(BQ) Part 1 book Principles of microeconomics has contents: The central idea, observing and explaining the economy, the supply and demand model, the demand curve and the behavior of consumers, the supply curve and the behavior of firms, the interaction of people in markets,...and other contents.
Principles of Microeconomics About the Authors John B Taylor is one of the field’s most inspiring teachers As the Raymond Professor of Economics at Stanford University, his distinctive instructional methods have made him a legend among introductory economics students and have won him both the Hoagland and Rhodes prizes for teaching excellence Professor Taylor is also widely recognized for his research on the foundations of modern monetary theory and policy One of his well-known research contributions is a rule—now widely called the Taylor Rule—used at central banks around the world Taylor has had an active career in public service, recently completing a four-year stint as the head of the International Affairs division at the United States Treasury, where he had responsibility for currency policy, international debt, and oversight of the International Monetary Fund and the World Bank and worked closely with leaders and policymakers from countries throughout the world He has also served as economic adviser to the governor of California, to the U.S Congressional Budget Office, and to the President of the United States and has served on several boards and as a consultant to private industry Professor Taylor began his career at Princeton, where he graduated with highest honors in economics He then received his Ph.D from Stanford and taught at Columbia, Yale, and Princeton before returning to Stanford Akila Weerapana is an Associate Professor of Economics at Wellesley College He was born and raised in Sri Lanka and came to the United States to his undergraduate work at Oberlin College, where he earned a B.A with highest honors in Economics and Computer Science in 1994 He received his Ph.D in Economics from Stanford in 1999, writing his dissertation on monetary economics under the mentorship of John Taylor Since then, Professor Weerapana has taught in the Economics Department at Wellesley College His teaching interests span all levels of the department’s curriculum, including introductory and intermediate macroeconomics, international finance, monetary economics, and mathematical economics He was awarded Wellesley’s Pinanski Prize for Excellence in Teaching in 2002 He also enjoys working with thesis students, advising projects ranging from a study of the economic benefits of eradication of river blindness in Ghana to an analysis of the determinants of enterprise performance in Russia In addition to teaching, Professor Weerapana has research interests in macroeconomics, specifically in the areas of monetary economics, international finance, and political economy Principles of Microeconomics Global Financial Crisis Edition JOHN B TAYLOR AKILA WEERAPANA Cengage Learning Principles of Microeconomics Global Financial Crisis Edition Taylor, Weerapana Vice President of Editorial, Business: Jack W Calhoun Editor-in-Chief: Alex von Rosenberg Executive Editor: Mike Worls Developmental Editor: Henry Cheek Editorial Assistant: Lena Mortis Sr Marketing Manager: John Carey Associate Marketing Manager: Betty Jung Marketing Coordinator: Suellen Ruttkay Sr Marketing Communications Manager: Sara Greber Sr Content Project Manager: Cliff Kallemeyn Media Editor: Deepak Kumar Sr First Print Buyer: Sandee Milewski © 2010 South-Western, Cengage Learning ALL RIGHTS RESERVED No part of this work covered by the copyright hereon may be reproduced or used in any form or by any means— graphic, electronic, or mechanical, including photocopying, recording, taping, Web distribution, information storage and retrieval systems, or in any other manner—except as may be permitted by the license terms herein For product information and technology assistance, contact us at Cengage Learning Customer & Sales Support, 1-800-354-9706 For permission to use material from this text or product, submit all requests online at www.cengage.com/permissions Further permissions questions can be emailed to permissionrequest@cengage.com Exam View® is a registered trademark of eInstruction Corp Windows is a registered trademark of the Microsoft Corporation used herein under license Macintosh and Power Macintosh are registered trademarks of Apple Computer, Inc used herein under license © 2010 Cengage Learning All Rights Reserved Sr Art Director: Michelle Kunkler Cover Image: © Harold Burch, New York City; © Stockbyte Permissions Manager: Katie Huha Library of Congress Control Number: 2009927980 ISBN-13: 978-1-4390-7821-1 ISBN-10: 1-4390-7821-1 Permissions Reseacher: Karyn Morrison Sr Photo Editor: Jennifer Meyer Dare Photo Researcher: Lisa Jelly Smith Production and Composition: S4 Carlisle South-Western Cengage Learning 5191 Natorp Boulevard Mason, OH 45040 USA Cover Designer: Rokusek Design Cengage Learning products are represented in Canada by Nelson Education, Ltd For your course and learning solutions, visit www.cengage.com Purchase any of our products at your local college store or at our preferred online store www.ichapters.com Printed in the United States of America 13 12 11 10 09 Brief Contents Principles of Economics Chapter Number Chapter Title PART 1 2A The Central Idea Observing and Explaining the Economy APPENDIX to Chapter 2: Reading, Understanding, and Creating Graphs The Supply and Demand Model Subtleties of the Supply and Demand Model: Price Floors, Price Ceilings, and Elasticity PART 5A The Economics of the Firm Costs and the Changes at Firms over Time APPENDIX to Chapter 8: Producer Theory with Isoquants The Rise and Fall of Industries Monopoly Product Differentiation, Monopolistic Competition, and Oligopoly Antitrust Policy and Regulation PART 13 14 15 16 16A Principles of Microeconomics The Demand Curve and the Behavior of Consumers APPENDIX to Chapter 5: Consumer Theory with Indifference Curves The Supply Curve and the Behavior of Firms The Interaction of People in Markets PART 8A 10 11 12 Introduction to Economics Markets, Income Distribution, and Public Goods Labor Markets Taxes,Transfers, and Income Distribution Public Goods, Externalities, and Government Behavior Capital and Financial Markets APPENDIX to Chapter 16: Present Discounted Value Principles of Principles of Microeconomics Macroeconomics Chapter Number Chapter Number PART PART 1 2A 2A PART 5A PART 8A 10 11 12 PART 13 14 15 16 16A 16: Financial Markets 16A v vi Brief Contents Economics Chapter Number Chapter Title Principles of Principles of Microeconomics Macroeconomics Chapter Number PART Principles of Macroeconomics 17 17A 18 19 20 21 21A 22 23 23A 24 25 26 27 5A 9A 10 Economic Fluctuations and Macroeconomic Policy PART The Nature