Ebook Microeconomics (7th edition): Part 2

(BQ) Part 2 book Microeconomics has contents: General equilibrium and economic welfare, monopoly, pricing and advertising, oligopoly and monopolistic competition, game theory, factor markets, interest rates, investments, and capital markets, uncertainty, externalities, open access, and public goods,...and other contents.

318 CHAPTER 10 General Equilibrium and Economic Welfare Figure 10.3 Endowments in an Edgeworth Box (a) Jane’s endowment is ej; she has 20 candy bars and 30 cords of firewood She is indifferent between that bundle and the others that lie on her indifference curve I1j (b) Denise is indifferent between her endowment, ed (60 candy bars and 20 cords of wood), and the other Firewood, Cords (b) Denise’s Endowment Denise’s wood ej 30 Jane’s wood I 1j 0j Jane’s candy 0d 20 ed 20 Candy, Bars I d1 60 Denise’s candy Candy, Bars (c) Edgeworth Box Denise’s candy 60 A Id1 e 30 20 f I 1j a Jane’s candy 30 B C 0j 0d Denise’s wood 80 50 Jane’s wood Firewood, Cords (a) Jane’s Endowment bundles on Id1 (c) Their endowments are at e in the Edgeworth box formed by combining panels a and b Jane prefers bundles in A and B to e Denise prefers bundles in B and C to e Thus, both prefer any bundle in area B to e 20 40 50 80 The height of the Edgeworth box represents 50 cords of firewood, and the length represents 80 candy bars, which are the combined endowments of Jane and Denise Bundle e shows both endowments Measuring from Jane’s origin, 0j, at the lower left of the diagram, we see that Jane has 30 cords of firewood and 20 candy bars at endowment e Similarly, measuring from Denise’s origin, 0d, at the upper-right corner, we see that Denise has 60 bars of candy and 20 cords of firewood at e 10.2 Trading Between Two People 319 Mutually Beneficial Trades Should Jane and Denise trade? The answer depends on their tastes, which are summarized by their indifference curves We make four assumptions about their tastes and behavior: ■ Utility maximization Each person maximizes her utility Usual-shaped indifference curves Each person’s indifference curves have the ■ Nonsatiation Each person has strictly positive marginal utility for each good, ■ usual convex shape ■ so each person wants as much of the good as possible (neither person is ever satiated) No interdependence Neither person’s utility depends on the other’s consumption (neither person gets pleasure or displeasure from the other’s consumption), and neither person’s consumption harms the other (one person’s consumption of firewood does not cause smoke pollution that bothers the other person) Figure 10.3 reflects these assumptions In panel a, Jane’s indifference curve, Ij1, through her endowment point, ej, is convex to her origin, 0j Jane is indifferent between ej and any other bundle on Ij1 She prefers bundles that lie above Ij1 to ej and prefers ej to points that lie below I1j Panel c also shows her indifference curve, Ij1 The bundles that Jane prefers to her endowment are in the shaded areas A and B, which lie above her indifference curve, Ij1 Similarly, Denise’s indifference curve, Id1, through her endowment is convex to her origin, 0d, in the lower left of panel b This indifference curve, Id1, is still convex to 0d in panel c, but 0d is in the upper right of the Edgeworth box (It may help to turn this book around when viewing Denise’s indifference curves in an Edgeworth box Then again, possibly many points will be clearer if the book is held upside down.) The bundles Denise prefers to her endowment are in shaded areas B and C, which lie on the other side of her indifference curve I1d from her origin 0d (above Id1 if you turn the book upside down) At endowment e in panel c, Jane and Denise can both benefit from a trade Jane prefers bundles in A and B to e, and Denise prefers bundles in B and C to e, so both prefer bundles in area B to their endowment at e Suppose that they trade, reallocating goods from Bundle e to f Jane gives up 10 cords of firewood for 20 more candy bars, and Denise gives up 20 candy bars for 10 more cords of wood As Figure 10.4 illustrates, both gain from such a trade Jane’s indifference curve Ij2 through allocation f lies above her indifference curve I1j through allocation e, so she is better off at f than at e Similarly, Denise’s indifference curve Id2 through f lies above (if you hold the book upside down) her indifference curve I1d through e, so she also benefits from the trade Now that they’ve traded to Bundle f, Jane and Denise want to make further trades? To answer this question, we can repeat our analysis Jane prefers all bundles above Ij2, her indifference curve through f Denise prefers all bundles above (when the book is held upside down) Id2 to f However, they not both prefer any other bundle because Ij2 and Id2 are tangent at f Neither Jane nor Denise wants to trade from f to a bundle such as e, which is below both of their indifference curves Jane would love to trade from f to c, which is on her higher indifference curve I3j , but such a trade would make Denise worse off because this bundle is on a lower indifference curve, Id1 Similarly, Denise prefers b to f, but Jane does not Thus, any move from f harms at least one of them The reason no further trade is possible at a bundle like f is that Jane’s marginal rate of substitution (the slope of her indifference curve), MRSj, between wood and 320 CHAPTER 10 General Equilibrium and Economic Welfare Figure 10.4 Contract Curve 80 50 60 Denise’s candy 40 Id0 Id1 30 d Contract curve I j4 e 20 Id2 c Id3 20 f B Jane’s wood b I j1 a 0j Jane’s candy Jane Denise 0d g Denise’s wood The contract curve contains all the Pareto-efficient allocations Any bundle for which Jane’s indifference curve is tangent to Denise’s indifference curve lies on the contract curve At such a bundle, because no further trade is possible, and we can’t reallocate goods to make one of them better off without harming the other Starting at an endowment of e, Jane and Denise will trade to a bundle on the contract curve in area B: bundles between b and c The table shows how they would trade to Bundle f 20 Endowment, e Wood Candy 30 20 20 60 40 Trade Wood Candy −10 +20 +10 −20 I j2 I j3 30 50 80 New Allocation, f Wood Candy 20 40 30 40 candy equals Denise’s marginal rate of substitution, MRSd Jane’s MRSj is - 12: She is willing to trade one cord of wood for two candy bars Because Denise’s indifference curve is tangent to Jane’s, Denise’s MRSd must also be - 12 When they both want to trade wood for candy at the same rate, they can’t agree on further trades In contrast, at a bundle such as e where their indifference curves are not tangent, MRSj does not equal MRSd Denise’s MRSd is - 13, and Jane’s MRSj is -2 Denise is willing to give up one cord of wood for three more candy bars or to sacrifice three candy bars for one more cord of wood If Denise offers Jane three candy bars for one cord of wood, Jane will accept because she is willing to give up two cords of wood for one candy bar This example illustrates that trades are possible where indifference curves intersect because marginal rates of substitution are unequal To summarize, we can make four equivalent statements about allocation f: contract curve the set of all Paretoefficient bundles The indifference curves of the two parties are tangent at f The parties’ marginal rates of substitution are equal at f No further mutually beneficial trades are possible at f The allocation at f is Pareto efficient: One party cannot be made better off without harming the other Indifference curves are also tangent at Bundles b, c, and d, so these allocations, like f, are Pareto efficient By connecting all such bundles, we draw the contract curve: the set of all Pareto-efficient bundles The reason for this name is that only at these points are the parties unwilling to engage in further trades or contracts—these allocations are the final contracts A move from any bundle on the contract curve would harm at least one person 10.3 Competitive Exchange 321 Solved Problem Are allocations a and g in Figure 10.4 part of the contract curve? 