(BQ) Part 2 book Microeconomics with calculus has contents: Monopoly and monopsony, pricing and advertising, game theory, factor markets, uncertainty, externalities and public goods, information, contract theory,...and other contents.
www.downloadslide.com Monopoly and Monopsony Monopoly: one parrot Apple started selling the iPad on April 3, 2010 The iPad was not the first tablet Indeed, it wasn’t Apple’s first tablet: Apple sold another tablet, the Newton, from 1993–1998 But the iPad was the most elegant one, and the first one that many consumers wanted to own Users interact with the iPad using Apple’s multi-touch, finger-sensitive touchscreen (rather than a pressure-triggered stylus that most previous tablets used) and a virtual onscreen keyboard (rather than a physical one) Most importantly, the iPad offers an intuitive interface and is well integrated with Apple’s iTunes music, eBooks, and various application programs People loved the original iPad Even at $499 for the basic model, Apple had a virtual monopoly on high-end tablets in its first year According to the research firm IDC, in 2010, Apple’s market share of all tablets was 87% Moreover, the other tablets available in 2010 were not viewed by most consumers as close substitutes Apple reported that it sold 25 million iPads worldwide in its first full year, 2010–2011 Within a year of iPad’s introduction, over a hundred iPad wanna-be tablets were launched To maintain its dominance, Apple replaced the original iPad with the feature-rich iPad in 2011, added the enhanced iPad in 2012, and cut the price of the iPad by $100 in 2012 Industry experts believe that Apple can produce tablets at far lower cost than most if not all of its competitors Apple has formed strategic partnerships with other companies to buy large supplies of components, securing a lower price from suppliers than its competitors Using its own patents, Apple avoids paying as many licensing fees as other firms Copycat competitors with 10-inch screens have gained some market share from Apple More basic tablets with smaller 7-inch screens that are little more than e-readers have sold a substantial number of units, so that the iPad’s share of the total tablet market was 68% in the first quarter of 2012, but it still has a stranglehold on the high-end market In this chapter, we’ll answer two questions about the iPad: How did Apple set the price for the iPad when it was essentially the only game in town? (See Solved Problem 11.2.) How did the presence of me-too rival products produced by firms with higher marginal costs affect Apple’s pricing more recently? (See the Challenge Solution.) 11 C hA l l e n g e Pricing Apple’s iPad 385 www.downloadslide.com 386 CHAPTEr 11 Monopoly and Monopsony A monopoly is the only supplier of a good for which there is no close substitute Monopolies have been common since ancient times In the fifth century bc, the Greek philosopher Thales gained control of most of the olive presses during a year of exceptionally productive harvests Similarly, the ancient Egyptian pharaohs controlled the sale of food In England, until Parliament limited the practice in 1624, kings granted monopoly rights called royal charters or patents to court favorites Today, virtually every country grants a patent—an exclusive right to sell that lasts for a limited time—to an inventor of a new product, process, substance, or design Until 1999, the U.S government gave one company, Network Solutions, the right to be the sole registrar of Internet domain names consumers hate monopolies because monopolies charge high prices A monopoly can set its price—it is not a price taker like a competitive firm is A monopoly’s output is the market output, and the demand curve a monopoly faces is the market demand curve because the market demand curve is downward sloping, the monopoly doesn’t lose all its sales if it raises its price, unlike a competitive firm As a consequence, the monopoly sets its price above marginal cost to maximize its profit consumers buy less at this high monopoly price than they would at the competitive price, which equals marginal cost As a result, welfare is lower than in a competitive market We also examine a monopsony: the only buyer of a good in a market We show that a profit maximizing monopsony sets its price below the competitive level, which lowers welfare compared to a competitive market In this chapter, we examine seven main topics Monopoly Profit Maximization Like all firms, a monopoly maximizes its profit by setting its price or output so that its marginal revenue equals its marginal cost Market Power and Welfare How much the monopoly’s price is above its marginal cost depends on the shape of the demand curve that the monopoly faces, and this gap between price and marginal cost lowers welfare relative to the competitive level Taxes and Monopoly Specific and ad valorem taxes increase the deadweight loss due to monopoly, may have consumer incidences in excess of 100%, and affect welfare differently from each other Causes of Monopolies Two major causes for a monopoly are a firm’s cost advantage over other potential firms and government actions government Actions That Reduce Market Power The welfare loss of a monopoly can be reduced or eliminated if the government regulates the price the monopoly charges or allows other firms to enter the market Monopoly Decisions over Time and Behavioral economics If its current sales affect a monopoly’s future demand curve, a monopoly that maximizes its long-run profit may choose not to maximize its short-run profit Monopsony A monopsony—a single buyer—maximizes its profit by paying a price below the competitive level, so welfare is lower than the competitive level 11.1 Monopoly Profit Maximization competitive firms and monopolies alike maximize their profits using a two-step procedure (chapter 8) First, the firm determines the output at which it makes the highest possible profit Second, the firm decides whether to produce at that output level or to shut down, using the rules described in chapter www.downloadslide.com 11.1 11.1 Monopoly Profit Maximization 387 For a competitive firm, we distinguished between a lowercase q, which represented a firm’s output, and an uppercase Q, which reflected the market quantity because a monopoly sells the entire market quantity, we use Q to indicate both the monopoly’s quantity and the market quantity The necessary Condition for Profit Maximization A monopoly’s first step is to pick its optimal output level A monopoly, like any firm (chapter 8), maximizes its profit by operating where its marginal revenue equals its marginal cost, as we now show formally A monopoly’s profit function is π(Q) = R(Q) - C(Q), where R(Q) is its revenue function and C(Q) is its cost function The necessary condition for the monopoly to maximize its profit is found by choosing that output Q* such that the derivative of its profit function with respect to output equals zero: d2π(Q*) dR(Q*) dC(Q*) = = 0, dQ dQ dQ (11.1) where dR/dQ = MR is its marginal revenue function (chapter 8) and dC/dQ = MC is its marginal cost function (chapter 7) Thus, Equation 11.1 requires the monopoly to choose that output level Q* such that its marginal revenue equals its marginal cost: MR(Q*) = MC(Q*) For profit to be maximized at Q*, the second derivative of the profit function with respect to output must be negative: d2π(Q*) dQ2 = d2R(Q*) dQ2 - d2C(Q*) 0, dQ (11.2) where d2R/dQ2 is the second derivative of the revenue function with respect to Q and d2C/dQ2 is the second derivative of the cost function by definition, d2R/dQ2 = dMR/dQ is the slope of its marginal revenue curve Similarly, d2C/dQ2 = dMC/dQ is the slope of the marginal cost curve Thus, Equation 11.2 requires that, at the critical point Q*, the slope of the marginal revenue curve be less than that of the marginal cost curve: d2R(Q*)/dQ2 d2C(Q*)/dQ2 or dMR(Q*)/dQ dMC(Q*)/dQ Typically, this condition is met because the marginal cost curve is constant or increasing with output (dMC/dQ Ú 0) and the monopoly’s marginal revenue curve is downward sloping (dMR/dQ 0), as we will now show Marginal Revenue and the Demand Curves A firm’s marginal revenue curve depends on its demand curve We will demonstrate that a monopoly’s marginal revenue curve is downward sloping and lies below its demand curve at any positive quantity because its demand curve is downward sloping The following reasoning applies to any firm that faces a downward-sloping demand curve—not just to a monopoly The monopoly’s inverse demand function shows the price it receives for selling a given quantity: p(Q) That price, p(Q), is the monopoly’s average revenue for a given quantity, Q Its revenue function is its average revenue or price times the number of units it sells: R(Q) = p(Q)Q Using the product rule of differentiation, we can write the monopoly’s marginal revenue function as MR(Q) = dR(Q) dp(Q)Q dQ dp(Q) dp(Q) = = p(Q) + Q = p(Q) + (11.3) dQ dQ dQ dQ dQ www.downloadslide.com 388 CHAPTEr 11 Monopoly and Monopsony The first term on the right-hand side of Equation 11.3, p(Q), is the price or average revenue The second term is the slope of the demand curve, dp(Q)/dQ, times the number of units sold, Q because the monopoly’s inverse demand curve slopes downward, dp(Q)/dQ 0, this second term is negative (In contrast, a competitive firm’s inverse demand curve has a slope of zero because it is horizontal, so the second term is zero, and the competitive firm’s marginal revenue equals the market price, as we saw in chapter 8.) Thus, at a given positive quantity, a monopoly’s marginal revenue is less than its price or average revenue by [dp(Q)/dQ]Q That is, a monopoly’s marginal revenue curve lies below its inverse demand curve at any positive quantity Figure 11.1 illustrates the reason a monopoly’s marginal revenue is less than its price The monopoly, which is initially selling Q units at p1, can increase the number of units it sells by one unit to Q + by lowering its price to p2 The monopoly’s initial revenue is R1 = p1Q = A + C When it sells the extra unit, its revenue is R2 = p2(Q + 1) = A + B Thus, its marginal revenue from selling one additional unit is MR = R2 - R1 = (A + B) - (A + C) = B - C The monopoly sells the extra unit of output at the new price, p2, so it gains extra revenue from that last unit of B = p2 * = p2, which corresponds to the p(Q) term in Equation 11.3 because it had to lower its price, the monopoly loses the difference between the new price and the original price, ∆p = (p2 - p1), on the Q units it originally sold, C = ∆p * Q, which corresponds to the (dp/dQ)Q term in Equation 11.3 Thus, the monopoly’s marginal revenue, B - C = p2 - C, is less than the price it charges by an amount equal to area C The demand curve shows the average revenue or price per unit of output sold The monopoly’s marginal revenue is less than the price p2 by area C (the revenue lost due to a lower price on the Q units originally sold) The monopoly’s initial revenue is R1 = p1 Q = A + C If it sells one more unit, its revenue is R2 = p2(Q + 1) = A + B = A + p2 Thus, its marginal revenue (if one extra unit is a very small increase in its output) is MR = R2 - R1 = B - C = p2 - C, which is less than p2 Price, p, $ per unit Figure 11.1 Average and Marginal revenue p1 p2 C Demand curve A B Q Q+1 Quantity, Q, Units per year www.downloadslide.com 11.1 11.1 Monopoly Profit Maximization 389 In general, the relationship between the marginal revenue and demand curves depends on the shape of the demand curve For all linear demand curves, the relationship between the marginal revenue and demand curve is the same SolveD PRoBleM 11.1 Show that if a monopoly’s inverse demand curve is linear, its marginal revenue curve is also linear, has twice the slope of the inverse demand curve, intersects the vertical axis at the same point as the inverse demand curve, and intersects the horizontal axis at half the distance as does the inverse demand curve Answer Write a general formula for any downward-sloping linear inverse demand curve Any linear demand curve can be written as p(Q) = a - bQ, where a and b are positive constants Derive the monopoly’s revenue function and then derive its marginal revenue function by differentiating the revenue function with respect to its output The monopoly’s revenue function is R = p(Q)Q = aQ - bQ2 The marginal revenue function is the derivative of the revenue function with respect to quantity: MR(Q) = dR/dQ = a - 2bQ Describe the properties of the marginal revenue function relative to those of the inverse demand function both the marginal revenue function and the inverse demand functions are linear both hit the vertical (price) axis at a: MR(0) = a - (2b * 0) = a and p(0) = a - (b * 0) = a The slope of the marginal revenue curve, dMR/dQ = -2b, is twice the slope of the inverse demand curve dp(Q)/dQ = -b consequently, the MR curve hits the quantity axis at half the distance of the demand curve: MR = = a - 2bQ, where