 2007, p. Al.

12.6 STRATEGIC MOVES AND INTERNATIONAL COMPETITIVENESS

Game theory can also be used to analyze the strategic trade and industrial policies that
a nation could use to gain a competitive advantage over other nations, particularly in the
field of high technology. This is best shown through an example.
Suppose that Boeing (the American commercial aircraft company) and Airbus
Industrie (a consortium of German, French, English, and Spanish companies) are both
deciding whether to produce a new aircraft. Suppose also that because of the huge cost
of developing the new aircraft, a single producer would have to have the entire world
404 PART FOUR Imperfectly Competitive Markets

EA Two-Firm Competition and Strategic Trade Policy

TABLE 12.8
Airbus

Produce Don’t Produce

Produce —10, —10 100, 0

.
Bone Don’t Produce 0, 100 0,0
eee SS eee
ee EE

market for itself to earn a profit, say of $100 million. If both firms produce the aircraft,
each loses $10 million. This information is shown in Table 12.8. The case in which both
firms produce the aircraft and each incurs a loss of $10 million is shown in the top left cell
of the table. If only Boeing produces the aircraft, Boeing makes a profit of $100 million
while Airbus makes a zero profit (the top right cell of the table). On the other hand, if
Boeing does not produce the aircraft while Airbus does, Boeing makes zero profit while
Airbus makes a profit of $100 million (the bottom left cell). Finally, if neither firm
produces the aircraft, each makes a zero profit (the bottom right cell).
Suppose that for whatever reason, Boeing enters the market first and earns a profit of
$100 million (we might call this the first-mover advantage). Airbus is now locked out of
the market because it could not earn a profit. This is the case shown in the top right cell of
the table. If Airbus entered the market, both firms would incur a loss (and we would have
the case shown in the top left column of the table). Suppose now that European govern-
ments give a subsidy of $15 million per year to Airbus. Airbus would then produce the air-
craft even though Boeing is already producing the aircraft, because with the $15 million
subsidy, Airbus would turn a loss of $10 million into a profit of $5 million. Without a sub-
sidy, however, Boeing will go from making a profit of $100 million (without Airbus in the
market) to incurring a loss of $10 million afterwards (we are still in the top left corner of
the table, but with the Airbus entry changed from —10 without the subsidy to +5 with the
subsidy). Because of its unsubsidized loss, Boeing will stop producing the aircraft,
thereby leaving the entire market to Airbus, which will then make a profit of $100 million
without any further subsidy (the bottom left cell of the table).”
The U.S. government could, of course, retaliate with a subsidy of its own to keep
Boeing producing the aircraft. Except in cases of national defense, however, the U.S. goy-
ernment is much less disposed to grant subsidies to firms than European governments.
Although the real world is certainly much more complex than this example, we can see
how a nation could overcome a market disadvantage and acquire a strategic comparative
advantage in a high-tech field by means of an industrial and strategic trade policy.
One serious shortcoming of the above analysis is that it is usually very difficult to
accurately forecast the outcome of government industrial and trade policies (i.e., get the
data to fill a table such as Table 12.8). Even a small change in the table could completely
change the results. For example, suppose that if both Airbus and Boeing produce the air-
craft, Airbus incurs a loss of $10 million (as before) but Boeing makes a profit of
$10 mil-
lion (without any subsidy), say, because of superior technology. Then, even
if Airbus

? This type of analysis was first introduced into international trade by J. Brander
and B. Spencer. See their
International R & D Rivalry and Industrial Strategy,” Review of Economic
Studies, October 1983, pp. 707-722.
See also M. Porter, The Competitive Advantage ofNations (New York: The
Free Press, 1990).
 CHAPTER 12 Game Theory and Oligopolistic Behavior 405

produces the aircraft with the subsidy, Boeing will remain in the market because it is able
to earn a profit without any subsidy. Then, Airbus would require a subsidy indefinitely,
year after year, in order to continue to produce the aircraft. In this case, giving a subsidy
to Airbus does not seem to be such a good idea.!° Thus, it is extremely difficult to carry
out this type of analysis in the real world (see Example 12-5). Getting the analysis wrong,
however, can be very harmful and may even result in the firm’s failure (see Example 12-6).
This is the reason that most U.S. economists today are against industrial policy and still
regard free trade as the best policy for the United States.!!
Airbus did decide in 2000 to build its super-jumbo A380 capable of transporting
550 passengers originally scheduled to be ready by 2006 at a cost of over $10 billion, and
thus compete head-on with the Boeing 747 (which has been in service since 1969 and can
carry up to 475 passengers). Boeing greeted Airbus’ decisions to build its A380 by
announcing in 2001 plans to build a new “sonic cruiser” jet that can transport, non-stop,
up to 300 passengers to any point on earth at close to the speed of sound. Boeing believes
that passengers prefer arriving at their destinations sooner and avoid congested hubs and
the hassle and delays of intermediate stops. It remains to be seen as to which strategy
turns out to be the winning or best one.!”

EXAMPLE 12-5.
Strategic Moves and Countermoves by Airbus and Boeing

In 2000, Airbus decided to build its super-jumbo A380, capable of transporting

550-800 passengers, and to be ready by 2006, at a development cost of nearly $10
billion, and thus compete head-on with the Boeing 747 (which has been in service
since 1969 and can carry up to 475 passengers). Boeing greeted Airbus’ decisions to
build its A380 by announcing in 2001 plans to build the new 787 Dreamliner, which
can transport, nonstop, up to 300 passengers to any point on earth at close to the speed
of sound. Boeing believes that passengers prefer arriving at their destinations sooner
and avoiding congested hubs and the hassle and delays of intermediate stops.
Nevertheless, Boeing announced in 2005 a stretched-out version of its 747 (the 747-8)
to compete better with the new A380. Airbus responded with the development of the
Airbus 350 to compete with the new Boeing 787.
The first delivery of the A380 was made in fall 2007 (with more than one year’s
delay and at a development cost of nearly $20 billion, or nearly twice what had been
Concept Check originally estimated), while deliveries of the 787 Dreamliner started in 2008. It
What strategic moves
remains to be seen which strategy turns out to be the winning or best one. The Boeing
has Airbus made in
trying to gain a
787 is already a smashing success (it is likely to be the most successful aircraft ever
competitive advantage built), and the A380 is also likely to be a success. Thus it seems that both were win-
over Boeing? ning strategies. The attempt by Boeing to put more life into the 747 by building the

10 See “A Paper Dart Against Boeing,” The Economist, June 11, 1994, pp. 61-62.
11 “Remember Clinton’s Industrial Policy? O.K. Now Forget It,” Business Week, December 12, 1994, p. 53;
and P. Krugman, “Is Free Trade Passé?,” Journal of Economic Perspectives, Fall 1987, pp. 131-144.
12 “The Birth of Giant,” Business Week, July 10, 2000, pp. 170-176 and “Boeing Opts to Build New Class
of “Sonic Cruiser” Jet,’ Financial Times, March 30, 2001, p. 1.
406 PART FOUR Imperfectly Competitive Markets

and the A350 will not come into

new 747-8 version will be no match for the A380,
heoretic moves and counter-
service for several years, but they do show the game-t
moves in the world’s most famous duopoly.
pp. 170-176; “Boeing Opts to Build New
Sources: “The Birth of Giant,” Business Week, July 10, 2000,
2001, p. 1; D. A. Irwin and N. Pavenik,
Class of ‘Sonic Cruiser’ Jet,’ Financial Times, March 30,
Market,” Journal of
“Airbus versus Boeing Revisited: International Competition in the Aircraft
for Boeing with 747 Advanced,’
International Economics, December 2004, pp. 223-245; “Headway
in a Challenge to Boeing,”
Financial Times, July 21, 2005, p. 18; “Airbus Offers Up Redesigned A350
Economist, October 13,
New York Times, July 18, 2006, p. C1; and “The Giant on the Runway,” The
2007, pp. 79-82.

EXAMPLE 12-6 _
Companies’ Strategic Mistakes and Failures

Nearly 100,000 businesses failed in the United States during 1992 (a recession year)
as compared with only about 35,000 in 2000 (the last year of the boom of the 1990s)
and nearly 40,000 in 2001 (a recession year). Although the reasons businesses fail are
many and the details differ from case to case, several general underlying causes can be
identified. First, many business failures arise because senior executives do not fully
understand the fundamentals of their business or core expertise and business of the
firm. Then the company drifts (often through mergers and acquisitions) into lines of
business about which it knows little. This, for example, happened to Kodak when it
diversified from its core camera and film business into pharmaceuticals and consumer
health products during the 1990s.
The second basic reason for business failures is lack of vision or the inability of
top management to anticipate or foresee serious problems that the business may face
down the road. For example, U.S. automakers (General Motors, Ford, and Chrysler)
failed to understand early enough the seriousness of the competitive challenge com-
ing from Japan and almost willingly ceded the small-car market to Japan (because of
the low profits per car earned in that market) during the 1970s in the erroneous belief
that Japan would never be able to compete effectively in the medium-range segment
of the market (where profit per automobile was much higher and American automak-
ers were stronger). This resulted in huge losses for American automakers during the
second half of the 1980s and early 1990s and almost drove Chrysler out of business
(this is examined in Example 13-6). Another example is provided by Sears, which
was unable or unwilling to understand the kind of change going on in consumer pret-
erences, and this eventually propelled Wal-Mart to replace it as the nation’s top mar-
keteer. Most dangerous are latent or stealthy competitors, who as a result of some
major and quick technological or market change can devastate the firm in its very core
business. A clear example of this is IBM’s inability to recognize early enough the
importance and dramatic growth of the PC market in the mid-1980s and subsequent
signing of Microsoft to develop the software and Intel to supply the chips for its PCs.
A third reason for business failures is the loading of the firm with a heavy debt
burden (usually to carry out a program of merger and acquisitions, often at overpriced
 CHAPTER 12 Game Theory and Oligopolistic Behavior 407

terms) which then robs the firm of its strength in a market downturn. This is precisely
what happened (together with greed, deceit, and financial chicanery) to Enron (one of
the world’s largest energy traders), which filed the largest U.S. claim for bankruptcy in
December 2001 (exceeded by WorldCom bankruptcy in July 2002).
Fourth, business failures arise when firms vainly try to recapture their past glo-
ries and become stuck on an obsolete strategy and are unable to respond to new and
major competitive challenges. This is, to some extent, what happened to General
Motors and IBM during the past decade before the brutal forces of the market shook
them out of their complacency. It is often more difficult to keep a business great
than to build it in the first place. Finally, a company may fail as a result of strikes
and hostilities from unhappy workers.
Sources: “Dinosaurs?,” Fortune, May 3, 1994, pp. 36-42; “Why Companies Fail,” Fortune, November
14, 1994, pp. 52-68; “How Good Companies Go Bad,” Harvard Business Review, July-August 1999,
pp. 42-52; “Why Enron Went Bust,” Fortune, December 24, 2001, pp. 58-68; “WorldCom Files for
Bankruptcy: Largest U.S. Case,” New York Times, July 22, 2002, p. 1; “Why Companies Fail,” Business
Week, May 22, 2002, pp. 50-62; and “Mapping Your Competitive Position,’ Harvard Business Review,
November 2007, pp. 110-120.

AT THE FRONTIER
The Virtual Corporation

T oday’s joint ventures and strategic alliances provide a glimpse of the virtual
Virtual corporation—the firm of the future. A virtual corporation is a temporary net-
corporation A work of independent companies (suppliers, customers, and even rivals) coming
temporary network together, with each contributing its core competence to quickly take advantage of
of independent fast-changing opportunities. In today’s world of fierce global competition, this win-
companies coming
dow of opportunity is often so frustratingly brief that it is impossible for a single firm
together, with each
contributing its
to have all the in-house expertise to quickly launch complex products in diverse mar-
core technology kets. By acting strategically and temporarily banding together to take advantage of a
to quickly take specific market opportunity, and with each company bringing its speciality, the vir-
advantage of tual firm is a “best-of-everything organization.” Informational networks and elec-
fast-changing tronic contracts will permit unusual partners to work together on a particular project
opportunities. and then disband when the opportunity has been fully exploited.
In a virtual firm, one of the partners may have the idea for a new product,
another may design the product, another may produce it, and still another market
it. For example, IBM, Apple Computer, and Motorola have come together to
develop a new operating system and computer chip for a new generation of com-
puters. MCI Communications entered into partnerships with as many as 100 com-
panies to provide a one-stop package of telecommunications hardware and services
based on MCI competencies in network integration and software development,
with the strength of other companies making all kinds of telecommunications
equipment before it was acquired by Verizon in 2005S.
Continued...
408 PART FOUR Imperfectly Competitive Markets

The Virtual Corporation Continued

the virtual cor-
Although power, flexibility, and quickness are crucial advantages,
joining such a network may
poration model does face two real risks. First, a company
lose control of its core technology. Second, by abandoning manufact uring, the company
may become “hollow” and become unable to resume the manufact uring of its tradi-
tional product in the future when the network dissolves. Some observer s point out that
IBM’s desire to quickly enter the personal computer (PC) market in 1981 by relying on
Intel for computer chips and Microsoft for the operating software left IBM without con-
trol of the market and encouraged hundreds of clone makers to eventually enter the mar-
ket with lower prices and better products.
Thus, not everyone is sold on the virtual firm model. In order to work, the virtual
firm (1) will have to be formed by partners that are dependable and are the best in
their field, (2) the network must serve the interests of all partners in a win-win situa-
tion, (3) each company must put its best and brightest people in the network to show
its partners that its link with them is important to the company, (4) the objective of
the network must be clearly defined as well as what each partner is expected to gain,
and (5) the network must build a common telecommunications network and other
infrastructures so that each partner can be in constant touch with the other partners to
anticipate problems and review progress. Creating and successfully operating a vir-
tual firm is not easy, but it may very well be the strategic way of the future.

Sources: “The Virtual Firm,” Business Week, February 8, 1993, pp. 98-102; “The Art of Managing Virtual
Teams: Eight Key Lessons.” Harvard Business Review, November 1998, pp. 4-5; H. Hammer, “The
Superefficient Company,” Harvard Business Review, September 2001, pp. 82-91; and J. Hughes and J. Weiss,
“Simple Rules for Making Alliances Work,” Harvard Business Review, November 2007, pp. 122-132.

| ~ | SUMMARY
1. Game theory is concerned with the choice of an optimal strategy in conflict situations.
Every game theory model includes players, strategies, and payoffs. The players are the
decision makers (here, the managers of oligopolist firms) whose behavior we are trying
to explain and predict. The strategies are the potential choices that can be made by the
players (firms). The payoff is the outcome or consequence of each combination of strategies
by the two players. The payoff matrix refers to all the outcomes of the players’ strategies.
A zero-sum game is one in which the gains or losses of one player equal the losses or
gains of the other.
2. The dominant strategy is the optimal choice for a player, no matter what the Opponent does.
The Nash equilibrium occurs when each player has chosen his or her optimal strategy, given
the strategy chosen by the other player. The Cournot solution is an
example of a Nash equilibrium. Not all games have a Nash equilibrium and some
games have more than one.
3k Oligopolistic firms often face a problem called the prisoners’ dilemma. This
refers to a situation
in which each firm adopts its dominant strategy but could do better (i.e., earn larger
profit) by
cooperating. Oligopolistic firms deciding on their pricing or advertising strategy
or on whether
to cheat on a cartel face the prisoners’ dilemma.
 CHAPTER 12 Game Theory and Oligopolistic Behavior 409

4. The best strategy for repeated or multiple-move prisoners’ dilemma games is tit-for-tat. This
strategy postulates that each firm should start by cooperating and continue to do so as long as
the rival cooperates, but stop cooperating once the rival stops cooperating.
. Oligopolists often make strategic moves. A strategic move is one in which a player
constrains its own behavior in order to make a threat credible so as to gain a competitive
advantage over a rival. The firm making the threat must be committed to carrying it out
for the threat to be credible. This may involve accepting lower profits or building excess
capacity.
. Just like firms, nations can make strategic moves, such as subsidizing and providing
export subsidies to a high-tech industry or adopting an industrial policy for the entire
nation, to gain a competitive advantage over other nations. Industrial policies lead to waste
if industries that are subsidized or otherwise supported do not become internationally
competitive. Similarly, not knowing the exact payoff or outcome of the strategic moves
open to it greatly complicates the development and conduct of business strategy by the firm.
The virtual corporation is a temporary network of independent companies coming together
with each contributing its core technology to quickly take advantage of fast-changing
opportunities.

KEY TERMS
Game theory Zero-sum game Repeated games
Players Nonzero-sum game Tit-for-tat
Strategies Dominant strategy Strategic move
Payoff Nash equilibrium Virtual corporation
Payoff matrix Prisoners’ dilemma

REVIEW QUESTIONS
I. In what way does game theory extend the analysis of 8. a. What is the incentive for the members of a cartel to
oligopolistic behavior presented in Chapter 11? cheat on the cartel?
. a. Can game theory be used only for oligopolistic b. What can the cartel do to prevent cheating?
interdependence? c. Under what conditions is a cartel more likely
b. In what way is game theory similar to playing chess? to collapse?
. Do we have a Nash equilibrium when each firm chooses 9. Do the duopolists in a Cournot equilibrium face a
its dominant strategy? prisoners’ dilemma? Explain.
_ a. Why is the Cournot equilibrium a Nash equilibrium? 10. How did the 1971 law banning cigarette advertising on
b. In what way does the Cournot equilibrium differ from television solve the prisoners’ dilemma for cigarette
the Nash equilibrium given in Table 12.2? producers?

. In what way is the prisoners’ dilemma related to the 11. a. What is the meaning of “tit-for-tat” in game theory?
choice of dominant strategies by the players in a game b. What conditions are usually required for
- and to the concept of Nash equilibrium? tit-for-tat strategy to be the best strategy?
. How can the concept of the prisoners’ dilemma be used to 12. a. How is a strategic move differentiated from a Nash
analyze price competition? equilibrium?
. How can introducing yearly style changes lead to a b. What is a credible threat? When is a threat not
prisoners’ dilemma for automakers? credible?
410 PART FOUR Imperfectly Competitive Markets

PROBLEMS
12.2.
1. From the following payoff matrix, where the payoffs are *4, Provide a hypothetical payoff matrix for Example
the profits or losses of the two firms, determine 5. From the following payoff matrix, where the payoffs (the
a. whether firm A has a dominant negative values) are the years of possible imprisonment
strategy. for individuals A and B, determine
b. whether firm B has a dominant a. whether individual A has a dominant strategy.
strategy. b. whether individual B has a dominant strategy.
c. the optimal strategy for each firm. c. the optimal strategy for each individual.
d. Do individuals A and B face a prisoners’
Firm B dilemma?

Low High Individual B

Price Price
Don’t
: Low Price Il. 3,-1 Confess Confess
ee HighPrice —1,3 20)
ok Confess —5,—5 —1,-—10
ATE NORE NW Don’t Confess —10, —1 —2, —2
2. From the following payoff matrix, where the payoffs are
the profits or losses of the two firms, determine
6. Explain why the payoff matrix in Problem | indicates
a. whether firm A has a dominant strategy.
that firms A and B face the prisoners’ dilemma.
b. whether firm B has a dominant strategy.
7. Do firms A and B in Problem 2 face the prisoners’
c. the optimal strategy for each firm.
dilemma? Why?
d. the Nash equilibrium, if there is one.
*8. From the following payoff matrix, where the payoffs refer
to the profits that firms A and B earn by cheating and not
Firm B cheating in a cartel,
Low High a. determine whether firms A and B face the prisoners’
Price Price dilemma.
b. What would happen if we changed the payoff in the
5 Low Price il. I 3, -1 bottom left cell to (5, 5)?
ees High Price =—1,3 4,2
Firm B
*3. From the following payoff matrix, where the payoffs are
Don’t
the profits or losses of the two firms, determine
Cheat Cheat
a. whether firm A has a dominant strategy.
b. whether firm B has a dominant strategy. , Cheat 43 8, 1
Firm A ?
c. the optimal strategy for each firm.
ae Don’t Cheat 2,6 6,5
d. the Nash equilibrium.
e. Under what conditions is the situation indicated in *9. Starting with the payoff matrix of Problem 1, show
the payoff matrix likely to occur? what the tit-for-tat strategy would be for the first
five of an infinite number of games if firm A starts by
Firm B cooperating but firm B does not cooperate in the next
period.
Small Large
Cars Cars 10. Given the following payoff matrix
a. indicate the best strategy for each firm.
Bones Small Cars 4,4 —2,-2 b. Why is the entry-deterrent threat by firm A to
Large Cars —2, —2 4,4 lower price not credible to firm B?

* = Answer provided at end of book.

 CHAPTER 12 Game Theory and Oligopolistic Behavior 411

c. What could firm A do to make its threat credible 11. Show how the payoff matrix in the table of Problem 10
without building excess capacity? might change for firm A to make a credible threat to
lower price by building excess capacity to deter firm B
from entering the market.
Firm B 12. What strategic industrial or trade policy would be
required (if any) in the United States and in Europe
Don’t if the entries in the top left cell of the payoff matrix in
Enter Enter Table 12.8 were changed to
a. 10, 10?
fous Low Price 3,-1 3, il
High Price 4,5 6, 3

|
_|_INTERNET SITE ADDRESSES
For an excellent presentation of game theory, see: http://www.iht.com/articles/2007/04/02/business/place.php
http://www.gametheory.net/news/concept.pl http://www. leeham.net/filelib/091007CAR.pdf
For the Fortune Global 500 companies, see: For competition in the commercial-aircraft industry, see:
http://fortune.com/global500 http://raven.stern.nyu.edu/networks/5.html
For competition in the computer industry, see: Lockheed Martin: http://www.lockheedmartin.com
http://www. iht.com/articles/2007/04/19/news/ Boeing: http://www.boeing.com
dell.php Airbus: http://www.airbus.com
Apple: http://www.apple.com You can play an interactive online prisoners’ dilemma
Dell: http://www.dell.com game at:
Hewlett-Packard: http://www.hp.com http://www. princeton.edu/~mdaniels/PD/PD.html
IBM: http://www.ibm.com For competition in retailing by Wal-Mart, see:
For competition in the airline industry, see: http://investor.walmartstores.com/
http://www. airlines.org/economics/finance/ phoenix.zhtml?c=112761 &p=irol-irhome
Annual+US+Financial+Results.htm http://retailtrafficmag.com/retailing/retail_walmarts_woes/
http://www.airlines.org/economics/review_ Data on business failures are found at:
and_outlook/annual+reports.htm http://www.BankruptcyData.com
 CHAPTER 13

Market Structure, Efficiency,

and Regulation
Chapter Outline List of Examples
13.1 Market Structure and Efficiency At the Frontier: Functioning of Markets and
13.2 Measuring Monopoly Power Experimental Economics
13.3 Social Costs and Dynamic Benefits of 13-1 Antitrust Policy in Action—The Breakup of
Monopoly Power AT&T and the Creation of Competition in
13.4 Controlling Monopoly Power: Antitrust Long-Distance Telephone Service
Policy 13-2 Regulation and the Price of International
13.5 Public-Utility Regulation Telephone Calls in Europe
13.6 The Deregulation Movement 13-3 Regulated Electricity Rates for Con Edison
13.7. Regulating International Competition: 13-4 Deregulation of the Airline Industry: An
Voluntary Export Restraints Assessment
13.8 Some Applications of Market Structure, 13-5 Antitrust and the New Merger Boom
Efficiency, and Regulation 13-6 Voluntary Restraints on Export of Japanese
Automobiles to the United States

After Studying This Chapter, You Should Be Able to:

e Know why inefficiencies and social costs arise in imperfect markets
e Know how monopoly power is measured
e Describe the aim and effect of antitrust policy
e Know why public utilities are regulated
e Describe the reasons for and the effect of the deregulation movement

D eople of the same trade seldom meet together, even for merriment and diversion,
but the conversation ends in a conspiracy against the public, or in some con-
trivance to raise prices.”! This is one of the most famous quotations in economics,
and it is as relevant today as two-and-a-quarter centuries ago when it was written.
It
explains in a nutshell why we are so interested in market structure, efficiency, antitrust,
and regulation. In this chapter, we examine the relationship between these elements.

' A. Smith, The Wealth of Nations (Toronto: Random House, 1937), p. 128.

412
 CHAPTER 13 Market Structure, Efficiency, and Regulation 413

We begin by reviewing why inefficiency and social costs arise in imperfect markets. We
then consider how to measure market imperfections and ways to minimize, prevent, or
overcome (through antitrust and regulation) the most serious social costs that arise from
these market imperfections. The examples and applications in the chapter show the
importance of the theory and its uses, while the “At the Frontier” section examines the rel-
atively new field of experimental economics.

131 MARKET STRUCTURE AND EFFICIENCY

Economic efficiency The concept and measure of efficiency, as well as the need for antitrust and regulation,
The situation where the is based on marginal analysis. Specifically, we have seen in previous chapters that the
price of a commodity
best level of output for a firm under any form of market organization (be it perfect
equals the marginal
competition, monopoly, monopolistic competition, or oligopoly) is where marginal
cost of producing it.
revenue equals marginal cost. If marginal revenue exceeds marginal cost, it pays for
the firm to expand output because by doing so the firm will add more to its total rev-
enue than to its total costs. On the other hand, if marginal cost exceeds marginal rev-
enue, it pays for the firm to reduce output because by doing so its total costs will
decline more than its total revenue. Thus, the best level of output is where marginal
revenue equals marginal cost.
Chapter 9 showed that a perfectly competitive firm faces an infinitely elastic demand
curve and so price equals marginal revenue. Thus, at the best level of output, P = MR =
MC. Since price measures the marginal benefit that consumers receive for the last unit of
the commodity consumed at the output where MR = MC, the marginal benefit to con-
sumers equals the marginal cost to producers under perfect competition. If less of the
commodity is produced, P = MR > MC, so that consumers’ satisfaction would increase
if firms produced more of the commodity. On the other hand, if more of the commodity is
produced, P = MR < MC. This means that consumers would benefit if some inputs were
shifted to the production of some other commodity. Thus, application of the P= MR =
MC tule by the firm leads to the highest consumer satisfaction when all markets are per-
fectly competitive. As pointed out in Figure 9.9, in long-run perfectly competitive equili-
brium, consumers can purchase the commodity at the lowest possible price (1.e., at
P = lowest LAC).
In imperfectly competitive markets (monopoly, monopolistic competition, and oli-
gopoly), however, the firm faces a negatively sloped demand curve, and so price exceeds
marginal revenue. Thus, at the best level of output P > MR = MC. This means that the
marginal benefit to consumers from the last unit of the commodity consumed exceeds the
marginal cost that the firm incurs in producing it. Consumers want more of the commod-
ity than is available, but producers have no incentive to produce more. As a result, con-
sumers’ satisfaction is not maximized. Furthermore, imperfect competitors do not
usually produce at the lowest point on their LAC curve when in long-run equilibrium,
and (except for monopolistic competitors) the price that they charge for the commodity
may also include a profit margin. The social cost resulting when a constant-cost per-
fectly competitive industry is suddenly monopolized was shown in Figure 10.7. In the
real world, we seldom if ever have (unregulated) monopoly, but firms in various indus-
tries have various degrees of monopoly power. Thus, it becomes important to examine
ways to measure the degree of monopoly power in order to assess the social costs result-
ing from it. This topic is explored in Section 13.2. Section 13.3 then compares the social
costs with the alleged dynamic benefits of monopoly power.
414 PART FOUR Imperfectly Competitive Markets

TABLE 13.1| Comparison of Market Structures

Firm's
Number Type of Conditions Influence Interdependence
Type of
Product of Entry Over Price Among Firms Examples
Market of Firms

Homogeneous Easy None None Some agricultural

Perfect Many
products and
competition
stock market
Many Differentiated Easy Little None Some retail trade
Monopolistic
and services
competition
Oligopoly Few Homogeneous Difficult Considerable A great deal Steels
or differentiated automobiles
Monopoly One No good Difficult or Substantial No direct Local telephone
substitutes impossible competitor service before
: deregulation
ot Daren oo wih od ashen janie hee a

In many industries, however, technological conditions require such a large scale of

Concept Check production (to take advantage of economies of scale) that only one firm (natural monop-
Why is perfect oly) or a handful of firms (oligopoly) arise. For example, it would be inconceivable and
competition not highly inefficient to have numerous small producers of automobiles, steel, aircraft, and
feasible in many many other products. In the case of oligopolies, the government usually relies on the
markets? enforcement of antitrust laws aimed at attaining some degree of workable competition.
This is examined in Section 13.4. In the case of natural monopoly, on the other hand,
the single firm is usually allowed to operate, but with the government regulating the
price and the quality of service. This is examined in Section 13.5. The rest of the chap-
ter deals with the deregulation movement, the regulation of international competition,
and price regulation. Table 13.1 summarizes and compares the various types of market
structure that we have examined in previous chapters, from perfect competition to
monopoly.

ie.2 MEASURING MONOPOLY POWER

In this section, we first define the Lerner index as a measure of the degree of a firm’s monop-
oly power and the Herfindahl index as a measure of the degree of monopoly power in an
industry. We then discuss how effective competition can occur even when there are only a
few firms, according to the contestable market theory.

Lerner index A The Lerner Index as a Measure of Monopoly Power

measure of the degree We have seen in Chapter 9 that P= MR = MC fora perfectly competitive firm but P >
of a firm’s monopoly
MR = MC for an imperfectly competitive firm (i.e., for a monopolistic competitor, oli-
power, which is given
gopolist, or monopolist). The greater the degree of monopoly power that a firm has,
by the ratio of the the
difference between more inelastic is the demand curve for the product that it faces, and so the larger
is the
price and marginal degree by which the commodity price exceeds the firm’s marginal revenue and
marginal
cost to price. cost. Thus, one way of measuring monopoly power is by the Lerner index.
This is given
 CHAPTER 13. Market Structure, Efficiency, and Regulation 415

by the ratio of the difference between price and marginal cost to price, as shown by
formula [13.1]:?
P—MC
i= a ise.
The Lerner index can have a value between zero and 1. For a perfectly competitive firm,
P = MC and L = 0. On the other hand, the more price exceeds marginal cost (i.e., the
greater the degree of monopoly power), the more the value of L approaches the value of 1.
The Lerner index can also be expressed in terms of the price elasticity of the demand
curve facing the firm. We can see this as follows. Since at the best level of output MR =
MC, we can substitute MR for MC in equation [13.1]. But from equation [5.8], we know
that MR = P(1 + 1/n), where 7 is the price elasticity of demand. Substituting this value of
MR for MC in [13.1], we get

pin [De AAO MEINE

P

Simplifying, we get

L=-1/n [1322]
For a perfectly competitive firm, 7 = oo and L = 0. The fewer and the more imper-
fect are the substitutes available for the firm’s product (i.e., the smaller is the absolute value
OL ij), sine Jarset is thesvaluesor J. For example, ifs7—= —4, = 0.25, bute if
1 = —2, L = 0.5.9 Note that a high value for L (implying a great deal of monopoly power)
is not necessarily associated with high profits for the firm, because profits refer to the
excess of price over average cost, and average costs can be high or low in relation to the
commodity price at the output level where MR = MC (see Problem 2, with the answer at
the end of the book).
Some difficulties may arise, however, in using the Lerner index. For example, a firm
with a great deal of monopoly power may keep its price low to avoid legal scrutiny or to
deter entry into the industry (limit pricing). Furthermore, the Lerner index is applicable in
a static context, but it is not very useful in a dynamic context when the firm’s demand and
cost functions shift over time.

Concentration and Monopoly Power: The Herfindahl Index

One method of estimating the degree of monopoly power in an industry as a whole 1s by
Herfindahl index A the Herfindahl index (named after Orris Herfindahl, who introduced it). This is given by
measure of the degree the sum of the squared values of the market sales shares of all the firms in the industry, as
of monopoly power in shown by
an industry, which is
given by the sum of the S=Si+ So 42.- Sh [13.3]
squared values of the
market sales shares of where S| is the market sales share of the largest firm in the industry, S> is the market sales
all the firms in the share of the second largest firm in the industry, and so on, in such a way that the sum of the
industry. market sales shares of all firms in the industry totals 1 or 100%. In general, the greater the
value of the Herfindahl index, the greater the degree of monopoly power in the industry.

2 A. P. Lerner, “The Concept of Monopoly and the Measurement of Monopoly Power,” Review of Economic
Studies, June 1934, pp. 157-175.
3 1f 1 = —1, then L = 1. This is the highest value for L because an imperfect competitor never produces in the
inelastic portion of its demand curve (where MR < 0).
416 PART FOUR Imperfectly Competitive Markets

that its mar-

For example, if we have a monopoly or a single firm in the industry, so
1,000 equal-sized
ket share is 100%, H = (100)* = 10,000. On the other hand, if there are
)° — ohh}
firms in the (competitive) industry, each with 0.1% of the market, H = 1,000(0.1
If there are 100 equal-sized firms in the (still competit ive) industry, each with 1% of the
market, H = 100. For an industry with 10 equal-siz ed firms, each with 10% market share,
H = 1,000. But for an industry with 11 firms, one with 50% market share and the other
10 firms with 5% market share each, H = 2,750. This points to the advantage of the
Herfindahl index over the concentration ratios discussed in Section 11.3. The Herfindahl
index uses. all the information and takes into account the size distribution of firms.
Specifically, by squaring the market share of each firm, the Herfindahl index gives much
more weight to larger firms in the industry than to smaller firms.
The Herfindahl index has become of great practical importance since 1982 when the
Justice Department announced new guidelines (revised in 1984) for evaluating proposed
mergers based on this index. According to these guidelines, if the postmerger Herfindahl
index is 1,000 or less, the industry is regarded as relatively unconcentrated and a merger
is unchallenged. On the other hand, an industry where the postmerger Herfindahl index is
greater than 1,800 is regarded as highly concentrated and a merger is likely to be chal-
lenged (the full set of guidelines is given in Section 13.4). Table 13.2 shows the
Herfindahl index (for the 50 largest firms rather than for all firms) in each of a selected
number of industries in the United States in 2002. The table shows that for some indus-
tries, such as food and paper, the Herfindahl index is very low; for others, such as motor
vehicles, the index is very high.
As with concentration ratios, however, the Hertindahl index must be used with cau-
tion. First, in industries where imports are significant (such as automobiles), the Herfindahl
index greatly overestimates the relative importance of concentration in the domestic
industry. Indeed, Raymond Vernon found that the Herfindahl index for the world
automobiles, petroleum, aluminum-smelting, and pulp-and-paper industries declined
sharply from 1950 to 1970, pointing to sharply increased international competition at

Herfindahl Index for Selected U.S. Industries

mn 2002)

Industry Index"
Food
101.1
Paper 25913
Footwear 408.9
Pharmaceutical and medicines 506.0
Audio and video equipment
649.9
Sugar
855.5
Computer and peripheral equipment
1,183.3
Telephone apparatus
1,398.5
Tires
1,630.9
Motor vehicles
DSS
Breakfast cereals
PSDs
“Index refers only to the largest 50 firms in each
industry.
ee
Ee
Source: U.S. Bureau of Census, 2002 Census of manufacturers, Concentrat
ion Ratios in Manufacturing
(Washington, DC: U.S. Government Printing Office, May 2006), Table
2, pp. 2-66.
 CHAPTER 13 Market Structure, Efficiency, and Regulation 417

home.* Second, the Herfindahl index for the nation as a whole may not be relevant when the
market is local (as in the case of cement where transportation costs are very high). Third,
how broadly or narrowly a product is defined is also very important. Fourth, the Herfindahl
index does not give any indication of potential entrants into the market and of the degree of
actual and potential competition in the industry. Indeed, as the theory of contestable markets
discussed next shows, vigorous competition can take place even among few sellers.

Contestable Markets: Effective Competition Even with Few Firms

Theory of contestable According to the theory of contestable markets developed during the 1980s, even if an
markets Postulates industry has a single firm (monopoly) or only a few firms (oligopoly), the industry would
that even if an industry
still operate as if it were perfectly competitive if entry is “absolutely free” (i.e., if other
has only one or a few
firms can enter the industry and face exactly the same costs as existing firms) and if exit
firms, it would still
operate as if it were is “entirely costless” (i.e., if there are no sunk costs so that the firm can exit the industry
perfectly competitive if without facing any loss of capital).> An example might be an airline that establishes a ser-
entry into the industry vice between two cities already served by other airlines—if the new entrant faces the
is absolutely free and if same costs as existing airlines and could subsequently leave the market by simply reas-
exit is entirely costless. signing its planes to other routes without incurring any loss of capital.
When entry is absolutely free and exit is entirely costless, the market is contestable.
Firms will then operate as if they were perfectly competitive and sell at a price that only
covers their average costs (so that they earn zero economic profit) even if there is only one
firm or a few firms in the market. In this view, competition within the market is less
important than the potential competition for the market. This can be seen in Figure 13.1.
In Figure 13.1, D is the market demand curve, and AC and MC are the average and
marginal cost curves, respectively, of each of two identical firms in the market. If the
market is contestable (i.e., if entry is absolutely free and exit is entirely costless), each
firm will sell 60 units of output at P = AC = MC = $6 (point E in the figure) and behave
as a perfect competitor facing horizontal demand curve AEE’ and earn zero economic
Concept Check
profits. The duopolists will not collude to charge a higher price and earn profits because
How can we foster
effective competition they know that other firms would quickly enter the market and sell at a slightly lower
in a market with few price. This would lower price to equal marginal cost at the lowest average cost and quickly
firms? eliminate all profits. This is true whether the potential entrants are domestic or foreign.
The theory of contestable markets is similar to limit pricing (discussed in Section 11.7).
With limit pricing, a firm charges a lower-than-the-profit-maximizing price to discourage
potential entrants into the market. But whereas profits can still be earned with limit pricing
(even though they are not maximized because the market is not entirely contestable), eco-
nomic profits are zero in a contestable market because entry is absolutely free and exit is
entirely costless. Even purely transitory profits will not be disregarded but result in entry-exit
or hit-and-run behavior on the part of potential entrants into the industry until all profit oppor-
tunities are entirely exhausted.
The extreme assumptions on which the theory of contestable markets is based have been
sharply criticized as unrealistic. That is, entry is seldom if ever absolutely free and exit is
seldom if ever entirely costless in the real world, and so the theory is thought to be of limited
applicability and usefulness.° Nevertheless, we have seen in Section 11.5 that a hypothesis

4 R. Vernon, “Competition Policy Toward Multinational Corporations,” American Economic Review, May 1974,
pp. 276-282. .
5 See W. J. Baumol, “Contestable Markets: An Uprising in the Theory of Industrial Structure,” American
Economic Review, March 1982, pp. 1—5.
6 W. G. Shepherd, “Contestability vs. Competition,” American Economic Review, September 1984, pp. 572-587.
418 PART FOUR Imperfectly Competitive Markets

FIGURE 13.1 Two Firms ina Contestable Market Dis

the market demand curve, and AC and MC are the average and |
marginal cost curves, respectively, of each of two identical firms :
in a contestable market. Each firm will sell 60 units of output at :
P= AC = MC = $6 (point E in the figure) and behave as a perfect |
|
competitor facing horizontal demand curve AEE’ and earn zero |
economic profits. Any higher price invites hit-and-run entrants. 0 60 120 Q

need not be based on entirely realistic assumptions to be acceptable and useful. Thus, the
theory of contestable markets can still be useful even if entry into and exit from the industry
are only reasonably easy rather than absolutely free and costless. Perhaps the importance of
the theory lies in cautioning us against uncritically accepting the view that a market with only
one or a few firms must necessarily be noncompetitive and in suggesting that easy entry and
exit can severely limit the exercise of monopoly power in contestable markets.

AT THE FRONTIER
Functioning of Markets and Experimental Economics

Experimental xperimental economics is a relatively new field of economics that uses labora-
economics Seeks to tory experiments to understand how real-world markets actually work under dif-
determine
een how
a real
one ad a eae fechasBe levels of information. The field has already provided
Pirtining how pail portant insights on the functioning of perfectly competitive
eran behave itn markets, stock market behavior, monopoly profit maximization, oligopolistic behavior,
a simple experimental bilateral monopoly (a monopolist in the product market facing a monopolist in the
institutional framework. factor market), auction behavior, consumer response to price changes, and the effect
of externalities (divergences between private and social costs and benefits).
 CHAPTER 13 Market Structure, Efficiency, and Regulation 4] Gg

According to Vernon Smith, one of the originators of the field (who shared the
2002 economics Nobel Prize in economics with Daniel Kahneman), there are many
important reasons for conducting experiments in economics. Some of these reasons
include (1) to test a theory or discriminate between theories, (2) to explore the causes
of a theory’s failure, (3) to establish empirical regularities that can form the basis for
a new theory, (4) to compare the effect of operating under different environmental and
institutional conditions, (5) to evaluate policy proposals, and (6) to determine the
effect of institutional changes.
The experiments are usually conducted with volunteers, often college students, who
are given money to buy and sell a fictitious commodity within a simple specified institu-
tional framework. The participants are allowed to keep some of the money that they earn
by acting in an economically rational way. For example, participants are allowed to retain
the profit from buying the commodity at a lower price from the experimenter or from
other participants and reselling it at a higher price to others in the simulated market.
In a simple experiment, it was shown that under certain conditions, the com-
modity price quickly converges to the equilibrium price even when there are only
a few buyers and sellers of the commodity. This would seem to confirm the con-
clusion of the theory of contestable markets, but from a completely different
approach. Whereas the theory of contestable markets reached this conclusion in a
purely deductive manner, experimental economics reaches the same conclusion by
pure empirical evidence within a simple experimental framework. The results
seem to suggest that the perfectly competitive model may have much wider
applicability than previously thought. If so, this would go a long way toward over-
coming the problems arising from the indeterminacy of oligopoly theory.
In another experiment, Vernon Smith handed out several thousand dollars of his own
money to a group of students participating in a simulated stock market study. The study
provided some interesting results. One conclusion is that stock market or speculative
“bubbles” occur regularly within the experimental framework. Traders seem to be car-
ried away in a rising market and continue to bid stock prices up far past the expected div-
idend and price-earnings ratio of the stock—inevitably leading to a crash. Despite the
very simple setting in which these experiments were conducted, their outcome closely
mimics the actual stock market crash of 1987. Only after the participants have been
through several boom-bust cycles do bubbles seem to disappear. As time passes, how-
ever, and the busts fade in investors’ memories, great volatility in stock prices reappears.
In an attempt to eliminate the bubbles, Smith modified the experiment by adding
futures trading (i.e., agreements to purchase or sell a stock at a specified price for
delivery at a specified future time), margin buying (1.e., requiring a down payment
when buying a stock on credit), and rules to stop trading when the market falls by a
specified percentage. Smith’s experiments showed that imposing limits on price
declines only postpones the crash and makes it deeper when it comes. Only the avail-
ability of futures trading seemed to reduce the size and duration of speculative bub-
bles. These experimental results could have important practical implications in
devising regulations to make the stock market less volatile in the real world.
Some of the other interesting results obtained by experimental economics are
(1) auctions with large numbers of bidders (at least 6 or 7) produce more aggressive

Continued...
420 PART FOUR Imperfectly Competitive Markets

Functioning of Markets and Experimental Economics Continued

(the winner's
bidding than with small numbers (3 or 4) and result in negative profits
curse), (2) consumer s more readily accept price increases resulting from rising costs
those that arise from higher profits, suggestin g that firms’ volun-
of production than
tary or mandated financial disclosure s can influence consumer behavior, (3) provid-
ing subjects with complete information retards rather than speeds the convergence
Concept Check of a market to equilibrium, (4) participants come to have common expectations
What is the usefulness Tegarding the value of a stock by market experience, not by being given common
of experimental information, and (5) market efficiency in buying and selling a commodity does not
economics? require the complete revelation of buyers’ and sellers’ preferences.
Despite its promising beginning, we must remember, however, that experimental
economics is still in its infancy, and many economists remain skeptical of the useful-
ness of results obtained in simplistic institutional settings and of their applicability in
devising regulatory policies in the real world. The number of converts is growing,
however, and the field has boomed in recent years. An important new development
that is likely to further stimulate the field is Internet-based experiments, which allow
large number of participants in experiments at different sites and over longer periods
of time as compared with experiments restricted to classroom laboratories.

Sources: G. W. Harrison and J. A. List, “Naturally Occurring Markets and Exogenous Laboratory
Experiments: A Case Study of the Winner’s Curse,’ NBER Working Paper No. 13072, April 2007; “A
Nobel that Bridges Economics and Psychology,’ New York Times, October 10, 2002, p. C1; “Experimental
Economists Try to Fathom Behavior Online,’ Wall Street Journal, October 2, 2000, p. B4; Sheryl B. Ball,
“Research, Teaching, and Practice in Experimental Economics,” Southern Economic Journal, January
1998, pp. 772-779; V. L. Smith, “Economics in the Laboratory,’ Journal of Economic Perspectives, Winter
1994, pp. 113-131; “Classroom Experimental Economics,’ Special Issue, Journal of Economic Education,
Fall 1993; C. R. Plott, “Will Economics Become an Experimental Science?,” Southern Economic Journal,
April 1991, pp. 901-919; V. L. Smith, “Theory, Experiment and Economics,” The Journal of Economic
Perspectives, winter 1989, pp. 151-170, and C. R. Plott, “Industrial Organization and Experimental
Economics,” Journal of Economic Literature, December 1982, pp. 1485-1527.

13.3 SOcIAL Costs AND DYNAMIC BENEFITS OF MONOPOLY PoweR

We have seen that in imperfectly competitive markets the best level of output is where
P > MR = MC. This means that the marginal benefit to consumers (as measured by the
commodity price) from the last unit of the commodity consumed exceeds the marginal
cost that the firm incurs in producing it. Consumers want more of the commodity than is
available, but producers have no incentive to produce more. The social cost resulting
when a constant-cost perfectly competitive industry is suddenly monopolized was shown
by triangle REM in Figure 10.7. It was also pointed out in Section 10.3 that there are
other
losses or social costs resulting from monopoly power. The first of these is that
monopo-
lists do not have much incentive to keep their costs as low as possible and
prefer instead
the quiet life (X-inefficiency).’ Second, monopolists waste a lot of resources
lobbying

GLa alates. fy, : ee

See H. Leibenstein, “Allocative Efficiency vs. X-Inefficiency,” American Economic Review,
June 1966
pp. 392-415.
.
 CHAPTER 13 Market Structure, Efficiency, and Regulation 421

and engaging in legal battles to avoid or defend themselves against regulation and
antitrust prosecution, installing excess capacity to discourage entry into the industry, and
advertising in an attempt to create and retain the monopoly power (i.e., engaging in rent-
seeking activities). Some economists believe that these other social costs of monopoly are
larger than those measured by the welfare triangle REM in Figure 10.7, but, as pointed out
in Section 10.3, there is disagreement on the exact size of these social costs.®
Measuring the social costs of imperfect competition by comparing it with perfect
competition begs the question, however, because the need for large-scale production often
precludes the existence of perfect competition. We could not, for example, produce steel,
automobiles, aluminum, aircraft, and most industrial products with numerous firms under
perfect competition— except at exorbitant costs. The benefits that would result if cost con-
ditions made perfect competition possible are thus irrelevant in these cases. Furthermore,
there are many alleged benefits that result from large firm size (i.e., with firms with mono-
poly power) that just would not be possible under perfect competition. These were empha-
sized by Schumpeter 60 years ago and remain very controversial today.”
According to Schumpeter and others, perfect competition is not the market structure
most conducive to long-run growth through technological change and innovations. Since
long-run profits tend toward zero in perfectly competitive markets, firms will not have the
necessary resources to undertake sufficient R&D to maximize growth. Furthermore, with
free entry under perfect competition, a firm introducing a cost-reducing innovation or a
new product would quickly lose its source of profits through imitation. Thus, Schumpeter
argued that large firms with some degree of monopoly power are essential to provide the
financial resources required for R&D and to protect the resulting source of profits.
Although monopoly leads to some inefficiency at one point in time (static inefficiency),
over time, it 1s likely to lead to much more technological change and innovation (dynamic
efficiency) than perfect competition.!°
In addition, according to Schumpeter, large firms with some monopoly power are not
sheltered from competition. On the contrary, they face powerful competition from new
products and new production techniques introduced by other large firms. For example,
aluminum is replacing steel in many uses, and plastic is replacing aluminum. Such com-
petition is much more dangerous and affects the very existence of the firm. This is the
Concept Check
process of “creative destruction” as new products and technologies constantly lead to new
What are some of the investments and the obsolescence of some existing capital stock. In this process, the role
dynamic benefits of of the entrepreneur is crucial. Indeed, the entrepreneur is the star performer in the dynamic
monopoly? process of creative destruction and growth in the economy.
Some economists disagree. They point out that it is not at all clear that monopoly
power leads to more R&D and innovations and faster long-run growth than perfectly
competitive markets. They also point out that a more decentralized market economy is

8 The charge often heard that monopolists suppress inventions (e.g., that they would avoid introducing a
longer-lasting light bulb) is not correct, however, since consumers would be willing to pay a higher price for
such light bulbs and this could lead to higher profits for the monopolist. Only if the monopolist believed that
the invention could not be patented and that this would result in loss of monopoly power would the
monopolist suppress the invention. See Section 10.8.
° See J. Schumpeter, Capitalism, Socialism, and Democracy (New York: Harper & Row, 1942), p. 106; and Z.
J. Acs and D. B. Audretsch, “Innovation in Large and Small Firms: An Empirical Analysis,” American
Economic Review, September 1988, pp. 678-690.
'0 The question of what is the institutional setting most conducive to technological change and innovations
over time is a crucial one, because technological change and innovations are the forces responsible for most of
the long-term growth in standards of living in modern societies.
422 PART FOUR Imperfectly Competitive Markets

consistent with individual free-

more adaptable and flexible to changes and 1s much more
dom of choice than an economy charact erized by great econom ic concentration. The chal-
is to devise policie s that correct the most serious
lenge, according to these economists,
economic distortions in the economy resultin g from monopo ly power and encourage a
encoura ging a large degree of decentralization,
high level of R&D, while retaining and
equity, and individual freedoms.
that
After a careful review of the empirical evidence, Scherer and Ross conclude
perfect competiti on cannot be the model for
Schumpeter was right in asserting that
monopoli es and tightly knit cartels. What is
dynamic efficiency. But neither can powerful
blend of competiti on and monopoly , with
needed for rapid technical progress is a subtle
more emphasis on the former than on the latter, especially in those industries in which
technical progress is relatively rapid. In other words, although some monopoly power
may be more conducive to innovation than perfect competition when technical progress
is relatively slow, a great deal of monopoly power is likely to retard innovations and
growth, especially when technical progress is rapid.!!

13.4 CONTROLLING MonopoLy Power: ANTITRUST POLICY

Starting in 1890, a number of antitrust laws were passed in the United States which were
aimed at preventing monopoly or undue concentration of economic power, protecting the
public against the abuses and inefficiencies resulting from monopoly or the concentration
of economic power, and maintaining a workable degree of competition in the economy.
The two core antitrust laws were the Sherman Antitrust Act and the Clayton Act.
Sherman Antitrust According to Section I of the Sherman Antitrust Act, passed in 1890: “Every con-
Act Prohibits all tract, combination ..., or conspiracy in restraint of trade or commerce among the several
contracts and states, or with foreign nations, is hereby declared to be illegal” in the United States. The
combinations in
Sherman Antitrust Act does not make monopoly, as such, illegal. What is illegal is collu-
restraint of trade and all
attempts to monopolize
sion (1.e., formal or informal agreements or arrangements in restraint of trade). These
the market. agreements refer to all types of cartels, but also to informal understandings to share the
market, price fixing, and price leadership. An illustration of collusion is provided by the
market-sharing cartel of the Ivy League colleges in Example 11-4. What the courts did
Conscious parallelism not rule as illegal is conscious parallelism, or the adoption of similar policies by oligop-
The adoption of similar olists in view of their recognized interdependence. Specifically, the courts have ruled that
policies by oligopolists parallel business behavior does not constitute proof of collusion or an offense under the
in view of their
Sherman Antitrust Act.
recognized
The most difficult part of applying Section I of the Sherman Antitrust Act is proving
interdependence.
tacit or informal collusion. Sometimes the case is clear-cut. For example, in 1936, the U.S.
Department of the Navy received 31 closed bids to supply a batch of steel, all of which
quoting a price of $20,727.26. Also in 1936, the U.S. Engineer’s Office received 11 closed
bids to supply 6,000 barrels of cement, each quoting a price of $3.286854 per barrel! The
probability of identical prices, down to the sixth decimal, occurring without some form of
collusion is practically zero. Most antitrust cases are seldom so clear-cut, however.
Section II of the Sherman Antitrust Act makes attempts to monopolize the market
illegal. The most famous of the recent court cases applying Section II of the Sherman

'' BM. Scherer and D. Ross, Industrial Market Structure and Economic Performanc
e (Boston: Houghton
Mifflin, 1990), pp. 644—660.
 CHAPTER 13 Market Structure, Efficiency, and Regulation 423

Antitrust Act are those brought against AT&T (see Example 13-1) in 1982 and
Microsoft in 1998 (see “At the Frontier” in Chapter 10). But monopolization can also
Clayton Act occur through merger. Section 7 of the Clayton Act, passed in 1914 (and amended by
Prohibits mergers that the Celler—Kefauver Act of 1950), prohibits mergers that “substantially lessen com-
“substantially lessen
petition” or tend to lead to monopoly. According to its 1984 guidelines, the Justice
competition” or tend to
Department would not usually challenge a horizontal merger (i.e., a merger of firms in
lead to monopoly.
the same product line) if the postmerger Herfindahl index was less than 1,000. If the
postmerger index was between 1,000 and 1,800 and the increase in the index as a result
of the merger was less than 100 points, the merger would usually also go unchallenged.
But if the postmerger index was between 1,000 and 1,800 and the merger led to an
increase in the index of more than 100 points, or if the postmerger index was more than
1,800 and the merger led to an increase in the index of more than 50 points, the Justice
Department was likely to challenge the merger. Since the mid-1990s, these guidelines
have been relaxed (see Example 13-5).
The Justice Department also considers other factors (besides the Herfindahl index) in
horizontal mergers. These include the financial condition of the firm being acquired, the
ease of entry into the industry, the degree of foreign competition, and the expected gains
in efficiency that the merger would make possible. The Justice Department is more likely
approve a horizontal merger if the merger would prevent the failure of the acquired firm,
if entry into the industry is easy, if the degree of foreign competition is strong, and if the
acquisition would lead to substantial economices of scale.'* Less clear-cut are the guide-
lines on vertical and conglomerate mergers. As a result of relaxed guidelines and in the
face of sharply increased foreign competition, the number and size of mergers and corpo-
rate acquisitions in the United States has increased sharply since the early 1980s.
Since antitrust laws are often broad and general, however, a great deal of judicial
interpretation based on economic analysis has often been required in their enforcement.
The problems of defining what is meant by “substantially lessening competition,” defin-
ing the relevant product and geographic markets, and deciding when competition is
“unfair” have not been easy to determine and often could not be resolved in a fully satis-
factory and uncontroversial way. The fact that many antitrust cases last many years,
Concept Check
What is the purpose of involve thousands of pages of testimony, and cost millions of dollars to prosecute is ample
antitrust laws and their evidence of their great complexity. Perhaps the most significant effect of the antitrust laws
most significant effect? is deterring collusion rather than fighting it after it occurs.

EXAMPLE 13-1
Antitrust Policy in Action—The Breakup of AT&T and the Creation of Competition
in Long-Distance Telephone Service

In 1974, the U.S. Justice Department filed suit (also under Section II of the Sherman
Act) against AT&T for illegal practices aimed at eliminating competitors in the mar-
ket for telephone equipment and in the market for long-distance telephone service.
At the time, AT&T was the largest private firm in the world. After 8 years of litigation

!2 See “Symposium on Mergers and Antitrust,” Journal of Economic Perspectives, Fall 1987, pp. 3-54; and
W. E. Kovaric and Carl Shapiro, “Antitrust Policy: A Century of Economic and Legal Thinking,” Journal of
Economic Perspectives, winter 2000, pp. 43-60.
424 PART.FOUR Imperfectly Competitive Markets

AT&T to
and a cost of $25 million to the government (and $360 million incurred by
decree, AT&T
defend itself), the case was settled on January 8, 1982. By consent
two-
agreed to divest itself of the 22 local telephone companies (which represented
thirds of its total assets) and lose its monopoly on long-distance telephone service.
In return, AT&T was allowed to retain Bell Laboratories and its manufacturing arm,
Western Electric, and it was allowed to enter the rapidly growing fields of cable TV,
electronic data transmission, video-text communications, and computers. The settle-
ment also led to an increase in local telephone charges (which had been subsidized
by long-distance telephone service by AT&T) and a reduction in long-distance tele-
phone rates.
By the end of 2001, WorldCom (which had acquired MCI Communications in
1999) and Sprint had captured more than 40% of the long-distance telephone market
from AT&T. Furthermore, AT&T, WorldCom, and Sprint entered the local telephone
market and the local Bell companies entered the long-distance market. The sharp
increase in competition and price wars resulted in much lower prices for local and
long-distance telephone services for U.S. consumers. At the end of 2001, AT&T sold
its cable-TV business to Comcast for $44 billion, thus ending its frenzied and costly
three-year effort to transform itself into a telecommunications powerhouse and return-
ing to being just a long-distance telephone company. Then, in 2005, AT&T itself was
acquired by the regional bell SBC, which subsequently adopted the name AT&T, thus
putting an end to independent long-distance telephony in the United States. In 2006, a
reborn AT&T acquired BellSouth, leaving only two other major telephone companies
in the United States (Verizon and Qwest; Sprint Nextel is now primarily a cellular
phone company).
Sources: “Ma Bell’s Big Breakup,” Newsweek, January 18, 1982, pp. 58-63; “Congress Votes to
Reshape the Communications Industry,” New York Times, February 2, 1996, p. 1; “Telecoms in
Trouble,” The Economist, December 16, 2000, pp. 77-79; “AT&T Long, Troubled Trip to Its Past,”
Wall Street Journal, December 21, 2001, p. B1; “Justice Department Approves Two Big Telecom
Deals,” New York Times, October 28, 2005, p. C4; and “A Reborn AT&T to Buy BellSouth,” Wall Street
Journal, March 6, 2006, p. Al.

EXAMPLE 13-2
Regulation and the Price of International Telephone Calls in Europe

Until the 1990s, state telephone monopolies ruled everywhere in continental Europe
and charged more than twice as much as AT&T charged its American customers for
transatlantic telephone calls (and even more for local telephone services). During the
1990s, pressure mounted in Europe to dismantle the legal OPEC-like cartel by which
national telecommunications companies cooperated to keep the price of internationa
l
telephone calls very high and far above actual costs. With AT&T on this side
of the
Atlantic and British Telecom in Europe creeping into continental European
markets
with lower rates and with European corporations clamoring for
rate reductions, the
European Commission decided to open the international telephone
market to compe-
tition throughout the 15-country European Union in 1998.
 CHAPTER 13 Market Structure, Efficiency, and Regulation 425

As a result, governments privatized their national telephone companies through

stock sales, and major European telephone companies rushed to form alliances with
other European and American telephone companies. Eventually, this could trigger
massive consolidations around four or five telephone superpowers in the world. As
these alliances take shape, price wars will be inevitable and are likely to result in
sharply lower prices for telephone calls in Europe, just as occurred in the United
States. Although still higher than in the United States, the price of local and interna-
tional telephone calls in Europe has in fact already fallen sharply during the past few
years.
Bigger and more frequent during the past few years have been mergers and acqui-
sitions of cellular telephone companies by other wireless operators (such as England’s
Vodafone’s acquisition of German Mannesmann) and by traditional telephone compa-
nies (such as France Telecom’s acquisition of Orange P.L.C.—Britain’s third largest
wireless operator for $37 billion—and Deutsche Telekom’s acquisition of American
VoiceStream Wireless Corporation for $45 billion). With the convergence of telecom-
munications, information technology, and media services, the European Union’s
Parliament passed a law in December 2001 aimed at unifying and increasing competi-
tion in the entire telecommunication field in the European Union.
Sources: “An Unlikely Trustbuster,’ Forbes, February 18, 1991, pp. 100-104, “Sky-High Overseas Phone
Bills May Drop,” Wall Street Journal, September 20, 1994, p. B2; “European Phone Companies Reach
Out for Partners,” Wall Street Journal, November 30, 1994, p. B4; “Europe Begins Liberalizing Phone
Sector,’ Wall Street Journal, December 5, 1994, p. A9F; “Who’s on First?” Wall Street Journal,
September 18, 2000, p. R2; “Telephone Regulation Is Approved,’ New York Times, December 12, 2001,
p. W1; and “The War of Wires,” The Economist, July 30, 2005, pp. 53-54.

13.5 PuBLic-UTILITyY REGULATION

In this section, we consider the need for regulating natural monopolies (such as public
utilities) and the dilemma faced by regulatory commissions in determining the appropri-
ate method and degree of regulation.

Public Utilities as Natural Monopolies

As defined in Section 10.1, natural monopoly refers to the case in which a single firm can
supply a service to the entire market more efficiently than a number of firms could.
Natural monopoly arises when the firm’s long-run average cost curve is still declining at
the point where it intersects the market demand curve. Examples of natural monopolies
are public utilities (local electrical, gas, water, and transportation companies). To have
more than one such firm in a given market would lead to duplication of supply lines and
to much higher costs per unit. To avoid this, local governments usually allow a single
Concept Check firm to operate in the market but regulate the price and quantity of the services provided
Why are public utilities so as to allow the firm only a normal rate of return (say, 10% to 12%) on its investment.
regulated? This is shown in Figure 13.2.
In Figure 13.2, the D and MR curves are, respectively, the market demand and mar-
ginal revenue curves for the service faced by the public utility, while the LAC and LMC
curves are its long-run average and marginal cost curves. The best level of output for the
426 PART FOUR Imperfectly Competitive Markets

\o9

DD
Ot
me

Q (million units)
FIGURE 13.2 Natural Monopoly Regulation A regularity commission
usually sets P = LAC = $3 (point G), at which output is 6 million units per time
period and the public utility breaks even in the long run. This, however, would
result in a welfare loss to society or social cost equal to about $1.50 million (the
area of shaded triangle GKH), since only at point H is P = LMC. This cost could
be avoided if the commission set P = LMC = $1. But this would result in a loss
of $1(JH) per unit and $8 million in total for the company, and the public utility
would not supply the service in the long run without a subsidy of $1 per unit.

unregulated monopolist in the long run is 3 million units per time period and is given by
point E, at which the LMC and MR curves intersect. For Q = 3 million units, the monop-
olist would charge the price of $6 (point A on the D curve) and incur a LAC = $5 (point
B on the LAC curve), thereby earning a profit of $1 (AB) per unit and $3 million (the area
of rectangle ABCF) in total. Note that at Q = 3 million units, the LAC curve is still declin-
ing. Note also that at the output level of 3 million units, P > LMC, so that more of the ser-
vice is desirable from society’s point of view. There is, however, no incentive for the
unregulated monopolist to expand output beyond Q = 3 million units per time period
because its profits are maximized at Q = 3 million.
To ensure that the monopolist earns only a normal rate of return on its investment, the
regulatory commission usually sets P = LAC. In Figure 13.2, this is given by point G, at
which P = LAC = $3 and output is 6 million units per time period. While the price is lower
and the output is greater than at point A, P > LMC at point G. Thus, consumers pay a price
for the last unit of the service purchased which exceeds the LMC of producing it (see the
figure). The welfare loss to society or social cost of setting P = LAC = $3 is about
 CHAPTER 13 Market Structure, Efficiency, and Regulation 427

(0.5)(1.50)(2) = $1.50 million (the area of shaded triangle GKH). The only way to avoid
this social cost is for the regulatory commission to set P = LMC = $1 so that output is 8 mil-
lion units per time period (point H in the figure). At Q = 8 million, however, the LAC = $2
(point J on the LAC curve), and the public utility would incur a loss of $1 (JH) per unit and
$8 million in total per time period. As a result, the public utility would not supply the ser-
vice in the long run without a subsidy of $1 per unit. In general, regulatory commissions
set P = LAC (point G in Figure 13.2) so that the public utility breaks even in the long run
without a subsidy.

Difficulties in Public-Utility Regulation

Although our discussion of public-utility regulation seems fairly simple and straightfor-
ward, the actual determination of prices (rates) for public-utility services by regulatory com-
missions (often called the rate case) is complex. For one thing, it is very difficult to
determine the value of the plant or fixed assets on which to allow a normal rate of return.
Should it be the original cost of the investment or the replacement cost? Usually regulatory
commissions decide on the former. Furthermore, since public-utility companies supply the
service to different classes of customers, each with different price elasticities of demand,
many different rate schedules can be used to allow the public utility to break even. Even
more troublesome is the fact that a public utility usually provides many services that are
jointly produced, and so it is impossible to allocate costs in any rational way to the various
services provided and customers served.
Regulation can also lead to inefficiencies. These result from the fact that, having been
guaranteed a normal rate of return on investment, public-utility companies have little incen-
tive to keep costs down. For example, managers may grant salary increases to themselves
in excess of what they would get in their best alternative employment, and they may pro-
vide luxurious offices and large expense accounts for themselves. Regulatory commissions
must, therefore, scrutinize costs to prevent such abuses. Regulated public utilities also have
little incentive to introduce cost-saving innovations because they would not be able to keep
the increased profits. An example of this is provided by the slowness with which AT&T
introduced automatic switching equipment during the 1970s.
Other inefficiencies arise because if rates are set too high, public utilities will over-
invest in fixed assets and use excessively capital-intensive production methods to avoid
showing above-normal returns (which would lead to rate reductions). On the other hand,
if public-utility rates are set too low, public-utility companies will underinvest in fixed
assets (i.e., in plant and equipment) and overspend on variable inputs, such as labor and
fuel, which tends to reduce the quality of services. Overinvestment or underinvestment in
plant and equipment resulting from the wrong public-utility rates being set is known as
Averch—Johnson the Averch-Johnson (A-J) effect (from Harvey Averch and Leland Johnson, who first
(A-J) effect The identified this problem) and can lead to large inefficiencies.'* And yet, it is difficult indeed
overinvestments or for regulatory commissions to come up with correct utility rates in view of the difficulty
underinvestments in of valuing the fixed assets of public utilities and because of the long planning and gesta-
plant and equipment
tion period of public-utility investment projects.!4
resulting when public
utility rates are set
Finally, there is usually a lag of 9 to 12 months from the time the need for a rate
too high or too low, change is recognized and the time it is granted. This regulatory lag results because public
respectively.
13 YH. Averch and L. Johnson, “Behavior of the Firm under Regulatory Constraint,’ American Economic
Review, December 1962, pp. 1052-1069.
'4 Recently, regulatory commissions have begun to pay more attention to the structure of rates so as to avoid
undue price discrimination against any class of customers.
428 PART FOUR Imperfectly Competitive Markets

can approve a requested rate

hearings must be conducted before a regulatory commission
are either political appointees
change. Since the members of the regulatory commissions
from consumer groups, they
or elected officials and are thus subject to political pressures
rate increases that a
usually postpone a rate increase as long as possible and tend to grant
ea - fixe
Concept Check smaller than necessary. During inflationary periods, this leads to puma
ae Be are
What are the difficulties assets and to the inefficiencies discussed above. To avoid these Sea
e costs Cc a
in public utility sometimes tied to fuel costs and are automatically adjusted as varia
However, most public utilities are now in the process of deregul ation (see Example 13-3).
regulation?

EXAMPLE 13-3
Regulated Electricity Rates for Con Edison

In February 1983, after nearly six months of public hearings and deliberations, the New
York Public Service Commission approved a 6.5% increase in electricity rates for the 2.7
million New York City customers served by the Consolidated Edison Company. The
increase in the monthly electricity charge was about half of the 12.4% that Con Edison
had asked and was expected to generate $240 million extra revenue per year for Con
Edison, to cover its increasing costs of operation.
Both Con Edison and consumer advocates immediately criticized the rate
increase—the former as inadequate and the latter as too high. In fact, the rate increase
actually generated $267 million in additional revenues per year for Con Edison,
instead of the $240 million expected and approved. In 1986, the city administration
threatened to sue Con Edison to have the excess profits returned to customers but
dropped its plan when Con Edison agreed not to seek another rate increase until March
1987. Con Edison did not get another rate increase until 1992. The rate increases that
it got from 1992 to 1995 were very small, and from 1996 to 1999 rates actually
declined slightly. The next rate increase came only in 2004. In 2007, Con Edison asked
for an increase in electricity rates that would generate an extra $1.2 billion in revenues
to cover increasing costs of energy, but got only $425 million in 2008.
Con Edison and other electric utilities in New York State and in about half of the
United States have now been deregulated, thus allowing customers to choose their
power company and bargain for rates, just as they do for long-distance telephone ser-
vices. Furthermore, whereas in the past electric utility companies produced, delivered,
metered, and billed for the electricity they sold, with the deregulation these functions
are being taken over (for the most part) by separate and more specialized companies.
Deregulation increased the efficiency of the electric industry, but it did not lead to
lower rates for every type of user. Deregulation also brought blackouts and sharply
higher electricity bills in California in 2000 and 2001, and this (together with the col-
lapse of Enron, one of the world’s largest energy traders at the end of 2001) convinced
many states to delay deregulation until enough generating capacity has been built to
ensure ample supply at stable electricity rates.
Source: “Con Edison Wins 6.5% Rise in Rates, Half of its Request,” New York Times, February 24,
1983,
p. B4; “Con Edison Puts Freeze on Its Electricity Rates.” New York Times, January 13, 1986,
p. B1; P. L.
Joskow, “Restructuring, Competition and Regulatory Reform in the U.S. Electric Sector,”
Journal of
Economic Perspectives, Summer 1997, pp. 119-138; “California Moving Toward Re-regulatin
g Energy,”
New York Times, September 21, 2001, p. 16; and “Con Ed Wins Approval for
a Big One-Time Increase in
Rates for Electric Service,” New York Times, March 20, 2008, p. B3.
 CHAPTER 13 Market Structure, Efficiency, and Regulation 429

13.6 THE DEREGULATION MOVEMENT

Regulation in the U.S. economy is not confined to cases of natural monopolies, where there
is a single seller of a commodity or service, but extends to many other sectors, especially
transportation, banking, and other financial services, where more than one firm operates.
For example, airlines needed government approval to enter a market and change fares, rail-
roads needed government approval to abandon a service or a line and change rates, the ser-
vices that banks can provide and the interest that they can pay on deposits were also
regulated, and so were the rates set by insurance companies and other financial institutions.
Regulation was justified to ensure that industries operated in a manner consistent with the
public interest, ensure a minimum standard of quality of services, and prevent the establish-
ment of monopoly.
Many economists oppose regulation because it restricts competition, contributes to
high prices, and reduces economic efficiency. One estimate put the social cost of regula-
tion at more than $100 billion in the year 1979 (of which about 5% were administrative
costs and the rest were the costs of compliance) and over $200 billion a year in the
1990s.!° Even though these estimates were challenged as grossly exaggerated,!® compli-
ance costs are surely very high, particularly in the area of social regulation (such as job
safety), energy and the environment, and consumer safety and health. Regulation often
leads to inefficiencies because regulators do not specify the desired result, but only the
method of compliance (such as the type of pollution-abatement equipment to use), in the
absence of adequate information and expertise. It is now generally agreed that it would
be much better if regulators specified the results wanted and left to industry the task of
determining the most efficient way to comply. In recent years, there has been a move-
ment in this direction.
Deregulation Since the 1970s, a growing deregulation movement has sprung up in the United
movement The States that led to deregulation of the air travel, trucking, railroads, banking, and telecom-
reduction or elimination munications industries. The Airline Deregulation Act of 1978 removed all restrictions
of many government
on entry, scheduling, and pricing in domestic air travel in the United States, and so did
regulations since the
the Motor Carrier Act of 1980 in the trucking industry. The Depository Institutions
mid-1970s in order to
increase competition Deregulation and Monetary Control Act of 1980 allowed banks to pay interest on check-
and efficiency. ing accounts and increased competition for business loans. The Railroad Revitalization
and Regulatory Reform Act of 1976 greatly increased the flexibility of railroads to
set prices and to determine levels of service and areas of operation. The settlement of
the AT&T Antitrust Case in 1982 (see Example 13-1) opened competition in long-
distance telephone service and in telecommunications. Natural gas pipelines and oil
are now deregulated, and so are the banking and electric power industries (see
Example 13-3).
Concept Check The general purpose of deregulation is to increase competition and efficiency in
What is the purpose and the affected industries and lead to lower prices without sacrificing the quality of service.
effect of the deregulation Most observers would probably conclude that, on balance, the net effect has been posi-
movement? tive. Competition has generally increased, and prices have fallen in industries that were

'5 Murray Weidenbaum, “The High Cost of Government Regulation,” Challenge, November—December 1979,
pp. 32-39 and “A New Project Will Measure the Cost and Effect of Regulation,” New York Times, March 30,
1998, p. D2.
16 See William K. Tabb, “Government Regulation: Two Sides of the Story,” Challenge, November—December
1980, pp. 40-48.
430 PART FOUR Imperfectly Competitive Markets

in some difficulties and

deregulated. As expected, however, deregulation has also resulted
r groups and some
strains in the industries affected, to the point where some consume
ate them. Nowhere
firms in recently deregulated industries are asking Congress to re-regul
tion has
is this more evident than in the airline industry (see Example 13-4). Deregula
the early
also encouraged and made possible the merger boom that has occurred since
1990s (see Example 13-5).

EXAMPLE 13-4
Deregulation of the Airline Industry: An Assessment

By 2007, all of the 16 air carriers that had started following the 1978 deregulation
went out of business or merged with established carriers (the last one was the
merger of America West Airlines with US Airways in 2005). Several mergers took
place among large, established carriers (such as American Airlines’ acquisition of
TWA in 2001), and Eastern Airlines and Pan Am went out of business. The result
was that in 2007 seven carriers handled 91% of all domestic air travel in the United
States (as compared with 11 carriers handling 87% of the traffic in 1978). From
1985 to 2007, the market share of the top five carriers jumped from 61% to 72%.
Instead of a large number of small and highly competitive airlines envisioned by
deregulation, the airline industry has become even more concentrated than it was
before deregulation.
Entry into the industry by established airlines was restricted by (1) long-term leas-
ing of the limited number of gates at most airports, (2) frequent flier programs that tie
passengers to a given airline, (3) computerized reservations system that give a com-
petitive advantage in attracting customers to the airlines owning the system, (4) the
emergence of “hub and spoke” operations, in which airlines funnel passengers through
centrally located airports where one or two companies often dominate service, and
(5) predatory pricing practices, under which established airlines lower the price and
increase flights to drive new entrants out. This, however, did not prevent a number of
new discount airlines (such as Skybus, JetBlue, Air Tran and ATA) coming into exis-
tence since 2001 and taking away some market share from established airlines with
their low-price strategy. Shyrocketing jet fuel prices, however, resulted in most dis-
count airlines shitting down in 2007-2008.
Airfares, after adjusting for inflation, have declined, on average, more than 30%
since deregulation, and this greatly stimulated domestic air travel (from about 250
million passengers in 1976 to over 600 million in 2007). However, delays at airports
and passenger complaints about lost luggage, canceled flights, overbooking, and gen-
eral declines in the quality of service have increased significantly since deregulation.
Clearly, some restructuring of the airline industry seems required in order to reduce
overcapacity, reduce costs, improve service, and avoid price wars. At the end of
March 2008, an open-skies agreement between the United States and the European
Union went into effect that deregulated transatlantic air travel, and Delta was
negotiating a merger with Northwest. Most domestic and foreign airlines are now
 CHAPTER 13 Market Structure, Efficiency, and Regulation 431

part of three major international airline alliances (the Star Alliance, the OneWorld
Alliance, and SkyTeam Alliance).
Sources: “Airline Deregulation,” Federal Reserve Bank of San Francisco Review, March 9, 1990; “Airlines
and Antitrust: A New World. Or Not,’ New York Times, November 18, 2001, p. 1; “For U.S. Airlines, a
Shakeout Runs into Heavy Turbulence,” Wall Street Journal, September 19, 2005, p. Al; “U.S. and EU
Abandon Air-Travel Limitations,” Wall Street Journal, March 29, 2008, p. AS; “ATA Shutdown Signals
Discount-Carrier Woes,” Wall Street Journal, April 4, 2008; and “Did Ending Regulation Help Fliers?”
New York Times, April 17, 2008, p. C1.

EXAMPLE 13-5
Antitrust and the New Merger Boom

Since the early 1990s there has been a huge merger boom in the United States and
abroad. The year 2000 was the biggest year in history for mergers and acquisitions, with
deals valued at more than $1.8 trillion. During the 1990s, mega-deals occurred in
telecommunications, defense, railroads, pharmaceuticals, retailing, health care, bank-
ing, entertainment, publishing, computers, consulting, and many other industries (see
Section 9.5). The biggest merger in history was the America Online (AOL) acquisition
of Time Warner for $110 billion in 2000. There were several forces that fueled this urge
to merger. The most important were massive technological changes, increased interna-
tional competition, and deregulation. Firms are under strong pressure to reduce excess
capacity, to cut costs, and to become major players in the global marketplace. Only with
the U.S. recession in 2001 did the merger boom subside, but it then resumed in 2004
and spread to Europe in 2005.
The new merger wave was also different from that of the 1980s, and so has been
the enforcement of antitrust laws. Whereas, in the 1980s many mergers were among
firms in unrelated industries (thus creating conglomerates) and raising few antirust
concerns, the merger wave since the early 1990s often involved the merger of com-
petitors, potentially giving the combined companies the power to dominate their
industries and, in theory, control prices and the availability of products. Starting from
the second half of the 1990s, the enforcement of antitrust laws thus changed its focus
from the doctrine that bigness leads to power and unfair behavior to that of protecting
consumers and thus refusing to approve mergers that reduced competition and that
were likely to increase prices. In short, enforcement has become pro-competition and
pro-consumer.
For example, the Federal Trade Commission (FTC) did not approve the proposed
merger of Staples and Office Depot, two chains of office-supply superstores, in 1997
because it found that Staples had lower prices in those locations where there was also
an Office Depot outlet, thus concluding that their merger would very likely have led to
higher consumer prices. Not approved for the same reason were many other proposed
mergers, among which were the WorldCom purchase of Sprint in 2000, the United
Airlines acquisition of American West, and the General Electric acquisition of
Honeywell in 2001 (which was blocked by the European Commission, even though
432 PART FOUR Imperfectly Competitive Markets

the U.S. Justice

the two companies are American and the merger had been cleared by
Department).
costs and
Whether, in fact, the recent merger boom led companies to reduce
on the type of merger taking place. In the
increase efficiency and revenue depends
promise of reduced costs and increase d effi-
defense and the health-care fields, the
others sectors, it is not too certain. Often the
ciency has been or can be realized. In
acquiring company paid a premium over the market price because of synergie s that the
acquiring company’s management saw but the market did not. When such synergies
failed to materialize or did not live up to expectations, the acquiring company and its
stockholders suffered, especially if the company took on huge debt loads to make the
acquisitions. The biggest loss resulted from the 2000 merger of AOL/Time Warner
($200 billion loss in stock market value and $54 billion write-down in the worth of the
combined company assets).
Sources: “The New Merger Boom,” Fortune, November 28, 1994, pp. 95-106; “Aiding Consumers Is
Now: the Thrust of Antitrust Push,” New York Times, March 22, 1998, p. 1; “Corporate Governance and
Merger Activity in the United States: Making Sense of the 1980s and 1990s,” Journal of Economic
Perspectives, Spring 2001, pp. 121-144; “Volatile Markets and Global Slowdown Cool Corporate Desire
to Merge,” Wall Street Journal, January 2, 2002, p. R10; “Mergers: Why Most Don’t Pay Off,” Business
Week, October 14, 2002, pp. 60-80; “What Mergers are Good For,” New York Times Magazine, June 5,
2005, pp. 56-62; “Europe’s M&A Boom Is Set to Hit $930 billion by End of the Year,” Financial Times,
November 7, 2005, p.1; and “The Outlook for Global M&A Activity,” Economic Outlook, May 2007,
pp. 21-27.

REGULATING INTERNATIONAL COMPETITION:

13.7 VOLUNTARY Export RESTRAINTS

Regulation affects not only domestic companies but also foreign firms. Consider
Voluntary export voluntary export restraints (VER). These are some of the most important nontariff
restraints (VER) The trade barriers and refer to cases in which an importing country induces another nation
situation in which an to reduce its exports of a commodity “voluntarily,” under the threat of higher all-
importing country
around trade restrictions, when these exports threaten an entire domestic industry.!”
induces another nation
to reduce its exports of
Voluntary export restraints have been negotiated since the 1950s by the United States
a commodity and other industrial countries to curtail textile exports from Japan, and more recently
“voluntarily” under the also to curb exports of automobiles, steel, shoes, and other commodities from Japan
threat of higher all- and other nations. These are the mature industries that faced sharp declines in employ-
around trade ment in the industrial countries during the past three decades. Sometimes called
restrictions. “orderly marketing arrangements,” these VER have allowed the United States and
other industrial nations making use of them to save at least the appearance of contin-
ued support for the principle of free trade.
When voluntary export restraints are successful, they have all the economic effects
of equivalent import tariffs, except that they are administered by the exporting country,
and so the revenue effect or monopoly profits are captured by foreign exporters.
An
example of this is provided by the “voluntary” restraint on Japanese automobile exports
to the United States negotiated in 1981 (see Example 13-6).

17
The effects of an import tariff were examined in Section 9.7.
oe ~ . ‘Ce . + .
 CHAPTER 13 Market Structure, Efficiency, and Regulation 433

Voluntary export restraints are likely to be less effective in limiting imports than
import quotas, because the exporting nations agree only reluctantly to curb their exports.
Foreign exporters are also likely to fill their quotas with higher-quality and higher-priced
units of the product over time. This product upgrading was clearly evident in the case of
ae Concept Check the Japanese voluntary restraint on automobile exports to the United States. Furthermore,
What is the purpose as a rule, only major supplier countries are involved, which leaves the door open for other
and effect of voluntary nations to replace part of the exports of the major suppliers and also for trans-shipments
export restraints? through third countries.

Voluntary Restraints on Export of Japanese Automobiles to the United States

From 1977 to 1981, U.S. automobile production fell by about one-third, the share of
imports rose from 18% to 29%, and nearly 300,000 autoworkers in the United States
lost their jobs. In 1980 the Big Three U.S. automakers (GM, Ford, and Chrysler) suf-
fered combined losses of $4 billion. As a result, the United States negotiated an agree-
ment with Japan that limited Japanese automobile exports to the United States to 1.68
million units per year from 1981 to 1983 and to 1.85 million units for 1984 and 1985.
Japan “agreed” to restrict its automobile exports out of fear of still more stringent
import restrictions by the United States.
U.S. automakers generally used the time from 1981 to 1985 wisely to lower
break-even points and improve quality, but the cost improvements were not passed
on to consumers, and Detroit reaped profits of nearly $6 billion in 1983, $10 billion
in 1984, and $8 billion in 1985. Japan gained by exporting higher-priced autos and
earning higher profits. The big loser, of course, was the American public, which had
to pay substantially higher prices for domestic and foreign automobiles. The U.S.
International Trade Commission (USITC) estimated that the agreement resulted in a
price $660 higher for U.S.-made automobiles and $1,300 higher for Japanese cars in
1984. The USITC also estimated that the total cost of the agreement to U.S. con-
sumers was $15.7 billion from 1981 through 1984, and that 44,000 U.S. auto jobs
were saved at a cost of more than $100,000 each. This was two to three times the
yearly earnings of a U.S. autoworker.
Since 1985, the United States has not asked for a renewal of the VER agreement,
but Japan unilaterally limited its auto exports (to 2.3 million from 1986 to 1991 and
1.65 million afterward) to avoid more trade friction with the United States. Since the
late 1980s, however, Japan has invested heavily to produce automobiles in the United
States in so-called transplant factories, and by 1996 it was producing more than 2 mil-
lion cars in the United States and had captured 23% of the U.S. auto market. By 2007,
Japanese automakers share of the U.S. market had reached 35% (between domestic
production and imports) out of a total of 46% for all foreign automakers. Following the
U.S. lead, Canada and Germany also negotiated restrictions on Japanese exports
(France and Italy already had very stringent quotas). A 1991 agreement to limit the
Japanese share of the European Union’s auto market to 16% expired at the end of
1999, when the share of Japanese cars (imports and production in Europe) was 11.4%
434 PART FOUR Imperfectly Competitive Markets

of the European market. That share exceeded 13% in 2007 and was expected to
continue to rise in the future.
Developments in the U.S. Automobile
Sources: U.S. International Trade Commission, A Review of Recent
Restraint Agreements (wasn ton: DC:
Industry, Including an Assessment ofthe Japanese Voluntary
American Capacity, Wall Street ae ;
February 1985); “Japanese Car Makers Plan Major Expansion of
Financial Times, September 15,
September 12, 1997, p. Al; “Japanese Carmakers Accelerate in Europe,”
Wall Street Journal, Jantialy sexs
2003, p. 8; “Foreign Auto Makers Aim to Boost U.S. Market Share,”
16, 2005, p. 1; Once Again
2005, p. Al; “Japanese Cars Set Europe Sales Record.” Japan Times, January
Here,” New York Times, Septembe r 30, 2007, p. 3; and U.S. Department
We're Driving What’s Not Made
Office, 2007).
of Commerce, The Road Ahead for the U.S. Auto Market (Washington, DC: U.S. Printing

SOME APPLICATIONS OF MARKET STRUCTURE,

13.8 EFFICIENCY, AND REGULATION

In this section, we discuss some important applications of the theory presented in this
chapter: the regulation of monopoly price, peak-load pricing, and transfer pricing. These
applications highlight the importance and relevance of the tools introduced in the chapter.

Regulating Monopoly Price

One way for the government to regulate a monopoly is to set a price below the price that
the monopolist would charge in the absence of regulation. This leads to a larger output
and lower profits for the monopolist, as shown in Figure 13.3.
The figure shows that, in the absence of regulation, the best level of output of the
monopolist is given by point M, where the LMC curve intersects the MR curve (the light
blue line) from below. Thus, Q = 3, P = $6 (point R), LAC = $4 (point NV), and profits are
$2 per unit (RN) and $6 in total.
If the government now set the maximum price that the monopolist could charge at
P = $5, the demand curve facing the monopolist would become CID (see the figure).
Thus, the monopolist’s demand curve would be horizontal until Q = 4 (since the monop-
olist cannot charge a price higher than $5) and would resume its usual downward shape
at Q > 4 (since the monopolist can charge prices lower than $5). As a result, the monop-
olist’s MR curve is also horizontal and coincides with the demand curve until point J and
resumes its usual downward shape when the demand curve does. That is, the monopo-
list’s MR curve becomes C/KW. Note that the MR curve has a discontinuous (vertical)
section at point /, where the demand curve has a kink.
With price set at P = $5, the best level of output for the monopolist is given by point
J’, where LMC = MR. Thus, Q = 4, P = $5 (point /), LAC = $3.60 (point J), and profits
are $1.40 per unit and $5.60 in total. Price is lower, output is larger, and the monopolist’s
profits are lower than without regulation.
If the government set the maximum price at point L, where the LMC curve intersects
Concept Check the D curve (so that P = LMC = $4), the best level of output for the monopolist would be
How can the price of a 5 units (see the figure). The monopolist would then earn a profit of $0.50 per unit and
monopolist be $2.50 in total. If the government, in an effort to eliminate all monopoly profits, were to set
regulated? the lower price (about $3.50) given by point H, where the monopolist’s LAC curve inter-
sects the D curve, a shortage of the commodity (and a black market) would arise.
This is
 CHAPTER 13 Market Structure, Efficiency, and Regulation 435

|
| | Yehe i l
0 3 4° 45 5 6 Q
FIGURE 13.3 Regulating Monopoly Price In the absence of regulation, Q = 3, P= $6,
LAC = $4, and profits are $2 per unit (RN) and $6 in total. If the government set the
maximum price at P = $5, the demand curve becomes C/D and the MR curve is CIKW. Then,
Q=4,P=$5, LAC = $3.60, and profits are $1.40 per unit (UV) and $5.60 in total.

because consumers would demand nearly 5.5 units of the commodity while the monopo-
list would only produce about 4.5 units (given by the point where P = LMC at about $3.50
in the figure).

Regulation and Peak-Load Pricing

The demand for some services (such as electricity) is higher during some periods (such
as in the evening and in the summer) than at other times (such as during the day or in
the spring). Electricity is also a nonstorable service (i.e., it must be generated when it
is needed). In order to satisfy peak demand, electrical power companies must bring into
operation older and less efficient equipment and thus incur higher costs. Power compa-
nies should, therefore, charge a higher price during peak than during off-peak periods
to reflect their higher marginal costs in the former than in the latter periods. Since such
price differences would be based on cost differences, they are not technically price dis-
crimination (nevertheless, they have sometimes been referred to as intertemporal price
discrimination).
Before deregulation, regulatory commissions often did not permit the public utility to
charge different prices during peak and off-peak periods, but required it to charge a con-
stant given price that covered the average of the generating costs during both periods
together. Such a constant price, in the face of different generating costs, did not represent
436 PART FOUR Imperfectly Competitive Markets

the best pricing policy. Assuming that the public utility operated in the short run with a
given plant and other equipment, the best pricing policy would be to charge the lower
price equal to the lower marginal cost during off-peak periods and charge the higher price
Peak-load pricing The equal to the higher marginal cost in peak periods. By adopting such peak-load pricing,
charging of a price consumer welfare would be higher than by the policy of constant pricing during both off-
equal to short-run peak and peak periods, and consumers generally would end up spending less on electric-
marginal cost, both in ity for the peak and off-peak periods combined. This is shown in Figure 13.4.
the peak period, when
demand and marginal
In the figure, D; is the market demand curve for electricity during the off-peak
cost are higher, and in period, and D> is the higher market demand curve for electricity during the peak period.
the off-peak period, The short-run marginal cost of the firm is given by SMC. The regulatory commission
when both are lower. sets the price of 4 cents per kWh at all times to cover average total costs in both periods
together. At P = 4 cents, the firm would sell 4 million kWh during the off-peak period
(point A; on D,) and 8 million kWh during the peak period (point Az on D2). At point
A,, however, the marginal benefit to consumers from one additional kWh (given by the
price of 4 cents per kWh) exceeds the marginal cost of generating the last unit of elec-
tricity produced (given by point B; on the SMC curve). From society’s point of view, it
would pay if the firm supplied more electricity until P = SMC = 3 cents (point EF) at
which D, and SMC intersect). The social benefit gained would be equal to the shaded
triangle A,B,E).

Cents

SMC

er)

Q
(Millions of kWh)
FIGURE 13.4 Peak-Load Pricing At the constant price of 4 cents per kWh,
the public utility sells 4 million kWh of electricity (point A;) during
the off-peak
period and 8 million during the peak period (point A>).
But at A;, PP+ SMC, while
at Az, P < SMC. With peak-load pricing, P = SMC = 3 cents
(point £;) in the
off-peak period and P = SMC = 5 cents (point E>) in the
peak period. The gain in
consumer welfare with peak-load pricing is thus given
by the sum of the two
Shaded triangles.
 CHAPTER 13 Market Structure, Efficiency, and Regulation 437

On the other hand, at point A>, the marginal benefit to consumers from one additional
kWh (given by the price of 4 cents per kWh) is smaller than the marginal cost of generating
the last unit of electricity produced (point B) on the SMC curve). From society’s point of
view, it would pay if the firm supplied less electricity until P= SMC = 5 cents (point E> at
which D» and SMC intersect). The social benefit gained (by using the same resources to pro-
duce some other service that society values more) would be equal to the shaded triangle
ByAE. Charging P = SMC = 3 cents in the off-peak period (point E; in the figure) and
P = SMC = 5 cents in the peak period (point E>) would be the most efficient pricing policy.
With deregulation, peak-load or time-of-day pricing is in fact now being used by
most electrical companies (telephone companies have been practicing second- and third-
degree price discrimination for a long time). For example, in April 2002, Con Edison
charged 7.89 cents per kWh for electricity from 10 A.M. to 10 P.M. and 0.70 cents from 10
P.M. to 10 A.M. and on weekends.'* What is surprising is that it took so long for regulatory
commissions to recognize peak-load pricing.
There are other effects from peak-load pricing, which are not shown in Figure 13.4. The
first results from the substitution of electricity consumption from peak to off-peak peri-
ods to take advantage of the lower price during the off-peak period. This tends to reduce
the benefit of peak-load pricing (see Problem 12, with the answer at the end of the book).
Another effect also not shown in Figure 13.4 is that with peak-load pricing the scale of
plant to meet peak-load demand is smaller (7 million kWh with peak-load pricing as
compared with 8 million kWh without peak-load pricing). Thus, in the long run, when the
public utility needs to replace the present plant, it can do so with a smaller and more effi-
cient one. One factor that militates against peak-load pricing is that it requires meters to
measure consumption at different times of the day, week, or year, and these can be quite
expensive to install.
Peak-load pricing is not confined to public utilities. It is equally applicable to such
private enterprises as hotels, restaurants, airlines, movie theaters, and so on, which face a
demand that fluctuates sharply and in a predictable way during peak and off-peak periods.
These enterprises usually charge lower rates during off-season or in periods of naturally
low demand (when marginal costs are lower) than during in-season or periods of high
demand (when marginal costs are higher).

Regulation and Transfer Pricing

The rapid rise of modern large-scale enterprises has been accompanied by decentral-
ization and the establishment of semiautonomous profit centers. This occurred because of
the need to contain the tendency toward increasing costs for communications and coordi-
nation among various divisions. Decentralization and the establishment of semiau-
Transfer pricing The tonomous profit centers also gave rise to the need for transfer pricing, or the need to
determination of the determine the price of intermediate products sold by one semiautonomous division of a
price of intermediate large-scale enterprise and purchased by another semiautonomous division of the same
products sold by one
enterprise. The appropriate pricing of intermediate products or transfer pricing 1s of cru-
semiautonomous
cial importance to the efficient operation of the individual divisions as well as the enter-
division of a
firm to another prise as a whole. If the wrong transfer prices are set, the various divisions and the firm as
semiautonomous a whole will not produce the optimum or profit-maximizing level of output and will not
division of the maximize total profits.
same enterprise.
18 See “Paying for Electricity by Time of Day,” New York Times, June 9, 1990, p. 48; and Con Edison, 2002.
438 PART FOUR Imperfectly Competitive Markets

Transfer pricing has also been used by multinational corporations to increase their
profits. Specifically, by artificially overpricing components shipped to an affiliate in a
higher-tax nation and underpricing products shipped from the affiliate in the high-tax
nation, the multinational corporation can minimize its tax bill and increase its profits. To
overcome this problem, government regulators usually apply the “arm’s length” test, under
which the price of parts shipped from one affiliate of a multinational corporation in one
country to another affiliate in another country is priced by regulators for taxing purposes
according to the price that the same part would be sold to nonaffiliates.
For simplicity, we assume in our analysis that the firm has two divisions, a production
division (indicated by the subscript p) and a marketing division (indicated by the subscript 7).
The production division sells the intermediate product only to the marketing division (.e.,
there is no external market for the intermediate product). The marketing division purchases
the intermediate product from the production division, completes the production process,
and markets the final product for the firm. We further assume that one unit of the interme-
diate product is required to produce each unit of the final product.
In Figure 13.5, MC, and MC,, are the marginal cost curves of the production and
marketing divisions of the firm, respectively, while MC is the vertical summation of

18

MC = MC, + MC,,
14

| |
0 20 40 60 Q
FIGURE 13.5 Transfer Pricing of the Intermediate Product with
No External
Market The marginal cost of the firm, MC, is equal to the vertical summation
of MCp
and MC,», the marginal cost curves of the firm's production
and marketing divisions.
Dy is the external demand for the final product faced by the
firm, and MR,» is the
Corresponding Marginal revenue curve. The firm’s best level of
output is 40 units and
Is given by point E,,, at which MRm, = MC, so that Pm = $14.
Since each unit of the
final product requires one unit of the intermediate product,
the transfer price for the
intermediate product, P;, is set equal to MCp at Qp = 40
(point Ep). Thus, P; = $6.
 CHAPTER 13 Market Structure, Efficiency, and Regulation 439

MC, and MC,, and represents the total marginal cost curve for the firm as a whole. The
figure also shows the external demand curve for the final product sold by the market-
ing division, D,,, and its corresponding marginal revenue curve, MR,,. The firm’s best,
or profit-maximizing, level of output for the final product is 40 units and is given by
point E,,, at which MR,, = MC. Therefore, P,,, = $14. Since 40 units of the intermedi-
ate product are required to produce the 40 units of the final product, the transfer price
for the intermediate product, P,, is set equal to the marginal cost of the intermediate
product (MC,) at QO, = 40. Thus, P, = $6 and is given by point E, at which Q, = 40.
The demand and marginal revenue curves faced by the production division of the firm
are then equal to the transfer price (i.e., D, = MR, = P,). Note that Q,, = 40 is the best
level of output of the intermediate product by the production division of the firm because
at Q, = 40, Dp = MR, = P; = MC, = $6. Thus, the correct transfer price for an interme-
diate product for which there is no external market is the marginal cost of production.!?

| ~ | SUMMARY
1. In this chapter we have made use of the basic principle that any activity should be carried out
until the marginal benefit equals the marginal cost to examine the relationship between market
structure and efficiency, public-utility regulation, and antitrust.
2. The Lerner index measures the degree of a firm’s monopoly power by the ratio of the
difference between price and marginal cost to price. The Herfindahl index estimates the degree
of monopoly power in an industry as a whole by the sum of the squared values of the market
sales shares of all the firms in the industry. According to the theory of contestable markets,
even if an industry has only one or a few firms, it would still operate as if it were perfectly
competitive if entry into the industry is absolutely free and if exit is entirely costless.
Experimental economics has been developing during the past two decades. This field seeks
to determine how real markets work by using paid volunteers within a simple experimental
institutional framework.
3. Static social costs of monopoly power arise because imperfect competitors produce where
P > MR = MC and also from rent-seeking activities. These must be balanced with the
benefits of economies of scale resulting from large-scale production and the possibility that
firms with monopoly power are more innovative than small firms without market power. A
great deal of disagreement exists, however, about the alleged dynamic benefits that larger
firms have over smaller ones.
4. Section I of the Sherman Antitrust Act, passed in 1890, declared that “Every contract,
combination... , or conspiracy in restraint of trade or commerce among the several states, or
with foreign nations, is hereby declared to be illegal.” This does not make monopoly as such,
or conscious parallelism, illegal. What is illegal is collusion to restrain trade. Section I of the
Sherman Antitrust Act makes attempts to monopolize the market illegal. Section VII of the
Clayton Act passed in 1914 (and amended by the Celler-Kefauver Act of 1950), prohibits
mergers that “substantially lessen competition” or tend to lead to monopoly.
5. Natural monopolies such as public utilities arise when the firm’s LAC curve is still declining at
the point where it intersects the market demand curve. The government then usually allows a

19 Ror a more detailed discussion of transfer pricing, including the case where there is an external market for
the intermediate product of the firm, see D. Salvatore, Managerial Economics in a Global Economy, 6" ed.
(New York: Oxford University Press, 2007).
440 PART FOUR Imperfectly Competitive Markets

single firm to operate but sets P = LAC (so that the firm earns only a normal return on
investment). Economic efficiency, however, requires that P = LMC, but this would result ina
loss and the company would not supply the service in the long run without a subsidy. Therefore,
P is usually set equal to LAC. Many difficulties arise in public-utility regulation, especially to
ensure that the utilities keep costs as low as possible.
. Since the mid-1970s, the government has deregulated airlines and trucking and reduced the
level of regulation for financial institutions, telecommunications, and railroads in order to
increase competition and avoid some of the heavy compliance costs of regulation. Even
though the full impact of deregulation has yet to be felt, deregulation seems to have led to
increased competition and lower prices, but it has also resulted in some problems such as
deterioration in the quality of the services provided.
. Voluntary export restraints (VER) refer to the case in which an importing country induces
another nation to reduce its exports of a commodity “voluntarily” under the threat of higher all-
around trade restrictions. When successful, the economic impact of voluntary export restraints
is the same as that of an equivalent import tariff, except for the revenue effect, which is now
captured by foreign suppliers. Voluntary export restraints have been negotiated to curtail
exports of textiles, automobiles, steel, shoes, and other commodities to the United States and
“other industrial countries.
. By setting price below the monopoly price, a monopolist can be induced to produce a
larger output and have lower profits. Peak-load pricing refers to the charging of a price
equal to short-run marginal cost, both in the peak period when demand and marginal
cost are higher and in the off-peak period when both are lower. The transfer price for
an intermediate product for which there is no external market is the marginal cost of
production.

|_| KEY TERMS

Efficiency Sherman Antitrust Act Voluntary export restraints (VER)
Lerner index Conscious parallelism Peak-load pricing
Herfindahl index Clayton Act Transfer pricing
Theory of contestable markets Averch—Johnson (A—J) effect
Experimental economics Deregulation movement

REVIEW QUESTIONS
l . Under what conditions will an economy operate most 6. What is the difference between limit pricing and the
efficiently? Why? theory of contestable markets?
. What can be done to increase efficiency if the price of the 7 . What are the most important
last unit consumed of a commodity exceeds the marginal
a. social costs of monopoly power?
cost of producing it?
. What is the value of the Lerner index if » = —5? if ba benelity associated wath monopoly: power?
Wee 8. How does the government decide whether to subject a
. What is the value of the Lerner index (L) if P= $10 and very large firm to antitrust action or regulation?
MR = $5? 9. The settlement of the AT&T antitrust case in 1982 involved
. What is the value of the Herfindahl index both good news and bad news for AT&T and its customers.
a. in a duopoly with one firm having 60% of the market? What was
b. with 1,000 equal-sized firms? a. the good news and bad news for AT&T?
 CHAPTER 13 Market Structure, Efficiency, and Regulation 441

b. the good news and bad news for users of telephone 11. Given the difficulties that the regulation of public utilities
services? face, would it not be better to nationalize public utilities,
10. a. How could a regulatory commission induce a public- as some European countries have done? Explain your
utility company to operate as a perfect competitor in answer.
the long run?
12. Peak-load pricing can be regarded as an
b. To what difficulty would this lead? application of the marginal principle. True
c. What compromise does a regulatory commission or false? Explain.
usually adopt?