10.3 Answer By showing that no mutually beneficial trades are possible at those points, demonstrate that those bundles are Pareto efficient The allocation at which Jane has everything, allocation g, is on the contract curve because no mutually beneficial trade is possible: Denise has no goods to trade with Jane As a consequence, we cannot make Denise better off without taking goods from Jane Similarly, when Denise has everything, a, we can make Jane better off only by taking wood or candy from Denise and giving it to Jane Bargaining Ability For every allocation off the contract curve, the contract curve has allocations that benefit at least one person If they start at endowment e, Jane and Denise should trade until they reach a point on the contract curve between Bundles b and c in Figure 10.4 All the allocations in area B are beneficial However, if they trade to any allocation in B that is not on the contract curve, further beneficial trades are possible because their indifference curves intersect at that allocation Where will they end up on the contract curve between b and c? That depends on who is better at bargaining Suppose that Jane is much better at bargaining Jane knows that the more she gets, the worse off Denise will be and that Denise will not agree to any trade that makes her worse off than she is at e Thus, the best trade Jane can make is one that leaves Denise only as well off as at e, which are the bundles on Id1 If Jane could pick any point she wanted along Id1, she’d choose the bundle on her highest possible indifference curve, which is Bundle c, where Ij3 is just tangent to Id1 After this trade, Denise is no better off than before, but Jane is much happier By similar reasoning, if Denise is sufficiently better at bargaining, the final allocation will be at b 10.3 Competitive Exchange Most trading throughout the world occurs without one-on-one bargaining between people When you go to the store to buy a bottle of shampoo, you read its posted price and then decide whether to buy it or not You’ve probably never tried to bargain with the store’s clerk over the price of shampoo: You’re a price taker in the shampoo market If we don’t know much about how Jane and Denise bargain, all we can say is that they will trade to some allocation on the contract curve If we know the exact trading process they use, however, we can apply that process to determine the final allocation In particular, we can examine the competitive trading process to determine the competitive equilibrium in a pure exchange economy In Chapter 9, we used a partial-equilibrium approach to show that one measure of welfare, W, is maximized in a competitive market in which many voluntary trades occur We now use a general-equilibrium model to show that a competitive market has two desirable properties (which hold under fairly weak conditions): ■ The First Theorem of Welfare Economics: The competitive equilibrium is efficient ■ Competition results in a Pareto-efficient allocation—no one can be made better off without making someone worse off—in all markets The Second Theorem of Welfare Economics: Any efficient allocations can be achieved by competition All possible efficient allocations can be obtained by competitive exchange, given an appropriate initial allocation of goods CHAPTER 10 General Equilibrium and Economic Welfare 322 Competitive Equilibrium When two people trade, they are unlikely to view themselves as price takers However, if the market has a large number of people with tastes and endowments like Jane’s and a large number of people with tastes and endowments like Denise’s, each person is a price taker in the two goods We can use an Edgeworth box to examine how such price takers would trade Because they can trade only two goods, each person needs to consider only the relative price of the two goods when deciding whether to trade If the price of a cord of wood, pw, is $2, and the price of a candy bar, pc, is $1, then a candy bar costs half as much as a cord of wood: pc /pw = 12 An individual can sell one cord of wood and use that money to buy two candy bars At the initial allocation, e, Jane has goods worth $80 = ($2 per cord * 30 cords of firewood) + ($1 per candy bar * 20 candy bars) A t these prices, Jane could keep her endowment or trade to an allocation with 40 cords of firewood and no candy, 80 bars of candy and no firewood, or any combination in between as the price line (budget line) in panel a of Figure 10.5 shows The price line is all the combinations of goods Jane could get by trading, given her endowment The price line goes through point e and has a slope of -pc /pw = - 12 Given the price line, what bundle of goods will Jane choose? She wants to maximize her utility by picking the bundle where one of her indifference curves, Ij2, is tangent to her budget or price line Denise wants to maximize her utility by choosing a bundle in the same way In a competitive market, prices adjust until the quantity supplied equals the quantity demanded An auctioneer could help determine the equilibrium The auctioneer could call out relative prices and ask how much is demanded and how much is offered for sale at those prices If demand does not equal supply, the auctioneer calls out Figure 10.5 Competitive Equilibrium The initial endowment is e (a) If, along the price line facing Jane and Denise, pw = $2 and pc = $1, they trade to point f, where Jane’s indifference curve, Ij2, is tangent to the price line and to Denise’s indifference curve, Id2 (b) No other price line results in an equilibrium If pw = $1.33 and pc = $1, Denise wants to buy 20 Id Jane’s wood 20 30 f Price line a 20 30 Id e 22 20 j d 40 32 Jane’s candy Id Ij Ij 0j 80 50 Jane’s wood 30 e (b) Prices That Do Not Lead to a Competitive Equilibrium Denise’s candy 80 60 43 0d 50 45 Denise’s wood Id 0d Denise’s wood (a) Price Line That Leads to a Competitive Equilibrium Denise’s candy 80 60 40 50 12 ( = 32 - 20) cords of firewood at these prices, but Jane wants to sell only ( = 30 - 22) cords Similarly, Jane wants to buy 10 ( = 30 - 20) candy bars, but Denise wants to sell 17 ( = 60 - 43) Thus, these prices are not consistent with a competitive equilibrium Ij Ij Price line a 0j Jane’s candy 20 30 60 80 50 10.3 Competitive Exchange 323 another relative price When demand equals supply, the transactions actually occur and the auction stops At some ports, fishing boats sell their catch to fish wholesalers at a daily auction run in this manner Panel a shows that when candy costs half as much as wood, the quantity demanded of each good equals the quantity supplied Jane (and every person like her) wants to sell 10 cords of firewood and use that money to buy 20 additional candy bars Similarly, Denise (and everyone like her) wants to sell 20 candy bars and buy 10 cords of wood Thus, the quantity of wood sold equals the quantity bought, and the quantity of candy demanded equals that supplied We can see in the figure that the quantities demanded equal the quantities supplied because the optimal bundle for both types of consumers is the same, Bundle f At any other price ratio, the quantity demanded of each good would not equal the quantity supplied For example, if the price of candy remained constant at pc = $1 per bar but the price of wood fell to pw = $1.33 per cord, the price line would be steeper, with a slope of -pc /pw = -1/1.33 = - 34 in panel b At these prices, Jane wants to trade to Bundle j and Denise wants to trade to Bundle d Because Jane wants to buy 10 extra candy bars but Denise wants to sell 17 extra candy bars, the quantity supplied does not equal the quantity demanded, so this price ratio does not result in a competitive equilibrium when the endowment is e The Efficiency of Competition In a competitive equilibrium, the indifference curves of both types of consumers are tangent at the same bundle on the price line As a result, the slope (MRS) of each person’s indifference curve equals the slope of the price line, so the slopes of the indifference curves are equal: MRS j = - pc = MRSd pw (10.1) The marginal rates of substitution are equal across consumers in the competitive equilibrium, so the competitive equilibrium must lie on the contract curve Thus, we have demonstrated the First Theorem of Welfare Economics: Any competitive equilibrium is Pareto efficient The intuition for this result is that people (who face the same prices) make all the voluntary trades they want in a competitive market Because no additional voluntary trades can occur, we cannot make someone better off without harming someone else (If an involuntary trade occurs, at least one person is made worse off A person who steals goods from another person—an involuntary exchange—gains at the expense of the victim.) Obtaining Any Efficient Allocation Using Competition Of the many possible Pareto-efficient allocations, the government may want to choose one Can it achieve that allocation using the competitive market mechanism? Our previous example illustrates that the competitive equilibrium depends on the endowment: the initial distribution of wealth For example, if the initial endowment were a in panel a of Figure 10.5—where Denise has everything and Jane has nothing—the competitive equilibrium would be a because no trades would be possible 324 CHAPTER 10 General Equilibrium and Economic Welfare Thus, for competition to lead to a particular allocation—say, f—the trading must start at an appropriate endowment If the consumers’ endowment is f, a Paretoefficient point, their indifference curves are tangent at f, so no further trades occur That is, f is a competitive equilibrium Many other endowments will also result in a competitive equilibrium at f Panel a shows that the resulting competitive equilibrium is f if the endowment is e In that figure, a price line goes through both e and f If the endowment is any bundle along this price line—not just e or f—the competitive equilibrium is f, because only at f are the indifference curves tangent To summarize, any Pareto-efficient bundle x can be obtained as a competitive equilibrium if the initial endowment is x That allocation can also be obtained as a competitive equilibrium if the endowment lies on a price line through x, where the slope of the price line equals the marginal rate of substitution of the indifference curves that are tangent at x Thus, we’ve demonstrated the Second Theorem of Welfare Economics: Any Pareto-efficient equilibrium can be obtained by competition, given an appropriate endowment The first welfare theorem tells us that society can achieve efficiency by allowing competition The second welfare theorem adds that society can obtain the particular efficient allocation it prefers based on its value judgments about equity by appropriately redistributing endowments 10.4 Production and Trading