and Causes of Economic Fluctuations APPENDIX to Chapter 23: Deriving the Formula for the Keynesian Multiplier and the Forward Looking Consumption Model The Economic Fluctuations Model Using the Economic Fluctuations Model Fiscal Policy Monetary Policy and the Financial Crisis PART 28 29 30 PART Macroeconomics: The Big Picture APPENDIX to Chapter 17: The Miracle of Compound Growth Measuring the Production, Income, and Spending of Nations The Spending Allocation Model Unemployment and Employment Productivity and Economic Growth APPENDIX to Chapter 21: Deriving the Growth Accounting Formula Money and Inflation PART Trade and Global Markets Economic Growth and Globalization The Gains from International Trade International Trade Policy Chapter Number 11 11A 12 13 14 15 PART PART 17 18 17 18 19 Contents Preface xvii PA R T C HAPTER Introduction to Economics The Central Idea Scarcity and Choice for Individuals Consumer Decisions 4 Opportunity Cost ■ Gains from Trade: A Better Allocation Producer Decisions Gains from Trade: Greater Production ■ Specialization, Division of Labor, and Comparative Advantage International Trade Scarcity and Choice for the Economy as a Whole Production Possibilities Increasing Opportunity Costs The Production Possibilities Curve 11 Inefficient, Efficient, or Impossible? 11 ■ Shifts in the Production Possibilities Curve 11 ■ Scarcity, Choice, and Economic Progress 13 Market Economies and the Price System Key Elements of a Market Economy 15 13 Freely Determined Prices 15 ■ Property Rights and Incentives 15 ■ Freedom to Trade at Home and Abroad 15 ■ A Role for Government 15 ■ The Role of Private Organizations 16 The Price System 16 Signals 16 ■ Incentives 17 ■ Distribution 17 Financial Crises and Recessions 17 Conclusion 20 Key Points 21 ■ Key Terms 21 Review 21 ■ Problems 22 ■ Questions for ECONOMICS IN ACTION: GAINS FROM TRADE ON THE INTERNET ECONOMICS IN ACTION: THE BOOM IN COMMUNITY COLLEGE ENROLLMENTS AND THE ECONOMIC DOWNTURN ECONOMICS IN THE NEWS: FINANCIAL CRISIS GENERATES HEATED DEBATE ABOUT THE ROLE OF GOVERNMENT IN THE ECONOMY 18 C HAPTER Observing and Explaining the Economy What Do Economists Do? 25 Understanding Fluctuations in the Price of Gasoline 26 Description 27 Data Limitations 28 Explaining an Economic Event 29 Correlation versus Causation 30 ■ The Lack of Controlled Experiments in Economics 30 Predicting the Impact of Future Changes 32 Economic Models 32 ■ Microeconomic versus Macroeconomic Models 32 ■ An Example: A Model with Two Variables 33 The Ceteris Paribus Assumption 35 ■ 24 The Use of Existing Models 35 The Development of New Models 35 Recommending Appropriate Policies 36 Positive versus Normative Economics 36 Economics as a Science versus a Partisan Policy Tool 36 Economics Is Not the Only Factor in Policy Issues 40 Disagreement Between Economists 40 Conclusion: A Reader’s Guide 40 ■ Key Terms 42 ■ Questions for ■ Problems 42 Key Points 41 Review 42 ECONOMICS IN ACTION: AN ECONOMIC EXPERIMENT TO STUDY DISCRIMINATION 31 vii viii Contents Scatter Plots 47 Pie Charts 47 ECONOMICS IN ACTION: THE PRESIDENT’S COUNCIL OF ECONOMIC ADVISERS IN ACTION 37 ECONOMICS IN THE NEWS: YOUNG ECONOMISTS AT WORK 38 APPENDIX TO CHAPTER Reading, Understanding, and Creating Graphs Visualizing Observations with Graphs Time-Series Graphs 44 44 Time-Series Graphs Showing Two or More Variables C HAPTER Demand 44 Graphs of Models with More Than Two Variables Key Terms and Definitions 50 ■ Questions for Review 50 ■ Problems 50 The Supply and Demand Model 53 60 The Supply Curve 60 Shifts in Supply 61 Technology 62 ■ Weather Conditions 63 ■ The Price of Inputs Used in Production 63 ■ The Number of Firms in the Market 63 ■ Expectations of Future Prices 63 ■ Government Taxes, Subsidies, and Regulations 63 Movements Along versus Shifts of the Supply Curve 64 C HAPTER 48 49 46 The Demand Curve 54 Shifts in Demand 54 Consumers’ Preferences 56 ■ Consumers’ Information 56 ■ Consumers’ Incomes 57 ■ Number of Consumers in the Market 57 ■ Consumers’ Expectations of Future Prices 57 ■ Prices of Closely Related Goods 57 Movements Along versus Shifts of the Demand Curve 58 Supply Visualizing Models with Graphs Slopes of Curves 48 52 Market Equilibrium: Combining Supply and Demand 65 Determination of the Market Price 66 Finding the Market Price 67 ■ Two Predictions 70 Finding the Equilibrium with a Supply and Demand Diagram 70 Market Outcomes When Supply or Demand Changes 71 Effects of a Change in Demand 71 ■ Effects of a Change in Supply 71 ■ When Both Curves Shift 74 Conclusion 77 Key Points 77 ■ Key Terms 78 Review 78 ■ Problems 78 ■ Questions for ECONOMICS IN THE NEWS: WHY ROSES COST MORE ON VALENTINE’S DAY 68 ECONOMICS IN ACTION: USING THE SUPPLY AND DEMAND MODEL TO ANALYZE REAL-WORLD ISSUES 75 Subtleties of the Supply and Demand Model: Price Floors, Price Ceilings, and Elasticity 80 Interference with Market Prices 81 Price Ceilings and Price Floors 81 Side Effects of Price Ceilings 82 ■ Dealing with Persistent Shortages 82 ■ Making Things Worse 84 Side Effects of Price Floors 84 Dealing with Persistent Surpluses 84 ■ Making Things Worse 84 Elasticity of Demand 86 Defining the Price Elasticity of Demand 86 The Size of the Elasticity: High versus Low 87 The Impact of a Change in Supply on the Price of Oil Working with Demand Elasticities 88 Elasticity of Supply 93 93 The Advantage of a Unit-Free Measure Elasticity versus Slope 94 Calculating the Elasticity with a Midpoint Formula Talking about Elasticities 96 Elastic versus Inelastic Demand 96 ■ Perfectly Elastic versus Perfectly Inelastic Demand 96 Revenue and the Price Elasticity of Demand 97 What Determines the Size of the Price Elasticity of Demand? 100 The Degree of Substitutability 100 ■ Big-Ticket versus Little-Ticket Items 100 ■ Temporary versus Permanent Price Changes 100 ■ Differences in Preferences 100 ■ LongRun versus Short-Run Elasticity 101 Income Elasticity and Cross-Price Elasticity of Demand 101 94 105 Working with Supply Elasticities 106 Perfectly Elastic and Perfectly Inelastic Supply 107 ■ Why the Size of the Price Elasticity of Supply Is Important 107 Contents Conclusion 110 Key Points 110 ■ Key Terms 111 Review 111 ■ Problems 111 ■ Questions for ECONOMICS IN ACTION: HOW POLICYMAKERS USE PRICE ELASTICITY OF DEMAND TO DISCOURAGE UNDERAGE DRINKING 87 PA R T C HAPTER ECONOMICS IN THE NEWS: INCREASING SCHOOL ENROLLMENT IN AFRICA 90 ECONOMICS IN ACTION: PREDICTING THE SIZE OF A PRICE INCREASE 92 ECONOMICS IN ACTION: WILL AN INCREASE IN THE MINIMUM WAGE BENEFIT POOR WORKERS? 