Q = a/(2b), and p = = a - bQ, where Q = a/b Marginal Revenue Curve and the Price elasticity of Demand The marginal revenue at any given quantity depends on the inverse demand curve’s height (the price) and the elasticity of demand From chapter 2, we know that the price elasticity of demand is ε = (dQ/dp)/(p/Q) 0, which tells us the percentage by which quantity demanded falls as the price increases by 1% According to Equation 11.3, MR = p + (dp/dQ)/Q by multiplying and dividing the second term by p, rearranging terms, and substituting using the definition of the elasticity of demand, we can write marginal revenue in terms of the elasticity of demand: MR = p + dp dp 1 Q = p + p = pJ1 + R = p¢ + ≤ (11.4) dQ dQ (dQ/dp)(p/Q) ε According to Equation 11.4, marginal revenue is closer to price as demand becomes more elastic In the limit where ε S -ϱ , a monopoly faces a perfectly elastic demand curve (similar to that of a competitive firm), and its marginal revenue equals its price www.downloadslide.com 390 CHAPTEr 11 Monopoly and Monopsony In Figure 11.2, we illustrate the relationship between the marginal revenue and the price elasticity of demand for a particular linear inverse demand function, p(Q) = 24 - Q (11.5) Its corresponding demand function is Q(p) = 24 - p The slope of this demand function is dQ/dp = -1, so the elasticity of demand at a given output level is ε = (dQ/dp)(p/Q) = -p/Q = -(24 - Q)/Q = - 24/Q From the results of Solved Problem 11.1, the monopoly’s marginal revenue function is MR(Q) = 24 - 2Q (11.6) Where the demand curve hits the price axis (Q = 0), the demand curve is perfectly elastic, so the marginal revenue equals price: MR = p At the midpoint of any linear demand curve, the demand elasticity is unitary (see chapter 2), ε = -1, so, using Equation 11.4, we know that the marginal revenue is zero: MR = p[1 + 1/ε] = p[1 + 1/(-1)] = In our example at the midpoint of the demand curve where Q = 12, the elasticity is ε = - 24/12 = -1, and the marginal revenue is MR = 24 - (2 * 12) = To the right of the midpoint of the demand curve, the demand curve is inelastic, -1 … ε … 0, so the marginal revenue is negative Figure 11.2 Elasticity of Demand and Total, Average, and Marginal revenue p, $ per unit The demand curve (or the average revenue curve), p = 24 - Q, lies above the marginal revenue curve, 24 MR = 24 - 2Q Where the marginal revenue equals zero, Q = 12, and the elasticity of demand is ε = - Perfectly elastic, ε → ∞ Elastic, ε < –1 ∆MR = –2 ∆Q = 12 ∆p = –1 ∆Q = ε = –1 Inelastic, –1 < ε < Demand (p = 24 – Q) 12 MR = 24 – 2Q Perfectly inelastic, ε = 24 Q, Units per day www.downloadslide.com 11.1 11.1 Monopoly Profit Maximization 391 An example of Monopoly Profit Maximization In chapter 8, we found that any type of firm maximizes its profit by selling its output such that its marginal cost equals its marginal revenue We now examine how a monopoly maximizes its profit using an example with the linear inverse demand function in Equation 11.5, p(Q) = 24 - Q, and a quadratic short-run cost function, C(Q) = VC(Q) + F = Q2 + 12, (11.7) where the monopoly’s variable cost is VC(Q) = Q2 and its fixed cost is F = 12 (see chapter 7) The firm’s marginal cost function is MC(Q) = dC(Q) = 2Q dQ (11.8) The average variable cost is AVC = Q2/Q = Q, so it is a straight line through the origin with a slope of The average cost is AC = C/Q = (Q2 + 12)/Q = Q + 12/Q, which is U-shaped Panel a of Figure 11.3 shows the MC, AVC, and AC curves The Profit-Maximizing output The firm’s highest possible profit is obtained by producing at the quantity Q* where its marginal revenue equals its marginal cost function: MR(Q*) = 24 - 2Q* = 2Q* = MC(Q*) Solving this expression, we find that Q* = Panel a of Figure 11.3 shows that the monopoly’s marginal revenue and marginal cost curves intersect at Q* = Panel b shows the corresponding profit and revenue curves The profit curve reaches its maximum at units of output, where marginal profit—the slope of the profit curve—is zero because marginal profit is marginal revenue minus marginal cost (chapter 8), marginal profit is zero where the marginal revenue curve intersects the marginal cost curve at units in panel a The height of the demand curve at the profit-maximizing quantity is p = 18 Thus, the monopoly maximizes its profit at point e, where it sells units per day at a price of $18 per unit Why does the monopoly maximize its profit by producing units where its marginal revenue equals its marginal cost? At smaller quantities, the monopoly’s marginal revenue is greater than its marginal cost, so its marginal profit is positive by increasing its output slightly, it raises its profit Similarly, at quantities greater than units, the monopoly’s marginal cost is greater than its marginal revenue, so it can increase its profit by reducing its output slightly The profit-maximizing quantity is smaller than the revenue-maximizing quantity The revenue curve reaches its maximum at Q = 12, where the slope of the revenue curve, the marginal revenue, is zero (panel a) In contrast, the profit curve reaches its maximum at Q = 6, where marginal revenue equals marginal cost because marginal cost is positive, marginal revenue must be positive when profit is maximized Given that the marginal revenue curve has a negative slope, marginal revenue is positive at a smaller quantity than where it equals zero Thus, the profit curve must reach a maximum at a smaller quantity, 6, than the revenue curve, 12 As we already know, marginal revenue equals zero at the quantity where the demand curve has a unitary elasticity because a linear demand curve is more elastic at smaller quantities, monopoly profit is maximized in the elastic portion of the demand curve (Here, profit is maximized at Q = where the elasticity of demand is -3.) Equivalently, a monopoly never operates in the inelastic portion of its demand curve www.downloadslide.com 392 CHAPTEr 11 Monopoly and Monopsony Figure 11.3 Maximizing Profit (a) Monopolized Market p, $ per unit (a) At Q = 6, where marginal revenue, MR, equals marginal cost, MC, profit is maximized The rectangle showing the maximum profit $60 is average profit per unit, p - AC = $18 - $8 = $10, times six units (b) Profit is maximized at a smaller quantity, Q = (where marginal revenue equals marginal cost), than revenue is maximized, Q = 12 (where marginal revenue is zero) MC 24 AC AVC e 18 π = 60 12 Demand MR 12 24 Q, Units per day R, π, $ (b) Profit, Revenue 144 Revenue, R 108 60 Profit, π 12 24 Q, Units per day APPlICATIon China’s New Monopolies china has replaced the United States as the world’s major supplier of rare earth elements or metals: 17 elements from the periodic table, found in minerals— primarily in bastnäsite and laterite nickel ore—in the earth’s crust In 2010, china’s mines supplied 97% of these elements, and more than 99% of two of these elements, dysprosium and terbium Dysprosium is used in the manufacture of lasers, fuel injectors for diesel engines, and compact discs www.downloadslide.com 11.1 11.1 Monopoly Profit Maximization 393 Terbium is used in solid-state devices, fuel cells that operate at high temperatures, sonar systems and sensors, and fluorescent lamps and color TV tubes because these elements are crucial for a variety of green energy technologies and military applications, such as missiles, china has many potential buyers Virtually all U.S mines stopped mining these elements, though one reopened recently in response to high prices Moreover, chinese firms have been trying to acquire a majority stake in the few remaining mines in Africa, South America, and Australia As china increases its stranglehold on these essential resources, it exercises its increased market power by reducing its exports of rare earths Moreover, china is trying to force manufacturers that rely on rare earths to build their factories in china However, china may have set its prices too high, inducing firms in other countries to enter the market After reaching a peak in 2011, rare earth prices plummeted in 2012 china is responding by cutting back exports substantially in 2013 The Shutdown Decision Should a profit-maximizing monopoly produce at the output level determined by its first-order condition, Q*, or shut down? In the short run, the monopoly shuts down if the monopoly-optimal price is less than its average variable cost In our short-run example in Figure 11.3, at the profit-maximizing output, the average variable cost is AVC(6) = 6, which is less than the price, p(6) = 18, so the firm chooses to produce Equivalently, the firm’s revenue, R(6) = p(6)6 = (24 - 6)6 = 108, exceeds its variable (or avoidable) cost, VC(6) = 62 = 36, so the firm chooses to produce Indeed, the monopoly makes a positive profit because its profit is π = p(Q)Q-C(Q), its average profit is π/Q = p(Q) - C(Q)/Q = p(Q) - AC Thus, its average profit (and hence its profit) is positive only if price is above the average cost At Q* = 6, its average cost, AC(6) = 8, is above its price, p(6) = 18 Its profit is π = 60, which is the shaded rectangle with a height equal to the average profit per unit, p(6) - AC(6) = 18 - = 10, and a width of units Choosing Price or Quantity Unlike a competitive firm, a monopoly can adjust its price, so it has the choice of setting its price or its quantity to maximize its profit (A competitive firm must set its quantity to maximize profit because it cannot affect market price.) The monopoly is constrained by the market demand curve because the demand curve slopes downward, the monopoly faces a trade-off between a higher price and a lower quantity or a lower price and a higher quantity The monopoly chooses the point on the demand curve that maximizes its profit Unfortunately for the monopoly, it cannot set both its quantity and its price and thereby pick a point that is above the demand curve If it could, the monopoly would choose an extremely high price and an extremely high output level and would become exceedingly wealthy If the monopoly sets its price, the demand curve determines how much output it sells If the monopoly picks an output level, the demand curve determines the price because the monopoly wants to operate at the price and output at which its profit is maximized, it chooses the same profit-maximizing solution whether it sets the price or the output In this chapter, we assume that the monopoly sets the quantity www.downloadslide.com 394 CHAPTEr 11 Monopoly and Monopsony effects of a Shift of the Demand Curve Shifts in the demand curve or marginal cost curve affect the monopoly optimum and can have a wider variety of effects in a monopolized market than in a competitive market In a competitive market, the effect of a shift in demand on a competitive firm’s output depends only on the marginal cost curve (chapter 8) In contrast, the effect of a shift in demand on a monopoly’s output depends on the marginal cost curve and the demand curve A competitive firm’s marginal cost curve tells us everything we need to know about the amount that the firm will supply at any given market price The competitive firm’s supply curve is its upward-sloping marginal cost curve above its minimum average variable cost A competitive firm’s supply behavior does not depend on the shape of the market demand curve because the firm always faces a horizontal residual demand curve at the market price Thus, if you know a competitive firm’s marginal cost curve, you can predict how much the firm will produce at any given market price In contrast, a monopoly’s output decision depends on its marginal cost curve and its demand curve Unlike a competitive firm, a monopoly does not have a supply curve Knowing the monopoly’s marginal cost curve is not sufficient for us to predict how much a monopoly will sell at any given price Figure 11.4 illustrates that the relationship between price and quantity is unique in a competitive market but not in a monopoly market If the market is competitive, the initial equilibrium is e1 in panel a, where the original demand curve D1 intersects the supply curve, MC, which is the sum of the marginal cost curves of a large number of competitive firms When the demand curve shifts to D2, the new competitive Figure 11.4 Effects of a Shift of the Demand Curve (a) A shift of the demand curve from D1 to D2 causes the competitive equilibrium to move from e1 to e2 along the supply curve (the horizontal sum of the marginal cost curves of all the competitive firms) because the competitive equilibrium lies on the supply curve, each quantity corresponds to only one possible equilibrium price (b) With a monopoly, this same shift of demand causes (b) Monopoly p2 p1 p, $ per unit p, $ per unit (a) Competition the monopoly optimum to change from E1 to E2 The monopoly quantity stays the same, but the monopoly price rises Thus, a shift in demand does not map out a unique relationship between price and quantity in a monopolized market: The same quantity, Q1 = Q2, is associated with two