: PROBLEMS
1s Explain why the value of the Lerner index can seldom if the price of the service that the public-utility
ever be equal to one (1.e., the value of L usually ranges commission would set and the quantity of the
from zero to smaller than one). service that would be supplied to the market at
. Show with the use of a diagram that a given value of the that price.
Lerner index is consistent with different rates of profits . Suppose that the market demand curve for the public-
for the firm. utility service shown in Figure 13.2 shifts to the right by
. In measuring the Herfindahl index, the market share of 1 million units at each price level, and, at the same time,
each firm in the industry is sometimes expressed in ratio the LAC curve of the public-utility company shifts
form rather than in percentages (as in the text). Find the upward by $1 throughout because of production
Herfindahl index if the market share of each firm is inefficiencies that escape detection by the public-utility
expressed as a ratio when commission. Draw a figure showing the price of the
a. there is a single firm in the industry. service that the public-utility commission would set and
the quantity of the service that would be supplied to the
b. there is a duopoly with one firm having 0.6 of the
market at that price.
total industry sales.
9. Compare the effects of a voluntary export restraint
c. there is one firm with sales equal to 0.5 of total
that restricts the export of commodity X to the nation
industry sales and ten other equal-sized firms.
to 200 units, with the effects of a $1 import tariff
d. there are ten equal-sized firms. imposed by the nation on commodity X shown in
e. there are 100 equal-sized firms in the industry. Figure 9.17.
f. there are 1,000 equal-sized firms in the industry. 10. Draw a figure showing how a regulatory commission
Starting with demand curve D in Figure 13.1, draw a could induce the monopolist of Figure 13.3 to behave as
figure showing three identical firms in the contestable a perfect competitor in the short run by setting the
market. appropriate price.
2B), Draw a figure similar to Figure 10.7 showing the net social . Explain why the problems arising in public-utility
losses of monopoly when the firm’s marginal cost curve is regulation do not arise in the case of a monopoly that 1s
rising, rather than horizontal as in Figure 10.7. not a natural monopoly.
Determine if the Justice Department would challenge a *12. a. Starting from Figure 13.4, draw a figure showing
merger between two firms in an industry with ten equal- peak-load pricing when substitution in consumption
sized firms, based on its Herfindahl-index guidelines only. is taken into consideration.
OTe Suppose that the market demand curve for the public- b. Is the benefit of peak-load pricing greater or
utility service shown in Figure 13.2 shifts to the right smaller when substitution in consumption 1s
by 1 million units at each price level but the LAC and taken into consideration than when it is not?
LMC curves remain unchanged. Draw a figure showing Why is this so?

* = Answer provided at end of book.

442 PART FOUR Imperfectly Competitive Markets

|
—_]|_ INTERNET SITE ADDRESSES
For measures of concentration and Herfindahl index in the The Internet sites for the Energy Regulatory Commission
United States, see: and for pricing by Con Edison are:
http://www.census.gov/prod/ec02/ http://www.ferc.ed.us
ecQ23 1srl.pdf http://www.conedison.com
Experimental economics is examined at: For conditions, deregulation, and antitrust cases in the airline
http://en.wikipedia.org/wiki/Experimental_ industry, see:
economics http://www.u.arizona.edu/~gowrisan/pdf_papers/
http://www.oswego.edu/~economic/exper.htm airline_competition.pdf
http://eeps.caltech.edu/ http://www.welcomeurope.com/default.asp
id=
Comprehensive antitrust links to the U.S. Department of 1300&idnews=4239&genre=9
Justice, the Federal Trade Commission, case summaries, http://www. libsci.sc.edu/bob/class/clis748/
journals, and so on are found at: Studentwebguides/Webguides2007/
http://www.antitrust.org SnedikerGuide2.html
http://www.usdoj.gov/atr/index.htm] For information on international trade regulations and rulings
http://www. findlaw.com/01topics/O1antitrust/ of the WTO, see:
index.html http://www.wto.org
 PART
FIVE

art Five (Chapters 14-16) presents the theory of Pricing and

p input pricing and employment. Until this point in the
text, we have assumed input prices to be given. In this
part, we examine how input prices and the level of their
Employment
employment are determined in the market. Chapter 14
deals with input pricing and employment under perfect
of Inputs
competition in the output and input markets. Chapter 15
examines input pricing and employment under imperfect
competition in the output and/or input markets. Chapter
16 deals with financial microeconomics; that is, the
allocation of inputs over time and the cost of capital. As in
previous parts of the text, the presentation of theory is
reinforced with many real-world examples and important
applications, while the “At the Frontier” sections present
some new and important developments in the analysis of
input or factor markets.
cor
at Hm ee

eee
 CHAPTER I4

Input Price and Employment

Under Perfect Competition
Chapter Outline Price Elasticity of Demand for Inputs in
14.1 Profit Maximization and Optimal Input Manufacturing Industries
Employment Leisure Time in the United States over the Past
14.2. The Demand Curve of a Firm for an Input Century
14.3. The Market Demand Curve for an Input and Its Labor Force Participation Rates
Elasticity Backward Bending Supply Curve of
14.4 The Supply Curve of an Input Physicians’ Services and Other Labor
14.5 Pricing and Employment of an Input Labor Productivity and Total Compensation in
14.6 Input Price Equalization Among Industries, the United States and Abroad
Regions, and Countries Convergence in Hourly Compensation in the
14.7 Economic Rent: An Unnecessary Payment to Leading Industrial Countries
Bring Forth the Supply of an Input Higher Tax Rates Reduce Hours of Work
14.8 Analysis of Labor Markets Under Perfect At the Frontier: Do Minimum Wages Really
Competition Reduce Employment?

List of Examples
14-1 The Increase in the Demand for Temporary
Workers

After Studying This Chapter, You Should Be Able to:

e Know how a firm determines the amount of each input to use to maximize profits
e Describe how a firm’s and the market demand curve for one or more variable inputs are derived
e Describe how the supply curve of labor of one individual is derived and why it could be backward sloping
e Explain how the equilibrium price and employment of an input is determined in a perfectly competitive
market
e Describe the effects of increasing the minimum wage

445
446 PART FIVE Pricing and Employment of Inputs

production
n Chapters 7 and 8 we examined how firms combine inputs to minimize
with the
costs on the assumption of given input prices. In Chapters 9 through 13 we dealt
the pricing and output of consumer s’ goods, again on the
product market and examined
assumption of given input prices. We now turn our attention to the input market and examine
how the price and employment of inputs are actually determined.
In many ways the determination of input prices and employment is similar to the
pricing and output of commodities. That is, the price and employment of an input is gen-
erally determined by the interaction of the forces of market demand and supply for the
input.
There are several important qualifications, however. First, whereas consumers
demand commodities because of the utility or satisfaction they receive in consuming the
commodities, firms demand inputs in order to produce the goods and services demanded
by society. That is, the demand for an input is a “derived demand”; it is derived from the
demand for the final commodities that the input is used in producing. Second, while con-
sumers demand commodities, firms demand the services of inputs. That is, firms demand
the flow of input services (e.g., labor time), not the stock of the inputs themselves. The
same is generally true for the other inputs. Third, the analysis in this chapter and in the
next deals with inputs in general; that is, it refers to all types of labor, capital, raw mate-
rials, and land inputs. However, since the various types of labor receive nearly three-
quarters of the national income, the discussion is couched in terms of labor.
We begin the chapter with a summary discussion of profit maximization and optimal
input employment. Then we derive a firm’s demand curve for an input. By adding the
demand curves for the input of all firms, we get the market demand curve for the input.
Next we discuss an individual’s decision between work and leisure and the market supply
curve of an input in general. The chapter then describes how the interaction of the market
demand and supply of an input determines its price and employment under perfect com-
petition (the case of imperfect competition is examined in the next chapter). Subsequently,
the chapter shows the process by which input prices tend to be equalized among industries
and regions of a country, and internationally among countries. A discussion of rent and
quasi-rent follows. This chapter concludes with several important applications and exten-
sions of the theory. The “At the Frontier” section examines the effect of minimum wages on
employment.

141 PROFIT MAXIMIZATION AND OPTIMAL INPUT EMPLOYMENT

In this section, we bring together and summarize the discussions of Chapters 7, 8, and 9
on the conditions for profit maximization and optimal input employment by firms operat-
ing under perfect competition. This is the first step in the derivation of the demand curve
for an input by a firm.
In Section 8.3, we saw that the least-cost input combination of a firm was given by
equation [8.5B], repeated below as [14.1]:

MP, /w = MPx/r [14.1]

where MP refers to the marginal (physical) product, L refers to labor, K to

capital, w to
wages or the price of labor time, and r to the interest rate or the rental price
of capital.
Equation [14.1] indicates that to minimize production costs, the extra output
or marginal
 CHAPTER 14 Input Price and Employment Under Perfect Competition 447

product per dollar spent on labor must be equal to the marginal product per dollar spent
on capital. If MP; = 5, MPx = 4, and w =r, the firm would not be minimizing costs,
because it is getting more extra output for a dollar spent on labor than on capital. To min-
imize costs, the firm would have to hire more labor and rent less capital. As the firm does
this, the MP, declines and the MPx increases (because of diminishing returns). The
process would have to continue until condition [14.1] held. If w were higher than r, the
MP, would have to be proportionately higher than the MPx for condition [14.1] to hold.
The same general condition would have to hold to minimize production costs, no matter
how many inputs the firm uses. That is, the MP per dollar spent on each input would have
to be the same for all inputs.
Going one step further, we can show that the reciprocal of each term (ratio) in equa-
tion [14.1] equals the marginal cost (MC) of the firm to produce an additional unit of out-
put. That is,

w/MP, =r/MPx = MC [14.2]

Consider labor first. The wage rate (w) is the addition to the total costs of the firm from
hiring one additional unit of labor, while MP, is the resulting increase in the total output
of the commodity of the firm. Thus, w/MP,, gives the change in total costs (in terms of
labor) per unit increase in output. This is the definition of marginal cost. That is,
w/MP, = MC.' For example, if the hourly wage is $10 and the firm produces five
additional units of the commodity with an additional hour of labor time, the marginal
cost per unit of output is $2 (w/MP, = $10/5 = $2 = MC). The same is true for cap-
ital. That is, r/MPx = MC.”
To maximize profits, the firm must use the optimal or least-cost input combination to
produce the best level of output. We saw in Section 9.3 that the best level of output for a
perfectly competitive firm is the output at which marginal cost (MC) equals marginal rev-
enue (MR) or price (P).° Thus, it follows that to maximize profits

w/MP, =r/MPx =MC = MR= P [14.3]

By cross multiplication and rearrangement of the terms, we get equations [14.4] and
[14.5]:

WNP Ye IMIR = Oe WR, 18 = 0 {14.4]

WYNPre SC INMUR =P OR WIPre OK IE Se ip [easy]

Thus, the profit-maximizing rule is that the firm should hire labor until the marginal prod-
uct of labor times the firm’s marginal revenue or price of the commodity equals the wage

' Specifically,
w _ ATC/AL _ ATC AL _ ATC aie
Wie ~ NONE ~ IG ISO INO)

> Specifically,
ig ATC/AK _ ATC SK _ ATC _ 4
MPx AQ/AK AK AQ AQ
3 Remember that with perfect competition in the commodity market, MR = P.
448 PART FIVE Pricing and Employment of Inputs

the
rate. Similarly, the firm should rent capital until the marginal product of capital times
Concept Check firm’s marginal revenue or price of the commodit y is equal to the interest rate. To maxi-
How does a firm mize profits, the same rule would have to hold for all inputs that the firm uses. In the next
determine how much section, we will see that this provides the basis for the firm’s demand curve for an input.
labor to hire to
maximize profits?

14.2 THE DEMAND CURVE OF A FIRM FOR AN INPUT

In this section, we build on the discussion of the last section and derive the demand curve
of a firm for an input—first, when the input is the only variable input and then, when the
input is one of two or more variable inputs.

The Demand Curve of a Firm for One Variable Input

We have stated-earlier that a firm demands an input in order to produce a commodity
Derived demand The demanded by consumers. Thus, the demand for an input is a derived demand—derived,
demand for an input that is, from the demand for the final commodities that the input is used in producing. The
that arises from the demand for an input by a firm shows the quantities of the input that the firm would hire at
demand for the final
various alternative input prices. We begin by assuming that only one input is variable (1.e.,
commodities that the
the amount used of the other inputs is fixed and cannot be changed). This assumption will
input is used in
producing. be relaxed in the next subsection.
According to the marginal concept, a profit-maximizing firm will hire an input as
long as the extra income from the sale of the output produced by the input is larger than
the extra cost of hiring the input. The extra income is given by the marginal product (MP)
Marginal revenue of the input times the marginal revenue (MWR) of the firm. This is called the marginal
product (MRP) The revenue product (MRP). That is,
marginal physical
product of the input
MRP = MP- MR [14.6]
(MP) multiplied by the
marginal revenue of the
commodity (MR). When the firm is a perfect competitor in the product market, its marginal revenue is
equal to the commodity price (P). In this case, the marginal revenue product is called the
Value of the marginal value of the marginal product (VMP). That is, when the firm is a perfect competitor in
product (VMP) The the product market (so that MR = P),
marginal (phystcal)
product of the input
MRP = MP -MR=MP.- P = VMP [14.6A]
(MP) multiplied by the
commodity price (P).
If the variable input is labor, we have

MRP; = MP; -MR=MP,-~P = VMP, [14.6B]

Thus, the MRP; or VMP, is the left-hand side of equation [14.4]. Similarly, the MRPx or
VMPx is the left-hand side of equation [14.5].
Marginal expenditure The extra cost of hiring an input, or marginal expenditure (ME), is equal to the price
(ME) The extra of the input ifthe firm is a perfect competitor in the input market. Perfect competition in the
expenditure for or cost input market means that the firm demanding the input is too small, by itself, to affect the
of hiring an additional
price of the input. In other words, each firm can hire any amount of the input (service) at the
unit of an input.
given market price for the input. Thus, the firm faces a horizontal or infinitely elastic sup-
ply curve for the input. For example, if the input is labor, this means that the
firm can hire
 CHAPTER 14 Input Price and Employment Under Perfect Competition 449

Marginal Revenue Product of Labor as the Firm’s

ents puemone scleduietorlabor 7
LE Qy MP, Py MRP, = VMP, ME, = w

0 0 35! $10 th $40

| 2 12 10 $120 40
2, De 10 10 100 40
3 30 8 10 80 40
4 36 6 10 60 40
5 40 4 10 40 40
6 42 2, 10 20 40

any quantity of labor time at the given wage rate. Thus, a profit-maximizing firm should hire
labor as long as the marginal revenue product of labor exceeds the marginal expenditure on
labor or wage rate and until MRP; = ME; = w, as indicated by equation [14.4]. Note that
the MRP = ME tule is entirely analogous to the MR = MC profit-maximizing rule
employed throughout our discussion of price and output determination in Chapters 9-13.
The actual derivation of a firm’s demand schedule for labor, when labor is the only
variable input (1.e., when capital and other inputs are fixed), is shown in Table 14.1. In Table
14.1, L refers to the number of workers hired by the firm per day. Qy is the total output of
commodity X produced by the firm by hiring various numbers of workers. The MP, is the
marginal or extra output generated by each additional worker hired. The MP, is obtained
by the change in Qy per unit change in L. Note that the law of diminishing returns begins to
operate with the hiring of the second worker. Px refers to the price of the final commodity,
which is constant (at $10) because the firm is a perfect competitor in the product market.
The marginal revenue product of labor (MRP_) is obtained by multiplying the MP; by MRx
(the marginal revenue from the sale of commodity X ) and is equal to the value of the mar-
ginal product of labor (VMP_) because Py = MR x.* The last column gives the marginal
expenditure on labor (ME), which is equal to the constant wage rate (w) of $40 per day that
the firm must pay to hire each additional worker (since the firm is a perfect competitor in the
labor market).
Looking at Table 14.1, we see that the first worker contributes an extra $120 to the
firm’s revenue (i.e., MRP; = $120), while the firm incurs an extra expenditure of only
$40 to hire this worker (i.e., ME; = w = $40). Thus, it pays for the firm to hire the first
worker. The MRP, of the second worker falls to $100 (because of diminishing returns),
but this still greatly exceeds the daily wage of $40 that the firm must pay the second (and
all) worker(s) hired. According to equation [14.4], the profit-maximizing firm should hire
workers until the MRP; = ME, = w. Thus, this firm should hire five workers, at which
VMP,, = w = $40. The firm will not hire the sixth worker because he or she will con-
tribute only an extra $20 to the firm’s total revenue while adding an extra $40 to its total
expenditures.

4 Note also that

A@Y ATR iS ATR
MRP, = MP, - MR =
Nip BO Oe SAT
450 PART FIVE Pricing and Employment of Inputs

Thus, the MRP, schedule gives the firm’s demand schedule for labor. It indicates the
Concept Check number of workers that the firm would hire at various wage rates. For example, if
How is a firm’s demand w = $120 per day, the firm would hire only one worker per day. If w= $100, the firm
curve for one variable would hire two workers. At w = $80, the firm would hire three workers. At w = $40,
input derived? L=5, and so on. If we plotted the MRP, values of Table 14.1 on the vertical axis and
L on the horizontal axis, we would get the firm’s negatively sloped demand curve for
labor when labor is the only variable input. This is shown next.

The Demand Curve of a Firm for One of Several Variable Inputs

We have seen that the declining MRP, schedule given in Table 14.1 gives the firm’s
demand schedule for labor in the short run when labor is the only variable input. This is
shown by the negatively sloped MRP, curve in Figure 14.1 (on the assumption that labor
is infinitesimally divisible or that workers can be hired for any part of a day). The MRP, or
demand for labor curve when labor is the only variable input shows that the firm will hire
three workers at w = $80 (point A in Figure 14.1) and five workers at w = $40 (point B).
However, when labor is not the only variable input (i.e., when the firm can also change
the quantity of capital and other inputs), the firm’s demand curve for labor can be derived
from the MRP, curve, but it is not the MRP, curve itself. Figure 14.1 shows the derivation of
the demand curve for labor by a firm when both labor and capital are variable. As a first step,
recall that at w = $80, the profit-maximizing firm would hire three workers (point A on the
MRP, curve in Figure 14.1). This gives the first point on the firm’s demand curve for labor
when only labor is variable and when both labor and capital are variable. When the daily
wage rate falls from w = $80 to w = $40, the firm does not move to point B on the given
MRP; curve and hire five workers (as shown before) if labor is not the only variable input.

MRP;,($)

| |
| |
|
|MRP"; dy,

| MRP, |
| | | | | |
0 3 5 6 8 16
FIGURE 14.1. Demand Curve for Labor of a Firm with Labor and Capital
Variable At w= $80, the firm will employ three workers per day (point A on
the MRP, curve). At w = $40, the firm would employ five workers if labor
were
the only variable input (point B on the MRP, curve). However, since capital is
also
variable and complementary to labor, as the firm hires more labor, the MRP
shifts to the right and the firm also employs more capital (not shown in
the figure).
But as the firm employs more capital, the MRP, curve shifts to the
right to MRP),
and the firm employs eight workers per day at w = $40 (point C
on MRP; ). By
Joining point A and point C, we derive d, (the firm’s demand
curve for labor)
 CHAPTER 14 Input Price and Employment Under Perfect Competition 451

To get another point on the firm’s demand curve for labor when both labor and capi-
Complementary tal are variable, we should realize that labor and capital are usually complementary
inputs Inputs related inputs, in the sense that when the firm hires more labor, it will also employ more capital
to one another in such a (e.g., rent more machinery). For example, when the firm hires more computer program-
way that an increase in
mers, it will usually also pay for the firm to rent more computer terminals, and vice versa.
the employment of one
raises the marginal Recall also that the MRP; curve is drawn on the assumption that the quantity of capital
product of the other. used is fixed at a given level. Similarly, the MRPx curve is drawn on the assumption of a
given amount of labor being used. If the quantity of labor used with various amounts of
capital increases (because of a reduction in wages), the entire MRPx curve will shift out-
ward or to the right. The reason for this is that with a greater amount of labor, each unit of
capital will produce more output (see Section 7.3). Given the (unchanged) rental price
of capital or interest rate, the profit-maximizing firm will then want to expand its use
of capital.
But the increase in the quantity of capital used by the firm will, in turn, shift the
entire MRP; curve outward or to the right because each worker will have more capital
with which to work (and produce more output). This is shown by the MRP’, in Figure
14.1. Thus, when the daily wage rate falls to w = $40, the profit-maximizing firm will
hire eight workers (point C on the MRP; curve) rather than five workers (point B on the
MRP, curve). Thus, point C is another point on the firm’s demand curve for labor when
labor and capital are both variable. Other points can be similarly obtained. Joining point
A and point C gives the firm’s demand curve for labor (d; in Figure 14.1) when labor and
capital are both variable and complementary.
To summarize, when w = $80, the firm will hire three workers (point A in
Figure 14.1). Point A is a point on the firm’s demand curve for labor, whether or not labor
is the only variable input. When the wage rate falls to w = $40, the firm will hire five
workers (point B on the MRP, curve) if labor is the only variable input. Thus, the MRP;
curve gives the firm’s demand curve for labor when labor is the only variable input. If cap-
ital is also variable and complementary to labor, as the firm hires more labor because of
the reduction in the wage rate, the MRPx curve (not shown in Figure 14.1) shifts to the
right and the firm uses more capital at the unchanged interest rate. However, as the firm
uses more capital, its MRP, curve shifts outward or to the right to MRP‘, and the firm
hires not just five workers (point B on the MRP, curve), but eight workers (point C on the
MRP’, curve). The reason is that only by hiring eight workers will MRP) = w = $40.
Concept Check Joining points A and C gives the demand curve for labor of the firm d; (see the figure)
How is a firm’s demand when labor and capital are both variable and complementary.
curve for one of several If capital or other inputs are substitutes for labor, the increase in the quantity of labor
variable inputs derived? used by the firm as a result of a reduction in the wage rate will cause the MRP curves of
these other inputs to shift to the left (as the utilization of more labor substitutes for, or
replaces, some of these other inputs). This, in turn, will cause the MRP, curve to shift out-
ward and to the right as in Figure 14.1. Thus, whether other inputs are complements or sub-
stitutes for labor, the MRP, shifts outward and to the right when the wage rate falls (and
the price of these other inputs remains unchanged). As a result, the firm will hire more
labor than indicated on its original MRP, curve at the lower wage rate (see Figure 14.1).
Thus, the d, curve is negatively sloped and generally more elastic than the MRP;
curve in the long run when all inputs are variable (whether the other inputs are comple-
ments or substitutes of labor, or both). In general, the better the complement and substi-
tute inputs available for labor, the greater the outward shift of the MRP, curve as a result
of a decline in the wage rate, and the more elastic is d;. The negative slope of the d; curve
means that when the wage rate falls, the profit-maximizing firm will hire more workers.
452 PART FIVE Pricing and Employment of Inputs

input falls, the firm

The same is generally true for other inputs. That 1s, as the price of any
the input of the firm is nega-
will hire more units of the input (i.e., the demand curve of
marginal adjustments 1n
tively sloped). In the process, however, the firm will also make
the use of all complementary and substitute inputs.

14.3 THE Market DEMAND CURVE FOR AN INPUT AND ITS ELASTICITY

In this section, we examine how to derive the market demand curve for an input from the
individual firms’ demand curves for the input. The determination of the market demand
curve for an input is important because the equilibrium price of the input is determined at
the intersection of the market demand and supply curves of the input under perfect com-
petition. After deriving the market demand curve for an input, we will discuss the deter-
minants of the price elasticity of the demand for the input.

The Market Demand Curve for an Input

The market demand curve for an input is derived from the individual firms’ demand
curves for the input. Although the process is similar to the derivation of the market
demand curve for a commodity from individuals’ demand curves for the commodity, the
market demand curve for an input is not simply the horizontal summation of the individ-
ual firms’ demand curves for the input. The reason is that when the price of an input
falls, not only this firm but all other firms will empioy more of this and other (comple-
mentary) inputs, as explained in Section 14.2. Thus, the output of the commodity
increases and its price falls. Since the MRP of an input is equal to the marginal product
of the input times the marginal revenue (which is here equal to the commodity price),
the reduction in the commodity price will cause each firm’s MRP and demand curves of
the input to shift down or to the left. The market demand curve for an input is then
derived by the horizontal summation of the individual firms’ demand curves for the
input after the effect ofthe reduction in the commodity price has been considered. This
is shown in Figure 14.2.
In the left panel of Figure 14.2, d; is the individual firm’s demand curve for labor
time derived in Figure 14.1. The d, curve was derived from the MRP, of the firm, which
itself depended on the marginal product of labor (i.e., MP;) and the commodity price of
P, = $10. The d, curve shows that at the wage rate of w = $80 per day the firm would
hire three workers per day (point A on d_). If there were 100 identical firms demanding
labor, all firms together would employ 300 workers at w = $80 (point A’ in the right
panel of Figure 14.2). Point A’ is then one point on the market demand curve for labor.
When the wage rate falls to w = $40, the firm would employ eight workers per day
(point C on d;). However, when we consider that all firms will be employing more labor
(and capital) when the wage rate falls, they will produce more of the commodity, and the
commodity price falls. The reduction in the commodity price will cause a leftward shift in
dy, Say to d; in the left panel, so that when the wage rate falls to w = $40, the firm will not
hire eight workers per day but six workers (point E on d;,). With 100 identical firms in the
market, all firms together will employ 600 workers (point E’ in the right panel). By
joining points A’ and E’ in the right panel, we get the market demand curve for labor,
D,. Note that Dz; is less elastic than if it were obtained by the simple straightforward
horizontal summation of the d;, curves. Example 14-1 examines the increase
in the
demand for temporary workers.
 CHAPTER 14 Input Price and Employment Under Perfect Competition 453

Firm Market
w($) w($)

80 - -80 “e

40, - 40

ae | Dy,
| dy, |
| | |
0) 3 6 8 ih, 0 300 (0X0) JL,

FIGURE 14.2 Derivation of the Market Demand Curve for Labor _ In the left panel, d;, is the
firm's demand curve for labor derived in Figure 14.1. At w = $80 the firm hires three workers (pointA
on d). One hundred identical firms employ 300 workers (point A’ in the right panel). Point A’ is one
point on the market demand curve for labor When w falls to w = $40, all firms employ more labor,
the output of the commodity rises, and its price falls. Then qd, shifts to the left to a, so that at w =
$40 the firm hires 6L (point E on a), and all firms together will employ 600L (point E’ in the right
panel). By joining point A’ and E’, we get Dy.

EXAMPLE 14-1
The Increase in the Demand for Temporary Workers

In recent years there has been a sharp increase in the demand for temporary workers not
only for work in offices but also on factory floors around the country. The trend is evi-
dent not only in small local firms but also in such large leading multinational corpora-
tions as IBM, Microsoft, General Electric, and Johnson & Johnson, and it involves not
only low-skilled workers but, increasingly, professionals such as lawyers, doctors, and
scientists. With many corporations facing increasing competition from home and
abroad, and having already pared their payrolls to the bone, skilled temporary workers
are becoming increasingly common in computer labs, operating rooms, and even exec-
utive suites.
The tendency to hire temporary workers is strongest during economic downturns,
but it persists even in times of strong demand. Some estimates indicate that as many as
30% of new jobs are now temporary, as compared with about 10% a decade ago. In
2007, temporary workers represented 2.2% of the nation’s overall work force, double
the level in 1991. Temporary workers usually earn significantly less than the perma-
nent employees and can be laid off far more easily than regular employees. They also
receive little in the way of nonwage benefits (health insurance, pension benefits, vaca-
tions, and so on). Although the lower labor costs make U.S. corporations more flexible
and competitive on world markets, hiring temporary workers creates major problems
for new entrants into the labor force and for older laid-off workers searching for a
new job. Indeed, if the present trend toward hiring temporary workers continues, the
454 PART FIVE Pricing and Employment of Inputs

paid vacations,
traditional American job, with a 40-hour workweek, medical benefits,
and a pension at 65, may become more and more rare.
jobs pro-
Although some workers like the flexibility and diversity that temporary
true for
vide, the vast majority would clearly prefer a more permanent job. This is also
who present themselv es as consulta nts when they fail to secure
the many professionals
a regular job. Tempora ry workers also have less loyalty to the firm than regular work-
ers and can leave suddenly when they find a more permane nt job or a better tempora ry
occupation. Furtherm ore, temporar y workers that are kept on a long time are likely to
become grumpy and wonder why they are not hired more permanen tly. Finally, tem-
porary workers create a strong need for society to provide a safety net separate from
people’s jobs to provide for their health care, pension, and job training.
Sources: “Regulators Probe U.S. Reliance on Temporary Workers,” Wall Street Journal, August 7, 2000,
p- A2; D. Ellwood et al., A Working Nation: Workers, Work, and Government in the New Economy (New
York: Russell Sage Foundation, 2000); “Temporary Work Is Sidestepping a Slowdown,” New York Times,
July7,2001, Section 3, p. 4; http://www.bls.gov/news.release/ empsit.t!2.htm.

Determinants of the Price Elasticity of Demand for an Input

In Section 5.2, we defined the price elasticity of demand for a commodity as the per-
centage change in the quantity demanded of the commodity resulting from a given per-
centage change in its price. The price elasticity of demand for an input can similarly be
defined as the percentage change in the quantity demanded of the input resulting from
a given percentage change in its price. The greater the percentage change in quantity
resulting from a given percentage change in price, the greater is the price elasticity of
demand. For example, if 2% more workers are employed as a result of a 1% reduction
in the wage rate, the price (wage) elasticity of the market demand for labor is —2. If the
quantity demanded of labor increased by only 1/2%, the wage elasticity of labor would
be —1/2.
The determinants of the price elasticity of demand for an input are generally the same
as the determinants of the price elasticity of demand for a commodity (discussed in
Section 5.2). First, the price elasticity of demand for an input is larger the closer and the
greater are the number of available substitutes for the input. For example, the price elas-
ticity of demand for copper is greater than the price elasticity of demand for chromium (a
metallic element used in alloys and in electroplating) because copper has better and more
substitutes (silver, aluminum, and fiber glass) than chromium. Thus, the same percentage
change in the price of copper and chromium elicits a larger percentage change in the
quantity demanded of copper than of chromium.
Second, since the demand for an input is derived from the demand for the final com-
modity produced with the input, the price elasticity of demand for the input is greater,
the larger is the price elasticity of demand of the commodity. The reason is that (as we
have seen in the previous section) a reduction in the price of an input results in a reduc-
tion in the price of the final commodity produced with the input. The more elastic is
the
demand for the final commodity, the greater is the increase in the quantity demanded of
the commodity, and so the greater is the quantity demanded of the input used
in the
production of the commodity. For example, if the wage rate falls, the price of
new homes
also declines. If the price elasticity of demand for new homes is very high,
then a price
 CHAPTER 14 Input Price and Employment Under Perfect Competition 455

reduction for new homes greatly increases the quantity demanded of new homes and
greatly increases the demand for labor and other inputs going into the production of new
homes.
Third, the price elasticity of demand for an input, say aluminum, is greater the larger
is the price elasticity of supply of other inputs for which aluminum is a very good substi-
tute in production. The reason is as follows. A reduction in the price of aluminum will
lead producers to substitute aluminum for these other inputs. This is the same as the first
reason discussed above, but it is not the end of the story. If the supply curves of these
other inputs are very elastic, the reduction (i.e., leftward shift) in their demand curves will
not result in a large decline in their prices, and so a great deal of the original increase in
the quantity demanded of aluminum as a result of a reduction in its price will persist. This
makes the demand curve for aluminum price elastic (if aluminum is a good substitute for
these other inputs). Had the supply of these other inputs been inelastic, a reduction in their
demand would have reduced their price very much, and checked the increase in the quan-
tity demanded (and the price elasticity of demand) for aluminum.
Fourth, the price elasticity of demand for an input is Jower the smaller is the percent-
age of the total cost spent on the input: For example, if the percentage of the total cost of
the firm spent on an input is only 1%, a doubling of the price of the input will only
increase the total costs of the firm by 1%. In that case, a firm is not likely to make great
efforts to economize on the use of the input. Therefore, the price elasticity of an input on
which the firm spends only a small percentage of its costs is likely to be low. This is usu-
ally, but not always, the case.
Finally, the price elasticity of an input is greater the longer the period of time allowed
for the adjustment to the change in the input price. For example, an increase in the wage
of unskilled labor may not reduce employment very much in the short run because the
firm must operate the given plant built to take advantage of the low wage of unskilled
labor. In the long run, however, the firm can build a plant using more capital-intensive
production techniques to save on the use of the now more expensive unskilled labor. Thus,
the reduction in the employment (and the wage elasticity of the demand) of unskilled
labor is likely to be greater in the long run than in the short run. In Figure 14.1, the dz
curve (which is the firm’s demand curve for labor when labor and other inputs are vari-
able) is more elastic than the MRP, curve (which is the firm’s short-run demand curve for
labor when labor is the only variable input). Example 14-2 examines the price elasticity
of the demand for inputs in some manufacturing industries.

EXAMPLE 14-2
Price Elasticity of Demand for Inputs in Manufacturing Industries

Table 14.2 presents the price elasticity of the demand for production labor, nonpro-
duction labor, capital, and electricity in the textile, paper, chemicals, and metals indus-
tries in Alabama estimated from data on input quantities, input prices, and outputs over
the 1971-1991 period. The data show that input demand is price inelastic, except for
nonproduction labor in the textile industry, where it is about unitary elastic. This
means that an increase in the price of an input reduces the quantity demanded of the
input less than proportionately. For example, the table shows that a 10% increase in the
456 PART FIVE Pricing and Employment of Inputs

Price Elasticity of Input Demand

TABLE 14.2 for Manufacturing Industries

Production Nonproduction
Labor Labor Capital Energy

Textile —0.50 =1.04 —0.41 —0.11

Paper —0.62 —0.97 —0.29 —0.16
Chemicals —0.75 —0.69 —0.12 —0.25
Metals —0,.41 —0.44 —0.91 —0.69

Source: A. H. Barnett, K. Reutter, and H. Thompson, “Electricity Substitution: Some Local

Industrial Evidence,’ Energy Economics, 20, 1998, 411-419.

wage of production workers tends to reduce the quantity demanded of production

workers in the textile industry by 5%. A 10% increase in the price of capital reduces
the quantity of capital demanded by the paper industry by 2.9%, while a 10% increase
in the price of energy reduces the quantity demanded of that input by 1.1% in the
textile industry (the lowest price elasticity shown in the table).

144 The Supply CURVE OF AN INPUT

In this section, we first derive an individual’s supply curve of labor. Then we examine the
substitution and the income effects of a wage increase. Finally, we discuss the market sup-
ply curve of an input in general, and the market supply of labor in particular. In the fol-
lowing section, we will use the market supply curve examined in this section and the
market demand curve derived in Section 14.3 to determine the equilibrium price of an
input (the wage rate).

The Supply of Labor by an Individual

The short-run supply curve of an input (like the supply curve of a final commodity) is gen-
erally positively sloped, indicating that a greater quantity of the input is supplied per unit
of time at higher input prices. For example, if the price of iron ore rises, mining firms will
Intermediate good supply more iron ore per time period. The same is true for an intermediate good such as
The output of a firm or steel (produced with iron ore), which is itself used as an input in the production of many
industry that is the _ final commodities such as automobiles. That is, steel producers will supply more steel at
es car eed higher steel prices. However, while natural resources (such as iron ore) and intermediate
Ae Tee goods (such as steel) are supplied by firms, and their supply curves are generally positively
sloped, labor is supplied by individuals and their supply curve may be backward-bending.
That is, after some wage rate, higher wage rates may result in individuals demanding more
leisure time and supplying fewer hours of work per day. This is shown in Figure 14.3.
The left panel of Figure 14,3 is used to derive the backward-bending supply curve
of
labor of an individual shown in the right panel. The movement from left to right on
the
horizontal axis of the figure in the left panel measures hours of leisure time
for the
 CHAPTER 14 Input Price and Employment Under Perfect Competition 457

240
F
NN

WO)
180
2)

Ss 10.00
Sy

120 we & 7.50

Sas 2
($)
income
Daily
©
N ©
M 00
XR
~= $2.59
E
SAS Us 2.50
U;
Uy
ee ie eet NE
Joe Ge 10, 1214) den 1s. 20 99" 94 PE RNG
Hours of leisure per day Hours of work per day
| | | | | | | | | | | |
oe eon Olt see 2 Ome Oe Or 4s 22 |)
Hours of work per day
FIGURE 14.3 Derivation of an Individual’s Supply Curve of Labor _ In the left panel, U;, U2, U3, and U4
show the trade-off between leisure and income for the individual, while the straight budget lines show the
trade-off between leisure and income in the market. The absolute slope of the budget lines gives the wage
rates. The individual maximizes Satisfaction at point H (with 18 hours of leisure per day and a daily income of
$15) on U; with w = $2.50, at point E (with 16 hours of leisure and income of $40) on U> with w = $5, and
so on. By plotting hours of work per day at various wage rates, we get the individual's backward-bending supply
curve of labor (S;) in the right panel.

individual (the top scale at the bottom of the figure). Subtracting hours of leisure from the
24 hours of the day, we get the hours worked by the individual per day (the bottom scale
in the left panel). Hours of leisure plus hours of work always equal 24. On the other hand,
the vertical axis in the left panel measures money income.
Indifference curves U;, U2, U3, and U4 in the left panel show the trade-off between
leisure and income for the individual. They are similar to the individual’s indifference
curves between two commodities, discussed in Section 3.2. For example, the individual is
indifferent between 14 hours of leisure (10 hours of work) and a daily income of $60 (point
M on U3) on the one hand, and 16 hours of leisure (8 hours of work) and a daily income of
$40 (point E on U>) on the other. Thus, the individual is willing to give up $20 of income to
increase leisure time by 2 hours. Indifference curves U3 and U4 provide more utility or
satisfaction to the individual than U2, and U2 provides more utility or satisfaction than U}.
Given the wage rate, we can easily define the budget line of the individual. When the
individual takes all 24 hours in leisure (i.e., works zero hours), the individual’s income is
458 PART FIVE Pricing and Employment of Inputs

at this point
zero regardless of the wage rate. Thus, any budget line of the individual starts
l worked 24
on the horizontal axis in the left panel. On the other hand, if the individua
hours per day, his or her income would be $60 if the wage rate were $2.50 (the lowest
budget line), his or her income would be $120 if w = $5 (the second budget line), $180 if
w = $7.50 (the third budget line), and $240 if w = $10 (the highest budget line). Note
that the wage rate is given by the absolute value of the slope of the budget line. Thus,
w = $60/24 hours = $2.50/hour for the lowest budget line, w = $120/24 hours = $5
for the second budget line, w = $180/24 hours = $7.50 for the third budget line, and
w = $240/24 hours = $10 for the highest budget line. These budget lines are similar to
the individual’s budget lines derived in Section 3.3.
As shown in Section 3.5, an individual maximizes utility or satisfaction by reaching
the highest indifference curve possible with his or her budget line. Thus, if the wage rate
is $2.50, the individual will take 18 hours in leisure (i.e., work 6 hours) and earn an
income of $15 per day (point H on U, in the left panel of Figure 14.3). This gives point
H' on the individual’s supply curve of labor (sz) in the right panel. With w = $5, the
individual takes 16 hours of leisure (i.e., works 8 hours) and earns an income of $40
per day (point E on U> in the left panel). This gives point E’ on s; in the right panel. At
w = $7.50, the individual chooses 16.5 hours of leisure (works 7.5 hours) and has an
income of $56.25 per day (point N on U3 and N’ on s;). Finally, at w = $10, the indi-
Concept Check vidual chooses 18 hours of leisure (works 6 hours) and has an income of $60 per day
How is the supply (point R on U4 and R’ on sr).
curve of labor of an Note that the individual’s supply curve of labor (s; in the right panel of Figure 14.3) is
individual derived?
positively sloped until the wage rate of $5, and it bends backward at higher wage rates.
Thus, the individual works more hours (i.e., takes less leisure) until the wage rate of $5 per
hour and works fewer hours (i.e., takes more leisure) at higher wage rates. Example 14-3
shows that, contrary to widespread belief, leisure time per capita seems to have remained
practically unchanged in the United States during the past century.

EXAMPLE 14-3
Leisure Time in the United States over the Past Century

Despite rising labor and business productivity and increasing use of labor-saving
household appliances, a 2006 study by Ramey and Francis concluded that Americans
seem to work as hard today and have no more leisure time than a century ago. Ramey
and Francis found that about 70% of the decline in hours worked in the marketplace
were offset by an increase in hours spent in school. At the same time, and despite the
increasing use of household appliances, Americans actually spend slightly more time
cooking, cleaning, caring for children, and in other “home production” activities, leav-
ing leisure per capita approximately the same today as it was in 1900.
These results seem to contradict the conclusions of other studies, which found
instead a large increase in leisure time over past decades. These other studies, however,
do not take into consideration the large changes that have taken place in labor-force
participation rates and in other nonleisure activities. For example in 1910, 25%
of male
children age 10 to 15 were employed, while child labor laws prevent any from
being
employed today. Furthermore, the proportion of the population age
65 and over
increased from 4% in 1900 to 12% in 2000. The net effect of all these
changes,
 CHAPTER 14 Input Price and Employment Under Perfect Competition 459

together with changes in other nonleisure activities, is that leisure per capita in the
United States seems to be no greater today than it was in 1900.
Sources: V. A. Ramey and N. Francis, “A Century of Work and Leisure,” NBER Working Paper No. 12264,
May 2006; M. Aguiar and E. Hurst, “Measuring Trends in Leisure: The Allocation of Time Over Five
Decades,” NBER Working Paper No. 12082, March 2006; and “The Real Reasons You’re Working So
hard,” Business Week, October 5, 2005, pp. 60-67.

Substitution and Income Effects of a Wage Increase

The reason that an individual’s supply curve of labor may be backward-bending can be
explained by separating the substitution effect from the income effect of the wage
increase. That is, an increase in wages (just like an increase in a commodity price) gives
rise to a substitution effect and an income effect. In the case of an increase in the price of
a normal good, the substitution and the income effects work in the same direction (to
reduce the quantity demanded of the commodity). On the other hand, in the case of an
increase in the wage rate, the substitution and the income effects operate in opposite direc-
tions, and (as explained next) this may cause the individual’s supply curve of labor to be
backward-bending.
According to the substitution effect, an increase in the wage rate leads an individual to
work more (1.e., to substitute work for leisure). That is, as the wage rate rises, the price of
leisure increases and the individual takes less leisure (1.e., works more). Thus, the substitu-
tion effect of the wage increase always operates to make the individual’s supply curve of
labor positively sloped. However, an increase in the wage rate also raises the individual’s
income, and with a rise in income, the individual demands more of every normal good,
including leisure (i.e., supplies fewer hours of work). Thus, the income effect of a wage
increase, by itself, always operates to make the individual’s supply curve negatively sloped.
The substitution and income effects operate over the entire length of the individual’s
supply curve of labor. Until the wage rate of w = $5 in Figure 14.3, the substitution effect
overwhelms the opposite income effect and the individual works more (i.e., his or her
supply curve of labor is positively sloped). At w = $5, the substitution effect is balanced
by the income effect and S; is vertical (point E£’ in the figure). At wage rates higher than
w = $5, the (positive) substitution effect is overwhelmed by the (negative) income effect
and s;, bends backward. Note that theory does not tell us at what wage rate the bend
Concept Check occurs. It only says that at some sufficiently high wage rate this is likely to occur. Since
Why can the supply individuals’ tastes differ, the wage rate at which an individual’s supply curve of labor
curve of an individual bends backward is likely to differ from individual to individual.
slope backward? Also note that although the substitution effect is usually greater than the income
effect for a commodity, this is not the case for labor. The reason is that a consumer spends
his or her income on many commodities, so that an increase in the price of any one com-
modity is not going to greatly reduce his or her real income (i.e., the income effect is
small in relation to the substitution effect). On the other hand, since most individuals’
incomes come primarily from wages, an increase in wages will greatly affect the individ-
uals’ incomes (so that the income effect may overwhelm the opposite substitution effect).
At the wage rate at which this occurs, s; will bend backward. The separation of the sub-
stitution and the income effects of a wage increase is shown graphically in Section 14.8.
It might be argued that individuals do not have a choice of the number of hours
they work per day, and so the above analysis is irrelevant. Yet, this is not entirely true.
460 PART FIVE Pricing and Employment of Inputs

on a part-time basis,
For example, an individual may choose to work any number of hours
six or seven hours of work per day instead of eight,
may choose an occupation that requires
or less vacation time, and may or may not agree
may choose an occupation that allows more
the analysis to be
to work overtime (see Section 14.8), and so on. All that is required for
some
relevant is for some occupations to require different hours of work per day and/or
flexibility in hours of work.
Note that as workers’ wages and incomes have risen over time, the average work week
(and the length of the average work day) has declined from ten hours per day for six days
per week at the turn of the century to eight hours per day for five days per week, or even
slightly less, today. However, the trend toward fewer hours of work per day and per week
seems to have come to an end or to have considerably slowed down over the past half a
century. It may even have been reversed in recent decades. Thus, the substitution and
income effects of higher wages must have been more or less in balance in recent decades.
Over the same period of time, however, the participation rate (i.e., the percentage of the pop-
ulation in the labor force) has increased, especially for married women (see Example 14-4).

EXAMPLE 14-4
Labor Force Participation Rates

Table 14.3 gives the labor force participation rates for the population as a whole, for
males and females, and for married females in the United States in 1960, 1970, 1980,
1990, and 2000. The table shows that from 1960 to 2000 the labor force participation
rate increased by about 11% for the population as a whole, declined by about 12% for
males, and increased by about 57% for all females and 90% for married females.
Many reasons are responsible for the dramatic increase in the labor force partici-
pation rate of married females in the United States over the 1960-2005 period. Some
of these are changes in family income, child-rearing practices, rates of unemployment,
and female educational levels. What must be true, however, is that the productivity of
married women in “market” jobs must have increased much more than for work in the
home during the past four-and-a-half decades, and so married females substituted a
great deal of work outside the home for work in the home.

Labor Force Participation Rates in the

TABLE 14. : :
4.3 United States (in percentages)
Total Married
Year Population Males Females Females
1960 59.4 83.3 S77, 31.9
1970 60.4 79.7 43.3 40.5
1980 63.8 717.4 aylto) 49.9
1990 66.5 76.4 575 58.4
2000 67.1 74.8 59.9 61.1
2005 66.0 Me 59.3
as 60.7

Source: Statistical Abstract of the United States (Washington, DC: U.S. Government
Printing
Office, 2001), pp. 373, 379.
 CHAPTER 14 Input Price and Employment Under Perfect Competition 461

w($)

FIGURE 14.4 Market Supply Curve of Labor Market

supply curve of labor S; shows that at the wage of $20 per Se
day, 400 people are willing to work in this market (point H). At 40
w = $40 per day, 600 people are willing to work (point E’). At
w = $60, 700 are willing to work (point G), and so on. S; is 20
positively sloped over the range of daily wages shown but
becomes less elastic at high wage rates (and may eventually
bend backward at still higher wage rates). 0

The Market Supply Curve for an Input

The market supply curve for an input is obtained from the straightforward horizontal
summation of the supply curve of individual suppliers of the input, just as in the case of
the supply curve of a final commodity (see Section 9.4). In the case of inputs of natural
resources and intermediate goods, which are supplied by firms, the short-run market sup-
ply curve of the input is generally positively sloped (as is the firm’s supply curve). The
market supply curve of labor is usually also positively sloped, but it may bend backward
at very high wages (see Example 14—5).
Figure 14.4 shows a hypothetical market supply curve of labor (S$;) measuring the
number of workers on the horizontal axis and the daily wage rate on the vertical axis. The
figure shows that at the wage of $20 per day, 400 people are willing to work in this mar-
ket (point H ). At w = $40 per day, 600 people are willing to work (point E’). At w = $60,
700 are willing to work (point G), and so on. Note that S$; is positively sloped over the
range of daily wages shown in the figure but becomes less elastic at high wage rates (and
may eventually bend backward at still higher wage rates).
The shape of S; is also the net result of two opposing forces. Higher daily wages will,
on one hand, induce some individuals to enter the labor market (to take advantage of the
higher wages), but they will also result in some individuals leaving the job market as their
spouse’s wages and income rise (see Example 14—5). Note that the supply curve of labor
is less likely to be backward-bending for a particular industry than for the economy as a
whole, because workers can always be attracted to an industry from other industries by
raising wages sufficiently.

EXAMPLE 14-5
Backward-Bending Supply Curve of Physicians’ Services and Other Labor

The enactment of Medicare (a subsidy for the medical care of the elderly) and Medicaid
(a subsidy for the medical care of the poor) in 1965, as well as the increased insurance
coverage for physicians’ bills, greatly increased the ability of broad segments of the
population to pay for medical services and resulted in a sharp rise in medical fees. The
rise in medical fees, however, seems to have led to a reduction, rather than to an
462 PART FIVE Pricing and Employment of Inputs

Elasticities of Labor Supply (Hours Worked)

TABLE 14.4 with Respect to Wages

Head’s Hours Spouse’s Hours Head’s Hours

with Respect to with Respect to with Respect to
Head’s Wage Spouse’s Wage Spouse’s Wage

Unmarried males 0.026

(no children)
Unmarried females 0.011
(no children)
Unmarried females 0.106
(with children)
One-earner family 0.007
(no children) —
One-earner family —0.078
(with children)
Two-earner family —(0.107 —0.028 —0.059
(no children)
Two-earner family —0.002 —0.086 —0.004
(with children)

Sources: J. H. Kohlhase, “Labor Supply and Housing Demand for One- and Two-Earner
Households,” Review of Economics and Statistics, Vol. 68, No. 1, 1986, pp. 48-57.

increase, in the quantity supplied of physicians’ services (i.e., the supply curve for
physicians’ services seems to be backward-bending).
Martin Feldstein found that the price elasticity of supply of physicians’ services
in the United States was between —0.67 and —0.91 over the 1948-1966 period. This
means that a 10% increase in the price of physicians’ services results in a reduction
in the quantity supplied of services of between 6.7% and 9.1%. Thus, according to
Feldstein’s results, the sharp increase in the fees for physicians’ services in recent
years actually resulted in a reduction in the quantity of services supplied. Nurses
also seem to have backward-bending supply curves (according to some but not oth-
ers), and, more generally, so do the head of one-earner families with children and the
head and the spouse of two-earner families, with or without children, as Table 14.4
shows.
From Table 14.4, we see that unmarried males and females with or without chil-
dren as well as one-earner families without children operate on the upward-sloping
portion of their labor supply curve, while all the others are on the backward-bending
portion of their labor supply curve. The price elasticities of supply of hours worked
with respect to wages for all groups, whether positive or negative, are quite small,
however (i.e., the labor supply curves are close to being vertical).
Sources: M. Feldstein, “The Rising Price of Physicians’ Services,” Review of Economics
and Statistics,
May 1970, pp. 121-133; D. Sullivan, “Monopsony Power in the Market for Nurses,” Journal
of Law and
Economics, October 1989, pp. S135—S178; and J, Burkett, “The Labor Supply of Nurses and
Nursing
Assistants in the United States,” Eastern Economic Journal, Fall 2005, pp. 585-599.
 CHAPTER 14 Input Price and Employment Under Perfect Competition 463

145 PRICING AND EMPLOYMENT OF AN INPUT

Just as in the case of a final commodity, the equilibrium price and employment of an input
is given at the intersection of the market demand and the market supply curve of the input
in a perfectly competitive market. The equilibrium price and level of employment for
labor are shown in Figure 14.5.
In Figure 14.5, D;, is the market demand curve for labor (from the right panel of
Figure 14.2), and S; is the market supply curve of labor (from Figure 14.4). The intersec-
tion of D; and S; at point E’ gives the equilibrium (daily) wage of $40 and level of
employment of 600 workers per day. At the lower wage rate of $20 per day, firms would
like to employ 800 workers per day, but only half that number are willing to work. Thus,
there is a shortage of 400 workers per day (HJ in the figure), and the wage rate rises. At
the high wage of $60 per day, 700 workers are willing to work, but firms would like to
Concept Check employ only 450. There is a surplus of 250 workers (FG), and the wage rate falls. Only at
How is the equilibrium w = $40 is the number of workers who are willing to work equal to the number of work-
price and employment ers that firms want to employ (600), and the market is in equilibrium.
of an input determined?
Note that at the equilibrium daily wage of $40, each of the 100 identical firms in the
market will employ six workers per day (point E on d;, in the left panel of Figure 14.2).
In a perfectly competitive input market, each firm is too small to perceptibly affect the
wage rate (i.e., the firm can employ any number of workers per day at the equilibrium
market wage rate of $40 per day). That is, the firm faces a horizontal or infinitely elastic
supply curve of labor at the given wage rate. Since the price of an input equals its mar-
ginal revenue product (MRP), the theory of input pricing and employment has been called
Marginal productivity the marginal productivity theory (see Example 14-6).
theory The theory Finally, note that we have implicitly assumed that all units of the input are identical
according to which (have the same productivity) and receive the same price. In the case of labor, the wages of
each input is paid a
price equal to its
marginal productivity.
Daily
Sr,
wage
($)
80 |-

60

40

ae Shortage
| | | | | |
0 300 400 500 600 700 800 L
Number of workers

FIGURE 14.5 Determination of the Equilibrium Wage Rate and

Level of Employment D, is the market demand curve for labor
(from the right panel of Figure 14.2), and S; is the market supply curve
of labor (from Figure 14.4). The intersection of D; and S, at point E’
gives the equilibrium (daily) wage rate of $40 and the equilibrium level
of employment of 600 workers per day.
464 PART FIVE Pricing and Employment of Inputs

attractive (or unat-

all workers would be the same only if all occupations were equally
and ifthere was no
tractive), if all workers had identical qualifications and productivity,
d in Section 14.8.
interference with the operation of the market. These topics are discusse

EXAMPLE 14-6
Labor Productivity and Total Compensation in the United States and Abroad

According to the marginal productivity theory, wages equal labor’s marginal revenue
product, and an increase in labor productivity should be reflected in a similar increase
in the real wage. From 1996 to 2006, however, real wages increased by a total of 15%
as compared with an increase in the productivity of U.S. labor of 22%. This has
prompted a strong debate on whether the long-term link between productivity and
wages has been broken. In fact, during the past 150 years, the share of GDP going to
labor has remained remarkably stable at between 65% and 69% in all advanced
economies. Has this strong regularity now been broken?
According to some economists, the present gap in the growth of real wages and
productivity is the beginning of a long-run decline in labor’s share of GDP. Others,
however, believe that comparing real wages to labor productivity is not appropriate
because the proportion of fringe benefits in total compensation has increased over
time. In fact, the increase in total real compensation was 21% over the 1996-2006
period—almost identical to the increase in total labor productivity of 22%. Using 1950
as the base, the increase in the real compensation of U.S. labor from 1950 to 2006 was
172% as compared with the increase in U.S. labor productivity of 176% over the same
period. Thus, the historical regularity between wages and productivity has not been
broken and persists. Furthermore, every time a gap arose between the growth in infla-
tion-adjusted compensation and the growth of labor productivity in the United States,
it invariably disappeared after a year or two.
The increase in labor productivity in the United States has been greater than in the
other Group of Seven (G-7) leading industrial nations (Japan, Germany, France,
Britain, Italy, and Canada) since the second half of the 1990s, but not earlier.
Specifically, labor productivity has increased at an annual average of 2.0% in the
United States from 1996 to 2006, as compared to 1.1% for the other G-7 nations. From
1981 to 1995, however, labor productivity increased at an average 1.2% per year in the
United States and 2.2% in the other G-7 nations. This has led to a great deal of wage
convergence to the higher U.S. levels in the G-7 countries (see Example 14-7). The
more rapid growth of labor productivity during the second half of the last decade in the
United States than in the other G-7 countries has been attributed to a more rapid spread
of the “new economy” based on the new information technology and greater flexibil-
ity in labor markets and in the economy in general in the United States than abroad.
Sources: “Productivity Is All, But It Doesn’t Pay Well,” New York Times, June 25, 1995, Section
Bap?
“As Worker’s Pay Lags, Causes Spur a Debate,” Wall Street Journal, July 31, 1995, p. Al;
“Productivity
Developments Abroad,” Federal Reserve Bulletin, October 2000: “Salaries Stagnate
as Balance of Power
Shifts to Employers,” Financial Times, May 11, 2005, p. 6; OECD, World Economic
Outlook, December
2007; D. Salvatore, ed. “Growth, Productivity, and Wages in the U.S. Economy,”
Special Issue, Journal of
Policy Modeling, June 2008.
 CHAPTER 14 Input Price and Employment Under Perfect Competition 465

INPUT PRICE EQUALIZATION AMONG INDUSTRIES,

REGIONS, AND COUNTRIES

In this section, we examine the process whereby input prices tend to be equalized through
the movement of inputs among industries and regions, but through trade among countries.
We deal specifically with the tendency of wage rates to equalize across industries,
regions, and countries on the assumption that all labor is identical. The same price-equal-
izing process generally tends to operate for each type of labor and capital.

Input Price Equalization Among Industries and Regions of a Country

If the wage rate differs between two industries or regions of a country, some labor will
leave the low-wage industry or region for the high-wage industry or region until the wage
difference is eliminated. This is shown in Figure 14.6.
In Figure 14.6, the left panel refers to industry or region A, while the right panel
refers to industry or region B. The vertical axes measure the daily wage, while the hori-
zontal axes measure the number of workers. In the left panel, the intersection of the
industry demand curve (D,) and supply curve (S4) at point E gives the equilibrium daily
wage of $30 in industry or region A. On the other hand, the right panel shows that the
equilibrium daily wage (given by point E at the intersection of Dg and Sz) in industry or

Daily Daily
wage Industry or region A wage Industry or region B
($) ($)
60 60

50 50

40 40

30 30

20 20

10 L 10

| | | | | | | |
0 1 2 a) 4 0 1 2 3 4
> ee ——_>

Millions of workers Millions of workers

FIGURE 14.6 Wage-Equalizing Shifts in Domestic Supply The left panel shows that Dy and Sa
intersect at point E defining the equilibrium daily wage of $30 in industry or region A, while the right
panel shows that Dg and Sg intersect at point E defining the equilibrium daily wage of $50 in industry
or region B. As labor leaves industry or region A, attracted by the higher wage in region B, Sa shifts to
the left to Sy’ in the left panel while Sg shifts simultaneously to the right to Sg in the right panel, so
that the daily wage in the two industries or regions becomes equal at $40 (point E’ in both panels).
466 PART FIVE Pricing and Employment of Inputs

A to take advantage of
region B is $50. Some workers will then leave industry or region
labor declines (1.e.,
the higher wages in industry or region B. As this occurs, the supply of
neously increases
the supply curve shifts to the left) in industry or region A and simulta
to S’,
(i.e., shifts to the right) in industry or region B. This continues until S4 has shifted
rate is equal
in the left panel and Sz has shifted to 5 in the right panel, so that the wage
panel
at $40 per day in both industries (see point E’ where D4 and S’, intersect in the left
move from
and where Dz and S', intersect in the right panel). In total, | million workers
industry or region A to industry or region B (see the direction and the length of the arrows
on the quantity axes in both panels).
If there are obstructions to the movement of labor, or if workers—other things being
equal—prefer working in industry or region A rather than in B, then less than | million
workers will move from industry or region A to industry or region B, and wage differ-
ences will only be reduced rather than be entirely eliminated. What is important, however,
is the process whereby changes or shifts in input supply in the two industries or regions
reduce interindustry or interregional wage differences. The same is true for each particu-
lar type of labor and other mobile inputs. They always tend to flow or move to find
employment in the industries or regions where returns or earnings are higher. In the
process, they reduce interindustry and interregional differences in the returns to homoge-
neous factors or inputs (i.e., the earnings of inputs of the same quality and productivity).
In fact, Bellante has found that when adjustment is made for regional differences in costs
of living, North-South real wage differences for the same type of labor have been elimi-
nated for the most part in the United States.°

Input Price Equalization Among Countries

The equalizing tendency in the returns or earnings of homogeneous inputs also operates
internationally, but it occurs mostly through international trade rather than through the
flow or migration of inputs from low- to high-return countries. The reason is that most
countries impose serious restrictions on the international flow of some inputs, especially
the migration of labor. Figure 14.7 shows how wage equalization occurs internationally
through trade. For simplicity, we assume that we have only two homogeneous inputs,
labor and capital.
The left panel shows that D, (the demand curve for labor in country 1) intersects S$}
(the supply curve of labor in country 1) at point £, giving the equilibrium daily wage of
$20 in country | in the absence of trade. The right panel shows that D> and S> intersect at
point EF, giving the equilibrium daily wage of $40 in country 2 in the absence of trade. We
assume that labor cannot migrate from country | to country 2. Wages can still tend to be
equalized between the two countries through trade, however.
. Because of lower wages, country | has a relative or comparative advantage in labor-
intensive commodities (i.e., commodities that require a relative abundance of labor in
production). Country 2 will then have a comparative advantage in capital-intensive com-
modities. With trade, country | will specialize in the production of and export labor-
intensive commodities in exchange for capital-intensive commodities from country
2.
The left panel shows that the demand curve for labor will then increase or shift to the right
from D) to D; in country | and defines the new equilibrium daily wage of $30 at
point E’

> See D. Bellante, “The North-South Wage Differential and the Migration of
Heterogeneous Labor,” America
Economic Review, March 1979, ?
 CHAPTER 14 Input Price and Employment Under Perfect Competition 467

Country | Country 2
Daily Daily So
wage wage

($) ($)

40 | 40

30 30

200 20

1 |= 10

| | | | | |
0 2 0 2 4 6 8 10
at

Millions of workers Millions of workers

FIGURE 14.7 International Wage-Equalization Through International Trade The left pane!
shows that in the absence of trade D, and S; intersect at point £, defining the equilibrium daily wage
of $20 in country 1, while the right panel shows that D2 and S> intersect at point E, defining the
equilibrium daily wage of $40 in country 2. As country 1 specializes in the production of and exports
labor-intensive commodities, D; shifts to the right to D4 and defines the new equilibrium daily wage of
$30 at point ’ in the left panel. On the other hand, as country 2 replaces some domestic production
of labor-intensive commodities with imports from country 1, D> shifts to the left to D>’ and defines the
new equilibrium daily wage of $30 at point E’ in the right panel.

(where Dj intersects $,). On the other hand, the right panel shows that the demand curve
for labor will decrease or shift to the left from D2 to D4 in country 2 (as country 2 replaces
some domestic production of labor-intensive commodities with imports from country 1)
and defines the new equilibrium daily wage of $30 at point E’ (where D% intersects S).
Note that now wages have been equalized in the two countries through international
trade without any migration of labor from country | to country 2. The reason for this is
that as long as wages are lower in country 1, labor-intensive commodities will be cheaper
in country | than in country 2, and country | will expand its exports of the labor-inten-
sive commodity. But as trade expands, country | will demand more labor until D; has
shifted all the way to the right to D (see the left panel). The demand for labor in coun-
try 2, on the other hand, will simultaneously decline until it reaches D4 (see the right
panel), so that wages are equalized at $30 in both countries. Thus, international trade is
a substitute for, or has the same effect on, wages as the international migration of labor
(which is often seriously restricted). However, while trade operates on the demand for
labor (i.e., shifts the demand curves for labor) in the two countries, international migra-
tion operates through the supply (i.e., shifts the supply curves) of labor in the two coun-
tries. This is true, however, only in the absence of trade restrictions. If some labor is
allowed to migrate from country | to country 2, this will reinforce the tendency of inter-
national trade to equalize wages in the two countries. Although we have dealt with labor
Concept Check
in general, the same process would operate to equalize the wages of each particular type
Why do input prices
tend to equalize across of labor and the price of each other type of input internationally. Example 14—7 shows
regions and countries that a great deal of convergence in real hourly compensation has in fact occurred during
with perfect mobility? the past decades among the G-7 countries.
468 PART FIVE Pricing and Employment of Inputs

EXAMPLE 14-7
Convergence in Hourly Compensation in the Leading Industrial Countries

As predicted by theory, Table 14.5 shows that real hourly compensation (wages plus
benefits) of production workers in manufacturing have indeed converged among the
leading (G-7) industrial countries during the past five decades. It is true that many
other forces (including international labor migration and capital flows) have con-
tributed to this convergence, but international trade was certainly a major reason. The
existence of transportation costs, trade restrictions, and other market imperfections
prevented the complete equalization of hourly compensation internationally, however.
One question remains unanswered. That is, if trade reduces wages in a higher-wage
country, why should the higher-wage country trade with a lower-wage country? The
reason (not shown in Figure 14.7) is that the higher-wage country will have a compara-
tive advantage in capital-intensive commodities. As it specializes in the production of
these commodities for export, the demand and returns on capital increase by more than
wages fall. Some of the capital owners’ gains from trade could then be taxed away and
redistributed to labor in such a way that both labor and capital gain from trade.

Real Hourly Compensation of Production Workers in

\:jaae7ay Manufacturing in the G-7 Countries as a Percentage
of U.S. Compensation

Country 1959 1983 2000

Japan 11 Syl! 99
Italy 23 62 88
France 27 62 93
United Kingdom 29 53 94
Germany 29 84 149
Canada 42 75 |
Unweighted Average 2h 65 102
United States 100 100 100
eee

Sources: Calculated from indices from: IMF, International Financial Statistics; OECD, Economic
Outlook; and U.S. Bureau of Labor Statistics, Bulletin.

EcONomic RENT: AN UNNECESSARY PAYMENT

TO BRING FORTH THE SUPPLY OF AN INPUT
Economic rent That Economic rent differs from the everyday meaning of the term rent, which
portion of a payment is a payment
made to lease an apartment, an automobile, or any other durable
made to the supplier of asset. Economic rent
originally referred only to the payment made to landowners to lease
an input that is in excess their land (which was
of what is necessary to assumed to be in fixed supply). Today, economic rent is defined
as that portion of the
retain the input in its payment to the supplier of any input (not just land) that
is in excess of the minimum
present employment in amount necessary to retain the input in its present use. It is the
excess payment to an input
the long run. over its opportunity cost. If the market supply of an input is
fixed, demand alone determines
 CHAPTER 14 Input Price and Employment Under Perfect Competition 469

P($) w($)

80 80
60 60
40 40 =
20 20

0 300 = 600-900 0 300 = 600-~——- 900

Acres of land per month Numbers of workers per day
FIGURE 14.8 Measurement of Economic Rent The left panel shows 600 acres of land
supplied per month regardless of the rental price. With D, the price is $40 (point E) and the entire
payment of $24,000 ($40 times 600) is rent. With D/P = $60 (point E’) and rent is $36,000.
With D”, P = $20 and rent is $12,000. In the right panel, S; is positively sloped. With D;, w = $40
and 600 workers are employed (point £). Shaded area EVR = $6,000 represents economic rent
or a payment that is not needed to retain the 600 workers in the particular industry,

the input price and all of the payment made to the input is rent. If the market supply of an
input is positively sloped, only the area above the supply curve and below the price of the
input represents rent. This is shown in Figure 14.8.
In the left panel of Figure 14.8, the market supply of the input, say, land, is fixed at
600 acres (i.e., S is vertical). If the market demand curve is D, the (rental) price is $40 per
acre (point £), and the entire payment of $24,000 ($40 times 600) per month made to the
owners of land is economic rent. If the market demand were D’, the rental price would be
$60 (point E’), and rent $36,000 per month. If the market demand for the input were D”, the
rental price would be $20 (point £”), and rent $12,000 per month. Note that regardless of
the level of demand and price, the same quantity of land is supplied per month, even at an
infinitesimally small rental price. Thus, all of the payments made to the landowners repre-
sent economic rent (since the opportunity cost of land is zero). This is true not only for land
but for any input in fixed supply. For example, since the supply of Picasso paintings is fixed,
they will be supplied (sold) at whatever price (including the retention or reservation price of
present owners) they can fetch. Therefore, all payments made to purchase Picassos repre-
sent economic rent.
In the right panel, the supply of the input, say, labor, to an industry is positively
sloped. This means that higher daily wages will induce more individuals to work in the
Concept Check industry. The equilibrium wage of $40 is determined at the intersection of D; and S; (point
What is the relationship E in the figure, at which 600 workers are employed). Each of the 600 (identical) workers
between the price of an receives a wage of $40 per day. Yet, one worker could be found who would work for a
input and economic wage of only $20, and 300 workers would be willing to work at a daily wage of $30 each
rent?
(see the S;, curve in the right panel). Thus, the shaded area above the supply curve and
below the equilibrium wage of $40 represents economic rent. It is the workers’ excess
earnings over their next-best employment. That is, the 600 workers receive a total wage of
$24,000 (the area of rectangle EMOR), but they only need to be paid EMON to be retained
470 PART FIVE Pricing and Employment of Inputs

represents economic
in the industry. Therefore, the area of shaded triangle ENR ($6,000)
to retain 600 workers
rent or the payment that need not be made by the particular industry
in the long run.
land could
Note that even land may not be fixed in supply to any industry, because some
whole, since
be bid away from other uses. Land may not even be fixed for the economy as a
ero-
over time, land can be augmented through reclamation and drainage and depleted through
In gen-
sion and loss of fertility. Thus, the payment to lease land, too, may be only partly rent.
eral, the more inelastic is the supply curve of an input to the industry, the greater is the
proportion of economic rent. In the extreme case, the supply curve is vertical and all the pay-
ment to the input is rent. The importance of this is that rent could all be taxed away without
reducing the quantity supplied of the input. This is an excellent tax since it does not discour-
age work or reduce the supply of labor (or other inputs) even in the long run. Note that eco-
nomic rent is analogous to the concept of producer surplus (see Section 9.8). Producer surplus
was defined as the excess of the commodity price over the marginal cost of producing a given
level of the commodity. Economic rent is the excess payment that an input owner receives over
the minimum that he or she requires to continue to keep the input in its present use.
While all or some of the payment made by an industry to the suppliers of an input is
rent, all payments made by an individual firm to employ an input are a cost to the firm,
which the firm must pay to retain the use of the input. If the firm tried to pay less than the
market price for the input, the firm would be unable to retain any unit of the input. For
example, if a firm tried to employ workers at less than the $40 daily wage prevailing in
the market, the firm would lose all of its workers to other firms. Finally, note that any pay-
Quasi-rent The ment made to temporarily fixed inputs is sometimes called quasi-rent. Thus, the returns
return or payment to fixed inputs in the short run are quasi-rents (see Problem 8). These payments need not
to inputs that are be made in order for these fixed inputs to be supplied in the short run. In the long run,
fixed in the short
however, all inputs are variable, and, unless they receive a price equal to their next-best
run (i.e., ZR —TVC),.
alternative, they will not be supplied. To the extent that they receive more than this, the
inputs receive economic rent. In long-run, perfectly competitive equilibrium, all inputs
receive payments equal to their marginal revenue product and the firm breaks even.

14.8 ANALYSIS OF LABOR MARKETS UNDER PERFECT COMPETITION

In this section, we discuss some important applications of the theory presented in this
chapter: separation of the substitution from the income effect of a change in wages, the
analysis of overtime pay, the cause of wage differentials, and the effect of minimum
wages. These applications clearly indicate the usefulness and applicability of the theory.

Substitution and Income Effects of a Wage Rate Change

We have seen in Section 14.4 that an increase in wages gives rise to a substitution effect and
an income effect. That is, when the wage rate rises, on one hand, the individual tends
to
substitute work for leisure (since the price of leisure has increased). On the other hand,
the
increase in income resulting from the wage increase leads the individual to demand
more of
every normal good, including leisure (i.e., to work fewer hours). We can separate
the substi-
tution effect from the income effect as in Section 4.3. The separation is shown in
Figure 14.9.
The movement from point £ to point R in Figure 14.9 is the combine
d substitution
and income effects of the wage increase from $5 to $10 (as in Figure
14.3). The substitu-
tion effect can be isolated by drawing the hypothetical budget line that
is tangent to U> at
 CHAPTER 14 Input Price and Employment Under Perfect Competition 471

Daily
income
($)
240

a
Cs

190

Z
Ni
<0

120
S35
Z —

70 - Y R
60 |-

40 N <
| UM
|
.
|| Us
Hours ofleisure per day ————> af
| | | | |
0 6 12 16 «618 24
Substitution
+.
Income effect
} eo

Net
«>

FIGURE 14.9 Separation of the Substitution Effect from the Income Effect of a Wage
Increase The movement from point E to point R Is the combined substitution and income
effects of the wage increase from $5 to $10 (as in Figure 14.3). We can isolate the substitution
effect by shifting the highest budget line down parallel to itself until it is tangent to indifference
curve U> at point 7. The movement along U2 from point E to point 7 measures the substitution
effect of the wage increase. The shift from point 7 on U2 to point R on U4 is the income effect.

point M with the slope reflecting the higher wage of $10. Since the consumer is on origi-
nal indifference curve U>, his or her income is the same as before the wage increase, and
the movement along U> from point E to point M measures the substitution effect. By
itself, the substitution effect shows that when w rises from $5 to $10, the individual
reduces leisure time from 16 to 12 hours (i.e., increases hours of work from 8 to 12 per
day). The shift from point M on U) to point R on Us, is the income effect of the
472 PART FIVE Pricing and Employment of Inputs

wage increase. In this case, the increase in wages raises the individual’s income by $50
($240 — $190; see the vertical axis of the figure). By itself, the income effect leads the
individual to increase leisure from 12 to 18 hours (i.e., to work 6 hours less). The net
result is that the individual increases leisure (works less) by 2 hours per day (ER).

Overtime Pay and the Supply of Labor Services

The hourly wage of many workers increases after a specific number of hours worked per
Overtime pay The day. This is called overtime pay. Figure 14.10 shows the additional number of hours
higher hourly wage worked per day by an individual as a result of overtime pay.
of many workers for Initially, at the wage rate of $5 per hour, the individual demands 16 hours of leisure
working additional
(works eight hours per day) and earns an income of $40 (point E on Up, as in Figures 14.3
hours after the regular
and 14.9). With an overtime pay of $20 per hour (the slope of ET in Figure 14.10), the
workday.
individual can be induced to work two additional hours per day and have a total income
of $80 per day (point T on higher indifference curve U3). Thus, the substitution effect
(which encourages work) exceeds the income effect (which discourages work), and the
individual works more hours with overtime pay.° Higher taxes, on the other hand, lead to
fewer hours worked (see Example 14-8).

Daily
income
($)
120

80

60

Hoursiotlesure
fie | | | | | | | |
0 2 6 10 Lh om G 20 24
Hours of work
FIGURE 14.10 Overtime Pay and the Supply of Labor Services Initially, at w = $5, the
Individual demands 16 hours of leisure (works 8 hours per day)
and earns $40 (point E on Up,
as In Figures 14.3 and 14.9). With overtime pay of w = $20 per hour
(the slope of ET), the
individual will work 2 additional hours per day and have a total
income of $80 (point 7 on U3).

6
The entire
3 :
overtime-pay é
system that was established during the Great Depression
and which requires
employers to pay a 50% premium to people working
over 40 hours per week is under attack, however, and
may be relaxed or even abolished. “Overtime-Pav Sv ; Sy os
March 13. 1995. olished. See “Overtime-Pay System May Spark a Battle,” Wall Street Journal,
 CHAPTER 14 Input Price and Employment Under Perfect Competition 473

EXAMPLE 14-8
Higher Tax Rates Reduce Hours of Work

Table 14.6 shows the ratio of hours worked in 2004 relative to hours worked in 1956
in 21 OECD (industrial) countries. For example, the value of 0.97 for Australia means
that the average number of hours of work per year in Australia in 2004 was 97% of
those in 1956. The table shows that the greatest decline in the number of hours of work
between 1956 and 2004 was in Germany and France (two very high-tax nations), while
hours of work stayed about the same in the United States (a relatively low-tax coun-
try). Other factors, such as unionization, employment protection, and the generosity of
unemployment insurance benefits, had only a small effect on hours of work across
nations.

Hours Worked in 2004 Relative to 1956

UEEAE in 21 OECD Countries
Australia 0.97 Germany 0.60 Norway 0.82
Austria 0.74 Greece 0.99 Portugal 0.84
Belgium 0.70 Ireland 0.70 Spain 0.86
Canada 0.71 Italy 0.74 Sweden 0.80
Denmark 0.71 Japan 0.85 Switzerland 0.83
Finland Od Netherlands 0.81 United Kingdom 0.79
France 0.67 New Zealand 1.05 United States 1.01

Source: L. Ohanian, A. Raffo, and R. Rogerson, “Long-Term Changes in Labor Supply and Taxes: Evidence
from OECD Countries, 1956-2004,” NBER Working paper No. 12786, December 2006; and R. Rogerson
and J. Wallenius, “Micro and Macro Elasticities in a Life Cycle Model with Taxes,’ NBER Working paper
No. 13017, April 2007.

Wage Differentials
Up to this point, we have generally assumed that all occupations are equally attractive and
that all units of an input, say, labor, are homogeneous (1.e., have the same training and pro-
ductivity), so that the wages of all workers are the same. If all jobs and workers were iden-
tical, wage differences could not persist among occupations or regions of a country under
perfect competition. As pointed out in Section 14.6, workers would leave lower-wage occu-
pations and regions for higher-wage occupations and regions until all wage differentials
disappeared.
In the real world, jobs differ in attractiveness, workers have different qualifications and
training, and markets may not be perfectly competitive. All of these factors can result in dif-
ferent wages for different occupations and for workers with different training and abilities.
Compensating wage More formally, wages differ among different jobs and categories of workers because of
differentials Wage
(1) compensating differentials, (2) the existence of noncompeting groups, and (3) imperfect
differences that
competition. We will now briefly examine each of these factors.
compensate workers
for the nonmonetary Compensating wage differentials are wage differences that compensate workers
differences among jobs. for the nonmonetary differences among jobs. Even though some jobs (such as garbage
474 PART FIVE Pricing and Employment of Inputs

one job (garbage

collection and being a porter in a hotel) may require equal qualifications,
Hence, the more
collection) may be more unpleasant than another (being a porter).
wage differen-
unpleasant job must pay a higher wage to attract and retain workers. These
persist
tials equalize or compensate for the nonmonetary differences among jobs and will
in time. In the real world, many wage differences reflect nonmonetary factors.
For example, police officers’ salaries are usually higher than fire fighters’ salaries
because of the alleged greater risk in being a police officer. Similarly, construction work
generally pays more than garbage collection because the former offers less job security.
Note that a particular individual may prefer being a police officer or a construction worker
even if the salary were the same as (or lower than) that of a fire fighter or garbage collector,
respectively. But it is the intersection of the market demand and supply curves of labor for
each occupation that determines the equilibrium wage in the occupation and the compen-
sating wage differentials among occupations that require the same general level of qualifi-
cations and training.
Noncompeting groups Noncompeting groups are occupations requiring different capacities, skills, educa-
Occupations requiring tion, and training and, therefore, receiving different wages. That is, labor in some occupa-
different capacities, tions does not directly compete with labor in some other occupations. For example,
skills, education, and physicians form one noncompeting group not in direct competition with lawyers (which
training and, therefore,
form another noncompeting group). Other noncompeting groups are engineers, accountants,
receiving different
wages. musicians, electricians, and so on. Engineers and electricians belong to different noncom-
peting groups because, although engineers could probably work easily as electricians, engi-
neers’ productivity and wages are so much higher when working as engineers that they form
a separate noncompeting group. On the other hand, electricians do not have the training and
may not have the ability to be engineers.
Each noncompeting group has a particular wage structure as determined by the
intersection of its demand and supply curves. Some mobility among noncompeting
groups 1s possible (as, for example, when an electrician becomes an engineer by attend-
ing college at night), and this possibility is greater in the long run than in the short run.
However, mobility among noncompeting groups is limited, even in the long run,
especially if based on innate ability (e.g., not everyone can be a brain surgeon or an
accomplished violinist).
An imperfect labor market can also result in wage differences for identical
jobs requiring the same ability and level of training. A labor market is imperfect if
Concept Check workers lack information on wages and job opportunities in other occupations, if they
What is the cause of are unwilling to move to other jobs and occupations, or if there are labor unions and
wage differentials? large employers able to affect wages. These topics will be explored in detail in the next
chapter.

Effect of Minimum Wages

In 1938, Congress passed the Fair Labor Standard Act, which established a minimum
wage of $0.25 per hour. The minimum wage was raised to $3.35 in 1981, to $4.25
in
1991, to $5.15 in 1997, to $5.85 in 2007, and to $6.55 in 2008, and it will be $7.25 from
July 2009.’ Had the minimum wage been adjusted for inflation, it would have
been $9.05
in January 2006. In 2006, 21 states had the minimum wage set above the federal
level of
$5.15. Since skilled workers generally have wages well above the minimum
wage, they

7 See “Minimum-Wage Increase to Take Effect,” Wall Street Journal.

July 24, 2007, p. 13.
 CHAPTER 14 Input Price and Employment Under Perfect Competition 475

Minimum wage Sr.

($/hour)

Dlib

FIGURE 14.11 Effect of Minimum Wages _ D, is the market

demand curve, and S; is the market supply curve for unskilled 4.95
workers. The equilibrium wage is $4.00 per hour at which 4 million
workers are employed (point £). A minimum wage of $5.15 results in

Ons
3.9 million workers being employed as opposed to 41 million willing
to work, leaving an unemployment gap of 200,000 workers (MN).
The disemployment effect is 100,000 workers (the movement from
point E to point M on D,). The increase in the minimum wage A [ | l
from $4.25 in 1991 to $515 in 1997 was estimated to increase the 0 3.9" 4.0741
unemployment gap by 100,000 (MN minus FG). Millions of workers

are not affected by it. We can analyze the effect of the minimum wage on unskilled work-
ers (assuming for the moment that all unskilled workers are identical) with the aid of
Figure 14.11.
In Figure 14.11, D; is the market demand curve, and S; is the market supply curve
for unskilled workers. In a perfectly competitive labor market, the equilibrium wage
would be $4.00 per hour ($24 per day with an 8-hour workday) and the equilibrium level
of employment would be 4 million workers (point F in the figure). The imposition of a
federal minimum wage of $5.15 per hour would result in firms hiring only 3.9 million
workers (point M on D;) as opposed to the 4.1 million workers (point NV on S;) willing to
work at this minimum wage. Thus, the minimum wage of $5.15 per hour would lead to a
Unemployment gap total unemployment gap of 200,000 workers (MN) from the equilibrium rate of $4.00
The excess in the per hour. This is composed of the 100,000 additional workers who would like to work at
quantity supplied over the minimum wage (the movement from point E to point N on the S; curve) plus the
the quantity demanded disemployment effect of another 100,000 workers as firms employ fewer workers at the
of labor at above-
above-equilibrium minimum wage (the movement from point E to point M on the D;
equilibrium wages.
curve). On the other hand, the increase in the minimum wage from $4.25 to $5.15 per
hour increases the unemployment gap by 100,000 jobs (MN minus FG in Figure 14.11).
Disemployment effect While an increase of a minimum wage benefits those unskilled workers who remain
The reduction in the employed, some unskilled workers would lose their jobs, and still more would like to
number of workers work but could not find employment.
employed as a result In 2005, 1.9 million workers, or 2.5% of the 76 million hourly labor force, earned no
of an increase in the
more than the federal minimum wage (not all workers are covered by the minimum
wage rate
wage), down from 4.4 million in 1998.° At the same time about 10% of the labor force
was affected by the minimum wage. The U.S. Labor Department estimated that the
increase in the minimum wage from $3.35 in 1981 to $4.25 in 1991 led to a loss of
100,000 jobs. Some researchers, however, questioned this estimate and the general

8 “Revising a Minimum-Wage Axiom,” New York Times, February 3, 2007, p. 4.

476 PART FIVE Pricing and Employment of Inputs

lead to more unemployment of

premise that higher minimum wages today would
fe
unskilled workers (see the nearby “At the Frontier’).
of a minim um wage rate
There are other ways by which the imposition or the raising
e in the minimu m wage may
can harm the very people it is supposed to help. An increas
as some health benefits,
lead some employers to reduce or cut other fringe benefits (such
employ ers may suspend
free or subsidized meals, free uniforms, and so on). Some
were hiring ata
apprenticeships and on-the-job training for unskilled workers whom they
m wage Is even
lower minimum wage. The harmful effect of an increase in the minimu
te more cap-
greater in the long run, when employers have a greater opportunity to substitu
ital-intensive production techniques for unskilled labor. The problem can be addressed by
can
providing more training to improve the skills of minimum-wage workers so that they
qualify for higher-paying jobs.

“AT THE FRONTIER

Do Minimum Wages Really Reduce Employment?

s the above analysis shows, economists have traditionally believed that an

A increase in the minimum wage, by increasing the cost of unskilled labor, leads
employers to hire fewer unskilled workers. This ingrained belief was shaken by
research by Princeton University’s professors David Card and Alan Krueger, who
found that increasing minimum wages did not destroy jobs and sometimes even
increased them.
In one study (see the first reference at the end of this section), Card found that the
reduction in employment after the 1990 and 1991 federal minimum-wage increases
was generally not bigger in states with a larger fraction of low-paid workers, such as
teenagers (the group expected to be most adversely affected by an increases in the
minimum wage) than in high-wage states. Thus, Card concluded that the reduction in
employment must have been due to causes other than the increase in the minimum
wage. In another study (see the second reference at the end), Card and Krueger found
that the additional 19% increase in New Jersey’s own minimum wage in April 1992
led to more, not fewer, jobs between February and December 1992 in the state’s fast-
food restaurants (which paid wages below the new minimum wage), as compared with
other New Jersey restaurants that were already paying wages exceeding the new
higher minimum wage and with fast-food restaurants in neighboring Pennsylvania,
which did not raise its minimum wage in 1992. In short, the new research seemed to
show that increasing the minimum wage did not destroy jobs, as previously believed,
and may have created them.
Other economists, however, immediately attacked these revisionist studies as
being seriously flawed. Donald Deere and Finis Welch of Texas A&M University and
Kevin Murphy of the University of Chicago showed that the 27% increase in the fed-
eral minimum wage from $3.35 to $4.25 in 1990 and 1991 resulted in a reduction in
teenage employment of 12% for males, 18% for females, and 6% for high-school
dropouts (the groups expected to be most adversely affected by an increase in the
 CHAPTER 14 Input Price and Employment Under Perfect Competition 477

minimum wage). Similarly, David Neumark of Michigan State University and

William Wascher of the Federal Reserve, using payroll records (which are more accu-
rate than the telephone poll data used by Card and Krueger in their New Jersey study),
found that the 19% increase in New Jersey’s minimum wages in April 1992 reduced
employment in New Jersey’s fast-food restaurants by 4.6% (rather than increased it,
as reported by Card and Krueger).
More recent research by David Neuman and William Wascher found that,
Concept because of recent welfare reforms that increased work incentives faced by the poor
Check and the near-poor, higher minimum wages did not lead to disemployment and unem-
Should the minimum ployment, except for young minority men and high-school-dropout young women, but
REI even for these the negative effects were rather small. While in previous decades higher
minimum wages may have led to higher unemployment of unskilled workers, in this
decade the effect has been rather small because of welfare reforms that increased work
incentives and was confined only to some groups of unskilled workers.

Sources: D. Card, “Using Regional Variation in Wages to Measure the Effects of the Federal Minimum
Wage,” Industrial and Labor Relations Review, October 1992; D. Card and A. Krueger, “Minimum Wages
and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania,” American
Economic Review, September 1994; D. Card and A. Krueger, Myth and Measurement: The New
Economics of the Minimum Wage (Princeton University Press, 1995); D. Deere, K. Murphy, and F. Welch,
“Employment and the 1990-1991 Minimum-Wage Hike,” American Economic Review, Papers and
Proceedings, May 1995; D. Neumark and W. Wascher, “The Effect of New Jersey’s Minimum Wage
Increase on Fast-Food Employment: A Reevaluation Using Payroll Records,” Working Paper 5224,
National Bureau of Economic Research, September 1995; D; and D. Neumark and W. Wascher,
“Minimum Wages, the Earned Income Tax Credit, and Employment: Evidence from the Post—Welfare
Reform Era,” NBER Working Paper No. 12915, February 2007.

SUMMARY
1. To maximize profits a firm must produce the best level of output with the least-cost input
combination. The optimal or least-cost input combination is the one at which the marginal
product per dollar spent on each input is the same. The ratio of the input price to the marginal
product of the input gives the marginal cost of the commodity. The best level of output of the
commodity for a perfectly competitive firm is the output at which the firm’s marginal cost
equals its marginal revenue or price.
2. A profit-maximizing firm will employ an input only as long as the input adds more to its total
revenue than to its total cost. If only one input is variable, the firm’s demand curve for the input
(d) is given by the marginal revenue product (MRP) curve of the input. The MRP equals the
marginal product (MP) of the input times the marginal revenue (MR). If the firm is a perfect
competitor in the product market (so that MR = P), then MRP = VMP (the value of the
marginal product). With more than one variable input, as the input price falls, the demand curve
for the input is obtained by points on different MRP curves of the input and will be more elastic
than the individual MRP curves.
3. When the price of an input falls, all firms will hire more of the input and produce more of the
final commodity. This will reduce the commodity price and shift the individual firm’s demand
curves for the input to the left. This must be considered in summing the individual firm’s demand
curves for the input to obtain the market demand curve. The price elasticity of demand for an
input is greater (1) the more and better are the available substitutes for the input, (2) the more
elastic is the demand for the final commodity made with the input, (3) the more elastic is the
supply of other inputs, and (4) the longer is the period of time under consideration.
478 PART FIVE Pricing and Employment of Inputs

on
. The market supply curve of an input is obtained by the straightforward horizontal summati
resources and
of the supply curves of the individual suppliers of the input. While natural
y
intermediate goods are supplied by firms and their supply curves are generally positivel
supply curves may be backward -bending .
sloped, labor is supplied by individuals and their
That is, as the wage rate rises, eventuall y the substitut ion effect (which, by itself, leads
individuals to substitute work for leisure) may be overwhelmed by the opposite income effect,
so that the individual’s supply curve of labor may bend backward. The market supply curve of
labor is usually positively sloped, but it may bend backward at very high wages.
. Under perfect competition, the equilibrium price and the level of employment of an input are
determined at the intersection of the market demand curve and the market supply curve of the input.
Each firm can then employ any quantity of the input at the given market price of the input. Since
each firm employs an input until the marginal revenue product equals its price, this theory is usually
referred to as the marginal productivity theory. If all inputs were identical (and all occupations
equally attractive for labor), all units of the same input would have the same price.
. With perfect mobility of inputs among industries and regions of a country, input prices will be
equalized by input flows (supply shifts) from the low-return to the high-return industries and
regions. On the other hand, free trade in commodities and services among countries under
perfect competition, with no transportation costs, would equalize input prices internationally by
shifts in input demands resulting from trade.
. Economic rent is that portion of the payment made to the supplier of an input that is in excess of
the minimum amount necessary (opportunity cost) to retain the input in its present employment.
When the supply of an input is fixed, demand alone determines its price and all the payment made
to the input is rent. When the market supply curve of an input is positively sloped, the area above
the supply curve and below the input price is rent. The return or payment to inputs that are fixed
in the short run are sometimes called quasi-rents.
. By correcting for the income effect of an input-price change, we can graphically isolate
the substitution effect as a movement along a consumer leisure-income indifference curve.
The same type of analysis can also be used to show the additional number of hours an
individual is willing to work per day with overtime pay. Wage differentials can be
compensating, and they can be based on the existence of noncompeting groups and
imperfect competition. Minimum wages lead to a disemployment effect and to an even
greater unemployment gap.

KEY TERMS
Derived demand Intermediate good Compensating wage differentials
Marginal revenue product (MRP) Marginal productivity theory Noncompeting sroups
Value of the marginal product (VMP) Economic rent Unemployment gap
Marginal expense (ME) Quasi-rent Discnplovment erect
Complementary inputs Overtime pay

REVIEW QUESTIONS
1. What is the function of input prices in the operation of a complementary to labor? If capital is a substitute for
free-enterprise system? labor?
2. Why is the marginal revenue product of a firm negatively 4. Why does the market price of a commodity fall with a
sloped? reduction in the price of an input used in the production
of
3. What happens to a firm’s marginal revenue product of the commodity?
labor curve if the rental price of capital falls and capital is
 CHAPTER 14 Input Price and Employment Under Perfect Competition 479

5. What effect will a fall in a commodity price have on the immigration should be stopped. Evaluate this
firm’s demand curve for an input used in the production of statement.
the commodity? 10. How is a higher interest on capital in industry or
6. How can indifference curve analysis be used to explain an region A than in industry or region B eliminated or
individual’s supply curve of labor? reduced?
7. Under what condition will an individual’s labor supply 11. Can higher wages persist for technicians in nuclear
curve be backward bending? plants as compared with technicians with the same
8. Interregional trade can be a substitute for interregional qualifications and training working in aircraft-engine
labor migration in reducing or eliminating interregional plants? Explain.
wage differences. True or false? Explain. 12. Why do we have minimum-wage laws if they increase
9. Mexican migrant or seasonal workers to the United States unemployment among unskilled workers?
take away jobs from American workers, and so

|__| PROBLEMS
*1. a. Express in terms of equation [14.1] the condition for a demand curve for labor of this firm. How many
firm utilizing too much labor or too little capital to workers will the firm hire per day at the wage rate of
minimize production costs. What is the graphic $20 per day?
interpretation of this? 4. Derive the market demand curve for labor if there
b. What is the graphic interpretation of a firm utilizing are 100 firms identical to the firm of Problem 3
the least-cost input combination but with its marginal demanding labor, and each individual firm’s demand
cost exceeding its MR? curve for labor shifts to the left by one unit when the
c. Express in terms of equation [14.3] the condition for a wage rate falls from w = $40 to w = $20 per day.
firm minimizing the cost of producing an output thatis *5. Assume that (1) U;, Uz, U3, and U4 given in the
too small to maximize profits. What is the graphic following table are the indifference curves of an
interpretation of this? individual, where H refers to hours of leisure per day
2. You are given the following production function of a and Y to the daily income, and (2) the wage rate rises
firm, where L is the number of workers hired per day (the from $1 per hour of work to $2, $3, and then to $4.
only variable input) and Qy is the quantity of the
commodity produced per day, and the constant U; U> U3 U4
commodity price of Py = $5 is assumed:
H if H if H if H if

i) 0) 10 3) 12 40 14 48
16 8 14 20 15 27 7 28
24 4 24 2 24 16 24 20

a. Find the marginal revenue product of labor and ;

plot it. a. Derive the individual’s supply curve of labor.

b. How many workers per day will the firm hire if the wage b. Why is the individual s supply curve of labor
rate is $50 per day? $40? $30? $20? $10? What is the backward bending?
firm’s demand curve for labor? 6. Given that the market demand curve is the one derived in
Problem 3 and that 400 individuals will work at w = $10,
ies). Assume that (1) labor is infinitesimally divisible (i.e.,
500 at w = $20, and 600 at w = $30, determine the
workers can be hired for any part of the day) in the
equilibrium wage rate and the level of employment. What
production function of the previous problem; (2) both
would happen if w = $10? If w = $30?
labor and capital are variable and complementary; and
(3) when the wage rate falls from $40 per day to $20 7. Given the industry demand function for labor, Dp =
per day, the firm’s value of the marginal product curve 800 — 15w, where w is given in dollars per day, draw
shifts to the right by two labor units. Derive the a figure showing the equilibrium wage and find the

* = Answer provided at end of book.