103 Principles of Microeconomics 115 The Demand Curve and the Behavior of Consumers Utility and Consumer Preferences 117 A Consumer’s Utility Depends on the Consumption of Goods 118 Important Properties of Utility 119 116 ECONOMICS IN ACTION: PEERING DEEPER INTO HOW INDIVIDUALS MAKE DECISIONS 124 ECONOMICS IN THE NEWS: CREATING CONSUMER SURPLUS FOR THE POOR 134 The Budget Constraint and Utility Maximization 121 The Budget Constraint 121 ECONOMICS IN ACTION: BUILDING ROADS AND BRIDGES WITH CONSUMER SURPLUS 136 Maximizing Utility Subject to the Budget Constraint 122 Deriving the Individual’s Demand Curve 123 Effect of a Change in Income: A Shift in the Demand Curve 124 ■ Income and Substitution Effects of a Price Change 126 Consumer Theory with Indifference Curves Willingness to Pay and the Demand Curve 127 Measuring Willingness to Pay and Marginal Benefit 127 Graphical Derivation of the Individual Demand Curve 128 The Price Equals Marginal Benefit Rule 130 The Market Demand Curve Different Types of Individuals Consumer Surplus 131 132 133 Conclusion 137 Key Points 138 ■ Key Terms 138 Review 139 ■ Problems 139 C HAPTER ■ The Budget Line 150 The Firm’s Profits 152 153 141 141 The Indifference Curve 142 Getting to the Highest Indifference Curve Given the Budget Line 143 The Utility-Maximizing Rule 143 Effect of a Price Change on the Quantity Demanded 144 Effect of an Income Change on Demand 144 Graphical Illustration of the Income Effect and the Substitution Effect 144 Key Points 145 ■ Key Terms and Definitions 145 ■ Questions for Review 146 ■ Problems 146 Questions for Your Own Firm: A Pumpkin Patch 150 Your Firm as a Price-Taker in a Competitive Market 150 Other Types of Markets 152 Total Revenue APPENDIX TO CHAPTER The Supply Curve and the Behavior of Firms Definition of a Firm ix 148 Production and Costs 153 The Time Period 154 ■ The Production Function 154 ■ Costs 155 ■ Graphical Representation of Total Costs and Marginal Cost 157 Profit Maximization and the Individual Firm’s Supply Curve 158 An Initial Approach to Derive the Supply Curve 159 A Profit Table 159 ■ A Profit Graph 160 188 CHAPTER The Interaction of People in Markets Efficiency and Income Inequality income inequality: disparity in levels of income among individuals in the economy REVIEW Efficiency is a very important goal of an economic system, but it is not the only goal Another goal is to avoid outcomes where a few people earn most of the income and most of the consumption in the economy while the rest of the population falls into dire economic circumstances Thus, reducing income inequality is also a desirable goal in most economic systems It is important to emphasize that efficiency and income equality are not the same thing An allocation of bread between Hugo and Mimi is efficient if their marginal benefit of bread is the same and if the marginal benefits equal the marginal cost of bread Then there is no mutually advantageous trade of bread between Hugo and Mimi that will make one better off without hurting the other However, suppose that Hugo has a low income, earning only $7,000 per year, and that Mimi has a high income, earning $70,000 per year Suppose a severe drought raises the price of wheat and thus the price of bread If the price of bread in the market gets very high, say, $3 a loaf, then Hugo will be able to buy few loaves of bread and may go hungry, especially if he has a family In this case, the economy gets good marks on efficiency grounds but fails on income inequality grounds To remedy the situation, a common suggestion is to put price controls on bread For example, to help Hugo and others like him, a law might be passed requiring that bread prices not exceed $.50 a loaf Although this may help the income inequality problem, it will cause inefficiency because it interferes with the market At $.50 a loaf, bread producers will not produce very much, and Mimi will probably start buying bread to feed the birds, wasting scarce resources The temptation to deal with income inequality problems in ways that interfere with the efficiency of the market is great in all societies Price ceilings (rent controls) on rental apartments in some U.S cities, which we examined in Chapter 4, are one example A better solution to the income inequality problem is to transfer income to Hugo and other low-income people from Mimi and other high-income people With a transfer of income—say, through an income-support payment to the poor—the market would be able to function and the inefficiencies caused by price controls on bread would not occur Even at the high price of bread, Hugo will be able to eat, perhaps buying some rice or a bread substitute, and the bread, which is so expensive to produce, will not be wasted on the birds We will see that such transfers have advantages and disadvantages Compared to price controls, their main advantage is that they allow the market to operate efficiently On the other hand, such transfer programs will typically have to be financed through taxes, which are often going to create inefficiencies themselves, as you will see in one of the sections that follows • Economic inefficiency implies a waste of resources A Pareto efficient outcome is one in which no person’s situation can be improved without hurting someone else • There are three conditions that must hold if an outcome is to be Pareto efficient These conditions are that (1) the marginal benefit of the last item produced must equal its marginal cost, (2) the marginal cost of production for all producers must be identical, and (3) the marginal benefit for all consumers must be identical • If marginal benefit exceeds marginal cost, then too little of the good is being produced, whereas if marginal cost exceeds marginal benefit, too much of the good is being produced In both cases, adjusting the quantity being produced would enhance efficiency Measuring Waste from Inefficiency 189 • If the marginal costs of producers were not identical, then it would be possible to increase production without increasing costs, simply by making the producer with the high marginal cost produce less and the producer with the low marginal cost produce more • Finally, if marginal benefits are not identical, then having the person with the high marginal benefit buy the item from the person with the low marginal benefit for a price that is in between the two marginal benefits would enhance efficiency by making both parties better off • One of the most desirable features of competitive markets is that at the equilibrium level of production, on the demand curve, marginal benefit equals the market price, while on the supply curve, marginal cost equals the market price Together these imply that marginal benefit equals marginal cost • Similarly, since all consumers and all firms face the same market price, the marginal benefits of each consumer will be identical (and equal to the market price), as will the marginal costs of each individual producer • Thus competitive markets are efficient Any change in consumption or production that makes one person better off must make someone else worse off • Efficiency is not the same thing as equality