different prices, p1 and p2 e2 MC, Supply curve p1 e1 E2 MC E1 MR D2 Q1 Q2 p2 D1 Q, Units per year MR Q1 = Q2 D2 D1 Q, Units per year www.downloadslide.com 786 Index Constrained consumer choice defined, 81 Lagrangian method applied to, 105–107 minimizing expenditure while maximizing well-being, 111–114 optimal bundles on convex sections of indifference curves, 111 perfect substitutes utility function, 108–109 quasilinear utility function, 109–111 utility maximization example (applied to music purchases), 107–108 Constraints maximizing functions with equality constraints, 728–731 maximizing functions with inequality constraints, 731–732 Consumer Price Index See CPI (Consumer Price Index) Consumer Reports, 663 Consumer surplus See CS (consumer surplus) Consumer theory demand and, 122–123 income elasticity of demand in, 131–132 substitution effect and, 154 Consumer welfare child-care subsidy example, 159, 189–190 comparing CS, CV, and EV, 168–171 CS (consumer surplus) as measure of, 161–163 CV (compensating variation) as measure of, 166–168 defined, 160 developing a welfare measure (willingness to pay), 161 EV (equivalent variation) as measure of, 168 exercises, 191–194 expenditure function and, 165–166 food stamps programs, 176–178 governmental policies, 174 large losses in consumer surplus and, 173–174 market consumer surplus falls as price rises, 172 overview of, 160–161 price change impacting consumer surplus, 164–165 quotas and, 174–176 summary, 190–191 Consumers bearing of tax on identical firms, 291 comparing effects of specific and ad valorem taxes, 66 determining quality of goods See Quality goods equilibrium effects not dependent on who is taxed, 65–66 fully informed, 270, 271 group price discrimination See Group price discrimination impact of uncertainty on consumer choice, 585 incidence of taxes on, 63–65 negative externalities and, 621 perfect price discrimination impacting, 436–438 purchases based on tastes, 33 screening to avoid lemons, 662 two-part pricing with differing consumers, 451–453 two-part pricing with identical consumers, 450 Consumers, maximization of well-being behavioral economics and, 114 budget constraints, 98–100 completeness property in consumer preferences, 82 convex indifference curves, 96–97 corner solutions to budget constraints, 108 endowment effects, 115–116 exercises, 119–121 indifference curves, 84–87, 97–98 interior solutions to budget constraints using calculus, 103–104 interior solutions to budget constraints using graphs, 100–103 Lagrangian method applied to budget constraints, 105–107 minimizing expenditure while maximizing well-being, 111–113 optimal bundles on convex sections of indifference curves, 111 ordinal preferences, 88–89 overview of, 80–81 perfect substitutes utility function, 108–109 preference maps, 84 preferences, 82 quasilinear utility function, 109–111 relationship of utility function to indifference curves, 90–91 right angle indifference curves, 95–96 salience and, 116–117 straight line indifference curves, 94–95 subject to constraints, 27–28 summary, 118–119 tests of transitivity, 114–115 transitivity property in consumer preferences, 83 utility functions, 87–88 utility maximization example (applied to music purchases), 107–108 willingness to substitute, 91–94 Consumers optimum, 101 Consumption distortion loss, 336 Contingent contracts client-lawyer contracts, 693–694 offering contract choice in hiring process, 702–703 profit-sharing contracts with asymmetric information, 690 profit-sharing contracts with full information, 689 revenue-sharing contracts with asymmetric information, 690 revenue-sharing contracts with full information, 687–688 types of contracts, 682–683 Continuity, properties of functions, 713 Contract curves, 358–360 Contracts asymmetric information, 689–690 checks on principals in, 703–705 choosing best option, 694 efficiency of contingency fee contract, 693–694 efficiency of fixed-fee contract, 692 efficiency of hourly contract, 693 efficient contracts, 683–685 exercises, 707–710 firms offering employees choice of, 702–703 full information in, 685–688 in music industry, 695 overview of, 680–681 principal-agent problem, 681–682 production efficiency, 684 productivity in agriculture and, 691 profit-sharing, 689–690 revenue-sharing, 687–688, 690 summary, 706–707 trade-offs between production and riskbearing, 691–692 types of, 682–683 Controls, price price ceilings, 68–70 price floors, 71–72 as supply/demand curve wedge, 324 Zimbabwe example, 70–71 Convex indifference curves, utility and, 96–97 Convexity indifference curves, 112 properties of functions, 713–715 Copyrights, time limits on, 407 Corner solutions to budget constraints, 100, 108, 110 demand functions and, 124 Corporations, ownership structures of forprofit firms, 197–198 Cost-benefit analysis, of externalities, 624–625 Cost curves differing short- and long-run, 292 estimating cost curves vs introspection, 254–255 long-run cost curves, 252–254 marginal cost curves, 286, 394–395 production functions and shape of, 237–240 short-run cost curves, 236–237 in short-run supply curve equation, 286 Cost-of-living adjustments See COLAs (cost-of-living adjustments) Costs capital costs, 231–232 cost advantages creating monopolies, 404–406 economies of scope, 262 effect of taxes on, 240–241 estimating cost curves vs introspection, 254–255 exercises, 264–267 factor price changes, 249 increase from factor price increase, 286 input choices and, 242 isocost line, 242–244 learning by doing results in lower costs, 258–260 long-run costs, 241–242 long-run costs varying with output, 250–252 lower in long run, 255 market entrance and, 268, 294–295, 305 maximizing output and, 248–249 measuring, 229–230, 274 minimizing, 244–247 negligible transaction, 270–271 opportunity costs, 230–231 overview of, 228–229 www.downloadslide.com Index of producing multiple goods, 260–262 production functions and shape of cost curves, 237–240 relationship of long-run average costs to short-run average cost, 255–257 shape of long-run cost curves, 252–254 short-run and long-run expansion paths, 257–258 short-run cost curves, 236–237 short-run cost measures, 233–236 summary, 263–264 sunk costs, 232–233 Cotton production, 297 Coupons, examples of price discrimination, 445 Cournot equilibrium See Nash-Cournot equilibrium Cournot oligopoly model applied to market with nonidentical firms, 520–523 characteristic actions of firms in, 504 comparing collusive, Nash-Cournot, Stackelberg, and competitive equilibria, 531–533 duopoly Nash-Cournot equilibrium, 512–516 exercises, 546–548 government subsidies to aircraft manufacturing industries, 544–545 with many firms, 516–519 overview of, 512 short-run factor demand curves and, 555 summary, 545 CPI (Consumer Price Index) adjusting for inflation, 148–150 overview of, 147–148 substitution bias, 151 CPUs (central processing units), 468–469, 495–496 Credible threat game theory and, 486–487 sequential movement in Stackelberg model and, 526 Critical mass eBay example, 416–417 network externalities and, 416 Cross-price elasticity of demand, 54 CRS (constant returns to scale) See Returns to scale, in production CS (consumer surplus) changes, and welfare lowering, 319–320 comparing CS, CV, and EV, 168–171 defined, 311 large losses in market consumer surplus, 173–174 market consumer surplus falls as price rises, 172 measuring, 161–163 overview of, 161 price change impacting, 164–165 CV (compensating variation) applied to Internet, 168 comparing CS, CV, and EV, 168–171 defined, 166 measuring with indifference curves, 166–168 D Deadweight loss (DWL) See DWL (deadweight loss) Decision making allocation of scarce resources, 24 decisions over time in monopolies, 415 game theory in See Game theory use of microeconomics in, 29 Decision nodes, game trees and, 483 Decreasing-cost market, 299 Deferred payments, preventing shirking, 698 Deficiency payments, 328 Dell, Michael, 275 Demand compensated and uncompensated demand curves, 141–143 consumer theory and, 122–123 cost-of-living adjustments (COLAs), 146, 150–151 CPI adjustment, 148–150 CPI substitution bias, 151 defined, 32 demand function, 34–35 deriving demand curves graphical, 125–127 elasticity of See Elasticity of demand exercises, 156–158 implications of shape of supply and demand curves, 49 income and substitution effects with inferior good, 140 income and substitution effects with normal good, 137–139 income changes shifting demand curves, 128–130 income-consumption curves and income elasticities, 132–133 income elasticity of demand, 131–132 inflation indexes, 146–148 nonprice factors causing shift in demand curve, 37 overview of, 33–34 price ceiling causing excessive demand, 68–69 price ceilings and, 68–70 price change causing movement along demand curve, 35–36 price elasticity of, 50–54 price floors and, 71–72 prices changes effecting, 136 quantity supplied need not equal quantity demanded, 67–68 Slutsky equation and, 144–146 substitution effects and, 154 summary, 155–156 summing demand functions, 38 system of demand functions, 123–125 theory of revealed preference, 152–154 weighted income elasticities, 134–135 Demand curves comparing short and long-run labor demand curves, 557–558 compensated and uncompensated, 141–143 competitive equilibrium and, 290 deriving graphically, 125–127 elasticity along, 51–53 factor demand in competitive markets, 558–560 horizontal in perfectly competitive markets, 270–271 horizontal, output decision for, 278 implications of shape of, 49 787 income changes shifting demand curves, 128–130 inverse demand functions (willingness to pay), 161 for leisure, 180 long-run factor demand, 556 long-run factor demand in competitive firms, 557 marginal revenue and demand curves in monopolies, 387–390 market power and shape of, 395–396 movement along due to price change, 35–37 overview of, 34–35 policy wedges between supply/demand curves, 324, 342, 344 price elasticity along, 50–54 residual, 272–274 shift along demand curve impacting monopolies, 394–395 shift in due to non-price factors, 37 short-run factor demand, 551–552 short-run factor demand in competitive firms, 552–553 wage change impacting demand for labor, 553–555 Demand functions overview of, 34–35 summing, 38 system of, 123–125 Demsetz auctions, 407 Derivatives higher-order derivatives, 719 overview of, 716–717 partial derivatives, 719–720 rules for calculating, 717–718 Detection, of cheating on cartel agreements, 510–511 Differentiated products Nash-Bertrand equilibrium with, 536–539 oligopolies and, 522–523 spurious differentiation, 523–524 welfare and, 539–540 Direct effect, network externalities and, 415 Discount rates applying to environmental issues, 570 exhaustible resources and, 572–573 interest rates and, 562–563 investing and, 607–609 time-varying discounting, 569–570 Discrimination, statistical discrimination in hiring, 674–675 Disequilibrium, 44 Disneyland, price discrimination example, 431 Diversification insurance for diversifiable risks, 605 as risk reduction method, 601–603 DOJ (Department of Justice) enforcing antitrust laws, 508–509 regulation of mergers, 511 Dominant firms, in airline industry, 521 Dominant strategies failure to maximize joint profits and, 476 in game theory, 471–472 Douglas, Paul H., 207 Drought, water quotas and, 176 DRS (decreasing returns to scale), 217 Duality, 111, 738 www.downloadslide.com 788 Index Duopoly model applied to airlines (United and American), 530–531, 533 Cournot oligopoly model, 512–516 Durability of products, deciding on, 568–569 Durable goods factor markets and, 550 renting, 561–562 Dutch (descending-bid) auctions defined, 490 strategies, 492 DVDs group price discrimination example, 440–441 producing, 299 DWL (deadweight loss) of Christmas presents, 322–323 defined, 320 effect of market power on welfare, 398–399 government regulation reducing monopoly impacts, 412–414 iTunes pricing example, 453 in oligopolies and monopolistic competitive markets, 532 patents and, 408 in price supports, 327 from rent seeking, 339 from specific sales tax, 325 from tariffs, 336 as underestimating true loss, 328, 330 Dynamic entry games first mover advantages/disadvantages, 489 overview of, 487–489 Dynamic games credible threat and, 486–487 dynamic entry games, 487–489 exercises, 499–501 overview of, 469, 481–482 repeated games, 482–483 sequential games, 483–484 subgame perfect Nash equilibrium, 484–486 summary, 496 E E-books, comparing American and German use, 80, 117–118 E-ZPass, example of pollution controls, 630 Earthquakes, insurance for natural disasters, 606 eBay bidders’ curse and, 493 critical mass and, 416–417 willingness to pay example, 163 EC Treaty (Treaty of the European Community), 508 Economic theory, testing with microeconomic models, 27 Edgeworth boxes, 355–356 Education, as signal of ability, 670–674 Efficiency of competition, 363–364 of competition with externalities, 621 of contingent contact, 693–694 defined, 381 exercises, 384 of fixed-fee contract, 692 of government role in economics, 