So far our discussion has been based on a pure exchange economy with no production We now examine an economy in which a fixed amount of a single input can be used to produce two different goods Comparative Advantage Jane and Denise can produce candy or chop firewood using their own labor They differ, however, in how much of each good they produce from a day’s work Production Possibility Frontier Jane can produce either candy bars or cords of firewood in a day By splitting her time between the two activities, she can produce various combinations of the two goods If α is the fraction of a day she spends making candy and - α is the fraction cutting wood, she produces 3α candy bars and 6(1 - α) cords of wood By varying α between and 1, we trace out the line in panel a of Figure 10.6 This line is Jane’s production possibility frontier, PPFj , which shows the maximum combinations of wood and candy that she can produce from a given amount of input (Chapter 7) If Jane works all day using the best available technology (such as a sharp ax), she achieves efficiency in production and produces combinations of goods on PPFj If she sits around part of the day or does not use the best technology, she produces an inefficient combination of wood and candy inside PPFj Marginal Rate of Transformation The slope of the production possibility frontier is the marginal rate of transformation (MRT).5 The marginal rate of transformation 5In the standard consumer model (Chapter 4), the slope of a consumer’s budget line is the marginal rate of transformation That is, for a price-taking consumer who obtains goods by buying them, the budget line plays the same role as the production possibility frontier for someone who produces the two goods 10.4 Production and Trading 325 Figure 10.6 Comparative Advantage and Production Possibility Frontiers (a) Jane (b) Denise (c) Joint Production Firewood, Cords Firewood, Cords possibility frontier, PPFd, has an MRT of - 12 (c) Their joint production possibility frontier, PPF, has a kink at 6 cords of firewood (produced by Jane) and candy bars (produced by Denise) and is concave to the origin Firewood, Cords (a) Jane’s production possibility frontier, PPFj , shows that in a day, she can produce cords of firewood or candy bars or any combination of the two Her marginal rate of transformation (MRT) is - (b) Denise’s production 1 MRT = – – (Denise) PPF MRT = –2 PPFd PPFj Candy, Bars comparative advantage the ability to produce a good at a lower opportunity cost than someone else MRT = –2 (Jane) MRT = – – Candy, Bars Candy, Bars tells us how much more wood can be produced if the production of candy is reduced by one bar Because Jane’s PPFj is a straight line with a slope of -2, her MRT is -2 at every allocation Denise can produce up to cords of wood or candy bars in a day Panel b shows her production possibility function, PPFd, with anMRT = - 12 Thus, with a day’s work, Denise can produce relatively more candy, and Jane can produce relatively more wood, as reflected by their differing marginal rates of transformation The marginal rate of transformation shows how much it costs to produce one good in terms of the forgone production of the other good Someone with the ability to produce a good at a lower opportunity cost than someone else has a comparative advantage in producing that good Denise has a comparative advantage in producing candy (she forgoes less in wood production to produce a given amount of candy), and Jane has a comparative advantage in producing wood By combining their outputs, they have the joint production possibility frontier PPF in panel c If Denise and Jane spend all their time producing wood, Denise produces 3 cords and Jane produces cords for a total of 9, which is where the joint PPF hits the wood axis Similarly, if they both produce candy, they can jointly produce bars If Denise specializes in making candy and Jane specializes in cutting wood, they produce candy bars and cords of wood, a combination that appears at the kink in the PPF If they choose to produce a relatively large quantity of candy and a relatively small amount of wood, Denise produces only candy and Jane produces some candy and some wood Jane chops the wood because that’s her comparative advantage The marginal rate of transformation in the lower portion of the PPF is Jane’s, -2, because only she produces both candy and wood Similarly, if they produce little candy, Jane produces only wood and Denise produces some wood and some candy, so the marginal rate of transformation in the higher portion of the PPF is Denise’s, - 12 In short, the PPF has a kink at cords of wood and candy bars and is concave (bowed away from the origin) 326 CHAPTER 10 General Equilibrium and Economic Welfare Benefits of Trade Because of the difference in their marginal rates of transformation, Jane and Denise can benefit from a trade Suppose that Jane and Denise like to consume wood and candy in equal proportions If they not trade, each produces candy bars and cords of wood in a day If they agree to trade, Denise, who excels at making candy, spends all day producing candy bars Similarly, Jane, who has a comparative advantage at chopping, produces cords of wood If they split this production equally, they can each have cords of wood and candy bars—50% more than if they don’t trade They better if they trade because each person uses her comparative advantage Without trade, if Denise wants an extra cord of wood, she must give up two candy bars Producing an extra cord of wood costs Jane only half a candy bar in forgone production Denise is willing to trade up to two candy bars for a cord of wood, and Jane is willing to trade the wood as long as she gets at least half a candy bar Thus, a mutually beneficial trade is possible How does the joint production possibility frontier for Jane and Denise in panel c of Figure 10.6 change if they can also trade with Harvey, who can produce cords of wood, candy bars, or any linear combination of wood and candy in a day? Answer Describe each person’s individual production possibility frontier Panels a and b of Figure 10.6 show the production possibility frontiers of Jane and Denise Harvey’s production possibility frontier is a straight line that hits the firewood axis at 5 cords and the candy axis at candy bars (not shown in Figure 10.6) Draw the joint PPF, by starting at the quantity on the horizontal axis that is produced if everyone specializes in candy and then connecting the individual production possibility frontiers in order of comparative advantage in chopping wood If all three produce candy, they make 14 candy bars in the figure Jane has a comparative advantage at chopping wood over Harvey and Denise, and Harvey has a comparative advantage over Denise Thus, Jane’s production possibility frontier is Firewood, Cords Solved Problem 10.4 14 1 MRT = – – (Denise) 11 PPF MRT = –1 (Harvey) MRT = –2 (Jane) 11 14 Candy, Bars 10.4 Production and Trading 327 the first one (starting at the lower right), then comes Harvey’s, and then Denise’s The resulting PPF is concave to the origin (If we change the order of the individual frontiers, the resulting kinked line lies inside the PPF Thus, the new line cannot be the joint production possibility frontier, which shows the maximum possible production from the available labor inputs.) The Number of Producers If the only two ways of producing wood and candy are Denise’s and Jane’s methods with different marginal rates of transformation, the joint production possibility frontier has a single kink (panel c of Figure 10.6) If another method of production with a different marginal rate of transformation—Harvey’s— is added, the joint production possibility frontier has two kinks (as in the figure in Solved Problem 10.4) If many firms can produce candy and firewood with different marginal rates of transformation, the joint production possibility frontier has even more kinks As the number of firms becomes very large, the PPF becomes a smooth curve that is concave to the origin, as in Figure 10.7 Because the PPF is concave, the marginal rate of transformation decreases (in absolute value) as we move up the PPF The PPF has a flatter slope at a, where the MRT = - 12, than at b, where the MRT = -1 At a, giving up a candy bar leads to half a cord more wood production In contrast, at b, where relatively more candy is produced, giving up producing a candy bar frees enough resources that an additional cord of wood can be produced The marginal rate of transformation along this smooth PPF tells us about the marginal cost of producing one good relative to the marginal cost of producing the The optimal product mix, a, could be determined by maximizing an individual’s utility by picking the allocation for which an indifference curve is tangent to the production possibility frontier It could also be determined by picking the allocation where the relative competitive price, pc /pf , equals the slope of the PPF Firewood, Cords Figure 10.7 Optimal Product Mix I2 Price line –1 – I1 PPF 50 a b 80 Candy, Bars Index comparing with Cournot and collusive equilibria, 450–451 graphical model (airline example), 447–449 why sequential movement is essential, 450 Natural disasters anti-price gouging laws, 308, 339–340 impact on equilibrium price, 309 insurance and, 581–582 Natural monopolies, 363–364 Negative externalities See also Externalities defined, 596 Spam example, 597 Net present value (NPV) approach to investments, 