An efficient outcome can coexist with an unequal outcome • Attempts to remedy an unequal situation by the use of price ceilings or by rationing lead to inefficiencies in production and consumption It may be better to redistribute resources from the more affluent to the less well off MEASURING WASTE FROM INEFFICIENCY We know from Chapters and that consumer surplus and producer surplus are measures of how much consumers and producers gain from buying and selling in a market The larger these two surpluses are, the better off people are Maximizing the Sum of Producer Plus Consumer Surplus An attractive feature of competitive markets is that they maximize the sum of consumer and producer surplus Producer and consumer surplus are shown in the market supply and market demand diagram in Figure Recall that the producer surplus for all producers is the area above the supply curve and below the market price line, and that the consumer surplus for all consumers is the area below the demand curve and above the market price line Both the consumer surplus and the producer surplus are shown in Figure The lightly shaded gray area is the sum of consumer surplus plus producer surplus The equilibrium quantity is at the intersection of the two curves Deadweight Loss We can show that at the equilibrium price and quantity, consumer surplus plus producer surplus is maximized Figure also shows what happens to consumer surplus plus producer surplus when the efficient level of production does not occur The middle panel of Figure shows what the sum of consumer surplus and producer surplus is at market equilibrium The top panel of Figure shows a situation in which the quantity produced is lower than the market equilibrium quantity Clearly, the 190 CHAPTER The Interaction of People in Markets PRICE Supply Deadweight loss: area A + B A B Market price Another way to think about the lightly shaded areas in the graphs: The sum of consumer surplus plus producer surplus is the triangular area between the demand curve and the supply curve— shown by the lightly shaded area in the middle graph of Figure The graph shows another way to think about this sum: The sum of consumer surplus plus producer surplus equals the marginal benefit minus the marginal cost of all the items produced Demand QUANTITY Too little PRICE Supply Market price Demand QUANTITY Efficient PRICE Supply Negative producer surplus: area C C D Market price FIGURE Measuring Economic Loss When production is less or more than the market equilibrium amount, the economic loss is measured by the loss of consumer surplus plus producer surplus In the top diagram, the quantity produced is too small In the bottom diagram, it is too large In the middle diagram, it is efficient Deadweight loss: area C + D Negative consumer surplus: area D Demand QUANTITY Too much The Deadweight Loss from Price Floors and Ceilings deadweight loss: the loss in producer and consumer surplus due to an inefficient level of production REVIEW 191 sum of consumer and producer surplus is lower By producing a smaller quantity, we lose the amount of the consumer and producer surplus in the darkly shaded triangular area A ϩ B The bottom panel of Figure shows the opposite situation, in which the quantity produced is too high In this case, we have to subtract the triangular area C ϩ D from the lightly shaded area on the left because price is greater than marginal benefit and lower than marginal cost, which means that consumer surplus and producer surplus are negative in the area C ϩ D In both the top and bottom panels of the figure, these darkly shaded triangles are a loss to society from producing more or less than the efficient amount Economists call the loss in this darkly shaded area the deadweight loss It is a measure of the waste from inefficient production Deadweight loss is not simply a theoretical curiosity with a morbid name; it is used by economists to measure the size of the waste to society of deviations from the competitive equilibrium By calculating deadweight loss, economists can estimate the benefits and costs of many government programs When you hear or read that the cost of U.S agricultural programs is billions of dollars or that the benefit of a world-trade agreement is trillions of dollars, it is the increase or decrease in deadweight loss that is being referred to In order to compute the deadweight loss, all we need is the demand curve and the supply curve • Consumer surplus and producer surplus are measures of how well off consumers and firms are as a result of buying and selling in the market The larger the sum of these surpluses, the better off consumers and firms (society as a whole) are • Competitive markets maximize producer surplus plus consumer surplus • If the quantity produced is either greater or less than the market equilibrium amount, the sum of consumer surplus plus producer surplus is less than at the market equilibrium The decline in consumer plus producer surplus measures the waste from producing the wrong amount It is called deadweight loss THE DEADWEIGHT LOSS FROM PRICE FLOORS AND CEILINGS In Chapter we used the supply and demand model to examine situations where governments have attempted to control market prices because they were unhappy with the outcome of the market, or because they were pressured by groups who would benefit from price controls We examined two broad types of price controls: price ceilings, which specify a maximum price at which a good can be bought or sold, and price floors, which specify a minimum price at which a good can be bought or sold An example of a price floor was the minimum wage, while an example of a price ceiling was a rent control policy Using the supply and demand model, we were able to illustrate some of the problems that stemmed from the imposition of price floors or ceilings When a price floor that is higher than the equilibrium price is imposed, the result will be persistent surpluses of the good This situation is illustrated by Figure The surpluses imply that an inefficient allocation of resources is going toward the good whose price has been artificially inflated Frequently, costly government programs will be created to buy up surplus production When a price ceiling that is lower than the equilibrium price is imposed on a market, then the result will be persistent shortages of the good These shortages mean that mechanisms like rationing, waiting lines, or black markets will be used to allocate the now scarce good This situation is illustrated by Figure 192 CHAPTER The Interaction of People in Markets Now that we understand the concepts of consumer and producer surplus as well as the idea of deadweight loss, we can use these tools to quantify the negative impacts of price ceilings and price floors PRICE Excess supply Supply Price floor The Deadweight Loss from a Price Floor