480 PART FIVE Pricing and Employment of Inputs

amount of economic rent if the supply function of 10. Starting with your answer to Problem 5 (also provided at
labor to the industry is S, = 500, S;, = 25w or S/ = the end of the book), draw a figure showing how many
50w — 500. additional hours the individual will work and his or her
. Draw a figure for a perfectly competitive firm in the total income (1) starting from w = $1 and overtime w =
product and input markets, and label the price at which $4 and (2) starting from w = $2 and overtime w = $10.
quasi-rent is (1) negative as P;, (2) zero as P2, (3) smaller lil, Starting from Figure 14.7, draw a figure showing the
than total fixed costs as P3, (4) equal to total fixed costs total demand and supply for labor in both industries or
as P4, and (5) exceeds total fixed costs as Ps. (Hint: See regions, the equilibrium wage rate, and the level of total
Figure 14.4.) employment.
oY), Separate the substitution effect from the income effect . Starting with Figure 14.7, draw a figure showing that
of an increase in wages from w = $2 to w = $4 in wages will not be equalized when we take
Problem 5. transportation costs into consideration.

INTERNET SITE ADDRESSES

A wealth of information on labor markets (employment, The effect of minimum wages on employment is found at:
unemployment, productivity, earnings, and others) is http://en.wikipedia.org/wiki/Minimum_wage
provided by the Bureau of Labor Statistics at: http://www.federalreserve. gov/pubs/feds/2003/200323/
http://stats.bls.gov 200323pap.pdf
http://www.bls.gov/news.release/empsit.t12.htm http://papers.ssrn.com/sol3/papers.cfm ?abstract_
http://www.bls.gov/news.release/pdf/empsit.pdf id=941970
For the backward-bending supply curve of physicians’ On economic rent, see:
services, see: http://www.economics.utoronto.ca/munro5/
http://lingli.ccer.edu.cn/he2007/ref/1014/extention.pdf ECONRENT.pdf
 CHAPTER 15

Input Price and Employment

Under Imperfect Competition
Chapter Outline List of Examples
15.1 Profit Maximization and Optimal Input 15-1 The Dynamics of the Engineers Shortage
Employment 15-2 Occupational Licensing, Mobility, and
15.2 The Demand Curve of a Firm for an Input Imperfect Labor Markets
15.3. The Market Demand Curve and Input Price 15-3 Monopsonistic Exploitation in Major League
and Employment Baseball
15.4 Monopsony: A Single Firm Hiring an Input 154 Imperfect Competition in Labor Markets and
15.5 Monopsony Pricing and Employment of One the Pay of Top Executives
Variable Input 15-5 British and Russian Brain Drain Is U.S. Brain
15.6 Monopsony Pricing and Employment of Gain
Several Variable Inputs 15-6 The Debate Over U.S. Immigration Policy
15.7 International Migration and the Brain Drain At the Frontier: Discrimination, and Gender
15.8 Analysis of Imperfect Input Markets and Race Wage Differentials

After Studying This Chapter, You Should Be Able to:

e Know how an imperfectly competitive firm determines the amount of each input to use to maximize
profits
e Describe how a firm’s demand curve and the market demand curve for one or more variable inputs
are derived
e Know why the marginal expenditure of labor curve is above the supply curve of labor for a monopsonist
e Explain how the equilibrium price and employment of an input are determined by a monopsonist
e Describe the effects of unions on wages and on discrimination in employment

n the previous chapter, we analyzed the pricing and employment of inputs when the firm
is a perfect competitor in both the product and input markets. In this chapter, we extend
the discussion to the pricing and employment of inputs when the firm is (1) an imperfect
competitor in the product market but a perfect competitor in the input market, and (2) an
imperfect competitor in both the product and input markets. As in Chapter 14, the analysis
deals with all inputs in general but is geared toward labor because of the greater importance
of labor.

481
482 PART FIVE Pricing and Employment of Inputs

lines as that of the

The presentation in this chapter proceeds along the same general
ation and optimal
previous chapter. We begin with a summary discussion of profit maximiz
imperfec t competi tion in the product market. Then we derive the
input employment under
examine how the
demand curve for an input by a firm and by the market as a whole, and we
interaction of the forces of demand and supply determi nes the price and employment of
the input under imperfec t competi tion in the product market but perfect competition in
the input market. We then turn to the case of imperfec t competi tion in input markets and
examine the pricing and employm ent of an input when only that input is variable and then
when all inputs are variable. A discussi on of internat ional migratio n and the “brain drain”
follows. Finally, the chapter presents several importan t applicat ions of the theory. The
“At the Frontier” section examine s the effect of discrimi nation on gender and race wage
differentials.

15.1 Prorit MAXIMIZATION AND OPTIMAL INPUT EMPLOYMENT

In this section, we extend the discussion of profit maximization and optimal input
employment of Section 14.1 to the case where the firm is an imperfect competitor in the
product market but is still a perfect competitor in the input markets. A firm that is an
imperfect competitor in the product market (a monopolist, an oligopolist, or a monopo-
listic competitor) faces a negatively sloped demand curve for the commodity it sells, and
its marginal revenue is smaller than the commodity price. Such a firm, however, can still
be one of many firms hiring inputs. That is, the firm can still be a perfect competitor in the
input markets, so that it can hire any quantity of an input at the given market price of the
input. This section and the next two sections of this chapter will examine this situation.
We have seen in Section 14.1 that to maximize profits, a firm must use the optimal or
least-cost input combination to produce the best level of output. The profit maximizing
condition was given by equation [14.3], which is repeated below as [15.1]:

w/MP;, =r/MPx =MC=MR [15.1]

where w is the wage rate, r is the rental price of capital, MP is the marginal (physical)
product, L refers to labor time, K refers to capital, MC is the marginal cost of the firm, and
MR 1s its marginal revenue. The only difference between equations [14.3] and [15.1] is
that equation [14.3] and the discussion in Section 14.1 referred to the case where the firm
was a perfect competitor in both the product and input markets. Thus, the marginal rev-
enue of the firm equaled the product price (P). Since the firm is now an imperfect com-
petitor in the product market, MR < P and equation [15.1] is the relevant condition for
profit maximization.
By cross multiplying and rearranging the terms of equation [15.1], we get equa-
tions [15.2] and [15.3]:

MP, x MR=w [13524

MPx x MR=r DER)

Thus, the profit-maximizing rule is that the firm should hire labor until the marginal prod-
uct of labor times the firm’s marginal revenue from the sale of the commodity equals
the
 CHAPTER 15 Input Price and Employment Under Imperfect Competition 483

wage rate. Similarly, the firm should rent capital until the marginal product of capital
Concept Check times the firm’s marginal revenue equals the rental price of capital. To maximize profits,
How does a firm that is the same rule would have to hold for all inputs that the firm uses. The condition is the
imperfectly competitive same as when the firm is a perfect competitor in the product market, except that in that
in the product but not case, MR = P. In the next section, we will see that equation [15.2] provides the basis for
in the input market
the derivation of the firm’s demand curve for labor.
determine how much
of an input to hire to
maximize profits?

| 5.2 THE DEMAND CURVE OF A FIRM FOR AN INPUT

We now extend the discussion of the last section and derive the demand curve of a firm
for an input, first when the input is the only variable input and then when the input is one
of two or more variable inputs.

The Demand Curve of a Firm for One Variable Input

We have seen in Section 14.2 that a profit-maximizing firm will hire more units of a vari-
able input as long as the income from the sale of the extra output produced by the input
is larger than the extra cost of hiring the input. When the firm is an imperfect competitor
(say, a monopolist) in the product market, the extra income earned by the firm is called
Marginal revenue the marginal revenue product (MRP) and is equal to the marginal product of the input
product (VRP) The times the marginal revenue of the firm. That is,
marginal physical
product of the input
MRP = MP x MR [15.4]
(MP) multiplied by the
marginal revenue of
the commodity (MR). If the variable input is labor, we have

MRP, = MP, x MR [15.4A]

Thus, the MRP, is the left-hand side of equation [15.2]. Similarly, the MRPx is the left-
hand side of equation [15.3]. Note that when the firm is a perfect competitor in the prod-
uct market, the firm’s marginal revenue equals the product price (i.e., MR = P) and the
marginal revenue product equals the value of the marginal product (i.e., MRP = VMP).
Since we are now dealing with a firm that is an imperfect competitor in the product mar-
ket and MR < P, MRP < VMP.
Because the firm is a perfect competitor in the input market (i.e., faces a horizontal or
infinitely elastic supply curve of the input), the extra cost or marginal expenditure (ME)
of hiring each additional unit of the variable input is equal to the price of the input. If the
variable input is labor, a profit-maximizing firm should hire labor as long as the marginal
revenue product of labor exceeds the wage rate and until MRP; = w, as indicated by
equation [15.2].
The actual derivation of a firm’s demand schedule for labor when labor is the only
variable input (i.e., when capital and other inputs are fixed), and when the firm is an
imperfect competitor (monopolist) in the product market but a perfect competitor in the
labor market is shown with Table 15.1. In Table 15.1, L refers to the number of workers
hired by the firm per day. Qy is the total output of commodity X produced by the firm by
hiring various numbers of workers. The MP is the marginal or extra output generated by
each additional worker hired. The MP, is obtained by the change in Qy per unit change in L.
484 PART FIVE Pricing and Employment of Inputs

The Marginal Revenue Product of Labor and the Firm’s

Demand Schedule for Labor

L Q, MP, P, TR, MRP, ME, — WwW

12 12 $13 $156 ae $40

|
22 10 12 264 $108 40
2
30 8 1] 330 66 40
3
4 37 i 10 370 40 40
5 43 6 2) 387 Ig 40
6 48 5 8 384 =3 40

Note that the law of diminishing returns begins to operate with the hiring of the second
worker. Py refers to the price for the final commodity, and it declines because the firm is
an imperfect competitor (monopolist) in the product market. Total revenue (TRx) is
obtained by multiplying Py by Qy. The marginal revenue product of labor (MRP) is then
given by the change in the firm’s total revenue by selling the output of commodity X that
results from the hiring of an additional worker. More briefly, MRP; = ATRx/AL. This
is the same as MP, times MR (not given in the table; see Problem 3, with the answer at
the end of the text). The MRP, declines because both the MP; and MRx decline. That is,
as the firm hires more labor and produces more units of the commodity, the MP, declines
(because of diminishing returns) and MRx also declines (because the firm must lower the
commodity price to sell more units of the commodity). The last column of Table 15.1
gives the daily wage rate (w) that the firm must pay to hire each worker. Since the firm is
a perfect competitor in the labor market, w is constant (at $40 per day) and is equal to the
increase in the firm’s total costs (the marginal expense) of hiring each additional worker.
Looking at Table 15.1, we see that the second worker contributes $108 extra revenue
to the firm (i.e., MRP; = $108), while the firm incurs a cost of only $40 to hire this
worker. Thus, it pays for the firm to hire the second worker. (Since the MRP of the first
worker is even greater than the MRP of the second worker, the firm should certainly hire
the first worker.) The MRP of the third worker falls to $66, but this still exceeds the daily
wage of $40 that the firm must pay each worker. Thus, the firm should also hire the third
worker. According to equation [15.2], the profit-maximizing firm should hire workers
until the MRP; = w. Thus, this firm should hire four workers, at which MRP; = w =
$40. The firm will not hire the fifth worker because he or she will contribute only $17 to
the firm’s total revenue while adding $40 to its total costs.
The MRP, schedule gives the firm’s demand schedule for labor. It indicates the num-
ber of workers that the firm would hire at various wage rates. For example, if w = $108
per day, the firm would hire only two workers per day. If w = $66, the firm would hire
three workers. At w = $40, L = 4, and so on. If we plotted the MRP, values of Table 15.1
on the vertical axis and L on the horizontal axis, we would get the firm’s negatively sloped
demand curve for labor when labor is the only variable input. This is shown in the next
section.
Note that since the firm is a monopolist in the product market, the MRP, is smaller
than the VMP, and the MRP, curve lies below the VMP, curve. As a result, the firm hires
less labor and produces less of the commodity than if the firm were a perfect competitor
in the product market. Joan Robinson called the excess of the VMP7_ over the MRP, at the
 CHAPTER 15 Input Price and Employment Under Imperfect Competition 485

FIGURE 15.1 Demand Curve for Labor of a Monopolist MESS

with All Inputs Variable As the wage rate falls and the firm $80
hires more labor (i.e, moves down its MRP, curve), the MRP
curve of inputs that are complements to labor shifts to the Oe
right and the MRP curve of inputs that are substitutes for labor
Shifts to the left. Both of these shifts cause the MRP, curve to 40
shift to the right to MRR! Thus, when the daily wage falls from
$66 to $40, the firm increases the number of workers hired 90
from three (point A on the MRP;. curve) to six (point C on
the MRA’curve). By joining points A and C, we get the firm’s
demand curve for labor (d,). 0

Monopolistic point where MRP; = w (the level of employment) monopolistic exploitation.' Yet, this
exploitation The emotionally laden term is somewhat misleading, because the firm does not pocket the dif-
excess of an input’s
ference between the VMP, and the MRP, (see Problem 3, with the answer at the end of
value of marginal
the text). That is, the last worker hired receives the entire increase in the total revenue of
product over its
marginal revenue the firm (the MRP) that he or she contributes.
product at the level of
utilization of the input.
The Demand Curve of a Firm for One of Several Variable Inputs
We have seen that the declining MRP, schedule given in Table 15.1 gives the firm’s
demand schedule for labor in the short run when labor is the only variable input. This is
shown by the negatively sloped MRP, curve in Figure 15.1 (on the assumption that labor
is infinitesimally divisible or that workers can be hired for any part of a day). The MRP;
or demand for labor curve when labor is the only variable input shows that the firm
will hire three workers at w = $66 (point A in Figure 15.1) and four workers at w = $40
(point B).
When labor is not the only variable input (i.e., when the firm can also change the
quantity of capital and other inputs), the firm’s demand curve for labor can be derived
from the MRP, curve, but it is not the MRP, curve itself. The derivation is basically the
same as explained in Section 14.2 and is shown in Figure 15.1. That is, as the wage rate
falls and the firm hires more labor (i.e., moves down its MRP; curve), the MRP curve of
inputs that are complements to labor shifts to the right, and the MRP curve of inputs that
are substitutes for labor shifts to the left (exactly as explained in Section 14.2). Both of
these shifts cause the MRP, to shift to the right, say, from MRP; to MRP, in Figure 15.1.
Concept Check Thus, when the daily wage falls from $66 to $40, the firm will increase the number of
How is an imperfectly workers hired from three (point A on the MRP, curve) to six (point C on the MRP_ curve)
competitive firm’s rather than to four (point B on the original MRP, curve). By joining points A and C, we
demand curve for one get the firm’s demand curve for labor (d; in Figure 15.1) when other inputs besides labor
or more variable inputs
are variable.
derived?
Note that the d, curve is negatively sloped and generally more elastic than the MRP,
curve in the long run, when all inputs are variable. In general, the better the complemen-
tary and substitute inputs available for labor are, the greater is the outward shift of the
MRP, curve as a result of a decline in the wage rate, and the more elastic is d,.

! J, Robinson, The Economics of Imperfect Competition (London: Macmillan, 1933), Chapter 25.
486 PART FIVE Pricing and Employment of Inputs

15.3 THE Market DEMAND CURVE AND INPUT PRICE AND EMPLOYMENT

The market demand curve for an input is derived from the individual firms’ demand
curves for the input. If all the firms using the input are monopolists in their respective
product markets, the market demand for the input 1s derived by the straightforward hori-
zontal summation of the individual firms’ demand curves for the input. The reason is that
the reduction in the commodity price (as each monopolist produces and sells more of its
commodity by hiring more inputs) has already been considered or incorporated in full
into the calculation of the MRP of the input.
The case is different when a commodity market is composed of oligopolists and
monopolistic competitors. That is, when all the oligopolists or monopolistic competitors
in a product market hire more inputs and produce more of the commodity, the commod-
ity price will decline. This decline in the price of the commodity causes a downward shift
in each firm’s demand curve for labor, exactly the same as when firms are perfect com-
petitors in the product market (see Section 14.3). The market demand curve is obtained by
adding the quantity demanded of each input on these downward shifting demand curves
of the input of each firm. The process is identical to that shown in Figure 14.2 in Section
14.3, and it is not repeated here (see Problem 6).
The equilibrium price and employment of an input are then given at the intersection
of the market demand and the market supply curves of the input, as described in Section
Concept Check 14.5. When all firms are perfect competitors in the input market, each firm can hire any
How is the marginal quantity of the input at the given market price of the input. Each firm will then hire the
expenditure curve of an input until the MRP of the input on the firm’s demand curve for the input equals the ME
input of a monopsonist
or input price.
derived?
If, for whatever reason, the market demand curve for the input rises (1.e., shifts
upward) from the equilibrium position, the market price and employment of the input will
also increase until a new equilibrium price is reached at which the MRP of the input
equals the MRC or input price. This usually does not occur instantaneously. During the
adjustment period, there will be a temporary shortage of the input (see Example 15-1).

EXAMPLE 15-1
The Dynamics of the Engineers Shortage

During the late 1950s and early 1960s a shortage of engineers existed in the United
States, which might have endangered winning the “space race” with the former Soviet
Union. This can be analyzed with the aid of Figure 15.2. The intersection of the hypo-
thetical market demand curve for engineers Dg and the market supply curve of engi-
neers Sg at point E determines the equilibrium daily wage of $40 for engineers. At
w = $40, the 600,000 engineers employed match the number of engineers demanded,
and there is no shortage. In the late 1950s and early 1960s, the demand for engineers
unexpectedly increased (i.e., shifted up, say, to DG) because of the space race. At the
original equilibrium wage rate of w = $40, there is a shortage of 500,000 (EF) engi-
neers and engineers’ wages rise. As this occurs, employers economize on the use of
engineers, and more students enter engineering studies. Thus, the shortage is some-
what alleviated. For example, at w = $50, the shortage declines to 250,000
(CM).
 CHAPTER 15 Input Price and Employment Under Imperfect Competition 487

FIGURE 15.2 Dynamics of the Engineer Shortage Day

The intersection of Dg and Sg at point E determines the ay
equilibrium daily wage of $40 for engineers. There are
600,000 engineers employed, and there is no $66 =--!n == )
shortage. If Dg shifts upward to Dé, a temporary BO)
shortage of 500,000 (EF) results at w = $40 and 40 is .
wages rise. As this occurs, the shortage is somewhat !
alleviated. At w = $50, the shortage declines to DG
250,000 (CM). Only after the wage rises to $66 and De
enough new engineers are trained is the temporary | el Sele ee UES
shortage eliminated and new equilibrium point E’ 0 300 600 800 1,100 L
reached. Number of engineers (thousands)

Only after several years, as wages rise to $66 and enough new engineers are trained, is
the shortage eliminated and new equilibrium point E’ reached with 800,000 engineers
employed.
If, over this time, the demand for engineers increases again, a new temporary
shortage emerges. On the other hand, if the demand for engineers declines by the time
an increasing number of them graduate in response to higher wages, or if the supply
response turns out to be excessive, a surplus of engineers develops. This is indeed what
occurred during the 1970s and 1980s. Because of the reduced pool of the college-age
population and high incomes in other occupations, the National Science Foundation
nevertheless predicted that a shortfall of about half a million engineers and scientists
would again develop by the end of the twentieth century in the United States. Indeed,
a shortage of engineers of about 350,000 was estimated to exist in the United States in
2001. More recent studies, however, have concluded that there is no shortage of engi-
neers in the United States and that any increase in future demand can be met by more
engineers being trained in the United States and by immigration.
Sources: K. Arrow and W. Capron, “Dynamic Shortages and Price Rises: The Engineer-Scientist Case,”
Quarterly Journal of Economics, May 1959; C. Holden, “Supply and Demand for Scientists and
Engineers: A National Crisis in the Making,” Science, April 1990; Duke Outsourcing Study: Industry
Trends in Engineering Offshoring (Duke University, October 2006); and R. A. Freeman, “The Market
for Scientists and Engineers,’ NBER Reporter, November 2007, pp. 6-8.

MonopsoNy: A SINGLE FIRM HIRING AN INPUT

Until this point we have assumed that the firm is a perfect competitor in the input market.
This means that the firm faces an infinitely elastic or horizontal supply curve of the input
and that the firm can hire any quantity of the input at the given market price of the input.
We now examine the case in which the firm is an imperfect competitor in the input mar-
Monopsony A single ket. When there is a single firm hiring an input, we have a monopsony. Thus, while
buyer of an input. monopoly refers to the single seller of a commodity, monopsony refers to the single buyer
of an input. As such, the monopsonist faces the (usually) positively sloped market supply
488 PART FIVE Pricing and Employment of Inputs

monopsonist must
curve of the input. This means that to hire more units of the input, the
pay a higher price per unit of the input. oe
An example of monopson y is provided by the “company towns” In nineteenth-
of labor
century America, where a mining or textile firm was practically the sole employer
an
in many isolated communities. A present-day example of monopsony might be
automaker that is the sole buyer of some specializ ed automobil e componen t or part, such
as radiators, from a number of small local firms set up exclusively to supply these com-
ponents or parts to the large firm (the automaker).
Monopsony arises when an input is specialized and thus much more productive toa par-
ticular firm or use than to any other firm or use. This allows the firm (in which the input is
more productive) to pay a much higher price for the input than other firms and so become a
monopsonist. Monopsony can also-result from lack of geographic and occupational mobil-
ity. For example, people often become emotionally attached to a given locality because of
family ties, friends, and so on, and are unwilling to move to other areas. Also, people may
lack the information, the money, or the qualifications to move to other areas or occupations.
In general, monopsony can be overcome by providing information about job opportunities
elsewhere, by helping to pay for moving expenses, and by providing training for other
occupations.
We have said that the monopsonist faces the usually positively sloped market supply
curve of the input, so that it must pay a higher price to hire more units of the input.
However, as all units of the input must be paid the same price, the monopsonist will have
to pay a higher price, not only for the last unit hired, but for all units of the input it hires.
Marginal expenditure As aresult, the marginal expenditure (ME) on the input exceeds the input price. This is
(ME) The extra expen- shown in Table 15.2 for labor. '
diture for or cost of hir- In Table 15.2, w is the daily wage rate that a monopsonist must pay to hire various
ing an additional unit of
numbers of workers (L). Thus, the first two columns of the table give the market supply
an input.
schedule of labor faced by the monopsonist. TE, is the total expenditure incurred by the
monopsonist to hire various numbers of workers and is obtained by multiplying L by w.
Marginal expenditure ME, is the marginal expenditure on labor and gives the extra expenditure that the
on labor (ME,) The monopsonist faces to hire each additional worker. That is ME; = ATC, /AL.
extra expenditure for or
Note that ME; > w. For example, the monopsonist can hire one worker at the wage
cost of hiring an addi-
rate of $10 for a total cost of $10. To hire the second worker, the monopsonist must
tional unit of labor.
increase the wage rate from $10 to $20 and incur a total expenditure of $40. Thus, the
increase in the total expenditure (i.e., the marginal expense) of hiring the second worker
is $30 and exceeds the wage rate of $20 that the monopsonist must pay for each of the two
workers.
Figure 15.3 gives the positively sloped market supply curve of labor (S,) faced by the
monopsonist (from columns | and 2 of Table 15.2) and the marginal expenditure curve

L Ww TE, ME,

| $10 $10 me
2 20 40 $30
3 30 90 50

4 40 160 70
5 50 250 90
 CHAPTER 15 Input Price and Employment Under Imperfect Competition 489

ME;
XO) |=

A=
7,
; 50 ee
FIGURE 15.3 A Monopsonist’s Supply and Marginal Expenditure on Labor ‘A ae
Curves —S, is the positively sloped market supply curve of labor faced by the 39 L
monopsonist (from columns 1and 2 of Table 15.2) and ME; is the marginal 90
expenditure on labor curve (from the first and the last columns of Table 15.2). 10 Ee
The ME, values are plotted between the various units of Lused, and the ME, ce Fe |e Pea |
Curve Is everywhere above the S; curve. 0 1 2 3 4 ee

(ME_,, from the first and the last columns of Table 15.2). Since the ME; measures the
changes in TE, per unit change in L used, the ME; values given in Table 15.2 are plotted
between the various units of labor hired. Note also that the ME; curve is everywhere
above the S; curve. Similarly, a firm that is the single renter of a particular type of spe-
cialized capital (1.e., a monopsonist in the capital market) faces the positively sloped mar-
Marginal expenditure ket supply curve of capital, so that the firm’s marginal expenditure on capital (MEx)
on capital (MEx) The curve is above the supply curve of capital (Sx).
extra expenditure for or
Although our discussion has been exclusively in terms of monopsony, there are
cost of hiring an addi-
other forms of imperfect competition in input markets. Just as we have monopoly, oli-
tional unit of capital.
gopoly, and monopolistic competition in product markets, so we can have monopsony,
Oligopsony The form oligopsony, and monopsonistic competition in input markets. Oligopsony refers to
of market organization the case where there are only a few firms hiring a homogeneous or differentiated input.
in which there are few Monopsonistic competition refers to the case where there are many firms hiring a dif-
firms hiring either a ferentiated input. As for the monopsonist, oligopsonists and monopsonistic competitors
homogeneous or a
must also pay higher prices to hire more units of an input, and so the marginal expendi-
differentiated input.
ture on the input exceeds the input price for them also.
Finally, note that when the firm is a perfect competitor in the input market, the mar-
Monopsonistic ginal expenditure on the input is equal to the input price, and the marginal expenditure
competition The curve is horizontal and coincides with the supply curve of the input that the firm faces.
situation where there That is, since the firm hires such a small quantity of the input, the supply curve of the
are many firms hiring input that the firm faces is infinitely elastic, even though the market supply curve of the
a differentiated input.
input is positively sloped. For example, if w = $10 no matter how many workers a firm
hires, then ME, = w = $10 and the ME, curve is horizontal at w = $10 and coincides
with the S;, curve (the supply curve of labor faced by the firm). Example 15—2 examines
the effect of occupational licensing on the functioning of labor markets.

2 Tn Section A.14 of the Mathematical Appendix, we derive an important relationship among input price,
marginal expenditure, and the price elasticity of input supply. This is analogous to the relationship among
commodity price, marginal revenue, and the price elasticity of commodity demand derived in Section 5.5.
490 PART FIVE Pricing and Employment of Inputs

EXAMPLE 15-2
Occupational Licensing, Mobility, and Imperfect Labor Markets
State governments in the United States require a license to engage in certain professional
activities. Occupational licensing now affects more than 20% of the U.S. labor force,
which is more than the workers affected by the minimum wage (about 10% of the U.S.
labor force) or unionization (about 13% of the U.S. labor force), and it is increasing.
About 50 occupations are now licensed in all states, and more than 800 occupations are
licensed in some states.
Although occupational licensing is imposed to ensure quality of service, it invari-
ably also restricts the flow of labor into the licensed occupations and increases the earn-
ings of licensed labor. Kleiner found that licensing reduced the growth rate of
employment by about 20%, increased hourly earnings about 10% to 17%, depending on
the occupation, compared to similar unlicensed occupations, and it cost the economy
_about $38 billion in lost service output per year. At the same time, he did not find that
licensing enhanced the quality of the service.
Not only do most states require many occupations to be licensed, but many of them
do not recognize the occupational license obtained in other states to pursue the occupa-
tion in their own state. This is often the case for dentists and lawyers. Invariably, these
nonreciprocity regulations are the result of lobbying on the part of the professions
involved as a way of restricting the possible competition that would arise from an inflow
of professionals from other states. On theoretical grounds, we would expect that the
income of professionals in states without reciprocity agreements would be higher than in
states with reciprocity. In fact, Shepard found that the fees and income of dentists in the
35 states that had no reciprocity agreements were 12% to 15% higher than in states with
reciprocity. If all states adopted reciprocity agreements, some lawyers and dentists in
states with lower fees and incomes would migrate to those states with higher fees and
incomes. This would reduce (and in the limit eliminate) all interstate differences in fees
and incomes and increase the degree of competition in these labor markets.
Sources: M. M. Kleiner, Licensing Occupations: Enhancing Quality or Restricting Competition (Kalamazoo,
MI.: Upjohn Institute, 2006); M. M. Kleiner, “Occupational Licensing,” Journal of Economic Perspectives,
Fall 2000; and L. Shepard, “Licensing Restrictions and the Cost of Dental Care,” Journal of Law and
Economics, October 1978.

15.5 MONOPSONY PRICING AND EMPLOYMENT OF ONE VARIABLE INPUT

As pointed out in Section 14.2, a firm using only one variable input maximizes profits by
hiring more units of the input until the extra revenue from the sale of the commodity
equals the extra expenditure on hiring the input. This is a general marginal condition and
applies whether the firm is a perfect or imperfect competitor in the product and/or
input
markets. If the variable input is labor and the firm is a monopsonist in the labor market,
the monopsonist maximizes its total profits by hiring labor until the marginal
revenue
product of labor equals the marginal expenditure on labor. That is, the
monopsonist
should hire labor until equation [15.5] or, equivalently, equation [15.5A]
holds:
MRP, = ME, [13:5]
MP, - MR = MRC, [15.5A]
 CHAPTER 15 Input Price and Employment Under Imperfect Competition 491

FIGURE 15.4 Optimal Employment of Labor and the Wage Rate Paid
by a Monopsonist The S; and the ME, curves are those of Figure 15.3. With
MRP, the monopsonist maximizes profits by hiring three workers (given by
point £, at which the MRP, curve intersects the ME, curve and
MRP, = ME, = $60). The monopsonist then pays w = $30 to each worker
(given by point E’ on S,). The excess of MRP; over w (EE’ = $30) atL = 3 is
called monopsonistic exploitation.

The wage rate paid by the monopsonist is then given by the corresponding point on the
market supply curve of labor (S;). This is shown in Figure 15.4.
In Figure 15.4, the S; and the ME; curves are those of Figure 15.3. With the firm’s
MRP, curve shown in Figure 15.4, the monopsonist maximizes profits by hiring three
workers (given by point E, at which the MRP, curve intersects the ME; curve and
Concept Check MRP, = ME, = $60). To prove this, consider that the second worker adds $80 (point A)
How are the to the monopsonist’s total revenue but only $40 (point A’) to its total expenditure. Thus,
equilibrium price and the monopsonist’s profits rise (by AA’ = $40) by hiring the second worker. On the other
employment of an input
hand, the monopsonist would not hire the fourth worker because he or she would add
of a monopsonist
more to total expenditure ($80, given by point B) than to total revenue ($40, given
determined?
by point B’), so that the monopsonist’s total profits would fall by $40 (BB’ in the
figure). Only at L = 3, MRP, = ME, = $60 (point E) and the monopsonist maximizes
total profits.
Figure 15.4 also shows that to hire three workers, the monopsonist must pay the wage
of $30. This is given by point E’ on the S; curve at L = 3. Thus, the intersection of the
MRP, and ME, curves gives only the profit-maximizing number of workers that the firm
should hire. The wage rate is then given by the amount that the firm must pay each
worker, and this is given by the point on the market supply curve of labor at the level of
employment. Note that MRP, = $60 (point E) exceeds w = $30 (point E’) at L = 3.
Joan Robinson called the excess of the marginal revenue product of the variable input
Monopsonistic over the input price (EE’ = $30 at L = 3 in Figure 15.4) monopsonistic exploitation.’ It
exploitation The arises because the monopsonist produces where the MRP; = ME, in order to maximize
excess of the marginal profits. Since the S;, curve is positively sloped, the ME; curve is above it, and ME; > w.
revenue product of an The more inelastic the market supply curve that the monopsonist faces, the greater the
input over the price of
degree of monopsonistic exploitation. If the firm in Figure 15.4 had been a perfect com-
the input at the level of
utilization of the input. petitor in the labor market, it would have hired four workers (given by point B’, at which
MRP, = ME, = w = $40). As we have seen, the monopsonist maximizes total profits by
restricting output and employment and by hiring only three workers (point E’). Example
15-3 examines monopsonistic exploitation in major league baseball. In Section 15.8, we
will see how government regulation and/or union power can reduce or eliminate monop-
sonistic exploitation.

3 J, Robinson, The Economics ofImperfect Competition (London: Macmillan, 1933), Chapter 26.
492 PART FIVE Pricing and Employment of Inputs

EXAMPLE 15-3
Monopsonistic Exploitation in Major League Baseball

Table 15.3 gives the net marginal revenue product (MRP) and the salary of mediocre,
average, and star hitters and pitchers in major league baseball calculated by Scully for
the year 1969. Scully found that the team’s winning record increased attendance and
revenues and that a team’s performance depended primarily on the “slugging average”
for hitters and on the ratio of “strikeouts to walks” for pitchers. Using these data,
Scully calculated the net MRP or extra gate revenues and broadcast receipts resulting
from each type of player’s performance after subtracting the player's development
cost. In 1969, development costs were as high as $300,000 per player. Table 15.3
shows that for mediocre players, the net MRP was negative (—$32,300 for hitters and
—$13,400 for pitchers). Of course, the team’s scouts and managers could not precisely
foresee which players would turn out to be mediocre, average, or stars. The table also
shows the average players’ salaries in each category.
Mediocre players reduced the team’s profits. Average players received salaries far
lower than their net MRP. Star players received salaries that were more than six times
lower than their net MRP. Thus, monopsonistic exploitation was large for average
players and very large for star players. On the other hand, mediocre players exploited
their team! This exploitation was made possible by the “reserve clause,’ under which
the player became the exclusive property of the team that first signed him. Aside from
being traded, a player could only play for the team for whatever salary the team
offered. Thus, the reserve clause practically eliminated all competition in hiring and
remuneration and essentially established a cartel of employers (teams) for major
league baseball players. As such, the cartel behaved much like a monopsonist and
exploited players.
In 1975, the reserve clause was substantially weakened. After six years of play-
ing for a team, players could declare themselves “free agents” and negotiate their
salaries and the team for which they would play. As anticipated, competition resulted
in startling increases in players’ salaries and sharply reduced the monopsonistic
power of baseball clubs. For example, Summers and Quinton found that free-agent
star pitchers had an average marginal revenue product of nearly $300,000 and

Net Marginal Revenue Product and Salaries

TABLE 15.3 inae
Major League Baseball, 1969 Average

Type of Player Quality of Player Net MRP Salary

Hitters Mediocre $32,300 $15,200
Average 129,500 28,000
Star 313,900 47,700
Pitchers Mediocre $—13,400 $13,700
Average 159,900 31,800
Star 397,000
FEEMESCEARSE CeRee ee TAI ASLAM ASDLNSL MENT ACOMEOML Ua61,000
N

Source: G. Scully, “Pay and Performance in Major League Baseball,” American

Economic
Review, December 1974, p. 928.
 CHAPTER 15 Input Price and Employment Under Imperfect Competition 493

received salaries of nearly $258,000 in 1980. Even after adjusting for inflation, this
represented a doubling of the 1969 salary of star pitchers. In an attempt to reduce
these huge salaries and restore some of their previous monopsony power, in 1986
club owners did not sign any player that had become a free agent in 1985. The play-
ers’ union filed a grievance in 1986, charging that the clubs had acted collusively and
thus illegally. In fall 1987, an arbitrator for major league baseball ruled that the clubs
had indeed conspired to destroy the free-agent market and that the affected players
should be awarded financial damages. By 1991, players’ salaries had shot up to more
than $500,000 per year and were equal, on the average, to their marginal revenue
product (thus essentially putting an end to exploitation in major league baseball).
Thirty-five players earned $3 million or more per year, with Boston Red Sox pitcher
Roger Clemens and New York Mets pitcher Dwight Gooden topping the list with
earnings in excess of $5 million per year.
On August 12 1994, players went on strike as a result of the owners’ decision to
put a salary cap on multimillion dollar star players’ salaries. The strike wiped out the
last 52 days of the 1994 season as well as the World Series (for the first time in 90
years), and it also led to a three-week delay in the starting of the 1995 season. The
strike was ended by a court injunction after the players agreed to some form of “ux-
ury tax” on clubs paying very high star players’ salaries (a partial victory for owners).
- This, however, was regarded as much too modest to equalize differences between the
affluent and poor teams.
In December 2000, the nation’s sporting establishment was left aghast by the
$252 million, 10-year contract—the largest ever in any sport—that shortstop Alex
Rodriguez signed with the Texas Rangers. This is more than Tom Hicks had paid for
the entire team two years earlier and almost 10 times more than some teams’ entire
payroll. The Rangers reason: its desire to win (in 1999 the Rangers had the worst
record in the league). But experience shows that one player, by himself, cannot turn a
team around no matter how great. In 1969, the overall average salary for a baseball
player was $34,000; by 2007, it had reached $2.9 million. Only the richest clubs can
now pay star salaries, and they almost always win. This takes the competition—and
some of the fun—out of baseball!
Sources: G. Scully, “Pay and Performance in Major League Baseball,’ American Economic Review,
December 1974; P.M. Summers and N. Quinton, “Pay and Performance in Major League Baseball: The
Case of the First Family of Free Agents,” Journal of Human Resources, Summer 1982; “Owners: 1,
Players: 0,” Business Week, April 17, 1995, pp. 32-33; “Bring Competition Back to Baseball,” New York
Times, April 5, 1999, p. 22; “Rodriguez Strikes It Rich in Texas,” New York Times, December 12, 2000, p.
D1. For data on salaries in 2007, see: http://sportsline.com/mlb/salaries/avgsalaries; http://sportsline.com/
mlb/players; and http://sportsline.com/mlb/salaries.

MONOPSONY PRICING AND EMPLOYMENT OF SEVERAL VARIABLE INPUTS

We have seen in Section 15.5 that when labor is the only variable input, a monopsonist
maximizes profits by hiring labor until the marginal revenue product of labor equals the
marginal expenditure on labor. This was given by equations [15.5] and [15.5A]. The same
condition holds when there is more than one variable input. That is, the monopsonist
maximizes profits by hiring each input until the marginal revenue product of the input
494 PART FIVE Pricing and Employment of Inputs

inputs,
equals the marginal expenditure on hiring it. With labor and capital as the variable
hold: .
the monopsonist should hire labor and capital until equations [15.6A] and [15.6B]

MP, - MR = ME, [15.6A]

MPx - MR = MEx [15.6B]

Dividing both sides of equations [15.6A] and [15.6B] by MP; and MPx, respectively,
and combining the results we get [15.7]

ME,,/MP,, = MEx /MPx = MC = MR [15.7]

This is identical to equation [15.1], except that w has been replaced by the ME; and r has
been replaced by the MEx to reflect the fact that the firm is now a monopsonist in the labor
and capital markets, and it must pay a higher wage and rental price to hire more labor and
rent more capital, respectively. That is, the optimal input combination is now given by
equation [15.7] rather than by equation [14.2], and each ratio in equation [15.7] equals the
MC of the firm:

ME,/MP;, = MEx/MPx = MC [15.8]

For example, if ME,/MP, is smaller than MEx/MPx, the monopsonist would not be
minimizing production costs. The monopsonist can reduce the cost of producing any level
of output by substituting labor for capital in production at the margin. As the monopson-
ist hires more labor, ME, rises and MP, declines, so that ME,/MP, rises. As the monop-
sonist rents less capital, MEx falls and MPx rises, so that MEx/MPx falls. To minimize
the cost of producing any level of output, the monopsonist should continue to substitute
labor for capital in production until equation [15.8] holds.
Note that the ME; /MP, and MEx/MPx measure the extra cost (in terms of labor and
capital, respectively) to produce an extra unit of the commodity. This is the marginal cost
of the firm. For example, if ME; = $10 and MP; = 5, the marginal cost of the firm is
ME,/MP, = $10/5 = $2. This means that it costs the monopsonist $2 extra to hire the
additional labor to produce one extra unit of the commodity. The same is true for capital.
That is, MEx/MPx = MC or the marginal cost of the firm (in terms of capital). The
best level of output is then given by the point where MC = MR (see equation [15.7]).
Example 15—4 shows the incredibly high compensation of top executives.

EXAMPLE 15-4
imperfect Competition in Labor Markets and the Pay of Top Executives

Table 15.4 gives the earnings of the 10 highest-paid chief executives in the United
States in 2006. The total pay ranged from $71.7 million for Terry Semel of Yahoo to
nearly $32 million for Luis Camilleri of Altria Group, for an average compensation of
$45.5 million for all 10 executives (as compared with $16.9 million in Europe). A large
portion of these incredible incomes resulted from stock options for CEOs (which
are
less visible to stockholders). While the average remuneration of CEOs was 56
times
the average worker’s pay in 1940 and 74 times it in 1950, this increased to 122
in 1990
and 350 in 2006. Union leaders have denounced these multimillion-dollar yearly
com-
pensations as the “annual executive pig-out.”
 CHAPTER 15 Input Price and Employment Under Imperfect Competition 495

Earnings of the 10 Highest-Paid CEOs in the

Malai) United States in 2006 (in millions of dollars)
Executive/ Salary Stock and Total
Company and Bonus Other Options Compensation

1. Terry Semel Yahoo $0.3 $71.4 $71.7

2. Bob Simpson XTO Energy 32.4 Dia 59.5
3. Ray Irani Occidental To 45.5 52.8
Petroleum
4. E. Stanley O’ Neil* 19.6 26.8 46.4
Merrill Lynch
5. H. Lawrence Culp, 5.0 abil 2 46.2
Jr. Danaher
6. Angelo Mozilo IBM 24.0 19.0 43.0
7. Alan Mulally Ford 195 19.6 3).
8. Todd Nelson Apollo Group 32.6 0.0 32.6
9. Edward Whitacre AT&T 9.6 D2 31.8
10. Luis Camilleri Altria Group Pay 10.0 S17

Source: Institute for Policy Studies, Executive Excess (Washington, DC: IPI, August 29, 2007).

The question is “Are these executives worth to their employer the huge compen-
sation that they are paid?” One answer is that since firms voluntarily make these pay-
ments, the marginal revenue product of these top executives must be at least as high.
These huge payments, however, also result because of a confluence of interests (collu-
sion) between CEOs and compensation committees and because the latter often have
inadequate information or fail to comprehend how rapidly the payments from a com-
plicated, long-term compensation package can escalate if all goes well.

15.7 INTERNATIONAL MIGRATION AND THE BRAIN DRAIN

International migration affects the supply of labor of the nations of emigration and immi-
gration. Migration can take place for economic as well as for noneconomic reasons. Most
of the international labor migration into the United States since the end of World War II
has been motivated by the prospects of earning higher real wages and incomes in the
United States than in the country of origin. Labor migration to the United States, however,
is highly restricted (i.e., international labor markets are not perfectly competitive).
We can examine the effect of labor immigration on a nation with Figure 15.5. The
figure is based on the assumption that the nation’s output is produced under conditions of
constant returns to scale with labor and capital inputs only. Before immigration, the
nation employs 3 million workers at the daily wage of $60. The total value of output is,
therefore, OFAG = $270 million, of which OHAG = $180 million goes to labor and the
remainder, or HFA = $90 million, goes to the owners of capital. With | million immi-
grants, the daily wage rate in the nation falls to $40 and the share of total output going to
capital owners increases to JFB = $160 million or by HABJ = $70 million. Since the
original workers’ earnings decline by the area of rectangle HACJ = $60 million, the
496 PART FIVE Pricing and Employment of Inputs

Net gain from

FIGURE 15.5 Effects of Immigration on the Earnings of Labor 60 ¢ immigration
|
and Capital Before immigration, the nation employs 3 million | B
workers at the daily wage of $60. Total output is OFAG = $270 40 @=-----
SI Ci
— |
million, of which OHAG = $180 million goes to labor and HFA = $90
Loli
million goes to the owners of capital. With 1 million immigrants, the | |
G MRP,
wage falls to $40 and the share of total output going to capital
pe
increases to JFB = $160 million, or by HAB/ = $70 million. Since the
0 3 Ss:
original workers’ earnings decline by HAC/ = $60 million, the nation ———_

receives a net gain equal to the area of triangle ABC = $10 million. Millions of workers

nation as a whole gains a net amount equal to the area of triangle ABC = $10 million.
With income redistribution (i.e., with taxes on earnings of capital and subsidies to labor),
both workers and owners of capital can gain from immigration.
This analysis is based on the implicit assumption that all labor is homogeneous and of
average productivity. This is not the case in the real world. Some labor is much more pro-
ductive because of better education and training. The immigration laws of the United States
and other industrial countries favor the immigration of skilled labor (such as nurses and
technicians) and professional people (doctors, engineers, scientists, etc.) and impose serious
Brain drain The obstacles to the immigration of unskilled labor, except temporary migrants. The immigra-
migration of highly tion of skilled workers and professionals is likely to provide even greater benefits to the
skilled people from one country of immigration because it saves the nation the costs of education and training, but
nation to another. represents a brain drain for the nation of emigration (see Examples 15—5 and 15-6).

From 1983 to 1988 more than 200 well-known scholars in the fields of history, philos-
ophy, political science, and physics left British universities to take positions in some of
the top universities in the United States. Their departure resulted from a combination
A peat 2 ues and pull” forces. Among the push forces were the budget cuts that froze pro-
heey eSSOrs Salaries and left many vacancies unfilled, the abolishment of tenure and the
Tie tre enti suspension of promotions, and reductions in funds for libraries and assistants. The
pull
Dba bin dein’ forces were U.S. salaries that often were more than three times higher than in
Britain,
and Whar iecis as well as the availability of large research funds, assistants, and sophisticat
ed labora-
effects on the tories. There was a time when it was almost impossible to induce a top scholar to leave
countries involved? Oxford or Cambridge University. In the late 1980s, on the other
hand, a British scholar
 CHAPTER 15 Input Price and Employment Under Imperfect Competition 497

who had not received at least one attractive offer from an American university started
even to question his reputation outside Britain.
With the collapse of communism in the Soviet Union in the late 1980s and early
1990s, a huge and growing exodus of top Russian scientists headed for the United
States either permanently or on temporary work visas. This surpassed the earlier British
exodus and became the largest brain drain to (and brain gain of ) the United States since
the end of World War II. Russia worried a great deal about losing many of its top scien-
tists. Virtually the entire faculty of the University of Minnesota’s Theoretical Physics
Institute in the mid-1990s was from Russia. Many top Russian scientists flowed into the
U.S. computer, biological, and chemical laboratories. As Russia struggled to restructure
its economy, few if any funds were available for science. “For science, there is no money,
no jobs, and no respect from the public,” says one recent emigree. My productivity in
America is 10 times more than in Russia,” says another. He might have added that in the
early 1990s his salary in the United States is also 100 times more than in Russia!
Another form of the brain drain is created when the large number of foreign stu-
dents getting advanced degrees in the United States chooses to remain. Nearly 600,000
foreign students were studying in the United States in 2004. Almost 50% of the stu-
dents receiving engineering doctorates in the United States are foreign born, and this
percentage is almost as high in mathematics and computer science. (It is nearly 40%
in economics.) More than 70% of these students chose to remain in the United States
after getting their doctorate.
Finally, in 1990 the H1-B visa program was established. This allowed up to 65,000
educated foreigners a year to fill specialized American jobs, largely in the high-tech
industry, for a period of six years (but requiring renewal after the first three years) if an
employer petitions the U.S. Immigration and naturalization Service on their behalf. The
maximum annual number of H1-B visas was raised to 115,000 in 1998 and to 195,000
in 2001, but it was then scaled back to 65,000 in 2004. Since then, legislation has been
under consideration in the U.S. Congress to increase sharply the number of such visas.
Sources: “British Brain Drain Enriches U.S. Colleges,’ New York Times, November 22, 1988, p. 1; “The
Soviet Brain Drain Is the U.S. Brain Gain,” Business Week, November 11, 1991, pp. 94-100; “Foreign
Students Spur U.S. Brain Gain,” Wall Street Journal, August 31, 1994, p. 9A; “Congress Approves a Big
Increase in Visas for Specialized Workers,” New York Times, October 4, 2000, p. 1; R. Freeman, “People
Flows in Globalization,’ NBER Working Paper No. 12315, February 2007; and “Skilled-Worker Visa
Applicants Expected to Soar,” Wall Street Journal, April 1, 2008, p. 19.

EXAMPLE 15-6
The Debate Over U.S. Immigration Policy

In 2007, 37.9 million Americans, or 12.6% of the U.S. population, were born else-
where. This was higher than in any other year since World War II (the all-time high
was 14.7% in 1910). Illegal immigrants are 11.3 million, or 29.8%, of the total. The
rapid increase in immigration (legal and illegal) in recent years has emerged as a hot
issue, especially in California and New York, the states with the highest proportion of
foreign born (28% and 22%, respectively). Indeed, an intense national debate is taking
place on the nation’s immigration policy.
498 PART FIVE Pricing and Employment of Inputs

The immigration of highly trained individuals and bright students coming to the
United States to get higher degrees and then remaining is clearly of great benefit to the
United States. Less clear is the case for immigration of uneducated and unskilled peo-
ple. U.S. Census data indicate that nearly 21% of recent immigrants over the age of 25
have bachelor’s degrees (as compared with about 15% for native Americans), but 31%
have no high school diploma (as compared with 8% of the U.S.-born population). Thus,
the majority of recent immigrants are either very educated or have little education.
In general, immigration is good for the country. But, at least in the short run,
Concept Check native workers receive lower wages than without immigration, whereas employers
What is the effect of gain by being able to pay lower wages. This explains why labor is generally opposed
immigration on wages to immigration whereas business favors it. The nation as a whole generally gains from
and employment in immigration because employers’ gains exceed labor’s losses. With an appropriate
the United States? redistribution policy, some of business’ gains could be taxed away and used to com-
pensate workers for their loss and also to provide workers with a share of the remain-
ing gains. In a recent study, Borjas estimated that every 10% increase in the supply of
foreign workers reduces the wage of competing U.S. workers by 3% or 4%.
Sources: S. A. Camarota, Immigrants in the United States, 2007 (Washington, DC: Center for Immigration
Studies, November 2007); “7-Year Immigation Rate Is Highest in U.S. History,” New York Times,
November 29, 2007, p. 20; G. J. Borjas, “The Labor Market Impact of High-Skill Immigration,” American
Economic Review, May 2005, pp. 56-60; “Higher Migration to U.S. Restrains Wages,” Financial Times,
November 11, 2005, p. 7; and J-C, Dumont and G. Lemaitre, “Counting Immigrants and Expatriates in
OECD Countries,” OECD Social, Employment, and Migration, Working Paper No. 25, 2004.

15.8 ANALYSIS OF IMPERFECT INPUT MARKETS

In this section, we discuss some important applications of the theory presented in the
chapter: the regulation of monopsony, bilateral monopoly, the effect of unions on wages,
and discrimination in employment. These applications clearly indicate the usefulness and
applicability of the theory presented in this chapter.

Regulation of Monopsony
By setting a minimum price for an input at the point where the marginal revenue product
curve of the input intersects the market supply curve of the input, the monopsonist can be
made to behave as a perfect competitor in the input market, and monopsonistic exploita-
tion is eliminated. If the input is labor, the minimum wage that would eliminate labor
exploitation can be set by the government or negotiated by the union. This is shown in
Figure 15.6.
In the absence of a minimum wage, the monopsonist of Figure 15.6 hires three work-
ers (given by point E, where the MRP, curve intersects the ME; curve) and the daily wage
is $30 (point £’ on S;) exactly as explained in Section 15.5 and Figure 15.4. Monopsonistic
exploitation of labor is given by the excess of the MRP, over w at L = 3 and is equal to
$30 per worker (EE’ in the figure). If the daily wage is set at $40 (point B’ in the figure, at
which the MRP, curve intersects S,), CB’'F becomes the new supply of labor curve
facing
the monopsonist. The new ME, curve is then CB’BG, with the vertical or discontinuou
s
portion directly above and caused by the kink (at point B’) on the new S;, curve.
 CHAPTER 15 Input Price and Employment Under Imperfect Competition 499

FIGURE 15.6 Regulation of Monopsony By setting w = $40, CBF

becomes the new supply of labor curve facing the monopsonist. The new
ME, curve is then CB‘BG, with the vertical or discontinuous portion directly
above and caused by the kink (at point B’) on the new S, curve. To maximize
total profits, the monopsonist now hires four workers (given by point B’, at
which the MAP, curve intersects the new ME, curve) and w = MRP, = $40
(so that monopsonistic exploitation is zero).

To maximize total profits when the minimum wage of $40 is imposed, the monopson-
ist hires four workers (given by point B’, at which the MRP, curve intersects the new
Concept Check ME, curve) and w = MRP, = $40. Thus, the monopsonist behaves as a perfect competitor
How can monopsony be in the input market (operates at point B’, where the MRP, curve intersects S;), and the
regulated? monopsonistic exploitation of labor is entirely eliminated. With a daily wage between $30
and $40, the monopsonist will hire three or four workers per day and only part of the labor
exploitation will be eliminated. Setting a wage above $40 will eliminate all labor
exploitation, but the monopsonist will hire fewer than four workers (see Problem 9, with
an answer at the end of the text). This neat result is often unreachable in the real world,
however, because of a lack of adequate data on the MRP, and ME;.

Bilateral Monopoly: A Monopsonistic Buyer Facing a Monopolistic Seller

Bilateral monopoly Bilateral monopoly is said to exist when the single buyer of a product or input (the
The case where the monopsonist) faces the single seller of the product or input (the monopolist). While this
monopsonist buyer of a is a rare occurrence in the real world, it is approximated by the “‘one-mill town” of yes-
product or input faces teryears facing the union of all of the town’s workers; by some military contractors such
the monopolist seller of
as Boeing, which is the sole seller of the F-18, and the U.S. Navy, the sole purchaser; and
the product or input.
(until 1982) by Western Electric, the sole producer of telephone equipment in the United
States, and AT&T, the sole buyer of telephone equipment.
In bilateral monopoly, price and output are indeterminate, in the sense that they can-
not be established by the profit-maximizing marginal calculations employed by econo-
mists. Rather, they are determined by the relative bargaining strength of the monopsonist
buyer and the monopolist seller of the product or input. This is shown in Figure 15.7.
In the figure, D is the monopsonist’s demand (MRP) curve for the product or input.
Curve D is also the market demand curve faced by the monopolist seller of the product
or input. Then MR is the corresponding marginal revenue curve of the monopolist. If the
monopolist’s marginal cost curve is as shown in the figure, the monopolist will maximize
profits by selling five units of the product (given by point B’, where its MC curve inter-
sects its MR curve from below) at the price of $15 per unit (point B on its D curve).
To determine the monopsonist’s profit-maximizing purchase of the product, we must
realize that the monopolist’s marginal cost curve is the supply curve of the product that
the monopsonist faces. This curve shows the price at which the monopsonist can purchase
500 PART FIVE Pricing and Employment of Inputs

$
: MC of monopolist
ye
20 ME of monopsonist OS eaced
monopsonist

16
15

MRP of monopsonist
= D faced by

ut monopolist

MR of monopolist

|
0 4 5 A Q

FIGURE 15.7 Bilateral Monopoly Dis the monopsonist’s demand (MRP) curve
for the product or input that the monopolist seller faces. MR is the monopolist's
marginal revenue curve. The monopolist maximizes profits at Q = 5 (given by point
B’, where MC = MR) at P = $15 (point B on the D curve). The monopolist’s MC curve
is the supply curve of the product that the monopsonist faces, and ME Is its marginal
expenditure curve. The monopsonist maximizes profits at Q = 4 (given by point E,
where MRP = ME) and P = $8 (given by point E’ on the supply curve that the
monopsonist faces). The solution is indeterminate and will be within area E’B’BE.

various quantities of the product. Thus, the monopsonist’s marginal expenditure curve for
the product is higher, as indicated by the ME curve in the figure. To maximize profits, the
Concept Check monopsonist must buy four units of the product (given by point £, at which the monop-
How are the sonist demand [D or MRP] curve intersects its ME of the product curve) and pay the price
equilibrium price and of $8 (given by point E’ on the supply curve of the product that the monopsonist faces).
employment of an input
Thus, to maximize profits, the monopolist seller of the product wants to sell Q = 5 at
determined under a
bilateral monopoly?
P=$15, while the monopsonist buyer of the product wants to purchase O=4 at
P = $8. The solution is indeterminate and depends on the relative bargaining strength of
the two firms. All we can say is that the level of output and sales of the product will be
between four and five units and the price will be between $8 and $16 (1.e., the solution will
be within area E’B'BE). The greater the relative bargaining strength of the monopolist
seller of the product, the closer output will be to five units and price to $15. The greater
the relative bargaining strength of the monopsonist buyer of the product, the closer the
purchase of the product will be to four units and the price to $8.
 CHAPTER 15 Input Price and Employment Under Imperfect Competition 501

Effect of Labor Unions on Wages

Labor union An A labor union is an organization of workers that seeks to increase the wages and the gen-
organization of workers —_ eral welfare of union workers through collective bargaining with employers. The Wagner
eee Act passed in 1935 prohibited firms from interfering with workers’ rights to form unions.
one eae iain Union membership as a percentage of the nonagricultural labor force of the United States
bargaining with peaked at 35.5% in 1947, but it had declined to 12% in 2008. Among the reasons for the
employers. decline is the increase in the proportion of workers in service industries and women in the
labor force, both of whom are less likely to join unions than male production workers.
Workers are also less likely to join a union if the union does not have much bargaining
clout or if workers lose théir jobs when they strike. Furthermore, many workers feel that
unions were needed when they started, but with more and more companies setting up
work-involvement programs (to avoid unionization), unions are less needed now.
A labor union can try to increase the wages of its members by (1) restricting the sup-
ply of union labor that employers must hire, (2) bargaining for an above-equilibrium wage,
or (3) increasing the demand for union labor. These strategies are shown in Figure 15.8. In
each of the three panels in the figure, the intersection of the market demand curve for
labor (D;) and market supply curve of labor (S;) at point E determines the equilibrium
wage rate of $40 and the equilibrium level of employment of 600 workers in the absence
of the union.
The left panel shows that if the union can reduce the supply of union labor that
employers must hire from $7, to S/, the equilibrium daily wage will rise to $66, at which
300 workers are hired (point F, where S/ intersects D,). The union can restrict the num-
ber of union members by high initiation fees and by long apprenticeship periods. The cen-
ter panel shows that the union can achieve the wage of $66 through bargaining with
employers. The result is the same as if the government set the minimum wage of $66.
Note that at w = $66, 800 workers would like to work, but only 300 find employment.
Thus, there is an unemployment gap of 500 workers (FG in the center panel), 300 of
whom represent the disemployment effect (see Section 14.8).
Finally, the right panel of Figure 15.8 shows that by shifting D; upward to D7, the
union can increase wages to $66 and employment to 800 workers (given by point G, where

w($) w($) w($)

Si.
Si. Sr

66 66 66
| | |
| | |

40 [-=--1--- KE 49 }-------- LE | L
ID

40 |
| | | \
| ,

| | Dr Bnet:
| bil | a
0 300 600 800 L 0 300 600 800 L 0 300 600 800 il
FIGURE 15.8 Methods by Which Labor Unions Can Increase Wages The union can increase wages
from $40 to $66 by reducing the supply of union labor from S; to S/’(the left panel), by bargaining with
employers for w = $66 (the center panel), or by increasing the demand for union labor from D, to D,' (the
right panel). Employment falls from 600 workers to 300 workers with the first two methods (the left and
center panels) and increases to 800 workers with the last method (the most difficult to accomplish).
502 PART FIVE Pricing and Employment of Inputs

labor by advertising to buy

Dj, intersects $7). The union can increase the demand for union
“union labels” and by lobbying to restrict imports. Thus, trying to increase union wages by
increasing the demand for union labor is the most advanta geous method to raise wages from
the point of view of union labor because it also increase s employm ent. This, however, 1s
also the most difficult for unions to accomplish.
There is a great deal of disagreement regarding the amount by which labor unions
on
have increased the wages of their members. To be sure, unionized workers do receive,
the average, higher wages than nonunionized workers. At least to some extent, however,
this is because unionized labor has traditionally been more skilled than nonunion labor, is
employed in more efficient large-scale industries, and received higher wages even before
unionization. On the other hand, wage differences between union and nonunion labor
underestimate the effectiveness of labor unions in raising wages because nonunionized
firms tend to increase wages when union wages rise in order to retain their workers and
avoid unionization. Empirical studies seem to indicate that labor unions, on the average,
have been able to increase union wages by 10% to 15% over what they would have been
in the absence of unions, but this varies according to occupations, industry, race, and gen-
der. Only during the 1970s and early 1980s were unions able to increase union-nonunion
wage differentials to 20% to 30%. By the late 1980s, however, union-nonunion wage
differentials returned to the traditional 10% to 15%, but declined in 2008 in the face of a
weakening economy.
In their actual negotiations with management, labor unions usually “demand” higher
Concept Check wage increases than they really expect to receive in order to leave room for bargaining.
What is the effect of The wage increases in a few major industries, such as the automobile and steel industries,
unions on wages and often set the pattern for wage demands in other industries. Union wage demands are also
employment? likely to be larger in periods of high profits and employment than in recessionary periods.
In the final analysis, the actual wage settlement in a particular industry or firm depends
on the relative bargaining strength of the union and the employer, along the lines of the
bilateral monopoly model. In making wage demands, unions do take into account the
effect of wage increases on employment. Labor unions also seem to have reduced wage
differentials among union workers of different skills and among different regions of the
country. By bargaining with management for higher wages, unions also tend to reduce
monopsonistic exploitation.*
Discrimination in
employment The
(illegal) unwillingness
Economics of Discrimination in Employment
on the part of Discrimination in employment can take many forms, but in this chapter we will con-
employers to hire some sider only discrimination between male and female workers of equal productivity and its
group of equally
effect on their wages and employment. This is shown in Figure 15.9, where Sp and Sy are
productive workers
the supply curves of female and male labor to a particular industry, respectively; S$, is the
based on gender, color,
religion, or national total supply of female and male labor; and D, is the total demand for labor by the indus-
origin under any try. The figure shows that in the absence of gender discrimination, the equilibrium wage
circumstances or at the is $40 for males and females (given by point E, at which S; intersects D;), and 200
same wage rate. females (point A) and 400 males (point B) are employed.

* For a discussion of labor unions and their effect on wages, see C. J. Parsley, “Labor
Unions’ Effects on Wage
Gains: A Survey of Recent Literature,” Journal of Economic Literature, March 1980;
R. B. Freeman and J. L
Medoft, What Do Unions Do? (New York: Basic Books, 1984); R. Edwards
and P. Swaim, Union Nominien
Earnings Differentials and the Decline of Private Sector Unionism,” American
Economic Review, May 1986;
M. W. Reder, “The Rise and Fall of Unions: The Public Sector and the Private,”
Journal of Economic Perspecvas
Spring 1988; and Unions Find the Economy is Tough on Bargeining, “Well Street
Journal, April 4, 2008, . B4 .
 CHAPTER 15 Input Price and Employment Under Imperfect Competition 503

Daily
wage
$100

Sm
60

Ap Sp = Sr+ Sy
45 |
40
35 F

20 Dr

| | |

| [ee |
0) 100 200 400 500 600 800 IE;

Number of workers

FIGURE 15.9 Effect of Gender Discrimination in Employment

Without discrimination, w = $40 for males and females (given by point E,
at which S; intersects D,), and 200 females (point A) and 400 males
(point B) are employed. If employers refused to hire females, 500 males
would be hired at w = $50 (point E’, where Sp intersects D,). Females
would have to find employment in other industries, and this would depress
wages for all workers in these other industries. With a less extreme form of
discrimination, employers may hire females if their wage is, say, $10 less
than for males of the same productivity. Employers would then hire 150
females at w = $35 (point A’) and 450 males at w = $45 (point B’).

However, if employers in the industry refused to hire females, the supply curve of
labor to the industry would be only Sj, and 500 male workers would be hired at w = $50
(point E, where Sy intersects D;,). No females would now be hired by the industry. Females
would have to find employment in other industries that do not practice gender discrimina-
tion, and this would depress wages for all workers in these other industries. Thus, the gains
of male workers from gender discrimination in the industry come at the expense of work-
ers (both males and females) in other industries where there is no gender discrimination.
With a less extreme form of gender discrimination against females, employers in the
industry may prefer to hire males over females at the same wage rate, but the employers’
“taste for discrimination” is not absolute and can be overcome by a sufficiently lower
wage for female labor than for male labor. For example, employers may also hire females if
the wage of female workers is, say, $10 less than for male workers of the same productivity.
504 PART FIVE Pricing and Employment of Inputs

(and their wages

Compared with the no-discrimination case, employers hire more males
fall) until the male-fe male maze difference 1s
rise) and fewer females (and their wages
at w = $35 (point A’) and 450 males at
$10. In Figure 15.9, employers hire 150 females
A and B,
w = $45 (point B’), compared with 200 females and 400 males at $40 (points
females
respectively) without discrimination. Once again, males gain at the expense of
and other employees of this and other industrie s. The gain is larger the greater is the
employers’ taste for discrimination in the industry.
If only some employers in the industry discriminated against females, they would
employ only male workers while nondiscriminating employers would employ mostly
females. If there are enough nondiscriminating employers in the industry to employ all
Concept Check the female workers, no male-female wage differences need arise in the industry. Even if
What is the effect of all employers in the industry discriminated against females so that female wages tended
discrimination on to be lower than the wages of male workers, more firms would enter the industry
wages and
(attracted by the lower female wages), and this, once again, would tend to eliminate gen-
employment?
der-based wage differences in the industry. Note that discrimination may also be prac-
ticed by employees and by customers. When there is employee discrimination, some
workers dislike working with women/minorities. When there is discrimination by cus-
tomers, some customers dislike buying from women/minorities.

AT THE FRONTIER
Discrimination, and Gender and Race Wage Differentials

able 15.5 shows that in 2005, the median weekly earnings of white females were
80% that of white males (up from 67% in 1985). The median weekly earnings of
black males were 75% that of white males (up from 73% in 1985), while the median
weekly earnings of black females were 67% that of white males (up from 60% in
1985). Thus, females and blacks earned substantially less than white males in 2007, but
the differential diminished over the 1985-2005 period. Male-female wage differentials
exist in all occupations indicated and are about of the same order of magnitude as the
average difference in overall female—male and black-white differences in earnings.
Empirical studies seem to indicate that most female—male and black-white wage
differences are due to differences in productivity based on different levels of education,
training, experience, age, hours of work, size of firm, and region of employment.
Whether and to what extent the remaining difference is due to discrimination or to other
still-unmeasured productivity factors has not yet been settled. The suspicion is that at
least part of the unexplained difference is due to discrimination—despite the Equal Pay
Act of 1964, which prohibits such discrimination.
An empirical study by Francine Blau and Marianne Ferber found that wage dis-
crimination may account for as much as 10-12% of the lower female—male earnings,
and occupational discrimination for another 5—9%. Thus, wage and occupational dis-
crimination, together, may account for between 16% and 21% of female—male wage
differentials. In addition, Francine Blau and Lawrence Kahn found that if black men
had the same productive characteristics of white men, they would receive 89% of
white men’s earnings. Thus, the upper limit on the effect of race discrimination on
black-white earnings differentials is about 11%.
 CHAPTER 15 Input Price and Employment Under Imperfect Competition 505

Median Weekly Earnings for Full-Time Workers

TABLE 15.5
by Sex and Race in 1985 and 2000 (in dollars)

As a Percentage of As a Percentage of
1985 White Male Earnings 2005 White Male Earnings

White males 417 100 743 100.

White females 281 67 596 80

Black males 73 559 75

Black females 60 499 67

Source: Department of Commerce, Bureau of Census, Statistical Abstract of the United States
(Washington, DC: U.S. Government Printing Office, 2007), p. 415.

Comparable worth To overcome possible discrimination, the comparable-worth doctrine proposes

The evaluation of the evaluation of jobs in terms of the knowledge and skills required, working conditions,
jobs in terms of the accountability, and the enforcement of equal pay for comparable jobs, or “comparable
knowledge and
worth.” Many economists, however, consider this too difficult or impossible to do. For
skills required,
working conditions,
example, many of the male-female wage differences are due to fewer work interrup-
accountability, and tions and longer job tenure for males than for females of equal age and comparable train-
the enforcement of ing. Others, however, point out that these work choices themselves are the result of
equal pay for discrimination against females. The major push for comparable worth wages in the
comparable jobs, or United States to date has come from state and local governments, but its effect on
“comparable worth. female—male wages differences has so far been small.

Sources: G. Becker, The Economics of Discrimination, 2nd ed. (Chicago: University of Chicago Press,
1971); F. D. Blau and M. A. Ferber, The Economics of Men, Women, and Work (Englewood Cliffs:
Prentice-Hall, 1992); F. D. Blau and L. M. Kahn, “Gender Differences in Pay,’ Journal of Economic
Perspectives, Fall 2000; F. D. Blau and D. Grutsky, eds., The Declining Significance & Gender? (New
York: Russell Sage Foundation, 2006); J. L. Hotchkiss and M. Pitts, “The Role of Labor Market
Intermittency in Explaining Gender Differentials,’ American Economic Review, May 2007, pp. 417-421;
S. Mitra and U. Sambammoorthi, “Disability and the Rural Labor Market in India: Evidence for Males in
Tamil Nadu,’ World Development, Vol. 36 (5), 2008, pp. 934-952; F. Welch, “Catching Up: Wages of
Black Men,” American Economic Review, May 2003, pp. 320-325; and P. England, Comparable Worth:
Theory and Evidence (New York: Aldine DeGruyter, 1993).

SUMMARY
1. A firm that is an imperfect competitor in the product market but a perfect competitor in the
input market will maximize profits by hiring any input until the marginal product of the input
times the firm’s marginal revenue from the commodity equals the price of the input.
2. If only one input is variable and the firm is a monopolist in the product market but a pertect
competitor in the input market, the firm’s demand curve for the input is given by the marginal
revenue product (MRP) curve of the input. MRP equals the marginal product (MP) of the
input times the marginal revenue (MR) from the commodity. The excess of an input’s VMP
506 PART FIVE Pricing and Employment of Inputs

on. When all

over MRP at the level of utilization of the input is called monopolistic exploitati
is obtained by points on different MRP
inputs are variable, the demand curve of an input
elastic than the MRP curves. A perfect competito r in an
curves of the input and will be more
input market will employ the input until the input’s MRP on its demand curve equals the
input price.
3. When all firms hiring an input are monopolists in their respective product markets, the
market demand curve of the input is obtained by the straightforward horizontal summation of
all the firms’ demand curves for the input. On the other hand, when the firms are oligopolists
or monopolistic competitors in the product market, the market demand curve of the input is
derived as in Section 14.3. The equilibrium price and employment of the input are then
determined at the intersection of the market demand and the market supply curve of the
input.
4. Monopsony refers to the case where there is a single buyer of an input. The monopsonist faces
the positively sloped market supply curve of the input so that its marginal expenditures on the
input exceeds the price of the input. Oligopsonists and monopsonistic competitors must also
pay higher prices to hire more units of an input. Monopsony arises when an input is much more
productive to a particular firm or use than to other firms or uses. It can also result from lack of
~ geographic or occupational mobility.
5. A monopsonist hiring a single variable input maximizes profits by hiring the input until the
marginal revenue product (MRP) of the input equals the marginal expenditure (ME) on the
input. The price of the input is then determined by the corresponding point on the market supply
curve of the input. A monopsonist hires less of the variable input and pays the input a lower
price than would a perfectly competitive firm in the input market. The excess of the MRP over
the price of the input at the point where MRP = ME is called monopsonistic exploitation.
6. To maximize profits a firm should hire any variable input until the marginal revenue product of
the input equals the marginal expenditure on hiring it. If the firm is a perfect competitor in the
product market, the marginal revenue product of the input is identical to the value of the
marginal product of the input. If the firm is a perfect competitor in the input market, the
marginal expenditure on the input equals the input price.
7. Immigration usually increases the earnings of capital and reduces those of labor. Since the
former usually exceeds the latter, however, the nation of immigration as a whole receives a net
gain. The emigration of skilled labor and professionals represents a brain drain on the nation of
emigration and an even greater gain for the nation of immigration.
8. Monopsonistic exploitation can be eliminated by the government setting the minimum price of
an input at the point where the MRP curve intersects the market supply curve of the input.
Bilateral monopoly occurs when the monopsonist buyer of a product or input faces the
monopolist seller of the product or input. Unions seem to have increased wages only slightly.
Among the most important goals of unions are higher wages and greater employment of union
labor. Discrimination in employment reduces the wages and/or the employment of the
discriminated category. The marginal resource cost of an input is related to the price of the
input and the price elasticity of the input supply.

KEY TERMS
Marginal revenue product (MRP) Marginal expenditure on capital (MEx) Bilateral monopoly
Monopolistic exploitation Oligopsony Labor union
Monopsony Monopsonistic competition Discrimination in employment
Marginal expenditure (ME) Monopsonistic exploitation Comparable worth
Marginal expenditure on labor (ME,) Brain drain
 CHAPTER 15 Input Price and Employment Under Imperfect Competition 507

REVIEW QUESTIONS
] . Why is the demand curve for an input less elastic when the 6. A firm that is a perfect competitor in the product market
firm is an imperfect rather than a perfect competitor in the hires more labor than a firm that is an imperfect
product market? competitor in the product market, everything else being
. Why are real average wages higher in the United States equal. True or false? Explain.
than in most other countries? Why have real wages in 7. How does immigration benefit the United States?
Germany and Japan been catching up with U.S. wages . What trade alternative can the United States use to slow
during the period after World War IL? down the inflow of illegal aliens from Mexico?
. Can a demand curve for an input be derived for a . Why are wages and employment indeterminate when a
monopsonist? Why? monopsonistic employer faces a monopolistic union?
. Monopsonistic exploitation is true exploitation while . Why might unionization in some industries lead to lower
monopolistic exploitation is not. True or false? Explain. wages in other industries?
. What is the general rule for a firm to maximize profits in . What are some of the ways by which labor unions can
hiring an input? What does the rule become when the firm increase and reduce labor productivity?
is a perfect competitor in the product market and/or in the
. What are the difficulties in establishing the existence and
input market?
measuring the extent of discrimination in a labor market?

| PROBLEMS
1. Fora firm that is amonopolist in the product market but a #3. From Table 15.1 in the text
perfect competitor in the input market, express the a. find the MRy, the MRP, by multiplying MRy by MP_,
condition prevailing if the firm and the VMP;.
a. utilizes too much labor or too little capital at the b. Plot on the same graph, the VMP, and the MRP, on
best output level. What is the graphic interpretation the assumption that labor is infinitesimally divisible.
of this? How many workers would the firm employ if it were a
b. utilizes the least-cost input combination but with its perfect competitor in the product market? What is the
marginal cost exceeding its MR. What is the graphic amount of monopolistic exploitation?
interpretation of this? . Repeat the procedure in Problem 3 for the data in Problem
Q . minimizes the cost of producing an output that is too 2 and on the assumption that the daily wage is $22.
small to maximize profits. What is the graphic . Assume that (1) labor is infinitesimally divisible (..e.,
interpretation of this? workers can be hired for any part of the day) in the
. You are given the following data where L is the number of production function of Problems 2 and 4, (2) all inputs
workers hired per day by a firm (the only variable input), are variable, and (3) when the wage rate falls from $40 to
Ox is the quantity of the commodity produced per day, $22 per day, the firm’s value of the marginal product
and Py is the commodity price: curve shifts to the right by two labor units. Derive the
demand curve for labor of this firm. How many workers
will the firm hire per day at the daily wage rate of $22?
a. Derive the market demand curve for labor if there are
100 monopolistically competitive firms identical to the
firm of Problem 5 in the labor market and each
individual firm’s demand curve for labor shifts to the
left by one unit when the wage rate falls from w = $40
a. Find the marginal revenue product of labor and
to w = $22 per day.
plot it.
b. If 200 workers are willing to work at the daily wage
b. How many workers per day will the firm hire if the
of $10, and 600 are willing to work at the daily wage
wage rate is $40 per day? $22? $7? What is the firm’s
of $40, what is the equilibrium wage and level of
demand curve for labor?

* — Answer provided at end of book.

508 PART FIVE Pricing and Employment of Inputs

employment? How many workers would each firm *10. Assume that all workers in a town belong to the union
hire at the equilibrium wage? and there is a single firm hiring labor in the town.
Suppose that the supply for labor function of the firm
7. a. From the following market supply schedule of labor
faced by a monopsonist, derive the firm’s marginal (a monopsonist) is S; = 2w (where w refers to wages,

expenditures on labor schedule. measured in dollars per day) and the demand of labor
function by the union (the monopolist seller of labor
L 2a ews cia time) is D, = 120 — 2w. Find the wage rate and
number of workers that the firm would like to hire and
w $10 11 [ 16 | 40 100 the wage and level of employment that the union would
seek if it behaved as a monopolist. What is the likely
b. Plot on the same set of axes the firm’s supply and result?
marginal expenditures on labor schedules.
eullleay Draw a figure showing that an increase in union wages
ge On your graph for Problem 7(b), superimpose the usually reduces employment in unionized industries
monopsonist’s value of marginal product and marginal and increases employment and lowers wages in
revenue product of labor curves from Problem 4. nonunionized industries.
Assuming that labor is the only variable input, determine
12. Given that (1) ME; = w(1 + 1/e€z,) where €, is the price
the number of workers that the firm hires, the wage rate,
(wage) elasticity of the supply curve of labor (this
and the amount of monopolistic and monopsonistic
formula is derived in Section A.15 of the Mathematical
exploitation if the firm is a monopolist in the product
Appendix), and (2) S, is a straight line through the
market and a monopsonist in the input market.
origin, find the value of ME; if
*Q. Starting with Figure 15.4, explain what happens if the
government sets the minimum wage at a. w = $40.
a. $35. b. w = $80.
b. $50.

|
__|_INTERNET SITE ADDRESSES
A wealth of information on labor markets (employment, The effect of immigration on labor markets is examined at:
unemployment, productivity, earnings and others) is http://www.immigration-usa.com/debate.html
provided by the Bureau of Labor Statistics at:
http://borderbattles.ssrc.org/Carter_Sutch/
http://stats.bls.gov
On the economic effect of labor unions, see:
For the shortage of engineers in the United States, see:
http://en.wikipedia.org/wiki/Trade_union
http://www.edn.com/article/CA529820.html
http://www.epinet.org/content.cfm/
http://www.cato.org/pubs/regulation/regv29n3/ briefingpapers_bp143
v29n3-2.pdf
http://www.becker-posner-blog.com/archives/2007/10/
http://www.physorg.com/news94979949
html the_decline_of_1.html
For the licensing of occupations, see: Antidiscrimination laws and the effect of discrimination in
http://www.upjohninst.org/publications/newsletter/ labor markets are found at:
MK_106.pdf http://www. journals.uchicago.edu/JLE/journal/issues/
http://www.reason.org/ps36 1.pdf v48n1/480105/480105.web.pdf
For the pay of top executives, see: http://www.bu.edu/econ/faculty/manove/
http://www.faireconomy.org/reports/2007/ DiscrimOnline Version.pdf
ExecutiveExcess2007.pdf http://www. washingtonpost.com/wp-dyn/content/article/
http://www.bls.gov/oco/ocos012.htm 2006/07/07/AR2006070701105.html
 CHAPTER 16

Financial Microeconomics: Interest,

Investment, and the Cost of Capital
Chapter Outline 16-2 Personal and Business Savings and Gross and
16.1 Lending—Borrowing Equilibrium Net Private Domestic Investment in the United
16.2 Saving—Investment Equilibrium States
16.3 Investment Decisions 16-3 Fields of Education and Higher Lifetime
16.4 Determinants of the Market Rates of Interest Earnings in the United States
16.5 The Cost of Capital 16—4 Nominal and Real Interest Rates in the United
16.6 Effects of Foreign Investments on the States: 1990-2006
Receiving Nation 16-5 Investment Risks and Returns in the United
16.7 Some Applications of Financial States
Microeconomics At the Frontier: Derivatives: Useful but
Dangerous
List of Examples 16-6 Fluctuations in the Flow of Foreign Direct
16-1 Personal Savings in the United States Investments to the United States

After Studying This Chapter, You Should Be Able to:

e Know how an individual can maximize satisfaction by borrowing or lending
e Know how the market rate of interest 1s determined
e Know the meaning of capital budgeting
e Understand how a firm estimates the cost of capital to invest
e Understand the meaning and importance of investment in human capital

n this chapter, we consider intertemporal choices or the optimal allocation of resources

over time. We examine the choice between consuming now or saving a portion of this
year’s income in order to consume more in the future. The alternative is borrowing
against future income to increase present consumption. An individual’s ability to exchange
present income for future income or consumption (by lending or borrowing) enables the
individual to maximize the total or joint satisfaction of present and future income and con-
sumption. For example, people save during their working lives to provide for retirement,
and by doing so, they maximize the lifetime satisfaction from their earnings. On the other
hand, students often borrow against their future income (i.e., they dissave).
Another way by which present income can be exchanged for future income is to
free some resources from the production of final commodities for present consumption
509
510 PART FIVE Pricing and Employment of Inputs

and so on),
(i.e., save) to produce more capital goods (i.e., invest in machinery, factories,
individuals
which will lead to larger output and consumption in the future. The ability of
and firms to trade present for future income and output and vice versa (through lending and
borrowing, saving and investing) is crucial in all societies. Indeed, a great deal of the increase
in the standards of living in modern societies is the result of investments in physical capital
(machinery, factories, etc.) and human capital (education, skills, health, and so on).
An individual usually requires a reward for postponing present consumption (i.e.,
saving) and lending a portion of this year’s income. The reward takes the form of a repay-
ment that exceeds the amount lent. This premium is the interest payment. The alternative
would be the borrowing of a given sum today and the repaying of a larger sum in the
future (the principal plus the interest). Similarly, individuals and firms will only invest in
machinery, factories, or in acquiring or providing skills if they can expect a return on their
investment in the form of higher future incomes or outputs than the amounts invested.
In this chapter, we examine the determination of the rate of interest that will balance
the quantity of resources lent and borrowed and that equilibrates saving and investment.
We also analyze the criteria used by individuals, business firms, and government agen-
cies in their investment decisions. Subsequently, we discuss the reasons for differences in
interest rates in the same nation, in different nations, and over time. The chapter also
explains how to measure the cost of capital and describes the effects of foreign invest-
ments. Since capital is a crucial input, its cost is very important to a firm’s production
decisions. Finally, several important applications of the theory introduced in the chapter
are presented. These range from investment in human capital to the pricing and manage-
ment of renewable and nonrenewable resources. These applications, together with the
numerous examples and the “At the Frontier” section on derivatives, add an important
element of realism to the analysis.

16.1 LENDING—BORROWING EQUILIBRIUM

In this section, we examine how an individual maximizes the total or joint satisfaction from
spending his or her present and future income by lending or borrowing. We also show how
the equilibrium market rate of interest is determined at the level at which the total quantity
demanded of loans (borrowings) equals the total quantity supplied of loans (lendings).

Lending
We begin by considering how a consumer can maximize satisfaction over time by lend-
ing. For simplicity, we assume that the consumer’s income is measured in terms of the
quantity of a commodity (say, corn) that he or she has or expects to receive. Also, to sim-
plify matters, we will deal with only two time periods: this year and the next year.
(This
assumption is relaxed in Section 16.3.) We also begin by assuming that the consumer
has
Endowment an endowment position, or receives Yo = 7.5 units of corn this year and Y;
= 3 units of
position The quantity corn next year (point A in the left panel of Figure 16.1).
of a commodity that the
consumer receives in
each year.
Uncertainty is ruled out here so that the consumer knows exactly how
much of the commodity he or she gets
thisSye
year and next year, This assumption is relaxed in Section 16.4. In
what follows
subscripts 0 and | denote,'
respectively, this year (or the present) and next year (or the future).
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 511

The consumer, however, is not bound to consume the Yo = 7.5 units of corn this year
and the Y, = 3 units of corn next year, because he or she can lend part of this year’s corn
or borrow against next year’s corn. The question is how should the consumer distribute
consumption between this year and next so as to maximize the total or joint satisfaction
over the two periods? This is analogous to the consumer’s choice between hamburgers
(commodity X) and soft drinks (commodity Y) examined in Section 3.5 and Figure 3.8.
The only difference is that here the choice is between the consumption of corn this year
or consumption the next.
In the left panel of Figure 16.1, the consumer’s tastes between consumption this year
and next are given by indifference curves U;, Uy, and U3. The consumer also faces bud-
get line F Wo. The latter shows the various combinations of present and future income and
consumption available to the consumer. Starting from endowment position A (Yo = 7.5
and Y; = 3), the consumer can lend part of this year’s corn endowment so that he or she
will consume less this year and more next year. This is represented by an upward move-
ment from point A along budget line F Wo. On the other hand, the consumer could
Concept Check
increase consumption this year by borrowing against next year’s endowment or income
How can a consumer
by moving downward from point A along F Wo.
maximize satisfaction
over time by lending The consumer maximizes satisfaction by reaching the highest indifference curve
part of this year’s possible with his or her budget line. The optimal choice is given by point FE, where
income? budget line FWo is tangent to indifference curve U. At point E, the individual consumes

and
Income
consumption
next
year consumption
and
Income
next
year

| “()

0 a) 4.5 5 G5 10
Income and consumption this year Income and consumption this year

FIGURE16.1 Lending Starting from endowmentA (Yo = 7.5 and Y) = 3), the consumer maximizes
satisfaction at point £, where the budget line FWo Is tangent to indifference curve U> in the left panel. The
consumer reaches point E by lending Yo — Co = 2.5 units from this year’s endowment and receiving 3 additional
rate
units next year. Thus, the slope of the budget line is 3/(—2.5) = — 1.2, or —1(1 + 0.2), and the interest
point is E’ (in the right panel), where the steeper budget line through
r= 0.2, or 20%, At r = 50%, the optimal
point A is tangent to indifference curve U3. Point E’ is reached by lending 3 units (instead of 2.5).
512 PART FIVE Pricing and Employment of Inputs

the left panel of Figure

Cy = 5 units of corn this year and C; = 6 units next year (see
of corn out of this
16.1). The consumer reaches point E by lending Yo — (Oy = 2.5 units
year’s endowment or output and by receiving 3 additional units next year.
the lender
The slope of the budget line gives the premium or the rate of interest that
t from point A to point E indicates that the consumer
receives. For example, the movemen
receives 3 units of the commodi ty next year by lending 2.5 units this year. Thus, the slope
of the budget line is 3/(—2.5) = —1.2, or —1(1 + 0.2), so>the interest rate r = 0.2,
or 20%. That is,
Ciel a
Se (ie 0) [16.1]
Co
— Yo

The negative sign reflects the downward-to-the-right inclination of the budget line.
This simply means that for the consumer to be able to consume more next year, he or she
will have to consume less this year. In this case, the consumer lends (i.e., reduces con-
sumption by) 2.5 units this year and gets 2.5(1 + 0.2) = 3 next year. If the consumer lends
all of this year’s income or endowment of Yo = 7.5 units at 20% interest, he or she will
receive 7.5(1 + 0.2) = 9 additional units next year (and reach point F on budget line FW).
The consumer could do this, but does not, because he or she would not be maximizing
satisfaction.
Rate of interest Returning to the slope of the budget line, we can say more generally that the rate of
(r) The premium interest (r) is the premium received by an individual next year by lending $1.00 today.
received in one year Another way of stating this is that the rate of interest is the excess in the price next year
for lending one dollar
(P) of $1.00 this year (Po). That is,
this year.

P}=Po0+7r) [16.2]
The individual receives ($1)(1 + r) next year (P)) by lending $1.00 this year (Po). If
the interest rate r is 0.2, or 20%, the individual receives ($1)(1 + 0.2) = $1.20 next year
by lending $1.00 this year. Of course, the person who borrows $1.00 today must repay
$1.20 next year if the rate of interest is 20%. Thus, the interest rate can be viewed as the
excess in the price next year of $1.00 lent or borrowed this year.
If the interest rate rises (i.e., if the budget line becomes steeper), lenders will usually
lend more. For example, starting with endowment position A in the right panel of
Figure 16.1, if the interest rate rises to 50% so that the slope of the budget line becomes
—( + 0.5), the optimal choice of the consumer is at point £’, where the new steeper bud-
get line through point A is tangent to higher indifference curve U3. The consumer can
reach point E’ by lending Yo — Co’= 3 units (instead of 2.5), for which he or she receives
C; — Y; = 4.5 units next year. That is, by lending 3 units at 50% interest, the consumer
receives 3(1 + 0.5) = 4.5 units next year. Thus, the increase in the rate of interest from
20% to 50% leads this individual (the lender) to increase lending from 2.5 to 3 units.”

> The increase in the rate of interest will usually, but not always, increase the amount
of lending. The reason
is that (as in the case of an increase in the wage rate), an increase in the rate of interest gives
rise to a
substitution effect and an income effect. According to the substitution effect, the increase
in the rate of
interest leads the individual to lend more. However, by increasing the future income
of the individual, the
increase in the rate of interest also gives rise to an income effect, which leads the
individual to lend less. At a
sufficiently high rate of interest, the negative income effect exceeds the positive
substitution effect and the
individual’s supply curve of loans bends backward. This is examined in Problem
S(a), with the answer at the
end of the text.
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 513

Borrowing
We will now show that if the endowment position of the consumer in the left panel of
Figure 16.1 had been to the left of point E on budget line FWo (rather than at point A), the
consumer would have been a borrower rather than a lender. This is shown in the left panel
of Figure 16.2. Specifically, suppose the endowment position of the consumer had been at
point B (Yo = 2.5 and Y; = 9) on budget line FWo. The consumer would maximize satis-
faction at point E (Cp = 5 and C; = 6), where budget line FW is tangent to indifference
curve U) (the highest the consumer can reach with budget line FWo). To reach point E, the
consumer would have to borrow Cp — Yo = 2.5 units of the commodity this year and
repay Y; — C; = 3-units next year.
Since 3/2.5 = 1.2, the rate of interest r = 0.2, or 20%, as in the lending example.
This means that in order to borrow 2.5 units this year, the individual must repay 3 units
next year if the market rate of interest is 20%. That is, 2.5 = 3/(1 + 0.2). The reason for
this is that 2.5 units this year will grow to 3 units next year at r = 0.2, or 20%. More gen-
erally, we can say that the price of $1.00 today (Po) is equal to $1.00 next year (P;)
divided by (1 + r). That is,

This is obtained by dividing both sides of equation [16.2] by (1 + r). For example, at r =
20%, $1.00 next year is equivalent to $1/(1 + 0.2) = $0.83 this year, because $0.83 lent
this year at 20% will grow to $1.00 next year.

consumption
and
Income
next
year consumption
and
Income
next
year
- alld 7
Yo Co o | Wo
-@ e e
7.5 10 0) AlN |Bee) 7.5 10
0 aS) 5
Income and consumption this year Income and consumption this year

FIGURE 16.2 Borrowing Starting from endowment B (Yo = 2.5 and Y; = 9), the consumer maximizes
satisfaction at point E, where budget line FWo is tangent to indifference curve U> in the left panel. The consumer
reaches point E by borrowing Co — Yo = 2.5 and repaying Y, — C; = 3 next year. Thus, the slope of the budget
line is —3/2 = —1.2, or —1(1 + 0.2), and the interest rate r = 0.2, or 20%. At r= 50%, the optimal point is E°
Point E* is
in the right panel, where the steeper budget line through point B is tangent to indifference curve U;.
reached by borrowing 2 units (instead of 2.5).
514 PART FIVE Pricing and Employment of Inputs

she could
If the individual borrowed all of next year’s income of Y; = 9, he or
year by $9/(1 + 0.2) = 7.5 and be at point Wo = 10. Point
increase consumption this
l’s income or
Wealth The Wo = 10 gives the wealth of the individual. This is equal to the individua
That is,
individual’s income this endowment this year plus the present value of next year’s income or endowment.
year plus the present the consumer’s wealth is given by
value of future income.

Wo=Yor(i/U +7 [16.4]

In our example, the income this year is Yo = 2.5 and the present value of next year’s
income is Y;/(1 +r) = 9/(1 + 0.2) =7.5, resulting in the individual’s wealth of 10.
Graphically, the wealth of the individual or consumer is given by the intersection of the
budget line with the horizontal axis. Thus, wealth plays the same role in intertemporal
choice as the consumer’s income plays in the consumer’s choice between two commodi-
ties during the same year. An increase in wealth, like an increase in income, will shift the
consumer’s budget line outward and allows the consumer to purchase more of every nor-
mal good or to consume more, both this year and next.
~ An increase in the rate of interest leads to a reduction in the amount the individual
wants to borrow. Since present consumption becomes more expensive in terms of the
future consumption that must be given up, the borrower will borrow less. This is shown
in the right panel of Figure 16.2. Starting once again with endowment position B in the
right panel of Figure 16.2, an increase in the rate of interest to 50% will result in a new
budget line with a slope of —(1 + 0.5). The optimal choice of the consumer is then at
point E*, where the steeper budget line through point B is tangent to lower indifference
curve U;. Indifference curve U, is the highest that the consumer can reach with his or her
initial endowment position B and r = 50%. To reach point E* (Cj) = 4.5 and C; = C; = 6),
the consumer will have to borrow Cj — Yo = 2 units (instead of 2.5) this year, and will
have to repay Y; — C; = 3 units next year. That is, 2 = 3/(1 + 0.5). Thus, the increase in
the rate of interest from 20% to 50% leads this individual to borrow less.*

The Market Rate of Interest with Borrowing and Lending

We now examine how the equilibrium rate of interest is determined in the market for bor-
rowing and lending. For simplicity, we assume that we have only two individuals in the
market for loans: individual B with endowment position B and individual A with endow-
ment position A on budget line FWo (see the left panel of Figure 16.2). That is, instead of
assuming as above that an individual has either endowment B (and is a borrower) or
endowment A (and is a lender), we now assume that we have two individuals, one with
endowment B (the borrower) and the other with endowment A (the lender) on F Wo. We
also assume for now that both individuals have the same tastes or time preferences for
present (this year) versus future (next year) consumption, as shown by indifference curves
U;, Uz, and U3 in the left panel of Figure 16.2.
As we can see from the left panel of Figure 16.2, the optimal choice for individual B is
to move from point B to point E along budget line FWo by borrowing 2.5 units of the com-
modity this year at the rate of interest of 0.20, or 20% (so he or she will have to repay 3 units

> As opposed to the supply curve of loans, which could bend backward at a sufficiently
high rate of interest,
the demand curve for loans is always negatively sloped (see Problem 5(b), with the answer
at the end of
the text).
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 515

=QO OrS

FIGURE 16.3 Borrowing-Lending Equilibrium

Borrowing-lending equilibrium occurs at point £, where the S hoS
demand curve for borrowing (Dg) intersects the supply curve
for lending (S,). Point E shows that r= 20% and 2.5 units are of
Market
interest
(7)
rate
borrowed and lent. At r= 50%, the quantity supplied of
lending of 3 units (point E’) exceeds the quantity demanded of | | |
borrowing of 2 units (point E*) and the interest rate falls to 0 2 25 3
20% (point E). The opposite is true at r lower than 20%. Quantity of borrowing and lending

next year). Thus, the quantity demanded of loans (borrowing) by individual B is 2.5 units at
r = 20%. On the other hand, the optimal choice of individual A is to move from point A to
point E along budget line FWo by lending 2.5 units of the commodity this year at the rate of
interest of 0.20 or 20% (so that he or she will receive an additional 3 units next year). Thus,
the quantity supplied of loans (lending) by individual A is 2.5 units at r = 20%.
Since we have assumed that A and B are the only two individuals in the market, the
equilibrium market rate of interest is 0.20 or 20%. This is the only market rate of interest at
which the desired quantity demanded of loans (borrowing) of 2.5 units equals the desired
quantity supplied of loans (lending) of 2.5 units, and the market for loanable funds is in
equilibrium. This is shown by point F in Figure 16.3, where the demand curve for borrow-
ing (Dz) intersects the supply curve for lending (S,). The figure also shows that at r = 50%,
individual B wants to borrow only 2 units (point E* on Dz, from the right panel of Figure
16.2) and individual A wants to lend 3 units (point E’ on D;, from the right panel of Figure
16.1). The resulting excess in the quantity supplied over the quantity demanded of loans of
1 unit (E*E’) at r = 50% causes the rate of interest to fall to the equilibrium level of r =
20% (point E).
In the above analysis, we have assumed for simplicity that there are only two indi-
viduals, A and B, in the market and that both have identical tastes or time preferences.’ In
Concept Check the real world, however, there are many individuals with different tastes. Yet, the process
How is the market rate by which the equilibrium market rate of interest is determined is basically the same. That
of interest determined is, the equilibrium market rate of interest is the one at which the total or aggregate quan-
with borrowing and tity demanded of borrowing matches the aggregate quantity supplied of lending. At a
lending only?
market rate of interest above the equilibrium rate, the supply of lending exceeds the
demand for borrowing and the interest rate falls. On the other hand, at a market rate of
interest below the equilibrium rate, the demand for borrowing exceeds the supply of lend-
ing and the market rate of interest rises toward equilibrium. Only at the equilibrium mar-
ket rate of interest does the quantity demanded match the quantity supplied and there is
no tendency for the interest rate to change. Example 16-1 gives examines data on
personal savings and disposable personal income in the United States.

4 The determination of the market rate of interest when consumers have different time preferences is
examined in Problem 4 (with the answer at the end of the text).
516 PART FIVE Pricing and Employment of Inputs

EXAMPLE 16-1
Personal Savings in the United States
the level of
Table 16.1 shows the total aggregate amount of personal savings (PS),
disposable (i.e., after-tax) personal income (DPI) in 2000 prices, and PS as a percent-
savings
age of DPI in the United States for selected years from 1960 to 2006. Personal
to a low
was $128.6 billion in 1960; it rose to a high of $386.7 billion in 1980 and fell
of $33.8 billion in 2006. As a percentage of GDP, personal savings was 7.3 in 1960, it
rose to 10.0 in 1980, and it was 0.4 in 2006. Americans are now dissaving.

Personal Savings and Disposable Personal

UNJELEE income (in billions of 2000 dollars)
Year PS DPI PS as a % of DPI

1960 $128.6 $1,759.7 73

1970 262.8 2,781.7 9.4
1980 386.7 B.Sove 10.0
1990 371.9 oy 7.0
1995 274.0 5,905.7 4.6
2000 168.5 7,194.0 es}
2002 178.4 WNP? 2.4
2004 167.6 8,008.9 DFsi\
2005 40.0 8,147.9 0.5
2006 33.8 8,396.9 0.4

Source: Council of Economic Advisors, Economic Report of the President (Washington, DC:
U.S. Government Printing Office, 2008), pp. 262-263.