541–542 example (Golden State Warriors), 543 internal rate of return and, 543 Network externalities behavioral economics and, 375–376 eBay example, 376–377 as explanation for monopolies, 376 overview of, 375 Nominal prices, inflation and, 539 Nonlinear price discrimination example of uniform pricing (iTunes), 410 overview of, 404–406 questions, 421–422 summary, 418 two-part pricing, 406–407 two-part pricing with identical consumers, 407–408 two-part pricing with nonidentical consumers, 408–409 types of price discrimination, 391 Nonprofit firms, 148–149 Nonsatiation property, consumer preferences, 75 Nonuniform pricing market power and, 384 price discrimination See Price discrimination tie-in sales, 410–413 two-part pricing, 406–409 Normal-form, representation of static games, 470–471 Normal goods fast-food example, 119–120 income effects, 120–124 income elasticities of, 117 some goods must be normal, 118 substitution effects, 120–124 Normative statements, in microeconomics, 5–6 NPV See Net present value (NPV) O Observable characteristics, identifying groups by, 402 Oligopolies applying static game to strategic advertising by oligopolies, 480–481 Bertrand oligopoly See Bertrand oligopoly cartels See Cartels comparing market structures, 426 Cournot oligopoly See Cournot oligopoly defined, 424 overview of, 424–425 Stackelberg oligopoly See Stackelberg oligopoly OPEC (Organization of Petroleum Exporting Countries) as example of cartel, 427 market power and price of exhaustible resources and, 552–553 Open-access common property, 611–612 Opportunistic behavior adverse selection See Adverse selection asymmetric information and, 624 moral hazards and, 624–625 restricting, 630–631 Opportunity costs of durable goods, 182–183 example problem, 181–182 of MBA degree, 181 overview of, 180–181 Opportunity sets bundle of goods and, 87 impact of income change on, 90 impact of price change on, 89–90 impact of water quotas on, 88–89 Optimal bundle on convex sections of indifference curves, 94–95 corner solution, 93 Giffen goods and, 124–125 interior solution, 91–92 A-85 more-is-better and, 95 overview of, 91–92 Options (stock), contracts for avoiding moral hazard, 662–663 Ordinal preferences, utility and, 83 Organization of Petroleum Exporting Countries (OPEC) as example of cartel, 427 market power and price of exhaustible resources and, 552–553 Organizational change productivity and, 172–173 Tata Motors example, 173 Outputs competitive factor and output markets, 516–517 competitive factor market and monopolized output markets, 517–518 converting inputs into, 148, 151 cost of producing multiple goods, 212 decisions in short-run competition, 231–234 determining profit-maximizing output in monopolies, 351–352 effect of adding extra labor, 156 graphing product curves, 155–156 isoquants for combining inputs for single level of output, 162–163 law of diminishing marginal returns, 157–159 learning curve and cumulative output, 210 long-run market supply when input prices vary with output, 248–250 market power in output markets, 516 monopolized factor market and competitive output markets, 518–519 monopoly in both input and output markets, 519–521 production function and, 151–152 profit maximization and, 228–229 profit maximization for labor, 509–510 reducing below competitive level lowers welfare, 277–279 relationship between labor market and output market, 508 A-86 Index Outputs (continued) relationship of product curves, 156–157 returns to scale varying by output levels, 169–170 of short-run production, 153–154 technical progress increasing levels of, 172 technological and economic efficiency and, 179 Overconfidence, biases in assessing risk probability, 585 Owners management of firms and, 150 what owners want, 150–151 Ownership, of for-profit firms, 149–150 P Package tie-in sales See Bundling (package tie-in sales) Pareto-efficient allocations competitive exchange and, 323 contract curves and, 320 efficiency of competition and, 329–330 government policies and, 332–334 obtaining any efficient allocation using competition, 323–324 Pareto principle government policies and, 332–333 in study of welfare, 309 Pareto, Vilfredo, 309 Partial-equilibrium analysis applied to effects of minimum wage, 32–34 applied to feedback between competitive markets, 311 overview of, 310 Partnerships, ownership of for-profit firms, 149–150 Patents brand name vs generic drugs, 344–345 example (Botox), 366–367 government role in creating monopolies, 365 as monopoly, 345 Pay cuts, vs layoffs, 672–674 Payoff function cooperation and, 478–479 in games, 469 Payoff (or profit) matrix, in static games, 471 Payoffs, in games, 469 Per-hour subsidies, for childcare, 107, 141–142 Perfect competition characteristics of, 222–223 comparing market structures, 426 deriving demand curve for competitive firm, 224–226 deviations from, 223–224 overview of, 221 price taking and, 221–222 questions, 257 reasons for studying, 226 summary, 256 Perfect complements, marginal rate of substitution and, 81 Perfect monitoring, 655 Perfect price discrimination calculating, A:17–A:18 efficiency of, 393–394 example (Botox), 395 overview of, 391–393 questions, 419–420 summary, 418 transaction costs and, 396 types of price discrimination, 390 Perfect substitutes Coke/Pepsi choice, 112–113, 115–116 marginal rate of substitution and, 80–81 Perfectly elastic demand, 47–48 Perfectly elastic supply, 54 Perfectly inelastic demand, 47–48 Perfectly inelastic supply, 53 Perpetuities, 544, A:26 Physical products See Products Piece-rate contracts, 663 Piracy, of software, 613 Policies See also Government policies and regulation creating barriers to entry or exit, 284 free trade vs ban on imports, 296–297 free trade vs quotas, 299–300 free trade vs tariffs, 297–299 regulating imports, 295–296 rent seeking and, 300–301 that create wedge between supply and demand, 285 that restrict number of firms, 281–283 that restrict number of firms (Taxicab example), 283 that shift supply and demand curves, 280–281 welfare effects of price ceilings, 293–295 welfare effects of price floors, 289–293 welfare effects of sales taxes, 285–288 welfare effects of subsidies, 288–289 Pollution Coase Theorem, 607–609 controlling by allocating property rights, 607 emissions fees, 602–603 emissions standards, 601–602 markets for pollution externalities, 609 regulating externalities, 600–601 regulating externalities (pulp and paper mill example), 602 taxes in controlling, 603 trade and, 617–619 welfare effects in competitive market, A:26–A:28 Pooling equilibrium, 641–642 Positive externalities See also Externalities defined, 597 markets for, 610 Positive monotonic transformation, 83 Positive statements, in microeconomics, 5–6 PPF See Production possibility frontier (PPF) Predictions of game outcome, 471 positive statements, Preference maps for bundle of goods, 76–77 indifference curves and, 77 properties, 77 Preferences, consumer curvature of indifference curves, 79–81 defined, 73 indifference curves, 77–79 indifference curves (food/clothing example), 82 ordinal preferences, 83 overview of, 74 preference maps, 76–77 properties, 74–76 willingness to substitute, 79 Index Preferences, social, 336–337 Present biases food stamp example, 546 time-varying discounting and, 545 Present value (PV) calculating real present value of payment, 540 interest rates connecting present and future value, 534–536 of stream of payments, 536–537, A:26 Price ceilings anti-price gouging laws, 308, 339–340 government regulation of monopolies, 367–369 nonoptimal price regulation, 369–371 social costs of, 295 supply and demand and, 30–32 welfare effects of, 293–294 Price-consumption curves demand curve corresponding to, 112 example (tobacco use), 111 taste (indifference curves) impacting, 110–111 Price discrimination due to false beliefs about quality, 634–635 example (Disneyland), 388 example (Google), 392–393 group See Group price discrimination nonlinear See Nonlinear price discrimination nonuniform pricing, 385 not all prices differences are due to price discrimination, 390 perfect See Perfect price discrimination preventing resale, 389–390 questions, 419–420 summary, 418–419 types of, 390–391 welfare effects of, 403–404 which firms can price discriminate, 388–389 why it pays, 386–388 Price elasticity of demand downward-sloping linear demand curve, 46–48 example (oil drilling in Arctic National Wildlife Refuge), 55–57 example (price of corn), 46 group price discrimination and, 399 horizontal demand curve, 48 Lerner Index and, 358 monopolies and, 349–350 over time, 51 overview of, 45–46 residual demand curves, A:14 revenue and, 49–51 Slutsky equation applied to, A:8–A:9 surplus and, A:15–A:16 total, average, and marginal revenue and, 348 vertical demand curve, 48–49 Price elasticity of supply along supply curve, 54–55 example (oil drilling in Arctic National Wildlife Refuge), 55–57 over time, 54 overview of, 53–54 Price floors agricultural, 290–292 supply and demand and, 32–33 welfare effects of, 289–290 Price supports, redistribution of wealth and, 330 Price taking, in competitive markets, 221–222 Prices/pricing advertising and, 638 allocations determined by, anti-price gouging laws, 308, 339–340 block pricing, 405–406, A:18–A:19 bundling tie-in sales, 411–413 choosing price vs quantity in monopolies, 350 compensating variation and equivalent variation and, 126 effect of price change on consumer surplus, 270–273 effect of price change on demand, 120, 144 effect of