370–372 of hourly contract, 693 of market equilibrium, 348 market power vs efficiency in hospital mergers, 512 of perfect price discrimination, 436–438 in product mix, 367 trade off of production efficiency with risk bearing See Production efficiency, trade-off with risk bearing vs equity, 377–378 of welfare distribution, 372–374 Efficiency wages, preventing shirking, 698–699 Efficient contracts principal-agent interactions in, 683–684 production efficiency and, 684–685 Elasticities defined, 32 overview of, 50 specific sales tax effects depend on, 62–64 Elasticity of demand for cigarettes, 127–128 cross-price elasticity of demand, 54 group price discrimination and, 441 income elasticity of demand, 54 Lerner index and, 396–397 marginal revenue and price elasticity of demand, 389–390 market power and, 395–396, 398 over time, 57–58 overview of, 50–51 price elasticity of demand, 50–55 residual, 273 substitution elasticity vs income elasticity, 145–146 Elasticity of substitution CES (constant-elasticity-of-substitution) functions, 96–97 constant elasticity, 215 linear, fixed, and Cobb-Douglas productions functions and, 215–216 overview of, 214 Elasticity of supply from differing firms, 288 from identical firms, 288 over time, 58 price elasticity of supply, 55–56 in worldwide trade, 300–301 Emissions, cap and trade program, 637 Emissions fees, 628, 630–631 Emissions standards, 627, 630–631 Employment See also Hiring compensating employees for relocation, 122, 154–155 compensating for occupational risk, 653–654 layoffs vs pay cuts, 703–705 minimum wage controls and, 71–72 Enderberry, Keppel, 332 Endowment effects, in behavioral economics, 115–116 Endowments, 355–356, 362 Enforcement, of cartel agreements, 510–511 Engel curves applied to fast-food restaurant, 133–134 plotting relationship between demand and income at constant price, 130–131 English (ascending-bid) auctions, 490, 492 Entry, market barriers See Barriers, market entry free, and zero profit, 311–312 limited, and zero profit, 312–314 long-run market supply with free, 295 long-run market supply with limited, 296 relative ease or difficulty of, 294–295 in Russian fast-food industry, 295 trucking industry and, 268, 304 Envelope Theorem, 143, 727–728, 734 Environmental (exogenous) variables, comparative statics and, 45 Environmental Protection Agency See EPA (Environmental Protection Agency) EPA (Environmental Protection Agency) assigning property rights in regulating externalities, 636 on benefits of Clean Air Act (1970 and 1990), 630 emissions standards, 627 Equality constraints, maximizing functions with, 728–731 Equalizing information, 657–658 Equilibrium competitive See Competitive equilibrium general See General equilibrium market See Market equilibrium Nash See Nash equilibrium Equilibrium price, 42–45 Equilibrium quantity, 42 Equity defined, 381 exercises, 384 governmental policies controlling, 370 welfare and, 374–377 Equivalent variation See EV (equivalent variation) Essential facilities, cost advantages creating monopolies, 405 Estimates confidence in, 740–741 estimating cost curves vs introspection, 254–255 frequency in probability estimation, 586–587 regression used for, 739–740 underestimating true loss, 328, 330 Ethanol processing plants, 293 subsidy as negative tax, 65 EU ETS (European Union Emissions Trading System), 637 Euler’s homogeneous function theorem, 721 European Commission, in regulation of mergers, 511 European Union Emissions Trading System (EU ETS), 637 EV (equivalent variation) applied to Internet, 168 comparing CS, CV, and EV, 168–171 defined, 166 measuring with indifference curves, 168 of a quota, 175 Excess supply curves, 299–300 Exclusion See Rivalry/exclusion Exhaustible resources See Resources, exhaustible Exit, market relative ease or difficulty of, 294 restrictions on, 324 Expected utility theory www.downloadslide.com Index behavioral economics and, 609 example of, 594–595 overview of, 591–592 prospect theory compared with, 612 risk aversion, 592–594 risk neutrality, 595–596 risk preferring, 595–596 violations of, 610–612 Expected value, mean and average measures of, 587–588 Expenditure function consumer welfare and, 160, 165–166 minimizing expenditure while maximizing well-being, 111–114 Explicit functions, 712 Exponent rule, in calculating derivatives, 718 Exponential rule, in calculating derivatives, 718 Extensive-form diagram (game tree), 483–484, 487 Externalities allocating property rights to reduce, 634–635 benefits vs costs in pollution control, 630 cap-and-trade markets for pollution, 636–637 Coase Theorem, 635–636 comparing emission fees and emission standards, 630–631 cost-benefit analysis, 624–625 emissions fees, 628 emissions standards, 627 example of negative externality, 620–621 exercises, 649–651 inefficiency of competition with, 621 market structures and, 632 monopolies and, 632–633 monopolies vs competitive welfare, 633 overview of, 620–621 per driver tax example, 629 property rights and, 619 regulating, 625–627 summary, 648–649 supply-and-demand analysis, 621–624 taxing in noncompetitive markets, 634 trade and pollution, 647–648 Extrema, of functions determining existence of, 721–722 determining uniqueness of, 722 finding, 723–727 interior extrema, 723 local and global extrema, 721 solving constrained extrema problem, 736–738 Extreme Value Theorem, 722–723 F Factor markets capital See Capital markets comparing short and long-run labor demand curves, 557–558 competitive factor market equilibrium, 560 competitive firm’s long-run factor demand curve, 557 competitive firm’s short-run factor demand curve, 552–553 deciding whether to go to college, 550, 579–580 demand curves in competitive markets, 558–560 exercises, 581–582 exhaustible resources See Resources, exhaustible labor demand varying by market structure, 556 long-run factor demand curve, 556 noncompetitive firm’s short-run factor demand curve, 555 overview of, 550–551 short-run factor demand curve, 551–552 summary, 581 wage change impacting short-run demand for labor, 553–555 Factor prices, 286, 293 Fair insurance, 603–605 Fair Labor Standards Act of 1938, 71 Farming See Agriculture Fast-food chains, in Russia, 295 Fat tax, 25 Federal Motor Carrier Safety Administration (FMCSA), 268 Federal Trade Commission Act of 1914, 508 Federal Trade Commission (FTC) on advertising price of goods, 667 enforcing antitrust laws, 508 Financial assets, 562 Firms demand curves of competitive firms, 272–274 exercises, 225 incidence of taxes on, 64 management of, 198 market entry and exit, 294 market supply with identical firms, 287 number of firms in monopolistic competitive market, 541–542 offering employees choice of contracts, 702–703 overview of, 195 owners intent to maximize profits, 198–199 ownership of for-profit firms, 197–198 predictions regarding income effects, 135 price discrimination and, 430–431 private, public, and nonprofit, 196–197 signaling technique for high quality goods, 664 summary, 224 use of microeconomics in decision making, 30 vertical integration as means of preventing resale, 432 First-degree price discrimination See Perfect price discrimination First-order condition, 725–727 First-price auctions, 490 First Theorem of Welfare Economics, 361 Fisher index, correcting CPI substitution bias, 152 Fisheries, as open-access common property, 638–639 Fixed costs, market entrance and, 268, 541–542 Fixed-fee contracts client-lawyer contracts, 692 offering contract choice in hiring process, 702–703 rental contract with asymmetric information, 690 rental contract with full information, 686–687 types of contracts, 682–683 789 Fixed inputs, in production, 200–201 Fixed production function elasticity of substitution and, 215–216 shape of isoquants and, 209 Flight insurance, 585, 614 Floods, insurance for natural disasters, 606 Flows, of capital goods, 562 FMCSA (Federal Motor Carrier Safety Administration), 268 Food stamp programs, 176–178 For-profit (private) firms, 196–198 Forbes, 275 Framing effect, violations of expected utility theory, 611 Franklin, Benjamin, 333 Free riding public goods and, 640–643 reducing, 645 Free trade, 333–335, 647 Frequency, in probability estimation, 586–587 FTA (free-trade agreements), 647 FTC (Federal Trade Commission) on advertising price of goods, 667 enforcing antitrust laws, 508 Full information contracts and, 685–688 fixed-fee rental contracts with, 686–687 hire contracts with, 687 profit-sharing contracts with, 688 Functions derivatives, 716–717 determining existence of extrema, 721–722 determining uniqueness of extrema, 722 Euler’s homogeneous function theorem, 720–721 finding extrema, 723–727 higher-order derivatives, 719 homogeneous, 715 indirect objective functions and the envelope theorem, 727–728 interior extrema, 723 local and global extrema, 721 maximizing with equality constraints, 728–731 maximizing with inequality constraints, 731–732 maximums and minimums of, 721 partial derivatives, 719–720 properties of, 712–715 properties of logarithmic functions, 715 residual demand, 272–274 rules for calculating derivatives, 717–718 of a several variables, 712 of a single variable, 711–712 FV (future value) interest rates and, 562–563 of stream of payments, 563–564 G Gambler’s fallacy, 609 Gambling Arrow-Pratt measure and willingness to gamble, 598–599 risk and, 596–597 Game theory analyzing Intel and AMD advertising strategies, 495–496 applying to young adults who return to live at home, 480–481 www.downloadslide.com 790 Index Game theory (continued) auctions See Auctions behavioral economics and See Behavioral game theory credible threat and, 486–487 dynamic entry games, 487–489 dynamic games, 481–482 exercises, 496–501 failure to maximize joint profits, 474–476 mixed strategies, 478–480 multiple equilibria, 477–478 normal-form games, 471–474 overview of, 468–470 repeated games, 482–483 sequential games, 483–484 static games, 470 strategic advertising example, 476–477 subgame perfect Nash equilibrium, 484–486 summary, 496 Game tree (extensive-form diagram), 483–484, 487 Gasoline See Petroleum/petroleum products GATT (General Agreement on Tariffs and Trade), 335 General Agreement on Tariffs and Trade (GATT), 335 General equilibrium analysis of interrelated markets, 350–352 analysis of minimum wage, 352–355 defined, 349 exercises, 382 general-equilibrium analysis, 349, 381 General Motors (GM), 494 General partnerships, 197 Genetically modified (GM) foods controversy regarding, 31–32 quantities and prices of, 73–74 Giffen goods income and substitution effects, 140 Slutsky equation applied to, 144–146 Giffen, Robert, 140 Gifts, efficient vs inefficient, 322–323 Global extrema, 721 Global warming, regulating negative externalities, 626 GM (General Motors), 494 GM (genetically modified) foods controversy regarding, 31–32 quantities and prices of, 73–74 Goldwyn, Samuel, 274 Gompers, Samuel, 315 Goods bundles of See Bundles of goods club goods, 620, 639–640 complements and substitutes, 33 durable, 550, 561–562 Giffen goods, 140, 144–146 inferior goods See Inferior goods luxury goods, 132 normal goods See Normal goods public goods See Public goods quality of See Quality goods trade-offs in production of goods and services, 24 Google auctions, 490 price discrimination example, 439 Government allocating property rights to reduce externalities, 634–635 allocating resources, 24 anti-price gouging laws, 347 competitive markets affected by government regulation, 310 creating and enforcing cartels, 511 creating monopolies, 407–409 encouraging competition, 414–415 granting monopoly rights to public utilities, 405 impact of regulations on consumer decisions, 33 impact of regulations on supply, 39 international trade policies, 332–333 predictions regarding income effects, 135 price discrimination policies, 432 price floors in minimum wage regulation, 71–72 problems with market intervention, 530–531 problems with regulation, 413 regulating externalities, 625–627 regulating monopolies, 410–413 restrictive licensing, 340 subsidies to aircraft manufacturing industries, 503–504, 544–545 subsidies to airlines, 528–530 supply curve shift caused by government policies, 311, 323–324 use of microeconomics in decision making, 29 Government policies, for consumer welfare food stamps programs, 176–178 overview of, 160, 174 quotas and, 174–176 Graphs deriving demand curves graphical, 125–127 interior solutions to budget constraints, 100–103 interpretation of production-related graphs, 202–204 Stackelberg oligopoly model, 526 Green Revolution (Borlaug), 206–207 Greenhouse gases, cap and trade program, 637 Group price discrimination Comparing with competition and monopolies, 447 identifying groups, 445–446 overview of, 439–440 prescription drug example, 442–444 with two groups, 440–442 types of price discrimination, 433 welfare effects of, 445–446 H Health insurance moral hazard and, 705–706 universal coverage as solution to opportunistic behavior, 656 Heinz, sale price example, 428, 461–462 Hidden actions, in asymmetric