Competitive price Figure shows how consumer and producer surplus are affected by the imposition of a price floor Prior to the imposition of the price floor, the sum of consumer and producer surplus is given by the area of the triangle ABC, of which the area Demand BCD denotes consumer surplus and the area ACD denotes producer surplus Now consider what happens to consumer surQUANTITY Quantity Quantity plus and producer surplus when a price floor is demanded supplied imposed The impact on producer surplus is ambiguous On the one hand, those producers FIGURE who are fortunate enough to sell at a higher price Price and Quantity Effects of a Price Floor will obtain more producer surplus But because the If the price floor is set higher than the competitive market price, the quantity quantity demanded is lower at the higher price, demanded by consumers decreases and the quantity supplied by firms there will be a loss of producer surplus for those increases, creating excess supply producers who were previously able to sell the good but now have no buyers Producer surplus would be given by the area AEFG, which reflects an increase of DEFI (shown in blue) and a decrease of CGI (shown in shaded green) from the previous level of producer surplus Consumer surplus is unambiguously reduced by the amount CDEF (shown in red) Overall, when we add up the lost consumer and producer surplus and the gained producer surplus, there is a deadweight loss equivalent to the area CFG in Figure PRICE B Lost consumer surplus F Price floor E FIGURE The Deadweight Loss from a Price Floor The price floor creates an excess supply of goods at the new higher price Consumers are unambiguously worse off Producers may be better off or worse off depending on whether they are able to sell at the higher price The sum of consumer and producer surplus is lower, indicating a deadweight loss associated with the floor Competitive price D H A Supply C I G Gain in producer surplus Qd Lost producer surplus Demand Qs QUANTITY The Deadweight Loss from Price Floors and Ceilings 193 The Deadweight Loss from a Price Ceiling PRICE Figure shows how consumer and producer surplus are affected by the imposition of a price Supply ceiling As before, prior to the imposition of the price ceiling, the sum of consumer and producer surplus is given by the area of the triangle ABC, of which the area BCD denotes consumer Competitive surplus and the area ACD denotes producer price surplus Now consider what happens to consumer surplus and producer surplus when a price ceilPrice ceiling ing is imposed The impact on consumer surplus Demand Excess demand is ambiguous: On the one hand, those consumers who are able to acquire the good at the lower price will obtain more consumer surplus But because only a smaller quantity of goods is availQuantity Quantity QUANTITY able for purchase, there will be a loss of consumer supplied demanded surplus for those who were previously able to buy FIGURE the good but now cannot Consumer surplus Price and Quantity Effects of a Price Ceiling would be given by the area BFGH, which reflects If the price ceiling is set below the competitive market price, the quantity an increase of DHGI (shown in blue) and a demanded by consumers increases and the quantity supplied by firms decrease of CFI (shown in red) from the previous decreases, creating excess demand level of consumer surplus Producer surplus is unambiguously reduced by the amount CDHG (shown by the green shaded area) Overall, when we combine the lost consumer and producer surplus with the gained consumer surplus, there is a deadweight loss equivalent to the area CFG in Figure PRICE B F E FIGURE The Deadweight Loss from a Price Ceiling The price ceiling creates an excess demand for goods at the new lower price Producers are unambiguously worse off Consumers may be better or worse off depending on whether they are able to buy at the lower price The sum of consumer and producer surplus is lower, indicating a deadweight loss associated with the ceiling Competitive D price Price ceiling H Gain in consumer surplus I Supply Loss of consumer surplus C G Lost producer surplus A Qs Demand Qd QUANTITY 194 CHAPTER The Interaction of People in Markets REVIEW • Both price floors and price ceilings bring about deadweight loss Some parties clearly lose; other parties may gain, but overall, the losses exceed the gains • In the case of a price floor, consumers unambiguously lose because they buy fewer units at a higher price Some producers gain because they are able to sell at a higher price than before Others lose because they are no longer able to sell the good because the government doesn’t allow them to lower the price to attract buyers • In the case of a price ceiling, producers unambiguously lose because they sell fewer units at a lower price Some consumers gain because they are able to buy the good at a lower price than before Others lose because they are no longer able to buy the good, even though they are willing to pay more, because the government doesn’t allow firms to raise the price THE DEADWEIGHT LOSS FROM TAXATION Another important application of deadweight loss is in estimating the impact of a tax To see how, let’s examine the impact of a tax on a good We will see that the tax shifts the supply curve, leads to a reduction in the quantity produced, and reduces the sum of producer surplus plus consumer surplus Figure shows a supply and demand diagram for a particular good In the absence of the tax, the sum of producer and consumer surplus is given by the area of the triangle ABC, of which the area BCD denotes consumer surplus and the area ACD denotes producer surplus A Tax Paid by a Producer Shifts the Supply Curve A tax on sales is a payment that must be made to the government by the seller of a product The tax may be a percentage of the dollar value spent on the products sold, in which case it is called an ad valorem tax A percent state tax on retail purchases is an ad valorem tax Or it may be proportional to the number of items sold, in which case the tax is called a specific tax A tax on gasoline of $.50 per gallon is an example of a specific tax Because the tax payment is made by the producer or the seller to the government, the immediate impact of the tax is to add to the marginal cost of producing the product Hence, the immediate impact of the tax will be to shift the supply curve For example, suppose each producer has to send a certain amount, say, $.50 per gallon of gasoline produced and sold, to the government Then $.50 must be added to the marginal cost per gallon for each producer The resulting shift of the supply curve is shown in Figure The vertical distance between the old and the new supply curves is the size of the sales tax in dollars The supply curve shifts up by this amount because this is how much is added to the marginal