price change on factor demand, 510 effect of price change on opportunity set, 89–90 effect of price change on revenue, 49 efficiency of perfect price discrimination, 393–394 A-87 example (buying discounts), 402–403 Giffen goods and, 124–125 group price discrimination, 396–397, A:18 group price discrimination (text book resale example), 399–402 group price discrimination with two groups, 397–399 identifying groups for price discrimination, 402 impact on quantity demanded, 12 impact on quantity supplied, 17–18 long-run market supply when input prices vary with output, 248–250 marginal revenue and price in monopolies, 346–347 market failure due to monopoly pricing, 359–362 market failure when marginal costs are not equal to price, 277 market failure when price exceeds marginal cost, 359 market power from price ignorance, 636 nominal vs real prices, 127 nonlinear price discrimination, 404–406 not all prices differences are due to price discrimination, 390 overview of, 384–385 perfect price discrimination, 391–393, A:17–A:18 preventing resale, 389–390 price discrimination, 390–391 price discrimination (Botox example), 395 price taking in competitive markets, 221 quantity vs price in monopolies, A:19–A:20 questions, 419–422 relationship to marginal cost in Lerner Index, 358 requirement tie-in sales, 410–411 sale prices, 417–418 sales prices, 384 sensitivity of quantity demanded to, 44–45 sensitivity of quantity supplied to, 53 short-run firm supply curve and, 237–238 A-88 Index Prices/pricing (continued) summary, 418–419 tie-in sales, 410 transaction costs and perfect price discrimination, 396 two-part pricing, 406–407 two-part pricing with identical consumers, 407–408 two-part pricing with nonidentical consumers, 408–409, A:19–A:20 uniform pricing (iTunes example), 410 welfare effects of price discrimination, 403–404 which firms can price discriminate, 388–389 why price discrimination pays, 386–388 Prices/pricing, of exhaustible resources constant or falling prices, 551–553 overview of, 547–550 scarce exhaustible resources (redwood tree example), 550–551 Principal-agent problem asymmetric information, 655–657 efficiency of contracts, 654 example (agriculture), 664 example (doctors), 656, 659–660 example (subprime loans), 657 overview of, 653–654 symmetric information, 654–655 Principals, checks on principals in contracts, 671–674 Prisoner’s dilemma game cooperation in repeated prisoner’s dilemma game, 481–483 dominant strategies in, 471–472 Private costs, cost of production without externalities, 597 Private firms overview of, 148–149 ownership of, 149–150 Private goods, rival goods compared with, 610–611 Private value auctions, 491 Probability of risk biases in assessing, 584–585 frequency of events and, 563 overview of, 563 probability distribution, 564–565 subjective probability, 564 Producer surplus (PS) applying, 274–275 block pricing and, 405–406 competition maximizing welfare, 276 effects of pollution, 598–599 effects of tariff or quotas, 298–299 example (rose production), 275 group price discrimination and, 403 loss from eliminating free trade, 296–297 measuring with supply curve, 273–274 monopsonies and, 524 nonoptimal price regulation, 370 optimal price regulation, 368 overview of, 273 perfect price discrimination and, 393–394 policies restricting number of firms, 281–283 reducing output below competitive level lowers welfare, 277–279 rent seeking and, 300–301 welfare effects of price ceilings, 294 welfare effects of price floors, 290–293 welfare effects of sales taxes, 285–288 welfare effects of subsidies, 289 Producer welfare See Producer surplus (PS) Producers, number of producers and comparative advantage, 327–328 Product curves, graphing, 155–157 Production average product of labor, 155 combining cost and production information, 196–197 constant, increasing, and decreasing returns to scale (CRS), 166–168 graphing product curves, 155–157 isoquants, 160–163 law of diminishing marginal returns, 157–159 long-run, 159–160 marginal product of labor, 154 overview of, 147–148 production function, 151–152 quantity vs price in monopolies, A:19–A:20 questions, 175–177 returns to scale by industry, 168–169 returns to scale varying by output levels, 169–170 short-run, 153 substituting inputs and, 163–166 summary, 175 total product in short-run production, 153–154 Production and trading comparative advantage, 324–328 competition and, 328–330 efficient product mixes, 328 overview of, 324 questions, 342–343 summary, 341 Production functions Cobb-Douglas production function See Cobb-Douglas production function determining shape of cost curves, 187–188 example (beer manufacturer), A:11–A:12 fixed-proportions production function, 161 relationship of inputs to outputs, 151–152 returns to scale and, 170 Production possibility frontier (PPF) comparative advantage and, 324–325 cost of producing multiple goods, 212–213 efficiency of competition and, 329–330 efficient product mixes, 328 example, 326–327 number of producers and, 327–328 optimal product mix, 327 Productivity innovations and technical progress and, 170–171 of labor during recession, 147, 173–174 organizational change and, 171–172 questions, 178 relative productivity, 170 summary, 175 Products See also Outputs adverse selection with products of unknown quality, 626–630 Index Bertrand oligopoly with differentiated products, 453–455 Bertrand oligopoly with identical products, 452–453 efficient product mixes, 328 example of spurious product differentiation (bottled water), 446–447 identical or homogeneous in competitive markets, 222 nonidentical firms with differentiated products in Cournot oligopoly, 444–446 as output, 151–152 Profit firms must maximize profit to survive, 266 formula for, 226–227 graphical approach to profit maximization, 351–352 mathematical approach to profit maximization, 352–354 maximizing, 150–151, A:15 maximizing for output, 509–510 maximizing for output (airlines example), 437–438 maximizing in long-run competition, 243 maximizing in monopolies, 346, A:19–A:20 maximizing in monopsonies, 521–523 maximizing in short-run competition, 226 output rules, 228–229 questions, 257–258 shutdown rule, 229–230 steps in maximizing, 227–228 summary, 257 zero long-run profit with free entry, 263–264 zero long-run profit with limited entry, 264–266 Profit-sharing contracts, 660–662 Properties consumer preferences, 74–76 preference maps, 77 Property rights, allocating to reduce externalities, 607 Prospect theory comparing with expected utility theory, 587–588 overview of, 587 properties of, 588–589 PS See Producer surplus (PS) Public firms overview of, 148–149 state-owned enterprises in China, 149 Public goods example (Radiohead), 615 free riding and, 613–615 overview of, 613 reducing free riding, 615–616 valuing, 616–617 Public utilities block pricing by, 405–406 as natural monopoly, 364 PV See Present value (PV) Q Quality goods price discrimination due to false beliefs about quality, 634–635 shipping fees and, 124 varying quality with asymmetric information, 629–630 warranties as signal of quality, 633 Quantity demanded cross-price elasticity of demand and, 52 demand curves and, 10–11 effect of prices on, 12 income elasticity of demand and, 52, 116–117 relationship to income, 113, 115–116 sensitivity to price, 44–45 Quantity supplied price and, 17 supply elasticity and, 53–54 Quotas effects of, 298 free trade vs., 299–300 impact on supply curves, 21 import policies and, 295 R Rate of return on bonds, 544 internal rate of return approach to investing, 543–544 Rawls, John, 337–338 Rawlsian welfare functions, 338 Real prices, inflation and, 539 A-89 Rebates, group price discrimination and, 403 Recessions layoffs vs pay cuts, 672–674 productivity of labor during, 147, 173–174 Reformulated Fuels Program (RFG), 252–253 Regression confidence in estimates, A:2–A:3 estimating economic relations, A:1–A:2 multiple regression, A:3 overview of, A:1 Regulations See Government policies and regulation Relative productivity, 170 Rent seeking policies, 300–301 Rents celebrities collecting, 265–266 example of zero long-run profit with limited entry, 264–266 on scarce resources, 549 Repeated games cooperation example (airlines), 483 cooperation in repeated prisoner’s dilemma game, 481–483 overview of, 480–481 questions, 500 strategies in dynamic games, 481 summary, 498 Reputation of employees, 674 screening by, 632 Requirement tie-in sales, 410–411 Resale prevention example (designer bags), 390 example (textbooks), 399–400 price discrimination and, 389–390 Reservation prices of lemon owners, 626 in perfect price discrimination, 391 Reserves, of exhaustible resources, 552 Residual demand curves deriving for competitive firm, 224–226 elasticity of, A:14 Residual supply curves example (cotton in Japan), 251 international trade and, 250 long-run market supply with trade and, 250 A-90 Index Resources allocating scarce See Allocation of scarce resources exhaustible See Exhaustible resources opportunity cost of using, 180 Retirement investments, diversification of, 577 Returns to scale constant, increasing, and decreasing, 166–168 by industry, 168–169 long-run costs and, 204 questions, 177–178 summary, 175 varying by output levels, 169–170 Returns to specialization, 170 Revenue (R) comparing competitive firm with monopoly, 347 demand elasticity and, 49–50 demand elasticity over time and, 51 impact of drought on revenue from corn, 50–51 marginal See Marginal revenue (MR) marginal revenue