information, 654 Hidden characteristics, in asymmetric information, 654 Hill of happiness, utility and, 90–91 Hire contracts with asymmetric information, 690 with full information, 687 types of contracts, 682–683 Hiring cheap talk problem, 668–670 education as signal of ability, 670–674 ignorance while hiring problems, 668 screening in hiring, 674–675 Hit-and-run entry/exit, 294 Homogeneous function theorem (Euler), 721 Homogeneous functions, 715 Hotels, zoning laws as barrier to entry by hotel chains, 543 Hourly contracts, client-lawyer contracts, 693 Housing, mortgage market meltdown (2007) example, 700–701 Hurricanes Hurricane Katrina, 347 insurance for natural disasters, 606 I IBM, tie-in sales example, 454 Identical firms equilibrium effects of tax on, 291 long-run market supply, 295 short-run market supply, 287 Identical products, 270–271 IMMA (International Model Managers Association, Inc.), 509–510 Imperfect substitutes, 95 Implicit functions, 712 Imports banned, vs free trade, 333–335 price discrimination and, 443–444 supply curves affected by import policies, 42 supply curves for long-run markets, 299 types of policy on, 333 Incentive compatibility, of efficient contracts, 685 Incidence of taxes on consumers, 63–65 on firms, 64 Income See also Budget constraints of the 1%, 370 changes shifting demand curves, 128–130 comparing American and German use of e-books, 117–118 impact on consumer decisions, 33 predictions regarding income effects, 135 rich to poor transfer of, 371 Income-consumption curves income changes and, 130 income elasticities and, 132–133 Income effect identifying, 141 inferior goods and, 140 labor markets and, 182–183 normal goods and, 137–139 price increases impacting demand, 136 Income elasticity of demand consumer theory and, 131–132 income-consumption curves and, 132–133 overview of, 54 weighted income elasticities, 134–135 Income taxes, labor supply curves and, 186–189 Income threshold model, purchase of consumer durables and, 25–26 Increasing-cost markets, 298 Increasing returns to scale (IRS), 217 www.downloadslide.com Index Indexes Consumer Price Index See CPI (Consumer Price Index) cost-of-living See COLAs (cost-ofliving adjustments) Fisher index, 152 inflation, 146–148 Laspeyres index, 151–152 Lerner index See Lerner index Paasche index, 151 Indifference curves applied to food and clothing, 97–98 comparing American and German use of e-books, 117–118 consumer preferences and, 84–87 convex indifference curves, 96–97 deriving with theory of revealed preference, 152 income effects causing movement along, 138 measuring compensating variation, 166–168 measuring equivalent variation, 168 movement along vs shift in, 138 mutually beneficial trades and, 356–357 optimal bundles on convex sections of, 111 relationship of utility function to, 90–91 right angle indifference curves, 95–96 straight line indifference curves, 94–95 utility functions and, 88 Indifference maps, 86 Indirect effect, network externalities and, 416 Individual price discrimination See Perfect price discrimination Inefficiency, of competition with externalities, 621 Inequality constraints, maximizing functions with, 731–732 Inferior goods demand falls as income rises, 132 fast-food example, 133–134 income and substitution effects with, 140 Inflation CPI adjustment, 148–150 indexes, 146–148 Information asymmetric See Asymmetric information impact on consumer decisions, 33 as risk reduction method, 600 symmetric See Symmetric information Ingredient branding, 468 Ingredients, secret and natural ingredients in advertising, 476–477 Innovations impact of patents on, 408 organizational change, 222 overview of, 221 Tata Motors example, 222–223 technical progress and, 221–222 Inputs, production firms converting into outputs, 196 input price constant, 295 input price varying with output, 297–299 isoquants for interpreting production inputs and outputs, 208–212 long-run production with two variable inputs, 207–208 scarce resources and, 313 short-run production with one variable and one fixed input, 201 substituting, 212–213 types of, 199 variability over time, 200 An Inquiry into the Nature and Causes of the Wealth of Nations (Smith), 318 Insurance controlling opportunistic behavior with universal coverage, 656 determining amount to buy, 603–604 for diversifiable risks, 605 fairness and, 604–605 flight insurance, 585, 614 medical insurance, 680, 705–706 moral hazard related to, 681 natural disaster insurance, 605–606 overview of, 603 Intel analyzing Intel and AMD advertising strategies, 468–469, 495–496 Nash-Cournot equilibrium for quantities and prices, 523 Nash equilibrium applied to advertising levels, 478 Interest rates capital markets and investing and, 571–572 discount rates, 563 present and future values and, 562–563 Interior extrema, 723 Interior solutions, demand functions and, 124 Interior solutions, to budget constraints defined, 100 quasilinear utility and, 110 using calculus, 103–104 using graphs, 100–103 Internal rate of return, comparing investments, 565, 567–568 International Model Managers Association, Inc (IMMA), 509–510 International trade, supply curves for longrun markets, 299–301 Internet, compensating variation and equivalent variation and, 168 Interviews, screening in hiring, 674 Introductory pricing, in a two-period monopoly, 417–418 Inverse demand functions (willingness to pay), 161 Investments based on attitude toward risk, 606–607 based on uncertainty and discounting, 607–609 capital markets and interest rates and, 571–572 diversification as risk reduction method, 602–603 internal rate of return on, 567–568 net present value of, 566–567 overview of, 565 Invisible hand analogy, forces driving market equilibrium, 44 iPad example of bandwagon effect, 416 pricing, 385, 422–423 profit maximization and, 397–398 IRS (increasing returns to scale), 217 Isoquants for electronics manufacturing firm, 209 MRTS (marginal rate of technical substitution) and, 212, 214 properties of, 208–209 791 for semiconductor integrated circuit, 211–212 shape of, 209–210 summarizing relationships between production inputs and outputs, 208 Isowelfare curves, 374 iTunes, uniform pricing example, 453 J Jefferson, Thomas, 310 K K (capital) See Capital Keynes, John Maynard, 347 Kuhn-Tucker method, 732–734 Kuhn-Tucker multipliers, 732 Kyoto agreement, cap-and-trade program and, 637 L Labor comparing short and long-run labor demand curves, 557–558 competitive firm’s long-run factor demand curve, 557 competitive firm’s short-run factor demand curve, 552–553 demand curves in competitive markets, 558–560 demand varying by market structure, 556 deriving supply curves for labor markets, 160, 179 elasticity of substitution and the capital-labor ratio, 214–216 impact of Black Death on factor markets, 560–561 income and substitution effects on labor markets, 182–183 income taxes and labor supply curves, 186–189 labor-leisure choice, 179–182 long-run factor demand curve, 556 marginal, average, and total products of, 201–204 price floors and, 71 as production inputs, 196, 199 production relationships with variable labor, 203 productivity during recessions, 195 shape of labor supply curves, 184–185 short-run factor demand curve, 551–552 wage change impacting short-run demand for, 553–555 Lagrange, Joseph Louis, 729 Lagrange multiplier, 729–731 Lagrangian method applied to budget constraints, 105–107 applied to constrained extema problem, 737 to define contract curve, 360 for finding interior solution, 105–107 solving constrained maximization problem, 729–731 Laspeyres index, correcting CPI substitution bias, 151–152 Law of Demand compensated demand curves and, 154 Giffen goods and, 140 overview of, 36 www.downloadslide.com 792 Index Law of diminishing marginal returns, 205–206 Laws/legality preventing cartels, 508–509 preventing opportunistic behavior, 662 Leisure, labor-leisure choice, 179–182 Lemons lemons market with fixed quality, 658–661 lemons market with variable quality, 661–662 limiting, 662–665 Lerner, Abba, 396 Lerner index applied to iPad, 398 elasticity of demand and, 396–397 market structures and, 522 Licensing barriers to market entry, 407 nonlinear pricing and, 449–4240 taxis, 310, 340–342, 346 Liebenstein, Harvey, 416 Lime manufacturing profit maximization, 279 short-run competitive equilibrium in, 290 short-run shutdown decision factors, 283 Limited liability, characteristics of corporations, 197–198 Limited market entry, 312–314 Linear production function elasticity of substitution and, 215–216 shape of isoquants and, 209 Local extrema, 721 Logarithm rule, in calculating derivatives, 718 Logarithmic functions, 715 Long-run competition competitive equilibrium, 302–304 firm supply curve, 292–293 market supply curve, 293–302 profit maximization, 292 zero profit for competitive firms in, 311–315 Long-run factor demand curves comparing short and long-run labor demand curves, 557–558 competitive firms and, 557 overview of, 556 Long-run production with two variable inputs, 207–208 variability of production inputs over time, 200 Lottery winner, 185–186 Luxury goods, 132 M Malthus, Thomas, 206 Management teams, 198 Managers, 198 Marginal cost cost-benefit analysis of pollution, 624–625 deciding whether to advertise, 458–459 market power and, 395–396 monopoly optimums and, 394–395 profit maximization in monopolies and, 387 short run supply and, 286 social vs private, 623 Marginal firms, 294 Marginal product of labor, 201–204 Marginal profit, 276 Marginal rate of substitution See MRS (marginal rate of substitution) Marginal rate of technical substitution See MRTS (marginal rate of technical substitution) Marginal rate of transformation See MRT (marginal rate of transformation) Marginal revenue deciding whether to advertise, 458–459 demand curves in monopolies and, 387–389 market power and, 395–396 price elasticity of demand and, 389–390 Marginal revenue product of labor (MRPL), 552 Marginal tax rate, 188 Marginal utility, 91, 357 Marginal willingness to pay, 161 Market basket, allocating of money in purchasing, 82 Market clearing price, 45 Market consumer surplus consumer welfare and, 160 falls as price rises, 172 large losses in, 173–174 overview of, 163 Market equilibrium See also General equilibrium with asymmetric information, 660–661 comparative statics with relatively large changes, 45–46 comparative statics with small changes, 46–47 defined, 32 determining efficiency/equitability of, 348 equilibrium effects of specific sales taxes not dependent on who is taxed, 65–66 finding, 42–43 forces driving, 44–45 impact of sales taxes on See Sales taxes, effects on equilibrium price and quantity implications of shape of supply and demand curves, 49 overview of, 42 shocking, 45 short-run competitive, 289–292 with symmetric information, 659–660 Market failure due to asymmetric information, 655 inefficient production or consumption, 322 Market power advertising and, 476 advertising and pricing and, 667–668 effect on welfare, 398–400 factor demand curves varying with, 555–556 monopsonies and, 418 overview of, 395 price discrimination and, 430 prices of exhaustible resources and, 578 resulting from price ignorance, 665 shape of demand curve and, 395–396 sources of, 398 tourist-trap model, 666–667 vs efficiency in hospital mergers, 512 Market price above average cost, 282 effect of demand curve shift, 302 factors affecting, 269 increasing output for increased, 285 market clearing price, 45 in a numerous small firm market, 270 Market structures exercises, 546 externalities and, 632 factor demand curves varying with, 555–556 market entrance and, 269 overview of, 505–506 summary, 545 Market supply curve long-run, 293–302 short-run, 287–289 Markets black markets, 70–71 competitive See Competitive markets decreasing-cost, 299 entry and exit of firms within, 294 factor markets See Factor markets failure of, 322, 655 free, 318 free entry/exit in, 271, 294 increasing- vs constant-cost, 297–299 interrelated, 350–352 market-wide risk, 602 perfectly competitive, 72, 269 Materials (M) factoring cost increase of, 286–287 types of inputs, 196 types of production inputs, 199 Maximization of well-being See Consumers, maximization of well-being Maximums and minimums, of functions determining existence of extrema, 721–722 determining uniqueness of extrema, 722 equality constraints, 728–731 finding extrema, 723–727 inequality constraints, 731–732 interior extrema, 723 local and global extrema, 721 overview of, 721 Mean value, predicting expected value, 588 Medical insurance See Health insurance Mergers antitrust and competition laws and, 511 market power vs efficiency in hospital mergers, 512 Microeconomic models maximizing well being subject to constraints, 27–28 overview of, 25 positive vs normative statements, 28–29 simplification by assumption, 25 testing theories, 26 uses of, 29–30 Microeconomics, introduction as allocation of scarce resources, 23–24 decision making regarding allocations, 24 defined, 23 models, 25–30 prices determining