costs of the producer (Observe that this upward shift can just as accurately be called a leftward shift because the new supply curve is above and to the left of the old curve Saying that the supply curve shifts up may seem confusing because when we say “up,” we seem to be meaning “more supply.” But the “up” is along the vertical axis, which has the price on it The upward, or leftward, movement of the supply curve is in the direction of less supply, not more supply.) The Deadweight Loss from Taxation 195 PRICE New supply curve Old supply curve B Deadweight loss New price FIGURE Deadweight Loss from a Tax In this graph the dark triangle represents the deadweight loss and the blue rectangle the amount of tax revenue that goes to the government The sales tax, which is collected and paid to the government by the seller, adds to the marginal cost of each item the producer sells Hence, the supply curve shifts up The price rises, but by less than the tax increase Price rises by this amount Old price Price received by sellers after sending tax to government Amount of sales tax F E C D G H A New quantity Old quantity Demand curve QUANTITY Quantity declines by this amount A New Equilibrium Price and Quantity What does the competitive equilibrium model imply about the change in the price and the quantity produced? Observe that there is a new intersection of the supply curve and the demand curve Thus, the price rises to a new, higher level, and the quantity produced declines The price increase, as shown in Figure 9, is not as large as the increase in the tax The vertical distance between the old and the new supply curves is the amount of the tax, but the price increases by less than this distance Thus the producers are not able to “pass on” the entire tax to the consumers in the form of higher prices If the tax increase is $.50, then the price increase is less than $.50, perhaps $.40 The producers have been forced by the market—by the movement along the demand curve—to reduce their production, and by doing so they have absorbed some of the impact of the tax increase Deadweight Loss and Tax Revenue Now consider what happens to consumer surplus and producer surplus with the sales tax Because the total quantity produced is lower, there is a loss in consumer surplus and producer surplus The right part of the triangle of consumer plus producer surplus, corresponding to the area CFG, has been cut off, and this is the deadweight loss to society, as shown in Figure Consumer surplus is now given by the triangle BEF, while producer surplus is given by the triangle AGH (keep in mind that producers not receive the new price; they only get the new price less the tax) The tax generates revenue for the government that can be used for financing government activity Some of what was producer surplus and consumer surplus thus goes to the government If the tax is $1 and 100 items are sold, the tax revenue is $100 This amount is shown by the ECONOMICS IN ACTION Price Controls and Deadweight Loss in the Milk Industry Since the 1930s, the federal government has intervened in the milk market (and other agricultural markets) in order to stabilize farm prices and provide some income protection for U.S farmers The government has used a combination of complex regulations that include government purchases and subsequent disposal of dairy products, import restrictions, export subsidies, and pricing mechanisms depending on the location and purpose of the production of milk We can see how price controls lead to deadweight loss by looking more closely at one of these programs The Food and Agriculture Act of 1977 was aimed at sustaining higher prices received by dairy farmers As we know, the competitive market price occurs when the quantity demanded equals the quantity supplied, but the higher price floor mandated by the government reduced the quantity demanded and gave farmers an incentive to produce more milk, causing excess supply To support the price floor, the government purchased the excess supply of milk in the form of dry milk, butter, and cheese Of course, there was a cost to this program: close to $2 billion a year in net government expenditures in the early 1980s In 1994 economists Peter Helmberger and Yu-Hui Chen estimated what would happen if the government deregulated the milk market In the short run, they found that consumer surplus would increase by $3.9 billion a year, producer surplus would decrease by $4 billion, and net government expenditures would decrease by $600 million, eliminating a deadweight loss of $500 million a year As you can see, the price floor is $500 million more expensive than a simple program in which the government directly transfers $3.9 billion from consumers to farmers and throws in an extra $100 million Interestingly, though, consumers would be much more likely to protest against such a blatant transfer of income than they are to complain about the much more wasteful and inefficient price support program The Federal Agricultural Improvement and Reform (FAIR) Act of 1996 mandated the elimination of the price support program by the end of 1999 However, the dairy subsidies were soon reinstated by the farm bill signed by President Bush in May 2002, which increased total agricultural subsidies from $100 billion to close to $200 billion a year The current system of dairy subsidies chose the market price of drinking milk in Boston as the standard for the rest of the country When that price falls below $16.94 per hundred pounds, all U.S dairy farmers receive a governmental subsidy of 45 percent of the difference between the Boston market price and $16.94 What you think have been the effects of this legislation on the milk market? In 2007, the current system of dairy subsidies was reexamined by Congress until 2011 As the renewal date approaches, you should read newspaper articles about the policy debate surrounding the renewal of dairy subsidies and see for yourself how much economic analysis is employed in public policy debates blue rectangle EFGH on the diagram Adding up consumer and producer surplus plus the government revenue gives us an area corresponding to ABFG, which differs from the original sum of consumer and producer surplus (ABC) by the magnitude of the deadweight loss (CFG) So even though taxes may be necessary to finance the government, they cause a deadweight loss to society in the form of lost consumer and producer surplus that are not available to anyone in the economy anymore 196 Informational Efficiency REVIEW 197 • The impact of a tax on the economy can be analyzed using consumer surplus and producer surplus • Taxes are necessary to finance government expenditures, but they lower the production of the item being taxed • The loss to society from the decline in production is measured by the reduction in consumer surplus and producer