product of labor See Marginal revenue product of labor (MRPL) profit and, 150 Reverse auctions, 403 RFG (Reformulated Fuels Program), 252–253 Risk assessment biases in, 584–585 expected value, 565–566 overview of, 563 probability of risk, 563–565 prospect theory, 587–589 questions, 591 summary, 590 variance and standard deviation from expected value, 566–567 violations of expected utility theory, 586–587 Risk attitudes expected utility theory and, 567–568 gambling and, 573–574 overview of, 567 questions, 591–592 risk aversion, 568–571 risk neutrality, 572 risk preference, 573 summary, 590 Risk aversion attitudes toward risk, 568–571 investing and, 582–584 unwillingness to take a fair bet, 568 Risk preferring attitudes toward risk, 572 indifferent regarding fair bet, 568 investing and, 582 overview of, 573–574 willing to take a fair bet, 568 Risk premiums, 571 Risk reduction diversification, 575–577 flight insurance example, 580 insurance, 577–581 natural disaster insurance, 581–582 obtaining information, 575 overview of, 574 questions, 592 summary, 590 Rival goods, 610–611 Rivalry/exclusion club goods, 612 free riding and, 615–616 open-access common property, 611–612 overview of, 610–611 piracy and, 613 public goods, 613–615 questions, 622 summary, 620 valuing public goods, 616–617 Robinson-Patman Act, 386 Rules, of games, 469 S Sales, of exhaustible resources, 547 Sales prices, 384 Sales taxes burden shared by firms and customers, 61–63 effect on supply-and-demand, 58 effects of ad valorem and specific taxes, 63–65 equilibrium effects of, 58–61 example (gasoline tax), 66–67 example (prevention of obesity), 62 impact on demand, 10 welfare effects of, 285–288 Salience, bounded rationality and, 100–101 Satiation more-is-better and, 95 mutually beneficial trades and, 319 Scale, return to See Returns to scale Scarce resources allocation of See Allocation of scarce resources causes of monopolies, 363 pricing, 547–550 Screening actions for equalizing information, 631–632 bad workers, 674 Sealed-bid auction overview of, 491 strategies in, 493 Second-degree price discrimination See Nonlinear price discrimination Second-price strategy in auctions, 492 example (eBay), 269–270 Second Theorem of Welfare Economics, 321, 324 Self-control problems, resulting in falling discount rate, 546 Sellers, in competitive markets, 222 Separating equilibrium, education as signal of ability and, 641 Sequential games credible threat and, 486–487 dynamic entry games, 487–488 dynamic entry games (airlines example), 488–489 game trees, 483–484 limit pricing, 489 overview of, 481, 483 questions, 501–503 subgames perfect Nash equilibrium, 484–486 summary, 498 Sequential movement, in Stackelberg oligopoly, 450 Services as output, 151 price determining allocations, trade-offs in resource allocation, Shareholders, 149 Shares, corporate, 149 Sherman Antitrust Act in 1890, 429 Index Shift in demand curve comparing competitive firm with monopoly, 355 effect of factors other than price on demand, 12–13 effects of rise in income on demand, 113 effects on monopolies, 354–355 equilibrium effects of, 25 labor example, 511 policies causing, 280–281 shocks to equilibrium, 24–26 Shift in supply curve causing movement along demand curve, 43 equilibrium effects of, 25 example, 19 policies causing, 280–281 shocks to equilibrium, 26 variables causing, 18–19 Shirking bonding to prevent, 667–669 contracts for avoiding moral hazard, 674–675 deferred payments to prevent, 669 efficiency wages to prevent, 669–670, A:28 monitoring for avoiding, 666 Shocks effects of supply shock depend on shape of demand curve, 43–44 feedback between competitive markets, 311 to market equilibrium, 24–26 Short and long-run expansion paths, 209–210 Short-run average cost curves (SRAC) laser printer example, 208–209 long-run average cost as envelope of short-run average cost curves, 207–208 Short-run competition competitive equilibrium, 240–242 firm supply curve, 237–238 market supply curve, 238–240 output decisions, 231–234 overview of, 230 questions, 258–260 shutdown decisions, 234–237 summary, 257 Short-run cost curves example (beer manufacturer), 190, A:11–A:12 long-run average cost as envelope of short-run average cost curves, 207–209 overview of, 186–187 production functions determining shape of, 187–188 shape of average cost curve, 189–190 shape of marginal cost curve, 189 shape of variable cost curve, 188–189 Short-run costs average, 185 fixed, variable, and total, 184 marginal, 184–185 overview of, 183–184 production functions and shape of cost curves, 187–188 shape of average cost curve, 189–190 shape of marginal cost curve, 189 shape of variable cost curve, 188–189 short-run cost curve (beer manufacturer example), 190 short-run cost curves, 186–187 summary, 193 taxes impacting, 191–192 Short-run demand demand elasticity over time, 51 factor demand in competitive factor market, 507–510 Short-run production average product of labor, 155 defined, 152 graphing product curves, 155–157 law of diminishing marginal returns, 157–159 marginal product of labor, 154 overview of, 153 questions, 176–177 summary, 175 total product, 153–154 Shutdown applied to oil sands and oil shale, 236–237 decisions in monopolies, 352 decisions in short-run competition, 234–236 example (ethanol processing plants), 244 rules in profit maximization, 229–230 A-91 Signaling actions for equalizing information, 632–633 education as signal of ability, 640–644 employees signaling regarding productivity, 674 strategies in dynamic games, 482 Simplification, models and, Single-price monopoly comparing welfare effects with of type of price discrimination, 403 group price discrimination compared with, 404 perfect price discrimination, 394 Slutsky equation, 120, A:8–A:9 Slutsky, Eugene, A:8 Snob effect, network externalities and, 376 Social costs cost of production with externalities, 598 social marginal costs, 599 Social producer surplus, 599 Social welfare functions efficiency vs equity, 338–339 in ranking allocations, 334–335 voting as means of ranking allocations, 337–338 SOEs (state-owned enterprises), in China, 149 Sole proprietorships, ownership of for-profit firms, 149–150 Specialization, returns to, 170 Specific taxes (unit taxes) equilibrium effects of, 59, 63–65, A:3–A:4 example (roses), 286 free trade vs tariffs, 297 impact on monopolies, 361–362, A:16–A:17 impact on short-run equilibrium, 242 types of sales taxes, 58 Spurious product differentiation Cournot oligopoly and, 444–445 example (bottled water), 446–447 SRAC (short-run average cost curves) laser printer example, 208–209 long-run average cost as envelope of short-run average cost curves, 207–208 A-92 Index Stackelberg game tree, 484 Stackelberg oligopoly comparing types of equilibria, 450–451 as dynamic entry game, 487–488 graphical model of, 447–449 limit pricing and, 489–490 overview of, 447 questions, 465 as sequential game (airline example), 483–487 sequential movement in, 450 summary, 463 Standard deviation, from expected value, 566–567 Standards, actions for equalizing information, 634 State-contingent contracts, 659–660 State-owned enterprises (SOEs), in China, 149 States of nature, decision making and, 562 Static games applying to strategic advertising by oligopolies, 479–480 best response and Nash Equilibrium, 472–474 cooperation and, 478–479 dominant strategies, 471–472 in explanation of parent/child interaction, 477–478 mixed strategies, 475–476 multiple Nash equilibria and, 475 normal-form representation of, 470–471 overview of, 470 predicting outcomes, 471 questions, 498–500 summary, 497 Statistical discrimination, in hiring, 644–646 Stocks (investment) investing in corporations, 149 retirement investments, 577 risk premium of, 571 Stocks (of durable goods), 531 Strategies, in game theory auction strategies, 492–493 best response and Nash Equilibrium, 472–474 defined, 469 dominant strategies in static games, 471–472 in dynamic games, 481 mixed strategies, 475–476 multiple Nash equilibria and, 475 in normal-form representation of static games, 471 pure strategy and mixed strategy, 474–475 in repeated prisoner’s dilemma game, 482–483 Stream of payments interest rates on, 536–538 present value of perpetuity, A:26 Subgames, in sequential games, 484 Subgames perfect Nash equilibrium, 484–486 Subjective probability, 564 Subsidies effects on supply and demand, 65–67 example (aircraft construction), 424, 461–462 example (childcare), 107, 141–142 example (Ethanol), 66 as negative tax, 62 welfare effects of, 288–289 Substitute goods cross-price elasticity of demand and, 53 demand and price and, 10 example (substituting alcohol for marijuana), 92 imperfect substitutes, 81 marginal rate of substitution (MRS) and, 79–81 market power and lack of, 358 perfect complements, 81 perfect substitutes, 80–81 Substitution bias, in CPI, 132 Substitution effects example (apple pie), 122–123 example (plate prices at two types of stores), 123–124 inferior goods and, 124–125 labor-leisure choice and, 135–137 with normal goods, 120–124 overview of, 120 Slutsky equation applied to, A:8–A:9 Sunk costs as barrier to entry, 284 overview of, 183 Supply excess supply, 24 impact of import policy on supply curves, 20–21 overview of, 17 policies creating wedge between supply and demand, 285 policies that cause demand to differ from supply, 29 policies that shift supply curves, 27–29 shock impact depending on shape of demand curve, 43–44 summing supply curves, 20 supply curve, 17–19 