Prior to the establishment of Social Security in 1935, individuals provided for

their retirement by voluntarily saving a portion of their earnings during their working
years. Social Security provided retirement income through a forced savings (Social
Security tax) program, thus reducing the need for personal savings. If the government
had saved the Social Security taxes it levied, net savings (personal plus government)
would have been more or less unchanged. Because the government chose not to “fund”
the system but to use Social Security taxes for current expenditures and pay future
Social Security benefits out of future taxes, the nation’s level of aggregate savings
declined. Michael Darby estimated that the Social Security program reduced the
nation’s savings by 5% to 20% in the 1970s (and by much more in the 1990s).
Source: Michael R. Darby, The Effects of Social Security on Income and Capital Stock (Washington, DC:
American Enterprise Institute, 1979).
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital Siliey

16.2 SAVING—INVESTMENT EQUILIBRIUM

In Section 16.1 we analyzed borrowing—lending equilibrium. For simplicity, we assumed
that no part of the current endowment or output was invested to increase future produc-
tive capacity. In this section, we begin with the opposite situation and examine saving—
investment equilibrium without borrowing or lending. That is, we begin by examining the
case in which an isolated individual (a Robinson Crusoe) consumes less than he or she
produces in this period (saves) in order to have more seeds, or to produce a piece of equip-
ment, to increase production in the next period (invests). Next, we relax the assumption
that the individual is isolated and that he or she cannot borrow or lend and examine
saving—investment equilibrium with borrowing and lending. Finally, we show how the
equilibrium rate of interest is determined with saving and investment and with borrowing
and lending.

Saving—Investment Equilibrium Without Borrowing and Lending

Suppose that an individual lives alone on an island and produces and consumes a single
commodity. This Robinson Crusoe has no possibility to borrow or lend (or trade) the
commodity and can only consume what he produces. Suppose that under present condi-
tions he can count on producing Yo = 7.5 units of the commodity during this year and
Y, = 3 units next year. This is shown by point A on the production-possibilities curve FQ
in Figure 16.4.
Production- Production-possibilities curve FQ shows how much Crusoe can produce and con-
possibilities curve sume next year by saving part of this year’s output and investing it to increase next year’s
Shows the alternative output. Saving refers to the act of refraining from present consumption. Investment
combinations of
refers to the formation of new capital assets. For example, Crusoe may use part of the
commodities that a nation
year to construct a rudimentary net rather than catch fish with a spear. Since he is not
can produce by fully
utilizing all of its catching fish while he is building the net, he is refraining from present consumption
resources with the best (saving). The net is an investment that will allow him to catch more fish in the future. In
technology available to it. this case, the saving and the investment are done by the same person, and are one and the
same thing.
Saving Refraining Disregarding for the moment the indifference curves in Figure 16.4, we see that the
from present FQ curve shows that if the individual consumes Cp = 6 units of the commodity this year,
consumption. he can produce and consume C) = 6.5 units of the commodity next year (point G on FQ).
Investment The
Starting from point A, this means that by saving and investing Yo — Co = 7.5 —-6= 1.5
formation of new units of the commodity this year, the individual can increase output by C; — Y; = 6.5 —3 =
capital assets. 3.5 units next year. Thus, the average yield or return on investment (in terms of next year’s
output) is 3.5/1.5 = 2.33 = (1 + 1.33), or 133%. Should the individual save and invest 3
units of the commodity this year, his output will increase by 6 units next year (the move-
ment from point A to point H on FQ), so that the average yield or rate of return would be
6/3 =2=(1 + 1), or 100%. Note that the larger the amount invested, the lower the rate
of return (because of the operation of the law of diminishing returns).
Starting at point A on production-possibilities curve FQ, the question is, “What is the
optimal amount of saving and investment for this individual?” The answer is 1.5 units.
The reason is that this will permit the individual to reach point G on indifference curve
U4. Indifference curve U4 is the highest that Crusoe can reach with his production-
possibilities curve. Note that indifference curves here show the trade-off or time prefer-
ence between consumption this year and next. Thus, starting from point A, Crusoe should
518 PART FIVE Pricing and Employment of Inputs

consumption
and
Production
next
year

e
| Co a Yo 4 Q
0 4.5 6 15) 8.0
Production and consumption this year
FIGURE 16.4 Saving-Investment Equilibrium Without Borrowing or
Lending Production-possibilities curve FQ shows how much an isolated
individual can produce and consume next year by saving and investing part
of this year’s output. Starting at point A on FQ, the optimal level of saving and
investment is 1.5 units. This level allows the individual to reach point G on the
highest indifference curve possible (U4). Saving and investing 1.5 units this
year allows the individual to produce and consume 3.5 more units next year
Thus, the average yield on investment is 133%.

save and invest 1.5 units of this year’s output so as to reach point G next year and maxi-
mize his total or joint utility or satisfaction over the two years.

Saving-Investment Equilibrium with Borrowing and Lending

Suppose that more people get stranded on Crusoe’s island, and they also start producing
and consuming the commodity. Now, borrowing and lending become possible. The opti-
mal choice for Crusoe is now to save and invest, borrow or lend, so as to reach the high-
est indifference curve possible (higher than U4)
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 519

consumption
and
Production
next
year

4.5 TY SO 10 12
Production and consumption this year

FIGURE 16.5 Saving-Investment Equilibrium with Borrowing and Lending Starting from
point A, the individual maximizes wealth (at Wo’= 12 units) by investing 3 units of the commodity
and reaching point H, where market line HE” Wo’ (with slope reflecting the market rate of interest)
is tangent to production-possibilities curve FQ. The individual then borrows 2.5 units (i.e, moves to
the right of point H on market line HE’ Wo’) and reaches point E” on Us (the highest indifference
curve possible). The individual invests 3 units, borrows 2.5, and saves 0.5.

To show this, we must realize that from every point of the production-possibilities
Market line A line curve there is a market line, the slope of which shows the rate at which the individual
from any point on the (Crusoe) can borrow or lend in the market. For example, starting at point A on the FQ
production-possibilities curve in Figure 16.5, the individual can borrow or lend along market line FAW at the rate
curve showing the of interest of r = 20% (as in the left panel of Figures 16.1 and 16.2). If starting from point
various amounts of a
A the individual only borrows or lends (or does neither), his wealth is Wo = 10 (given by
commodity that the
individual can consume
the intersection of market line FAW with the horizontal axis).
in each period by However, with the possibility of saving and investment, and borrowing or lending
borrowing or lending. now open, the optimal choice for Crusoe is to invest first (so as to maximize wealth) and
then to borrow (so as to reach the highest indifference curve possible). Wealth is maxi-
mized by reaching the highest market line (with slope reflecting the market rate of interest)
520 PART FIVE Pricing and Employment of Inputs

Wo. which is paral-

that is possible with the FQ curve. This is given by market line HE”
bilities curve FQ
lel to market line FAWg (so that r = 20%) and tangent to production-possi
Wo = 12:
at point H. Market line HE’ W,, shows that the maximum attainable wealth is
curve, the individu al can attain market line HE Wo and
Starting from point A on the FQ
maximize wealth by investing Yo — Qo = 3 units of this year’s output. This allows him to
reach point H on this production-possi bilities curve and produce Q; = 9 units of the com-
modity next year. .
Having attained the highest wealth possible by investing 3 units of the commodity
(point H on market line HE” W,), the individual can then borrow Co — Qo = 2.5 units
(i.e., moveto the right of point H on market line HE” W,) and reach point E” on Us. This
is the highest indifference curve that the individual can reach with optimal investment and
borrowing. Point E” on indifference curve Us is superior to point A on Up (see Figure
16.4) without borrowing or investing, it is superior to borrowing alone (to the right of
pointA along budget line FEWo), and it is superior to point G on U4 (see Figure 16.4) with
saving equal to investment and no borrowing.
To summarize, the optimal choice of the individual is to invest Yo — Qo = 3 units
(i.e., to move from point A to point H on the FQ curve) in order to maximize wealth
(at Wj = 12) and to borrow Co — Qo = 2.5 units (the movement from point H to point
E" on indifference curve Us) to maximize total or joint satisfaction or utility over both
years. Of the total amount of Yo — Qo = 3 invested, the individual borrows Cy — Qo =
2.5 and saves Yo — Cy = 0.5. That is, the individual is saving a portion of his current
output, but not enough to “finance” all of his investment. Therefore, other individuals
must be saving 2.5 units of the commodity more than they invest in order to lend this
amount to our individual.
If the market rate of interest rises above r = 20%, the market line becomes steeper
and tangent to production-possibilities curve FQ to the right of point H, and the individ-
ual will invest less (see Figure 16.6 and Problem 6). If the individual borrows more than
he invests, he will be dissaving (see Problem 7). If indifference curve Us had been tangent
to market line HW to the left of point H in Figure 16.5, the individual would have been
investing and lending (rather than investing and borrowing) so that his saving would equal
the sum of the two (see Problem 8).

The Market Rate of Interest with Saving and Investment,

Borrowing and Lending
We now examine how the equilibrium rate of interest is determined in the market with
saving and investment and borrowing and lending. For simplicity, we assume that only
our individual, borrows and invests while all other individuals collectively only want to
lend 2.5 units of the commodity at the rate of interest of r = 20%. The equilibrium rate of
interest is then 20% and is shown in Figure 16.6 in two different ways: (1) by point E,
where the demand curve of borrowing of our individual (Dz) intersects the supply curve
of lending of all other individuals (S_) as in Figure 16.3, or equivalently, (2) by point E”,
where the demand curve for investment of our individual (D,) intersects the total supply
curve of savings of this and other individuals (Ss).
At the equilibrium market rate of interest of r = 20%, the quantity of desired
bor-
rowing of 2.5 units (done exclusively by our individual) equals the quantity
of desired
lending of 2.5 units (supplied by all other individuals). In addition, at r
= 20%, the total
amount of desired savings of 3 units (2.5 units by other individuals and
0.5 units by our
individual) matches the desired level of investment of 3 units (undertaken
exclusively by
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 521

S
2 0.50+
2
g
iy

e)
o

g
4= 0.20
=

|
0 Deo nes 4
Quantity of borrowing and lending, investment and saving

FIGURE 16.6 Rate of Interest with Borrowing and Lending,

Investment and Saving The equilibrium rate of interest is 20% and
is shown (1) by point £, where the demand curve for borrowing (Dz)
intersects the supply curve of lending (S,), and (2) by point E”, where
the demand curve for investment (D)) intersects the total supply curve of
savings (Ss). Atr > 20%, desired lending exceeds desired borrowing,
and desired savings exceeds desired investments, and rfalls. The
opposite is true at r < 20%.

our individual). That is, at equilibrium, desired borrowing equals desired lending (point
E) and desired savings equals desired investment (point E”). Note that the excess
between the saving-investment equilibrium and the borrowing-lending equilibrium refers
to the amount of investment that is self-financed from the investor’s own savings rather
than from borrowing in the market.°
At arate of interest above equilibrium, there will be (1) an excess in the quantity sup-
plied of lending over the quantity demanded of borrowing, and (2) an excess in the total
Concept Check quantity supplied of savings over the total quantity demanded of investment (see Figure
How is the market rate 16.6). As a result, the interest rate will fall to the equilibrium level. The opposite is true at
of interest determined rates of interest below equilibrium. Of course, in the real world, there are many borrowers
by saving and investing and many lenders, and many savers and investors, but the principles by which the equilib-
and by borrowing and
rium rate of interest is determined are the same (when capital markets are perfectly com-
lending?
petitive). That is, at equilibrium, aggregate desired borrowing equals aggregate desired
lending, and aggregate desired investment equals aggregate desired saving. Example 16—2
examines data on personal and business savings, and gross and net private domestic invest-
ment in the United States.

5 Just as some people can borrow more than they invest so that they dissave, so some individuals can consume
more than the sum of what they produce, borrow, and invest. Such individuals would be disinvesting or failing
to maintain (i.e., not replacing depreciated) capital stock. To some extent, these individuals are “living off their
capital.” This may also be true for society as a whole during periods of war or natural disaster, or when it
borrows abroad to increase present consumption.
522 PART FIVE Pricing and Employment of Inputs

EXAMPLE 16-2
Personal and Business Savings and Gross and Net Private Domestic Investment
in the United States

Table 16.2 presents the total (aggregate) amount of personal savings (PS), business sav-
ings (BS), gross private domestic investment (GPDI), and net private domestic invest-
ment (NPDIJ) in the United States in terms of 2000 prices for selected years from 1960 to
2006. NPDI equals GPDI minus capital consumption allowances or depreciation result-
ing from the production of the given year’s output. Table 16.2 also shows the level of real
net national product (NNP) and NPDI as a percentage of NNP during the same years.
From the table, we see that business savings steadily increased (except in 2002) at
the same time that personal savings sharply declined. Net private domestic investment
is the net addition to society’s capital stock and an important contributor to the growth
of the economy and standards of living. Personal and business savings are required to
provide for the replacement of the capital consumed during the course of producing
current output and for the net additions to the capital stock of the country. Not included
in the table are government savings and investments and foreign investments. The lat-
ter have become increasingly significant over the years.

Personal and Business Savings and Gross and Net

s/\2}asa(e~e Private Domestic Investment in the United States
(in billions of 2000 dollars)

NPDI as a
Year PS BS GPDI NPDI NNP % of NNP

1960 $128.6 $222.4 $266.6 $159.2 52.252 4 ce

1970 262.8 293.0 427.1 Pew 3,407.5 as
1980 386.7 365.6 645.3 334.1 4,589.3 18
1990 371.9 546.6 895.1 503.8 6,320.5 8.0
1995 274.0 649.2 1,134.0 683.3 TLVS.8 9.6
2000 168.5 716.5 1,735.5 1,167.7 8,668.1 13.5
2002 178.4 624.8 15571 939.2 8,840.0 10.6
2004 160.6 804.2 17702 1,141.9 9,438.0 12%
2005 40.0 831.9 1,869.3 1,212.4 9,640.3 12.6
2006 33°8 870.9 1,919.5 1,256.4 9,985.0 12.6
Source: Council of Economic Advisors, Economic Report of the President (Washington, DC:
U.S.
Government Printing Office, 2008), pp. 244, 256, 262.

16.3 INVESTMENT DECISIONS

The previous discussion has important practical applications and is the
basis for very valu-
able decision rules used by firms and government agencies in determin
ing which invest-
ment project to undertake. For example, a bank may have to decide
whether to purchase or rent
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 523

a large computer, a government agency whether to build a dam, and a manufacturing firm
whether it should purchase a more expensive machine that lasts longer or a cheaper one
that lasts a shorter period of time. The decision rule to answer these questions and to rank
Capital budgeting various investment projects is called capital budgeting. Capital budgeting decisions
The ranking of all require consideration of costs and returns that arise not only in the current period but also
investment projects
in the future and so we must find a way to compare future to present costs and returns. Our
from the highest
discussion of capital budgeting begins by considering a simple two-period time frame-
present value to
the lowest. work. We then extend and generalize the discussion to a multiperiod time horizon.

Net Present Value Rule for Investment Decisions: The Two-Period Case
An investment project involves a cost (to purchase the machinery, build the factory,
acquire a skill, and so on) and a return in the form of an increase in output or income in
the future. In a two-period framework, the cost is usually incurred in the current year and
the return or benefit comes the following year. However, since one unit of a commodity
or a dollar next year is worth less than a unit of the commodity or a dollar today, costs and
benefits occurring at different times cannot simply be added together to determine
whether to undertake the project.
For example, for a project that involves the expenditure of $1.00 this year and results
in $1.50 return next year, we cannot simply add the —$1.00 of cost this year to the $1.50
return next year and say that the net value of the project is $0.50. The reason is that
$1.50 next year is worth less than $1.50 today.® Specifically, if the rate of interest is 20%,
$1.50 next year is worth $1.50/(1.2) = $1.25 today. The reason is that $1.25 today will
grow to $1.50 next year. That is, $1.25(1 + 0.2) = $1.50 if the interest rate or the rate of
return is 20%. Thus, to determine the net return of an investment we must compare the
cost incurred today with the value of the benefits today.
Net present value The net present value (NPV) of an investment is the value today of all the net cash
(NPV) The value today flows of the investment. Expenditures or outflows are subtracted from revenues or inflows
from the stream of net in each year to find the net cash flow. For a two-period time horizon, NPV is given by
cash flows (positive and
negative) from an
[16.5]
investment project.

where C is the capital investment cost in the current year when the investment is made,
R, is the net cash flow next year, and r is the rate of interest. For example, suppose that
a firm purchases a machine this year for $100, and this increases the firm’s net income
by $120 next year. Suppose also that the rate of interest is 10%, and the machine has no
salvage or scrap value at the end of the next year. The net present value of the machine
(NPV) is

NPV =$100 +>" = — $100 + $109.09 = $9.09

y (1+0.1) — .
This means that the purchase of the machine will increase the wealth of the firm by $9.09.
Suppose the firm had to decide between the above project (with net present value
of $9.09) and another project that costs $150 and generates a net income of $180 next
year. The firm should choose the second project because its net present value of
—$150 + $180/(1 + 0.1) = $13.64 exceeds the net present value of $9.09 for the

6 We assume throughout this discussion that there is no price inflation. This assumption is relaxed in Section 16.4.
524 PART FIVE Pricing and Employment of Inputs

or cannot usu-
previous project. Such a choice arises because firms do not usually have
to undertak e all of the projects that have a
ally borrow all of the resources required
positive net present value.
We will see in the next section that the rule to undertake a project if its net present
value is positive or to choose the project with the highest net present value is a general
Concept Check rule and applies to all projects, regardless of the number of periods or years over which
How does a firm the costs and returns of the project are spread. Furthermore, this rule is independent of the
determine whether or tastes or time preference of the investor. That is, regardless of the shape and location of
not to undertake an
the indifference curves of investors, the general investment or capital budgeting rule is to
investment project?
maximize the wealth of the firm. This is achieved by investing in projects with the high-
est (positive) net present value. The tastes of investors will then determine whether they
will borrow or lend and how they will choose to use their (maximized) wealth. This
means that if capital markets are perfect and costless (i.e., if borrowers and lenders are too
small individually to affect the rate of interest and can borrow or lend at the same rate),
then individuals’ production and consumption decisions can be kept completely separate.
Separation theorem This is sometimes called the separation theorem.
The independence
of the optimum
investment decision Net Present Value Rule for Investment Decisions: The Multiperiod Case
from the individual’s
preferences. Most investment projects last longer than (1.e., give rise to net cash flows over more than)
two periods. Thus, the investment rule given above must be extended to consider many
periods (years). This can easily be done by “stretching” equation [16.5] to deal with many
(n) years. This is given by

NPV = —C + + = $+ ——*—
R, R> R,
[16.6]
Ler ae Chetan)a OR ais
where NPV is the net present value of the investment, C is the capital investment cost
incurred this year when the investment is made, R, is the net cash flow from the invest-
ment next year, R is the net cash flow in two years, R,, is the net cash flow in n years, and
r is the rate of interest. Net cash flows refer to the revenue of the firm resulting from the
investment during any given year minus the expenses or costs of the project during the
same year. Thus, equation [16.5] is a special case of equation [16.6], applicable when
there is no net cash flow after the first year.’
For example, suppose that a firm purchases a machine this year for $150, and this
increases the firm’s net income by $100 in each of the next two years. If the rate of inter-
est is 10% and the machine has no salvage value after two years, the net present value of
the machine (NPV) is

R,
NPV sc Gite) ca eeR> a $100
oc) ee $100
fcr Gare Leod (eo
= —$150 + $90.91 + $82.64 = $23.55

7 If we simply wanted to find the present discounted value (PDV) of a given sum (R) to
be received in each
of n years, starting with the next year, the equation would simply be

R R R
PDV =
d+n aie
7 Gen? ee eee
Saar
If the given sum (R) were to be received in each year indefinitely or in perpetuity
(an example of this is the
British “consols”), then PDV = R/r (see Section A.15 of the Mathematic
al Appendix).
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 525

This means that the purchase of the machine will increase the wealth of the firm by
$23.55. Specifically, $100 received next year is worth $100/(1 + 0.1) = $90.91 this year,
because $90.91 this year grows to $100 next year at r= 10%. On the other hand, $100
received two years from now is worth $100/(1 + 0.1)? = $82.64 this year, because
$82.64 this year grows to $90.91 next year at r = 10%,8 and the $90.91 next year grows
to $100 the year after (i.e., two years from now) at r = 10%. That is, $82.64 today times
(1 + 0.1), or 1.21, equals $100 two years from now.
If the project generated a net cash flow of $100 in the third year also, this would be
“worth” $100/(1 + 0.1)? = $100/(1.331) = $75.13 this year because $75.13 this year
will grow to $100 (except for rounding errors) in three years at r = 10%. Similarly, $100
in 10 years is worth $100/(1 + 0.1)'° = $38.55 this year because $38.55 this year will
grow to $100 in 10 years at r = 10%. Finally, $100 in n years (where n is any number of
years) is worth $100/(1 + 0.1)” this year because this sum today will grow to $100 in n
years at r= 10%.
The NPV for any net cash flow is inversely related to r. For example, if r had
been 5% in the previous example, the net present value of the investment (VPV’) would
have been

$100 a $100
NPV’ = —$150+
(1+ 0.05)! (1+0.05)2

= —$150 + $95.24 + $90.70 = $35.94

(as compared with the NPV of $23.55 with r= 10%). On the other hand, if r had
been 20%,

$100 $100
BI
2 Ss ae oyme CEO 2)?
PLUae Teo
= —$150 + $83.33 + $69.44 = $2.77

The lower NPV when r is higher is due to the fact that with a higher r, the net cash
flows from the project are “discounted” more heavily than the cost, because the net
cash flows arise later in time than cost. Also note that the net cash flows should include
the extra income generated by the machine minus the extra expense (such as mainte-
nance and the higher cost of hiring more skilled workers) to operate the machine dur-
ing each year. Similarly, the value today of the salvage value of the machine (if any)
must also be included.
For example, suppose that the benefits and costs of an investment project (the pur-
chase of a piece of machinery) are those given in Table 16.3. The table shows that the
machine costs $1,000 to purchase this year and also gives rise to $200, $300, $300, and
$400 maintenance and other expenses in each of the subsequent four years. The revenues
from the investment are $600, $800, $800, and $800, and the salvage value of the
machine is $200 at the end of the fourth year. The net revenue is the revenue from the
investment minus the expenses in each year. The present value coefficient is 1/(1 + 0.1)”.
For example, for the first year the present value coefficient is 1/(1 + 0.1)! = 0.909.

8 Actually, ($82.64)(1.1) equals $90.904 rather than $90.91 (as indicated) because of rounding errors.
526 PART FIVE Pricing and Employment of Inputs

ie | Benefit-Cost Analysis of an Investment Project

TABLE 16.3
Present
Investment Value Present
End (Year O) Net Coefficient Value of
of Year and Cost Revenue Revenue 1(1 +017 Net Revenue

0 $1,000 we —$1,000 oes —$1,000

200 $600 400 0.909 364
2) 300 800 500 0.826 413
3 300 800 500 0.751 376
4 400 800 400 0.683 273
4 200* 200 0.683 v7
$563
ET

*Salvage value.

For the second year, it is 1/(1 + 0.1)? = 0.826, and so on. The present value of the net
revenue in each year is obtained by multiplying the net revenue (R) by the present value
coefficient for that year. By adding together all present values of the net revenues, we get
the net present value of the project (Vo) of $563. Since NPV is positive, the firm should
purchase the machine.
Sometimes, complications may arise in applying the net present value rule for invest-
ment decisions. First, projects may be interdependent, so that the stream of net cash flows
from a project depends on whether other projects are undertaken at the same time. In such
a case, the net present value of a group of projects may have to be evaluated together and
compared with the net present value of other groups of projects. Second, it may some-
times be difficult to accurately forecast the future stream of net cash flows from a project.
Third, the firm may not have the resources and may not be willing or able to borrow to
undertake all of the projects that have a positive net present value. The firm should then
choose those projects with the highest net present value.

EXAMPLE 16-3
Fields of Education and Higher Lifetime Earnings in the United States

Table 16.4 gives the present value of the higher lifetime earnings with a college degree
in various fields in the United States in 2007. Present values were calculated by capi-
talizing (i.e., finding the present discounted value of) the difference between the higher
yearly salaries with a bachelor’s degree in the various fields over the average salary of
workers with only a high school diploma. The interest rate used to find the present val-
ues was 5%. Only the benefits of going to college were included: the earnings foregone
or opportunity costs and other costs (tuition, books, and so on) of going to college
were
not included. To be pointed out is that the higher earnings of the recipients of
the bach-
elor’s degree over the earnings of non—college graduates cannot be attributed
entirely
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 527

Personal Values of Higher Lifetime Earnings with

TABLE 16.4 Bachelor's Degree in Various Fields, 2007
Field of Study Higher Lifetime Earnings

Electrical engineering $690,660

Computer sciences 645,020
Economics 539,640
Finance 512,840
Business 449,120
Political science 289,220
History 285,840
Sociology 227,220
English 222,480

Source: Calculated from data reported in Salary Survey, National Association of Colleges and
Employers, Fall 2007.

to college education. At least in part, the higher incomes of college graduates may be
due to their higher level of intelligence, longer working hours, and more inherited
wealth than for non—college graduates. Earnings differentials with and without a col-
lege degree declined during the 1970s and increased since 1980.
Sources: J. Bound and G. Johnson, “Changes in the Structure of Wages in the 1980s: An Evaluation of
Alternative Explanations,’ American Economic Review, June 1992, pp. 371-392; J. Mincer, “Investment in
U.S. Education and Training,” National Bureau of Economic Research, Working Paper No. 4844, October
1995; C. Goldin and L. F. Katz, “The Race Between Education and Technology: The Evolution of U.S.
Educational Wage Differentials, 1890 to 2005,’ NBER Working Paper No. 12984; and College Board,
Education Pays (Washington, DC: September 2007).

DETERMINANTS OF THE MARKET RATES OF INTEREST

Until now we have discussed “the” interest rate; however, the rate of interest varies at dif-
ferent times and in different markets. Even at a given point in time and in a specific capi-
tal market, there is not a single rate of interest but many. That is, there is a different
interest rate on different loans or investments depending on differences in (1) risk, (2)
Default risk The duration of the loan, (3) cost of administering the loan, and (4) tax treatment. We now
possibility that a loan briefly examine each of these in turn.
will not be repaid. The major reason for differences in rates of interest at a given point in time and place
is the risk of the loan. In general, the greater the risk, the higher the rate of interest. Two
Variability risk The types of risk can be distinguished: default risk and variability risk. Default risk refers to
possibility that the the possibility that the loan will not be repaid. If the chance of default is 10%, the lender
return on an will usually charge a rate of interest 10% higher than on a loan with no risk of default,
investment, such as
such as a government bond. Similarly, loans unsecured by collateral (such as installment
on a stock, may vary
credit) usually charge higher rates of interest than loans secured by collateral (such as
considerably above
or below the average.
home mortgages). Variability risk refers to the possibility that the yield or return on an
investment, such as a stock, may vary considerably above or below the average. Given the
528 PART FIVE Pricing and Employment of Inputs

yield for invest-

usual aversion to risk, investors generally demand a premium or a higher
ments whose returns are more uncertain.
Loans
The second reason for differences in rates of interest is the duration of the loan.
for shorter
for longer periods of time usually require higher rates of interest than loans
longer
durations. The reason is that the lender has less flexibility or liquidity with loans of
duration, and so he or she will require a higher rate of interest. It is for this reason that sav-
ings deposits offer lower rates of interest than six-month certificates of deposit.’
The third reason for differences in rates of interest is the cost of administering the
loan. Smaller loans and loans requiring frequent payments (such as installment loans)
usually involve greater bookkeeping and service costs per dollar of the loan and, as a
result, usually involve a higher interest charge. Finally, the tax treatment of interest and
investment income can lead to differences in rates of interest among otherwise compara-
ble loans and investments. For example, state and municipal bonds are exempted from
federal income tax, and since investors look at the after-tax return, state and local gov-
ernments can usually borrow at lower interest rates than corporations.
Thus, at a given point in time and in a given capital market there is a large number of
interest rates depending on relative risk, term structure, administration costs, and tax treat-
ment. Yet all of these rates of interest are related. If individuals and firms collectively
decide to save less (a leftward shift in the aggregate supply curve of savings), interest rates
will rise. Interest rates will also rise if the time preference of consumers shifts in favor of
Concept Check the present or if the net productivity or yield of capital increases. In addition, a rise in short-
On what does the term rates will lead to higher long-term rates, and vice versa. Furthermore, higher interest
market interest rate rates for comparable instruments in one market than in another market will lead to an out-
depend?
flow of funds from the latter to the former. These flows of funds will reduce (and may even-
tually eliminate) interest rate differences between the two markets. Specifically, the supply
curve of funds will shift to the left (1.e., the supply of funds decreases) and interest rates
will rise in the market with lower rates of interest. The opposite occurs in the market with
the higher rates of interest, causing interest rates to fall there.
Finally, a distinction must be made between real and nominal or money interest rates.
Real rate of interest Until this point, we have been discussing the real rate of interest (r). This refers to the
(r) The premium on a premium on a unit of a commodity or real consumption income today compared to a unit
unit of a commodity or
of the commodity or real consumption income in the future. However, in the everyday
real consumption
usage of the term, the interest rate refers to the nominal or money rate of interest. The
income today compared
to a unit of the
nominal rate of interest (r’) refers to the premium on a unit of a monetary claim today
commodity or real compared to a unit of monetary claim in the future. The nominal rate of interest (r’) is
consumption income affected by the anticipated rate of price inflation (7), while the real rate of interest is not.
in the future. Thus, the nominal rate of interest equals the real rate of interest plus the anticipated rate of
price inflation. That is,
Nominal rate of
interest (r’) The real rear [16.7]
rate of interest plus
the anticipated rate of The reason for this is that during the period of the loan, the general price level may rise
price inflation.
(1.e., inflation may occur) so that the loan is repaid with dollars of lower purchasing power
than the dollars borrowed. Therefore, the nominal rate of interest must be sufficiently
high to cover any increase in the price level (or in the price of real claims) during the loan
period. It is primarily to avoid this complication (and to deal with the real rate
of interest)
that we chose to borrow and lend a commodity in Sections 16.1 and 16.2.

(as : : ee
Regulation may also account for part of the difference.
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 529

Anyone who borrows money now and repays in money in the future must expect to
pay an additional monetary amount to cover any anticipated increase in the monetary
price of real claims by the time of repayment. Only if anticipated inflation is zero will
r’ =r, Since some price inflation is always occurring, r’ usually exceeds r. For example,
if r’ = 11% and i = 6%, then r = 5%. We have concentrated on the real rate of interest
throughout most of the chapter because it is the real, and not the nominal, rate of interest
that primarily affects incentives to borrow and lend, and to save and invest.

EXAMPLE 16-4
Nominal and Real Interest Rates in the United States: 1990-2006

Table 16.5 shows the nominal annual interest rates on three-month U.S. Treasury bills,
the change in the Consumer Price Index, and the real interest rate (the difference between
the nominal interest rate and the change in the Consumer Price Index) in the United
States from 1990 to 2006. The implicit assumption made here is that the anticipated rate
of inflation is equal to the actual rate of inflation. Since the nominal interest rate was
greater than the change in the Consumer Price Index (except for 1993 and 2002, when
they were equal, and in 2003 and 2004, when they were smaller), the real interest rate
was positive. Note that the expectation that the nominal interest rate would move in the
same direction as the change in the Consumer Price Index was true only in some years.

Nominal and Real Interest Rates on Three-Month

TABLE 16.5 U.S. Treasury Bills: 1990-2006

Nominal Change in Consumer Real

Year Interest Rate Price Index Interest Rate

1990 7.5 5.4 a

1991 5.4 4.2 Ld
1992 3.5 3.0 0.5
1993 3.0 3.0 0.0
1994 4.3 2.6 Ly
1995 3D 2.8 PE
1996 5.0 3.0 2.0
1997 5:1 23 2.8
1998 4.8 1.6 Bye)
1999 4.7 22 ji)
2000 5.9 3.4 25
2001 35 2.8 0.7
2002 1.6 1.6 0.0
2003 1.0 Ihe) -1.3
2004 1.4 27 -1.3
2005 3h 3.4 0.2
2006 4.7 Sh leo)
LT DSB 9 41 A BE ae I aI SA etORE A Boe

Source: Council of Economic Advisers, Economic Report of the President (Washington, DC: U.S.
Government Printing Office, 2008), 300, 312.
530 PART FIVE Pricing and Employment of Inputs

EXAMPLE 16-5
Investment Risks and Returns in the United States
corporate
Table 16.6 shows that riskier assets, such as common stocks or long-term
bonds, have provided higher average real rates of returns than more liquid and less
the
risky assets, such as U.S. (three-month) Treasury Bills, in the United States over
period from 1926 to 2006. While corporate bonds can provide higher returns than
stocks during some years, over many years, the reverse is usually true. Risk is here
measured ‘as the standard deviation of the real return as a percentage of the mean or
average real return. Common stocks involve a great deal of variability risk while long-
term corporate bonds involve a greater default risk and are less liquid (and therefore
provide higher average real returns) than U.S. Treasury Bills. Clearly, risk-averse
investors must balance expected return against risk in their investment decisions.

Investment Risks and Inflation-Adjusted

TABLE 16.6
16.6 Returns in the United States, 1926-2006

Real Rate of Risk

Asset Return (%) (Standard Deviation, %)
Common stocks oul 20.2
Long-term corporate bonds 3.2 9.6
U.S. Treasury Bills 0.7 4.0

Source: Ibbotson & Associates, Stocks, Bonds, Bills, and Inflation, 2007 Yearbook (Chicago,
2007), p. 120.

16.5 THE COST OF CAPITAL

We now examine how a firm estimates the cost of raising capital to invest. This is an
essential element of the capital budgeting process. The firm can raise investment funds
internally (i.e., from undistributed profits) or externally (i.e., by borrowing and/or from
selling stocks). The cost of using internal funds is the opportunity cost or foregone return
on these funds outside the firm. The cost of external funds is the lowest rate of return that
lenders and stockholders require to lend to or invest their funds in the firm. In this section,
we examine how the cost of debt (i.e., the cost of raising capital by borrowing) and the
cost of equity capital (i.e., the cost of raising capital by selling stocks) are determined.
The estimation of the cost of debt is fairly straightforward. On the other hand, there are at
least three methods of estimating the cost of equity capital: the risk-free rate plus pre-
mium, the dividend valuation model, and the capital asset pricing model (CAPM). These
methods will be examined in turn.

Cost of debt The net Cost of Debt

(after-tax) interest rate
paid by a firm to The cost of debt is the return that lenders require to lend their funds to the firm.
Since the
borrow funds. interest payments made by the firm on borrowed funds are deductible from
the firm’s
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 531

taxable income, the after-tax cost of borrowed funds to the firm (k,) is given by the inter-
est paid (r) multiplied by | minus the firm’s marginal tax rate, t. That is,

Concept Check kg =r(1—-t) [16.8]

How is the cost of debt
to a firm measured?
For example, if the firm borrows at a 12.5% interest rate and faces a 40% marginal tax rate
on its taxable income, the after-tax cost of debt capital to the firm is

Kg .ovo(1—“).40) = 7.5%

Cost of Equity Capital: The Risk-Free Rate Plus Premium

As pointed out earlier, the cost of equity capital is the rate of return that stockholders
require to invest in the firm. The cost of raising equity capital externally usually exceeds
the cost of raising equity capital internally by the flotation costs (i.e., the costs of issuing
the stock). For simplicity, we disregard these costs in the following analysis and treat both
types of equity capital together. Since dividends paid on stocks (as opposed to the interest
paid on bonds) are not deductible as a business expense (i.e., dividends are paid out after
corporate taxes have been paid), there is no tax adjustment in determining the equity cost
of capital.
One method employed to estimate the cost of equity capital (k,) is to use the risk-free
rate (rf) plus a risk premium (r,). That is,

ke =p +l [16.9]

The risk-free rate (r/) is usually taken to be the six-month U.S. Treasury bill rate.'° This
is because the obligation to make payments of the interest and principal on government
securities is assumed to occur with certainty. The risk premium (r,) that must be paid in
raising equity capital has two components. The first component results because of the
greater risk that is involved in investing in a firm’s securities (such as bonds) as opposed
to investing in federal government securities. The second component is the additional risk
resulting from purchasing the common stock rather than the bonds of the firm. Stocks
involve a greater risk than bonds because dividends on stocks are paid only after the firm
has met its contractual obligations to make interest and principal payments to bondhold-
ers. Because dividends vary with the firm’s profits, stocks are more risky than bonds, so
that their return must include an additional risk premium. If the premiums associated with
these two types of risk are labeled p; and p2, we can restate the formula for the cost of
equity capital as

ke =r+ pit po [16.10]

The first type of risk (i.e., p;) is usually measured by the excess of the rate of interest
on the firm’s bonds (r) over the rate of return on government bonds (77). The additional
risk involved in purchasing the firm’s stocks rather than bonds (i.e., p2) is usually taken to
be about four percentage points. This is the historical difference between the average
yield (dividends plus capital gains) on stocks as opposed to the average yield on bonds

10 Some securities analysts prefer to use instead the long-term government bond rate for r,.
532 PART FIVE Pricing and Employment of Inputs

government
issued by private companies. For example, if the risk-free rate of return on
total risk premium (7p) involved in
securities is 8% and the firm’s bonds yield 11%, the
purchasing the firm’s stocks rather than government bonds is

op + pr = (11% — 8%) + 4% = 3% + 4% =71%

so that the firm’s cost of equity capital is

ke= rp t+pi + po = 8% + 3% + 4% = 15%

Cost of Equity Capital: The Dividend Valuation Model

Dividend valuation The equity cost of capital to a firm can also be estimated by the dividend valuation
model The method of model. To derive this model, we begin by pointing out that, with perfect information, the
measuring the equity value of a share of the common stock of a firm should be equal to the present value of all
cost of capital to the
future dividends expected to be paid on the stock, discounted at the investor’s required
firm with the ratio of
rate of return (k,). If the dividend per share (D) paid to stockholders is expected to remain
the dividend per share
of the stock to the price constant over time, the present value of a share of the common stock of the firm (P) is then

(Pe Sie
of the stock, plus the CO

expected growth rate a 16.1]

of dividend payments. XG + ke)! ei
If dividends are assumed to remain constant over time and to be paid indefinitely, equa-
tion [16.11] can be rewritten as

[16.12]

If dividends are instead expected to increase over time at the annual rate of g, the price of
a share of the common stock of the firm will be greater and is given by
D
P= [16.13]
ke-—8

Solving equation [16.13] for k., we get the following equation to measure the equity cost
of capital to the firm:
, D
aan +g [16.14]

That is, the investor’s required rate of return on equity is equal to the ratio of the divi-
dend paid on a share of the common stock of the firm to the price of a share of the stock
(the so-called dividend yield) plus the expected growth rate of dividend payments
by the firm (g). The value of g is the firm’s historic growth rate or the earnings growth
forecasts of securities analysts (based on the expected sales, profit margins, and com-
petitive position of the firm) published in Business Week, Forbes, and other business
publications.
For example, if the firm pays a dividend of $20 per share on common stock
that sells
for $200 per share and the growth rate of dividend payments is expected
to be 5% per
year, the cost of equity capital for this firm is

$20
e
= $200 + 0.05 = 0.10 + 0.05 = 0.15, or 15%
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 533

Cost of Equity Capital: The Capital Asset Pricing Model (CAPM)

Capital asset pricing Another method commonly used to estimate the equity cost of capital is the capital asset
model (CAPM) The pricing model (CAPM). This model considers not only the risk differential between
method of measuring common stocks and government securities but also the risk differential between the com-
the equity cost of
mon stock of the firm and the average common stock of all firms, or broad-based market
capital as the risk-free
rate plus the beta
portfolio. The risk differential between common stocks and government securities is mea-
coefficient (f) times the sured by (k,, — ry), where k,, is the average return on all common stocks and rpis the return
risk premium on the on government securities.
average stock. The risk differential between the common stock of a particular firm and the common
stock of all firms is called the beta coefficient, 8. This is the ratio of the variability in the
Beta coefficient (/) return of the common stock of the firm to the variability in the average return on the com-
The ratio of the mon stocks of all firms. Beta coefficients for individual stocks can be obtained from the
variability of the return
Value Line Investment Survey, Merrill Lynch, or other brokerage firms.
on the common stock
A beta coefficient of 1 means that the variability in the returns on the common
of the firm to the
variability of the stock of the firm is the same as the variability in the returns on all stocks. Thus,
average return on investors holding the stock of the firm face the same risk as holding a broad-based mar-
all stocks. ket portfolio of all stocks. A beta coefficient of 2 means that the variability in the
returns on (i.e., risk of holding) the stock of the firm is twice that of the average stock.
On the other hand, holding a stock with a beta coefficient of 0.5 is half as risky as hold-
ing the average stock.
The cost of equity capital to the firm estimated by the capital asset pricing model
(CAPM) is then measured by

ke = eo PG, 7) [16.15]

where k, is the cost of equity capital to the firm, ry is the risk-free rate, 6 is the beta coef-
ficient, and k,, is the average return on the stock of all firms. Thus, CAPM postulates that
Concept Check the cost of equity capital to the firm is equal to the sum of the risk-free rate plus the beta
How does the capital coefficient (8) times the risk premium on the average stock (k,, — r). Note that multiply-
asset pricing model ing B by (k», — rf) gives the risk premium on holding the common stock of the particular
(CAPM) measure the
firm.
cost of equity capital?
For example, suppose that the risk-free rate (77) is 8%, the average return on common
stocks (k,,) is 15%, and the beta coefficient (8) for the firm is |. The cost of equity capi-
tal to the firm (k,) is then

ke=
8% + 115% — 8%) = 15%

That is, since a beta coefficient of | indicates that the stock of this firm is as risky as the
average stock of all firms, the equity cost of capital to the firm is 15% (the same as the
average return on all stocks). If 6 = 1.5 for the firm (so that the risk involved in holding
the stock of the firm is 1.5 times larger than the risk on the average stock), the equity cost
of capital to the firm would be

ke= 8% + 1.5(15% — 8%)= 18.5%

On the other hand, if 6 = 0.5, then

ko= 8% + 0.5(15% — 8%) = 11.5%

 s

534 PART FIVE Pricing and Employment of Inputs

the div-
In this example and in the examples using the risk-free rate plus premium and
the equity cost of capital was found to be the same (15%). This is
idend valuation model,
seldom the case. That is, the different methods of estimatin g the equity cost of capital to a
firm are likely to give somewhat different results. Firms are thus likely to use all three
methods and then attempt to reconcile the differences to arrive at an equity cost of capital
for the firm.

Weighted Cost of Capital

In general, a firm is likely to raise capital from undistributed profits, by borrowing, and
by the sale of stocks, and so the marginal cost of capital to the firm is a weighted aver-
age of the cost of raising the various types of capital. Since the interest paid on borrowed
funds is tax deductible while the dividends paid on stocks are not, the cost of debt is gen-
erally less than the cost of equity capital. The risk involved in raising funds by borrow-
ing, however, is greater than the risk on equity capital because the firm must regularly
make payments of the interest and principal on borrowed funds before paying dividends
on stocks. Thus, firms do not generally raise funds only by borrowing but also by selling
stock (as well as from undistributed profits).
Firms often try to maintain or achieve a particular long-term capital structure of debt
to equity. For example, public utility companies may prefer a capital structure involving
60% debt and 40% equity, whereas auto manufacturers may prefer 30% debt and 70%
equity. The particular debt-equity ratio that a firm prefers reflects the risk preference of
its managers and stockholders and the nature of the firm’s business. Public utilities
accept the higher risk involved in a higher debt-to-equity ratio because of their more sta-
ble flow of earnings than automobile manufacturers. When a firm needs to raise invest-
ment capital, it borrows and sells stocks so as to maintain or achieve a desired
debt-to-equity ratio.
Composite cost of The composite cost of capital to the firm (k,) is then a weighted average of the cost
capital The weighted of debt capital (kz) and equity capital (k,), as given by
average of the cost of
debt and equity capital
ie = Waka + Weke [16.16]
to the firm.

where wa and w, are, respectively, the proportion of debt and equity capital in the firm’s
capital structure. For example, if the (after-tax) cost of debt is 7.5%, the cost of equity
capital is 15%, and the firm wants to have a debt-to-equity ratio of 40:60, the composite
or weighted marginal cost of capital to the firm is

k, = (0.40)(7.5%) + (0.60)(15%) = 3% + 9% = 12%

That is, the proportion of debt to equity that the firm seeks to achieve or maintain in
the long run is not usually defined for individual projects but for all the investment pro-
jects that the firm is considering. Note that the marginal cost of capital eventually rises
as the firm raises additional amounts of capital by borrowing and selling stocks because
of the higher risk that lenders and investors face as the firm’s debt-to-e
quity ratio
increases.
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 535

AT THE FRONTIER
Derivatives: Useful but Dangerous

D uring the past decade, news about derivatives has been all over the financial
Derivatives Financial and front pages of our newspapers. Derivatives are financial instruments or
instruments or contracts whose value is derived from the price of such underlying financial assets as
oe aa stocks, bonds, commodities, and currencies. Derivatives are offered by banks and bro-
from the price of
kerage firms to corporations and investors who wish to protect themselves against
; : : s : ; ; :
such underlying such risks as a decrease in the international value of the dollar, an increase in the price
fipancialassets as of a commodity, or an increase in interest rates. Used properly, derivatives can be a
stocks, bonds, very useful risk-management tool; used without a clear understanding of all their
commodities, and implications, they can be very dangerous and can lead to huge losses. Despite the dan-
currencies. gers and risks involved in their use, derivatives have been growing at a very rapid rate
during the past decade and are clearly here to stay. The value of the underlying assets
on which derivatives are based (called notional value) now exceeds $400 trillion (as
compared with the $14 trillion of the U.S. gross domestic product, or GDP, in 2007).
Derivatives come in two basic categories: option-type contracts and forward-type
contracts. These may be listed on the exchanges or negotiated privately between insti-
tutions (1.e., over the counter). Options give buyers the right, but not the obligation, to
buy (a call) or sell (a put) an asset at a specific price over a given time period. The
option price or premium is usually a small percentage of the price of the value of the
underlying asset. Although the buyer can never lose more than the premium he or she
paid for the option (by not exercising it), the seller’s potential losses are unlimited. For
example, you can buy a call on GE stock for a specified time, at a specified price, and
for a specified premium. If within the specified time the price of the GE stock falls
below the specified price, you do not exercise the call option to buy the stock and your
losses are limited to the premium that you paid for the call. On the other hand, if the
price of GE stock rises above the specified price, you exercise the call and buy
the stock and gain the difference between the higher market price of the stock and the
agreed call price.
Forward-type contracts, on the other hand, include forwards, futures, and swaps.
Forwards commit both buyer and seller to trade a fixed amount of a given asset for a spe-
cific price at a specific future date. For example, a corporation that has to purchase a given
amount of petroleum in three months faces the risk that the price of petroleum may be
much higher in three months. The corporation can protect itself (i.e., hedge) this risk by
entering today into a contract to purchase the quantity of petroleum that it will need at a
price agreed upon today for delivery and payment in three months. In three months, the
corporation will get the specified quantity of petroleum by paying the agreed price—
whatever the price of petroleum is on that day.
Futures are standardized forward agreements to buy or sell a fixed amount of an
asset (currency, bond, stock, or commodity) traded on an exchange. Swaps are agree-
ments involving an exchange of streams of payments over time according to terms
agreed today. The most common type is an interest rate swap, in which one party hold-
ing a fixed-interest rate mortgage and believing that interest rates will fall exchanges it
for a flexible exchange rate mortgage owned by another party who believes that interest
Continued...
536 PART FIVE Pricing and Employment of Inputs

Derivatives: Useful but Dangerous Continued

rates will rise. The first party will then pay the other’s flexible rate mortgage in exchange
for the second paying the fixed rate mortgage of the first.
Many derivatives are in the form of the simple options, forwards, futures, and
swaps discussed above (called “plain vanilla” derivatives). They form the bread and
butter of the derivatives market and are used mostly to hedge risks, but provide deal-
ers only thin profit margins. Some of these derivatives, such as currency options and
futures, have been used by U.S. and foreign corporations for decades and have been
spared criticism. The derivatives that have caught most of the attention and criticism
in recent years are the customized, over-the-counter, exotic derivatives whose daz-
zling growth to over $350 trillion since the late 1980s have provided huge profits for
dealers and tremendous risks for users. Examples of exotic derivatives are options that
depend on the amount by which one asset will outperform another, or that gamble that
the price of oil will not fall below a specified price or that interest rates do rise above
a given level. The list of derivatives products is very long and new ones are being cre-
ated every day.
By allowing users to make big bets with little or no money down (1.e., by provid-
ing huge leverage), derivatives became very popular during the 1992—1993 bull mar-
ket in bonds, when heavy bets were made that interest rates would continue to fall. As
long as interest rates did fall, these derivatives provided huge profits for users and fat
fees for providers. But when interest rates abruptly reversed course in early 1994, a
number of companies that had invested heavily in these exotic derivatives faced huge
losses. A fund managed by Orange County, California, lost more than $1.5 billion and
was forced to declare bankruptcy. Similar losses by the use of derivatives were
incurred by some large European and Asian corporations during the past decade. In
September 1998, Long-Term Capital Management (LTCM), the Connecticut-based
investment firm, lost $3.6 billion and failed as a result of massive speculative bets
gone wrong. Investors in LTCM had little or no information on the fund’s investments
strategy and no idea on its huge leverage (the ratio of borrowed funds used to the
firm’s capital). The financial crisis that erupted in the middle of 2007 started in the
U.S. subprime (or high-risk) home mortgage loans market and then spread worldwide.
Despite these spectacular failures, there are still few or no disclosure require-
ments in the United States and abroad on derivatives users. Most derivatives are
treated as “off-balance-sheet” items and mentioned in footnotes in companies’ finan-
cial statements. The systemic danger to which this gives rise is that a party to a deriv-
Concept Check ative transaction may be unable to meet the terms of the transaction and lead to the
What are derivatives? insolvency of its counterparty (the other party of the derivative transaction), and that
What is their this may trigger a domino effect of defaults that could threaten the stability of the
usefulness? Why are
entire financial system. The Federal Reserve System and other regulators now face the
they dangerous?
delicate task of regulating the derivatives market without leading this very lucrative
business for many U.S. banks (which are world leaders in this market) to relocate
abroad. One proposal is for firms to report their derivatives profits or losses on their
earnings statements, rather than carrying them on their books at cost. as they do now.

Source: “The Risk That Won't Go Away,” Fortune, March 7, 1994, pp. 40-60; “Untangling
Derivatives
Mess,” Fortune, March 20, 1995, pp. 51-68; “Hedge Funds Managers Are
Back, Profiting in Others’ Bad
Times,” New York Times, July 26, 2002, p. C1; “Banks Gone Wild.’ New York
Times, November 23, 2007
p. 37; and IMF, Global Financial Stability Report (Washington, DC: IMF, 2007)
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 5ST

16.6 EFFECTS OF FOREIGN INVESTMENTS ON THE RECEIVING NATION

Foreign investments reduce the supply of investment funds in the investing nation and
increase them in the receiving nation. Foreign investments flow from the nation where the
rate of return on investment is lower to the nation where the rate of return is higher.
During the 1980s, the United States was the recipient of a large net inflow of foreign
investments because of the higher rate of return on investments in the United States than
abroad. We can examine the effect of foreign investments on the receiving nation with
Figure 16.7. For simplicity, we assume that the rate of interest on borrowed capital is the
same as the rate of return on both borrowed and equity capital in the nation.
In Figure 16.7, D is the nation’s demand curve for investment funds, while S is the
domestic supply curve of investment funds. D and S intersect at point E indicating that, in
the absence of foreign investments, $300 billion is invested in the nation at the rate of
return (7) of 0.15, or 15%. With $150 billion of foreign investment, the nation’s supply
curve shifts to the right to S’. The intersection of D and S’ defines the new equilibrium
point of E’, which indicates that total investments in the nation are $400 billion and the
rate of return on domestic and foreign investments is 0.10, or 10%. Thus, foreign invest-
ments reduced the rate of return on domestic investments from 15% to 10% (and this led
to a reduction in the quantity supplied of domestic investments to $250 billion).
The $150 billion foreign investment increases the total output of the receiving nation
by GEE™M (about $12.5 billion), of which GCE = $10 billion is paid out to foreign
investors as the return on their investment, and EEC (about $2.5 billion) represents the net
benefit or gain to the nation receiving the foreign investments. Some of this net benefit
goes to domestic labor because the inflow of foreign investments increases the capital—
labor ratio and thus the productivity and wages of domestic labor. Another benefit (not
shown in the figure) accruing to the nation receiving the foreign investments is the taxes
paid by foreigners on the income (the return on investments) earned in the nation.
In 1985, the United States changed from being a net creditor to being a net debtor
nation (i.e., the amount that foreigners lent and invested in the United States began to
exceed the amount that the United States lent and invested abroad) for the first time since
1914. Indeed, with a net foreign debt of about $2 trillion in 2000, the United States was
by far the most indebted nation in the world. This large debt sparked a lively debate

FIGURE 16.7 Effects of Foreign Investments on the

Receiving Nation Dis the demand curve for and Sis the
supply curve of investment funds in the nation in the absence of
foreign investments. D and S intersect at point E, defining the
equilibrium rate of return (1) of 0.15, or 15%, and level of
investments of $300 billion. With $150 billion of foreign
investments, S shifts to S’, defining the new equilibrium point of 0.10
E’, at which total investments in the nation rise to $400 billion
($250 billi on domestic and $150 billion foreign) and rfalls to Market
of
(7)
interest
rate
010, or 10%. The $150 billion foreign investment increases the Glen
total output of the nation by GEE’M (about $12.5 billion), of inne) ° ee,
0 250-1 300 400 ©450
which GECE’M = $10 billion is the return on foreign investments
—+ Billions of dollars
and EE’C (about $2.5 billion) is the net gain of the nation.
538 PART FIVE Pricing and Employment of Inputs

regarding
among economists, politicians, and government officials in the United States
the benefits, and risks of this recent development.
In terms of benefits, foreign investments allowed the United States to finance about
half of its budget deficit without the need for still higher interest rates and more “erowd-
ing out” of private investments. To the extent that foreign investments went into directly
productive activities and the return on this investment was greater than the interest and
dividend payments flowing to foreign investors, this investment was beneficial to the
United States.!! To the extent, however, that foreign investments simply financed larger
consumption expenditures in the United States, the interest and dividend payments flow-
ing to foreign investors represent a real burden or drain on future consumption and growth
in the United States. Some experts are concerned that a growing share of capital inflows
to the United States since 1983 cannot be clearly identified as productive investments, and
to that extent they may represent a real burden on the U.S. economy in the future.
There is also the danger that foreigners, for whatever reason, may suddenly withdraw
their funds. This would lead to a financial crisis and much higher interest rates in the
United States. Some economists and government officials also fear that foreign compa-
nies operating in the United States will transfer advanced American technology abroad.
They further fear some loss of domestic control over political and economic matters. The
irony is that these fears were precisely the complaints usually heard from Canada, smaller
European nations, and developing countries with regard to the large American invest-
ments in their countries during the 1950s and 1960s. With the great concern often voiced
in the United States today about the danger of foreign investments, the tables now seem
to have turned. !?

EXAMPLE 16-6
Fluctuations in the Flow of Foreign Direct Investments to the United States

Table 16.7 shows that the flow of foreign direct investments (FDI) to the United States
was $65.9 in 1990. It declined to $15.3 billion 1992 before rising to $321.3 billion in
2000. Afterwards, it declined to $63.8 billion in 2003 and then rose to $180.6 billion
in 2006. Foreign direct investments include acquisitions, the formation of new busi-
nesses, and the construction of new plants. They do not include the purchase of stocks
and bonds.
During the second half of the 1980s, many Americans became concerned that for-
eigners, particularly the Japanese, were “buying up” America. These fears subsided
during the early 1990s, as slow growth and recession made FDI in the United States
less attractive to foreigners. With the resumption of rapid growth in the United States
since 1993, however, FDI in the United Stated shot up again to much higher levels than
during the late 1980s (this time coming mostly from Europe instead of Japan), but
with

" Of course, the United States would have benefitted even more if it had financed its domestic investments
entirely through domestic savings. But with inadequate domestic savings, the second best situation was to
receive foreign investments and pay the return on investments to foreign investors.
'? See “A Note on the United States as a Debtor Nation,” Survey of Current Business (Washington, D.C.:
U.S. Government Printing Office, 1985), p. 28.
nied
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 539

Foreign Direct Investment Flows to the United

Malden States, 1990-2006 (billions of U.S. dollars)
Year FDI Year FDI
1980 $122 1990 $65.9
1981 23.2 1991 25.5
1982 10.8 1992 15.3
1983 8.1 1993 26.2
1984 ey) 1994 49,9
1985 Dees 1995 60.8
1986 39.2 1996 84.5
1987 40,3 1997 103.4
1988 oh 1998 174.4
1989 WW 1999 295.0
1990 65.9 2000 281.1
Source: U.S. Department of Commerce, Survey of Current Business (Washington, DC: U.S.
Government Printing Office, various issues).

the United States doing much better in international competitiveness than in the 1980s
(see “At the Frontier” for Chapter 7), the new upsurge in FDI did not cause much con-
cern in the United States. At the same time, the flow of U.S. FDI abroad remained high
and reached a peak of $279.1 billion in 2004 and was $235.4 billion in 2006.

16.7 SOME APPLICATIONS OF FINANCIAL MICROECONOMICS

In this section, we discuss some important applications of the theory presented in the chap-
ter. These applications include investment in human capital, the effect of investment in
human capital on hours of work, the pricing of exhaustible resources, and the manage-
ment of nonexhaustible resources. These applications clearly indicate the usefulness and
applicability of the theory.

Investment in Human Capital

Investment in human Investment in human capital is any activity on the part of a worker or potential worker
capital Any activity, that increases his or her productivity. It refers to expenditures on education, job training,
such as education and health, migration to areas of better job opportunities, and so on. Like any other invest-
training, that increases
ment, investments in human capital involve costs and entail returns. For example, going
an individual’s
to college involves explicit and implicit, or opportunity, costs. The explicit costs are
productivity.
tuition, books, fees, and all other out-of-pocket expenses of attending college. The
implicit costs are the earnings or opportunities foregone while attending college (the
individual could have worked or could have worked more by not attending college). As
we have seen in the example in Section 9.1, the implicit costs of attending college are
nearly as high as the explicit costs. The returns of attending college take the form of
540 PART FIVE Pricing and Employment of Inputs

(see
higher lifetime earnings with a college education than without a college education
Example 16-3).
As with any other investment, we can find the present value of the stream of net cash
(because
flows from a college degree. Net cash flows are negative during the college years
of the explicit and implicit or opportunity costs of attending college) and positive during
the working life of the college graduate until retirement. The same is generally true for
other investments in human capital. That is, they also lead to a stream of net cash flows and
should be undertaken only if their net present value is positive or higher than the present
value of other investments (such as the purchasing of a stock). Using this method, it was
estimated that the return to a college education was about 10% to 15% per year during the
1950s and 1960s. This was substantially higher than the return on similarly risky invest-
ments (such as the purchasing of a stock). During the 1970s, and as a result of the sharp
increases in tuition and relatively lower starting salaries, the returns to a college education
declined to about 7% per year, but they increased during the 1980s and early 1990s.!°
These studies, however, face a number of statistical problems. For example, not all
expenditures for education represent an investment (as, for example, when a physics stu-
dent takes a course in Shakespeare). In addition, at least part of the higher earnings of col-
Concept Check lege graduates may be due to their being more intelligent or from working harder than
What are the returns to noncollege graduates (see the next section). Nevertheless, there are benefits from a col-
college education? lege education that cannot be easily measured. For example, college graduates seem to
enjoy their jobs more than noncollege graduates, have happier marriages, and generally
suffer less mental illness. In spite of these measurement difficulties, however, the concept
of investment in human capital is very important and commonly used. Most differences
in labor incomes can be explained by differences in human capital. Juries routinely deter-
mine the amount of damages to award injury victims (or their survivors, in cases of fatal
accidents) on the basis of the human capital or income lost by the injured party.
Developing countries complain about the brain drain or the emigration to rich nations of
their young and skilled people (who embody a great deal of human capital), and so on.

Investment in Human Capital and Hours of Work

People may work more hours as a result of investment in human capital. This can be shown
with the aid of Figure 16.8. In Figure 16.8, the movement from left to right on the hori-
zontal axis measures hours of leisure per day. The movement from right to left measures
the hours of work. The sum of the hours of leisure and the hours of work always adds up
to the 24 hours of the day. The vertical axis measures the daily income of the individual.
We begin by assuming that the individual portrayed in Figure 16.8 has a daily prop-
erty income of FC ($30). If the hourly wage is $2.50, the individual’s budget line is FB
(so that the negative of the slope of the budget line gives the wage rate). Before investing
in education, the individual maximizes utility or satisfaction at point E£, where indiffer-
ence curve U is tangent to budget line FB. The individual works 8 hours per day and has
a daily income of $50 (FC, or $30, from property income plus HE, or $20, from
working
8 hours at the wage rate of $2.50 per hour). i

'° R. B. Freeman, “The Decline in the Economic Rewards to College Education,

g : The Review
eview of ; Economics
Tony
and Statistics, February 1977, pp. 18-29; “The Soaring Payoff from Higher
Education.” The Margin,
January/February, 1990, p. 6; “The New Math of Higher Education,” Business
Week, March 18. 1996 p. 39;
“College Degree Still Pays, But It’s Leveling Off,” New York Times, January
13, 2005, p. Cl; and Goitere )
Board, Education Pays (Washington, DC: September 2007)
x
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 541

Daily
wage

$120

90

70

50

FIGURE 16.8 Education and Hours of Work The

individual has a daily property income of FC = $30
30
and faces budget line FB (with the negative of the
Slope giving the wage of $2.50 per hour). The
individual maximizes utility at point E, where
indifference curve U is tangent to FB. The individual
works 8 hours and has a daily income of $50 (of
0 6 10 16 A
which HE = $20 is labor income). Suppose the
individual invests all property income in education and Hours of leisure per day ————>
as a result earns $5 per hour. The budget line is now
CA. The individual maximizes utility at point G, where | | |
U is tangent to CA, and works 14 hours for a daily 24 18 14 8 0
income of $70. Hours of work per day

Suppose that now the individual decides to invest all of his or her endowed property
income in education (1.e., sacrifice all of his or her nonhuman capital) and that as a result he
or she can earn a wage rate of $5 per hour. With education, the budget line of the individual
is now CA (see the figure), reflecting zero property income available for consumption and the
wage of $5 per hour (the negative of the slope of budget line CA). Assuming that the individ-
ual’s tastes remain unchanged as a result of the education, the individual will now maximize
utility at point G, where indifference curve U is tangent to budget line CA. The individual
now works 14 hours per day for a daily income of $70 (all of which is labor income).
Thus, education seems to induce individuals to work more hours (1.e., have fewer
leisure hours) and earn higher incomes. Having made the investment in education, the
individual will work more hours and earn a higher income to maximize utility. This seems
to be confirmed in empirical studies. For example, Lindsay found that physicians work on
average 62 hours per week, far more than the average worker. '4 The same seems to be true
for other professionals as opposed to nonprofessionals.

14C. M. Lindsay, “Real Returns to Medical Education,” Journal of Human Resources, Summer 1982, p. 338.
See also “Wages and the Workday,” Economic Inquiry, spring 2000, p. 15, and “Why High Earners Work
Longer Hours,” NBER Reporter, July 2006, p. 4.
542 PART FIVE Pricing and Employment of Inputs

Pricing of Exhaustible Resources

Will become
One of the great concerns of modern societies is that the world’s resources
le or nonexhau stible.
depleted. Resources can generally be classified as exhaustib
minerals, that are available
Exhaustible Exhaustible resources are those, such as petroleum and other
such as
resources Nonrenewable in fixed quantities and are nonreplenishable. Nonexhaustible resources are those
resources, such as fertile land, forests, rivers, and fish, which can last forever if they are properly managed.
petroleum and other
We first examine the pricing of exhaustible or nonrenewable resources and then look at
the pricing of nonexhaustible or renewable resources under proper management.
minerals, which are
available in fixed
quantities and are During the 1970s (and to a large extent as a result of the petroleum crisis), there was
nonreplenishable. great concern that exhaustible resources would soon be depleted. Doomsday models were
built that predicted when various exhaustible resources would run out, thereby threaten-
Nonexhaustible ing the living standard and the very future of humanity.'> Such fears are again being
resources Renewable expressed today. Economists, while not entirely shrugging off the danger, were skeptical
resources, such as for the most part. They pointed out that as the price of exhaustible resources tend to rise
fertile land, forests,
over time, this would lead to conservation and to the discovery of substitutes. Thus,
rivers, and fish, which
need never be depleted
doomsday models were not to be taken too seriously. Let us see why economists proved
if they are properly to be generally right.
managed We begin by pointing out that the owner of an exhaustible resource will keep it in
the ground and available for future use if the present value of the resource in future use
is greater than its current price. For example, suppose that the price of the resource is
$100 per unit today, it is expected to be $120 next year, and the market rate of interest
is 10% per year. The owner will sell the resource next year, since the present value of a
unit of the resource sold next year is $120/(1 + 9.1) = $109.09 and this exceeds its
price of $100 today.
In a perfectly competitive market, the net price of the resource (1.e., the price minus
the cost of extraction) will rise at a rate equal to the market rate of interest, and this will
spread available supplies over time. If the net price of a resource is expected to rise faster
than the market rate of interest, more of the resource will be held off the market for future
sale. This increases the current price and reduces the future price until the present value
of the future net price is equal to the present net price. On the other hand, if the net price
of the resource is expected to rise at a slower rate than the market rate of interest, more of
the resource will be sold in the present. This will reduce the present price and increase the
future price until the present value of the expected future net price equals the present net
price. This is shown in Figure 16.9.
In the left panel of the figure, time is measured along the horizontal axis, and the price
of the exhaustible resource and its average total cost (assumed to be constant, and thus
equal to marginal cost) are measured along the vertical axis. The right panel shows the
market demand curve for the resource (input). The net price or benefit to the owners of
the resource is given by the difference (AB at time zero) between the (gross) price of the
resource and the assumed constant cost of extracting it. The owner can obtain these net
benefits now or in the future (by leaving the resource in the ground). For the owner of the
resource to be indifferent between extracting the resource now or in the future. the net

'S See J. W. Forrester, World Dynamics (Cambridge, MA.: Wright-Allen Press, 1971): D.
H. Mead OWS et al.,
The Limits to Growth: A Report for the Club of Rome's Project on the Predicament
of Mankind (New York:
Universe Books, 1972); M. Mesarovic and E. Pestel, Mankind at the Turning Point:
The Second Report to the
Club of Rome (New York: American Library, 1974); and “Study Warns of Gloomy
Future for Resources.”
Financial Times, October 26, 2007, p. 3.
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 543

RAVEE 12

G F'

B Z B'e D
A ATC = MC |NG
|
: é
0 t, Time 0 Cc Quantity

FIGURE 16.9 The Price of Exhaustible Resources _ In the left panel, time is measured along
the horizontal axis, and the price of the exhaustible resource and its average cost (assumed constant
and equal to MC) is measured along the vertical axis. The right panel shows the demand curve for
the resource. At P = OB, the net benefit is AB per unit and the quantity demanded is OC. Over time,
the net benefit or net price rises at the same rate as the market rate of interest until at P = OF, the
supply of the resource is exhausted (point G in the left panel), and the quantity demanded is zero
(point F’ in the right panel).

benefit or net price of the resource must appreciate over time at a rate equal to the mar-
ket rate of interest.
The right panel of Figure 16.9 shows that at the resource (gross) price P = OB’, the
quantity demanded of the resource is OC. Over time, the net price rises at the same rate
Concept Check as the market rate of interest (from AB to EG in the left panel) until at P = OF’ the sup-
How is the price of ply of the resource is exhausted (point G in the left panel) and the quantity demanded of
exhaustible resources the resource is zero (point F’ in the right panel). Thus, in perfectly competitive markets,
measured?
exhaustion of the resource coincides with zero quantity demanded. If exhaustion occurs
before time f, at P = OF, owners of the resource could have sold the resource at a higher
price (and net benefit) over time than indicated by line BG. On the other hand, if the
resource is not exhausted by f, at P = OF, owners would have gained by selling the
resource at a lower price over time.'® In the real world, the net price of most resources
increases at a smaller rate than the market rate of interest (and the net price of many
resources actually falls) over time because of new discoveries, technological improve-
ments in extraction, and conservation.

Management of Nonexhaustible Resources

Nonexhaustible or renewable resources such as forests and fish grow naturally over time.
Unless the rate of utilization of the resource exceeds its rate of natural growth, the
resource will never be depleted.'” If the renewable resource is trees, the question is when

16 See H. Hotelling, “The Economics of Exhaustible Resources, “Journal of Political Economy, April 1931,
pp. 137-175.
'7 The term “renewable” is, perhaps, more appropriate than “nonexhaustible” because if the rate of utilization
of the resource exceeds its natural growth rate, the resource can be exhausted. For example, if you cut all the
trees or catch all the fish now, there will be no trees or fish in the future.
544 PART FIVE Pricing and Employment of Inputs

Net
value

$14

V(t)

Time(t)

FIGURE 16.10 Optimal Management of a Standing

Forest The top panel shows the net value of the trees if
harvested at time t, V(t). The trees should be cut when the
erowth in the net value of the standing trees (AV) is equal
to the growth in the net receipts from cutting the trees and
investing the proceeds at the market rate of interest (rV).
This equilibrium occurs at t = 6 when the AV, or MV, curve
crosses the rV curve (point C’ in the bottom panel) and
WV Ne

should the trees be cut? The answer (as you might suspect by now) is that the trees should
be allowed to grow as long as the rate of growth in the net value of the trees exceeds the
market rate of interest. Cutting the trees when the rate of growth in their net value exceeds
the market rate of interest would be equivalent to taking money out of a bank paying a
higher rate of interest and depositing the money in another bank that pays a lower rate of
interest. We can analyze this situation with the aid of Figure 16.10.
The top panel of Figure 16.10 shows the net value of the trees if harvested at time f.
This is given by the V(t) curve. The net value is the total market value of the trees minus
the cost of harvesting them. We assume zero maintenance or management costs. The top
panel shows that V(t) grows at an increasing rate at first. At time t = 3 (point A), dimin-
ishing returns begin. V(t) reaches the maximum value of $14 million at t= 9 (point B),
after which disease, age, and decay set in.
When should the trees be cut? The answer is not at t= 9 when V(t) is maximum.
This would be the case only if the market rate of interest were zero. With a positive mar-
ket rate of interest, the correct answer is to cut the trees when the growth in the net value
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 545

of the standing trees (AV) is equal to the growth of the net receipts from cutting the trees
and investing the proceeds at the market rate of interest (rV). That is, the trees should be
cut when

DVieaaV | EiGeey|
or
BV IV 7 [16.17A]

This says that trees should be cut when the rate of growth in the value of the standing
trees (AV/V) equals the market rate of interest (7).
In terms of Figure 16.10, the trees should be cut at t = 6 when the AV curve crosses
the rV curve (point C’ in the bottom panel). The AV curve (in the bottom panel) is the
marginal value curve or slope of the V(t) curve in the top panel (i.e, AV = MV). The rV
curve in the bottom panel is 0.25 or 25% of the V(t) curve, at r = 25%. To the left of point
C’, MV exceeds rV (i.e., AV/V > r) and it pays for the firm to let the trees continue to
grow. To the right of point C’, MV is smaller than rV (i.e., AV/V < r) and it pays for the
firm to cut the trees. The optimal choice is to cut the trees at point t = 6 (point C’, where
MV =rV). This is the usual marginal rule applicable in all optimization decisions.

SUMMARY
1. Given the consumer’s income or endowment for this year and the next, and the rate of interest,
we can define the consumer’s budget line. The rate of interest is the premium received next year
for lending or borrowing one dollar this year. The optimal consumer’s choice involves lending
or borrowing so as to reach the highest possible indifference curve showing the consumer’s
time preference between present and future consumption. The wealth of an individual is given
by the sum of the present income and the present value of future income. If the rate of interest
rises, the borrower will borrow less and the lender will usually lend more. The equilibrium rate
of interest is determined at the intersection of the market demand curve for borrowing and the
market supply curve for lending.
i) . For an isolated individual, optimal saving and investment is given by the point where the
production-possibilities curve is tangent to an indifference curve. With saving and investment,
and borrowing and lending, the optimal choice of the individual is first to maximize wealth
(by reaching the market line that is tangent to the production-possibilities curve) and then to
borrow or lend along the market line until the individual reaches the highest indifference curve
possible. The equilibrium rate of interest is given by the intersection of (1) the aggregate
demand curve for borrowing and the aggregate supply curve of lending, or (2) the aggregate
demand curve for investment and the aggregate supply curve of savings.
3. A firm should undertake an investment only if the net present value of the investment is
positive. The net present value (NPV) of the investment is the value today from the stream of
the net cash flows (positive and negative) from the investment. In choosing between any two
projects, the firm will maximize attained wealth by undertaking the project with the highest net
present value. The separation theorem refers to the independence of the optimum production
decision from the individual’s preferences in perfect capital markets.
4. The rate ofinterest usually varies at different times and in different markets. Even at a given point
in time and ina specific capital market, there is not a single rate of interest, but many. That is,
there is a different interest rate on loans or investments depending on differences in (1) default
and variability risks, (2) duration of the loan, (3) cost of administering the loan, and (4) tax
treatment. Interest rates rise if society decides to save less or to borrow and invest more. The
nominal rate of interest equals the real rate of interest plus the anticipated rate of price inflation.
546 PART FIVE Pricing and Employment of Inputs

a The cost that a firm incurs for using internal funds is the foregone return on these funds
invested outside the firm. The cost of external funds is the rate of return that lenders and
funds
stockholders require to lend or invest funds in the firm. The after-tax cost of borrowed
is given by the interest paid times (1 — 1), where fis the firm’s marginal tax rate. The cost of
equity capital can be measured by (1) the risk-free rate plus a risk premium, (2) the dividend
valuation model, and (3) the capital asset pricing model (CAPM). The composite cost of capital
is the weighted average of the cost of debt and equity capital.
. Foreign investments result in a reduction in the rate of return on domestic investments but a net
gain for the recipient nation. Labor in a nation receiving foreign investments shares in the gains
through higher wages from the higher productivity resulting from an increased capital-labor
ratio. The nation also collects taxes on foreign earnings. The United States is now the largest
debtor nation in the world. Concern has been voiced on the dangers arising from a sudden
withdrawal of foreign investments, technology transfer, and foreign domination.
These dangers may be exaggerated.
. Investment in human capital refers to expenditures on education, job training, health, or
migration to areas of better job opportunities that increase the productivity of an individual.
Like any other investment, investments in human capital involve costs and entail returns.
\ Education seems to induce people to work more hours. The net price of exhaustible resources
tends to rise at the same rate as the market rate of interest, and this spreads the available supply
of the resource over time and stimulates the discovery of substitutes. A nonexhaustible resource
should be harvested when the growth in its net value equals the market rate of interest.

KEY TERMS
Endowment position Net present value (NPV) Capital asset pricing model (CAPM)
Rate of interest (7) Separation theorem Beta coefficient ()
Wealth Default risk Composite cost of capital
Production-possibilities curve Variability risk Derivatives
Saving Real rate of interest (r) Investment in human capital
Investment Nominal rate of interest (r’) Exhaustible resources
Market line Cost of debt Nonexhaustible resources
Capital budgeting Dividend valuation model

REVIEW QUESTIONS
1. How much interest must an individual be paid to save part 4. What is the present discounted value of an inheritance of
of his or her income this year if his or her time preference $10,000 to be paid in two years, if the market rate of
is zero? What happens to the individual’s satisfaction this interest is 10%?
year and next if the individual saves part of this year’s 5 - Should you prefer $100 one year from today
income and spends it next year? What happens to the or $110 two
years from today if the market rate of interest is 5% per
individual’s combined satisfaction for this year and next if year? Why?
the individual saves part of this year’s income and spends
6. What is the rate of interest or discount if an individual is
it next year?
indifferent between receiving $11,111.11 today or $1,000
. In what way is intertemporal optimum consumer choice
at the end of each year in perpetuity?
analogous or similar to optimum consumer choice at one
point in time?
7. Why is the cost of debt capital usually lower than the cost
of equity capital for a firm?
. Is microeconomic theory concerned primarily with the real
or with the nominal interest
rate? Why? 8. What additional risks do the stockholders of a firm face in
comparison to holders of government securities?
 CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost of Capital 547

g: A corporation can sell bonds at an interest rate of 11. What are some of the benefits and costs of foreign
9%, and the interest rate on government securities investments not captured by Figure 16.7? When all
is 7%. What is the cost of equity capital for benefits and costs are considered, can we still say that
this firm? foreign investments are beneficial for the receiving nation?
10. If labor and capital are the only inputs, what are the total 12. Does a nation gain or lose from foreign investments
gains of labor in Figure 16.7 when the nation receives when all benefits and costs from foreign investments are
$100 billion of foreign investments? considered?

PROBLEMS
il, Suppose that an individual is endowed with Yo = 7.5 b. Why is a borrower’s demand curve for loans
units of a commodity this year and Y; = 2.75 units next (borrowing) negatively sloped throughout?
year. Draw a figure showing that the individual lends 2.5 6. Draw a figure similar to Figure 16.5 showing that a rise
units of this year’s endowment for 2.75 units next year. in the rate of interest will reduce the individual’s level
What is the rate of interest? On the same figure show of investment and borrowing.
that the individual lends 3 units for 4.2 units. What 7. Starting from Figure 16.5, draw a figure showing that if
would the rate of interest be then? indifference curve Us had been tangent to market line
Suppose that an individual is endowed with Yo = 2.5 HW,, to the right of point A, the individual would have
units of a commodity this year and Y, = 8.25 units next been dissaving.
year. Draw a figure showing that the individual borrows . Starting from Figure 16.5, draw a figure showing that if
oo
2.5 units this year and repays 2.75 units next year. What indifference curve Us had been tangent to market line
is the rate of interest? On the same figure, show that the HW, to the left of point H, the individual would have
individual borrows 2 units this year and repays 2.80 been saving more than he or she invested.
units next year. What would the rate of interest be then?
*9. Reestimate the net present value of the project given in
1S). Assume that (1) the consumer of Problem 2 (call Table 16.4 for r= 5%.
him or her individual B or the borrower) 1s a different *10. A firm expects to earn $200 million after taxes for the
individual from the consumer of Problem 1 (call him current year. The company has a policy of paying out
or her individual A or the lender), and that (2) both half of its net after-tax income to the holders of the
individual A and B have the same tastes or time company’s 100 million shares of common stock. A
preference. Draw a figure showing how the equilibrium share of the common stock of the company currently
rate of interest is determined if A and B are the only sells for eight times current earnings. Management and
individuals in the market. What would happen at outside analysts expect the growth rate of earnings and
r=A0%? Atr=5%? dividends for the company to be 7.5% per year.
7 Assume that (1) individuals A and B have identical Calculate the cost of equity capital to this firm.
endowments of a commodity of Yo = 5 this year and 11. A company pays the interest rate of 11% on its bonds,
Y, = 6 next year, and that (2) the optimal choice for the marginal income tax rate that the firm faces is 40%,
individual B is to borrow 2.5 units this year and repay the rate on government bonds is 7.5%, the return on the
3 units next year, while the optimal choice for individual average stock of all firms in the market is 11.55%, the
A is to lend 2.5 units this year and receive 3 units next estimated beta coefficient for the common stock of the
year. Draw a figure similar to Figures 16.1 and 16.2 for firm is 2, and the firm wishes to raise 40% of its capital
the above. What is the equilibrium rate of interest if A by borrowing. Determine:
and B are the only individuals in the market? On the a. The cost of debt.
same figure show that at r = 50%, individual B wants to
b. The cost of equity capital.
borrow 2 units instead of 2.5 this year and repay 3 units
c. The composite cost of capital for this firm.
next year, while individual A wants to lend 3 units
12. Draw a figure showing the effect of the following on the
this year and receive 4.5 units next year. Why is r = 50%
not the equilibrium rate of interest? price of an exhaustible resource.
a. A decrease in the market rate of interest.
*5, a. Why does a lender’s supply curve of loans (lending)
bend backward at sufficiently high rates of interest? b. An increase in the demand for the resource.

* — Answer provided at the end of the book.

548 PART FIVE Pricing and Employment of Inputs

INTERNET SITE ADDRESSES

Data and analyses of interest rates, savings and investments, Financial calculators that can be used to calculate present
and the financial situation in the leading industrial nations discounted values can be found at:
are provided in The Economic Report of the President, The http://www. biznizportal.com/calculators/bus 1 0/java/Bus
Federal Reserve Bank of St. Louis, the European iness Valuation.html
Commission (EC), National Bureau of Economic Research For the cost of capital analysis for over 300 industries,
(NBER), The Peterson Institute. The Websites are: see the site of the Ibbotson Associates’ Cost of Capital
http://www. gpoaccess.gov/eop/tablesO7.htm] Review at:
http://www.stls.frb.org http://valuation.ibbotson.com
http://ec.europa.eu/economy_finance/indicators_en.htm The data on foreign direct investments are published by the
http://www. nber.org United Nations in the World Investment Report (yearly), the
http://www.petersoninstitute.org OECD in the International Investment Statistics Yearbook,
and the Bureau of Economic Analysis on the following
Information and data on emerging financial markets are
found on the Websites of the Bank for International
Websites:
Settlements (BIS), International Monetary Fund (IMP), and http://www.unctad.org/Templates/WebFlyer.asp?intltem
World Bank (WB) at: ID=4361 &lang=1 fs
http://www.bis.org http://www.unctad.org/Templates/WebF lyer.asp?intItem
http://www.imf.org ID=4361 &lang=1
http://www.worldbank.org http://bea.doc.gov/bea/dil .htm
 PART
SIX

D art Six (Chapters 17-19) presents the theory of general G @ N e ld |

equilibrium and welfare economics, examines the role
of government, and deals with the economics of informa- Eq U |||b a U Mm j
tion. Chapter 17 describes general equilibrium theory and
welfare economics. It examines the interdependence or Effi C l
eC N Cy a N qd
relationship among all products and input markets and )
shows how the various individual markets (studied in Parts 1
Two through Five) fit together to form an integrated eco- p U D||C G O O dS
nomic system. The chapter also considers questions of
equity in the distribution of income. Chapter 18 concen-
trates on externalities, public goods, and the role of govern-
ment. It studies why externalities (such as pollution) and the
existence of public goods (such as national defense) lead to
economic inefficiencies and discusses policies that can be
used to overcome these inefficiencies. It also presents the
theory of public choice. Finally, Chapter 19 deals with the
economics of information. It examines the economics of
search and the problems arising from asymmetric informa-
tion (i.e., the situation where one party to a transaction has
more information than another) and moral hazard (i.e., the
increased probability of a loss when an economic agent can
shift some of its costs to others). As in previous parts of the
text, the presentation of theory is reinforced with many real-
world examples and important applications, while the At
the Frontier sections present some new and important
developments.
 CHAPTER | /

General Equilibrium and

Welfare Economics
Chapter Outline List of Examples
fa Partial Versus General Equilibrium Analysis 17-1 Effect of a Reduction in Demand for
V2 General Equilibrium of Exchange and Domestically Produced Automobiles in the
Production United States
jy) General Equilibrium of Production and Watering Down Efficiency in the Pricing of Water
Exchange and Pareto Optimality The Basis of and the Gains from International
17.4 Perfect Competition, Economic Efficiency, and Trade
Equity “The Painful Prescription: Rationing Hospital Care”
173 General Equilibrium of Production and From Welfare to Work—The Success of
Exchange with International Trade Welfare Reform in the United States
17.6 Welfare Economics and Utility-Possibilities At the Frontier: The Hot Issue of Income
Frontiers Inequality in the United States
Wats Social Policy Criteria
| 17-6 Welfare Effects of Removing U.S. Trade
17.8 Trade Protection and Economic Welfare Restrictions

After Studying This Chapter, You Should Be Able to:

e Know the meaning of partial and general equilibrium analysis and when each is appropriate
e Know the meaning and conditions for general equilibrium in exchange and production
e Understand the meaning and importance of the concept of Pareto optimality
e Understand the relationship between efficiency and equity
e Know how changes in social welfare can be measured

|| ntil this point we have examined the behavior of individual decision-making units
(individuals as consumers of commodities and suppliers of inputs, and firms as
employers of inputs and producers of commodities) and the workings of individ-
ual markets for commodities and inputs under various market structures. Generally miss-
ing from our presentation has been an examination of how the various individual pieces
fit together to form an integrated economic system.
In this chapter, we take up the topic of interdependence or relationship among the var-
ious decision-making units and markets in the economy. This allows us to trace both the
effect of a change in any part of the economic system on every other part of the system, and

551
552 PART SIX General Equilibrium, Efficiency, and Public Goods

by cee
the repercussions from the latter on the former. We begin the chapter
and general equilibr ium analysis and by examining
between partial equilibrium analysis
type of analysis is appropri ate. Then, we discuss the con-
the conditions under which each
to be in general equilibr ium of exchange , producti on, and
ditions required for the economy
eously, and we examine their welfare implicat ions. The
production and exchange simultan
numerous examples add realism to the presentation while the Ar the Frontier section
examines the hot issue of growing income inequality in the United States today.

171 PARTIAL. VERSUS GENERAL EQUILIBRIUM ANALYSIS

Partial equilibrium In Parts Two through Five (Chapters 3-16) we conducted partial equilibrium analysis.
analysis Studies the That is, we studied the behavior of individual decision-making units and individual markets
behavior of individual viewed in isolation. We examined how an individual maximizes satisfaction subject to his or
decision-making units
her income constraint (Part Two, Chapters 3—6), how a firm minimizes its costs of produc-
and individual markets,
tion (Part Three, Chapters 7-9) and maximizes profits under various market structures (Part
viewed in isolation.
Four, Chapters 10-13), and how the price and employment of each type of input is deter-
mined (Part Five, Chapters 14-16). In doing so, we have abstracted from all the intercon-
nections that exist between the market under study and the rest of the economy (the ceteris
paribus assumption). In short, we have shown how demand and supply in each market deter-
mine the equilibrium price and quantity in that market independent of other markets.
However, a change in any market has spillover effects on other markets, and the
change in these other markets will, in turn, have repercussions or feedback effects on the
General equilibrium original market. These effects are studied by general equilibrium analysis. That is, gen-
analysis Studies the eral equilibrium analysis studies the interdependence or interconnections that exist
interdependence that among all markets and prices in the economy and attempts to give a complete, explicit, and
exists among all
simultaneous answer to the questions of what, how, and for whom to produce. In terms of
markets in the
economy.
Section 1.3 (examining the circular flow of economic activity), general equilibrium analy-
sis examines simultaneously the links among all commodity and input markets, rather than
Interdependence The studying each market in isolation.
relationship among all For example, a change in the demand and price for new, domestically produced auto-
markets in the economy mobiles will immediately affect the demand and price of steel, glass, and rubber (the inputs
such that a change in
of automobiles), as well as the demand, wages, and income of auto workers and of the work-
any of them affects all
the others.
ers in these other industries. The demand and price of gasoline and of public transportation
(as well as the wages and income of workers in these industries) are also affected. These
affected industries have spillover effects on still other industries, until the entire economic
system is more or less involved, and all prices and quantities are affected. This is like throw-
ing a rock in a pond and examining the ripples emanating in every direction until the stabil-
ity of the entire pond is affected. The size of the ripples declines as they move farther and
farther away from the point of impact. Similarly, industries further removed or less related
to the automobile industry are less affected than more closely related industries.
What is important is that the effect that a change in the automobile industry has on
the rest of the economy will have repercussions (through changes in relative prices and
incomes) on the automobile industry itself. This is like the return or feedback effect of the
ripples in the pond after reaching the shores. These repercussions or feedback effects
are
likely to significantly modify the original partial equilibrium conclusions (price
and out-
put) reached by analyzing the automobile industry in isolation (see Example 17-1).
When (as in the automobile example) the repercussions or feedback effects
from the
other industries are significant, partial equilibrium analysis is inappropriate.
By measuring
only the impact effect on price and output, partial equilibrium analysis
provides a misleading
 CHAPTER 17 General Equilibrium and Welfare Economics 553

measure of the total, final effect after all the repercussions or feedback effects from the ori g-
inal change have occurred. On the other hand, if the industry in which the original change
occurs 1s small and the industry has few direct links with the rest of the economy (for exam-
ple, the U.S. wristwatch industry), then partial equilibrium analysis provides a good first
approximation to the results sought.
The logical question is why not use general equilibrium analysis all the time and
Concept Check immediately obtain the total, direct, and indirect results of a change on the industry (in
What is the meaning of which the change originated) as well as on all the other industries and markets in the econ-
partial equilibrium omy? The answer is that general equilibrium analysis, dealing with each and all industries
analysis? When is it in the economy at the same time, is by its very nature difficult, time consuming, and expen-
appropriate?
sive. Happily for the practical economist, partial equilibrium analysis often suffices. In any
event, partial equilibrium analysis represents the appropriate point of departure, both for
the relaxation of more and more of the ceteris paribus or “other things equal” assumptions,
and for the inclusion of more and more industries in the analysis, as required.
The first and simplest general equilibrium model was introduced in 1874 by the great
French economist, Léon Walras.' This model and subsequent general equilibrium models
are necessarily mathematical in nature and include one equation for each commodity and
input demanded and supplied in the economy, as well as market clearing equations.7
More recently, economists have extended and refined the general equilibrium model the-
oretically and proved that under perfect competition, a general equilibrium solution of the
model usually exists with all markets simultaneously in equilibrium.*

EXAMPLE 17-1
Effect of a Reduction in Demand for Domestically Produced Automobiles
in the United States

With the sharp increase in the price of imported petroleum from 1973 to 1980, the
demand for new, large domestically produced automobiles declined, as from D to D’ in
panel (a) of Figure 17.1, while the demand for small fuel-efficient, foreign-produced
automobiles increased. This reduced the real (i.e., the inflation-adjusted) price and
quantity of domestically produced automobiles, as from P to P’ and from Q to Q’,
respectively, in panel (a). This impact effect is what partial equilibrium analysis mea-
sures. However, the reduction in the demand for the domestically produced automobiles
had spillover effects that disturbed the equilibrium in the steel [panel (b)] industry and
other industries that supply inputs to the domestic automobile industry, as well as in the
petroleum industry [panel (c)]. The inflation-adjusted price and quantity of steel and
other inputs fell, and part of the original increase in the price of gasoline was neutral-
ized. Other industries related to these industries were also affected.
But this is not the end of the story. The demand for workers in the automobile
industry [panel (d)] and other affected industries fell, and so did real wages, employ-
ment, and incomes. The fall in real incomes reduced the demand, price, and quantity of
steaks [panel (e)] and other normal goods purchased. To be sure, the demand for public

!L. Walras, Elements of Pure Economics, translated by William Jaffé (Homewood, IL: Irwin, 1954).
2 See Section A.16 of the Mathematical Appendix at the end of the text.
3 kK. J. Arrow and G. Debreu, “Existence of an Equilibrium for a Competitive Economy,” Econometrica,
July 1954, pp. 265-290; and L. W. McKenzie, “On the Existence of General Equilibrium for a Competitive
Market,” Econometrica, January 1959, pp. 54-71.
554 PART SIX General Equilibrium, Efficiency, and Public Goods

Price ($) Price ($) %

Price ($)

S
P ta ca te P eee Ye

[Pa == p’ pa ee
Pp’ hake ne ot | |

| ONS
els | | 1D
ddl cas tec —
0 Q’ Q Quantity 0 Q’Q Quantity 0 Q’ Q Quantty
(a) New automobiles: (b) Steel (c) Gasoline
Impact effect

Wage ($) Price ($) Price ($)

W iS ---- = ee bea ia PeN—S---

P' wae es
iB One, ae ao |
pt ee ea,

a Imo ig pe

“4 sade Z D
dies
ee
esses
ad?
[est
: a
0 Q’ Q Quantity 0 Q’ Q Quantity 0 Q"Q’ Q Quantity
(d) Autoworkers (e) Steaks (£) New automobiles:
General equilibrium
implications
FIGURE 17.1 General Equilibrium Implications of a Reduction in the Demand for New Domestically
Produced Automobiles The impact or partial equilibrium effect of a reduction in the demand for new
domestically produced automobiles is to reduce price from P to P’ and quantity from Q to Q’ [panel (a)]. This
reduces the demand for (and price and quantity of) steel [panel (b)] and gasoline [panel (c)], and the demand
for (and wages and employment of) workers in the automobile [panel (d)] and other affected industries. This,
in turn, has spillover effects on the market for steaks [panel (e)] and other commodities, and feedback effects
onthe domestic automobile industry itself [panel (f)].

transportation (buses, trains, and drivers and other attendants) and cheaper substitutes
for steaks increased, but the net effect of the reduction in the demand for domestically
produced cars was to reduce the demand and real income of labor. This, in turn, had
feedback effects on the automobile industry, further reducing the demand, the inflation-
adjusted price, and the output of domestically produced automobiles [panel (f)]. The
same process continued throughout the 1980s and 1990s (long after the petroleum crisis
ended), as Japanese automobile exports to and production in the United States displaced
more and more domestic production by the big three U.S. automakers.
Panel (f) of Figure 17.1 shows that the feedback effects on the domestic automobile
industry were significant. The inflation-adjusted price fell from P to P” rather than to P’,
and quantity fell from Q to Q” instead of falling only to Q’. Thus, partial equilibrium
alysis gives only a rough first approximation to the final solution. Note that a first round
 CHAPTER 17 General Equilibrium and Welfare Economics aSo

of spillover and feedback effects (as shown in the above analysis) can be measured by the
cross and income elasticities (see Sections 5.3 and 5.4), but these only carry us part of the
way. The complete, final effects on the domestic automobile industry and on all other
industries can only be measured through full-fledged general equilibrium analysis. This
is necessarily mathematical in nature—words and graphs simply fail us.
Sources: “U.S. Giving Up on Making Small Cars,” U.S. News and Worm Report, December 19, 1983,
p. 56; “Auto Industry in U.S. Is Sliding Relentlessly into Japanese Hands,” Wall Street Journal, February
16, 1990, p. Al; “Detroit Takes the Offensive,” Forbes, September 28, 1992, pp. 108-112; “American
Auto Makers Try to Redefine Their Brands,” Wall Street Journal, October 30, 1995, p. B1; “Detroit Fights
Back,” Forbes, September 17, 2001, pp. 76-78.; and “Big Three Face New Obstacles in Restructuring,”
Wall Street Journal, January 26, 2007, p. Al.

v7 2 GENERAL EQUILIBRIUM OF EXCHANGE AND PRODUCTION

In this section, we examine separately general equilibrium of exchange and of produc-

tion, and we derive the production-possibilities frontier. In the next section, we examine
how both equilibria are achieved simultaneously and the conditions for maximum eco-
nomic efficiency.

General Equilibrium of Exchange

Let us begin by examining general equilibrium of exchange for a very simple economy
composed of only two individuals (A and B), two commodities (X and Y), and no pro-
duction. This allows us to present the general equilibrium of exchange graphically.*
The general equilibrium of exchange for this simple economy of two individuals, two
commodities, and no production was presented earlier in Section 4.5. That analysis is
now summarized and extended, and it will be used throughout the rest of the chapter.
Edgeworth box The Edgeworth box diagram for exchange of Figure 17.2 is that of Figure 4.8,
diagram for exchange except that the indifference curves of individual A, convex to origin Oa, are given by Aj,
A diagram constructed A», and A3 (rather than by U;, U2, and U3 as in Figure 4.8) and the indifference curves of
from the indifference
individual B, convex to origin Og, are given by B,, Bo, and B; (rather than by U;, U3, and
curves diagram of two
U;). The dimensions of the box are given by the total amount of the two commodities
individuals, which can
be used to analyze (10X and 8Y) owned by the two individuals together.° Any point inside the box indicates
voluntary exchange. how the total amount of the two commodities is distributed between the two individuals.
For example, point C indicates that individual A has 3X and 6Y, while individual B has 7X
and 2Y, for the combined total of 10X and 8Y (the dimensions of the box).
Suppose that point C does in fact represent the original distribution of commodities X
and Y between individuals A and B. Since at point C, indifference curves A, and B; inter-
sect, their slope or marginal rate of substitution of commodity X for commodity Y (MRSyxy)
differs. Starting at point C, individual A is willing to give up 4Y to get one additional unit of

+ However, the analysis can be generalized mathematically to more than two individuals and more than two
commodities. The graphic presentation in the text follows the well-known article by F. M. Bator, “The Simple
Analytics of Welfare Maximization,” American Economic Review, March 1957, pp. 22-59.
5 As explained in Section 4.5, the Edgeworth box was obtained by rotating individual B’s indifference curves
diagram by 180 degrees (so that origin Og appears in the top right-hand corner) and superimposing it on
individual A’s indifference curves diagram (with origin at 0,) in such a way that the size of the box refers to
the combined amount of the X and Y owned by the two individuals together.
556 PART SIX General Equilibrium, Efficiency, and Public Goods

(Individual B)

Y
Commodity

(Individual A) Commodity X
FIGURE 17.2 Edgeworth Box Diagram for Exchange A point such as C indicates that
individual A had 3X and 6Y (viewed from origin Og), while individual B has 7X and 2Y (viewed from
origin Og) for a total of I]OX and 8Y (the dimensions of the box). A's indifference curves (A;, A>, and
A3) are convex to Oa, while B’s indifference curves (B,, Bz, and B3) are convex to Og. Starting from
point C where A, and B; intersect, individuals A and B can reach points on DEF, where one or both
individuals gain. Curve OaDEFOg is the contract curve for exchange. It is the locus of tangencies of the
indifference curves (at which the MRSyy are equal) for the two individuals and the economy is in
general equilibrium of exchange.

X (and move to point D on A), while individual B is willing to accept 0.2Y in exchange for
one unit of X(and move to point H on B)).° Because A is willing to give up much more Y
than necessary to induce B to give up LX, there is a basis for exchange that will benefit
either or both individuals. This is true whenever, as at point C, the MRSyy for the two indi-
viduals differs.
For example, starting from point C, if individual A exchanges 4Y for 1X with indi-
vidual B, A moves from point C to point D along indifference curve Aj, while B moves
from point C on B; to point D on B3. Thus, individual B receives all of the gains from
exchange while individual A gains or loses nothing (since A remains on A)). At point D,
A, and B; are tangent, so that their slopes (MRSyy) are equal, and there is no further basis
for exchange.’
Alternatively, if individual A exchanged 1Y for 5X with individual B, individual A
would move from point C on A; to point F on A3, while individual B would move from
point C to point F along By. Then, A would reap all of the benefits from exchange while B

® That is, MRSyy = 4 for A, and MRSyy = 0.2 for B.