surplus, the deadweight loss due to the tax INFORMATIONAL EFFICIENCY We have shown that a competitive market works well in that the outcome is Pareto efficient For every good, the sum of consumer surplus and producer surplus is maximized These are important and attractive characteristics of a competitive market Another important and attractive characteristic of a competitive market is that the market processes information very efficiently For example, in a competitive market, the price reflects the marginal benefit for every buyer and the marginal cost for every seller If a government official were asked to set the price in a real market, there would be no way that such information could be obtained, especially with millions of buyers and sellers In other words, the market seems to be informationally efficient Pareto efficiency is different from this informational efficiency In the 1930s and 1940s, as the government of the Soviet Union tried to centrally plan production in the entire economy, economists became more interested in the informational efficiency of markets One of the most outspoken critics of central planning, and a strong advocate of the market system, was Friedrich Hayek, who emphasized the importance of the informational efficiencies of the market In Hayek’s view, a major disadvantage of central planning—where the government sets all the prices and all the quantities—is that it is informationally inefficient Coordination without a Market Although prices provide a valuable coordination role in a market economy, some activities are better coordinated without the market It would not be efficient to coordinate each of the hand and foot movements of these 100 skydivers with prices 198 CHAPTER The Interaction of People in Markets If you had all the information about all the buyers and sellers in the market, you could set the price to achieve a Pareto efficient outcome To see Hayek’s point, it is perhaps enough to observe that without private information about every one of the millions of buyers and sellers, you or any government official would not know where to set the price However, economists not have results as neat as the first theorem of welfare economics to prove Hayek’s point The reason is that in some situations, the market would be unwieldy, and it is difficult to describe these situations with any generality Difficulties arise in using a market system in situations where prices will not bring about a sufficiently precise or speedy response For example, if demand for furniture made out of mahogany timber rises, it is difficult for producers to meet that demand immediately because it takes several dozen years for a mahogany tree to reach maturity In such a situation, unscrupulous producers may chop down mahogany trees in a public forest to meet the demand This implies that we should not rely solely on the competitive market system to motivate producers to increase production in situations where property rights are weak or where there are communal resources that need to be managed Nevertheless, a competitive market system offers considerable informational advantages over other systems REVIEW • The market has the ability to process information efficiently The lack of informational efficiency is a key reason why central planning does not work well in complex and changing environments • For some activities, however, the market has few informational advantages A production process in situations where property rights are weak or where there are communal resources that need to be managed will be poorly coordinated through prices CONCLUSION Adam Smith’s idea of the “invisible hand” is perhaps the most important discovery in economics: Individuals, by freely pursuing their own interests in a market economy, are led as if by an invisible hand to an outcome that is best overall The first theorem of welfare economics is the modern statement of Adam Smith’s famous principle; in tribute to Smith’s seminal idea, we call it the “invisible hand theorem.” Understanding why, and under what circumstances, the invisible hand theorem is true is an important part of thinking like an economist Understanding the theorem has required an investment in economic model building: The behavior of consumers and the behavior of firms were combined into a competitive equilibrium model describing how consumers and firms interact in markets This model is an extension of the supply and demand model we used in Chapters and Building the competitive equilibrium model has had payoffs beyond understanding this most important theorem in economics We can use individual demand curves and individual firm supply curves to determine the actions of each individual consumer and each individual producer at the market equilibrium price Armed Questions for Review 199 with the ideas of consumer surplus and producer surplus, we can measure the costs of deviations from the competitive market equilibrium Such measures are used by economists to assess the costs and benefits of government programs that interfere, for bad or good, with the market outcomes Starting with Chapter 10, we will see that deviations from the competitive market equilibrium are caused by monopolies and other factors But first we will look more closely at how costs and production within individual firms and competitive industries change over time We this in Chapters and KEY POINTS Processing information and coordinating and motivating millions of consumption and production decisions is difficult, but the market is a device that can the job remarkably well The interaction of producers and consumers in a market can be explained by the competitive equilibrium model, which is the supply and demand model with consumer and firm behavior made more explicit Using the competitive equilibrium model, we can not only find the equilibrium price and quantity, but also use each individual’s demand curve to find that individual’s consumption decision and use each individual firm’s supply curve to figure out its production decision An outcome is Pareto efficient if it is not possible to change production or consumption in a way that will make one person better off without hurting someone else Pareto efficiency requires three criteria to hold: marginal benefit must equal marginal cost for the last item produced, all producers must have identical marginal costs, and all consumers must have identical marginal benefits A competitive market is Pareto efficient In a competitive market, the sum of producer surplus and consumer surplus is maximized Efficiency is not the same thing as equality An efficient outcome can coexist with an unequal outcome Attempts to remedy an unequal situation by the use of price ceilings or floors lead to inefficiencies in production and consumption Using transfers to redistribute resources from the more affluent to the less well off may be better than imposing price or quantity controls Such transfers often need to be financed by tax revenue The imposition of a tax that reduces the quantity produced creates deadweight loss for society The competitive equilibrium model can be used to calculate the magnitude of this deadweight loss 10 The market also has the ability to process information much more efficiently than a central planner could However, there are no general theorems that prove the informational efficiency of the market KEY TERMS invisible hand competitive equilibrium model equilibrium price surplus (excess supply) shortage (excess demand) Pareto efficient first theorem of welfare economics income inequality deadweight loss QUESTIONS FOR REVIEW What are the information-processing, coordination, and motivation functions that arise when buyers and sellers interact? Why is it difficult for one person or group of persons to perform the functions listed in question 1? How does the market perform these functions? 