supply function, 19 when supply need not equal demand, 33–34 when to use supply-and-demand model, 34–36 Supply and demand demand curves, 10–11 demand function, 14–16 effect of factors other than price on demand, 12–13 equilibrium effects of government interventions, 26 example (genetically modified food), import policy impacting supply curves, 20–21 market equilibrium, 22–24 overview of, policies that cause demand to differ from supply, 29 policies that shift supply curves, 27–29 price ceilings, 30–32 price floors, 32–33 questions, 37–41 shocks to equilibrium, 24–26 summary, 36–37 summing demand curves, 16–17 summing supply curves, 20 supply curves, 17–19 supply function, 19 when supply need not equal demand, 33–34 Supply-and-demand model applying demand and supply elasticity (oil drilling example), 55–57 cross-price elasticity of demand, 52–53 demand elasticity along downward-sloping linear curve, 46–48 Index demand elasticity along horizontal curve, 48 demand elasticity along vertical curve, 48–49 demand elasticity and revenue, 49–51 demand elasticity over time, 51 effects of ad valorem and specific taxes, 63–65 effects of sales taxes, 58 effects of subsidies, 65–67 equilibrium effects of specific sales tax, 58–61 example (gasoline tax), 42 income elasticity of demand, 52 overview of, 43 price elasticity of demand, 45–46 price elasticity of supply, 53–54 quantity demanded sensitivity to price, 44–45 quantity supplied sensitivity to price, 53 sales tax burden shared by firms and customers, 61–63 shapes of supply and demand curves, 43–44 summary, 67 supply elasticity along supply curve, 54–55 supply elasticity over time, 54 use by economists, when to use, 34–36 Supply curves defined, 17 determining market equilibrium, 22 effects of specific tax on short-run equilibrium, 242 example (avocados), 18 example (cotton), 248 example (gasoline), 252–254 import policy impacting, 20–21 long-run competitive equilibrium and, 254–255 long-run firm supply curve, 243–244 long-run market supply curve, 245–246 measuring producer surplus, 273–274 monopsonies and, 521 movement along See Movement along supply curve overview of, 17–19 shape of, 43–44 shift in See Shift in supply curve short-run firm supply curve, 237–238 short-run market supply curve, 238–240 summing, 20 supply elasticity along, 54–55 Supply curves, for labor deriving, 132 income and substitution effects applied to labor-leisure choice, 135–137 income tax rates and, 139–141 labor-leisure choice, 132–135 shape of, 137–139 Supply function, 19 Surplus consumer surplus See Consumer surplus (CS) producer surplus See Producer surplus (PS) Symmetric information, in efficient contracts, 654–655 T Tangency rule, minimizing costs and, 197–198 Tariffs (duty) example (chicken tax), 300 free trade vs., 297–299 import policies and, 295 resale prevention, 389 Tastes, consumer See also Preferences, consumer, Taxes bounded rationality and tax salience, 100 burden of sales tax shared by firms and customers, 61–63 effect of sales tax on supply-anddemand, 58 effects of ad valorem and specific taxes, 63–65 effects of specific tax on monopolies, 361–362 effects of specific tax on short-run equilibrium, 242 effects of tax on output on demand for labor, 510–511 equilibrium effects of specific sales tax, 58–61 example (gasoline tax), 66–67 example (tobacco use), 111 A-93 on externalities in noncompetitive markets, 607 impact of sales taxes on demand, 10 incidence of, 61–62 income tax rates and labor supply curve, 139–141 for pollution control, 603–604 redistribution of wealth and, 330 shifting burden to middle class, 331–332 short-run costs impacted by, 191–192 subsidies as negative tax, 62 urban flight due to tax on wages, 317 welfare effects of sales taxes, 285–288 who pays the gasoline tax, 42–43 Technical progress defined, 171 example (Tata Motors), 173 impact on price of exhaustible resources, 552 productivity and, 170–171 Technological efficiency choices at home vs abroad, 214–215 long-run costs and, 194 maximizing profits, 151 output decisions, 179 Testing theories, with microeconomic model, 4–5 Tests of transitivity, 98–99 Thales, 345 Third-degree price discrimination See Group price discrimination Third-party information, actions for equalizing information, 633–634 Threatening to punish credibility of in sequential dynamic games, 486–487 strategies in dynamic games, 481–482 Tie-in sales bundling, 411–413 overview of, 410 questions, 422 requirement tie-in sales, 410–411 summary, 418–419 Time choices over, 541 investing and See Investments A-94 Index Time (continued) price elasticity of demand over, 51 supply elasticity over, 54 time-varying discounting, 545–546 Total costs (C) long-run cost curves, 203 overview of, 184 short-run cost curves, 187 Total effects apple pie example, 122–123 labor-leisure choice and, 135–137 as sum of income and substitution effects, 122 Total product See Outputs Tourist-trap model monopoly pricing, 637 overview of, 636 uncompetitive pricing, 636–637 Trade benefits of, 325–326 long-run market supply with, 250–254 pollution and, 617–619 trade wars (chicken tax example), 300 Trade laws, resale prevention, 389 Trade-offs marginal rate of transformation measuring, 88 resource allocation and, Trades, between two people bargaining ability and, 321 endowment as basis of, 317–318 mutually beneficial trades, 319–321 overview of, 317 questions, 342 summary, 340 Transaction costs in competitive markets, 222–223 perfect price discrimination and, 396 resale difficult when transaction costs are high, 389 Transitivity property, consumer preferences, 74–75 Transitivity (rationality) assumption, 335 Trigger strategy, in dynamic games, 482 Trusts See also Cartels, 429 Two-part pricing with identical consumers, 407–408 with nonidentical consumers, 408–409, A:19–A:20 overview of, 406–407 questions, 422 summary, 418 types of nonuniform pricing, 385 Two-period monopoly model, 377 U Ultimatum games, 494–495 Uncertainty assessing risk, 563 behavioral economics of, 584 biases in assessing risk probability, 584–585 diversification as risk reduction method, 575–577 example (British Petroleum), 561–562, 589–590 example (flight insurance), 580 expected utility theory and, 567–568 expected value in assessing risk, 565–566 information in risk reduction, 575 insurance as risk reduction method, 577–581 investing and, 582 natural disaster insurance, 581–582 overview of, 562 probability of risk, 563–565 prospect theory, 587–589 questions, 590–594 reducing risk, 574 risk attitudes, 567 risk-averse investing, 582–584 risk aversion, 568–571 risk-neutral investing, 582 risk neutrality, 572 risk preferring, 573–574 summary, 590 variance and standard deviation from expected value, 566–567 violations of expected utility theory, 586–587 Unified Carrier Registration Agreement, 220 Uniform pricing example (iTunes), 410 overview of, 384 Unions, as monopoly, 519 Unit taxes See Specific taxes (unit taxes) Unitary elasticity, of supply, 54 Universal coverage, restricting opportunistic behavior, 630 Utility defined, 73 expected utility, 567–568 indifference curves and, 83–85, A:4–A:6 in labor-leisure choice, A:9–A:10 marginal rate of substitution (MRS), 86 marginal utility, 85–86 maximizing in mutually beneficial trades, 319 maximizing subject to budget constraint, 91–92, A:6–A:8 ordinal preferences, 83 overview of, 82 risk aversion and, 568–570 risk neutrality and, 572 risk preferring and, 573 social welfare functions maximizing, 337–338 utility function, 82–84 Utility function, 82–84 V Variable costs (VC) overview of, 184 shape of variable cost curve, 188–189 short-run cost curves, 187 shutdown decisions in short-run competitive firms, 234–236 taxes impacting short-run cost curves, 191 Variable inputs, 152 Variance, from expected value, 566–567 VC See Variable costs (VC) Vertical integration, as means of preventing resale, 389 von Neumann, John, 567 Voting, as allocation method, 335–337 W Wages compensating differentials for occupational safety, 623–624 efficiency wages to prevent moral hazard, 669–670 Index factor demand impacted by change in, 509–510, A:24–A:25 income and substitution impacted by change in, 135–136 layoffs vs pay cuts, 672–674 minimum wages with incomplete coverage, 314–316 occupational licensing and, 27 price floors, 32–34 shape of labor supply curves, 137 unions ability to raise, 519 urban flight resulting from tax on, 317 Warranties, as signal of quality, 633 Water quotas, impacting opportunity set, 88–89 Wealth government programs in redistribution of, 330 inequitable distribution of, 331–332 Welfare applying producer surplus and, 274–275 barriers to entry or exit reducing, 284 block pricing and, 405–406 competition maximizing, 276 of consumers See Consumer surplus (CS) deadweight loss and, 276–277 deadweight loss (Christmas presents example), 279–280 differentiated products and, 455 in economists’ terminology, 262 effects of monopsonies, 524–526 effects of nonoptimal price regulation, 370 effects of optimal price regulation, 368 effects of pollution, 598–599, A:26–A:28 effects of price ceilings, 293–295 effects of price changes, 270–273 effects of price discrimination, 403–404 effects of price floors, 289–293 effects of restrictions on number of firms, 281–283 effects of sales taxes, 285–288 effects of subsidies, 288–289 government policies and, 333–334, 280 group price discrimination and, 403 maximizing, 334 measuring consumer surplus with demand curve, 267–270 measuring producer