allocations, 24 summary, 30 trade-offs in resource allocation, 24 Microsoft Works, bundling example, 455 Miner Safety and Health Act (2010), 654 Minimum average cost, 282 www.downloadslide.com Index Minimum wage with incomplete coverage, 352–355 as price floor, 71–72 Mixed bundling, tie-in sales and, 455–457 Mixed (public-private) enterprises, 197 Mixed strategies, applied to boomerang generation example, 480–481 Modeling agency cartel, 509–510 Money, how much is enough, 83–84 Monitoring, for reducing moral hazard, 695–696 Monopolies ad valorem tax effects, 403–404 advertising as means of increasing profit, 429 causes of, 404 China’s new monopolies, 392–393 choosing price vs quantity in, 393–394 comparing group price discrimination with competition and monopolies, 447 cost advantages creating, 404–406 deciding how much to advertise, 459–460 decisions over time and behavioral economics, 415 defined, 386 determining profit-maximizing output, 392 exercises, 424–427 externalities and, 632–633 governments creating, 407–409 governments encouraging competition, 414–415 governments regulating, 410–413 introductory pricing in a two-period monopoly, 417–418 Lerner index and, 396–397 marginal revenue and demand curves, 387–390 market power and shape of demand curve, 395–396 market power effecting welfare, 398–400 market structures and, 506 network externalities and, 415–416 overview of, 386–387 as price setters, 72, 505 prices and, 666–667 profit maximization in, 387, 390–393 shift in demand curve impacting, 394–395 short-run factor demand curves in, 555–556 shutdown decisions, 393 sources of market power, 398 specific tax effects, 400 summary, 423–424 Monopolistic competition deadweight loss (DWL) in, 532 exercises, 549 fixed costs and number of firms, 541–543 monopolistically competitive equilibrium, 540–541 overview of, 504, 540 as price setters, 505 summary, 546 Monopolistically competitive equilibrium, 540–541 Monopsonies defined, 386 exercises, 427 overview of, 418 profit maximization, 418–421 summary, 424 welfare effects of, 422–423 Monopsony power, 420 Monotonicity property, of functions, 713 Moral hazard after-the-fact monitoring, 699–700 bonding and, 696–698 characteristics of opportunistic behavior, 655–656 checks on principals in contracts, 703–705 contract choice offered as means of preventing, 702 deferred payments, 698 efficiency wages, 698–699 examples of, 680 exercises, 709–710 medical insurance and, 680, 705–706 monitoring for reducing, 695–696 mortgage market meltdown (2007) example, 700–701 summary, 706 More-is-better property, consumer preferences, 83 Morgenstern, Oskar, 591 Mortgage market meltdown (2007) example, 700–701 Moves, in game theory, 469 MRPL(marginal revenue product of labor), 552 MRS (marginal rate of substitution) compared with marginal rate of transformation, 100 diminishing rate of substitution, 92–93 marginal utility and, 91–92 willingness to substitute and, 91 MRT (marginal rate of transformation) budget constraints and, 99 trade production and, 365 MRTS (marginal rate of technical substitution) diminishing, 213–214 elasticity of substitution and, 214 substituting inputs and, 212–213 Multimarket-equilibrium analysis, 349, 351 Multiperiod (repeated) games, 469, 481–483 Multiple regression, 741 Multipliers Kuhn-Tucker multipliers, 732 Lagrange multiplier, 729–731 Music industry, contracts in, 695 Mutual funds, diversification as risk reduction method, 602 N Nash-Bertrand equilibrium See also Bertrand oligopoly model with differentiated products, 536–539 with identical products, 534–536 Nash-Cournot equilibrium See also Cournot oligopoly model applied to duopoly, 512–516 applied to market with many firms, 516–519 applied to market with nonidentical firms, 520–523 comparing collusive, Nash-Cournot, Stackelberg, and competitive equilibria, 531–533 government subsidies and, 528–530 793 Nash-Bertrand equilibrium compared with, 535–536 Nash equilibrium applied to AMD and Intel advertising levels, 478 applied to boomerang generation example, 480–481 applied to free rider problem, 641 applied to oligopolies, 504 determining best response in game theory, 473–474 dynamic entry games and, 488–489 failure to maximize joint profits and, 474–476 in mixed strategies, 479 multiple equilibria, 477–478 subgame perfect Nash equilibrium, 484–486 Nash-in-prices equilibrium See NashBertrand equilibrium Nash-in-quantities equilibrium See NashCournot equilibrium Natural disasters insurance for, 605–606 price gouging laws and, 347 Natural gas See Petroleum/petroleum products Natural ingredients, advertising and, 476–477 Natural monopolies overview of, 405–406 regulating natural gas, 413–414 Necessities, demand rises less than proportion to income increase, 132 Negative externalities in competitive markets, 623–624 overview of, 620–621 regulating, 625–627 spam example, 621 Net present value comparing investments, 565–567 risk and investments and, 607 Network externalities direct and indirect effects, 415–416 as explanation for monopolies, 416 New Entrant Safety Assurance Process, 268 Nike, 314 Nominal price, inflation indexes and, 146 Noncompetitive firms, 555 Nondiversifiable risks, 605 Nondurable services, 550 Nonlinear price discrimination exercises, 465–466 overview of, 448–449 summary, 463 types of price discrimination, 433 Nonprofit firms, 197 Nonuniform pricing bundling, 429 overview of, 428 price discrimination See Price discrimination tie-in sales See Tie-in sales two-part pricing See Two-part pricing Normal-form representation of static games, 471–474 representation of subgame perfect Nash equilibrium, 484 Normal goods demand rises as income rises, 132 income and substitution effects with, 137–139 overview of, 134 www.downloadslide.com 794 Index Normative (value judgments) statements in microeconomic models, 28–29 positive statements contrasted to, 81 Number of units, auctions and, 490 O Objective function defined, 724 indirect objective functions and the envelope theorem, 727–728 Observable characteristics, of consumers, 445 Occupational safety, compensating wage differentials, 653–654 Oil See Petroleum/petroleum products Oligopolies advertising and, 476 applying game theory to firm actions, 469 Bertrand model See Bertrand oligopoly model cartels See Cartels Cournot model See Cournot oligopoly model deadweight loss (DWL) in, 532 exercises, 546–549 game theory applied to See Game theory government subsidies to aircraft manufacturing industries, 503–504, 544–545 market structures and, 505–506 overview of, 504 as price setters, 72–73, 505 short-run factor demand curves in, 555–556 Stackelberg model See Stackelberg oligopoly model summary, 545–546 tendency toward collusion, 506 Oligopolistic markets, 272 Oligopsonies, 418 1%, richest, 370–373 OPEC (Organization of Petroleum Exporting Countries) as cartel, 508–509 example of demand elasticity over time, 57–58 impact of price controls on, 68–69 Open-access common property nonexclusive but rival property, 638–639 overview of, 620 Opportunistic behavior adverse selection and moral hazard, 655–656 asymmetric information resulting in, 654–655 controlling with universal coverage, 656 laws preventing, 662 moral hazard related to, 681 Opportunity cost, deadweight loss and, 320 Opportunity sets, budget constraints and, 99 Optimal bundles, on convex sections of indifference curves, 111 Optimal product mix, 367 Ordinal preferences, 88–89 Organization of Petroleum Exporting Countries See OPEC (Organization of Petroleum Exporting Countries) Organizational change, innovations impacting production process, 222 Outcomes, states of nature and, 585 Outputs, production changes, and welfare lowering, 319, 321 determining in short-run competitive firm, 278–282 determining optimal in monopolies, 387 determining profit-maximizing output in monopolies, 392 firms converting inputs into, 196 input prices varying with, 297–299 profit maximization decisions, 275 rules defining, 275–277 transforming input into, 199 Overconfidence, biased assessment of probabilities, 609–610 Ownership owners intention to maximize profits, 198–199 of for-profit firms, 197–198 P Paasche index, correcting CPI substitution bias, 151 Pacific Gas & Electric (PG&E), 568–569 Package tie-in sales See Bundling Paper mills emissions fees, 628 emissions standards, 627 Parasite singles, in Japan, 480 Pareto efficient, 348, 358 Pareto improvement, 348 Pareto principle, 348, 372 Partial-equilibrium analysis, 349, 351 Partnerships, ownership structures of forprofit firms, 197 Patents government actions creating monopolies, 407–409 as type of monopoly, 386 Payoff (profit) matrix applied to boomerang generation example, 480–481 failure to maximize joint profits, 474–476 normal-form representation of static games, 471–474 Payoffs, in game theory, 469 Pepsi, 536–539 Per driver tax example, 629 Per seat license (PSL), 450 Per unit license, 449 Perfect competition in Chicago Commodity Exchange, 271 defined, 305 deviations from, 271–272 exercises, 306 importance of, 274 misused by politicians, 318 price taking and, 72, 269–271 Perfect complements demand functions for, 124 right angle indifference curves and, 95–96 Perfect price discrimination calculus of, 435 efficient but harms consumers, 436–438 graphical analysis of, 434–435 overview of, 433 types of price discrimination, 433 Perfect substitutes coffee/tea example, 130 demand functions for, 124–125 straight line indifference curves and, 94–95 utility function, 108–109 Petroleum/petroleum products demand elasticity over time, 57–58 discount rates applied to consuming, 572–573 import policies, 333–334 oil sands/shale production, 284–285 OPEC role in setting oil prices, 508–509 as open-access common property, 638–639 policy debate regarding oil drilling in Arctic refuge, 58–61 price ceilings on gasoline, 68–69 price ceilings on natural gas, 332 price gouging laws, 347, 380–381 Reformulated Fuels Program (RFG), 301 regulating natural gas, 413–414 PG&E (Pacific Gas & Electric), 568–569 Policies equity control, 370 impact on competitive markets, 310 import, 42, 333–334 international trade, 332–333 mergers, 511 price discrimination, 432 shift in supply curve due to, 311, 323– 324, 342, 344 subsidies, 528–530 taxes, 117 Policies, for consumer welfare food stamps programs, 176–178 overview of, 160, 174 quotas and, 174–176 Pollution allocating property rights to reduce externalities, 634–635 analyzing water pollution in paper industry, 621–622 benefits vs costs in controlling, 630 cap-and-trade markets, 636–637 cost-benefit analysis, 624–625 emissions fees, 628 emissions standards, 627 inefficiency of competition with externalities, 621 monopolies and externalities and, 632–633 regulating negative externalities, 625–627 trade and, 647–648 welfare effects of pollution in competitive markets, 622–624 Polynomial rule, in calculating derivatives, 717–718 Population growth, Malthus predictions, 206 Pork market, example of impact of specific sales tax, 62 Positive externalities, 620–621 Positive statements consumer role in positive economic analyses, 81 in microeconomic models, 28–29 Postal service, as monopoly, 407–408 Power rule, in calculating derivatives, 717 PPF (Production possibility frontier), 364–365 Predictions positive statements, 28 regarding income effects, 135 use of models for, 25, 29 www.downloadslide.com Index Preference maps, 84 Preferences, consumer completeness property, 82 defined, 81 indifference curves, 84–87 ordinal preferences, 88–89 overview of, 82 preference maps, 84 transitivity property, 83 utility functions representing preference relations, 88 Prescription drug, group price discrimination example, 442–444 Present-biased preferences, time-varying discounting and, 570–571 Present value (PV), 562–563 Price ceilings anti-gouging laws, 384 on natural gas, 332 supply and demand and, 68–70 welfare effects of, 330–332 Price discrimination calculus analysis of perfect price discrimination, 435 comparing group price discrimination with competition and monopolies, 447 exercises, 463–465 graphical analysis of perfect price discrimination, 434–435 group price discrimination, 439–440 Heinz sale price example, 428, 461–462 identifying groups for, 445–446 nonlinear, 448–449 not all prices differences are due to, 432–433 perfect price discrimination, 433 perfect price discrimination is efficient but harms consumers, 436–438 prescription drug example, 442–444 preventing resale and, 431–432 summary, 463 transaction costs and, 438–439 with two groups, 440–442 types of, 433 welfare effects of group price discrimination, 445–446 which firms can price discriminate, 430–431 why it pays, 430 Price elasticity of demand See also Elasticity of demand along demand curve, 51–53 overview of, 50–51 Price elasticity of supply See also Elasticity of supply, 55–56 Price floors effect on welfare, 326–329 supply and demand, 71–72 Price setters in monopolies and oligopolies, 72–73 monopolies as, 386 Price takers, in perfectly competitive markets, 72, 269 Price theory, 