” At point D, the amount of Y that A is willing to give up for LX is exactly equal to what B requires to
give up LX.
Any further exchange would make either individual worse off than he or she is at point D.
 CHAPTER 17 General Equilibrium and Welfare Economics Dil

would neither gain nor lose. At point F, MRSyy for A equals MRSyy for B and there is no
further basis for exchange. Finally, if Aexchanges 3Y for 3X with B and gets to point E,
both individuals gain from exchange since point E is on Ay and B>. Thus, starting from
point C, which is not on line DEF, both individuals can gain through exchange by getting
to a point on line DEF between D and F. The greater A’s bargaining strength, the closer the
final equilibrium point of exchange will be to point F, and the greater will be the propor-
tion of the total gains from exchange going to individual A (so that less will be left over for
individual B).
Contract curve for Curve 0,DEFOg is the contract curve for exchange. It is the locus of tangency
exchange The locus of points of the indifference curves of the two individuals.* That is, along the contract curve
tangency points of the
for exchange, the marginal rate of substitution of commodity X for commodity Y is the
indifference curves for
two individuals when
same for individuals A and B, and the economy is in general equilibrium of exchange.
the economy is in Thus, for equilibrium,
general equilibrium of
exchange. MRS}y = MRS8,y [17a]

Starting from any point not on the contract curve, both individuals can gain from exchange
Concept Check by getting to a point on the contract curve. Once on the contract curve, one of the two indi-
How is the consumption viduals cannot be made better off without making the other worse off. For example, a move-
contract curve derived? ment from point D (on A; and B3) to point E (on Az and B2) makes individual A better off
but individual B worse off. Thus, the consumption contract curve is the locus of general
equilibrium of exchange. For an economy composed of many consumers and many com-
modities, the general equilibrium of exchange occurs where the marginal rate of substitu-
tion between every pair of commodities is the same for all consumers consuming both
commodities.

General Equilibrium of Production

Now that we have examined general equilibrium in a pure exchange economy with no
production, we turn to general equilibrium of production in a simple economy in which
no exchange takes place.
To examine general equilibrium of production, we deal with a very simple economy
that produces only two commodities (X and Y) with only two inputs, labor (L) and capital
(K). We construct an Edgeworth box diagram for production from the isoquants for com-
modities X and Y in a manner completely analogous to the Edgeworth box diagram for
exchange of Figure 17.2. This is shown in Figure 17.3.
Edgeworth box The Edgeworth box diagram for production shown in Figure 17.3 was obtained
diagram for production by rotating the isoquant diagram for commodity Y by 180 degrees (so that origin Oy
A diagram constructed appears in the top right-hand corner) and superimposing it on the isoquant diagram for
from the isoquants
commodity X (with origin Ox) in such a way that the size of the box refers to the total
diagram of two
amount of L and K available to the economy (12L and 10K).Any point inside the box
commodities, which can
be used to analyze indicates how the total amount of the two inputs is utilized in the production of the two
general equilibrium of commodities. For example, point R indicates that 3L and 8K are used in the production
production. of X, of commodity X, and the remaining 9L and 2K are used to produce Y, of Y. Three
of X’s isoquants (convex to origin Ox) are X), X2, and X3. Three of Y’s isoquants (con-
vex to origin Oy) are Yj, Y2, and Y3.

8 Such tangency points are assured because indifference curves are convex and the field is dense (i.e., there is
an infinite number of indifference curves).
558 PART SIX General Equilibrium, Efficiency, and Public Goods

(Commodity Y)
Oy
Wl
10 |

]
K
wi
2
8
3
a
4
6) |=

5
5
6
a \-
7
= le
g
§ 25 8

Mis 9
xy
| 10
Ox |
(Commodity X) Labor (2) ———

FIGURE 17.3 Edgeworth Box Diagram for Production A point such as R indicates that 3L and 8K (viewed from origin
Oy) are used to produce X; of commodity X, and the remaining 9L and 2K (viewed from origin Oy) are used to produce
Y, of Y. The isoquants for X (X7, X2, and X3) are convex to Oy, while the isoquants of Y (Yj, Yo, and Y3) are convex to
Oy. Starting from point R, where X; and Y intersect, the economy can produce more of X, more of Y, or more of both
by moving to a point on JMN. Curve Ox JMNOy is the contract curve for production. It is the locus of tangencies of the
isoquants (at which the MRTS;« are equal) for both commodities, and the economy Is in general equilibrium of production.

If this economy was initially at point R, it would not be maximizing its output of
commodities X and Y because, at point R, the marginal rate of technical substitution of
labor for capital (MRTS_,x) in the production of X (the avsolute slope of X;) exceeds the
MRTS_x in the production of Y (the absolute slope of Y;).? By simply transferring 6K
from the production of X to the production of Y and 1L from the production of Y to the
production of X, the economy can move from point R (on X; and Y;) to point J (on X; and
Y3) and increase its output of Y without reducing its output of X.
Alternatively, this economy can move from point R to point N (and increase its out-
put ofX from Xj to X3 without reducing its output of Y;) by transferring 2K from the pro-
duction of X to the production of Y and 6L from Y to X. Or, by transferring 4K from the
production ofX to the production of Y and 4L from Y to X, this economy can move from
point R (on X, and Y;) to point M (on X> and Y>), and increase its output of both X and Y.
At points J, M, and N, an X isoquant is tangent to a Y isoquant so that the MRTS_x in the
production of X equals MRTS,x in the production of Y.

” Review, if necessary, the definition and measurement of the marginal rate of technical substitution
in Section 7.4.
 CHAPTER 17 General Equilibrium and Welfare Economics 559

Contract curve for Curve 0x;JMNOy is the contract curve for production. It is the locus of tangency
production The locus points of the isoquants for X and Y at which the marginal rate of technical substitution of
of tangency points of
labor for capital is the same in the production ofX and Y. That is, the economy is in gen-
the isoquants for two
commodities when the
eral equilibrium of production when
economy is in general
equilibrium of MRIS, , = MRIS: ¢ [17.2]
production.
Thus, by simply transferring some of the given and fixed amounts of available L and K
between the production of X and Y, this economy can move from a point not on the con-
tract curve for production to a point on the curve and increase its output of either or both
commodities. Once on its production contract curve, the economy can only increase the
output of either commodity by reducing the output of the other. For example, by moving
from point J (on X; and Y3) to point M (on X> and Y>), the economy increases its output
Concept Check
of commodity X (by transferring 3L and 2K from the production of Y to the production
How can two firms gain
by moving from a point of X), but its output of commodity Y falls. For an economy of many commodities and
off the production many inputs, the general equilibrium of production occurs where the marginal rate of
contract curve to a technical substitution between any pair of inputs is the same for all commodities and
point on it? producers using both inputs.

Derivation of the Production-Possibilities Frontier

From the production contract curve, we can derive the corresponding production-possibili-
ties frontier or transformation curve by simply plotting the various combinations of out-
puts directly. For example, if isoquant X, in Figure 17.3 referred to an output of 4 units of
commodity X and isoquant Y3 referred to an output of 13 units of commodity Y, we can
go from point J (X;, Y3) in Figure 17.3 to point J’ (4X, 13Y) in Figure 17.4. Similarly, if
isoquant X> referred to an output of 10X and isoquant Y> to an output of 8Y, we can go
from point M (X), Y2) in Figure 17.3 to point M’ (10X, 8Y) in Figure 17.4. Finally, if X3 =
12X and Y, = 4Y, we can plot point N (X3, Y,) from Figure 17.3 as point N’ (12X, 4Y) in
Figure 17.4. By joining points J’M’N’ and other points similarly obtained, we derive
the production-possibilities frontier or transformation curve of X for Y, TT, shown in
Figure 17.4. Thus, the production-possibilities frontier is obtained by simply mapping or
transferring the production contract curve from input space to output space.
Production- The production-possibilities frontier or transformation curve shows the various
possibilities frontier combinations of commodities X and Y that the economy can produce by fully utilizing all
Shows the alternative of the fixed amounts of labor and capital with the best technology available. Since the pro-
combinations of
duction contract curve shows all points of general equilibrium of production, so does the
commodities that a
production-possibilities frontier. That is, the production-possibilities frontier shows the
nation can produce
by fully utilizing all of
maximum amount of either commodity that the economy can produce, given the amount
its resources with the of the other commodity that the economy is producing. For example, given that the econ-
best technology omy is producing 10X, the maximum amount of commodity Ythat the economy can pro-
available to it. duce is 8Y (point M’ in Figure 17.4), and vice versa.
A point inside the production-possibilities frontier corresponds to a point off the pro-
duction contract curve and indicates that the economy is not in general equilibrium of pro-
duction, and it is not utilizing its inputs of labor and capital most efficiently. For example,
point R’, inside production-possibilities frontier 7T in Figure 17.4, corresponds to point R
in Figure 17.3, at which isoquant X; and Y; intersect. By simply reallocating some of the
fixed labor and capital available between the production of X and Y, this economy can
increase its output of Y only (and move from point R’ to point J’ in Figure 17.4), it can
560 PART SIX General Equilibrium, Efficiency, and Public Goods

iano 4 6 ee een
FIGURE 17.4 Production-Possibilities Frontier The
production-possibilities frontier or transformation curve
TT is derived by mapping the production contract curve of
Figure 17.3 from input to output space. Starting from point A’,
the economy could increase its output of X (point N’), of Y
(point J’), or of both X and Y (point M7’). The absolute slope
or MRTxy = 3/2 at point M’ means that 3/2 of Y must be
given up to produce one additional unit of X. MRTyy increases
as we move down the frontier Thus, at point NV’, MRTyy = 3.

increase the output of X only (and move from point R’ to point N’), or it can increase its
Concept Check output of both X and Y (the movement from point R’ to point M’). On the other hand, a
How is the production- point outside the production-possibilities frontier cannot be achieved with the available
possibilities frontier inputs and technology.
derived? Once on the production-possibilities frontier, the output of either commodity can be
increased only by reducing the output of the other. For example, starting at point J’ (4X and
13Y) on the production-possibilities frontier in Figure 17.4, the economy can move to point
M’ and produce 10X only by reducing the amount produced of Y by 5 units (i.e., to 8Y).
The amount of commodity Y that the economy must give up, at a particular point on the
production-possibilities frontier, so as to release just enough labor and capital to produce
Marginal rate of one additional unit of commodity X, is called the marginal rate of transformation of
transformation of X X for Y (MRTyy). This is given by the absolute value of the slope of the production-
for Y (MRTyy) The possibilities frontier at that point. For example, at point M’ on production-possibilities
amount of Y that must
frontier TT in Figure 17.4, MRTyy = 3/2 (the absolute value of the slope of the tangent to
be given up to release
just enough labor and the production-possibilities frontier at point M’).
capital to produce one The marginal rate of transformation of X for Y is also equal to the ratio of the mar-
additional unit of X. ginal cost of X to the marginal cost of Y. That is, MRTxy = MCy/MCy. For example,
at point M’, MRTxy = 3/2. This means that 3/2 of Y must be given up to produce one
additional unit of X. Thus, MCy = 3/2 MCy, and MRTyy = 3/2. Another way of looking
at this is that if MCy = $10 and MCy = $15, this means that to produce one additional unit
of X requires 1.5 or 3/2 more units of labor and capital than to produce one additional unit
 CHAPTER 17 General Equilibrium and Welfare Economics 561

of Y, so that 3/2 of Y must be given up to produce one additional unit of X. This is exactly
what the MRTyy measures. Thus, at point M’, MRTyy = MGy
LM Cy 13/2)
As we move down the production-possibilities frontier (and produce more X and
less Y), the MRTyy increases, indicating that more and more Y must be given up to produce
each additional unit of X. For example, at point N’, the MRTyy or absolute value of the
slope of the production-possibilities frontier is 3 (up from 3/2 at point M’). The reason for
this is that, as the economy reduces its output of Y (in order to produce more of X), it
releases labor and capital in combinations that become less and less suited for the produc-
tion of more X. Thus, the economy incurs increasing MCy in terms of Y. It is because of
this imperfect input substitutability between the production of X and Y (and rising MCy in
terms of Y) that the production-possibilities frontier is concave to the origin.!°

GENERAL EQUILIBRIUM OF PRODUCTION AND EXCHANGE

17.3 AND Pareto OPTIMALITY

In this section, we examine general equilibrium of production and exchange and define
the concept of Pareto optimality, which summarizes the marginal conditions for economic
efficiency.

Simultaneous General Equilibrium of Production and Exchange

We now can use the production-possibilities frontier and the contract curve for exchange
to examine how our very simple economy composed of two individuals (A and B), two
commodities (X and Y), and two inputs (Z and K) can reach simultaneous general equi-
librium of production and exchange. This equilibrium is shown in Figure 17.5.
The production-possibilities frontier of Figure 17.5 is that of Figure 17.4, which was
derived from the production contract curve of Figure 17.3. Thus, every point on produc-
tion-possibilities frontier 77 is a point of general equilibrium of production. Suppose that
this economy produces 10X and 8Y, given by point M’ on production-possibilities fron-
tier TT in Figure 17.5.'! By dropping perpendiculars from point M’ to both axes, we can
construct in Figure 17.5 the Edgeworth box diagram for exchange between individuals A
and B of Figure 17.2. Note that the top right-hand corner of the Edgeworth box diagram
for exchange of Figure 17.2 coincides with point M’ on production-possibilities frontier
TT in Figure 17.5. Given the indifference curves of individuals A and B and the output of
10X and 8Y, we derived contract curve 0,DEFOg for exchange in Figure 17.2. This curve is
reproduced in Figure 17.5. Every point on the contract curve for exchange in Figure 17.5
is a point of general equilibrium of exchange.
Thus, every point on production-possibilities frontier 77 in Figure 17.5 is a point of
general equilibrium of production, and every point on the contract curve for exchange is
a point of general equilibrium of exchange. However, to be simultaneously in general
equilibrium of production and exchange, the marginal rate of transformation of commod-
ity X for commodity Y in production must be equal to the marginal rate of substitution of
commodity X for commodity Y in consumption for individuals A and B. That is,

MRTxy = MRS%, = MRS¥y [17.3]

10 Tf Jabor and capital were perfectly substitutable in the production of Xand Y, MCy would be constant in
terms of Y, and the production-possibilities frontier would be a negatively sloped straight line.
!! How this particular output level is determined is examined in Section 17.4.
562 PART SIX General Equilibrium, Efficiency, and Public Goods

|
0 2 4 6 8 10 12 14 X
(04)
FIGURE 17.5 General Equilibrium of Production and Exchange — Production-possibilities
frontier TT is that of Figure 17.4. Every point on 7T is a point of general equilibrium of production.
Starting from point M7’ (10x, 8Y) on the production-possibilities frontier, we constructed in
Figure 17.4 the Edgeworth box diagram for exchange between individuals A and B shown
in Figure 17.2. Every point on contract curve O,DEFOg |s a point of general equilibrium of
exchange. Simultaneous general equilibrium of production and exchange is at point £, at
which MRTxy = MRSby= MRSBy= 3/2.

Geometrically, this equation corresponds to the point on the contract curve for exchange
Concept Check at which the common slope of an indifference curve of individual A and individual B
What are the conditions equals the slope of production-possibilities frontier TT at the point of production. In
for simultaneous Figure 17.5, this occurs at point E, where
general equilibrium in
production and
exchange ?
MRS, = MRS8y = MRTxy = 3/2 ee
Thus, when producing 10X and 8Y (point M’ on production-possibilities frontier TT), this
economy is simultaneously in general equilibrium of production and exchange when indi-
vidual A consumes 6X and 3Y (point E on his or her indifference curve A2) and individual
B consumes the remaining 4X and 5Y (point E on his or her indifference curve Bp).
If condition [17.3] did not hold, the economy would not be simultaneously in general
equilibrium of production and exchange. For example, suppose that individuals A and B
consumed at point D on the contract curve for exchange rather than at point FE in
 CHAPTER 17 General Equilibrium and Welfare Economics 563

Figure 17.5. At point D, the MRSyy (the common absolute value of the slope of indiffer-
ence curves A, and B3) is 3. This means that individuals A and B are willing (indifferent)
to give up 3¥Y to obtain one additional unit of X. Since in production only 3/2 Y needs to
be given up to produce an additional unit of X, society would have to produce more of X
and less of Y to be simultaneously in general equilibrium of production and exchange.
That is, if MRSyy = 3, this society would not have chosen to produce at point M’, but
would have produced at point N’ (12X and 4Y), where MRSyy = MRTyy = 3.
The opposite is true at point F. That is, at point F, MRSyy = 1/2. Since MRTyy = 3/2
at point M’ (the point of production), more of Y needs to be given up in production to
obtain one additional unit of X than individuals A and B are willing to give up in con-
sumption. If this were the case, this society would have chosen to produce at point J’ (4X
and 13Y) where MRSyy = MRTyy = 1/2, rather than at point M’. Only by consuming at
point E will MRTyy = MRSyy for both individuals, and society will be simultaneously in
general equilibrium of production and exchange when it produces at point M’.
We conclude the following about this simple economy when it is in general equilib-
rium of production and exchange: (1) it produces 10X and 8Y (point M’ in Figure 17.5);!?
(2) individual A receives 6X and 3Y, and individual B receives the remaining 4X and SY
(point E in Figure 17.5); (3) to produce 10X, 7L and 4K are used, while to produce 8Y, the
remaining 5L and 6K are used (see point M in Figure 17.3)."°

_ Marginal Conditions for Economic Efficiency and Pareto Optimality

Economic efficiency With general equilibrium of production and exchange, economic efficiency is maximum
The situation in which and we have Pareto optimality.'* According to this concept, a distribution of inputs among
the marginal rate of commodities and of commodities among consumers is Pareto optimal or efficient if no
transformation in
reorganization of production and consumption is possible by which some individuals are
production equals the
made better off (in their own judgment) without making someone else worse off: Any change
marginal rate of
substitution in that improves the well-being of some individuals without reducing the well-being of others
consumption. clearly improves the welfare of society as a whole and should be undertaken. This will move
society from a Pareto nonoptimal position to Pareto optimum. Once at Pareto optimum, no
Pareto optimum The reorganization of production and exchange is possible that makes someone better off with-
situation in which no out, at the same time, making someone else worse off. To evaluate such changes requires
reorganization of interpersonal comparisons of utility, which are subjective and controversial.
production or In a very simple economy of two individuals, two commodities (X and Y), and no
consumption can lead
production, the contract curve for exchange (along which the MRSxy is the same for both
to an increase in the
welfare of some individuals) is the locus of Pareto optimum in exchange and consumption. As we have
without at the same seen in Section 17.2, a movement from a point off the contract curve to a point on it
time reducing the improves the condition of either or both individuals, with the given quantities of the two
welfare of others. commodities. Once on the contract curve, the economy is in general equilibrium or Pareto
optimum in exchange, in the sense that either individual can be made better off only by
making the other worse off. In an economy of many individuals and many commodities,
Pareto optimum in exchange requires that the marginal rate of substitution between any
pair of commodities be the same for all individuals consuming both commodities.

!2 As pointed out in footnote 11, we will see how this level of output is determined in Section 17.4.
13 In Section 17.4, we will also determine the relative price of commodity X (i.e., Py /Py) and the relative
price oflabor time (i.e., P, / Px or w/r) for this simple economy when it is simultaneously in general
equilibrium of production and exchange.
14 Vilfredo Pareto was the great Italian economist of the turn of the century who, in 1909, expressed the
condition for maximum economic efficiency, which became known as Pareto optimality. See V. Pareto,
Manual ofPolitical Economy, translated by William Jaffé (New York: August Kelly, 1971).
564 PART SIX General Equilibrium, Efficiency, and Public Goods

In a very simple economy of two commodities, two inputs (L and K), and no
Concept Check exchange, the production contract curve (along which the MRTS;x is the same for both
What is the relationship commodities) is the locus of Pareto optimum in production. As we have seen in Section: ,
between Pareto 17.2, a movement from a point off the production contract curve to a point on it makes it
optimality and possible for the economy to produce more of either or both commodities, with the given
economic efficiency?
inputs and technology. Once on the production contract curve, the economy is in general
equilibrium or Pareto optimum in production in the sense that the economy can increase
the output of either commodity only by reducing the output of the other. In an economy
of many commodities and many inputs, Pareto optimum in production requires that the
marginal rate of technical substitution between any pair of inputs be the same for all
commodities and producers using both inputs.
Finally, Pareto optimum in production and exchange simultaneously in an economy
of many inputs, many commodities, and many individuals requires that the marginal rate
of transformation in production equals the marginal rate of substitution in consumption
for every pair of commodities and for every pair of individuals consuming both com-
modities. In the case of a very simple economy composed of only two commodities and
two individuals (A and B), Pareto optimality in production and consumption requires that

MRTxy = MRSSy = MRS8,

This was shown graphically in Figure 17.5 by the point on the contract curve
for exchange at which the common slope of an indifference curve of individual A and
individual B is equal to the slope of the production frontier at the point of production.

ES EE RE AS Let EFomegs :
FIGURE 17.6 Efficiency in Production and Exchange in a “Robinso
n
Crusoe” Economy Ina single-person economy, economic efficiency in
production and exchange (and maximum social welfare) is achieved
at
point /7°, at which indifference curve A> for individual A (the
only individual
iN society) is tangent to his or her production-possibilities frontier,
7’ T’.
Output is 6X and 3Y, and MRTyy = MRSxy = 3/2.
 CHAPTER 17 General Equilibrium and Welfare Economics 565

If we assume that there is only one individual (a Robinson Crusoe) in society, we

achieve considerable graphic simplification in showing the point of economic efficiency
in production and consumption.'? This is given by point M* in Figure 17.6, at which indif-
ference curve A> for individual A (the only individual in society) is tangent to his or her
production-possibilities frontier, T’T’. Any point on T’T’ represents a point of efficient
production. Given T’T’, Ao is the highest indifference curve that the individual can reach
with his or her production-possibilities frontier. At point M* (the tangency point of A> to
T'T’), output is 6X and 3Y, and MRTyy = MRSyy = 3/2. Production and consumption
are economically efficient, and society (the individual) maximizes welfare.

17.4 PERFECT COMPETITION, ECONOMIC EFFICIENCY, AND EQUITY

In this section we show why perfect competition leads to economic efficiency or Pareto
optimum, but not necessarily to equity.

Perfect Competition and Economic Efficiency

With perfect competition in all input and commodity markets, the three marginal condi-
tions for economic efficiency or Pareto optimum in production and exchange
(Section 17.3) are automatically satisfied. This is the basic argument for perfect competi-
_ tion. We can easily prove that perfect competition leads to economic efficiency.
We have seen in Section 3.5 that a consumer maximizes utility or satisfaction when
he or she reaches the highest indifference curve possible with his or her budget line. This
occurs where an indifference curve is tangent to the budget line. At the tangency point, the
slope of the indifference curve (the MRSyy) is equal to the slope of the budget line
(Px/Py). Since Py and Py, and thus Px/Py, are the same for all consumers under perfect
competition, the MRSyy is also the same for all consumers consuming both commodities.
This is the first marginal condition for economic efficiency or Pareto optimum in
exchange. We can now also establish that for the simple economy examined in Section
17.3, Px/Py = 3/2 (the absolute value of the slope of the common tangent to indifference
curves A> and B; at point F in Figure 17.5).
We have also seen in Section 8.3 that efficiency in production requires that the MRTS;x
(the absolute value of the slope of an isoquant) be equal to P;/Px or w/r (the ratio of the
input prices given by the absolute value of the slope of the isocost line). Since P; or w and
Pxorr, and thus P,/Px or w/r, are the same for all producers under perfect competition, the
MRTS_x is also the same for all producers using both inputs. This is the second marginal
condition for economic efficiency or Pareto optimum in production. We can now also estab-
lish that for the simple economy examined in Section 17.3, P,/Px or w/r=2/3 (the
absolute value of the common tangent to isoquants X> and Y> at point M in Figure 17.3).!°

'6 Note that in microeconomic theory, we are only concerned with relative, not absolute, input and commodity
prices. This means that proportionate changes in (e.g., doubling or halving) all input prices and/or all
commodity prices do not change the solution to the general equilibrium model. If we want to get unique
absolute (dollar) values for Py, Py, Px (or w), and Px (or r), we would have to add a monetary equation, such
as Fisher’s “equation of exchange” to our model. This is done in a course in macroeconomic theory but is not
needed in microeconomics.
'5 Since in this very special case there is no problem of interpersonal comparison of utility, the point of maximum
economic efficiency in production and consumption also represents the point of maximum social welfare.
566 PART SIX General Equilibrium, Efficiency, and Public Goods

in Section 9.3
Finally, we have seen in Section 17.3 that MRTyy = MCx/MCy, and
MCy = Px and MCy = Py. Therefore,
that perfectly competitive firms produce where
also seen above that under perfect competi-
MCx/MCy = Px/Py = MRTxy. Since we have
g both commodit ies, we conclude that
tion MRTyy = Px/Py for all consumers consumin
MRT yy = MRSvyy for all consumers consuming both commodit ies. This is the third marginal
condition for economic efficiency and Pareto optimum in production and exchange. Thus,
when the simple economy examined in Section 17.3 produces 10X and 8Y (point M’ in
Figure 17.5), MRTxy= MRS oe MRS¥., = 3/2. Individual A should then consume 6X
and 3Y, and individual B should consume the remaining 4X and 5¥Y (point EF in Figure 17.5)
for the economy to be simultaneously at Pareto optimum in production and exchange. .
The output of 10X and 8Y at point M’ in Figure 17.5 is based on a particular distribu-
tion of inputs (income) between individuals A and B and on their tastes. A different distri-
bution of income and/or tastes for individuals A and B would lead to a different
combination of goods X and Y demanded. This would result in a different Py/Py, different
quantities of X and Y produced, and different levels of satisfaction for A and B. For exam-
ple, suppose that individuals A and B demanded 12X and 4Y (point N’ in Figure 17.5).
Then, general equilibrium of production and exchange or Pareto optimality requires that
MRT xy = Px/Py = MRS4, = MRS¥y = 3 (the absolute slope of TT at point N’). This
involves constructing an Edgeworth box diagram from point N’ and retracing all the steps
of the analysis in Section 17.3. In a purely exchange economy (i.e., one in which there is
no production), the equilibrium Px/Py is the one that exactly matches the desired quantity
ofX and Ythat each individual wants to exchange. If B wants more ofX for a given amount
of ¥ than A is willing to exchange, then Py/Py will rise until the demand for the quanti-
ties ofX and Y to be exchanged match. Similarly, if B wants less ofX for a given amount
of Y than A is willing to exchange, Px/Py will fall until equilibrium is reached.

Efficiency and Equity

The fact that perfect competition leads to optimum economic efficiency and Pareto optimum
in production and exchange is no small achievement. It proves Adam Smith’s famous law of
Law of the invisible
hand The law that the invisible hand stated more than 200 years ago. Smith’s law postulates that in a free mar-
postulates that in a free ket economy, each individual by pursuing his or her own selfish interests is led, as if by an
market economy, each invisible hand, to promote the well-being of society more than he or she intends or even
individual, by pursuing understands.'? This law leads to the first theorem of welfare economics, which postulates
his or her own selfish that an equilibrium produced by competitive markets exhausts all possible gains from
interests, also promotes exchange, or that equilibrium in competitive markets is Pareto optimal. There is also a see-
the welfare of society.
ond theorem of welfare economics. This postulates that when indifference curves are con-
First theorem of vex to their origin, every efficient allocation (every point on the contract curve for exchange)
welfare economics is a competitive equilibrium for some initial allocation of goods or distribution of inputs
Postulates that (income). The significance of the second welfare theorem is that the issue of equity in dis-
equilibrium in
tribution is logically separable from the issue of efficiency in allocation. This means that
competitive markets is
Pareto optimum.
whatever the redistribution of income that society wants would lead to the exhaustion of all
possible gains from exchange under perfect competition. Pareto optimality does not, there-
Second theorem of fore, imply equity. Society can use taxes and subsidies to achieve what it considers to be a
welfare economics more equitable distribution of income. These may discourage work, however, and show that
Postulates that equity in there is usually a trade-off between efficiency and equity (see Example 17—5).!8
distribution is logically
separable from
'7 See A. Smith, The Wealth of Nations (Toronto: Random House, 1937), Book TV,
efficiency in allocation. Chapter 2, p. 423; and
J. Persky, “Adam Smith’s Invisible Hand,” Journal of Economic Perspectives, fall 1989, pp.
195-201.
'S See A. Okun, Equality and Efficiency: The Big Tradeoff (Washington, DC: Brookings Institution,
1975),
We will return to questions of equity in Sections 17.6 and 17.7.
 CHAPTER 17 General Equilibrium and Welfare Economics 567

For economic efficiency and Pareto optimum to be reached, there should be no mar-
Market failures The ket failure. Market failures arise in the presence of imperfect competition, externalities,
existence of monopoly, and public goods. Externalities and public goods will be examined in the next chapter.
monopsony, price
Here, we examine why imperfect competition in the product and input markets leads to
controls, externalities,
and public goods that
economic inefficiency and Pareto nonoptimality.
prevent the attainment To show that imperfect competition in the product market leads to economic ineffi-
of economic efficiency ciency and Pareto nonoptimality, remember that in Part Four of the text it was shown that
or Pareto optimum. a profit-maximizing firm always produces where marginal revenue (MR) equals marginal
cost (MC). If commodity Y is produced in a perfectly competitive market, Py = MRy =
MCy. On the other hand, if commodity X is produced by a monopolist (or other imperfect
competitor), Py > MRy = MCy. Then,

MRT yy =
MCx _= MRx _
<<
Px
= MRSxy
MCy MRy Py

That is, MRTyy < MRSyy, so that the third condition for Pareto optimum and economic
efficiency (discussed in Section 17.3) is violated.
To show that imperfect competition in the input market leads to economic ineffi-
ciency and Pareto nonoptimality, remember that in Part Five of the text it was shown that
a profit-maximizing firm always produces where the marginal revenue product (MRP) of
each input equals the marginal resource cost (MRC) for the input. If P is the price of
the input, and the input market is perfectly competitive, MRP = MRC = P. Otherwise,
MRP = MRC > P. Now suppose that all markets in the economy are perfectly competi-
Concept Check tive, except that the firm producing commodity X is a monopsonist in its labor market
Why does imperfect (1.e., it is the sole employer of labor in its labor market). Therefore, MRP = MRC > P in
competition lead to the production of commodity X, while MRP = MRC = P in the production of Y. That is,
economic inefficiency? MRTS*, > MRTS*x, so that the first of the conditions for Pareto optimum and economic
efficiency (discussed in Section 17.4) is violated.
Finally, note that perfect competition leads to efficiency and Pareto optimum in pro-
duction and exchange at a particular point in time. Over time, tastes, the supply of inputs,
and technology change; what is most efficient at one point in time may not be most effi-
cient over time. In short, perfect competition leads to static, but not necessarily to
dynamic, efficiency. (This was discussed in Section 13.3.)

EXAMPLE 17-2
Watering Down Efficiency in the Pricing of Water

In some counties (Los Angeles, for example), the price of water is lower for irrigation
than for most other purposes. This reduces economic efficiency because the marginal rate
of technical substitution between water and other inputs differs in irrigation than in other
uses. For example, suppose that the price of 1,000 cubic feet of water when used for irri-
gation is equal to the daily wage of an unskilled worker, but when used to wash cars it
is twice the daily wage of the unskilled worker. So, a farmer will use water until the
marginal rate of technical substitution between water and labor is equal to 1, but a car-
washing firm will do so until MRTS = 2. Water and labor inputs are then utilized at a point
(such as R in Figure 17.3) at which the isoquants intersect off the production contract
curve, and production is inefficient. In this case, the farmer will use too much water and
too little labor, whereas the car-washing firm will underutilize water and overutilize labor.
568 PART SIX General Equilibrium, Efficiency, and Public Goods

car-washing firm,
If the price of water were the same for both the farmer and the
Each produce r would then use water
economic efficiency in production would increase.
would be equal to the relative price of
and labor until the MRTS between water and labor
output declines and car-was hing produc-
these two inputs. The result is that agricultural
of
tion increases, for a net increase in overall state output, with the given quantity
increase in the demand for water in
water and unskilled labor available. With the sharp
California as a result of rapid population growth and with the reduced supply due to
drought and climate change, the efficient use of scarce water resources became even
more important in California since the early 1980s. This has generally meant an
increase in the relative availability of water for nonirrigation purposes and an increase
in the relative price of water in all uses. We will see fewer golf courses in the desert and
less cotton and rice grown in California!
Sources: J. Hirschleifer, J. C. DeHaven, and W. J. Milliman, Water Supply: Economics, Technology, and
Policy (Chicago: University of Chicago Press, 1960); Subcommittee on Water and Power, C entral Valley
Project Improvement Act (Washington, DC: U.S. Government Printing Office, 1992); “California's Water:
The Eternal Challenge,” The Economist, August 27, 2005, p. 28; and J. Brewer, et al; “Water in the West:
Prices, Trading, and Contractual Forms,” NBER Working Paper No. 13002, March 2007; and M. Greenstone,
“Tradable Water Rights,” Democracy Journal, No. 8, Spring 2008, pp. 1-2.

GENERAL EQUILIBRIUM OF PRODUCTION AND EXCHANGE

17.5 WITH INTERNATIONAL TRADE

An important example of general equilibrium of production and exchange is provided by

international trade, say, between nations A and B. Suppose that nation A is endowed with
an abundance of labor (L) relative to capital (K) with respect to nation B, and commodity
X is labor intensive (i.e., the L/K ratio in the production of X is greater than in the pro-
duction of Y). Given the same technology and tastes in the two nations, the cost (in terms
of the amount of Y to be given up) of producing an additional unit of X (i.e., MRTyy =
Comparative Py/Py) is lower in nation A than in nation B. We say that nation A has a comparative
advantage The greater advantage in commodity X and nation B has a comparative advantage in commodity Y.
relative efficiency that
With trade, nation A specializes in the production of commodity X (i.e., it produces
an individual, firm,
more of X than it demands for internal consumption) in order to exchange it for com-
region, or nation has
over another in the
modity Y from nation B. On the other hand, nation B specializes in the production of
production of a good commodity Y (i.e., it produces more of Y than it demands for internal consumption) in
or service. order to exchange it for commodity X from nation A. With each nation specializing in
the production of the commodity of its comparative advantage (nation A in commodity X
and B in Y), the combined output of X and Y by the two nations is larger than without
specialization. Both nations then share the increased output of X and Y through volun-
tary exchange (trade), and both are better off than without trade.
As each nation specializes in the production of the commodity of its comparative
advantage, it will incur increasing opportunity costs. Specialization in production reaches
the equilibrium level when MRTyy = Px/Py is the same in both nations. The two nations
are then simultaneously in general equilibrium of production and exchange (trade) when
MRTxy= Px/Py = MRS$y = MRS2,.?

See D. Salvatore, International Economics, 8th ed. (New York: John Wiley & Sons, 2003), Chapter
5.
 CHAPTER 17 General Equilibrium and Welfare Economics 569

EES Ze M Ee) ihn Paalhan 9b

The Basis of and the Gains from International Trade

We can show general equilibrium of production and exchange and the gains from
specialization in production and trade with the aid of Figure 17.7. The production-
possibilities frontier is AA for nation A and BB for nation B. The different shapes of
the two production-possibilities frontiers result from nation A having a relative abun-
dance of labor and commodity X being the labor-intensive commodity, with nation B
having a relative abundance of capital and commodity Y being the capital-intensive
commodity. For simplicity, we assume that both technology and tastes are the same in
both nations. Suppose that in the absence of trade, nation A is observed to be producing
and consuming at point C, while nation B is observed to be at point C’.*° Since
MRTxy = Px/Py (the absolute slope of the production-possibilities frontier) is lower at
point C for nation A than at point C’ for nation B, nation A has a comparative advan-
tage in commodity X, while nation B has a comparative advantage in commodity Y.

MRTyy ss Py /Py = 1

A
0 XY 40) TOO Teo) xX

FIGURE 17.7. Graphic Analysis of General Equilibrium with Trade

The production-possibilities frontier is AA for nation A and BB for nation B.
In the absence of trade, nation A is at point C and nation B is at
point C’. Since MRTxy = Px/Py (the absolute value of the slope of the
production-possibilities frontier) is lower at point C than at point C’; nation
A has a comparative advantage in X while nation B has a comparative
advantage in Y. With trade, A produces at point D, exchanges 40X for
AOY with B, and consumes at E > C. Nation B produces at point D’,
exchanges 40Y for 40X with A, and consumes at E’> C’.

in
20 This means that MRTyy = MRSyy = Px/Py in each country, so that each country is simultaneously
equilibrium of production and exchange in isolation (1.e., in the absence of trade).
570 PART SIX General Equilibrium, Efficiency, and Public Goods

(moves down
With the opening of trade, nation A specializes in the production of X
point C) and incurs increasi ng opportunity
its production-possibilities frontier from
B Spee
costs in the production of more X (i.e., the MRTyy = Px/Py rises). Nation
in the production of Y (moves up its production-possibilities frontier from point C’) and
incurs increasing opportunity costs in the production of more Y (i.e., the MRT xy =
Py/Px rises, which means that MRTyy = Px/Py falls). Specialization in production pro-
ceeds until nation A has reached point D and nation B has reached point D’, at which
MRTxy = Py/Py is the same in both nations. Nation A might then exchange 40X (DF)
for 40Y (FE) with nation B and reach point E. At point E, nation A consumes 10X and
20Y more than at point C without trade. With trade, nation B consumes at point E’ (= E)
or 20X and 10Y more than at point C’ without trade. Production and trade is in (general)
equilibrium, and both nations gain.
Note that with trade, both nations consume 80X and 80Y (i.e., point £ for nation A
coincides with point E’ for nation B). This would be true if both nations not only had
the same technology and tastes but were also of equal size. These simplifying assump-
tions were made to simplify the graphic analysis. However, we can show comparative
advantage (i.e., the basis for trade) and the gains from trade graphically even if the two
nations have different technologies and tastes, and if they are unequal in size.7!

17.6 WELFARE ECONOMICS AND UTILITY-POSSIBILITIES FRONTIERS

Having completed our analysis of general equilibrium, we now move on to examine wel-
fare economics. We begin by examining the meaning of welfare economics and then we will
go on to derive the utility-possibilities frontier and the grand utility-possibilities frontier.

The Meaning of Welfare Economics

Welfare economics Welfare economics studies the conditions under which the solution to the general equi-
Examines the librium model presented earlier in this chapter can be said to be optimal. It examines the
conditions for conditions for economic efficiency in the production of output and in the exchange of
economic efficiency commodities, and equity in the distribution of income. This is to be clearly distinguished
in the production of from the everyday usage of the term “welfare,” which refers mostly to government pro-
output and in the
grams to aid low-income families. That topic is only a very small part of what welfare
exchange of
commodities and
economics covers.
for equity in the The maximization of society’s well-being requires the optimal allocation of inputs
distribution of among commodities and the optimal allocation of commodities (i.e., distribution of
income. income) among consumers. The conditions for the optimal allocation of inputs among
commodities and exchange of commodities among consumers have already been dis-
cussed. These are objective criteria devoid of ethical connotations or value judgments. On
the other hand, it is impossible to objectively determine the optimal distribution
of
income. This necessarily requires interpersonal comparisons of utility and value judg-
ments on the relative “deservingness” or merit of various members of society,
and differ-
ent people will inevitably have different opinions.
For example, taxing $100 away from individual A and giving it as a subsidy
to
individual B will certainly make B better off and A worse off. But who
is to say that the:
society composed of both individuals is better or worse off as a whole?
Determining this
|
See D. Salvatore, International Economics, op. cit., Chapter 3.
. . .
 CHAPTER 17 General Equilibrium and Welfare Economics = 571

involves comparing the utility lost by individual A to the utility gained by individual B (i.e.,
making interpersonal comparison of utility). And even if A has a high income and B has a
low income to begin with, different people will have different opinions on whether this
increases social welfare, reduces it, or leaves it unchanged. Therefore, no entirely objective
or scientific rule can be defined. The difficulty in making interpersonal comparisons of
utility is clearly demonstrated in rationing hospital care, discussed in Example 17-4.

EXAMPLE 17-4 a
“The Painful Prescription: Rationing Hospital Care”

The great difficulty with interpersonal comparison of utility in making social choices
is aptly exemplified by the need to ration hospital care. New therapeutic techniques
(such as open-heart surgery) and new diagnostic devices (such as CAT scanners) have
improved medical care but have greatly added to costs. For example, open-heart
surgery costs tens of thousands of dollars and replaces the much cheaper (but some-
what less effective) use of drugs in treating patients with heart disease. This develop-
ment raises difficult choices for society in general, and for physicians and hospitals in
particular, as they try to contain the ever-rising costs of medical care. In England, only
a handful of patients over the age of 55 with chronic kidney failure are referred for
expensive dialysis; the others are simply allowed to die of chronic renal failure. The
idea of rationing medical care is generally alien to Americans, accustomed as they are
to expect the best care that can be medically provided. Nevertheless, ever-increasing
medical costs have inevitably led to rationing in the use of some new and expensive
techniques and diagnostic devices.
As pointed out by Fuchs, medical care has always been rationed in the United
States and elsewhere, because “no nation is wealthy enough to provide all the care that
is technically feasible and desirable....” Therefore, the change is not between “no
rationing and rationing, but rather in the way rationing takes place—who does the
rationing and who is affected by it.” The way hospital care (particularly the use of the
more advanced and costly new diagnostic techniques) is to be rationed has given rise
to a prolonged national debate in the United States. The introduction of “managed
competition” with HMOs (see Example 1-1) during the last decade allows insurance
companies to provide consumers with incentives to “price shop” when choosing doc-
tors and hospitals as a way of keeping health-care costs down. The courts need also to
redefine negligence so as to limit medical malpractice suits and higher physicians’
insurance costs (which are then passed on to consumers in the form of higher costs of
medical care). Be that as it may, health-care costs are likely to continue to rise as a
proportion of GDP in the United States in the coming years. The same strain is experi-
enced by government-financed health-care services in Canada, Britain, Germany, and
Scandinavia, among other countries.
Sources: V. R. Fuchs, “The ‘Rationing’ of Medical Care,” The New England Journal of Medicine,
December 13, 1984, pp. 1572-1573; H. J. Aaron and W. B. Schwartz, The Painful Prescription: Rationing
Hospital Care (Washington, D.C.: Brookings Institution, 1984); “How Managed Care Will Allow Market
Forces to Solve the Problems,” New York Times, August 13, 1995, p. 12; M. Feldstein, “The Economics of
Health and Health Care: What Have We Learned? What Have I Learned?” American Economic Review,
Papers and Proceedings, May 1995, pp. 28-31; “Medicine Isn’t an Economic-Free Zone,” Wall Street
Journal, June 22, 2001, p. A14; “Canada Health Care Shows Strains,” New York Times, October 11, 2001,
p. 12; and “Beyond Those Health Care Numbers,” New York Times, December 4, 2007, Sect. IV, p. 4.
Siz PART SIX General Equilibrium, Efficiency, and Public Goods

Utility-Possibilities Frontier
B
By assigning utility rankings to the indifference curves of individual A and individual
or transfer the contract curve for exchange of Figure 17.5
in Figure 17.5, we can map
from output or commodity space to utility space, and thus derive utility-possibilities fron-
to
tier Uy Uy in Figure 17.8. Specifically, if indifference curve A, in Figure 17.5 refers
200 units of utility for individual A (i.e., Ua = 200 utils) and B3 refers to Ug = 600 utils, we
can go from point D (on A, and B3) in commodity space in Figure 17.5 to point D’ in utility
space in Figure 17.8. Similarly, if Az refers to Ua = 400 utils and Bp refers to Ug = 500
utils, we can go from point E (on A> and B>) in Figure 17.5 to point E’ in Figure 17.8.
Concept Check
Finally, if A3 refers to Ua = 500 utils and B, refers to Ug = 200 utils, we can go from point
How is the utility-
possibilities frontier F (on Aj and B;) in Figure 17.5 to point F’ in Figure 17.8.7 By joining points D’E’F’ and
derived? What does other points similarly obtained, we derive utility-possibilities frontier Uy Uy in Figure
it show? 17.8. Thus, the utility-possibilities frontier is obtained by mapping or transferring the con-
tract curve for exchange from output or commodity space into utility space.
Utility-possibilities The utility-possibilities frontier shows the various combinations of utilities
frontier Shows the received by individuals A and B (i.e., Ua and Ug) when this simple economy is in general
various combinations of equilibrium or Pareto optimum in exchange. It is the locus of maximum utility for one
utilities received by two individual for any given level of utility for the other individual. For example, given that
individuals at which the
U, = 400 utils, the maximum utility of individual B is Ug = 500 utils (point E’). A point
economy (composed of
the two individuals) is such as C in Figure 17.2 (at which indifference curves A, and B, intersect off exchange
in general equilibrium contract curve 04DEFOg) corresponds to point C’ inside utility-possibilities frontier
or Pareto optimum in Uy Uy: in Figure 17.8. By simply redistributing the 10X and 8Yavailable to the economy
exchange. (point M’ in Figure 17.5) between individuals A and B, the economy can move from point

Up

700 |—

600

500

FIGURE 17.8 Utility-Possibilities Frontier —Utility-possibilities 400

frontier Upy-U shows the various combinations of utilities received
by individuals A and B (i.e, Ug and Ug) when the economy 30)
composed of individuals A and B is in general equilibrium or Pareto :
optimum in exchange. The frontier is obtained by mapping exchange 900
contract curve O,DEFOsg in Figure 17.5 from output or commodity 3
space to utility space. Specifically, if Ay refers to U, = 200 utils and 100
B3 to Ug = 600 utils, point D in Figure 17.5 can be plotted as point
D’ in this figure. Point E can be plotted as point E’, and point F as F’.
Uy
By joining points D’E’F’, we get utility-possibilities frontier UpyUpy. 0) 100 200 300 400 ‘500 600 U,A

ee Note that the scale along the horizontal axis refers only to individual A,
while the scale along the vertical
axis refers only to B. Thus, U, = 400 utils is not necessarily smaller
than Ug = 500 utils, ve
interpersonal comparison of utility is implied. Furthermore, the scale
along either axis is ordinal, not cardinal
That is, Us = 300 utils is greater than Uy = 200 utils, but not
necessarily 1.5 times larger. Note alse that
utility-possibilities frontier Uj Uy’, is negatively sloped, but irregularly
rather than smoothly shaped
 CHAPTER 17 General Equilibrium and Welfare Economics 573

C’ to point D’ in Figure 17.8 and increase Ug, or to point F’ and increase Ua, or to point
E’ and increase both U, and Ug. A point outside the utility-possibilities frontier cannot
be reached with the available amounts of commodities X and Y. Of all points of Pareto
optimality in exchange along utility-possibilities frontier Uy Uy, in Figure 17.8, only
point E’ (which corresponds to point E in Figure 17.5) is also a point of Pareto optimal-
ity in production. That is, at point E’, MRS¥, = MRS’, = MRTxy = Px/Py = 3/2.

Grand Utility-Possibilities Frontier

We have seen that utility-possibilities frontier Uy,Uy, in Figure 17.8 (repeated in
Figure 17.9) was derived from the contract curve for exchange drawn from point 0 to point
M’ on the production-possibilities frontier in Figure 17.5. If we pick another point on the
production-possibilities frontier of Figure 17.5, say, point N’, we can construct another
Edgeworth box diagram and get another contract curve for exchange, this one drawn
from point 0 to point N’ in Figure 17.5. From this different contract curve for exchange
(not shown in Figure 17.5), we can derive another utility-possibilities frontier (Uy Uy’ in
Figure 17.9) and obtain another Pareto optimum point in production and exchange (point
H’ in Figure 17.9). By then joining points E’, H’, and other points similarly obtained, we
can derive grand utility-possibilities frontier GE'H’G in Figure 17.9).”*

0 100 200 300 400 500 600 700 800 900 U4

FIGURE 17.9 Grand Utility-Possibilities Frontier Utility-possibilities

frontier Uy Uy: is that of Figure 17.8. Utility-possibilities frontier UnyUy Is
derived from the contract curve for exchange in the Edgeworth box diagram
constructed from point V’ on the production-possibilities frontier of Figure
175. By joining E’, H’, and other Pareto optimum points of production and
exchange similarly obtained, we get grand utility-possibilities frontier GE’H'G.

from
23 Note that the various utility-possibilities frontiers and the grand utility-possibilities frontier derived
them are negatively sloped but are usually irregularly shaped (as in Figure 17.9).
574 PART SIX General Equilibrium, Efficiency, and Public Goods

Thus, the grand utility-possibilities frontier is the envelope to the utility-

Grand utility-
grand
possibilities frontier possibilities frontiers at Pareto optimum points of production and exchange. The
on-exchange
The envelope to utility- utility-possibilities frontier indicates that no reorganization of the producti
someone better off without, at the same time, making
Bass biltics frontiers a process is possible that makes
far as objective analysis goes. To determin e the Pareto
Sa ne someone else worse off. This is as
of production and social welfare is maximum, we need
eeehance optimum point in production and exchange at which
xchange.
a social welfare function. However, since this is based on interpersona l comparison s of
utility (which is not allowed), we cannot determine the point of maximum social welfare.

EXAMPLE 17-5
From Welfare to Work—The Success of Welfare Reform in the United States

A 1995 study by Tanner, Moore, and Hartman found that welfare payments provided
welfare recipients with higher incomes than they would have received from many entry-
level jobs, thus discouraging welfare recipients from finding work. The study measured
the combined value of the benefits for a typical welfare family from various programs
[such as Aid to Families with Dependent Children (AFDC), food stamps, Medicaid, and
housing, nutrition, and energy assistance] and compared it with the income a worker
would have to earn to get the same after-tax benefit as under the welfare program.
The study found that in the early 1990s in order to match the value of the welfare
benefits, a mother of two children would have to earn as much as $36,000 in Hawaii
(the state with the most generous welfare program) and $11,500 in Mississippi (the
least generous state). Welfare paid the equivalent of $8 per hour in 40 states, $10 per
hour in 17 states, and more than $12 per hour in Hawaii, Alaska, Massachusetts,
Connecticut, Washington, D.C., New Work, New Jersey, and Rhode Island. Welfare
benefits were even higher in large cities. For example, welfare provided the equivalent
of an hourly pretax wage of $14.75 in New York City, $12.45 in Philadelphia, $11.35
in Baltimore, and $10.90 in Detroit. The study also found that welfare paid more than
the entry-level salary for a computer programmer in 6 states, more than first-year
salary of a teacher in 9 states, more than the average salary of a secretary in 29 states,
and more than the salary of a janitor in 47 states. The study concluded that because of
generous welfare benefits, welfare recipients were likely to choose welfare over work
and become permanently dependent. Indeed, 70% of welfare recipients were found not
to be looking for work. It is not difficult to see why: The typical untrained, uneducated
welfare mother was not likely to find a job that paid $10 to $12 per hour (more than
twice the minimum wage at the time).
All of this changed with the Personal Responsibility and Work Opportunity
Reconciliation Act of 1996 (PRWORA), otherwise known as welfare reform. This ended
welfare as entitlements, available to all persons who qualified, and required recipients to
look for work as a condition for continued assistance. Rather than simply disbursing pay-
ments to welfare recipients on demand, the Federal Government provided states with a
block of funds to run this portion of the welfare program with the aim of getting welfare
recipients off the welfare lists by encouraging them to find jobs. Welfare reform was a
stunning success: It cut the number of welfare recipients from 12.2 million in 1996
to
5.8 million in 2000. The reform also led to an increase in the income of poor people,
but
at a slower rate than the reductions in welfare rolls. The rapidly growing
economy
 CHAPTER 17 General Equilibrium and Welfare Economics ois)

helped, but most of the reduction in the number of welfare recipients was due to welfare
reform. The proof? During periods of rapid economic expansion in the 1980s and early
1990s, welfare rolls generally increased. Since the welfare reform of 1996, they were cut
by more than half. Welfare reform could be improved further by tidying up the food-
stamps program, getting rid of the marriage penalty tax for the poor, and expanding the
earned-income tax credit for the working poor.
Sources: M. Tanner, S. Moore, and D. Hartman, The Work vs. Welfare Trade-Off (Washington, D.C.: Cato
Institute, 1995); “Rewriting the Social Contract,” Business Week, November 20, 1995, pp. 120-134;
“From Welfare to Work,” Brookings Review, fall 1999, pp. 27-30; “America’s Great Achievement,” The
Economist, August 25, 2001, pp. 25-27; and “Welfare Reform: Ten Years Later,’ New York Times,
August 26, 2006, p. 9.

17.7 SOCIAL POLICY CRITERIA

In this section we examine some very important criteria for measuring changes in social
welfare and Arrow’s impossibility theorem.

Measuring Changes in Social Welfare

There are four different criteria to determine whether a particular policy raises social wel-
Pareto criterion fare. The first is the Pareto criterion, discussed in Section 17.3 and accepted by nearly all
Postulates that a change economists. According to this criterion, a policy increases social welfare if it benefits some
increases social welfare members of society (in their own judgment) without harming anyone. In terms of
if it benefits some
Figure 17.10, a movement from point C*, inside grand utility-possibilities frontier GG, to
members of society
without harming
points E’, H’, or any point between E’ and H’ (such as point V) on GG, benefits one or both
anyone. individuals and harms none; thus, it passes the Pareto criterion. In contrast, a movement
from point C* to point Z on GG makes individual B much better off but individual A a little
worse off, and so it does not pass the Pareto criterion. Because most policies will benefit
some and harm others,‘ the Pareto criterion does not go very far, and it is biased in favor of
the status quo.
To overcome this limitation of the Pareto criterion, Kaldor and Hicks introduced the
Compensation second welfare criterion, which is based on the compensation principle.*? According to
principle The amount the Kaldor—Hicks criterion, a change is an improvement if those who gain from the
that gainers from a change can fully compensate the losers and still retain some gain. In terms of the move-
change could pay losers ment from point C* to point Z in Figure 17.10, individual B (the gainer) could fully com-
to fully compensate
pensate individual A for his or her loss, so that society could move from point C* to point
them for their losses.
E’ (instead of from point C* to Z) on GG and we can determine that social welfare is
Kaldor-Hicks higher.”° Yet, this conclusion is not as clear-cut as it may seem.
criterion Postulates
that a change is an 4 For example, a tax on high-income people to finance aid to low-income families benefits the latter but harms
improvement if those the former. Even the breakup of a monopoly harms someone (the monopolist who loses the source of profits).
who gain from the 25 N. Kaldor, “Welfare Propositions in Economics and Interpersonal Comparisons of Utility,’ Economic
change can fully Journal, December 1939, pp. 549-552; and J. R. Hicks, “The Foundations of Welfare Economics,” Economic
compensate the losers Journal, December 1939, pp. 696-712.
and still retain some of 26 One real-world example of actual compensation is given by the trade adjustment assistance provided since
the gain. 1962 by the Trade Expansion Act for U.S. workers displaced by negotiated tariff reductions. This assistance
was justified by the much greater benefits to society as a whole resulting from trade liberalization. See D.
Salvatore, International Economics, op. cit., Chapter 9.
576 PART SIX General Equilibrium, Efficiency, and Public Goods

E | | | | | G
0 100 200 300 400 500 600 700 800 900 U4

FIGURE 17.10 Measuring Changes in Social Welfare A movement

from point C*to a point from E’ to H’ on grand utility-possibilities frontier GG
benefits one or both individuals and harms no one. Thus, the movement
increases social welfare according to the Pareto criterion. A movement from
point C* to pointZ increases social welfare according to the Kaldor—Hicks
criterion, since individual B could fully compensate individual A for his or her
loss and still retain some gain. However, since this type of reasoning is based
on interpersonal comparisons of utility, social welfare need not be higher

First, it is possible (though unusual) for the Kaldor—Hicks criterion to indicate that a
given policy increases social welfare but also to indicate that, after the change, a movement
back to the original position also increases social welfare. This limitation can be overcome
Scitovsky criterion with the third or Scitovsky criterion.” This is a double Kaldor—Hicks test. That is, accord-
Postulates that a change ing to Scitovsky, a change is an improvement if it satisfies the Kaldor—Hicks criterion, and,
is an improvement if it after the change, a movement back to the original position does not satisfy the Kaldor—Hicks
satisfies the Kaldor—
criterion.
Hicks criterion and if,
after the change, a
Another shortcoming of the Kaldor—Hicks criterion is more serious. It arises because
movement back to the the compensation principle measures the welfare changes of the gainers and losers in
original position does monetary units. For example, if a policy increases the income of individual B by $100 but
not satisfy the Kaldor— lowers the income of individual A by $60, social welfare has increased according to the
Hicks criterion. Kaldor—Hicks criterion (because individual B could transfer $60 of his or her $100
income gain to individual A and retain $40).** Since compensation is not actually
required, the Kaldor—Hicks criterion is based on the assumption that the gain in utility of

*1 T. Scitovsky, “A Note on Welfare Propositions in Economics,” Review of Economics and Statistics,

November 1941, pp. 77-78.
°8 If compensation actually took place (something that is not required by the Kaldor—Hicks
criterion), the
Pareto criterion would suffice (since individual B is better off and individual A is not
harmed), and the
Kaldor—-Hicks criterion would be superfluous.
 CHAPTER 17 General Equilibrium and Welfare Economics 577

Bergson social welfare individual B (when his or her income rises by $100) is greater than the loss of utility to
function A social individual A (when his or her income falls by $60). Yet, this line of reasoning is based on
welfare function based
interpersonal comparisons of utility, and social welfare need not be higher.
on the explicit value
judgments of society.
The only way to overcome this limitation of the Kaldor—Hicks criterion is to squarely
face the problem of interpersonal comparison of utility. This leads us to the fourth welfare
criterion, which is based on the construction of a Bergson social welfare function from
Concept Check the explicit value judgments of society.”’ A particular policy can then be said to increase
How can changes in social welfare if it puts society on a higher social indifference curve. However, as we will
social welfare be see in the next section, a social welfare function is extremely difficult or impossible to
measured? construct by democratic vote.

Arrow’s Impossibility Theorem

Nobel laureate Kenneth Arrow proved that a social welfare function cannot be derived by
democratic vote (i.e., reflect the preferences of all the individuals in society). This proof
Arrow’s impossibility is known as Arrow’s impossibility theorem.*”
theorem Postulates Arrow lists the following four conditions that he believes must hold for a social
that a social welfare welfare function to reflect individual preferences:
function cannot be
derived by democratic |. Social welfare choices must be transitive. That is, ifX is preferred to Y and Y is
vote to reflect the preferred to Z, then X must be preferred to Z.
preferences of all the 2. Social welfare choices must not be responsive in the opposite direction to
individuals in society.
changes in individual preferences. That is, if choice X moves up in the ranking
of one or more individuals and does not move down in the ranking of any other
individual, then choice X cannot move down in the social welfare ranking.
3. Social welfare choices cannot be dictated by any one individual inside or outside
the society.
4. Social choices must be independent of irrelevant alternatives. For example, if
society prefers X to Y and Y to Z, then society must prefer X to Y even in the
absence of alternative Z.

Arrow showed that a social welfare function cannot be obtained at by democratic

voting without violating at least one of the four conditions. This can easily be proved for
the first of the conditions. For example, suppose that Ann, Bob, and Charles (the three
individuals in a society) rank alternatives X, Y, and Z as in Table 17.1.

Rankings of Alternatives X, Y, and Z by Ann, Bob,

and Charles
Alternative

Individuals xX % eh

Ann Ist 2nd 3rd

Bob 3rd Ist 2nd
Charles 2nd 3rd Ist

29 A. Bergson, “A Reformulation of Certain Aspects of Welfare Economics,” Quarterly Journal of Economics,

February 1938, pp. 310-334.
30 K. J. Arrow, Social Choice and Individual Values (New York: Wiley, 1951).
578 PART SIX General Equilibrium, Efficiency, and Public Goods

(Ann and Charles)

Consider first the choice between alternatives X and Y. The majority
Z. The majority (Ann ay
prefers X to Y. Now consider the choice between alternatives Y and
y prefers X to Y and
Bob) prefers Y to Z. It might then be concluded that since the majorit
However, from
to Z, the society composed of Ann, Bob, and Charles would prefer X to Z.
the prefer-
Table 17.1, we see that the majority (Bob and Charles) prefers Z to X. Therefore,
inconsis tent with the preferen ces of the individu als making up the
ence of the majority is
majority. In short, this society cannot derive a social welfare function by democra tic vOUne
even if individual preferen ces are consisten t. This is sometim es referred to as the “voting
paradox.” ti
While disturbing, it must be noted that the above conclusion 1s based on considering

Concept Check
only the rank and not the intensity with which various alternatives are preferred. Thus, if
What is Arrow’s half of society mildly preferred more space exploration while the other half strongly pre-
impossibility theorem? ferred more aid to low-income families instead, the difference in the intensities of these
What is its importance? preferences would have to be disregarded in the decision process according to Arrow.

AT THE FRONTIER
The Hot Issue of Income Inequality
in the United States

VW e have seen in Section 17.2 that once two individuals are on the contract
curve for exchange, one of the two individuals cannot be made better off
without making the other worse off. Thus, different points on the contract curve refer
to different distributions of income between the two individuals. Income inequality
has become a hotly debated issue in recent years—especially since the income gap
between the rich and poor in the United States is wider than in other industrial coun-
tries and has increased somewhat during the past two decades.
The best known summary measure of income inequality is provided by the
Lorenz curve A Lorenz curve and the Gini coefficients. A Lorenz curve shows the cumulative per-
curve showing centages of total income (from 0% to 100%) measured along the vertical axis, for var-
income inequality ious cumulative percentages of the population (also from 0% to 100%) measured
by measuring
along the horizontal axis. The Gini coefficient is calculated from the Lorenz curve as
cumulative
percentages of
indicated below. An illustration of two Lorenz curves, obtained by plotting the data of
total income for Table 17.2, is given in Figure 17.11.
various cumulative The table and the figure show that the 20% of the families with the lowest income
percentages of the received only 0.9% of the national income before all taxes and transfers to aid low-
population. income families, but 4.8% of national income after all taxes and transfers. The 40% of
the families with the lowest income received 8% of total income before taxes and
transfers, but 15.5% afterwards, and so on, until 100% of the families received the
entire national income. Note that the after-taxes and after-transfers Lorenz curve has
a smaller curvature than the before-taxes and before-transfers Lorenz curve, indicat-
ing a smaller income inequality after than before taxes and transfers.
If income were equally distributed, the Lorenz curve would coincide with
the straight-line diagonal. On the other hand, if one family received the entire income
 CHAPTER 17 General Equilibrium and Welfare Economics 579

Distribution of Annual Family Income Before

and After Taxes and Transfers in the United
States in 1993

Cumulative Percent of Total Income

Cumulative Percent Before Taxes After Taxes

of Families and Transfers and Transfers

Lowest 20 0.9 4.8

40 8.0 ISS)
60 22.6 31.6
80 46.6 Se)?
100 100.0 100.0

Source: U.S. Bureau of the Census, Current Population Survey (Washington, DC).

100

80
Line of perfect
income equality ——~+

60 Lorenz curve
for before taxes
and transfers
40
of
total
income
Lorenz curve
Cumulative
percent
for after taxes
20 and transfers

l hes | be
0 20) 40 60 80 100
Cumulative percent of families
FIGURE 17.11 Lorenz Curves A Lorenz curve gives the cumulative
percentages of total income (measured along the vertical axis) for various
cumulative percentages of the population or families (measured along the
horizontal axis). The after-taxes and after-transfers Lorenz curve has a smaller
curvature (or outward bulge from the diagonal) than the before-taxes and
before-transfers Lorenz curve, indicating a smaller income inequality after
taxes and transfers than before.

Continued...
580 PART SIX General Equilibrium, Efficiency, and Public Goods

The Hot Issue of Income Inequality in the United States Continued

Gini
Gini coefficient A of the nation, the Lorenz curve would be a right angle (OFG in the figure). The
ratio of the area between the Lorenz curve and the straight-
measure of income coefficient is given by the
inequality line diagonal to the total area of triangle OFG. The Gini coefficient can range from 0
calculated from the
with perfect equality (when the Lorenz curve coincides with the diagonal) to | with
Lorenz curve and
perfect inequality (when only one family receives all of the income and the Lorenz
ranging from 0 (for
perfect equality) to curve is given by OFG).
| (for perfect For the United States, the Gini coefficient was 0.39 before all taxes and transfers
inequality). and 0.36 afterwards in 1993, compared with the average of 0.34 for all advanced
countries and 0.46 for developing nations. The Gini coefficient (i.e., income inequal-
ity) increased in the United States from 0.35 in 1975 and to 0.41 in 2000 (the last year
for which this coefficient was available), and it was, on the average, higher than in
other advanced countries but lower than in developing countries.

Source: Organization for Economic Cooperation and development (OECD), /ncome Distribution in
OECD Countries (Paris: OECD, October 1995); U.S. Bureau of Census, Measuring the Effect and
Benefits of Taxes on Income and Property: 1993, Current Population Report, Series P-60, No. 185RD
(Washington, DC: U.S. Government Printing Office, 1995); F. Campano and D. Salvatore, /ncome
Distribution (New York: Oxford University Press, 2006); D. Salvatore, ed., “Income Distribution,”
Special Issue, Journal of Policy Modeling, July/August, 2007; and UN, Human Development
Report 2008 (New York, UN, 2008), pp. 282-284.

| 178 | TRADE PROTECTION AND ECONOMIC WELFARE

By increasing commodity prices, trade protection benefits domestic producers and harms
domestic consumers (and usually the nation as a whole). However, since producers are few
and stand to gain a great deal from protection, they have a strong incentive to lobby the gov-
ernment to adopt protectionist measures. On the other hand, since the losses are diffused
among many consumers, each of whom loses very little from the protection, they are not
likely to effectively organize to resist protectionist measures. Thus, there is a bias in favor of
protectionism. For example, the sugar quota raises individual expenditures on sugar by only
a few dollars per person per year in the United States. But with more than 300 million peo-
ple in the United States, the quota generates nearly $1 billion in rents to the few thousand
sugar producers.
In industrial countries, protection is more likely to be provided to labor-intensive indus-
tries employing unskilled, low-wage workers who would have great difficulty finding alter-
native employment if they lost their present jobs. Some empirical support has also been
found for the pressure-group or interest-group theory, which postulates that industries that
are highly organized (such as the automobile industry) receive more trade protection than
lessorganized industries. An industry is more likely to be organized if it is composed of only
a few firms. Also, industries that produce consumer products generally are able to obtain
more protection than industries producing intermediate products used as inputs by
other
industries, because the latter industries can exercise countervailing power (1.e., apply
oppos-
ing pressure) and block protection (since protection would increase the price of
their inputs).
Furthermore, more protection seems to go to geographically decentra
lized indus-
tries that employ large numbers of workers than to industries that Operate
in only some
 CHAPTER 17 General Equilibrium and Welfare Economics 581

regions and employ relatively few workers. The large number of workers have strong
voting power to elect government officials who support protection for the industry.
Decentralization ensures that elected officials from many regions support the trade pro-
tection. Another theory suggests that trade policies are biased in favor of maintaining the
status quo. That is, it is more likely for an industry to be protected now if it was protected
in the past. Governments also seem reluctant to adopt trade policies that result in large
changes in the distribution of income, regardless of who gains and who loses. The most
highly protected industries in the United States today are the textile and apparel, auto-
mobile, and steel. Example 17-6 provides estimates of the effect of removing protection
to these industries.

Table 17.3 shows that removing all quantitative restrictions (QRs) on textile and
apparel exports to the United States would result in a gain of $11.92 billion for the
United States at 1984 prices. Retaining QRs but capturing the rents from foreigners
(e.g., by auctioning off export quotas to foreign firms) would result instead in a gain of
$6.05 billion for the United States. The gains are smaller for automobiles and much
smaller for steel. Removing QRs also leads to employment losses in the industry

Welfare Benefits and Employment Effects of Removing

Quantitative Restrictions (QRs) on Export of Textiles,
Automobiles, and Steel to the United State

Employment Change Employment Change

Welfare Gain in Industry in Rest of Economy
(billions of dollars) (1,000 worker-years) (1,000 worker-years)

Textile and apparel

Remove QRs 11.92 —157.2 157.2
Capturing rents from 6.05 =3.1 28.4
foreigners
Automobiles
Remove QRs VDD) —1.2 1.3
Capturing rents from Goll ales) Biee
foreigners
Steel
Remove QRs 0.86 —20.7 223
Capturing rents from 0.74 Onl By)
foreigners
eneIn nnn ne ULEEE EEE

Sources: J. de Melo and D. Tarr, A General Equilibrium Analysis of U.S. Foreign Trade Policy (Cambridge, MA:
MIT Press, 1992); and H. J. Wall, “Using the Gravity Model to Estimate the Costs of Protection,” Federal Reserve
Bank of St. Louis Review, January/February 1999, pp. 211-244.
582 PART SIX General Equilibrium, Efficiency, and Public Goods

than matched by
losing the QRs, but these employment losses are matched or more
economy-wide employment gains. Removing QRs on all three products leads to a total
for the United States. A more
welfare gain of $20.28 ($11.92 + $7.50 + $0.86) billion
g all forms of trade protec-
recent study by Wall (1999) found that the benefit removin
tion on U.S. imports in 1996 was equal to $112 billion, which represented more than
15 percent of U.S. imports and more 1.9 percent of U.S. GDP in 1996.

|_| SUMMARY
1. Partial equilibrium analysis studies the behavior of individual decision-making units
and individual markets, viewed in isolation. General equilibrium analysis studies the
interdependence that exists among all markets in the economy. Only when an industry
is small and has few direct links with the rest of the economy is partial equilibrium
_antalysis appropriate. The first general equilibrium model was introduced by Walras
in 1874. Under perfect competition, a solution to the general equilibrium model usually
exists.
2. A simple economy of two individuals (A and B), two commodities (X and Y), and two inputs
(L and K) is in general equilibrium of exchange when the economy is on its contract curve for
exchange. This is the locus of tangency points of the indifference curves (at which the MRSyy
are equal) for the two individuals. The economy is in general equilibrium of production when it
is on its production contract curve. This is the locus of the tangency points of the isoquants (at
which MRTS_x are equal) for the two commodities. By mapping or transferring the production
contract curve from input to output space, we derive the corresponding production-possibilities
frontier.
3. For the economy to be simultaneously in general equilibrium of production and exchange,
the marginal rate of transformation of X for Y in production must be equal to the
marginal rate of substitution of X for Y in consumption for individuals A and B. That is,
MRTxy = MRS‘y = MRS*.,,. Geometrically, this corresponds to the point on the contract
curve for exchange at which the common slope of the indifference curve of the two
individuals equals the slope of the production-possibilities frontier at the point of production.
A distribution of inputs among commodities and of commodities among consumers is Pareto
optimal or efficient if no reorganization of production and consumption is possible by which
some individuals are made better off without making someone else worse off. Thus, the
conditions for Pareto optimality are the conditions for general equilibrium of production
and exchange.
4. Under perfect competition in all input and output markets, all the conditions for Pareto
optimum are automatically satisfied. This is the basic argument in favor of perfect
competition and proof of Adam Smith’s law of the invisible hand. The first theorem of
welfare economics postulates that equilibrium in competitive markets is Pareto optimal.
The second theorem of welfare economics postulates that equity in distribution is logically
separable from efficiency in allocation. Perfect competition leads to maximum economic
efficiency only in the absence of market failures (which arise from imperfect competition,
externalities, and public goods). Perfect competition leads to static but not necessarily
to
dynamic efficiency.
5. Starting from the general equilibrium condition at which MRTyxy = Py/Py =
MRSxy
in each country in the absence of trade, the country with the lower MRTyy or
Py/Py
 CHAPTER 17 General Equilibrium and Welfare Economics 583

will have a comparative advantage in commodity X. With trade, each nation will
specialize in the production of the commodity of its comparative advantage until
MRTyy or Px/Py becomes equal in both countries. Then each country will trade until
MRTxy = Px/Py = MRSyxy so as to be in general equilibrium once again. By specializing
in production and trading, each country can consume more of both commodities than
it can without trade.
6. Welfare economics studies the conditions under which the solution to the general
equilibrium model can be said to the optimal. It examines the conditions for economic
efficiency in the production of output and in the exchange of commodities, and for equity
in the distribution of income. A utility-possibilities frontier is derived by mapping or
transferring a contract curve for exchange from output or commodity space to utility
space. It shows the various combinations of utilities received by two individuals at which
the economy is in general equilibrium or Pareto optimum in exchange. We can construct
an Edgeworth box and contract curve for exchange from each point on the production-
possibilities frontier. From each contract curve for exchange, we can then construct the
corresponding utility-possibilities frontier and determine on it the point of Pareto
optimum in production and exchange. By joining points of Pareto optimality in
production and exchange on each utility-possibilities frontier, we can derive the grand
utility-possibilities frontier.
7. A change that benefits some but harms others can be evaluated with the Kaldor—Hicks—Scitovsky
criterion. However, this is based on the compensation principle which measures the welfare
changes of the gainers and the losers in monetary units. The only way to overcome this
shortcoming is with a social welfare function. Arrow proved that a social welfare function
cannot be derived by democratic vote. This is known as Arrow’s impossibility theorem.
Income inequality can be measured by the Lorenz curve and the Gini coefficient. These
are higher in the United States than in other industrial countries and have increased
since 1975.

. By increasing the commodity price, trade protection benefits producers and harms consumers
(and usually the nation as a whole). Protection is more likely to be provided to industries that
(1) are labor-intensive and employ unskilled, low-wage workers, (2) are highly organized (such
as the automobile industry), (3) produce consumer products rather than intermediate products,
and (4) are geographically decentralized.

[| | _CKEY TERMS
Partial equilibrium analysis Marginal rate of transformation Welfare economics
General equilibrium analysis ofX for Y (MRTyy) Utility-possibilities frontier
Interdependence Economic efficiency Grand utility-possibilities frontier
Edgeworth box diagram for Pareto optimality Pareto criterion
exchange Law of the invisible hand Compensation principle
Contract curve for exchange First theorem of welfare Kaldor-Hicks criterion
Edgeworth box diagram for economics Scitovsky criterion
production Second theorem of welfare Bergson social welfare function
Contract curve for production economics Arrow’s impossibility theorem
Production-possibilities Market failures Lorenz curve
frontier Comparative advantage Gini coefficient
584 PART SIX General Equilibrium, Efficiency, and Public Goods

REVIEW QUESTIONS
il Are all points on the contract curve for exchange equally 6. What makes general equilibrium analysis objective while
desirable from society’s point of view? Why? welfare economics is subjective?
i) . How will an increase in the quantity of labor available to _ Would the Robinson Crusoe of Figure 17.6 maximize
society affect its Edgeworth box diagram for production? utility or welfare by producing and consuming 5X and
What effect will that have on the contract curve for 4.5Y? Why?
production? oo. What is the relationship between Adam Smith’s
law of
. How can we show a 10% improvement in technology the invisible hand and Pareto optimum?
in the production of commodities X and Y in the . Why do market disequilibria lead to inefficiencies and
Edgeworth diagram and production-possibilities non-Pareto optimum?
frontier? . Perfect competition is the best form of market
. Why would the economy of Figure 17.5 not be at general organization at one point in time but not over time. True
equilibrium if production took place at point M’ and or false? Explain.
consumption at point D? . What is meant by the “voting paradox?” How is this
. If MRTyy = 3/2 while MRSyy = 2 for individuals A and related to Arrow’s impossibility theorem?
B, should the economy produce more of X or more 12. Why is international trade often restricted if it benefits
of Y to reach equilibrium of production and exchange few domestic producers but harms many domestic
simultaneously? Why? consumers?

| PROBLEMS
|. Starting from a position of general equilibrium in the entire B’s Indifference Curves
economy, if the supply curve of commodity X falls (1.e., Sy
shifts up}, examine what happens B, Bz B3
a. in the markets for commodity _X, its substitutes, X Y xX ) XxX ‘ie
and complements.
u 2) 6 4 8 4
b. in the input markets.
2, 3 4 2 6 6
c. to the distribution of income.
1 4 3 Fi So) 8
. Suppose that the indifference curves of individuals A
and B are given by Aj, A», A3, and Bj, B 2, B3, respectively,
3. For the Edgeworth box diagram of Problem 2 (shown in
in the accompanying table. Suppose also that the total
Appendix B at the end of the text):
amount of commodities X and Y available to the two
individuals together is 1OX and 10Y. Draw the Edgeworth a. Explain how, starting from the point at which
box diagram for exchange, and show the contract curve A, and B; intersect, mutually advantageous
for exchange. exchange can take place between individuals
A and B.
A's Indifference Curves b. What is the value of the MRSyy at points E, D,
and F?
Ay A? A3
*4. Suppose that the isoquants for commodities X and Y are
xX Vie x VA Xx Ve given by X), X2, X3, and Yj, Y2, Y3, respectively, in the
following table. Suppose also that a total of 14L and 9K
3 7 5 6 6 WD are available to produce commodities X and Y. Draw the
4 3 6 4 8 6 Edgeworth box diagram for exchange and show the
6 | 8 3 9:5 D5) production contract curve.

* — Answer provided at end of book.

 CHAPTER 17 General Equilibrium and Welfare Economics 585

X’s Isoquants b. If MCy = $100 at point M’, what is MCx?

x) X2 X3 c. Why is the production-possibilities frontier concave
to the origin?
L kK L K iL K
d. When would the production-possibilities frontier be
5 i 8 3) 10 if a straight line?
6 2 3 11 5) *8. Superimpose the Edgeworth box diagram for exchange
if ] 11 2 13 4.5 of Problem 2 on the production-possibilities frontier of
Problem 4 (both shown in Appendix B at the end of the
text), and determine the general equilibrium of
Y’s Ilsoquants production and exchange.
\o. Explain why the economy portrayed in the answer to
Y Yo Y3
Problem 8 would not be simultaneously in general
L K L K L K equilibrium of production and exchange at points D
and F.
9 2 7 4 10 4 10. Given that the economy of Problem 8 produces at point
3 4 5 6 8 if M’ on its production-possibilities frontier, determine
] 6 4 8 eS 8.5 a. how much of commodities X and Y it produces.
b. how this output is distributed between individuals A
5. For the Edgeworth box diagram of Problem 4 (shown in and B.
Appendix B at the end of the text): (o) . how much labor (L) and capital (K) are used to
a. Explain how, starting from the point at which X; and produce commodities X and Y.
Y, intersect, the output of both commodities can be d. What questions have been left unanswered in the
increased by simply reallocating some of the fixed model?
amounts of L and K available between the production —= . Suppose that the economy represented by the figure in
of X and Y. the answer to Problem 8 (shown in Appendix B at the
b. What is the value of the MRTS_x at points M, J, end of the text) grows over time and/or has available a
and N? more advanced technology. Explain how this affects the
6. Suppose that in the figure in the answer to Problem 4, figure and general equilibrium analysis.
Xp ean) Ye" 135 Xo, — NO X-and yo = OY, and *12. Suppose that in the figure in the answer to Problem 8
X3 = 14X and Y, = 4Y. Derive the production-possibilities (see Figure 17c in Appendix B), A; = 100 utils, Az =
frontier corresponding to the production contract curve 300 utils, Az = 450 utils, and B; = 200 utils, By = 400
given in the figure in the answer to Problem 4. What utils, and B3; = 450 utils.
does a point inside the production-possibilities frontier a. Derive the utility-possibilities frontier
indicate? A point outside? corresponding to contract curve 04 DEF Og for
7. a. Find the MRTyy at points J’, M’, and N’ for the exchange in Figure 17c in Appendix B.
production-possibilities frontier of Problem 6. b. Derive the grand utility-possibilities frontier.

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 CHAPTER 10

Externalities, Public Goods, and

the Role of Government
18-2 Commercial Fishing: Fewer Boats but
Chapter Outline
Exclusive Rights?
18.1 Externalities
18-3 The Economics of a Lighthouse and Other
18.2 Externalities and Property Rights
: Public Goods
or
18.4 een Analysis
Benefit—Cost At theTax Frontier:
US. Svst
Efficiency Versus Equity in
18.5 The Theory of Public Choice p> pLOAs VStem
18-4 Benefit—Cost Analysis and the SST
18.6 Strategic Trade Policy
18-5 Strategic Trade and Industrial Policies in the
18.7. Government Control and Regulation of
United States
Environmental Pollution
18-6 The Market for Dumping Rights
List of Examples 18-7 Congestion Pricing
18-1 The Case for Government Support for
Basic Research

After Studying This Chapter, You Should Be Able to:

e Know the meaning of externalities and public goods and why they lead to economic inefficiencies
e Understand the meaning and importance of the Coase theorem
e Know why the existence of public goods can lead to underinvestment and a free-rider problem
e Understand how government decisions are made and implemented
e Understand why the optimal level of pollution is not zero

n this chapter, we examine why the existence of externalities and public goods leads
to economic inefficiencies and to an allocation of inputs and commodities that is not
Pareto optimum. We then consider how the government (through regulation, taxes,
and subsidies) could attempt to overcome or at least reduce the negative impact of these
distortions on economic efficiency. Because these distortions and government attempts
to overcome them are fairly common in most societies, the importance of the topics pre-
sented in this chapter can hardly be overstated. The “At the Frontier” section examines
the shift from equity to efficiency in tax reform in the United States. In this
chapter, we
also discuss the theory of public choice (i.e., how government decisions
are made and

586
 CHAPTER 18 Externalities, Public Goods, and the Role of Government 587

implemented) and strategic trade policy (i.e., how comparative advantage can be created
by subsidies, trade protection, and other government policies). We conclude by applying
the tools of analysis developed in the chapter to the problem of environmental pollution.

18.1 EXTERNALITIES
Externalities Harmful or In this section, we define externalities and examine why their existence prevents maxi-
beneficial side effects mum economic efficiency or Pareto optimum, even under perfect competition.
borne by those not directly
involved in the production
or consumption of a Externalities Defined
commodity.
External costs Harmful In the course of producing and consuming some commodities, harmful or beneficial side
side effects borne by effects arise that are borne by firms and people not directly involved in the production or
those not directly consumption of the commodities. These side effects are called externalities because
involved in the production they are felt by economic units (firms and individuals) not directly involved with (i.e.,
or consumption of a
that are external to or outside) the economic units that generate these side effects.!
commodity.
Externalities are called external costs when they are harmful and external benefits
External benefits
when they are beneficial. An example of an external cost is the air pollution that may
Beneficial side effects
received by those not accompany the production of a commodity. An example of an external benefit is the
directly involved in the reduced chance of the spreading of a communicable disease when an individual is inoc-
production or consumption ulated against it.
of a commodity. Externalities are classified into five different types. These are external diseconomies
External diseconomies of production, external diseconomies of consumption, external economies of production,
of production external economies of consumption, and technical externalities. Each of these will be
Uncompensated costs examined in turn. External diseconomies of production are uncompensated costs
borne by those not
imposed on others by the expansion of output by some firms. For example, the increased
directly involved in the
production of a
discharge of waste materials by some firms along a waterway may result in antipollution
commodity. legislation that increases the cost of disposing of waste materials for all firms in the area.
External diseconomies External diseconomies of consumption are uncompensated costs imposed on others by
of consumption the consumption expenditures of some individuals. For example, the riding of a snowmo-
Uncompensated costs bile by an individual imposes a cost (in the form of noise and smoke) on other individu-
borne by those not als who are skiing, hiking, or ice fishing in the area.
directly involved in the On the other hand, external economies of production are uncompensated benefits
consumption of a conferred on others by the expansion of output by some firms. An example arises when
commodity.
some firms train more workers to increase output, and some of these workers go to work
External economies
for other firms (which, therefore, save on training costs). External economies of con-
of production
Uncompensated benefits
sumption are uncompensated benefits conferred on others by the increased consumption of
received by those not a commodity by some individual. For example, increased expenditures to maintain his or
directly involved in the her lawn by a homeowner increase the value of the neighbor’s house. Finally, technical
production of a externalities arise when declining long-run average costs as output expands lead to
commodity. monopoly, so that price exceeds marginal cost. Not even regulation to achieve competi-
External economies tive marginal cost pricing is then viable (see Section 13.5).
of consumption
Uncompensated benefits
received by those not
directly involved in the
consumption of a | The presentation of this chapter follows F. M. Bator’s “The Anatomy of Market Failure,” Quarterly Journal
commodity. of Economics, August 1958, pp. 351-379, which was drawn from the work of the great English economist
Technical externalities Arthur Cecil Pigou (1877-1959).
Economies of scale.
588 PART SIX General Equilibrium, Efficiency, and Public Goods

Externalities and Market Failure

We have seen in Section 17.4 that perfect competition leads to maximum economic effi-
ciency and Pareto optimum. However, this is true only when private costs equal social
costs and when private benefits equal social benefits (i.e., in the absence of externalities).
This was implicitly assumed to be the case until now. When externalities are present, the
“invisible hand” is led astray and Pareto optimum is not achieved, even under perfect
competition. This is shown in Figure 18.1.
We assume that commodity X in Figure 18.1 is produced by a competitive industry.
Concept Check The industry supply curve (S) is the horizontal summation (above minimum average vari-
How do externalities able costs) of the individual firm’s marginal (private) cost curves (1.e., S = UMPC). Given
lead to market failures? market demand curve D for the commodity, the equilibrium price is $12 and the equilib-
rium quantity is 6 million units per time period (given by the intersection of D and S at
point £ in the figure). Suppose that the production of commodity X involves rising exter-
nal costs (in the form of air pollution, water pollution, traffic congestion, and so on) that

Px($)

Corrective
tax

E
0 4 Ox
—
Million units per time period
FIGURE 18.1 Competitive Overproduction with External
Costs With perfect competition, Py = $12 and Qy = 6 million
units (given by point E at which D and S intersect). S reflects only
marginal private costs, while S’ equals marginal private (internal
)
costs plus marginal external costs. Efficiency and Pareto
optimality
require that Py = $14 and Qy = 4 million units (given
by point E’, at
which D and S’ intersect). This can be achieved with a
$4 per-unit
corrective tax on producers that shifts S to 5”
 CHAPTER 18 Externalities, Public Goods, and the Role of Government

the firms producing commodity X do not take into account. The industry supply
curve that includes both the private and external costs might then be given by S’
(see the figure). Curve S’ shows that the marginal social cost (MSC) of producing
6 million units of commodity X exceeds the marginal private cost (MPC) of $12
by an amount equal to the marginal external cost (MEC) of $6 (AE) in the figure).
Thus, efficiency or Pareto optimality requires that Py = $14 and Qy = 4
million (given by the intersection of D and S’ at point E’ in the figure). Only then
would the commodity price reflect the full social cost of producing it. Starting
with S (showing the MPC), this could be achieved with a $4 per-unit corrective
tax on producers of commodity X, which shifts S upward to §” and defines
equilibrium point E’ at the intersection of D and S”’.* As we will see in the next
chapter, efficiency and Pareto optimality might also be achieved by the proper
specification of property rights. Without any such corrective action, the perfectly
competitive industry would charge too low a price and produce too much of
commodity X (compare point E with E’ in the figure).
Efficiency and Pareto optimality are not achieved whenever private and
social costs or benefits differ. With external diseconomies of consumption, con-
sumers do not pay the full marginal social cost of the commodity and consume
too much of it. Corrective action would then require a tax on consumers rather
than on producers. On the other hand, with external economies of production
and consumption, the commodity price exceeds the marginal social cost of the
commodity so that production and consumption fall short of the optimum level.
Efficiency and Pareto optimum in production and in consumption would then
require a subsidy (rather than a tax) on producers and on consumers, respec-
tively (see Problem 5, with the answer at the end of the text). Finally, technical
externalities (economies of large-scale production) over a sufficiently large
range of outputs lead to the breakdown of competition (natural monopoly). In
this case, marginal cost pricing is neither possible nor viable, and Pareto opti-
mum cannot be achieved.

EXAMPLE 18-1 j red wither i

The Case for Government Support for Basic Research

Basic research refers to efforts to discover fundamental relationships in nature, such as

natural laws. Often, these cannot be patented and do not have immediate commercial
applications. It is also practically impossible for the firm that makes a discovery of this
nature to take advantage of the full range of commercial applications that might result
from its discovery. Thus, the social benefits from basic research greatly exceed private
benefits. As a result, there is likely to be underinvestment in basic research by the private
sector. Since technological change and innovations are the most important contributors
to growth in modern societies, there is a strong case for government support for basic
research. Indeed, past government expenditures in basic research, such as for space

2 However, the marginal external costs created by firms in different areas of the market are likely to be different,
so that different corrective per-unit taxes may be required to achieve Pareto optimality. Furthermore, MEC may
be constant rather than rising. The corrective tax may also have some unintended side effects that lead to
inefficiency (such as the utilization of a less efficient technology).
590 PART SIX General Equilibrium, Efficiency, and Public Goods

industries, from
exploration, laid the foundations of many of today’s most productive
aerospace to computers.
world.
The same arguments that apply to firms in a nation apply to nations in the
less than the optimal level of basic
That is, the government of a nation may support
research because additions to fundamental knowledg e made by a nation can easily be
utilized by other nations. For example, until the 1980s, Japan stressed the finding of
commercial applications for basic discoveries made by other nations, mostly the
United States, rather than doing basic research itself. Primarily to overcome this prob-
lem, since 1990 the United States has been supporting generic and precompetitive
technologies, such as superconductivity, that could have widespread industrial appli-
cations but which take many years to develop and commercialize. Many economists,
however, believe that the government has no business picking “winners and losers”;
that is, substituting its judgment for that of the market by selecting among technolo-
gies and firms may not lead to optimal results (see Example 18-5).
Sources: National Academy of Science, Basic Research and National Goals (Washington, D.C.: U.S.
Government Printing Office, 1965); The MIT Commission on Industrial Productivity, Made in America:
Regaining the Productive Edge (Cambridge, MA: The MIT Press, 1989), Chapter 5; “Basic Research Is
Losing Out as Companies Stress Results,” New York Times, October 8, 1996, p. 1; “How to Nurture a
High-Technology Culture,” Financial Times, September 14, 2001, p. 13; C. Wessner, “The Advanced
Technology Program: It Works,” Issues in Science and Technology, Fall 2001, pp. 59-65; and IEEE-USA,
Federal Support for Basic Research, (Washington, DC: IEEE-USA, February 16, 2007.

18.2 EXTERNALITIES AND PROPERTY RIGHTS

We have seen in the previous section that externalities, by driving a wedge between pri-
vate and social costs or benefits, prevent economic efficiency and Pareto optimality. But
why do externalities arise in some cases and not in others? Suppose you own a car. You
have a clear property right in the car, and anyone ruining it is liable for damages. The
courts will uphold your right to compensation. In this case there are no externalities.
Private and social costs are one and the same thing. Compare this with the case of a firm
polluting the air. Neither the firm nor the people living next to the firm own the air. That
Common property is, the air is common property. Since no resident owns the air, no one can sue the firm
Property, such as air, for damages resulting from the air pollution generated by the firm. The firm imposes an
owned by no one.
external (1.e., an uncompensated) cost on the individual. These two simple examples
clearly demonstrate that externalities arise when property rights are not adequately spec-
ified. In the first case, you have a clear property right to the car and there are no external-
Coase theorem
ities. In the second case, no one owns the air and externalities arise. This situation leads
Postulates that when
property rights are
to the famous Coase theorem.*
clearly defined and The Coase theorem postulates that when property rights are clearly defined, perfect
transaction costs are competition results in the internalization of externalities, regardless of how property
zero, perfect competition rights are assigned among the parties (individuals or firms). For example, suppose
that a
results in the absence of
externalities, regardless
of how property rights *R. R. Coase, “The Problems of Social Cost.” Journal ofLaw and Economics,
October 1960, pp. 1-44.
are assigned among the “A Nobel-Prize Winning Idea, Conceived in the 30’s Is a Guide for Net Business,”
New York Times, October 2,
parties involved. 2000, p. C12; and “The Tragedy of the Commons,” Forbes, September 10,
2001, pp. 61-63.
 CHAPTER 18 Externalities, Public Goods, and the Role of Government 591

brewery is located downstream from a paper mill that dumps waste into the stream.
Suppose also that in order to filter and purify the water to make beer, the brewery incurs a
cost of $1,000 per month, while the paper mill would incur a cost of $400 to dispose of its
waste products by other means and not pollute the stream. If the brewery has the property
right to clean water, the paper mill will incur the added cost of $400 per month to dispose
of its waste without polluting the stream (lest the brewery sue it for damages of $1,000
per month). On the other hand, if the paper mill has the property right to the stream and
can freely use it to dump its wastes in it, the brewery will pay the paper mill $400 per
month not to pollute the stream (and thus avoid the larger cost of $1,000 to purify the
water later).
The cost of avoiding the pollution is internalized by the paper mill in the first instance
and by the brewery in the second. That is, the $400 cost per month of avoiding the pollu-
tion becomes a regular business expense of one party or the other and no externalities
Internalizing external result. The socially optimal result of internalizing external costs and avoiding the pollu-
costs The process tion at $400 per month, rather than cleaning up afterwards at a cost of $1,000 per month, is
whereby an external achieved regardless of who has the property right to the use of the stream.’ Thus, external-
cost becomes part of
ities are avoided (and economic efficiency and Pareto optimum achieved) under perfect
the regular business
expense of a firm. competition, if property rights are clearly defined and transferable. Transaction costs must
also be zero.>
Transaction costs are the legal, administrative, and informational expenses of draw-
Concept Check ing up, signing, and enforcing contracts. These expenses are small when the contracting
What is the relationship parties are few (as in the above example). When the contracting parties are numerous (as
between the Coase in the case of a firm polluting the air for possibly millions of people in the area), it would
theorem and the be practically impossible or very expensive for the firm to sign a separate contract with
internalizing of each individual affected by the pollution it creates. Contracting costs are then very large,
external costs?
and externalities (and inefficiencies) arise. This is especially true in the case of environ-
mental pollution (see Section 18.7).°

EXAMPLE 18-2
Commercial Fishing: Fewer Boats but Exclusive Rights?

As a response to catastrophic overfishing by foreigners during the 1960s, the United

States passed the Fisheries Conservation and Management Act of 1976. The act
extended the U.S. exclusive economic (fishing) zone from the traditional 3-mile limit
to 200 miles and created eight U.S. regional councils dominated by local fishing inter-
ests to distribute exclusive rights to the catch. Economists strongly supported the plan
to move from public to private ownership as the best method of preventing overfishing

4 Note that the cost of pollution abatement is minimized rather than entirely eliminated. The only way to
completely avoid the cost of pollution is for the paper mill to stop production. But this would result in the
greater social cost of the lost production. The above conclusion is also based on the assumption of a zero
income effect on the demand curve for the use of the stream regardless of who has the property right of it.
5 Bven if neither the brewery nor the paper mill had a property right to the use of the stream, the conclusion
would generally be the same as long as transaction costs are zero. That is, it pays for the brewery to pay the paper
mill $400 per month not to pollute. This is equivalent to the paper mill having the right to the use of the stream.
6 However, the development of class action lawsuits has greatly reduced transaction costs in these cases.
 PART SIX General Equilibrium, Efficiency, and Public Goods

ment as to
and preserving fisheries for future generations. However, strong disagree
nt,
who should benefit from the distribution of the rights to the catch (the governme
tion
current owners of fishing boats, or fishermen) has so far prevented the privatiza
ing by
plan from being implemented. As a result, the act has only eliminated overfish
foreigners but not by American s, so the catches remained well above biologica lly sus-
tainable levels. Even though a small number of boats could catch the maximu m sus-
tainable yield at the lowest possible cost, there remained a strong incentive to
overinvest in the industry as long as it was profitable to bring new boats into operation.
Until the year 2000, the attempt to reduce overfishing took the form of sharply
reducing the length of the fishing seasons and the size of the catch. For example, off
Alaska, the halibut season consisted of only two or three days per year. Since then
however, cooperatives began to be created that face annual fishing quotas set by
marine biologists to preserve fishing stocks, rather than trip limits on the catch. When
fully operational by 2011, this would essentially establish property rights that elimi-
nate overfishing, reduce costs, and increase the efficiency in U.S. fisheries.
Sources: “A Change in Commercial Fishing: Fewer Boats but Exclusive Rights,” New York Times, April 2,
1991; “Not Enough Fish in the Stormy Sea,” U.S. News & World Report, August 15, 1994, pp. 55-56;
“One Answer to Overfishing: Privatize the Fisheries,” New York Times, May 11, 1995, p. D2; “Fish Stock
Face Global Collapse,” Financial Times, February 18, 2002, p. 5; and “One Fish, Two Fish, No Fish,” U.S.
News & World Report, August 27, 2007, pp. 50-56.

18.3 PUBLIC GOODS

We have seen in Section 17.4 that perfect competition leads to maximum economic effi-
Public goods ciency and Pareto optimum in the absence of market failures. One type of market failure
Commodities for which results from the existence of public goods. In this section, we examine the nature of pub-
consumption by some lic goods and their provision.
individuals does not
reduce the amount
available to others. Nature of Public Goods
Nonrival consumption If consumption of a commodity by one individual does not reduce the amount available
The distinguishing for others, the commodity is a public good. That is, once the good is provided for some-
characteristic of a
one, others can also consume it at no extra cost. Examples of public goods are national
public good whereby its
consumption by some
defense, law enforcement, fire and police protection, and flood control (provided by the
individuals does not government), but also radio and TV broadcasting (which are provided by the private sec-
reduce the amount tor in many nations, including the United States).
available to others. The distinguishing characteristic of public goods is nonrival consumption. For
example, when one individual watches a TV program, he or she does not interfere with
Nonexclusion The the reception of others. This is to be contrasted with private goods, which are rival in con-
situation in which it is
sumption, in that if an individual consumes a particular quantity of a good, such as
impossible or apples,
these ‘same apples are no longer available for others to consume.
prohibitively expensive
to confine the benefit or Nonrival consumption must be distinguished from nonexclusion. Nonexcl
usion
the consumption of a means that it is impossible or prohibitively expensive to confine the benefits
of the con-
good to the people sumption of a good (once produced) to selected people (such as only
to those paying for it).
paying for it. Whereas nonrival consumption and nonexclusion often go hand in hand,
a public good is
 CHAPTER 18 Externalities, Public Goods, and the Role of Government 59

defined in terms of nonrival consumption only. For example, since national defense and
TV broadcasting are nonrival in consumption (i.e., the same amount can be consumed by
more than one individual at the same time), they are both public goods. However, national
defense also exhibits nonexclusion (i.e., when it is provided for some individuals, others
Concept Check
cannot be excluded from also enjoying it), while TV broadcasting can be exclusive (e.g.,
What is the relationship only paying customers can view cable TV). We will see in the next section that public
between public goods, goods (i.e., goods that are nonrival in consumption) will not be provided in the optimal
nonrival consumption, amount by the private sector under perfect competition, thus requiring government inter-
and nonexclusion? vention. First, however, we must determine what is the optimal amount of a public good.
Because a given amount of a public good can be consumed by more than one indi-
vidual at the same time, the aggregate or total amount of a public good is obtained by the
vertical (rather than by the horizontal) summation of the demand curves of the various
individuals who consume the public good. This is shown in Figure 18.2. In the figure, D4
is the demand curve of Ann and Dz is the demand curve of Bob for public good X. If Ann
and Bob are the only two individuals in the market, the aggregate demand curve for good
X, Dr, is obtained by the vertical summation of D, and Dg. The reason for this is that each
unit of public good X can be consumed by both individuals at the same time.’