surplus with supply curve, 273–274 monopolies vs competitive welfare with externalities, 606–607 overproduction causing decrease in, 278–279 A-95 perfect price discrimination and, 393–394 of producers See Producer surplus (PS) Welfare economics, 262 Willingness-to-accept (WTA), deadweight loss of Christmas presents and, 279 Willingness-to-pay (WTP), deadweight loss of Christmas presents and, 279 Willingness to substitute See Marginal rate of substitution (MRS) Winner’s curse, 493–494 World Trade Organization (WTO) aircraft subsidies and, 424 pressure on governments to reduce/eliminate barriers to trade, 372 ruling on genetically modified crops, Z zero long-run profit for competitive firms with free entry, 263–264 for competitive firms with limited entry, 264–266 Zoning laws, as barrier to entry by hotel chains, 460–461 Credits p 8: AGE Fotostock/SuperStock p 12: © 2013 Zach Weinersmith/smbc-comics.com p 14: Shutterstock p 30: United States Government Printing Office p 32: Jeffrey M Perloff p 42: Jeffrey M Perloff p 333 bottom left: Breaker boys working in Ewen Breaker of Pennsylvania Coal Co (1911), Lewis Wickes Hine Library of Congress Prints and Photographs Division [LC-USZ62-12876] p 333 middle right: Library of Congress Prints and Photographs Division [LC-USZ62-13040] p 43: Pearson Education, Inc p 333 far right: Pete Souza/Library of Congress Prints and Photographs Division [LC-DIG-ppbd-00358] p 50: Shutterstock p 344: Jeffrey M Perloff p 56: United States Geological Survey (USGS) p 357: Jeffrey M Perloff p 72: Jeffrey M Perloff p 359: Pearson Education, Inc p 79: Pearson Education, Inc p 366: John W Shore, M.D p 98: United States Department of Agriculture (USDA) p 384: Jeffrey M Perloff p 107: Jim West/Alamy p 388: Jeffrey 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of Boeri, SRL p 308: National Oceanic and Atmospheric Administration (NOAA) p 568: Jeffrey M Perloff p 332 top: Abraham Lincoln (5 Feb 1865), Alexander Gardner Gelatin silver print Library of Congress Prints and Photographs Division [LC-USZ62-11896] p 580: Pearson Education, Inc p 332 bottom: George Washington (Vaughan Portrait) (1795), Gilbert Stuart Oil on canvas, 73 x 60.5 cm (28 3/4 x 23 13/16 in.) Andrew W Mellon Collection, National Gallery of Art, Washington, DC p 602: Shutterstock p 333 top left: Destitute pea pickers in California Mother of seven children Age thirty-two Nipomo, California (“Migrant Mother”) (1936), Dorothea Lange Library of Congress Prints and Photographs Division [LC-USZ62-95653] A-96 p 573: Jeffrey M Perloff p 595: Barry Sweet/AP Images p 600: Pearson Education, Inc p 609: Doral Chenoweth III/The Columbus Dispatch/AP Images p 623: Davis Turner/EPA/Newscom p 626: Pearson Education, Inc p 631: Pearson Education, Inc p 651: Pearson Education, Inc p 659: Damian Dovarganes/AP Images Symbols Used in This Book α [alpha] = ad valorem tax (or tariff) rate, or an exponent in a Cobb-Douglass production function ᏸ = lump-sum tax Δ [capital delta] = change in the following variable (for example, the change in p between Periods and is Δp = p2 - p1, where p2 is the value of p in Period and p1 is the value in Period 1) ρ [rho] = profit tax rate ε [epsilon] = the price elasticity of demand ω [omega] = share η [eta] = the price elasticity of supply ξ [xi] = the income elasticity of demand π [pi] = profit = revenue - total cost = R - C σ [sigma] = standard deviation θ [theta] = probability or share Abbreviations, Variables, and Function Names AFC = average fixed cost = fixed cost divided by output = F/q MR = marginal revenue = ΔR/Δq MRS = marginal rate of substitution AVC = average variable cost = variable cost divided by output = VC/q MRTS = marginal rate of technical substitution AC = average cost = total cost divided by output = C/q n = number of firms in an industry MUZ = marginal utility of good Z APZ = average product of input Z (for example, APL is the average product of labor) p = price C = total cost = variable cost + fixed cost = VC + F PS = producer surplus = revenues - variable costs = R - VC CRS = constant returns to scale PPF = production possibility frontier CV = compensating variation Q = market (or monopoly) output _ Q = output quota D = market demand curve q = firm output Dr = residual demand curve R = revenue = pq DRS = decreasing returns to scale r = price of capital services DWL = deadweight loss s = per-unit subsidy F = fixed cost S = market supply curve i = interest rate So = supply curve of all the other firms in the market CS = consumer surplus I = indifference curve IRS = increasing returns to scale K = capital L = labor LR = long run m = constant marginal cost M = materials SC = a market of economies of scope SR = short run t = specific or unit tax (or tariff) T = tax revenue (α pQ, τQ, ρπ) U = utility VC = variable cost MC = marginal cost = ΔC/Δq w = wage MPZ = marginal (physical) product of input Z (for example, MPL is the marginal product of labor) Y = income or budget W = welfare Featured Applications in This Book Chapter 1: Income Threshold Model and China Chapter 2: Calorie Counting at Starbucks Aggregating Corn Demand Curves Occupational Licensing Price Controls Kill 13 16 27 31 Do Farmers Benefit from a Major Drought? 50 Oil Drilling in the Arctic National Wildlife Refuge 55 Taxes to Prevent Obesity 62 The Ethanol Subsidy 66 Chapter 4: You Can’t Have Too Much Money 75 Indifference Curves Between Food and Clothing 85 Substituting Alcohol for Marijuana 92 Benefiting from Food Stamps 98 Opt In Versus Opt Out 100 Unaware of Taxes 101 Chapter 5: 111 119 124 126 130 138 Chapter 6: Chinese State-Owned Enterprises Malthus and the Green Revolution 162 168 171 173 Chapter 7: Chapter 3: Smoking Versus Eating and Phoning Fast-Food Engel Curve Shipping the Good Stuff Away What’s the Value of Using the Internet? Paying Employees to Relocate Working After Winning the Lottery A Semiconductor Integrated Circuit Isoquant Returns to Scale in Various Industries A Good Boss Raises Productivity Tata Nano’s Technical and Organizational Innovations 149 158 The Opportunity Cost of an MBA 181 Short-Run Cost Curves for a Beer Manufacturer 190 Economies of Scale in Nuclear Power Plants 205 Long-Run Cost Curves in Beer Manufacturing 208 Choosing an Inkjet or a Laser Printer 208 Learning by Drilling 211 Economies of Scope 213 Chapter 10: Urban Flight The Wealth and Income of the 1% How You Vote Matters 317 331 336 Chapter 11: Apple’s iPad Cable Cars and Profit Maximization Botox Patent Monopoly Natural Gas Regulation Generic Competition for Apple’s iPod Critical Mass and eBay 353 357 366 372 373 377 Chapter 12: Chapter 8: Oil, Oil Sands, and Oil Shale Shutdowns The Size of Ethanol Processing Plants Fast-Food Firms’ Entry in Russia Upward-Sloping Long-Run Supply Curve for Cotton Reformulated Gasoline Supply Curves The Deadweight Cost of Raising Gasoline Tax Revenue 286 How Big Are Farm Subsidies and Who Gets Them? 292 The Social Cost of a Natural Gas Price Ceiling 295 The Chicken Tax Trade War 300 236 244 245 248 252 Chapter 9: Tiger Woods’ Rent 266 Willingness to Pay and Consumer Surplus on eBay 269 Goods with a Large Consumer Surplus Loss from Price Increases 271 Deadweight Loss of Christmas Presents 279 Licensing Cabs 283 Disneyland Pricing 338 Preventing Resale of Designer Bags 390 Google Uses Bidding for Ads to Price Discriminate 392 Botox Revisited 395 Warner Brothers Sets Prices for a Harry Potter DVD 397 Reselling Textbooks 399 Buying Discounts 402 iTunes for a Song 410 Ties That Bind 411 Super Bowl Commercials 416 Chapter 13: Catwalk Cartel 431 Casket Entry 433 Hospital Mergers: Market Power Versus Efficiency 434 Mobile Number Portability 442 Bottled Wate 446 Welfare Gain from More Toilet Paper 455 Monopolistically Competitive Food Truck Market 456 Zoning Laws as a Barrier to Entry by Hotel Chains 460 Chapter 14: Tough Love Strategic Advertising Dominant Airlines Bidder’s Curse GM’s Ultimatum 477 479 488 494 495 Winning the Lottery Falling Discount Rates and Self-Control Redwood Trees 540 546 550 Chapter 17: Stocks’ Risk Premium 571 Gambling 573 Diversifying Retirement Funds 577 Flight Insurance 580 Limited Insurance for Natural Disasters 581 Biased Estimates 585 Chapter 15: Unions and Profits Wal Mart’s Monopsony Power 609 610 613 615 616 Chapter 19: Changing a Firm’s Name Adverse Selection on eBay Motors Reducing Consumers’ Information 632 633 635 Chapter 20: 519 523 Chapter 16: Power of Compounding Saving for Retirement Buying a Town Acid Rain Program Piracy Radiohead’s “Public Good” Experiment What’s Their Beef? 534 538 Chapter 18: Negative Externalities from Spam 597 Pulp and Paper Mill Pollution and Regulation 602 Why Tax Drivers 603 Protecting Babies 604 Selfless or Selfish Doctors? Contracts and Productivity in Agriculture Music Contracts: Changing Their Tunes Abusing Leased Cars Layoffs Versus Pay Cuts 656 664 665 671 672 ... 1981–19 82 Deep recession 1938 Fair Labor Standards Act creates a minimum wage 42. 6 35.4 32. 1 35.1 33 .2 30.1 30.7 30 30 28 .7 27 .8 28 26 .1 BIG BUSINESS 31 31.4 36.6 35.1 32. 7 34.6 30.3 22 .6 19.8... in an equilibrium If pw = $1.33 and pc = $1, Denise wants to buy 20 Id Jane’s wood 20 30 f Price line a 20 30 Id e 22 20 j d 40 32 Jane’s candy Id Ij Ij 0j 80 50 Jane’s wood 30 e (b) Prices That... shows how they would trade to Bundle f 20 Endowment, e Wood Candy 30 20 20 60 40 Trade Wood Candy −10 +20 +10 20 I j2 I j3 30 50 80 New Allocation, f Wood Candy 20 40 30 40 candy equals Denise’s