200 CHAPTER The Interaction of People in Markets What is the relationship between the competitive equilibrium model and the supply and demand model? How does a competitive market satisfy the conditions that are needed for Pareto efficiency to hold? How does the competitive equilibrium model explain the decisions of individual consumers and producers? Why is the sum of consumer surplus and producer surplus maximized in the competitive market? What is the meaning of Pareto efficiency? How does the imposition of a price floor create deadweight loss for the economy? What are the conditions that are needed for Pareto efficiency to hold? Why would the violation of any one of those conditions bring about a situation that is not Pareto efficient? 10 How does the imposition of a tax create deadweight loss for the economy? PROBLEMS Suppose that in a competitive market for ukuleles, there are three buyers (Peter, Paul, and Mary) with the marginal benefit (MB) schedules below Firm A and firm B both produce the same product with the following total costs: Firm A Quantity MB—Peter MB—Paul MB—Mary 150 120 90 60 30 140 110 80 50 20 130 100 70 40 10 If the equilibrium price is $80, calculate the following: a The quantity purchased by each buyer b The consumer surplus for each buyer c The consumer surplus for the market as a whole In the same market, there are three sellers (John, George, and Ringo) with the marginal cost (MC) schedules shown below Quantity MC—John MC—George MC—Ringo 30 60 90 120 150 20 50 80 110 140 10 40 70 100 130 If the equilibrium price is $80, calculate the following: a The quantity produced by each seller b The producer surplus for each seller c The producer surplus for the market as a whole Using the answers you provided above for problems and 2, verify that the three efficiency conditions are satisfied for the ukulele market Firm B Quantity Produced Total Costs Quantity Produced Total Costs 11 15 14 20 Consider a situation in which the market price is $3 and units are produced in total: Firm A produces units, and firm B produces units a Explain why this situation is not Pareto efficient b Come up with two different production allocations for the two firms that allow the items to be produced at a lower overall total cost c Which of these two allocations would be the outcome in a competitive market where both firms maximized profits? d How would the actions of the two firms be coordinated in a competitive market to achieve this outcome? Suppose that in the ukulele market described in problem 2, the government imposes a $40 sales tax, which causes the equilibrium price to go up to $100 Calculate the following: a The quantity purchased by each buyer, the consumer surplus for each buyer, and the consumer surplus for the market as a whole b The quantity produced by each seller, the producer surplus for each seller, and the producer surplus for the market as a whole Problems c The amount of revenue collected by the government d The deadweight loss for the economy resulting from the tax Consider the following supply and demand schedule for candy bars: Price $.25 $.50 $.75 $1.00 $1.25 $1.50 $1.75 Supply Demand (millions of candy bars) (millions of candy bars) 10 14 18 22 26 14 12 10 a Sketch the market supply and demand curves Show the equilibrium quantity and price b Graphically show the producer surplus and consumer surplus in the market for candy bars c What would happen to the price of this product if a tax of $.75 per candy bar sold were enacted by the government? Show your answer graphically d Show the deadweight loss due to the tax on your diagram Suppose that an unanticipated bout of good weather results in almost ideal growing conditions, leading to a substantial increase in the supply of wheat in the United States a Draw a supply and demand diagram to show what will happen to the equilibrium price and quantity of wheat in the United States, assuming that the demand curve does not shift 201 b Suppose the U.S government observes that the price of wheat is likely to fall rapidly and imposes a price floor equal to the original equilibrium price What effect does the price floor have on the quantity supplied and demanded of wheat? c How are consumer and producer surplus affected by the price floor? d Graphically show the deadweight loss created by the price floor High international prices for soybeans in recent years led many Argentinean farmers to switch land that had been used as pasture to raise cattle to soybean production This resulted in a shortfall in the supply of beef a Draw a supply and demand diagram to show what will happen to the equilibrium price and quantity of beef in Argentina, assuming that the demand curve does not shift b In March of 2007, the Argentinean government, concerned about the rising price of beef, imposed a price ceiling on beef Assuming that the price ceiling was equal to the original equilibrium price before the supply decreased, what effect does the price ceiling have on the quantity supplied and demanded of beef? c How are consumer and producer surplus affected by the price ceiling? d Graphically show the deadweight loss created by the price ceiling This page intentionally left blank ... Chapter 16 : Present Discounted Value Principles of Principles of Microeconomics Macroeconomics Chapter Number Chapter Number PART PART 1 2A 2A PART 5A PART 8A 10 11 12 PART 13 14 15 16 16 A 16 : Financial... Types of Individuals Consumer Surplus 13 1 13 2 13 3 Conclusion 13 7 Key Points 13 8 ■ Key Terms 13 8 Review 13 9 ■ Problems 13 9 C HAPTER ■ The Budget Line 15 0 The Firm’s Profits 15 2 15 3 14 1 14 1 The... Perfectly Inelastic Supply 10 7 ■ Why the Size of the Price Elasticity of Supply Is Important 10 7 Contents Conclusion 11 0 Key Points 11 0 ■ Key Terms 11 1 Review 11 1 ■ Problems 11 1 ■ Questions for ECONOMICS