Px($)

FIGURE 18.2 Optimal Amount of a Public Good Aggregate

demand curve D; for public good X is obtained by the vertical
summation of individual demand curves Dy and Dg. This is because
each unit of public good X can be consumed by both individuals at the
same time. Given market supply curve Sy, the optimal amount of X’ is
8 units per time period (given by the intersection of Dy and Sy at point
E). At point £, the sum of the individuals’ marginal benefits equals the
marginal social costs (i.e, AB + AC = AE).

7 This is to be contrasted with the market demand curve for a private or rival good, which, as we have seen in
Problem 10,
Section 5.1, is obtained from the horizontal summation of the individuals’ demand curves (see
with the answer at the end of the text).
594 PART SIX General Equilibrium, Efficiency, and Public Goods

of X is 8 units
Given market supply curve Sy for public good X, the optimal amount
Dr and Sx at point E in the figure). At point |
per time period (given by the intersection of
or margina l social benefit equals the mar-
E. the sum of the individuals’ marginal benefits
once again that the margina l principl e
ginal social cost (i.e., AB + AC = AE). Thus, note
than the optimal amount of public good X
isat work. The problem is that, in general, less
this prevents the attainme nt of maximu m
will be supplied under perfect competition, and
efficiency and Pareto optimum.

EXAMPLE 18-3
The Economics of a Lighthouse and Other Public Goods

A lighthouse is a good example of a public good. Once a lighthouse is built, it can

send signals to ships during storms at practically zero extra cost. That is, lighthouse
signals are nonrival in consumption. Lighthouse signals are not exclusive, however,
as it was originally believed. That is, each user can be charged for the service.
Indeed, historical research has shown that lighthouses were privately owned in
England from 1700 to 1834, and that they must have been doing a good business
because their number increased over the period. Lighthouse owners charged ships at
dock (according to their tonnage) for their land-demarcation light signals during
storms. Usually only one ship at a time was in sight of the lighthouse, and ships were
identified by their flag. If a ship had not paid for the service, the light signals were
not shown.
The lighthouse provides an example of a public good that is exclusive (so that
users can be charged for the service). The same is true for the North Atlantic Treaty
Organization (NATO), under which Western European nations and the United
States contributed to provide for their mutual protection against past Soviet military
threat. A similar public good is education. Entrepreneurs often show great ingenu-
ity in making public goods exclusive. An example is the provision of in-place pay-
ing binoculars at Niagara Falls and other scenic sights. Another example is the
placing of super-large TV screens in some bars. These and other similar services
would not be provided if they were not, or if they could not be made, exclusive (i.e.,
if consumers could not be charged for them). Other examples of public goods that
can be made exclusive are the findings of government-paid basic research and the
use of advertising to pay for radio and TV broadcasts. Although any firm can make
use of basic-research findings, the specific offshoots or commercial applications
of basic research developed by a particular firm can be patented and thus made
exclusive.
Sources: Ronald R, Coase, “The Lighthouse in Economics,” Journal of Law and Economics, October
1974.” pp. 357-376; “So, It’s a Lighthouse. Now Leave Me alone,” New York Times, April 18, 2002, p. 1;
“Vast Sums for New Discoveries Pose Threat to Basic Science.” New York Times, May 27, 1990, p. 1;
“Do Firms Run Schools Well?” U.S. News & World Report, January 8, 1996, pp. 46—49: “Woes
for
Company Running Schools, New York Times, May 14, 2002, p. 1; and “Public vs. Private
Schools.”
New York Times, July 19, 2006, p. 20.
 CHAPTER 18 Externalities, Public Goods, and the Role of Government 595

Provision of Public Goods

We have seen that the optimal amount of a public good is the amount at which the sum of
the marginal benefits of all the individuals consuming the good equals its marginal cost.
Graphically, this is given by the point at which the aggregate demand curve for the good
(obtained from the vertical summation of the individuals’ demand curves) intersects the
market supply curve of the good. However, less than this optimal amount of the public
good is likely to be supplied by the private sector.
There are two related reasons for this. First, when the public good is nonexclusive
(i.e., when those individuals not paying for it cannot be excluded from also consuming it),
Free-rider problem there is a tendency for each consumer to be a free rider. A free-rider problem arises
The problem that arises because each consumer believes that the public good will be provided anyway, whether
when an individual he or she contributes to its payment or not. That is, because there are many people shar-
does not contribute to
ing the cost of providing the public good, each individual feels that withdrawing his or her
the payment of a public
good in the belief that it
financial support will practically go unnoticed by others and will have little or no effect
will be provided on the provision of the good. The problem is that since many individuals behave this
anyway. way (i.e., behave as free riders), less than the optimal amount of the public good will be
provided.* In general, as the group size increases, the free-rider problem becomes more
acute. This problem can be, and generally is, overcome by the government taxing the gen-
eral public to pay for the public good. A good example of this is national defense.?
Concept Check
How does the free-rider
Sometimes governments go to great lengths to induce people to pay their fair share of
problem arise in the taxes to provide public goods. For example, at the turn of the century, the government of
provision of public China retained the right to purchase an individual’s house to avoid the owner’s incentive
goods? to undervalue it for tax purposes.
The second (related) problem cannot be resolved as satisfactorily by government
intervention. This arises because each individual has no incentive to accurately reveal his
or her preferences or demand for the public good. Therefore, it is practically impossible
for the government to know exactly what is the optimal amount of the public good that it
should provide or induce the private sector to provide. There is also the problem of possi-
ble government inefficiency in providing public goods and in otherwise intervening in the
market (see Section 18.5).

AT THE FRONTIER
Efficiency Versus Equity in the U.S. Tax System

axpayers everywhere complain that they pay too much. Contrary to popular belief,
however, taxes in the United States are lower than in all other major advanced
nations except Japan. Table 18.1 shows that total tax receipts as a percentage of gross
domestic product (GDP) were 34.1% in the United States in 2006, compared with an

Continued...

8 Note that even a private (rival) good leads to market failure if it is characterized by nonexclusion (i.e., if each
individual consuming it cannot be adequately charged for it).
° Sometimes a free-rider problem can partially be resolved by the private sector. Examples are educational
television stations, tenants’ associations, and charitable associations such as the Salvation Army.
596 PART SIX General Equilibrium, Efficiency, and Public Goods

Efficiency Versus Equity in the U.S. Tax System = Continued

Mi Taxes as a Percentage of GDP in the Leading

UAE advanced Nations in 1990, 2000, and 2006
Country 1990 2000 2006

Sweden 64.7 60.9 57.6

France Aq II 50.1 Sil
Belgium 45.5 49.1 49.1
Netherlands 49.1 46.1 47.2
Italy 41.5 45.3 45.6
Germany 41.7 46.4 43.9
United Kingdom 40.6 41.5 42.2
Canada 43.0 44.1 40.3
Spain 38.7 38.1 40.3
United States 32.8 Bons 34.1
Japan 3339 31.4 539

Source: OECD Economic Outlook, June 2007, p. 265.

average of over 45.5% in the Euro area. Another difference is that the United States
raises most of its revenues from income and profit taxes, while European countries rely
mostly on consumption taxes, such as the value-added tax (taxes imposed on the value
added at each stage of the production and distribution chain).
Although Europeans pay much higher taxes than Americans, they also get much
greater benefits. Europeans have good free medical and nursing home care, nearly free
college education, and generous pension and unemployment safety nets. They also
have lower crime rates, cleaner streets, state-of-the-art mass transit, less income and
wealth inequality, and less social instability, and this makes them more willing to
accept higher taxes. In the United States, people do not see such a strong association
between taxes and tangible benefits, and so there is a much greater resistance to higher
taxes. The very strong welfare state in Europe, where people rely on government for
cradle-to-grave care, has its shortcomings, however. For one thing, even with very
high taxes, most European nations have big budget deficits and are being forced to
scale down welfare benefits. There is also much less labor mobility and much higher
rates of unemployment, fewer patents, and much less entrepreneurship than in the
United States, and these reduce European international competitiveness and future
growth prospects.
The recent drive to reduce federal welfare programs and cut taxes represents, to
Concept Check some extent, a fundamental change in the U.S. tax system, from stressing equity and
Why is there often a fairness to striving for efficiency and growth. This increased the international compet-
conflict between itiveness of the U.S. economy during the past decade, but it is also increased income
efficiency and equity inequalities, both absolutely and relative to other advanced nations.
in taxation? Although most people agree that major tax reform is needed in the United States,
this is not happening. One proposal for tax reforms is the so-called “fair tax,” which
would tax consumption (say, with a retail sales tax) rather than income (which
discourages economic activity, saving, and investment) and eliminate all exemptions,
 CHAPTER 18 Externalities, Public Goods, and the Role of Government 597

deductions, exceptions, and special tax provisions. According to its supporters, this
would broaden the tax base, significantly reduce tax rates, and improve efficiency.
This, however, would require repealing the XVI Amendment (which allows
Washington to impose an income tax) and, according to its opponents, would dramat-
ically raise prices of many goods and services. Another tax proposal is the flat tax,
which would impose a simple tax rate on personal income and corporate profits, with
general exemptions for low-income families. This would greatly stimulate economic
activity according to its supporters, but it is a loser on both economic and moral
grounds according to its opponents.

Sources: “Gap in Wealth in U.S. Called Widest in West,” New York Times, April 17, 1995, p. 1; “European
Shrug as Taxes Go Up,” New York Times, February 16, 1995, p. 10; “How Fair Are Our Taxes,” Wall Street
Journal, January 10, 1996, p. A12; D. Altig et al.; “Simulating Fundamental Tax Reforms in the United
States,” American Economic Review, June 2001, pp. 574-595; D. Salvatore, “Relative Taxation and
Competitiveness in the European Union: What the European Union Can Learn from the United States,”
Journal of Policy Modeling, May 2002, pp. 401-410; L. J. Kotlikoff, “The Case for the ‘Fair Tax,’ “ Wall
Street Journal, March 7, 2005, p. A18; “One Simple Rate,” Wall Street Journal, August 15, 2005, p. Al2;
“Fair Taxes? Depends What You Mean by “Fair,” New York Times, July 15, 2007, Sec. IV, p. 4; “Income
Tax Foes Regroup,” Wall Street Journal, August 20, 2007, p. A4; and “The Bag of Tricks Is Almost
Empty,” New York Times, February 10, 2008, p. 9 (Business Section).

| 18.4 | BeNeFiT—Cost ANALYSIS

Governments play many roles in modern societies. These roles range from the provision
of public goods, to the redistribution of income, the regulation of monopoly, and pollution
control. In carrying out these functions, government agencies must constantly decide
which projects to implement and which to reject. A useful procedure for determining the
Benefit-cost analysis | most worthwhile projects is benefit-cost analysis. This analysis compares the present
A procedure for value of the benefits of a project to the present value of the costs of a project. Government
determining the most should carry out a project only if the present value of the social benefits from the project
worthwhile public exceeds the present value of its social costs (i.e., if the benefit-cost ratio for the project
projects for the
exceeds 1). Often, the government does not have the resources (1.e., cannot raise taxes or
government to
undertake.
borrow sufficiently) to undertake all the projects with a benefit—cost ratio exceeding 1. In
such cases, government should rank all possible projects from the highest to the lowest
(but exceeding |) benefit—cost ratio, and starting at the top of the list, it should undertake
all projects until its resources are fully utilized.
Although this sounds straightforward, a number of serious difficulties arise in the
actual application of benefit-cost analysis, because it is often very difficult to correctly
estimate the social benefits and the social costs of a project and to determine the appro-
priate rate of interest to use to calculate the present value of benefits and costs. First, since
the benefits and the costs of most public projects (such as a dam, a highway, a training
program, and so on) take place over many years, it is difficult to estimate them correctly
so far into the future.
Second, benefits and costs are frequently estimated on the basis of current or pro-
jected prices, even though these prices may not reflect the true scarcity value or opportu-
nity cost of the outputs resulting from or the inputs used in the project. For example,
commodity prices under imperfectly competitive commodity markets exceed their marginal
598 PART SIX General Equilibrium, Efficiency, and Public Goods

yed labor, the

cost. Similarly, if a project results in the employment of otherwise unemplo
workers. In
real cost of hiring labor is zero, in spite of the positive wage paid to these
ity value of the benefits and costs of the project that
other words, it is the real or opportun
cost analysis. But it may be difficult to estimate them. Real
should be used in benefit-
costs may also rise as the project increases the demand for inputs.
Third, some of the benefits and costs of a project may not be quantifiable. For exam-
train-
ple, while it may be possible to estimate the rise in workers’ income resulting from a
ing program, it is next to impossible to assign a value to their enhanced self-estee m and
to their becoming more responsibl e citizens. Similarly, it is practicall y impossibl e to
assign a value to the loss of scenery resulting from the construction of a dam. Yet, all of
these social benefits and costs should be included in benefit-cost analysis for it to lead to
appropriate public investment decisions.
The fourth and perhaps the most serious difficulty with benefit-cost analysis arises
in the choice of the proper interest rate to be used to find the present value of the benefits
and costs of the project. That is, since the benefits and costs of most projects occur Over a
number of years, they must be discounted to the present. For this a rate of interest must be
used, as discussed in Section 16.3.'!° The question is which is the proper interest rate to
use? As indicated in Section 16.4, there are a large number of rates of interest in the mar-
ket (ranging from nearly zero to 40%) depending on the risk, duration, cost of adminis-
tering, and the tax treatment of the loan. Since the use of resources by the government
competes with private use, the interest (discount) rate to be used to find present values
should reflect the opportunity cost of funds for a project of similar riskiness, duration, and
administrative costs in the private sector. However, because different people may come up
with a different rate of interest to use, benefit-cost analysis is usually prepared for a range
of interest rates (from a low, to a medium, and a high one) rather than for a single interest
rate. The lower the interest rate (or range of interest rates) used, the higher the
benefit—cost ratio usually is and the greater the likelihood of the project being undertaken.
The reason for this is that the benefits of a project usually arise later or over a longer
period of time than its costs.
In spite of the great difficulties inherent in benefit—cost analysis, it is nevertheless a
very valuable procedure for organizing our thoughts on the social benefits and the social
costs of each project. If nothing else, it forces government officials to make explicit all the
assumptions underlying the analysis. Scrutiny of the assumptions has sometimes led to
decision reversals. For example, in 1971, the Federal Power Commission (now the
Federal Energy Regulatory Commission) approved the construction of a hydroelectric
dam on the Snake River, which flows from Oregon to Idaho and forms Hell’s Canyon (the
deepest in North America). The decision was based on a benefit-cost analysis that
ignored some environmental costs. Because these costs were not accounted for, the
Supreme Court, on appeal from the secretary of the interior, revoked the order to build the
dam pending a new benefit-cost analysis that properly included all benefits and costs.
Eventually, Congress passed a law prohibiting the construction of the dam.!!
Although benefit-cost analysis is still more of an art than a science and is somewhat
subjective, its usefulness has been proven in a wide variety of projects—water, transportation,

'"Tn Section 16.3 we showed how to find the present value of a project. For benefit—cost
analysis we need to
find the present value of the benefits and costs of the project separately. The
procedure, however, is the same.
Note that a positive present value for a project is equivalent to a greater-than
-one benefit—cost ratio.
'! J. V. Krutilla and A. C. Fisher, The Economics of Natural Environments: Studies
in the Valuation of
Commodity and Amenity Resources (Baltimore: Johns Hopkins University Press,
1975), pp. 101-103.
 CHAPTER 18 Externalities, Public Goods, and the Role of Government 599

health, education, and recreation. In fact, in 1965, the federal government formally began
to introduce benefit-cost analysis for its budgetary procedures under the Planning-
Programming-Budgeting System (PPBS). The practice has now spread to state and local
governments as well. The process suffered a setback, however, when the Supreme Court
Concept Check ruled in February 2001 in Whitman v. American Trucking Associations Inc. that the EPA
Whntare the uses and must consider only the requirements of public health and safety in setting national air
shortcomings of quality standards and may not engage in cost-benefit analysis, as the American Trucking
benefit-cost analysis? Associations Inc. had argued.!*

EXAMPLE 18-4 es
Benefit—Cost Analysis and the SST

In 1971, after a benefit-cost analysis, the development of the supersonic transport

plane (SST) was abandoned by the United States. The benefits were simply not large
enough to justify the costs. The French and British governments, however, jointly pur-
sued the project and built the Concorde, at a huge cost. Only a handful of such planes
was built, and they were operated exclusively by the British and French national air-
lines in flights between New York and Paris or London from 1976 until it was
grounded in 2003. With operating costs more than four times higher than for the
Boeing 747, the Concorde must be classified as a clear market failure. Specifically, a
one-way seat from New York to London was $6,000, and from New York to Paris it
was $5,000, which was more than the roundtrip price from New York and London or
Paris on the Boeing 747. This meant that passengers paid more than $1,000 for each
hour saved by traveling on the Concorde. Modern people may be hurried today but not
that hurried!
British Airways and Air France insisted all along that the Concorde broke even.
Even so, the huge development cost of $8 billion was never recouped. And business on
the Concorde was not brisk—British Airways and Air France found it increasingly dif-
ficult to fill the Concorde. It seems that in their zeal to fly the only supersonic plane,
the British and French greatly overestimated the benefits and grossly underestimated
the costs of building and running the Concorde in their benefit-cost analysis. This is an
example of how imprecise benefit-cost analysis and how costly national pride can
sometimes be.
Be that as it may, the Concorde was a marvel of air travel, with no rival in sight. A
European project to build the “Concorde 2,” with double the capacity of the past
Concorde, was scrapped in 1995. Similarly, a 10-year study on the feasibility of build-
ing an American supersonic passenger plane by the National Aeronautics and Space
Administration and involving Boeing and engine makers General Electric and Pratt &
Whitney that cost $1.8 billion was shut down in 1998. Only France and Japan have
expressed the intention of trying jointly to develop a supersonic commercial plane.
The problem is not technological but economic. Although small supersonic jets are

12 “RFP.A.’s Right to Set Air Rules Wins Supreme Court Backing,” New York Times, February 28, 2001, p. 1;
and D. Clement, “Cost v. Benefit: Clearing the Air?” The Region, Federal Reserve Bank of Minneapolis,
December 2001, pp. 19-57.
600 PART SIX General Equilibrium, Efficiency, and Public Goods

supersonic pas-
being developed, there is no possibility at present of building a large
senger aircraft that could be operated at a profit.
p. 26; “Supersonic on the
Sources: “The Concorde’s Destination,” New York Times, September 28, 1979,
Hurdles,”
Back Burner.” The Economist, March 6, 1999, p. 74; “Concorde Successor Faces Many
” New York
Financial Times, December 12, 2001, p. V; “France and Japan Seek Concorde Alternative,
ubercool.co m/2007/06/2 5/supersoni c-travel-re invented.
Times, June 16, 2005, p. C4; and http://www.

18.5 THE THEORY OF PuBLic CHOICE

In this section we examine the meaning, importance, and policy implications of public-
choice theory. Specifically, we explore the process by which government decisions are
made and the reasons that these decisions might not increase social welfare.

Meaning and Importance of Public-Choice Theory

Theory of public The theory of public choice is the study of how government decisions are made and
choice The study of implemented. It studies how the political process and government actually work rather
how government than how they should work, and it recognizes the possibility of government failures or
decisions are made and
situations in which government policies do not reflect the public’s interests and reduce
implemented.
rather than increase social welfare. The fact that markets do not operate efficiently does not
Government failures necessarily mean that government policies will improve the situation; it is always possible
Situations where that government intervention will make a bad situation worse. The opposite situation 1s
government policies do also invalid. That is, the fact that government policies are inefficient does not necessarily
not reflect the public’s
mean that private markets can do better. For example, great waste in government defense
interests and reduce
rather than increase
expenditures does not mean that the provision of national defense can be left to private
social welfare. markets.
The theory of public choice is based on the premise that individuals attempt to fur-
ther their own personal interests in the political arena just as they seek to further their own
economic interests in the marketplace. According to the law of the invisible hand postu-
lated by Adam Smith over two centuries ago, an individual who pursues his or her own
selfish economic interests also and at the same time promotes the welfare of society as a
whole. This was the basis for favoring and stimulating competition in the marketplace.
The theory of public choice seeks to answer the question of whether such an invisible
hand mechanism is also at work in the political system. That is, as each individual
attempts to further his or her own interests in political activities, is he or she also and at
the same time promoting society’s welfare?

The Public-Choice Process

The theory of public choice examines how government decisions are made and imple-
mented by analyzing the behavior of individuals within each of four broad groups or par-
ticipants in the political process. These groups are voters, politicians, special-interest
groups, and bureaucrats. Let us examine each in turn.

Voters The voter in the political process can be regarded as the counterpart
of the con-
sumer in the marketplace. Rather than purchasing goods and services for himself
or herself
 CHAPTER 18 Externalities, Public Goods, and the Role of Government 601

in the marketplace, the voter elects government representatives who make and enforce
government policies and purchase goods and services for the community as a whole.
Other things being equal, voters tend to vote for candidates who favor policies that will
further their own individual interests. This is, in fact, the general process by which elected
officials are responsive to the electorate.
According to public-choice theorists, however, voters are much less informed about
political decisions than about their individual market decisions. This lack of information
Rational ignorance is often referred to as rational ignorance. There are three reasons for ignorance. First,
The condition whereby with elected officials empowered to act as the purchasing agents for the community, there
voters are much less
is less need for individual voters to be fully informed about public choices. Second, it is
informed about
generally much more expensive for individuals to gather information about public
political decisions than
about their individual choices than to become informed about individual market choices. For example, it is
market decisions much more difficult for an individual to evaluate the full implications of a proposed
because of the higher national health insurance plan than to evaluate the implications of an individual insurance
costs of obtaining policy. Third, as a single individual, a voter feels—and, indeed, is—less influential in and
information and the less affected by public choices than by his or her own private market choices.
smaller direct benefits
that they obtain from Politicians Politicians are the counterpart in the political system of the entrepreneurs or
the former than from managers of private firms in the market system. Both seek to maximize their personal
the latter. benefit. While the entrepreneur or manager of a private firm seeks to maximize his or her
interest by maximizing the firm’s profits, the politician seeks to maximize chances of
reelection. In doing so, politicians often respond to the desires of small, well-organized,
well-informed, and well-funded special-interest groups. These include associations of
farmers, importers, medical doctors, and many others. Faced with rational ignorance on
the part of the majority of voters, politicians often support policies that greatly benefit
small, vocal interest groups (who can contribute heavily to a candidate’s reelection cam-
paign) at the expense of the mostly silent and uninformed majority.
For example, in the early 1980s, U.S. automobile manufacturers were able to greatly
increase their profits by having the U.S. government restrict auto imports from Japan (see
the example in Section 13.7). The fact that politicians face reelection every few years may
also lead politicians to pay undue attention to the short run, even when this leads to more
serious long-run problems. For example, public policies are often adopted to reduce the
rate of unemployment at election time in November, even though this might lead to higher
inflation later. Such policies have led some to postulate the existence of a “political busi-
ness cycle.”
Special-Interest Groups Perhaps the most maligned of the groups participating in the
political process are special-interest groups. These pressure groups or organized lobbies
seek to elect politicians who support their cause, and they actively support the passage of
laws and regulations that further their interests. For example, for decades the American
Medical Association succeeded in limiting admissions to medical schools, thereby
increasing doctors’ incomes; farmers’ associations successfully lobbied the government
to provide billions of dollars in subsidies each year; as pointed out earlier, U.S. automak-
ers succeeded in having auto imports from Japan restricted in the early 1980s, thereby
greatly increasing their profits. Even though not all lobbies are as successful as those
mentioned here, thousands are in operation, and this, according to many, represents the
worst aspects of our political system.!°

'3 Tn recent years, lobbying in Washington by foreign firms and nations (especially Japan) has increased sharply.
602 PART SIX General Equilibrium, Efficiency, and Public Goods

that they are

The reason some of these special-interest groups are so influencial is
deal when their efforts are successfu l. Thus,
well organized and stand to benefit a great
millions of dollars in financial support to politi-
they are very vocal and often can provide
time, most people are usually not aware of
cians who advocate their cause. At the same
the costs (usually small) that they individua lly face from these laws and regulatio ns.
Furthermore, these laws and regulations are invariably rationalized in terms of the
national interest. For example, import restrictions on shoes might only increase the price
of shoes by $1 per pair while providing millions of dollars in extra profits to the few
remaining shoe manufacturers in the nation. Supposedly, these import restrictions are
temporary and are essential to give time to American producers to increase efficiency and
be able to meet what is regarded as unfair foreign competition.
Bureaucrats Bureaus are the government agencies that carry out the policies enacted by
Congress. They do so by receiving annual lump-sum appropriations to cover the costs of
providing the services that they are directed to provide. Bureaus often provide these ser-
vices under conditions of monopoly (i.e., without any competition from other bureaus or
private firms) and so have little incentive to promote internal efficiency. While it is diffi-
cult to compare the efficiency of government bureaus and private firms, there have been
spectacular cost overruns in many defense projects. For example, the cost of the
Lockheed C5A transport plane increased from an estimated $3.4 billion in 1965 to
$5.3 billion in 1968.
According to public-choice theory, bureaucrats are not simply passive executors of
adopted policies, but seek to influence such policies in order to further their own personal
interests. They do so by constantly seeking to increase the scope of the bureau’s activities
and the amount of funding, even when the raison d’étre for the bureau no longer exists.
This is because a top bureaucrat’s career, income, power, prestige, and promotion are, in
general, closely related to the size and growth of the bureau. In essence, the bureau often
becomes a separate special-interest group within the government!

Policy Implications of Public-Choice Theory

The above characterization of the political process by public-choice theorists is, perhaps,
excessively cynical. Voters elect only politicians who promote their individual interests, and
are mostly ignorant and indifferent about most other public choices; politicians only seek to
maximize their chances of reelection; special-interest groups only seek special advantages
at the expense of the mostly silent and ignorant majority; and bureaucrats only seek to max-
imize their own interests by promoting the bureau’s growth at the expense of efficiency.
Although there is some truth in all of this, we must also point out that many voters
are well informed and often unselfish; many politicians have refused to compromise their
principles simply to maximize their chances of reelection; many powerful special-interest
groups have been unsuccessful in furthering their causes; and many bureaucracies have
operated efficiently and sometimes even proposed their own abolition when their function
was no longer required. For example, in the past, the majority of U.S. voters consistently
voted for and supported most social welfare policies, even though these policies involved
a redistribution of income to poor people; President Reagan refused to back away from
large defense spending in spite of strong opposition in and out of Congress and the result-
ing huge budget deficits; the American Medical Association is no longer able to restrict
admissions to medical schools as it did over many decades; and the CAB (the
Civil
Aeronautics Board) proposed its own abolition and is now no longer in existence.
 CHAPTER 18 Externalities, Public Goods, and the Role of Government 603

These examples, however, do not necessarily represent contradictions of the theory

of public choice. This theory seeks only to identify the forces that must be examined to
properly analyze public choices. The theory concludes that while public policies can
improve the functioning of the economic system in the presence of market failures,
the government itself is subject to systematic forces that can lead to government fail-
ures. Public policies could then reduce, rather than increase, social welfare. More
importantly, perhaps, the theory of public choice can be used to suggest specific insti-
tutional changes and to devise policies that can lead to improvements in public-sector
performance.
One way that public-choice theory suggests for improving public-sector perfor-
mance is to subject government bureaus or agencies to competition whenever feasible.
One method of achieving this is by contracting out to private firms as many public ser-
vices as possible. For example, market evidence suggests that garbage collection and fire
protection can be provided more efficiently by private contractors than by public agen-
cies. The same may be true for running school systems and jails.'* Another method advo-
cated by public-choice theory to promote efficiency in public choices is to allow private
firms to compete with government agencies in the provision of services that are not
entirely public in nature.'? For example, families could be given vouchers that they could
use for public or private education. Giving parents the option and funding to choose pri-
vate schools over public schools would stimulate public schools to provide better educa-
tion and increase efficiency. Still another method of increasing efficiency in government
is to encourage interagency competition. While streamlining government operations is
likely to eliminate some duplication and waste, it also eliminates competition and incen-
tives for efficient operation. For example, it has been estimated that the cost-effectiveness
of the Department of Defense operations declined by one-third following the consolida-
tion of the three branches of the armed forces within the department.
Public-choice theory also suggests at least two ways of reducing the influence of
special-interest groups. One option would be to rely more on referenda to decide impor-
tant political issues. Although the influence of special-interest groups is not entirely
eliminated (since they can still spend a great deal of money on influencing the general
public through advertisements), reverting from representative to direct democracy in
deciding some important issues does overcome the interaction between special-interest
groups and politicians. Today, referenda are much more common in European countries
than in the United States. Another method of reducing the influence of special-interest
groups is to specify the total amount of public funds budgeted for the year and encour-
age different groups to compete for government funding. Because the total amount of
funds is fixed, one group can only gain at the expense of others. Each group is then likely
Concept Check to present its best case for funding while exposing the weaknesses in competitors’ fund-
How does the theory of
ing requests. In the process, a great deal of essential information is made available to
public choice examine
how government government officials, who can therefore allocate funds more effectively. Many policies
decisions are made and (such as import restrictions), however, do not involve direct public funding, and so this
implemented? is not possible.

14 “Hartford Hires Group to Run School System,” New York Times, October 4, 1994, p. B1; “For Privately Run
Prisons, New Evidence of Success,” New York Times, August 19, 1995, p. 7; M. Haririan and T. A. Bonomo,
“Privatization and the Emergence of For-Profit Prisons,” Central Business Review, winter 1996, pp. 11-15;
“Do Firms Run Schools Well?” U.S. News & World Report, January 8, 1996, pp. 46—49; and “Pennsylvania
Abandons Plan to Privatize School Offices,’ New York Times, November 21, 2001, p. 14.
15 See “Public Services Are Found Better if Private Agencies Compete,” New York Times, April 28, 1988, p. 1.
604 PART SIX General Equilibrium, Efficiency, and Public Goods

18.6 STRATEGIC TRADE POLICY

international
One qualified argument in favor of an activist government policy in the
g to this argument, a nation can create a com-
Strategic trade policy arena is strategic trade policy. Accordin
trade protection , subsidies, tax benefits, and coop-
The attempt by a nation parative advantage (through temporary
in such fields as semicondu ctors, computers ,
to create a comparative erative government-industry programs)
the
advantage in some
telecommunications, and other industries that are deemed crucial to future growth in
high-tech field through
nation. These high-tech industries are subject to high risks, require large-scale production
temporary trade
protection, subsidies, tax to achieve economies of scale, and give rise to extensive external economies when suc-
benefits, and cooperative cessful. Strategic trade policy suggests that by encouraging such industries, a nation can
government-industry reap the resulting large external economies and enhance its future growth prospects. Most
programs. nations encourage development in these industries. Indeed, some economists would go so
far as to say that a great deal of the post-World War II industrial and technological success
of Japan is due to its strategic industrial and trade policies.
Examples of strategic trade and industrial policies can be found in the steel industry
in the 1950s and in semiconductors in the 1970s and 1980s in Japan; in the development
of the supersonic aircraft, the Concorde, in the 1970s (see Example 18—4); and in the
Airbus aircraft in the 1980s in Europe. Semiconductors in Japan are usually given as the
textbook case of successful strategic trade and industrial policy. The market for semicon-
ductors (such as computer chips that are used in many products) was dominated by the
United States in the 1970s. Starting in the mid-1970s, Japan’s powerful Ministry of
International Trade and Industry (MITI) targeted the development of this industry by
financing research and development, granting tax advantages for investments in the
industry, and fostering government-industry cooperation, while protecting the domestic
market from foreign (especially U.S.) competition.
These policies are credited for Japan’s success in challenging the United States’ lead-
ing position in the semiconductor market in the mid-1980s. Most economists remain skep-
tical, however, and attribute Japan’s stunning performance in this field primarily to other
forces, such as greater educational emphasis on science and mathematics, higher rates of
investment, and a willingness to take a long-run view of investments rather than stressing
quarterly profits, as in the United States. In steel, the other targeted industry in Japan, the
rate of return was lower than the average return for all Japanese industries during the post-
war period. In Europe, the Concorde was a technological feat but a commercial disaster,
and Airbus Industries would not have survived without continued heavy government
subsidies.
While strategic trade policy can theoretically improve the market outcome in oligop-
olistic markets subject to extensive external economies and increase the nation’s growth
and welfare, even the originators and popularizers of this theory recognize the serious dif-
ficulties in implementing it. First, it is extremely difficult to pick winners (i.e., choose the
industries that will provide large external economies in the future) and devise appropriate
policies to successfully nurture them. Second, since most leading nations undertake
strategic trade policies at the same time, efforts are largely neutralized, so that the poten-
tial benefits to each nation may be small. Third, when a country does achieve substantial
Concept Check
success with strategic trade policy, this comes at the expense of other countries (i.e., itis
What are the uses and a
dangers of strategic beggar-thy-neighbor policy), and so other countries are likely to retaliate. Faced with
all
trade and industrial these practical difficulties, even supporters of strategic trade policy grudgingly
acknowl-
policies? edge that free trade is still the best policy, after all.
 CHAPTER 18 Externalities, Public Goods, and the Role of Government 605

EXAMPLE 18-5 " e carl itn

Strategic Trade and Industrial Policies in the United States

In the early 1980s, the U.S. government drew up a list of 26 generic and critical tech-
nologies which it was willing to support in a limited way. Among these were electronic
materials, high-performance metals and alloys, flexible computer integrated manufac-
turing, software, high-performance computing networking, high-definition imaging
displays, applied molecular biology, medical technology, aeronautics, and energy
technologies. The best example of direct federal support for civilian technology
is Semitech. This was an Austin-based consortium of 14 major U.S. semiconductor
manufacturers which was established in 1987 with an annual budget of $225 million
($100 million from the government and the rest from the 14 member firms). Its aim
was to help develop state-of-the-art manufacturing techniques for computer chips for
its members and help firms producing equipment used in the manufacturing of com-
puter chips develop and test more advanced equipment.
By 1991, Semitech claimed that, as a result of its efforts, U.S. computer chip com-
panies had caught up with their Japanese competitors. Since then, Semitech has
become entirely private (i.e., it no longer receives U.S. government financial support),
and in 1998 it created Semitech International, a wholly owned subsidiary of 12 major
U.S. and foreign computer chip companies. It is now (2008) called International
Semitech Manufacturing Initiative (ISMI) and has 16 members.
Despite being hailed as a successful model of government-industry cooperation
in support of high-tech research and development (R&D) before it was privatized, a
recent study found that participating in Semitech led firms to spend less on their own
R&D than would have been expected, given the behavior of these firms prior to
Semitech and given the behavior of U.S. computer chip firms that did not join
Semitech. The study also found that the resurgence of the U.S. computer chip industry
after 1987 was due more to the sharp depreciation of the U.S. dollar with respect to the
Japanese yen (which made U.S.-made computer chips cheaper than Japanese ones) and
the U.S._Japanese computer chip agreement, which insulated U.S. computer chip firms
against Japanese competition, than to Semitech.
Sources: D. Irwin and P, Klenow, “High Tech R & D Subsidies: Estimating the Effect of Semitech,”
National Bureau of Economic Research, Working Paper No. 4974, July 1995; and “When the
State Picks Winners,” The Economist, January 9, 1993, pp. 13-14; C. Wessner, “The Advanced
Technology Program: It Works,” Issues in Science and Technology, Fall 2001, pp. 59-64; and
http://ismi.sematech.org.

GOVERNMENT CONTROL AND REGULATION

18.7 OF ENVIRONMENTAL POLLUTION

Now we will use the tools of analysis developed in this chapter to analyze environmental
pollution and the best way for government to control or regulate it.
606 PART SIX_ General Equilibrium, Efficiency, and Public Goods

Environmental Pollution
by
We have seen in Section 18.2 that externalities (and inefficiencies) may be eliminated
the clear definition of property rights if the parties involved are not very numerous.
the
Otherwise, transaction costs are too high and externalities persist. This is precisely
case with environmental pollution, which refers to air pollution, water pollution, ther-
Environmental
pollution The mal pollution, pollution resulting from garbage disposal, and so on. Environmental pollu-
lowering of air, water, tion has become one of the major political and economic issues in recent decades.
scenic, and noise
Environmental pollution results from and is an example of negative externalities.'®
qualities of the world
Air pollution results mostly from automobile exhaust and smoke from factories and
around us that results
from the dumping of electrical generating plants through the combustion of fossil fuels, which releases parti-
waste products. cles into the air, While it is difficult to measure precisely the harmful effects of sulfur
dioxide, carbon monoxide, and other air pollutants, they are known to cause damage to
health (in the form of breathing illnesses and aggravating other diseases, such as circula-
tory problems) and to property (in the form of higher cleaning bills, and so on). Water pol-
lution results from dumping raw (untreated) sewage, chemical waste products from
factories and mines, and runoff of pesticides and fertilizers from farms into streams,
lakes, and seashores. This reduces the supply of clean water for household uses (drinking,
bathing, and so on) and recreational uses (swimming, boating, fishing, and so on).
Thermal pollution results from the cooling off of electrical power plants and other
machinery. This increases water temperature and kills fish. The disposal of garbage such
as beer cans, newspapers, cigarette butts, and so on, spoils natural scenery, as do bill-
boards and posters. To this visual pollution must be added noise pollution and many other
forms of pollution.
Environmental pollution results whenever the environment is used (abused) as a con-
venient and cheap dumping ground for all types of waste products. It is convenient and
cheap from the private point of view to use the environment in this manner because no
one owns property rights to it. As a result, air and water users pay less than the full social
cost of using these natural resources, and by so doing they impose serious external costs
on society. In short, society produces and consumes too much of products that generate
environmental pollution. Since property rights are ambiguous and the parties involved are
numerous (often running into the millions), it is impossible and impractical (too costly)
to identify and negotiate with individual agents. The external costs of environmental pol-
lution cannot be internalized by the assignment of clear property rights and so govern-
ment intervention is required. This intervention can take the form of regulation or
taxation. However, appropriate corrective action on the part of the government requires
knowledge of the exact cost of pollution.

Optimal Pollution Control

If a staunch environmentalist were asked how much environmental pollution society should
tolerate, the answer would probably be zero. This would be the wrong answer. The optimal
level of pollution is the level at which the marginal social cost of pollution equals the mar-
ginal social benefit (in the form of avoiding alternative and more expensive methods of
waste disposal). Zero pollution is an ideal situation, but as long as pollution is the inevitable

© See “Priority One: Rescue the Environment,” Science, February

16, 1990, p. 777; M. L. Cropper and
W. Oates, “Environmental Economics: A Survey,” Journal of Economic
Literature, June 1992, pp. 675-740:
and “Where Money Is No Object.” Forbes, March 5, 2001, p. 78.
 CHAPTER 18 Externalities, Public Goods, and the Role of Government 607

by-product of the production and consumption of commodities that we want, it is silly to

advocate zero pollution. Economists advocate optimal pollution control instead. That is, we
should be prepared to accept (as inevitable) that amount of pollution which, at the margin,
balances the social costs and benefits of pollution. This is shown in Figure 18.3.
In Figure 18.3, the horizontal axis measures the quantity of pollution per year, and
the vertical axis measures costs and gains in dollars. The MC curve, for example, could
measure the value of the marginal loss of fish suffered by fishermen for various amounts
of water pollution generated by a firm. The marginal loss (cost) increases with rising
amounts of pollution. The MB curve would then measure the marginal benefit or saving
that the polluting firm receives by being able to freely dump its waste into the water rather
than disposing of it by the next-best alternative method (at a positive cost). The MB is
negatively sloped, indicating declining benefits for the firm for each additional unit of
pollution that it discharges into the water.
When the firm does not incur any cost for discharging waste into the water, it will do
so until the marginal benefit is zero (point A in the figure). That is, as long as the firm
saves some cost by discharging its waste into the water, it will do so until the MB is zero.
However, pollution does impose a cost on society as a whole. The optimal amount of pol-
lution from society’s point of view is 8 units, given by the intersection of the MC and the
MB curves at point E. Only when pollution is 8 units per year is the marginal benefit to
the individual and to society equal to the marginal social cost of pollution. To the left of
Concept Check __. point E, MB > MC and it pays for society to increase the level of pollution (see the fig-
What is the optimal ure). The opposite is true to the right of point E. As strange as it may have sounded ear-
level of pollution? lier, we now know that the optimal level of pollution is not zero, but is positive.

BE

4tE

|
|

| l A
0 8 16 24
Units of pollution per year

FIGURE 18.3. Optimal Pollution Control The MC curve shows the rising marginal
cost or loss to society from increasing amounts of pollution. The MB curve shows the
declining marginal benefit to the polluter (and to society) by being able to freely dump
increasing amounts of waste into the water rather than disposing of it by other costly
alternatives. Since the firm does not pay for discharging its waste into the water, it will do so
until MB = O (point A). From society's point of view, the optimal level of pollution for the
firm is 8 units per year (point £, at which MC = MB).
608 PART SIX General Equilibrium, Efficiency, and Public Goods

Direct Regulation and Effluent Fees for Optimal Pollution Control

view is not
We have just seen that the optimal level of pollution from society’s point of
zero, but is given by the level at which the marginal cost of pollution is equal to the pri-
vate (and social) marginal benefit of disposing of waste by the cheapest method possible.
Even though this prescription is theoretica lly precise, it is often very difficult to actually
estimate the marginal social costs and benefits of pollution. Without governme nt inter-
vention, environmental pollution is certainly likely to be excessive (compare point A to
point E in Figure 18.3).
There are generally two ways to achieve the optimal amount of pollution control:
direct regulation and effluent fees. By direct regulation, government could legislate that
the industry limit pollution to the optimal level (8 units per year in Figure 18.3) or install
Effluent fee A tax that a particular pollution-abatement device. Alternatively, government could set the effluent
a firm must pay for fee that brings the private cost of pollution equal to its social cost. An effluent fee 1s a tax
discharging waste or that a firm must pay to the government for discharging waste or otherwise polluting. For
polluting. example, an effluent fee of $4 per unit of waste or pollution per year in Figure 18.3 results
in the optimal level of pollution of 8 units per year. That is, an effluent fee of $4 per unit
will make the marginal private (and social) cost of pollution equal to its marginal private
(and social) benefit.
While direct regulation is sometimes necessary (as in the case of radioactive and other
very dangerous waste materials), economists generally prefer effluent fees to achieve opti-
Concept Check
Why are effluent fees
mal pollution control. There are two reasons for this. First, effluent fees generally require
usually better than less information on the part of the government than direct regulation. Second, and more
regulation for achieving importantly, effluent fees minimize the cost of optimal pollution control, whereas direct
optimal pollution control? regulation does not. This is because with effluent fees, each polluter will pollute until the
marginal benefit of pollution equals the effluent fee. Thus, the optimal amount of pollution
is allocated to those firms that benefit the most from polluting. As a result, the social cost of
pollution is minimized.
One way to use effluent fees to reduce pollution is by the sale ofpollution rights by
the government. Under such a system, the government determines the amount of pollu-
tion that it thinks is socially tolerable (based on the benefits that result from the activities
that generate the pollution) and then auctions off licenses to firms that generate pollution
up to the specified amount. Pollution costs are thus internalized (i.e., they are considered
part of regular production costs) by firms and the allowed amount of pollution is utilized
in activities in which it is more valuable (see Example 18-6). Another way to overcome a
negative externality is congestion pricing (see Example 18-7).

EXAMPLE 18-6
The Market for Dumping Rights

The Clean Air Act of 1990 led to the establishment of a market for dumping rights.
In
such a market, the Environmental Protection Agency decides how much pollution
it
wants to allow and then issues marketable rights for that quantity of pollution.
Since
these dumping rights are marketable (i.e., can be bought and sold by
firms), they
are likely to be used in those activities in which they are most valuable. For
example,
 CHAPTER 18 Externalities, Public Goods, and the Role of Government 609

suppose that the EPA has imposed specific dumping restrictions on two firms. If the
cost of reducing emission by | unit is $10,000 for one firm and $50,000 for a second
firm, the first firm could sell the right to dump that unit of emission to the second firm
for a price between $10,000 and $50,000. The result would be that both firms (and
society) would gain without any overall increase in pollution. In fact, the only way that
a new firm can build a plant that pollutes the air in an area that does not meet federal
air-quality standards is to purchase the right to a specific amount of pollution from an
already existing and polluting firm in the area. The EPA can then gradually lower the
level of overall pollution over time by reducing the amount of right-to-pollute credits
or pollution allowances it issues while allowing each firm to decide to comply with the
law by installing antipollution equipment or buying right-to-pollution credits from
other firms that have some to spare.
After 1992, when the first right-to-pollute credits were traded, the market grew
rapidly, and we now have pollution-rights banks, which act as brokers between firms
that want to sell pollution rights and firms that want to purchase them. The concept of
marketable pollution rights has also been extended by the so-called “bubble policy.”
Under this policy, a firm with several plants operating in a single air-pollution area is
given a total permissible emission level for all its plants rather than a limit for each
one. This allows the firm to concentrate its emission-reduction efforts in plants where
it can be done more cheaply. As a result of such a program, electric utilities now emit
about 25% fewer tons of sulfur oxide in the atmosphere while producing 41% more
electricity and also saving $3 billion. By 2000, the number of generating units partic-
ipating in the program had risen from 445 to 2,200 and the cap on sulfur emissions
was reduced by another 25%. With the quantity demanded of pollution rights far
exceeding the quantity supplied, the price of pollution rights skyrocketed from
$1,500 in January 1998 to $7,600 in March 1999. Since then, the quantity of pollu-
tion rights declined and their price fell to $1,400, because it became cheaper for com-
panies to reduce pollution by installing antipollution equipment than by purchasing
pollution rights.
The establishment of a market for pollution permits represents a significant vic-
tory for economists (who have been advocating this for many years) and changes the
direction of antipollution efforts in the United States for decades to come. In July
2001, a historic accord that set targets for industrialized countries to cut the emission
of greenhouse gases that contribute to global warming was signed as part of the
implementation of the Kyoto Protocol on climate change signed in 1997. The United
States refused to sign the agreement, calling its targets arbitrary and too costly for the
United States to comply with. The Kyoto Protocol stimulated the development of a
market for emissions trading on a global scale. After trading unofficially since 2003,
the European Union’s carbon-trading program, called the European Emission
Trading System (EETS), formally started on January 1, 2005, and it is already valued
at billions of dollars annually. The right to release one ton of carbon monoxide into
the atmosphere increased from $6 in 2003 to $35 in 2005 in this market. This is the
most cost-effective solution to global warming and provides a model on which a
future global climate policy can be based. In 2007, the U.S. Congress was consider-
ing a national law to replace a growing number of state carbon-emission laws. A tax
on carbon emissions will increase the price of using a “dirtier” fuel, such as coal, in
favor of cleaner fuels, such as wind power and natural gas. At a UN conference on
610 PART SIX General Equilibrium, Efficiency, and Public Goods

g the United
climate change held in Bali in December 2007, 190 nations (includin
succeed the Kyoto
States) signed an agreement to negotiate a new treaty by 2012 to
s of heat-
Protocol, which expires in 2012, that would call for the halving of emission
trapping gases by 2050.
Sources: “A Market Place for Pollution Rights,” U.S. News & World Report, November 12, 1990, p. 79;
April 4, 1992,
“New Rules Harness the Power of Free Markets to Curb Air Pollution,” Wall Street Journal,
p. Al; “Cheapest Protection of Nature May Lie in Taxes, Not Laws,” New York Times, November 24,
1992, p. C1; “How Much Is the Right to Pollute Worth?”, Wall Street Journal, August 1, 2001, p. AlS5;
“New Limits on Pollution Herald Change in Europe, New York Times, January 1, 2005, p. C2; “Europe’s
Emissions Trading Is a Model for the World,” Financial Times, June 8, 2006, p. 13; “Climate Wars: Episode
Two,” Business Week, April 23, 2007, pp. 90-92; “The Carbon Calculus,” New York Times, November 7,
2007, p. H1; “Bali Aims to Share Weight of Emissions Cuts,” Wall Street Journal, December 12, 2007,
p. A3; and “U.N. Effort to Curtail Emissions in Turmoil,” Well Street Journal, April 12, 2008, p. Al.

EXAMPLE 18-7
Congestion Pricing

Every time a driver enters a congested highway or a congested city center he or she
slows down the travel speed of all the other drivers (imposes a negative externality on
Congestion pricing them). Although congestion pricing, or the charging of a higher price for a good or
The charging of service at times of heavy use, is well established for hotels, long-distance telephone
different prices at service, and air travel, it has been applied only slowly on U.S. roads. Variations of con-
different times of day
gestion pricing based on charging different prices at different times of day and on the
or based on the
degree of congestion. degree of congestion are in effect only on stretches of California Route 91, in Orange
County, on Interstate 15 near San Diego, and in Houston, Minneapolis, and Denver—
despite the fact that the concept has been known for nearly 40 years (it was introduced
by William Vickery, the 1996 Nobel Prize-winning economics professor of Columbia
University).
London has had such a congestion-pricing system since 2003 and Stockholm
since 2006. Traffic cameras enforce a daily fee of $16 (which can be paid online, by
phone, or at gas stations) to drive in central London. This was highly successful and
reduced the number vehicles in central London by 10%. Fees for traveling within
Stockholm vary according to peak driving time, with higher tolls during rush hours.
Fees range from a low of $1.38 from 6:30 to 7:00 AM and 6:00 to 6:30 PM to a high fee
of $2.76 from 7:30 to 8:30 AM and 4:00 to 5:30 pM, with fees in between these
extremes at other times of day. In 2008, New York’s mayor proposed to charge a fee of
$8 each time a driver brings his or her car into traffic-congested Manhattan and $21 for
a trucks; however, it was rejected. Many other cities throughout the world are now con-
sidering congestion pricing.
Congestion pricing is now being considered as a way to encourage airlines
to spread their flights more evenly throughout the day, in the pricing of electricity,
and even for parking meters. One study estimated that flight delays at New
York’s
 CHAPTER 18 Externalities, Public Goods, and the Role of Government 611

airports in 2007 cost passengers nearly $200 million in lost productivity. Congestion
pricing would reduce these delays (i.e., internalize these costs) and lead to more
efficient use of scarce resources in a way that is consistent with individual freedom
of choice.
Sources: “Stockholm’s Syndrome,” Wall Street Journal, August 29, 2006, p. B1; “What’s the Toll? It
Depends on the Time of Day,” New York Times, February 11, 2007, Sect. IV, p. 7; “London Adds to Its
Zone for Road Tolls,” New York Times, February 18, 2007, p. 8; “Study Puts Price Tag on Delays at
Airports,” New York Times, December 2, 2007, p. 41; “$8 Traffic Fee for Manhattan Fails in Albany,” New
York Times, April 8, 2008, p. 1; and “U.S. Plans Steps to Ease Congestion at Airports,” New York Times,
May 17, 2008, p. B1.

|__| SUMMARY
1 . Externalities are harmful or beneficial side effects borne by those not directly involved in
the production or consumption of a commodity. Externalities are classified into external
economies or diseconomies of production or consumption, and technical externalities. With
external diseconomies of production or consumption, the commodity price falls short of the
full social cost of the commodity and too much of the commodity is produced or consumed.
With external economies of production or consumption, the commodity price exceeds the full
social cost of the commodity and too little of the commodity is produced and consumed.
Technical externalities may prevent marginal cost pricing.
. Externalities arise when property rights are not clearly defined and transaction costs are
very high. The Coase theorem postulates that when property rights are clearly defined and
transaction costs are zero, perfect competition results in the absence of externalities,
regardless of how property rights are assigned among the parties involved.
. Public goods are commodities that are nonrival in consumption. That is, consumption of a
public good by some individual does not reduce the amount available for others (at zero
marginal cost). Some public goods, such as national defense, exhibit nonexclusion. That is,
once the good is produced, it is impossible to confine its use to only those paying for it. Other
public goods, such as TV broadcasting, can exhibit exclusion. Because of the free-rider
problem, public goods are usually underproduced and underconsumed.
. Benefit—cost analysis is based on the government calculating the ratio of the present value of
all the benefits to the present value of all the costs for each proposed public project. The
projects are then ranked from the highest to the lowest in terms of benefit-cost ratios.
Government should undertake those projects with the highest benefit-cost ratio (as long as
the ratio exceeds 1) and until government resources are fully employed. There are many
difficulties in estimating all benefits and costs of a project and in determining the interest rate
to use to find the present value of the benefits and costs.
. According to the theory of public choice, individuals vote for politicians who promote their
individual interests; politicians seek to maximize their chances of reelection; special-
interest groups seek special advantages for their group; and bureaucrats seek to promote the
bureau’s growth. The theory postulates that it is possible for government policies to reduce
rather than increase social welfare (government failures). It proposes to increase efficiency
by increasing competition in public choices and by relying more on referenda to decide
important issues.
612 PART SIX General Equilibrium, Efficiency, and Public Goods

ive advantage (through

6. According to strategic trade policy, a nation can create a comparat
tax benefits, etc.) in such fields as computers, that can
temporary trade protection, subsidies,
external economie s, and which are deemed crucial to future growth in
give rise to extensive
and other
the nation. However, it is very difficult to determine which industry to promote,
nations are likely to retaliate.
of unclearly
7. Environmental (air, water, thermal, scenic, and noise) pollution arises because
optimal level of pollution from
defined property rights and too-high transaction costs. The
society’s point of view is not zero, but is given by the level at which the marginal cost
of pollution to society is equal to the private (and social) marginal benefit of disposing
of waste by the cheapest method available. Optimal pollution control can be achieved
by direct regulation or effluent fees. Although direct regulation is Sometimes necessary
(as in the case of dangerous waste materials), economists generally prefer effluent
fees and the establishment of a market for pollution permits because they are much
more efficient.

[| Key TERMS
Externalities Technical externalities Benefit—cost analysis
External costs Common property Theory of public choice
External benefits Coase theorem Government failures
External diseconomies of production Internalizing external costs Rational ignorance
External diseconomies Public goods Strategic trade policy
of consumption Nonrival consumption Environmental pollution
External economies of production Nonexclusion Effluent fee
External economies of consumption Free-rider problem Congestion pricing

REVIEW QUESTIONS
1. How can typing a report late at night create a negative 7. Why is it generally more difficult to estimate the
externality? How can this result in an externality that is benefits and the costs of a public than of a private
mutually harmful? project?
2. Why is a public-housing project in a high-income 8. Everyone agrees that large federal budget deficits are
neighborhood not likely to satisfy the Pareto optimality bad. Why do budget deficits then persist?
criterion: 9. What is the unifying concept by which public-choice
3. Why does free access to a common resource usually lead to theory analyzes individual behavior in the political
the overuse of the resource? process?
4. Why, during the Cold War period, did the knowledge that 10. What policies does the theory of public choice prescribe
the United States would not have accepted a Soviet (a) in order to increase efficiency in
invasion of Europe lead to less defense expenditures in public choices and reduce government failures,
Western Europe? and (b) to reduce the influence of special-interest
5. What is the basic difference between using a subsidy to groups?
induce producers to install antipollution equipment and 11. Is there a conflict between the theory of comparative
using a tax on producers who pollute? advantage and strategic trade policy?
6. How does the market demand for a public good differ 12. When would direct regulation be better than effluent fees
from the market demand of a private good? in pollution control?
 CHAPTER 18 — Externalities, Public Goods, and the Role of Government 613

PROBLEMS
1. Explain why that D’ portrays the marginal social benefit of the
a. in a system of private education (i.e., a system in public consuming various quantities of the
which individuals pay for their own education), commodity.
there is likely to be underinvestment in education. b. Does D’ indicate the existence of external
b. the discussion of external economies and economies or diseconomies of production or
diseconomies is in terms of marginal rather than total consumption?
social costs and benefits. c. What is the marginal external benefit or cost and the
2. Start with D and S as in Figure 18.1. marginal social benefit or cost at the equilibrium
a. Draw D’ with the same vertical intercept as D but point?
with twice the absolute value of its slope. Suppose d. What is the socially optimum price and
that D’ portrays the marginal social benefit of the consumption of the commodity?
public consuming various quantities of the dh a. Draw a figure showing the corrective tax or subsidy
commodity. that would induce the society to consume the socially
b. Does D’ indicate the existence of external optimal amount of the commodity.
economies of production or consumption? b. What is the total value of the economic gain resulting
c. What is the marginal external benefit or cost and the from the imposition of the corrective tax or subsidy?
marginal social benefit or cost at the competitive . Explain what would be the outcome if the cost of
equilibrium point? avoiding polluting the stream (with its waste products) by
d. What is the socially optimal price and consumption the paper mill of Section 18.2 was $1,200 rather than
of the commodity? $400 per month, and property rights to the stream were
*3.a. Draw a figure showing the corrective tax or subsidy assigned to the
that would induce society to consume the socially a. brewery.
optimum amount of the commodity. b. paper mill.
b. What is the total value of the economic gain resulting c. When would the socially optimal solution be
from the imposition of the corrective tax or subsidy? reached?
4. Start with D and S as in Figure 18.1. *9. Explain why, in each of the following cases,
a. Draw S’ with the same vertical intercept as S but externalities arise and how they would be avoided
with half of its slope. Suppose that S’ portrays the or corrected when
marginal social costs of supplying various a. one individual owns an oil field next to another oil
quantities of the commodity. field owned by another individual.
b. Does S” indicate the existence of external b. a firm develops a recreational site (golf, skiing,
economies or diseconomies of production or boating, or the like).
consumption? *10. a. Draw a figure showing the market demand curve for
c. What is the marginal external cost or benefit and the good X for Figure 18.2 if good X were a private rather
marginal social cost at the competitive equilibrium than a public good.
point? b. State the condition for the Pareto optimal output of
d. What is the socially optimum price and output of the commodity X when X is a private good and when it is a
commodity? public good.
*5_ a. Draw a figure showing the corrective tax or subsidy c. What is the relationship between public goods and
that would induce the industry to produce the socially externalities?
optimal amount of the commodity. . Three possible solutions were proposed at the time of
b. What is the total value of the economic inefficiency the severe water shortage experienced by New York City
eliminated by the corrective tax or subsidy? in 1949-1950. These solutions were (1) building a dam
6. Start with D and S as in Figure 18.1. that would cost $1,000 per million gallons of water
supplied, (2) sealing leaks in water mains, which would
a. Draw D’ with the same vertical intercept as D but
cost about $1.60 per million gallons of water gained, or
with half the absolute value of its slope. Suppose

* — Answer provided at end of book.

614 PART SIX General Equilibrium, Efficiency, and Public Goods

(3) installing water meters that would cost $160 per 12. With reference to Figure 18.3, calculate the total social
million gallons of water saved. The city gains by
chose the first project. Was New York’s choice the a. increasing the level of pollution from 4 to 8 units
most efficient? If not, why might New York have per year.
made this choice? b. reducing pollution from 12 to 8 units per year.

INTERNET SITE ADDRESSES

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States, see: strategic %20trade% 20-%20Palgrave.pdf
http://www. fairtax.org/site/PageServer http://www. keidanren.or.jp/english/policy/
http://money.cnn.com/2007/10/25/pf/taxes/ 2001/029. html
rangel_tax_reform/index.htm
Information on government control and regulation of
http://www.newamerica.net/publications/articles/ environmental pollution as well as on the market for
2007/hopes_for_tax_reform_in_2007_4655 dumping rights and tradable permits is found at:
For benefit-cost analysis, see: http://www.epa.gov
http://www.costbenefit.com/index.htm http://www.environment.tas.gov.au/em_environmental_
http://www.humboldt.edu/~envecon/ppt/423/index.html management_pollution_control_act_ 1994. html
http://www.ubercool.com/2007/06/25/ http://www.eny-econ.net/2005/07/
supersonic-travel-reinvented free_market_env.html
 CHAPTER 19

The Economics of Information

Chapter Outline List of Examples
19.1 The Economics of Search 19-1 No-Haggling Value Pricing in Car Buying
19.2 Asymmetric Information: The Market for At the Frontier: The Internet and the
Lemons and Adverse Selection Information Revolution
19.3. Market Signaling 19-2 Increased Disability Payments Reduce Labor
19.4 The Problem of Moral Hazard Force Participation
19.5 The Principal-Agent Problem 19-3 Medicare and Medicaid and Moral Hazard
19.6 The Efficiency Wage Theory 19-4 Do Golden Parachutes Reward Failure?
19-5 The Efficiency Wage at Ford

After Studying This Chapter, You Should Be Able to:

Know the rule as to how long a consumer should search for lower prices
Know the meaning and importance of asymmetric information and adverse selection
Understand how the problem of adverse selection can usually be resolved by market signaling
Understand how moral hazard can arise in the insurance market and how it can be overcome by
coinsurance
Understand the meaning of the principal-agent problem and how it can be resolved by golden
parachutes

n this chapter we study the economics of information. This field of study is becoming
increasingly important in economics—and deservingly so. The chapter begins by
examining the economics of search: search costs, the process of searching for the
lowest price, and the informational content of advertising. The chapter goes on to dis-
cuss asymmetric information and the market for lemons (i.e., defective products), the
insurance market and adverse selection, market signaling, moral hazard, the principal-
agent problem, and the efficiency wage theory. The examples and applications of the the-
ory provided in the chapter show the real-world importance and great relevance of
the economics of information, while the At the Frontier section on the Internet and the
information superhighway examines one of the most important and recent forms of the
current worldwide information revolution.

615
616 PART SIX General Equilibrium, Efficiency, and Public Goods

1911 THE ECONOMICS OF SEARCH

for the
We begin our study by discussing search costs, outlining the process of sea
lowest commodity price, and examining the informatio nal content of advertisin g.'

Search Costs
One cost of purchasing a product is the time and money we spend seeking information
about the product—what are the properties of the product, what are the alternatives, how
good is the product, how safe, how much does the product cost in one store as opposed to
Search costs The time another? Search costs include the time spent reading ads, telephoning, traveling, inspect-
and money spent ing the product, and comparative shopping for the lowest price. Although the most
seeking information important component of search costs is the time spent learning about the attributes of the
about a product. product, consumers sometimes also spend money purchasing information to aid them in
their search. They might purchase Consumer Reports magazine to check on the quality of
a product, pay an impartial mechanic to evaluate a used car before deciding on purchas-
ing it, or seek professional help from a financial advisor before making a major invest-
ment. In most cases, however, the major cost of search is the time required to learn about
the product. Often the government provides a great deal of this information; for example,
the government requires mileage disclosures for new automobiles, safety standards for
some products, and weather forecasts, all of which greatly reduce uncertainty in the pur-
chasing of many products.
One of the most important and time-consuming aspects of purchasing a product is com-
parison shopping for the lowest price. Even when a product is standardized and conditions of
sale are identical (i.e., locational convenience, courteousness of service, availability of credit,
returns policy, etc.), there will be a dispersion of prices in the absence of perfect information
on the part of buyers. Since it takes time and money to gather information, and different con-
sumers place different valuations on their time, some price dispersion will persist in the mar-
ket even if the product is perfectly standardized and sales conditions are identical.
The general rule is that a consumer should continue the search for lower prices as long
as the marginal benefit from continuing the search exceeds the marginal cost, and until the
marginal benefit equals the marginal cost. The marginal benefit (MB) is equal to the degree
Concept Check
How long should a by which a lower price is found as a result of each additional search times the number of
consumer search for units of the product purchased at the lower price. The marginal cost (MC) of continuing the
lower prices? search depends on the value that consumers place on their time (assuming that consumers
do not find shopping itself pleasurable). Since the value that consumers place on their time
differs for different consumers, the product will be purchased at different prices by different
consumers when each consumer behaves according to the MB = MC rule. Specifically,
those consumers forgoing higher wages when searching for lower prices will stop the search
before consumers who face lower opportunity costs for their time, and thus will purchase
the product at a higher price.” On the other hand, with the MC curve of search shifting down
because of the Internet, consumers search more now than a decade ago.

' This discussion draws heavily on George J. Stigler, “The Economics of Information.” Journal ofPolitical
Economy, June 1961, pp. 213-225; and Joseph E. Stiglitz, “The Contributions of the Economics
of Information
to Twentieth Century Economics,” Quarterly Journal of Economics, November 2000, pp
1441-1478.
> The same general rule applies in searching for a better-quality product. A consumer
should continue the
search as long as the MB exceeds the MC and until MB = MC. The actual application
of this rule, however,
is usually more difficult than in searching for lower product prices because
it is difficult to assign higher
monetary values correctly for better-quality products.
 CHAPTER 19 The Economics of Information 617

Searching for the Lowest Price

At any time, there will be a dispersion of prices in the market even for a homogeneous
product. A consumer can accept the price quoted by the first seller of the product he or she
approaches, or the consumer can continue the search for lower prices. Unless the con-
sumer knows that the price quoted by the first seller is the lowest price in the market, he
or she should continue the search for lower prices as long as the marginal benefit from
continuing the search exceeds the marginal cost of additional search. In general, the mar-
ginal benefit from searching declines as the time spent searching for lower prices contin-
ues. Even if the marginal cost of additional search is constant, a point is reached where
MB = MC. At that point, the consumer should end the search.
For example, suppose that a consumer wants to purchase a small portable TV of a
given brand and knows the prices of different sellers range from $80 to $120. All sellers
are identical in location, service, and so on, so that price is the only consideration.
Suppose also that sellers are equally divided into five price classifications: Sellers of type
I charge a price of $80 for the TV, type II sellers charge $90, type II charge $100, type IV
charge $110, and type V charge $120. For a single search, the probability of each price is
1/5, and the expected price is the weighted average of all prices, or $100.° The consumer
can now purchase the TV at the price of $100, or she can continue the search for lower
prices. With each additional search the consumer will find a lower price, until the lowest
price of $80 is found. The reduction in price with each search gives the marginal benefit
of the search. How many searches the consumer conducts depends on the marginal cost
that she faces. The consumer will end the search when the marginal benefit from the
search equals the marginal cost.
We can use a simple formula to obtain the approximate lowest price expected with
each additional search.* This is
Range of Prices
ice
Expected Price = Lowest Pri
Nis aaumreilancimberonceacher: +1 Ute
es
For example, the lowest TV price expected from one search is

$40 ,
Expected Price = $80 + aeca = $100 (as found earlier)

The approximate lowest expected price from two searches is $80 + ($40/3) = $93.33.°
Thus, the approximate marginal benefit from the second search is $100 — $93.33 = $6.67.
The lowest expected price with three searches is $80 + ($40/4) = $90, so MB = $3.33. The
lowest expected price with four searches is $80 + ($40/5) = $88, so MB = $2. The low-
est expected price with five searches is $80 + ($40/6) = $86.67, so MB = $1.33.
Note how the marginal benefit from each additional search declines. MB = $6.67 for
the second search, $3.33 for the third search, $2 for the fourth search, $1.33 for the fifth

3 The expected price is equal to $80(1/5) + $90(1/5) + $100(1/5) + $110(1/5) + $120(1/5) = $16 + $18 +
$20 + $22 + $24 = $100.
4 The formula gives only an approximation of the lowest price found with each additional search, because
prices are discrete rather than continuous variables (i.¢., market prices are not infinitesimally divisible).
Nevertheless, the formula provides a quick method of showing that the marginal benefit (in the form of lower
prices) declines with each additional search. To calculate the precise lowest price for the second search, see
Problem 1, with the answer at the end of the book.
5 The precise expected price with two searches is $92 and is found with a much longer calculation, as shown
in the answer to Problem | at the end of the book.
618 PART SIX General Equilibrium, Efficiency, and Public Goods

search for the consumer is $2,

search, and so on. If the marginal cost of each additional
with the fourth
the consumer should, therefore, conduct four searches, because only
fewer searches , MB > MC,
search is the marginal benefit equal to the marginal cost. For
and it pays for the consumer to continue the search. For more than four searches,
that many searches .
MB < MC, and it does not pay for the consumer to conduct
Furthermore, the higher the price of the commodity, and the greater the range of product
mar-
prices, the more searches a consumer will undertake. The reason for this is that the
ginal benefit of each search is then greater (see Problem 3). Finally, note that because con-
sumers face different marginal costs of search, they will end the search at differen t points
and end up paying different prices for the product. This allows different producers to
charge different prices. Producers selling the product at a higher price will sell only to
those consumers who have less information because they stop searching for lower prices.

Search and Advertising

Even though most advertising contains an important manipulative component, it also
provides a great deal of useful information to consumers on the availability of products,
their use and properties, the firms selling particular products, retail outlets that carry the
product, and product prices. Thus, advertising greatly reduces consumers’ search costs. In
most cases, it also reduces both price dispersion and average prices. For example, we saw
in Section 11.2 that the price of eyeglasses was much higher in New York, which prohibits
advertising by optometrists, than in New Jersey, which does not prohibit such advertising.
Concept Check Similarly, the price of an uncontested divorce dropped from $350 to $150 in Phoenix,
In what way does Arizona, after the Supreme Court allowed advertising for legal services. Clearly, adver-
advertising lower tising often results in increased competition among sellers and lower product prices, and
consumers’ search it provides very useful information to consumers.
costs?
In examining the role of advertising, Philip Nelson distinguishes between search
goods and experience goods.° Search goods are those goods whose quality can be eval-
Search goods Goods
uated by inspection at the time of purchase. Examples of search goods are fresh fruits
whose quality can be
evaluated by inspection
and vegetables, apparel, and greeting cards. Experience goods, on the other hand, are
at the time of purchase. those which cannot be judged by inspection at the time of purchase but only after using
them. Examples of experience goods are automobiles, TV sets, computers, canned
Experience goods
foods, and laundry detergents. Some goods, of course, are borderline. For example, the
Goods whose quality
content of a book or magazine can be partially gathered by quick inspection at the book-
can only be judged
after using them. store before purchasing it. But its quality can only be fully evaluated after reading it
more carefully after the purchase.
Nelson points out that the advertisements of search goods must by necessity contain
a large informational content. Any attempt on the part of the seller to misrepresent the
product in any way would be easily detected by potential buyers before the purchase and
would thus be self-defeating. The situation is different for experience goods, where the
buyer cannot determine the true properties of the product before use. Nevertheless, the
very fact that a large and established seller is willing to spend a great deal on advertising
the product provides indirect support for the seller’s claims. After all, a large seller that
has been in business for a long time must have enjoyed repeated purchases from other
satisfied customers.
In 2005, about $276 billion was spent on advertising in the United States, of which
20.5% was on direct mail, 17.4% in newspapers, 16.4% in broadcast TV, 8.9%
on cable
° P. Nelson, “Advertising as Information,” Journal of Political Economy, July/August
1974, pp. 729-754.
 CHAPTER 19 The Economics of Information 619

TV, 7.2% on radio, 5.2% on Yellow Pages, 4.7% on magazines, 2.9% on the Internet, and
the rest in other forms of advertising.’ Newspaper advertising was found to be the most
informative, while TV advertising was found to be the least informative among major
forms of advertising.» Another study found that industries with higher-than-average
advertising expenditures relative to sales had lower rates of price increases and higher
rates of output increases than the average for 150 major industries.” From this, it can be
inferred that advertising has a large informational content.
When the cost of gathering information is very high or when use of the product can
be dangerous, the government usually steps in to provide the information (as in the case
of gas mileage for automobiles) or regulates the use of the product (as in the case of
prescription drugs). The spread of information is now growing by leaps and bounds as a
result of the phenomenal growth of the Internet (see the “At the Frontier’ section).
Sometimes the seller announces the lowest possible price at which it will sell a product
without bargaining in order to eliminate the need of searching for the lowest price by con-
sumers. An example of this is the recent no-haggling value pricing introduced by General
Motors (see Example 19-1).

EXAMPLE 19-1
No-Haggling Value Pricing in Car Buying

During the past decade, General Motors (GM) has been gradually moving toward no-
haggling value pricing for some of its cars. Other carmakers have also been experi-
menting with this policy in the United States. Although some Americans may find it
stimulating, most consider the time-honored business of haggling over the price of a
new car intimidating and even humiliating. One-price selling was first instituted at
GM’s Saturn division when it began building cars in 1990. Ford has also started exper-
imenting with one-price selling on a few of its vehicles, and in 2001 Mercedes-Chrysler
began to phase in its new N.F-P. (negotiation-free) policy. Although no-haggle pricing
in car buying may yet become the rule in the future, as of 2007 only the Saturn divi-
sion of General Motors had successfully adopted the approach on a large scale.
Dealers’ great fear of one-price selling is that customers will simply take the offer else-
where and use it to negotiate a better deal. Advocates of one-price selling respond that
dealers can avoid being undercut by combining one-price selling with value pricing
and accepting smaller profit margins. They believe that customers are not going to go
to other dealers to haggle over $40 or $50 if they know that they are already getting
good value for their money.
Although many independent car dealers are retraining their sales force for negoti-
ations-free selling, there is no telling how far this will spread, because most dealers
still consider a fixed-price policy heresy. And yet polls indicate that about 65% of

7 U.S. Department of Commerce, Statistical Abstract of the United States (Washington, DC: U.S. Government
Printing Office, 2007), p. 785.
8 BM. Scherer and D. Ross, Industrial Market Structure and Economic Performance (Boston: Houghton
Mifflin, 1990), p. 572. a9" .
9B. W. Eckard, “Advertising, Concentration Changes, and Consumer Welfare,” Review of Economics and
Statistics, May 1988, pp. 340-343.
620 PART SIX General Equilibrium, Efficiency, and Public Goods

Many dealers that

American car buyers say they would rather not haggle over price.
d by local competitors.
have tried no-haggle selling gave it up after being undersol
For example, selling cars
Those that stuck to it, however, say that it saves them money.
by haggling takes an average of 4% hours as compare d with 45 minutes with fixed
prices. Not having to advertise the sale of the week also saves dealers on average
another $300 per automobile sold. It also requires fewer manager s to O.K. a sales-
man’s negotiated price and leads to more loyal customers. With more and more infor-
mation available and more automobiles sold on the Internet, value pricing or lower
prices are in, but some haggling still takes place in most automobile purchases.
Sources: “Buying Without Haggling as Cars Get Fixed Prices,” New York Times, February 1, 1994, p. 1;
“At Car Dealers, a No-Haggle Policy Sets Off a Battle,’ New York Times, August 29, 1999, Sect. 3, p. 4;
“The Best Way to Buy a Car,” Wall Street Journal, November 12, 2001, p. R4; “Motoring Online,” The
Economist, April 2, 2005, pp. 11-12; and “Haggling Starts to Go the Way of the Tail Fin,” Business Week,
October 29, 2007, pp. 71-72.

AT THE FRONTIER
The Internet and the Information Revolution

nformation available to individuals, consumers, and firms is increasing by leaps and

Internet A collection bounds as a result of the development of the Internet. The Internet, or simply “the
of thousands of Net,” is a collection of more than | billion computers throughout the world linked
computers, businesses,
together in a service called the World Wide Web (www). In 2007, more than 170 mil-
and millions of people
lion individuals in the United States and nearly | billion people scattered throughout
throughout the world
linked together in a the world were connected through the Web, with hundreds of thousands of new indi-
service called the viduals joining each week. In short, the entire globe is very rapidly becoming a single
World Wide Web. unified information superhighway through the Internet. The Internet has been
around since the 1960s, but it is only during the last decade that its use has been
Information greatly simplified, which led to massive growth.
superhighway The This means that individuals, researchers, firms, and consumers could hook up
ability of researchers, with libraries, databases, and marketing information and have at their fingertips a vast
firms, and consumers
amount of information as never before. Information technology is being applied to
to hook up with
libraries, databases,
fields as diverse as science, manufacturing, finance, and marketing, which is revolu-
and marketing tionizing the way business is conducted. An individual can use the Internet to send
information through a electronic mail (e-mail) and examine thousands of multimedia documents from any-
national high-speed where in the world, browse through a firm’s catalogue, and be able (in an increasing
computer network and number of cases) to click on a “buy” button and fill in an electronic order form, includ-
have at their fingertips
ing shipping and credit card information.
a vast amount of
From 1997 to 2007, worldwide business-to-consumer or retail e-commerce
information as never
before. increased from less than $20 billion to nearly $100 billion. More than half of world-
wide retail e-commerce is now in the United States, but this is expected to fall below
 CHAPTER 19 The Economics of Information 621

50% ina few years because of its even more rapid growth outside the United States.
Concept Check Many times larger than retail e-commerce are business-to-business (B2B) sales on
Why does the creation _the Internet. The reasons are that (1) business-to-business spending is far larger than
of the Internet represent Consumer spending and (2) businesses are more willing and able than individuals to
an information use the Internet. Wal-Mart, for one, now conducts all of its business with suppliers
revolution? over a proprietary B2B network. Nearly half of business-to-business e-commerce is
in the computer and electronics industries, while for business-to-consumer e-com-
merce the largest three categories are travel, PCs, and books. Even though e-com-
merce accounts for only 15% of global gross domestic product (GDP), it is already
having a significant effect on large economic sectors, such as communications,
finance, and retailing. For example, trading securities on the Web exceeded nearly
one-third of all retail equity trades in the United States in 2007, up from practically
zero in 1995.
Producers and sellers have found that online connections with consumers, on the
one hand, and corporate customers and suppliers, on the other, have led to a dramatic
fall in the cost of doing business, a cut in reaction times, and an expansion of sales
reach. For example, while the cost of processing a paper check by banks averages
$1.20 and that of processing a credit card payment averages $0.50, the cost of pro-
cessing an electronic payment is as low a $0.01.
The Internet is not without problems, however. For one thing, even though the
Web is making the Internet easier to use and hundreds of companies are developing
software to make it easier still, finding what you want in the ocean of information
available on the Internet can be maddening slow. Then there is the risk: A file travel-
ing on the Internet could be examined, copied, or altered without the intended recipi-
ent’s being aware of it. The Internet was simply not designed to ensure secure
commerce. For example, in 1995 a hacker, or computer expert, tapped into the
Citibank computing system and transferred $10 million to various bank accounts
throughout the world. Although this computer fraud was quickly discovered and only
$400,000 was actually withdrawn, it vividly points out the danger of doing business
on the Internet. Identity theft is also possible via the Internet. All of this can be
avoided by encrypting the data (1.e., transmitting the data in code) and then unen-
crypting it on arrival at the intended recipient. But this still cannot be done easily and
conveniently. The Internet also creates problems for publishers, since any copyrighted
material can easily be copied and transmitted, thus undermining copyright laws.
Furthermore, Internet censorship is spreading rapidly and it is already being practiced
by about two dozen countries. It is likely that all these problems will be overcome in
time, but at present they present some thorny problems for Internet users.

Sources: “An Information Superhighway,” Business Week, February 1991, p. 28; “The Internet,” Business
Week, November 14, 1994, pp. 80-88; “Citibank Fraud Case Raises Computer Security Questions,” New
York Times, August 19, 1995, p. 31; “Putting the Internet in Perspective,” Wall Street Journal, April 16,
1998, p. B12; B. Fraumeni, “E-Commerce: Measurement and Measurement Issues,’ American Economic
Review, May 2001, pp. 318-322; D. Lucking-Reiley and D. F. Spulber, “Business-to-Business Electronic
Commerce,” Journal of Economic Perspectives, Winter 2001, pp. 55-68; “Identity Left Unplugged,” Wall
Street Journal, October 9, 2005, p. B1; “Life in a Connected World, Fortune, July 10, 2006, pp. 99-100;
“The Future of the Web,” MIT Sloan management Review, Spring 2007, pp. 49-64; and “Web Censorship
Spreading Around the World, Report Finds,” Financial Times, March 15, 2007, p. 1.
622 PART SIX General Equilibrium, Efficiency, and Public Goods

ASYMMETRIC INFORMATION: THE MARKET FOR LEMONS

19.2 AND ADVERSE SELECTION
prob-
We now discuss asymmetric information and the market for lemons as well as the
lem of adverse selection in the insurance market.

Asymmetric Information and the Market for Lemons

Often one party to a transaction (i.e., the seller or the buyer of a product or service) has
more information than the other party regarding the quality of the product or service.
Asymmetric This is a case of asymmetric information. An example of the problems created dy
information The asymmetric information is the market for “lemons” (i.e., defective products, such as
situation where one used cars, that will require a great deal of costly repairs and are not worth their price),
party to a transaction
discussed by Ackerlof.'®
has more information
For example, sellers of used cars know exactly the quality of the cars that they are sell-
on the quality of a
product or service ing while prospective buyers do not. As a result, the market price for used cars will depend
offered for sale than on the quality of the average used car available for sale. As such, the owners of “lemons”
does the other party. would then tend to receive a higher price than their cars are worth, while the owners of
high-quality used cars would tend to get a lower price than their cars are worth. The owners
of high-quality used cars would therefore withdraw their cars from the market, thus lower-
Concept Check ing the average quality and price of the remaining cars available for sale. Sellers of the now
How does asymmetric
above-average quality cars withdraw their cars from the market, further reducing the qual-
information lead to
ity and price of the remaining used cars offered for sale. The process continues until only
adverse selection?
the lowest-quality cars are sold in the market at the appropriate very low price. Thus, the
end result is that low-quality cars drive high-quality cars out of the market. This is known
Adverse selection The as adverse selection.
situation where low- The problem of adverse selection that arises from asymmetric information can be
quality products drive overcome or reduced by the acquisition of more information by the party lacking it. For
high-quality products
example, in the used-car market, a prospective buyer can have the car evaluated at an
out of the market as a
result of the existence independent automotive service center, or the used-car dealer can provide guarantees for
of asymmetric the cars they sell. With more information on the quality of used cars, buyers would be
information between willing to pay a higher price for higher-quality cars, and the problem of adverse selec-
buyers and sellers. tion can be reduced. More generally, brand names (such as Bayer aspirin), chain retail-
ers (such as Sears, McDonald’s, and Hilton), and professional licensing (of doctors,
lawyers, beauticians, etc.) are important methods of ensuring the quality of products and
services, and thus reduce the degree of asymmetric information and the resulting prob-
lem of adverse selection. Travelers are often willing to pay higher prices for nationally
advertised products and services than for competitive local products, because they do not
know the quality of local products and services. This is why tourists often pay more for
products and services than residents. Sometimes, higher prices are themselves taken as
an indication of higher quality.!!

!0G.A. Ackerlof, “The Market for ‘Lemons’: Qualitative Uncertainty and the Market Mechanism,”
Quarterly
Journal of Economics, August 1970, pp. 488-500.
'' See J. E. Stiglitz, “The Causes and Consequences of the Dependence of Quality
on Price,” Journal of
Economic Literature, March 1987, pp. 1-48.
 CHAPTER 19 The Economics of Information 623

The Insurance Market and Adverse Selection

The problem of adverse selection arises not only in the market for used cars, but in any mar-
ket characterized by asymmetric information. This is certainly the case for the insurance
market. Here, the individual knows much more about the state of her health than an insur-
ance company can ever find out, even with a medical examination. As a result, when an
insurance company sets the insurance premium for the average individual (i.e., an individ-
ual of average health), unhealthy people are more likely to purchase insurance than healthy
people. Because of this adverse selection problem, the insurance company is forced to raise
the insurance premium, thus making it even less advantageous for healthy individuals to
purchase insurance. This increases even more the proportion of unhealthy people in the pool
of insured people, thus requiring still higher insurance premiums. In the end, insurance pre-
miums would have to be so high that even unhealthy people would stop buying insurance.
Why buy insurance if the premium is as high as the cost of personally paying for an illness?
The problem of adverse selection arises in the market for any other type of insurance
(i.e., for accidents, fire, floods, and so on). In each case, only above-average risk people
buy insurance, and this forces insurance companies to raise their premiums. The worsen-
ing adverse selection problem can lead to insurance premiums being so high that in the
end no one would buy insurance. The same occurs in the market for credit. Since credit
card companies and banks must charge the same interest rate to all borrowers, they attract
more low- than high-quality borrowers (1.e., more borrowers Who either do not repay their
debts or repay their debts late). This forces up the interest rate, which increases even more
the proportion of low-quality borrowers, until interest rates would have to be so high that
it would not pay even for low-quality borrowers to borrow.
Insurance companies try to overcome or reduce the problem of adverse selection by
requiring medical checkups, charging different premiums for different age groups and
occupations, and offering different rates of coinsurance, amounts of deductibility, length
of contracts, and so on. These limit the variation in risk within each group and reduce the
problem of adverse selection. Because there will always be some variability in risk within
each group, however, the problem of adverse selection cannot be entirely eliminated in
this way. The only way to avoid the problem entirely is to provide compulsory insurance
to all the people in the group. Individuals facing somewhat lower risks than the group
average will then get a slightly worse deal, while individuals facing somewhat higher
risks will get a slightly better deal (in relation to the equal premium that each group mem-
ber must pay). Indeed, this is an argument in favor of universal, government-provided,
compulsory health insurance and no-fault auto insurance. On the other hand, credit com-
panies significantly reduce the adverse selection problem that they face by sharing “credit
histories” with other credit companies. Although such sharing of credit histories is justi-
fiably attacked as an invasion of privacy, it does allow the credit market to operate and
keep interest charges to acceptably low levels.

s3| MARKET SIGNALING

Market signaling The problem of adverse selection resulting from asymmetric information can be resolved
Signals that convey or greatly reduced by market signaling.’ If sellers of higher-quality products, lower-risk
product quality, good
insurance or credit
risks, and high 12 A.M. Spence, Market Signaling (Cambridge, MA: Harvard University Press, 1974); and A. M. Spence,
productivity. “Job Market Signaling,” Quarterly Journal of Economics, August 1973, pp. 355-379.
624 PART SIX General Equilibrium, Efficiency, and Public Goods

somehow inform or
individuals, better-quality borrowers, or more productive workers can
or greater producti vity to potential buyers
send signals of their superior quality, lower risk,
of the products, insurance companies, credit companie s, and employer s, then the problem
of adverse selection can, for the most part, be overcome . Individu als would then be able to
identify high-quality products; insurance and credit compani es would be able to distin-
guish between low and high-risk individuals and firms; and firms would be able to identify
higher-productivity workers. As a result, sellers of higher-q uality products would be able
to sell their products at commensurately higher prices; lower-ri sk individu als could be
charged lower insurance premiums; better-quality borrower s would have more access to
credit; and higher-productivity workers could be paid higher wages. Such market signal-
ing can thus overcome the problem of adverse selection.
A firm can signal the higher quality of its products to potential customers by adopt-
ing brand names, by offering guarantees and warranties, and by a policy of exchanging
defective items. A similar function is performed by franchising (such as McDonald’s) and
the existence of national retail outlets (such as Sears) that do not produce the goods they
sell themselves, but select products from other firms and on which they put their brand
name as an assurance of quality. The seller, in effect, is saying “I am so confident of the
quality of my products that I am willing to put my name on them and guarantee them.”
The high rate of product returns and need to service low-quality merchandise would make
it too costly for sellers of low-quality products to offer such guarantees and warranties.
The acceptance of coinsurance and deductibles by an individual or firm similarly sends a
powerful message to insurance companies indicating that they are good risks. The credit
history of a potential borrower (indicating that he or she has repaid past debts in full and
on time) also sends a strong signal to credit companies that he or she is a good credit risk.
Education serves as a powerful signaling device regarding the productivity of poten-
tial employees. That is, higher levels of educational accomplishments (such as years of
schooling, degrees awarded, grade-point average achieved, etc.) not only represent an
investment in human capital (see Section 16.7) but also serve as a powerful signal to an
employer of the greater productivity of a potential employee. After all, the individual had
the intelligence and perseverance to complete college. A less intelligent and/or a less
motivated person is usually not able to do so, or it might cost her so much more (for exam-
ple, it may take five or six years rather than four years to get a college degree) as not to
pay for her to get a college education even if she could. Thus, a college degree provides a
powerful signal that its holder is in general a more productive individual than a person
without a degree. Even if education did not in fact increase productivity, it would still
serve as an important signal to employers of the greater innate ability and higher produc-
tivity of a potential employee.'?
A firm could fire an employee if it subsequently found that the employee’s productiv-
ity was too low. But this is usually difficult (the firm would have to show due cause) and
expensive (the firm might have to give severance pay). In any event, it usually takes a great
deal of on-the-job training before the firm can correctly evaluate the productivity of a new
employee. Thus, firms are eager to determine as accurately as possible the productivity of a
potential employee before he or she is hired. There is empirical evidence to suggest that edu-
cation does in fact provide such an important signaling device. Liu and Wong found that
while firms pay higher initial salaries to holders of educational certificates (such as college
degrees) than to non—certificate holders, employees’ salaries subsequently depend
on their

'®3 See K. J. Arrow, “ry: .

“Higher Education sates ;
as a Filter,” Journal of Public Economics, July 1973, pp. 193-216.
 CHAPTER 19. The Economics of Information 625

actual on-the-job productivity.!* Thus, the firm relies on the market signal provided by
Concept Check education when it first hires an employee, for lack of a better signaling device, but then
How can market relies on actual performance after it has had adequate opportunity to determine the
signaling overcome or employee’s true productivity on the job.
greatly reduce adverse
selection?

THE PROBLEM OF MorRAL HAZARD

Moral hazard The Another problem that arises in the insurance market is that of moral hazard. This refers
increased probability to the increase in the probability of an illness, fire, or other accident when an individual is
of a loss when an
insured than when he or she is not. With insurance, the loss from an illness, fire, or other
economic agent can
accident is shifted from the individual to the insurance company. Therefore, the individ-
shift some of its costs
to others. ual will take fewer precautions to ayoid the illness, fire, or other accident, and when a loss
does occur he or she may tend to inflate the amount of the loss. For example, with med-
ical insurance, an individual may spend less on preventive health care (thus increasing the
probability of getting ill); and if he or she does become ill, will tend to spend more on
treatment than if he or she had no insurance. With auto insurance, an individual may drive
more recklessly (thus increasing the probability of a car accident) and then may be likely
to exaggerate the injury and inflate the property damage suffered if the driver does get
into an accident. Similarly, with fire insurance, a firm may take fewer reasonable precau-
Concept Check
Why does a problem of
tions (such as the installation of a fire-detector system, thereby increasing the probability
moral hazard usually of a fire) than in the absence of fire insurance; and then the firm is likely to inflate the
arise in the insurance property damage suffered if a fire does occur. Indeed, the probability of a fire is high if the
market? property is insured for an amount greater than the real value of the property.
If the problem of moral hazard is not reduced or somehow contained, it could lead
to unacceptably high insurance rates and costs and thus defeat the very purpose of insur-
ance. The socially valid purpose of insurance is to share given risks of a large loss among
many economic units. But if the ability to buy insurance increases total risks and claimed
losses, then insurance is no longer efficient and may not even be possible. One method
by which insurance companies try to overcome the problem of moral hazard is by spec-
ifying the precautions that an individual or firm must take as a condition for buying
insurance. For example, the insurance company might require yearly physical checkups
as a condition for continuing to provide health insurance to an individual, increase insur-
ance premiums for drivers involved in accidents, and require the installation of a fire
detector before providing fire insurance to a firm. By doing this, the insurance company
tries to limit the possibility of illness, accident, or fire, and thereby reduce the number
and amount of possible claims it will face.
Another method used by insurance companies to overcome or reduce the problem of
Coinsurance moral hazard is coinsurance. This refers to insuring only part of the possible loss or value
Insurance that covers of the property being insured. The idea is that if the individual or firm shares a significant
only a portion of a portion of a potential loss with the insurance company, the individual or firm will be more
possible loss. prudent and will take more precautions to avoid losses from illness or accidents. Although
we have examined moral hazard in connection with the insurance market, the problem of
moral hazard arises whenever an externality is present (i.e., any time an economic agent
Concept Check can shift some of its costs to others). This is clearly shown in Examples 19-2 and 19-3.
How can coinsurance
overcome or reduce the
problem of moral \4 P W. Liu and C. Wong, “Educational Screening by Certificates: An Empirical Test,” Economic Inquiry,
hazard? January 1984, pp. 72-83.
626 PART SIX General Equilibrium, Efficiency, and Public Goods

The Social Security program that pays disability benefits to individuals who are able to
prove that they are unable to work is a socially useful program. Nevertheless, it may
have resulted in a moral hazard problem by encouraging some individuals, who would
otherwise be working despite their disability, to withdraw from the job market when
receiving disability benefits. For example, an individual who is injured in a non-job-
related accident and is unable to walk could train to be an accountant or to hold another
sedentary occupation, but that individual may choose instead to remain unemployed
and live on disability benefits. There are, of course, many forms of disability that would
prevent an individual from doing any type of work, but this is not always the case.
Some indirect evidence exists that providing disability benefits since the early
1950s and raising them over time has led to a moral hazard problem. For example, the
labor nonparticipation rate for men between the ages of 45 and 54 increased from
nearly 4% in 1950 to more than 14% in 1993 at the same time that the Social Security
disability-recipiency rate for men in the same age group increased from zero to about
5.3%. The nonparticipation rate refers to the proportion of people in a particular age
group who are neither working nor seeking employment because of all causes (disabil-
ity and other). On the other hand, the Social Security disability-recipiency rate refers to
the proportion of people in a particular age group who are neither working nor seeking
employment because of a disability.
Providing disability benefits and increasing them over time, thus, seems to have
resulted in a moral hazard problem. There are, of course, other reasons besides dis-
ability that might have led to the large increase in the nonparticipation rate since the
1950s. However, the sharp and parallel increase in the two rates over time leads to
the suspicion that a moral hazard problem was also at work. By providing disincen-
tives for work, U.S. welfare programs also seem to have led to the same situation. In
fact, when the welfare reform of 1996 ended welfare as entitlements, available to all
persons who qualified, and required recipients to seek work as a condition for con-
tinued assistance, the number of people on welfare fell sharply (see Example 17-5).
Sources: Donald O. Parsons, “The Decline in Labor Force Participation,” Journal of Political Economy,
February 1980, pp. 117-134; “Disability Insurance and Male Labor-Force Participation,” Journal of
Political Economy, June 1984, pp. 542-549; Robert Moffitt, “Incentive Effects of the U.S. Welfare System:
A Review,” Journal of Economic Literature, March 1992, pp. 1-61; U.S. Statistical Abstract (Washington,
D.C.: U.S, Government Printing Office, 2007) p. 357; “U.S. Disability Policy in a Changing World,”
Journal of Economic Perspectives, Winter 2002, pp. 213-224; “Welfare Reforms: Ten Years Later.” New
York Times, August 26, 2006, p. 9; and B. Madrian, “The U.S. Health Care System and labor Markets.”
NBER Working Paper No. 11980, January 2006; and S. Mitra, “The Reservation Wages of Social Security
Disability Insurance Beneficiaries,” Social Security Bulletin, Col. 67 (4), 2008, pp. 89-111.

EXAMPLE 19-3
Medicare and Medicaid and Moral Hazard

Medicare is a government program that covers most of the medical expenses of the
elderly, while Medicaid covers practically all medical expenses of the poor. Both pro-
grams were enacted in the United States in 1965. While socially useful, Medicare
and
 CHAPTER 19 The Economics of Information 627

Medicaid may lead to a moral hazard problem by encouraging more doctors’ visits by
the elderly and the poor, resulting in higher prices for medical services for the rest of
the population. The effect of Medicare and Medicaid on the price and quantity of med-
ical services consumed by people not covered by either program is analyzed in a sim-
ple manner in Figure 19.1. For simplicity, we assume that all medical costs of the
elderly and the poor are covered by the programs and all medical services take the
form of doctors’ visits.
In the figure, D, is the demand curve of medical services of the elderly and the
poor before the subsidy or coverage under Medicare and Medicaid, while D,, is the
demand curve of the rest of the population. D, + D, = D,. The intersection of D, and
S (point £) defines the equilibrium price of $15 per visit (and a total of 900 million vis-
its) for the to-be covered group and for the noncovered group. At P = $15, the elderly
and the poor purchase 200 million doctors’ visits per year, while the rest of the popu-
lation consumes 700 million per year, for a total of 900 million visits for the entire
population.
When the government covers the entire cost of the doctors’ visits of the elderly and
the poor, their demand curve becomes D!. This is vertical at the quantity purchased at
zero price. That is, the covered group will demand 400 million visits per year regardless
of price. D’ + D, = D}. The intersection of D/ and S (point E’) defines the new equi-
librium price of $20 for the noncovered group. The noncovered group now pays a higher
price than before ($20 per visit instead of $15) and consumes a smaller quantity of med-
ical services as indicated by D,, (600 million instead of the previous 700 million visits per
year). The nonsubsidized group also pays the taxes to pay for the subsidy; the covered
group, as well as doctors, receive the benefits. The conclusion of the foregoing analysis
has been broadly borne out by the events that followed the adoption of Medicare and
Medicaid. In short, Medicare and Medicaid led to a moral hazard problem.

Price of a
doctor’s D

visit ($) iM

ZAG) |=

1b

0) 2 4 6 i 9 10 12 Q

Hundred million visits per year

FIGURE 19.1 Medicare and Medicaid and the Price of Medical Services D; is the demand curve of
of the
medical services of the elderly and the poor before the subsidy, while Dy is the demand curve of the rest
population. De + Dn = D;. With D, and S, P = $15 (point E). The to-be-covered group purchases 200 million visits
and the others 700 million. When the government covers the entire cost of the doctors’ visits of the elderly and
the poor, their demand curve becomes D!. D! + Dy = D,. Then P = $20 and Q = 600 million (point E’) for the
noncovered group.
628 PART SIX General Equilibrium, Efficiency, and Public Goods

19.5 THE PRINCIPAL-AGENT PROBLEM

Principal-agent A firm’s managers act as the agents for the owners or stockholders (legally referred to as
problem The fact that the principals) of the firm. Because of this separation of ownership from control in the
the agents (managers modern corporation, a principal-agent problem arises.!> This problem refers to the fact
and workers) of a firm
that while the owners of the firm want to maximize the total profits or the present value
seek to maximize their
of the firm, the managers or agents want to maximize their own personal interests, such as
own benefits (such as
salaries) rather than the
their salaries, tenure, influence, and reputation.!° The principal-agent problem often
total profits or value of becomes evident in the case of takeover bids for a firm by another firm. Although the own-
the firm, which is the ers or stockholders of the firm may benefit from the takeover if it raises the value of the
owners’ or principals’ firm’s stock, the managers may oppose it for fear of losing their jobs in the reorganization
interest. of the firm that may follow the takeover.
One way of overcoming the principal-agent problem and ensuring that the firm’s
managers act in the stockholders’ interests is by providing managers with golden
Concept Check
parachutes. These are large financial settlements paid out by a firm to its managers if
How can a principal-
agent problem arise in
they are forced out or choose to leave as a result of the firm being taken over. With golden
the management of a parachutes, the firm is in essence buying the firm managers’ approval for the takeover.
modern corporation? Even though golden parachutes may cost a firm millions of dollars, they may be more
than justified by the sharp increase in the value of the firm that might result from a
Golden parachute A takeover. Note that a principal-agent problem may also arise in the acquiring firm.
large financial Specifically, the agents or managers of a firm may initiate and carry out a takeover bid
settlement paid out by a more for personal gain (in the form of higher salaries, more secure tenure, and the
firm to its managers if
enhanced reputation and prestige in directing the resulting larger corporation) than to fur-
they are forced or
choose to leave as a
ther the stockholders’ interest. In fact, the managers of the acquiring firm may be carried
result of a takeover that away by their egos and bid too much for the firm being acquired.
greatly increases the More generally (and independently of takeovers) a firm can overcome the principal-
value of the firm. agent problem by offering big bonuses to its top managers based on the firm’s long-term
performance and profitability or a generous deferred-compensation package, which
provides relatively low compensation at the beginning and very high compensation in the
Concept Check future. Such incentives would induce managers to stay with the firm and strive for its long-
How can a golden term success. In the case of public enterprises such as a public-transportation agency, or in
parachute be used to a nonprofit enterprise such as a hospital, an inept manager can be voted out or removed.
overcome a principal-
As Example 19-4 shows, trying to overcome the principal-agent problem between
agent problem?
owners or stockholders (principals) and managers (agents) with golden parachutes may
not solve the principal-agent problem and may lead to abuses.