23 Prices allocation of scarce resources and, 24 changes impacting demand, 136 choosing price vs quantity in monopolies, 393–394 competitive long-run equilibrium, 302–303 consumer surplus falls as price rises, 172 controls See Controls, price discrimination See Price discrimination of exhaustible resources, 575–576 factor, and short-run supply curves, 286 government regulation reducing market power, 410–411 impact of change on consumer surplus, 164–165 impact on consumer decisions, 33 import ban raising domestic prices, 333 including in advertisements, 667–668 input prices vary with output, 293, 297–299 introductory pricing in a two-period monopoly, 417–418 iPad, 385 market power resulting from price ignorance, 665 monopsonies and, 418 movement along demand curve due to change in, 35–36 nominal and real, 146 not all prices differences are due to price discrimination, 432–433 price gouging, 347, 380–381 reservation price, 430 tourist-trap model, 666–667 two-part pricing See Two-part pricing uniform and nonuniform, 428 why price of exhaustible resource might not rise, 577–578 Principals, in contracts checks on, 703–705 controlling moral hazard and, 681 doctor example, 684 efficient contracts and, 683–684 model for principal-agent contracts, 682 principal-agent problem, 681–682 types of contracts and, 682–683 Prisoner’s dilemma game best response and Nash Equilibrium, 472–473 dominant strategies, 472 failure to maximize joint profits and, 475 Private (for-profit) firms, 196–198 Private marginal costs, vs social marginal costs, 623 Private value, of auctioned goods, 491 Probabilities altering, 608–609 biased assessment of, 609–610 risk assessment and, 586–587 Probability distributions, 587–588 Producer surplus changes, and welfare lowering, 319–320 defined, 311, 342 exercises, 343 supply curve to measure, 315–317 using, 317–318 Producers equilibrium effects not dependent on who is taxed, 65–66 joint production possibility frontier and, 367 Product differentiation Nash-Bertrand equilibrium with, 536–539 oligopolies and, 522–523 spurious differentiation, 523–524 welfare and, 539–540 795 Product rule, in calculating derivatives, 717 Production See also Outputs, production changes, and welfare lowering, 319, 321 constant, increasing, and decreasing returns to scale, 216–219 costs impacting supply, 39 cotton production, 297 diminishing marginal rates of technical substitution, 213–214 efficiency of, 364 elasticity of substitution, 214–216 exercises, 225–227 firm behavior and, 269 innovations, 221–223 input variability over time, 200 interpretation of production-related graphs, 202–204 isoquants for interpreting production inputs and outputs, 208–212 law of diminishing marginal returns, 205 long-run production with two variable inputs, 207–208 production functions, 199–200 productivity during recessions, 223–224 relative productivity, 220–221 short-run production with one variable and one fixed input, 201 substituting inputs, 212–213 summary, 224–225 trade and, 364–370, 381, 383 trade-offs in production of goods and services, 24 varying returns to scale, 219–220 Production efficiency, trade-off with risk bearing asymmetric information and, 689–690 choosing best contract and, 694 contract efficiency scenarios (lawyer examples), 692–694 efficient contracts and, 684–685 full information and, 685–688 overview of, 684 trade-offs between production efficiency and risk-bearing, 691–692 Production functions Cobb-Douglas production function, 207 elasticity of substitution and, 215–216 overview of, 199–200 shape of isoquants and, 209 Production possibility frontier (PPF), 364–365 Productivity innovations and, 221–223 during recessions, 195, 223–224 relative, 220–221 technical change and, 220 Products deciding on durability of, 568–569 identical, 270, 271 optimal mix of, 367 Profit maximization deciding how much to advertise, 459–460 defining profit, 274–275 determining profit-maximizing output in monopolies, 392 examples, 390–393 exercises, 306 failure to maximize joint profits in game theory, 474–476 impact of specific tax on profit in monopolies, 401–403 www.downloadslide.com 796 Index Profit maximization (continued) lime manufacture case study, 279–280 long-run competitive, 292 in monopolies, 386–387 in monopsonies, 418–421 necessary condition for, 387 as necessary to survival, 315 overview of, 269, 305 quantity/price variable graph, 285 short-run competitive, 278–285 shutdown decisions and, 393 two steps to, 275–278 Profit-sharing contracts with asymmetric information, 690 with full information, 688 Profits/profitability defined, 274–275 effect of restrictive licensing on, 310 marginal, 276 owners intent to maximize profits, 198–199 short- vs long-run, 292 Promotion, advertising as, 457–458 Properties consumer preferences, 82–83 functions, 712–715 logarithmic functions, 715 Property rights achieving optimal levels of pollution via, 635–636 allocating as means to reduce externalities, 634–635 overview of, 619 Prospect theory compared with expected utility theory, 612 properties of, 612–613 value function, 613 PSL (per seat license), 450 Public firms, 196–197 Public goods expert information as, 663 free riding, 640–643 optimal provision of, 643–644 overview of, 620, 640 Radiohead example, 643 reducing free riding, 645 valuing, 645–646 Public utilities, as natural monopoly, 405 Pulp mills, 627 Pure bundling, tie-in sales, 455–456 Pure strategies See also Strategies, in game theory, 478, 480–481 PV (present value), 562–563 Q Quality goods ignorance of quality drives out highquality goods, 658 lemons market with fixed quality, 658–661 lemons market with variable quality, 661–662 limiting lemons, 662–665 Quantity demanded See Demand Quantity supplied See Supply Quasilinear utility function demand functions for, 124 indifference curves and, 96–97 overview of, 109–111 Quotas consumer welfare policies, 174–176 international trade and, 338–339 Quotient rule, in calculating derivatives, 718 R Radiohead, 643 Rainfall See Weather Rare earth elements (metals), China’s new monopolies, 392–393 Rate of return, on investment, 565 Rationing, government quotas and, 174 Rawls, John, 377 Reaction function See Best-response analysis Real price, inflation indexes and, 146 Rebates, examples of price discrimination, 446 Recessions, productivity during, 195, 223–224 Reciprocal rule, in calculating derivatives, 718 Reciprocity, in behavioral game theory, 494–495 Redwood trees, discount rates and, 576–577 Refineries, California gasoline, 301–302 Reflection effect, risk attitudes and, 611 Reformulated Fuels Program (RFG), 301 Regression confidence in estimates, 740–741 economists use of, 739 estimating economic relations, 739–740 multiple regression, 741 Relative productivity, 220–221 Rent durable goods, 561–562 earned by celebrities, 314 fixed-fee rental contracts, 686–687, 690 rent seeking, 339 for scarce resources, 313–314, 575 and zero long-run profit, 312 Repeated (multiperiod) games, 469, 481–483 Requirement tie-in sales, 454 Resale ability to prevent or limit, 430 designer bags example, 432 price discrimination and, 431–432 prohibition across borders allows price discrimination, 443–444 Reservation price bundling and, 455 calculus of, 435 graphical analysis of, 434 of lemon owners, 659 positively correlated, 455 price discrimination and, 430 selling at, 433 Residual demand curves, 272–274, 513 Residual supply curves, 299–300 Resources, exhaustible exercises, 583–584 overview of, 572–573 pricing scarce exhaustible resources, 573–577 selling exhaustible resources, 573 summary, 577–578 why price of exhaustible resource might not rise, 577–578 Resources, scarce microeconomics as allocation of, 23 monopoly control of essential facilities, 405 rents for, 313–314 Restaurants, fast-food, 295 Retirement, saving for, 564–565 Returns to scale, in production constant, increasing, and decreasing, 216–218 U.S manufacturing example, 218–219 varying, 219–220 Returns to specialization, 219 Revealed preference defined, 123 theory of, 152–154 Revenue-sharing contracts with asymmetric information, 690 with full information, 687–688 Reverse auctions, 446 RFG (Reformulated Fuels Program), 301 Right angle indifference curves, 95–96 Risk assessing, 586 attitudes toward, 590–591 behavioral economics and, 609 efficiency of risk bearing in contracts, 683–684 insurance for diversifiable risks, 605 investing and, 606–607 probability of, 586–587 as quantifiable uncertainty, 585 variance and standard deviation and, 589–590 Risk aversion Arrow-Pratt measure of, 597–599 expected utility theory and, 591 gambling and, 597 insurance and, 603 investing and, 607 overview of, 592 risk premium and, 594–595 unwillingness to take a fair bet, 592–594 Risk neutrality efficient contracts and, 683–684 investing and, 606 net present value in investing, 607 overview of, 595 Risk pooling (diversification), 601 Risk preferring, 595–596 Risk premium, 594–595 Risk reduction diversification, 601–603 insurance, 603–606 overview of, 599 as risk reduction method, 600 saying no to risk, 600 Rivalry/exclusion club goods, 639–640 exercises, 651–652 free riding, 640–643 market failure due to lack of rivalry, 620 open-access common property, 638–639 optimal provision of public goods, 643–644 property rights and, 619 public goods and, 640 reducing free riding, 645 summary, 649 valuing public goods, 645–646 Rogers, Will, 323 www.downloadslide.com Index Rules in game theory, 469–470 output production, 275–277 shutdown, 277–278 S S&Ls (Savings and Loans), in mortgage market meltdown (2007), 701 Sale prices, Heinz example, 428, 461–462 Sales, of exhaustible resources, 573 Sales taxes effects on welfare, 325–326 as supply/demand curve wedge, 324 vs tariffs, 335–336 Sales taxes, effects on equilibrium price and quantity ad valorem taxes having similar effects as specific taxes, 66–67 defined, 32 equilibrium effects of specific sales taxes, 61–62 equilibrium effects of specific sales taxes not dependent on who is taxed, 65–66 relationship of sales tax effect to elasticities, 62–64 types of sales taxes and, 61 Salience, in behavioral economics, 116–117 Scale elasticity, 218 Scale, return to See Returns to scale, in production Scarce resources See Resources, scarce Screening consumer screening, 662 equalizing information, 657 in hiring, 674–676 Sealed-bid auction, 490 Second best, theory of, 378–380 Second-degree price discrimination See Nonlinear price discrimination Second-order condition, 725–726 Second-price auctions, 490–492 Second Theorem of Welfare Economics, 361 Secret ingredients, advertising and, 476 Self-control problems, time-varying discounting and, 571 Sequential games credible threat and, 486–487 dynamic entry games, 487–489 game tree, 483–484 having different outcome than simultaneous-move game, 486 overview of, 469–470, 483 subgame perfect Nash equilibrium, 484–486 types of dynamic games, 481 Sequential movement, in Stackelberg oligopoly model, 526–527 Services, trade-offs in production of goods and services, 24 Shale, oil, 284 Shareholders, in corporations, 197 Shaw, George Bernard, 268 Sherman Antitrust Act in 1890, 508 Shift along demand curve income changes causing shift, 128–130 monopolies and, 394–395 nonprice factors causing shift in demand curve, 37 Shift along supply curve, 40–41, 46 Shirking after-the-fact monitoring, 699–700 bonding to prevent, 696–697 deferred payments to prevent, 698 efficiency wages to prevent, 698–699 as moral hazard, 681 preventive techniques, 696 Shocking the Equilibrium See Comparative statics Short-run competition competitive equilibrium, 289–292 firm supply curve, 285–287 market supply curve, 287–289 profit maximization, 278–285 Short-run factor demand comparing short and long-run labor demand curves, 557–558 in competitive firms, 552–553 overview of, 551–552 wage change impacting demand for labor, 553–555 Short-run production with one variable and one fixed input, 201 variability of production inputs over time, 200 Shutdown decisions monopolies, 393 for non-well oil production firms, 284 for profit maximization, 275 short-run competitive firm, 282–284 Shutdown rules, 277–278 Signaling education as signal of ability, 670–674 equalizing information, 657–658 firms indicating high quality goods, 664 Simultaneous entry game having different outcome than sequential move game, 486 multiple equilibria and, 477–478 Slater condition, 734 Slope, summarizing how functions time as argument changes, 716–717 Slutsky equation, 144–146, 170 Smith, Adam, 318, 506 Smith, Terry, 284 SNAP (Supplemental Nutrition Assistance Program), 176 Snob effect, negative network externalities, 416 Social demand curve, for public goods, 641 Social marginal costs, welfare effects of pollution in competitive markets, 623 Social welfare function, 376–377 Sole proprietorships, 197 Spam, example of negative externality, 620–621 Specialization, returns to, 219 Specific tariff, 335 Specific (unit) sales taxes ad valorem taxes having similar effects as, 66–67 effect on monopolies, 