EXAMPLE 19-4
Do Golden Parachutes Reward Failure?

Some firms use golden parachutes to overcome their managers’ objections to a

takeover that might greatly increase the value of the firm. The proliferation and size of
golden parachutes has sharply increased during the great wave of mergers that has

ke See E. F. Fama, “Agency Problems of the Theory of the Firm,” Journal of Political Economy,
April 1980, pp. 288-307.
’ See W. Baumol, Business Behavior, Value, and Growth (New York: Harcourt-Br
ace, 1967); and O. Williamson
Corporate Control and Business Behavior (Englewood Cliffs, NJ: Prentice-Hal
l, 1964). at
 CHAPTER 19. The Economics of Information 629

taken place in the United States since the early 1980s. Some of the largest and most
controversial golden parachutes (amounting to a total of nearly $100 million) were set
up for ten of Primerica’s executives for retiring as a result of its friendly merger with
the Commercial Credit Corporation in 1988. These golden parachutes represented 6%
of Primerica’s $1.7 billion book value and cost stockholders $1.88 a share. Gerald
Tsai, Jr., the chairman of Primerica, who arranged the merger, was to receive $19.2
million as severance pay, $8.6 million to defray the excise taxes resulting from the
compensation agreement, and several other millions of dollars from Primerica’s long-
term incentive, life insurance, and retirement benefits program—for an overall total of
nearly $30 million!
Even before the final approval of the merger in December 1988, some of Primerica’s
stockholders filed suit in New York State Supreme Court charging that Primerica’s
top executives had violated their fiduciary role and had acted in their own interest
and against the stockholders’ interests; they demanded that the termination agreements
for the ten executives be canceled. The lawsuit pointed out that golden parachutes
were originally set up in 1985 for six of Primerica’s executives to cover only hostile
takeovers; they were then extended to ten executives in 1987; and finally they were
revised in 1988, three months after Primerica agreed to the merger, to also cover friendly
takeovers.
It has been estimated that 15% of the nation’s largest corporations offered
golden parachutes to its top executives in 1981. This figure rose to 33% in 1985 and
to nearly 50% in 1990. Indeed, golden parachutes are no longer confined to the cor-
poration’s top executives; they are offered farther and farther down the corporate lad-
der to middle-level management and sometimes even to all employees. This has
resulted in a public outcry and has led the Securities and Exchange Commission to
rule that a firm must hold a shareholder vote on its golden parachute plans. Until the
early 1990s, corporations typically did not make public their offer of golden para-
chutes. Not only are they now required to do so, but some companies are even begin-
ning to demand restitution.
The practice of giving golden parachutes, nevertheless, continues. Indeed, after
observing huge severance packages given to CEOs who “were let go” in 2000, Dean
Foust of Business Week (see the reference below) remarked “failure has never looked
more lucrative.” For example, in August 2000, Proctor & Gamble gave Durk Jager, its
just-ousted CEO, a $9.5 million bonus even though he had been at P&G less than one-
and-half years and P&G stock had fallen by 50% during his tenure. Also in 2000,
Conseco Inc. gave a $49.3 million going-away gift to CEO Stephen Hilbert, who prac-
tically bankrupted the company with his ill-fated move into sub-prime lending.
Similarly, Mattel gave a parachute package worth nearly $50 million in severance pay
to Jill Barard, its departing CEO, and Ford gave Jacques Nasser, its ousted CEO, a com-
pensation package worth $23 million in 2001 even though the company lost $5.5 billion
that year, Large-company boards point out, however, that at the point of firing the
CEO they usually have limited discretion, if any, in the payouts, due to contractual
obligations and other entitlements. Thus, Stanely O’Neil walked away from Merrill
Lynch in November 2007 with a $161.5 million package after the company announced
a staggering $8.4 billion write-down of securities backed by subprime mortgages, and
630 PART SIX General Equilibrium, Efficiency, and Public Goods

with a $104.7 million

Charles Prince left Citigroup soon after, for the same reason,
exit package.
Pay,” Wall Street
Sources: “Ten of Primerica Executives’ Parachutes Gilded in $98.2 Million Severance
‘Golden Parachutes’,” Wall
Journal, November 29, 1988, p. A3; “Primerica Holders File Lawsuit to Halt
Plans,’ Wall Street
Street Journal, December 2, 1988, p. A9; “Ruling by SEC May Threaten Parachute
September 11,
Journal, January 1990, p. A3; “CEO Pay: Nothing Succeeds Like Failure,” Business Week,
2000, p. 46; “When Bosses Get Rich from Selling the Company,” Business Week, March 30, 1998,
p. A17;
p. 33-34; “Golden Parachutes’ Emerge in European Deals.” Wall Street Journal, February 14, 2000,
Receives $23 million in 2001,” New York Times, April 10, 2002, p. C6; “How Golden Is
“Bx-Ford Chief
Their Parachutes?” Business Week, November 26, 2007, p 34; and http://dealbook.blogs.nytimes.com/2007/
12/05/whos-to-blame-for-big-golden-parachutes.

19.6 THE EFFICIENCY WAGE THEORY

We have seen in Section 14.5 that in a perfectly competitive labor market, all workers
who are willing to work find employment and the equilibrium wage rate reflects (1.e., is
equal to) the marginal productivity of labor. In the real world, however, we often observe
higher-than-equilibrium wages and a great deal of involuntary unemployment. Why, then,
don’t firms lower wages?
Efficiency wage According to the efficiency wage theory, firms willingly pay higher-than-equilibrium
theory Postulates that wages to induce workers to avoid shirking, or slacking off on the job.'’ The theory begins
firms willingly pay by pointing out that it is difficult or impossible for firms to monitor workers’ productivity
higher-than-equilibrium
accurately (thus, firms face a principal-agent problem resulting from asymmetric infor-
wages to induce
mation). If workers are paid the equilibrium wage, they are likely to shirk, or slack off on
workers to avoid
shirking, or slacking the job, because, if fired, they can easily find another, equal-paying job (remember, there
off on the job. is no involuntary unemployment at the equilibrium wage, and in any event it is not easy
for a firm to catch a worker shirking). According to the efficiency wage theory, by paying
a higher-than-equilibrium or efficiency wage, the firm can induce employees to work
more productively and not to shirk, because the employees fear losing their high-paying
Concept Check
What is an efficiency jobs. Even if all firms paid efficiency wages, employees would not shirk and not risk
wage? Why would a being fired, because it is not easy to find another similarly rewarding job in view of the
firm pay it? great deal of unemployment that exists at the efficiency wage.
The efficiency wage theory can be examined graphically with Figure 19.2. In the
figure, D; is the usual negatively sloped demand curve for labor of the firm, and S;, is the
supply curve of labor (assumed to be fixed for simplicity) facing the firm. The intersec-
tion of D; and S; at point E determines the equilibrium wage of $10 per hour and equi-
librium number of 600 workers hired by the firm. There are no unemployed workers and
this wage is equal to the marginal productivity of labor.
But at this equilibrium wage, workers have an incentive to shirk. To induce workers
not to shirk, the firm will have to pay a higher or efficiency wage. The higher the efficiency
wage is, the smaller the level of unemployment, because workers can then more easily
find another job at the efficiency wage (if fired from the present job because of shirking).

'” See J. L. Yellen, “Efficiency Wage Models of Unemployment,” American Economic Review,
May 1984,
pp. 200-205; and J. E. Stiglitz, “The Causes and Consequences of the Dependence of Quality
on Price,”
Journal of Economic Literature, March 1987, pp. 1-48.
 CHAPTER 19 The Economics of Information 631

(No-shirking
constraint)
Wage ($)

10

0 200 300 400 500 600

Number of workers hired

FIGURE 19.2 Efficiency Wage and Unemployment in a

Shirking Model OD, and S are, respectively, the firm’s
demand and the supply curve for labor Their intersection at
point E determines the equilibrium wage of $10 per hour at
which the firm employs 600 workers and there is no
unemployment. Workers, however, have an incentive to shirk at
this wage. The no-shirk constraint (NSC) curve is positively
Sloped and shows that the efficiency or minimum wage that
the firm must pay to avoid shirking is higher the smaller the
level of unemployment. The no-shirking equilibrium is
determined at point E* where D; and NSC cross. The efficiency
wage is $20 per hour and 200 workers (BE*) are unemployed.

This is shown by the no-shirking constraint (VSC) curve shown in the figure. The NSC
curve shows the minimum wage that workers must be paid for each level of unemploy-
ment to avoid shirking. For example, the efficiency wage of $10 requires 300 workers
(EA) to be unemployed. With 200 workers (BE*) unemployed the efficiency wage is $20,
and with only 100 workers unemployed (CF) the efficiency wage will have to be $40.
Note that the NSC curve is positively sloped (1.e., the efficiency wage is higher the smaller
the level of unemployment) and gets closer and closer to the fixed S; curve but never
crosses it (i.e., there will always be some unemployment at the efficiency wage).
In Figure 19.2, the intersection of the D; and NSC at point E* determines the effi-
ciency wage of $20 per hour. At this wage rate, the firm employs 400 workers and 200
workers are unemployed. The reason that $20 is the equilibrium efficiency wage is that
only at this wage is the level of unemployment (BE*) just enough to avoid shirking. For
$10 to be the efficiency wage, 300 workers (EA) would have to be unemployed. But at the
wage of $10 there is no unemployment (point £). Thus, the equilibrium efficiency wage
must be higher. On the other hand, for $40 to be the efficiency wage, only 100 workers
(FE) need to be unemployed. But at the wage of $40, 350 workers (FG ) are unemployed.
Thus, the equilibrium efficiency wage must be lower. The efficiency wage is $20 because
only at this wage is the number of unemployed workers (200 = BE*) just right for work-
ers not to shirk.
632 PART SIX General Equilibrium, Efficiency, and Public Goods

EXAMPLE 19-5
The Efficiency Wage at Ford

One example of the efficiency wage theory is provided by the decision by Henry Ford
in January 1914 to reduce the length of the working day from nine to eight hours while
increasing the minimum daily wage from $2.34 to $5 for assembly-line workers. What
prompted Ford to adopt such a radical (for the time) wage decision was the low pro-
ductivity and very high turnover of assembly-line workers at Ford’s plants under the
previous traditional wage system. For example, labor turnover at Ford was 380% in
1912 and nearly 1000% in 1913. This sharply increased costs and reduced profits. The
paying of a wage much higher than the going wage by Ford did have the intended
effect. Ford was able to attract more productive and loyal workers, absenteeism was
cut in half, and productivity increased by more than 50%. In fact, the sharply reduced
labor turnover and increased labor productivity was sufficient to actually reduce the
cost of producing each automobile. The new wage system was also great publicity,
which increased Ford’s sales. Lower production costs and higher sales meant higher
profits for Ford (Ford’s profits rose from $30 million in 1914 to nearly $60 million
in 1916). In short, what Ford did in 1914 was to pay the efficiency wage—and it took
70 years for economists to develop the theory to fit the facts!
Sources: J. R. Lee, “So-Called Profit Sharing System in the Ford Plant,’ Annals ofthe American Academy
of Political and Social Science, May 1915, pp. 297-310; D. Raff and L. Summers, “Did Henry Ford Pay
Efficiency Wages,’ Journal of Labor Economics, October 1987, pp. SS7—S58; G. A. Ackerlof and J. L. Yellen,
(eds.), Efficiency Wage Models of the Labor Market (New York: Cambridge University Press, 1986; and
“What Is the Best Way to Pay Employees?,” MIT Sloan Management Review, Winter 2007, pp. 8-9.

SUMMARY
1. Search costs refer to the time and money we spend seeking information about a product.
The general rule is to continue the search for lower prices, higher quality, and so on until
the marginal benefit from the search equals the marginal cost. In most instances,
advertising provides a great deal of information and greatly reduces consumers’ search
costs, especially for search goods. These are goods whose quality can be evaluated by
inspection at the time of purchase (as opposed to experience goods, which can only be
judged after using them).
N . When one party to a transaction has more information than the other on the quality of the
product (i.e., in the case of asymmetric information), the low-quality product, or “lemon,”
will drive the high-quality product out of the market. One way to overcome or reduce such
a problem of adverse selection is for the buyer to get, or the seller to provide, more
information on the quality of the product or service. Such is the function of brand names,
chain retailers, professional licensing, and guarantees. Insurance companies try to
overcome the problem of adverse selection by requiring medical checkups, charging
different premiums for different age groups and occupations, and offering different
rates
of coinsurance, amounts of deductibility, and length of contracts. The only
way to avoid
the problem entirely is with universal compulsory health insurance.
Credit companies
reduce the adverse selection process that they face by sharing “credit
histories” with other
insurance companies.
 CHAPTER 19 The Economics of Information 633

. The problem of adverse selection resulting from asymmetric information can also be resolved
or greatly reduced by market signaling. Brand names, guarantees, and warranties are used as
signals for higher-quality products, for which consumers are willing to pay higher prices.
The willingness to accept coinsurance and deductibles signals low-risk individuals to whom
insurance companies can charge lower premiums. Credit companies use good credit
histories to make more credit available to good-quality borrowers, and firms use educational
certificates to identify more-productive potential employees who may then receive higher
salaries.
. The insurance market also faces the problem of moral hazard, or the increase in the probability
of an illness, fire, or other accident when an individual is insured than when he or she is
not. If not contained, moral hazard could lead to unacceptably high insurance costs. Insurance
companies try to overcome the problem of moral hazard by specifying the precautions that an
individual or firm must take as a condition of insurance, and by coinsurance (i.e., insuring
only part of the possible loss). The problem of moral hazard arises whenever an externality
iS present (1.e., any time an economic agent can shift some of its costs to others).
. Because ownership is divorced from control in the modern corporation, a principal-agent
problem arises. This refers to the fact that managers seek to maximize their own benefits rather
than the owners’ or principals’ interests, which are to maximize the total profits or value of
the firm. The firm may use golden parachutes (large financial payments to managers if they
are forced out or choose to leave if the firm is taken over by another firm) to overcome the
managers’ objections to a takeover bid that sharply increases the value of the firm. The firm
may also set up generous deferred-compensation schemes for its managers to reconcile their
long-term interests with those of the firm.
. According to the efficiency wage theory, firms willingly pay higher than equilibrium wages to
induce workers to avoid shirking or slacking off on the job. The no-shirk constraint curve is
positively sloped and shows that the efficiency or minimum wage that the firm must pay to
avoid shirking is higher the smaller the level of unemployment. The equilibrium efficiency
wage is given by the intersection of the firm’s demand curve for labor and the no-shirking
constraint curve.

KEY TERMS
Search costs Asymmetric information Principal-agent problem
Search goods Adverse selection Golden parachutes
Experience goods Market signaling Efficiency wage theory
Internet Moral hazard
Information superhighway Coinsurance

REVIEW QUESTIONS
1. a. In which market structure was perfect information 2. On which do you think consumers spend more time
assumed on the part of all economic agents? shopping for lower prices, sugar or coffee? Why?
b. If all consumers have perfect information, can a price 3. Can you explain why the price dispersion for salt is much
dispersion for a given homogeneous product exist in greater than the price dispersion for sugar?
the market if all conditions of the sale are identical? 4. Frozen vegetables are search goods because they are
Why? purchased frequently by consumers. True or false?
Explain.
634 PART SIX General Equilibrium, Efficiency, and Public Goods

5. Most advertising is manipulative and provides very little e) a. What problem can arise for the Ford Corporation by
information to consumers. True or false? Explain. providing a 50,000-mile guarantee for its new
automobiles sold?
6. What is the relationship between speculation and the
economics of information? b. How can Ford reduce this problem?
7. a. Adverse selection is the direct result of asymmetric - Should education be viewed as an investment in human
information. True or false? Explain. capital or a market signaling device? Explain.
b. How can the problem of adverse selection be overcome? . What is the relationship between moral hazard and
externalities?
8. a. How do credit companies reduce the adverse selection
problem that they face? . What is meant by the efficiency wage? What problem is
this intended to solve?
b. What complaint does this give rise to?

|_| PROBLEMS
*], Determine the precise expected price for the TV from the EO: Connect to the Internet from your computer or from any
second search in the problem discussed in the section on PC and go to http://www.priceline.com. What is
“Searching for the Lowest Price” without the use of Priceline.com?
equation [19.1]. . Go to http://www.ebay.com and explain what it 1s.
2. Draw a figure showing the marginal benefit and the So Suppose that there are only two types of used cars in the
marginal cost of each additional search, and show the market (high-quality and low-quality), and that all the
point of equilibrium for the TV problem using the high-quality cars are identical and all the low-quality
information given in the text. cars are identical. With perfect information, the quantity
*3. a. Suppose that type I sellers charged the price of $60 for demanded of high-quality used cars is zero at $16,000
the portable TV, type II sellers charged $80, type III and 100,000 at $12,000, while the quantity demanded
sellers charged $100, type IV sellers charged $120, and of low-quality used cars is zero at $8,000 and 100,000
type V sellers charged $140. Determine the expected at $4,000. Suppose also that the supply curve for high-
lowest price for the TV from one, two, three, four, and quality used cars is horizontal at $12,000, while the
five searches. supply curve of low-quality used cars is horizontal at
b. Determine the marginal benefit from each additional $4,000 in the relevant range. Draw a figure showing
search. that with asymmetric information, no high-quality
4. Using the data of Problem 3, indicate used cars will be sold and 100,000 low-quality
a. How many searches should a consumer undertake if used cars will be sold at the price of $4,000 each.
the marginal cost of each additional search is $4? Explain the precise sequence of events that leads
b. If it is $2? to this result.

c. How many searches should a consumer undertake if . Draw another figure similar to the figure in the answer to
the marginal cost of each additional search is $5.34 Problem 8 but with the supply curves of high-quality and
and the consumer plans to purchase two TV sets? low-quality used cars positively sloped rather than
a i) . Suppose that type I sellers charged the price of $96 for horizontal. Assume further that used cars are of many
different qualities rather than being simply of high quality
the portable TY, type II sellers charged $98, type III
and low quality. With reference to the figure, explain the
sellers charged $100, type IV sellers charged $102, and
precise sequence of events that leads to only cars of the
type V sellers charged $104. Determine the expected
lowest price for the TV from one, two, three, four, and lowest quality being sold.
five searches. . Explain how franchising signals quality.
b. Determine the marginal benefit from each additional 11 . Suppose that the returns to education are 12% for an
search. intelligent and motivated person but only 8% for a less
Q . How many searches should a consumer undertake if the intelligent and less motivated person (because it takes
marginal cost of each additional search is $1.00? longer for the latter to get a college degree). Suppose

* — Answer provided at end of book.

 CHAPTER 19 The Economics of Information 635

also that the return on investing in stock is 10% and that 12. An insurance company is considering providing fire
such an investment is as risky as getting a college insurance for $120,000, $100,000, or $80,000 to the
education. Suppose furthermore that getting a college owner of a house with a market value of $100,000.
education is viewed as a strictly investment undertaking
a. How much insurance is the company likely to sell
(i.e., assume that there are no psychological benefits to
for the house? Why?
getting a college education). Explain how a college
education can serve as a market signaling device in b. If the probability of a fire is 1 in 1,000, what would
this case. be the premium charged by the company?

| INTERNET SITE ADDRESSES

For more information on the companies examined in this http://www.ncsall net/?id=667
chapter, see: http://www.aeaweb.org/joe/signal/
http://www.gm.com For moral hazard, see:
http://www.ford.com http://en.wikipedia.org/wiki/Moral_hazard
http://www.amzon.com http://www.investopedia.com/terms/m/moralhazard.asp
http://www.barnsandnoble.com http://ingrimayne.com/econ/RiskExclusion/Risk.html
http://www. priceline.com http://www.questia.com/googleScholar.qst?docId=
http://www.ebay.com 5000372319
http://www.gm.com http://online.wsj.com/article/SB 1 18696170827295489.
html
For more information on the Internet and e-commerce, see: http://www.americanthinker.com/2007/08/
http://en.wikipedia.org/wiki/Internet#Growth the_moral_hazard_of_regulating.html

http://en. wikipedia.org/wiki/Electronic_commerce http://www.gladwell.com/2005/2005_08_29_a_

hazard. html
http://www.internetworldstats.com/stats.htm
For the principal-agent problem, see:
Asymmetric information is examined at:
http://en.wikipedia.org/wiki/Principal-agent_problem
http://www.nobel.se/economics/laureates/2001/
ecoadv.pdf http://www?2.chass.ncsu.edu/garson/pa765/agent.htm
http://papers.ssrn.com/sol3/papers.cfm ?abstract_id= http://bdm.cqpress.com/chap5/05%20BdM%203e%
670128 20WT.ppt# 1
http://gulzar05.blogspot.com/2007/05/ http://economics.about.com/od/economicsglossary/g/
insurance-policies.html principalag.htm
Market signaling is examined at: Efficiency wages are discussed at:
http://www. berkeley.edu/berkeleyan/2001/10/ http://en. wikipedia.org/wiki/Efficiency_wages
17_asyme.html http://www.answers.com/topic/efficiency-wages
http://en.wikipedia.org/wiki/Signalling_(economics) http://www.econ.puc-rio.br/pdf/ribeiro.pdf
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 APPENDIX A

Mathematical Appendix

A.1 INDIFFERENCE CURVES on the same indifference curve. Higher subscripts refer
to higher indifference curves. Thus, U2 > U}.
(Refers to Section 3.2, page 62) Taking the total differential of equation [1A],
Suppose that a consumer’s purchases are limited to we get
commodities X and Y, then _ ou oU
ONO! == Vo yi WE
~ Ox oY Al
U=UCY) [1A]
Since a movement along an indifference curve leaves
is a general utility function. Equation [1A] postulates utility unchanged, we set dU = 0 and get
that the utility or satisfaction that the consumer oU dU
receives is a function of or depends on, the quantity of ayo aE ay) =) [4A]
commodity X and commodity Y that he or she con-
sumes. The more of X and Y the individual consumes, so that
the greater the level of utility or satisfaction that he or
she receives. seit = -— ay [SA]
Using a subscript on u to specify a given level of
utility or satisfaction, we can write and
dV 9 y0U OX TMU ie 6A]
U; = U(X, Y) [2A] dX @dU/aY MUy
This is the general equation for an indifference curve. Equation [6A] indicates that the negative value of the
Equation [2A] postulates that the individual can get U; slope of an indifference curve (—dY/dX) is equal to the
of utility by various combinations of X and Y. Of ratio of the marginal utility of X to the marginal utility of
course, the more of X the individual consumes, the less Y(MUx/MUy), which, in turn, equals the marginal rate of
of Y he or she will have to consume in order to remain substitution of X for YWMRSyy).

637
638 APPENDIXA

A.2 UTILITY MAXIMIZATION A.3 CONSUMER SURPLUS

(Refers to Section 3.5, page 74) (Refers to Section 4.5, page 106)

We now wish to maximize utility (i.e., equation [1A]) In Section 4.5, we defined consumer surplus as the dif-
subject to the budget constraint. The budget constraint ference between what a consumer is willing to pay for
of the consumer is a given quantity of a good and what he or she actually
pays for it. Graphically, consumer surplus is given by
PxX + PyY=I [7A] the difference in the area under the demand curve and
the area representing the total expenditures of the con-
where Py and Py are the price of commodity X and sumer for the given quantity of the good that he or she
commodity Y, respectively, X and Y refer to the quan- purchases.
tity X and commodity Y, and / is the consumer’s Starting with P = g¢(Q), g is the inverse of Q = f(P).
income, which is given and fixed at a particular point in For a given price (P;) and its associated quantity (Q)),
time. Q\
To maximize equation [1A] subject to equation consumer =|| g(Q)dQ — P\Q; [12A]
0
[7A], we form surplus

V=UCG, Y) + AU — PxX — PyY) [8A] where the integral sign (/) represents the process of
calculating the area under inverse demand function
where A is the Lagrangian multiplier. P = g(Q) between zero quantity of the commodity and
Taking the first partial derivative of V with respect quantity Q;, and P)Q, is the total expenditure of the
to X and Y and setting them equal to zero gives consumer for Q; of the commodity.
OV =0U
— = — —jPy =0
Dy mex *
A.4 SUBSTITUTION AND INCOME EFFECTS
OV aU
— = — —APy =0 |9A| (Refers to Section 4.3, page 97)
OY OY

It follows that
The substitution effect of a price change can be mea-
sured by a movement along a given indifference curve
(so that utility or purchasing power is constant). With a
——
gu XP n d —$ a= XP: LOA
ax es ae ‘ Have change in the price of commodity X, we have

Dividing, we get etry J (

substitution effect = with constant utility(U)
( ey
[13A]
dU /0X MU te
. i = —~ =MRSyy=— [NA]
dU/aY MUy Py The income effect can be measured by a shift to a
different indifference curve (to reflect the change in
Equation [1 1A] indicates that the consumer maximizes utility or purchasing power) with prices constant. This
utility at the point utility at the point where the mar- is given by the change in the demand for X per dollar
ginal rate of substitution of X for Y, (@U/0X)/ increase in income, weighed by the quantity of X pur-
(dU/0Y"), equals the ratio of the price of X to the price chased. That is,
of Y. Graphically, this occurs at the point where the
budget line is tangent to the highest indifference curve - aX
income effect = X (=) with constant prices
possible (and their slopes are equal). Equation [1 1A] is C

only the first order condition for maximization (and [14A]

minimization). The second order condition for maxi- When the price of X falls, the income effect tells us how
mization is that the indifference curves be convex to much the consumer’s income should be reduced in
the origin. order to leave his or her purchasing power constant.
 Mathematical Appendix 639

Combining the substitution and the income effects For example, if b = —2 and P/O =1, then n= —2.
we get the Slutsky equation: Since P/Q is different at every point on the negatively
sloped, straight-line demand curve, 7 varies at every
aX aX x (ox point.
OPy OPx on For a curvilinear demand curve of the form

for constant U for constant [ISA] Q=aP” [21A]

prices
d
The first term on the right side gives the substitution = See [22A]
effect (shown by a movement along a given indiffer-
ence curve). The second term gives the income effect and
(shown by a shift to a different indifference curve but yl he?
with constant goods prices).

since aP” = Q. Thus, equation [21A] is a demand curve

with a constant price elasticity equal to the exponent of
A.5 — ELASTICITIES P6201) =) wLUS, 10 Di=i2, pr 2 at every, point
(Refers to Section 5.2 to 5.4, pages 128-139) on the demand curve. As pointed out in Chapter 5.2,
demand is elastic if |7| > 1 and inelastic if |7| < 1.
In Chapter 5.2 we defined the price elasticity of The income elasticity of demand, 7; 1s defined as the
demand, n, as the percentage change in the quantity ratio of the relative change in the quantity purchased (Q)
demanded of a commodity divided by the percentage to the relative change in income (/), other things remain-
change in its price. That is, for Q = f(P), ing constant. That is, for Q = f(/),

_AQ/Q AQP [24A]

“SD ipip BAP O fae
For the following linear income-demand function
We also pointed out that since quantity and price move
in opposite directions, the value of 7 is negative. Q=a+cl [25A]
Equation [16A] can be used to measure are elasticity.
In that case, P and Q refer to the average price and the where c > 0, the derivative of Q with respect to / is
average quantity, respectively.
As the change in price approaches zero in the limit,
dQ
SS 76 [26A]
dl
we can measure point elasticity by

v(9)
Therefore,
NOME
i= poet [17A]
dP Q [27A]
If the demand curve is linear and given by
For the following nonlinear income-demand
Q=a+bP [18A] function

the slope of the demand curve is constant and 1s Oa [28A]

given by the derivative of Q with respect to / is

ds
ao = ES =b
dP NIP
[19A] Li pte [29A]
dl
and Therefore,
P
ess acI©
ap [20A] my =acl° |= raya: [30A]
gle O
640 APPENDIX A

As pointed out in Chapter 5.3, a commodity is the derivative of Q, with respect to P is

normal if 7; > 0 and inferior if n; < 0. A normal good
is luxury if n;> 1 and a necessity if 7, is between Uys [38A]
0 and 1.
dP
The cross elasticity of demand of commodity X for Therefore,
commodity Y, nxy, is defined as the ratio of the relative
change in the quantity purchased of commodity X (Qx)
P
€ =b— [39A]
to the relative change in the price of commodity Y (Py). OF
That is,
Substituting equation [37A] for Q, into equation [39A],
0
Si 7) OOa Gee
ae [1A] we get
ues dPy / Py dPy Qx
bP
Consider the following linear demand function for = [40A]
a+bP
commodity X:
Thus, if a= 0 (so that the supply curve starts at the ori-
Oy=a-+ bPxy+ cPy (32A] gin), € = 1 throughout the supply curve, regardless of
the value of its slope (b). If a > 0 (so that the supply
The above function indicates that Qy depends on Py curve cuts the quantity axis), € < | throughout the sup-
and Py. The derivative of the function with respect to ply curve. If a < 0 (so that the supply curve cuts the
P.Y is price axis), « > 1 throughout. When a #0, € varies
with price.
[33A]

If the Py remains unchanged when Py changes, then A.6 — RELATIONSHIP AMONG INCOME
ELASTICITIES
dP d
sO Melee ee [34A]
dPy dPy (Refers to Sections 5.2 and 5.3, pages 128 and 135)

Therefore, If a consumer’s income increases, say by 10% and the

consumption of some commodities increases by less
P.

nxy = oir [35A] than 10%, the consumption of other commodities must
increase by more than 10% for the entire increase in the
As pointed out in Chapter 5.4, commodities X consumer’s income to be fully spent. This leads to
and Y are substitutes if yyy > 0 and complements if the proposition that the income elasticity of demand
must be unity, on the average, for all commodities.
nxy < 0.
The price elasticity of supply, €, is defined as the Assuming, for simplicity, that the entire consumer’s
ratio of the relative change in the quantity supplied of a income is spent on commodities X and Y, we can restate
commodity (Q,) to the relative change in its price (P). the above proposition mathematically as
MnatisetOr (cr—07 (2):
Kxnix + Kyniy = 1 [41A]
- — 4s/Qs _ dQsP nee where Ky is the proportion of the consumer’s income
AEP aPSOs
(7) spent on commodity X (i.e., Ky = PxX/D, nix is
Since the quantity supplied and price move in the same the income elasticity of demand for commodity X,
direction (i.e., supply curves are usually positively Ky is the proportion of income elasticity of demand
sloped), € is positive. Tors
For the following linear supply function Starting with the consumer’s budget constraint [7A]

I = PxX + PyY [7A]

 Mathematical Appendix 641

we can prove proposition [41A] by differentiating where, 77 1s the coefficient of price elasticity of demand.
equation [7A] with respect to income, while holding For example, if P= $12 and n = —3, MR= $8. If
prices constant. This gives = —co, P= MR = $12,

[42A]
A.8 —ISOQUANTS
If we multiply the first term on the right-hand side by
(X/X)(/I), which equals one, and the second term by (Refers to Sections 7.3 and 7.4, pages 198 and 201)
(Y/Y)U/I), which equals one, the value of the expres- Suppose that there are two inputs, labor and capital. The
sion will not change, and we get

pee eee aya eve O=SOUe Ka) [47A]

a x ee a ye] aes is a general production function. Equation [47A] postu-
Rearranging equation [42A’], we get lates that output (Q) is a function of, or depends on, the
quantity of labor (L) and capital (K) used in production.
PeXdX I | Py¥d¥ I _, rn The more L and K are used, the greater is Q.
Tr lax POR aE Kop Yat Using a subscript on Q to specify a given level of
Since PyX/I = Ky, (dX/dI)(I/X) = mx, Py¥/I = Ky, output, we can write
and (dY/dI)(I/Y) = ny, we have
Q; = QL, K) [48A]
Kynix + Kyny = 1 [41A]
This is the general equation for an isoquant. Equation
That is, with the K’s providing the weights, the
[48A] postulates that output Q; can be produced with
weighted average of all income elasticities equals
various combinations of L and K. The more L is used,
unity. Thus, the income elasticity of demand of
the less K will be required to remain on the same iso-
a commodity on which the consumer spends a great
quant. Higher subscripts refer to higher isoquants.
proportion of his or her income cannot be too differ-
Thus, Op > Q).
ent from unity (see Problem 12 in Chapter 5).
Taking the total differential of equation [47A],
we get
dQ dQ
A.7 — RELATIONSHIP AMONG MARGINAL dQ = —-dl. + dk 494
ip aK 2a)
REVENUE, PRICE, AND ELASTICITY
Since a movement along an isoquant leaves output
(Refers to Section 5.6, page 142) unchanged, we set dQ = 0 and get
Let P and Q equal the price and the quantity of a com-
3 a
modity, respectively. Then the total revenue of the 20 7 4 22 a =0 [50A]
seller of the commodity (TR) is given by aL aK
so that
eat £o) [44A] A 3
em ea, [S1A]
aK aL
and the marginal revenue is
and
d(TR) dP
MR = —_—_ =P + O- 45A]
dQ 270 a aL MP
Kea
dL @8Q/0K MPx
Manipulating expression [45A] mathematically, we get
Equation [52A] indicates that the negative value of
the slope of an isoquant (—dk/dL) is equal to the ratio
"
mr=P (1+ Dales
2) —P(1+--) [46A]
46A of the marginal product of L to the marginal product of
642 APPENDIX A

K (MP_/MPx), which, in turn, equals the marginal rate is only the first order condition for minimization (and
of technical substitution of L for K (MRTS_x). maximization). The second order condition for mini-
mization is that the isoquant be convex to the origin.

A.9 Cost MINIMIZATION

(Refers to Section 8.2, page 228) A110 PRrorit MAXIMIZATION
A firm may wish to minimize the cost of producing a (Refers to Section 9.3, page 265)
given level of output. The total cost of the firm (TC) is
A firm usually wants to produce the output that maxi-
given by
mizes its total profits. Total profits (77) are equal to total
TC =wL+rK [53A] revenue (7R) minus total cost (TC). That is,
where w is the wage rate of labor and r is the rental
price (per unit) of capital. A given level of output (Q)
can be produced with various combinations of L and K: where zr, TR, and TC are all functions of output (Q).
O- OAK) [54A] Taking the first derivative of 2 with respect to Q
To minimize equation [53A] subject to equation [54A], and setting it equal to zero gives
we form
dx _= d(TR)
— ——
(TC) _=0
— — 60A
Z=wh+rK+a*(O — O(L,K)| [55A] dQ dQ dQ ened
where A* is the Lagrangian multiplier. so that
Taking the first partial derivative of Z with respect d(TR) e d(TC) [61]
to L and K and setting them equal to zero gives dQ dQ
and
ee
OL aL MR = MC [62A]
and
Equation [62A] indicates that in order to maximize
OZ dQ profits, a firm must produce where marginal revenue
SS oh 56A
OK OK 20 (MR) equals marginal cost (MC).
It follows that Furthermore, since for a perfectly competitive firm
P is constant and d(TR)/dQ = MR = P, the first order
dQ dQ condition becomes
w — oT
Nea Ate 9? =a 7hNe
aR [S7A]

Dividing, we get
MR = P= MC [63A]

w 0Q/dL Vie an Equation [61

A] is only the first order condition for
2 MOS ae pon maximization (and minimization). The second
condition for profit maximization requires that the
order

Equation [58A] indicates that a firm minimizes the second derivative of with respect to Q be negative.
cost of producing a given level of output by hiring That is,
labor and capital up to the point where the ratio of the
input prices (w/r) equals the ratio of the marginal dak dR )iee(76)
0 [64A]
products of labor and capital, (9Q/L)/(0Q/AK) which dQ? dQ? ee
equals the marginal rate of technical substitution of
so that
labor for capital (MRTS;x). Graphically, this occurs at
the point where a given isoquant is tangent to an iso- da?(TR) Wed? (7G)
cost line (and their slopes are equal). Equation [58A] 14028 < ai02 [65A}
 Mathematical Appendix 643

According to equation [65A], the algebraic value of the where the bar on P refers to the equilibrium price.
Slope of the MC function must be greater than the alge- Since parameters a, b, c, and d are all positive, P is also
braic value of the MR function. Under perfect competi- positive.
tion, MR is constant (i.e., the MR curve of the firm is To find the equilibrium quantity (Q) that corre-
horizontal) so that equation [65A] requires that the MC sponds to P, we substitute equation [70A] into equa-
curve be rising at the point where MR = MC for the tion [67A] or [68A]. Substituting equation [70A] into
firm to maximize its total profits (or minimize its total equation [67A], we get
losses).
Under imperfect competition, P > MC and so the ~ b(a+c)
first order condition becomes simply Ce" RaGeR
MR = MC [63B] pe CE) = 0(Ganc) es
fir b+d bed ie
The second order condition remains [65A], but with
MR now declining, the second order condition is for the Since the denominator of equation [71A], (b + d), is
MC curve to intersect the MR curve from below. positive, for QO to be positive (and for the model to be
economically meaningful) the numerator, (ad — bc),
must also be positive. That is, ad > bc.
A111 Price DETERMINATION
(Refers to Sections 9.4 and 10.2, pages 271 and 312) A12 Price DISCRIMINATION
At equilibrium, the quantity demanded of a commodity (Refers to Section 10.5, page 326)
(Qz) 1s equal to the quantity supplied of the commodity
A monopolist selling a commodity in two separate
(Q;). That is,
markets must decide how much to sell in each market
04= Q; [66A] in order to maximize total profits. The total profits of
the monopolist (zr)are equal to the sum of the total rev-
The demand function can be written as enue that it receives from selling the commodity in the
two markets (i.e., TR; + TR>) minus the total cost of
Qy=a— bP(a, b > 0) [67A]
producing the total output (TC). That is,
where a is the positive quantity intercept, and —b is
the negative of the multiplicative inverse of the slope TLR air hg aa Cy [72A]
of the demand curve (so that when P rises, Qz falls).
The supply function can take the form of Taking the first partial derivative of 7 with respect
to Q, (the quantity sold in the first market) and Q> (the
Oro ai (Cc, a >')) [68A] quantity sold in the second market), and setting them
equal to zero, we get
where —c refers to the negative quantity intercept (so
that the supply curve crosses the price axis at a positive
price), and d is the positive of the multiplicative inverse
an _ ATR) ATC) _ 9
of the slope of the supply curve (so that when P rises, dQ\ dQ, dQ,
Q, also rises). dm O(TRx) (TC) | 0 [73A]
Setting Q, = Q, for equilibrium, we get
80. 80. 8Qn
a—bP=-—c+dP [69A] or

Solving for P, we have MR, = MR2 = MC [74A]

= @aP€ That is, in order to maximize its total profits, the

Pea [70A]
bere monopolist must distribute its sales between the two
644 APPENDIX A

markets in such a way that the marginal revenue is the When P, w, and r are constant, the firm is a perfect
same in both markets and equal to the common mar- competitor in the product and input markets.
ginal cost. If MR; > MR», the monopolist could Taking the first partial derivative of 7 with respect
increase its total profits by redistributing sales from to L and K and setting them equal to zero gives
market 2 to market |, until MR; = MR>.
Equations [73A] and [74A] give the first order on = ae = i) =

condition for profit maximization. The second order dian) anole

condition is given by
hed GILOBS a [79A]
2 q? : aKie ) Ok
EREiy cetih a a [75A]
JOy dQ; It follows that

Since we know from equation [46A] that a a

pee Samed pe <r (BO
MR = P(1 + 1/n) [46A]
or

profit maximization requires that MRP;=w and MRPg=r ([81A]

Pi + 1/1) = Pol + 1/12) [76A] Equation [81 A] indicates that a firm maximizes profits
by hiring labor and capital up to the point where
where P, and P) are the prices in market | and market the marginal revenue product of labor [MRP; =
2, respectively, and 7; and 12 are the coefficients of P(dQ/0,)] equals the wage rate (w) and the marginal
price elasticity of demand in market | and market 2. If revenue product of capital [MRPx = P(dQ/0K)]
In1| < |n2|, equation [76A] will hold only if P; > Po. equals the rental price of capital (7). Geometrically,
That is, in order to maximize total profits the monopo- this occurs where the MRP, curve intersects the (hor-
list must sell the commodity at a higher price in the izontal) supply curve of labor and the MRPx curve
market with the lower price elasticity of demand (see intersects the (horizontal) supply curve of rental capi-
also Figure 9.11). For example, if 7; = —2, no = —3,
tal. Equation [81A] is only the first order condition for
and P> = $6, then P; = $8 (so that MR; = MR> = $4).
maximization. The second order condition is that the
MRP, and MRPx curves be negatively sloped (i.e.,
that the firm produce in the area of diminishing
A113 EMPLOYMENT OF INPUTS returns).
(Refers to Section 14.5, page 463)

A firms employs the quantity of inputs that allows it to

produce the profit-maximizing level of output. As indi-
A.14 INPUT Price, MARGINAL EXPENSE,
cated by equation [59A], total profits (7) are equal to AND THE PRICE ELASTICITY OF INPUT
total revenue (TR) minus total cost (TC). Total revenue SUPPLY
is given by
(Refers to Sections 15.4 and 15.5, pages 487 and 490)
WE SID [77A]
The total cost (TC) of a firm hiring nly labor is given by
where P is the price of the commodity that the firm -
produces and Q is the output, such that O = O(L, K). LG = wL [82A]
The total cost of the firm was defined by equation
[53A]. Thus, the firm employs labor and capital so as to where w is the wage rate and L is the number of work-
maximize: ers hired.
If the firm is a monopsonist (i.e., the only
m = PO(L, K) — (wk + rK) [78A] employer of labor in the market), it will have to pay
 Mathematical Appendix 645

higher wages the more labor it wants to hire. That is, To derive equation [86A], we start with
the wage rate is a function of or depends on the amount
of labor the firm hires (and the amount of labor the firm R R R
PDV
hires depends on the wage rate). Dies) aoa dry
The firm’s marginal resource cost of labor (MRC,) [87A]
is then given by
which is similar to equation [15-6] in Section 15.3.
If we let 1/(1 +r) =k, then
WIRE, = = =wt i [83A]
PDV=RKk+kh +---k") [88A]
Rearranging equation [83A], we get
Multiplying both sides of equation [88A] by k, we get

L dw
MRC, = w (:+ =) [84A] kKPDV = Re + +e kr) [89A]

Subtracting equation [89A] from equation [88A]

Therefore,
we have

MRC, =w (:=e =] [85A] PDV — kPDV = R(k — k"*") [90A]

where €, is the price (wage) elasticity of the supply From equation [90A], we get
curve of labor. Graphically, this means that the MRC, R(k ete a)
curve lies above the (positively sloped) S; curve (see 2D = a Stioe [91A]
also Figure 15.3). The same would be true for capital or
any other input for which the firm is the only employer Since k = 1/(1 +r) is smaller than 1, for n very
in the market. large, k"+! is very small and can be ignored. Thus, we
If the firm were a perfect competitor in the labor are left with
market, €; — oo and MRC, = w (i.e., the MRC; curve
would coincide with the horizontal S; curve faced by k
IAIDY = IR (5) [92A]
the firm at the given level of w). l1—k

Substituting 1/(1 + r) for k into equation [92A], we get

A.15_ DERIVATION OF THE FORMULA
TO FIND THE PRESENT VALUE
OF AN INVESTMENT PDV=R aoe
(Refers to Section 16.3, page 522) ear
We have seen in Section 16.3 that the present dis- 1
counted value (PDV) of an investment that yields a
= l+r
constant stream of net cash flows in each future year is = 1+r-1
given by equation [86A]:
l+r
R

eux ae)
PDV == [86A] i 1
ip
l+r r
where R is the constant net cash flow received the next
R
year and in every subsequent year (i.e., in perpetuity), =— ; [93A]
and r is the rate of interest.
646 APPENDIX A

A MOobeEL OF GENERAL EQUILIBRIUM 1 (p;). The second equation gives the expenditure on
A16
each input to produce one unit of commodity 2, and this
(Refers to Section 17.5, page 568) is equal input to produce one unit of commodity 2, and
this is equal to p>. The same is true for each of the n
In this section we outline the Walras-Cassel general
equilibrium model.* commodities. The aj,-s are called input or production
Let x1, x2, ..-, X» refer to the quantity of the coefficients, and they are assumed to be fixed in our
simple model.
n commodities in the economy, with prices p),
Pome py Letrt, 2,--- fn reter to the quantity of the m Setting the total demand for each resource or input
resources or inputs in the economy, with prices vj, (required to produce all commodities) equal to the total
Wap 5 a0 Ware
supply of the input, we have
The market demand equations for the n commodi-
Oia ar Qian ae °° an AinXn = 1)
ties can be written as
Q\X1 + 022X2 +--- am ArnXp = [96A]
x] = fi(P1, Pr; ~++>Dns V1, V2,-+- > Vm)

1) fp, JO 200 9)]bip Wilp Vay 30 0 3 Via) [94A] Am1X1 + Am2X2 + +++ + AmnXn = Tm

Xn = Fr P1. P2 - Pas V1, V2, OO tv) Va) where a,x; is the quantity of resource or input |
The market demand for each commodity is the sum of required to produce x; units of commodity 1, a@;2x2 is
the demand for the commodity by each consumer and the quantity of input 1 required to produce x2 of com-
is a function of, or depends on, the prices of all com-
modity 2, and a),x, 1s the quantity of input | required
modities and of all inputs. Input prices affect individu- to produce x, of commodity n. Thus, the first equa-
als’ incomes and, thus, influence the demand for tion sets the total quantity demanded of input 1
commodities. (required to produce x;, x2, to x,) equal to the total
Since in long-run perfectly competitive equilib- supply of resource or input | (7;). Similarly, the sec-
rium, commodity prices equal their production costs, ond equation sets the total quantity demanded of
we have input 2 used in all commodities to equal the quantity
supplied of input 2, and so on for each of the m
QV) + A91V2 F °° + GmiVm = Pi resources of inputs.
Q12V1 + A22V2 + + +> + Gm2Vm = P2 [95A] The last step to close the model is to specify the set
of equations that relate the supply of each resource or
AinV\ ar a2nV2 SP ooo Se AmnVvm = Pn input to prices. This is given by

where aj, refers to the quantity of input | required to Ti = 21( P15 Pas - 313 Par Vin VPA Va
produce one unit of commodity 1. Since v, is the price DS 82(P1, Po etsicns eVls! Voss ners Vn) [97A]
of input 1, a;v; is then the dollar amount spent on input
1 to produce on unit of commodity 1. On the other hand, Li Qmn( Pi P2 Pn; V1, V2; Vin)
dy, refers to the quantity of input 2 required to produce
one unit of commodity 1, so that az;v2 is the dollar That is, the supply of each resource or input is a func-
amount spent on input 2 to produce one unit of com- tion of, or depends on, the price of all puts (the vu‘s)
modity |. Finally, a,,; is the amount of input m required and the price of all commodities (the DP;‘s). For exam-
to produce one unit of commodity 1, and a,,\Vv,», is the ple, the supply of steel depends on the price of steel, the
expenditure on input m to produce one unit of com- price of aluminum, the wages of auto workers, and
modity 1. Therefore, the left-hand side of equation [95A] other input prices. The price of steel also depends on
refers to the total cost of producing one unit of com- the price of automobiles, washing machines, steaks,
modity 1. This is equal to the unit price of commodity and other commodity prices. Therefore, a change in

* The presentation is adapted from R. Dorfman, P.A. Samuelson,

and R.M. Solow, Linear Programming and Economic Analysis
(New York: McGraw-Hill, 1958), pp. 351-355.
 Mathematical Appendix 647

any part of the system affects every other part of the satisfied, the last one must also be satisfied. However,
system. we can arbitrarily set any commodity price, say, p; = |
Summing up, in equation [94A] to equation [97A] and express all other prices in terms of p; (the
we have 2n + 2m equations and an equal number of numéraire). This reduces the number of unknowns in
unknowns (the X;8, the Pj the v;s, and the rjs). the system by 1, so as to equal the number of inde-
However, according to Walras’s law, equations [94A] pendent equations. The system may the have a unique
and [97A] have only n+ m-— 1 independent equa- solution (i.e., a set of prices and quantities that simul-
tions, since if all but one of these n + m equations are taneously satisfies all the equations of the model).
 APPENDIX B

Answers to Selected Problems

Chapter 1 8. One way to measure the interdependence of the

U.S. economy with the rest of the world is to calcu-
i We study microeconomic theory to understand the late the percentage of U.S. imports and exports in
economic behavior of individual consumers,
relation to GNP. This percentage increased from
resource owners, and business firms; to examine
about 8% in 1970 to almost 20% in 1996. Thus,
how individual commodity and resource prices are
U.S. interdependence has increased sharply during
determined; and to understand the conditions for
the past two decades.
the efficient allocation of consumption and pro-
duction in a free-enterprise economy. One cannot . a. The positive income aspects of positive analysis
become an expert in any other field of economics refer to such things as the shift in the kinds and quan-
without a thorough understanding of microeco- tities of goods and services produced and their effect
nomic theory. on employment and incentives to work, on economic
growth, and so on. All of these can be objectively
6. a. With a price ceiling, consumers want to pur-
measured or estimated.
chase more of the commodity than producers are
willing to produce. This results in a shortage of the b. The normative aspects of income redistribution
commodity, which leads to rationing and a black refer to the value-based disagreement on how much
market. income should be redistributed.

b. With a price floor, consumers want to pur- Chapter2

chase less of a commodity than producers are
Did,
willing to produce. This results in a surplus of
the commodity. P($) 2) 4 S 2 1 0
QD’ LOTTE 202 | SOF ie0M PSOne G0 a7 Ormeed

648
 Answers to Selected Problems 649

b. See Figure 2a.

P($)

(ee)
<=)
(op)

Oo
ROT
FIGURE 2b
ee
nO
e. A per-unit subsidy is the opposite of a per-unit
=) tax. The per-unit subsidy increases the supply of
FIGURE 2a hamburgers, causing the same effect as in part (c).
I2asoce Figure 2c:
c. D’ represents an increase in demand because
consumers demand more of the commodity at each
and every price.

al Ble

MARKET SUPPLY SCHEDULE, MARKET DEMAND

SCHEDULE, AND EQUILIBRIUM
Quantity Quantity Surplus (+) Pressure
Price Supplied Demanded Deficit (—) on Price

$6 60 0) 60 Down
5 50 10 40 Down
4 40 20 20 Down FIGURE 2c
3 30 30 0 Equilibrium
2 20 40 —20 Up
1 10 50 —40) Up b. See Figure 2d.
0 0 60 —60 Up

b. See Figure 2b.

9. a. The demand for hamburgers increases, result-
ing in a higher price and quantity.
b. The supply of hamburgers declines, resulting in
an increase in the equilibrium price and a reduc-
tion in the equilibrium quantity.
c. The supply of hamburgers increases, lowering
the equilibrium price and increasing the quantity
purchased.
d. The demand for hamburgers increases, causing
the same effect as in part (a). FIGURE 2d
 650 APPENDIX B

Chapter 3 curve) equals Px/Py (the absolute slope of the

budget line).
a. See Figure 3a.
c. Points A and G are on U; even though the indi-
vidual spends all income.
Good Y
d. The individual does not have sufficient income
to reach U3 and U4.

a. The individual would spend $4 to purchase 4y

C
and the remaining $3 to purchase 3Y.
B’s indifference curve
b. MUx/Py = MUy/Py = 6/$1 and ($1)(4X) +
A’s indifference curve
(S1)(3Y) 155s

0 Good X c. The individual would receive 41 utils from

FIGURE 3a consuming 4X (the sum of the MUx up to 4X)
plus 27 utils from purchasing 3Y (the sum of the
b. Point C is the original equal endowment of MUy up to 3Y) for a total utility of 68 utils. If the
good X and good Y of individual A and individual individual spent all $7 on 7X, he or she would get
B. Since A prefers X to Y, A’s indifference curve is 49 utils (the sum of all MUx). If the individual
steeper than B’s indifference curve. That is, A is spent all income on 7Y, he or she would get 38
willing to give up more of Y for an additional unit utils (the sum of all MUy).
of X, and MRSyy for A at point C is greater than
We See Figure 3c. The vertical intercepts in the two
for B.
figures measure the amount of material goods
. a. See Figure 3b. that each couple could enjoy without children.
The slope of the budget lines measures the
amount of material goods per year that each cou-
Qy ple would have to give up per child. The couple
15 portrayed in the top panel is at corner equilib-
rium A and chooses to have no children. The cou-
ple in the bottom panel is in equilibrium at point
B by having one child. This couple is willing to
give up the amount of material goods indicated
on the vertical axis of the graph to have one
child.
As the possibility for women to find high-
paying jobs has increased in the United States and
20 Qy in other industrial countries since World War II,
birth rates have declined because the opportunity
FIGURE 3b
costs of having children have increased. High-
income people seem to have fewer children but
b. The individual maximizes utility at point E, tend to spend more on their education, health, and
where U) is tangent to the budget line, by pur- so on. It seems that high-income people have
chasing 9X and 6Y. To maximize utility, the indi- traded the number of children for a better quality of
vidual should spend all income in such a way that life for their children.
MRSvxy (the absolute slope of the indifference
 Answers to Selected Problems 651

Quantity of | by buying 4X. This gives point B’ in the bottom

material goods panel. Joining points G’E’B’ in the bottom panel
for adults’ we derive dy.
consumption

per year
A Qy
15

10

OU

0
Number of children 0 7.5 15 30 Qx

Quantity of
material goods
for adults’
consumption
per year

Material goods
given up per
year per child 0 4 g 14 Qy

| FIGURE 4a
|
| 5. See Figure 4b. The sequence in the figure is from A
, to B toC.
0 1 2 3
Number of children Qy
FIGURE 3c

Chapter 4
3. a. See Figure 4a.
b. At Py = $0.50, the consumer maximizes utility
at point G, where U4 is tangent to budget line 3, by
purchasing 14X. This gives point G’ in the bottom
panel. With Py = $1, the optimum is at point E
where U> is tangent to budget line 2 and the con- Substitution
sumer purchases 9X. This gives point E’ in the bot- anne
tom panel. ee
Finally, with Py = $2, the consumer is at opti- Net effect
mum at point B where U is tangent to budget line FIGURE 4b
652 APPENDIX B

7. In very poor Asian countries, people can purchase family’s food consumption (even if more expen-
little else besides rice. If the price of rice falls, the sive) if one of its aims 1s to improve nutrition.
substitution effect tends to lead people to substi-
tute rice for other goods. However, if rice is an Chapter 5
inferior good in these nations, the increase in real
income resulting from the decline in the price of 4. a. When two demand curves are parallel, their
rice leads people to purchase less rice. People slopes (~AP/AQ) and their inverse (—AQ/AP)
spend most of their income on rice, so a decline in are the same at every price. However, P/Q (the
the price of rice will lead to a relatively large other component of the price elasticity formula) is
increase in purchasing power, which will allow smaller (since Q is larger) for the demand curve
people to purchase so much more of other goods further to the right at every price. Therefore, the
that they need to purchase less rice. price elasticity of the demand curve further to the
That is, it is conceivable that the substitution right is smaller.
effect (which leads people to purchase more rice b. When two demand curves intersect, P/Q is
when its price falls) could be overwhelmed by the the same for both demand curves at the point of
opposite income effect. The net effect would then intersection. However, —AQ/AP is larger for the
be that people purchase less rice when its price flatter demand curve. Therefore, the flatter
falls, so that the demand curve for rice would be demand curve is more elastic at the point where
positively sloped in these countries. However, the demand curves intersect.
there is no proof that this is indeed true.
a. In a two-commodity world, both commodities
See Figure 4c. The poor family is originally max- cannot be luxuries because this would imply that
imizing utility at point A where Uj is tangent to a consumer could increase the quantity pur-
budget line 1. With the government paying half of chased of both commodities by a percentage
the family’s food bill, we have budget line 2. larger than the percentage increase in his or her
With budget line 2, the poor family maximizes income. This is impossible if the consumer
utility at point B on U2. To get to point B, the already spent all income on the two commodities
family spends $2,000 of its income (FG). before the increase in income (and does not bor-
Without the subsidy the family would have to pay row money).
$4,000 (FL).
b. A 10% increase in income results in a 25%
increase in the quantity of cars purchased if the
Income ($) income elasticity is 2.5. That is, since 2.5 =
% AQ/10%, (2.5)10%) = 25%.
6,500
10. a. Since 7 = 0.13 in the short run and 1.89 in the
5,000 long run, the demand for electricity is inelastic in
the short run and elastic in the long run. With a
3,000 ¢7-- Ne- 10% increase in price, the quantity demanded of
electricity will decline by 1.3% in the short run
and by 18.9% in the long run.
L000
b. Since the income elasticity of demand exceeds
unity, electricity is a luxury. With a 10% increase
0 Food
in income, consumers would purchase 19.4%
FIGURE 4¢
more electricity.
c. Since the cross elasticity of demand between
Thus, the cost of the subsidy to the govern-
electricity and natural gas is positive, natural gas
ment is $2,000. The family, however, could reach
isa substitute for electricity. However, a 10%
U2 at point C with a cash subsidy of $1,500 (FM).
increase in the price of natural gas increases elec-
The government may still prefer to subsidize the
tricity consumption by only 8%.
 Answers to Selected Problems 653

13. a. Since Ky = 0.75, Ky must be 0.25. Thus, c. Since both projects have the same expected value
($4,800) but the standard deviation of invest-
(0.75)(0.90) + (0.25)(j7y) = 1 ment I is lower than that of investment II, a risk
averse individual should choose investment I.

ny = 1.3 4. a. The expected value of project A is

b. Commodity Y is a luxury, and commodity X is a (0.4)(—$5) + (0.5)($35) + (0.1)($95)

necessity. For Y to be an inferior good, ny must be = —$2 + $17.50 + $9.50 = $25
negative. For this to occur, (0.75)(n;y) must be
The expected value of project B is
larger than 1, which means that 1 must exceed
1.33. Since most goods are normal, the income (0.4)(—$15) + (0.5)($45) + (0.1)($135)
elasticity of demand of a commodity on which the = —$6 + $22.50 + $13.50 = $30
consumer spends a great proportion of his or her
income cannot be much higher than 1. Project B is preferred.
b. The standard deviation is the square root of the
variance. The variance of project A is
Chapter 6
is a. The expected value of investment I is (0.4)(—$5 — $25)? + (0.5)($35 — $25)? +
(0.1)($95 — $25)?
($4,000)(0.6) + ($6,000)(0.4)
= (0.4)(—$307) + (0.5)(107) + (0.1)($707)
= $2,400 + $2,400 = $4,800
= (0.4)($900) + (0.5)($100) + (0.1)($4,900)
The expected value of investment II is = $360 + $50 + $490 = $900

($3,000)(0.4) + ($5,000)(0.3) + ($7,000)(0.3) So the standard deviation of the expected return to

Project A is $30. The variance of project B is
= $1,200 + $1,500 + $2,100 = $4,800
(0.4)(—$457) + (0.5)($157) + (0.1)($1057)
b. The calculation of the standard deviation of each
investment is shown in the following table. = $2,025

Deviation from Deviation Deviation Squares

Expected Value Squared Probability Times Probability

Investment I

$4,000 — $4,800 = —$800 $640,000 0.6 $384,000

6,000 — 4,800 = 1,200 1,440,000 0.4 $576,000
Sum of deviations squared = Variance = $960,000
Standard deviation = Square root of variance = $979.80

Investment II

$3,000 — $4,800 = —$1,800 $3,240,000 0.4 $1,296,000

5,000 — 4,800 = 200 40,000 0.3 12,000
7,000 — 4,800 = 2,200 4,840,000 0.3 1,452,500
Sum of deviations squared = Variance = $2,760,000
Standard deviation = Square root of variance = $1,661,000
654 APPENDIX B

So the standard deviation of the expected return to Chapter 7

Project A is $45. Ut See Figure 7. The right angle or L-shaped isoquant
(c) The expected value of project A ($25) 1s lower shows no possibility of substituting one input for
than the expected value of project B ($30), but the the other in production. The straight-line isoquant
standard deviation of project A ($30) is also lower shows that inputs are perfectly substitutable for
than the standard deviation of project B ($45). In each other in production (the MRTS_x is constant).
this case the risk-verse individual should prefer That is, the given level of output could be pro-
the project with the highest expected value per duced with only labor or only capital.
dollar of standard deviation. This is $25/$30 =
0.83 for project A and $30/$45 = $0.66 for pro- K
ject B. Therefore, the individual should prefer
project A.
7. a. Expected value of A = (0.4)($0) + (0.5)($16)
+ (0.1)($49) = $12.90
Expected value of B = -(0.4)($4) + (0.5)($9) +
(0.1)($49) = $11.00
Project A is preferred.

(b) Expected utility of A = (0.4)(0 utils) + FIGURE 7

(0.5)(4 utils) + (0.1)(7 utils) = 2.70 utils
Expected utility of B = (0.4)(2 utils) + (0.5) . At 50 mph (point A), traveling the 600 miles
(3 utils) + (0.1)(7 utils) = 3.0 utils requires 12 hours and 16 gallons of gasoline for a
Project B is preferred. total cost of (12)($6) + (16)($1.50) = $96. At 60
mph, the total cost is (10)($6) + (20)($1.50) =
(c) The individual is risk averse because the util- $90. At 66.7 mph, the total cost is (9)($6) +
ity function of profit increases at a decreasing rate (30)($1.50) = $99. Thus, the cost of traveling the
or faces down so that the marginal utility of profit 600 miles is minimized at the speed of 60 mph.
diminishes. Specifically, if profit were $1, the util-
ity of the profit of $1 is the square root of 1, which 10. a. The production function Q = 10/LK exhibits
is 1; if profit were $2, the square root of $2 = constant returns to scale throughout. For example,
1.41, and if profit were $3, the square root of $3 is when L= 1 and K=1, Q = 10/1 = 10. When
1.732. If you plot profits of $1, $2, and $3 on the L=2 and K=2, Q = 10/4 = 20. When L=3
horizontal axis of a figure and the expected utility andK = 3, Q = 10/9 = 30. WithL = 4 and K = 4,
on the vertical axis, you will see that the expected QO = 10/16 = 40, and so on.
utility of profit curve will be convex or increasing b. The production function exhibits diminishing
at a decreasing rate, thus making marginal utility returns to capital and labor throughout. For exam-
diminishing and the individual risk averse. ple, holding capital constant at K = | and increas-
“IPD, The U.S. importer can hedge his foreign- ing labor from L = | to L = 2 increases Q from 10
exchange risk with a forward purchase of to 10./2 = 14.14. Therefore, the marginal product
£100,000 for $202,000 at today’s three-month of labor (MPL) is 4.14. Increasing labor to L = 3
forward rate of $2.02/£1. In three months, the results in Q = 10/3 =17.32. Thus, MPL declines
importer will pay $202,000 and obtain the to 3.18. The law of diminishing returns operates
£100,000 with which to pay for his imports. throughout, but MPL always remains positive. The
The U.S. importer is usually willing to pay same is true if labor is held constant and capital
this extra $2,000 as the cost in insuring against changes.
having to pay much more in three months if the le a. False. As long as returns are diminishing but
foreign currency appreciates (i.e., if the dollar positive, the student still benefits from additional
depreciates) a great deal. hours of study.
 Answers to Selected Problems 655

b. True. If economies of scale were present, Thus, AC equals the antilog of 2.4, which equals
larger and more efficient firms would drive $251.19 (obtained by imply entering the log of
smaller and less efficient firms out of business. 2.4in your calculator and pressing the antilog
key). The AC for the 100th unit of the product
Chapter 8 is $251.19.
I a. The explicit costs are $10,000+ $30,000 + b. For Q = 200, we have
$15,000 = $55,000.
log(AC) = log(1,000) — 0.3 log(200)
b. The implicit costs are the foregone earnings of
= — 0.3(72-30103)
$15,000 in the previous occupation.
=e a) 000)39
c. The total costs are equal to the $55,000 of
= 2509691
explicit costs plus the $15,000 of implicit costs, or
$70,000. Since the total earnings or revenues are
Thus, AC for the 200th unit of the product
only $65,000, from the economist’s point of view,
equals the antilog of 2.309691, which equals
the woman actually lost $5,000 for the year by
$204.03.
being in business for herself.
a. Since electrical utility companies bring into oper- c. For Q = 400, we have
ation older and less efficient equipment to expand
log(AC) = log(1,000) — 0.3 log(400)
output in the short run to meet peak electricity
demand, their short-run marginal costs rise sharply. = 3 — 0.3(2.60206)

b. New generating equipment would have to be

= 3 — 0.780618
run around the clock, or nearly so, for AFC to be 2 29382
sufficiently low to make ATC lower than for older
Thus, AC for the 400th unit of the product equals
equipment. To meet only peak demand, older and
the antilog of 2.219382, which equals $165.72.
fully depreciated equipment is cheaper.
a. The LTC curve would be a positively sloped d. Figure 8 shows the figure for the learning curve
straight line through the origin when constant estimated above.
returns to scale operate at all levels of output.
b. The LAC and the LMC curves would coincide
and be horizontal at the value of the constant slope Learning curve
of the LTC curve.
SS
NO
c. Horizontal LAC and LMC curves are consistent
with U-shaped SATC curves. 150)=
($)
Average
cost | | |
12, a. Rewriting learning curve equation AC = 0 100 200 400
1,0000~°? in double log form we get
Cumulative total output (Q)
log(AC) = log(1,000) — 0.3 log(Q) FIGURE 8
Substituting the value of 100 for Q into the previ-
ous equation we get
log(AC) = log(1,000) — 0.3 log(100)
Chapter 9
ly a. ODF=05:
Substituting 3 for the log of 1,000 and 2 for the log
of 100 (obtained by simply entering the numbers
4,750 — 50P = 1,750 +- 50P
1,000 and 100, respectively, in your calculator and
pressing the “log” key), we get 3,000 = 100P
log(AC) = 3 — 0.3(2) = 2.4 P = $30 (equilibrium price)
656 APPENDIX B

b. See the following table. figure such as Figure 9b is called a break-even

chart.
MARKET DEMAND AND
SUPPLY SCHEDULES
$
P(S) QD Qs TR

50 2,250 4,250 800 }-

40 DN) 3/50
30 3,250 3,250 600 |— ie
20 37D) PDHSO)
10 4,250 2,250 400 , P
Break-even point

c. See Figure 9a.

Gly, He conte lO),
4. a. See Figure 9b. In Figure 9b, the slope of the TR
curve refers to the constant price of $10 at which FIGURE 9b
the perfectly competitive firm can sell its output.
The TC curve indicates total fixed costs of $200
and a constant average variable cost of $5 (the b. An increase in the price of the commodity can
slope of the TC curve). This is often the case for be shown by increasing the slope of the 7R curve;
many firms for small changes in outputs. The firm an increase in the total fixed costs of the firm can
breaks even at Q = 40 per time period (point B in be shown by an increase in the vertical intercept of
the figure). The firm incurs a loss at smaller out- the TC curve, and an increase in average variable
puts and earns a profit at higher output levels. A costs by an increase in the slope of the TC curve.

Perfectly competitive market Perfectly competitive firm

P( P($)
50 F s 50
40 - 40
E
30 ne 30 —__——9 9g (= P= MR)
|
|

20 - 20
|

10+ | D 10
|

AA, 1 a
|
| | | | L
0 2,000 3,000 MG 4,000 Q 0 10 20 30 40 Q
3,250
FIGURE 9a
 Answers to Selected Problems 657

The chart will then show the change in the break- market period, mostly on price in the short run,
even point of the firm and the profits or losses at and mostly on output in the long run. With a
other output levels. Thus, the break-even chart is a constant-cost industry, long-run adjustment would
flexible tool to analyze quickly the effect of chang- fall entirely on output.
ing conditions on the firm.

c. An important shortcoming of break-even charts P($)

is that they imply that firms will continue to earn
80
larger and larger profits per time period with
greater output levels. From our discussion in
70
Chapter 9, we know that, eventually, the TC curve
will begin to rise faster than TR, and total profits
60
will fall. Thus, break-even charts must be used
with caution. Nevertheless, under the appropriate
50
set of circumstances, they can be a useful tool;
they are being used extensively today by business
40
executives, government agencies, and nonprofit
organizations.
30
See Figure 9c.
20
. See Figure 9d. The original long-run equilibrium
point is E (where D crosses S and LS). If D shifts
10
up to D’, the equilibrium point is E’ in the market
period (where D’ and S cross), E” in the short run
(where D’ and S’ cross), and E° in the long run
0 1,000 1,100 1,200 Q
(where D’ crosses LS). Thus, the adjustment to an
increase in demand falls entirely on price in the FIGURE 9d

YMC'=S XMC

3.5 4 Q 0 350400 =Q
FIGURE 9c
658 APPENDIX B

Chapter 10 and

4. a. See Figure 10a. The best level of output is about Doe Ceara
1+1
ras
1+1/n
Q =2, where the MC curve intersects the MR’
curve from below.
Since we were given P; = $4.50, we need only to
be Since-at O' = 2) P=$20 whilé:ATC = $30; the
calculate 7; and 2 to prove that P; should be $7.
firm incurs a loss of $10 per unit and $20 in total.
By extending Dy to the horizontal axis and labeling
However, since AVC = $15, the monopolist covers
$10 out of its total fixed costs of $30. Were the
monopolist to go out of business, it would incur a
total loss equal to its TFC = $30. The shut down
point of the monopolist is at Q = 2.5, where P =
AVC = $14.
7. a. See Figure 10b.
b. See Figure 10c.

10. With third degree price discrimination, MR, =

MR>. Also with formula [5-6], MR; = P,(1 +
LAC
1/71) and MR = P2(1 + 1/n2). Setting MR, equal
to MRo, we get

Pi + 1/1) = Pol + 1/72),

so that MR

fig LSP a
Py VE 17x FIGURE 10b

$ MC

FIGURE 10a
 Answers to Selected Problems 659

Substituting the 7), 72, and P> values into the for-
mula for P; derived above, we get

ie
Prt |i
3 15=(
2/3/ Jas
ee as

-(3)e2-6)Goo
12. a. See the following table and Figure 10d. The
prime indicates the effect of the lump-sum tax
of $4.50.
0 Q Q Q STC MC AIC STG, AIC’
FIGURE 10c
0 $6 = = $10.50 =
1 10 $4 $10 14.50 $14.50
2 12 2 6 16.50 8.25
HA the intersection point at Q = 11 and also label- 3} 13.50 1.50 4.50 18 6
4 19 5.50 4.75 23.50 5.88
ing J the point on the horizontal axis directly
5) 30 11 6 34.50 6.90
below point-A, we get 7, = —JH/OJ_=—7/4.
6 48 18 8 52.50 8.75
Doing, the’ same for D>, we. get. Ho = —3.

FIGURE 10d
660 APPENDIX B

The STC’ values are obtained by adding $4.50 to equilibrium point is 2.5 units, given at point G’
the STC values. where the MC’ curve intersects the MR curve from
ATC’ = STC’/Q. Since the lump-sum tax is below. At Q = 2.5, P = $6.50, ATC’ = $7.50, and
like a fixed cost, it does not affect MC. Thus, the the monopolist incurs a loss of $0.50 per unit and
best level of output of the monopolist remains at $1.25 in total (as opposed to a profit of $4.50 before
three units, at which P = $6, ATC’ = $6, and the the per-unit tax). Thus, the monopolist can shift part
monopolist breaks even. of the burden ofthe per-unit tax to consumers.

b. See the following table and Figure 10e, where Ch

apter 11
the prime indicates the effect of a $2.50 per-unit tax.
2 The more price elastic the demand curve faced by a
Q_ SIC MC AIC STC MC AIC monopolistically competitive firm when in long-run
equilibrium, the closer to the lowest point on its
1 $10 $4 $10 $12.50 = $12.50 LAC curve will the firm be when in long-run equi-
2 12 2 6 17 $ 4.50 8.50
librium. Since excess capacity is measured by the
3 $13.50 1.50 4.50 21 4 7
distance between the two points, the more elastic the
4 19 5.50 4.75 29 8 NPIS
5 30 $11 6 42.50 $13.50 8.50
demand curve, the smaller the amount of excess
capacity under monopolistic competition.
The STC’ values are obtained by adding $2.50 per 6 . a. See Figure lla. If the demand curve that the
unit of output to STC. oligopolist faces shifts up by $0.50 but the kink
Al Che SIC /OLMC =ASTC AO. ssince remains at P= $8, we get demand curve d* or
a per-unit tax is like a variable cost, both the ATC and A*B*C*,. The marginal revenue curve is then mr*
the MC curves shift up to ATC’ and MC’. The new or H*K*F*G*. Since the SMC curve intersects

ATG
MC’ MC

AG

FIGURE 10e
 Answers to Selected Problems 661

the mr* curve at point K*, Q = 6 and price remains b. With P = $8 and SATC, = $5 at O = 2, duopo-
ati 8: list | earns a profit of $3 per unit and $6 in total.
With P = $8 and SATC = $8 at Q = 1, duopolist
2 breaks even. At P = $10 duopolist 2 would have
earned a profit of $2. Thus, only duopolist 1 maxi-
mizes profits.
If the high-cost duopolist would go out of
business at the profit-maximizing price set by the
low-cost duopolist, the latter would probably set a
price sufficiently high to allow the high-cost duop-
olist to remain in the market and avoid possible
prosecution under antitrust laws for monopolizing
the market. In that case, the low-cost firm would
not be maximizing profits.

FIGURE 11a
b. See Figure 1 1b. If the demand curve that the oli-
gopolist faces shifts down by $0.50 but the kink
remains at P = $8, we get demand curve d** or
A**B**C**, The-marginal revenue curve is then
mr orH**J**J*G** Since the SMC’ curve inter-
sects the mr** curve at point J*, Q = 2 and price
remains at P = $8.

FIGURE 11¢
12. a. The markup that the oligopolist should use in
pricing its product is

m=-—I/(n+ 1)

FIGURE 11b
|
9. a. See Figure 11c. Duopolist | (the low-cost duopo- or 33.33%.
mer
list) produces 2 units of the commodity and charges
b. Since AVC = $10 and the markup (mm) equals
P = $8 (given by point £), at which SMC; = mr, as
33.33%, the oligopolist should charge
in Figure 11.6). Duopolist 2 produces | unit of the
commodity and would like to charge P = $10 (given P=AVC(1 +m)
by point E>, at which SMC; = mr). However, since = 100. + 0.3333)
the commodity is homogeneous, duopolist 2 (the
= LOM3333)
high-cost duopolist) is forced to also sell at P = $8
set by low-cost duopolist 1. = ls:33
662 APPENDIX B

Chapter 12 The payoff matrix in this table shows that when

other computer companies do not sell computers
3. a. If firm B produces small cars, firm A will earn a through mail orders, Dell Computers earns zero
profit of 4 if it produces small cars and have a payoff profit if it also does not sell through the mail (since
of —2 (i.e., incurs a loss of 2) if it produces large cars. Dell was created specifically to sell only through
If firm B produces large cars, firm A will incur a loss the mail) but earns a profit of 6 if it does. Similarly,
of 2 if it also produces small cars and firm A earns a when other computer companies do sell through
profit of 4 if it produces large cars. Therefore, firm A the mail, Dell earns zero profits if it does not
does not have a dominant strategy. sell through the mail and 4 if it does. Thus, Dell’s
b. If firm A produces large cars, firm B will earn a dominant strategy is to sell computers through
profit of 4 if it produces small cars and will have a the mail, regardless of what the other computer
payoff of —2 (i.e., incur a loss of 2) if it also pro- companies do.
duces large cars. If firm A produces small cars, firm On the other hand, when Dell does not sell
B will incur a loss of 2 if it also produces small cars through the mail (i.e., when Dell is not in the
and will earn a profit of 4 if it produces large cars. market), other computer companies earn a profit
Therefore, firm B does not have a dominant strategy. of 1 if they do not sell through the mail and 8 if
they do (at least that is what they believe). But if
c. The optimal strategy is for one firm to produce
Dell is in the market and sells through the mail,
small cars and the other to produce large cars. In
other computer companies will earn 2 if they do
that case, each firm earns a profit of 4. If both firms
not accept mail orders and 4 if they do. Thus, the
produce either small cars or large cars, each incurs a
other computer companies do not have a domi-
loss of 2.
nant strategy.
d. In this case we have two Nash equilibria: either With Deil in the market and following its
firm A produces large cars and firm B produces small dominant strategy of selling through the mail,
cars (the top left cell in the payoff matrix), or firm A however, the other computer companies are also
produces small cars and firm B produces large cars forced to enter the mail-order business. This is the
(the bottom right cell in the payoff matrix). Nash equilibrium.

e. A situation such as that indicated in the payoff 8. a. Each firm adopts its dominant strategy of cheating
matrix of this problem might arise if each firm does (the top left cell) but could do better by cooperating
not have the resources to invest in the plant and not to cheat (the bottom right cell). Thus, the firms
equipment necessary to produce both large and face the prisoners’ dilemma.
small cars, and the demand for either small or large
b. If the payoff in the bottom right cell were
cars is not sufficient to justify the production of
changed to (5, 5), the firms would still face the pris-
small or large cars by both firms. Specifically, if oners’ dilemma by cheating.
both firms produce the same type of car, the over-
supply of that type of car will result in low car 9. The tit-for-tat strategy for the first 5 of an infinite
prices and losses for both firms. number of games for the payoff matrix of Problem
1, when firm A begins by cooperating but firm B
. The following table is a hypothetical payoff matrix does not cooperate in the next period, is given by the
for Example 2 in Chapter 12. following table:

OTHER COMPUTER
FIRMS Period Firm A Firm B

No Mail Mail
Orders Orders

Dell No Mail Orders 0, | 0,8

_
Computers Mail Orders (9), 4,4 ABWNE Nowe
 Answers to Selected Problems 663

The preceding table shows that in the first period, 5. In Figure 13b, D is the market demand curve and
firm A sets a high price (i.e., cooperates) and so MC is the positively sloped marginal cost curve
does firm B (so that each firm earns a profit of 2). faced by the monopolist. The demand curve shows
If in the second period firm B does not cooperate the maximum price that consumers would be will-
and sets a low price, while firm A is still cooperat- ing to pay and the marginal benefit that they would
ing and setting a high price, firm B earns a profit receive for various quantities of the commodity.
of 3 and firm A incurs a loss of 1. In the third On the other hand, the MC curve shows the oppor-
period, firm A retaliates and also sets a low price. tunity cost (in terms of the commodities foregone
As a result, each firm earns a profit of only | in that could have been produced with the same
period 3. In period 4, firm B cooperates again by inputs) of producing various quantities of the
setting a high price. With firm A still setting a low commodity. The best level of output for the
price, firm A earns a profit of 3 while firm B monopolist is Q* at which MR = MC (point E).
incurs a loss of 1. In the fifth period, firm A also The price of the commodity is then P*. The excess
cooperates again and sets a high price. Since both of P* over MC between outputs Q* and Q’
firms are now setting a high price, each earns a (shaded triangle P*EE’ in Figure 13b) measures
profit of 2. the net social losses of monopoly. Other social
losses arise from the rent-seeking activities of the
monopolist.
Chapter 13
2. In Figure 13a, P = $8 at the best level of output of
Q = 4 given by-point E at which MR = MC = $4,
so that L = (8 — 4)/8 =0.5. This value of the
Lerner index and the MC curve in Figure 12a is
consistent with ATC, and ATC? and with profits of
$3 per unit and $12 in total with ATC; and $2 per
unit and $8 in total with ATC). All that is required
is that both the ATC; and ATC) intersect the MC
curve at the lowest points of the former. Thus, a
high degree of monopoly power is consistent with
high or low profits for the firm.

0 Q’ Q Q
FIGURE 13b

. In Figure 13c, D and D’ are, respectively, the orig-

inal and new market demand curves. With the new
demand curve D’ and the unchanged LAC curve,
the regulatory commission would set P’ = LAC =
$2 (point G’) and the public-utility company
would supply 8 million units of the service per
time period (as compared with P = LAC = $3 with
Q=6 million units per time period shown by
point G on D). In either case, the public-utility
FIGURE 13a company breaks even.
664 APPENDIX B

substitution in consumption is taken into account

than when it is not. The reason is that the demand —
curves differ less with peak-load pricing when sub-
stitution in consumption is taken into account than
when it is not.

Chapter 14
1. a. MP,/w < MPx/r. This means that the firm 1s
above the AVC curve at the point where its MC
G |
T curve intersects its MR curve.
|
pee ee b. The firm is on its AVC cost curve to the right of
Dy the point of intersection of its MC and MR curves.
Q (million units)
c. w/MP; = r/MPx = MC < MR. The firm is on
its AVC curve to the left of the intersection of its MC
FIGURE 13¢
and MR curves.
12. a. When substitution in consumption is taken
5. a. See Figure 14a. The left panel of Figure 14a
into account with peak-load pricing, the off-peak
shows that the individual maximizes satisfaction at
demand will be higher and the peak demand will
point H (with 16 hours of leisure per day, 8 hours
be lower as compared with the case where substi-
of work, and a daily income of $8) on U, with
tution in consumption is not taken into account.
w = $1; at point E (with 14 hours of leisure, 10
This is shown by D} and D5, respectively, in
hours of work, 8 and an income of $20) on U> with
Figure 13d.
w = $2; at point N (with 15 hours of leisure, 9
b. The gain in shifting from constant pricing to hours of work, and an income of $27) on U3 with
peak-load pricing (shown by the sum of the two w = $3; and at point R (with 17 hours of leisure,
shaded triangles in Figure 13d) is smaller when 7 hours of work, and an income of $28) on U4 with

Cents

4 5 nn 66 7 8
Q (million kWh)

FIGURE 13d
 Answers to Selected Problems 665

Daily
Income
($)

96

72

48

(ee
a
O24 10-8 10 1271 4416.18)20,2204 0 Bo A eH 7S DO
Hours of leisure per day — Hours of work per day
| al SE ll | a pal a
26 22 ONS LO 14 120 S648 2° 0
~— Hours of work per day
FIGURE 14a

w = $4. Plotting the hours of work per day at var- of hours of work (S$; is vertical). Above w = $2,
ious wage rates, we get the individual’s supply the substitution effect is smaller than the oppo-
curve of labor ($;) in the right panel. Note that S$; site income effect and the individual works fewer
bends backward at the wage rate of $2 per hour. hours (1.e., S; 1s negatively sloped or bends
backward).
b. An increase in the wage rate, just like an increase
in the price of a commodity, leads to a substitution 9. See Figure 14b. The movement from point E to
effect and an income effect. The substitution effect point R is the combined substitution and income
leads individuals to substitute work for leisure when effects of the wage increase from $2 to $4 (as
the wage rate (the price of leisure) increases. On the in Figure 14a). The substitution effect can be
other hand, an increase in wages increases the indi- isolated by drawing the budget line with slope
vidual’s income, and when income rises, the indi- w = $4 which is tangent to U> at point M. The
vidual demands more of every normal good, movement along U2 from point M to point E mea-
including leisure. Thus, the income effect, by itself, sures the substitution effect. By itself, it shows
leads the individual to demand more leisure and that the increase in w leads the individual to
work fewer hours. reduce leisure time and increase work by 4 hours
Up to w= $2 (point E’ on S, in the right per day.
panel of Figure 14a), the substitution effect The shift from point M on U> to point R on U4 is
exceeds the opposite income effect and the indi- the income effect of the wage increase. By itself, the
vidual supplies more hours of work (i.e., Sz is income effect leads the individual to increase
positively sloped). At w= $2, the substitution leisure and reduce work by 7 hours. The net result is
effect and the opposite income effect are in bal- that the individual increases leisure (works less) by
ance and the individual supplies the same number 3 hours per day (ER).
666 APPENDIX B

Daily
income ($)

96

ee

48

Hours of leisure per day

| | |
0 10 14 l ~I pe(oe) hoqe

Substitution
>!

Income effect

Net effect

FIGURE 14b

11. See Figure 14c. In Figure 14c, Dr is the total Daily

demand for labor and Sv is the total supply of labor wage ($)
in both industries or regions. Dr is obtained from 2
the horizontal summation of D4 and Dp, while S4
is obtained from the horizontal summation of S14 40
and Sa

Dry and Sr intersect at point F, defining the

equilibrium daily wage of $40 per day (the same as
in both panels of Figure 14.6) and the equilibrium |
employment of labor of 6 million workers—the 0
sum of the workers employed in industry or region Millions of workers
A (the left panel in Figure 14.6) and industry or FIGURE 14c
region B (the right panel of Figure 14.6).
 Answers to Selected Problems 667

Chapter 15
3. a. See the following table.

L Qy MP, Py TRy MRy MRP, VMP, WwW

i Wy 12 $13 $156 — — — $40

2 9p 10 12 264 $10.80 $108 $120 40
3 ae 8 {El 330 8.25 66 88 40
AL Ry i 10 370 Sil 40 70 40
SS AB 6 9 387 2.83 / 54 40
6 48 5 8 376 —1.80 —9 40 40

MRx is obtained by the change in TRy per unit

change in the quantity of the commodity sold. That
FIGURE 15a
is, MRy = ATRy/AQy = ATRx/MP,. For exam-
ple, when the firm increases the number of workers
it hires from one to two, Qx rises from 12 to 22 units
(i.e., MP; = 10) and TRy rises from $156 to $264 or
by $108. Thus, MRy = $108/10 = $10.80. When
the firm increases the number of workers it hires 100
from two to three, TRy increases by $66 and Ox
increases by (i.e., MP, equal to) eight units. Thus,
MRx = $66/8 = $8.25, and so on. 80
MRP, = (MP_)(MkRx). For example, when the
firm increases the number of workers hired from one
60
to two workers, MP, = 10 and MRy = $10.80. Thus,
MRP, = (10)($10.80) = $108. This is equal to
ATRy/AL or $108/1 = $108 (as found in the text).
VMP_, = (MP_)(Px). For example, when the
firm increases the number of workers it hires from
one to two, MP; = 10 and Py= $12, so that the
VMP, =(10)($12) = $120.

b. See Figure 15a. If the firm were a perfect com- | | | |

373.074 5 ib,
petitor in the product market as well as in the labor
market, the firm would hire six workers (point £) FIGURE 15b
because only by hiring six workers would VMP; =
w = $40.
Since the firm is a monopolist in the product
market but a perfect competitor in the labor market, workers on a full time basis and one worker on a
it hires only four workers (point B) because only by half-time basis (given by point NV, where the MRP;
hiring four workers would the MRP; = w = $40. curve intersects the vertical segment of the new
The difference between the VMP, and the MRP, at
ME, curve). Monopsonistic exploitation is NM or
L = 4 (BC = $30 per worker and $120 in total) is $15 per worker.
the amount of monopolistic exploitation. b. See Figure 15c. The monopsonist’s supply curve
a. See Figure 15b. The monopsonist’s supply curve becomes TNF, and the ME; curve becomes 7TNFG.
becomes HMB’ and the ME; curve becomes HMNRB. The monopsonist maximizes profits by hiring three
The monopsonist maximizes profits by hiring three workers on a full time basis and one worker on a
668 APPENDIX B

half-time basis (given by point N, where the MRP; maximize profits by employing 40 workers (given
curve intersects the horizontal segment of the new by point E’, where its D; or MRP, curve intersects
ME, curve). Now, MRP; = w = $50 at L = 3.5, and its ME; curve) at w = $20 (point E on its S; curve).
the monopsonistic exploitation of labor is zero. Thus, there is agreement between the union
and the firm on the number of workers to be

$ ME; employed, but not on the wage. The greater the rel-
: ative bargaining strength of the union, the closer
100 the wage rate will be to $40. The greater the rela-
tive bargaining strength of the firm, the closer the
wage rate will be to $20. Note that it is not certain
oe that the union will behave entirely as a monopolist
(see Section 15.8).

ae 11. See Figure 15e. In the figure, the demand for union
50 i labor (Dy) plus the demand for nonunion labor (Dy)
AQ = gives the total demand for labor (D7). The intersec-
tion of Dr and S; (the market supply of labor) at
ae point E determines the equilibrium daily wage of
3 $60 for union and nonunion labor (in the absence of
any effect of unions on the wages). At w = $60, 4
million union workers (point £’) and 8 million
0 L nonunion workers (point E”’) are employed.
FIGURE 15c If unions are now successful in raising union
wages from $60 to $65, the employment of union
10. See Figure 15d. The union (the monopolist seller labor falls from 4 to 3 million (point A on Dy). The
of labor time) would like to have 40 workers 1 million workers who cannot find union employ-
employed (given by point E, where MR = MC) at ment will now have to find employment in the
the daily wage of $40 (point E’ on D,). The firm nonunion sector. This increases employment in the
(the monopsonist employer of labor) would nonunion sector from 8 to 9 million workers. But 9

ME, of firm

MC of union
= S$, of firm

Dr

MR of union

0 100 20sea308 40° "350. Cho

FIGURE 15d
 Answers to Selected Problems 669

Daily
wage ($)

65

60

Dr = Dy 4 Dy

Millions of workers

FIGURE 15e

million workers can only be employed in the r= 50%). Since at r= 50% desired lending
nonunion sector at w = $55 (point B on Dy). exceeds desired borrowing, r = 50% is higher than
Thus, when unions increase wages in the the equilibrium rate of interest and r will fall
unionized sector, employment in the unionized toward 20%.
sector falls. More workers must find employment
in the nonunionized sector and nonunion wages 5. a. The supply curve of loans (lending) is usually
fall. Thus, what union workers gain comes mostly positively sloped, indicating that lenders will lend
at the expense of nonunion workers. more at higher rates of interest. However, when the
interest rate rises, the lender will face a substitution
effect and an income or wealth effect (just as a
worker does when the wage rate rises). The substi-
Chapter 16 tution effect induces the lender to substitute future
4. See Figure l6a. Starting at point B (Yo =5 and for present consumption and lend more since the
Y, = 6) in the figure, individual B moves to point E reward for lending has increased.
(7.5, 3) on indifference curve U2 by borrowing 2.5 On the other hand, when the interest rate rises,
units of the commodity at r= 20%. On the other the lender’s wealth rises and he or she will want to
hand, starting from point A (Yo = 5 and Y; = 6) in consume more both in the present (and lend less)
the figure, individual A moves to point E’(2.5,9) on and in the future. Thus, the substitution effect tends
indifference curve U; by lending 2.5 units of the to lead the lender to lend more while the wealth
commodity at r = 20%. Since at r = 20% desired effect leads the lender to lend less.
borrowing equals desired lending, this is the equi- Up to a point, the substitution effect over-
librium rate of interest. whelms the wealth effect and the lender will lend
On the other hand, at r= 50%, individual B more at higher rates of interest. After a point, how-
moves from point B to point E* on U, by borrow- ever, higher rates of interest will cause the wealth
ing only 2 units of the commodity this year and effect to exceed the opposite substitution effect so
repaying 3 units next year, while individual A that the lender will lend less. Thus, at a sufficiently
moves from point A to point E” on U} by lending high rate of interest, the lender’s supply curve will
bend backward (as at r* in Figure 16b).
3 units this year for 4.5 units next year (so that
670 APPENDIX B

Ane dat
12

10.5

Yo
e ® , Y vl

5 Teta) 10 Yo, Co, Co

FIGURE 16a

b. For borrowers, both the substitution effect and

the wealth effect operate to reduce the amount of
Sr. desired borrowing when the rate of interest rises,
so that the demand curve for borrowing is nega-
tively sloped throughout. The substitution effect
reduces the amount of borrowing as the rate of
interest rises, because future consumption becomes
more expensive in terms of the present consump-
r*@
tion to be given up. The wealth effect also tends to
reduce the amount of borrowing, because an
increase in the rate of interest reduces the bor-
rower’s wealth.

. See the following table. Note that the net present

value of the project is higher with r = 5% than with
Tien) Gas
0 Quantity of lending
FIGURE 16b
 Answers to Selected Problems 671

BENEFIT—COST ANALYSIS OF AN and g is the expected annual growth rate of divi-

INVESTMENT PROJECT dend payments.
Invest- Present Present Since the company pays half of its expected
End ment Net Value Value $200 million in net after-tax earnings in dividends
of (yearO) Reve- Reve- Coefficient of Net and there are 100 million shares of common stock
Year andCost nue nue 1/(1 + 0.05)” Revenue of the firm, the dividend per share is $1. With a
share of the common stock of the firm selling for
0 $1,000 — —$1,000 —- —$1,000 eight times current earnings, the price of a share of
i 200 $600 400 0.952 381
the common stock of the firm is $8.
2 300 800. 500 0.907 454
With the expected annual growth of earnings
3 300 800 500 0.864 432
and dividends of the firm of 7.5%, the cost of
4 400 800 400 0.823 329
4 — 200* 200 0.823 E165)
equity capital for this firm is
$761
*Salvage value
k, = $1/$8 + 0.075
(=)

= ON25-- 0075020
10. The cost of equity capital for this firm (k,) can be or 20%.
calculated with the dividend valuation model, as
follows
Chapter 17
k,=D/P+e8
2. See Figure 17a. The Edgeworth box diagram of
where D is the-amount of the yearly dividend paid Figure 17a was obtained by rotating individual
per share of the common stock of the firm, P is the B’s indifference curve diagram by 180 degrees (so
price of a share of the common stock of the firm, that Og appears in the top right-hand corner) and

FIGURE 17a
672 APPENDIX B

FIGURE 17b

superimposing it on individual A’s indifference

curve diagram (with origin 04) in such a way that
the size of the box is 10X and LOY (the combined
amount ofX and Y owned by individuals A and B).
The contract curve for exchange 1s 04DEFOz, and is
given by the tangency points of the indifference
curves (at which MRSyy are equal) for the two
individuals.

4. See Figure 17b. The Edgeworth box diagram of | MRSyy =1

Figure 17b was obtained by rotating the isoquant
diagram for commodity Y by 180 degrees (so that Oy
appears in the top right-hand corner) and superim-
posing it on the isoquant diagram for commodity X
(with origin Ox) in such a way that the size of the box
is 14Z and 9K (the total amount of ZL and K avail-
able). The production contract curve is OyJMNOy and
is given by the tangency points of the isoquants (at
which MRTS_x are equal) for commodities X and Y.

See Figure 17c. The simple economy portrayed in FIGURE 17c

Figure 17c would be simultaneously in general
equilibrium of production and exchange at point E,
where 12. a. See Figure 17d. Point D’ in Figure 17d
corresponds to point D (on A; and B3) in Figure
MRTxy = MRS%y = MRS8, = 1 17a, point E’ corresponds to point E (on A> and B>),
 Answers to Selected Problems 673

for exchange in the Edgeworth box diagram drawn

from point N’ on the production-possibilities fron-
tier in Figure 17b (not shown in that figure). By
joining E’, H’, and other Pareto optimum points of
production and exchange, we get grand utility-
possibilities frontier GE’ H’G in Figure 17e.

Chapter 18
3. a. See Figure 18a. A corrective tax of $4 per unit
imposed on the consumers of commodity X will
make D” the new industry demand curve. With D”,
| |
0 100 200 300 450 600 Us, Py = $10 and Qy = 4 million units per time period
(given by the intersection of D” and S at point E’).
FIGURE 17d This is the socially optimum price and output.
Consumers would now pay Py = $10 plus the $4 tax
and point F’ to point F (on A; and B;). Other points per unit (E’B) or a net Py = $14 (compared with
can be similarly obtained. By joining these points, Py = $12 under the previous competitive equilib-
we get utility-possibilities frontier Uy Uy. This rium at point £).
shows the various combinations of utilities b. The total value of the economic gain resulting
received by individuals A and B at which this econ- from the imposition of the corrective tax 1s equal to
omy (composed of individuals A and B) is in gen- $6 million (given by area EE’A in the figure). This
eral equilibrium and Pareto optimum in exchange. is the excess of the MSC (shown by supply curve S)
A point outside Ujy/ Uy cannot be reached with the over MSB (shown by demand curve D’) between
available amount of commodities X and Y. Oxy = 4 and Oy = 6 million units.

b. See Figure 17e. Utility-possibilities frontier . a. See Figure 18b. A corrective subsidy of $4 per
Uy Uy is that of part (a). Utility-possibilities unit given to producers of commodity X will make
frontier Uy Uy: is derived from the contract curve S” the new industry supply curve. With S”, Py = $10

Um’ | G
0) 100 200 300 400 500 600 700 800 Ux,
FIGURE 17e
674 APPENDIX B

Px($) of the marginal social value (shown by demand

curve D) over the MSC (shown by supply curve S’)
Corrective between Qy = 6 and Qy = 8 million units.
tax on a. Each individual will drill more wells and pump
consumers oil faster than he or she would if no other oil field
were located adjacent to his or hers in order to pre-
vent some of the oil under his or her field to flow to
the neighbor’s field. The external diseconomies
arise because oil is pumped faster than is socially
desirable. The external diseconomies can be
avoided by merging the two adjacent oil fields
under joint ownership, by government regulation,
or by taxation.
| | | | | b. The development of a recreational site confers
0 2 A Ope Se 10k? Os external benefits to owners of shops, gasoline sta-
tions, and motels in the area. In order to internalize
(Million units per time period)
the external benefits, the recreational site devel-
FIGURE 18a oper may also set up and operate establishments
that provide these other services near the recre-
ational .site.
Px($)
. a. See Figure 18c. Market demand curve Dy
(CFEG) is obtained by the horizontal summation
of demand curves D4 and Dz. Dy and Sy inter-
sect at point & and define equilibrium price of
Py = $5.50 and the equilibrium quantity of Qy =
7.5, if the market for commodity X is perfectly
competitive. Individual A consumes LX, and indi-
vidual B consumes 6.5X.
b. When X is a private good, the condition for
Corrective
Pareto optimal output is MRTyy= MRS%y oi
subsidy
to
MRS¥,. That is, at the optimal output level, the
producers marginal benefit that each consumer receives from
come l an additional unit of commodity X equals its mar-
(=) 4 aoa 101207 ginal cost. That is, HJ = FR = EV in Figure 18c.
ae On the other hand, when X is a public good, the
(Million units per time period) condition for the Pareto optimal output is
FIGURE 18b MRTyy = MRS, + MRS4,. That is, since each
consumer can consume the same quantity of com-
modity X when X is a public good, it is the sum of
and Qy = 8 million units per time period (given by the marginal benefits that each consumer receives
the intersection of D and S” at point E’). This is from the additional unit of commodity X that must
the socially optimum price and output. Producers equal its marginal cost (i.e., AB + AC=AE in
would now receive Py = $10 plus the $4 subsidy Figure 18.2).
per unit (BE’) for a total of $14 per unit.
c. Public goods that exhibit nonexclusion convey
b. The total value of the economic inefficiency elim- external economies of consumption on free riders
inated by the corrective subsidy is equal to $3 million (1.e., on the consumers not paying for the public
(given by area EE’A in the figure). This is the excess goods).
 Answers to Selected Problems 675

Px($)
2

10

or ioe)
Om

|S 10120 416 Nis 80;

7.5
(R) (V)
FIGURE 18¢

Chapter 19 price, averaging $85. Thus, the expected minimum

price for search two in this case is
1. Because there isan equal number of five types of
sellers, each price will be encountered one-fifth of
$100(3/5) + $85(2/5) = $94.
the time on the first search.
If search one yields the price of $120, four-
If search one yields the price of $90, four-fifths
fifths of the time search two will yield a lower
of the time search two will yield a price of $90 or
price, averaging $95, and so the expected mini-
higher (but in that case any price higher than $90 on
mum price for search two is
search two would be disregarded), and one-fifth of
the time search two will yield a price of $80. Thus,
$120(1/5) + $95(4/5) = $24 + $86 the expected minimum price for search two in this
= $100. case is $90(4/5) + $80(1/5) = $88.
If search one yields the price of $80, the con-
If search one yields the price of $110, two- sumer will end the search because $80 is already
fifths of the time search two will yield a price of the lowest price possible.
$120 or $110 (but in that case the price of $120 on The expected minimum price for the second
search two would be disregarded), and three-fifths search is then the average of the above expected
of the time search two will yield a lower price, minimum prices for the second search. That is, the
averaging $90. Thus, the expected minimum price precise minimum price on the second search is
for search two in this case is ($100 +°$98 + $944 588 + $80)/5 = $92
(compared with $93.33 found with the use of
formula [19-1] in the text).
$110(2/5) + $90(3/5) = $44 + $54
a: 3. a. The formula for the lowest expected price for
each search is
If search one yields the price of $100, three- Expected Price = Lowest Price
fifths of the time search two will yield a price of
$100 or higher (but in that case any price higher
Range of Prices
than $100 on search two would be disregarded), and
two-fifths of the time search two will yield a lower Number of Searches + 1
676 APPENDIX B

The lowest expected price with one search is For the third search, MB = $86.67 — $80.00 =
$6.67. For the fourth search, MB = $80.00 —
80
$60 + pe = > L00 00; $76.00 = $4.00. For the fifth search, MB = $76.00 —
Ware IB 33 B20).
With two searches, the lowest expected price is Note that the marginal benefits of each addi-
tional search are now twice as large as those found
$60 + =80 = $86.67. in the text where the range of prices was half what
they are in this problem.
With three searches, the lowest expected price is . Priceline is an Internet firm that allows buyers to
name their own price for flights, hotel rooms, mort-
80
$60 + = = $80.00. gages, cars, and, most recently, groceries. The only
condition is that the buyer be flexible as to seller or
With four searches, the lowest expected price is brand name. For example, in the purchase of an air-
line ticket the buyer cannot specify the airline or the
80
$60 + = = $76.00. time of flight, but has to take what is offered by the
carrier that accepts the bid. This allows airlines to
With five searches, the lowest expected price is sell empty seats without losing their regular cus-
tomers. As customers gain experience and learn to
$80 make more realistic bids, and as Priceline adds
$60 + erie Sie.33:
more airline and flights to the scheme, more and
b. The marginal benefit from each search is mea- more bids are likely to be successful (they are now
sured by the reduction in the expected price result- successful less than half of the time).
ing from the search. Thus, for the second search the . See Figure 19. In the figure, the subscripts H, L, and
marginal benefit (MB) is $100 — $86.67 = $13.37. A refer, respectively, to high quality, low quality,

P(S)

16,000
14,000 P(S)
12,000 12,000
10,000 10,000

8,000 8,000

6,000 6,000

4,000 4,000
. SI
|

2.000 2.000 :
Dy D, Ds
e |
0 100,000 Q 0 100,000 Q
FIGURE 19
 Answers to Selected Problems 677

and average quality. In the absence of perfect infor- high-quality cars will be offered for sale at the price
mation (i.e., with asymmetric information), the
of $12,000.
demand for used cars will be the average of But with all the high-quality cars withdrawn
the demand curves for the high-quality and the low- from the market, only the low-quality cars will be
quality used cars that would prevail in the market if offered for sale. Thus, D4 will fall to D;, in the right
all potential buyers had perfect information. As a panel and only the 100,000 low-quality cars will be
result, the left panel of Figure 19 shows that no
sold in the market at P; = $4,000.
 APPENDIX C

Glossary

Adverse selection The situation where low-quality quality of a product or service offered for sale than
products drive high-quality products out of the market does the other party.
as a result of the existence of asymmetric information
Auction The mechanism by which commodities are
between buyers and sellers.
bought and sold (and their price determined) through a
Alternative or opportunity cost doctrine The doc- formal bidding process.
trine that postulates that the cost to a firm in using any
Average fixed cost (AFC) Total fixed costs divided
input (whether owned or hired) is what the input could
by output.
earn in its best alternative use.

Appreciation A decrease in the domestic-currency Average product (AP) The total product divided by
price of a foreign currency. the quantity of the variable input used.

Arbitrage The purchase of a commodity or currency Average revenue (AR) Total revenue divided by the
where it is cheaper and its sale where it is more expensive. quantity sold.

Arc elasticity of demand The price elasticity of Average total cost (ATC) Total costs divided by out-
demand between two points on the demand curve; it put. Also equals AFC + AVC.
uses the average price and the average quantity in cal-
culating the percentage change in price and quantity. Average variable cost (AVC) Total variable costs
divided by output.
Arrow’s impossibility theorem The theorem that
postulates that a social welfare function cannot be Averch-—Johnson (A-J) effect The overinvestments
derived by democratic vote to reflect the preferences of or underinvestments in plant and equipment resulting
all the individuals in society. when public utility rates are set too high or too low,
respectively.
Asymmetric information The situation where one
party to a transaction has more information on the Bad_ An item of which less is preferred to more.

678
 Glossary 679

Bandwagon effect The situation where some people Bundling A common form of tying in which the
demand a commodity because other people purchase it monopolist requires customers buying or leasing one of
(1.e., in order to “keep up with the Jonesses” or because its products or services also to buy or lease another
the commodity becomes more useful the more people product or service when customers have different tastes
buy it). but the monopolist cannot price discriminate.
Barometric firm An oligopolistic firm that is recog- Capital or investment goods The machinery, facto-
nized as a true interpreter or barometer of changes in ries, equipment, tools, inventories, irrigation, trans-
demand and cost conditions warranting a price change portation, and communications networks that can be
in the industry. used to produce goods and services.

Behavioral economics The study of how people Capital asset pricing model (CAPM) The method
actually make choices in the real world by drawing on of measuring the equity cost of capital as the risk-free
insights from psychology and economics. rate plus the beta coefficient (6) times the risk premium
on the average stock.
Benefit—cost analysis A procedure for determining
Capital budgeting The ranking of all investment
the most worthwhile public projects for the govern-
projects from the highest present value to the lowest.
ment to undertake. It prescribes that government
should undertake those projects with the highest bene- Cardinal utility The ability to actually provide an
fit-cost ratio, as long as that ratio exceeds 1, and until index of utility from consuming various amounts of a
government resources are fully employed. good or baskets of goods.

Bergson social welfare function A social welfare Cartel An organization of suppliers of a commodity
function based on the explicit value judgments of aimed at restricting competition and increasing profits.
society. Centralized cartel A formal agreement of the sup-
pliers of a commodity that sets the price and allocates
Bertrand model The duopoly model in which each
output and profits among its members so as to increase
firm assumes that the other will keep its price constant.
joint profits. It can result in the monopoly solution.
It leads to the perfectly competitive solution even with
only two firms. Certainty The situation where there is only one pos-
sible outcome to a decision and this outcome is known
Beta coefficient (8) The ratio of the variability of the precisely; risk-free.
return on the common stock of the firm to the variabil-
Characteristics approach to consumer theory The
ity of the average return on all stocks.
theory that postulates that a consumer demands a good
Bilateral monopoly The case where the monopson- because of the characteristics, properties, or attributes
ist buyer of a product or input faces the monopolist of the good, and it is these characteristics that give rise
seller of the product or input. to utility.

Brain drain The migration of highly skilled people Circular flow of economic activity The flow of
from one nation to another. This benefits the receiv- resources from households to business firms and the
ing nation and harms the nations of emigration. opposite flow of money incomes from business firms to
households. Also, the flow of goods and services from
Break-even point The point where total revenues business firms to households and the opposite flow of
equal total costs and profits are zero. consumption expenditures from households to business
Budget constraint The limitation on the amount of firms.
goods that a consumer can purchase imposed by his or Clayton Act Prohibits mergers that “substantially
her limited income and the prices of the goods. lessen competition” or tend to lead to monopoly.

Budget line A line showing the various combinations Closed innovation model The situation where com-
of two goods that a consumer can purchase by spending panies generate, develop, and commercialize their own
all income at the given prices of the two goods. ideas, innovations, or technological breakthoughts.
680 APPENDIX C

Coase theorem Postulates that when property rights new product or component on a computer screen,
are clearly defined and transaction costs are zero, perfect quickly experiment with different alternative designs,
competition results in the absence of externalities, and test each design’s strength and reliability.
regardless of how property rights are assigned among Computer-aided manufacturing (CAM) The com-
the parties involved. puter instructions to a network of integrated machine
Cobb-Douglas production function The relation- tools to produce a prototype of a new or changed
ship between inputs and output expressed by Q = product.
AL°K®, where Q is output, L is labor, K is capital, and
Concentration ratio The percentage of total indus-
A, a, and f are positive parameters estimated from try sales of the 4, 8, and 20 largest firms in the industry.
the data.
Concept of the margin The central unifying theme
Coinsurance Insurance that covers only a portion of in all of microeconomics, according to which the total
a possible loss. net benefit is maximized when the marginal benefit is
Collusion A formal or informal agreement among equal to the marginal cost.
the suppliers of a commodity to restrict competition.
Congestion pricing The charging of different prices
Common property Property, such as air, owned by at different times of day or based on the degree of
no one. congestion.

Comparable worth The evaluation of jobs in terms Conscious parallelism The adoption of similar
of the knowledge and skills required, working condi- policies by oligopolists in view of their recognized
tions, accountability, and the enforcement of equal pay interdependence.
for comparable jobs, or “comparable worth.”
Constant-cost industry An industry with a horizon-
Comparative advantage The greater relative effi- tal long-run supply curve. It results if input prices
ciency that an individual, firm, region, or nation has remain constant as industry output expands.
over another in the production of a good or service.
Constant returns to scale Output changes in the
Comparative static analysis The analysis of the same proportion as inputs.
effect of a change in demand and/or supply on the equi-
Constrained utility maximization The process by
librium price and output of a commodity.
which the consumer reaches the highest level of satis-
Compensating wage differentials Wage differences faction given his or her income and the prices of goods.
that compensate workers for the nonmonetary differ- This occurs at the tangency of an indifference curve
ences among jobs. with the budget line.

Compensation principle The amount that gainers Consumer equilibrium Constrained utility maxi-
from a change could pay losers to fully compensate mization.
them for their losses.
Consumer optimization Constrained utility maxi-
Complementary inputs Inputs related to one mization.
another in such a way that an increase in the employ-
Consumer surplus The difference between what the
ment of one raises the marginal product of the other.
consumer is willing to pay for a given quantity of a
Complements Two commodities are complements if good and what he or she actually pays for it.
an increase in the price of one of them leads to less of
the other being purchased. Contract curve for exchange The locus of tangency
points of the indifference curves (at which the MRSXY
Composite cost of capital The weighted average of are equal) for two individuals when the economy is in
the cost of debt and equity capital to the firm. general equilibrium of exchange.
Computer-aided design (CAD) The process that Contract curve for production The locus of tan-
allows research and development engineers to design a gency points of the isoquants (at which the MRTSLK are
 Glossary 681

equal) for two commodities when the economy is in gen- Differentiated oligopoly An oligopoly where the
eral equilibrium of production. product is differentiated.
Corner solution Constrained utility maximization Differentiated products Products that are similar
with the consumer spending all of his or her income on but not identical and that satisfy the same basic need.
only one or some goods.
Diminishing marginal utility of money The decline
Cost of debt The net (after-tax) interest rate paid by in the extra utility received from each dollar increase in
a firm to borrow funds. income.
Cost-plus pricing The setting of a price equal to Discrimination inemployment The (illegal) unwill-
average cost plus a markup. ingness on the part of employers to hire some group of
Cournot equilibrium The situation where there is equally productive workers based on gender, color,
religion, or national origin under any circumstances or
no tendency for each of two duopolists to change the
at the same wage rate.
quantity each sells.

Cournot model The duopoly model in which each Diseconomies of scope The higher costs that a firm
firm assumes that the other keeps output constant. With can experience when it produces two or more products
jointly rather than separate firms producing the prod-
two firms, each will sell one-third of the perfectly com-
petitive output. ucts independently.
Disemployment effect The reduction in the number
Cross elasticity of demand (yyy) The percentage
of workers employed as a result of an increase in the
change in the quantity purchased of a commodity
wage rate (as with the imposition of an effective mini-
divided by the percentage change in the price of
mum wage).
another commodity.
Diversification The spreading of risks.
Deadweight loss The excess of the combined loss of
consumers’ and producers’ surplus from a tax. Dividend valuation model The method of measur-
ing the equity cost of capital to the firm with the ratio of
Decreasing-cost industry An industry with a nega- the dividend per share of the stock to the price of the
tively sloped long-run supply curve. It results if input stock, plus the expected growth rate of dividend
prices fall as industry output expands. payments.
Decreasing returns to scale Output changes by a Division of labor The breaking up of a task into a
smaller proportion than inputs. number of smaller, more specialized tasks and assign-
Default risk The possibility that a loan will not be ing each of these tasks to different workers.
repaid. Dominant strategy The optimal strategy for a player
no matter what the other player does.
Depreciation An increase in the domestic-currency
price of a foreign currency. Dumping International price discrimination, or the sale
of a commodity at a lower price abroad than at home.
Deregulation movement The reduction or elimina-
tion of many government regulations since the mid- Duopoly An oligopoly of two firms.
1970s in order to increase competition and efficiency. Economic efficiency The situation in which the mar-
Derivatives Financial instruments or contracts ginal rate of transformation in production equals the
whose values are derived from the price of such under- marginal rate of substitution in consumption for every
lying financial assets as stocks, bonds, commodities , pair of commodities and for every pair of individuals
and currencies. consuming both commodities.

Derived demand The demand for an input that arises Economic growth The increase in resources, com-
from the demand for the final commodities that the modities, and incomes, and the improvements in tech-
input is used in producing. nology over time.
682 APPENDIX C

Economic rent That portion of a payment made to Environmental pollution The lowering of air, water,
the supplier of an input that is in excess of what is nec- scenic, and noise qualities of the world around us that
essary to retain the input in its present employment in results from the dumping of waste products. It arises
the long run. because of unclearly defined property rights and too-
high transaction costs.
Economic resources Resources that are limited in
supply or scarce and thus command a price. Equilibrium The condition that, once achieved,
tends to persist. It occurs when the quantity demanded
Economics A field of study that deals with the allo-
of a commodity equals the quantity supplied and the
cation of scarce resources among alternative uses to
market clears.
satisfy human wants.
Equilibrium price The price at which the quantity
Economies of scope The lowering of costs that a
demanded equals the quantity supplied of a good or
firm often experiences when it produces two or more
service.
products jointly rather than separate firms producing
the products independently. Excess capacity The difference between the output
indicated by the lowest point on the LAC curve and the
Edgeworth box diagram A_ diagram constructed
output actually produced by a monopolistically com-
from the indifference map diagrams of two individuals,
petitive firm when in long-run equilibrium.
which can be used to analyze voluntary exchange.
Excess demand The amount by which the quantity
Edgeworth box diagram for exchange A diagram
demanded of a commodity is larger than the quantity
constructed from the indifference curves diagram of
supplied of the commodity at below-equilibrium
two individuals, which can be used to analyze volun-
prices; with a tradable commodity, it gives the quantity
tary exchange.
demanded of imports of the commodity.
Edgeworth box diagram for production A diagram
Excess supply The amount by which the quantity
constructed from the isoquants diagram of two com-
supplied of a commodity is larger than the quantity
modities, which can be used to analyze general equilib-
demanded of the commodity at above-equilibrium
rium of production.
prices; for a tradable commodity, it gives the quantity
Efficiency The situation where the price of a com- supplied of exports of the commodity.
modity (which measures the marginal benefit to con-
Exchange The trade of one good for another through
sumers) equals the marginal cost of producing the
the medium of money.
commodity.
Exchange rate The price of a unit of a foreign cur-
Efficiency wage theory Postulates that firms will-
rency in terms of the domestic currency.
ingly pay higher-than-equilibrium wages to induce
workers to avoid shirking, or slacking off on the job. Excise tax A tax on each unit of the commodity.

Effluent fee A tax that a firm must pay for discharg- Exhaustible resources Nonrenewable _ resour-ces,
ing waste or polluting. such as petroleum and other minerals, which are avail-
able in fixed quantities and are nonreplenishable.
Endowment position The quantity of a commodity
that the consumer receives in each year. Expansion path The line joining the origin with
the points of tangency of isoquants and isocost lines
Engel curve Shows the amount of a good that a con-
with input prices held constant. It shows the least-
sumer would purchase at various income levels.
cost input combination to produce various output
Engel’s law Postulates that the proportion of total levels.
expenditures on food declines as family income rises.
Expected income (1) The probability of one level of
Entrepreneurship The introduction of new tech- income (/p) times that income level plus the probability
nologies and products to exploit perceived profit of an alternative income (1 — p) times that alternative
opportunities. income level.
 Glossary 683

Expected utility The sum of the product of the util- Externalities Harmful or beneficial side effects
ity of each possible outcome of a decision or strategy borne by those not directly involved in the production
and the probability of its occurrence. or consumption of a commodity.
Expected value The sum of the products of each Firm An organization that combines and organizes
possible outcome of a decision or strategy and the resources for the purpose of producing goods and ser-
probability of its occurrence. vices for sale at a profit.

Expected value of money The sum of the product of First-degree price discrimination The charging of
the amount of money involved from each possible out- the highest price for each unit of a commodity that each
come of a decision or strategy and the probability of its consumer is willing to pay rather than go without it.
occurrence.
First theorem of welfare economics Postulates that
Experience goods Goods whose quality can only be equilibrium in competitive markets is Pareto optimum.
judged after using them. Fixed inputs The resources that cannot be varied or
Experimental economics The newly developing field can be varied only with excessive cost during the time
of economics that seeks to determine how real markets period under consideration.
operate by examining how paid volunteers behave Food stamp program A federal program under
within a simple experimental institutional framework. which eligible low-income families receive free food
Explicit costs The actual expenditures of the firm to stamps to purchase food.
purchase or hire inputs. For whom to produce The way that output is dis-
tributed among the members of society.
External benefits Beneficial side effects received by
those not directly involved in the production or con- Foreign-exchange market The market where national
sumption of a commodity. currencies are bought and sold.

External costs Harmful side effects borne by those Foreign-exchange rate The price of a unit of a for-
not directly involved in the production or consumption eign currency in terms of the domestic currency.
of a commodity. Forward contract An agreement to purchase or sell
External diseconomies of consumption Un- a specific amount of a foreign currency at a rate speci-
compensated costs borne by those not directly involved fied today for delivery at a specified future date.
in the consumption of a commodity. Forward or futures transaction The purchase and
External diseconomies of production Uncom- sale of a commodity or currency for future delivery at a
pensated costs borne by those not directly involved in price agreed upon today.
the production of a commodity. Forward or futures market The market where for-
ward transactions take place.
External diseconomy An upward shift in all firms’
per-unit cost curves resulting from an increase in input Forward or futures price or rate The price or rate
prices as the industry expands. at which a commodity or currency is bought and sold in
the forward market.
External economies of consumption Uncom-pensated
benefits received by those not directly involved in the Free-enterprise system The form of market organi-
consumption of a commodity. zation where economic decisions are made by individ-
uals and firms.
External economies of production Uncom-pensated
benefits received by those not directly involved in the Free-rider problem The problem that arises when an
production of a commodity. individual does not contribute to the payment of a pub-
lic good, in the belief that it will be provided anyway.
External economy A downward shift in all firms’
per-unit cost curves resulting from a decline in input Fringe benefits Goods and services provided to
prices as the industry expands. employees and paid by employers.
684 APPENDIX C

Futures contract A standardized forward contract How to produce The way resources or inputs are
for predetermine d quantities of the currency and combined to produce the goods and services that con-
selected calendar dates. sumers want.

Gambler An individual who is willing to pay a small Human wants All the goods, services, and the con-
sum of money in order to have the small probability of ditions of life that individuals desire, which provide the
a large gain or win; a risk seeker or lover. driving force for economic activity.

Game theory The theory that examines the choice of Identification problem The difficulty sometimes
optimal strategies in conflict situations. encountered in estimating the market demand or supply
curve of acommodity from quantity—price observations.
General equilibrium analysis Studies the interde-
pendence that exists among all markets in the economy. Implicit costs The value of the inputs owned and
used by the firm; value is imputed from the best alter-
Giffen good An inferior good for which the positive
native use of the inputs.
substitution effect is smaller than the negative income
effect, so less of the good is purchased when its price Import tariff A per-unit tax on an imported commodity.
falls.
Incidence of tax The relative burden of a tax on buyers
Gini coefficient A measure of income inequality and sellers.
calculated from the Lorenz curve and ranging from 0
(for perfect equality) to | (for perfect inequality). Income—consumption curve The locus of consumer
optimum points resulting when only the consumer’s
Globalization of economic activity The increasing income varies.
proportion of consumer goods, and parts and compo-
nents of manufactured goods imported from abroad; Income effect The increase in the quantity purchased
the increasing share of domestic production exported; of a good resulting only from the increase in real
and the rising repercussions of domestic policies on income that accompanies a price decline.
other nations. Income elasticity of demand (7;) The percentage
Golden parachute A large financial settlement paid change in the quantity purchased of a commodity over a
out by a firm to its managers if they are forced or specific period of time divided by the percentage change
choose to leave as a result of a takeover that greatly in consumers’ income.
increases the value of the firm.
Income elasticity of demand for imports The per-
Good A commodity of which more is preferred centage change in the demand for imports by a nation
to less. over a specific period of time divided by the percentage
change in the income of the nation.
Government failures Situations where government
policies do not reflect the public’s interests and reduce Income elasticity of demand for exports The per-
rather than increase social welfare. centage change in the demand for the exports of a nation
over a specific period of time divided by the percentage
Grand utility-possibilities frontier The envelope to
change in the income of other nations.
utility-possibilities frontiers at Pareto optimum points
of production and exchange. Income or expenditure index (£) The ratio of
period-1 to base-period money income or expenditures.
Hedging The covering of risks arising from changes
in future commodity and currency prices. Increasing-cost industry An industry with a posi-
tively sloped long-run supply curve. It results if input
Herfindahl index A measure of the degree of
monopoly power in an industry, which is given by the prices rise as industry output expands.
sum of the squared values of the market sales shares of Increasing returns to scale Output changes by a
all the firms in the industry. larger proportion than inputs.
Homogeneous of degree 1 In production, it refers to Indifference curve The curve showing the various
constant returns to scale. combinations of two commodities that give the consumer
 Glossary 685

equal satisfaction and among which the consumer is Investment The formation of new capital assets.
indifferent.
Investment in human capital Any activity, such as
Indifference map The entire set of indifference education and training, that increases an individual’s
curves reflecting the consumer’s tastes and preferences. productivity.

Individual’s demand curve Shows the quantity that Isocost line Shows the various combinations of two
the individual would purchase of a good per unit of inputs that the firm can hire with a given total cost
time at various alternative prices of the good while outlay.
keeping everything else constant.
Isoquant A curve showing the various combinations
Inferior good A good of which a consumer pur- of two inputs that can be used to produce a specific
chases less with an increase in income. level of output.

Information superhighway The ability of reseach- Kaldor-Hicks criterion Postulates that a change is
ers, firms, and consumers to hook up with libraries, an improvement if those who gain from the change can
databases, and marketing information through a fully compensate the losers and still retain some of the
national high-speed computer network and have at gain.
their fingertips a vast amount of information as never Kinked—demand curve model The model that seeks
before. to explain price rigidity by postulating a demand curve
Inputs The resources or factors of production used with a kink at the prevailing price.
to produce goods and services. Labor or human resources’ The different types of
skilled and unskilled workers that can be used in the
Insurer An individual who is willing to pay a small
production of goods and services.
sum of money in order to ensure against the small prob-
ability of a large loss; a risk averter. Labor union An organization of workers devoted to
increasing the wages and welfare of its members
Interdependence The relationship among all mar-
through bargaining with employers.
kets in the economy such that a change in any of them
affects all the others. Land or natural resources The land, its fertility,
mineral deposits, and forests that can be used to pro-
Intermediate good The output of a firm or industry
duce goods and services.
that is the input of another firm or industry producing
final commodities. Laspeyres price index (L) The ratio of the cost of
purchasing base-period quantities at period-1 prices
Internalizing external costs The process whereby relative to base-period prices.
an external cost becomes part of the regular business
expense of a firm. Law of demand The inverse price—quantity relation-
ship illustrated by the negative slope of the demand
International economies of scale The lower costs curve.
resulting from a firm’s integration of its entire system
Law of diminishing marginal utility Each addi-
of manufacturing operations around the world.
tional unit of a good eventually gives less and less extra
Internationalization of economic activity The utility.
trend toward producing and distributing goods
Law of diminishing returns After a point, the mar-
throughout the world.
ginal product of the variable input declines.
Internet A collection of thousands of computers,
Law of the invisible hand The law stated by Adam
businesses, and millions of people throughout the world Smith over 200 years ago that postulates that in a free
linked together in a service called the World Wide Web. market economy, each individual by pursuing his or
Intraindustry trade International trade in the differ- her own selfish interests is led, as if by an invisible
entiated products of the same industry or broad product hand, to promote the welfare of society more so than
group. he or she intends or even understands.
686 APPENDIX C

Learning curve The curve showing the decline in Marginal cost The change in the total cost, or extra
average costs with rising cumulative total outputs over cost, resulting from an economic action.
time. The extra expenditure
Marginal expenditure (ME)
Least-cost input combination The condition where for or cost of hiring an additional unit of an input.
the marginal product per dollar spent on each input is ‘The extra
Marginal expenditure on capital (MEx)
equal. Graphically, it is the point where an isoquant is or cost of hiring an additional unit of
expenditure for
tangent to an isocost line.
capital.
Lerner index A measure of the degree of a firm’s Marginal expenditure on labor (ME;) The extra
monopoly power, which is given by the ratio of the dif- expenditure for or cost of hiring an additional unit of
ference between price and marginal cost to price.
labor.
Limit pricing The charging of a sufficiently low
Marginal product (MP) The change in total product
price by existing firms to discourage entry into the
per unit change in the variable input used.
industry.
Marginal productivity theory The theory according
Long run The time period when all inputs can be
to which each input is paid a price equal to its marginal
varied.
productivity.
Long-run average cost (LAC) The minimum per-
Marginal rate of substitution (MRS) The amount
unit cost of producing any level of output when a firm
of a good that a consumer is willing to give up for an
can build any desired scale of plant. It equals long-run
total cost divided by output. additional unit of another good while remaining on the
same indifference curve.
Long-run marginal cost (LMC) The change in
long-run total costs per unit change in output; the slope Marginal rate of technical substitution (MRTS)
of the LTC curve. The absolute value of the slope of the isoquant. It also
equals the ratio of the marginal product of the two
Long-run total cost (LTC) The minimum total cost inputs.
of producing various levels of output when a firm can
build any desired scale of plant. Marginal rate of transformation of X for Y (MRT yy)
The amount of Y that must be given up to release just
Lorenz curve A curve showing income inequality enough labor and capital to produce one additional unit
by measuring cumulative percentages of total income of X. It is equal to the absolute value of the slope of the
along the vertical axis, for various cumulative percent- production-possibilities frontier and to the ratio of the
ages of the population (from the lowest to the highest
marginal cost ofX to the marginal cost of Y.
income) measured along the horizontal axis.
Marginal revenue (MR) The change in total revenue
Luxury A commodity with income elasticity of
per unit change in the quantity sold.
demand greater than 1.
Marginal revenue product (MRP) The marginal
Macroeconomic theory The study of the total, or
physical product of the input (MP) multiplied by the
aggregate, level of output, national income, national
marginal revenue of the commodity (MR).
employment, consumption, investment, and prices for
the economy viewed as a whole. Marginal utility (MU) The extra utility received
from consuming one additional unit of a good.
Marginal analysis The analysis based on the applica-
tion of the marginal concept according to which net ben- Market An institutional arrangement under which
efits increase as long as the marginal benefit exceeds the buyers and sellers can exchange some quantity of a
marginal cost and until they are equal. good or service at a mutually agreeable price.
Marginal benefit The change in the total benefit, or Market demand curve Shows the quantity demanded
extra benefit, resulting from an economic action. of a commodity in the market per time period at various
 Glossary 687

alternative prices of the commodity while holding Methodology of economics The proposition that a
everything else constant. model is tested by its predictive ability, the consistency
Market demand schedule A table showing the of its assumptions, and the logic with which the predic-
quantity of a commodity that consumers are willing tions follow from the assumptions.
and able to purchase during a given period of time at Microeconomic theory The study of the economic
each price while holding constant all other relevant behavior of individual decision-making units such as
economic variables on which demand depends. individual consumers, resource owners, and business

Market failures The existence of monopoly, monop- firms, and the operation of individual markets in a free-
enterprise economy.
sony, price controls, externalities, and public goods that
prevent the attainment of economic efficiency or Pareto Micromarketing Narrowing a marketing strategy to
optimum. the individual store or consumer.
Market line A line from any point on the production- Minimal income maintenance The transfer or sub-
possibilities curve showing the various amounts of a sidy going to families that have no other income under
commodity that the individual can consume in each a negative income-tax program.
period by borrowing or lending.
Minimum efficient scale (MES) The smallest quan-
Market period The time period during which the tity at which the LAC curve reaches its minimum.
market supply of a commodity is fixed. Also called the
Mixed economy An economy, such as that in the
very short run.
United States, characterized by private enterprise and
Market-sharing cartel An organization of suppliers government actions and regulations.
of a commodity that overtly or tacitly divides the Mixed strategy The best strategy for each player in a
market among its members. non-strictly determined game.
Market signaling Signals that convey product qual- Model Another name for theory, or the set of
ity, good insurance or credit risks, and high productivity. assumptions from which the result of an event is
Market supply curve The graphic representation of deduced or predicted.
the market supply schedule showing the quantity sup- Monopolistic competition The form of market orga-
plied of a commodity per time period at each commod- nization in which there are many sellers of a differenti-
ity price, while holding constant all other relevant ated product and entry into or exit from the market is
economic variables on which supply depends. rather easy in the long run.
Market supply schedule A table showing the quan- Monopolistic exploitation The excess of an input’s
tity supplied of a commodity at each price for a given value of marginal product over its marginal revenue
period of time while holding constant technology, product at the level of utilization of the input.
resource prices, and, for agricultural commodities,
Monopsonistic competition The situation where there
weather conditions.
are many firms hiring a differentiated input.
Marketing research approaches to demand
Monopsonistic exploitation The excess of the mar-
estimation The estimation of consumer demand for
ginal revenue product of an input over the price of the
a product or service by consumer surveys, consumer
input at the level of utilization of the input.
clinics, or market experiments.
Monopsony A single buyer of an input.
Markup The percentage over average cost in cost-
plus pricing. Moral hazard The increased probability of a loss
when an economic agent can shift some of its costs to
Maximum social welfare The point at which a
others.
social indifference curve is tangent to the grand
utility-possibilities frontier; also called constrained Multiple regression A_ statistical technique that
bliss. allows the economist to disentangle the independent
688 APPENDIX C

effects of the various determinants of demand so as to Nonzero-sum game A game where the gains of one
identify from the data the average market demand player do not come at the expense of or are not equal to
curve for the commodity. the losses of the other player.

Nash equilibrium The situation when each player Normal good A good of which the consumer pur-
has chosen his or her optimal strategy, given the strat- chases more with an increase in income.
egy chosen by the other player.
Normative analysis The study of what ought to be or
Natural monopoly The case of declining long-run how the basic economic functions should be per-
average costs over a sufficiently large range of outputs formed. It is based both on positive economics and
so as to leave a single firm supplying the entire value judgments.
market. Oligopoly The form of market organization in which
Necessity A commodity with income elasticity of there are few firms selling either a homogeneous or a
demand between 0 and 1. differentiated product.

Negative income tax (NIT) A type of welfare pro- Oligopsony The form of market organization in
gram involving declining cash transfers to low-income which few firms are hiring either a homogeneous or a
families as the family’s earned income rises. differentiated input.

Net present value (VPV) The value today from the Open innovation model The situation where com-
stream of net cash flows (positive and negative) from an panies commercialize both their own ideas and innova-
investment project. tions as well as the innovations of other firms and
deploy external as well as internal, or in-house, path-
Neuter A commodity of which an individual is indif- ways to market.
ferent between having more or less.
Opportunity cost What an input could earn in its
Nominal rate of interest (r’) The real rate of interest best alternative use.
plus the anticipated rate of price inflation.
Ordinal utility The rankings of the utility received
Nonclearing markets theory Theories that seek to by an individual from consuming various amounts of a
explain the persistence of surpluses and shortages in good or various baskets of goods.
some real-world markets.
Output elasticity of capital The percentage increase
Noncompeting groups Occupations requiring dif- in output resulting from a 1% increase in the quantity
ferent capacities, skills, education, and training and, of capital used. For the Cobb-Douglas production
therefore, receiving different wages. function, this is given by the exponent of K.
Nonexclusion The situation in which it is impossible Output elasticity of labor The percentage increase
or prohibitively expensive to confine the benefit or the in output resulting from a 1% increase in the quantity of
consumption of a good (once produced) to selected labor used. For the Cobb—Douglas production function,
people (such as only to those paying for it). this is given by the exponent of L.
Nonexhaustible resources Renewable resour-ces, Overtime pay The higher hourly wage of many
such as fertile land, forests, rivers, and fish, which need workers for working additional hours after the regular
never be depleted if they are properly managed. workday.
Nonprice competition Competition based on adver- Paasche price index (P) The ratio of the cost of pur-
tising and product differentiation rather than on price. chasing period-1 quantities at period-1 prices relative
Nonrival consumption The distinguishing characteristic to base-period prices.
of a public good whereby its consumption by some Pareto criterion Postulates that a change increases
individuals does not reduce the amount available to social welfare if it benefits some members of society
others. (in their own judgment) without harming anyone.
 Glossary 689

Pareto optimality The situation in which no reorga- Price elasticity of demand (7) The percentage
nization of production and consumption is possible by change in the quantity demanded of a commodity dur-
which some individuals are made better off without ing a specific period of time divided by the percentage
making someone else worse off. change in its price.
Pareto optimum The situation in which no reorgani- Price elasticity of demand for imports The percent-
zation of production or consumption can lead to an age change in the quantity purchased of imports by a
increase in the welfare of some without at the same nation divided by the percentage change in their prices.
time reducing the welfare of others.
Price elasticity of demand for exports The percent-
Partial equilibrium analysis Studies the behavior of age change in the quantity purchased of a nation’s
individual decision-making units and individual mar- exports divided by the percentage change in the price
kets, viewed in isolation. of the nation’s exports.
Payoff The outcome or consequence of each combina- Price elasticity of supply (€) The percentage change
tion of strategies by the players in game theory. in the quantity supplied of a commodity during a spe-
Payoff matrix The table of all the outcomes of the cific period of time divided by the percentage change in
players’ strategies. its price.

Peak-load pricing Refers to the charging of a price Price floor A minimum price for a commodity. If the
equal to short-run marginal cost, both in the peak price floor is above the equilibrium price, it leads to a
period, when demand and marginal cost are higher, and surplus of the commodity.
in the off-peak period, when both are lower.
Price leadership The form of market collusion in
Perfectly competitive market A market where no oligopolistic markets whereby the firm that serves as
buyer or seller can affect the price of the product, all the price leader initiates a price change and the other
units of the product are homogeneous, resources are firms in the industry soon match it.
mobile, and knowledge of the market is perfect.
Price system The system whereby the organization
Planning horizon The time period when a firm can and coordination of economic activity is determined by
build any desired scale of plant; the long run. commodity and resource prices.

Players The decision makers in the theory of games Price theory Another name for microeconomic the-
(here, the oligopolistic firm or its managers) whose ory that stresses the importance of prices in the deter-
behavior we are trying to explain and predict. mination of what goods are produced and in what
quantities, the organization of production, and the dis-
Point elasticity of demand The price elasticity of
tribution of output or income.
demand at a specific point on the demand curve.
Principal-agent problem The fact that the agents
Positive analysis The study of what is or how the
(managers and workers) of a firm seek to maximize
economic system performs the basic economic func-
their own benefits (such as salaries) rather than the total
tions. It is entirely statistical in nature and devoid of
profits or value of the firm, which is the owners’ or
ethical or value judgments.
principals’ interest.
Price ceiling The maximum price allowed for a com-
Prisoners’ dilemma _ The situation where each player
modity. If the price ceiling is below the equilibrium
adopts his or her dominant strategy but could do better
price, it leads to a shortage of the commodity.
by cooperating.
Price-consumption curve The locus of consumer opti-
Private costs The costs incurred by individuals and
mum points resulting when only the price of a good varies.
firms.
Price discrimination Charging different prices (for
Probability The chance or odds that an event will
different quantities of a commodity or in different mar-
occur.
kets) that are not justified by cost differences.
690 APPENDIX C

Probability distribution The list of all possible out- Rational consumer An individual who seeks to
maximiz e utility or satisfac tion in spending his or her
comes of a decision or strategy and the probability
attached to each. income.

Producer surplus The excess of the market price of Rational ignorance The condition whereby voters
the commodity over the marginal cost of production. are much less informed about political decisions than
about their individual market decisions because of the
Product group The sellers of a differentiated
higher costs of obtaining information and the smaller
product.
direct benefits that they obtain from the former than
Product cycle model The introduction of new prod- from the latter.
ucts by firms in an advanced nation, which are then
Rationing Quantitative restrictions imposed by the
copied and produced by firms in lower-wage countries.
government on the amount of a good that an individual
Product innovation The introduction of new or can purchase per unit of time.
improved products.
Rationing over time The allocation of a given
Process innovation The introduction of new or amount of a commodity over time.
improved production processes.
Reaction function A formula that shows how a
Production The transformation of resources or duopolist reacts to the other duopolist’s action.
inputs into outputs of goods and services.
Real rate of interest (r) The premium on a unit of a
Production function The unique — relationship commodity or real consumption income today com-
between inputs and outputs represented by a table, pared to a unit of the commodity or real consumption
graph, or equation showing the maximum output of a income in the future.
commodity that can be produced per period of time
with each set of inputs. Relative price The price of one good in terms of that
of another.
Production-possibilities frontier or transformation
curve Shows the alternative combinations of com- Repeated games Prisoners’ dilemma games of more
modities that a nation can produce by fully utilizing than one move.
all of its resources with the best technology available
Ridge lines The lines that separate the relevant (i.e.,
to it.
the negatively sloped) from the irrelevant (or the posi-
Product variation Differences in some of the char- tively sloped) portions of the isoquants.
acteristics of differentiated products.
Risk The situation where there is more than one
Public goods Commodities for which consumption possible outcome to a decision and the probability of
by some individuals does not reduce the amount avail- each possible outcome is known or can be estimated.
able to others. That is, once the good is provided for
someone, others can consume it at no additional cost.
Risk averter An individual for whom the marginal
utility of money diminishes; he or she would not accept
Pure monopoly The form of market organization in a fair bet.
which there is a single seller of a commodity for which
there are no close substitutes. Risk neutral An individual for whom the marginal
utility of money is constant; he or she is indifferent to a
Pure oligopoly An oligopoly in which the product of fair bet.
the firms in the industry is homogeneous.
Risk premium The maximum amount that a risk-
Quasi-rent The return or payment to inputs that are averse individual would be willing to pay to avoid a risk.
fixed in the short run (i.e., TR — TVC),.
Risk-return indifference curve A curve showing
Rate of interest (r) The premium received in one the various risk-return combinations among which a
year for lending one dollar this year. manager or investor is indifferent.
 Glossary 691

Risk seeker or lover An individual for whom the Social costs The costs incurred by society as a whole.
marginal utility of money increases; he or she would
accept a fair bet and even some unfair bets. Specialization The use of labor and other resources
to perform those tasks in which each resource is most
Saddle point The solution or outcome of a strictly efficient.
determined game.
Speculator An individual or firm that buys a com-
Saving Refraining from present consumption. modity or currency when it expects the price to rise,
Scitovsky criterion Postulates that a change is an and sells the commodity or currency if it expects the
improvement if it satisfies the Kaldor—Hicks criterion price to fall.
and if, after the change, a movement back to the origi- Spot market The market where spot transactions
nal position does not satisfy the Kaldor—Hicks criterion. take place.
Search costs The time and money spent seeking Spot price or rate The price or rate of a commodity
information about a product. or currency in the spot market.
Search goods Goods whose quality can be evaluated Spot transaction The purchase and sale of a com-
by inspection at the time of purchase. modity or currency for immediate delivery and
Second-degree price discrimination Charging a payment.
lower price for each additional batch or block of the Stackelberg model The extension of the Cournot
commodity. model in which one duopolist knows how the other
Second theorem of welfare economics Postulates behaves and, by using this information, earns higher
that equity in distribution is logically separable from profits than in the Cournot solution, at the expense of
efficiency in allocation. the other duopolist.

Selling expenses Expenditures (such as advertising) Standard deviation (sd) A measure of the dispersion
that the firm incurs to induce consumers to purchase of possible outcomes from the expected value of a distri-
more of its product. bution; the square root of the variance.

Separation theorem The independence of the opti- Strategies The potential choices that can be made by
mum investment decision from the individual’s prefer- the players (firms) in the theory of games.
ences. Strategic move A player’s strategy of constraining
Sherman Antitrust Act Prohibits all contracts and his or her own behavior to make a threat credible so as
combinations in restraint of trade and all attempts to to gain a competitive advantage.
monopolize the market. Strategic trade policy The attempt by a nation to
Shortage The excess quantity demanded of a com- create a comparative advantage in some high-tech field
modity at lower than equilibrium prices. through temporary trade protection, subsidies, tax
benefits, and cooperative government—industry programs.
Short run The time period when at least one input is
fixed. Substitutes Two commodities are substitutes if an
increase in the price of one of them leads to more of the
Shutdown point The output level at which price other being purchased.
equals average variable cost and losses equal total
fixed costs, whether the firm produces or not. Also, the Substitution effect The increase in the quantity
lowest point on the AVC curve, at which MC = AVC. demanded of a good when its price falls, resulting only
from the relative price decline and independent of the
Snob effect The situation where some people change in real income.
demand a smaller quantity of a commodity as more
people consume it in order to be different and Surplus The excess quantity supplied of a commod-
exclusive.
ity at higher than equilibrium prices.
692 APPENDIX C

division of a firm to another semiautonomous division

Technical externalities Economies of scale.
of the same enterprise.
Technological progress Refers to the development of
new and better production techniques to make a given, Two-part tariff The pricing practice whereby a
improved, or entirely new product. monopolist maximizes its total profits by charging a
usage fee or price equal to its marginal cost and an ini-
Theory of contestable markets The theory that pos- tial or membership fee equal to the entire consumer
tulates that even if an industry has only one or a few surplus.
firms, it would still operate as if it were perfectly com-
petitive if entry into the industry is absolutely free and Tying The requirement that a consumer who buys or
if exit is entirely costless. leases a monopolist’s product also puchase another
product needed in the use of the first.
Theory of public choice The study of how govern-
ment decisions are made and implemented. Uncertainty The situation where there is more than
one possible outcome to a decision and the probability
Theory of revealed preference The theory that pos- of each specific outcome is not known or even mean-
tulates that a consumer’s indifference curve can be ingful.
derived from the consumer’s market behavior and with-
out any need to inquire directly into his or her prefer- Unemployment gap The excess in the quantity
ences. supplied over the quantity demanded of labor at
above-equilibrium wages.
Third-degree price discrimination Charging a
higher price for a commodity in the one market of two Util The arbitrary unit of measure of utility.
that has the less elastic demand in such a way as to Utility The ability of a good to satisfy a want.
equalize the MR of the last unit of the commodity sold
in the two markets. Utility-possibilities frontier Shows the various
combinations of utilities received by two individuals at
Tit-for-tat The best strategy in repeated prisoners’ which the economy (composed of the two individuals)
dilemma games, which postulates, “Do to your oppo- is in general equilibrium or Pareto optimum in
nent what he or she has just done to you.” exchange.
Time budget line A line showing the various combi- Value of the marginal product (VMP) The mar-
nations of two goods that an individual can obtain with ginal (physical) product of the input (MP) multiplied
his or her available time. by the commodity price (P).
Total costs (TC) TFC plus TVC. Variability risk The possibility that the return on an
Total fixed costs (TFC) The total obligations of a investment, such as on a stock, may vary considerably
firm per time period for all fixed inputs. above or below the average.

Total product (TP) Total output. Variable inputs The resources that can be varied
easily and on short notice during the time period under
Total revenue (TR) The price of a commodity times consideration.
the quantity sold of the commodity.
Veblen effect The situation in which some people
Total utility (TU) The aggregate amount of purchase more of certain commodities the more expen-
satisfaction received from consuming various amounts sive they are; also called conspicuous consumption.
of a good or baskets of goods.
Virtual corporation A temporary network of inde-
Total variable costs (TVC) The total obligations of pendent companies coming together, with each con-
a firm per time period for all the variable inputs the tributing its core technology to take quickly advantage
firm uses. of fast-changing opportunities.
Transfer pricing The determination of the price of Voluntary export restraints (VER) The situation
intermediate products sold by one semiautonomous in which an importing country induces another
 Glossary 693

nation to reduce its exports of a commodity “volun- the exchange of commodities and for equity in the dis-
tarily” under the threat of higher all-around trade tribution of income.
restrictions.
What to produce Which goods and services a soci-
Water-diamond paradox The question of why ety chooses to produce and in what quantities.
water, which is essential to life, is so cheap while dia-
Winner’s curse The overbidding or the paying of a
monds, which are not essential, are so expensive.
price higher than the true (but unknown) value of an
Wealth The individual’s income this year plus the asset by the highest bidder at an auction.
present value of future income.
Zero-sum game A game where the gains of one
Welfare economics Examines the conditions for player equal the losses of the other (so that total gains
economic efficiency in the production of output and in plus total losses sum to zero).
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 NAME INDEX

Aaron, H. J., 571 Chesbrough, H. W., 213 Galbraith, J. K., 350

Ackerlof, G. A., 622, 632 Christensen, L., 244, 246 Garrett, T. A., 173
Adams, W., 137, 233, 281, 307 Clement, D., 599 Gaviria, A., 76
Aguiar, M., 459 Coase, R. R., 590, 594 Gilligan, T., 248
Alston, R. M., 21 Coate, D., 97 Glaeser, E., 164
Anderson, W., 134, 140 Cohen, H., 246 Goldin, C., 527
Argote, L., 250 Conslik, J., 180 Greene, W., 246
Arrow, K., 172, 173, 250, 487 (Cos, ID) IL, Ill Greenstone, M., 79, 568
Audretsch, D. B., 421 Cournot, A. A., 355 Griliches, Z., 246, 368
Averch, H., 427, 440 Cropper, M. W., 606 Grossman, M., 97
Axelrod, R., 399 Cyert, R. M., 372 Gupta, V. K., 246

Bailey, E. E., 247 De Melo, J., 581 Halvorsen, R., 155, 157
Bain, J., 367 DeBondt, W. F. M., 180 Hamilton, B. W., 121
Bajic, V., 68, 368 Debreu, G., 553 Hammer, H., 408
Banks, J., 180 Dehaven, J. C., 568 Harberger, A., 323
Barnett, A. H., 456 Dickens, W. T., 76, 164 Harrison, B. W., 420
Bator, F. M., 555, 587 Hartman, D., 575
Baumol, W. J., 417, 628 Eads, G., 246 Hashimoto, K., 259
Baye, M. R., 134, 140 Eckard, E. W., 351, 619 Heath, J. A., 259
Becker, G. S., 505 Edwards, R., 502 Heien, D. M., 140
Bell, F., 246 Ehrlich, I., 76, 164 Hicks, John, 81, 139, 575
Bellante, D., 466 Eldstein, D. E., 275 Hirshleifer, J., 568
Benham, L., 351 Epple, D., 250 Hotelling, H., 543
Benkard, C. L., 251 Ericson, N., 274 Houthakker, H. S., 134, 137
Bergson, Abram, 577
Berry, S., 68 Fama, E. F.,, 628 Irwin, D. A., 250, 251, 406, 605
Bertrand, J., 357 Feldstein, M., 6, 462
Bhuyan, S., 323 Ferber, M. A., 505 Jansen, D. W., 134, 140
Blau, F. D., 505 Fischer, A. C., 598 Jensen, R. T., 104
Blendon, R. J., 21 Fisher, F., 323, 368 Johnson, J. A., 134
Blundel, R., 180 Forrester, J. W., 542 Johnson, L., 427
Borenstein, S., 375 Francis, N., 459 Jorgenson, D. W., 121
Borjas, G. J., 510 Frech, H. E., 246
Boskin, M. J., 121 Freeman, R. B., 487, 502, 541 Kahn, L. M., 505
Brander, James, 414 Fretz, D., 134 Kahneman, D., 180
Brewer, J., 79 Frey, B. S., 62 Kaldor, N., 575
Friedlaender, A. F., 247 Kaysen, C., 368
Calemaker, F., 137 Friedman, M., 173 Kearl, J. R., 21
Camarota. S. A., 498 Frijters, P., 62 Klarman, H., 246
Camerer, C., 180 Froot, K., 180 Klein, B., 335
Campano, F., 580 Fuchs, V. R., 571 Klenow, P. J., 250, 251, 605
Chamberlin, E. H., 347 Fujii, E. T., 140 Koenker, R., 246

695
696 Name Index

Nelson, P., 618 Shepherd, W. G., 417

Kohlhase, J. H., 462
Nerlove, M., 246 Shleifer, A., 180
Kovaric, W. E., 423
Siegfried, J., 323
Kreps, D., 400
Oates, W., 606 Simon, H., 180
Krueger, A. B., 477
Odean, T., 180 Smirlock, M., 248
Krugman, P. R., 405
Oi, W., 334 Smith, A., 412, 566
Krutilla, J. V., 598
Smith, V. L., 420
Laibson, D., 180 Pakes, A., 68 Sobel, R. S., 173
Lakshmanan, G. R., 134, 140 Panzar, J. C., 247 Spence, A. M., 623
Lancaster, K., 112 Pareto, V., 564 Spencer, B., 404
Lang, D. M., 328 Parsley, C. J., 502 Stigler, G. J., 359, 616
Lave, C. A., 206, 239 Parsons, D. O., 626 Stiglitz, J. E., 616, 622,
Lee, T. W., 134, 140 Pestel, E., 542 630
Lee, Wh (Ca, Pigou, A. C., 587 Stutzer, A., 62
Leibenstein, H., 420 Porter, M., 211, 400, 404 Stutss Deis 74238
Lerner, Abba P., 415 Sullivan, D., 462
Lester, J., 246 Quinton, N., 493 Summers, L., 632
Levin, R. E., 212 Summers, P. M., 493
Levinsohn, J., 68 Raduche, W., 246 Sutton, J., 247
Lindsay, C. M., 541 Raff, D., 632 Swaim, P., 502
Liu, W., 625 Reder, M. W., 502
Lopez, R. A., 323 Reutter, K., 456 Tabb, W. K., 429
Lyin, IK Sos MOY Robinson, J., 485, 491 Taheler, R., 180
Rogerson, W., 323 Taheri, A. A., 101
MacCrimmon, K. R., 67 R@Se, ING IL, S/S) Tanner, M., 575
Malthus, T., 197 Rosen, S., 103 Tanner, S., 180
Mianeln, dh. Gey 372 Ross, D., 422, 619 Aerie ID. Sys
Markowitz, H. M., 176 Taylor, L. S., 134, 137
Marshall, W., 248 Sacerdote, B., 164 Thiel, S., 294
Masson, R. T., 371 Spaniti, 1b, IE, Saks) Thompson, H., 456
McKenzie, L. W., 553 Salvatore, Di, U2 18s LOS i42" Tiemann, T., 323
McKibbin, W., 281 154, 182, 281, 291, 298, Tirole, J., 402
Meadows, D. H., 542 300, 388, 439, 464, 568, Toda, M., 67
Medoff, J. L., 502 570, 580, 597
Mesarovic, M., 542 Samuel, A., 233 Vaughn, M. B., 21
Milgrom, P., 294 Samuelson, P., 81, Veall, M. R., 134
Miller, N. H., 104 Savage, L., 173 Vernon, R., 417
Milliman, J. W., 502 Schelling, T., 400
Mincer, J., 527 Scherer, F. M., 323, 422, 619 Wall, H. J., 581
Mitra, S., 626 Schmidt, E., 375 Walras, L., 553
Mobley, R. L., 246 Schumpeter, J., 421 Weindenbaum, M., 429
Moffitt, Robert, 626 Schwartz, W. B., 571 Willig, R., 109, 247
Morgan, P., 274 Scitovsky, T., 576 Wilson, R., 400
Morgenstern, O., 390 Scully, G., 492, 493 Wong, C., 625
Moroney, J. R., 224 Shaanan, J., 371
Muller, C. A., 94 Shapiro, C., 423 Yan, M., 109
Murphy, N., 246 Shepard, L., 490 Yellin. 6305632
 SUBJECT INDEX

Adverse selection, 622-623, 678 Asymmetric information, 622-623, Beta coefficient, 533, 679
Advertising: 678 Bilateral monopoly, 499-500, 679
informative, 618-619 Auctions, 33, 293-294 Borrowing, 513-514
in monopolistically competitive Average costs, 229-247 Brain drain, 496-497, 679
markets, 349-351 of corn, 233-234 Break-even point, 266, 679
price of eyeglasses and, 351 input prices, and, 259-260 Budget constraint, 71, 679
Agent. See Principal-agent problem long-run, 239-265 Budget line, 71-72
Aggregates, study of. See short-run, 229-234 changes in income and prices and,
Macroeconomic theory Average fixed costs, 229, 678 72-73
Agricultural support programs, 42-44 Average product, 193-198 defined, 679
Agriculture, Department of, 147 defined, 678 Bundling, 335-336, 679
Air pollution, 606 of labor, 193-194 Bureau of Labor Statistics, 120
Airline: Average revenue, 142, 678 Bureaucrats, public choice theory
Deregulation Act of 1978, 430-431 Average total costs, 229-230 and, 602
deregulation of, 430-431 defined, 678
fare wars, 398-399 short-run, 314 Capacity, excess, 349, 682
Alaskan shale oil, 273-274 Average variable costs: Capital:
Allocation over time, 509-522 defined, 678 composite cost of, 534, 680
Alternative (opportunity) cost short-run, 316-317 cost of, 530-534
doctrine, 226-227, 678 Averch-Johnson (A—J) effect, 427, cost of equity, 531-534
Aluminum Company of America 678 defined, 679
(Alcoa), 306-307 human, 539-541
Amazon.com, 92 Bad, 62, 678 output elasticity of, 220, 688
American Medical Association, 361, Bandwagon effect, 126, 679 weighted cost of, 534
601 Barometric firm, 364, 379 Capital asset pricing model, 533-534,
American Telephone & Telegraph Barriers to entry, 306-308 679
(AT&T), 351, 424-425, 427 limit pricing as, 370-371 Capital budgeting, 523-526, 679
Analysis: Base period money or expenditures, Capitalization, 320-321
benefit-cost, 597-600 117-118 Cardinal utility, 60, 679
comparative static, 34-37 Base period quantities, 117-118 Cartels, 359-364
demand and supply. See Demand; Baseball. See Major league baseball antitrust laws and, 422-423
Behavioral Economics, 180 centralized, 359-361, 679
Supply
general equilibrium. See General Benefit(s): cheating, 360
equilibrium analysis of exchange, 110-112 collusion and, 359
marginal, 12-16, 80-81, 266-270 external, 587, 683 defined, 679
market, 26-27 marginal, 13 in diamond industry, 311
regression, 153-155 of monopoly power, 420-422 market-sharing, 362-364, 687
Antitrust laws, 422-425 Benefit-cost analysis, 597-599 in oil industry, 361
Appreciation, of dollar, 298, 678 defined, 679 price leadership in, 364-366
Arbitrage, 678 of investment project, 522-527 Celler-Kefauver Act of 1950, 423
Arc elasticity of demand, 129, 678 Bergson social welfare function, 577, Centralized cartel, 359-361, 679
Arrow’s impossibility theorem, 679 Certainty, 159, 679
577-578, 678 Bertrand Model, 679 Ceteris paribus assumption, 34, 552

697
698 Subject Index

Consumer clinics, 148 total fixed, 228, 692

Characteristics approach to consumer
Consumer equilibrium, 75, 680 total variable, 228, 692
theory, 112-114, 679
Circular flow of economic activity, Consumer price index (CPI), variable, 228-234
7-9, 679 120-121, 529-230 Cost minimization,
Civil Aeronautics Board, 602 Consumer surplus, 108-110, 680 in long run and short run,
Clayton Act of 1914, 422-423, 679 Consumers: 237-239
Closed Innovation model, 212 behavior of, and individual input substitution in production
Coase theorem, 590-591, 680 demand, 57-123 and, 256-259
Cobb-Douglas production function, borrowing by, 513-514 Cost-plus pricing, 371-372, 681
219-224, 679 budget constraints of, 71 Cost theory, 225-260
Coefficient: choices by, risk and, 158-186 applications of, 227, 233-234,
beta, 533, 679 endowment position of, 510, 682 238-239, 243-244, 250,
technical, 155 income of, 70-73 258-259
Coffee, price of, 36-37 lending by, 510-512 long run and, 234-239
Coinsurance, 625, 680 optimization by, 75—76, 680 short run and, 228-234
Collective bargaining. See Labor rational, 74, 690 Cotton textile industry, 280-281
unions tastes and preference of, 62—64 Cournot model, 355-357, 384-386,
Collusion: utility maximization by, 74-81 681
cartels and, 359 welfare of, 117-120. See also Credibility. See Game theory
defined, 680 Welfare economics, 118-123 Cross elasticity of demand, 138-140
Commodities. See Goods Consumption: defined, 681
Common property, 590, 680 external diseconomies of, 587, 683 formula for, 138
Comparable-worth doctrine, 505, 680 external economies of, 587, 683 for selected commodities, 139-140
Comparative advantage, 568-570, 680 onrival, 592, 688 Cross-section data, 223
Comparative static analysis, 34, 680 Contestable markets, theory of, 355, Currency. See Dollar; Exchange rates
Compensating wage differentials, 692 Curve. See specific curves
473-474, 680 Contract curve:
Compensation principle, 575, 680 for exchange, 557, 680 Data, cross-section, 223
Competition: for production, 579, 680 Deadweight loss, 290, 681
antitrust laws promoting, 422-425 Copper, price of, 274-276 Debt, cost, 530-531
imperfect, 303-411 Corn production: Decreasing cost industry, 283-284,
international, 213-215, 284-286, average and marginal costs in, 681
monopolistic, 345-352 233-234 Decreasing returns to scale,
monopsonistic, 489 Corner solution, 77—78, 681 206-210
nonprice, 396-398 Cost(s): Default risk, 527, 681
perfect, 261-301 alternative (opportunity), 226-227 Dell Computers, 394-395
Complementary inputs, 451-452, 680 of attending college, 227 Demand:
Complements, 139 average, 229-234 adjustment to changes in, 34
defined, 680 average fixed, 229, 678 changes in, 27—29
Composite cost of capital, 534, 680 average total, 229-230, 678 derived, 448, 681
Computer-aided design, 215-216, 680 average variable, 229, 678 elasticity of. See Elasticity of
Computer-aided manufacturing, of capital, 530-534 demand
215-216, 680 composite, of capital, 534 for electricity, in U.S., 155-157
Con Edison: of debt, 530, 681 empirical estimation of, 153-155
price discrimination by, 330-331 explicit, 226, 683 excess, 38, 682
regulation of, 428 external, 587, 683 imports and, 37-39
Concentration ratios, 354, 680 fixed, 228-230 individual, 96
Concorde, 599-600 implicit, 226, 684 for inputs, 448-452, 483-485
Congestion pricing, 610-611 marginal, 229-231, 686 law of, 27
Conscious parallelism, 422, 680 per-unit, 229-23] marginal revenue and, 142-145
Constant cost industry, 281-282, 680 private, 226, 689 market, 26-29
Constant returns to scale, 206, 680 of production, 225—260 for new domestic automobiles,
Constrained utility maximization, search, 616, 691 effect of change in, 553-555
75-78, 680 social, 226, 691 shifts in, 28-29
Constraint, budget, 71-72, 679 total, 228-229, 692 total revenue and, 142-144
 Subject Index 699

Demand curve: exchange rate for. See Exchange general equilibrium, 555
changes in, 27-29 rates for production, 557-559, 682
faced by monopolist, 308-310 Dominant firm model, 364-366 Education:
faced by monopolistic competitor, Dominant strategy, 392-393, 681 earnings and, 526-527
347-349 Dumping, 331-333 hours of work and, 540-541
faced by oligopolist, 355-359 defined, 681 Efficiency:
faced by perfectly competitive firm, persistent, 332 defined, 682
262-264 predatory, 332 market structure and, 413-414
for Giffen good, 101—104 sporadic, 332 Efficiency wage, 631-632
individual, 96, 685 Dumping rights, 608-610 Efficiency wage theory, 630-632,
for inferior good, 101-104 Duopoly, 681 682
for input, 448-452, 483-485 Efficient-market hypothesis, 263-264
kinked, 355-359 Earnings. See Wages Effluent fees:
market. See Market demand curve eBay, 292 defined, 682
movement along, 28-29 e-commerce, 292 optimal pollution control and, 608
shifts in, 28—29 Economic activity: Elasticity of demand:
unitary elastic, 133 circular flow of, 7-9, 679 cross, 138-140, 681
Depository Institutions and Monetary internationalization of, 16-18, income, 135-138, 684
Control Act of 1980, 429 685 price. See Price elasticity of
Depreciation, of dollar, 298, 681 Economic efficiency: demand
Deregulation, 429-432, 681 defined, 681 Elasticity of substitution, 258-259
of airline industry, 430-431 externalities and, 587-590 Elasticity of supply, price. See Price
Derivatives, 535-536, 681 marginal conditions for, and Pareto elasticity of supply
Derived demand, 448 optimality, 12-15 Electricity:
Diamond industry, 311 market structure and, 413-414 demand for, in U.S., 155-157
Diamond-water paradox, 109 perfect competition and, 565-568 generation of, long-run average
Differentiated oligopoly, 353, 681 Economic goods, 62 costs curve in, 243-244
Differentiated products, 263, 346, 681 Economic growth, 7, 681 peak-load pricing for, 435-437
Digital factory, 216 Economic rent, 468-470 price discrimination in rates for,
Diminishing marginal utility of defined, 682 330-331
money, 165, 681 measurement of, 469 Employment discrimination,
Diminishing returns, law of, 196-197, Economic resources, 4-5, 682 502-504, 681
685 Economic system: Endowment position, 510, 682
distinguished from decreasing free-enterprise, 6 Engel curve, 88-90, 136
returns, 207 functions of, 6-7 defined, 682
Disability payments, 626 government’s role in, 11—12 income elasticity of demand and,
Discrimination: mixed, 11 136
in gender, 504—S05 planned, 11—12 Engel’s law, 90-91, 135-137, 682
in employment, 502-504, 681 Economics: Engineers’ shortage, 486-487
in pricing. See Price discrimination defined, 682 Entrepreneurship, 191, 680
Diseconomies: as “dismal science,” 197-198 Entry, barriers to. See Barriers to
of consumption, 587 experimental, 418—420 entry
external, 284, 587, 683 methodology, 18-19 Entry deterrence. See Game theory
of production, 587 normative, 19-20 Environmental pollution, 605—608,
of scale, 207—209 positive, 19-20 682
of scope, 248, 681 welfare, 570-575 Environmental Protection Agency
Disemployment effect, 475, 681 Economies: (EPA), 608-610
Dismal science, 197-198 of consumption, 587 Equal Pay Act of 1964, 504
Diversification, 681 external, 288, 587 Equilibrium:
Dividend valuation model, 532, 681 of scale, 251—253 consumer, 75
Division of labor, 16, 681 of scope, 247-248, 682 Cournot, 385, 681
Doctors. See Physicians Edgeworth box diagram, 110-112, defined, 682
Dollar: 555-559 demand-supply model of, 31-34
appreciation of, 298, 678 defined, 682 general. See General equilibrium
depreciation of, 298, 681 for exchange, 555—557, 682 lending-borrowing, 514-515
700 Subject Index

Equilibrium: (continued) U.S. price and income elasticities Foreign exchange rate. See Exchange
long run, 277-280, 319-320, 325 of, 140-142 rate
voluntary restraints on, 432-434 Foreign investment, 537-539
in monopolistic competition,
External benefits, 587, 683 Forward. See Futures
347-351
in monopoly, 312-315, 319-320, External costs, 587, 683 Forward contract, 535, 683
323-325 internalizing, 591 Free enterprise system, 6, 683
Nash, 385, 393-395, 688 External diseconomies: Free goods, 4
in oligopoly, 355-359 of consumption, 587, 683 Free resources, 4
in perfect competition, 276-280 defined, 284, 683 Free-rider problem, 595, 683
saving-investment, 517-520 of production, 587, 683 Free trade. See International trade
short run, 276-277, 312-315, External economies: Fringe Benefits, 683
323-325 of consumption, 587, 683 Fundamental economic fact, 5
Stackelberg, 386-388, 691 defined, 284, 683 Furniture, increasing returns to scale
supply curve and, 271-276 of production, 587, 683 in, 223-224
Equilibrium price: Externalities, 587-590 Futures, 535
defined, 31, 682 defined, 587-588, 683 Futures contract, 535, 684
excise tax and, 42-44 market failure and, 588-589 Futures markets, 535
in perfect competition, 264-265 property rights and, 590-592 Futures price or rate, 535
saving-investment, 517-522 technical, 587 Futures transaction, 535
short run, 265—271, 312-315,
347-349 Failure: Gambler, 168-169, 171-173, 684
supply curve and, 271-273 government, 600, 684 Game theory:
Equity capital, cost of, 531-534 market, 567, 687 commitment in, 400-401
Excess capacity, 349, 682 Fair Labor Standards Act of 1938, credibility, 400-401
Excess demand, 38, 682 475 criticisms, 404
Excess supply, 38, 682 Farm support programs, 40-42 defined, 390, 684
Exchange: Federal Energy Regulatory dominant strategy in, 392-393, 681
benefits of, 110-112 Commission (Federal Power entry deterrence, 401-403
contract curve for, 557 Commission), 599 Nash equilibrium, 385, 393-395
defined, 682 Federal Trade Commission, 351 payoff, 390, 689
Exchange rate, 141, 297-300, 682 Financial microeconomics, 509-548 payoff matrix, 390, 689
Excise tax: applications of, 539-545 players, 390, 689
defined, 682 Firm: prisoners’ dilemma, 395-396, 690
equilibrium price and, 42-44 barometric, 364, 679 repeated games, 399, 690
per-unit, 336-337 defined, 190, 679 strategic moves, 400-402
welfare effects of, 289-290 dominant, 364-366 strategies, 390, 691
Executives, salaries of, 494-495 entrepreneurship and, 191 threats, 400
Exhaustible resources: global, 376-380 tit for tat, 399, 691
defined, 682 monopolistic, 306 Gasoline:
pricing of, 542-543 monopolistically competitive, consumption of, 205—206
Expansion path, 239-241, 682 346-347 price-inelastic demand for, 134
Expected income, 169, 682 oligopolistic, 352-355 speed limit and consumption of, 206
Expected utility, 166, 683 perfectly competitive, 262-263 tax rebate proposal, 100-101
Expected value, 161, 683 First degree price discrimination, 326, taxes on, effect of, 100-101
Expected value of money, 683 683 General equilibrium:
Expenditure index, 117 First theorem of welfare economics, of exchange, 555-557
Expenses, selling, 349-351, 691 566, 683 international trade and, 568-570
Experience goods, 618-619, 683 Fixed costs, 228 model of, 569-570
Experimental economics, 418-420, 683 Fixed inputs, 192, 683 of production, 557-559
Explicit costs, 226, 683 Fixed-proportions production of production and exchange,
Exploitation: functions, 204—206 561-563
monopolistic, 485, 687 Food stamp program, 106-107, 683 General equilibrium analysis,
monopsonistic, 491-493, 687 For whom to produce, 7, 683 549-582
Exports: Ford Taurus, 68 applications of, 553-555,
composition of, and revealed Foreign exchange market, 297-300, 567-568
comparative advantage, 568 683 defined, 552, 684
 Subject Index 701

partial equilibrium analysis versus, Immigration, labor earnings and, marginal rate of substitution and,
552-553 495498 65-66
Walras model for, 553 Imperfect competition, 303-442 special types of, 66-68
General Motors, 209-210 input pricing and employment Indifference map, 64, 685
Giffen good, 103, 684 under, 481—505 Individual demand curve, 96, 685
Gillette Sensor Razor, 69-70 Imperfect labor market, 490 Industrial concentration:
Gini Coefficient, 580, 684 Implicit costs, 226, 684 Herfindahl index of, 415-417, 684
Global oligopolists, 376-377 Import tariff, 45-46 Lerner index of, 414-415, 686
Golden parachutes, 628-630, 684 defined, 684 in U.S., 354-355
Good(s): effects of, 290-291 See also Monopoly power
defined, 62, 684 reduction in, social welfare and, Industry:
economic, 62 290-291 constant cost, 281-282, 680
experience, 618-619, 683 Imports: decreasing cost, 283-284, 681
free, 4 comparative advantage, 568 existence of, price discrimination
Giffen. See Giffen good composition of, and revealed, and, 338-339
inferior, 91-94, 685 38-39 increasing cost, 282-283, 684
intermediate, 456, 685 domestic demand and, 37-39 long-run equilibrium of, 278-281
luxury, 135-137, 686 US. price and income elasticities protection for, 580-582
necessary, 135-137, 688 of, 140-142 short-run equilibrium of, 276-277
normal, 91—94, 688 Impossibility theorem, Arrow’s, supply curve for, 271-273
public, 592-597, 690 577-578, 678 Inferior good, 91—95, 685
search, 618-619, 691 Incidence of the tax, 44, 684 Information:
substitution of. See Substitution Income: advertising and, 618-619
effect consumer, 70—74 asymmetric, 622, 678
Government: expected, 169, 682 economics of, 616-63 1
benefit-cost analysis and, 597—600 inequality of, 578-580 search costs, 616, 691
creation of monopolies by, 308 personal disposable, 516 superhighway, 620
failure of, 600, 684 Income constraint, 71—72 Inputs:
product warnings by, 76-77 Income-consumption curve, 88-89, classification of, 191-192
public-choice theory and, 600-603 684 complementary, 451, 680
rent controls by, 40-42 Income effect: defined, 191, 685
role of, in economic system, 11 of change in wage rate, 459-460 demand curve for, 448-453
subsidies by, to agriculture, 42-44 defined, 684 fixed, 192
support for basic research, 589-590 formula for, 638 international trade in, 465-468
water rationing by, 78-79 for inferior goods, 101-104 optimal combination of, 234-238,
Grand utility-possibilities frontier, substitution effect and, 97-104 446-448
573-574, 684 Income elasticity of demand, 135-137 price and employment of, 443-477
Gross private domestic investment, defined, 684 price elasticity of demand for,
Dy), formula for, 135 454-456
for imports, 140-142, 684 substitution among, 256
Hedging, 684 Income or expenditure index, 117, supply curve of, 456-463
Hedonic prices, 68 684 variable, 192, 692
Herfindahl index, 415-416, 684 Income redistribution: Insurance market, 623
Homogeneous commodity, in perfect and social welfare, 575-578 moral hazard and, 625-627
competition, 262 in U.S., 578-582 Insurer, 169-171, 685
Homogeneous of degree, 220, 684 Increasing cost industry, 282-283, Interdependence, 353, 552, 685
Hospital care, rationing of, 571 684 Interest rates:
How to produce, 6, 684 Increasing returns to scale: defined, 512, 690
Human capital, 539-540 defined, 206-207, 684 determinants of, 514-515,
Human wants, 4, 684 in furniture, 223-224 520-521, 527-529
budget constraints and, 71—72 Indexes: equilibrium, 510-521
defined, 4, 684 of monopoly power, 414-417 intertemporal choice and, 520-521
price, 117-121 real versus nominal, 529
IBM Corporation, 17—18 Indifference curve, 62-68, 106-112 Intermediate good, 454, 685
IBM PC, 17-18 characteristics of, 64-65 Internalizing external costs, 591,
Identification problem, 153, 684 defined, 62, 684 685
702 Subject Index

Kaldor-Hicks criterion, 575-576, 685 marginal costs in, 240, 686

International competition:
domestic economy and, 284—285 Kinked-demand curve model, price and output determination in,
358-359, 685 277-280, 319-320, 325
migration of labor and, 495-498
price discrimination and, 331-332 Kodak, and antidumping, 332-333 supply curve in, 277-279, 319-320
Kyoto protocol, 609 theory of cost in, 234-238
price equalization and, 465-468
protection of domestic industry total costs in, 234-235, 686
and, 580-582 Labor: Long-run equilibrium:
specialization in production and, demand for, 448-452 in monopolistic competition,
466-467 marginal expenditure, 448, 488, 686 347-349
voluntary export restraints on, output elasticity of, 220 in monopoly, 319-320, 325
432-434 overtime pay and, 472-473 in oligopoly, 366-369
International economies of scale, supply of, 456-458 in perfect competition, 277-281
251-253, 685 total, average, and marginal product Lorenz curve, 578—580, 686
International trade: of, 192-194, 446-448 Loss minimization, 270-271
foreign investments and, 537-539 wage elasticity of, 455-456 Loss, deadweight, 289-290, 681
free, 284—285 Labor market: Luxury, 135-137, 686
general equilibrium and, 568-570 effect of disability payments on, foreign travel as, 137-138
in inputs, 468-470 626-627
strategic policy for, 604—605 effect of immigration on, 495-498 Macroeconomic theory, 7, 686
International Trade Commission, U.S. effect of occupational licensing on, Major league baseball, monopsonistic
(USIME@) 7433 490 exploitation in, 492-493
Internationalization of economic effect of overtime pay on, 472-473 Margin, concept of, 12-15, 680
activity, 16-18, 685 imperfect competition in, 494-495 Marginal analysis, 12-15, 80-81,
Intertemporal choice: Labor unions, 501-502 265-271, 686
investment decisions and, 523-525 defined, 504, 685 Marginal benefit, 13, 686
lending-borrowing equilibrium effect of, on wages, 501-502 Marginal costs, 13, 229, 266, 314-316
and, 515 Lagrangian multiplier, 638 of corn, 233-234
saving-investment equilibrium and, Laspeyres price index, 117, 685 defined, 686
518-519 Law of: input prices and, 256
Intertemporal price discrimination, comparative advantage, 568 long-run, 240
435 demand, 27, 685 pricing and, 265-271, 314-316
Interviews, 148 diminishing marginal utility, 60, 685 short-run, 265-271, 314-316
Intra-industry trade, 214, 685 diminishing returns, 196, 685 Marginal expenditure, 448, 483, 686,
Inventions, monopoly and, 338-340 the invisible hand, 566, 685 of capital, 488, 686
Investment: Walras’, 553 defined, 686
defined, 517—685 Learning curve, 248-251, 686 of labor, 448, 488, 686
foreign, 537-539 Least-cost input combination, Marginal product, 193-194, 446-448
gross and net private, in U.S., 522 236-237 defined, 686
in human capital, 539-541, 685 defined, 686 of labor, 193
saving and, 520 of gasoline and driving time, value of the, 448-450, 692
Investment decisions, 522-526 238-239 Marginal productivity theory, 463, 686
interest rate and, 523-526 Lemons, 622 Marginal rate:
present-value rule for, 523 Lending, 510-512 of substitution, 65-66, 686
Invisible hand, law of the, 566 interest rate and, 514-515, 520-521 of technical substitution, 201-203,
Irrigation, water pricing and, 567-568 Lending-borrowing equilibrium, 515 686
Isocost lines, 234—235, 685 Lerner index, 414-415, 686 of transformation of X for Y, 560,
Isoquants, 198-206 Lighthouse, economics of, 594 686
characteristics of, 201-203 Limit pricing: Marginal revenue curve, 142-145
defined, 198, 685 as barrier to entry, 370-371 Marginal revenue product, 448,
derivation of total product curves defined, 367, 686 483-485, 686
from, 199-201 Long distance telephone service, price elasticity of demand and,
Ivy cartel, 363-364 423-424 452-453
Long run: Marginal utility, 58, 80-81, 686
Junk food, 76 average costs in, 240, 242-246, 686 Market:
Justice, Department of, 423 defined, 686 defined, 26, 686
merger guidelines of, 422-424 cost minimization in, 237—238 forward or futures, 535
 Subject Index 703

functioning of, and experimental Ministry of International Trade and Monopsonistic competition:
economics, 418—420 Industry (MITT) of Japan, 604 defined, 489, 687
impersonality of, 263 Mixed economy, 11, 687 in major league baseball, 492-493
insurance, 623 Model, 18, 687 pricing and employment of inputs
labor, 470-477 capital asset pricing, 533-534, in, 490-494
perfectly competitive, 262-263, 689 679 Monopsony:
spot, 691 Cournot, 355-357, 384-386, 681 characteristics of, 487-488
theory of contestable, 355, 692 defined, 18, 687 defined, 487, 687
Market analysis, 26 dividend valuation, 532, 681 pricing and employment of inputs
Market demand, 26-27 general equilibrium, 555—565 in, 490-494
empirical estimation of, 153—157 kinked-demand curve, 358-359, 685 regulation of, 498-499
price elasticity of, 128-135 product cycle, 213, 690 welfare effects of, 490-491
Market demand curve, 27, 125-128, 686 Monopolistic competition, 346-352, Moore’s Law, 251
for a commodity, 125-128 687 Moral hazard, 625-628, 687
defined, 686 defined, 346, 687 Medicare and Medicaid and, 626-627
derivation of, 125 demand curve in, 347-351 Motor Carrier Act of 1980, 429
for electricity, 155-157 excess capacity and, 349 Multipart price discrimination, 328
for an input, 452-453, 486 long-run equilibrium in, 347-351 Multiple regression, 153-155, 687
Market demand schedule, 27, 687 nonprice competition in, 346-347
Market experiment, 418-420 price and output decisions under, Nash equilibrium, 392-395, 688,
Market failure: 347-351 payoff, 390, 689
defined, 567, 687 product groups in, 347 payoff matrix, 390, 689
externalities and, 588-589 product variations in, 349-351 players, 390, 689
Market line, 519, 687 selling expenses in, 349 prisoners’ dilemma and, 395-398
Market period, 264-265, 687 short-run equilibrium in, 347-349 repeated games, 399
Market-sharing cartel, 362-364, 687 usefulness of theory of, 352 strategic moves, 400
Market signaling, 623-625, 687 Monopolistic exploitation, 485, 683 strategies, 390
Market supply, 29-31 Monopoly: threats, 400
elasticity of, 272 barriers to entry and, 306-308 tit-for-tat, 399, 692
Market supply curve, 29-31 bilateral, 499-500, 679 National Association of Broadcasters,
defined, 687 definition and sources of, 306-308 Boll
for an input, 461-462 divestiture of, 423-424 National income, aggregate level of,
of labor, 456-458 inventions and, 338-340 516
market period, 264 legality of, 422-423 Natural monopoly:
See also Supply curve multiplant, profit maximization by, defined, 308, 688
Market supply schedule, 29 323-325 public utility as, 425-427
Marketing research approaches to natural, 308, 688 Necessity, 688
demand estimation, 148—150, price and output in, 312-314, 319-321 Net present value (NPV):
687 price discrimination by, 326-331 defined, 522-527, 688
Markup, 371, 687 profit maximization by, 316-318, derivation of formula for, 523
Matrix, payoff, 159, 390, 689 319-321 for multiperiod case, 524-526
Maximum social welfare, 573-574, 687 pure, 306, 690 for two-period case, 523-524
Medallions, taxi, 320-321, 361 regulation of, 422-423, 425-428 Net private domestic investment, 522
Medicare and Medicaid, 626-627 social costs of, 321—322, 420-422 Neuter, 66, 688
moral hazard and, 626-627 welfare effects of, 321-322 New York Stock Market, 263-264
Mergers, 422-423 Monopoly power: Nominal rate of interest, 528-529,
Methodology of economics, 18-19, 687 antitrust laws and, 422-423 688
Microeconomic theory, 3-4, 7 experimental economics and, Nonclearing markets theory, 47-48,
defined, 687 418-420 688
financial, 509-510 Herfindahl index of, 415-416, 684 Noncompeting groups, 474, 688
international framework of, 16-18 Lerner index of, 414-415, 686 Nonexclusion, 592, 688
margin concept in, 12-13 measurement of, 414-417 Nonexhaustible resources:
models and methodology in, 18-19 social costs and dynamic benefits defined, 542
Micromarketing, 149, 687 of, 420-422 management of, 543-545
Minimum efficient scale, 687 theory of contestable markets and, Nonprice competition, 367-368, 688
Minimum wages, 473-477 3)5)9), (2 Nonrival consumption, 592, 688
704 Subject Index

Paasche price index, 117, 688 Planned economies, | 1

Nonzero-sum game, 391, 688
Normal good, 91-93, 688 Pareto criterion, 577, 688 Planned-Programming-Budgeting
Normative analysis, 19-20, 688 Pareto optimum: System, 599
defined, 15, 689 Planning horizon, 243, 689
Occupational licensing, 490 marginal conditions for economic Players, 390, 689
Oil industry, 361 efficiency and, 563-565 Point elasticity of demand, 129
Alaskan shale oil project and, 361 meaning of welfare economics and, Point elasticity of supply, 640
cartels in, 361-363 570-571 Politicians, public-choice theory and,
price leadership in, 364-366 Partial equilibrium analysis: 600-602
Oligopoly, 352-355, 688 defined, 552-553, 689 Pollution, environmental, 606
Cournot model of, 363-365 general equilibrium analysis Portfolio, choosing a, 175-176
defined, 355-357 versus, 552-555 Positive economics, 19-20, 689
differentiated, 353 Patents, 306, 596 Predatory dumping, 332
distinguishing characteristic of, 353 Payoff, 390, 689 Preferences, consumer. See
efficiency implications of, 413 Payoff matrix, 159, 390, 689 Consumers, tastes and
game theory and, 389-408 Peak-load pricing, 435-437 preferences of
global, 376-380 defined, 436, 689 Price:
kinked-demand curve mode! of, regulation and, 435-437 changes in, 73, 94-97
358-359 Per-unit costs, 229-234 equilibrium, 31
long-run adjustments of, 366-367 Per-unit excise tax, 336-337 of exhaustible resources, 542-543
market-sharing cartel and, 362—364 Perfect competition, 261—294 forward or futures, 535
nonprice competition of, 367-368 constant cost industries in, 281—282 function of, 9-10
price and output of, 352-380 consumer and producer surplus hedonic, 68
pure, 352 and, 286-290 marginal revenue and price
sources of, 353 decreasing cost industries in, elasticity of demand and,
Stackelberg model of, 386-388 283-284 145-148
welfare effects of, 368-369 defined, 262 of medical services, 461-462
Oligopsony, 489, 688 demand curve in, 263 relative, 99
Open innovation model, 212 efficiency and, 565-566 searching for lowest, 617-618
Opportunity (alternative) cost doctrine, increasing cost industries in, 282—283 short-run equilibrium, 264-265,
226 input price and employment under, 312-319
Optimal pollution control, 606-607 445-477 spot, 691
Optimization, consumer, 75 long-run equilibrium in, 277—281 of a stock, 263-264
Optimum, Pareto, 563-565, 570-571 as market structure, 262—264 of water, economic efficiency and,
Options, 535-536 and optimal input employment, 567-568
Ordinal utility, 60, 688 446-448 Price ceilings, 40
Organization of Petroleum Exporting price and output under, 264-270 black markets and, 42
Countries (OPEC), 361 price determination in market or rent, 40-42
Output: period and, 264-271 Price constraints, 70-73
aggregate level of, 7 profit maximization in, 270-271 Price-consumption curve, 94-97, 689
inputs related to, 192-198, 219-224 short-run equilibrium in, 265-271, defined, 94
in monopolistic competition, 276-277 derivation of individual’s demand
347-351 short-run supply curve in, 271 curve and, 94—96
in monopoly, 303-341 stock market as example of, 263-264 price elasticity of demand and, 94-97
in oligopoly, 352-380 supply curve in, 271-276 Price controls, 40
in perfect competition, 261-301 Perfect knowledge, 262 welfare effects of, 40-44
profit-maximizing level of, Perfect price discrimination, 326 Price determination:
270-281, 312-320 Perfect substitutes, 66 of commodities, 9-10, 643
short-run equilibrium, 265-277, Perfectly competitive market, 26, 689 of inputs, 9-10, 443-477
312-319 Persistent dumping, 331-333 in market period, 264-265
Output elasticity: Personal disposable income, 516 in monopolistic competition,
of capital, 220, 688 Petroleum. See Oil industry 347-352
of labor, 220, 688 Pharmaceutical industry, 380 in monopsony, 493-494
Overtime pay: Physicians: in oligopoly, 352-380
defined, 472, 688 supply curve for services of, in perfect competition, 264-301,
and supply of labor, 472 461-462 443-477
 Subject Index 705

Price discrimination, 326-333, 338, Product innovation, 210, 690 Property:

643-644 Product variation, 349-351 common, 590
defined, 326, 689 Production, 190 rights in, 590-591
in electrical rates, 330-331 contract curve for, 559 Protection, of industry, 580-581
existence of an industry and, 338 costs of, 225—260. See also Costs Public-choice theory, 600-603
first degree (perfect), 326 defined, 190, 690 bureaucrats and, 602
international, 331-333 economic region of, on isoquant, defined, 600
intertemporal, 435 203-204 meaning and importance of, 600
second degree (multipart), 328, 691 Edgeworth box diagram for, policy implications of, 602-603
third degree, 328-331 557-558 politicians and, 601
Price elasticity of demand, 129-135, elasticity of substitution of inputs special-interest groups and,
639 in, 259 601-602
arc, 129, 639 external economies and voters and, 600-601
defined, 129, 689 diseconomies of, 587 Public goods, 592-595
determinants of, 132-133 in free-enterprise system, 6-7 defined, 592
for exports, 140-142 general equilibrium of, 557-561 distinguishing characteristic of, 592
formula for, 639 international specialization in, free-rider problem and, 595
graphic measurement of, 131 251-253, 466-467 nonexclusion of, 592
for imports, 140-142 law of diminishing returns and, nonrival consumption of, 592
for an input, 454-456 196-197 provision of, 595
importance of, in economic long-run (Cobb-Douglas production Public utilities:
decisions, 132-133 function), 219-224 as natural monopolies, 425—427
marginal revenue and, 145-148 new revolution in. See Computer- regulation of, 425-428
marginal revenue and price and, aided design; Computer-aided Pure monopoly, 306, 690. See also
145-148 manufacturing Monopoly
price-consumption curve and, 94-97 organization of, 190-191 Pure oligopoly, 352, 690. See also
for selected commodities, 134 relationship of outputs to inputs Oligopoly
total expenditures and, 131-132 and, 189-198
Price elasticity of supply, 272, 640 substitution of inputs in, to Quasi-rent, 470, 690
defined, 272, 689 minimize costs, 256-259
formula for, 273, 640 technological progress and, 210 Railroad Revitalization and
Price floor, 42, 689 variable inputs and, 192 Regulatory Reform Act of 1976,
Price index: Production function, 192-198 429
consumer (CPI), 120-121, 529-530 Cobb-Douglas, 219-224 Rates:
Laspeyres, 118 defined, 192 for electricity, 330-331
Paasche, 117 fixed-proportions, 204—205 forward or futures, 535
Price leadership, 364-366, 689 Production-possibilities frontier of interest. See Interest rates of
Price supports, 42-44 (curve): return, 531-536
Price system, 6 defined, 517, 559, 690 spot, 691
Price taker, 263 derivation of, 559-561 Rate case, 427
Price theory, 10 scarcity and, 4-5 Ratio, concentration, 354, 680
Pricing: Production theory, 187-302 Rational consumer, 75, 690
cost-plus, 371-372 Profit: Rational ignorance, 601
limit, 370-37 1 entrepreneurship and, 191 Rationing:
peak-load, 435-437 maximization of. See Profit defined, 78-79, 690
transfer, 437-439 maximization of hospital care, 571
Principal-agent problem, 628-630 Profit maximization, 270-271, over time, 7, 690
Prisoners’ dilemma, 395-399, 689 316-320, 347-351, 446-448, water, 78-79
Private costs, 226, 689 642-643 Reaction function, 384, 690
Probability, 161 in monopolistic competition, Real rate of interest, 529
Probability distribution, 161-162 347-352 Regression analysis, 153-155
Process innovation, 210, 690 in monopoly, 316-320 Regulation:
Producer surplus, 286-288 in monopsony, 490-495 of monopoly, 422-427, 434-439
Product cycle models, 213-214 in oligopoly, 352-380 of monopsony, 498-499
in perfect competition, 270-271, peak-load pricing and, 435-437
Product differentiation, 263, 346, 681
Product group, 347, 690 446-448 transfer pricing and, 437-439
706 Subject Index

Regulatory lag, 427 Short run: Substitutes, 66

Relative commodity price, 94-97 average costs in, 229-234 defined, 66, 691
Relative price, 99, 690 average total costs in, 229-234 perfect, 66
average variable costs in, 229-231, Substitution effect, 97-104
Rent, 468
economic, 468—469 316-318 changes in wage rate and, 470-472
Rent control, 40-42 cost minimization in, 237—239 cost minimization and, 256
Repeated games, 399 defined, 192, 691 defined, 99, 691
Research, government support of, marginal costs in, 229-234, between domestic and foreign
589-590 266-270, 268-270, 318-319 goods, 104-106
Resources: marginal revenue in, 266-270 elasticity of, 258-259
defined, 4, 542-543 price and output decisions in, income effect and, 97-104
economic, 4, 682 264-277, 312-319 for inferior goods, 101-104
exhaustible, 542 theory of cost in, 228-234 Supersonic transport (SST),
free, 4 total costs in, 228-234 benefit-cost analysis of, 599-600
mobile, in perfect competition, 262 total revenue in, 266, 267, Supply:
nonexhaustible, 542 312-314 adjustment to changes in, 34-37
Restraints, voluntary export (VER), total variable costs in, 230 changes in, 30-31
432-434, 693 — Short-run equilibrium: domestic, 37-39
Returns to scale: in monopolistic competition, elasticity of. See Elasticity of supply
diminishing, in U.S. manufacturing. 347-352 excess, 38
See Law of diminishing returns in monopoly, 312-319, 323-324 imports and, 37-39
Revealed preference. See Theory of in oligopoly, 355-363 market, 29-31
revealed preference in perfect competition, 265—277 short-run marginal costs and,
Revenue: Shortage: 271-274
average, 142—147 defined, 32, 691 Supply curve:
marginal, 142-147 of engineers, 486-487 changes in, 30-31
total, 142-147 Shutdown point, 271, 691 industry, 272
Ridge lines, 203, 690 Slutsky equation, 639 of an input, 456-462
Risk: Snob effect, 126, 691 of labor, 456-458
consumer choice and, 158-186 Social costs: long-run, 277-281
default, 527 defined, 226, 691 market, 29-31
variability, 527-528 of monopoly, 321-322, 420-422 for physicians’ services, 461-462
Risk averter, 165 Social policy criteria, 575-578 shifts in, 30-31
Risk neutral, 165 Social Security, 626 short-run, 271-274
Risk Seeker, 165 disability benefits under, 626 Surplus:
Social welfare function. See Bergston consumer, 108-110, 638, 680
Salaries. See Wages social welfare function defined, 31, 691
Saturation point, 58 Special-interest groups, public choice producer, 286-288
Saving: theory and, 601 Swaps, 535-536
business, 522 Specialization, 691 Synthetic Fuel Corp., 273-274
defined, 691 Speculator, 691
interest rate and, 520-521 Speed limit: Tariff, import, 290-291. See also
investment and, 517—522 and cost of trip, 205-206 Industry, protection of
personal, 522 gasoline consumption and, Tastes, consumer. See Consumers,
Scale, 206 205-206 tastes and preferences of
Scitovsky criterion, 576, 691 Sporadic dumping, 332 Tax:
Search costs, 616, 691 Spot market, 691 excise, 289-290
Search goods, 618, 691 Spot price of rate, 691 incidence of the, 44
Second degree price discrimination, Spot transactions, 691 per-unit, 336-337
388, 691 Stackelberg model, 386-388, 691 price elasticity of demand and,
Second theorem of welfare Standard deviation, 162-163 44-46
economics, 566, 691 Standard of living, 118 Taxi industry, monopoly profits in,
Selling expenses, 349-351, 691 Stock market, 263-264 320-321
Separation theorem, 524, 691 Strategic trade policy, 604—605 Technical coefficient, 219
Sherman Antitrust Act of 1890, 422. Strategic moves, 400 Technical externalities, 587,692
691 Strategies, 390 Technological progress, 210-211, 692
 Subject Index 707

Technology, 210-211 Transfer pricing: education and, 526-527

Textile industry, 280-281 defined, 437, 692 effect of immigration on, 495-498
Theory of contestable markets: regulation and, 437-439 effect of labor unions on, 501—502
defined, 355, 692 Transformation curve. See equalization of, 465-468
monopoly power and, 417-418 Production-possibilities frontier equilibrium rate for, 463
Theory of public choice. See Public- Two-part tariff, 333-334 of executives, 494-495
choice theory Tying, 335 imperfect labor market competition
Theory of revealed preference, 81-83 and, 474
Thermal pollution, 606 Unemployment gap, 475 minimum, 474-476
Third degree price discrimination, Unitary elastic demand curve, 133 substitution and income effects of
328-331 United States International Trade changes in, 459-460
Threats, 400 Commission (USITC), 433 Wal-Mart, 402-403
Time: Util, 58, 692 Walras general equilibrium model,
as economic good, 74 Utility, 58-61 SPs
Time budget line, 692 cardinal, 60 Wants, human. See Human wants
Tit-for-tat, 399, 691 defined, 58, 692 Warnings, government, 76-77
Total costs, 228-229, 312-314 marginal, 58-60 Water-diamond paradox, 109, 693
average, 230-231 ordinal, 60 Water pollution, 606
defined, 228-229, 692 total, 58-60 Water pricing, 567-568
long-run, 234-235 Utility maximization, 75-81, 638 Water rationing, 78-79
short-run, 228-234, 312-317 constrained, 75 Wealth, of individual, 693
Total expenditures, 131-132 defined, 75-76 Welfare economics, 570
Total fixed costs, 228-230, 692 marginal utility approach to, 80-81 applications of, 570-571
Total product, 192-194, 256 Utility-possibilities frontier, 572-575 Arrow’s impossibility theorem
defined, 192, 692 defined, 572, 692 and, 577-578
derivation of, from isoquant map, grand, 573-575 defined, 570, 693
of labor, 199-201 general concept of, 570-578
total variable costs curve derived Value of marginal product, 448-450, maximum social welfare and,
from, 256 692 570-575
Total revenue, 142-145, 266, Variable costs: social policy criteria and,
312-314, 642, 692 average, 229 575-577
Total utility, 58—60, 692 total, 228 social welfare function and,
Total variable costs, 256, 316-317, Variable inputs, 192, 692 S77
692 production with one, 192-198 trade protection and, 580-582
Trade: production with two, 198-201 triangle, 322
free, 604 Variability risk, 527-528 utility-possibilities frontiers and,
strategic policy for, 604-605 Veblen effect, 126, 692 572-573
See also International competition; Virtual corporation, 692 Welfare effects:
International trade Voluntary export restraints (VER), of excise tax, 289-290
Trade Expansion Act of 1962, 575 432-434 of monopoly, 321-322
Trade protection: defined, 432, 692 of monopsony, 490-491
pressure-group theory of, 580 on Japanese automobiles, 433-434 of oligopoly, 368-369
welfare economics and, 580-582 Voters: of price controls, 40-42
See also Import tariffs public-choice theory and, 600 Welfare triangle, 322
Transaction costs, 591 rational ignorance theory and, 601 What to produce, 6, 693
Transactions: Winner’s curse, 693
forward or futures, 535 Wages:
spot, 691 differences in, 465, 473-474 Zero-sum game, 390, 693
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 ions presents all the standard
i Fur revised and expanded, thisfifthedition of Microeconomics: Theory and Applicat
a modern approac h that reflects the many exciting recent
" topics of traditional microeconomic theory while offering this is an ideal.text
and clear presenta tion of graphs,
developments in the field. With its studentfriendly writing style
busines s program s. é
for undergraduate courses in intermediate microeconomics and
ee e FEATURES OF THE FIFTH EDITION
and concerns
© Offers a balance of traditional microeconomic topics while addressing contemporary issues
globalization -
e Introduces an important international diménsion to microeconomics, reflecting the strong trend toward
in tastes, production, and distributionintoday’s world a
of more
© Presents an “at the Frontier” section in each chapter that highlights the most exciting recent examples
advanced theoretical developments in microecono mics .

NEW AND EXPANDED TREATMENT IN THE FIFTH EDITION

“e Includes electronic commerce, behavioral economics, auctioning airwaves, effect of outsourcing on employment and
wages in the United States, fields of education and lifetime earnings, effect of taxation on business decisions
© Provides more than 140 new and updated real-world examples of how microeconomic theory can be used to
analyze and possibly resolve important present-day economic problems
© Offers expanded treatment of important topics such as game theory; financial microeconomics; the new international
~ economies of scale; economics of information; and market structure, efficiency, and regulation
© Features Internet site addresses for the most important topics in each chapter

WEBSITE
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PRAISE FOR MICROECONOMICS, FOURTH EDITION

“Microeconomics is an excellent text . . . Sal atore has done a great job integrating the more traditional with the
‘newer’ topics in the field.” —Rosemary Thomas Cunningham, Agnes Scott College
f

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full of very appropriate applications.” —K. Choudhury, Southern University

, Pee
|

ICR OECNMIKs. eee

=
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Dominick Salvatore is Distinguished Proféuuns a SALUT 3:THEORY PLICATIONS (CL) re we |
the Shanghai Finance University.He is Chaim oTH :
7,
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World Bank, and the Economic Policy Ing ae—

Outline of Microeconomic Theory, Fourtliaes

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one-half million copies. “Ty

Cover design: Eve Siegel : at. ciel

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