400 effects depend on elasticities, 62–64 equilibrium effects not dependent on who is taxed, 65–66 equilibrium effects of, 61–62 example problem of incidence on consumers, 64 797 impact on short-run demand for labor, 554–555 for pollution control, 629 types of sales taxes, 61 welfare effects of ad valorem tax vs., 403–404 Spillover effect, 349 Spurious differentiation, 523–524 Stackelberg game, 483 Stackelberg, Heinrich von, 524 Stackelberg oligopoly model applying to strategic trade policy, 528–531 calculus solution, 525–526 characteristic actions of firms in, 504 comparing collusive, Nash-Cournot, Stackelberg, and competitive equilibria, 531–533 graphical solution, 526 overview of, 524–525 sequential movement in, 526–527 summary, 545, 548 Standard deviation, measuring risk, 589–590 Standard error, 741 Standards emissions standards, 627 screening techniques for avoiding opportunistic behavior, 663–664 States of nature predicting expected value, 588–589 in principal-agent interactions, 682 uncertainty and, 585 Static equilibrium See Comparative statics Static games applying to young adults who return to live at home, 480–481 exercises, 496–499 failure to maximize joint profits, 474–476 mixed strategies, 478–480 multiple equilibria, 477–478 normal-form games, 471–474 overview of, 470 strategic advertising example, 476–477 summary, 496 Statistical discrimination, screening in hiring, 674–675 Stock, of capital goods, 562 Stocks (investment), diversification as risk reduction method, 602 Straight line indifference curves, 94–95 Strategies, auction, 491–492 Strategies, in game theory applied to boomerang generation example, 480–481 best response and Nash Equilibrium, 472–474 dominant strategies, 471–472 dynamic games and, 481 mixed strategies, 478–480 normal-form representation of static games and, 471 overview of, 469 static games and, 470 Stream of payments, 563–564 Subgames game trees and, 484 subgame perfect Nash equilibrium, 484–486 Subjective probability, 586–587 www.downloadslide.com 798 Index Subsidies to aircraft manufacturing industries, 503–504, 544–545 allocation of farming, 330 cash subsidy compared with food stamps, 177–178 child-care subsidy example, 159, 189–190 Ethanol example, 65 government policies and, 528–530 labor, 354 welfare effects of, 379 Substitutes CES (constant-elasticity-of-substitution) functions, 96–97 imperfect substitutes, 95 market power and, 398 perfect substitutes, 94–95, 130 perfect substitutes utility function, 108–109 prices of goods and, 33 willingness to substitute, 91–94 Substitutes, production diminishing marginal rates of technical substitution, 213–214 elasticity of substitution, 214–216 input substitution, 212–213 substitutability of inputs, 210 Substitution bias, CPI (Consumer Price Index), 151 Substitution effect consumer theory and, 154 identifying, 141 inferior goods and, 140 labor markets and, 182–183 normal goods and, 137–139 price increases impacting demand, 136 Substitution elasticity of demand, 145–146 Substitution method for finding interior solution, 103 solving constrained maximization problem, 729 Super Bowl commercials, value of, 461 Supplemental Nutrition Assistance Program (SNAP), 176 Supply choosing price vs quantity in monopolies, 393–394 defined, 32 implications of shape of supply and demand curves, 49 import policies effecting supply curves, 42 overview of, 38–39 price ceilings and, 68–70 price floors and, 71–72 quantity supplied need not equal quantity demanded, 67–68 summing supply functions, 41–42 supply function, 39–40 Supply and demand ad valorem taxes having similar effects as specific taxes, 66–67 analyzing water pollution in paper industry, 621–624 comparative statics with relatively large changes, 45–46 comparative statics with small changes, 46–47 demand, 33–34 demand elasticity, 50–55 demand elasticity over time, 57–58 demand function, 34–35 elasticities in general, 50 equilibrium effects of specific sales taxes, 61–62 equilibrium effects of specific sales taxes not dependent on who is taxed, 65–66 exercises, 75–79 externalities and, 621–624 finding market equilibrium, 42–43 forces driving market equilibrium, 44–45 impact of volcanic eruption on cut flower market, 56 implications of shape of supply and demand curves, 49 import policies affecting supply curves, 42 nonprice factors causing shift in demand curve, 37 overview of, 31–32 price ceilings and, 68–70 price change causing movement along demand curve, 35–36 price floors and, 71–72 quantity supplied need not equal quantity demanded, 67–68 relationship of sales tax effect to elasticities, 62–64 summary, 74–75 summing demand functions, 38 summing supply functions, 41–42 supply, 38–39 supply elasticity, 55–56 supply elasticity over time, 58 supply function, 39–40 types of sales taxes and, 61 when to use supply-and-demand model, 72–74 Supply curves deriving for labor markets, 160, 179 equilibrium effect of shift in, 46 for free-trade imports, 333 implications of shape of, 49 import policies effecting, 42 income taxes and labor supply curves, 186–189 for labor, 181 to measure producer surplus, 315–317 monopsonies and, 418 movement along vs shift in, 40–41 policies that shift, 311, 323–324, 342, 344 policy wedges between supply/demand curves, 324, 342, 344 residual, 299, 301, 352 shape of labor supply curves, 184–185 Supply curves, long-run cotton industry graph by nation, 297 with differing firms, 296 factoring world trade into, 299–301 for firms, 292 with identical firms and free entry, 295 with limited entry, 296 when input prices vary with output, 297–299 Supply curves, short-run calculated from short-run cost function, 286 with differing firms, 288–289 factor prices and, 286–287 with identical firms, 287–288 tracing, 285–286 vs long-run, 293 Supply functions overview of, 39–40 summing, 41 Support, price, 327 Surveillance, for reducing moral hazard, 695–696 Symmetric information market equilibrium with, 659–660 overview of, 654 T Tariffs ad valorem tariffs, 335 free trade vs., 335–338 policies supporting price discrimination, 432 two-part tariffs See Two-part pricing Tastes, consumer See also Preferences, consumer, 81, 117–118 Tata Motors, 222–223 Tax salience, 116–117 Taxes ad valorem See Ad valorem taxes carbon tax, 626 cigarette taxes increasing price of cigarettes relative to other goods, 127–128 equilibrium effects on identical firms, 291 on externalities in noncompetitive markets, 634 fat tax, 25 income taxes and labor supply curves, 186–189 marginal tax rates and tax revenues, 188 per driver tax example, 629 for pollution control, 628–629 reaction by competitive firm, 280–282 specific See Specific (unit) sales taxes wage, 354–355 Taxis, licensing, 310, 340–342, 346 Technology innovations impacting production process, 221–222 prices of exhaustible resources and, 578 in production, 199 superior technology resulting in cost advantages and monopolies, 405 Tests, for screening in hiring, 674 Tests, of transitivity, 114–115 Theories, testing with microeconomic models, 26 Theory of revealed preference, 152–154 Theory of the Second Best, 378–380 Tidelands Oil Production Company, 284 Tie-in sales bundling, 455–457 exercises, 466–467 overview of, 454 requirement tie-in sales, 454 summary, 463 Time-varying discounting, 569–571 Total product of labor, 201 Tourist-trap model, 666–667 Trade applying Stackelberg model to trade policy, 528–531 www.downloadslide.com Index benefits, 366 exercises, 345–346 free vs banned, 333–335 free vs quotas, 338–339 free vs tariff, 335–338 governmental policies controlling, 332–333, 342 mutually beneficial, 356–359 policies supporting price discrimination, 432 pollution and, 647–648 production for, 348, 364–370, 381, 383 between two people, 355–360, 381, 382 welfare effects of subsidies, 379 Trade-offs in allocation of scarce resources, 24 in microeconomics, 81 between production and risk-bearing, 691–692 Tradeable Energy Quotas, 174 Transaction costs negligible, 270–271 price discrimination and, 438–439 resale difficult when transaction costs are high, 431 Transitivity consumer preferences and, 83 tests of, 114–115 Treaty of the European Community (EC Treaty or Treaty of Rome), 508 Tropical storms, insurance for natural disasters, 606 Trucking industry entrance fees/regulations, 268, 304 exercises, 309 Trusts See also Cartels, 508 Two-part pricing defined, 429 with differing consumers, 451–453 exercises, 466 with identical consumers, 450 overview of, 449–450 summary, 463 Two-part tariffs See Two-part pricing Two-stage games, 481 U UGG boots, example of bandwagon effect, 416 Ultimatum games, 494–495 Uncertainty attitudes toward risk, 590–591 behavioral economics and, 609 biased assessments, 609–610 diversification as risk reduction method, 601–603 emissions fees vs emissions standards, 630–631 exclusion, 615–618 expected utility theory, 591–592 expected value and, 587–588 flight insurance example, 614 gambling example, 596–597 information for risk reduction, 600 insurance as risk reduction method, 603–606 investing and, 606–609 measuring risk aversion, 597–599 overview of, 585 probability of risk, 586–587 prospect theory, 612–613 risk assessment, 586 risk aversion, 592–595 risk neutrality, 595 risk preferring, 595–596 risk reduction, 599 saying no to risk, 600 summary, 614–615 variance and standard deviation and, 589–590 violations of expected utility theory, 610–612 Unemployment, due to minimum wage controls, 71–72 Uniform pricing, 428, 453 United Airlines See Airlines Universal coverage, controlling opportunistic behavior, 656 Unobserved actions, moral hazards and, 680 U.S Patient Protection and Affordable Care Act, 680 Utility convex indifference curves, 96–97 defined, 81 expected utility theory, 591–592 indifference curves applied to food and clothing, 97–98 maximization, 107–108, 356 ordinal preferences, 88–89 overview of, 87–88 possibility frontier, 374 relationship of utility function to indifference curves, 90–91 right angle indifference curves, 95–96 straight line indifference curves, 94–95 utility functions, 88 willingness to substitute, 91–94 Utility functions demand functions for, 124 overview of, 88 perfect substitutes utility function, 108–109 quasilinear utility function, 109–111 relationship of utility function to indifference curves, 90–91 relationship to indifference curves, 90–91 V Value function, in prospect theory, 613 Value, of auctioned goods, 491 Variables functions of a several variables, 712 functions of a single variable, 711–712 long-run production with two variable inputs, 207–208 short-run production with one variable and one fixed input, 201 time and variability of production inputs, 200 Variance, measuring risk, 589–590 Vegetable oil firms, 287, 296, 303 Vertical integration, as means of preventing resale, 432 Video game firms, as oligopoly, 503 Voltaire, 318 799 von Neumann, John, 591 Voting, 375–376 W Wages Black Death causing rise in, 560–561 compensating wage differentials for occupational safety, 653–654 efficiency wages, 698–699 income and substitution effects, 182–183 taxing, 354 wage change impacting short-run demand for labor, 553–555 Water as open-access common property, 638–639 quotas, 176 Watson, Thomas J., 292 Wealth, distribution of, 370–372 Weather insurance for natural disasters, 606 predicting expected rainfall, 589 predicting impact on sales, 600 Welfare See also Consumer welfare competition maximizing, 311, 342–343 defined, 310 distribution of wealth, 370–373 effect of market power on, 398–400 effect of monopsonies on, 422–423 effect of pollution on, 621–624 effect of price ceilings on, 330–332 effect of sales tax on, 325–326 effect of trade policies on, 333 effect of trade subsidies on, 379 efficiency of distribution and, 372–374 equity and social, 374–377 lowered by under-producing competitive output, 319–320 maximizing, 374 measuring, 319 monopolies vs competitive welfare with externalities, 633 product differentiation and, 539–540 role of government in social, 370 Welfare economics, 310, 361 Welfare measure (willingness to pay), 161 Well-being, maximizing See Consumers, maximization of well-being Willingness-to-pay curve, for public goods, 641 Winner’s curse, 492–493 Woods, Tiger, 314 WTO (World Trade Organization) role in elimination of market barriers, 415 on subsidies to aircraft manufacturing industry, 503 Wynne, Christopher, 295 Z Zero profit, for competitive firms defined, 311 exercises, 343 with free entry, 311–312 long run, 342 Zoning laws, as barrier to entry by hotel chains, 543 www.downloadslide.com Credits Cover: Olga Lyubkina/Shutterstock p 31: AGE Fotostock/SuperStock p 59: Corbis p 68: U.S Government Printing Office p 70: Desmond Kwande/Getty Images p 80: Courtesy of the author p 91: Cornered © 2007 Mike Baldwin Distributed by Universal Uclick All Rights Reserved [LC-USZ62-13040]; President Obama official portrait: Pete Souza/Library of Congress Prints and Photographs Division [LC-DIG-ppbd-00358] p 385: © Alexander 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